SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
Commission File Number 0-6964
21ST CENTURY INSURANCE GROUP
(Exact name of registrant as specified in its charter)
DELAWARE 95-1935264
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6301 OWENSMOUTH AVENUE
WOODLAND HILLS, CALIFORNIA 91367
(Address of principal executive offices) (Zip Code)
(818) 704-3700 WWW.21ST.COM
(Registrant's telephone number, including area code) (Registrant's web site)
SECURITIES REGISTERED PURSUANT TO SECTION 12 (B) OF THE ACT:
NAME OF EACH EXCHANGE ON
TITLE OF EACH CLASS WHICH REGISTERED
--------------------- ----------------
Common Stock, Par Value $0.001 New York Stock Exchange
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 [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements,
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
The aggregate market value of the voting stock held by non-affiliates of 21st
Century Insurance Group, based on the average high and low prices for shares of
the registrant's Common Stock on June 30, 2003, as reported by the New York
Stock Exchange, was approximately $350,000,000.
There were 85,435,505 shares of common stock outstanding on January 30, 2004.
DOCUMENT INCORPORATED BY REFERENCE:
Part III of this Form 10-K incorporates by reference certain information from
the registrant's definitive proxy statement for the Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission within 120
days after the close of the year ended December 31, 2003.
TABLE OF CONTENTS
Page
Description Number
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Part I
Item 1. Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Geographic Concentration of Business. . . . . . . . . . . . . . . . . . . . . 4
Types and Limits of Insurance Coverage. . . . . . . . . . . . . . . . . . . . 5
Personal Auto Product Innovations . . . . . . . . . . . . . . . . . . . . . . 6
Marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Consumer Advocacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Customer Retention and Vehicles in Force. . . . . . . . . . . . . . . . . . . 7
Underwriting and Pricing. . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Servicing of Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Claims. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Growth and Profitability Objectives . . . . . . . . . . . . . . . . . . . . . 10
Underwriting Expense Ratio - Personal Auto Lines. . . . . . . . . . . . . . . 10
Loss and Loss Adjustment Expense Reserves . . . . . . . . . . . . . . . . . . 11
Estimating the Frequency of Auto Accidents. . . . . . . . . . . . . . . . . 11
Estimating the Severity of Auto Claims. . . . . . . . . . . . . . . . . . . 12
Estimating Loss and LAE for Lines in Runoff . . . . . . . . . . . . . . . . 12
Loss and Reserve Development. . . . . . . . . . . . . . . . . . . . . . . . . 12
Auto Lines Reserve Development. . . . . . . . . . . . . . . . . . . . . . . 16
Homeowner and Earthquake Lines in Runoff. . . . . . . . . . . . . . . . . . 16
Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
State Regulation of Insurance Companies . . . . . . . . . . . . . . . . . . . 18
Holding Company Regulation. . . . . . . . . . . . . . . . . . . . . . . . . . 18
Non-Voluntary Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Employees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Debt Offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Item 2. Properties. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Item 4. Submission of Matters to a Vote of Security Holders . . . . . . . . . . 20
Part II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters. . 20
Item 6. Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . 21
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . 22
Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Financial Condition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Liquidity and Capital Resources . . . . . . . . . . . . . . . . . . . . . . . 24
21st Century Insurance Group. . . . . . . . . . . . . . . . . . . . . . . . 24
Insurance Subsidiaries. . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Transactions with Related Parties . . . . . . . . . . . . . . . . . . . . . 25
Contractual Obligations and Commitments . . . . . . . . . . . . . . . . . . . 25
Off Balance Sheet Arrangements. . . . . . . . . . . . . . . . . . . . . . . . 26
Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Underwriting Results. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Personal Auto . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Homeowner and Earthquake Lines in Runoff. . . . . . . . . . . . . . . . . . 28
Loss and LAE Incurred . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1
Page
Description Number
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Investment Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Other Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Write-off of Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Critical Accounting Policies. . . . . . . . . . . . . . . . . . . . . . . . . 30
Losses and Loss Adjustment Expenses . . . . . . . . . . . . . . . . . . . . 31
Property and Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Income Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Deferred Policy Acquisition Costs . . . . . . . . . . . . . . . . . . . . . 32
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Stock-Based Compensation. . . . . . . . . . . . . . . . . . . . . . . . . . 35
New Accounting Pronouncements . . . . . . . . . . . . . . . . . . . . . . . . 35
Forward-Looking Statements. . . . . . . . . . . . . . . . . . . . . . . . . . 35
Item 7A. Quantitative and Qualitative Disclosures about Market Risk . . . . . . 37
Item 8. Financial Statements and Supplementary Data. . . . . . . . . . . . . 38
Report of Independent Auditors. . . . . . . . . . . . . . . . . . . . . . . . 38
Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . 39
Notes to Consolidated Financial Statements. . . . . . . . . . . . . . . . . . 43
Note 1. Description of Business. . . . . . . . . . . . . . . . . . . . . . 43
Note 2. Summary of Significant Accounting Policies . . . . . . . . . . . . 43
Note 3. Earnings (Loss) per Common Share . . . . . . . . . . . . . . . . . 47
Note 4. Investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Note 5. Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Note 6. Deferred Policy Acquisition Costs. . . . . . . . . . . . . . . . . 50
Note 7. Property and Equipment . . . . . . . . . . . . . . . . . . . . . . 51
Note 8. Unpaid Losses and Loss Adjustment Expenses . . . . . . . . . . . . 51
Note 9. Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Note 10. Reinsurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Note 11. Employee Benefit Plans . . . . . . . . . . . . . . . . . . . . . . 56
Note 12. Commitments and Contingencies. . . . . . . . . . . . . . . . . . . 58
Note 13. Capital Stock. . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Note 14. Stock-Based Compensation . . . . . . . . . . . . . . . . . . . . . 62
Note 15. Statutory Financial Data . . . . . . . . . . . . . . . . . . . . . 64
Note 16. Northridge Earthquake. . . . . . . . . . . . . . . . . . . . . . . 65
Note 17. Unaudited Quarterly Results of Operations. . . . . . . . . . . . . 66
Note 18. Results of Operations by Line of Business. . . . . . . . . . . . . 67
Note 19. 21st Century Insurance Company of Arizona. . . . . . . . . . . . . 68
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure. . . . . . . . . . . . . . . . . . . . . . . . . 69
Item 9A. Controls and Procedures. . . . . . . . . . . . . . . . . . . . . . . . 69
Part III. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
Item 10. Directors and Executive Officers of the Registrant . . . . . . . . . 69
Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . 70
Item 12. Security Ownership of Certain Beneficial Owners and Management . . . 70
Item 13. Certain Relationships and Related Transactions . . . . . . . . . . . 70
Item 14. Principal Accountant Fees and Services . . . . . . . . . . . . . . . 70
Part IV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K. . . 70
Schedule II - Condensed Financial Information of Registrant . . . . . . . . 74
Signatures of Officers and Board of Directors . . . . . . . . . . . . . . . 78
2
Exhibits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
4.1 Indenture, dated December 9, 2003, between 21st Century Insurance
Group and The Bank of New York, as trustee.
4.2 Exchange and Registration Rights Agreement, dated December 9, 2003.
10(i) 2003 Short Term Incentive Plan.
10(l) Lease Agreements for Registrant's Principal Offices substantially in
the form of this Exhibit.
10(m) Forms of Amended and Restated Stock Option Agreements.
10(n) Form of Restricted Shares Agreement.
10(o) Retention Agreements substantially in the form of this Exhibit for
executives Richard A. Andre, Michael J. Cassanego, G. Edward Combs,
Carmelo Spinella and Dean E. Stark.
10(p) Sale and Leaseback Agreement between 21st Century Insurance Company
and General Electric Capital Corporation, for itself, and as agent for
Certain Participants, as amended, dated December 31, 2002.
14 Code of Ethics.
21 Subsidiaries of Registrant.
23 Consent of Independent Auditors.
31.1 Certification of President and Chief Executive Officer Pursuant to
Exchange Act Rule 13a-14(a).
31.2 Certification of Chief Financial Officer Pursuant to Exchange Act Rule
13a-14(a).
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
3
PART I
ITEM 1. BUSINESS
GENERAL
21st Century Insurance Group (together with its subsidiaries, referred to
hereinafter as the "Company", "we", "us" or "our") is an insurance holding
company registered on the New York Stock Exchange (NYSE: TW).
We primarily market and underwrite personal automobile, motorcycle, and umbrella
insurance in California. We also provide personal automobile insurance in four
other western states (Arizona, Nevada, Oregon and Washington) and three
midwestern states (Illinois, Indiana and Ohio). We began offering personal auto
insurance in Illinois, Indiana and Ohio on January 28, 2004(1). Twenty-four
hours per day, 365 days a year, customers have the option to purchase insurance,
service their policy or report a claim over the phone directly through our
centralized licensed insurance agents at 1-800-211-SAVE or through our full
service Internet site at www.21st.com. We believe that we have a reputation for
high quality customer service and for being among the most efficient and lowest
cost providers of personal auto insurance in the markets we serve.
The Company was founded in 1958, and until recently was incorporated in
California. Effective December 4, 2003, we were reincorporated under the laws of
the State of Delaware. Several subsidiaries of American International Group,
Inc. (hereinafter referred to as "AIG") together currently own approximately 63%
of our outstanding common stock.
Copies of our filings with the Securities and Exchange Commission on Form 10-K,
Form 10-Q, Form 8-K and proxy statements are available along with copies of
earnings releases on the Company's web site at www.21st.com. Copies may also be
obtained free of charge directly from the Company's Investor Relations
Department (6301 Owensmouth Avenue, Woodland Hills, California 91367, phone
818-701-3595).
GEOGRAPHIC CONCENTRATION OF BUSINESS
We write private passenger automobile insurance primarily in California (97% of
policyholders Our remaining business is written in Arizona, Nevada, Oregon and
Washington.
-----------
1 Results from these markets are not expected to be material in 2004.
4
The following table presents a geographical summary of our direct premiums
written for the past five years (in millions):
Direct Premiums Written
------------------------------------------------------------------------
Years Ended December 31, 2003 2002 2001 2000 1999
------------------------------------------------------------------------
Personal auto lines(1)
California $1,189.5 $967.3 $879.4 $861.6 $848.9
Arizona(2) 21.2 13.0 - - -
Nevada 6.7 8.1 8.9 7.7 2.7
Oregon 1.4 1.6 2.0 2.2 0.8
Washington 4.6 5.8 8.5 9.7 3.4
------------------------------------------------------------------------
Total personal auto lines 1,223.4 995.8 898.8 881.2 855.8
------------------------------------------------------------------------
Lines in runoff
Homeowner(3) and Earthquake(4) 0.1 2.4 30.5 29.5 24.7
------------------------------------------------------------------------
Total $1,223.5 $998.2 $929.3 $910.7 $880.5
------------------------------------------------------------------------
The table below summarizes the concentrations of our California vehicles in
force for the voluntary personal auto lines excluding personal umbrella and
motorcycle coverages as of the end of each of the past five years. Our
California market share reflects a weighted distribution that tracks the
concentration of households and population. At the end of 2003, 32% of the
vehicles insured by us were garaged in Los Angeles County. In comparison, data
from the California Department of Motor Vehicles indicates that 27% of its
registrations were for vehicles in Los Angeles County.
Concentration of
Voluntary Personal Auto Lines California Vehicles in Force
---------------------------------------------------------------------------
December 31, 2003 2002 2001 2000 1999
---------------------------------------------------------------------------
Los Angeles County 32.3% 37.2% 42.0% 43.6% 45.2%
San Diego County 13.5 13.4 13.4 12.6 12.3
Southern California excluding Los
Angeles and San Diego Counties(5) 21.4 23.5 25.9 26.5 26.8
Central and Northern California(6) 32.8 25.9 18.7 17.3 15.7
---------------------------------------------------------------------------
100.0% 100.0% 100.0% 100.0% 100.0%
---------------------------------------------------------------------------
TYPES AND LIMITS OF INSURANCE COVERAGE
Our private passenger auto insurance contract generally covers: bodily injury
liability; property damage; medical payments; uninsured and underinsured
motorist; rental reimbursement; uninsured motorist property damage and collision
deductible waiver; towing; comprehensive; and collision. All of our policies are
written for a six-month term except for policies sold to the involuntary market,
which are for twelve months.
Minimum levels of bodily injury and property damage are required by state law
and typically cover the other party's claims when our policyholder causes an
accident. Uninsured and underinsured motorist are optional coverages and cover
our policyholder when the other party is at fault and has no or insufficient
liability insurance to cover the insured's injuries and loss of income.
Comprehensive and collision
------------
1 Includes motorcycle and personal umbrella coverages, which are immaterial
for all periods presented.
2 Excludes amounts not consolidated prior to our acquisition of a majority of
the voting interests in 21st of Arizona: $12.8 million in 2001; $14.7
million in 2000; and $12.9 million in 1999.
3 We no longer have any California homeowner policies in force. See further
discussion in Item 7 under the caption Underwriting Results - Homeowner
and Earthquake Lines in Runoff.
4 We ceased writing earthquake coverage in 1994, but we have remaining loss
reserves from the 1994 Northridge Earthquake that are subject to upward
development. See further discussion in Item 7 under the captions
Underwriting Results - Homeowner and Earthquake Lines, Critical Accounting
Policies, and the Notes to Consolidated Financial Statements.
5 Includes the following counties: Imperial, Kern, Orange, Riverside, Santa
Barbara, San Bernardino and Ventura.
6 Includes all California counties other than Los Angeles County, San Diego
County, and those specified in Footnote 5.
5
coverages are also optional and cover damage to the policyholder's automobile
whether or not the insured is at fault. In some states, we are required to offer
personal injury protection coverage in lieu of the medical payments coverage
required in California.
Various limits of liability are underwritten with maximum limits of $500,000 per
person and $500,000 per accident. Our most popular bodily injury liability
limits in force are $100,000 per person and $300,000 per accident.
Our personal umbrella policy ("PUP") provides a choice of liability coverage
limits of $1.0 million, $2.0 million or $3.0 million in excess of underlying
automobile liability coverage that we write. The $2.0 million and $3.0 million
limits were added in May 2002. We require minimum underlying automobile limits,
written by us, of $250,000 per person and $500,000 per accident for PUP policies
sold since May 2002 (limits of $100,000 per person and $300,000 per accident
were previously required). We reinsure 90% of any PUP loss with unrelated
reinsurers.
PERSONAL AUTO PRODUCT INNOVATIONS
Starting in May 2002, we began offering motorcycle coverage primarily to our
auto policyholders in California. In August 2002, we introduced a new private
passenger auto policy in California that does not have certain standard features
found in our primary policy. This limited-feature product is similar in most
respects to the product offered by many of our competitors, and is positioned as
a lower-cost alternative for customers who believe they need less coverage than
provided by our standard product. In October 2002, we enhanced our underwriting
guidelines allowing us to provide quotes to more customers who do not meet
California's statutory "good driver" definition, but who are considered to be
insurable risks within our class plan.
The foregoing product innovations account for approximately 9% of new auto
policies written in California in 2003. Each innovation was designed to earn an
underwriting profit equivalent to the rest of the California auto product (with
the exception of Assigned Risk program). Initial results for each product
innovation are in line with expected profit levels.
MARKETING
While we offer personal auto policies in eight states, most of our marketing
efforts are focused on the larger urban markets in California(1). Beginning in
late 2002, we resumed active marketing in Arizona.
Our marketing and underwriting strategy is to appeal to careful and responsible
drivers who desire a feature-rich product at a competitive price. We use direct
mail, broadcast and print media, outdoor, community events and the Internet to
generate inbound telephone calls, which are served by centralized licensed
insurance agents. Because our sales agents are centralized, we can deliver a
highly efficient and professional experience for our California and Arizona
customers 24 hours per day, 365 days per year through a convenient, toll-free
800-211-SAVE telephone number. California and Arizona customers may also obtain
an auto rate quotation and purchase a policy on our web site.
The following table summarizes advertising expenditures (in millions) and total
new auto policies written in California, our primary market, for the past five
years:
Years Ended December 31, 2003 2002 2001 2000 1999
-----------------------------------------------------------------------------
Total advertising expenditures $ 53.9 $ 43.3 $ 16.9 $ 9.8 $ 21.3
New auto policies written in
California(2) 254,830 185,927 51,002 50,901 86,703
------------
1 We began offering personal auto insurance in Illinois, Indiana and Ohio on
January 28, 2004. Results from these new markets are not expected to be
material in 2004.
2 Includes new PUP and motorcycle policies, which are insignificant for all
periods presented.
6
CONSUMER ADVOCACY
We have introduced several publications and community events designed to assist
customers and potential customers in making choices about their auto insurance
and automobile safety. The Insider's Guide to Buying California Auto Insurance,
currently available in both English and Spanish, compares coverage and service
features of products offered by the Company and its major competitors. The
comparisons are explained in understandable language to help "demystify" the
choices consumers must make in selecting their personal auto insurance carrier.
We also publish the Child Safety Seat Guide, Crash Test Ratings Guide, and A
Driving Need - A Guide for Mature Drivers and Those Who Care about Them. All of
these publications are available free of charge on our web site at
www.21st.com/company/getmore/safety/safety.jsp. We have also distributed these
publications in California movie theaters, county fairs, direct mail promotions
and other venues.
We extended our partnership with the California Highway Patrol to address the
critical safety issues of proper child safety seat installation and distracted
driving. Working in conjunction with Highway Patrol officers we held 16 child
safety seat inspection events in under-served communities throughout California.
During these events more than 1,600 inspections were conducted, 800
unsafe/recalled seats were replaced and 1,000 new seats were donated. We also
posted billboards carrying the message "Wrap Your Most Important Package Safely"
in high visibility locations around the state. On the issue of distracted
driving we developed a handout discouraging cell phone usage by drivers in
traffic as well as a billboard campaign under the theme of "Just Drive." All of
the materials are co-branded by the Company and the Highway Patrol.
CUSTOMER RETENTION AND VEHICLES IN FORCE
Customer retention in California, measured based on the number of insured
vehicles and the number of vehicles in force, were as follows as of the end of
each of the past five years:
December 31, 2003 2002 2001 2000 1999
-----------------------------------------------------------------------------------------
Average customer retention -
California personal auto(1) 92% 93% 92% 96% 96%
California vehicles in force 1,383,175 1,178,459 1,051,982 1,150,643 1,179,928
All other states vehicles in
force 33,332 27,174 23,489 31,337 18,130
-----------------------------------------------------------------------------------------
Total auto lines exposure 1,416,507 1,205,633 1,075,471 1,181,980 1,198,058
-----------------------------------------------------------------------------------------
California auto base rate +3.9% +5.7% +4.0% +6.4% -6.9%
changes APRIL May July November February
From March 1996 to February 1999, we implemented six rate decreases which
resulted in a cumulative reduction in rates of nearly 23% in our California
Personal Auto Program. As a result of this series of rate decreases, retention
rates rose to record levels for us through 2000. Growth in vehicles in force
during this period was modest as our major competitors also lowered their rates.
In the year 2000, we recognized that loss costs had stopped declining and were
again rising. While our competitors took no action or, in some cases, continued
to take rate decreases, we took decisive action to improve our results and
position us for profitable growth when the marketplace ultimately did react to
these adverse trends. In 2000, we curtailed our advertising, adopted stricter
underwriting measures, modified our class plan rating system, and increased our
California auto program base rate by 6.4%, followed by a further rate increase
of 4% in 2001. These actions contributed to the declines in retention and
vehicles in force in 2000 and 2001. Beginning in the latter half of 2001, our
major California competitors began implementing rate increases and we restarted
active marketing and advertising, both of which contributed
------------
1 Represents an overall measure of customer retention, including new
customers as well as long-time customers. Retention rates for new customers
are typically lower than for long-time customers.
7
to the increases in our retention and vehicles in force in 2002. In January
2003, the Company received approval for a 3.9% rate increase, which we
implemented for new and renewal policies effective March 31, 2003.
UNDERWRITING AND PRICING
The regulatory system in California requires the prior approval of insurance
rates. Within the regulatory framework, we establish our premium rates based
primarily on actuarial analyses of our own historical loss and expense data.
This data is compiled and analyzed to establish overall rate levels as well as
classification differentials.
Our rates are established at levels intended to generate underwriting profits
and vary for individual policies based on a number of rating characteristics.
These rates are a blend of base rates and class plan filings made with the
California Department of Insurance ("CDI"). Base rates are the primary amount
projected to generate an adequate underwriting profit. Class plan changes are
filings that serve to modify the factors that impact the base rates so that each
individual receives a rate that reflects their respective losses and expenses.
Class plan changes are generally meant to be revenue neutral to us, but
ultimately are done in conjunction with a base rate filing.
California law requires that the primary rating characteristics that must be
used for automobile policies are driving record (e.g., history of accidents and
moving violations), annual mileage and number of years the driver has been
licensed. A number of other "optional" rating factors are also permitted and
used in California, which include characteristics such as automobile garaging
location, make and model of car, policy limits and deductibles, and gender and
marital status.
The following table summarizes changes in our base premium rates for each of the
past five years. Positive numbers represent increases; negative numbers
represent decreases.
Changes in Our Base Premium Rates
---------------------------------------------------------------------
Years Ended December 31, 2003 2002 2001 2000 1999
---------------------------------------------------------------------
Personal auto lines excluding PUP
California 3.9% 5.7% 4.0% 6.4% (6.9)%
Arizona 3.0 3.7 16.5 20.0 (9.7)
Nevada - 22.0 12.6 - -
Oregon - 3.1 14.0 21.0 -
Washington - 10.7 44.9 - -
Lines in runoff
Homeowner N/A 13.2 4.0 - (7.5)
Earthquake N/A N/A N/A N/A N/A
We are required to offer insurance to any California applicant who meets the
statutory definition of a "Good Driver." This definition includes all drivers
licensed more than three years with no more than one violation point count under
criteria contained in the California Vehicle Code. These criteria include a
variety of moving violations and certain at-fault accidents.
We review many of our policies prior to the time of renewal and as changes occur
during the policy period. Some mid-term changes may result in premium
adjustments, cancellations or non-renewals because of a substantial increase in
risk.
COMPETITION
The personal automobile insurance market is highly competitive and is comprised
of a large number of well-capitalized companies, many of which operate in a
number of states and offer a wider variety of products than us. Several of these
competitors are larger and have greater financial resources than us on a
stand-alone basis. According to A.M. Best, we were the seventh largest writer of
private
8
passenger automobile insurance in California based on direct premiums written
for 2002. Our main competition comes from other major writers who concentrate on
the good driver market.
Market shares in California of the top ten writers of personal automobile
insurance, based on direct premiums written, according to A.M. Best, for the
past five years were as follows:
Market Share in California
Based on Direct Premiums Written
--------------------------------------------------------------------------------
Years Ended December 31, 2002 2001 2000 1999 1998
--------------------------------------------------------------------------------
21ST CENTURY INSURANCE GROUP 6% 6% 6% 6% 6%
State Farm Group 14 13 13 14 15
Zurich/Farmers Group 11 12 13 14 15
California State Auto Group 9 10 10 10 10
Allstate Insurance Group 9 11 10 9 8
Automobile Club of Southern California Group 9 9 9 9 8
Mercury General Group 9 8 8 8 7
USAA Group 3 3 3 3 3
Government Employees Group (GEICO) 3 3 3 2 2
Progressive Insurance Group 2 2 2 3 2
SERVICING OF BUSINESS
Computerized systems provide the information resources, telecommunications and
data processing capabilities necessary to manage our business. These systems
support the activities of our marketing, sales, service and claims people who
are dedicated to serving the needs of customers. New technology investments have
been focused on making it faster and easier for customers to transact business
while ultimately lowering our per-transaction costs.
Using our web site, most customers are now able to receive and accept
quotations, bind policies, pay their bills, inquire about the status of their
policies and billing information, make most common policy changes, submit first
notice of loss on a claim and access a wealth of consumer information. New
technology provides our sales and service agents with integrated knowledge about
customer contacts and enables speedier and even more convenient customer
service.
CLAIMS
Claims operations include the receipt and analysis of initial loss reports,
assignment of legal counsel when necessary, and management of the settlement
process. Whenever possible, physical damage claims are handled through the use
of Company drive-in claims facilities, vehicle inspection centers and Direct
Repair Program ("DRP") providers. The claims management staff administers the
claims settlement process and oversees the work of the legal and adjuster
personnel involved in that process. Each claim is carefully analyzed to provide
for fair loss payments, compliance with our contractual and regulatory
obligations and management of loss adjustment expenses. Liability and property
damage claims are handled by specialists in each area.
We make extensive use of our DRP to expedite the repair process. The program
involves agreements between us and more than 160 independent repair facilities.
We agree to accept the repair facility's damage estimate without requiring each
vehicle to be reinspected by our adjusters. All DRP facilities undergo a
screening process before being accepted, and we maintain an aggressive
inspection audit program to assure quality results. Our inspection teams visit
all repair facilities each month and perform a quality control inspection on
approximately 40% of all repairable vehicles in this program. The customer
benefits by getting the repair process started faster and by having the repairs
guaranteed for as long as the customer owns the vehicle. We benefit by not
incurring the overhead expense of a larger staff of adjusters and by negotiating
repair prices we believe are beneficial. Currently, more than 30% of all damage
repairs are handled using the DRP method.
9
Our policy is to use original equipment manufacturer ("OEM") parts. As a result,
we believe we do not have exposure to the types of class action suits some
competitors have drawn over their use of after market parts.
We have established 12 claims division service offices in areas of major
customer concentrations. Our eight vehicle inspection centers, located in
Southern and Northern California, handle total losses, thefts and vehicles that
are not drivable.
The claims services division is responsible for subrogation and medical payment
claims. We also maintain a Special Investigations Unit as required by the
California State Insurance Code, which investigates suspected fraudulent claims.
We believe our efforts in this area have been responsible for saving several
million dollars annually.
We utilize internal legal staff to handle most aspects of claims litigation.
These attorneys handle approximately 75% of all lawsuits against our
policyholders. Suits directly against us and those which may involve a conflict
of interest, are assigned to outside counsel.
GROWTH AND PROFITABILITY OBJECTIVES
We have stated that our long-term goal is to build an organization that
consistently produces a 96% combined ratio prepared using accounting principles
generally accepted in the United States of America ("GAAP"), or better, and at
least 15% annual growth in direct written premiums. To achieve these goals, we
have undertaken many steps since 1999 including:
- Restored pricing and underwriting discipline;
- Successfully restarted active advertising for new customers;
- Introduced product innovations to spur growth and profitability; and
- Launched numerous initiatives to lower unit transaction costs.
UNDERWRITING EXPENSE RATIO - PERSONAL AUTO LINES
Our direct statutory underwriting expense ratio for private passenger auto
(defined as direct underwriting expenses on a statutory basis divided by direct
premiums written), was lower than seven of our nine largest competitors in the
markets in which we served for 2002.
The following table presents statutory underwriting expense ratio information
extracted from statutory filings by A.M. Best for the top ten California
personal automobile insurance companies for 1998 through 2002, the most recent
data available.
Statutory Underwriting Expense Ratio (1)
------------------------------------
Years Ended December 31, 2002 2001 2000 1999 1998
-----------------------------------------------------------------------------------
21ST CENTURY INSURANCE GROUP 20.3%(2) 15.0% 14.1% 13.8% 10.9%
Zurich/Farmers Group 27.0% 26.2% 25.8% 26.6% 26.1%
Mercury General Group 25.1% 25.8% 25.9% 26.7% 26.3%
State Farm Group 23.0% 22.6% 23.5% 22.9% 21.6%
California State Auto Group 22.8% 23.9% 25.1% 15.7% 19.0%
Allstate Insurance Group 22.7% 23.1% 25.5% 24.1% 22.7%
Progressive Insurance Group 21.5% 22.8% 21.1% 21.8% 22.7%
Automobile Club of Southern California Group 21.2% 21.6% 22.2% 22.2% 22.1%
Government Employees Group (GEICO) 14.7% 14.2% 17.0% 18.1% 17.7%
USAA Group 12.0% 12.7% 12.3% 13.7% 11.7%
------------
1 There is generally a difference between underwriting expense ratios
prepared using statutory accounting principles and GAAP. In 2003, our GAAP
underwriting expense ratio was 17.9% compared to our statutory underwriting
expense ratio of 16.7%.
2 In the third quarter of 2002, we recorded a pre-tax charge to write-off
$37.2 million of previously capitalized software costs for abandoned
portions of an advanced personal lines processing system. The underwriting
expense ratio excluding such write-down would have been 16.6%.
10
Our direct statutory underwriting expense ratio for 2003 was 16.7%. Excluding
the effects of the 2002 software write-off recorded in the third quarter of 2002
our direct statutory, underwriting expense ratio increased by 0.1% from 16.6% to
16.7% in 2003 over 2002. Comparable 2003 figures for our competitors are not yet
available. In 2002, the capacity of the Company's new business call center was
doubled, enabling us to handle a record volume of new business throughout the
year. Several productivity enhancement initiatives are underway aimed at
reducing per-unit process costs. The increases in our ratio from 1998 through
2001 were primarily due to the cumulative 23% decrease in rate level in
California from 1996 to 1999, and increases in data processing, depreciation and
advertising expenditures.
LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
The cost to settle a customer's claim is comprised of two major components:
losses and loss adjustment expenses.
Losses in connection with third party coverages represent damages as a result of
an insured's acts that result in property damage or bodily injury. First party
losses involve damage or injury to the insured's property or person. In either
case, the ultimate cost of the loss is not always immediately known and, over
time, may be higher or lower than initially estimated. When establishing
initial and subsequent estimates, the amount of loss is reduced for salvage
(e.g., proceeds from the disposal of the wrecked automobile) and subrogation
(e.g., proceeds from another party who is fully or partially liable, such as the
insurer of the driver who caused the accident involving one of our customers).
Loss adjustment expenses ("LAE") represent the costs of adjusting, investigating
and settling claims, and are primarily comprised of the cost of our claim
department, external inspection services, and internal and external legal
counsel. Corporate support areas such as human resources, finance, and
information technology support our overall operations, and, accordingly, a
portion of their operational costs are also allocated to LAE. The LAE allocable
portion of such corporate support costs is reviewed periodically as changes
occur in our organization, and we modify the allocation percentages as
appropriate. During 2003, such changes effectively decreased our ratio of LAE to
earned premium by approximately 1.8% from 6.2% in 2002 to 4.4% in 2003.
Accounting for losses and LAE is highly subjective because these costs must be
estimated, often weeks, months or even years in advance of when the payments
actually are made to claimants, attorneys, claims personnel and others involved
in the claims settlement process. At the time of sale of an auto policy, for
example, the number of claims that will happen is unknown, and so is the
ultimate amount it will take to settle them.
Accounting principles require insurers to record estimates for loss and LAE in
the periods in which the insured events, such as automobile accidents, occur.
This estimation process requires us to estimate both the number of accidents
that may have occurred (called "frequency") and the ultimate amount of loss and
LAE (called "severity") related to each accident. We employ actuaries who are
professionally trained and certified in the process of establishing estimates
for frequency and severity. From time to time, actuarial experts from outside
firms are engaged to review the work of our actuaries. Historically, our
actuaries have not projected a range around the carried loss reserves. Rather,
they have used several methods and different underlying assumptions to produce a
number of point estimates for the required reserves. Management reviews the
assumptions underlying the loss ratios and selects the carried reserve after
carefully reviewing the appropriateness of the underlying assumptions.
Estimating the Frequency of Auto Accidents. By studying the historical lag
between the actual date of loss and the date the accident is reported by the
customer to the claims department, our actuaries can make a reasonable, yet
never perfect, estimate for the number of claims that ultimately will be
reported for a given period. This measurement is often referred to as frequency.
The difference between the estimated ultimate number of claims that will be made
and the number that have actually been reported in any given period is often
referred to as "IBNR" (incurred but not reported) claims.
11
For example, when estimating the frequency of accidents, history has shown that
approximately 99.7% of property damage claims and 89.2% of liability claims are
reported by year-end. Accordingly, in this illustration, our actuaries add an
estimated 0.3% to the number of property damage claims and 10.8% to the number
of liability claims to provide for incurred but not reported ("IBNR") claims.
In making these estimates, a fundamental assumption is that past events are
representative indicators of future outcomes.
Estimating the Severity of Auto Claims. Adjusters in our claim department
establish loss estimates for individual claims based upon various factors such
as the extent of the injuries, property damage sustained, and the age of the
claim. Our actuaries review these estimates, giving consideration to the
adjusters' historical ability to accurately estimate the ultimate claim and
length of time it will take to settle the claim, and provide for development in
the adjusters' estimates as applicable. Generally, the longer it takes to settle
a claim, the higher the ultimate claim cost. The ultimate amount of the loss is
considered the "severity" of the claim. In addition, the actuaries estimate the
severity of the IBNR claims.
The severities are estimated by our actuaries each month based on historical
studies of average claim payments and the patterns of how the claims were paid.
Again, the fundamental assumption used in making these estimates is that past
events are reliable indicators of future outcomes.
Estimating Loss and LAE for Lines in Runoff. While the personal auto lines
represent our core business, we also have losses and LAE relating to
developments on remaining loss reserves for homeowners and earthquake lines.
These lines are said to be "in runoff" because we no longer have policies in
force. As discussed in the Notes to Consolidated Financial Statements, we have
not written any earthquake policies since 1994 and we exited the homeowners
insurance business at the beginning of 2002. Developing reserve estimates for
the earthquake line is particularly subjective because most of the remaining
earthquake claims are in litigation. Our actuaries evaluate the homeowners
reserve requirement on a quarterly basis, while personnel in our legal and
claims areas prepare monthly evaluations of the earthquake reserves.
LOSS AND RESERVE DEVELOPMENT
Management believes that our reserves are adequate and represent our best
estimate based on the information currently available. However, because reserve
estimates are necessarily subject to the outcome of future events, changes in
estimates are unavoidable in the property and casualty insurance business. These
changes sometimes are referred to as "loss development" or "reserve
development."
For the personal auto lines, our actuaries prepare a monthly evaluation of loss
and LAE indications by accident year, and we assesses whether there is a need to
adjust reserve estimates. Homeowners reserves are reviewed quarterly. The
adequacy of earthquake reserves is reviewed monthly by personnel in our legal
and claims areas. As claims are reported and settled and as other new
information becomes available, changes in estimates are made and are included in
earnings of the period of the change.
12
The changes in prior accident year estimates recorded in each of the past five
calendar years, net of applicable reinsurance, are summarized below (in
thousands)(1):
Changes in the Calendar Year of Prior
Accident Year Estimates, Net of Reinsurance
---------------------------------------------------------------------------
Years ended December 31, 2003 2002 2001 2000 1999
---------------------------------------------------------------------------
Personal auto $11,159 $16,200 $ 45,742 $42,178 $(14,239)
Homeowner and Earthquake(2) 40,048 56,158 72,265 2,845 5,543
---------------------------------------------------------------------------
$51,207 $72,358 $118,007 $45,023 $ (8,696)
---------------------------------------------------------------------------
To understand these changes, it is useful to put them in the context of the
cumulative reserve development experienced by the Company over a longer time
frame. The tables on the following pages present the development of loss and LAE
reserves for the personal auto lines (Table 1) and for the homeowner and
earthquake lines in runoff (Table 2), for the years 1993 through 2003. The
figures in both tables are shown gross of reinsurance.
A redundancy (deficiency) exists when the original reserve estimate is greater
(less) than the re-estimated reserves. Each amount in the tables includes the
effects of all changes in amounts for prior periods. The tables do not present
accident year or policy year development data. Conditions and trends that have
affected the development of liabilities in the past may not necessarily occur in
the future. Therefore, it would not be appropriate to extrapolate future
deficiencies or redundancies based on the table. A detailed discussion of loss
reserve development follows the tables.
The top line of each table shows the reserves at the balance sheet date for each
of the years indicated. The upper portion of the table indicates the cumulative
amounts paid as of subsequent year-ends with respect to that reserve liability.
The lower portion of the table indicates the re-estimated amount of the
previously recorded reserves based on experience as of the end of each
succeeding year, including cumulative payments made since the end of the
respective year. The estimates change as more information becomes known about
the frequency and severity of claims for individual years.
------------
1 Positive amounts represent deficiencies in loss and LAE expenses, while
negative amounts represent redundancies.
2 We no longer have any California homeowners policies in force. We ceased
writing earthquake coverage in 1994, but we have remaining loss reserves
from the 1994 Northridge Earthquake that are subject to upward development.
See further discussion in Item 7 under the captions Underwriting Results -
Homeowner and Earthquake Lines in Runoff, Critical Accounting Policies, and
the Notes to Consolidated Financial Statements.
13
------------------------------------------------------------------------------------------------------------------------------
TABLE 1 - Auto Lines as of December 31,
(Amounts in thousands, except claims) 1993 1994 1995 1996 1997 1998 1999 2000
------------------------------------------------------------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $525,892 $552,872 $506,747 $468,257 $403,263 $329,021 $261,990 $286,057
PAID (CUMULATIVE) AS OF:
One year later 319,938 329,305 318,273 260,287 253,528 247,317 242,579 268,515
Two years later 393,731 403,462 392,420 336,538 319,064 307,797 311,659 332,979
Three years later 410,808 429,595 416,541 354,854 333,349 324,778 324,740 352,592
Four years later 422,640 435,795 422,393 357,913 340,907 326,932 327,745
Five years later 425,021 437,041 423,429 363,068 341,446 327,418
Six years later 425,397 437,052 427,723 362,824 341,374
Seven years later 425,041 437,015 427,355 362,508
Eight years later 424,982 436,737 427,059
Nine years later 424,745 436,518
Ten years later 424,571
RESERVES RE-ESTIMATED AS OF:
One year later 451,054 465,934 440,158 365,566 359,262 313,192 309,953 352,709
Two years later 429,602 438,672 424,091 366,858 337,258 321,711 340,914 354,720
Three years later 418,576 439,125 425,404 359,925 335,246 341,695 328,190 361,264
Four years later 424,630 438,895 424,643 357,607 355,605 326,506 329,182
Five years later 425,880 436,397 422,389 377,414 340,537 326,565
Six years later 424,475 435,878 442,024 361,980 340,552
Seven years later 424,188 451,478 426,719 361,865
Eight years later 424,603 448,972 426,636
Nine years later 424,435 436,237
Ten years later 424,388
------------------------------------------------------------------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $101,504 $116,635 $ 80,111 $106,392 $ 62,711 $ 2,456 $(67,192) $(75,207)
------------------------------------------------------------------------------------------------------------------------------
Supplemental Auto Claims Data:
Claims reported during the year for CA only 315,558 352,182 324,143 294,615 279,211 295,905 307,403 323,395
Claims pending at year-end for CA only 62,892 70,717 63,142 58,172 55,738 56,739 57,134 54,760
------------------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------
TABLE 1 - Auto Lines as of December 31,
(Amounts in thousands, except claims) 2001 2002 2003
----------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $301,985 $333,113 $419,913
PAID (CUMULATIVE) AS OF:
One year later 239,099 249,815
Two years later 312,909
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
RESERVES RE-ESTIMATED AS OF:
One year later 323,791 348,865
Two years later 338,338
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $(36,353) $(15,752)
------------------------------------------------------------------
Supplemental Auto Claims Data:
Claims reported during the year for CA only 298,417 293,955 331,734
Claims pending at year-end for CA only 50,365 51,488 58,577
----------------------------------------------------------------------------
See Notes 8 and 16 of the Notes to Consolidated Financial Statements
14
TABLE 2 - Homeowner and Earthquake
Lines in Runoff as of December 31,
(Amounts in thousands) 1993 1994 1995 1996 1997 1998 1999
-------------------------------------------------------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $51,598 $ 203,371 $ 78,087 $ 75,272 $ 34,624 $ 52,982 $ 14,258
PAID (CUMULATIVE) AS OF:
One year later 26,936 193,887 55,738 75,100 30,232 48,848 13,103
Two years later 34,717 236,406 119,211 100,296 74,127 58,281 37,404
Three years later 37,052 295,768 139,792 142,850 82,974 81,887 83,985
Four years later 39,504 314,225 180,799 151,342 106,274 128,266 147,856
Five years later 40,550 354,324 188,987 174,513 152,592 192,121
Six years later 41,217 362,379 211,771 220,805 216,383
Seven years later 42,318 385,161 257,839 284,455
Eight years later 42,339 431,154 321,169
Nine years later 42,455 494,260
Ten years later 42,502
RESERVES RE-ESTIMATED AS OF:
One year later 41,685 253,775 116,741 101,903 77,445 58,582 18,024
Two years later 40,189 290,526 142,071 145,635 82,716 61,393 72,546
Three years later 39,657 316,256 182,616 150,434 85,519 116,429 125,089
Four years later 41,025 355,690 186,631 153,521 140,532 169,157 163,045
Five years later 41,205 359,084 190,334 208,533 193,375 207,064
Six years later 41,586 363,260 245,267 261,389 231,217
Seven years later 42,599 418,407 298,161 299,109
Eight years later 42,450 471,330 335,657
Nine years later 42,524 508,639
Ten years later 42,579
-------------------------------------------------------------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $ 9,019 $(305,268) $(257,570) $(223,837) $(196,593) $(154,082) $(148,787)
-------------------------------------------------------------------------------------------------------------------------
(Amounts in thousands) 2000 2001 2002 2003
-----------------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $ 12,379 $ 47,305 $ 50,896 $18,410
PAID (CUMULATIVE) AS OF:
One year later 30,706 58,274 71,147
Two years later 78,647 125,447
Three years later 143,564
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
RESERVES RE-ESTIMATED AS OF:
One year later 68,245 103,470 89,281
Two years later 121,176 142,211
Three years later 159,331
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
--------------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $(146,952) $(94,906) $(38,385)
--------------------------------------------------------------------------
NOTE: Costs associated with claims that were re-opened as a result of SB 1899
are displayed in the table as a 1994 event (since they all related to the
Northridge Earthquake), even though the legislation allowing the re-opening of
related claims was not passed until almost seven years later.
See Notes 8 and 16 of the Notes to Consolidated Financial Statements
15
Auto Lines Reserve Development. As shown in the ten-year development table, our
auto lines historically developed redundancies prior to 1999 and have exhibited
adverse development for 1999 through 2002. The period from 1993 to 1999 was
quite unusual in that, during that time, we experienced declining frequencies
and declining severities in our auto line. As Table 1 shows, we did not
immediately have confidence in these declining trends and did not immediately
lower our reserve estimates.
Much of the decline in trend occurred between 1996 and 1998 because of
moderation in health care costs due to greater use of HMO's and laws that were
enacted in California that limited the ability of uninsured motorists and drunk
drivers to collect non-economic damages. During 1999, we assumed that the past
trend of declining frequencies and severities would continue. However, in
retrospect, it can now be seen that the favorable decline in trends ended and
loss costs began to increase. In 2000, we continued to assume lower loss
severity primarily because of what then seemed to be an acceleration in the
pattern of claims payments and the uncertainty inherent in identifying a change
in multi-year patterns. In 2001, we experienced significant, unexpected
development in our uninsured motorist coverage while the actuarial indications
for most prior accident years were adjusted upward as more data became
available. The changes in injury trends affected the entire California market
and occurred, to a greater or lesser degree, in virtually every state in the
country.
Starting in 2001, we improved the quality and timeliness of the data available
to make initial estimates and periodic changes in estimates. We have dedicated
more resources to better understand the underlying drivers of the changes in
frequency and severity trends as they begin emerging. For example, in the second
quarter of 2003 we began making accident month actuarial analyses of our
reserves for the auto lines.
Homeowner and Earthquake Lines in Runoff. In Table 2, substantially all of the
development relates to the earthquake line. A major earthquake occurred on
January 17, 1994, centered in the San Fernando Valley community of Northridge
(the "Northridge Earthquake"). Through December 31, 2003, we have settled over
46,000 Northridge Earthquake claims at a total cost (i.e., loss plus LAE) of
over $1.2 billion.
In September 2000, the State of California enacted Senate Bill 1899 ("SB 1899"),
which allowed Northridge Earthquake claims barred by contract and the statute of
limitations to be reopened during calendar year 2001. Please see Note 16 of the
Notes to Consolidated Financial Statements for additional background on the
Northridge Earthquake and SB 1899, including a discussion of factors that have
contributed to the difficulty of obtaining accurate loss and LAE estimates in
the wake of that legislation.
The loss development in Table 2 is easiest to understand by dividing it into
"pre-SB 1899" and "post-SB 1899" segments. This is because the costs relating to
the re-opened claims are displayed in the table as a 1994 event (since they all
related to the Northridge Earthquake), even though the legislation allowing the
re-opening of certain claims was not passed until almost seven years later.
Before SB 1899 was passed in late 2000, we had only approximately 50 earthquake
claims remaining to be resolved out of an initial 35,000 homeowner earthquake
claims. Although we settled 98% of the claims within a year of the quake, many
upward changes in estimates were required in 1994 and beyond as new information
emerged on the severity of the damages and as settlements of litigated claims
occurred. As a result, we recorded the following upward changes in loss
estimates after 1994, but before SB 1899 came into play: 1995 - $57 million;
1996 - $40 million; 1997 - $24.8 million; 1998 - $40 million; 1999 - $2.5
million; and 2000 - $3.5 million.
Calendar year 2001 was the one-year window SB 1899 permitted for claimants to
bring additional insurance claims and legal actions allegedly arising out of the
Northridge Earthquake. Prior to the enactment of this law, such claims were
considered by previously applicable law to be fully barred, or settled and
closed. Any additional legal actions with respect to such claims were barred
under the policy contracts, settlement agreements, and/or applicable statutes of
limitation. As a result of the enactment of this unprecedented legislation,
claimants asserted additional claims against the Company allegedly related to
damages that occurred in the 1994 earthquake but which were now being reported
seven years later in 2001. Plaintiff attorneys and public adjusters conducted
extensive advertising campaigns to solicit claimants. Hundreds of claims were
filed in the final days and hours before the December 31, 2001 deadline.
16
During 2001, the Company recorded an additional $70 million of pre-tax losses
related to the 1994 earthquake, including $50 million in the fourth quarter to
cover the indemnity and inspection portion of the claims. The Company lacked
sufficient information to record a reasonable estimate of the related legal
defense costs until the third quarter of 2002, at which time an additional
provision of $46.9 million was recorded. In the first two quarters of 2002, we
expensed an additional $11.9 million of legal defense costs as they were paid.
Based on subsequent developments, we recorded an additional provision of $37.0
million in the first quarter of 2003.
At the end of each month, legal and claim personnel within the Company review
the adequacy of the remaining SB 1899 reserves based on the most current
information available. Based on that review, we believe our remaining earthquake
reserves are adequate as of December 31, 2003. However, we continue to caution
that these estimates are subject to a greater than normal degree of uncertainty
and possible future material adjustment as new facts become known.
REINSURANCE
A reinsurance transaction occurs when an insurer transfers or cedes a portion of
its exposure to a reinsurer for a premium. The reinsurance cession does not
legally discharge the insurer from its liability for a covered loss, but
provides for reimbursement from the reinsurer for the ceded portion of the risk.
We periodically monitor the continuing appropriateness of our reinsurance
arrangements to determine that our retention levels are reasonable and that our
reinsurers are financially sound, able to meet their obligations under the
agreements and that the contracts are competitively priced.
The majority of our cessions are with AIG subsidiaries, which have earned A.M.
Best's highest financial rating of A++. The A.M. Best financial ratings of our
other reinsurers range from A- to A+. Our reinsurance arrangements are discussed
in more detail in Note 10 of the Notes to Consolidated Financial Statements.
Our net retention of insurance risk after reinsurance for 2004 and the preceding
five years is summarized below:
Contracts Incepting During
-----------------------------------------
Net Retention 2004 2003 2002 2001 2000 1999
------------------------------------------------------------------------
Auto and motorcycle lines 100% 100% 97%(1) 94% 92% 90%
Personal umbrella policies(2) 10 10 10 16 37 36
Homeowner line in runoff 0 0 0 94 92 0
We also have catastrophe reinsurance agreements relating to the auto line with
Endurance Specialty Insurance Ltd., Folksamerica Reinsurance Company and
Transatlantic Reinsurance Company (a majority held AIG subsidiary), which
reinsure any covered events up to $30.0 million in excess of $15.0 million
($45.0 million in excess of $20.0 million effective January 1, 2004).
------------
1 Effective September 1, 2002, we entered into an agreement to cancel future
cessions under our quota share with AIG subsidiaries. The treaty would have
ceded 4% of premiums for the auto and motorcycle lines to AIG subsidiaries
in the remainder of 2002 and would have declined to 2% in 2003. After
September 1, 2002, 100% of auto and motorcycle premiums are retained by us.
2 Personal umbrella coverage is only available to our auto customers.
Approximately 1% of the auto customers have umbrella coverage.
17
STATE REGULATION OF INSURANCE COMPANIES
Insurance companies are subject to regulation and supervision by the insurance
departments of the various states. The insurance departments have broad
regulatory, supervisory and administrative powers, such as:
- Licensing of insurance companies, agents and customer service employees;
- Prior approval, in California and some other jurisdictions, of premium
rates;
- Establishment of capital and surplus requirements and standards of
solvency;
- Nature of, and limitations on, investments insurers are allowed to hold;
- Periodic examinations of the affairs of insurers;
- Annual and other periodic reports of the financial condition and results
of operations of insurers;
- Establishment of statutory accounting rules;
- Issuance of securities by insurers;
- Restrictions on payment of dividends; and
- Restrictions on transactions with affiliates.
Currently, the California Department of Insurance ("CDI") has primary regulatory
jurisdiction over our subsidiaries, including prior approval of premium rates.
The CDI typically conducts a financial examination of our affairs every three
years. The most recently completed triennial examination, for the three years
ended December 31, 1999, did not require us to restate our 1999 statutory
financial statements. In general, the current regulatory requirements in the
other states in which our subsidiaries are licensed insurers are no more
stringent than in California.
In addition to regulation by the CDI, we and the personal lines insurance
business in general are also subject to legislative, judicial and political
action in addition to the normal business forces of competition between
companies and the choices of consumers.
To our knowledge, no new laws were enacted in 2003 by any state in which we do
business that are expected to have a material impact on the auto insurance
industry. However, under the preceding Insurance Commissioner, the State of
California began hearings for the purpose of implementing generic rating factors
in connection with the Commissioner's authority to approve insurance rates,
including the rating of auto insurance. The draft regulations made public by the
CDI focus on restricting an insurer's rate of return rather than on the price
charged by the insurer to the consumer. If implemented, we believe these draft
regulations could negatively affect our profitability.
HOLDING COMPANY REGULATION
Our subsidiaries are also subject to regulation by the CDI pursuant to the
provisions of the California Insurance Holding Company System Regulatory Act
(the "Holding Company Act"). Many transactions defined to be of an
"extraordinary" nature may not be effected without the prior approval of the
CDI. In addition, the Holding Company Act limits the amount of dividends our
insurance subsidiaries may pay. An extraordinary transaction includes a dividend
which, together with other dividends or distributions made within the preceding
twelve months, exceeds the greater of (i) 10% of the insurance company's
policyholders' surplus as of the preceding December 31 or (ii) the insurance
company's statutory net income for the preceding calendar year.
The insurance subsidiaries currently have $75.1 million of statutory unassigned
surplus that could be paid as dividends to the parent company without prior
written approval from insurance regulatory authorities in 2004. However, given
the current uncertainty surrounding the taxability of dividends received by
holding companies from their insurance subsidiaries (see further discussion in
Item 3 of this report and Note 15 of the Notes to Consolidated Financial
Statements), it is unlikely that our insurance subsidiaries will make any
dividend payments to us in 2004. There is no assurance that the related tax
issue will be favorably resolved in the near term, in which case we face the
prospect of raising additional capital at the holding company level, cutting or
ceasing dividends to stockholders, or having to pay the additional tax on
dividends from the insurance company to the holding company.
18
NON-VOLUNTARY BUSINESS
Automobile liability insurers in California are required to participate in the
California Automobile Assigned Risk Plan ("CAARP"). Drivers whose driving
records or other relevant characteristics make them difficult to insure in the
voluntary market may be eligible to apply to CAARP for placement as "assigned
risks." The number of assignments for each insurer is based on the total
applications received by the plan and the insurer's market share. As of December
31, 2003, the number of assigned risk insured vehicles was 3,678 compared to
2,436 at the end of 2002. The CAARP assignments have historically produced
underwriting losses. As of December 31, 2003, this business represented less
than 1% of our total direct premiums written, and the underwriting losses were
$0.5 million in 2003, $0.5 million in 2002 and $0.7 million in 2001.
Insurers offering homeowner insurance in California are required to participate
in the California FAIR Plan ("FAIR Plan"). FAIR Plan is a state administered
pool of difficult to insure homeowners. Each participating insurer is allocated
a percentage of the total premiums written and losses incurred by the pool
according to its share of total homeowner direct premiums written in the state.
Participation in the current year FAIR Plan operations is based on the pool from
two years prior. Since we ceased writing direct homeowners business in 2002, the
Company will continue to receive assignments in the 2004 calendar year. Our FAIR
Plan underwriting results for 2003, 2002 and 2001 were immaterial. However, a
major shortfall in FAIR Plan operations, such as might be caused by a
catastrophe, could result in an increase in costs.
EMPLOYEES
We had approximately 2,700 full and part-time employees at December 31, 2003. We
provide medical, pension and 401(k) savings plan benefits to eligible employees,
according to the provisions of each plan.
DEBT OFFERING
In December 2003, we completed a private offering of $100 million principal
amount of 5.9 percent Senior Notes due in December 2013. The effective interest
rate on the Senior Notes when all offering costs are taken into account and
amortized over the term of the Senior Notes is approximately 6 percent per
annum. Of the $99.2 million net proceeds from the offering, $85 million was used
to increase the statutory surplus of our wholly-owned subsidiary, 21st Century
Insurance Company, and the balance was retained by our holding company.
Under a registration rights agreement executed in connection with the offering,
we have agreed to, among other things: (i) file a registration statement on or
before April 7, 2004 enabling holders to exchange the notes for publicly
registered notes; (ii) use our reasonable best efforts to cause the
registration statement relating to the exchange offer to become or be declared
effective on or before June 6, 2004; (iii) use our reasonable best efforts to
consummate the exchange offer within 45 days after the effective date of the
registration statement. In the event such registration statement does not become
effective by June 6, 2004, the interest rate on the Senior Notes will increase
by 0.25%.
ITEM 2. PROPERTIES
We lease approximately 400,000 square feet of office space for our headquarters
facilities, which are located in Woodland Hills, California. The lease term
expires in February 2015, and the lease may be renewed for two consecutive
five-year periods.
We also lease office space in 17 other locations, of which 9 locations are in
California primarily for claims-related employees. We anticipate no difficulty
in extending these leases or obtaining comparable office facilities in suitable
locations.
On December 31, 2002, the Company entered into a sale-leaseback transaction for
$15.8 million of equipment and leasehold improvements and $44.2 million of
software. The leaseback transaction has been accounted for as a capital lease.
For a summary of the Company's lease obligations, see discussion under Item 7 of
this report and Notes 7 and 12 of the Notes to Consolidated Financial
Statements.
19
ITEM 3. LEGAL PROCEEDINGS
In the normal course of business, the Company is named as a defendant in
lawsuits related to claims and insurance policy issues, both on individual
policy files and by class actions seeking to attack the Company's business
practices. A description of the legal proceedings to which the Company and its
subsidiaries are a party is contained in Note 12 of the Notes to Consolidated
Financial Statements.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On October 17, 2003, the majority holder of the Company's common stock approved
by written consent (i) to change the Company's state of incorporation from
California to Delaware pursuant to a merger of the Company with and into a
wholly owned subsidiary of the Company organized under the laws of the State of
Delaware and (ii) a form of indemnity agreement for the Company's directors and
officers. The Company's Certificate of Incorporation and Bylaws, attached as
Appendices B and C, respectively, to the Information Statement filed with the
SEC on November 13, 2003, are incorporated by reference.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
(a) PRICE RANGE OF COMMON STOCK
The following table sets forth the high and low bid prices on the New York Stock
Exchange for the common stock for the indicated periods.
2003 2002
HIGH LOW High Low
----------------------------------------------
Fourth Quarter $14.50 $13.00 $14.24 $ 9.60
Third Quarter 16.05 13.03 19.67 9.15
Second Quarter 17.25 12.00 21.80 17.70
First Quarter 13.50 11.20 19.50 15.82
(b) HOLDERS OF COMMON STOCK
The approximate number of holders of our common stock on December 31, 2003 was
600.
(c) DIVIDENDS
We paid quarterly cash dividends of $0.08 per share from the first quarter of
2001 through the third quarter of 2002. Quarterly dividends of $0.02 per share
were paid from the fourth quarter of 2002 through the fourth quarter of 2003.
The Company's Board of Directors considers a variety of factors in determining
the timing and amount of dividends. Accordingly, the Company's past history of
dividend payments does not assure that future dividends will be paid.
(d) SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
Securities authorized for issuance under equity compensation plans at December
31, 2003 are as follows:
COLUMN (A) COLUMN (B) COLUMN (C)
WEIGHTED- NUMBER OF SECURITIES
NUMBER OF SECURITIES AVERAGE EXERCISE REMAINING AVAILABLE FOR
TO BE ISSUED UPON PRICE OF FUTURE ISSUANCE UNDER EQUITY
EXERCISE OF OUTSTANDING COMPENSATION PLANS
OUTSTANDING OPTIONS, OPTIONS, (EXCLUDING SECURITIES
WARRANTS AND RIGHTS WARRANTS AND REFLECTED IN COLUMN (A))
PLAN CATEGORY (IN THOUSANDS) RIGHTS (IN THOUSANDS)
------------------------------ --------------------- ----------------- -----------------------------
Equity compensation plans
approved by security holders 6,744 $ 17.05 2,780
Equity compensation plans not
approved by security holders None N/A N/A
------------------------------ --------------------- ----------------- -----------------------------
Total 6,744 $ 17.05 2,780
------------------------------ --------------------- ----------------- -----------------------------
See note 14 to the Notes to Consolidated Financial Statements for additional
information.
20
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data for each of the years in the five-year
period ended December 31, 2003 should be read in conjunction with the Company's
consolidated financial statements and the accompanying notes included in Item 8
of this report.
All amounts set forth in the following tables are in thousands, except for
ratios and per share data.
Years Ended December 31, 2003 2002 2001 2000 1999
-----------------------------------------------------------------------------------------
PERSONAL AUTO LINES DATA
Direct premiums written $1,223,377 $995,794 $898,862 $881,212 $ 855,783
Ceded premiums written(1) (4,858) (18,902) (56,205) (72,675) (86,974)
-----------------------------------------------------------------------------------------
Net premiums written 1,218,519 976,892 842,657 808,537 768,809
Net premiums earned 1,172,679 924,559 838,489 803,770 770,234
Loss and LAE ratio(2) 78.6% 82.9% 88.1% 90.8% 77.4%
Underwriting expense ratio(3) 17.9 15.6 14.9 14.2 12.3
-----------------------------------------------------------------------------------------
Combined ratio(4) 96.5% 98.5% 103.0% 105.0% 89.7%
-----------------------------------------------------------------------------------------
ALL LINES DATA
Direct premiums written $1,223,484 $998,248 $929,315 $910,720 $ 880,531
Ceded premiums written(5) (4,854) (32,949) (60,359) (78,592) (111,718)
-----------------------------------------------------------------------------------------
Net premiums written 1,218,630 965,299 868,956 832,128 768,813
Net premiums earned 1,172,677 924,559 864,145 825,486 770,423
Total revenues 1,246,464 981,295 914,078 869,762 832,681
Loss and LAE ratio 82.0% 89.4% 96.7% 90.8% 78.6%
Expense ratio(3) 17.9 15.5 15.0 14.4 12.9
-----------------------------------------------------------------------------------------
Combined ratio(6) 99.9% 104.9% 111.7% 105.2% 91.5%
-----------------------------------------------------------------------------------------
NET INCOME (LOSS) $ 53,575 $(12,256) $(27,568) $ 12,945 $ 87,528
EARNINGS (LOSS) PER SHARE
Basic $ 0.63 $ (0.14) $ (0.32) $ 0.15 $ 1.00
Diluted 0.63 (0.14) (0.32) 0.15 1.00
DIVIDENDS DECLARED 0.08 0.26 0.32 0.48 0.64
------------
1 The decrease in premiums ceded from 1999 through 2003 was caused primarily
by scheduled decreases in the AIG subsidiaries quota share program, which
was terminated effective September 1, 2002.
2 The loss and LAE ratios have decreased since 2000 primarily due to
increases in net premiums earned and the favorable impact on claim
frequency of drought conditions that have largely prevailed in southern
California over the past 36 months.
3 The increase in the 2003 and 2002 expense ratios is primarily due to
increased acquisition costs in advertising and staffing. The increase in
the expense ratio from 1999 to 2001 reflects higher depreciation charges
due to investments in new technology and the effects of rate decreases
taken in 1997 to 1999.
4 The combined ratio for the personal auto lines was impacted by the
following items: $37.2 million of costs related to a write-off of software
in 2002; $13.6 million of costs associated with workforce reductions and
the settlement of litigation matters in 2001; Year 2000 remediation costs
of $2.4 million in 1999; and unfavorable (favorable) prior accident year
loss and LAE development of $11.2 million, $16.2 million, $45.7 million,
$42.2 million and $(14.2) million in 2003, 2002, 2001, 2000, and 1999,
respectively.
5 In addition to the AIG subsidiaries cession discussed in Note 1 above, our
homeowners line was 100% reinsured in 1998, 1999 and 2002.
6 In addition to the effect of the items described in footnote 4 above, the
combined ratio for all lines was impacted by adverse development on
remaining loss reserves from the homeowner and earthquake lines, which are
in runoff, of $40.2 million in 2003, $58.8 million in 2002, $77.6 million
in 2001, $2.7 million in 2000, and $13.1 million in 1999.
21
December 31, 2003 2002 2001 2000 1999
---------------------------------------------------------------------------------------
BALANCE SHEET DATA:
Total investments and cash $1,283,741 $1,030,478 $ 884,633 $ 920,327 $ 988,578
Total assets 1,737,187 1,470,037 1,354,398 1,340,916 1,383,076
Unpaid losses and loss
adjustment expenses 438,323 384,009 349,290 298,436 276,248
Unearned premiums 312,254 266,477 236,473 236,519 232,702
Debt(1) 149,686 60,000 - - 67,500
Total liabilities 1,036,497 814,429 695,092 620,355 662,239
Stockholders' equity 700,690 655,608 659,306 720,561 720,837
Book value per common
share 8.20 7.67 7.72 8.46 8.39
Statutory surplus(2) 531,658 397,381 393,119 475,640 581,440
Net premiums written to
surplus ratio(3) 2.3:1 2.4:1 2.2:1 1.7:1 1.3:1
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
We primarily market and underwrite personal automobile, motorcycle, and umbrella
insurance in California. We also provide personal automobile insurance in four
other western states (Arizona, Nevada, Oregon and Washington) and three
midwestern states (Illinois, Indiana and Ohio). We began offering personal auto
insurance in Illinois, Indiana and Ohio on January 28, 2004. We believe that we
have a reputation for high quality customer service and for being among the most
efficient and lowest cost providers of personal auto insurance in the markets we
serve.
Our primary goals include realizing 15% revenue growth and attaining a 96%
combined ratio for our personal auto lines. Our net premiums earned grew in
excess of 20%, our best growth rate since 1987, and we improved our personal
auto lines combined ratio by two points to 96.5%. For the year ended December
31, 2003, our net premiums earned increased to $1,218.5 million from $976.9
million in 2002. For the years ended December 31, 2003 and 2002, the combined
ratio for the personal auto lines was 96.5% and 98.5%, respectively.
Net income for 2003 was $53.6 million, compared to net losses in 2002 and 2001
of $12.3 million and $27.6 million, respectively. Results for the year ended
December 31, 2003 include a first quarter after-tax charge of $24.1 million to
strengthen earthquake reserves and certain nonrecurring, nonoperational items
that increased second quarter net income by $9.6 million after-tax. In 2002, the
Company's results included third quarter after-tax charges for earthquake and
software write-offs totaling $58.4 million.
For the year ended December 31, 2003, cash flow from operations was $187.5
million compared to $76.3 million for 2002. Total assets also increased to $1.7
billion at December 31, 2003 from $1.5 billion at December 31, 2002. In December
2003, the Company completed a $100 million senior debt offering and used $85
million of the proceeds to increase the statutory surplus of its principal
insurance subsidiary.
See "Results of Operations" for more details as to our overall and personal auto
lines results.
------------
1 Amount shown for 2002 is a capital lease obligation (see Note 7 of the
Notes to Consolidated Financial Statements).
2 Amount shown for 2002 would be $343,661 were it not for the sale-leaseback
transaction described in Note 7 of the Notes to Consolidated Financial
Statements.
3 Amount shown for 2002 would be 2.8:1 were it not for the sale-leaseback
transaction referred to above.
4 Results from these markets are not expected to be material in 2004.
22
The remainder of our Management's Discussion and Analysis provides a narrative
on the Company's financial condition and performance that should be read in
conjunction with the accompanying financial statements. It includes the
following sections:
- Financial Condition
- Liquidity and Capital Resources
- Contractual Obligations and Commitments
- Off Balance Sheet Arrangements
- Results of Operations
- Underwriting Results
- Loss and LAE Incurred
- Investment Income
- Other Income
- Write-off of Software
- Critical Accounting Policies
- New Accounting Pronouncements
- Forward-Looking Statements
FINANCIAL CONDITION
Investments and cash increased $253.2 million (24.6%) since the prior year
primarily due to improved cash flow from operations of $187.5 million in 2003,
and the $100 million senior notes private offering in December 2003.
Investment-grade bonds comprised substantially all of the fair value of the
fixed-maturity portfolio at December 31, 2003. Of our total investments at
December 31, 2003, approximately 61.7% were invested in tax-exempt, fixed-income
securities, compared to 54.5% at December 31, 2002.
Increased advertising, compensation and other operating costs through December
31, 2003, associated with increased customer volume, contributed to an increase
in deferred policy acquisitions costs (DPAC) of $6.9 million to $53.1 million,
compared to $46.2 million at December 31, 2002. The Company's DPAC is estimated
to be fully recoverable (see Critical Accounting Policies - Deferred Policy
Acquisition Costs).
Our loss and LAE reserves, gross and net of reinsurance, are summarized in the
following table:
AMOUNTS IN THOUSANDS 2003 2002
December 31, GROSS NET Gross Net
--------------------------------------------------------------
Unpaid Losses and LAE:
Personal auto lines $419,913 $413,348 $333,113 $320,032
Homeowner lines 4,172 1,774 10,952 3,682
Earthquake lines 14,238 14,237 39,944 39,944
--------------------------------------------------------------
Total $438,323 $429,359 $384,009 $363,658
--------------------------------------------------------------
Gross unpaid losses and LAE increased by $54.3 million since the prior year
primarily due to a reserve increase of $62.1 million in the personal auto lines
as a result of growth in our customer base. The increase in the personal auto
lines was offset by the $17.0 million net decrease in the homeowner and
earthquake lines, which are in runoff.
23
Unearned premiums increased 17.2% to $312.3 million at the end of 2003 compared
to the prior year end, due to higher volume in our personal auto lines.
Debt increased $89.7 million as a result of a private $100 million senior notes
offering executed in December 2003 (see Note 10 of the Notes to Consolidated
Financial Statements) offset by principal payments on a capital lease
obligation. The primary purpose of the 2003 debt offering was to increase the
statutory surplus of 21st Century Insurance Company, our wholly-owned
subsidiary.
Claims and other outstanding checks payable increased 14.0% at the end of 2003
from a year-ago, consistent with our increased business volume. Other
liabilities rose $30.0 million primarily because of increases relating to
various accruals for customer advances, taxes, and personnel costs.
Stockholders' equity and book value per share increased to $700.7 million and
$8.20, respectively, at December 31, 2003, compared to $655.6 million and $7.67
at December 31, 2002. The increase for the year ended December 31, 2003, was due
to net income of $53.6 million, other increases relating to common stock of $0.3
million, less a decrease in other comprehensive income of $2.0 million and
dividends to stockholders of $6.8 million.
Effective December 4, 2003, we changed our state of incorporation from
California to Delaware. In connection with the change, our common stock was
assigned a par value of $0.001 per share, resulting in a reclassification of
$419.2 million from common stock to additional paid-in capital. Delaware is the
state of incorporation for 58% of the Fortune 500 and 51% of all publicly traded
companies, and was selected by our Board of Directors after a careful study.
There was no change in the location of company operations, location of
employees, or in the way we do business.
LIQUIDITY AND CAPITAL RESOURCES
21st Century Insurance Group. Our holding company's main sources of liquidity
historically have been dividends received from our insurance subsidiaries and
proceeds from issuance of debt or equity securities. Apart from the exercise of
stock options and restricted stock grants to employees, the effects of which
have not been significant, we have not issued any equity securities since 1998
when AIG exercised its warrants to purchase common stock for cash of $145.6
million. Our insurance subsidiaries have not paid any dividends to our holding
company since 2001 due to the current uncertainty surrounding the taxability of
dividends received by holding companies from their insurance subsidiaries (see
further discussion in Note 15 of the Notes to Consolidated Financial
Statements).
In December 2003, we completed a private offering of $100 million principal
amount of 5.9 percent Senior Notes due in December 2013. The effective interest
rate on the Senior Notes when all offering costs are taken into account and
amortized over the term of the Senior Notes is approximately 6 percent per
annum. Of the $99.2 million net proceeds from the offering, $85 million was used
to increase the statutory surplus of our wholly-owned insurance subsidiary, 21st
Century Insurance Company, and the balance was retained by our holding company.
Effective December 31, 2003, the California Department of Insurance approved an
intercompany lease whereby 21st Century Insurance Company will lease certain
computer software from our holding company. The monthly lease payment, currently
$0.4 million, started in January 2004 and is subject to upward adjustment based
on the cost incurred by the holding company to complete certain enhancements to
the software.
Our holding company's significant cash obligations over the next several years
consist of interest payments on the Senior Notes (approximately $5.9 million
annually) and the estimated cost to complete certain software enhancements
(approximately $33.1 million), exclusive of any dividends to stockholders that
our directors may declare, and the repayment of the $100 million principal on
the Senior Notes due in 2013. We expect to be able to meet those obligations
from sources of cash currently available - i.e., payments received from the
intercompany lease and cash and investments currently on hand at the holding
company, which
24
totaled $24.4 million at December 31, 2003(1) - plus additional funds obtained
from the capital markets or from dividends received from our insurance
subsidiaries. Absent a favorable resolution of the state income tax issue
regarding taxability of intercompany dividends received by insurance holding
companies, we may have to pay additional state income taxes of up to
approximately 8.9% on the amount of any such dividends received.
Our insurance subsidiaries in 2004 could pay $75.1 million as dividends to us
without prior written approval from insurance regulatory authorities. We are
unlikely to have our insurance subsidiaries pay dividends to our holding company
in 2004 as long as the uncertainty persists over the taxability by the state of
intercompany dividends.
Insurance Subsidiaries. We have achieved underwriting profits in our core auto
insurance operations for the last eight quarters and have thereby enhanced our
liquidity. In California, where approximately 97.7% of our policies are written,
we implemented a 3.9% auto premium rate increase effective March 31, 2003. This
increase followed a 5.7% rate increase in May of 2002. However, there can be no
assurance that insurance regulators will grant future rate increases that may be
necessary to offset possible future increases in claims cost trends. Also, we
remain exposed to possible upward development in previously recorded reserves
for claims pursuant to SB 1899. As a result of such uncertainties, underwriting
losses could occur in the future. Further, we could be required to liquidate
investments to pay claims, possibly during unfavorable market conditions, which
could lead to the realization of losses on sales of investments. Adverse
outcomes to any of the foregoing uncertainties would create some degree of
downward pressure on the insurance subsidiaries' earnings, which in turn could
negatively impact our liquidity.
As of December 31, 2003, our insurance subsidiaries had a combined statutory
surplus of $531.7 million compared to $397.4 million at December 31, 2002. The
change in statutory surplus was primarily due to statutory net income of $76.1
million, a capital contribution of $37.9 million and a decrease in nonadmitted
assets of $20.9 million. Our ratio of net premiums written to statutory surplus
was 2.3 at December 31, 2003, compared to 2.4 at December 31, 2002.
The CDI is currently examining the statutory financial statements for the three
year period ended December 31, 2002. We are not aware of any proposed
adjustments to the statutory financial statements. On October 23, 2002, the CDI
finalized its examination report on the 1999 statutory financial statements for
the Company's California-domiciled insurance subsidiaries. The report did not
require the insurance subsidiaries to restate those financial statements.
Transactions with Related Parties. Since 1995, we have entered into several
transactions with AIG subsidiaries, including various reinsurance agreements,
which are discussed under "Item 1. Business." At December 31, 2003, reinsurance
recoverables, net of payables, from AIG subsidiaries were $5.8 million, compared
to $18.4 million at December 31, 2002. Other transactions with AIG subsidiaries,
which are immaterial, have resulted from competitive bidding processes for
certain corporate insurance coverages and certain software and data processing
services. In October 2003, as a result of a competitive bidding process, we
entered into an agreement with an AIG subsidiary to provide investment
management services to us; the agreement was subject to approval by the
California Department of Insurance, which granted such approval in October 2003.
Apart from the foregoing, we have no material transactions with related parties.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
We have various contractual obligations that are recorded as liabilities in our
consolidated financial statements. Certain contractual obligations, such as
operating lease obligations, are not recognized as liabilities in our
consolidated financial statements, but are required to be disclosed.
------------
1 On December 15, 2003, the Company declared a $1.7 million cash dividend to
stockholders of record on December 29, 2003, which was paid January 23,
2004.
25
The following table summarizes our significant contractual obligations and
commitments at December 31, 2003, and the future periods in which such
obligations are expected to be settled in cash. In addition, the table reflects
the timing of principal payments on outstanding senior notes.
Payments Due by Period
-----------------------------------------------
2005 2007 Remaining
through through years after
AMOUNTS IN MILLIONS TOTAL 2004 2006 2008 2008
------------------------------------------------------------------------------
Senior notes $159.0 $ 5.9 $ 11.8 $ 11.8 $ 129.5
Capital lease obligation 55.8 14.0 27.8 14.0 -
------------------------------------------------------------------------------
Debt 214.8 19.9 39.6 25.8 129.5
Operating Leases(1) 175.2 19.8 36.0 29.0 90.4
------------------------------------------------------------------------------
Total $390.0 $39.7 $ 75.6 $ 54.8 $ 219.9
------------------------------------------------------------------------------
The capital lease obligation above resulted from the sale-leaseback transaction
discussed earlier. The lease includes a covenant that if AIG ceases to have a
majority interest in us, or if statutory surplus falls below $300.0 million, or
if the net premiums written to surplus ratio is greater than 3.8:1, or if claims
paying ratings fall below BBB+ (as rated by Standard & Poor's), Baa1 (as rated
by Moody's) or B++ (as rated by A.M. Best) we will either deliver a letter of
credit to the lessor or pay the lessor the then outstanding balance, including a
prepayment penalty of up to 3%.
Our largest insurance subsidiary is the obligor on both the capital lease
obligation and the operating lease obligations.
We sponsor defined benefit pension plans that may obligate us to make
contributions to the plans from time to time. We do not expect to be required to
contribute to our qualified defined benefit plan in 2004, and contributions
required for 2005, if any, and future years will depend on a number of
unpredictable factors including the market performance of the plan's assets and
future changes in interest rates that affect the actuarial measurement of the
plan's obligations.
We had estimated liabilities for losses and LAE of $438.3 million at December
31, 2003, the majority of which will be required to be paid in 2004 as the
related claims are settled. We expect operating cash flow to be sufficient to
meet our obligations to pay claims and we have readily marketable investments
available for sale should operating cash flows prove to be inadequate.
We have no material purchase obligations or other on- or off-balance sheet long-
term liabilities or obligations at December 31, 2003 (see further discussion in
Note 2 of Notes to Consolidated Financial Statements).
OFF BALANCE SHEET ARRANGEMENTS
We currently have no letters of credit, have issued no guarantees on behalf of
others (other than the guarantee by 21st Century Insurance Group of the capital
lease obligation described above), have no trading activities involving
non-exchange-traded contracts accounted for at fair value, and have no
obligations under any derivative financial instruments. In addition, the Company
has no material retained interests in assets transferred to any unconsolidated
entity (see further discussion in Note 2 of Notes to Consolidated Financial
Statements).
RESULTS OF OPERATIONS
Overall Results. We reported net income of $53.6 million, or $0.63 earnings per
share (basic and diluted), on direct premiums written of $1,223.5 million for
the year ended December 31, 2003, compared to a net loss of $12.3 million, or
$0.14 loss per share, on direct premiums written of $998.2 million for the year
ended December 31, 2002. For the year ended December 31, 2001, we reported a net
loss of $27.6 million, or $0.32
------------
1 Includes amounts due under long-term software license agreements of
approximately $15.1 million.
26
loss per share, on direct premiums written of $929.3 million. The results for
2003, 2002 and 2001 include: (i) after-tax charges for 1994 Northridge
earthquake costs of $24.1 million, $34.2 million and $45.6 million,
respectively; (ii) after-tax net income of $9.6 million for the year ended
December 31, 2003, resulting from nonrecurring, nonoperational items and a
favorable tax settlement with the IRS; (iii) an after-tax charge of $24.2
million, for the year ended December 31, 2002, relating to a write-off of
software; and (iv) $13.6 million for the year ended December 31, 2001,
associated with workforce reductions and the settlement of litigation matters.
The following table presents the components of our personal auto lines
underwriting profit or loss and the components of the combined ratio for the
past three years:
AMOUNTS IN THOUSANDS Personal Auto Lines
---------------------------------
Years Ended December 31, 2003 2002 2001
---------------------------------------------------------------------------------
Direct premiums written $1,223,377 $995,794 $898,862
---------------------------------------------------------------------------------
Net premiums written $1,218,519 $976,892 $842,657
---------------------------------------------------------------------------------
Net premiums earned $1,172,679 $924,559 $838,489
Net losses and loss adjustment expenses 922,122 768,277 738,335
Underwriting expenses incurred 209,551 142,899 124,564
---------------------------------------------------------------------------------
Personal auto lines underwriting profit (loss) $ 41,006 $ 13,383 $(24,410)
---------------------------------------------------------------------------------
Ratios:
Loss and LAE ratio 78.6% 82.9% 88.1%
Underwriting expense ratio 17.9% 15.6% 14.9%
---------------------------------------------------------------------------------
Combined ratio 96.5% 98.5% 103.0%
---------------------------------------------------------------------------------
The following table reconciles our personal auto lines underwriting profit or
loss to our consolidated net income (loss):
AMOUNTS IN THOUSANDS
Years Ended December 31, 2003 2002 2001
-------------------------------------------------------------------------------
Personal auto lines underwriting profit (loss) $ 41,006 $ 13,383 $(24,410)
Homeowner and earthquake lines in runoff,
underwriting loss (40,175) (58,768) (77,598)
Net investment income 45,833 46,345 45,930
Realized investment gains 13,177 10,391 5,001
Write-off of software - (37,177) -
Other income (expense) 14,777 - (998)
Interest and fees expense (3,471) - -
Federal income tax (expense) benefit (17,572) 13,570 24,507
-------------------------------------------------------------------------------
Net income (loss) $ 53,575 $(12,256) $(27,568)
-------------------------------------------------------------------------------
Comments relating to the underwriting results of the personal auto and the
homeowner and earthquake lines in runoff are presented below.
UNDERWRITING RESULTS
The tables presented in the Notes to Consolidated Financial Statements summarize
the Company's unaudited quarterly results of operations for each of the two
years in the period ended December 31, 2003, and the results of operations by
line of business for each of the three years then ended. The following
discussion of underwriting results by line of business should be read in
conjunction with the information presented in those tables and elsewhere herein.
27
Personal Auto. Personal automobile insurance is our primary line of business.
Vehicles insured outside of California accounted for less than 3% of our direct
written premium in 2003, 2002 and 2001.
Direct premiums written for the year ended December 31, 2003, increased $227.6
million (22.9%) to $1,223.4 million in 2003 compared to $995.8 million in 2002
and $898.9 million in 2001. Of the $227.6 million increase in 2003, $35.2
million was due to rate increases, while $192.4 million was due to a higher
number of insured vehicles. Of the $96.9 million increase in 2002, $36.7 million
was due to rate increases, $12.9 million was due to the effects of the
consolidation of 21st of Arizona, and $47.3 million resulted from a higher
number of insured vehicles. Current growth is being generated through active
advertising for new customers and product innovations.
California auto retention was 92% for the year ended December 31, 2003, compared
to 93% and 92% for the years ended December 31, 2002 and 2001, respectively. The
decline in 2003 is primarily due to the April 2003 rate increase and the
substantial increase in new customers, who typically have a lower retention rate
than long-time customers.
Net premiums earned increased $248.1 million (26.8%) to $1,172.7 million in
2003, compared to $924.6 million in 2002 and $838.5 million in 2001. The
increases in 2003, 2002 and 2001 are greater than the proportional increase in
the corresponding direct premiums written because of the decrease in the quota
share reinsurance arrangement with AIG subsidiaries from 6% in 2001 to 4% until
September 1, 2002, at which time we entered into an agreement to cancel future
cessions under this treaty. The cancellation resulted in a one-time pre-tax
charge of $0.9 million.
The combined ratio was 96.5% for the year ended December 31, 2003, compared to
98.5% and 103.0% for 2002 and 2001, respectively. Our management remains focused
on achieving sustainable 15% growth and a combined ratio of 96%. In 2003, we
achieved an underwriting profit in each quarter and achieved growth of 22.9%,
our best growth since 1987.
Net losses and LAE incurred increased $153.8 million (20.0%) to $922.1 million
in 2003 compared to $768.3 million and $738.3 million in 2002 and 2001,
respectively. The loss and LAE ratios were 78.6%, 82.9% and 88.1% for the years
ended December 31, 2003, 2002 and 2001, respectively. The effects on the loss
and LAE ratios of changes in estimates relating to insured events of prior years
were 1.0% in 2003, 1.8% in 2002 and 5.5% in 2001. These changes in estimates
pertained mainly to development in average paid loss severities beyond amounts
previously anticipated. For additional discussion of the factors that led to
these changes in estimates, please see Item 1 of this report under the heading
Loss and Loss Adjustment Expense Reserves. In general, changes in estimates are
recorded in the period in which new information becomes available indicating
that a change is warranted, usually in conjunction with our monthly actuarial
review.
The ratios of underwriting expenses to net premiums earned were 17.9%, 15.6% and
14.9% for the years ended December 31, 2003, 2002 and 2001, respectively. The
increase was primarily due to growth in advertising expenditures and costs
associated with increasing the number of new sales agents to handle record
volume of new business during the latter half of 2002 and all of 2003. Several
productivity enhancement initiatives are underway aimed at reducing per unit
process costs and lowering fixed costs in corporate support areas.
In the third quarter of 2002 the Company entered into a catastrophe reinsurance
agreement, which reinsures any covered events, defined as auto physical damage,
up to $30.0 million in excess of $15.0 million. This agreement expired on
December 31, 2003. Effective January 1, 2004 we entered into a new, one-year
catastrophe reinsurance agreement, which provides reinsurance on covered events
up to $45 million in excess of $20 million. The premium for this reinsurance
coverage is approximately $0.1 million per month.
Homeowner and Earthquake Lines in Runoff. The homeowner and earthquake lines,
which are in runoff, experienced adverse development on the remaining loss
reserves of $40.1 million, compared to adverse development of $56.2 million in
2002 and $72.3 million in 2001, of which development related to SB 1899
earthquake claims accounted for $36.9 million, $52.6 million, and $70.3 million,
respectively.
28
We have executed various transactions to exit from our homeowner line. Under a
January 1, 2002 agreement with Balboa Insurance Company ("Balboa"), a subsidiary
of Countrywide Financial Corporation ("Countrywide"), 100% of homeowner unearned
premium reserves and losses on or after that date were ceded to Balboa. Under
the terms of this agreement, we retain certain loss adjustment expenses. We
began non-renewing homeowner policies expiring on February 21, 2002, and
thereafter. Substantially all of these customers were offered homeowner coverage
through an affiliate of Countrywide. We have completed this process and no
longer have any homeowner policies in force.
We caution that the recorded loss and LAE estimates for our earthquake lines are
subject to a greater than normal degree of uncertainty for a variety of reasons
(see Note 16 of the Notes to Consolidated Financial Statements).
LOSS AND LAE INCURRED
The following table summarizes losses and LAE incurred, net of reinsurance, for
the periods indicated:
AMOUNTS IN THOUSANDS
Years Ended December 31, 2003 2002 2001
---------------------------------------------------------------------------------------
Net Losses and LAE incurred related to insured events of:
Current year:
Personal auto lines $910,963 $752,077 $692,593
Homeowner lines 141 2,222 25,636
Earthquake lines - - -
---------------------------------------------------------------------------------------
Total current year 911,104 754,299 718,229
---------------------------------------------------------------------------------------
Prior years:
Personal auto lines 11,159 16,200 45,742
Homeowner lines 3,125 3,519 1,952
Earthquake lines 36,923 52,639 70,313
---------------------------------------------------------------------------------------
Total prior years 51,207 72,358 118,007
---------------------------------------------------------------------------------------
Total $962,311 $826,657 $836,236
---------------------------------------------------------------------------------------
Historically, our actuaries have not projected a range around the carried loss
reserves. Rather, they have used several methods and different underlying
assumptions to produce a number of point estimates for the required reserves.
Management reviews the assumptions underlying the loss ratios and selects the
carried reserves after carefully reviewing the appropriateness of the underlying
assumptions in relation to the outstanding exposures. These assumptions include,
but are not limited to, the following: prior accident year and policy year loss
ratios; rate changes in coverage, reinsurance, or mix of business; and changes
in external factors impacting results, such as trends in loss costs or in the
legal and claims environment. If our carried reserves are supported by actuarial
methods and assumptions that are also believed to be reasonable, then the
carried reserves would generally be considered reasonable, and no adjustment
would be considered. The ultimate process by which the actual carried reserves
are determined considers not only the actuarial point estimate, but also a
number of other factors.
Other internal and external factors considered include a qualitative assessment
of inflation and other economic conditions, changes in legal, regulatory, and
judicial environments underlying policy pricing, terms and conditions, and
claims handling.
Generally, actual historical loss development factors are the primary
assumptions used to project future loss development. However, there can be no
assurance that future loss development patterns will be the same as in the past.
Historically, our carried loss reserves have developed both redundancies and
deficiencies. Adverse development for our personal auto lines was less than 5%
of carried personal auto lines reserves in 2003 and 2002, and approximately 15%
of such reserves in 2001. If future loss
29
development differed by 5 percent from those assumptions utilized in the
year-end 2003 personal auto lines loss reserve review, there would be
approximately a $21.0 million redundancy or deficiency in the overall personal
auto lines reserve position.
While we have settled earthquake claims and are making progress in resolving
outstanding litigation, estimates of both the litigation costs and ultimate
settlement or judgment amounts related to these claims are subject to a high
degree of uncertainty. Please see Note 16 of the Notes to Consolidated Financial
Statements for additional background on the Northridge Earthquake and SB 1899,
including a discussion of factors that have contributed to the difficulty of
obtaining accurate loss and LAE estimates in the wake of that legislation.
INVESTMENT INCOME
We utilize a conservative investment philosophy. No derivatives or
nontraditional securities are held in our investment portfolio and less than 1%
of the portfolio consists of equity securities. Substantially the entire
portfolio is investment grade. Net investment income was $45.8 million in 2003,
compared to $46.3 million in 2002 and $45.9 million in 2001. Average invested
assets increased 17.9% in 2003 and 1.3% in 2002 from each of the respective
prior years. The average annual pre-tax yields on invested assets were 4.2% in
2003, 5.1% in 2002 and 2001. The average annual after-tax yields on invested
assets were 3.6% in 2003, 4.3% in 2002 and 4.5% in 2001.
Net realized gains on the sale of investments and fixed assets were $13.2
million in 2003 (gross realized gains were $13.7 million and gross realized
losses were $0.5 million), compared to $10.4 million in 2002 (gross realized
gains were $13.1 million and gross realized losses were $2.7 million) and net
realized gains of $5.0 million in 2001. At December 31, 2003, $791.6 million
(64.9%) of our total investments at fair value were invested in tax-exempt bonds
with the remainder, representing 35.1% of the portfolio, invested in taxable
securities, compared to 60.7% and 39.3%, respectively, at December 31, 2002.
As of December 31, 2003, we had a pre-tax net unrealized gain of $36.1 million
compared to a net unrealized gain on fixed maturity investments of $38.5 million
in 2002 and a net unrealized loss of $1.5 million in 2001. We recognized no
other-than-temporary impairments in 2003, 2002, or 2001 (see discussion under
Critical Accounting Policies).
OTHER INCOME
Other income in the year ended December 31, 2003, included $9.3 million
resulting from a nonrecurring, nonoperational item from the settlement of
litigation, interest income of $4.8 million relating to a favorable settlement
with the Internal Revenue Service ("IRS"), and miscellaneous items of $0.7
million.
WRITE-OFF OF SOFTWARE
In the third quarter of 2002, we recorded a one-time pre-tax charge to write-off
$37.2 million of previously capitalized software costs for abandoned portions of
an advanced personal lines processing system.
CRITICAL ACCOUNTING POLICIES
Our financial statements are prepared in accordance with accounting principles
generally accepted in the United States of America. The financial information
contained within those statements is, to a significant extent, financial
information that is based on approximate measures of the financial effects of
transactions and events that have already occurred. Our significant accounting
policies are described in Note 2 of Notes to Consolidated Financial Statements
and are essential to understanding Management's Discussion and Analysis of
Results of Operations and Financial Condition. Some of our accounting policies
require significant judgment to estimate values of either assets or liabilities.
In addition, significant judgment may be needed to apply what often are complex
accounting principles to individual transactions to determine the most
appropriate treatment. We have established procedures and processes to
facilitate making the judgments necessary to prepare financial statements.
The following is a summary of the more judgmental and complex accounting
estimates and principles. In each area, we have discussed the assumptions most
important in the estimation process. We have used the
30
best information available to estimate the related items involved. Actual
performance that differs from our estimates and future changes in the key
assumptions could change future valuations and materially impact our financial
condition and results of operations.
Management has discussed our critical accounting policies and estimates,
together with any changes therein, with the Audit Committee of our Board of
Directors.
Losses and Loss Adjustment Expenses. The estimated liabilities for losses and
loss adjustment expenses ("LAE") include the accumulation of estimates of losses
for claims reported prior to the balance sheet dates, estimates (based upon
actuarial analysis of historical data) of losses for claims incurred but not
reported, the development of case reserves to ultimate values and estimates of
expenses for investigating, adjusting and settling all incurred claims. Amounts
reported are estimates of the ultimate costs of settlement, net of estimated
salvage and subrogation. The estimated liabilities are necessarily subject to
the outcome of future events, such as changes in medical and repair costs, as
well as economic and social conditions that impact the settlement of claims. In
addition, time can be a critical part of reserving determinations since the
longer the span between the incidence of a loss and the payment or settlement of
the claim, the more variable the ultimate settlement amount can be.
Accordingly, short-tail claims, such as property damage claims, tend to be more
reasonably predictable than long-tail liability claims. For our current mix of
auto exposures, which include both property and liability exposures, an average
of approximately 80% of the ultimate losses are settled within twelve months of
the date of loss. Given the inherent variability in the estimates, management
believes the aggregate reserves are adequate, although we continue to caution
that the reserve estimates relating to SB 1899 are subject to a greater than
normal degree of variability and possible future material adjustment as new
facts become known. The methods of making such estimates and establishing the
resulting reserves are reviewed and updated monthly and any resulting
adjustments are reflected in current operations. Changes in the estimates for
these liabilities flow directly to the income statement on a dollar-for-dollar
basis. For example, an upward revision of $1 million in the estimated liability
for unpaid losses and loss adjustment expenses would decrease underwriting
profit, and pre-tax income, by the same $1 million amount. Conversely, a
downward revision of $1 million would increase pre-tax income by the same $1
million amount.
Property and Equipment. Accounting standards require a write-off to be
recognized when an asset is abandoned or an asset group's carrying value exceeds
its fair value. For purposes of recognition and measurement of an impairment
loss, a long-lived asset or assets are grouped with other assets and liabilities
at the lowest level for which identifiable cash flows are largely independent of
the cash flows of other assets and liabilities. Accounting standards require
asset groups to be tested for possible impairment under certain conditions. In
the third quarter of 2002, we recorded a pre-tax charge to write-off $37.2
million of previously capitalized software costs for abandoned portions of an
advanced personal lines processing system. As such, in 2002 we assessed the
asset group that included the advanced personal lines processing system for
impairment. However, an impairment was not triggered by the abandonment as we
determined that the impairment recognition criterion had not been met. Future
cash flows expected to be generated by the asset group exceeded their carrying
amount. There have been no events or circumstances in 2003 that would require a
reassessment of the asset group for impairment.
Income Taxes. Determining the consolidated provision for income tax expense,
deferred tax assets and liabilities and any related valuation allowance involves
judgment. Generally accepted accounting principles require deferred tax assets
and liabilities ("DTAs" and "DTLs," respectively) to be recognized for the
estimated future tax effects attributed to temporary differences and
carryforwards based on provisions of the enacted tax law. The effects of future
changes in tax laws or rates are not anticipated. Temporary differences
31
are differences between the tax basis of an asset or liability and its reported
amount in the financial statements. For example, we have a DTA because the tax
bases of our loss and LAE reserves are smaller than their book bases. Similarly,
we have a DTL because the book basis of our capitalized software exceeds its tax
basis. Carryforwards include such items as alternative minimum tax credits,
which may be carried forward indefinitely, and net operating losses ("NOLs"),
which can be carried forward 15 years for losses incurred before 1998 and 20
years thereafter. A summary of the significant DTAs and DTLs relating to the
Company's temporary differences and carryforwards is included in Note 5 of the
Notes to Consolidated Financial Statements.
At December 31, 2003, our DTAs total $149.1 million, and our DTLs total $72.5
million. The net of those amounts, $76.6 million, represents the net deferred
tax asset reported in the consolidated balance sheet.
We are required to reduce DTAs (but not DTLs) by a valuation allowance to the
extent that, based on the weight of available evidence, it is "more likely than
not" (i.e., a likelihood of more than 50%) that any DTAs will not be realized.
Recognition of a valuation allowance would decrease reported earnings on a
dollar for dollar basis in the year in which any such recognition were to occur.
The determination of whether a valuation allowance is appropriate requires the
exercise of management judgment. In making this judgment, management is required
to weigh the positive and negative evidence as to the likelihood that the DTAs
will be realized.
Portions of our NOL carryforward are scheduled to expire beginning in 2009, as
shown in the table below (amounts in millions):
YEAR OF NOL EXCLUDING SRLY(1) NOL OF CONSOLIDATED
EXPIRATION 21ST OF ARIZONA 21ST OF ARIZONA NOL
-------------------------------------------------------------
2009 $37.9 $ - $37.9
2011 - 0.6 0.6
2017 - 2.0 2.0
2018 - 1.1 1.1
2019 - 1.5 1.5
2020 80.5 3.2 83.7
2021 134.6 2.2 136.8
2022 37.3 - 37.3
-------------------------------------------------------------
Totals $290.3 $10.6 $300.9
-------------------------------------------------------------
Our core business has generated an underwriting profit for the past two years.
Management believes it is reasonable to expect future underwriting profits and
to conclude it is at least more likely than not that we will be able to realize
the benefits of our DTAs. If necessary, we believe we could implement
tax-planning strategies, such as investing a higher proportion of our investment
portfolio in taxable securities, in order to generate sufficient future taxable
income to utilize the NOL carryforwards prior to their expiration. Accordingly,
no valuation allowance has been recognized as of December 31, 2003. However,
generating future taxable income is dependent on a number of factors, including
regulatory and competitive influences that may be beyond our ability to control.
Future underwriting losses could possibly jeopardize our ability to utilize our
NOLs. In the event adverse development or underwriting losses due to either SB
1899 matters or other causes were to occur, management might be required to
reach a different conclusion about the realization of the DTAs and, if so,
recognize a valuation allowance at that time.
Deferred Policy Acquisition Costs. Deferred policy acquisition costs ("DPAC")
include premium taxes and other variable costs incurred in connection with
writing business. These costs are deferred and amortized over the 6-month policy
period in which the related premiums are earned.
------------
1 "SRLY" stands for Separate Return Limitation Year. Under the Federal tax
code, only future income generated by 21st of Arizona may be utilized
against this portion of our NOL.
32
Management assesses the recoverability of deferred policy acquisition costs on a
quarterly basis. The assessment calculates the relationship of actuarially
estimated costs incurred to premiums from contracts issued or renewed for the
period. We do not consider anticipated investment income in determining the
recoverability of these costs. Based on current indications, no reduction in
DPAC is required.
The loss and LAE ratio used in the recoverability estimate is based primarily on
the assumption that the future loss and LAE ratio will approximate that of the
recent past. While management believes that is a reasonable assumption, actual
results could differ materially from such estimates.
Investments. Impairment losses for declines in value of fixed maturity
investments below cost attributable to issuer-specific events are based upon all
relevant facts and circumstances for each investment and are recognized when
appropriate in accordance with Staff Accounting Bulletin ("SAB") 59, Noncurrent
Marketable Equity Securities, Emerging Issues Task Force ("EITF") No. 99-20,
Recognition of Interest Income and Impairment of Certain Investments, EITF No.
03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments, and related guidance, which is evolving. For fixed maturity
investments with unrealized losses due to market conditions or industry-related
events, where we have the positive intent and ability to hold the investment for
a period of time sufficient to allow a market recovery or to maturity, declines
in value below cost are not assumed to be other-than-temporary. Where declines
in values of securities below cost or amortized cost are considered to be other
than temporary, a charge is required to be reflected in income for the
difference between cost or amortized cost and the fair value. No such charges
were recorded in 2003, 2002 or 2001.
The determination of whether a decline in market value is "other than temporary"
is necessarily a matter of subjective judgment and the guidance is continually
evolving. The timing and amount of realized losses and gains reported in income
could vary if conclusions other than those made by management were to determine
whether an other-than-temporary impairment exists. However, there would be no
impact on equity because any unrealized losses are already included in
accumulated other comprehensive income.
A summary by issuer of non-investment grade securities and unrated securities
held at year-end follows:
AMOUNTS IN THOUSANDS
December 31, 2003 2002
------------------------------------------------------------------------
Non-investment grade securities (i.e., rated below BBB):
Corning, Inc. $ - $ 850
Unrated securities:
Impact Community Capital LLC(1) 2,023 2,023
Impact C.I.L. Parent 2,444 -
------------------------------------------------------------------------
Total non-investment grade and unrated securities $4,467 $2,873
------------------------------------------------------------------------
-----------
1 Impact Community Capital LLC, is a limited partnership that was
established under California's COIN program (California Organized
Investment Network), a voluntary association of California insurers
providing funding for low cost housing projects.
33
The following table summarizes realized gains and losses for the past three
years. Additional information has been provided with respect to how long
securities sold at a loss in each year were in an unrealized loss position.
AMOUNTS IN THOUSANDS
Years Ended December 31, 2003 2002 2001
---------------------------------------------------------------------------------------------------
Realized (losses) on sales of securities:
Held for less than one year $ (229) $(322) (322) $ (147)
---------------------------------------------------------------------------------------------------
Held one year or more
In an unrealized loss position at December 31, 2002 (148) - N/A
In an unrealized loss position at December 31, 2001 - (83) N/A
In an unrealized loss position at December 31, 2000 - - -
In an unrealized loss position at December 31, 1999 - (196) (372)
In an unrealized loss position at December 31, 1998 - (1,567) (141)
In an unrealized loss position at December 31, 1997 - - (216)
In an unrealized gain position at December 31, 2002 (5) - N/A
In an unrealized gain position at December 31, 2001 - (15) N/A
In an unrealized gain position at December 31, 2000 - - (235)
In an unrealized gain position at December 31, 1999 - - -
---------------------------------------------------------------------------------------------------
Total realized losses on sales of fixed maturity securities held
one year or more(1) (153) (1,861) (964)
---------------------------------------------------------------------------------------------------
Total realized loss on sales of securities (382) (2,183) (1,111)
Total realized gain on sales of securities 13,715 13,053 5,912
Realized gain (loss) on disposal of property and equipment (156) (479) 200
---------------------------------------------------------------------------------------------------
Total realized investment gains $13,177 $ 10,391 $ 5,001
---------------------------------------------------------------------------------------------------
The following table summarizes the fair values of fixed maturity securities sold
at a loss or at a gain on the date of sale:
Fair Value of Fixed Maturity
AMOUNTS IN THOUSANDS Securities Sold at a Loss
----------------------------
Years Ended December 31, 2003 2002 2001
-------------------------------------------------------------------------------------
Fair value of securities sold at a loss on date of sale $ 21,002 $111,144 $140,334
Fair value of securities sold at a gain on date of sale $297,230 $470,043 $363,467
The following table summarizes securities held by us having an unrealized loss
of $0.1 million or more and aggregate information relating to all other
investments in unrealized loss positions as of December 31:
2003 2002
-----------------------------------------------------------------------------------------------------------------------------
AMOUNTS IN THOUSANDS,
EXCEPT NUMBER OF ISSUES UNREALIZED # Unrealized
December 31, # ISSUES FAIR VALUE LOSS issues Fair Value Loss
-----------------------------------------------------------------------------------------------------------------------------
Fixed maturity securities with unrealized losses:
Exceeding $0.1 million and for:
Less than 6 months 4 $50,512 $680 3 $20,769 $1,601
6-12 months 2 8,509 662 2 7,431 530
More than 1 year - - - 1 850 131
Less than $0.1 million 83 179,166 2,074 16 44,590 405
-----------------------------------------------------------------------------------------------------------------------------
Total(2) 89 $238,187 $3,416 22 $73,640 $2,667
-----------------------------------------------------------------------------------------------------------------------------
-----------
1 Amount represents less than 0.001% of total fixed maturity securities.
2 Fair value of fixed maturity securities with unrealized losses represents
less than 20% of total fixed maturity securities.
34
A summary by contractual maturity of bonds in an unrealized loss position by
year of maturity follows:
2003 2002
--------------------------------------------
AMOUNTS IN THOUSANDS AMORTIZED CARRYING AMORTIZED CARRYING
December 31, COST VALUE COST VALUE
--------------------------------------------------------------------------------------
Bond Maturities
Due in one year or less $ 2,519 $ 2,515 $ - $ -
Due after one year through five years 78,687 77,590 5,415 5,076
Due after five years through ten years 47,026 45,975 30,099 28,280
Due after ten years 113,371 112,107 40,792 40,284
--------------------------------------------------------------------------------------
$ 241,603 $ 238,187 $ 76,306 $ 73,640
--------------------------------------------------------------------------------------
Stock-based compensation. Under the provisions of Statement of Financial
Standards No. 123, Accounting for Stock-Based Compensation, we have elected to
continue using the intrinsic-value method of accounting for stock-based awards
granted to employees in accordance with Accounting Principles Board Opinion No.
25, Accounting for Stock Issued to Employees. Accordingly, we have not
recognized in income any compensation expense for the fair value of stock
options awarded to employees. Companies electing to continue to follow the
intrinsic-value method must make pro forma disclosures, as if the fair value
based method of accounting had been applied. A summary of the expense that would
have been recorded, together with the underlying assumptions, had we recognized
for the fair value of stock-based awards is included in Notes 2 and 14 of the
Notes to Consolidated Financial Statements.
NEW ACCOUNTING PRONOUNCEMENTS
In May 2003, the Financial Accounting Standards Board ("FASB") issued SFAS No.
150, Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity. SFAS No. 150 establishes standards for how an issuer
classifies and measures certain financial instruments with characteristics of
both liabilities and equity. The adoption of SFAS No. 150 in the third quarter
of 2003 did not have an impact on the Company's results of operation or
financial position.
In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of
Variable Interest Entities an interpretation of ARB No. 51 ("FIN 46"), and
amended it in December 2003. An entity is subject to the consolidation rules of
FIN 46 and is referred to as a variable interest entity ("VIE") if it lacks
sufficient equity to finance its activities without additional financial support
from other parties or if its equity holders lack adequate decision making
ability based on criteria set forth in the interpretation. We do not have any
material VIEs that we need, or will need, to consolidate or disclose (see Note 2
of the Notes to Consolidated Financial Statements for additional discussion
related to VIEs).
FORWARD-LOOKING STATEMENTS
This report contains statements that constitute forward-looking information.
Investors are cautioned that these forward-looking statements are not guarantees
of future performance or results and involve risks and uncertainties, and that
actual results or developments may differ materially from the forward-looking
statements as a result of various factors. You should not rely on
forward-looking statements in this annual report on Form 10-K. Forward-looking
statements are statements not based on historical information and which relate
to future operations, strategies, financial results or other developments. You
can usually identify forward-looking statements by terminology such as "may,"
"will," "should," "expect," "plan," "anticipate," "believe," "estimate,"
"predict," "intend," "potential," or "continue" or with the negative of these
terms or other comparable terminology.
35
Although we believe that the expectations reflected in these forward-looking
statements are reasonable, we cannot guarantee our future results, level of
activity, performance or achievements. Forward-looking statements may address,
among other things: discussions concerning our potential expectation, beliefs,
estimates, forecasts, projections and assumptions:
- Our strategy for growth;
- Underwriting results;
- Our expected combined ratio and growth of written premiums;
- Product development;
- Computer systems;
- Regulatory approvals;
- Market position;
- Financial results;
- Dividend policy; and
- Reserves.
It is possible that our actual results, actions and financial condition may
differ, possibly materially, from the anticipated results, actions and financial
condition indicated in these forward-looking statements. Important factors that
could cause our actual results and actions to differ, possibly materially, from
those in the specific forward-looking statements include those discussed in this
report under the heading "Management's Discussion and Analysis of Financial
Condition and Results of Operations" as well as:
- The effects of competition and competitors' pricing actions;
- Adverse underwriting and claims experience, including as a result of
revived earthquake claims under SB 1899;
- Customer service problems;
- The impact on our operations of natural disasters, principally earthquake,
or civil disturbance, due to the concentration of our facilities and
employees in Woodland Hills, California;
- Information system problems, including failures to implement information
technology projects on time and within budget;
- Adverse developments in financial markets or interest rates;
- Results of legislative, regulatory or legal actions, including the
inability to obtain approval for rate increases and product changes and
adverse actions taken by state regulators in market conduct examinations;
and
- Our ability to service the senior notes, including our ability to receive
dividends and/or sufficient payments from our subsidiaries to service our
obligations.
We do not undertake any obligation to update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.
36
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and
interest rates. In addition to market risk we are exposed to other risks,
including the credit risk related to our financial instruments and the
underlying insurance risk related to our core business and the exposure of the
personal lines insurance business, as a regulated industry, to legal,
legislative, judicial, political and regulatory action. The following table
shows the financial statement carrying values of our financial instruments,
which are reported at fair value. The estimated fair values at adjusted market
rates/prices assumes a 100 basis point increase in market interest rates for the
investment portfolio and a 100 basis point decrease in market interest rates for
the debt. The following sensitivity analysis summarizes only the exposure to
market interest rate risk as of December 31, 2003.
Estimated Fair Value Change in
at Adjusted Market Value as a
AMOUNTS IN MILLIONS Carrying Rates/Prices Percentage of
December 31, 2003 Value Indicated Below Carrying Value
------------------------------------------------------------------------------------------------
Fixed maturity investments available for sale $ 1,219.7 $ 1,121.9 8.02%
Debt 149.7 158.9 6.15%
Our cash flow from operations and short-term cash position generally is more
than sufficient to meet our obligations for claim payments, which by the nature
of the personal automobile insurance business tend to have an average duration
of less than a year. As a result, it has been unnecessary for us to employ
elaborate market risk management techniques involving complicated asset and
liability duration matching or hedging strategies. For all of our financial
assets and liabilities, we seek to maintain reasonable average durations,
currently approximately 6 years, consistent with the maximization of income
without sacrificing investment quality and providing for liquidity and
diversification. Financial instruments are not used for trading purposes.
The sensitivity analysis provides only a limited, point-in-time view of the
market risk sensitivity of our financial instruments. The actual impact of
market interest rate and price changes on the financial instruments may differ
significantly from those shown in the analysis.
37
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT AUDITORS
STOCKHOLDERS AND BOARD OF DIRECTORS
21ST CENTURY INSURANCE GROUP
In our opinion, the consolidated financial statements listed in the index
appearing under Item 15(a)(1) on page 70 present fairly, in all material
respects, the financial position of 21st Century Insurance Group and its
subsidiaries at December 31, 2003 and 2002, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2003 in conformity with accounting principles generally accepted in the
United States of America. In addition, in our opinion, the financial statement
schedule for each of the three years in the period ended December 31, 2003
listed in the index appearing under Item 15(a)(2) on page 70 presents fairly, in
all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements. These financial
statements and financial statement schedule are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements and financial statement schedule based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
Los Angeles, California
February 10, 2004
38
21ST CENTURY INSURANCE GROUP
CONSOLIDATED BALANCE SHEETS
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
December 31, 2003 2002
-------------------------------------------------------------------------------------------------
ASSETS
Fixed maturity investments available-for-sale, at fair value
(amortized cost: $1,183,526 and $886,047) $1,219,676 $ 924,581
Cash and cash equivalents 64,065 105,897
-------------------------------------------------------------------------------------------------
Total investments and cash 1,283,741 1,030,478
Accrued investment income 14,746 13,230
Premiums receivable 104,638 91,029
Reinsurance receivables and recoverables 12,135 28,105
Prepaid reinsurance premiums 1,719 1,893
Deferred income taxes 76,611 88,939
Deferred policy acquisition costs 53,079 46,190
Leased property under capital lease, net of deferred gain of
$4,698 and $6,280 and net of accumulated amortization of
$12,397 and $0 42,534 53,720
Property and equipment, at cost less accumulated depreciation of
$60,070 and $52,125 101,237 87,274
Other assets 46,747 29,179
-------------------------------------------------------------------------------------------------
Total assets $1,737,187 $1,470,037
-------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Unpaid losses and loss adjustment expenses $ 438,323 $ 384,009
Unearned premiums 312,254 266,477
Debt 149,686 60,000
Claims and other outstanding checks payable 44,757 39,304
Reinsurance payable 1,761 4,952
Other liabilities 89,716 59,687
-------------------------------------------------------------------------------------------------
Total liabilities 1,036,497 814,429
-------------------------------------------------------------------------------------------------
Commitments and contingencies
Stockholders' equity:
Common stock, par value $0.001 per share in 2003, no par value in
2002; 110,000,000 shares authorized; shares issued & outstanding
85,435,505 and 85,431,505 85 418,984
Additional paid-in capital 419,245 -
Retained earnings 259,808 213,067
Accumulated other comprehensive income (loss):
Unrealized gains on available-for-sale investments, net of
deferred income tax expense of $12,653 and of $13,487 23,497 25,047
Minimum pension liability in excess of unamortized prior
service cost, net of deferred income tax benefit of $1,047 and $802 (1,945) (1,490)
-------------------------------------------------------------------------------------------------
Total stockholders' equity 700,690 655,608
-------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $1,737,187 $1,470,037
-------------------------------------------------------------------------------------------------
See accompanying Notes to Consolidated Financial Statements.
39
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Years Ended December 31, 2003 2002 2001
-----------------------------------------------------------------------------------------
REVENUES
Net premiums earned $ 1,172,677 $ 924,559 $ 864,145
Net investment income 45,833 46,345 45,930
Net realized investment gains 13,177 10,391 5,001
Other income 14,777 - (998)
-----------------------------------------------------------------------------------------
Total revenues 1,246,464 981,295 914,078
-----------------------------------------------------------------------------------------
LOSSES AND EXPENSES
Net losses and loss adjustment expenses 962,311 826,657 836,236
Policy acquisition costs 202,189 123,642 102,558
Other operating expenses 7,346 19,645 27,359
Write-off of software - 37,177 -
Interest and fees expense 3,471 - -
-----------------------------------------------------------------------------------------
Total losses and expenses 1,175,317 1,007,121 966,153
-----------------------------------------------------------------------------------------
Income (loss) before provision for income taxes 71,147 (25,826) (52,075)
Provision for income taxes 17,572 (13,570) (24,507)
-----------------------------------------------------------------------------------------
Net income (loss) $ 53,575 $ (12,256) $ (27,568)
-----------------------------------------------------------------------------------------
EARNINGS (LOSS) PER COMMON SHARE
Basic and diluted $ 0.63 $ (0.14) $ (0.32)
-----------------------------------------------------------------------------------------
Weighted average shares outstanding - basic 85,432,838 85,414,076 85,340,461
-----------------------------------------------------------------------------------------
Weighted average shares outstanding - diluted 85,637,672 85,414,076 85,340,461
-----------------------------------------------------------------------------------------
See accompanying Notes to Consolidated Financial Statements.
40
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
AMOUNTS IN THOUSANDS, Common Stock
----------------------------------
EXCEPT SHARE DATA No par $0.001 par Accumulated
value value Additional Other
---------------------------------- Paid in Retained Comprehensive
Shares Amount Amount Capital Earnings Income (Loss) Total
------------------------------------------------------------------------------------------------------------------------------
Balance - January 1, 2001 85,145,817 $ 415,064 $ - $ - $ 303,714 $ 1,783 $720,561
Comprehensive loss (27,568)(1) (8,103)(2) (35,671)
Cash dividends declared on
common stock ($0.32 per share) (27,310) (27,310)
Other 216,031 1,927 (201) 1,726
------------------------------------------------------------------------------------------------------------------------------
Balance - December 31, 2001 85,361,848 416,991 - - 248,635 (6,320) 659,306
Comprehensive (loss) income (12,256)(1) 29,877 (2) 17,621
Cash dividends declared on
common stock ($0.26 per share) (22,210) (22,210)
Other 69,657 1,993 (1,102) 891
------------------------------------------------------------------------------------------------------------------------------
Balance - December 31, 2002 85,431,505 418,984 - - 213,067 23,557 655,608
Comprehensive income (loss) 53,575 (1) (2,005)(2) 51,570
Cash dividends declared on
common stock ($0.08 per share) (6,834) (6,834)
Other 4,000 346 346
Effects of reincorporation (419,330) 85 419,245 -
------------------------------------------------------------------------------------------------------------------------------
Balance - December 31, 2003 85,435,505 $ - $ 85 $ 419,245 $ 259,808 $ 21,552 $ 700,690
------------------------------------------------------------------------------------------------------------------------------
(1) Net (loss) income for the year.
(2) Net change in accumulated other comprehensive income (loss) for 2003, 2002 and 2001 is as follows:
Years Ended December 31, 2003 2002 2001
----------------------------------------------------------------------------------------------------------------------
Unrealized gain (loss) on available-for-sale investments, net of tax expense (benefit) of
$3,833, $17,811 and $(152), respectively $ 7,116 $33,078 $ (282)
Less reclassification adjustment for investment gains included in net income, net of tax
expense of $4,667, $3,805 and $1,784, respectively 8,666 7,065 3,314
Minimum pension liability in excess of unamortized prior service cost, net of deferred
income tax expense (benefit) of $245, $(2,081), and $2,427, respectively (455) 3,864 (4,507)
----------------------------------------------------------------------------------------------------------------------
Total $(2,005) $29,877 $(8,103)
----------------------------------------------------------------------------------------------------------------------
See accompanying Notes to Consolidated Financial Statements
41
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Years Ended December 31, 2003 2002 2001
-------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net income (loss) $ 53,575 $ (12,256) $ (27,568)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization 23,962 20,341 21,031
Write-off of software - 37,177 -
Amortization of restricted stock grants 346 506 695
Provision (benefit) for deferred income taxes 13,406 (5,370) (19,418)
Realized gains on sale of investments (13,177) (10,391) (5,001)
Changes in assets and liabilities:
Reinsurance balances 12,953 17,542 11,797
Federal income taxes (2,825) 4,670 5,759
Other assets (25,562) (38,068) (5,264)
Unpaid losses and loss adjustment expenses 54,314 34,720 50,854
Unearned premiums 45,777 30,004 (46)
Claims and other outstanding checks payable 5,453 3,198 123
Other liabilities 19,293 (5,781) 19,572
-------------------------------------------------------------------------------------------
Net cash provided by operating activities 187,515 76,292 52,534
-------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Fixed maturities available-for-sale
Purchases (641,433) (625,690) (461,578)
Calls or maturities 38,592 41,850 15,783
Sales 314,648 564,398 502,254
Net purchases of property and equipment (23,355) (19,140) (61,247)
-------------------------------------------------------------------------------------------
Net cash used in investing activities (311,548) (38,582) (4,788)
-------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Proceeds from issuance of debt 99,871 60,000 -
Repayment of debt (10,185) - -
Payment of debt issuance costs (650) - -
Dividends paid (per share: $0.08; $0.26; and $0.32) (6,835) (22,210) (27,310)
Proceeds from the exercise of stock options - 1,488 1,233
-------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities 82,201 39,278 (26,077)
-------------------------------------------------------------------------------------------
Net (decrease) increase in cash and cash equivalents (41,832) 76,988 21,669
Cash and cash equivalents, beginning of year 105,897 28,909 7,240
-------------------------------------------------------------------------------------------
Cash and cash equivalents, end of year $ 64,065 $ 105,897 $ 28,909
-------------------------------------------------------------------------------------------
SUPPLEMENTAL INFORMATION
Income taxes paid (refunded) $ - $ (12,920) $ (11,435)
Interest paid 2,975 - -
See accompanying Notes to Consolidated Financial Statements.
42
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 1. DESCRIPTION OF BUSINESS
--------------------------------
21st Century Insurance Group is an insurance holding company founded in 1958,
which until recently was incorporated in California. Effective December 4, 2003,
the Company was incorporated under the laws of the State of Delaware. The term
"Company," unless the context requires otherwise, refers to 21st Century
Insurance Group and its consolidated subsidiaries, all of which are wholly
owned: 21st Century Insurance Company, 21st Century Casualty Company, 21st
Century Insurance Company of Arizona(1) ("21st of Arizona"), 20th Century
Insurance Services, Inc., and i21 Insurance Services. The latter two companies
are not property and casualty insurance subsidiaries, and their results are
immaterial.
The common stock of the Company is traded on the New York Stock Exchange under
the trading symbol "TW." Through several of its subsidiaries, American
International Group, Inc. ("AIG") currently owns approximately 63% of the
Company's outstanding common stock.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
---------------------------------------------------
BASIS OF CONSOLIDATION AND PRESENTATION
The accompanying consolidated financial statements include the accounts and
operations of the Company. All material intercompany accounts and transactions
have been eliminated. The consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United States
of America ("GAAP"). The preparation of the financial statements in conformity
with GAAP requires management to make estimates and assumptions that affect the
amounts reported in the financial statements. Actual results could differ from
these estimates.
On October 16, 2003, the board of directors voted to change 21st Century
Insurance Group's state of incorporation from California to Delaware. There was
no change in the location of Company operations, location of employees, or in
the way the Company does business. The reincorporation was accomplished through
the merger of the 21st Century Insurance Group with and into a newly formed and
wholly-owned Delaware subsidiary. Shareholders holding a majority of the voting
power approved the reincorporation by written consent on October 17, 2003. The
reincorporation became effective December 4, 2003.
21ST CENTURY INSURANCE COMPANY OF ARIZONA
Prior to 2002, 21st of Arizona was a joint venture between the Company and AIG.
On January 1, 2002, the Company acquired AIG's 51% interest in 21st of Arizona
for $4.4 million. The Company's equity in the net loss of this venture amounted
to $1.0 million in 2001, and is included in other income in the Consolidated
Statements of Operations (see Note 19 of the Notes to Consolidated Financial
Statements).
------------
1 21st of Arizona was incorporated in Arizona in 1995 as a joint venture
owned 49% by the Company and 51% by AIG; the Company acquired AIG's
interest on January 1, 2002.
43
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
INVESTMENTS
The Company classifies its investment portfolio as available-for-sale and
carries it at fair value. Fair values for fixed maturity and equity securities
are based on quoted market prices, broker quotes and other valuation techniques.
The cost of investment securities sold is determined by the specific
identification method.
Unrealized investment gains and losses, net of any tax effect, are included as
an element of accumulated other comprehensive income (loss), which is classified
as a separate component of stockholders' equity.
Impairment losses for declines in value of fixed maturity investments below cost
are recognized when attributable to issuer-specific events based upon all
relevant facts and circumstances in accordance with Staff Accounting Bulletin
("SAB") 59, Noncurrent Marketable Equity Securities, Emerging Issues Task Force
("EITF") No. 99-20, Recognition of Interest Income and Impairment of Certain
Investments, EITF No. 03-1, The Meaning of Other-Than-Temporary Impairment and
Its Application to Certain Investments, and related guidance, which is evolving.
For fixed-maturity investments with unrealized losses due to market conditions
or industry-related events, where the Company has the positive intent and
ability to hold the investment for a period of time sufficient to allow a market
recovery or to maturity, declines in value below cost are not assumed to be
other than temporary. Where declines in values of securities below cost or
amortized cost are considered to be other than temporary, a charge is reflected
in income for the difference between cost or amortized cost and fair value. No
such charges were recorded in 2003, 2002 or 2001.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash, demand deposits and short-term
investments in money market mutual funds having a maturity of three months or
less at the date of purchase.
RECOGNITION OF REVENUES
Insurance premiums and reinsurance ceding commissions are recognized pro rata
over the terms of the policies. The unearned portion of premiums is included in
the consolidated balance sheets as a liability for unearned premiums.
Installment and other fees for services are recognized in the periods the
services are rendered.
DEFERRED POLICY ACQUISITION COSTS
Deferred policy acquisition costs ("DPAC") include premium taxes and other
variable costs incurred in connection with writing business. These costs are
deferred and amortized over the 6-month policy period in which the related
premiums are earned. The Company does not consider anticipated investment income
in determining the recoverability of these costs. Based on current indications,
management believes that these costs will be fully recoverable and, accordingly,
no reduction in DPAC has been recognized.
LEASED PROPERTY UNDER CAPITAL LEASE
Leased property under capital lease is recorded as a capital asset and amortized
on a straight-line basis over the estimated useful lives of the property, which
range from 3 to 10 years. The related lease obligation, which is included in
debt, is disclosed on the balance sheet.
PROPERTY AND EQUIPMENT
Property and equipment is recorded at cost and depreciated on a straight-line
basis. The estimated useful lives used for depreciation purposes are: furniture
and leasehold improvements - 7 years; equipment - 3 to 5 years; automobiles - 5
years; software currently in service - 3 to 10 years.
44
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Management assesses the Company's property and equipment, including software
development projects in progress, for impairment in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. The assessment of impairment involves a
two-step process prescribed in SFAS No. 144, whereby an initial assessment for
potential impairment is performed, by comparing the carrying value and cost to
complete, if any, to estimates of future undiscounted cash flows from operations
at the lowest level for which identifiable cash flows are largely independent of
cash flows of other assets and liabilities. If future undiscounted cash flows
are insufficient, an impairment write down is recorded for the difference
between the carrying value and estimated fair value of the asset group.
LOSSES AND LOSS ADJUSTMENT EXPENSES
The estimated liabilities for losses and loss adjustment expenses ("LAE")
include the accumulation of estimates of losses for claims reported prior to the
balance sheet dates, estimates (based upon actuarial analysis of historical
data) of losses for claims incurred but not reported, the development of case
reserves to ultimate values, and estimates of expenses for investigating,
adjusting and settling all incurred claims. Amounts reported are estimates of
the ultimate costs of settlement, net of estimated salvage and subrogation.
These estimated liabilities are necessarily subject to the outcome of future
events, such as changes in medical and repair costs as well as economic and
social conditions that impact the settlement of claims. Management believes that
the aggregate reserves are adequate and represent our best estimate based on the
information currently available. The methods of making such estimates and for
establishing the resulting reserves are reviewed and updated as applicable, and
any adjustments resulting therefrom are reflected in current operations.
A necessarily more subjective process is used to estimate earthquake losses
arising out of California Senate Bill 1899 ("SB 1899") because most of the
remaining earthquake claims are in litigation. See Note 16 of the Notes to
Consolidated Financial Statements for a discussion of the factors considered by
management in establishing those liabilities.
REINSURANCE
In the normal course of business, the Company seeks to reduce its exposure to
losses that may arise from catastrophes and to reduce its overall risk levels by
obtaining reinsurance from other insurance enterprises or reinsurers.
Reinsurance premiums and reserves on reinsured business are accounted for on a
basis consistent with those used in accounting for the original policies issued
and the terms of the reinsurance contracts.
Reinsurance contracts do not relieve the Company from its obligations to
policyholders. The Company periodically reviews the financial condition of its
reinsurers to minimize its exposure to losses from reinsurer insolvencies. It is
the Company's policy to hold collateral under related reinsurance agreements in
the form of letters of credit for unpaid losses for all reinsurers not licensed
to do business in the Company's state of domicile.
Reinsurance assets include balances due from other insurance companies under the
terms of reinsurance agreements. Amounts applicable to ceded unearned premiums,
ceded loss payments and ceded claim liabilities are reported as assets in the
accompanying balance sheets. The Company believes the fair value of its
reinsurance recoverables approximates their carrying amounts.
INCOME TAXES
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years the differences are expected to
be recovered or settled. The Company reviews its deferred tax assets and
liabilities for recoverability.
45
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
STOCK-BASED COMPENSATION
SFAS No. 123, Accounting for Stock-based Compensation, encourages, but does not
require, companies to account for stock options using the fair value method,
which generally results in compensation expense recognition. As also permitted
by SFAS No. 123, the Company accounts for its fixed stock options using the
intrinsic-value method, prescribed in Accounting Principles Board ("APB")
Opinion No. 25, Accounting for Stock Issued to Employees, which generally does
not result in compensation expense recognition. Under the intrinsic value
method, compensation cost for stock options is measured at the date of grant as
the excess, if any, of the quoted market price of our stock over the exercise
price of the options.
In addition to stock options, we also grant restricted stock awards to certain
officers and employees. Upon issuance of grants under the plan, unearned
compensation equivalent to the market value on the date of grant is charged to
paid-in capital and subsequently amortized over the vesting period of the grant.
The Company becomes entitled to an income tax deduction in an amount equal to
the taxable income reported by the holders of the restricted shares when the
restrictions are released. Restricted shares are forfeited if officers and
employees terminate prior to the lapsing of restrictions. We record forfeitures
of restricted stock as treasury share repurchases and any compensation cost
previously recognized is reversed in the period of forfeiture. This accounting
treatment results in compensation expense being recorded in a manner consistent
with that required under SFAS No. 123, and, therefore, pro forma net income and
earnings per share amounts for the Restricted Share Plan would be unchanged from
those reported in the financial statements.
Had compensation cost for our plans been determined based on the estimated fair
value at the grant dates of options consistent with the method defined in SFAS
No. 123, our net income and earnings per share would have been reduced to the
pro forma amounts indicated below for the years ended December 31 (amounts in
thousands, except per share data):
Years Ended December 31, 2003 2002 2001
----------------------------------------------------------------------------------------
NET INCOME (LOSS), AS REPORTED $53,575 $(12,256) $(27,568)
Add: Stock-based employee compensation expense 346 329 243
included in reported net income (loss), net of related
tax effects
Deduct: Total stock-based employee compensation (6,812) (5,637) (3,413)
expense determined under fair value based method
for all awards, net of related tax effects
------------------------------
NET INCOME (LOSS), PRO FORMA $47,109 $(17,564) $(30,738)
==============================
BASIC AND DILUTED EARNINGS (LOSS) PER SHARE
As reported $ 0.63 $ (0.14) $ (0.32)
Pro forma $ 0.55 $ (0.21) $ (0.36)
EARNINGS PER SHARE ("EPS")
Basic EPS is computed by dividing income available to common stockholders by the
weighted average number of common shares outstanding for the period. Diluted EPS
reflects the potential dilution that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock,
or resulted from issuance of common stock that then shared in the earnings of
the Company.
46
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NEW ACCOUNTING PRONOUNCEMENTS
In May 2003, the Financial Accounting Standards Board ("FASB") issued SFAS No.
150, Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity. SFAS No. 150 establishes standards for how an issuer
classifies and measures certain financial instruments with characteristics of
both liabilities and equity. The adoption of SFAS No. 150 in the third quarter
of 2003 did not have an impact on the Company's results of operation or
financial position.
In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of
Variable Interest Entities an interpretation of ARB No. 51 ("FIN 46"), and
amended it in December 2003. An entity is subject to the consolidation rules of
FIN 46 and is referred to as a variable interest entity ("VIE") if it lacks
sufficient equity to finance its activities without additional financial support
from other parties or if its equity holders lack adequate decision making
ability based on criteria set forth in the interpretation.
On August 29, 2003, the Company funded a revolving loan agreement with Impact
C.I.L., LLC ("Impact C.I.L."), a VIE. At present the Company has contributed
$2.4 million to be used to purchase mortgage loans in economically disadvantaged
areas. The Company is not the primary beneficiary of the VIE and participates at
an 11.11% level in the entity's funding activities. Potential losses are limited
to the amount invested as well as associated operating fees.
The Company's maximum commitment is for up to 11.11% ($24 million) of $216
million of participation. The mortgages purchased with these funds may be
securitized. Otherwise, the loan will be liquidated in 10 years from the initial
date of the agreement.
Impact C.I.L. is a subsidiary of Impact Community Capital, LLC ("Impact"), whose
charter is to provide real estate loans in economically disadvantaged areas. At
present, the Company has a $2.0 million note receivable from Impact in addition
to the $2.4 million investment noted above. The Company has voting rights and
ownership of Impact in proportion to its investment (approximately 10%).
The Company does not have any material VIEs that it needs, or will need, to
consolidate or disclose.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the current year
presentation.
NOTE 3. EARNINGS (LOSS) PER COMMON SHARE
-----------------------------------------
For each of the three years in the period ended December 31, 2003, the numerator
for the calculation of both basic and diluted earnings (loss) per common share
is equal to net income (loss) reported for that year. The denominator for the
computation of basic earnings (loss) per share was 85,432,838 shares, 85,414,076
shares and 85,340,461 shares for 2003, 2002 and 2001, respectively. The
denominator for diluted earnings (loss) per share was 85,637,672 shares,
85,414,076 shares and 85,340,461 shares for 2003, 2002 and 2001, respectively.
The difference between basic and diluted earnings (loss) per share denominators
is due to dilutive stock options.
Options to purchase an aggregate of 5,121,446 shares, 5,010,411 shares and
3,122,081 shares of common stock were considered anti-dilutive during 2003, 2002
and 2001, respectively, and were not included in the computation of diluted EPS
because the options' exercise price was greater than the average market price of
the common stock for each respective period. These options expire through June
2013 (see Note 14 of the Notes to Consolidated Financial Statements).
47
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 4. INVESTMENTS
--------------------
A summary of net investment income follows:
Years Ended December 31, 2003 2002 2001
-----------------------------------------------------------------------------------------
Interest on fixed maturities $45,668 $45,777 $44,722
Interest on cash equivalents 857 922 1,602
Investment expense (692) (354) (394)
-----------------------------------------------------------------------------------------
Net investment income $45,833 $46,345 $45,930
-----------------------------------------------------------------------------------------
A summary of realized investment gains (losses) follows:
Years Ended December 31, 2003 2002 2001
-----------------------------------------------------------------------------------------
Realized losses on sales of fixed maturity securities $ (382) $(2,183) $(1,111)
Realized gains on sales of fixed maturity securities 13,715 13,053 5,912
Realized (loss) gain on disposal of property and equipment (156) (479) 200
-----------------------------------------------------------------------------------------
Total realized investment gains (losses) $13,177 $10,391 $ 5,001
-----------------------------------------------------------------------------------------
A summary of fixed maturity investments follows:
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
---------------------------------------------------------------------------------------------------
DECEMBER 31, 2003
U.S. Treasury securities and obligations of U.S.
Government corporations and agencies $ 192,936 $ 2,312 $ (970) $ 194,278
Obligations of states and political subdivisions 834,058 32,679 (1,392) 865,345
Corporate securities 156,532 4,575 (1,054) 160,053
---------------------------------------------------------------------------------------------------
Total fixed maturity investments $1,183,526 $ 39,566 $ (3,416) $1,219,676
---------------------------------------------------------------------------------------------------
December 31, 2002
U.S. Treasury securities and obligations of U.S.
Government corporations and agencies $ 95,268 $ 4,764 $ - $ 100,032
Obligations of states and political subdivisions 548,919 26,053 (207) 574,765
Corporate securities 241,860 10,384 (2,460) 249,784
---------------------------------------------------------------------------------------------------
Total fixed maturity investments $ 886,047 $ 41,201 $ (2,667) $ 924,581
---------------------------------------------------------------------------------------------------
The Company has no non-interest bearing investments, non-accrued investment
income or any individual securities in excess of 10% of equity. Fixed maturities
available-for-sale at December 31, 2003, are summarized by contractual maturity
year as follows:
Amortized Fair
Cost Value
---------------------------------------------
Fixed maturities due:
2004 $ 21,277 $ 22,471
2005-2008 267,883 276,094
2009-2013 807,898 832,050
2014 and thereafter 86,468 89,061
---------------------------------------------
Total $1,183,526 $1,219,676
---------------------------------------------
48
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Expected maturities of the Company's investments may differ from contractual
maturities because certain borrowers have the right to call or prepay
obligations with or without call or prepayment penalties.
The following table summarizes the Company's gross unrealized losses and
estimated fair values on investments, aggregated by investment category and
length of time that individual securities have been in a continuous unrealized
loss position, at December 31, 2003.
Less than 12 Months 12 Months or More Total
----------------------------------------------------------------------------
Unrealized Unrealized Unrealized
December 31, 2003 Fair Value Losses Fair Value Losses Fair Value Losses
------------------------------------------------------------------------------------------------------------------------------
U.S. Treasury securities and obligations of U.S.
Government corporations and agencies $ 103,816 $ 970 $ - $ - $ 103,816 $ 970
Obligations of states and political
subdivisions 90,425 1,352 2,118 40 92,543 1,392
Corporate securities 41,828 1,054 - - 41,828 1,054
------------------------------------------------------------------------------------------------------------------------------
Total fixed maturity investments $ 236,069 $ 3,376 $ 2,118 $ 40 $ 238,187 $ 3,416
------------------------------------------------------------------------------------------------------------------------------
The Company held 89 investment positions with unrealized losses as of December
31, 2003. As all of these investments are investment grade, none of the
unrealized losses are considered to be credit related. In addition, at December
31, 2003, the Company had two investments that were in an unrealized loss
position for 12 months or more.
Cash and securities with carrying values of $6.7 million and $6.8 million as of
December 31, 2003 and 2002 were on deposit with state regulatory authorities in
accordance with the related statutory insurance requirements.
NOTE 5. INCOME TAXES
-----------------------------
Income tax expense (benefit) consists of:
Years Ended December 31, 2003 2002 2001
-------------------------------------------------------------
Current tax expense (benefit) $ 4,166 $ (8,200) $ (5,089)
Deferred tax expense (benefit) 13,406 (5,370) (19,418)
-------------------------------------------------------------
$17,572 $(13,570) $(24,507)
-------------------------------------------------------------
A reconciliation of income tax computed at the federal statutory tax rate of 35%
to total income tax expense (benefit) follows:
Years Ended December 31, 2003 2002 2001
---------------------------------------------------------------------------------------
Federal income tax expense (benefit) at statutory rate $24,902 $ (9,039) $(18,227)
Tax-exempt income, net (8,581) (9,377) (11,067)
State and local taxes, net of federal benefit 560 5,151 4,706
Research and experimentation tax credit (374) (1,040) -
Nondeductible political contributions 135 766 81
Effect on prior years of settlement of tax dispute 949 - -
Other - net (19) (31) -
---------------------------------------------------------------------------------------
Income tax expense (benefit) $17,572 $(13,570) $(24,507)
---------------------------------------------------------------------------------------
49
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
There were no income tax payments required for the years ended December 31,
2003, 2002 and 2001. As of December 31, 2003, the Company's federal income tax
refund receivable was $9.6 million.
The Company's net deferred tax asset is comprised of:
December 31, 2003 2002
----------------------------------------------------------------
Deferred tax assets:
Net operating loss carryforward $105,317 $128,581
Alternative minimum tax credit 10,717 9,451
Unearned premiums 22,377 19,156
Unpaid losses and loss adjustment expenses 8,107 6,793
Other 2,621 -
----------------------------------------------------------------
149,139 163,981
----------------------------------------------------------------
Deferred tax liabilities:
EDP software development costs 40,729 36,262
Deferred policy acquisition costs 18,578 16,166
Unrealized investment gains 11,605 12,685
Employee benefits 1,616 1,276
Other - 8,653
----------------------------------------------------------------
72,528 75,042
----------------------------------------------------------------
Net deferred tax asset $ 76,611 $ 88,939
----------------------------------------------------------------
During 2002, the Company had a tax net operating loss of approximately $37.0
million. As of December 31, 2003, the Company has a tax net operating loss
carryforward of approximately $300.9 million for regular tax purposes of which
approximately $37.9 million expires in the year 2009 and $263.0 million expires
on or after 2011; and an alternative minimum tax credit carryforward of $10.7
million. Alternative minimum tax credits may be carried forward indefinitely to
offset future regular tax liabilities.
The Company is required to establish a "valuation allowance" for any portion of
the deferred tax asset that management believes will not be realized. The
Company believes that because of tax planning strategies available, it is more
likely than not that the Company will realize the full benefit of its deferred
tax assets. Accordingly, no valuation allowance has been established.
NOTE 6. DEFERRED POLICY ACQUISITION COSTS
-----------------------------------------
Following is a summary of policy acquisition costs deferred for amortization
against future income and the related amortization charged to income from
operations (policy acquisition costs are amortized over the 6-month policy
period):
Years Ended December 31, 2003 2002 2001
----------------------------------------------------------------------------------------
Deferred policy acquisition costs, beginning of year $ 46,190 $ 30,631 $ 25,228
Acquisition costs deferred 209,078 139,201 107,961
Acquisition costs amortized and charged to income
during the year (202,189) (123,642) (102,558)
----------------------------------------------------------------------------------------
Deferred policy acquisition costs, end of year $ 53,079 $ 46,190 $ 30,631
----------------------------------------------------------------------------------------
Total advertising costs included in acquisition costs deferred during 2003, 2002
and 2001 were $53.9 million, $43.3 million and $16.9 million, respectively.
50
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 7. PROPERTY AND EQUIPMENT
-------------------------------
A summary of property and equipment follows:
December 31, 2003 2002
-----------------------------------------------------------------------------------
Furniture and equipment $ 37,666 $ 34,936
Automobiles 1,505 2,855
Leasehold improvements 11,890 9,716
Software currently in service 34,136 25,144
Software development projects in progress 76,110 66,748
-----------------------------------------------------------------------------------
Subtotal 161,307 139,399
Less accumulated depreciation, including $19,057 and $14,927
for software currently in service (60,070) (52,125)
-----------------------------------------------------------------------------------
$101,237 $ 87,274
-----------------------------------------------------------------------------------
Depreciation expense on software currently in service was $4.2 million, $9.6
million and $10.4 million in 2003, 2002 and 2001, respectively. In the third
quarter of 2002, we recorded a one-time pre-tax charge to write-off $37.2
million of previously capitalized software costs for abandoned portions of an
advanced personal lines processing system. Substantially all software
development projects in progress, which primarily relate to the advanced
personal lines processing system, are expected to be completed by 2005.
NOTE 8. UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
---------------------------------------------------
Accounting for losses and LAE is highly subjective because these costs must be
estimated, often weeks, months or even years in advance of when the payments
actually are made to claimants, attorneys, claims personnel and others involved
in the claims settlement process. At the time of sale of an auto policy, for
example, the number of claims that will happen is unknown, and so is the
ultimate amount it will take to settle them.
Accounting principles require insurers to record estimates for loss and LAE in
the periods in which the insured events, such as automobile accidents, occur.
This estimation process requires the Company to estimate both the number of
accidents that may have occurred (called "frequency") and the ultimate amount of
loss and LAE (called "severity") related to each accident. The Company employs
actuaries who are professionally trained and certified in the process of
establishing estimates for frequency and severity. From time to time, external
actuarial experts are engaged from consulting firms to review the work of the
Company's actuaries.
Management believes that the Company's reserves are adequate. However, because
reserve estimates are necessarily subject to the outcome of future events,
changes in estimates are unavoidable in the property and casualty insurance
business. These changes sometimes are referred to as "loss development" or
"reserve development."
51
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
The following analysis provides a reconciliation of the activity in the reserve
for unpaid losses and loss adjustment expenses:
Years Ended December 31, 2003 2002 2001
-----------------------------------------------------------------------------------
At beginning of year:
Reserve for losses and LAE, gross of reinsurance $384,009 $349,290 $298,436
Reinsurance recoverable (20,351) (23,512) (31,483)
Acquisition of 21st of Arizona - 6,749 -
-----------------------------------------------------------------------------------
Reserve for losses and LAE, net of reinsurance 363,658 332,527 266,953
-----------------------------------------------------------------------------------
Losses and LAE incurred, net of reinsurance:
Current year 911,104 754,299 718,229
Prior years 51,207 72,358 118,007
-----------------------------------------------------------------------------------
Total 962,311 826,657 836,236
-----------------------------------------------------------------------------------
Losses and LAE paid, net of reinsurance:
Current year 590,678 513,738 506,294
Prior years 305,932 281,788 271,117
-----------------------------------------------------------------------------------
Total 896,610 795,526 777,411
-----------------------------------------------------------------------------------
At end of year:
Reserve for losses and LAE, net of reinsurance 429,359 363,658 325,778
Reinsurance recoverable 8,964 20,351 23,512
-----------------------------------------------------------------------------------
Reserve for losses and LAE, gross of reinsurance $438,323 $384,009 $349,290
-----------------------------------------------------------------------------------
The provision for losses and LAE recorded in 2003, 2002 and 2001 for insured
events of prior years primarily resulted from the Company's recognition of
earthquake losses under SB 1899, as discussed in Note 16 of the Notes to
Consolidated Financial Statements, and from adverse development in personal auto
loss severity.
For the personal auto lines, the Company's actuaries prepare a monthly
evaluation of loss and LAE indications by accident year, and the Company
assesses whether there is a need to adjust reserve estimates pertaining to
previous accounting periods. Our actuaries evaluate the homeowners reserve
requirement on a quarterly basis, while personnel in our legal and claims areas
prepare monthly evaluations of the earthquake reserves. As claims are reported
and settled and as other new information becomes available, changes in estimates
are made and are included in earnings of the period of the change.
The increases in prior accident year estimates recorded in each of the past
three years, net of applicable reinsurance, are summarized below:
Years ended December 31, 2003 2002 2001
-------------------------------------------------------
Personal auto $11,159 $16,200 $ 45,742
Homeowner and Earthquake(1) 40,048 56,158 72,265
$51,207 $72,358 $118,007
-----------
1 The Company no longer has any California homeowners policies in force. The
Company ceased writing earthquake coverage in 1994, but has remaining loss
reserves from the 1994 Northridge Earthquake that are subject to upward
development.
52
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
The following table shows unpaid losses and LAE on a gross and net basis:
2003 2002
------------------ ------------------
December 31, GROSS NET Gross Net
------------------------------------------------------------------
Unpaid Losses and LAE
Personal auto lines $419,913 $413,348 $333,113 $320,032
Homeowner and earthquake 18,410 16,011 50,896 43,626
------------------------------------------------------------------
Total $438,323 $429,359 $384,009 $363,658
------------------------------------------------------------------
The $86.8 million increase in the gross auto reserves for the year ended
December 31, 2003, is comprised of growth in reserves attributable to the higher
number of insured automobiles of approximately $57.9 million, approximately
$17.7 million relating to the effects of higher average loss costs and
approximately $11.2 million for strengthening of prior accident year reserves.
NOTE 9. DEBT
-------------
Debt at December 31 consisted of:
2003 2002
-------------------------------------------------------------------------------
Senior Notes (5.9%; maturing in 2013) $ 99,872 $ -
Obligation under capital lease (5.7%; maturing through 2008) 49,814 60,000
-------------------------------------------------------------------------------
Total debt $149,686 $60,000
-------------------------------------------------------------------------------
In December 2003, the Company completed a private offering of $100 million
principal amount of 5.9 percent Senior Notes due in December 2013 at a discount
of $0.8 million. The effective interest rate on the Senior Notes, when all
offering costs are taken into account and amortized over the term of the Senior
Notes, is approximately 6 percent per annum. Of the $99.2 million in net
proceeds from the Senior Notes, $85 million was used to increase the statutory
surplus of 21st Century Insurance Company, a wholly-owned subsidiary of the
Company, and the balance was retained by the holding company.
The Senior Notes are redeemable at the Company's option, at any time in whole,
or from time to time in part, prior to maturity at a redemption price equal to
the greater of (A) 100% of the principal amount of the notes and (B) the sum of
the present values of the remaining scheduled payments of principal and interest
thereon (exclusive of interest accrued through the date of redemption)
discounted to the redemption date on a semi-annual basis (assuming a 360-day
year consisting of twelve 30-day months) at the Treasury Rate, plus 25 basis
points (plus in each case, accrued interest thereon to the date of redemption).
Under a registration rights agreement executed in connection with the offering,
the Company has agreed to, among other things: (i) file a registration statement
on or before April 7, 2004 enabling holders to exchange the notes for publicly
registered notes; (ii) use reasonable best efforts to cause the registration
statement relating to the exchange offer to become or be declared effective on
or before June 6, 2004; (iii) use reasonable best efforts to consummate the
exchange offer within 45 days after the effective date of the registration
statement. In the event such registration statement does not become effective by
June 6, 2004, the interest rate on the Senior Notes will increase by 0.25%.
Interest on the Senior Notes and capital lease obligation is payable
semiannually and monthly, respectively. The first interest payment on the Senior
Notes of approximately $3.0 million will be paid on June 15, 2004, of which $0.4
million was accrued at December 31, 2003. The capital lease obligation called
for an interest-only payment on February 14, 2003, of $0.3 million and,
commencing
53
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
at the same date, 59 monthly payments of approximately $1.2 million with a
bargain purchase option at the end of the term.
On December 31, 2002, the Company entered into a sale-leaseback transaction for
$15.8 million of equipment and leasehold improvements and $44.2 million of
software. The transaction is accounted for as a capital lease under SFAS No. 13,
Accounting for Leases, as amended by SFAS No. 28, Accounting for Sales with
Leasebacks. The lease includes a covenant that if AIG ceases to have a majority
interest in the Company, or if statutory surplus falls below $300.0 million, or
if the net premiums written to surplus ratio is greater than 3.8:1, or if claims
paying ratings fall below BBB+ (as rated by Standard & Poor's), Baa1 (as rated
by Moody's) or B++ (as rated by A.M. Best) the Company will either deliver a
letter of credit to the lessor or pay the lessor the then outstanding balance,
including a prepayment penalty of up to 3%. The lessor has been granted a
security interest in the property and equipment subject to the sale-leaseback.
See Note 12 of the Notes to Consolidated Financial Statements for the related
contractual commitment schedule.
Depreciation expense for leased property under capital lease for 2003 was $12.4
million. There was no depreciation expense on leased property under capital
lease for 2002.
NOTE 10. REINSURANCE
---------------------
Effective January 1, 2003, the 90% quota share reinsurance treaty covering the
Company's Personal Umbrella Policies ("PUP") was amended so that the reinsurers
are as follows: The TOA Reinsurance Company of America - 25%, Swiss RE
Underwriters - 45%, Hannover Ruckversicherungs - 20%.
In the third quarter of 2002, the Company entered into a catastrophe reinsurance
agreement on its auto lines with AIG subsidiaries, Folksamerica Reinsurance
Company and Transatlantic Reinsurance Company (a majority owned AIG subsidiary),
which reinsures any covered events up to $30.0 million in excess of $15.0
million ($45.0 million in excess of $20.0 million effective January 1, 2004).
Effective September 1, 2002, the Company entered into an agreement to cancel
future cessions under its quota share reinsurance treaty with AIG subsidiaries
resulting in a pre-tax charge of $0.9 million. The treaty would have ceded 4% of
premiums to AIG subsidiaries in the remainder of 2002 and 2% in 2003.
54
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
The following summarizes the approximate percentage of business retained and
ceded under various reinsurance programs with AIG subsidiaries and unrelated
insurers. Most programs provide for ceding commissions that approximate the
Company's direct policy acquisition costs and other operating expenses.
Contracts Incepting During
----------------------------
2003 2002 2001
-----------------------------------------------------------------------
AUTO POLICIES
Retained 100% 97% 94%
Ceded - 3% 6%
Catastrophe cover excess $15 million $30,000 $30,000 -
HOMEOWNER POLICIES(1)
Retained - - 94%
Ceded 100% 100% 6%
Catastrophe cover excess $10 million(2) - - $75,000
PUP POLICIES
Retained 10% 10% 16%
Ceded 90% 90% 84%
Reinsurance coverages related to historical earthquake losses have been
exhausted.
The effect of reinsurance on premiums written and earned is as follows:
2003 2002 2001
----------------------------------------------------------------------------------------------
Years Ended December 31, WRITTEN EARNED Written Earned Written Earned
----------------------------------------------------------------------------------------------
Gross $1,223,484 $1,177,705 $998,248 $971,059 $929,315 $929,361
Ceded (4,854) (5,028) (32,949) (46,500) (60,360) (65,216)
----------------------------------------------------------------------------------------------
Net $1,218,630 $1,172,677 $965,299 $924,559 $868,955 $864,145
----------------------------------------------------------------------------------------------
Gross losses and loss adjustment expenses have been reduced by reinsurance ceded
as follows:
Years Ended December 31, 2003 2002 2001
-----------------------------------------------------------------------------------
Gross losses and loss adjustment expenses incurred $966,512 $870,402 $893,139
Ceded losses and loss adjustment expenses incurred (4,201) (43,745) (56,903)
-----------------------------------------------------------------------------------
Net losses and loss adjustment expenses incurred $962,311 $826,657 $836,236
-----------------------------------------------------------------------------------
At December 31, 2003 and 2002, the Company's reinsurance recoverables, net of
payables, from AIG subsidiaries were $5.8 million and $18.4 million,
respectively. The Company ceded $0.9 million, $29.1 million, and $60.3 million
in net premiums earned to AIG subsidiaries in 2003, 2002 and 2001, respectively.
Losses and loss adjustment expenses incurred of $1.6 million, $28.4 million and
$55.6 million were ceded to AIG subsidiaries in 2003, 2002 and 2001,
respectively.
------------
1 The Company's homeowner policies did not include any earthquake coverage.
2 This catastrophe coverage provided protection from the potential for fire
following an earthquake and other catastrophes.
55
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 11. EMPLOYEE BENEFIT PLANS
--------------------------------
The Company sponsors a contributory savings and security plan for eligible
employees. The Company provides matching contributions equal to 75% of the
lesser of 6% of an employee's compensation or the amount contributed by the
employee up to the maximum allowable under IRS regulations. Contributions
charged against operations were $4.4 million, $4.2 million and $4.0 million in
2003, 2002 and 2001, respectively. The plan offers a variety of investment types
among which employees exercise complete discretion as to choice and investment
duration, including any amounts the employee elects to invest in Company common
stock.
The Company has both funded and unfunded non-contributory defined benefit
pension plans, which together cover essentially all employees who have completed
at least one year of service. For certain key employees designated by the Board
of Directors, the Company sponsors an unfunded nonqualified supplemental
executive retirement plan. The supplemental plan benefits are based on years of
service and compensation during the three highest of the last ten years of
employment prior to retirement and are reduced by the benefit payable from the
pension plan and 50% of the social security benefit. For other eligible
employees, the pension benefits are based on employees' compensation during all
years of service. The Company's funding policy is to make annual contributions
as required by applicable regulations. In 2003 and 2002, the Company made
additional contributions to fully fund the accumulated benefit obligation of its
qualified plan.
Other information regarding the Company's defined benefit pension plans follows:
Years Ended December 31, 2003 2002
-------------------------------------------------------------------------
Change in benefit obligation:
Benefit obligation at beginning of year $ 78,684 $ 68,943
Service cost 4,607 3,788
Interest cost 5,627 5,008
Plan amendments 85 553
Actuarial loss 14,161 2,523
Benefits paid (2,230) (2,131)
-------------------------------------------------------------------------
Benefit obligation at end of year $100,934 $ 78,684
-------------------------------------------------------------------------
Change in plan assets:
Fair value of plan assets at beginning of year $ 58,276 $ 45,544
Actual return on plan assets net of expenses 14,053 (6,661)
Employer contributions 7,000 21,524
Benefits paid (2,230) (2,131)
-------------------------------------------------------------------------
Fair value of plan assets at end of year $ 77,099 $ 58,276
-------------------------------------------------------------------------
Reconciliation of funded status:
Funded status $(23,835) $(20,408)
Unrecognized net loss 36,026 33,074
Unrecognized prior service cost 788 807
-------------------------------------------------------------------------
Net pension asset recognized at year end $ 12,979 $ 13,473
-------------------------------------------------------------------------
Amounts recognized in the balance sheet consist of:
Prepaid pension cost - qualified plan $ 19,849 $ 18,449
Accrued benefit liability - nonqualified plan (6,870) (4,976)
Additional minimum liability - nonqualified plan (3,742) (3,058)
Intangible asset 750 766
Accumulated other comprehensive income, pre-tax 2,992 2,292
-------------------------------------------------------------------------
Net pension asset recognized at year end $ 12,979 $ 13,473
-------------------------------------------------------------------------
56
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
The accumulated benefit obligation for all defined benefit pension plans was
$83,433 and $63,422 at December 31, 2003 and 2002, respectively.
Information for the unfunded supplemental executive retirement plan, which has
an accumulated benefit obligation in excess of plan assets, is as follows:
Years Ended December 31, 2003 2002
--------------------------------------------------
Projected benefit obligation $16,552 $11,967
Accumulated benefit obligation 11,586 9,907
Fair value of plan assets 974 1,873
--------------------------------------------------
Net pension costs for all plans were comprised of the following:
Years Ended December 31, 2003 2002 2001
--------------------------------------------------------------------------------
Service cost $ 4,607 $ 3,788 $ 3,509
Interest cost 5,627 5,008 4,554
Expected return on plan assets (4,857) (4,193) (3,737)
Amortization of unrecognized transition obligation - 181 181
Amortization of prior service cost 105 105 233
Amortization of net loss 2,012 1,012 394
--------------------------------------------------------------------------------
$ 7,494 $ 5,901 $ 5,134
--------------------------------------------------------------------------------
ADDITIONAL INFORMATION
The increase (decrease) in minimum liability included in other comprehensive
income for the years ended December 31, 2003 and 2002 was $0.7 million and
$(6.3) million, respectively.
ASSUMPTIONS
December 31, 2003 2002
----------------------------------------------------------------
Weighted-average assumptions used to determine the
benefit obligations:
Discount rate 6.10% 6.75%
Rate of compensation increase 4.60% 5.60%
----------------------------------------------------------------
Years Ended December 31, 2003 2002
----------------------------------------------------------------
Weighted-average assumptions used to determine the
net cost:
Discount rate 6.75% 7.00%
Expected return on plan assets 8.50% 8.50%
Rate of compensation increase 5.60% 5.60%
----------------------------------------------------------------
The overall expected long-term rate of return on assets is a weighted-average
expectation for the return on plan assets. The Company considers historical
performance and current benchmarks to arrive at expected long-term rates of
return in each asset category. The Company assumed that 75% of its portfolio
would be invested in equity securities, with the remainder invested in debt
securities.
57
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
PLAN ASSETS
The Company's pension plan weighted-average asset allocations at December 31,
2003 and 2002, by asset category are as follows:
December 31, 2003 2002
-------------------------------
Equity Securities 72% 59%
Debt Securities 19% 20%
Other 9% 21%
-------------------------------
Total 100% 100%
-------------------------------
The Company's pension plan assets are managed by outside investment managers.
The Company's investment strategy is to maximize return on investments while
minimizing risk. The Company believes the best way to accomplish this goal is to
take a conservative approach to its investment strategy by investing in
high-grade equity and debt securities. Policy requires that equity securities
comprise between 66% and 84% of the total portfolio, and that 22% to 28% be
invested in debt securities.
CASH FLOWS
The Company does not currently expect to be required to contribute to its
qualified plan in 2004.
NOTE 12. COMMITMENTS AND CONTINGENCIES
---------------------------------------
CONTRACTUAL COMMITMENTS
The Company leases office space in Woodland Hills, California. The lease for the
Company's corporate office expires in February 2015 and may be renewed for two
consecutive five-year periods. The Company also leases automobiles and office
equipment as well as office space in several other locations throughout
California, primarily for claims services. The Company also has service
agreements with terms greater than one year. Minimum commitments under the
Company's noncancelable commitments at December 31, 2003 are as follows:
Operating Capital
Leases(1) ease
---------- --------
2004 $ 19,847 $ 13,962
2005 19,256 13,962
2006 16,691 13,962
2007 14,539 13,962
2008 14,429 -
Thereafter 90,411 -
-------------------------------------------------------------
$ 175,173 55,848
Less: amount representing interest 6,034
-------------------------------------------------------------
Present value of minimum lease payments $ 49,814
-------------------------------------------------------------
Total rental expense charged to operations for the years ended December 31,
2003, 2002 and 2001 was $17.5 million, $16.4 million and $15.6 million,
respectively.
------------
1 Includes amounts due under long-term software license agreements of
approximately $15.1 million.
58
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
The Company owns an 11.11% interest in Impact, an entity whose purpose is to
provide real estate loans in economically disadvantaged areas. Through one of
its subsidiaries, Impact C.I.L., the Company has a commitment to fund up to $24
million in loans over the next ten years.
LEGAL PROCEEDINGS
In the normal course of business, the Company is named as a defendant in
lawsuits related to claims and insurance policy issues, both on individual
policy files and by class actions seeking to attack the Company's business
practices. Many suits seek unspecified extracontractual and punitive damages as
well as contractual damages under the Company's insurance policies in excess of
the Company's estimates of its obligations under such policies. The Company
cannot estimate the amount or range of loss that could result from an
unfavorable outcome on these suits and it denies liability for any such alleged
damages. The Company has not established reserves for potential extracontractual
or punitive damages, or for contractual damages in excess of estimates the
Company believes are correct and reasonable under its insurance policies.
Nevertheless, extracontractual and punitive damages, if assessed against the
Company, could be material in an individual case or in the aggregate. The
Company may choose to settle litigated cases for amounts in excess of its own
estimate of contractual damages to avoid the expense and/or risk of litigation.
Other than possibly for the contingencies discussed below, the Company does not
believe the ultimate outcome of these matters will be material to its results of
operations, financial condition or cash flows. A range of potential losses in
the event of a negative outcome is discussed where known. The Company has
recorded its best estimate of liability for these matters.
Dana Poss v. 21st Century Insurance Company was filed on June 13, 2003, in Los
-------------------------------------------
Angeles Superior Court. The Complaint requests injunctive and restitutionary
relief under Business and Professions Code ("B&P") Sec.17200 for alleged unfair
business practices in violation of California Insurance Code ("CIC")
Sec.1861.02(c) relating to company rating practices. The Company is vigorously
defending the action.
21st Century Insurance Group, 21st Century Casualty Company and 21st Century
----------------------------------------------------------------------------
Insurance Company v. Kai Insurance Marketing, Inc. was filed on January 31,
--------------------------------------------------
2003, in United States District Court, Central District of California, Western
Division. The Company alleges Kai violated the Lanham Act, infringed upon and
diluted trademarks, made a false designation of origin and engaged in unfair
competition. Kai has filed a Counterclaim, as amended, against 21st Century
Insurance Group, and 21st Century Insurance Company; the remaining allegations
under the Counterclaim are infringement and unfair competition under B&P
Sec.17200.
Cecelia Encarnacion, individually and as the Guardian Ad Litem for Nubia Cecelia
--------------------------------------------------------------------------------
Gonzalez, a Minor, Hilda Cecelia Gonzalez, a Minor, and Ramon Aguilera v. 20th
------------------------------------------------------------------------------
Century Insurance was filed on July 3, 1997, in Los Angeles Superior Court.
-----------------
Plaintiffs allege bad faith, emotional distress, and estoppel involving 20th
Century's handling of a homeowner's claim. Ramon Aguilera shot Mr. Gonzalez (the
minor children's father) and was sued by Ms. Encarnacion for wrongful death. On
August 30, 1996, judgment was entered against Ramon Aguilera for $5.6 million.
The Company paid for Aguilera's defense costs through the civil trial; however,
the homeowner's policy did not provide indemnity coverage for the shooting
incident, and the Company refused to pay the judgment. After the trial, Aguilera
assigned a portion of his action against the Company to Encarnacion and the
minor children. Aguilera and the Encarnacion family then sued the Company
alleging that 20th Century had promised to pay its bodily injury policy limit if
Aguilera pled guilty to involuntary manslaughter. In August 2003, the trial
court held a bench trial on the limited issues of promissory and equitable
estoppel, and policy forfeiture. On September 26, 2003, the trial court issued a
ruling that 20th Century cannot invoke any policy exclusions as a defense to
coverage. Plaintiffs contend that as a result of the ruling, 20th Century owes
the full amount of the wrongful death judgment, plus interest and attorneys'
59
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
fees. 20th Century contends that the court should not award damages to Aguilera
as a result of his own inequitable conduct. A jury trial on the remaining issues
is set for June 1, 2004.
Bryan Speck, individually, and on behalf of others similarly situated v. 21st
-----------------------------------------------------------------------------
Century Insurance Company, 21st Century Casualty Company, and 21st Century
--------------------------------------------------------------------------
Insurance Group, was filed on June 20, 2002 in Los Angeles Superior Court.
---------------
Plaintiff seeks national class action certification, injunctive relief, and
unspecified actual and punitive damages. The complaint contends that 21st
Century uses "biased" software in determining the value of total-loss
automobiles. Plaintiff alleges that database providers use improper methodology
to establish comparable auto values and populate their databases with biased
figures and that the Company and other carriers allegedly subscribe to the
programs to unfairly reduce claim costs. This case is consolidated with similar
actions against other insurers for discovery and pre-trial motions. The Company
intends to vigorously defend the suit with other defendants in the coordinated
proceedings.
Thomas Theis, on his own behalf and on behalf of all others similarly situated
------------------------------------------------------------------------------
v. 21st Century Insurance, was filed on June 17, 2002, in Los Angeles
-------------------------
SuperiorCourt. Plaintiff seeks national class action certification, injunctive
relief and unspecified actual and punitive damages. The complaint contends that
after insureds receive medical treatment, the Company uses a medical-review
program to adjust expenses to reasonable and necessary amounts for a given
geographic area. Plaintiff alleges that the adjusted amount is "predetermined"
and "biased," creating an unfair pretext for reducing claim costs. This case is
consolidated with similar actions against other insurers for discovery and
pre-trial motions. The Company intends to vigorously defend the suit with other
defendants in the coordinated proceedings.
On October 10, 2002, a Los Angeles Superior Court granted the Company's motion
for summary judgment in the matter of 21st Century Insurance Company vs. People
-----------------------------------------
of the State of California ex rel.Bill Lockyer, Attorney General et al. The
----------------------------------------------------------------------
court determined that the Company's April 21, 1999, settlement with the
California Department of Insurance ("CDI") with respect to regulatory actions
arising out of the 1994 Northridge Earthquake was fully valid and enforceable.
The Court denied the Attorney General's motion seeking to have the settlement
declared void and unenforceable, a result that may have allowed the CDI to
reinstitute regulatory proceedings with respect to the Company's handling of
claims arising out of the 1994 Northridge Earthquake. The CDI has appealed the
ruling.
SB 1899, effective from January 1, 2001, to December 31, 2001, allowed the
re-opening of previously closed earthquake claims arising out of the 1994
Northridge Earthquake. The Company's first constitutional challenge to SB 1899
came to an unsuccessful result on April 29, 2002, when the United States Supreme
Court declined to hear the Company's case. A subsidiary of the Company, 21st
Century Casualty Company, filed a new challenge to the constitutionality of SB
1899 on February 13, 2003. During the first quarter of 2003, a 9th Circuit Court
of Appeals decision in Noah et al v. Allstate Insurance Company again found SB
----------------------------------------
1899 (California Code of Civil Procedure 340.9) to be constitutional. As a
result of the 9th Circuit's decision, the Company's subsidiary, 21st Century
Casualty Company, voluntarily dismissed the action it initiated on February 13,
2003, seeking to have SB 1899 declared unconstitutional. Allstate's petition to
the United States Supreme Court for review of the Noah decision has been denied.
----
The Company currently has lawsuits pending against it in connection with claims
under SB 1899; some of these lawsuits have multiple plaintiffs or are seeking
class action status. Possible future judgments for damages in excess of the
Company's reasonable estimates for these claims could be material individually
or in the aggregate.
60
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
The Company has filed a civil complaint against California-based Unlimited
Adjusting Company ("Unlimited") and its principal Jung Ho Park ("John Park").
The complaint was filed on December 16, 2002, in Superior Court of California,
County of Orange and transferred to Superior Court of California, County of Los
Angeles on April 15, 2003. The suit alleges Unlimited and John Park illegally
induced insureds into filing additional unnecessary and fraudulent claims with
the Company stemming from the 1994 Northridge Earthquake. The Company is
ultimately seeking up to $10 million in compensatory damages. The defendant has
filed a cross complaint against the Company alleging fraud, negligent
misrepresentation, interference with contractual relations, and unfair
competition under Section 17200 of the California Business and Professions Code.
In a December 21, 2000 court ruling, Ceridian Corporation v. Franchise Tax
-------------------------------------
Board, a California statute that allowed a tax deduction for the dividends
------
received from wholly owned insurance subsidiaries was held unconstitutional on
the grounds that it discriminated against out-of-state insurance holding
companies. Subsequent to the court ruling, the staff of the California Franchise
Tax Board ("FTB") took the position that the discriminatory sections of the
statute are not severable and the entire statute is invalid. As a result, the
FTB is disallowing dividend-received deductions for all insurance holding
companies, regardless of domicile, for open tax years ending on or after
December 1, 1997. Although the FTB has not made a formal assessment for tax
years 1997 through 2000, the Company anticipates a retroactive disallowance that
would result in additional tax assessments.
The amount of any such possible assessments and the ultimate amounts, if any,
that the Company may be required to pay, are subject to a wide range of
estimates because so many long-settled aspects of California tax law have been
thrown into disarray and uncertainty by the action of the courts. In the absence
of legislative relief, years of future litigation may be required to determine
the ultimate outcome. The possible losses, net of federal tax benefit, range
from close to zero to approximately $22.0 million depending on which position
future courts may decide to uphold or on whether the California legislature may
decide to enact corrective legislation. The Company believes it has adequately
provided for this contingency.
NOTE 13. CAPITAL STOCK
-----------------------
Effective December 4, 2003, the Company changed its state of incorporation from
California to Delaware. In connection with the change, the Company's stock was
assigned a par value of $0.001 per share, resulting in a transfer of $419.2
million from common stock to additional paid-in capital. There was no impact to
the Company's financial condition or results of operations as a result of the
reincorporation.
The Company is authorized to issue up to 500,000 shares of preferred stock, $1
par value, and 376,126 shares of Series A convertible preferred stock, $1 par
value, none of which were outstanding at December 31, 2003 or 2002.
Shares of common stock issued pursuant to the exercise of employee stock options
and restricted stock grants were 4,000 in 2003, 69,657 in 2002 and 39,893 in
2001. No shares were repurchased in 2003 or 2002.
61
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 14. STOCK-BASED COMPENSATION
----------------------------------
A summary of securities issuable and issued for both the 1995 Stock Option Plan
and the Restricted Shares Plan at December 31, 2003, follows:
1995 Stock Restricted
AMOUNTS IN THOUSANDS Option Plan Shares Plan
----------------------------------------------------------------------------------
Total securities authorized 10,000 1,422
Number of securities issued (476) (1,049)
Number of securities issuable upon the exercise of all
outstanding options and rights (6,744) -
Number of securities forfeited (1,436) -
Number of securities forfeited and returned to plan 1,436 156
----------------------------------------------------------------------------------
Number of securities remaining available for future
grants under each plan 2,780 529
----------------------------------------------------------------------------------
1995 STOCK OPTION PLAN
The aggregate number of common shares authorized under the plan currently is
limited to 10,000,000. At December 31, 2003, 2,780,214 common shares remain
available for future grants. The plan has been approved by the Company's
stockholders, and all options granted have ten-year terms. As a consequence of
AIG's acquiring a controlling interest in the Company, vesting was accelerated
for all options previously granted through July 27, 1998. Options granted after
July 27, 1998, vest over various future periods.
A summary of the Company's stock option activity and related information
follows:
Weighted-
Number of Average
Options Exercise Price
------------------------------------------------------------------
Options outstanding January 1, 2001 2,846,724 $ 20.88
Granted in 2001 1,854,079 18.09
Exercised in 2001 (79,901) 15.60
Forfeited in 2001 (620,964) 20.51
------------------------------------------------------------------
Options outstanding December 31, 2001 3,999,938 $ 19.75
Granted in 2002 1,523,708 16.09
Exercised in 2002 (86,881) 16.46
Forfeited in 2002 (294,865) 18.93
------------------------------------------------------------------
Options outstanding December 31, 2002 5,141,900 $ 18.77
Granted in 2003 1,801,556 12.03
Exercised in 2003 - -
Forfeited in 2003 (199,538) 17.07
------------------------------------------------------------------
Options outstanding December 31, 2003 6,743,918 $ 17.05
------------------------------------------------------------------
62
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
The following table summarizes information about stock options outstanding at
December 31, 2003:
Outstanding Exercisable
------------------------------------- ---------------------
Weighted Weighted Weighted
Average Average Average
Number of Remaining Exercise Number of Exercise
Range of Exercise Prices Options Contractual Life Price Options Price
------------------------- --------- ---------------- --------- --------- ---------
$11.68 - $15.48 1,822,856 9.1 Years $ 12.07 119,841 $ 12.32
16.03 - 17.81 2,129,890 7.2 Years 16.53 1,319,863 16.83
17.90 - 18.15 1,417,340 7.4 Years 18.15 1,057,586 18.15
18.19 - 24.19 993,082 4.9 Years 21.08 983,083 21.10
28.75 - 29.25 380,750 4.2 Years 29.22 380,750 29.22
------------------------- --------- ---------------- --------- --------- ---------
$11.68 - $29.25 6,743,918 7.2 Years $ 17.05 3,861,123 $ 19.36
Options exercisable at the end of 2002 and 2001 numbered 2,574,577 and
1,803,917, respectively.
The weighted average fair value for options granted during 2003, 2002 and 2001
was $4.80, $6.33 and $6.36, respectively. The fair value of each option grant
was estimated on the date of grant using the Black-Scholes option-pricing model
with the following assumptions:
Years Ended December 31, 2003 2002 2001
----------------------------------------------------------------------------
Risk-free interest rate:
Minimum 2.65% 3.75% 4.73%
Maximum 3.75% 4.79% 5.28%
Dividend yield 0.67% 2.49% 2.50%
Volatility factor of the expected market price
Of the Company's common stock:
Minimum 0.38 0.35 0.33
Maximum 0.40 0.38 0.34
Weighted-average expected life of the options 6 YEARS 8 years 8 years
RESTRICTED SHARES PLAN
The Restricted Shares Plan, which was approved by the Company's stockholders,
currently provides for grants of up to 1,421,920 shares of common stock to be
made available to key employees. In general, twenty percent of the number of
shares granted vest on the anniversary date of each of the five years following
the year of grant. Total amortization expense relating to the Restricted Shares
Plan was $0.4 million, $0.5 million and $0.7 million in 2003, 2002 and 2001,
respectively. Unamortized restricted stock grants totaled $0.7 million, $1.0
million and $1.8 million at the end of 2003, 2002 and 2001, respectively.
63
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
A summary of activity under the plan from 2001 through 2003 follows:
Common Market Price Per
Shares Share on Date of Grant
-----------------------------------------------------------------
Outstanding, January 1, 2001 176,138
Granted in 2001 - $ -
Vested and distributed in 2001 (33,039)
Canceled or forfeited (40,008)
----------------------------------------
Outstanding, December 31, 2001 103,091
Granted in 2002 - -
Vested and distributed in 2002 (25,629)
Canceled or forfeited (17,224)
----------------------------------------
Outstanding, December 31, 2002 60,238
Granted in 2003 4,000 14.45
Vested and distributed in 2003 (19,345)
Canceled or forfeited -
----------------------------------------
Outstanding, December 31, 2003 44,893
----------------------------------------
NOTE 15. STATUTORY FINANCIAL DATA
----------------------------------
Statutory surplus and statutory net income (loss) for the Company's insurance
subsidiaries were as follows:
Years Ended December 31, 2003 2002 2001
-----------------------------------------------------------
Statutory surplus $531,658 $397,381 $393,119
Statutory net income (loss) 76,063 (39,771) (53,157)
The Company's insurance subsidiaries file financial statements prepared in
accordance with Statutory Accounting Principles ("SAP") prescribed or permitted
by domestic insurance regulatory agencies. The Company's SAP-basis financial
statements differ from those prepared in accordance with GAAP primarily because
certain assets recognized under GAAP are treated as nonadmitted assets under
SAP, such as deferred policy acquisition costs, most of the Company's property
and equipment and a portion of deferred income taxes. Differences also exist in
the accounting treatment of sale-leaseback transactions. Further, under SAP, all
bonds are carried at amortized cost and unpaid losses, loss adjustment expenses
and unearned premium reserves are presented net of reinsurance. The following
table reconciles consolidated GAAP net income (loss) to statutory net income
(loss).
Years Ended December 31, 2003 2002 2001
------------------------------------------------------------------------------
Net income (loss) - GAAP basis $53,575 $(12,256) $(27,568)
Deferred federal income tax expense (benefit) 24,323 (10,816) (19,418)
Change in deferred policy acquisition costs (6,889) (19,032) (1,816)
Net loss (income) from non-insurance entities 2,369 4,319 (4,355)
Other, net 2,685 (1,986) -
------------------------------------------------------------------------------
Net income (loss) - SAP basis $76,063 $(39,771) $(53,157)
------------------------------------------------------------------------------
64
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
The following table reconciles consolidated GAAP stockholders' equity to
statutory surplus.
December 31, 2003 2002
----------------------------------------------------------------------------------------------
Stockholders' equity - GAAP $700,690 $ 655,608
Assets/gains (liabilities/losses) recognized under GAAP but not
under SAP:
Net book value of fixed assets under sale-leaseback transaction (47,231) (60,000)
Deferred gain under sale-leaseback transaction (305) -
Capital lease obligation 49,814 60,000
Non admitted net deferred tax assets (93,656) (125,088)
Deferred tax liabilities relating to items nonadmitted under SAP 55,030 55,483
Intercompany receivables 214 (13,500)
Fixed assets (12,162) (16,797)
Deferred policy acquisition costs (53,079) (46,190)
Prepaid pension costs and intangible pension asset (22,781) (19,215)
Unrealized gains on bonds (35,690) (38,582)
Other prepaid expenses (9,612) (7,478)
Equity in non-insurance entities 1,680 (45,117)
Salvage and subrogation receivable - (1,030)
Other, net (1,254) (713)
----------------------------------------------------------------------------------------------
Statutory Surplus $531,658 $ 397,381
----------------------------------------------------------------------------------------------
The Company is also regulated by the provisions of the California Insurance
Holding Company System Regulatory Act (the "Holding Company Act"). Many
transactions that are defined to be of an "extraordinary" nature may not be
effected without the prior approval of the CDI. In addition, there are limits on
the insurance subsidiaries' dividend paying capacity. In 2004, the Company
estimates that its insurance subsidiaries have capacity to pay approximately
$75.1 million in dividends to their parent without prior approval of the CDI.
NOTE 16. NORTHRIDGE EARTHQUAKE
-------------------------------
SB 1899, effective from January 1, 2001, to December 31, 2001, allowed the
re-opening of previously closed earthquake claims arising out of the 1994
Northridge earthquake. During the first quarter of 2003, the Company increased
its 1994 Northridge earthquake/SB 1899 reserves by $37.0 million, resulting in
an after-tax charge of $24.1 million. Also during the first quarter, a decision
by the 9th Circuit Court of Appeals involving Allstate Insurance Company, again
found SB 1899 (California Code of Civil Procedure 340.9) to be constitutional.
As a result of the 9th Circuit's decision in Noah et al v. Allstate Insurance
Company, the Company's subsidiary, 21st Century Casualty Company, voluntarily
dismissed the action it initiated on February 13, 2003, seeking to have SB 1899
declared unconstitutional. Allstate's petition to the United States Supreme
Court for review of the Noah decision has been denied.
----
Most of the Company's remaining 1994 Earthquake claims are in litigation,
including two seeking class action status. While the reserves now held are the
Company's current best estimate of the cost of resolving its 1994 Earthquake
claims, the reserves for this legislatively created event continue to be highly
uncertain. The estimate currently recorded by the Company assumes that
relatively few of the remaining cases will require a full trial to resolve, that
any trial costs will approximate those encountered by the Company in the past,
that most cases will be settled without need for extensive
65
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
pre-trial preparation, and that no cases seeking class action status will be
certified as a class action. While a substantial majority of the claims and
litigation brought against the Company related to the Northridge Earthquake have
now been settled, trials for most of the cases not settled have been scheduled
beginning in June 2004 and thereafter. Current reserves contain no provisions
for extracontractual or punitive damages, bad faith judgments or similar
unpredictable hazards of litigation that possibly could result in the event an
adverse verdict were to be sustained against the Company. To the extent those
and other underlying assumptions prove to be incorrect, the ultimate amount to
resolve these claims could exceed the Company's current reserves, possibly by a
material amount. The Company continues to seek reasonable settlements of claims
brought under SB 1899 and other Northridge earthquake related theories, but will
vigorously defend itself against excessive demands and fraudulent claims. The
Company may, however, settle cases in excess of its assessment of its
contractual obligations in order to reduce the future cost of litigation.
The Company has received some Northridge Earthquake claims reported after the
closing of the window established by SB 1899 which are based upon alternative
legal theories. The Company is contesting these claims and has only nominal
reserves for them. Should the courts determine that these claims, or additional
claims brought in the future, are not barred by the applicable statute of
limitations and the provisions of SB 1899, additional reserves may be needed to
resolve these claims.
NOTE 17. UNAUDITED QUARTERLY RESULTS OF OPERATIONS
---------------------------------------------------
The summarized unaudited quarterly results of operations were as follows:
Quarters Ended March 31, June 30, September 30, December 31,
-------------------------------------------------------------------------------------------
2003
Net premiums earned $ 271,441 $ 287,231 $ 303,675 $ 310,330
Net investment income 11,637 11,673 11,350 11,173
Realized investment gains 4,580 7,700 836 61
Net income (loss) (6,711) 29,151 12,709 18,426
Earnings (loss) per common share(1) $ (0.08) $ 0.34 $ 0.15 $ 0.22
2002
Net premiums earned $ 215,111 $ 220,191 $ 234,666 $ 254,591
Net investment income 11,265 11,384 11,729 11,967
Realized investment gains 1,663 2,635 3,045 3,048
Net income (loss) 8,323 9,859 (45,235) 14,797
Earnings (loss) per common share(1) $ 0.10 $ 0.11 $ (0.53) $ 0.17
First quarter 2003 and third quarter 2002 results were impacted by adverse
development related to 1994 SB 1899 reserves of $37.0 million and $46.9 million,
respectively. Second quarter 2003 results include nonrecurring, nonoperational
items of $9.3 million resulting from the settlement of litigation and interest
income of $4.8 million relating to a favorable settlement with the Internal
Revenue Service ("IRS"). In addition, the third quarter of 2002 included a
charge of $37.2 million for the write-off of software development costs.
------------
1 Basic and diluted amounts are the same for all periods presented.
66
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 18. RESULTS OF OPERATIONS BY LINE OF BUSINESS
---------------------------------------------------
The following table presents premium revenue and underwriting profit (loss) for
the Company's insurance lines on a GAAP basis for the years ended December 31.
Homeowner and
Personal Earthquake
2003 Auto Lines Lines in Runoff Total
------------------------------------------------------------------------
Direct premiums written $ 1,223,377 $ 106 $1,223,484
Net premiums earned 1,172,679 (2) 1,172,677
Underwriting profit (loss) 41,006 (40,175) 831
Loss and LAE ratio 78.6% N/M(1) 82.0%
Underwriting ratio 17.9% N/M(1) 17.9%
Combined ratio 96.5% N/M(1) 99.9%
2002
------------------------------------------------------------------------
Direct premiums written $ 995,794 $ 2,454 $ 998,248
Net premiums earned 924,559 - 924,559
Underwriting profit (loss) 13,383 (58,768) (45,385)
Loss and LAE ratio 82.9% N/M(1) 89.4%
Underwriting ratio 15.6% N/M(1) 15.5%
Combined ratio 98.5% N/M(1) 104.9%
2001
------------------------------------------------------------------------
Direct premiums written $ 898,862 $ 30,453 $ 929,315
Net premiums earned 838,489 25,656 864,145
Underwriting loss (24,410) (77,598) (102,008)
Loss and LAE ratio 88.1% 381.6% 96.7%
Underwriting ratio 14.9% 20.9% 15.0%
Combined ratio 103.0% 402.5% 111.7%
Personal Auto Lines. The underwriting gain for the personal auto lines in 2003
and 2002 was due to an increase in the number of insured vehicles, rate
increases and the favorable impact on claim frequency of drought conditions that
have largely prevailed in Southern California during the past year. The
underwriting loss for the personal auto lines in 2001 resulted from the effects
of adverse development on prior accident year loss reserves.
Homeowner and Earthquake Lines in Runoff. The underwriting loss for the
homeowner and earthquake lines decreased by $18.6 million in 2003 compared to
2002 and $18.8 million in 2002 compared to 2001, respectively due to losses and
loss adjustment expenses related to SB 1899. See Notes 8 and 16 of the Notes to
Consolidated Financial Statements.
-----------
1 The ratio cannot be calculated, as the denominator is zero.
67
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 2003
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 19. 21STCENTURY INSURANCE COMPANY OF ARIZONA
--------------------------------------------------
Effective January 1, 2002, the Company acquired AIG's 51% interest in 21st of
Arizona. The Company previously held a 49% interest in 21st of Arizona, which
writes personal auto exclusively in Arizona. The Company's primary purpose in
acquiring 21st of Arizona was to provide an additional entity to facilitate the
Company's planned expansion into other states.
The purchase price was $4.4 million, which approximated 51% of 21st of Arizona's
GAAP book value. No research and development assets were acquired, and no
goodwill was recorded.
The purchase agreement included a one-year contingency for subsequent loss and
LAE reserve development for 2001 and prior accident years. Under its terms, at
December 31, 2002, 33% of any additional loss and LAE development would be
reimbursed to the Company by AIG, while a reduction in the loss and LAE
development would be paid to AIG. Based on the 2002 year-end results, the amount
receivable from AIG at December 31, 2001 was $.05 million.
The following table summarizes actual results of the Company and pro forma
results as if 21st of Arizona had been consolidated with the Company for the
year ended December 31, 2001.
Consolidated Results
Year Ended December 31, 2001 As Reported Pro Forma
--------------------------------------------------------
Revenue $ 914,078 $ 929,576
Net loss (27,568) (28,607)
Loss per share (0.32) (0.34)
68
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
We have established disclosure controls and procedures to ensure that material
information relating to the Company, including its consolidated subsidiaries, is
made known to the officers who certify the Company's financial reports and to
other members of senior management and the Board of Directors.
Based on their evaluation as of December 31, 2003, the Chief Executive Officer
and Chief Financial Officer of 21st Century Insurance Group have concluded that
21st Century Insurance Group's disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are
effective to ensure that the information required to be disclosed by 21st
Century Insurance Group in reports that it files or submits under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in SEC rules and forms. There have been no significant
changes in the Company's internal controls or in other factors that could
significantly affect internal controls subsequent to their evaluation.
The Company intends to review and evaluate the design and effectiveness of its
disclosure controls and procedures on an ongoing basis and to improve its
controls and procedures over time and to correct any deficiencies that may be
discovered in the future in order to ensure that senior management has timely
access to all material financial and non-financial information concerning the
Company's business. While management believes that the present design of the
Company's disclosure controls and procedures is effective to achieve these
results, future events affecting the Company's business may cause management to
modify its disclosure controls and procedures.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information related to directors, executive officers, and beneficial ownership
required in Item 10 is incorporated by reference from the Company's definitive
proxy statement to be filed in connection with the Company's 2004 Annual Meeting
of Stockholders pursuant to Instruction G(3) of Form 10-K.
In the wake of well-publicized corporate scandals, the Securities and Exchange
Commission and the New York Stock Exchange have issued multiple regulations that
require the implementation of policies and procedures in the corporate
governance area. The Company has adopted Corporate Governance Guidelines and
charters for its Audit Committee, Nominating and Corporate Governance Committee,
and other Committees of its Board of Directors. It has also adopted a Code of
Business Conduct covering all Employees and a Code of Ethics for the Chief
Executive Officer, Chief Financial Officer, and Financial Managers. Each of
these documents are available on the Company's website, www.21st.com, and a copy
will be mailed upon request from the Company's Investor Relations Department
(6301 Owensmouth Avenue, Woodland Hills, California 91367, phone 818-701-3595).
The Company intends to disclose any amendments to, or waivers of, the Code of
Ethics on behalf of the Company's Chief Executive Officer, Chief Financial
Officer, Controller, and persons performing similar functions on the Company's
website, at www.21st.com under the "About Us" caption, promptly following the
date of such amendment or waiver.
69
ITEM 11. EXECUTIVE COMPENSATION
Information in response to Item 11 is incorporated by reference from the
Company's definitive proxy statement to be filed in connection with the
Company's 2004 Annual Meeting of Stockholders pursuant to Instruction G(3) of
Form 10-K.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information in response to Item 12 is incorporated by reference from the
Company's definitive proxy statement to be filed in connection with the
Company's 2004 Annual Meeting of Stockholders pursuant to Instruction G(3) of
Form 10-K.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Certain Information in response to Item 13 is incorporated by reference from the
Company's definitive proxy statement to be filed in connection with the
Company's 2004 Annual Meeting of Stockholders pursuant to Instruction G(3) of
Form 10-K. All related party transactions, which require disclosure, are
included in the Management's Discussion and Analysis or the Notes to
Consolidated Financial Statements.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information in response to Item 14 is incorporated by reference from the
Company's definitive proxy statement to be filed in connection with the
Company's 2004 Annual Meeting of Stockholders pursuant to Instruction G(3) of
Form 10-K.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) DOCUMENTS FILED WITH THIS REPORT
(1) FINANCIAL STATEMENTS
The following consolidated financial statements of the Company are filed as
a part of this report:
PAGE
(i) Report of independent auditors 38
(iii) Consolidated balance sheets - December 31, 2003 and 2002; 39
(iv) Consolidated statements of operations - Years ended December 31,
2003, 2002 and 2001; 40
(v) Consolidated statements of stockholders' equity - Years ended
December 31, 2003, 2002 and 2001; 41
(vi) Consolidated statements of cash flows - Years ended December 31,
2003, 2002 and 2001; 42
(vii) Notes to consolidated financial statements 43
70
(2) SCHEDULES
The following financial statement schedule required to be filed by Item 8
and by paragraph (d) of Item 15 of Form 10-K is submitted as a separate
section of this report.
Schedule II - Condensed Financial Information of Registrant 74
Schedules I, III, IV, V and VI have been omitted as all required data is
included in the Notes to Consolidated Financial Statements.
All other schedules for which provision is made in the applicable
accounting regulations of the Securities and Exchange Commission are not
required under the related instructions or are inapplicable and, therefore,
have been omitted.
(b) REPORTS ON FORM 8-K.
During the quarter ended December 31, 2003, the Company filed the following
Reports on Form 8-K:
(1) Current report on Form 8-K filed on October 24, 2003, setting forth
the press release that announced that the Board of Directors approved
the reincorporation of 21st Century Insurance Group, changing its
state of incorporation from California to Delaware.
(2) Current report on Form 8-K filed on November 6, 2003, setting forth
the earnings release for the quarter ended September 30, 2003.
(3) Current report on Form 8-K filed on December 5, 2003, setting forth
the press release that announced that the Company intends, subject to
market and other customary conditions, to privately offer up to $100
million principal amount of senior notes due 2013.
(4) Current report on Form 8-K filed on December 9, 2003, setting forth
the press release that announced that the reincorporation that changed
the Company's state of incorporation from California to Delaware
became effective on December 4, 2003.
71
(c) EXHIBITS REQUIRED
The following exhibits required by Item 601 of Regulation S-K and by
paragraph (c) of Item 15 of Form 10-K are listed by number corresponding to
the Exhibit Table of Item 601 of Regulation S-K and are filed as part of
this Annual Report on Form 10-K or are incorporated herein by reference:
3(i) Certificate of Incorporation incorporated herein by reference to Appendix B from
the Registrant's Information Statement on Form DEF 14C filed on November 13,
2003.
3(ii) By-laws incorporated herein by reference to Appendix C from the Registrant's
Information Statement on Form DEF 14C dated November 13, 2003.
4.1 Indenture, dated December 9, 2003, between 21st Century Insurance Group and The
Bank of New York, as trustee.
4.2 Exchange and Registration Rights Agreement, dated December 9, 2003.
10(a) Amendment to Registrant's Restricted Shares Plan incorporated herein by reference
from the Registrant's Form 10-K for year ended December 31, 2001.
10(b) Split Dollar Insurance Agreement between Registrant and Stanley M. Burke, as
trustee of the 1983 Foster Insurance Trust incorporated herein by reference from the
Registrant's Form 10-K for year ended December 31, 2001.
10(c) Registrant's Supplemental Executive Retirement Plan as amended incorporated
herein by reference from the Registrant's Form 10-K for year ended December 31,
2001.
10(d) Registrant's Pension Plan, 1994 Amendment and Restatement, incorporated herein
by reference from the Registrant's Form 10-K for year ended December 31, 2001.
10(e) Investment and Strategic Alliance Agreement incorporated herein by reference from
the Registrant's Form 10-K for year ended December 31, 2001.
10(f) Amendment to the Investment and Strategic Alliance Agreement incorporated
herein by reference from the Registrant's Form 10-K for year ended December 31,
2001.
10(g) Registrant's 1995 Stock Option Plan incorporated herein by reference from the
Registrant's Form S-8 dated July 26, 1995.
10(h) Amendment to Registrant's 1995 Stock Option Plan incorporated herein by
reference from the Registrant's DEF 14A dated April 18, 1997.
10(i) 2003 Short Term Incentive Plan.
10(j) Amendment to Registrant's 1995 Stock Option Plan incorporated herein by
reference from the Registrant's DEF 14A dated April 30, 2001.
10(k) Registrant's Savings and Security Plan incorporated herein by reference from the
Registrant's Form 10-K for year ended December 31, 2001.
10(l) Lease Agreements for Registrant's Principal Offices substantially in the form of this
Exhibit.
10(m) Forms of Amended and Restated Stock Option Agreements.
10(n) Form of Restricted Shares Agreement.
10(o) Retention Agreements substantially in the form of this Exhibit for executives
Richard A. Andre, Michael J. Cassanego, G. Edward Combs, Carmelo Spinella and
Dean E. Stark.
10(p) Sale and Leaseback Agreement between 21st Century Insurance Company and
General Electric Capital Corporation, for itself, and as agent for Certain
Participants, as amended, dated December 31, 2002.
14 Code of Ethics.
72
21 Subsidiaries of Registrant.
23 Consent of Independent Auditors.
31.1 Certification of President and Chief Executive Officer Pursuant to
Exchange Act Rule 13a-14(a).
31.2 Certification of Chief Financial Officer Pursuant to Exchange Act Rule 13a-14(a).
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
73
SCHEDULE II
21ST CENTURY INSURANCE GROUP (PARENT COMPANY)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
AMOUNTS IN THOUSANDS
December 31, 2003 2002
--------------------------------------------------------------------------------------------------
ASSETS
Cash $ 24,361 $ 5,946
Fixed maturities available-for-sale, at fair value - 1,031
Accounts receivable from subsidiaries 242 225
Unamortized debt issuance costs 1,274 -
Investment in unconsolidated insurance subsidiaries and affiliates, at equity 702,580 610,703
Property and equipment at cost less accumulated depreciation of $19,430
in 2003 and $16,257 in 2002, including software leased to a subsidiary
of $84,242 in 2003 (net of accumulated depreciation of $18,591) 84,361 64,107
Other assets 5 34
--------------------------------------------------------------------------------------------------
Total assets $812,823 $682,046
--------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Debt $ 99,871 $ -
Dividends payable 1,709 1,708
Accounts payable and accrued expenses 10,324 10,412
Deferred tax liabilities 229 818
Accounts payable to subsidiaries - 13,500
--------------------------------------------------------------------------------------------------
Total liabilities 112,133 26,438
--------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------
Common stockholders' equity 700,690 655,608
--------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $812,823 $682,046
--------------------------------------------------------------------------------------------------
74
SCHEDULE II
21ST CENTURY INSURANCE GROUP (PARENT COMPANY)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF OPERATIONS
AMOUNTS IN THOUSANDS
Years Ended December 31, 2003 2002 2001
-----------------------------------------------------------------------------------------
REVENUES
Dividends received from subsidiaries $ - $ - $ 3,076
Realized investment gains - 289 706
Interest and other income 792 1,100 4,644
-----------------------------------------------------------------------------------------
Total revenues 792 1,389 8,426
-----------------------------------------------------------------------------------------
EXPENSES
Loan interest and fees 378 - -
General and administrative 3,198 72 10
-----------------------------------------------------------------------------------------
Total expenses 3,576 72 10
-----------------------------------------------------------------------------------------
(Loss) income before provision for income taxes (2,784) 1,317 8,416
Provision for income taxes (415) (5,436) (529)
-----------------------------------------------------------------------------------------
Net income (loss) before equity in undistributed loss of
Subsidiaries (3,199) (4,119) 7,887
Equity in undistributed income (loss) of subsidiaries 56,774 (8,137) (35,455)
-----------------------------------------------------------------------------------------
Net income (loss) $53,575 $(12,256) $(27,568)
-----------------------------------------------------------------------------------------
75
SCHEDULE II
21ST CENTURY INSURANCE GROUP (PARENT COMPANY)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF CASH FLOWS
AMOUNTS IN THOUSANDS
Years Ended December 31, 2003 2002 2001
----------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net income (loss) $ 53,575 $(12,256) $(27,568)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Realized gains on sale of investments - (289) (706)
Provision (benefit) for deferred income taxes 415 5,436 529
Equity in undistributed income of subsidiaries (56,774) 8,137 35,455
Other (128) (2,304) 3,001
----------------------------------------------------------------------------------------
NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES (2,912) (1,276) 10,711
----------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Capital contributed to subsidiaries (37,917) (1,000) -
Advance from subsidiary 9,300 - -
Repayment of advance from subsidiary (47,083) (2,688) 0
Net proceeds from investments available for sale 1,000 23,726 18,531
Net purchases of property and equipment 3,641 (236) 5,073
----------------------------------------------------------------------------------------
NET CASH (USED IN) PROVIDED BY INVESTING ACTIVITIES (71,059) 19,802 23,604
----------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Proceeds from exercise of options - 1,488 1,233
Proceeds from issuance of debt 99,871 - -
Payment of debt issuance costs (650) - -
Dividends paid (6,835) (22,210) (27,310)
----------------------------------------------------------------------------------------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 92,386 (20,722) (26,077)
----------------------------------------------------------------------------------------
Net increase (decrease) in cash 18,415 (2,196) 8,238
Cash and cash equivalents, beginning of year 5,946 8,142 (96)
----------------------------------------------------------------------------------------
Cash and cash equivalents, end of year $ 24,361 $ 5,946 $ 8,142
----------------------------------------------------------------------------------------
76
SCHEDULE II
21ST CENTURY INSURANCE GROUP (PARENT COMPANY)
NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT
DECEMBER 31, 2003
The accompanying condensed financial statements of 21st Century Insurance Group
(the "Registrant") should be read in conjunction with the consolidated financial
statements and notes thereto of 21st Century Insurance Group and subsidiaries
included in the Registrant's 2003 Annual Report.
Debt - Debt at December 31, 2003 consisted of 5.9% senior notes maturing in
December 2013. Debt includes amounts the Registrant has borrowed and contributed
to the capital of its insurance subsidiaries or borrowed for other long-term
purposes. The entire principal amount is due at maturity.
77
SIGNATURES OF OFFICERS AND BOARD OF DIRECTORS
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.
Date: February 10, 2004 21ST CENTURY INSURANCE GROUP
(Registrant)
By: /s/ Bruce W. Marlow
-----------------------
Bruce W. Marlow
President and Chief 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 on the 10th of February, 2004.
SIGNATURE TITLE
/s/ Bruce W. Marlow
-----------------------------------
Bruce W. Marlow President and Chief Executive Officer and Director
(Principal Executive Officer)
/s/ Carmelo Spinella
-----------------------------------
Carmelo Spinella Sr. Vice President and Chief Financial Officer
(Principal Financial Officer)
/s/ Robert M. Sandler
-----------------------------------
Robert M. Sandler Chairman of the Board
/s/ John B. De Nault, III
-----------------------------------
John B. De Nault, III Director
/s/ R. Scott Foster, M.D.
-----------------------------------
R. Scott Foster, M.D. Director
/s/ Roxani M. Gillespie
-----------------------------------
Roxani M. Gillespie Director
/s/ Jeffrey L. Hayman
-----------------------------------
Jeffrey L. Hayman Director
/s/ Fred J. Martin, Jr.
-----------------------------------
Fred J. Martin, Jr. Director
/s/ James P. Miscoll
-----------------------------------
James P. Miscoll Director
/s/ Keith W.Renken
-----------------------------------
Keith W. Renken Director
78
/s/ Gregory M. Shepard
-----------------------------------
Gregory M. Shepard Director
/s/ Howard I. Smith
-----------------------------------
Howard I. Smith Director
79