10-Q 1 edgar062001.txt 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 -------------------------------------------------------------------------- FORM 10-Q /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended June 30, 2001 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ------------------------------------- Commission File Number 33-94670-01 ------------------------------------- FARMERS GROUP, INC. (Exact name of registrant as specified in its charter) NEVADA (State or other jurisdiction of incorporation or organization) 95-0725935 (IRS Employer Identification No.) 4680 WILSHIRE BOULEVARD, LOS ANGELES, CALIFORNIA 90010 (Address of principal executive offices)(Zip Code) (323) 932-3200 (Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / Registrant's Common Stock outstanding on June 30, 2001 was 1,000 shares. 2 [THIS PAGE INTENTIONALLY LEFT BLANK] 3 FARMERS GROUP, INC. AND SUBSIDIARIES TABLE OF CONTENTS FORM 10-Q FOR THE PERIOD ENDED JUNE 30, 2001 PART I. FINANCIAL INFORMATION PAGE ---- ITEM 1. Financial Statements (Unaudited) Consolidated Balance Sheets - Assets June 30, 2001 and December 31, 2000 4 Consolidated Balance Sheets - Liabilities and Stockholders' Equity June 30, 2001 and December 31, 2000 5 Consolidated Statements of Income Six Month Periods ended June 30, 2001 and June 30, 2000 6 Consolidated Statements of Comprehensive Income Six Month Periods ended June 30, 2001 and June 30, 2000 7 Consolidated Statements of Income Three Month Periods ended June 30, 2001 and June 30, 2000 8 Consolidated Statements of Comprehensive Income Three Month Periods ended June 30, 2001 and June 30, 2000 9 Consolidated Statement of Stockholders' Equity Six Month Period ended June 30, 2001 10 Consolidated Statement of Stockholders' Equity Six Month Period ended June 30, 2000 11 Consolidated Statements of Cash Flows Six Month Periods ended June 30, 2001 and June 30, 2000 12 Notes to Interim Financial Statements 13 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 20 ITEM 3. Quantitative and Qualitative Disclosures about Market Risks 26 PART II. OTHER INFORMATION 27 SIGNATURES 28 4 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Amounts in thousands) (Unaudited) ASSETS

5 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Amounts in thousands) (Unaudited) LIABILITIES AND STOCKHOLDERS' EQUITY

6 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Amounts in thousands) (Unaudited)

7 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Amounts in thousands) (Unaudited)

8 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Amounts in thousands) (Unaudited)

9 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Amounts in thousands) (Unaudited)

10 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY For the six month period ended June 30, 2001 (Amounts in thousands) (Unaudited)

11 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY For the six month period ended June 30, 2000 (Amounts in thousands) (Unaudited)

12 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in thousands) (Unaudited)

13 FARMERS GROUP, INC. AND SUBSIDIARIES NOTES TO INTERIM FINANCIAL STATEMENTS (Unaudited) A. Basis of presentation and summary of significant accounting policies The accompanying consolidated balance sheet of Farmers Group, Inc. ("FGI") and its subsidiaries (together, the "Company") as of June 30, 2001, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for the six month periods ended June 30, 2001 and June 30, 2000, and the consolidated statements of income and comprehensive income for the three month periods ended June 30, 2001 and June 30, 2000, have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP") for interim periods and are unaudited. However, in management's opinion, the consolidated financial statements include all adjustments (consisting of only normal recurring adjustments) necessary for a fair presentation of results for such interim periods. These statements do not include all of the information and footnotes required by GAAP for complete financial statements and should be read in conjunction with the consolidated balance sheets of the Company as of December 31, 2000 and 1999, and the related consolidated statements of income, comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2000. Interim results are not necessarily indicative of results for the full year. All material inter-company transactions have been eliminated. Certain amounts applicable to prior years have been reclassified to conform with the 2001 presentation. The preparation of the Company's financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. The Company is attorney-in-fact ("AIF") for three inter-insurance exchanges: Farmers Insurance Exchange, Fire Insurance Exchange and Truck Insurance Exchange (collectively the "Exchanges"), which operate in the property and casualty insurance industry. On March 7, 2000, the Exchanges acquired Foremost Corporation of America and its subsidiaries ("Foremost"), a prominent writer of insurance for manufactured homes, recreational vehicles and other specialty lines. Each policyholder of the Exchanges appoints the Company as the exclusive AIF to provide management services. For such services, the Company earns management fees based on a percentage of gross premiums earned by the Exchanges, their respective subsidiaries, Farmers Texas County Mutual Insurance Company, Foremost County Mutual Insurance Company and Foremost Lloyds of Texas (collectively the "P&C Group"). The P&C Group is owned by the policyholders of the Exchanges, Farmers Texas County Mutual Insurance Company and Foremost County Mutual Insurance Company as well as the underwriters of Foremost Lloyds of Texas. Accordingly, the Company has no ownership interest in the P&C Group. Farmers New World Life Insurance Company ("Farmers Life"), a Washington based insurance company, is a wholly owned subsidiary of the Company. Farmers Life markets a broad line of individual life insurance products, including universal life, term life and whole life insurance, structured settlement and annuity products, predominately flexible premium deferred annuities, as well as variable universal life insurance and variable annuity products. These products are sold directly by the P&C Group's agents. Farmers Reinsurance Company ("Farmers Re"), a wholly owned subsidiary of the Company, reinsures a percentage of the auto physical damage business ("APD") written by the P&C Group. Effective April 1, 2001, the APD reinsurance agreement between Farmers Re and the P&C Group which had been in force since January 1998 was cancelled and replaced with a similar APD reinsurance agreement supported by multiple reinsurers. As a result of this new agreement, the monthly premiums assumed by Farmers Re decreases from $83.3 million to $16.7 million. Farmers Re continues to assume a quota share percentage of ultimate net losses sustained by the P&C Group in its APD line of business. This treaty, which will remain in effect until terminated by either party, also provides for the P&C Group to receive a ceding commission of 18% of premiums with additional experience commissions that depend 14 on loss experience. This experience commission arrangement limits Farmers Re's potential underwriting gain on the assumed business to 2.5% of premiums assumed. On March 31, 2001, Farmers Re and the P&C Group commuted $89,936,000 of losses and loss adjustment expenses associated with the 2000 accident year. As a result, in May 2001, Farmers Re paid the P&C Group $89,936,000 of losses and loss adjustment expenses and $8,766,000 of accrued interest in settlement of this commutation. References to the "Insurance Subsidiaries" within the consolidated financial statements are to Farmers Life and Farmers Re. In December 1988, B.A.T Industries p.l.c. ("B.A.T"), acquired 100% ownership of the Company through its wholly owned subsidiary BATUS Financial Services. Immediately thereafter, BATUS Financial Services was merged into FGI. The acquisition was accounted for as a purchase and, accordingly, the acquired assets and liabilities were recorded in the Company's consolidated balance sheets based on their estimated fair values at December 31, 1988. In September 1998, the financial businesses of B.A.T, which included the Company, were merged with Zurich Insurance Company ("ZIC"). The businesses of ZIC and the financial services businesses of B.A.T were transferred to Zurich Group Holding ("ZGH"), formerly known as Zurich Financial Services, a Swiss company with headquarters in Zurich, Switzerland. This merger was accounted for by ZGH as a pooling of interests under International Accounting Standards. As a result of a unification of the holding structure of the Zurich Financial Services Group in October 2000, Zurich Financial Services was renamed Zurich Group Holding, as noted above, and a new group holding company, Zurich Financial Services, was formed. As such, references to "Zurich" are to the new group holding company, Zurich Financial Services. In 1998, the Financial Accounting Standards Board ("FASB") released Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities". This Statement establishes accounting and reporting standards for derivative instruments (including certain derivative instruments embedded in other contracts) and for hedging activities. SFAS No.133 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at market value. Subsequently, in June 1999, the FASB released SFAS No. 137, "Deferral of the Effective Date of FASB Statement No. 133", which deferred the effective date of SFAS No. 133 to fiscal years beginning after June 15, 2000. Finally, in June 2000, the FASB released SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities". This Statement amends the accounting and reporting standards of SFAS No. 133 for the following items: normal purchases and normal sales exception, interest rate risk, recognized foreign-currency-denominated debt instruments and intercompany derivatives. This Statement also amends SFAS No. 133 for certain provisions related to the implementation guidance arising from the Derivative Implementation Group process. SFAS No. 133, No. 137, and No.138 are effective for financial statements issued by the Company for periods ending after December 31, 2000. The adoption of these Statements did not have a material impact on the Company's consolidated financial statements. In September 2000, the FASB issued SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". This Statement revises accounting standards for securitizations and other transfers of financial assets and collateral. SFAS No. 140 replaces SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities", and rescinds SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125". This Statement, which is required to be applied prospectively with certain exceptions, is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. Additionally, this Statement is effective for recognition and reclassification of collateral and for disclosures relating to securitization transactions and collateral for fiscal years ending after December 15, 2000. The adoption of this Statement did not have a material impact on the Company's consolidated financial statements. 15 In June 2001, the FASB issued SFAS No. 141, "Business Combinations". This Statement, effective for all business combinations initiated after June 30, 2001, establishes standards for accounting and reporting business combinations. It requires that all business combinations be accounted for by the purchase method and prohibits the pooling of interest method of accounting except for transactions initiated before July 1, 2001. This Statement supersedes Accounting Principles Board ("APB") Opinion No. 16, "Business Combinations", and FASB Statement No. 38, "Accounting for Preacquisition Contingencies of Purchased Enterprises". The adoption of this Statement did not have a material impact on the Company's consolidated financial statements. In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets". This Statement addresses financial accounting and reporting for intangible assets acquired individually or with a group of other assets (but not those acquired in a business combination) at acquisition. This Statement also addresses financial accounting and reporting for goodwill and other intangible assets subsequent to their acquisition. Upon adoption of this Statement, goodwill and other intangible assets that are determined to have an indefinite useful life will no longer be amortized. Instead, goodwill will be tested for impairment on an annual basis and intangible assets with indefinite useful lives will be evaluated each reporting period to determine whether an indefinite useful life is still supported. Any intangible asset that is determined to have a finite useful life shall be amortized over this period and its useful life shall be evaluated each reporting period to determine whether revisions to the remaining amortization period are warranted. This Statement is effective for financial statements issued for fiscal years beginning after December 15, 2001 and supersedes APB Opinion No. 17, "Intangible Assets". Early application is permitted for entities with fiscal years beginning after March 15, 2001, provided that the first interim financial statements have not previously been issued. This Statement is required to be applied at the beginning of an entity's fiscal year and to be applied to all goodwill and other intangible assets recognized in its financial statements at that date. The Company is currently assessing but has not yet determined the impact of SFAS No. 142 on its consolidated financial statements. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations". This Statement, effective for fiscal years beginning after June 15, 2002, establishes the standard to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. The Company does not expect the adoption of this Statement to have a material impact on its consolidated financial statements. B. Capital structure As of June 30, 2001, the Company had three classes of common stock - Class A Common Stock (the "Class A Shares"), Class B Common Stock (the "Class B Shares") and Class C Common Stock (the "Class C Shares"). Prior to a recapitalization of the Company's capital structure which occurred in connection with a private placement of an aggregate of $1,125,000,000 of securities by six Zurich RegCaPS Funding Trusts on February 9, 2001, the Company had 500 shares of Class A Common Stock, par value $1.00 per share, and 500 shares of Class B Common Stock, par value $1.00 per share. All Class A Shares were wholly owned by ZGH and all Class B Shares were wholly owned by Allied Zurich Holdings Limited, an affiliated company created during the restructuring of B.A.T. Subsequently, on February 9, 2001, in connection with the private placement of the $1,125,000,000 of securities, ZGH exchanged 50 Class A Shares for 50 shares of Class C Common Stock, par value $1.00 per share. The Class C Shares were issued in six series (C-1 through C-6). ZGH subsequently contributed each respective series of the Class C Shares to one of six Zurich RegCaPS Funding Limited Partnerships (collectively, the "Partnerships"), which are controlled by ZIC. As a result, upon completion of the recapitalization, 450 Class A Shares were owned by ZGH, 500 Class B Shares were owned by Allied Zurich Holdings Limited and 50 Class C Shares were owned by the Partnerships. The holders of the Class A Shares are entitled to 1.0694444 votes per share and the holders of Class B Shares are entitled to .1111111 of a vote per share (each subject to adjustment in the event of any stock dividend, stock split, stock distribution or combination with respect to any shares of capital stock of the Company) upon the election of directors and on all other matters upon which stockholders generally are entitled to vote. In the event of a liquidation, dissolution or winding up of the Company, the holders of Class A Shares are entitled to share equally and ratably with the holders of Class C Shares in the assets of the Company, if any, remaining after payment of all 16 liabilities of the Company and the Class C Share liquidation preference, to the exclusion of the holders of Class B Shares. Subject to the rights of the holders of Class C Shares, the holders of Class A Shares and the holders of Class B Shares shall be entitled to receive dividends, when and if declared by the Board of Directors, out of funds legally available therefor. The holders of Class C Shares are entitled to 0.375 of a vote per share upon the election of directors and on all other matters upon which stockholders generally are entitled to vote. However, at no time shall the aggregate voting power of the Class C Shares be greater than 3.375% of the total voting power of the Company. Upon any dissolution, liquidation or winding up of the Company, after payment of the liabilities of the Company and the expenses of such dissolution, liquidation or winding up, the holders of Class C Shares will be entitled to receive in the aggregate out of the assets of the Company, before any payment or distribution is made to the holders of Class A Shares or Class B Shares, $1,125,000,000 in liquidation preference (the "Class C Liquidation Preference"). To the extent the amount available for distribution upon liquidation, dissolution or winding up exceeds the Class C Liquidation Preference, the holders of Class C Shares are entitled to receive 7.4503311% (as adjusted from time to time based upon the percentage of the Company's fair market value represented by the Class C Shares at the time of such adjustment) of the aggregate amount available for payment of distributions on liquidation with respect to the Company's common stock. Amounts payable on the Class C Shares in connection with the liquidation of the Company in excess of the Class C Liquidation Preference are payable on a pari passu basis with the holders of the Class A Shares and any other shares that rank junior to the Class C Shares with respect to payments upon liquidation. The holders of Class C Shares are entitled to receive non-cumulative dividends when, as and if declared by the Board of Directors out of funds legally available therefor. No cash dividends may be declared or paid on any Class A Shares, Class B Shares or any other shares of common stock that rank junior to the Class C Shares with respect to payment of dividends, unless (i) full dividends have been declared for payment on the Class C Shares in an amount at least equal to the greater of (A) the dividends payable or set apart during the dividend period during which such cash dividends are paid at the respective Class C Share indicative rate (as defined in the Certificates of Designations of Class C-1 through Class C-6 Shares) or (B) 7.4503311% (as adjusted as set forth above) of the amount of dividends paid or set apart for payment by the Company on its common shares (including the Class C Shares) during any relevant dividend period, (ii) the Partnerships have set apart or paid the full amount of cash remittances (the "RegCaPS Payments") payable to the holders of the regulatory capital preferred securities (the "RegCaPS") issued by the Partnerships during any RegCaPS Payments period, (iii) the six Zurich RegCaPS Funding LLCs (collectively, the "LLC") who hold the RegCaPS, have set apart or paid certain cash payments during any LLC payment period on the LLC preferred interests issued by each LLC, and (iv) such dividend does not cause the net worth of the Company to be less than $3 billion (as adjusted from time to time). C. Material contingencies The Company is a party to numerous lawsuits arising from its normal business activities. These actions are in various stages of discovery and development, and some seek punitive as well as compensatory damages. In the opinion of management, the Company has not engaged in any conduct which should warrant the award of any material punitive or compensatory damages. The Company intends to vigorously defend its position in each case, and management believes that, while it is not possible to predict the outcome of such matters with absolute certainty, ultimate disposition of these proceedings should not have a material adverse effect on the Company's consolidated results of operations or financial position. D. Company Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trusts Holding Solely Junior Subordinated Debentures In 1995, Farmers Group Capital and Farmers Group Capital II (the "Subsidiary Trusts"), consolidated wholly owned subsidiaries of Farmers Group, Inc., issued $410 million of 8.45% Cumulative Quarterly Income Preferred Securities ("QUIPS"), Series A and $90 million of 8.25% QUIPS, Series B, respectively. In connection with the 17 Subsidiary Trusts' issuance of the QUIPS and the related purchase by Farmers Group, Inc. of all of the Subsidiary Trusts' Common Securities ("Common Securities"), Farmers Group, Inc. issued to Farmers Group Capital $422,680,399 principal amount of its 8.45% Junior Subordinated Debentures, Series A due on December 31, 2025, (the "Junior Subordinated Debentures, Series A") and issued to Farmers Group Capital II $92,783,505 principal amount of its 8.25% Junior Subordinated Debentures, Series B due on December 31, 2025 (the "Junior Subordinated Debentures, Series B" and, together with the Junior Subordinated Debentures, Series A, the "Junior Subordinated Debentures"). The sole assets of Farmers Group Capital are the Junior Subordinated Debentures, Series A. The sole assets of Farmers Group Capital II are the Junior Subordinated Debentures, Series B. In addition, these arrangements are governed by various agreements between Farmers Group, Inc. and the Subsidiary Trusts (the Guarantee Agreements, the Trust Agreements, the Expense Agreements, the Indentures and Junior Subordinated Debentures) which considered together constitute a full and unconditional guarantee by Farmers Group, Inc. of the Subsidiary Trusts' obligations under the Preferred Securities. Under certain circumstances, the Junior Subordinated Debentures may be distributed to holders of the QUIPS and holders of the Common Securities in liquidation of the Subsidiary Trusts. As of September 27, 2000, Farmers Group, Inc. had the option to redeem, in whole or in part, the Junior Subordinated Debentures. The QUIPS are subject to mandatory redemption upon repayment of the Junior Subordinated Debentures at maturity, or upon their earlier redemption, at a redemption price of $25 per Preferred Security, plus accrued and unpaid distributions thereon to the date fixed for redemption. As of June 30, 2001 and 2000, a total of 20,000,000 shares of QUIPS were outstanding. E. Management fees As AIF, the Company, provides management services to the non-claims side of the P&C Group and receives management fees for the services rendered. As a result, the Company received management fees from the P&C Group of $777,489,000 and $726,386,000 for the six month periods ended June 30, 2001 and June 30, 2000, respectively. F. Related parties As of June 30, 2001, the Company held a $250,000,000 note receivable from Orange Stone (Delaware) Holdings Limited ("OSDH"), a subsidiary of Zurich. The Company loaned $250,000,000 to OSDH on December 15, 1999 and, in return, received a medium-term note with a 7.50% fixed interest rate that matures on December 15, 2004. Interest on this note is paid semi-annually. Income earned on this note totaled $9,375,000 in each of the six month periods ended June 30, 2001 and June 30, 2000. In addition, as of June 30, 2001, the Company held $302,000,000 of notes receivable from Zurich (UKISA) Limited ("UKISA"), a subsidiary of Zurich. The Company purchased $1,057,000,000 of notes from UKISA on September 3, 1998. Subsequently, on March 1, 2000, Eagle Star Life Assurance Company Limited ("Eagle Star"), also an affiliate of Zurich, assigned $175,000,000 of matured surplus notes of the P&C Group to the Company and, in return, the Company reduced the outstanding balance of the notes receivable from UKISA by $175,000,000. Additionally, on September 3, 2000, $25,000,000 of the notes receivable from UKISA, bearing interest at a coupon rate of 5.44% with an original maturity date of September 3, 2000, were renewed for medium-term notes with a 6.80% fixed interest rate maturing in September 2002. Finally, on October 23, 2000, to help fund the payment of a $1,075,000,000 special dividend associated with the Zurich capital structure unification in October 2000, the Company sold $580,000,000 of notes receivable from UKISA to ZIC for par value. As a result, as of June 30, 2001, the Company held $302,000,000 of notes receivable from UKISA with the following amounts, maturity dates and coupon rates: $207,000,000 maturing in September 2001 at a coupon rate of 5.48% and $95,000,000 maturing in September 2002, $25,000,000 of which is at a coupon rate of 6.80% and $70,000,000 of which is at a coupon rate of 5.67%. Interest on the UKISA notes is paid semi-annually and for the six month periods ended June 30, 2001 and June 30, 2000 totaled $9,058,000 and $26,543,000, respectively. 18 G. Certificates of contribution and surplus notes of the P&C Group As of June 30, 2001, the Company held $175,000,000 of surplus notes of the P&C Group. These notes bear interest at 8.50% annually and mature in March 2005. These notes were obtained in March 2000 with the assignment of the $175,000,000 of matured surplus notes of the P&C Group from Eagle Star (see Note F). Additionally, as of June 30, 2001, the Company held $370,000,000 of certificates of contribution of the P&C Group bearing interest at 7.85% annually. These certificates of contribution of the P&C Group were purchased on March 7, 2000 to help fund the Exchanges' acquisition of Foremost. Furthermore, the Company continued to hold $23,330,000 of miscellaneous other certificates of contribution of the P&C Group, which bear interest at various rates, and a $119,000,000 surplus note of the P&C Group, which bears interest at 6.10% annually. Conditions governing repayment of these amounts are outlined in the certificates of contribution and the surplus notes. Generally, repayment may be made only when the surplus balance of the issuer reaches a certain specified level, and then only after approval is granted by the issuer's governing Board and the appropriate state insurance regulatory department. H. Supplemental cash flow information For financial statement purposes, the Company considers all investments with original maturities of 90 days or less as cash equivalents. Following is a reconciliation of the balance sheet cash and cash equivalent totals to the consolidated cash flow total:

Cash payments for interest were $1,795,000 and $1,678,000 for the six month periods ended June 30, 2001 and June 30, 2000, respectively, while the cash payment for dividends to the holders of the Company's QUIPS was $21,035,000 for each of the six month periods ended June 30, 2001 and June 30, 2000. Cash payments for income taxes were $218,969,000 and $190,935,000 for the six month periods ended June 30, 2001 and June 30, 2000, respectively. On March 7, 2000, the Company purchased $370,000,000 of certificates of contribution of the P&C Group to help fund the Exchanges' acquisition of Foremost (see Note G). I. Operating segments The Company's principal activities are the provision of management services to the P&C Group and the ownership and operation of the life and reinsurance subsidiaries. These activities are managed separately as each offers a unique set of services. As a result, the Company is comprised of the following three reportable operating segments as defined in SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information": the management services segment, the life insurance segment and the reinsurance segment. As AIF, the management services segment is primarily responsible for providing management services to the P&C Group. Management fees earned from the P&C Group totaled $777,489,000 and $726,386,000 for the six 19 month periods ended June 30, 2001 and June 30, 2000, respectively. The life insurance segment provides individual life insurance products, including universal life, term life and whole life insurance and structured settlement and annuity products, as well as variable universal life and annuity products. Finally, the reinsurance segment provides reinsurance coverage to a percentage of the auto physical damage business written by the P&C Group. The basis of accounting used by the Company's management in evaluating segment performance and determining how resources should be allocated is referred to as the Company's GAAP historical basis, which excludes the effects of the purchase accounting ("PGAAP") adjustments related to the acquisition of the Company by B.A.T in December 1988 (see Note A). This differs from the basis used in preparing the Company's financial statements included in the SEC Form 10-K and 10-Q reports, which incorporates the effects of these adjustments. The Company accounts for intersegment transactions as if they were to third parties and, as such, records the transactions at current market prices. There were no intersegment revenues among the Company's three reportable operating segments for the six month periods ended June 30, 2001 and June 30, 2000. Information regarding the Company's reportable operating segments follows:

(a) Revenues for the insurance operating segments include net investment income and net realized gains/(losses). (b) Amount includes PGAAP adjustments associated with the amortization of the AIF relationships ($21.4 million) and goodwill ($30.0 million). (c) Amount includes PGAAP adjustments associated with the amortization of the VOLBA asset and the reversal of amortization associated with the pre-1988 DAC asset. 20 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations General The Company's principal activities are the provision of management services to the P&C Group and the ownership and operation of the Insurance Subsidiaries. Revenues and expenses relating to these principal business activities are reflected in the Company's Consolidated Financial Statements prepared in accordance with GAAP, which differs from statutory accounting practices ("SAP"), which the Insurance Subsidiaries are required to use for regulatory reporting purposes. On March 7, 2000, the Exchanges acquired Foremost. Foremost is the country's leading writer of manufactured homes and a prominent insurer of recreational vehicles and other specialty lines. The Company provides management services in respect of this business and receives compensation based on a percentage of gross premiums earned. Farmers Life, a wholly owned subsidiary of the Company, underwrites and sells life insurance, structured settlement and annuity products as well as variable universal life and variable annuity products. Revenues attributable to traditional life insurance products, such as whole life or term life contracts, as well as structured settlements with life contingencies are classified as premiums as they become due. Future benefits are associated with such premiums (through increases in liabilities for future policy benefits), and prior period capitalized costs are amortized (through amortization of DAC) so that profits are generally recognized over the same period as revenue income. Revenues attributable to universal life, variable universal life and variable annuity products consist of policy charges for the cost of insurance, policy administration charges, surrender charges and investment income on assets allocated to support policyholder account balances on deposit. Revenues for deferred annuity products consist of surrender charges and investment income on assets allocated to support policyholder account balances. Expenses on universal life and annuity policies as well as on variable products include interest credited to policyholders on policy balances as well as benefit claims incurred in excess of policy account balances. Revenues attributable to structured settlements without life contingencies consist of investment income on assets allocated to support the policyholder benefits schedule and expenses consist of interest credited to policyholders on policy balances. Farmers Re, a wholly owned subsidiary of the Company, reinsures a percentage of the auto physical damage business written by the P&C Group. Effective April 1, 2001, the APD reinsurance agreement between Farmers Re and the P&C Group which had been in force since January 1998 was cancelled and replaced with a similar APD reinsurance agreement supported by multiple reinsurers. As a result of this new agreement, the monthly premiums assumed by Farmers Re decreases from $83.3 million to $16.7 million. Farmers Re continues to assume a quota share percentage of ultimate net losses sustained by the P&C Group in its APD line of business. This treaty, which will remain in effect until terminated by either party, also provides for the P&C Group to receive a provisional ceding commission of 18% of premiums. This experience commission arrangement limits Farmers Re's potential underwriting gain on the assumed business to 2.5% of premiums assumed. Three Months Ended June 30, 2001 Compared to Three Months Ended June 30, 2000 Management Services to Property and Casualty Insurance Companies; and Other Operating Revenues. Operating revenues increased from $396.8 million for the three months ended June 30, 2000 to $413.6 million for the three months ended June 30, 2001, an increase of $16.8 million, or 4.2%. Operating revenues primarily consist of management fees paid to the Company as a percentage of gross premiums earned by the P&C Group. Such premiums increased from $2,851.5 million in the second quarter of 2000 to $3,034.4 million in the second quarter of 2001, an increase of $182.9 million, or 6.4% due mainly to continued growth in all lines of business. 21 Operating Expenses. Salaries and Employee Benefits. Salaries and employee benefits decreased from $104.1 million for the three months ended June 30, 2000 to $99.0 million for the three months ended June 30, 2001, a decrease of $5.1 million, or 4.9%, due primarily to a decrease in profit sharing expenses. Buildings and Equipment Expenses. Buildings and equipment expenses decreased from $27.1 million for the three months ended June 30, 2000 to $26.6 million for the three months ended June 30, 2001, a decrease of $0.5 million, or 1.9%, due primarily to savings generated by renegotiated lease contracts. Amortization of Attorney-In-Fact Relationships and Goodwill. Purchase accounting entries related to the acquisition of the Company by B.A.T in December 1988 include goodwill (capitalized at $2.4 billion) and the value of the AIF relationships of the P&C Group (capitalized at $1.7 billion). Amortization of these two items, which is being taken on a straight-line basis over forty years, reduced pretax income by approximately $25.7 million in each of the three month periods ended June 30, 2001 and June 30, 2000. General and Administrative Expenses. General and administrative expenses increased from $70.8 million for the three months ended June 30, 2000 to $85.1 million for the three months ended June 30, 2001, an increase of $14.3 million, or 20.2%. This increase was primarily due to increased levels of business activity between periods and increased postage expense resulting from the recent privacy notice requirements called for by the Gramm-Leach-Bliley Act. Net Investment Income. Net investment income decreased from $32.6 million for the three months ended June 30, 2000 to $22.5 million for the three months ended June 30, 2001, a decrease of $10.1 million, or 31.0%. This decrease was due mainly to lower investment yields and a decrease in the average invested asset base resulting from the fact that a sizable portion of the investment portfolio was liquidated to help fund the payment of the $1,075.0 million special dividend associated with the Zurich capital structure unification in October 2000 (see Note F). Net Realized Gains. Net realized gains decreased $10.3 million, from $19.0 million for the three months ended June 30, 2000 to $8.7 million for the three months ended June 30, 2001, due primarily to unfavorable market conditions experienced during the three month period ended June 30, 2001, and the $1,075.0 million special dividend paid in 2000. Dividends on Preferred Securities of Subsidiary Trusts. Dividend expense related to the $500.0 million of QUIPS issued in 1995 was $10.5 million for the three months ended June 30, 2001 and June 30, 2000. Provision for Income Taxes. Provision for income taxes decreased from $85.0 million for the three months ended June 30, 2000 to $79.3 million for the three months ended June 30, 2001, a decrease of $5.7 million, or 6.7%, due mainly to a decrease in pretax income between periods. Management Services Income. As a result of the foregoing, management services income decreased from $125.2 million for the three months ended June 30, 2000 to $118.6 million for the three months ended June 30, 2001, a decrease of $6.6 million, or 5.3%. Insurance Subsidiaries Farmers Re As a result of the new quota share reinsurance agreement, effective April 1, 2001, Farmers Re's assumed premiums decreased from $250.0 million for the three month period ended June 30, 2000 to $50.0 million for the three month ended June 30, 2001. Losses and loss adjustment expenses incurred under this treaty were $34.4 million for the three months ended June 30, 2001 and $164.5 million for the three months ended June 30, 2000 and non-life reinsurance commissions were $14.4 million for the three months ended June 30, 2001 and $79.2 million for the 22 three months ended June 30, 2000. Income before taxes decreased $1.3 million from $15.1 million for the three months ended June 30, 2000 to $13.8 million for the three months ended June 30, 2001 due primarily to the decrease in underwriting gain between periods resulting from the new reinsurance agreement. For the three month periods ended June 30, 2001 and June 30, 2000, Farmers Re's contribution to net income was $9.5 million and $10.5 million, respectively. Farmers Life Total Revenues. Total revenues increased from $199.7 million for the three months ended June 30, 2000 to $212.9 million for the three months ended June 30, 2001, an increase of $13.2 million, or 6.6%. Life and Annuity Premiums. Life and annuity premiums increased $5.9 million for the three months ended June 30, 2001, or 10.5%, over the three months ended June 30, 2000. This increase was due to a 15.4% growth in the volume of traditional life insurance in-force, as well as an 82.2% increase in structured settlement with life contingencies premiums over the three month period ended June 30, 2001. Life Policy Charges. Life policy charges increased $0.5 million for the three months ended June 30, 2001, or 0.9%, over the three months ended June 30, 2000, reflecting growth in universal life-type insurance in-force. Net Investment Income. Net investment income increased $5.4 million for the three months ended June 30, 2001, or 6.8%, over the three months ended June 30, 2000. The increase was due to an increase in average invested assets. Net Realized Gains. Net realized gains increased by $1.4 million, from $10.2 million for the three months ended June 30, 2000 to $11.6 million for the three months ended June 30, 2001 due to fixed income and equity gains. Total Operating Expenses. Total operating expenses increased from $136.4 million for the three months ended June 30, 2000 to $138.5 million for the three months ended June 30, 2001, an increase of $2.1 million, or 1.5%. Life Policyholders' Benefits and Charges. Life policyholders' benefits expense and charges increased from $11.0 million for the three months ended June 30, 2001, or 11.5%, over the three months ended June 30, 2000. Policy Benefits. Policy benefits, which consist primarily of death and surrender benefits on life products, increased $1.8 million for the three months ended June 30, 2001, to $38.4 million, due to growth in the volume of life insurance in-force. Increase in Liability for Future Benefits. Increase in liability for future benefits expense increased from $18.4 million for the three months ended June 30, 2000 to $22.8 million for the three months ended June 30, 2001. This increase was primarily attributable to a 82.2% increase in deposits for structured settlement products. Interest Credited to Policyholders. Interest credited to policyholders, which represents the amount credited to policyholder funds on deposit under universal life-type contracts and deferred annuities, increased from $40.3 million for the three months ended June 30, 2000 to $45.1 million for the three months ended June 30, 2001, an increase of $4.8 million or 11.9%. This increase reflects a growth in the universal life and fixed annuity fund balances. General Operating Expenses. General operating expenses decreased from $41.1 million for the three months ended June 30, 2000 to $32.2 million for the three months ended June 30, 2001, a decrease of $8.9 million, or $21.7%. 23 Amortization of DAC and Value of Life Business Acquired. Amortization expense decreased from $27.3 million for the three months ended June 30, 2000 to $20.6 million for the three months ended June 30, 2001, due to favorable persistency on the Farmers Flexible Universal Life ("FFUL") and Farmers Universal Life ("FUL") product lines as well as differences in the mix of business. Net Commissions. Net commissions decreased from $1.1 million for the three months ended June 30, 2000 to ($0.5) million for the three months ended June 30, 2001, due to a 55.1% growth in reinsurance activity. General and Administrative Expenses. General and administrative expenses decreased from $12.7 million for the three months ended June 30, 2000 to $12.1 million, or 4.7%, for the three months ended June 30, 2001. This decrease was due largely to a premium tax refund from California. Provision for Income Taxes. Provision for income taxes decreased $22.3 million for the three months ended June 30, 2000 to $21.2 million for the three months ended June 30, 2001. Farmers Life Income. As a result of the foregoing, Farmers Life income increased from $41.0 million for the three months ended June 30, 2000 to $53.2 million for the three months ended June 30, 2001, an increase of $12.2 million, or 29.8%. Consolidated Net Income Consolidated net income of the Company increased from $176.7 million for the three months ended June 30, 2000 to $181.3 million for the three months ended June 30, 2001, an increase of $4.6 million, or 2.6%. Six Months Ended June 30, 2001 Compared to Six Months Ended June 30, 2000 Management Services to Property and Casualty Insurance Companies; and Other Operating Revenues. Operating revenues increased from $772.1 million for the six months ended June 30, 2000 to $828.7 million for the six months ended June 30, 2001, an increase of $56.6 million, or 7.3%. This growth reflects higher gross premiums earned by the P&C Group, which increased from $5,586.1 million in the first six months of 2000 to $6,014.6 million in the first six months of 2001 due mainly to continued growth in all lines of business. Also contributing to the increase between periods was the fact that revenues earned in connection with the provision of management services on the business the P&C Group assumed from Foremost increased $12.0 million due to the fact that the Foremost acquisition was not completed until March 2000. Operating Expenses. Salaries and Employee Benefits. Salaries and employee benefits increased from $200.8 million for the six months ended June 30, 2000 to $210.0 million for the six months ended June 30, 2001, an increase of $9.2 million, or 4.6%, due primarily to an increase in expenses incurred in connection with providing management services to the business assumed from Foremost. Buildings and Equipment Expenses. Buildings and equipment expenses increased from $50.2 million for the six months ended June 30, 2000 to $51.4 million for the six months ended June 30, 2001, an increase of $1.2 million, or 2.4%, due to expenses incurred in connection with providing management services to the business assumed from Foremost. This increase in expense was partially offset by savings generated by renegotiated lease contracts. 24 Amortization of Attorney-In-Fact Relationships and Goodwill. Amortization expense was $51.4 million in each of the six month periods ended June 30, 2001 and June 30, 2000. General and Administrative Expenses. General and administrative expenses increased from $131.7 million for the six months ended June 30, 2000 to $160.0 million for the six months ended June 30, 2001, an increase of $28.3 million, or 21.5%. This increase was primarily due to increased levels of business activity between periods, increased postage expense resulting from the recent privacy notice requirements called for by the Gramm-Leach-Bliley Act as well as an increase in expenses incurred in connection with providing management services to the business assumed from Foremost. Net Investment Income. Net investment income decreased from $66.5 million for the six months ended June 30, 2000 to $43.4 million for the six months ended June 30, 2001, a decrease of $23.1 million, or 34.7%. This decrease was due mainly to lower investment yields and a decrease in the average invested asset base resulting from the fact that a sizable portion of the investment portfolio was liquidated to help fund the payment of the $1,075.0 million special dividend associated with the Zurich capital structure unification in October 2000 (see Note F). Net Realized Gains. Net realized gains decreased $23.5 million, from $36.7 million for the six months ended June 30, 2000 to $13.2 million for the six months ended June 30, 2001, due primarily to unfavorable market conditions experienced during the six month period ended June 30, 2001, and the $1,075.0 million special dividend paid in 2000. Dividends on Preferred Securities of Subsidiary Trusts. Dividend expense was $21.0 million in each of the six month periods ended June 30, 2001 and June 30, 2000. Provision for Income Taxes. Provision for income taxes decreased from $171.1 million for the six months ended June 30, 2000 to $160.4 million for the six months ended June 30, 2001, a decrease of $10.7 million, or 6.3%, due mainly to an decrease in pretax income between periods. Management Services Income. As a result of the foregoing, management services income decreased from $249.1 million for the six months ended June 30, 2000 to $231.1 million for the six months nded June 30, 2001, a decrease of $18.0 million, or 7.2%. Insurance Subsidiaries Farmers Re As a result of the new quota share reinsurance agreement, effective April 1, 2001, Farmers Re's assumed premiums decreased from $500.0 million for the six month period ended June 30, 2000 to $300.0 million for the six months ended June 30, 2001. Losses and loss adjustment expenses incurred under this treaty were $212.7 million for the six months ended June 30, 2001 and $329.0 million for the six months ended June 30, 2000 and non-life reinsurance commissions were $79.8 million for the six months ended June 30, 2001 and $158.6 million for the six months ended June 30, 2000. Income before taxes decreased $2.2 million from $31.4 million for the six months ended June 30, 2000 to $29.2 million for the six months ended June 30, 2001 due primarily to the decrease in underwriting gain between periods resulting from the new reinsurance agreement. For the six month periods ended June 30, 2001 and June 30, 2000, Farmers Re's contribution to net income was $20.0 million and $21.7 million, respectively. Farmers Life Total Revenues. Total revenues increased from $389.4 million for the six months ended June 30, 2000 to $427.9 million for the six months ended June 30, 2001, an increase of $38.5 million, or 9.9%. Life and Annuity Premiums. Life and annuity premiums increased $25.1 million for the six months ended June 30, 2001, or 23.1%, over the six months ended June 30, 2000. This increase was due to a 24.3% 25 growth in the volume of traditional life insurance in-force, as well as a 168.2 % increase in structured settlement with life contingencies premiums over the six months ended June 30, 2000. Life Policy Charges. Life policy charges increased $0.9 million for the six months ended June 30, 2001, or 0.9%, over the six months ended June 30, 2000, reflecting a 1.4% growth in universal life-type insurance in-force. Net Investment Income. Net investment income increased $11.4 million for the six months ended June 30, 2001, or 7.3%, over the six months ended June 30, 2000. The increase was due to an increase in average invested assets. Net Realized Gains. Net realized gains increased by $1.1 million or 6.9%, from $16.0 million for the six months ended June 30, 2000 to $17.1 million for the six months ended June 30, 2001. Total Operating Expenses. Total operating expenses increased from $269.1 million for the six months ended June 30, 2000 to $301.9 million for the six months ended June 30, 2001, an increase of $32.8 million, or 12.2%. Life Policyholders' Benefits and Charges. Life policyholders' benefits expense and charges increased from $185.1 million for the six months ended June 30, 2000 to $224.1 million for the six months ended June 30, 2001, an increase of $39.0 million, or 21.1%. Policy Benefits. Policy benefits increased $9.3 million for the six months ended June 30, 2001 to $81.1 million, due to a 7.1% growth in the volume of life insurance in-force. Increase in Liability for Future Benefits. Increase in liability for future benefits expense increased from $32.7 million for the six months ended June 30, 2000 to $55.2 million for the six months ended June 30, 2001. This increase was primarily attributable to a 168.2% increase in deposits for structured settlement products. Interest Credited to Policyholders. Interest credited to policyholders increased from $80.6 million for the six months ended June 30, 2000 to $87.8 million for the six months ended June 30, 2001, an increase of $7.2 million or 8.9%, reflecting growth in the universal life and fixed annuity fund balances. General Operating Expenses. General operating expenses decreased from $84.0 million for the six months ended June 30, 2000 to $77.8 million for the six months ended June 30, 2001, a decrease of $6.2 million, or 7.4%. Amortization of DAC and VOLBA. Amortization expense decreased from $57.0 million for the six months ended June 30, 2000 to $50.3 million for the six months ended June 30, 2001 due primarily to favorable persistency on the FFUL and FUL product lines as well as differences in the mix of business. Net Commissions. Net commissions decreased $2.9 million from $2.6 million for the six months ended June 30, 2000 to ($0.3) million for the six months ended June 30, 2001, due to a 51.7% growth in reinsurance activity. General and Administrative Expenses. General and administrative expenses increased from $24.4 million for the six months ended June 30, 2000 to $27.8 million for the six months ended June 30, 2001, an increase of $3.4 million or 13.9%, due primarily to business growth and new initiatives. 26 Provision for Income Taxes. Provision for income taxes decreased from $42.3 million for the six months ended June 30, 2000 to $39.3 million for the six months ended June 30, 2001. Farmers Life Income. As a result of the foregoing, Farmers Life income increased from $78.0 million for the six months ended June 30, 2000 to $86.7 million for the six months ended June 30, 2001, an increase of $8.7 million, or 11.2%. Consolidated Net Income Consolidated net income of the Company decreased from $348.8 million for the six months ended June 30, 2000 to $337.8 million for the six months ended June 30, 2001, a decrease of $11.0 million, or 3.2%. Liquidity and Capital Resources As of June 30, 2001 and June 30, 2000, the Company held cash and cash equivalents of $396.5 million and $255.9 million, respectively. In addition, as of June 30, 2001, the Company had available revolving credit facilities enabling it to borrow up to $500.0 million in the event such a need should arise. Net cash provided by operating activities increased from $508.2 million for the six months ended June 30, 2000 to $528.5 million for the six months ended June 30, 2001, an increase of $20.3 million. This increase in cash was due primarily to a $46.5 million increase in life insurance policy liabilities and a $19.7 million increase resulting from gains on sales of assets. Partially offsetting these increases in cash were a $20.5 million net decrease resulting from changes in current and non-current assets and liabilities, an $11.0 million decrease in consolidated net income as well as a $9.7 million decrease in equity in earnings of joint ventures. Net cash used in investing activities decreased from $177.5 million for the six months ended June 30, 2000 to $102.8 million for the six months ended June 30, 2001, an increase in cash of $74.7 million. This increase in cash was the result of a $548.5 million increase in proceeds from sales and maturities of investments available-for-sale and a $370.0 million increase resulting from the purchase of certificates of contribution of the P&C Group in March 2000. Partially offsetting these increases in cash was an $862.7 million increase in purchases of investments available-for-sale. Net cash used in financing activities decreased from $388.2 million for the six months ended June 30, 2000 to $245.9 million for the six months ended June 30, 2001, resulting in an increase in cash of $142.3 million. This increase in cash was due primarily to a $126.7 million decrease in dividends paid to stockholders coupled with higher cash flows from annuity contracts. ITEM 3. Quantitative and Qualitative Disclosures about Market Risks The market risks associated with the Company's investment portfolios have not changed materially from those disclosed at year-end 2000. 27 PART II. OTHER INFORMATION Item 1. Legal Proceedings. The Company is a party to numerous lawsuits arising from its normal business activities. These actions are in various stages of discovery and development, and some seek punitive as well as compensatory damages. In the opinion of management, the Company has not engaged in any conduct which should warrant the award of any material punitive or compensatory damages. The Company intends to vigorously defend its position in each case, and management believes that, while it is not possible to predict the outcome of such matters with absolute certainty, ultimate disposition of these proceedings should not have a material adverse effect on the Company's consolidated results of operations or financial position. In addition, the Company is, from time to time, involved as a party to various governmental and administrative proceedings. Item 2. Changes in Securities. None. Item 3. Defaults upon Senior Securities. None. Item 4. Submission of Matters to a Vote of Security Holders. None. Item 5. Other Information. None. Item 6. Exhibits and Report on Form 8-K. (a) Exhibits. 16. Letter regarding change in Certifying Accountant. (b) Reports on Form 8-K. On June 7, 2001, FGI filed a report on Form 8-K announcing a change in its Certifying Accountant. 28 FARMERS GROUP, INC. AND SUBSIDIARIES SIGNATURES Pursuant to the requirements 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. Farmers Group, Inc. (Registrant) August 13, 2001 /s/ Martin D. Feinstein --------------------------------------------- Date Martin D. Feinstein Chairman of the Board, President and Chief Executive Officer August 13, 2001 /s/ Gerald E. Faulwell --------------------------------------------- Date Gerald E. Faulwell Senior Vice President, Chief Financial Officer and Director

FARMERS GROUP INC 10-Q