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SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
[x] Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934
For the quarter ended March 31, 2003.
--------------
[ ] Transition Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934
For the transition period from to
Commission File Number 0-05544
OHIO CASUALTY CORPORATION
(Exact name of registrant as specified in its charter)
OHIO
(State or other jurisdiction of incorporation or organization)
31-0783294
(I.R.S. Employer Identification No.)
9450 Seward Road, Fairfield, Ohio
(Address of principal executive offices)
45014
(Zip Code)
(513) 603-2400
(Registrant's telephone number)
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 whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act).
Yes X No
The aggregate market value as of May 1, 2003 of the voting stock held by
non-affiliates of the registrant was $704,511,818.
On May 1, 2003, there were 60,845,141 shares outstanding.
Page 1 of 27
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INDEX
Page
----
PART I
Item 1. Financial Statements 3
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures
about Market Risk 23
Item 4. Controls and Procedures 23
PART II
Item 1. Legal Proceedings 23
Item 2. Changes in Securities and Use of Proceeds 23
Item 3. Defaults Upon Senior Securities 24
Item 4. Submission of Matters to a Vote of Security Holders 24
Item 5. Other Information 24
Item 6. Exhibits and reports on Form 8-K 24
Signature 25
Certifications 26
Exhibit 3 Code of Regulations of Ohio Casualty Corporation,
as approved by the shareholders at the annual
meeting on April 16, 2003
Exhibit 10 The Ohio Casualty Insurance Company 2003 Officer
Annual Incentive Program
Exhibit 99.1 Certification of Chief Executive Officer of
Ohio Casualty Corporation in accordance with
Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 99.2 Certification of Chief Financial Officer of
Ohio Casualty Corporation in accordance with
Section 906 of the Sarbanes-Oxley Act of 2002
2
PART I
ITEM 1. FINANCIAL STATEMENTS
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
(Dollars in millions, except share data) (Unaudited) 2003 2002
- -----------------------------------------------------------------------------------
Assets
Investments:
Fixed maturities:
Available-for-sale, at fair value $2,847.2 $3,139.8
(amortized cost: $2,672.8 and $2,967.5)
Held-to-maturity, at amortized cost
(fair value: $368.6) 368.8 -
Equity securities, at fair value
(cost: $84.3 and $92.6) 270.3 312.5
Short-term investments 23.9 49.8
- ----------------------------------------------------------------------------------
Total investments 3,510.2 3,502.1
Cash 20.8 12.4
Premiums and other receivables, net of allowance
for bad debts of $4.5 and $4.3, respectively 328.7 324.7
Deferred policy acquisition costs 178.8 181.3
Property and equipment, net of accumulated
depreciation of $144.8 and $145.9, respectively 95.4 97.8
Reinsurance recoverable 464.9 419.9
Agent relationships, net of accumulated
amortization of $35.4 and $34.1, respectively 156.5 161.3
Interest and dividends due or accrued 40.0 46.0
Deferred income taxes 6.1 2.4
Other assets 26.6 31.1
- ----------------------------------------------------------------------------------
Total assets $4,828.0 $4,779.0
==================================================================================
Liabilities
Insurance reserves:
Losses $2,012.2 $1,978.8
Loss adjustment expenses 460.3 454.9
Unearned premiums 675.9 668.7
Debt 198.2 198.3
Other liabilities 413.2 419.6
- ----------------------------------------------------------------------------------
Total liabilities 3,759.8 3,720.3
Shareholders' Equity
Common stock, $.125 par value
Authorized shares: 150,000,000
Issued shares: 72,418,344; 72,418,344 9.0 9.0
Common stock purchase warrants 21.1 21.1
Accumulated other comprehensive income 235.4 246.2
Retained earnings 956.6 936.7
Treasury stock, at cost:
(Shares: 11,659,377; 11,692,976) (153.9) (154.3)
- ----------------------------------------------------------------------------------
Total shareholders' equity 1,068.2 1,058.7
- ----------------------------------------------------------------------------------
Total liabilities and shareholders' equity $4,828.0 $4,779.0
==================================================================================
Accompanying notes are an integral part of these financial statements. For
complete disclosures see Notes to Consolidated Financial Statements on pages
57-70 of the Corporation's 2002 Form 10-K.
3
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF INCOME
Three Months
(Dollars in millions, except share data) Ended March 31,
(Unaudited) 2003 2002
- ----------------------------------------------------------------------------
Premiums and finance charges earned $349.3 $361.3
Investment income less expenses 53.2 50.9
Investment gains realized, net 19.3 22.8
- ----------------------------------------------------------------------------
Total revenues 421.8 434.7
Losses and benefits for policyholders 208.8 211.8
Loss adjustment expenses 47.4 51.5
General operating expenses 30.2 26.2
Amortization of agent relationships 1.9 2.7
Write-down of agent relationships 2.9 5.3
Amortization of deferred policy acquisition costs 97.5 92.2
Depreciation and amortization expense 3.3 3.9
- ----------------------------------------------------------------------------
Total expenses 392.0 393.6
- ----------------------------------------------------------------------------
Income before income taxes 29.8 41.1
Income tax expense:
Current 7.7 1.2
Deferred 2.2 13.0
- ----------------------------------------------------------------------------
Total income tax expense 9.9 14.2
- ----------------------------------------------------------------------------
Net income $ 19.9 $ 26.9
============================================================================
Average shares outstanding - basic 60,728,489 60,186,697
============================================================================
Earnings per share - basic
Net income, per share $ 0.33 $ 0.45
============================================================================
Average shares outstanding - diluted 60,968,486 61,061,794
============================================================================
Earnings per share - diluted
Net income, per share $ 0.33 $ 0.44
============================================================================
Accompanying notes are an integral part of these financial statements. For
complete disclosures see Notes to Consolidated Financial Statements on pages
57-70 of the Corporation's 2002 Form 10-K.
4
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF
SHAREHOLDERS' EQUITY
Accumulated
Additional Common other Total
(Dollars in millions, except Common paid-in stock purchase comprehensive Retained Treasury shareholders'
share data) (Unaudited) Stock capital warrants income earnings stock equity
- --------------------------------------------------------------------------------------------------------------------------
Balance
January 1, 2002 $11.8 $ 4.1 $21.1 $274.4 $1,221.4 $(452.9) $1,079.9
Net income 26.9 26.9
Net change in unrealized gain
net of deferred income tax
benefit of $23.2 (43.1) (43.1)
---------
Comprehensive loss (16.2)
Net issuance of treasury
stock (192,205 shares) (0.1) (0.1) 2.5 2.3
Retirement of treasury
stock (22,000,000 shares) 2.8 (4.0) (283.6) 290.4 -
- -------------------------------------------------------------------------------------------------------------------------
Balance,
March 31, 2002 $ 9.0 $ - $21.1 $231.3 $ 964.6 $(160.0) $1,066.0
=========================================================================================================================
Balance
January 1, 2003 $ 9.0 $ - $21.1 $246.2 $ 936.7 $(154.3) $1,058.7
Net income 19.9 19.9
Net change in unrealized gain
net of deferred income tax
benefit of $5.8 (10.8) (10.8)
----------
Comprehensive income 9.1
Net issuance of treasury
stock (33,599 shares) 0.4 0.4
- --------------------------------------------------------------------------------------------------------------------------
Balance,
March 31, 2003 $ 9.0 $ - $21.1 $235.4 $ 956.6 $(153.9) $1,068.2
==========================================================================================================================
Accompanying notes are an integral part of these financial statements. For
complete disclosures see Notes to Consolidated Financial Statements on pages
57-70 of the Corporation's 2002 Form 10-K.
5
Ohio Casualty Corporation & Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
Three Months
Ended March 31,
(Dollars in millions) (Unaudited) 2003 2002
- ---------------------------------------------------------------------------
Cash flows from Operating Activities:
Net income $ 19.9 $ 26.9
Adjustments to reconcile net income
to cash from operations:
Changes in:
Insurance reserves 46.0 18.1
Income taxes 17.1 20.5
Premiums and other receivables (3.9) (11.8)
Deferred policy acquisition costs 2.5 (4.3)
Reinsurance recoverable (45.0) (0.3)
Other assets 3.7 2.7
Other liabilities (21.7) (17.0)
Amortization and write-down of agent
relationships 4.8 8.0
Depreciation and amortization 3.5 4.1
Investment gains (19.3) (22.8)
- ---------------------------------------------------------------------------
Net cash provided by operating activities 7.6 24.1
- ---------------------------------------------------------------------------
Cash Flows from Investing Activities:
Purchase of securities:
Fixed maturity, available-for-sale (300.6) (335.4)
Proceeds from sales of securities:
Fixed maturity, available-for-sale 231.3 265.6
Equity 28.6 42.1
Proceeds from maturities and calls of
securities:
Fixed maturity, available-for-sale 13.1 0.6
Equity 3.9 -
Property and equipment:
Purchases (1.7) (6.4)
Sales 0.2 0.2
- ---------------------------------------------------------------------------
Net cash used in investing activities (25.2) (33.3)
- ---------------------------------------------------------------------------
Cash Flows from Financing Activities:
Debt:
Proceeds from the issuance of convertible
note - 201.3
Payments (0.2) (205.2)
Payment of issuance costs - (7.2)
Proceeds from exercise of stock options 0.3 2.3
- ---------------------------------------------------------------------------
Net cash provided by (used in) financing
activities 0.1 (8.8)
- ---------------------------------------------------------------------------
Net decrease in cash and cash equivalents (17.5) (18.0)
Cash and cash equivalents, beginning of period 62.2 92.3
- ---------------------------------------------------------------------------
Cash and cash equivalents, end of period $ 44.7 $ 74.3
===========================================================================
Accompanying notes are an integral part of these financial statements.
For complete disclosures see Notes to Consolidated Financial Statements
on pages 57-70 of the Corporation's 2002 Form 10-K.
6
Ohio Casualty Corporation & Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Ohio Casualty Corporation (the Corporation) is the holding company of The
Ohio Casualty Insurance Company (the Company), which is one of six property-
casualty companies that make up the Ohio Casualty Group (the Group).
NOTE I - INTERIM ADJUSTMENTS
It is believed that all material adjustments necessary to present a fair
statement of the results of the interim period covered are reflected in this
report. The operating results for the interim periods are not necessarily
indicative of the results to be expected for the full year. These statements
should be read in conjunction with the financial statements and notes thereto
in the Corporation's 2002 Annual Report to Shareholders.
NOTE II - STOCK OPTIONS
The Corporation accounts for stock options issued to employees in accordance
with Accounting Principles Board Opinion (APB) No. 25," Accounting for Stock
Issued to Employees." Under APB 25, the Corporation recognizes expense based
on the intrinsic value of options. Had the Corporation adopted FAS 123
"Accounting for Stock Based Compensation," the Corporation's net income and
earnings per share would have been reduced to the pro forma amounts disclosed
below:
March 31 March 31
($ in millions) 2003 2002
- -------------------------------------------------------------------------
Net income
As reported $19.9 $26.9
Compensation expense, net of tax 1.4 1.3
----- -----
Pro forma $18.5 $25.6
Basic EPS
As reported $.33 $.45
Pro Forma $.30 $.43
Diluted EPS
As reported $.33 $.44
Pro Forma $.30 $.42
=========================================================================
7
NOTE III - EARNINGS PER SHARE
Basic and diluted earnings per share are summarized as follows (in millions,
except per share data):
Three months ended
March 31
2003 2002
---- ----
Net income $19.9 $26.9
Weighted average common shares
outstanding - basic (thousands) 60,728 60,187
Basic earnings per weighted
average share $.33 $.45
==========================================================================
Weighted average common shares
outstanding (thousands) 60,728 60,187
Effect of dilutive securities (thousands) 240 875
- --------------------------------------------------------------------------
Weighted average common shares
outstanding - diluted (thousands) 60,968 61,062
Diluted earnings per weighted
average share $.33 $.44
==========================================================================
NOTE IV -- SEGMENT INFORMATION
The Corporation has determined its reportable segments based upon its method
of internal reporting, which was organized by product line. The property and
casualty segments are Commercial Lines, Specialty Lines, and Personal Lines.
These segments generate revenues by selling a wide variety of personal,
commercial and surety insurance products. The Corporation also has an all
other segment which derives its revenues from investment income and premium
financing.
Each segment of the Corporation is managed separately. The property and
casualty segments are managed by assessing the performance and profitability
of the segments through analysis of industry financial measurements including
statutory loss and loss adjustment expense ratios, statutory combined ratio,
premiums written, premiums earned and statutory underwriting gain/loss. The
following tables present this information by segment as it is reported
internally to management. Asset information by reportable segment is not
reported, since the Corporation does not produce such information internally.
8
Three Months Ended March 31
($ in millions)
Commercial Lines Segment 2003 2002
- ----------------------------------------------------------------------
Net premiums written $205.2 $192.8
% Change 6.4% 8.1%
Net premiums earned 189.8 174.2
% Change 9.0% (4.5)%
Underwriting loss (before tax) (26.8) (21.2)
Loss ratio 61.3% 54.2%
Loss expense ratio 13.3% 18.0%
Underwriting expense ratio 36.6% 36.1%
Combined ratio 111.2% 108.3%
Specialty Lines Segment 2003 2002
- ----------------------------------------------------------------------
Net premiums written $32.9 $39.5
% Change (16.7)% 31.4%
Net premiums earned 38.4 29.9
% Change 28.4% 3.7%
Underwriting gain (before tax) 5.4 1.0
Loss ratio 23.8% 36.6%
Loss expense ratio 17.9% 4.8%
Underwriting expense ratio 51.5% 42.0%
Combined ratio 93.2% 83.4%
Personal Lines Segment 2003 2002
- ----------------------------------------------------------------------
Net premiums written $114.1 $142.6
% Change (20.0)% (12.4)%
Net premiums earned 121.1 156.9
% Change (22.8)% (7.7)%
Underwriting loss (before tax) (10.4) (7.5)
Loss ratio 68.4% 67.8%
Loss expense ratio 12.6% 11.9%
Underwriting expense ratio 29.3% 27.6%
Combined ratio 110.3% 107.3%
Total Property & Casualty 2003 2002
- ----------------------------------------------------------------------
Net premiums written $352.2 $374.9
% Change (6.1)% 1.0%
Net premiums earned 349.3 361.0
% Change (3.2)% (5.8)%
Underwriting loss (before tax) (31.8) (27.7)
Loss ratio 59.6% 58.7%
Loss expense ratio 13.6% 14.3%
Underwriting expense ratio 35.6% 33.5%
Combined ratio 108.8% 106.5%
Impact of catastrophe losses on
combined ratio 3.1% 0.9%
All other 2003 2002
- ----------------------------------------------------------------------
Revenues $1.8 $ (.5)
Expenses 2.6 1.3
- ----------------------------------------------------------------------
Net loss $(.8) $(1.8)
Reconciliation of Revenues 2003 2002
- ----------------------------------------------------------------------
Net premiums earned for
reportable segments $349.3 $361.0
Investment income 51.5 50.7
Realized gains 16.4 22.5
- ----------------------------------------------------------------------
Total property and casualty
revenues (Statutory basis) 417.2 434.2
Property and casualty statutory
to GAAP adjustment 2.8 1.1
- ----------------------------------------------------------------------
Total revenues property and
casualty (GAAP basis) 420.0 435.3
Other segment revenues (expenses) 1.8 (.6)
- ----------------------------------------------------------------------
Total revenues $421.8 $434.7
======================================================================
Reconciliation of Underwriting
loss (before tax) 2003 2002
- ----------------------------------------------------------------------
Property and casualty under-
writing loss (before tax)
(Statutory basis) $(31.8) $(27.7)
Statutory to GAAP adjustment (7.8) (2.4)
- ----------------------------------------------------------------------
Property and casualty under-
writing loss (before tax)
(GAAP basis) (39.6) (30.1)
Net investment income 53.2 50.9
Realized gains 19.3 22.8
Other losses (3.1) (2.4)
- ----------------------------------------------------------------------
Income before income taxes $ 29.8 $ 41.2
======================================================================
9
NOTE V - AGENT RELATIONSHIPS
The agent relationships asset is an identifiable intangible asset acquired in
connection with the 1998 Great American Insurance Company (GAI) commercial
lines acquisition. The Corporation follows the practice of allocating
purchase price to specifically identifiable intangible assets based on their
estimated values as determined by appropriate valuation methods. In the GAI
acquisition, the purchase price was allocated to agent relationships and
deferred policy acquisition costs. Periodically, agent relationships are
evaluated as events or circumstances indicate a possible inability to recover
their carrying amount. In the first quarter of 2003, the Corporation wrote
off the agent relationships asset by $2.9 million for agency cancellations
and impairment. The first quarter 2002 included a write off of $5.3 million
to the agent relationships asset for agency cancellations and impairment.
The remaining portion of the agent relationships asset will be amortized on a
straight-line basis over the remaining useful period of approximately 21
years. Amortization expense for the periods 2003 through 2007 is expected to
approximate $8.0 million before tax per year.
Based on historical data the remaining agents have been profitable. Future
cancellation of agents included in the agent relationships intangible asset
or a diminution of certain former Great American agents' estimated future
revenues or profitability is likely to cause further impairment losses beyond
the quarterly amortization of the remaining asset value over the remaining
useful lives.
NOTE VI - INTERNALLY DEVELOPED SOFTWARE
In accordance with SOP 98-1, "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use," the Corporation capitalizes costs
incurred during the application development stage for the development of
internal-use software. These costs primarily relate to payroll and payroll-
related costs for employees along with costs incurred for external
consultants who are directly associated with the internal-use software
project. Costs such as maintenance, training, data conversion, overhead and
general and administrative are expensed as incurred. Management believes the
expected future cash flows of the asset exceed the carrying value. The
expected future cash flows are determined using various assumptions and
estimates, changes in these assumptions could result in an impairment of the
asset and a corresponding charge to net income. The costs associated with
the software are amortized on a straight-line basis over an estimated useful
life of 10 years commencing when the software is substantially complete and
ready for its intended use. Unamortized software costs and accumulated
amortization in the consolidated balance sheet were $50.3 million and $4.2
million at March 31, 2003, and $50.3 million and $3.7 million at December 31,
2002, respectively.
NOTE VII - CONVERTIBLE DEBT
In 2002, the Corporation completed an offering of 5.00% convertible notes, in
an aggregate principal amount of $201.3 million, due March 19, 2022 and
generated net proceeds of $194.0 million. The net proceeds of the offering,
along with $10.5 million of cash, were used to pay off the balance and
terminate an outstanding credit facility. The issuance and related costs are
amortized over the life of the bonds and are recorded as related fees. The
Corporation uses the effective interest rate method to record the interest
and related fee amortization. Interest is payable on March 19 and September
19 of each year, and began September 19, 2002. The notes may be converted
into shares of the Corporation's common stock under certain conditions,
including: if the sale price of the Corporation's common stock reaches
specific thresholds; if the credit rating of the notes is below a specified
level or withdrawn, or if the notes have no credit rating during any period;
or if specified corporate transactions have occurred. The conversion rate is
44.2112 shares per each one thousand dollar principal amount of notes,
subject to adjustment in certain circumstances. The convertible debt impact
on earnings per share will be based on the "if-converted" method. The impact
on diluted earnings per share is contingent on whether or not certain
criteria have been met for conversion. As of March 31, 2003, the common
share price criterion had not been met and, therefore, no adjustment to the
number of diluted shares in the earnings per share calculation was made for
the convertible debt. On or after March 23, 2005, the Corporation has the
option to redeem all or a portion of the notes that have not been previously
converted at the following redemption prices (expressed as a percentage of
principal amount):
10
During the twelve months commencing Redemption Price
- ----------------------------------- ----------------
March 23, 2005 102%
March 19, 2006 101%
March 19, 2007 until maturity of the notes 100%
The holders of the notes have the option to require the Corporation to
purchase all or a portion of their notes on March 19 of 2007, 2012 and 2017
at 100% of the principal amount of the notes. In addition, upon a change in
control of the Corporation occurring anytime prior to maturity, holders may
require the Corporation to purchase for cash all or a portion of their notes
at 100% of the principal amount plus accrued interest.
On July 31, 2002, the Corporation entered into a revolving credit agreement.
Under the terms of the credit agreement, the lenders agreed to make loans to
the Corporation in an aggregate amount up to $80.0 million for general
corporate purposes. Interest is payable in arrears, and the interest rate on
borrowings under the credit agreement is based on a margin over LIBOR or the
LaSalle Bank Prime Rate, at the option of the Corporation. The Corporation
has capitalized approximately $0.4 million in fees related to establishing
the line of credit and amortizes the fees over the term of the agreement. In
addition, the Corporation is obligated to pay agency fees and facility fees
of up to $0.2 million annually. These fees are expensed when incurred by the
Corporation. The agreement requires the Corporation to maintain minimum net
worth of $800.0 million. The credit facility agreement also includes a
minimum statutory surplus for The Ohio Casualty Insurance Company of $625.0
million through September 30, 2003, increasing to $650.0 million thereafter.
The credit agreement will expire on March 15, 2005. Additionally, financial
covenants and other customary provisions, as defined in the agreement, exist.
The outstanding loan amount of the revolving line of credit was zero at March
31, 2003.
During 1999, the Corporation signed a $6.5 million low interest loan with the
state of Ohio used in conjunction with the home office purchase. The Ohio
Casualty Insurance Company granted a mortgage on its home office property as
security for the loan. As of March 31, 2003, the loan bears a fixed interest
rate of 2%, increasing to the maximum rate of 3% in December 2004. The loan
requires annual principal payments of approximately $0.6 million and expires
in November 2009. The remaining balance at March 31, 2003 was $4.4 million.
NOTE VIII - CONTINGENCIES
In the fourth quarter of 2001, Ohio Casualty of New Jersey, Inc. (OCNJ)
entered into an agreement to transfer its obligations to renew private
passenger auto business in New Jersey to Proformance Insurance Company
(Proformance). The transaction effectively exited the Group from the New
Jersey private passenger auto market. The Group continues to write private
passenger auto in other markets. Under the terms of the transaction, the
Group member OCNJ agreed to pay Proformance $40.6 million to assume its
renewal obligations. Payments were made over the course of twelve months
beginning in early 2002 with final payment made during the first quarter of
2003. The contract stipulates that a premiums-to-surplus ratio of 2.5 to 1
must be maintained on the transferred business during the next three years.
If this criteria is not met, OCNJ will have a contingent liability of up to
$15.6 million to be paid to Proformance to maintain this premiums-to-surplus
ratio. As of March 31, 2003, the Group has evaluated the contingency based
upon financial data provided by Proformance. The Group has concluded that it
is not probable the liability will be incurred and, therefore, has not
recognized a liability in the financial statements. The Group will continue
to monitor the contingency for any future liability recognition.
In the normal course of business, the Corporation and its subsidiaries are
involved in lawsuits related to their operations. In each of the matters,
the Corporation believes the ultimate resolution of such litigation will not
result in any material adverse impact to operations or financial condition of
the Corporation.
11
NOTE IX - TREASURY STOCK
During the first quarter of 2003, the Corporation did not retire any shares
of its treasury stock. In the first quarter of 2002, the Corporation retired
22 million shares of its treasury stock. The retirement did not have a net
impact on total shareholders' equity.
NOTE X - INVESTMENTS
During the first quarter of 2003, the Corporation and the Group transferred
$368.8 million of its fixed maturity securities from the available-for-sale
classification into the held-to-maturity classification. This transfer was
made as the Corporation and the Group have both the ability to hold the
securities to maturity and the positive intent to do so.
NOTE XI - SUBSEQUENT EVENT
On May 8, 2003 the Corporation filed a universal shelf registration statement
on Form S-3 with the Securities and Exchange Commission with respect to the
issuance of up to $500 million of securities, including debt securities,
common and preferred shares, warrants and share purchase contracts and units,
as well as trust preferred securities or a combination of the above. This
registration statement, when effective, will replace the Corporation's
previously filed shelf and provide the Corporation greater flexibility and
access to capital markets in the future. Although the Corporation has no
intention currently to issue securities from the new filing, after the
registration statement becomes effective, the Corporation may issue
securities for general corporate purposes.
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Ohio Casualty Corporation (the Corporation) is the holding company of The
Ohio Casualty Insurance Company (the Company), which is one of six property-
casualty companies that make up the Ohio Casualty Group (the Group).
RESULTS OF OPERATIONS
Net income
The Corporation reported net income of $19.9 million, or $.33 per share for
the first quarter ending March 31, 2003, compared with $26.9 million, or $.44
per share in the same quarter of 2002.
Investment Results
First quarter consolidated before-tax investment income increased 4.5% to
$53.2 million compared to $50.9 million for the same period last year.
During the first quarter of 2003, net investment income was positively
impacted by a settlement of $1.25 million for the termination of an
investment management agreement. The effective tax rate on investment income
for the first quarter of 2003 was 33.1% compared with 32.9% for the
comparable period in 2002.
For the first quarter 2003, consolidated before-tax realized gains were $19.3
million compared with $22.8 million for the first three months of 2002. The
Corporation and the Group continued to reduce equity holdings in favor of
investment grade fixed maturity investments in order to reduce the effect on
statutory surplus of future stock market volatility. Management of the
Corporation believes the significant volatility of realized investment gains
and losses limits the usefulness of net income as a measure of current
operating performance. Management uses the non-GAAP financial measure of net
income before realized gains and losses to further evaluate current operating
performance. Net income before realized gains and losses is reconciled to
net income in the table below:
12
Three months
Ended March 31
($ in millions) 2003 2002
- --------------- ---- ----
Net income before realized gains and losses $ 7.4 $12.1
After-tax realized gains and losses 12.5 14.8
------ -----
Net income $19.9 $26.9
For the first quarter 2003, consolidated after-tax realized gains positively
impacted net income by $12.5 million compared with $14.8 million for the
first three months of 2002. The Corporation and the Group did not sell any
securities with a material realized loss during the first quarter of 2003 and
2002.
In the first quarter of 2003, management decided to transfer $368.8 million
of its fixed maturity securities from the available-for-sale classification
into the held-to-maturity classification. This transfer was made as the
Corporation and the Group have both the ability to hold the securities to
maturity and the positive intent to do so.
The largest assets of the Corporation and the Group are their invested
assets. Consequently, accounting policies related to investments are
critical. See further discussion of investment accounting policies in the
"Critical Accounting Policies" section on page 37 of the Corporation's 2002
Form 10-K. The Corporation and the Group continually evaluate all of their
investments based on current economic conditions, credit loss experience and
other developments. The Corporation and the Group evaluate the difference
between the cost/amortized cost and estimated fair value of their investments
to determine whether a decline in value is temporary or other-than-temporary
in nature. This determination involves a degree of uncertainty. If a
decline in the fair value of a security is determined to be temporary, the
decline is recorded as an unrealized loss in shareholders' equity. If there
is a decline in a security's fair value that is considered to be other than
temporary, the security is written down to the estimated fair value with a
corresponding realized loss recognized in the consolidated statements of
income.
The assessment of whether a decline in fair value is considered temporary or
other-than-temporary includes management's judgement as to the financial
position and future prospects of the entity issuing the security. It is not
possible to accurately predict when it may be determined that a specific
security will become impaired. Future impairment charges could be material
to the results of operations of the Corporation and the Group. The amount of
impairment charge before tax was $5.6 million in the first quarter of 2003,
compared to $4.7 million in the first quarter of 2002.
Management believes that it will recover the cost basis in the securities
held with unrealized losses as it has both the intent and ability to hold the
securities until they mature or recover in value. Securities are sold to
achieve management's investment goals, which include the diversification of
credit risk, the maintenance of adequate portfolio liquidity and the
management of interest rate risk. In order to achieve these goals, sales of
investments are based upon current market conditions, liquidity needs and
estimates of the future market value of the individual securities.
The following table summarizes, for all available-for-sale securities, the
total gross unrealized losses, not including gross unrealized gains, by
investment category as of March 31, 2003 and December 31, 2002:
($ in millions) March 31, 2003 Dec 31, 2002
- -----------------------------------------------------------------------
Fixed maturities $(27.4) $(32.7)
Equities (5.8) (10.2)
- -----------------------------------------------------------------------
Total unrealized loss $(33.2) $(42.9)
As part of the evaluation of the entire $33.2 million aggregate unrealized
loss on the investment portfolio, management performed a more intensive
review of securities with a relatively higher degree of unrealized loss,
which is the difference between cost/amortized cost and estimated fair value.
In the review for other than temporarily impaired securities as of March 31,
2003, management concluded that of this group of securities with a relatively
higher degree of difference between cost/amortized cost and estimated fair
value, 13 securities, with an aggregate unrealized loss of $11.0 million,
were suffering only temporary
13
declines in fair value. Of this unrealized loss amount, $4.4 million
represented unrealized losses in the securities of Delta Airlines, Inc. All
securities are monitored by portfolio managers who consider many factors such
as a company's degree of financial flexibility, management competence and
industry fundamentals in evaluating whether the decline in fair value is
temporary. Should management subsequently conclude the decline in fair value
is other-than-temporary, the book value of the security is written down to
fair value with the realized loss recognized in the consolidated statements
of income.
The following table summarizes, for all available-for-sale securities in an
unrealized loss position, the gross unrealized loss by length of time the
securities have continuously been in an unrealized loss position at March 31,
2003:
Amortized Fair Unrealized
($ in millions) Cost Value Loss
- -------------------------------------------------------------------------
Fixed maturities
0-6 months $191.6 $185.3 $(6.3)
7-12 months 67.3 57.5 (9.8)
Greater than 12 months 108.0 96.7 (11.3)
- -------------------------------------------------------------------------
Total $366.9 $339.5 $(27.4)
Equity
0-6 months $ 2.6 $ 2.4 $ (.2)
7-12 months 26.3 20.7 (5.6)
Greater than 12 months .5 .5 -
- -------------------------------------------------------------------------
Total $29.4 $23.6 $(5.8)
Of the securities in an unrealized loss position as of March 31, 2003, the
only material concentration by industry segment was in the airline industry.
The amount of unrealized loss in this industry as of March 31, 2003 was $5.7
million.
The amortized cost and estimated fair value of available-for-sale fixed
maturity securities in an unrealized loss position at March 31, 2003, by
contractual maturity are shown below. Expected maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
Amortized Estimated Unrealized
($ in millions) Cost Fair Value Loss
- ---------------------------------------------------------------------------
Due in one year or less $ 9.1 $ 8.2 $ (.9)
Due after one year through
five years 31.5 28.7 (2.8)
Due after five years through
ten years 117.9 106.7 (11.2)
Due after ten years 208.4 195.9 (12.5)
- ---------------------------------------------------------------------------
Total $366.9 $339.5 $(27.4)
Agent Relationships
The agent relationships asset is an identifiable intangible asset
representing the excess of cost over fair value of net assets acquired in
connection with the acquisition of the commercial lines business from Great
American Insurance Company in 1998. Generally Accepted Accounting Principles
(GAAP) require the Corporation to perform a periodic comparison of estimated
future cash flows to the carrying value of the intangible asset. If the
estimated future cash flows are less than the carrying value for any
individual agent included in the asset, that portion of the asset must be
written down to its estimated fair value. For the first quarter of 2003, the
agent relationship impairment was $2.9 million, compared to first quarter
2002 impairment of $5.3 million. The calculation of impairment follows
accounting guidelines that do not permit increasing the intangible value for
agents who are now projected to generate more profit than was expected at the
time of the initial assignment of the intangible value to each agent.
Overall, the estimated future cash flows for the remaining acquired agents
exceed the remaining current asset book value of $156.5 million.
14
The determination of impairment involves the use of management estimates and
assumptions. Due to the inherent uncertainties and judgments involved in
making these assumptions and the fact that the asset cannot be increased for
any agent, further reductions in the valuation of the agent relationships
asset are likely to occur in the future and could be significant based on
uncertainties such as which agents will experience events such as changes in
revenue production or profitability.
Statutory Results
Management uses statutory financial criteria to analyze the Group's property
and casualty results and statutory financial measures are required to be
reported to insurance industry regulators. Management analyzes statutory
results through the use of insurance industry financial measures including
statutory loss and loss adjustment expense ratios, statutory underwriting
expense ratio, statutory combined ratio, net premiums written and net
premiums earned. The statutory combined ratio is a commonly used gauge of
underwriting performance measuring the percentages of premium dollars used to
pay insurance losses and related expenses. The combined ratio is the sum of
the loss ratio, the loss adjustment expense ratio and the underwriting
expense ratio. All references to combined ratio or its components in the
MD&A are calculated on a statutory accounting basis and are calculated on a
calendar year basis unless specified as calculated on an accident year basis.
A discussion of the differences between statutory accounting and generally
accepted accounting principles in the United States is included in Item 15
pages 67 and 68 of the Corporation's Form 10-K for the year ended December
31, 2002.
At March 31, 2003 and 2002, statutory surplus, a financial measure that is
required by insurance regulators and used to monitor financial strength, was
$733.8 million and $778.7 million, respectively. The ratio of twelve months
ended net premiums written to statutory surplus as of March 31, 2003 and
March 31, 2002 was 1.9 to 1.
Premium Revenue Results
Premium revenue reflects premiums earned by the Group. The Group's premiums
are earned principally on a monthly pro rata basis over the term of the
policy. Management analyzes premium revenues primarily by premiums written
in the current period. Net premiums written differs from gross premiums
written by premiums ceded to reinsurers.
The table below summarizes the increase (decrease) in property and casualty
premium results on a gross and net basis compared with same period prior year
results:
2003 increase (decrease) from 2002 ($ in millions)
Gross Premiums Net Premiums
Written Written
First Quarter First Quarter
-------------- -------------
Business Units
- --------------
Commercial Lines Segment $ 13.1 $ 12.3
Specialty Lines Segment 6.5 (6.5)
Personal Lines Segment (30.1) (28.5)
------- -------
All Lines $(10.5) $(22.7)
Agency cancellations, withdrawal from certain states and the exit from the
New Jersey private passenger auto market led to the decreases in personal
lines gross and net premiums written for the current quarter. The Commercial
Lines increase was driven by renewal price increases which averaged 13.2% in
the first quarter 2003 compared to 14.9% in the first quarter 2002.
Increased competition in several markets and more conservative underwriting
partially offset the price increases for net premiums written. Increased
reinsurance costs on commercial umbrella business drove the decline in net
premiums written for Specialty Lines. Specialty Lines premiums on a gross
basis, before reinsurance, increased 12.6% over first quarter 2002.
Commercial umbrella, the largest Specialty Lines product, recognized a 20.5%
average renewal price increase for the first quarter 2003, compared to 45.1%
in the same period in 2002. Renewal price
15
increase means the average increase in premium for policies renewed by the
Group. The average increase in premium for each renewed policy is calculated
by comparing the total expiring premium for the policy with the total renewal
premium for the same policy. Renewal price increases include, among other
things, the effects of rate increases and changes in the underlying insured
exposures of the policy. Only policies issued by the Group in the previous
policy term with the same policy identification codes are included.
Therefore, renewal price increases do not include changes in premiums for
newly issued policies or business assumed through reinsurance agreements.
Renewal price increases also do not reflect the cost of any reinsurance
purchased on the policies issued.
All Lines Discussion
The combined ratio for the first quarter was 108.8%, an increase of 2.3
points from the first quarter 2002 combined ratio of 106.5%. Catastrophe
losses increased 2.2 points over the first quarter 2002 contributing to the
deterioration in this ratio. In addition to catastrophe losses, the first
quarter 2003 included a higher frequency of non-catastrophe large property
losses and higher costs related to New Jersey personal auto results. Non-
catastrophe large property losses that exceeded $250,000 per loss negatively
impacted the first quarter 2003 combined ratio by 2.4 points, which was 1.3
points worse than the same quarter in 2002. New Jersey personal auto results
negatively impacted the current quarter All Lines combined ratio by 1.5
points compared to 1.2 points in the first quarter 2002 and 2.5 points for
the full year 2002. The underwriting expense ratio increased 2.1 points as
explained later in this MD&A. Also impacting the combined ratio were
assessments for the Group's share of underwriting losses on residual market
pools for workers' compensation. This negatively impacted first quarter 2003
combined ratio by .8 points versus .6 points in the same quarter in 2002 and
..2 points for the year 2002. The first quarter 2003 results included an
increase in the estimate of losses not yet reported by the pools based on
trends in reported results. The Group's reduction in workers' compensation
premium writings are expected to mitigate the negative impact of assessments
for the remainder of 2003. The above negative factors are partially offset
by improvements to loss ratios and other areas relating to better pricing and
improved underwriting.
The loss adjustment expense ratio for the first three months of 2003 was
13.6%. The ratio was .7 points lower than the first quarter 2002 loss
adjustment expense ratio of 14.3%. The decrease was primarily the result of
efforts to more effectively manage claims legal expenses. During the first
quarter of 2003, the Group announced a reorganization of its claims
operations, including a reduction in staff, which was effective in March
2003. The reduction will result in a net savings of approximately $1.8
million in 2003, after a first quarter 2003 charge of approximately $1.0
million for severance pay and other related expenses.
The first quarter catastrophe losses were $10.7 million and accounted for 3.1
points on the combined ratio. This compares with $3.3 million and a .9 point
catastrophe impact on the combined ratio for the same period in 2002. The
effect of future catastrophes on the Corporation's results cannot be
accurately predicted. Severe weather patterns can have a material adverse
impact on the Corporation's results. During the first quarter of 2003, there
were 5 additional catastrophes with the largest catastrophe generating $4.2
million in incurred losses as compared with 3 additional catastrophes in the
first quarter of 2002 with the largest catastrophe generating $2.0 million in
incurred losses. For additional disclosure of catastrophe losses, refer to
Item 15, Losses and Loss Reserves in the Notes to the Consolidated Financial
Statements on page 65 of the Corporation's 2002 Form 10-K.
The loss and loss adjustment expense (LAE) ratios, which measure losses and
LAE as a percentage of net earned premiums, were impacted by .8 points in
2003 by adjustments to estimated losses related to prior years' business
compared to 1.2 points in 2002. The loss and LAE ratio component of the
accident year combined ratio measures losses and LAE arising from insured
events that occurred in the respective accident year. The current accident
year excludes losses and LAE for insured events that occurred in prior
accident years. In total, this increase in provisions for prior accident
years' losses and LAE recognized during the year 2003 was $2.7 million before
tax compared to $4.2 million in the first quarter of 2002.
16
The table below summarizes the impact of changes in provision for all prior
accident year losses and LAE:
First Quarter
($ in millions) 2003 2002
- --------------------------------------------------------------------------
Statutory net liabilities, beginning of period $2,078.7 $1,982.0
Increase in provision for prior
accident year claims $2.7 $4.2
Increase in provision for prior
accident year claims as % of premiums earned 0.8% 1.2%
The first quarter 2003 underwriting expense ratio, which measures
underwriting expenses as a percentage of net written premiums, was 35.6% or
2.1 points higher than 33.5% for the first quarter of 2002 and .7 points
higher than the full year 2002 ratio of 34.9%. Although the Corporation
continues to monitor and manage expenses closely, the expense ratio increased
in the current quarter resulting from higher expenses related to investment
in technology, the impact of lower net premiums written and increased premium
related taxes and assessments.
The Group's internally developed software for policy administration and
rating, known as P.A.R.I.S.sm, is expected to be rolled out for all Commercial
Lines products in 2003. Information systems personnel costs were incurred
during the first quarter 2003 to maintain the software and were expensed as
incurred. During the first quarter of 2002, similar costs were capitalized
as the software was in the application development phase. This shift from
development to maintenance caused the majority of the increase in software
expenses. This higher expense plus amortization of expenses capitalized in
prior years totaled $4.2 million. This increase in expenses related to
investment in technology increased the first quarter 2003 underwriting
expense ratio by 1.1 points over the first quarter 2002.
The Group's remaining non-commission and non-tax related underwriting
expenses of $49.4 million in the first quarter 2003 decreased $4.0 million,
compared to the first quarter 2002. This positive impact on the expense
ratio was largely offset by lower net premiums written in the calculation of
the underwriting expense ratio. The impact of the decline in net premiums
written on these expenses was .9 points. This group of expenses is comprised
primarily of personnel related items and reflects the continued decline in
the employee count.
During the first quarter 2003, premium related taxes and assessment payments
for the current quarter were higher than similar taxes and assessments in the
first quarter of last year. The payments were primarily related to state
insurance funds such as guaranty funds and workers' compensation second
injury funds. The increased premium related taxes and assessments increased
the underwriting expense ratio by .7 points for the first quarter 2003
compared to the same quarter a year ago.
The table below summarizes the variance between the first quarter 2002 and
the first quarter 2003 expense ratio:
Variance from
First Qtr 2002
--------------
Underwriting expense ratio - first quarter 2002 33.5%
Additional expenses related to investment in technology 1.1%
Impact of decrease in net premiums written 0.9%
Impact of premium related taxes and assessments 0.7%
Impact of all other underwriting expense ratio items (0.6)%
------
Underwriting expense ratio - first quarter 2003 35.6%
The employee count continues to decline. As of March 31, 2003, the employee
count was 2,859, compared with 3,233 at March 31, 2002 and approximately
3,000 at December 31, 2002.
Segment Discussion
The Corporation's organizational structure is based on three operating units:
Commercial Lines, Specialty Lines and Personal Lines.
17
Commercial Lines Segment
Commercial Lines combined ratio for the first quarter of 2003 increased 2.9
points to 111.2% from 108.3% in the first quarter of 2002. The increase in
the 2003 combined ratio was due to a higher frequency of both catastrophes
and other large property losses as well as increases to the workers'
compensation loss ratio related to the National Workers' Compensation Pool.
The impact of the residual market pool for workers' compensation was 1.8
points in the first quarter in 2003 compared to 1.5 points during the first
quarter of 2002. The first quarter 2003 Commercial Lines loss ratio of 61.3%
increased 7.1 points from the loss ratio of 54.2% in the first quarter of
2002. The Commercial Lines average renewal price increases for direct
premiums written was 13.2% in the current quarter compared to 14.9% in the
first quarter of 2002.
The general liability combined ratio decreased in the first quarter of 2003
to 125.3%, from 144.4% in the same period of 2002. This line of business was
impacted in 2002 by additions to construction defect related reserves and
increased estimates of legal costs on claims from prior years. Construction
defect claims filed under general liability insurance policies involve
allegations of defective work on construction projects, such as condominiums,
apartment complexes, housing developments and office buildings. These claims
usually involve multiple parties and carriers. The loss estimates for these
claims are based on currently available information. However, given the
expansion of coverage and liability by the courts and legislatures, there is
uncertainty as to the ultimate liability. The 2003 accident year combined
ratio for general liability was 113.8%, 11.5 points lower than the calendar
year results.
Workers' compensation combined ratio for the first three months of 2003 was
134.8%, compared with 131.4% during the same period last year. Although the
Group has taken actions to improve workers' compensation results, assessments
for the National Workers' Compensation Pool contributed to the unfavorable
first quarter results in both 2003 and 2002. The impact of the National
Workers' Compensation residual market pool added 8.4 and 6.9 points to the
workers' compensation combined ratio for March 31, 2003 and 2002,
respectively.
Specialty Lines Segment
Specialty Lines combined ratio for the first quarter of 2003 was 93.2%,
compared with 83.4% in the same period of 2002. The Specialty Lines combined
ratio increased 9.8 points in the first quarter 2003 due almost entirely to
the ceded premium accrual relating from the reinstatement of prior years'
reinsurance layers which added 8.4 points in the current quarter. Renewal
price increases in the umbrella line of business averaged 20.5% in the first
quarter of 2003, compared with 45.1% for the same quarter in 2002. Net
premiums written for the first quarter 2003 for Specialty Lines were $32.9
million, compared to $39.5 million in the same period of 2002. Increased
reinsurance costs on commercial umbrella business drove the decline in net
premiums written as Specialty Lines premiums before reinsurance increased
12.6%. Higher reinsurance costs were driven by the inclusion of the ceding
commission, by increased reinsurance rates per dollar of premium, and an
accrual of ceded premiums related to reinstatement of previous reinsurance
contracts.
Personal Lines Segment
The Personal Lines combined ratio increased to 110.3% in the first quarter of
2003 from 107.3% in the first three months of 2002. The increase was driven
by poor New Jersey private passenger auto results which added 4.4 points to
the Personal Lines combined ratio in the first quarter of 2003 compared to
2.5 points in the first quarter of 2002.
The combined ratio for homeowners increased 7.0 points to 114.5% from 107.5%
and impacted the Personal Lines combined ratio by 1.8 points in the first
quarter 2003. The increase in the homeowners combined ratio resulted from an
increased number of large claims. Catastrophe losses added 8.6 points to the
first quarter of 2003 homeowners combined ratio compared to 8.3 points for the
first quarter 2002.
Private passenger auto recorded a 2003 three-month combined ratio of 108.0%,
increasing from 106.8% in the first quarter of 2002. New Jersey results
added 7.1 and 4.0 points to the private passenger auto
18
combined ratios for first quarter 2003 and 2002, respectively. The first
quarter 2003 private passenger auto loss ratio decreased 1.0 point to 66.5%
from 67.5% in the same quarter of 2002. New Jersey results added 5.6 and 4.6
points to these private passenger auto loss ratios in the first quarter 2003
and 2002, respectively. The product line's results continue to benefit from
the implementation of insurance scoring, elimination of unprofitable business,
the withdrawal from the New Jersey market and targeted underwriting.
The following table presents combined ratios for both calendar year and
accident year 2003 and 2002 as of March 31, 2003:
Statutory Combined Ratios
Calendar Year Accident Year
Year to Date Year to Date Calendar Accident
(By operating segment, including March 31, March 31, Year Year
selected major product lines) 2003 2003(a) 2002 2002(a)
- ----------------------------------------------------------------------------------------
Commercial Lines Segment 111.2% 109.7% 115.1% 103.2%
Workers' compensation 134.8% 125.8% 129.2% 121.4%
Commercial auto 106.0% 103.6% 110.2% 100.8%
General liability 125.3% 113.8% 171.3% 113.2%
CMP, fire & inland marine 101.1% 105.9% 95.8% 95.8%
Specialty Lines Segment 93.2% 103.3% 94.0% 93.8%
Commercial umbrella 100.3% 111.1% 97.7% 97.7%
Fidelity & surety 73.5% 80.4% 81.7% 85.3%
Personal Lines Segment 110.3% 107.1% 114.1% 110.8%
New Jersey personal auto 289.9% 125.0% 154.8% 139.0%
Other personal lines 105.9% 105.0% 107.9% 106.6%
Other personal auto 100.9% 102.6% 107.1% 105.7%
Homeowners 114.5% 115.9% 110.3% 111.2%
- ---------------------------------------------------------------------------------------
Total All Lines 108.8% 108.0% 112.8% 105.5%
=======================================================================================
(a) The loss and LAE ratio component of the accident year combined ratio
measures losses and LAE arising from insured events that occurred in
the respective accident year. The current accident year excludes
losses and LAE for insured events that occurred in prior accident
years. The measurement date for accident year data is March 31, 2003.
Partial and complete accident periods may not be comparable due to
seasonality, claim reporting and development patterns, claim settlement
rates and other factors.
LIQUIDITY AND FINANCIAL STRENGTH
Investments
At March 31, 2003, the available-for-sale fixed maturity portfolio of the
Corporation and the Group had a market value of $2.8 billion, which consisted
of 96.4% investment grade securities. The available-for-sale fixed maturity
portfolio includes non-investment grade securities and non-rated securities
that had a fair value of $102.4 million and comprised 3.6% of the available-
for-sale fixed maturity portfolio. This compares to a fair value of $105.3
million at December 31, 2002. These securities comprised 3.4% of the
available-for-sale fixed maturity portfolio at December 31, 2002. The held-
to-maturity fixed maturity portfolio of the Corporation and the Group is
accounted for at amortized cost which was $368.8 million at March 31, 2003
and consists entirely of investment grade securities. The Corporation and
the Group classify securities as below investment grade based upon the higher
of the ratings provided by Standard & Poor's Ratings Group (S&P) and Moody's
Investors Service (Moody's) and upon other rating agencies, including the
National Association of Insurance Commissioners, when a security is not rated
by either S&P or Moody's. The market value of available-for-sale split-rated
fixed maturity securities (i.e., those having an investment grade rating from
one rating agency and a below investment grade rating from another rating
agency) was $44.9 million at March 31, 2003 and $45.8 million at December 31,
2002.
Investments in below investment grade securities have greater risks than
investments in investment grade securities. The risk of default by borrowers
that issue below investment grade securities is significantly greater because
these borrowers are often highly leveraged and more sensitive to adverse
economic
19
conditions, including a recession or a sharp increase in interest rates.
Additionally, investments in below investment grade securities are generally
unsecured and subordinate to other debt. Investment grade securities are
also subject to significant risks, including additional leveraging, changes
in control of the issuer or worse than previously expected operating results.
In most instances, investors are unprotected with respect to these risks, the
effects of which can be substantial.
Following is a table displaying non-investment grade and non-rated available-
for-sale securities in an unrealized loss position at March 31, 2003 and
December 31, 2002:
Amortized Fair Unrealized
(in millions) Cost Value Loss
- -----------------------------------------------------------------------
March 31, 2003 $52.1 $47.1 $ (5.0)
December 31, 2002 $73.0 $60.9 $(12.1)
The investment portfolio of the Corporation and the Group include non-
publicly traded securities such as private placements, non-exchange traded
equities and limited partnerships which are carried at fair value. Fair
values are based on valuations from pricing services, brokers and other
methods as determined by management to give the most accurate price. The
carrying value of this portfolio at March 31, 2003 was $303.9 million
compared to $319.4 million at December 31, 2002.
The consolidated fixed maturity portfolio of the Corporation and the Group
has an intermediate duration and a laddered maturity structure. The
Corporation and the Group always remain fully invested and do not time
markets. The Corporation and the Group also have no off-balance sheet
investments or arrangements as defined by section 401(a) of the Sarbanes-
Oxley Act of 2002.
At March 31, 2003, the Corporation and the Group's equity portfolios were
7.7%, or $270.3 million, of the total investment portfolio. The Corporation
and the Group mark the value of their equity portfolios to fair market value
on their balance sheets. As a result, shareholders' equity and statutory
surplus fluctuate with changes in the value of the equity portfolio. As of
March 31, 2003, the equity portfolio consisted of stocks in 45 separate
entities in 35 different industries. As of March 31, 2003, 23.3% of the
Corporation's equity portfolio was invested in five companies and the largest
single position was 5.3% of the equity portfolio.
For further discussion of the Corporation's investments, see Item 1 pages 8
through 10 of the Corporation's Form 10-K for the year ended December 31,
2002.
Loss and Loss Adjustment Expenses
The Group's largest liabilities are reserves for losses and loss adjustment
expenses. The accounting policies related to the loss and loss adjustment
expense reserves are considered critical. Loss and loss adjustment expense
reserves are established for all incurred claims and are carried on an
undiscounted basis before any credits for reinsurance recoverable. Actual
losses and loss adjustment expenses may change with further developments.
These reserves amounted to $2.5 billion at March 31, 2003 and $2.4 billion at
December 31, 2002. As of March 31, 2003, the reserves by operating segment
were as follows: $1.6 billion in Commercial Lines, $0.4 billion Specialty
Lines and $0.5 billion Personal Lines.
Results for the first quarter 2003 were negatively impacted by losses and
loss adjustment expenses for prior accident years totaling $2.7 million
before tax on an All Lines basis. For the Commercial Lines operating
segment, the losses and loss adjustment expenses for prior accident years
recorded during first quarter 2003 were $2.8 million before tax and were
concentrated in the general liability and workers' compensation product
lines. Comparable Commercial Lines amounts for first quarter 2002 were $7.7
million and were also concentrated in the workers' compensation and general
liability product lines.
For the Specialty Lines operating segment, the losses and loss adjustment
expenses for prior accident years recorded during first quarter 2003 were
$(3.9) million and were concentrated in the commercial umbrella product line.
Comparable amounts for first quarter 2002 were $(3.9) million. In 2002, this
was concentrated in the commercial umbrella and bond product lines.
20
For the Personal Lines operating segment there were $3.8 million losses or
loss adjustment expenses for prior accident years recorded during first
quarter 2003. Comparable amounts for first quarter 2002 were $0.4 million.
The losses and loss adjustment expenses on prior accident years totaling $2.7
million for the first quarter 2003 reflect an update to estimates for
reserves based on new information during the first quarter of 2003, resulting
in recognition during 2003. Each quarter a thorough loss reserve study is
conducted using data and other information updated and available as of the
end of each quarter. Based on these studies, liabilities for loss and loss
adjustment expenses are established for the estimated ultimate costs of
settling claims for insured events, for both reported claims and incurred but
not reported claims. As more information becomes available and claims are
settled in subsequent periods, the estimated liabilities are adjusted upward
or downward.
Reserve development in the first quarter 2003 occurred as follows: $(20.7)
million for accident year 2002, $8.9 million for accident year 2001 and $14.5
million for accident years 2000 and prior. Reserve development in the first
quarter 2002 occurred as follows: $(20.3) million for accident year 2001,
$(14.9) million for accident year 2000 and $39.4 million for accident years
1999 and prior.
Losses and loss adjustment expenses for prior accident years were recognized
during the year 2003 due to new information that caused a revision to prior
estimates for loss and loss reserves as described above. There is
considerable uncertainty in these estimates for reasons such as: the
external environment including coverage litigation, judicial decisions,
legislative changes, claimants and juries attitudes with respect to
settlements; claim frequency and severity; the emergence of unusual types or
sizes of claims; changes in underwriting quality of the book of business over
time; and changes in claims handling which affects the payment rate or case
reserve adequacy.
Because of the inherent uncertainties in estimating ultimate costs of claims,
actual loss and loss adjustment expenses may deviate substantially from the
amounts recorded. Furthermore, the timing, frequency and extent of
adjustments to the estimated liabilities cannot be predicted since conditions
and events which established historical loss and loss adjustment expense
development and which serve as the basis for estimating ultimate claim cost
may not occur in exactly the same manner, if at all.
Cash Flow
Net cash generated by operations was $7.6 million for the first three months
of the year compared with $24.1 million for the same period in 2002. An
increase in payments to reinsurers for premium cessions and contingent
commission bonus payments to agents as well as final payment of the
replacement carrier fee for New Jersey private passenger auto business all
contributed to the deterioration of cash generated by operations. Net cash
used in investing was $25.2 million in 2003 compared with $33.3 million
during the first quarter of 2002. Current operational liquidity needs of the
Group are expected to be met by scheduled bond maturities, dividend payments,
interest payments and cash balances. Cash provided by financing operations
was $.1 million in the first three months of 2003 compared with cash used of
$8.8 million in the first quarter of 2002. The 2002 cash includes the
repayment of the Corporation's $205.0 million credit facility and issuance of
new convertible debt with net proceeds of $201.3 million.
Debt
As of March 31, 2003, the Corporation had $205.6 million of principal
outstanding on debt that includes a $4.4 million low interest loan with the
state of Ohio. During the year 2002, the Corporation completed an offering
of 5.00% convertible notes, in an aggregate principal amount of $201.3
million, due March 19, 2022 and generated net proceeds of $194.0 million.
The issuance and related costs are amortized over the life of the notes and
are recorded as related fees. The liability for debt is reported on the
balance sheet net of the unamortized fees. The Corporation uses the
effective interest rate method to record the interest and related fee
amortization. Interest is payable on March 19 and September 19 of each year,
beginning September 19, 2002. The notes may be converted into shares of the
Corporation's common stock under certain conditions, including: if the price
per share of the Corporation's common stock reaches specific thresholds; if
the credit rating of the notes is below a specified level or withdrawn, or if
the notes
21
have no credit rating during any period; or if specified corporate
transactions have occurred. The conversion rate is 44.2112 shares per each
$1,000 principal amount of notes, subject to adjustment in certain
circumstances. If all outstanding notes are converted, the total outstanding
common shares would increase by 8.9 million shares. The convertible debt
impact on earnings per share is based on the "if-converted" method. The
impact on diluted earnings per share is contingent on whether or not certain
criteria have been met for conversion. As of March 31, 2003, the common
share price criterion had not been met and, therefore, no adjustment to the
number of diluted shares on the earnings per share calculation was made for
the convertible debt. On or after March 23, 2005, the Corporation has the
option to redeem all or a portion of the notes that have not been previously
converted at the following redemption prices (expressed as a percentage of
principal amount):
During the twelve Redemption
months commencing Price
- -----------------------------------------------------------------
March 23, 2005 102%
March 19, 2006 101%
March 19, 2007 until maturity of the notes 100%
The holders of the notes have the option to require the Corporation to
purchase all or a portion of their notes on March 19 of 2007, 2012 and 2017
at 100% of the principal amount of the notes. In addition, upon a change in
control of the Corporation occurring anytime prior to maturity, holders may
require the Corporation to purchase for cash all or a portion of their notes
at 100% of the principal amount plus accrued interest.
On July 31, 2002 the Corporation also entered into a revolving credit
agreement. Under the terms of the credit agreement, the lenders agreed to
make loans to the Corporation in an aggregate amount up to $80.0 million for
general corporate purposes. The agreement requires the Corporation to
maintain minimum net worth of $800.0 million. The credit agreement also
includes a minimum statutory surplus requirement for The Ohio Casualty
Insurance Company of $625.0 million through September 30, 2003, increasing to
$650.0 million thereafter. Additionally, other covenants and customary
provisions are included in the agreement. The credit agreement expires on
March 15, 2005. The Corporation has not drawn on the revolver as of March
31, 2003.
To further strengthen its financial position, the Corporation did not pay any
shareholder dividends during the first quarter of 2003 or at any time during
2002.
The Corporation is dependent on dividend payments from its insurance
subsidiaries in order to meet operating expenses, debt obligations and to pay
dividends. Insurance regulatory authorities impose various restrictions and
prior approval requirements on the payment of dividends by insurance
companies and holding companies. Dividend payments to the Corporation from
the Company are limited to approximately $112.5 million during 2003 without
prior approval of the Ohio Insurance Department based on 100% of the
Company's net income for the year ended December 31, 2002. Additional
restrictions may result from the minimum net worth and surplus requirements
contained in the credit agreement.
Rating Agencies
Regularly the Group's financial strength is reviewed by independent rating
agencies. These agencies may upgrade, downgrade, or affirm their previous
ratings of the Group. These agencies may also place an outlook on the
Group's rating. On March 11, 2002, Standard & Poor's Rating Services (S&P)
removed its negative outlook and placed a stable outlook on the Group's "BBB"
financial strength rating. S&P also announced that it assigned its "BB"
senior debt rating on the Corporation's convertible notes. Following the
Corporation's announcement of third quarter 2002 results, S&P indicated that
financial strength rating would be reviewed for possible downgrade. S&P
revised its outlook to negative from stable based upon the Corporation's
announcement of third quarter 2002 results. On April 30, 2003, S&P affirmed
its "BBB" financial strength rating for the Group and maintained its negative
outlook. On March 13, 2002, Moody's Investor Services (Moody's) assigned its
"Baa2" rating to the Corporation's convertible notes. On November 27, 2002,
Moody's downgraded the Group's "A2" financial strength rating to "A3" and
placed a stable outlook on the Group's rating. Moody's also announced that
it placed a "Baa3" rating on the
22
Corporation's convertible notes. On March 14, 2002, Fitch, Inc. (Fitch)
assigned its "BBB-" rating to the Corporation's convertible notes and placed
a stable outlook on its rating. On November 5, 2002, Fitch, affirmed its
"BBB-" rating on the Corporation's convertible notes and placed a stable
outlook on its rating. On September 6, 2002, A.M. Best Company affirmed the
Group's financial strength rating of "A-" and assigned a positive outlook.
In addition, A.M. Best Company assigned an initial rating of "bbb" to Ohio
Casualty Corporation's convertible notes.
Forward Looking Statements
Ohio Casualty Corporation publishes forward-looking statements relating to
such matters as anticipated financial performance, business prospects and
plans, regulatory developments and similar matters. The statements contained
in this Management's Discussion and Analysis that are not historical
information, are forward-looking statements. The Private Securities
Litigation Reform Act of 1995 provides a safe harbor under the Securities Act
of 1933 and the Securities Exchange Act of 1934 for forward-looking
statements. The operations, performance and development of the Corporation's
business are subject to risks and uncertainties which may cause actual
results to differ materially from those contained in or supported by the
forward looking statements. The risks and uncertainties that may affect the
operations, performance, development and results of the Corporation's
business include the following: changes in property and casualty reserves;
catastrophe losses; premium and investment growth; product pricing
environment; availability of credit; changes in government regulation;
performance of financial markets; fluctuations in interest rates;
availability and pricing of reinsurance; litigation and administrative
proceedings; rating agency actions; acts of war and terrorist activities;
ability of Ohio Casualty to retain business acquired from the Great American
Insurance Company; ability to achieve targeted expense savings; changes in
estimated future cash flows and related impairment charges for the agent
relationships intangible asset; ability to achieve premium targets and
profitability goals; and general economic and market conditions.
ITEM 3. Quantitative And Qualitative Disclosures About Market Risk
There have been no material changes in the information about market
risk set forth in the Corporation's Annual Report on Form 10-K.
ITEM 4. Controls and Procedures
(a) The Company's Chief Executive Officer and Chief Financial Officer
evaluated the disclosure controls and procedures (as defined under
Rules 13a-14(c) and 15d-14(c) of the Securities Exchange Act of
1934, as amended) as of a date within ninety days of the filing
date of this quarterly report. Based upon that evaluation, the
Chief Executive Officer and Chief Financial Officer have concluded
that the Company's disclosure controls and procedures are
effective.
(b) There were no significant changes in the Company's internal
controls or in other factors that could significantly affect
these controls subsequent to the date of their evaluation.
PART II
ITEM 1. Legal Proceedings -
There are no material pending legal proceedings against the
Corporation or its subsidiaries other than litigation arising in
connection with settlement of insurance claims as described on
page 11 in the Corporation's 2002 Form 10-K.
ITEM 2. Changes in Securities and Use of Proceeds - None
23
ITEM 3. Defaults Upon Senior Securities - None
ITEM 4. Submission of Matters to a Vote of Security Holders
At the annual meeting on April 16, 2003, shareholders voted on
board of director seats.
Elected for terms expiring in 2006 included:
William P. Boardman For 54,549,812; Withheld 597,127
Jack E. Brown For 54,542,196; Withheld 604,743
Robert A. Oakley For 54,581,892; Withheld 565,047
Jan H. Suwinski For 53,595,544; Withheld 1,551,395
The other directors whose term of office continued after the meeting
were: Terrence J. Baehr, Dan R. Carmichael, Catherine E. Dolan,
Philip G. Heasley, Stephen S, Marcum, Ralph S. Michael III and
Stanley N. Pontius.
At the annual meeting on April 16, 2003, shareholders approved an
amendment to the Company's Code of Regulations to change requirements
for meetings of shareholders and directors. The amendment was
approved with a final vote of:
For 45,048,938; Against 9,811,917; Abstain 286,084
At the annual meeting on April 16, 2003, shareholders approved an
amendment to the Company's Code of Regulations to eliminate the
requirement that directors be holders of at least 100 shares. The
amendment was approved with a final vote of:
For 53,493,838; Against 1,392,971; Abstain 260,130
At the annual meeting on April 16, 2003, shareholders approved an
amendment to the Company's Code of Regulations to make changes to
the stated duties and responsibilities of the Company's officers.
The amendment was approved with a final vote of:
For 53,196,749; Against 1,375,579; Abstain 574,611
ITEM 5. Other Information - None
ITEM 6. Exhibits and reports on Form 8-K -
I. Reports on Form 8-K:
The Corporation filed a Form 8-K on February 5, 2003 to report under
Items 5 and 7, the filing of a press release announcing the
Corporation's fourth quarter 2002 results; and a press release
announcing that Howard L. Sloneker III would not seek re-election
as a member of the Board of Directors of Ohio Casualty Corporation.
Exhibits to the Form 8-K consisted of the press releases dated
February 5, 2003.
II. Exhibits:
3 Code of Regulations of Ohio Casualty Corporation, as
approved by the shareholders at the annual meeting on
April 16, 2003
10 The Ohio Casualty Insurance Company 2003 Officer Annual
Incentive Program
99.1 Certification of Chief Executive Officer of Ohio Casualty
Corporation in accordance with Section 906 of the
Sarbanes-Oxley Act of 2002
99.2 Certification of Chief Financial Officer of Ohio Casualty
Corporation in accordance with Section 906 of the
Sarbanes-Oxley Act of 2002
24
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
OHIO CASUALTY CORPORATION
--------------------------------
(Registrant)
May 13, 2003 /s/ Donald F. McKee
---------------------------------
Donald F. McKee, Executive Vice
President and Chief Financial Officer
(on behalf of Registrant and as
Principal Accounting Officer)
25
CERTIFICATION
I, Dan R. Carmichael, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Ohio
Casualty Corporation;
2. Based on my knowledge, this quarterly report does not contain
any untrue statement of a material fact or omit to state a material
fact necessary to make the statements made, in light of the
circumstances under which such statements were made, not misleading
with respect to the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly
present in all material respects the financial condition, results of
operations and cash flows of the registrant as of, and for, the
periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible
for establishing and maintaining disclosure controls and procedures
(as defined in Exchange Act Rules 13a-14 and 15d-14) for the
registrant and we have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including
its consolidated subsidiaries, is made known to us by others
within those entities, particularly during the period in which
this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors
and the audit committee of registrant's board of directors (or
persons performing the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data and
have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes
in internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: May 13, 2003 /s/Dan R. Carmichael
-------------------------------
Dan R. Carmichael
President and Chief Executive
Officer
26
CERTIFICATION
I, Donald F. McKee, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Ohio Casualty
Corporation;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and
the audit committee of registrant's board of directors (or persons
performing the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial
data and have identified for the registrant's auditors any
material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes
in internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: May 13, 2003 /s/ Donald F. McKee
-----------------------------
Donald F. McKee
Executive Vice President and
Chief Financial Officer
27