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2002
annual
report
and
form 10-k
TABLE OF CONTENTS
Page
----
Financial Highlights 1
Letter to Stockholders 2
Stockholder Return Chart 3
Form 10-K Facing Page 5
Glossary of Selected Insurance Terms 6
Part I
Item 1. Business 11
A. General 14
B. Commonwealth Automobile Reinsurers 15
C. Marketing 17
D. Underwriting 19
E. Reinsurance 21
F. Settlement of Claims 21
G. Loss and Loss Adjustment Expense Reserves 22
H. Operating Ratios 24
I. Investments 25
J. Regulation 25
K. Competition 28
L. Other Matters 30
Item 2. Properties 30
Item 3. Legal Proceedings 31
Item 4. Submission of Matters to a Vote of Security Holders 31
Item 4A. Executive Officers of the Registrant 32
Part II
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters 33
Item 6. Selected Financial Data 34
Item 7. Management's Discussion & Analysis 35
Item 7a. Qualitative and Quantitative Disclosures about Market Risk 77
Item 8. Financial Statements and Supplementary Data 77
Notes to Financial Statements and Supplementary Data 84
Item 9. Changes in and Disagreements with Independent Auditors on Accounting
and Financial Disclosure 126
Part III
Item 10. Directors and Executive Officers of the Registrant 126
Item 11. Executive Compensation 126
Item 12. Security Ownership of Certain Beneficial Owners and Management 126
Item 13. Certain Relationships and Related Transactions 126
Item 14. Controls and Procedures 126
Part IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K 127
Signatures 128
Index to Financial Statement Schedules 130
Statement under Section 906 of the Sarbanes-Oxley Act of 2002 141
Certifications 142
Index to Exhibits 144
Organizational Chart 145
Directors 146
Officers 150
Stockholder Information 152
FINANCIAL HIGHLIGHTS
(Dollars in Thousands, Except Per Share Amounts)
2002 2001 2000
-------------------------------------------
(Restated)
Direct premiums written $ 1,406,856 $ 1,152,407 $ 1,071,649
===========================================
Net premiums written $ 1,313,014 $ 1,078,967 $ 1,008,911
Earned premiums $ 1,210,040 $ 1,043,652 $ 954,483
Net investment income 98,466 99,563 96,830
Premium finance and service fees 21,498 17,819 15,227
Amortization of excess of book value of
subsidiary interest over cost - 3,389 3,390
Net realized investment gains (losses) (82,385) (10,633) 29,550
Other income 9,500 - -
-------------------------------------------
Total revenues $ 1,257,119 $ 1,153,790 $ 1,099,480
===========================================
Earnings before income taxes, change in
accounting principle and minority interest $ 52,026 $ 107,782 $ 170,066
Income taxes 17,063 18,392 38,306
Change in accounting principle, net of taxes 11,237 - -
-------------------------------------------
Net earnings before minority interest 46,200 89,390 131,760
Minority interest in net loss of subsidiary 555 863 320
-------------------------------------------
Net earnings $ 46,755 $ 90,253 $ 132,080
===========================================
Comprehensive income $ 59,625 $ 90,814 $ 168,570
Net earnings per common share:
Basic $ 1.43 $ 2.69 $ 3.87
Diluted $ 1.42 $ 2.67 $ 3.87
Operating earnings (1) $ 104,680 $ 98,880 $ 109,631
Operating earnings per share (1)
Basic $ 3.19 $ 2.94 $ 3.21
Diluted $ 3.17 $ 2.93 $ 3.21
Cash dividends paid per share $ 1.23 $ 1.19 $ 1.15
Weighted average number of common shares
outstanding:
Basic 32,773,519 33,608,804 34,121,047
Diluted 33,028,081 33,794,938 34,121,047
Total investments at market value
and equity value $ 1,577,070 $ 1,498,201 $ 1,472,562
Total assets $ 2,382,688 $ 2,154,631 $ 2,075,614
Total liabilities $ 1,588,530 $ 1,345,198 $ 1,292,665
Minority interest $ 4,106 $ - $ 1,068
Total stockholders' equity $ 790,052 $ 809,433 $ 781,881
Total stockholders' equity per share $ 24.60 $ 24.43 $ 23.16
Certain statutory financial ratios (unaudited):
Loss and LAE ratio 75.1% 74.5% 71.7%
Underwriting expense ratio 23.6 24.2 25.1
-------------------------------------------
Combined ratio 98.7% 98.7% 96.8%
===========================================
Net premiums written to policyholders' surplus 198.3% 150.7% 152.6%
===========================================
- --------------------
The above figures are presented to provide information to the reader
due to the amount of, and fluctuations in, net realized gains and
(losses). The amounts noted, which exclude the after-tax impact of
net realized investment gains (losses), the income effect of a
required change in accounting principle and the after-tax impact of
variable accounting stock option treatment are important measures of
corporate performance.
1
[LOGO]
March 26, 2003
To Our Stockholders:
In 2002, your Company experienced satisfactory financial results for
the 27th consecutive year. From the very first day the funding of The
Commerce Insurance Company was accomplished (April 3, 1972) through
December 31, 2002, we have achieved underwriting profit of $300.6 million
on total premiums written of $11.4 billion. This underwriting profit
represents 2.6% of total premiums written.
In December 2002, the 2003 personal automobile insurance rate
decision was announced by the Massachusetts Insurance Commissioner. Despite
the industry's request for a 7.0% increase, 2003 rates were increased on
average by 2.7%. Most companies, including yours, continued to modify safe
driver deviations and/or affinity group discounts in response to the 2003
rate decision, although the number and amount of such were generally
reduced for 2003. The Massachusetts marketplace remains highly competitive.
Throughout these ongoing competitive times, your Company's share of the
Massachusetts personal automobile market has continued to grow, and at
year-end, our market share was 25.9%, up from 23.2% in 2001.
In 2002, direct premiums written countrywide were $1.4 billion and
surpassed $1 billion for the third consecutive year. Earned premiums were
in excess of $1 billion for the second straight year. Your Company will
continue to pursue the goals of growing and expanding geographically beyond
the borders of Massachusetts. In furtherance of this goal, direct premiums
written outside of Massachusetts now represent 13.4% of our total business
as compared to 12.4% in 2001.
Your Company has continued to grow and prosper. The Commerce
Insurance Company continues to be the largest writer of Massachusetts
private passenger automobile insurance, the second largest writer of
Massachusetts homeowners insurance, as well as the third largest writer of
Massachusetts commercial automobile insurance. The combined insurance
companies were also ranked as the 26th largest personal automobile
insurance group in the country by A.M. Best Co., based on the most recently
available direct premium written information. Additionally, I am very
pleased to report that your Company again received a group rating of A+
(Superior) from A.M. Best Co.
Written premiums, earned premiums, total assets and total
stockholders' equity per share, as illustrated in the bar graph on the
facing page, are all at new highs. For those of you who are interested in
the details, I draw your attention to the pages in this report labeled
"Management's Discussion and Analysis of Financial Condition and Results of
Operations". Behind these numbers are an extremely dedicated group of
people: Our policyholders (represented by over 1,205,000 policies in
force); Agents (1,491); Employees (1,874); Officers (42); Commerce Group
Directors (17); and, of course, our Stockholders (over 5,000, including our
Employee Stock Ownership Plan participants, who now number 2,061).
Property-liability insurance remains a good business to be in and The
Commerce Group, Inc. will continue its efforts to be one of the most
profitable long-term players. Your Company's management continues to
believe that owners' interests are its primary constituency.
Our sincere thanks to those who have helped in this building process,
especially our Agents, Employees, Officers and Board of Directors. This
diverse force of committed, ethical and hard working people will continue
to build on our past successes and look to the future with excitement and
opportunity. Their individual ingenuity, enthusiasm, dedication and
professionalism will continue to serve our stockholders well.
Your comments or questions regarding this report, or The Commerce
Group, Inc. affairs in general, are solicited as always, at any time.
/s/ Arthur J. Remillard, Jr.
Arthur J. Remillard, Jr.
President, Chief Executive Officer
and Chairman of the Board
Caring in everything we do.
2
The bar graph on page 4 illustrates the Company's annual total
stockholders' equity per share value and annual total stockholders' equity
per share value including cumulative cash dividends paid per share through
each December 31, year-end, over the most recent fifteen year period. The
X-axis lists the years beginning with 1988 through 2002. The Y-axis lists
the dollar values starting at $0.00 and increasing in one-dollar increments
to $33.00. The graph depicts a total stockholders' equity per share value
in 1988 of $1.95, 1989 of $2.53, 1990 of $3.36, 1991 of $4.80, 1992 of
$7.42, 1993 of $10.09, 1994 of $10.88, 1995 of $14.96, 1996 of $16.28, 1997
of $18.11, 1998 of $19.72, 1999 of $19.44, 2000 of $23.16, 2001 of $24.43,
and 2002 of $24.60. The graph also depicts the total stockholders' equity
per share value adjusted to include cumulative dividends paid per share.
The total of these amount to the per share value in 1988 of $1.95, 1989 of
$2.53, 1990 of $3.36, 1991 of $4.80, 1992 of $7.42, 1993 of $10.09, 1994 of
$11.03, 1995 of $15.34, 1996 of $17.47, 1997 of $20.33, 1998 of $23.01,
1999 of $23.84, 2000 of $28.71, 2001 of $31.17, and 2002 of $32.57.
3
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4
===========================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______________ to____________.
Commission file number 001-13672
The Commerce Group, Inc.
(Exact name of registrant as specified in its charter)
Massachusetts 04-2599931
(State or other jurisdiction (IRS Employer
of incorporation) Identification No.)
211 Main Street 01570
Webster, Massachusetts (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (508) 943-9000
Securities registered pursuant to Section 12(b) of the Act:
Name of each Exchange
Title of each Class on Which Registered
------------------- ---------------------
Common Stock, $.50 Par Value Per Share New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None
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 Exchange Act Rule 12b-2). Yes [X] No [ ]
The aggregate market value of the voting stock held by non-affiliates
of the registrant as of March 21, 2003, was approximately $758,122,241.
As of March 21, 2003, the number of shares outstanding of the
registrant's common stock (exclusive of treasury shares) was 31,879,835.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive Proxy Statement for its
annual meeting of stockholders, which the Company intends to file within
120 days after the end of the registrant's fiscal year ended December 31,
2002, are incorporated by reference into Part III hereof as provided
therein.
===========================================================================
5
GLOSSARY OF SELECTED INSURANCE TERMS
Affinity group marketing program In Massachusetts, an "affinity group
marketing program" is any system,design
or plan whereby motor vehicle or
homeowner insurance is afforded to
employees of an employer or to members
of a trade union, association or
organization in accordance with those
provisions of M.G.L. c. 175, s. 193R,
distinguishing such plans from a "mass-
merchandising plan".
Specifically, an affinity group
marketing program contemplates the
issuance of such insurance through
standard policies that generally
preclude individual underwriting,
contain an option to continue coverage
at a standard rate upon termination of
employment or membership, restrict
cancellation, require the continuance
of certain participation in ways not
applicable to standard policies, and
provide for the downward modification
of rates based upon the experience of
the insured group.
Assumed premiums Premiums acquired or allocated to an
insurer other than through its
independent agencies.
A.M. Best A.M. Best Company, Inc. is a rating
agency reporting on the financial
condition of insurance companies. A.M.
Best's statistics cited in this Form
10-K are based upon information
voluntarily submitted to it by
insurers.
Casualty insurance Insurance which is primarily concerned
with the losses of the insured due to
injuries to other persons and to the
property of others, and the legal
liability imposed on the insured
resulting therefrom.
Catastrophe, catastrophic loss A severe loss, usually involving many
risks such as conflagration,earthquake,
windstorm, explosion and other similar
events.
Combined ratio A combination of the underwriting
expense ratio and the loss and loss
adjustment expense ("LAE") ratio
determined in accordance with Statutory
Accounting Practices ("SAP").The
underwriting expense ratio measures the
ratio of underwriting expenses to net
premiums written, determined in
accordance with SAP. The loss and LAE
ratio measures the ratio of incurred
losses and LAE to earned premiums,
determined in accordance with SAP.
Commissioner The Commissioner of the Division of
Insurance of the Commonwealth of
Massachusetts.
6
Commonwealth Automobile
Reinsurers ("CAR") CAR is a Massachusetts mandated
reinsurance mechanism, under which all
premiums, expenses and losses on ceded
business are shared by all insurers. It
is similar to a joint underwriting
association because a number of
insurers act as Servicing Carriers for
the private passenger and/or commercial
automobile risks insured.
Direct Refers to premiums, losses, LAE and
expenses on policies which a company
writes before accounting for business
ceded and assumed through reinsurance.
Direct loss ratio The ratio of direct incurred losses and
LAE to direct earned premiums.
Direct premiums written Total premiums for insurance sold to
nsureds, as opposed to, and not
including, reinsurance premiums.
Domestic insurer An insurance company that operates in
the state in which it is licensed.
Earned premiums The portion of net premiums written
that is equal to the expired portion of
policies recognized for accounting
purposes as income during a period.
Also known as premiums earned.
Excess of loss reinsurance Reinsurance which indemnifies the
reinsured against all or a specified
portion of losses under reinsured
policies in excess of a specific dollar
amount or "retention".
Exclusive representative
producer ("ERP") A Massachusetts automobile insurance
agency which does not have a voluntary
agency automobile insurance
relationship with an insurer, and which
is assigned by CAR to an insurer who is
a Servicing Carrier.
Exposure An insurable unit defined as an
automobile.
Frequency The relative incidence of claims in
relation to an exposure, or group of
exposures.
Hard market An insurance market in which the demand
for insurance exceeds the readily
available supply and premiums are
relatively high.
Incurred but not reported
reserves ("IBNR") Reserves for estimated losses which
have been incurred by insureds but not
yet reported to the insurer.
Incurred losses The total losses sustained by an
insurance company under a policy or
policies, whether paid or unpaid.
Incurred losses include a provision for
IBNR and salvage and subrogation.
Inherent diminished value An alleged loss in market value caused by
a supposed perception that a car that has
been involved in an accident, even when
fully repaired, is not worth as much as an
otherwise identical car that has not been
involved in an accident.
7
Inland marine insurance As used by the Company, insurance that
provides protection for specific
types of personal property, such as
jewelry, coins and fine arts, over the
limits covered in a standard homeowners
insurance policy.
Loss adjustment expenses The expenses relating to settling
claims, including legal and other fees
and the portion of general company
expenses allocated to claim settlement
costs.
LAE ratio The ratio of LAE, net of reinsurance
recoveries, to earned premiums.
Loss and LAE ratio The ratio of incurred losses plus LAE,
net of reinsurance recoveries, to
earned premiums.
Loss reserves Liabilities established by insurers to
reflect the estimated cost of claims
payments and the related expenses that
the insurer will ultimately be required
to pay in respect of insurance it has
written. Reserves are established for
losses and for LAE.
Net premiums written Direct premiums written for a given
period less premiums ceded to
reinsurers during such period plus
premiums assumed during such period.
Participation ratio A Massachusetts insurer's share of the
CAR deficit based upon the insurer's
market share of automobile risks not
reinsured through CAR, adjusted for
utilization of CAR and credits for
voluntarily writing less desirable
under-priced business and ceded
exclusions.
Premium-to-surplus ratio The ratio of net premiums written to
policyholders' surplus.
Property insurance Insurance that indemnifies a person
with an insurable interest in tangible
property for loss related to damage to
or loss of use of the subject property.
Pure loss ratio The ratio of net incurred losses,
excluding LAE, to premiums earned.
Quota share reinsurance Reinsurance in which the reinsured
shares a proportion of the original
premiums and losses under the reinsured
policy. Also known as pro-rata
reinsurance.
Rate deviation A specific state approved departure
from an otherwise applicable state set
rate level provided to safe drivers.
Rate discount A specific state approved discount from
an otherwise applicable state set rate
level provided to members of affinity
group marketing programs.
8
Reinsurance The acceptance by one or more insurers,
called reinsurers, of all or a
portion of the risk underwritten by
another insurer who has directly
written the coverage. However, the
legal rights of the insured generally
are not affected by the reinsurance
transaction and the insurance company
issuing the insurance policy remains
liable to the insured for payment of
policy benefits.
Safe Driver Insurance Plan
("SDIP") A program mandated by Massachusetts
state law that encourages safe driving
by rewarding drivers who do not cause
an accident, or incur a traffic law
violation and by charging high risk
drivers a greater amount of premiums.
Under SDIP, drivers incur surcharge
points for traffic violations and at-
fault accidents. Drivers also earn
credit points for each incident free
year. Drivers begin at a starting or
neutral SDIP Step 15. Drivers can earn
credits down to SDIP Step 9, the lowest
step for good drivers, and incur
surcharge points up to SDIP Step 35,
the highest step for bad drivers. The
SDIP is set to be revenue neutral
industry-wide, wherein credits received
by good drivers are offset with
surcharges paid by bad drivers.
Salvage The sale of damaged goods, for which
the insured has been indemnified by
the insurance company.
Servicing Carrier An automobile insurer writing business
in Massachusetts which can reinsure
risks through CAR while remaining
responsible for servicing the related
private passenger and/or commercial
automobile policies and which must
provide a market for ERPs assigned to
it by CAR. There are 20 companies
servicing private passenger automobile
and 28 companies servicing commercial
automobile. In total, 35 carriers
service either the private passenger or
commercial markets.
Severity The relative magnitude of the dollar
amount of a claim, or group of claims.
Soft market An insurance market in which the supply
of insurance exceeds the current demand
and premiums are relatively low.
Statutory accounting practices Recording transactions and preparing
financial statements in accordance
with the rules and procedures
prescribed or permitted by an insurer's
state insurance regulatory authority
for the purposes of financial reporting
to regulators, which in general reflect
a liquidating, rather than going
concern, concept of accounting.
Statutory surplus The excess of admitted assets over
total liabilities (including loss
reserves), determined in accordance
with SAP.
9
Subrogation The substitution of the insurer's right
to recover in place of the insured's
right to recover from a third party
responsible for a loss paid by the
insurer.
Take-all-comers A phrase used to characterize the
Massachusetts personal automobile
insurance system under which all
insurers are required to underwrite and
accept virtually all risks submitted to
them.
Underwriting The insurer's process of reviewing
applications submitted for insurance
coverage, deciding whether to accept
all or part of the coverage requested
and determining the applicable
premiums.
Underwriting expenses The aggregate of policy acquisition
costs, including commissions, and the
portion of administrative, general and
other expenses attributable to
underwriting operations.
Underwriting expense ratio The ratio of underwriting expenses to
net premiums written determined in
accordance with SAP.
Unearned premiums The portion of a premium representing
the unexpired amount of the contract
term as of a certain date.
10
PART I
(Dollars in thousands except for ratios and per share data unless
noted otherwise)
ITEM 1. BUSINESS
The Commerce Group, Inc. (the "Company") was incorporated in 1976.
The Company is engaged in providing personal and commercial property and
casualty insurance primarily in Massachusetts through its principal
subsidiary, The Commerce Insurance Company ("Commerce"), which was
incorporated in 1971 and began writing business in 1972. The Company's
predominant insurance line is motor vehicle insurance, primarily covering
Massachusetts personal automobiles. The Company also offers commercial
automobile, homeowners, inland marine, fire, general liability, commercial
multi-peril and personal and commercial umbrella insurance. The Company
also writes insurance in California and Oregon through Commerce West
Insurance Company ("Commerce West") located in Pleasanton, California,
which primarily focuses on personal automobile insurance and also writes
commercial automobile insurance. Additionally, the Company writes
insurance through American Commerce Insurance Company ("American
Commerce"), which writes primarily personal automobile insurance and also
writes homeowner insurance. Located in Columbus, Ohio, American Commerce,
is a wholly-owned subsidiary of ACIC Holding Co., Inc. ("AHC") with
policies in 26 states and licenses in 17 others.
Effective January 1, 2002, the ownership interests in AHC were
recapitalized. Prior to the recapitalization at December 31, 2001,
Commerce maintained an 80% common stock interest and AAA Southern New
England ("AAA SNE") maintained a 20% common stock interest in AHC.
Additionally, all AHC preferred stock was owned by Commerce. The
recapitalization resulted in redeeming of all the AHC preferred stock by
Commerce in exchange for 3,000 additional shares of AHC common stock. This
resulted in Commerce increasing its AHC common stock interest to 95% with
AAA SNE maintaining a 5% AHC common stock interest with no preferred stock
outstanding. The recapitalization also resulted in the creation of $4.5
million in minority interest for AAA SNE.
Since 1995, Commerce has maintained an affinity group marketing
relationship with AAA Insurance Agency, Inc., a subsidiary of AAA SNE. AAA
Insurance Agency, Inc. has been a licensed insurance agent of Commerce
since 1985. In addition to the property and casualty insurance business,
the Company originates residential and commercial mortgages, within
Massachusetts and on a limited basis in Connecticut and operates an
insurance agency dealing in a full line of insurance products, including
those of the Company.
The Company's business strategy is to focus its insurance activities
primarily on the personal automobile market. The Company has over
1,205,000 polices in force. Commerce and Citation Insurance Company
("Citation") service over 996,000 throughout the Commonwealth of
Massachusetts and Commerce services over 7,000 in the State of New
Hampshire. Commerce West and American Commerce service over 205,000
policies in 27 states. The Company, through Commerce and Citation, wholly-
owned subsidiaries of Commerce Holdings, Inc. ("CHI"), which is a wholly-
owned subsidiary of the Company, has been the largest writer of personal
property and casualty insurance in Massachusetts in terms of market share
of direct premiums written since 1990. At year-end 2002, the Company's
Massachusetts private passenger automobile market share was 25.9%, up from
23.2% in 2001. The Company is the second largest writer of Massachusetts
homeowners insurance and the third largest writer of commercial automobile
insurance in the Commonwealth, based on the most recently available data.
In addition, the Company's combined insurance companies were ranked the
26th largest personal automobile insurance group in the country by A.M.
Best, based on the most recently available direct premium written
information.
11
The accompanying table lists direct premiums written for the years ended
December 31, 2002 and 2001 for Massachusetts and other states business:
Direct Premiums Written, Year Ended December 31, 2002
- -----------------------------------------------------
Massachusetts All Other States Total % of Total
-------------------------------------------------------------
Personal Automobile $1,032,438 $155,045 $1,187,483 84.4%
Homeowners 87,634 27,376 115,010 8.2
Commercial Automobile 74,879 5,151 80,030 5.7
Other Lines 23,569 764 24,333 1.7
--------------------------------------------------------
Total $1,218,520 $188,336 $1,406,856 100.0%
========================================================
Direct Premiums Written, Year Ended December 31, 2001
- -----------------------------------------------------
Massachusetts All Other States Total % of Total
-------------------------------------------------------------
Personal Automobile $ 859,922 $122,320 $ 982,242 85.2%
Homeowners 73,254 18,710 91,964 8.0
Commercial Automobile 58,088 1,514 59,602 5.2
Other Lines 17,885 714 18,599 1.6
--------------------------------------------------------
Total $1,009,149 $143,258 $1,152,407 100.0%
========================================================
The Company attributes its success primarily to its strong
relationships with professional independent agencies that provide quality
business for the Company along with fair and prompt settlement of claims.
Other factors that have been important to its success include an in-depth
understanding of the Massachusetts regulatory and underwriting
environments, an ability to operate efficiently with economies of scale,
advanced information systems, an extensive underwriting database and,
beginning in 1995, the ability to compete in an affinity group marketing
environment.
Because the Company offers its product lines only through independent
agencies, its relationships with those agencies are critical to its
continued success. The Company believes that it is the preferred provider
for most of its agencies and that, as a result of such position, it has
gained access to policyholders with average or above-average underwriting
profit characteristics. The Company carefully selects and retains agencies
whose premium growth and loss ratio experience meet the Company's agency
criteria, and devotes substantial resources to fostering and maintaining
strong relationships with its existing agencies. The Company pays its
agencies significant compensation in the form of profit sharing, which is
based in part on the underwriting profits of the agency's business written
with the Company. In addition, the Company occasionally sponsors incentive
award trips to encourage agent profitability and growth. Refer to "Part I,
Item 1C-Marketing" for the details. Based upon agency surveys conducted
several times a year, the Company believes it is attentive to the needs and
requirements of its agencies and insureds. The Company emphasizes its
commitment to the Massachusetts insurance market by its responsiveness in
servicing claims and its internal support for agency operations, including
direct billing of insureds, direct claim reporting, agency upload and
download systems, on-line inquiry systems for its agents and by providing
competitively priced automobile and property insurance programs and
products.
Massachusetts Business
The Company's focus on automobile and homeowners insurance primarily
in Massachusetts (85% of total direct premiums written) has also been a
significant factor in its success. The terms, conditions and mandated
rates of personal automobile insurance are subject to extensive regulation.
Because the Company has primarily served the Massachusetts market, it has
both an
12
in-depth understanding of this market and the ability to respond
effectively to shifts in the state's regulatory and underwriting
environments. Currently, the Company is required to accept virtually all
private passenger automobile insurance business submitted to it by its
agencies. The Company's ability to underwrite this business profitably,
however, depends on its understanding of the risks in the business as well
as its management of reinsurance through CAR.
The Company has actively pursued affinity group marketing programs
since 1995. The primary purpose of affinity group marketing programs is to
provide participating groups with a convenient means of purchasing
discounted private passenger automobile insurance through associations and
employer groups. For additional information, please refer to "Part II,
Item 7-Massachusetts Automobile Business" section of the Management
Discussion and Analysis (MD&A).
The Company's other than personal automobile products tend to be
derived from its other two core product lines and therefore have had
relatively predictable risk profiles. The Company offers a preferred risk
homeowners product through Citation, which has an alternative pricing
schedule for selected insureds meeting more restrictive underwriting
guidelines. Citation also provides a separate rating tier for preferred
commercial automobile business. Approximately 15% of the voluntary
commercial automobile premium produced by its voluntary agents in 2002 was
written by Citation. Citation also produced approximately 51% of
Massachusetts homeowner business based on direct premiums written. The
Company expects that these secondary rating tiers will continue to assist
the Company in retaining its better commercial automobile and homeowner
accounts. Commerce was the largest writer of voluntary commercial
automobile business in 2002.
The Company also offers homeowners insurance in Massachusetts,
including a very limited amount of policies in designated coastal areas.
The Company's average homeowners policy is an all risk, replacement cost
insurance policy covering a dwelling and the contents contained therein.
The Company's published limits of liability for property damage to a
dwelling are a minimum coverage of $60 and a maximum coverage of $750 in
Massachusetts. Some policies over this amount are written on an exception
basis. For personal liability, the minimum coverage is $100 and the
maximum coverage is $1,000. The average dwelling coverage amount per
policy is approximately $185 in Massachusetts. Generally, the average
amount of contents coverage is 70% of the amount of coverage for the
dwelling, with limitations on the amount of coverage per item placed on
securities, cash, jewelry, furs, silverware, computer equipment and
firearms. However, additional coverage for such items can be purchased on
a scheduled personal property basis. The Company also offers $1,000,
$2,000 and $3,000 personal liability umbrella coverage which is reinsured
through Employers Reinsurance Corporation.
The Company's long-term commitment to providing consistent markets
for Massachusetts independent agencies, coupled with the withdrawal by
several national companies from the Massachusetts personal automobile
market, which primarily occurred during the years 1987 through 1991, has
been a significant factor in enabling the Company to increase and maintain
its market share by contracting with agencies which meet its agency
criteria. The Company believes that Massachusetts agencies are more likely
to seek to develop and expand relationships with domestic insurers, which,
like the Company, have a long-term commitment to, and focus on, the
Massachusetts personal automobile market.
Other States Business
Commerce writes personal lines insurance through 30 independent
insurance agencies in the state of New Hampshire. Commerce West
predominantly writes private passenger automobile insurance in California
and Oregon through 808 independent insurance agencies and brokers. All
business is underwritten at Commerce West's headquarters located in
Pleasanton, California. Although primarily writing preferred private
passenger automobile business, Commerce West also
13
writes non-standard private passenger automobile business and commercial
automobile business. American Commerce predominantly writes private
passenger automobile and homeowners insurance in 26 states exclusively
through 32 AAA independent insurance agencies. Products are similar to
those offered by Commerce and Citation, although pricing of products is
determined on a company by company and state by state basis. All business
is underwritten at American Commerce's headquarters located in Columbus,
Ohio. Both companies target preferred insurance risks. For additional
information, please refer to "Part II, Item 7-Other States" (MD&A).
A. General
Insurance Lines
Commerce and Citation, the Company's Massachusetts property and
casualty insurance subsidiaries, currently have a combined A.M. Best's
rating of A+ (Superior). Commerce West, and American Commerce currently
have A.M. Best's ratings of A (Excellent). According to A.M. Best, an
insurer with a Superior rating has achieved superior overall performance
and has shown the strongest ability to meet their policyholder and other
contractual obligations when compared to the norms of the property and
casualty insurance industry. An insurer with an Excellent rating has
demonstrated, in A.M. Best's opinion, excellent overall performance when
compared to standards developed by A.M. Best.
The Company's principal insurance line is personal automobile
insurance. The Company offers automobile policyholders the following types
of coverage: bodily injury liability coverage, including underinsured and
uninsured motorist coverage, personal injury protection coverage, property
damage liability coverage and physical damage coverage, including fire,
theft and other hazards specified in the policy. In Massachusetts and New
Hampshire, policies are written for one-year terms. Personal automobile
policies written by Commerce West and American Commerce are primarily
written for a policy term of six months. The Company's published maximum
liability limits for Massachusetts business written by Commerce are $500
per person and $1,000 per accident for bodily injury, and $100 for property
damage. For New Hampshire, the Company's published maximum limits of
liability are $500 per person and $1,000 per accident for bodily injury,
and $250 for property damage. Liability limits of $100 per person injured,
$300 per accident and $100 for property damage are the limits most commonly
purchased from the Company in Massachusetts. For California business
written by Commerce West, liability limits of $15 per person injured and
$30 per accident are most commonly purchased. For Oregon business written
by Commerce West, liability limits of $25 per person insured and $50 per
accident are most commonly purchased. For business written by American
Commerce, liability limits of $100 per person injured and $300 per accident
are most commonly purchased.
Massachusetts Automobile Business
Massachusetts automobile business is the major segment of the
Company's operation. For additional information about Massachusetts
automobile business, please refer to "Part II, Item 7-Massachusetts
Automobile Business" section (MD&A).
Mortgage Operations
Insurance companies are authorized to invest in mortgages. The
Company formed Bay Finance Company, Inc. ("Bay Finance") to originate and
service residential and commercial mortgages in Massachusetts and, on a
limited basis, in Connecticut. During fiscal 2002, 2001 and 2000 the
mortgage operations accounted for approximately $2,737, or 0.2%, $3,592, or
0.3% and $5,407, or 0.5% of the Company's consolidated total revenues,
respectively.
14
Insurance Agency
Clark-Prout Insurance Agency, Inc. ("Clark-Prout") is a wholly-owned
insurance agency that writes both for the Company and for other insurance
companies. During fiscal 2002, 2001 and 2000, Clark-Prout's revenues
amounted to $622, or 0.1%, $629, or 0.1% and $717, or 0.1% of the Company's
consolidated total revenues, respectively.
Segment Information
The Company has four reportable segments: (1) property and casualty
insurance-Massachusetts; (2) property and casualty insurance-other than
Massachusetts; (3) real estate and commercial lending; and, (4) corporate
and other. For additional information, please refer to "Part II, Item 8-
Notes to Financial Statements, NOTE O".
B. Commonwealth Automobile Reinsurers ("CAR")
A significant aspect of the Company's automobile insurance business
relates to its interaction with CAR. CAR is a Massachusetts-mandated
reinsurance mechanism, which enables the Company and the other Servicing
Carriers to reinsure any under-priced automobile risk. Servicing Carriers,
which are responsible for over 99% of total direct premiums written for
personal automobile insurance in Massachusetts, are required to offer
automobile insurance coverage to all eligible applicants pursuant to "take-
all-comers" regulations, but may reinsure under-priced business with CAR.
In addition, Servicing Carriers are obligated to accept involuntary
agencies, known as ERPs, from CAR and to provide an automobile insurance
market in Massachusetts for those agencies. ERP assignments occur by line
of business and may apply to personal automobile only, commercial
automobile only, or both lines.
CAR maintains separate pools for liability and physical damage
coverage for personal and commercial automobile risks. All companies
writing automobile insurance in Massachusetts share in the underwriting
results of CAR business for their respective product line or lines, whether
or not they are Servicing Carriers. Since its inception, CAR has annually
generated multi-million dollar underwriting losses, primarily in the
personal automobile pool. Accordingly, each automobile insurer attempts to
develop and implement underwriting strategies that will minimize its
relative share of the CAR deficit while maintaining acceptable loss ratios
on risks not reinsured through CAR.
In general, the CAR reinsurance mechanism operates as follows.
Within established time frames, a Servicing Carrier must identify which
policies it wishes to retain and which policies it wishes to cede to CAR.
A Servicing Carrier pays to CAR all of the premiums generated by the
policies it has ceded and also reimburses CAR the difference between
standard rates and the reduced premium resulting from affinity group
marketing discounts or safe driver deviations on policies ceded to CAR.
CAR reimburses Servicing Carriers for all losses incurred on account of
ceded policies, although, as with reinsurance generally, reinsurance of a
policy through CAR does not legally discharge the Servicing Carrier from
its liability to the policyholder for the full amount of the policy. In
addition, Servicing Carriers also receive fees for servicing ceded policies
based upon the expense structure established by CAR.
Member companies of CAR have joint and several liabilities for the
obligations of CAR. If one member of CAR fails to pay its assessments, the
remaining members of CAR will be required to pay the pro-rata share of the
member who fails to pay their obligations. At the present time, the
Company is not aware of any CAR member company who has failed to meet its
obligations.
An insurer's proportionate share of the CAR deficit is allocated on
the basis of a formula called a participation ratio, which can vary
significantly between the personal and commercial pools, and between
different policy years. Under current regulations, an insurer's share of
the
15
CAR deficit is based upon its market share for retained automobile risks
for the particular pool, adjusted by a utilization formula, such that, in
general, its participation ratio is disproportionately and adversely
affected if its relative use of CAR reinsurance exceeds that of the
Massachusetts industry and favorably affected if its relative use of CAR
reinsurance is less than that of the Massachusetts industry. The current
formula also contains a provision whereby certain high risk and/or under-
priced business, if reinsured through CAR, is excluded in determining an
insurer's participation ratio. Finally, for the personal automobile CAR
pool, an insurer's participation ratio may be affected by credits received
for not reinsuring through CAR automobile risks in selected under-priced
classes and territories. An insurer's participation ratio will be
favorably affected if its relative use of credits exceeds that of the
Massachusetts industry. Credit values are set annually by CAR and the
Company cannot forecast whether the yearly changes will be beneficial or
detrimental to its personal automobile results.
Company Private Passenger Participation Ratio for CAR versus Market
Share
Company Participation Company
Year Ratio in CAR Market Share
------------------------------------------------
2002* 17.8% 25.9%
2001 16.8% 23.2%
2000 16.9% 22.3%
- --------------------
* Estimated.
The Company's objective is to develop and implement underwriting
strategies to obtain the optimum balance between its CAR participation
ratio and the loss ratios on automobile risks written voluntarily. For each
automobile risk, the Company makes a judgment as to whether the projected
impact on the Company's profitability from retaining the risk outweighs the
incremental cost of reinsuring the risk through CAR. In general, increased
voluntary retention levels result in higher voluntary loss ratios but lower
CAR participation costs. In determining the incremental cost of reinsuring
a risk through CAR, the Company estimates its participation ratio for a
given period by modeling the anticipated Massachusetts industry-wide CAR
trends. Once the Company estimates its participation ratio, it is then
able to compare the incremental effect on the Company's share of the CAR
deficit of either reinsuring or retaining the particular automobile risks.
Finally, for personal automobile risks, the Company utilizes its internal
underwriting database and internally-developed actuarial reporting and
decision support systems to develop a projected underwriting loss ratio for
each risk. It then compares the impact of the automobile risk on the
Company's participation ratio in order to estimate whether, after taking
all CAR and other factors into account, the Company's profitability will be
enhanced by reinsuring or retaining such risk. The Company believes that,
because of its leading share of the Massachusetts personal automobile
insurance market, it can utilize statistically credible data for a greater
array of underwriting factors than its competitors, which in turn gives it
a competitive advantage in deciding which personal automobile risks to
reinsure through CAR.
The CAR utilization-based participation ratio has been in place since
1994, and individual companies in the marketplace make minor yearly changes
to find their optimum balance between voluntary and ceded writings. In
2002, the Company ceded approximately $75,436 or 7.3% of the Company's
Massachusetts personal automobile direct premiums written, compared to
$60,277, or 7.0% in 2001. The Company's strategy has been to maintain
above average voluntary retention levels, as well as to voluntarily retain
personal automobile business that receive credits, favorably impacting the
utilization formula. These credits result from voluntarily writing
business in under-priced territories and for under-priced classes. This
favorably affects the Company's participation ratio, as indicated in the
above table, as the Company's participation ratio is several percentage
points below the Company's estimated 25.8% share of the Massachusetts
personal automobile
16
market. This strategy also may increase the Company's voluntary loss
ratios as under-priced business generally produces higher loss ratios.
Although commercial automobile insurance is a relatively smaller
portion of the Company's total insurance writings, the related commercial
automobile risk selection decisions remain an important element in
determining profitability. In 2002, the Company ceded approximately
$12,762 or 17.0% of its Massachusetts commercial automobile direct premiums
written, as compared to $9,062 or 15.6% in 2001.
CAR rule changes occur, as CAR adjusts the operations of the personal
and commercial reinsurance mechanisms to address the needs of the
Massachusetts automobile insurance market. In a letter to the
Massachusetts Insurance Commissioner (the "Commissioner") dated June 25,
2002, the Massachusetts Attorney General reported that, based on his
examination of available information, he "believes that the CAR plan for
providing access to insurance in the residual market does not comply with
the CAR enabling statute, and must be changed to produce a fair and
equitable market". The Attorney General's letter describes several factors
that he believes support his findings and which he believes should be
corrected in order to comply with Massachusetts law governing CAR. The
Attorney General's letter calls on the Commissioner to work with him to
address these issues. It is uncertain whether and to what extent the
issues raised by the Attorney General will be addressed by the
Commissioner. We cannot be certain whether changes, if any, would have a
material impact on the Company.
C. Marketing
The Company markets its insurance products through a network of
licensed independent agencies, 628 throughout Massachusetts (of which 179
are ERPs), 30 throughout New Hampshire, 808 in California and Oregon for
Commerce West, and 32 in 26 states for American Commerce. The non-ERP
independent agencies may also represent other insurance companies, some of
which may compete directly with the Company. ERP's may represent other
companies for lines of business other than personal and/or commercial
automobile. For these other lines, the ERP's may represent companies that
compete with the Company. The independent insurance agencies are under
contract with the Company's subsidiaries and must conduct their business
according to the provisions of their contract. Contracts for Massachusetts
agencies may be terminated by the Company upon 180 days' notice (90 days in
New Hampshire) to the agency or at will by the agency. ERP contracts may
be terminated by the Company if the ERP violates CAR rules, and the
Company's actions are upheld by the CAR governing committee.
Massachusetts Business
The Company seeks to establish long-term relationships with agencies
that can generate a sizable volume of business with profitable underwriting
characteristics and for which the Company will be among the top one or two
preferred writers of private passenger automobile. As previously
mentioned, the Company markets its insurance products through 628 licensed
independent agencies. Of these, 230 have been licensed with the Company
for less than 5 years. This is primarily the result of 127 new
appointments in 2002. The Company also had 108 agencies with licenses from
6 to 10 years and 290 licensed agencies that have been writing business
with the Company for over 10 years, of which 171 have been associated with
the Company for over 15 years. The Company also assesses whether the mix
of a prospective agency's business will expand the Company's presence in
one or more of its core product lines. In 2002, each agency representing
the Company in Massachusetts produced an average of approximately $1,925 of
Company direct premiums written or a 1.7% increase as compared to 2001.
Also in Massachusetts during 2002, 208 agencies produced between $1.0
million and $2.0 million of direct premiums written, an additional 77
agencies produced between $2.0 million and $3.0 million, an additional 38
agencies produced between $3.0 million and $4.0 million and lastly, an
additional 56 agencies produced over $4.0 million. The Company's three
largest agencies produced approximately $79.8, $28.5 and
17
$22.0 million of the Company's Massachusetts direct premiums written,
respectively, or approximately 6.5%, 2.3% and 1.8% in 2002.
Included in the premium increase for Massachusetts personal
automobile direct premiums written are premiums that were the result of
appointments of new agents. During 2002, Commerce had 127 new
appointments. Of these new appointments, 89 were voluntary agents
resulting in an additional $50,470 in premium. The remainder of the new
appointments resulted from ERPs. Business obtained from new ERPs amounted
to $16,953 during 2002.
Once appointed, each agency's performance is carefully monitored. An
Agency Evaluation Committee, comprised of representatives of the Company's
Marketing, Underwriting and Premium Accounting departments, utilizes a host
of pre-established criterion (loss ratio, premium volume, etc.) to
continuously evaluate agencies. Generally, the Company will counsel an
agency on how to improve its underwriting and profitability before any
agency will be terminated. During 2002, only 6 agencies were terminated by
the Company.
Company agencies receive commissions on policies written for the
Company and are eligible to receive contingent commissions through a profit
sharing arrangement. The Commissioner annually establishes a minimum
average direct commission for personal automobile insurance, which in 2002
was 11.7%. The Company's contingent commissions are tied to the
underwriting profit on policies written by an agency. The Company
generally pays a qualifying agency up to 45% of the rolling three-year
underwriting profit attributable to the agency's business. The arrangement
for Massachusetts business utilizes a three-year rolling plan, with one
third of each of the current and the two prior years profit or loss
calculations, summed to a single amount. This amount, if positive, is
multiplied by the profit sharing rate and paid to the agent. To qualify
for profit sharing, a three-year average loss ratio of 50% to 55% or better
is generally required. CAR credits for voluntary business written in
under-priced territories or credits for writing youthful operators on a
voluntary basis can increase the loss ratio eligibility for profit sharing.
Books of business with limited credits must achieve a lower loss ratio,
generally around 50%. In 2002, total commission expensed by the Company to
its agencies amounted to 15.1% of direct premiums written, of which direct
commissions and contingent commissions constituted 13.6% and 1.5%,
respectively, versus total commission expensed of 15.5%, of which 14.1% was
direct and 1.4% was contingent in 2001. Direct commissions are higher than
the personal automobile minimum commission rates primarily due to higher
commission rates on SDIP Step 9 business coupled with higher commissions on
other lines of business. The decrease in direct commissions from last year
was due to a decrease in the stated mandated personal automobile commission
rate. In 2002, the Company's expense for contingent commissions was $18.2
million versus $14.0 million in 2001.
The Company also occasionally sponsors incentive award trips to
encourage and reward agency profitability and growth. In late 2001, the
Company initiated a 2003 Island Adventure Sales Incentive Contest with the
qualification period running from January 1, 2002 to April 30, 2003.
Qualification criteria includes profitability, written premium volume,
private passenger and commercial automobile growth, longevity and use of
Company services which increase Agency/Company efficiencies. Expenses in
2002 related to the 2003 Sales Incentive trip amounted to $954. In
addition, the Company will hold similar Sales Incentive contests, for which
qualifying growth will run between 2003 and 2005, with trips taking place
in 2004 and 2005.
During the past few years, the Company has devoted substantial time
and resources to the development of its current information systems, which
enhanced both its underwriting and its agency support. Through the use of
several customized software programs, the Company has the ability to
analyze its internal historical underwriting data and use such information
in making, in the Company's belief, more informed underwriting decisions.
In particular, the Company believes that the amount and extent of detail
data accumulated as a result of its share of the Massachusetts personal
automobile market gives the Company a competitive advantage in determining
which personal automobile risks to reinsure through CAR. The Company's
information systems
18
also enable it to provide extensive support to its agencies. This support
includes a direct billing system, which covers over 98% of the Company's
policyholders, an on-line inquiry system, which allows agencies to
ascertain the status of pending claims and direct bill information via the
internet. The system also allows agents on-line access to manuals, reports
and forms. The Company also offers an agency upload for personal
automobile and an agency download product for personal automobile and
homeowners. The Company will expand these offerings in 2003. In addition,
the Company provides access to a system that allows Company agencies to
quote premiums for the Company's three core product lines directly to
policyholders. During 2002, more than 90% of our agents had access to one
or more of these systems.
The Company believes that, because of its compensation arrangements
and by providing a consistent market with emphasis on service, an
increasing number of the Company's agencies will rely on it as their
principal supplier of insurance products. The Company believes that it is
the preferred provider for most of its agencies. Although the Company
believes, based on annual surveys of its agencies, that its relationships
with its independent agencies are excellent, any disruption in these
relationships could adversely affect the Company's business.
As previously mentioned, since the latter part of 1995, Commerce has
been a leader in affinity group marketing through agreements with the four
AAA clubs. For additional information, please refer to "Part II, Item 7-
Massachusetts Automobile Business" section (MD&A).
Agreements for the Transfer of Massachusetts Business from Other Companies
in 2002
During late 2001 and 2002, the Company entered into agreements with
MassWest Insurance Company and Berkshire Mutual Insurance Company for the
transfers of Massachusetts personal automobile business written by those
companies in 2002. During 2001 the Company also formed an alliance with
Horace Mann Educators Corporation. For additional information regarding
these agreements, please refer to "Part II, Item 7-Massachusetts Automobile
Business" section (MD&A).
Other States
Commerce writes personal lines insurance through 30 independent
insurance agencies in the state of New Hampshire. Commerce West
predominantly writes private passenger automobile insurance in California
and Oregon through 808 independent insurance agencies and brokers. All
business is underwritten at Commerce West's headquarters located in
Pleasanton, California. Although Commerce West primarily writes preferred
and non-standard automobile insurance, it also writes commercial automobile
insurance in California. This program was introduced in late 2000.
American Commerce predominantly writes preferred private passenger
automobile and homeowners insurance in 26 states exclusively through 32 AAA
independent insurance agencies. All business is underwritten at American
Commerce's headquarters located in Columbus, Ohio. Both companies target
preferred insurance risks.
D. Underwriting
The Company seeks to achieve an underwriting profit, as measured by a
statutory combined ratio of less than 100%, in each of its product lines,
in both hard and soft markets. The strategy is designed to achieve
consistent profitability with substantial growth in net premiums written
during hard markets and more modest growth during soft markets. All of the
Company's policies have been written on a "claims incurred basis," meaning
that the Company covers claims based on occurrences that take place during
the policy period.
Agencies are authorized to bind the Company on risks as limited by
the Company's written underwriting rules and practices, which set forth
eligibility rules for various policies and coverages, unacceptable risks,
and maximum and minimum limits of liability. With respect to non-
19
automobile policies, other than certain umbrella policies, the Company's
agencies have the ability to bind the Company for a limited period,
typically 60 days, during which time the Company reviews all risks to
determine whether it will accept or reject the policy. During this review
period, the Company is obligated to pay any claim, which would be covered
under the policy. Violation of the Company's underwriting rules and
practices is grounds for termination of the agency's contract with the
Company.
Massachusetts Business
The Company and each of the approximately 19 other Servicing Carriers
must write all private passenger automobile risks submitted to them.
Massachusetts personal automobile insurance rates are fixed annually by the
Commissioner. All companies writing personal automobile policies are
required to use such mandated rates, unless they have received prior
approval from the Commissioner to offer a lower rate. The actual premium
paid by a particular policyholder, however, is adjusted, either up or down,
based upon the SDIP record of the insured operator. Moving violations and
accidents for which the insured was at fault within the most recent six
year period are used to determine each operator's SDIP surcharge or credit.
The competitive nature of the Massachusetts personal automobile insurance
market, which began in late 1995, continued through 2002.
Company voluntary Massachusetts commercial automobile insurance rates
are set competitively, subject to the Commissioner's authority to
disapprove such rates. The rate for commercial automobile risks reinsured
through CAR is mandated by the Commissioner, except for private passenger
type non-fleet business. The Company's rates for other product lines,
including homeowners and commercial lines of general liability and property
insurance, are based in part on loss cost data from the Insurance Services
Office ("ISO"), which is an industry bureau providing policy forms and rate
making data, and in part, on the Company's own experience and industry
price levels.
The Company is not obligated by statute to accept every homeowners
risk submitted to it. Accordingly, risks meeting the Company's
underwriting guidelines are accepted, and all other risks are declined or
not renewed. The Company has established an independent rate level for its
homeowners product line, based on its own loss experience and recognizing
the price levels available in the competitive marketplace. The Company
uses ISO policy forms and has added special coverage features to meet its
product needs. Rates and forms are filed with, and approved by the
Commissioner.
Under Massachusetts law, residential property owners are strictly
liable for damages caused by lead poisoning in children under age six
residing in the premises, unless the property owner has a Letter of
Compliance or a Letter of Interim Control (i.e. has taken or is taking
specific measures to prevent lead poisoning). The Company has reduced its
exposure to lead poisoning by (i) excluding from coverage all intra-
familial claims for bodily injury or medical expenses brought by minors
living in an insured's household, (ii) revising its underwriting standards
for new and renewal business to avoid insuring properties with lead
poisoning hazards and (iii) excluding from homeowners and dwelling fire
liability coverage all lead poisoning perils to children under the age of
six on policies for properties built prior to 1978 that contain rental
units and where strict liability for lead poisoning would otherwise apply.
Effective on March 1, 1998 a similar exclusion was added to the Business
Owners Program. With regard to the exclusion described in (iii),
policyholders may buy a reinstatement of the excluded coverage through a
policy endorsement for an additional premium, but very few such
endorsements have been written. As a result of these remedial steps and
its historical claims experience, the Company does not believe that its
exposure to lead poisoning claims is material. The Company held reserves
in the amount of $1,680 and $1,600 for lead paint related claims at
December 31, 2002 and 2001, respectively.
20
Also included in the financial results are claims for other
environmental related claims such as oil spills and mold. For additional
information, please refer to "Part II, Item 8-Notes to Financial
Statements, NOTE E".
The Company believes that its information systems give it a
competitive advantage in making underwriting decisions, particularly in
deciding which personal automobile risks should be reinsured through CAR.
Utilizing data the Company accumulates as a result of its major market
presence in the Massachusetts personal automobile line, the Company
believes that its information systems allow it to make informed risk
assessments and to respond effectively to shifts in the automobile
insurance markets and regulatory environment.
Other States
In keeping with the Company's long-term growth objective to expand
outside Massachusetts, the Company, in 1995, acquired Commerce West, a
personal automobile insurer, located in Pleasanton, California. The
Company formed a joint-venture (ACIC Holding Co., Inc.) in November 1998,
and in January 1999 acquired American Commerce, located in Columbus, Ohio.
Commerce West predominantly writes private passenger automobile insurance
in California and Oregon through 808 independent insurance agencies and
brokers. All business is underwritten at Commerce West's headquarters
located in Pleasanton, California. Although primarily writing preferred
private passenger automobile business, Commerce West also writes non-
standard private passenger automobile business and writes commercial
automobile business. American Commerce predominantly writes preferred
private passenger automobile and homeowners insurance in 26 states
exclusively through 32 AAA independent insurance agencies. All business is
underwritten at American Commerce's headquarters located in Columbus, Ohio.
American Commerce primarily targets preferred insurance risks. Beginning
in the latter part of 2001, Commerce began writing personal lines insurance
in the state of New Hampshire. Currently, Commerce writes New Hampshire
business through 30 independent insurance agencies.
E. Reinsurance
In addition to participating in CAR, the Company reinsures with other
insurance companies on a claims incurred basis, a portion of its potential
exposure under the policies it has written, protecting itself against
severe loss under individual policies, or catastrophic occurrences where a
number of claims can produce an extraordinary aggregate loss. Reinsurance
does not legally discharge the Company from its primary liability to the
insured for the full amount of the policies, but it does make the reinsurer
liable to the Company to the extent of the reinsured portion of any loss
ultimately suffered. The Company seeks to utilize reinsurers that it
considers adequately capitalized and financially able to meet their
respective obligations under reinsurance agreements with the Company. The
Company utilizes a variety of reinsurance mechanisms to protect itself
against loss. For additional information, please refer to "Part II-Item 8,
Notes to Financial Statements, NOTE F".
F. Settlement of Claims
Claims under insurance policies written by the Company are
investigated and settled primarily by claims adjusters employed by the
Company. In Massachusetts at year-end, Commerce employed a staff of 834
people at its claims department, located in Webster, Massachusetts. In
addition to these individuals, Commerce utilizes the services of
approximately 30 independent appraisal firms and 11 independent property
adjusting companies who are strategically located throughout the
Commonwealth of Massachusetts and State of New Hampshire. Commerce also
has a special unit that investigates suspected insurance fraud and abuse.
At year-end, American Commerce employed a staff of 82 people that settled
claims at three regional claims offices strategically located throughout
the country as well as the Company's Massachusetts location. In addition
to these individuals, American Commerce utilized the services of
approximately 88
21
independent appraisal firms and 77 independent property adjusting companies
who are also strategically located throughout the country as well as the
Company's Massachusetts location. At year-end, Commerce West settled
claims at their home office, employing a staff of 30 in the claims
department. In addition, Commerce West utilizes the services of
approximately 14 independent appraisal firms strategically located in
California and Oregon. If a claim or loss cannot be settled and results in
litigation, the companies retain outside counsel to represent them.
The Company believes that, based on surveys of its agency force and
insureds, through its claims staff of experienced adjusters, appraisers,
managers, and administrative staff, it has higher customer satisfaction
than many of its competitors. All claims office staff members work closely
with agents, insureds and claimants with a goal of settling claims fairly,
rapidly and cost effectively.
The Massachusetts Unfair Claims Settlement Practices Act ("Chapter
176D"), and other similar provisions in states in which the Company does
business, prohibits insurers from engaging in certain claim settlement
practices. These include failing to acknowledge and act reasonably
promptly upon communications with respect to claims arising under insurance
policies, refusing to pay claims without conducting a reasonable
investigation based upon all available information, failing to effectuate
prompt, fair and equitable settlements of claims in which liability has
become reasonably clear, and compelling insureds to institute litigation to
recover amounts due under an insurance policy by offering substantially
less than the amounts ultimately recovered in actions brought by such
insureds. An insurer's violation of any of these obligations expressly
violates a number of state laws, including the Massachusetts Consumer
Protection Act ("Chapter 93A"). Any party, including claimants and
insureds, whose rights are affected by an insurer's violation of Chapter
176D, is entitled to bring a claim against the insurer under Chapter 93A.
Similar provisions exist in other states where the Company does business.
The damages available under Chapter 93A may not necessarily be
related to the harm caused by the insurer's violation of Chapter 176D.
Chapter 93A provides in effect that the party that brings a successful 93A
claim will be entitled, at a minimum, to the amount of the judgment on all
claims arising out of the same underlying occurrence, plus their legal
fees, regardless of the limits of the policy issued by the insurer.
Moreover, Chapter 93A permits the court to double or triple the party's
damages if the insurer's violation of Chapter 176D was willful or knowing.
If the underlying policy risk was ceded to CAR, the Company may seek
reimbursement from CAR for legal expenses on any successfully defended
claim. This is the only instance in which CAR will make any reimbursement
on a 93A claim.
Since 1996, Commerce has been expanding a twenty-four (24) hour claim
reporting service in Massachusetts to third-party claimants and insureds of
interested agencies. This service allows customers to report their first
notice of a loss at any time of the night or day; 365 days a year. This
reporting methodology allows the Company to improve customer satisfaction
by making the initial claim handling much faster and ultimately reducing
indemnity payments such as rental and storage.
Certain of Commerce's Massachusetts agencies have settlement
authority for claims for other than automobile property losses, which are
less than $2.5. The settlement authority of agencies under automobile
policies is limited to claims for towing. As of December 31, 2002, there
were 291 Massachusetts agents who signed up for this claim payment
methodology. This service is available to all agents and their use of the
service fluctuates on an ongoing basis.
G. Loss and Loss Adjustment Expense Reserves
The following table represents the development of reserves, net of
reinsurance, for 1992 through 2002. The top line of the table shows the
reserves at the balance sheet date for each of the indicated years. This
represents the estimated amounts of losses and LAE for claims arising in
22
all years that were unpaid at the balance sheet date, including losses that
had been incurred but not yet reported to the Company. The upper portion
of the table shows the cumulative amounts paid as of successive years
expressed as a percentage with respect to that year's ending reserve
liability. The lower portion of the table shows the re-estimated amount as
a percentage 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 estimate changes as more information
becomes known about the payments, frequency and severity of claims for
individual years. Favorable loss development exists when the original
reserve estimate is greater than the re-estimated reserves at December 31,
2002.
For additional information, please refer to "Part II, Item 7 - MD&A -
Liquidity and Capital Resources" and "Part II, Item 8 - Notes to Financial
Statements, NOTE E".
In evaluating the cumulative information in the table, it should be
noted that each year's amount includes the cumulative effects of all
changes in amounts for prior periods. This table does not present accident
or policy year development data. Conditions and trends that have affected
development of the liability in the past may not necessarily occur in the
future. Accordingly, it is not appropriate to extrapolate future
development based on this table.
Year ended December 31,
------------------------------------------------------------------------------------------------------------
2002 2001(2) 2000 1999 1998(1) 1997 1996 1995 1994 1993 1992
------------------------------------------------------------------------------------------------------------
(Restated) (Dollars in thousands)
Reserves for
losses and loss
adjustment
expenses $678,349 $594,155 $585,867 $558,779 $561,239 $529,765 $533,980 $493,910 $455,460 $422,224 $316,264
Paid (cumulative)
as a percentage
of current re-
serves as of:
One year
later 49.3 51.9 50.9 47.5 50.9 50.5 48.5 47.7 52.7 51.1
Two years
later 71.4 72.5 70.2 74.0 72.5 70.3 68.4 71.8 76.8
Three years
later 83.3 81.3 88.3 84.8 84.2 80.8 82.1 86.0
Four years
later 86.7 94.2 93.1 90.8 89.6 88.4 91.1
Five years
later 97.1 95.9 96.0 92.8 93.1 94.0
Six years
later 97.1 96.9 95.9 94.3 96.7
Seven years
later 97.6 96.3 96.3 97.1
Eight years
later 96.8 96.4 98.5
Nine years
later 96.8 98.6
Ten years
later 99.0
Reserves re-
estimated as
a percentage of
initial reserves
as of:
One year
later 97.6 94.0 92.4 92.9 88.4 84.3 82.2 83.6 83.9 87.2
Two years
later 93.7 90.3 91.9 85.6 79.3 74.1 73.2 75.9 78.6
Three years
later 90.3 91.3 85.1 77.4 71.5 68.9 69.4 73.0
Four years
later 91.3 84.7 77.3 69.7 67.8 67.3 68.8
Five years
later 84.4 77.1 70.4 66.3 66.4 67.0
Six years
later 76.8 70.1 66.9 65.7 66.7
Seven years
later 69.9 66.8 66.2 65.9
Eight years
later 66.7 66.1 66.5
Nine years
later 66.1 66.4
Ten years
later 66.6
Redundancy
expressed as
a percent of
year-end reserves 2.4 6.3 9.7 8.7 15.6 23.2 30.1 33.3 33.9 33.4
(footnotes on following page)
23
- --------------------
The 1998 amount includes an adjustment to add $63,112 in loss and LAE
reserves for American Commerce at January 29, 1999. For additional
information about losses and LAE, gross and net of reinsurance, see
"Part II, Item 8 - Noted to Financial Statements, NOTE E -
Reinsurance".
Reserves for loss and loss adjustment expenses differ from the amount
originally reported by $3,822. This difference was caused by the
employee stock option accounting change from fixed to
variable. For additional information, please refer to "Part II, Item
7" MD&A.
H. Operating Ratios
Loss and Underwriting Expense Ratios
Loss and underwriting expense ratios are used to interpret the
underwriting experience of property and casualty insurance companies.
Losses and LAE are stated as a percentage of premiums earned because losses
may occur over the life of a policy. Underwriting expenses on a statutory
basis are stated as a percentage of net premiums written rather than earned
premiums because most underwriting expenses are incurred when policies are
written and are not spread over the policy period. Underwriting profit
margins are reflected by the extent to which the combined loss and
underwriting expense ratios, the combined ratio, is less than 100%. The
combined ratio is considered the best simple index of current underwriting
performance of an insurer. The Company's loss and LAE ratio, underwriting
expense ratio and combined ratio, and the industry combined ratio, on a
statutory basis, are shown in the following table. The Company's ratios
include lines of insurance other than automobile as do the industry
combined ratios for all writers. Data for the property and casualty
industry generally may not be directly comparable to Company data. This is
due to the fact that the Company conducts its business primarily in
Massachusetts where approximately 86.6% of direct premiums are written.
Years ended December 31,
-------------------------------------------
2002 2001 2000 1999 1998
-------------------------------------------
Company Statutory Ratios
(unaudited)
Loss and LAE Ratio 75.1% 74.5% 71.7% 72.0% 71.6%
Underwriting Expense Ratio 23.6 24.2 25.1 26.5 26.5
--------------------------------------------
Combined Ratio 98.7% 98.7% 96.8% 98.5% 98.1%
============================================
Industry Combined Ratio
(all writers)(1) 103.8% 109.7% 109.7% 104.4% 02.2%
============================================
- --------------------
Source: A.M. Best's Review Preview (2003), as reported by A.M. Best
for all property and casualty insurance companies and weighted to
reflect the Company's product mix. The 2002 industry information is
estimated by A.M. Best.
24
Premiums to Surplus Ratio
The following table shows, for the periods indicated, the Company's
and the industry's statutory ratios of net premiums written to
policyholders' surplus. While there is no statutory requirement applicable
to the Company that establishes a permissible net premiums to surplus
ratio, guidelines established by the National Association of Insurance
Commissioners ("NAIC") provide that this ratio should be no greater than
300%.
Years ended December 31,
------------------------------------------------------------------
2002 2001 2000 1999 1998
------------------------------------------------------------------
(Dollars in thousands)
Net premiums written by the
Company $1,313,014 $1,078,967 $1,008,911 $911,993 $745,048
Policyholders' surplus of the
Company's insurance
subsidiaries $ 662,009 $ 715,932 $ 660,962 $518,974 $563,503
The Company's ratio 198.3% 150.7% 152.6% 175.7% 132.2%
Industry ratio(1) 129.7% 111.7% 94.4% 85.8% 84.5%
- --------------------
Source: A.M. Best's Review Preview (2003), for all property and
casualty insurance companies. The 2002 industry information is
estimated by A.M. Best.
I. Investments
Investment income is an important source of revenue for the Company
and the return on its investment portfolio has a material effect on its net
earnings. The Company's investment objective continues to focus on
maximizing after-tax investment income through investing in high quality
securities coupled with acquiring equity investments, which may forego
current investment yield in favor of potential higher yielding capital
appreciation in the future.
For additional information, please refer to "Part II, Item 7",
(MD&A), and "Part II, Item 8-Notes to Financial Statements, NOTE A2 and B".
J. Regulation
General
The Company's primary business is subject to extensive regulation.
In Massachusetts, the Commissioner is appointed by the Governor of
Massachusetts and has broad authority to fix and establish maximum policy
rates and minimum agent commission levels on personal automobile insurance.
In addition, the Commissioner grants and revokes licenses to write
insurance, approves policy forms, sets reserve requirements, determines the
form and content of statutory financial statements and establishes the type
and character of portfolio investments. The Commissioner also approves
company submissions regarding affinity group insurance programs and
corresponding discounts along with SDIP deviations. Consequently, the
policies and regulations set by the Commissioner are an important element
of writing insurance in Massachusetts. In states outside of Massachusetts,
premium rates generally must be filed with, and approved by the
Commissioner of Insurance in that particular state. In general, minimum
commissions to agents are not set by the other states commissioners.
State Divisions of Insurance are responsible for conducting periodic
examinations of insurance companies. Both Commerce and Citation were last
examined for the five year period ended December 31, 1998. Commerce West
was last examined in 2001 by the California Division of Insurance for the
three year period ended December 31, 1999. American Commerce was exam-
25
ined in 1999 by the Ohio Division of Insurance for the three year period
ending December 31, 1997. The concluded examinations produced no material
findings. Massachusetts Division of Insurance regulations provide that
insurance companies will be examined every five years or more frequently as
deemed prudent by the Commissioner. California Division of Insurance
regulations provide that insurance companies will be examined every three
years. Ohio Division of Insurance regulations provide that insurance
companies will be examined at least every five years.
Automobile Insurance Regulation Overview
Massachusetts has required compulsory automobile insurance coverage
since 1925. States outside of Massachusetts generally have varying levels
of minimum compulsory insurance. Under current law, all Massachusetts
motorists are required to carry certain minimum coverages mandated by the
State. The Commissioner fixes and establishes, among other things, the
maximum rates insurers may charge for the compulsory personal automobile
coverages. With very limited exceptions, each insurer writing automobile
insurance in Massachusetts must accept all risks submitted to it for the
compulsory coverage, but is permitted to reinsure these risks (including
affinity group marketing insurance risks) through CAR.
Compulsory Coverage-Compulsory coverage includes no-fault coverage,
limited bodily injury coverage, property damage coverage and coverage
against uninsured or hit and run motorists. The Massachusetts no-fault
statute provides for personal injury protection ("PIP") coverage, which
entitles a party to be reimbursed directly by the party's own insurer for
certain medical expenses, lost wages and other defined expenses arising
from an automobile accident, up to a specific amount, even if another party
caused the accident.
Rates and Commissions-Massachusetts personal automobile insurance
rates are fixed and established annually by the Commissioner. Affinity
group marketing insurance programs and safe driver rate deviations must be
annually approved by the Commissioner. For Massachusetts commercial
automobile insurance, the rates for the voluntary market are competitive,
with insurers filing rates for review by the Commissioner based on their
own experience. The rates for the Massachusetts commercial automobile
risks reinsured through CAR are recommended by CAR and approved by the
Commissioner, except for non-fleet, private passenger-type automobiles.
For additional information, please refer to "Part I - Section A - General".
In fixing classifications of risks and establishing personal
automobile rates, the Commissioner must consider numerous factors,
including driver and automobile characteristics and the claim rate in the
state's designated geographical territories. These factors are based upon
data that are two or more years old. Premiums charged to a policyholder
are adjusted based upon the SDIP record of the operator. Moving violations
and at-fault accidents affect each driver's SDIP record. In addition, the
Extra Risk Rating regulations permit insurers to deny or charge surcharged
rates for physical damage coverage to both high risk vehicles and insureds
with excessive prior loss or violation activity.
The Commissioner sets an average minimum direct agency commission
rate for personal automobile insurance, which in 2002 was 11.7%. With
respect to risks reinsured through CAR, the maximum amount of commissions
that CAR will reimburse is fixed at that prescribed rate.
Outside of Massachusetts, rates and commissions are set competitively
on a company by company and state by state basis.
Mandatory Underwriting-Massachusetts law specifies that all
individuals holding a valid driver's license are entitled to purchase the
mandatory automobile insurance coverages regardless of their driving
experience or accident record. The Massachusetts Legislature has also
placed certain restraints on insurers' discretion to refuse to renew
automobile insurance policies. Policyholders are generally entitled to
renew except in cases of fraud, material misrepresentation,
26
revocation or suspension of an operator's license or nonpayment of
premiums. With very limited exceptions, Servicing Carriers writing
automobile insurance in Massachusetts must accept every automobile risk
submitted to them.
Under the Massachusetts system of rate regulation, some personal
automobile insurance risks are purposefully under-priced by the
Commissioner, and therefore, absent state-intervention, insurers would not
ordinarily choose to write those risks. The CAR reinsurance program
described below is intended to mitigate the burden imposed by the
Massachusetts take-all-comers system, by allowing insurers to transfer the
exposure for under-priced risks to an industry pool, and by granting
participation credits for certain under-priced risks.
Commonwealth Automobile Reinsurers
General-CAR is a Massachusetts state-mandated reinsurance mechanism,
under which all premiums, expenses and losses on ceded business are pooled
and shared by all insurers. It is similar to a joint underwriting
association because a number of insurers (35, including the Company) act as
Servicing Carriers for the ceded risks.
Agencies-In general, agencies licensed to issue automobile insurance
policies are entitled to be assigned to at least one Servicing Carrier.
There are two categories of agencies: those who have voluntary agreements
with one or more Servicing Carriers and those who do not. The latter are
assigned by CAR, generally to a single Servicing Carrier, or non-servicing
carrier, and are known as ERPs. There can be ERP's for private passenger
automobile or commercial automobile or both.
CAR Operations-All companies writing automobile insurance in
Massachusetts share in the underwriting results of the CAR business for
their respective product line or lines, whether or not they are Servicing
Carriers. An insurer's share of the CAR deficit is allocated on the basis
of a formula called a participation ratio, which can vary significantly
between the personal and commercial pools, and between different policy
years. See "Part I, Item 1B-Business-Commonwealth Automobile Reinsurers"
for a detailed discussion of the method of calculating the participation
ratio.
An insurer may terminate its participation in CAR, for example,
surrendering its license to write automobile policies in Massachusetts.
Termination does not discharge or otherwise affect liability of an insurer
incurred prior to termination. A withdrawing insurer is assessed a share
of CAR's projected deficits for future years based on the insurer's prior
years' participation in CAR. The assessment paid by the withdrawing
insurer is redistributed to the remaining insurers based upon their
participation ratios.
An insurer can transfer its obligations for its personal insurance
policies to another insurer who formally agrees to assume these
obligations. The transferring insurer is there-by relieved of future CAR
obligations which otherwise would have arisen as a consequence of the
business transferred. See "Part I, Item 1B-Business-Commonwealth Automobile
Reinsurers."
Insurance Holding Company Structure
As an insurance holding company, the Company is subject to regulation
under the insurance holding company statutes of the states in which any of
its subsidiary insurance companies are domiciled. Because the Company's
subsidiaries are members of an insurance holding company system, they are
required to register with their respective Divisions of Insurance and to
submit reports describing the capital structure, general financial
condition, ownership and management of each insurer and any person or
entity controlling the insurer, the identity of every member of the
insurance holding company system and the material outstanding transactions
between the insurer and its affiliates. California and Ohio have similar
laws as Massachusetts.
27
Each member of the insurance holding company system must keep
current the information required to be disclosed by reporting all material
changes or additions within 15 days of the end of the month in which it
learns of such change or addition.
Massachusetts law prohibits a party that is not a domestic insurer
from acquiring "control" of a domestic insurer or of a company controlling
a domestic insurer without prior approval of the Commissioner. Control is
presumed to exist if a party directly or indirectly holds, owns or controls
more than ten percent of the voting stock of another party, but may be
rebutted by showing that control does not exist. California and Ohio have
similar laws as to those in Massachusetts.
In the event of the insolvency, liquidation or other reorganization
of any of the Company's insurance subsidiaries, the creditors and
stockholders of the Company will have no right to proceed against the
assets of those subsidiaries, or to cause the liquidation or bankruptcy of
any company under federal or state bankruptcy laws. State laws govern such
liquidation or rehabilitation proceedings and the Division of Insurance
would act as receiver for the particular company. Creditors and
policyholders of the insurance subsidiaries would be entitled to payment in
full from such assets before the Company, as a stockholder, would be
entitled to receive any distribution there from.
Payment of Dividends
Under Massachusetts' law, insurers may pay cash dividends only from
earnings and statutory surplus, and the insurer's remaining surplus must be
both reasonable in relation to its outstanding liabilities and adequate to
its financial needs. California and Ohio have similar laws as those in
Massachusetts.
Protection Against Insurer Insolvency
All insurance companies are required to participate in Insurance
Insolvency fund programs in the states they write in. For further
information, please refer to "Part II, Item 8-Notes to Financial
Statements, NOTE Q".
Protection Against Insurer Insolvency-NAIC Guidelines
Insurance Regulatory Information System Ratios-The NAIC Insurance
Regulatory Information System ("IRIS") was developed by a committee of
state insurance regulators and is intended primarily to assist state
insurance regulators in executing their statutory mandates to oversee the
financial condition of insurance companies operating in their respective
states. IRIS identifies eleven industry ratios and specifies "usual
values" for each ratio. Departure from the "usual values" on four or more of
the ratios can lead to inquiries from individual state insurance
commissioners as to certain aspects of an insurer's business. For the year
ended December 31, 2002, the Company's consolidated property and casualty
operations had no ratios outside the "usual values".
Risk-Based Capital ("RBC")-In order to enhance the regulation of
insurer insolvency, the NAIC developed a formula and model law to provide
for RBC requirements for property and casualty insurance companies. RBC
requirements are designed to assess capital adequacy and to raise the level
of protection, that statutory surplus provides for policyholder
obligations. Please refer to "Part II, Item 7 - Risk Based Capital"
section (MD&A).
K. Competition
The property and casualty insurance industry is highly cyclical,
characterized by periods of increasing premium rates and limited
underwriting capacity, followed by periods of intensive price
28
competition and abundant underwriting capacity. This industry also is
highly competitive, with a large number of companies, many of which operate
in more than one state, offering automobile, homeowners, commercial
property and other lines of insurance. Some of the Company's competitors
have larger volumes of business and greater financial resources and some
sell insurance directly to policyholders rather than through independent
agents.
Massachusetts
The Company is the largest writer of private passenger automobile
insurance, the second largest writer of homeowner insurance and the third
largest writer of commercial automobile insurance in Massachusetts. For
additional information, please refer to "Part II, Item 7-General" (MD&A).
In 2002 and 2003, in response to the average personal automobile rate
decisions over the last several years, the Company did not file for SDIP
Step 9 or Step 10 deviations. For 2003, Commerce reduced its affinity
group marketing discount from 6% to 5% for policies incepting in the 2003
policy year.
Because the Company's insurance products are marketed exclusively
through independent agencies, most of whom represent more than one company,
the Company faces competition within each agency. The Company competes for
business within independent agencies by offering a more attractively priced
product to the consumer and by paying agents significant compensation in
the form of commissions and profit sharing, which are based in part on the
underwriting profits or losses of the agency business written with the
Company. The Company also provides a consistent market, the prompt
servicing of policyholder claims and agency support services. The Company
believes, based upon regular surveys of its agencies, its relationships
with its independent agencies are excellent. Any disruption in these
relationships could adversely affect the Company's business. The Company
also believes its relationship with the four AAA clubs that sponsor the AAA
affinity group marketing program to be excellent. Commerce and the AAA
clubs have agreed that Commerce shall be their exclusive underwriter of
Massachusetts personal automobile group programs. A rolling three-year
contract between Commerce and the AAA clubs exists, which renews
automatically and may be terminated upon a minimum of three years written
notice to either party.
The Company believes the Massachusetts regulatory environment, which
fixes maximum personal automobile insurance rates, assigns ERPs to
servicing carriers, apportions losses incurred by CAR and establishes
minimum agency commissions, has discouraged certain companies with more
diverse geographic markets and interests from establishing a presence or
expanding their market share in Massachusetts. Any material change in this
situation could adversely affect the Company's business.
Other States
Both Commerce West and American Commerce file and receive approval
for premium rates with the respective divisions of insurance in the states
they do business. Commerce West competes for business by utilizing 808
independent insurance agencies and brokers that offer competitively priced
products and provide quality service. Agents and brokers are offered
compensation in the form of commissions and profit sharing, which are based
in part on the underwriting profits and losses of the agency business
written with Commerce West. American Commerce competes for business by
utilizing 32 AAA owned and operated independent agencies that offer
competitively priced products and provide quality service. The AAA owned
independent agencies are offered compensation in the form of commission and
profit sharing, based primarily on loss ratios, as well as stock options
and bonuses based on the year over year increase in the volume of agency
business written with American Commerce. Commerce offers competitively
priced products
29
and commissions to agents in New Hampshire. Profit sharing, based on loss
experience, is also offered as an inducement for exceptional business.
L. Other Matters
Human Resources
As of December 31, 2002, the Company and its subsidiaries employed
1,874 people. Commerce employed 1,618 people; Commerce West employed 79
people; American Commerce employed 177 people. The Company is not a party
to any collective bargaining agreements and believes its relationship with
employees to be very good.
The Company offers benefits, compensation and employee relations
programs to assure a productive and positive working environment. The
Company monitors job grades and salary scales of peer companies to assure
that its compensation levels and benefits are competitive both within the
property and casualty insurance industry and geographically in the areas
its subsidiaries operate. The Company has been recognized for its
progressive programs designed to meet the needs of a modern-day workforce.
On-site child care has been offered to Massachusetts employees since 1986,
making Commerce one of the first businesses in the region to offer this
benefit. The child care center can currently accommodate up to 200
children of our employees. Alternative work schedules, casual dress, and
free parking are provided.
The Company offers significant benefit programs to its employees.
For further information, please refer to "Part II, Item 8-Notes to
Financial Statements, NOTES I and J".
Additional Information
For information called for by this item and not otherwise provided
please refer to "Part II, Item 8-Notes to Financial Statements, NOTE A4 and
NOTE C for Deferred Policy Acquisition Costs", and "Notes to Financial
Statements, NOTE A9 and G for Deferred Income Tax Assets".
Information Available on Website
The Company makes available, free of charge, on the Commerce
Insurance website (http://www.commerceinsurance.com) the Company's Annual
Report on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K, and amendments to those reports filed or furnished pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as
reasonably practicable after we electronically file such material with, or
furnish it to, the Securities and Exchange Commission, beginning with the
Quarterly Report on Form 10-Q for the quarter ended September 30, 2002.
ITEM 2. PROPERTIES
The Company conducts its Massachusetts operations from approximately
436,000 square feet of space in several buildings that it owns in Webster,
Massachusetts, which is located approximately 50 miles southwest of Boston.
The Company's principal administrative offices in Webster consist of
recently rehabilitated and newly constructed buildings. Its data
processing and operational departments are housed in modern office
buildings on a separate twenty-eight acre site. The Company has a 20,000
square foot child care center located on a separate seven acre site in
Webster, Massachusetts. The Company operated child care center can provide
care for up to 200 children of employees. During 2001, Commerce purchased
a 130,000 square foot building. Commerce expended approximately $13
million renovating the building in 2002. Commerce West currently leases
approximately 17,000 square feet of office space in Pleasanton, California.
Commerce West anticipates it will relocate within the next one to three
years. American Commerce conducts its operations from approximately 40,000
square feet of space in a building located on a
30
two acre site in Columbus, Ohio. American Commerce also leases property at
three district claims offices. The Company considers that its properties
are in good condition, are well maintained, and are generally suitable to
carry on the Company's business. For additional information, please refer
to "Part II-Item 8, Notes to Financial Statements-NOTE D".
ITEM 3. LEGAL PROCEEDINGS
As is common with property and casualty insurance companies, the
Company is a defendant in various legal actions arising from the normal
course of its business, including claims based on Massachusetts Chapter
176D and Chapter 93A. Similar provisions exist in other states where the
Company does business. These proceedings are considered to be ordinary to
operations or without foundation in fact. Management is of the opinion
that these actions will not have a material adverse effect on the
consolidated financial position of the Company.
The Company previously disclosed that a purported class action
lawsuit was pending in Massachusetts state court against The Commerce
Insurance Company ("Commerce"). The lawsuit, titled "Elena Given,
individually and as a representative of all persons similarly situated v.
The Commerce Insurance Company," alleges damages as a result of the alleged
inherent diminished value to vehicles that are involved in accidents. In
April 2002, the trial judge in that case entered partial summary judgment
for the plaintiff on the issue of whether the Massachusetts automobile
policy covers her claim, ruling that the plaintiff would be entitled to
reimbursement under the policy if the plaintiff were able both to prove
that her vehicle suffered "inherent diminished value" in the accident and
to quantify the amount of such diminution in value. Subsequently the
Massachusetts Division of Insurance issued an Advisory ruling in which it
stated, among other things, its position that the policy does not cover
claims for "inherent diminished value." In July of 2002, the trial judge,
stayed the trial and granted the Company's motion to have the appellate
court review the issue of whether the Massachusetts automobile policy
provides coverage for inherent diminished value. During the third quarter
of 2002, the Company applied for direct appellate review of this issue by
the Supreme Judicial Court of Massachusetts ("SJC"), and this application
was granted. Another Superior Court judge in Massachusetts ruled, in a
similar case brought by the same plaintiff counsel against another insurer,
that claims for diminution of value are not covered by the Massachusetts
automobile insurance policy. The Company's and the other insurer's cases
have been paired and oral arguments were heard at the SJC on March 4, 2003. A
decision is expected within 120 days of the oral argument. If the SJC agrees
with the Given trial judge's interpretation of the Massachusetts personal
automobile insurance policy, then the case will be remanded to the trial
court, where the Company would vigorously oppose class certification. No
reserve has been established for the potential liability in connection with
this case because the Company is unable to estimate the potential exposure
of this purported class action lawsuit. However, if there were a final
decision certifying that a relatively large class of the Company's
policyholders is entitled to recover damages based upon the inherent
diminished value theory, the Company may have to increase materially its
loss and loss adjustment expense reserves as a result. Other insurance
companies face similar suits in cases outside of Massachusetts.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during
the fourth quarter of 2002.
31
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The Company's executive officers are as follows:
Name Age Primary Position with Company
- --------------------------------------------------------------------------------------------
Arthur J. Remillard, Jr. 72 President, Chief Executive Officer, Chairman of the Board
Gerald Fels 60 Executive Vice President, Chief Financial Officer, Director
Regan P. Remillard 39 Senior Vice President and Director
Arthur J. Remillard, III 47 Senior Vice President-Policyholder Benefits, Assistant
Clerk, Director
David H. Cochrane 49 Senior Vice President-Underwriting of Commerce and
Citation
Peter J. Dignan 51 Senior Vice President-Marketing and Premium Accounting
of Commerce and Citation
James A. Ermilio 40 Senior Vice President and General Counsel
Joseph J. Staffieri 56 Senior Vice President-Human Resources
Henry R. Whittier, Jr. 61 Senior Vice President-Management Information Systems
of Commerce and Citation
Randall V. Becker 42 Treasurer and Chief Accounting Officer
Arthur J. Remillard, Jr. has been the President, Chief Executive
Officer and Chairman of the Board of the Company since 1976. Mr.
Remillard, Jr. has been Chief Executive Officer and Chairman of the Board
of The Commerce Insurance Company ("Commerce") since 1972 and President of
Commerce from 1972 to November, 2001. Mr. Remillard, Jr. is also Chairman
of the Governing Committee, Chairman of the Actuarial Committee, Vice
Chairman of the Governing Committee Review Panel, Chairman of the Budget
Committee and Vice Chairman of the Personnel Committee of the Commonwealth
Automobile Reinsurers ("CAR"). Mr. Remillard, Jr. is also Chairman of the
Governing Committee and a member of the Budget Committee, Executive
Committee and Nominating Committee of the AIB.
Gerald Fels, a Certified Public Accountant, was appointed President
and Chief Operating Officer of Commerce in November 2001, and Executive
Vice President of the Company in November, 1989. From 1981 to November,
1989, Mr. Fels was Senior Vice President of the Company. Mr. Fels was the
Treasurer of the Company from 1976 to 1995 and of Commerce from 1975 to
1995. Mr. Fels has also been Chief Financial Officer of the Company since
1976 and of Commerce since 1975. Mr. Fels is also Vice Chair and a
director of American Nuclear Insurers and an Advisory Committee Member of
several investment funds managed by Conning Capital Partners.
Regan P. Remillard was appointed President of American Commerce in
2001, President of AHC in 1998 and Vice Chairman of the Board and Chief
Executive Officer of American Commerce in 1999. Mr. Remillard has been
President of Commerce West since 1996. Mr. Remillard has been a Senior
Vice President of the Company since 1995. From 1995 to February 2000, Mr.
Remillard was General Counsel of the Company. From 1994 to 1995, Mr.
Remillard was a practicing attorney at Hutchins, Wheeler & Dittmar, a
Massachusetts law firm specializing in corporate law and
32
litigation. From 1989 to 1993, Mr. Remillard was Government Affairs
Monitor of the Company. Mr. Remillard is a member of the Massachusetts
Bar.
Arthur J. Remillard, III was appointed Senior Vice President of
Policyholder Benefits in 1988 and has been Assistant Clerk of the Company
since 1982. From 1981 to 1988, Mr. Remillard, III had been Vice President-
Mortgage Operations. In addition, Mr. Remillard, III was elected Vice
Chairman of the Board of Governors of the Insurance Fraud Bureau of the AIB
in 2002 and he has served on that Board since 1991. Additionally he has
served on the CAR Claims Advisory Committee since 1990 and the AIB Claims
Committee since 1991.
David H. Cochrane has been the Senior Vice President of Underwriting
for Commerce and Citation since 1988. For approximately four years prior
to that, Mr. Cochrane was the Vice President of Financial Services of CAR.
Mr. Cochrane has also served on the CAR Market Review Committee since 1988.
Peter J. Dignan was appointed the Senior Vice President of Marketing
and Premium Accounting for Commerce and Citation in 1997. From 1989 to
1997, Mr. Dignan was Vice President of Premium Accounting for Commerce and
Citation. From 1987 to 1989 Mr. Dignan was Assistant Vice President of
Premium Accounting for Commerce and Citation.
James A. Ermilio was appointed as Senior Vice President for the
Company in May 2001. Mr. Ermilio was also appointed General Counsel of the
Company in February 2000 and was a Vice President of the Company from
November 1998 to May 2001. Mr. Ermilio is also General Counsel and
Secretary of American Commerce and Secretary of AHC. Mr. Ermilio had been
the Associate General Counsel of the Company since September 1998. Mr.
Ermilio was Counsel for Glaxo Wellcome, Inc. (currently known as
GlaxoSmithKline, Inc.) from 1993 to September 1998. Prior to 1993, Mr.
Ermilio was an Associate with the law firm currently known as Bingham
McCutchon. Mr. Ermilio is a member of the Massachusetts and District of
Columbia Bars.
Joseph J. Staffieri was appointed the Senior Vice President of Human
Resources for Commerce in November 2002. From May 2001 to November 2002,
Mr. Staffieri was Vice President of Human Resources of Commerce. Prior to
May of 1997 through April of 2001, Mr. Staffieri was the Vice President of
Human Resources for Ames Department Stores.
Henry R. Whittier, Jr. was appointed the Senior Vice President of
Management Information Systems for Commerce and Citation in November 2002.
From 1995 to November 2002, Mr. Whittier was Vice President of Management
Information Systems for Commerce and Citation.
Randall V. Becker, a Certified Public Accountant, has been Treasurer
and Chief Accounting Officer of the Company since 1994. From 1990 to 1994,
Mr. Becker was Assistant Treasurer and Comptroller of the Company. From
1986 to 1990, Mr. Becker was the Director of Internal Audit for the
Company.
The only family relationship among the executive officers is that
Arthur J. Remillard, III and Regan P. Remillard are the sons of Arthur J.
Remillard, Jr.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS
For the information required by this Item, please refer to "Part II,
Item 7-Common Stock Price and Dividend Information" section (MD&A).
33
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The data below should be read in conjunction with the consolidated
financial statements, related footnotes, and other financial information
included herein. The financial statements for the five years ended
December 31, 2002 have been audited by Ernst & Young LLP. All dollar
amounts set forth in the following tables are in thousands, except per
share data:
December 31,
------------------------------------------------------------------
2002 2001 2000 1999 1998
------------------------------------------------------------------
(Restated)
Statement of Earnings Data:
Net premiums written $1,313,014 $1,078,967 $1,008,911 $ 911,993 $ 745,048
(Increase) decrease in
unearned premiums (102,974) (35,315) (54,428) (40,163) 572
------------------------------------------------------------------
Earned premiums 1,210,040 1,043,652 954,483 871,830 745,620
Net investment income 98,466 99,563 96,830 89,789 86,501
Premium finance and service
fees 21,498 17,819 15,227 14,774 13,440
Amortization of excess of book
value of subsidiary interest
over cost - 3,389 3,390 3,019 -
Net realized investment gains
(losses) (82,385) (10,633) 29,550 (16,378) 7,150
Other income 9,500 - - - -
------------------------------------------------------------------
Total revenues 1,257,119 1,153,790 1,099,480 963,034 852,711
------------------------------------------------------------------
Losses and loss adjustment
expenses 909,769 781,631 686,157 625,090 531,429
Policy acquisition costs 295,324 264,377 243,257 233,660 196,434
------------------------------------------------------------------
Total expenses 1,205,093 1,046,008 929,414 858,750 727,863
------------------------------------------------------------------
Earnings before income taxes,
change in accounting
principle and minority
interest 52,026 107,782 170,066 104,284 124,848
Income taxes 17,063 18,392 38,306 16,667 26,583
Change in accounting
principle net of taxes 11,237 - - - -
------------------------------------------------------------------
Net earnings before minority
interest 46,200 89,390 131,760 87,617 98,265
Minority interest in net loss
of subsidiary 555 863 320 1,059 -
------------------------------------------------------------------
Net earnings $ 46,755 $ 90,253 $ 132,080 $ 88,676 $ 98,265
==================================================================
Comprehensive income $ 59,625 $ 90,814 $ 168,570 $ 40,730 $ 96,594
==================================================================
Earnings Per Share Data:
Basic $ 1.43 $ 2.69 $ 3.87 $ 2.54 $ 2.73
==================================================================
Diluted $ 1.42 $ 2.67 $ 3.87 $ 2.54 $ 2.73
==================================================================
Cash dividends paid per share $ 1.23 $ 1.19 $ 1.15 $ 1.11 $ 1.07
==================================================================
Weighted average number of
shares outstanding:
Basic 32,773,519 33,608,804 34,121,047 36,940,074 36,042,652
==================================================================
Diluted 33,028,081 33,794,938 34,121,047 34,940,074 36,042,652
==================================================================
December 31,
------------------------------------------------------------------
2002 2001 2000 1999 1998
------------------------------------------------------------------
(Restated)
Balance Sheet Data:
Total investments $1,577,070 $1,498,201 $1,472,562 $1,295,995 $1,262,500
Premiums receivable 297,610 246,221 230,580 195,160 162,878
Total assets 2,382,688 2,154,631 2,086,279 1,889,146 1,757,514
Unpaid losses and loss
adjustment expenses 815,626 695,192 684,805 670,968 593,927
Unearned premiums 687,148 563,456 519,885 457,095 391,424
Stockholders' equity 790,052 809,433 781,881 668,005 710,852
Stockholders' equity per share 24.60 24.43 23.16 19.44 19.72
34
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Thousands of Dollars Except Per Share Data Unless Noted Otherwise)
General
The property and casualty insurance industry continues to remain
highly competitive and inherently volatile in nature. Property and
casualty insurance company results have traditionally been impacted by the
typical forces unique to the industry, such as competition, frequency and
severity of losses, the overall economy and the general regulatory
environment in those states in which the insurer operates. Additional
forces are impacting the industry in the form of deregulation, on-line
commerce, price competition, empowered customers and technological
advancement. According to A.M. Best Co. ("A.M. Best"), "the unprecedented
events of September 11 have forever changed the way the insurance industry
defines risk. Both property and liability lines have been exposed to
catastrophic risks that cannot be priced using traditional actuarial
methods". A.M. Best goes on to state, "Against the backdrop of weak
financial trends, this new risk environment has accelerated the hardening
of the U.S. property/casualty market". Given this increased risk
environment, A.M. Best "expects to see a renewed flight to quality that
will benefit financially strong insurers". The financial losses due to the
events of September 11 were significant to the insurance industry, however,
due to the limited exposure that The Commerce Group, Inc. (the "Company")
has outside of Massachusetts, the direct financial impact to the Company
was not material. Additionally, price competition remains quite heavy in
many areas of the country, although it has improved in 2002 among
independent agency companies in Massachusetts. Beyond Massachusetts,
industry underwriting results are expected to continue to deteriorate in
the near future which further emphasizes the importance of competitive
advantages gained by affinity marketing and efficient operations. With
these issues on the forefront, the Company continues to position itself to
respond to the prevailing forces and conditions in the market. The Company
has utilized its strong agency relationships, a low-cost structure,
affinity group alliances and a 1999 joint-venture acquisition all in an
effort to keep the Company responsive in today's competitive environment.
The Company, incorporated in 1976, is a holding company for several
property and casualty insurers, and, through these insurance subsidiaries,
offers predominantly private passenger motor vehicle insurance along with a
broad range of other property and casualty insurance products. These
products are marketed to affinity groups, individuals, families and
businesses through the Company's strong relationships with professional
independent insurance agencies. The Company writes insurance primarily in
the Commonwealth of Massachusetts through The Commerce Insurance Company
("Commerce") and Citation Insurance Company ("Citation"), both wholly-owned
subsidiaries of Commerce Holdings, Inc. ("CHI").
Additionally, the Company writes insurance in the States of
California and Oregon through Commerce West Insurance Company ("Commerce
West"), a wholly-owned subsidiary of Commerce, located in Pleasanton,
California. The Company also writes insurance through American Commerce
Insurance Company ("American Commerce"), which it acquired in January 1999.
Located in Columbus, Ohio, American Commerce is a wholly-owned subsidiary
of ACIC Holding Co., Inc., ("AHC") with policies in 26 states and licenses
in several others. Commerce also began writing personal lines business in
New Hampshire in the later part of 2001.
Effective January 1, 2002, the ownership interests in AHC were
recapitalized. Prior to the recapitalization at December 31, 2001, Commerce
maintained an 80% common stock interest and AAA Southern New England ("AAA
SNE") maintained a 20% common stock interest in AHC. Additionally, all AHC
preferred stock was owned by Commerce. The recapitalization resulted in
redeeming of all the AHC preferred stock by Commerce in exchange for 3,000
additional shares of AHC common stock. This resulted in Commerce
increasing its AHC common stock interest to 95% with AAA SNE maintaining a
5% AHC common stock interest with no preferred stock outstand-
35
ing. The recapitalization also resulted in the creation of $4.5 million in
minority interest for AAA SNE.
FIX THIS PAGE BREAK
Since 1995, Commerce has maintained an affinity group marketing
relationship with AAA Insurance Agency, Inc., a subsidiary of AAA SNE. AAA
Insurance Agency, Inc. has been a licensed insurance agent of Commerce
since 1985.
The Company's business strategy remains focused on activities
primarily related to personal automobile insurance. The Company has been
the largest writer of personal property and casualty insurance in the
Commonwealth of Massachusetts in terms of market share of direct premiums
written since 1990. The Company's share of the Massachusetts personal
automobile market increased to 25.9% in 2002, as exhibited in the table
below, exceeding our two nearest competitors, which both maintained a 10.4%
market share.
Growth of Massachusetts Personal Automobile
Insured Vehicles
Commerce Year-End
Year Industry Commerce Market Share
--------------------------------------------------
2002* 1.8% 13.9% 25.9%
2001 1.7% 6.1% 23.2%
2000 1.9% 6.5% 22.3%
- --------------------
* Estimated by CAR.
As mentioned, the Company predominantly writes private passenger
automobile insurance. The following tables indicate direct premiums
written for private passenger automobile, commercial automobile and
homeowners. Total direct premiums written increased $254,449 or 22.1% in
2002 over 2001. The 2002 increase was primarily attributable to a $172,516
or 20.1% increase in Massachusetts private passenger automobile direct
premiums written. This was the result of a 13.8% increase in written
exposures coupled with an increase of 5.3% in average premiums per
exposure. Private passenger premiums written for all other states
increased $32,725 or 26.8%, primarily attributable to an increase in
American Commerce premiums of $26,633 or 31.3%, due primarily to book
rollovers of business from existing agents, partially offset by decreases
in states where the Company is not actively pursuing writings coupled with
an increase of $3,916 or 10.5% additional premiums from Commerce West.
Direct Premiums Written, Year Ended December 31, 2002
Massachusetts All Other States Total % of Total
-------------------------------------------------------------
Personal Automobile $1,032,438 $155,045 $1,187,483 84.4%
Homeowners 87,634 27,376 115,010 8.2
Commercial Automobile 74,879 5,151 80,030 5.7
Other Lines 23,569 764 24,333 1.7
--------------------------------------------------------
Total $1,218,520 $188,336 $1,406,856 100.0%
========================================================
Direct Premiums Written, Year Ended December 31, 2001
Massachusetts All Other States Total % of Total
-------------------------------------------------------------
Personal Automobile $ 859,922 $122,320 $ 982,242 85.2%
Homeowners 73,254 18,710 91,964 8.0
Commercial Automobile 58,088 1,514 59,602 5.2
Other Lines 17,885 714 18,599 1.6
--------------------------------------------------------
Total $1,009,149 $143,258 $1,152,407 100.0%
========================================================
36
Massachusetts Automobile Business
In Massachusetts, private passenger automobile insurance is subject
to extensive regulation. Owners of registered automobiles are generally
required to maintain certain minimum automobile insurance coverages. With
very limited exceptions, private passenger automobile insurers are required
by law to issue a policy to any applicant seeking to obtain such coverages.
Companies in Massachusetts are also assigned agents, known as Exclusive
Representative Producers ("ERPs"), based primarily on market share, that
have been unable to obtain a voluntary contract with an insurance carrier.
Marketing and underwriting strategies for companies operating in
Massachusetts are limited by maximum premium rates and minimum agency
commission levels for personal automobile insurance, both of which are
mandated by the Massachusetts Commissioner of Insurance ("Commissioner").
In Massachusetts, accident rates, bodily injury claims, and medical care
costs continue to be among the highest in the nation. According to the
Automobile Insurers Bureau of Massachusetts ("AIB"), Massachusetts "has
higher than average medical costs and liability claims involving
attorneys". According to the AIB, Massachusetts personal automobile
premium per policy, based on 2000 premium information, was the 4th highest
in the nation.
During the three-year period from 2000 to 2002, average mandated
Massachusetts personal automobile insurance premium rates decreased an
average of 2.5% per year. The Commissioner approved an average increase of
2.7% in personal automobile premiums for 2003, as compared to no rate
change in 2002. Coinciding with the 2003 rate decision, the Commissioner
also approved an increase of 1.3% in the commission dollar rate agents
receive for selling private passenger automobile insurance in 2002.
State-Mandated Actual
Average State Average Commerce Average Rate
Year Rate Change Rate Change(2) Change Per Exposure
---- -------------- -------------- ---------------------
2003(1) 2.7% 8.1% 8.0%
2002 0.0% 5.0% 5.3%
2001 (8.3)% (3.5)% (1.9)%
2000 0.7% 6.2% 6.2%
- --------------------
Estimated.
Based on Massachusetts Division of Insurance Filings.
Although average mandated personal automobile premium rates were
unchanged in 2002, Commerce's average rate increased 5.3% per exposure.
The increase for 2002 was the result of (1) a decrease in the Safe Driver
Insurance Plan ("SDIP") deviations for Step 9 drivers, the best driver SDIP
classification in Massachusetts and (2) the facts that the announced rate
decision rate change did not include the impact of expected purchases of
new automobiles in the year to which the rate decision applied, the
Company's mix of personal automobile business differs from that of the
industry, and changes to the Company's distribution of risks by class,
territory and coverage.
The actual state average rate change represents the change in the
average rate paid by drivers in Massachusetts, as opposed to the state-
mandated average rate change. As can be seen above, the Commerce average
rate change per exposure corresponds more closely to the actual state
average rate change. The reason for this is that both take into account
newer vehicles, as compared to the state mandated average rate change which
does not.
The Company's performance in its personal and commercial automobile
insurance lines is integrally tied to its participation in Commonwealth
Automobile Reinsurers ("CAR"), a state-mandated reinsurance mechanism,
which permits the Company and most other writers of automo-
37
bile insurance in Massachusetts to reinsure any automobile risk that the
insurer perceives to be under-priced at the premium level permitted by the
Commissioner. All companies writing automobile insurance in Massachusetts
share in the underwriting results of CAR business for their respective
product line or lines. Since its inception, CAR has annually generated
multi-million dollar underwriting losses in primarily the personal pool.
The Company is required to share in the underwriting results of CAR
business for its respective product lines. Under current regulations, the
Company's share of the CAR personal or commercial deficit is based upon its
market share for retained automobile risks for the particular pool,
adjusted by a "utilization" concept, such that, in general, the Company is
disproportionately and adversely affected if its relative use of CAR
reinsurance exceeds that of the industry, and favorably affected if its
relative use of CAR reinsurance is less than that of the industry. For
personal automobile writers, companies can reduce their participation ratio
by writing credit eligible business voluntarily. Companies are provided
credits against their participation ratio for writing those classes and
territories of business that are purposefully under-priced in the
Massachusetts rate setting process. The Company's strategy has been to
maintain above average voluntary retention levels, as well as to
voluntarily retain private passenger automobile business that receives
credits. This favorably impacts the Company's participation ratio compared
to its market share, but also adversely impacts the Company's voluntary
loss ratio.
Significant changes in the utilization of the CAR private passenger
pooling mechanism are not expected under the current system. Various CAR
participation formula changes have been fully implemented since 1994 with
only minor changes since then. The Company's strategy has been to
voluntarily retain more of the types of private passenger automobile
business that generate credits, favorably impacting the utilization
formula. These credits primarily result from voluntarily writing business
in under-priced territories and for under-priced risks. As a result of
increased voluntary retention in excess of the industry, the credits
impacting the utilization formula have favorably affected the Company's
participation ratio, however, at the same time, adversely affected its
voluntary loss ratio. As indicated in the accompanying table, this ratio
is several percentage points below the Company's estimated 25.9% share of
the Massachusetts personal automobile market. The Company continues to
expect the marketplace to make minor annual adjustments to find the optimum
balance between voluntary and ceded writings.
Company Private Passenger Participation Ratio for CAR versus Market
Share
Company Participation Company
Year Ratio in CAR Market Share
---- --------------------- ------------
2002* 17.8% 25.9%
2001 16.8% 23.2%
2000 16.9% 22.3%
- --------------------
* Estimated.
Servicing Carriers, who are responsible for over 99% of total direct
premiums written for personal automobile insurance in Massachusetts, are
required to offer automobile insurance coverage to all eligible applicants
pursuant to "take-all-comers" regulations, but may reinsure business with
CAR.
38
Written premiums, earned premiums, losses and LAE incurred,
underwriting expenses incurred and the liabilities for unearned premiums,
unpaid losses and LAE ceded to and assumed from CAR were as follows:
Years ended December 31,
------------------------------------------------------------------
2002 2001 2000
------------------------------------------------------------------
Ceded Assumed Ceded Assumed Ceded Assumed
------------------------------------------------------------------
Income Statement
Written premiums $ 88,198 $ 96,269 $70,973 $ 79,360 $67,451 $ 81,659
Earned premiums 80,241 90,594 72,648 80,176 69,120 81,300
Losses and LAE.
incurred 114,578 128,071 80,053 108,353 67,987 109,788
Underwriting expenses - 31,047 - 28,270 - 28,753
Balance Sheet
Unearned premiums 52,374 47,374 44,399 41,699 44,791 42,515
Unpaid losses and LAE 112,102 115,566 87,271 105,092 89,350 106,787
The Company pays to CAR all of the premiums generated by the policies
it has ceded and CAR reimburses the Company for all losses incurred on
account of ceded policies. In addition, the Company receives a fee for
servicing ceded policies based on the expense structure established by CAR.
For the years ended December 31, 2002, 2001 and 2000, these servicing fees
amounted to $18,668, $17,161 and $16,783, respectively.
The Company presents assets and liabilities gross of reinsurance.
The Residual Market Receivable represents the gross amount of reinsurance
recoverable from CAR including unpaid losses, unearned premiums, paid
losses recoverable and unpaid ceded and assumed premiums.
The current CAR utilization-based participation ratio has been in
place for the personal automobile market since 1994. During 2002, 2001 and
2000 the Company's amount of personal automobile exposures it reinsured
through CAR approximated 4.9% for each year, as compared to industry
averages of 7.5%, 7.7% and 8.4%, respectively.
Member companies of CAR have joint and several liabilities for the
obligations of CAR. If one member of CAR fails to pay its assessments, the
remaining members of CAR will be required to pay the pro-rata share of the
member who fails to pay its obligations. At the present time, the Company
is not aware of any CAR member company who has failed to meet its
obligations.
In a letter to the Massachusetts Insurance Commissioner (the
"Commissioner") dated June 25, 2002, the Massachusetts Attorney General
reported that, based on his examination of available information, he
"believes that the CAR plan for providing access to insurance in the
residual market does not comply with the CAR enabling statute, and must be
changed to produce a fair and equitable market". The Attorney General's
letter describes several factors that he believes support his findings and
which he believes should be corrected in order to comply with Massachusetts
law governing CAR. The Attorney General's letter calls on the Commissioner
to work with him to address these issues. It is uncertain whether and to
what extent the issues raised by the Attorney General will be addressed by
the Commissioner. We cannot be certain whether changes, if any, would have
a material impact on the Company.
The percentage of commercial automobile premiums ceded to CAR by the
industry was estimated by the Company to be 28% in 2002. The percentage of
commercial automobile business ceded to CAR by the Company was
approximately 17.0%. CAR depopulation over the last several years, coupled
with CAR rate increases for ceded commercial business, have led to a
reduction in the size of the annual commercial automobile deficits. The
Company intends to continue to re-
39
spond to the profit opportunities within the market, as well as the
incentives and disincentives provided by CAR rules, as deemed necessary and
appropriate.
The Company provides a separate rating tier for preferred
Massachusetts commercial automobile business through Citation.
Approximately 15% of the Company's Massachusetts commercial automobile
premiums produced by voluntary agents in 2002 were written in Citation.
The Company expects that this secondary rating tier will continue to assist
the Company in retaining its better commercial automobile accounts, while
also further increasing the percentage of commercial automobile business
that can be retained voluntarily by the Company in 2003 and beyond.
Commerce has actively pursued affinity group marketing programs since
1995. The primary purpose of affinity group marketing programs is to
provide participating groups with a convenient means of purchasing
discounted private passenger automobile insurance through associations and
employer groups. Emphasis is placed on writing larger affinity groups,
although accounts with as few as 25 participants are considered. Affinity
groups are eligible for rate discounts, which must be filed annually with
the Division of Insurance. In general, the Company looks for affinity
groups with mature/stable membership, favorable driving records and below
average turnover ratios. Participants who leave the sponsoring group
during the term of the policy are allowed to maintain the policy until
expiration. At expiration, a non-discounted Commerce policy may be issued
through the agency, at the insured's option.
Since the latter part of 1995, Commerce has been a leader in affinity
group marketing, through agreements with the four American Automobile
Association Clubs of Massachusetts ("AAA clubs"), offering discounts on
private passenger automobile insurance to the clubs' members who reside in
Massachusetts. A 5% discount was approved for policies effective January
1, 2003. Membership in these clubs is estimated to represent approximately
one-third of the Massachusetts motoring public, and has been the primary
reason for an 85.2% increase in the number of personal automobile exposures
written by Commerce since year-end 1995 (the AAA affinity group program
incepted in October of 1995). In 2002, total direct premiums written
attributable to the AAA group business were $619,020 or 44.0% of the
Company's total direct premiums written (60.0% of the Company's total
Massachusetts personal automobile premium), an increase of 13.5% over 2001.
Total exposures attributable to the AAA clubs group business were 625,335
or 59.8% of total Massachusetts personal automobile exposures in 2002, as
compared to 581,455 or 63.3% in 2001. The decreased percentage from 2001
was attributable to a higher rate of increase in non-group business as
compared to the increase in the AAA program. Of the total Massachusetts
automobile exposures written through the AAA affinity group program by the
Company, approximately 13.5% were written through insurance agencies owned
by the AAA clubs (8.5% of total Massachusetts automobile exposures). The
remaining 86.5% of the AAA group program was written through Commerce's
network of independent agents (91.5% of total Massachusetts automobile
exposures).
Massachusetts law allows two years to reach the required group
penetration level of 35%. Commerce has continued to maintain AAA member
participation in excess of 35% through December 31, 2002, when it was
estimated at approximately 43%. The two-year penetration requirement was
waived by the Massachusetts Legislature for 2002, 2001 and 2000. Waiving
the penetration requirements allows insurance companies to continue
offering group discounts without the particular group reaching the 35%
penetration level.
Commerce and the AAA clubs have agreed that Commerce shall be their
exclusive under-writer of Massachusetts personal automobile group programs.
A rolling three-year contract between Commerce and the AAA clubs exists,
which renews automatically and may be terminated upon a minimum of three
years written notice to either party.
40
Agreements for the Transfer of Massachusetts Business from Other Companies
in 2002
Commerce entered into an agreement on September 28, 2001, with
Berkshire Mutual Insurance Company ("Berkshire") for the transfer of
Massachusetts personal automobile business written by Berkshire to
Commerce, effective January 1, 2002. Under terms of the agreement,
Commerce offered agency contracts to independent agencies that represented
Berkshire for personal automobile insurance in Massachusetts. This allowed
agents of Berkshire the opportunity to offer Commerce automobile insurance
policies to their customers whose policies renewed in 2002. Commerce
assumed all of Berkshire's obligations for future policy years beyond 2001
under CAR, including assignment of Berkshire's involuntary agents. As
consideration, the Company received a cash payment of $7,000 from Berkshire
in early January, 2002.
Commerce announced the formation of a marketing alliance with Horace
Mann Educators Corporation on October 18, 2001. Under the terms of an
agency agreement between Commerce and Horace Mann Service Corporation
("HMSC"), a licensed brokerage agency in the Commonwealth of Massachusetts,
HMSC provided its personal automobile customers with Commerce policies.
New personal automobile policies sold by HMSC were insured with Commerce,
beginning no later than January 1, 2002, at the policyholder's option. All
personal automobile policies written by HMSC were converted to Commerce
policies upon renewal in 2002.
Commerce entered into an agreement on July 15, 2002, with MassWest
Insurance Company ("MassWest") for the transfer of Massachusetts personal
automobile business written by MassWest to Commerce, effective November 1,
2002. Under terms of the agreement, Commerce offered agency contracts to
independent agencies that represented MassWest for personal automobile
insurance in Massachusetts. This allowed agents of MassWest the
opportunity to offer Commerce automobile insurance policies to their
customers, who were insured by MassWest, beginning with policies that
renewed after that date. Commerce assumed all of MassWest's obligations
for future policy years beyond 2002 under the Massachusetts residual market
system, commonly known as CAR, and received consideration of $2.5 million
from MassWest.
Other States
Commerce West predominantly writes private passenger automobile
insurance in California and Oregon through 808 independent insurance
agencies and brokers. All business is underwritten at Commerce West's
headquarters located in Pleasanton, California. Although primarily writing
preferred business, Commerce West also writes non-standard personal
automobile business and a small amount of lower limit commercial automobile
business. American Commerce predominantly writes private passenger
automobile and homeowners insurance in 26 states exclusively through 32 AAA
independent insurance agencies. Products are similar to those offered by
Commerce and Citation. All business is underwritten at American Commerce's
headquarters located in Columbus, Ohio. Both companies primarily target
preferred insurance risks.
Direct premiums written in states other than Massachusetts by
Commerce West and American Commerce, increased $42,220 or 29.5%. Commerce
West direct premiums written increased $7,545 or 19.5%. Personal
automobile direct premiums written by Commerce West increased $3,916, or
10.5%, while commercial automobile direct premiums written increased
$3,637, or 240.2%. The growth from Commerce West is primarily attributable
to expansion of the commercial and preferred personal automobile programs.
American Commerce direct premiums written increased $34,675 or 33.2%,
primarily due to an increase in personal automobile premiums of $26,633 or
31.3%. American Commerce also experienced a 42.7% increase in homeowners
premiums written, primarily as a result of book transfers from existing
agents and the contraction of authority to write homeowner business by
competitors. American Commerce, which writes business in 26 states, wrote
greater than 90% of its business in eleven states.
41
Commerce West premiums and the eleven states with the highest
premiums written by American Commerce are shown in the following table:
% of Direct Premiums
Written by State
--------------------
Company State 2002 2001
----------------------------------------------------------
Commerce West California $ 40,861 $ 34,816
Oregon 5,464 3,964
--------------------
Total $ 46,325 $ 38,780
====================
American Commerce Arizona $ 30,396 $ 21,798
Rhode Island 17,371 14,912
Ohio 16,923 13,170
Washington 16,339 8,327
Oregon 13,046 10,986
Oklahoma 13,010 8,048
Kentucky 8,289 6,115
Indiana 6,242 4,806
Tennessee 3,376 2,534
Idaho 3,010 2,595
West Virginia 2,885 2,657
Other states 8,266 8,530
--------------------
Total $139,153 $104,478
====================
Commerce writes personal lines business in New Hampshire through 30
independent insurance agencies, direct written premiums amounted to $2,859
and $352 for 2002 and 2001, respectively.
Reinsurance Activity - Other than CAR
The Company has reinsurance contracts for casualty and catastrophe
coverages. These reinsurance arrangements minimize the Company's losses
arising from large risks and protect the Company against numerous losses
from a single occurrence or event. The Company also has a quota share
reinsurance contract on its other than automobile business.
Property, Catastrophe and Quota Share Reinsurance
The Company maintains a 75% quota share reinsurance program, covering
all non-automobile property and liability business, except umbrella
policies. The program is split among Munich American Re-Insurance Company,
Employers Reinsurance Corporation, Hartford Fire Insurance Company and
Swiss Reinsurance America Corporation. The maximum per occurrence dollar
recovery is equal to 250% of the net premiums ceded to the quota share
arrangement in a contract year. The maximum aggregate per year dollar
recovery under the quota share contract is equal to 350% of the net premium
ceded to the quota share arrangement in a contract year. A sliding scale
commission, based on loss ratio, is utilized under this program. This
program provides the Company with sufficient protection for catastrophe
coverage so as to enable the Company to forego pure catastrophe reinsurance
coverage, which was previously tailored in conjunction with the former
quota share arrangement.
Effective July 1, 2002, the Company amended its quota share
reinsurance program in the event of terrorist acts. The maximum
reimbursement to the Company from its quota share reinsurers will be
limited to $50,000 in the event of certain defined terrorist acts. The
Company believes its exposure to terrorist acts to be very limited based
upon the types of coverage offered by the Company and its exposure above
the limit to be extremely remote. The Company's main
42
area of business is in the personal lines market and it has very minimal
single retained exposure in excess of $1,000.
The table below provides information depicting the approximate
recovery under the quota share contract (described below) at various loss
scenarios, if a single catastrophe were to strike:
Net Loss
Total Reinsurance Retained by
Loss Recovery the Company
--------------------------------------
$ 50,000 $ 37,500 $12,500
100,000 65,000 35,000
150,000 90,000 60,000
200,000 115,000 85,000
250,000 152,500 97,500
Under the above scenario and based on the business subject to the
quota share reinsurance contract for 2002, the Company has no reinsurance
recoveries for a single event catastrophe in excess of a total loss of
approximately $262.0 million. The level of reinsurance protection
increases (decreases) when the company cedes more (less) premium to the
reinsurers. The Company's estimated total losses on its other than
automobile business for 100 and 250-year hurricanes (including American
Commerce) are approximately $173.5 million and $291.2 million,
respectively. The Company estimates were derived through the services of
Swiss Reinsurance America Corporation (rated A++ by A.M. Best), which
utilized the RMS (Risk Management Solutions) risk assessment system. Most
property and casualty insurance companies establish their catastrophe
reinsurance programs up to the 100 year storm estimate.
Written premiums ceded in 2002, 2001 and 2000 under the above
referenced program were $98.0 million, $78.6 million and $69.4 million,
respectively. The 24.7% increase in written premiums ceded in 2002 versus
2001 in this program was primarily the result of a $14,380 or 19.6%
increase in Massachusetts homeowner direct written premium, coupled with an
$8,666 or 46.3% increase in direct homeowner writings in states other than
Massachusetts, as previously mentioned. Ceding commission income is
calculated on a ceded earned premium basis.
Casualty Reinsurance
Casualty reinsurance is on an excess of loss basis for any one event
or occurrence with a maximum recovery of $9.0 million over a net retention
of $1.0 million. This coverage is placed with Swiss Reinsurance America
Corporation (rated A++ by A.M. Best).
Personal and commercial liability umbrella policies are reinsured on
a 95% quota share basis in regard to limits up to $1.0 million and 100%
quota share basis for limits in excess of $1.0 million but not exceeding
$5.0 million for policies with underlying automobile coverage of $250/$500
or more. The Company also has personal liability umbrella reinsurance
coverage for policies with underlying automobile coverage of $100/$300, on
a 65% quota share basis in regard to limits up to $1.0 million and 100%
quota share basis for limits in excess of $1.0 million but not exceeding
$3.0 million. The personal liability coverage was placed with Munich
American Re-Insurance (rated A+ by A.M. Best) through year-end 2002.
Effective January 1, 2003, the Company entered into a 95% Personal Umbrella
quota share agreement with Employers Reinsurance Corporation (rated A+ by
A.M. Best). Through July 15, 2002 the Company's commercial liability
umbrella policies were placed with Munich American Re-Insurance Company.
On July 15, 2002, the Company entered into a 95% commercial umbrella quota
share agreement with Employers Reinsurance Corporation.
43
Earned premiums and losses and loss adjustment expenses are stated in
the accompanying consolidated financial statements after deductions for
ceded reinsurance. Those deductions for reinsurance other than CAR are as
follows:
Years ended December 31,
------------------------------
2002 2001 2000
------------------------------
Income Statement
Written premiums ceded $101,913 $81,827 $76,946
Earned premiums ceded 90,075 77,226 73,354
Losses and loss adjustment expenses ceded 47,658 40,514 30,797
Balance Sheet
Unpaid losses and loss adjustment expenses 43,380 32,101 28,491
Unearned premiums 55,023 42,258 36,828
The Company, as primary insurer, would be required to pay losses in
their entirety in the event that the reinsurers were unable to discharge
their obligations under the reinsurance agreements.
Effective July 1, 2002, Commerce entered into a retrocessional
reinsurance agreement with one of its quota share reinsurers who maintained
a one third participation in the Company's 75% quota share treaty. For a
premium paid to Commerce, Commerce will indemnify the reinsurer if the
reinsurer incurs a loss for a single event or occurrence over a certain
threshold. Losses assumed by the reinsurer must first exceed $15,000
before a reimbursement will be made, by Commerce, to the reinsurer.
Commerce's exposure to the reinsurer under this agreement is for a maximum
of $35,000. The threshold translates into a $60,000 total loss event or
occurrence to Commerce, $15,000 of which represents the reinsurers 25%
portion of the quota share treaty, before the reinsurer would receive any
benefit.
Insurance Ratios
Underwriting profit margins are reflected by the extent to which the
combined ratio is less than 100%. This ratio is considered the best simple
index of current underwriting performance of an insurer. During the five-
year period ended December 31, 2002, the property and casualty insurance
industry's combined ratio, as reported by A.M. Best and weighted to reflect
the Company's product mix ("weighted industry average"), has ranged from a
low of 102.2% in 1998 to a high of 109.7% in both 2000 and 2001 on a
statutory accounting principles basis. During this same period of time,
the Company's combined ratio has consistently remained below the weighted
industry average, ranging from a low of 96.8% in 2000 to a high of 98.7% in
both 2001 and 2002. On an average basis, the Company's combined ratio was
98.2% for the five-year period ended December 31, 2002 compared to a
weighted industry average of 106.0%.
Years ended December 31,
---------------------------------------------
2002 2001 2000 1999 1998
---------------------------------------------
Company Statutory Ratios (unaudited)
Loss and LAE Ratio 75.1% 74.5% 71.7% 72.0% 71.6%
Underwriting Expense Ratio 23.6 24.2 25.1 26.5 26.5
---------------------------------------------
Combined Ratio 98.7% 98.7% 96.8% 98.5% 98.1%
=============================================
Industry Combined Ratio
(all writers)(1) 103.8% 109.7% 109.7% 104.4% 102.2%
=============================================
- --------------------
Source: A.M. Best's Review Preview (2003), as reported by A.M. Best
for all property and casualty insurance companies and weighted to
reflect the Company's product mix. The 2002 industry information is
estimated by A.M. Best.
44
Regulatory Matters
General
Although the U.S. federal government does not directly regulate the
insurance industry, federal initiatives often have an impact on the
business. Congress and certain federal agencies continue to investigate
the current condition of the insurance industry (encompassing both life and
health and property and casualty insurance) in the United States in order
to decide whether some form of federal role in the regulation of insurance
companies would be appropriate. Congress conducts hearings relating, in
general, to the solvency of insurers and has proposed federal legislation
from time to time on this and other subjects.
In November 1999, the Gramm-Leach-Bliley Act was signed into law. The
Act (1) repealed the Glass-Steagall Act of 1933, which had prohibited the
merger of banks and securities firms, and (2) substantially modified the
Bank Holding Company Act of 1956, which had the effect of separating
banking and insurance underwriting business. The law contains provisions
that govern competition, created safe-harbor protections for specific state
laws, and established consumer protections that govern bank-insurance
sales.
The Terrorism Risk Insurance Act of 2002 was passed by Congress and
signed into law by President Bush on November 26, 2002. The purpose of the
Act is to establish a temporary Federal program that provides for a system
of shared public and private compensation for insured losses resulting from
acts of terrorism. The Act defines a "certified" act of terrorism as "an
act that is certified by the Secretary of the Treasury as resulting in
aggregate losses in excess of $5,000, is a violent act or dangerous to
human life, property or infrastructure, and is committed by an
individual(s) acting on behalf of any foreign person or interest as part of
an effort to coerce the civilian population of the United States or to
influence the policy or affect the conduct of the United States Government
by coercion." Due to the types of coverage offered by the Company and the
limited exposure the Company has outside of Massachusetts, management
believes the financial impact as a result of the Act will not be material.
At the state level, various forms of automobile insurance reform are
continuously debated. New regulations and legislation are often proposed
with the goal of reducing the need for premium increases. For further
details, please refer to the general discussion on insurance regulation and
premium rates.
Personal Automobile Insurance
As previously mentioned, since 1995, the Company has been a leader in
affinity group marketing in Massachusetts by providing discounts to members
of the AAA clubs. Membership in these clubs is estimated to represent
approximately one-third of the Massachusetts motoring public. The Company
increased its Massachusetts private passenger automobile insurance
exposures by 13.9%, ending the year with approximately 25.9% of the
Massachusetts private passenger automobile market.
Through 2000, the Company offered its Massachusetts customers safe
driver deviations to drivers with SDIP classifications of either Steps 9 or
10 and to only Step 9 drivers in 2001. Safe driver deviations are rate
discounts based on the customer's driving record and resulting SDIP
classification and must be approved annually by the Commissioner. Steps 9
and 10 are the two best driver SDIP classifications in Massachusetts,
representing drivers with no at fault accidents and not more than one minor
moving vehicle violation in the last six years. In 2002 and 2003, in
response to the average personal automobile rate decisions over the last
several years, the Company did not file for SDIP Step 9 deviations, for
policies incepting in the 2002 or 2003 calendar years. The accompanying
table depicts the AAA Affinity Group Discount, SDIP Deviations and their
combined reduction from Massachusetts average mandated rates:
45
AAA Affinity Group Discount and SDIP Deviations 2003* 2002 2001 2000
- --------------------------------------------------------------------------------------------
AAA Affinity Group Discount 5.0% 6.0% 6.0% 6.0%
SDIP Step 9 Deviation 0.0% 0.0% 2.0% 6.0%
SDIP Step 10 Deviation 0.0% 0.0% 0.0% 2.0%
Combined AAA Affinity Group Discount and Step 9 Deviation 5.0% 6.0% 7.9% 11.6%
=============================
Combined AAA Affinity Group Discount and Step 10 Deviation 5.0% 6.0% 6.0% 7.9%
=============================
- --------------------
* For policies with effective dates as of January 1, 2003 or
thereafter.
Risk-Based Capital ("RBC")
In order to enhance the regulation of insurer insolvency, the NAIC
developed a formula and model law to provide for RBC requirements for
property and casualty insurance companies. RBC requirements are designed
to assess capital adequacy and to raise the level of protection that
statutory surplus provides for policyholder obligations. The RBC model for
property and casualty insurance companies measures three major areas of
risk facing property and casualty insurers: (i) underwriting, which
encompasses the risk of adverse loss development and inadequate pricing;
(ii) declines in asset values arising from credit risk; and, (iii) other
business risks from investments. Insurers having less statutory surplus
than required by the RBC calculation will be subject to varying degrees of
regulatory action, depending on the level of capital inadequacy.
The RBC model formula proposes four levels of regulatory action. The
extent of regulatory intervention and action increases as the percentage of
surplus to RBC falls. The first level, the Company Action Level (as
defined by the NAIC), requires an insurer to submit a plan of corrective
actions to the regulator if surplus falls below 200% of the RBC amount.
The Regulatory Action Level (as defined by the NAIC) requires an insurer to
submit a plan containing corrective actions and permits the Commissioner to
perform an examination or other analysis and issue a corrective order if
surplus falls below 150% of the RBC amount. The Authorized Control Level
(as defined by the NAIC) allows the regulator to rehabilitate or liquidate
an insurer in addition to the aforementioned actions if surplus falls below
100% of the RBC amount. The fourth action level is the Mandatory Control
Level (as defined by the NAIC), which requires the regulator to ehabilitate
or liquidate the insurer if surplus falls below 70% of the RBC amount.
The following table provides the key RBC information for the
Company's insurance subsidiaries, Commerce, Citation, Commerce West, and
American Commerce:
Commerce American
Commerce Citation West Commerce
--------------------------------------------
(Dollars in millions)
At December 31, 2002
Statutory surplus $554 $ 108 $ 28 $ 70
200% RBC Company action level 189 5 7 25
----------------------------------------
Statutory surplus in excess
of RBC Company action level $365 $ 103 $ 21 $ 45
========================================
RBC amounts $ 94 $ 2 $ 3 $ 12
========================================
% of surplus to RBC amounts 589% 5,400% 933% 583%
========================================
46
2001 Restatement for Employee Stock Option Variable Accounting Treatment
For employee stock options issued by the Company from 1999 through
2001, the Company utilized fixed accounting treatment through September 30,
2002. This accounting treatment was reviewed with the Company's
independent auditors, Ernst & Young LLP, who concurred with the Company's
treatment throughout this period. On January 25, 2003, a question was
raised by Ernst & Young LLP as to the appropriateness of the fixed
accounting treatment for some of the Company's option grants. Ernst &
Young LLP advised the Company that it could no longer concur with fixed
accounting for the options granted to employees in 1999 and 2000.
Therefore, the Company applied variable accounting treatment in 2002 and
also retroactively to 2001 and prior years. Accordingly, the Company
restated its 2001 and first three quarters of 2002 results. The impact of
the restatement for the year ended 2001 resulted in a decrease to net
earnings of $2.8 million or $0.08 per diluted share. The year to date
impact through the third quarter of 2002 resulted in an increase to net
earnings of $1.2 million or $0.04 per diluted share. Although the change
in accounting for employee options was also applied to 2000 and 1999, no
restatements were required for those years. The impact of variable
accounting for the year ended December 31, 2002 was a decrease to net
earnings of $2.1 million or $0.07 per diluted share.
47
Year Ended December 31, 2002 compared to Year Ended December 31, 2001
(Restated)
Premiums
The following table compares direct premiums written, net premiums
written and earned premiums for the years ended December 31, 2002 and 2001:
Years ended December 31,
------------------------------------------------
2002 2001 $ Change % Change
------------------------------------------------
Direct Premiums Written:
Personal Automobile in Massachusetts $1,032,438 $ 859,922 $172,516 20.1%
Personal Automobile in All Other States 155,045 122,320 32,725 26.8%
Commercial Automobile in Massachusetts 74,879 58,088 16,791 28.9%
Commercial Automobile in All Other States 5,151 1,514 3,637 240.2%
Homeowners in Massachusetts 87,634 73,254 14,380 19.6%
Homeowners in All Other States 27,376 18,710 8,666 46.3%
Other Lines in Massachusetts 23,569 17,885 5,684 31.8%
Other Lines in All Other States 764 714 50 7.0%
----------------------------------------------
Total Direct Premiums Written $1,406,856 $1,152,407 $254,449 22.1%
==============================================
Net Premiums Written:
Personal Automobile in Massachusetts $1,039,141 $ 864,900 $174,241 20.1%
Personal Automobile in All Other States 152,796 122,256 30,540 25.0%
Commercial Automobile in Massachusetts 77,839 60,986 16,853 27.6%
Commercial Automobile in All Other States 4,968 1,477 3,491 236.4%
Homeowners in Massachusetts 25,149 20,364 4,785 23.5%
Homeowners in All Other States 6,142 4,576 1,566 34.2%
Other Lines in Massachusetts 6,744 4,236 2,508 59.2%
Other Lines in All Other States 235 172 63 36.6%
----------------------------------------------
Total Net Premiums Written $1,313,014 $1,078,967 $234,047 21.7%
==============================================
Earned Premiums:
Personal Automobile in Massachusetts $ 878,739 $ 776,552 $102,187 13.2%
Personal Automobile in All Other States 146,381 116,479 29,902 25.7%
Commercial Automobile in Massachusetts 55,752 43,008 12,744 29.6%
Commercial Automobile in All Other States 3,139 711 2,428 341.5%
Homeowners in Massachusetts 22,620 19,119 3,501 18.3%
Homeowners in All Other States 5,459 3,731 1,728 46.3%
Other Lines in Massachusetts 6,069 3,290 2,779 84.5%
Other Lines in All Other States 206 158 48 30.4%
Assumed Premiums from CAR 90,593 80,176 10,417 13.0%
Assumed Premiums from Other than CAR 1,082 428 654 152.8%
----------------------------------------------
Total Earned Premiums $1,210,040 $1,043,652 $166,388 15.9%
==============================================
Earned Premiums in Massachusetts $ 963,180 $ 841,969 $121,211 14.4%
Earned Premiums-Assumed 91,675 80,604 11,071 13.7%
Earned Premiums in All Other States 155,185 121,079 34,106 28.2%
----------------------------------------------
Total Earned Premiums $1,210,040 $1,043,652 $166,388 15.9%
==============================================
48
The $172,516 or 20.1% increase in Massachusetts personal automobile
direct premiums written resulted primarily from increases of 13.8% and
14.0% in the number of Massachusetts personal automobile exposures for
liability and physical damage coverage, respectively, and by increases in
rates for the coverage types noted below. The components of these changes
for 2002 and 2001 were as follows:
2002 2001
Coverage Type Rate Change (1) Rate Change (1)
------------------------------------------------------------------
Liability:
Bodily Injury 6.0% (2.1)%
Personal Injury Protection 18.7% (12.9)%
Property Damage to Others 3.9% 1.0%
Physical Damage:
Collision 4.8% (0.1)%
Comprehensive 0.1% (7.6)%
Total (2) 5.3% (1.9)%
- --------------------
Represents change in the Company's average rate per exposure from the
Company's prior year average rate for Massachusetts private passenger
automobile premiums.
The total rate change depicted is the result of the weighted average
of premiums written for all coverages divided by liability exposures
only, due to the fact that all exposures are required to carry
liability coverage.
The above percentage changes were primarily the result of rate
modifications in the individual coverage components in the 2002 state-
mandated rates, changes in the Company's safe driver rate deviations, and
changes in the distribution of the Company's business by class and
territory. The combination of these factors resulted in a 5.3% increase in
the average personal automobile premium per exposure in 2002. Despite no
change from the previous year for the 2002 state-mandated average rates,
the Company's increase in the average personal automobile premium per
exposure was primarily due to the above noted changes coupled with the fact
that the announced rate decision does not include the effect of future
purchases of new automobiles in the year to which the rate decision
applies, and the Company's mix of personal automobile business differs from
that of the industry. In 2002, the Company did not offer its customers
safe driver deviations.
Included in the premium increase for Massachusetts personal
automobile direct premiums written are premiums that were the result of
appointments of new agents. During 2002 Commerce had 127 new appointments,
of these new appointments 89 were from voluntary agents resulting in an
additional $50,470 in premium. The remainder of the new appointments
resulted from ERP's (involuntary agents). Business obtained from new ERP's
amounted to $16,953 during 2002.
The AAA affinity group discount for 2002 was established at 6.0%,
which was unchanged from 2001. In 2001, for drivers who qualified, the
Company's AAA affinity group discount and safe driver deviations could be
combined for up to a 7.9% reduction from state-mandated rates. In 2002,
the Company did not offer a safe driver discount.
Other states personal automobile direct premiums written increased
$32,725 or 26.8%, however, an overall depressed rate environment and
adverse development of prior year reserves resulted in diminished
underwriting profits. The Company continues to evaluate a number of it's
other than Massachusetts state rating structures, has filed for increases
in several states and will seek additional rate increases where
appropriate. Personal automobile direct premiums written by American
Commerce increased $26,633 or 31.3% to $111,757 as compared to $85,124 due
prima-
49
rily to book rollovers of business from existing agents, partially offset
by decreases in states where the Company is not actively pursuing writings.
Personal automobile direct premiums written from Commerce West increased
$3,916 or 10.5% to $41,112 as compared to $37,196. Both companies
primarily target preferred insurance risks and Commerce West's recent
growth is attributable to preferred personal automobile business. Both
American Commerce and Commerce West write predominantly personal automobile
insurance. American Commerce writes personal automobile insurance in 26
states while Commerce West writes personal automobile insurance in the
states of California and Oregon. Personal automobile policies for both
companies are written primarily for a policy term of six months.
Direct premiums written for Massachusetts commercial automobile
insurance increased by $16,791 or 28.9%, due primarily to an increase of
approximately 14.0% in the number of policies written, combined with a
13.0% increase in the average commercial automobile premium per policy.
The increase in premium per policy was attributable to a hardening of the
commercial automobile market, as well as the Company increasing its volume
of larger commercial automobile accounts. The Company experienced an
increase of approximately $1,900 from policies with premiums in excess of
$50. In addition, base rates for other voluntary commercial automobile
policies have increased moderately, and a reduction in Individual Risk
Premium Modification ("IRPM") credits has occurred, favorably impacting
average premiums per policy. In addition, an approximate 3.0% increase in
rates for policies written through CAR was experienced. The increased
business was attributable to the Company's initiative to expand writings.
Direct premiums written for Massachusetts homeowners insurance
increased by $14,380 or 19.6% due primarily to a 10.8% increase in the
number of Massachusetts policies written coupled with a 7.3% increase in
the average Massachusetts premium per policy. The Company's increase in
Massachusetts homeowner premium is primarily related to an increased number
of agents, fewer carriers writing homeowner business, the Company's pricing
position in the marketplace, and agents writing more homeowner business to
achieve a homeowner discount for their customers, when the Company also
insures the customers' automobile. Other states homeowners insurance
written by American Commerce increased $8,666 or 46.3% to $27,376 due
primarily to book rollovers of business from existing agents, and the
impact caused by contraction of authority to write homeowner business by
competitors. Homeowner policies in all states are written primarily for a
policy term of one year.
The $234,047 or 21.7% increase in net premiums written was primarily
due to the growth in direct premiums written as described above offset by
an increase in premiums ceded to CAR and the quota share agreement. Net
premiums written for homeowner's in all other states increased $1,566, with
net premiums written of $6,142 in 2002, as compared to $4,576 in 2001.
The $166,388 or 15.9% increase in earned premiums during 2002, as
compared to 2001, was primarily due to increases in written premiums as
described above and 2001 written premiums being earned in 2002.
50
Net Investment Income
Net investment income is affected primarily by the composition of the
Company's investment portfolio and yield thereon. The following table
summarizes the composition of the Company's investment portfolio at cost,
at December 31, 2002 and 2001:
December 31,
----------------------------------------------
% of % of
Investments, at cost 2002 Invest. 2001 Invest.
- -----------------------------------------------------------------------------------------
GNMA & FNMA mortgage-backed bonds $ 208,260 13.2% $ 98,198 6.7%
Corporate bonds 119,698 7.6 133,506 9.1
U.S.Treasury bonds and notes 222 - 104 -
Tax exempt state and municipal bonds 338,730 21.5 386,967 26.2
--------------------------------------------
Total fixed maturities 666,910 42.3 618,775 42.0
--------------------------------------------
Preferred stocks 301,141 19.1 256,582 17.4
--------------------------------------------
Common stocks 81,602 5.2 87,704 5.9
--------------------------------------------
Closed-end preferred stock mutual funds 294,192 18.7 294,948 20.0
--------------------------------------------
Mortgages and collateral loans (net of
allowance for possible loan losses) 26,754 1.7 39,505 2.7
Cash and cash equivalents 169,946 10.8 148,630 10.1
Other investments 35,015 2.2 28,291 1.9
--------------------------------------------
Total investments $1,575,560 100.0% $1,474,435 100.0%
============================================
The Company's investment strategy focuses on maximizing after-tax
investment income through investing in high quality securities coupled with
acquiring equity investments, which may forego current investment yield in
favor of potential higher yielding capital appreciation in the future.
As depicted in the accompanying table, 2002 net investment income
before taxes decreased $1,097 or 1.1%, compared to 2001, principally as a
result of a decrease in yield offset by an increase in average invested
assets at cost. The decrease in yield is primarily due to lower short-term
yields, coupled with an environment of lower long-term yields and higher
yielding investment securities being called. The Company continues to
monitor interest rates on medium and long-term securities and intends to
maintain its relatively high cash position until such time as the Company
believes medium and long-term rates have appropriately firmed. During
2002, the Company purchased approximately $142 million of FNMA securities.
The Company believes these FNMAs will have a duration of less than three
years. This will allow the Company to achieve higher yields until longer
term investments are acquired. Net investment income as a percentage of
total average investments was 6.3% in 2002, compared to 6.6% in 2001. Net
investment income after-tax, as a percentage of total average investments,
was 5.0% in 2002 and 5.3% in 2001.
Years Ended December 31,
-------------------------
Investment Return 2002 2001
- -------------------------------------------------------------------------------------------
(Restated)
Average month-end investments (at cost) $1,576,219 $1,506,485
Net investment income before tax 98,466 99,563
Net investment income after-tax 78,236 79,124
Net investment income as a percentage of average net
investments (at cost) 6.3% 6.6%
Net investment income after-tax as a percentage of average net
investments (at cost) 5.0% 5.3%
51
Premium Finance and Service Fees
Premium finance and service fees increased $3,679 or 20.6% during
2002, as a result of increased business and a service fee increase on
Massachusetts new and renewal business from three dollars to four dollars
per installment payment, for policies with effective dates of July 1 and
forward.
Investment Gains and Losses
Net realized investment losses totaled $82,385 during 2002 as
compared to $10,633 in 2001. Net realized investment losses during 2002
were primarily centered in to two areas, preferred stock mutual funds and
other-than-temporary impairments. Declines in the market values of utility
common stocks held by preferred stock mutual funds were the primary reasons
for losses, totaling $44,602. The Company reflects these declines through
realized losses because its significant level of ownership requires the use
of the equity method of accounting for these funds. The 2002 realized
losses were also impacted by write-downs for other-than-temporary declines
in the market value of certain fixed maturities, preferred and common
stocks totaling $32,114.
A focus of management's judgments and estimates relating to
investments involves the potential impairment of investments for other-
than-temporary declines in market value. An impairment in an investment is
deemed to be other-than-temporary when a security's market value has
diminished to less than 75% of cost for two consecutive calendar quarters.
If the contractual terms of the security are being complied with,
management performs a cash flow valuation to determine the potential
impairment of the security. If the security is deemed impaired, the
Company adjusts the security's cost to market value through realized loss
based on publicly available information or, in the absence of such, to a
value based on cash flow modeling. Gross accumulated other comprehensive
losses were $15,666 and $27,399 at year-end 2002 and 2001, respectively.
These amounts represent securities whose market values were greater than
75%, but less than 100%, of cost. Market value declines for these
securities relate primarily to interest rate changes and not to significant
declines in a security's rating, financial situation or sector issues and
are not considered impaired due to the Company's ability and intent to hold
these securities to maturity.
Carrying values of investments in fixed maturities, which include
taxable and non-taxable bonds, and investments in common and preferred
stocks, are derived from market prices supplied by the Company's investment
custodian. Unrealized investment gains and losses on these investments, to
the extent that there is no other-than-temporary impairment of value,
are credited or charged to a separate component of stockholders' equity,
known as "net accumulated other comprehensive income (loss)", net of tax,
until realized. Fair market value of fixed maturities and preferred and
common stocks is based on quoted market prices. For other investments,
fair market value equals quoted market price, if available. If a quoted
market price is not available, fair market value is estimated using quoted
market prices for similar securities.
When investment securities are sold, the realized gain or loss is
determined on a specific identification basis.
52
Gross realized gains and losses for the years ended December 31, 2002
and December 31, 2001 were as follows:
2002
--------------------------------
Gross Gross
Realized Realized
Proceeds Gains Losses
--------------------------------
Sales:
Closed-end preferred stock mutual funds $ 6,362 $ 820 $ (309)
Calls, Maturities & Paydowns:
Corporate bonds 2,091 - (142)
Preferred stocks 21,734 843 (1,009)
Obligations of states and political subdivisions 112,667 962 (1,036)
GNMA & FNMA mortgage-backed bonds 62,792 16 (1,406)
Equity in Earnings:
Closed-end preferred stock mutual funds - Equity
in Earnings - 218 (45,330)
Other-than-Temporary Impairment:
Corporate bonds - - (16,063)
Obligations of states and political subdivisions - - (856)
Preferred stocks - - (9,094)
Common stocks - - (6,101)
Other:
Venture capital fund investments 1,902 53 (3,705)
Other investments 15,526 254 (500)
--------------------------------
Total $223,074 $3,166 $(85,551)
================================
2001
--------------------------------
Gross Gross
Realized Realized
Proceeds Gains Losses
--------------------------------
Sales:
Closed-end preferred stock mutual funds $ 2,945 $ 603 $ -
Corporate bonds 6,835 128 (147)
U.S. Treasury notes 2,854 118 -
Obligations of states and political subdivisions 9,392 429 (213)
Preferred stocks 2,402 - (22)
Calls, Maturities & Paydowns:
Corporate bonds 555 1 (4)
Preferred stocks 48,366 128 (2,313)
Obligations of states and political subdivisions 72,930 264 (1,607)
GNMA & FNMA mortgage-backed bonds 22,925 26 (631)
Equity in Earnings*:
Closed-end preferred stock mutual funds - Equity
in Earnings - 4,582 -
Other-than-Temporary Impairment:
Corporate bonds - - (1,180)
Preferred stocks - - (1,485)
Other:
Venture capital fund investments 5,735 586 (9,656)
Other investments 14,506 219 (459)
--------------------------------
Total $189,445 $7,084 $(17,717)
================================
- --------------------
* Includes $3,215 in 2001 relating to the amortization of negative
goodwill, at the time of purchase, of these securities.
53
Gross accumulated other comprehensive income and losses at December
31, 2002 and December 31, 2001 were as follows:
December 31, 2002
--------------------------------------------------------------------------------------------
Gross Gross Other Compr. Loss Timeframe Securities with
Accum. Accum. ------------------------------------------- Compr. Losses
Other Other Less Six to Over --------------------
Compr. Compr. Number than twelve twelve Amort. Market
Income Losses of Sec. six mos. mos. mos. Cost Value
--------------------------------------------------------------------------------------------
Corporate bonds $ 8,064 $ (1,695) 5 $ (517) $ - $ (1,178) $ 27,204 $ 25,509
U.S. Treasury bonds
and notes 6 - - - - - - -
GNMA & FNMA mortgage-
backed bonds 4,355 - - - - - - -
Obligations of states
and political
subdivisions 9,784 (3,613) 38 (15) (457) (3,141) 92,346 88,733
--------------------------------------------------------------------------------------------
Total fixed
maturities 22,209 (5,308) 43 (532) (457) (4,319) 119,550 114,242
Preferred stocks 12,636 (8,720) 51 (756) (540) (7,424) 157,817 149,097
Common stocks 19,854 (1,638) 6 (34) - (1,604) 9,748 8,110
--------------------------------------------------------------------------------------------
Total $54,699 $(15,666) 100 $(1,322) $ (997) $(13,347) $287,115 $271,449
============================================================================================
December 31, 2001
--------------------------------------------------------------------------------------------
Gross Gross Other Compr. Loss Timeframe Securities with
Accum. Accum. ------------------------------------------- Compr. Losses
Other Other Less Six to Over --------------------
Compr. Compr. Number than twelve twelve Amort. Market
Income Losses of Sec. six mos. mos. mos. Cost Value
--------------------------------------------------------------------------------------------
Corporate bonds $ 7,754 $ (4,754) 8 $ - $ - $ (4,754) $ 48,523 $ 43,769
U.S. Treasury bonds
and notes 1 - - - - - - -
GNMA & FNMA mortgage-
backed bonds 1,602 (815) 1 (815) - - 52,817 52,002
Obligations of states
and political
subdivisions 8,890 (4,971) 37 (1,407) (192) (3,372) 106,567 101,596
Total fixed
maturities 18,247 (10,540) 46 (2,222) (192) (8,126) 207,907 197,367
Preferred stocks 6,354 (14,835) 44 (132) (392) (14,311) 140,450 125,615
Common stocks 21,778 (2,024) 6 - (2,022) (2) 22,642 20,618
--------------------------------------------------------------------------------------------
Total $46,379 $(27,399) 96 $(2,354) $(2,606) $(22,439) $370,999 $343,600
============================================================================================
Chart above does not include minority interest impact
The chart above provides a detailed breakdown of the Company's net
accumulated other comprehensive income, prior to minority interest and
income taxes. The chart also provides an aging of the gross accumulated
other comprehensive losses, along with the number of securities those
losses are represented by and the cost and current market value of those
securities that have losses. The percentage of fixed maturities at cost
that have gross accumulated other comprehensive losses with less than an
investment grade rating or no rating is 11.0% at December 31, 2002.
54
During 2002, $3,652 in realized investment losses were also incurred
related to the Company's investments in venture capital funds. These
investments primarily provide seed capital for start-up companies with
emerging high technology initiatives in the financial
services industry. These investments are made in limited partnerships and
the Company's exposure to loss is limited to its actual investment.
Investments in these venture capital funds are accounted for on an equity
basis.
Losses and Loss Adjustment Expenses
Losses and loss adjustment expenses ("LAE") incurred (on a statutory
basis) as a percentage of insurance premiums earned ("loss ratio")
increased to 75.1% in 2002 as compared to 74.5% in 2001. The primary
reasons for this increase were higher private passenger automobile losses
from CAR as a result of increased participation from CAR and higher CAR
loss ratios, coupled with an increase in personal automobile bodily injury
claim frequency compared to last year. Another factor in the increase
resulted from business written outside of Massachusetts where the loss
ratio for other than Massachusetts business increased to 86.4% during 2002
as compared to 84.6% for 2001. These factors were somewhat offset by a
lower physical damage claim frequency and better experience in the
Massachusetts commercial automobile line.
The following table sets forth a reconciliation of beginning and
ending reserves for losses and loss adjustment expense, net of reinsurance
deductions from all reinsurers including CAR, as shown in the Company's
consolidated financial statements for the periods indicated.
Years ended December 31,
------------------------
2002 2001
------------------------
(Restated)
Loss and loss adjustment expense reserves, beginning of year,
prior to effect of ceded reinsurance recoverable $594,156 $585,867
----------------------
Incurred losses and loss adjustment expenses:
Provision for insured events of the current year 924,206 816,951
Decrease in provision for insured events of prior years (14,437) (35,320)
----------------------
Total incurred losses and loss adjustment expenses 909,769 781,631
----------------------
Payments:
Losses and loss adjustment expenses attributable to insured
events of the current year 539,555 487,918
Losses and loss adjustment expenses attributable to insured
events of prior years 286,022 285,424
----------------------
Total payments 825,577 773,342
----------------------
Loss and loss adjustment expense reserves prior to effect of
ceded reinsurance recoverable 678,348 594,156
Ceded reinsurance recoverable 137,278 101,036
----------------------
Reserves for losses and loss adjustment expenses at the end of
year per financial statements $815,626 $695,192
======================
The decrease in provision for insured events of prior years
represents redundancies for reserves established for prior year. This
decrease in provision was principally the result of re-estimation of unpaid
losses and loss adjustment expenses principally on the personal automobile,
commercial automobile and homeowners lines of business.
The $14,437 amount for 2002 indicates that Management's estimate for
the year-end 2001 loss reserves was within 2.4% of the amount established
at December 31, 2001. Because of the inherently difficult task of
estimating the amount required to ultimately settle all losses several
years into the future, it is probable that actual amounts will be either
higher or lower than the
55
originally established reserves at any given point in time. Management's
intent when establishing its estimate for reserves is to be within a
tolerance of plus or minus five percent of the reserve required to
ultimately settle all losses.
Management gauges its selected reserve estimate to the ranges as determined
by the Company's actuaries in order to determine the reasonability of its
estimate. To the extent that Management's selected reserve is within the
range of the actuarial estimates, Management will not adjust its estimates;
instead, it will rely on its independently calculated reserve amounts.
For all of the Company's insurance subsidiaries, the aggregate
actuarial estimate for the loss and LAE reserves, prior to the effect of
ceded reinsurance recoverable, ranges from a low of $607.3 million to a
high of $700.6 million. The Company's financial statement loss and LAE
reserves, based on Management's best estimate, was established at $678.3
million for year-end 2002. Management calculates its estimate
independently from those amounts as calculated by the Company's actuaries
and, therefore, the final results are most often not the same. Management
estimates its amounts primarily by reviewing historical loss and LAE data,
focusing mainly on payment data. It also reviews and compares most recent
loss frequency, severity and payment data to historical trends in an
attempt to determine if patterns are remaining consistent or not.
Management attempts to establish its reserve estimate as close to the
amount required for the ultimate future payments necessary to settle all
losses. The accuracy of this estimate is reflected by the line noted above
entitled "decrease in provision for insured events of prior years".
Policy Acquisition Costs
As a percentage of net premiums written, underwriting expenses for
the insurance companies (on a statutory basis) decreased to 23.6% in 2002
as compared to 24.2% in 2001. The improvement was primarily due to a lower
mandated Massachusetts personal automobile commission rate and lower
general underwriting expenses. Another factor in the decrease resulted
from business written outside of Massachusetts where the underwriting
expense ratio decreased to 29.7% for 2002 as compared to 32.6% for 2001.
These factors were offset by higher contingent commission expenses and
higher insolvency assessments. The 2002 underwriting ratio includes a
$4,496 charge versus $3,111 in 2001, representing the Company's allocation
from the Massachusetts Insurers Insolvency Fund.
Combined Ratios
The combined ratio of losses and expenses (on a statutory basis) was
98.7% for 2002 and 2001. This resulted in an underwriting profit of 1.3%
for 2002 and 2001. This was the result of the factors mentioned above.
Income Taxes
The Company's effective tax rate was 32.8% and 17.1% for the years
ended December 31, 2002 and 2001, respectively. In 2002, the effective tax
rate was impacted by the write-off of a deferred tax asset of $14.8 million
previously established for realized investment losses and the non-
deductible capital loss recognized for financial statement purposes but
ineligible for tax purposes offset by tax-exempt interest income and the
corporate dividends received deduction. In 2001, the effective rate was
lower than the statutory rate of 35% primarily due to tax-exempt interest
income and the corporate dividends received deduction.
Change in Accounting Principle
Due to the effect of a change in accounting principle related to
Statement of Financial Accounting Standards ("SFAS") No.142, the Company
recorded income in the first quarter of 2002, net of taxes, of $11,237 or
$0.34 per share (diluted). This amount represented the remaining
unamortized negative goodwill related to preferred stock mutual funds and
the remaining excess
56
of book value of subsidiary interest over cost relating to the 1999
acquisition of American Commerce. Negative goodwill and the excess of book
value of subsidiary interest over cost occurred in these acquisitions
because the underlying value of the assets purchased exceeded the purchase
price. The subsequent recognition of income that occurred as these items
were eliminated was not a taxable event but instead became part of the
basis of the acquired asset.
Minority Interest in Net Loss of Subsidiary
Effective January 1, 2002, the ownership interests in ACIC Holding
Co., Inc. ("AHC") were recapitalized. Prior to the recapitalization at
December 31, 2001, Commerce maintained an 80% common stock interest and AAA
Southern New England ("AAA SNE") maintained a 20% common stock interest in
AHC. Additionally, all AHC preferred stock was owned by Commerce. The
recapitalization resulted in redeeming of all the AHC preferred stock by
Commerce in exchange for 3,000 additional shares of AHC common stock. This
resulted in Commerce increasing its AHC common stock interest to 95% with
AAA SNE maintaining a 5% AHC common stock interest, with no preferred stock
outstanding. The recapitalization also resulted in the creation of $4.5
million in minority interest for AAA SNE.
Net Earnings
Net earnings decreased $43,498 or 48.2% to $46,755 during 2002 as
compared to $90,253 in 2001, as a result of the factors previously
mentioned.
Pro-Forma Operating Earnings
Pro-forma operating earnings represent net earnings adjusted for
certain items the Company believes are not indicative of operating results.
Pro-forma operating earnings, which consist of net earnings exclusive of
the after-tax impact of net realized investment losses, the income effect
of a required change in accounting principle and the after-tax impact of
employee stock option variable accounting treatment, were $104,680, or
$3.17 per share (diluted), in 2002, compared to $98,880, or $2.93 per share
(diluted), in 2001.
December 31, December 31,
2002 2001
----------------------------
(Restated)
Pro-Forma Operating Earnings:
Net Earnings $ 46,755 $ 90,253
Plus Net Realized Investment Losses, Net of Tax Benefit 68,361* 5,786
Less Change in Accounting Principle (11,237) -
Plus Impact of Employee Stock Option Variable Accounting 801 2,841
-------------------------
Pro-Forma Operating Earnings $104,680 $ 98,880
=========================
Pro-Forma Operating Earnings Per Share (Diluted):
Net Earnings Per Share $ 1.42 $ 2.67
Plus Per Share Net Realized Investment Losses, Net of Tax
Benefit 2.07 0.18
Less Per Share Change in Accounting Principle (0.34) -
Plus Impact of Employee Stock Option Variable Accounting 0.02 0.08
-------------------------
Pro-Forma Operating Earnings Per Share $ 3.17 $ 2.93
=========================
- --------------------
* The actual tax benefit of the realized investment loss portion is
lower than the calculated statutory rate of 35%. This is primarily
due to the write-off of a $14.8 million deferred tax asset previously
established for realized investment losses and the non-deductible
capital loss recognized for financial statement purposes but
ineligible for tax purposes.
57
Year Ended December 31, 2001 (Restated) Compared to Year Ended
December 31, 2000
Premiums
The following table compares direct premiums written, net premiums
written and earned premiums for the years ended December 31, 2001 and 2000:
Years ended December 31,
------------------------------------------------
2001 2000 $ Change % Change
------------------------------------------------
Direct Premiums Written:
Personal Automobile in Massachusetts $ 859,922 $ 827,180 $ 32,742 4.0%
Personal Automobile in All Other States 122,320 103,496 18,824 18.2%
Commercial Automobile in Massachusetts 58,088 43,243 14,845 34.3%
Commercial Automobile in All Other States 1,514 104 1,410 *
Homeowners in Massachusetts 73,254 65,662 7,592 11.6%
Homeowners in All Other States 18,710 16,498 2,212 13.4%
Other Lines in Massachusetts 17,885 14,860 3,025 20.4%
Other Lines in All Other States 714 606 108 17.8%
----------------------------------------------
Total Direct Premiums Written $1,152,407 $1,071,649 $ 80,758 7.5%
==============================================
Net Premiums Written:
Personal Automobile in Massachusetts $ 864,900 $ 839,394 $ 25,506 3.0%
Personal Automobile in All Other States 122,256 103,719 18,537 17.9%
Commercial Automobile in Massachusetts 60,986 44,848 16,138 36.0%
Commercial Automobile in All Other States 1,477 104 1,373 *
Homeowners in Massachusetts 20,364 17,547 2,817 16.1%
Homeowners in All Other States 4,576 (1,658) 6,234 *
Other Lines in Massachusetts 4,236 4,916 (680) (13.8)%
Other Lines in All Other States 172 41 131 319.5%
----------------------------------------------
Total Net Premiums Written $1,078,967 $1,008,911 $ 70,056 6.9%
==============================================
Earned Premiums:
Personal Automobile in Massachusetts $ 776,552 $ 714,972 $ 61,580 8.6%
Personal Automobile in All Other States 116,479 100,101 16,378 16.4%
Commercial Automobile in Massachusetts 43,008 32,548 10,460 32.1%
Commercial Automobile in All Other States 711 19 692 *
Homeowners in Massachusetts 19,119 17,364 1,755 10.1%
Homeowners in All Other States 3,731 4,186 (455) (10.9)%
Other Lines in Massachusetts 3,290 3,434 (144) (4.2)%
Other Lines in All Other States 158 162 (4) (2.5)%
Assumed Premiums from CAR 80,176 81,300 (1,124) (1.4)%
Assumed Premiums from Other than CAR 428 397 31 7.8%
----------------------------------------------
Total Earned Premiums $1,043,652 $ 954,483 $ 89,169 9.3%
==============================================
Earned Premiums in Massachusetts $ 841,969 $ 768,318 $ 73,651 9.6%
Earned Premiums-Assumed 80,604 81,697 (1,093) (1.3)%
Earned Premiums in All Other States 121,079 104,468 16,611 15.9%
----------------------------------------------
Total Earned Premiums $1,043,652 $ 954,483 $ 89,169 9.3%
==============================================
- --------------------
* Calculation is not meaningful.
58
The $32,742 or 4.0% increase in Massachusetts personal automobile
direct premiums written resulted primarily from increases of 5.8% and 7.1%
in the number of Massachusetts personal automobile exposures for liability
and physical damage coverage, respectively, offset in 2001 by decreases in
rates for the coverage types noted below. The components of these changes
from the previous year for 2001 and 2000 were as follows:
2001 2000
Coverage Type Rate Change (1) Rate Change (1)
------------------------------------------------------------------
Liability:
Bodily Injury (2.1)% 1.0%
Personal Injury Protection (12.9)% 6.4%
Property Damage to Others 1.0% 20.8%
Physical Damage:
Collision (0.1)% 1.7%
Comprehensive (7.6)% 2.4%
Total (2) (1.9)% 6.2%
- --------------------
Represents change in the Company's average rate per exposure from the
Company's prior year average rate for Massachusetts private passenger
automobile premiums.
The total rate change depicted is the result of the weighted average
of premiums written for all coverages divided by liability exposures
only, due to the fact that all exposures are required to carry
liability coverage.
The above percentage changes were primarily the result of rate
modifications in the individual coverage components in the 2001 state
mandated rates, offset by changes in the Company's safe driver rate
deviations, and changes in the distributions of the business written by the
Company. The combination of these factors resulted in a 1.9% decrease in
the average personal automobile premium per exposure in 2001. Despite the
2001 state mandated average rate decrease of 8.3%, the smaller Company
decrease in the average personal automobile premium per exposure was
primarily due to the above noted changes coupled with the fact that the
announced rate decision does not estimate future purchases of new auto-
mobiles in the year to which the rate decision applies and the Company's
mix of personal automobile business differs from that of the industry. In
2001, the Company offered its customers safe driver deviations of 2.0% to
drivers with SDIP classifications of Step 9 and 0.0% for Step 10 (6.0% for
Step 9 and 2.0% for Step 10 in 2000).
The AAA affinity group discount for 2001 was established at 6.0%,
which was unchanged from 2000. In 2001, for drivers who qualified, the
Company's AAA affinity group discount and safe driver deviations could be
combined for up to a 7.9% reduction (11.6% in 2000) from state mandated
rates.
Other states personal automobile direct premiums written increased
$18,824 or 18.2%, however, an overall depressed rate environment resulted
in diminished underwriting profits. The Company continues to evaluate a
number of its other than Massachusetts state rating structures, has filed
for increases in several states and will seek additional rate increases
where appropriate. Personal automobile direct premiums written by American
Commerce increased $7,319 or 9.4% to $85,124 as compared to $77,805 due
primarily to book rollovers of business from existing agents, partially
offset by decreases in states where the Company is not actively pursuing
writings. Personal automobile direct premiums written from Commerce West
increased $11,505 or 44.5% to $37,196 as compared to $25,691. Both
companies target preferred insurance risks, however, Commerce West's recent
growth is attributable to the introduction of a non-standard auto product
in late 1999. Both American Commerce and Commerce West write predominantly
personal auto-
59
mobile insurance. American Commerce writes personal automobile insurance
in 26 states while Commerce West writes personal automobile insurance in
the states of California and Oregon. Personal automobile policies for both
companies are written primarily for a policy term of six months. Homeowner
and other policies in all states are written primarily for a policy term of
one year.
Direct premiums written for Massachusetts commercial automobile
insurance increased by $14,845 or 34.3%, due primarily to an increase of
approximately 9.0% in the number of policies written, combined with a 23.5%
increase in the average commercial automobile premium per policy. The
increase in premium per policy was attributable to a hardening of the
commercial automobile market, as well as the Company increasing its volume
of larger commercial automobile accounts. The Company experienced an
increase of approximately $3,700 from policies with premiums in excess of
$50. In addition, base rates for other voluntary commercial automobile
policies have increased moderately, and a reduction in IRPM credits has
occurred, favorably impacting average premium per policy. In addition, an
approximate 10% increase in rates for policies written through CAR was
experienced. The increased business was attributable to the Company's
initiative to expand writings.
Direct premiums written for Massachusetts homeowners insurance
increased by $7,592 or 11.6% due primarily to a 6.4% increase in the number
of Massachusetts policies written coupled with a 5.0% increase in the
average Massachusetts premium per policy. The increase in business was
primarily attributable to existing and newly appointed agents. Other
states homeowners insurance written by American Commerce increased $2,212
or 13.4% to $18,710 due primarily to book rollovers of business from
existing agents.
The $70,056 or 6.9% increase in net premiums written was primarily
due to the growth in direct premiums written as described above offset by
an increase in premiums ceded to CAR coupled with an increase in premiums
ceded to reinsurers other than CAR. Net premiums written for homeowners in
all other states increased $6,234, with net premiums written of $4,576 in
2001, as compared to ($1,658) in 2000. The reason for negative written
premium in 2000 was due to American Commerce joining the quota share
reinsurance agreement effective January 1, 2000. An unearned premium
transfer of $6,033 occurred effective January 1, 2000, which has a direct
impact to net written premium.
The $89,169 or 9.3% increase in earned premiums during 2001, as
compared to 2000, was primarily due to increases in written exposures for
Massachusetts personal automobile liability and physical damage, coupled
with an increase in earned premium per exposure. The increase in earned
premium per exposure occurs (versus a decrease in written premium per
exposure) because of the time lag in earning the premium once it is
written. This resulted in a $61,580 or 8.6% increase for Massachusetts
personal automobile earned premium.
60
Investment Income (2001 Restated)
Net investment income is affected primarily by the composition of the
Company's investment portfolio and yield thereon. The following table
summarizes the composition of the Company's investment portfolio, at cost,
at December 31, 2001 and 2000:
December 31,
----------------------------------------------
% of % of
Investments, at cost 2001 Invest. 2000 Invest.
- -----------------------------------------------------------------------------------------
GNMA & FNMA mortgage-backed bonds $ 98,198 6.7% $ 67,274 4.7%
Corporate bonds 133,506 9.1 130,775 9.1
U.S. Treasury bonds and notes 104 - 3,428 0.2
Tax exempt state and municipal bonds 386,967 26.2 464,404 32.1
--------------------------------------------
Total fixed maturities 618,775 42.0 665,881 46.1
--------------------------------------------
Preferred stocks 256,582 17.4 215,823 14.9
--------------------------------------------
Common stocks 87,704 5.9 87,704 6.1
--------------------------------------------
Closed-end preferred stock mutual funds 294,948 20.0 327,980 22.7
--------------------------------------------
Mortgages and collateral loans (net of
allowance for possible loan losses) 39,505 2.7 51,661 3.6
Cash and cash equivalents 148,630 10.1 70,521 4.9
Other investments 28,291 1.9 25,475 1.7
--------------------------------------------
Total investments $1,474,435 100.0% $1,445,045 100.0%
============================================
The Company's investment strategy is to maximize after-tax investment
income through investing in high quality securities coupled with acquiring
equity investments, which may forego current investment yield in favor of
potential higher yielding capital appreciation in the future.
As depicted in the following table, 2001 net investment income
increased $2,781 or 2.9%, compared to 2000, principally as a result of an
increase in average invested assets (at cost), offset by a decrease in
yield. The decrease in yield is primarily due to lower short-term yields
on larger cash and cash equivalent balances, coupled with an environment of
higher yielding fixed maturities being called. The Company continues to
monitor interest rates on long-term securities and intends to maintain its
high cash position until such time as the Company believes long-term rates
have appropriately firmed. Net investment income as a percentage of total
average investments was 6.6% in 2001 compared to 6.9% for 2000. Net
investment income after tax as a percentage of total average investments
was 5.3% and 5.7% for 2001 and 2000, respectively.
Years ended December 31,
-------------------------
Investment Return 2001 2000
- ---------------------------------------------------------------------------------------------
(Restated)
Average month-end investments (at cost) $1,506,485 $1,395,159
Net investment income before tax 99,563 96,830
Net investment income after-tax 79,124 79,547
Net investment income as a percentage of average net investments
(at cost) 6.6% 6.9%
Net investment income after-tax as a percentage of average net
investments (at cost) 5.3% 5.7%
61
Premium Finance and Service Fees
Premium finance and service fees increased $2,592 or 17.0% during
2001, as a result of increased premiums as discussed earlier.
Amortization of Excess of Book Value of Subsidiary Interest over Cost
As a result of the acquisition of American Commerce, the amount
representing the excess of the fair value of the net assets acquired over
the purchase price at January 29, 1999 was $16,947. This amount is being
amortized into revenue on a straight-line basis over a five-year period.
The amount amortized into revenue in 2001 was $3,389, compared to $3,390 in
2000.
Investment Gains and Losses
Net realized investment losses totaled $10,633 during 2001 as
compared to gains of $29,550 in 2000. Of the net realized losses during
2001, $9,071 was a result of the Company's venture capital fund
investments. These investments primarily provide seed capital for start-up
companies with emerging high technology initiatives in the financial
services industry. These investments are made in limited partnerships and
the Company's exposure to loss is limited to its actual investment. In
2001, the Company began to account for these investments on an equity
basis. The equity in the operating results of these funds has been
reflected in realized gains and losses. Prior to this change, the
operating results were not material and were therefore reflected in
accumulated other comprehensive income and loss.
The undistributed operating results of closed-end preferred stock
mutual funds have been reflected in realized gains and losses.
Gross realized gains and losses for the years ended December 31, 2001
and December 31, 2000 were as follows:
2001 2000
---------------------------------------------
Gross Gross Gross Gross
Realized Realized Realized Realized
Gains Losses Gains Losses
---------------------------------------------
Fixed maturities $ 957 $ (3,773) $ 223 $(3,995)
Preferred stocks 128 (3,820) 1,748 (462)
Common stocks 1,526 (923) 4,370 -
Closed-end preferred stock
mutual funds* 5,197 (615) 26,641 (66)
Venture capital fund investments - (9,071) 460 -
Other investments - (239) 631 -
-------------------------------------------
Total $7,808 $(18,441) $34,073 $(4,523)
===========================================
- --------------------
* Includes $3,215 in 2001 and $9,260 in 2000, respectively, relating to
the amortization of the net discount, at the time of purchase, of
these securities.
62
Gross accumulated other comprehensive income and losses at December
31, 2001 and December 31, 2000 were as follows:
December 31, 2001 December 31, 2000
----------------------------------------------------------------
Gross Gross Gross Gross
Accumulated Accumulated Accumulated Accumulated
Other Other Other Other
Comprehensive Comprehensive Comprehensive Comprehensive
Income Losses Income Losses
----------------------------------------------------------------
Fixed maturities $17,994 $(10,287) $16,247 $(12,193)
Preferred stocks 6,289 (14,770) 999 (16,739)
Common stocks 21,590 (1,836) 28,126 (3)
Other investments - - 1,327 -
----------------------------------------------------------
Total $45,873 $(26,893) $46,699 $(28,935)
==========================================================
Loss and Loss Adjustment Expenses (2001 Restated)
Losses and loss adjustment expenses ("LAE") incurred increased
$95,474 or 13.9% in 2001. Massachusetts operations experienced declining
underwriting results primarily due to increased losses in the homeowners
property business and in comprehensive personal automobile, due to more
adverse weather conditions compared to last year. The ratio of net
incurred losses, excluding LAE, to premiums earned ("pure loss ratio") on
Massachusetts personal automobile was 65.4% in 2001 compared to 63.1% in
2000. The commercial automobile pure loss ratio increased to 61.8% in 2001
compared to 59.7% in 2000. This increase was primarily due to higher
bodily injury losses and to higher physical damage losses coupled with
worse experience in the business assumed from CAR during this period. For
Massachusetts homeowners (gross of reinsurance), the pure loss ratio was
47.6% in 2001 compared to 40.0% in 2000. This increase was the result of
more claims for Massachusetts homeowner business due to less favorable
weather conditions, as compared to last year, primarily during the first
six months of 2001. Pure loss ratios of subsidiaries in other states
increased to 67.5% in 2001 compared to 62.9% in 2000. The loss ratio (on a
statutory basis) for Commerce West and American Commerce was 85.1% and
84.4%, respectively, in 2001, compared to 69.3% and 84.5% respectively, in
2000. The increase in the loss ratio for Commerce West was primarily
attributable to a substantial increase in non-standard automobile writings
with loss ratios that are significantly higher than for standard automobile
policies.
63
The following table sets forth a reconciliation of beginning and
ending reserves for losses and loss adjustment expense, net of reinsurance
deductions from all reinsurers including CAR, as shown in the Company's
consolidated financial statements for the periods indicated.
Years ended December 31,
------------------------
2001 2000
------------------------
(Restated)
Loss and loss adjustment expense reserves, beginning of year,
prior to effect of ceded reinsurance recoverable $ 585,867 $ 558,779
-----------------------
January 29, 1999 American Commerce loss and loss adjustment
expense reserves - -
-----------------------
Incurred losses and loss adjustment expenses:
Provision for insured events of the current year 816,951 728,582
Decrease in provision for insured events of prior years (35,320) (42,425)
-----------------------
Total incurred losses and loss adjustment expenses 781,631 686,157
-----------------------
Payments:
Losses and loss adjustment expenses attributable to insured
events of the current year 487,918 402,040
Losses and loss adjustment expenses attributable to insured
events of prior years 285,424 257,029
-----------------------
Total payments 773,342 659,069
-----------------------
Loss and loss adjustment expense reserves prior to effect of
ceded reinsurance recoverable 594,156 585,867
Ceded reinsurance recoverable 101,036 98,938
-----------------------
Reserves for losses and loss adjustment expenses at the end of
year per financial statements $695,192 $ 684,805
======================
The decrease in provision for insured events of prior years
represents redundancies for reserves established for prior year. This
decrease in provision was principally the result of re-estimation of unpaid
losses and loss adjustment expenses principally on the personal automobile,
commercial automobile and homeowners lines of business.
Policy Acquisition Costs (2001 Restated)
Policy acquisition costs expensed increased by $21,120 or 8.7% in
2001. As a percentage of net premiums written, the Company's statutory
underwriting expense ratio for 2001 was 24.2% compared to 25.1% in 2000.
The decreased 2001 underwriting expense ratio resulted primarily from a
lower provision for accrued contingent commissions, lower insolvency
assessments and lower expenses due to the continued effects of certain cost
reduction programs. The 2000 underwriting ratio includes a $4,900 charge
versus $3,111 in 2001, representing the Company's allocation from the
Massachusetts Insurers Insolvency Fund. The underwriting expense ratio (on
a statutory basis) for Commerce West was 32.7% for 2001 as compared to
35.8% for 2000. The underwriting expense ratio (on a statutory basis) for
American Commerce, was 32.6% for 2001 compared to 29.3% for 2000.
Income Taxes (2001 Restated)
The Company's effective tax rate was 17.1% and 22.5% for the years
ended December 31, 2001 and 2000, respectively. In both years the
effective rate was lower than the statutory rate of 35% primarily due to
tax-exempt interest income and the corporate dividends received deduction.
64
Minority Interest in Net Loss of Subsidiary
As a result of the joint venture with AAA SNE and acquisition of
American Commerce, the Company's interest in ACIC Holding Co., Inc.,
through Commerce, a wholly-owned subsidiary of CHI, is represented by
ownership of 80% of the outstanding shares of common stock at December 31,
2001. AAA SNE maintains a 20% common stock ownership. The minority
interest of $863 included in the consolidated statement of earnings for
2001 represents 20% of the net loss for ACIC Holding Co., Inc., calculated
after the $9,582 preferred stock dividend paid to Commerce, to the extent
of the minority interest. This compares to $320 minority interest in net
loss of subsidiary after $9,178 in preferred stock dividends paid to
Commerce in 2000. During the third quarter of 2001, the net losses of ACIC
Holding Co., Inc. exceeded the minority interest balance sheet component.
Net Earnings (2001 Restated)
Net earnings decreased $41,827 or 31.7% to $90,253 during 2001 as
compared to $132,080 in 2000, as result of the factors previously
mentioned.
Pro-Forma Operating Earnings
Pro-forma operating earnings represent net earnings adjusted for
certain items the Company believes are not indicative of operating results.
Pro-forma operating earnings, which consist of net earnings exclusive of
the after-tax impact of net realized investment losses, the income effect
of a required change in accounting principle and the after-tax impact of
employee stock option variable accounting treatment, were $98,880, or $2.93
per share (diluted), in 2001, compared to $109,631, or $3.21 per share
(diluted), in 2000.
December 31, December 31,
2001 2000
----------------------------
(Restated)
Pro-Forma Operating Earnings:
Net Earnings $90,253 $132,080
Plus (Less) Net Realized Investment (Gains) Losses, Net of Tax Benefit 5,786 (22,449)
Plus Impact of Employee Stock Option Variable Accounting 2,841 -
-----------------------
Pro-Forma Operating Earnings $98,880 $109,631
=======================
Pro-Forma Operating Earnings Per Share (Diluted):
Net Earnings Per Share $ 2.67 $ 3.87
Plus (Less) Per Share Net Realized Investment (Gains) Losses, Net of
Tax Benefit 0.18 (0.66)
Plus Impact of Employee Stock Option Variable Accounting 0.08 -
-----------------------
Pro-Forma Operating Earnings Per Share $ 2.93 $ 3.21
=======================
Liquidity and Capital Resources
The focus of the discussion of liquidity and capital resources is on
the Consolidated Balance Sheets and the Consolidated Statements of Cash
Flows located in "Part II-Section 8 Financial Statement and Supplementary
Data". Stockholders' equity decreased by $19,381, or 2.4%, in 2002 as
compared to 2001. The decrease resulted from dividends paid to
stockholders of $40,277 and Treasury Stock purchased of $48,819, offset by
net earnings of $46,755, an increase in other comprehensive income, net of
income taxes, on fixed maturities and preferred and common stocks of
$12,870 and a $10,090 increase which resulted from the issuance of capital
stock. Total assets at December 31, 2002 increased $228,057, or 10.6% to
$2,382,688 as compared to total assets of
65
$2,154,631 at December 31, 2001. Invested assets, at market value and
equity, increased $78,869 or 5.3%. Premiums receivable increased $51,389,
or 20.9%. The increase in premiums receivable from December 31, 2001, was
primarily attributable to increases in the Company's business, coupled with
the seasonality of the policy effective dates of the Company's business.
Deferred policy acquisition costs increased $21,684 or 18.6%. Receivable
from reinsurers increased $24,044 or 32.3%, which was primarily
attributable to the increase in other than automobile business previously
discussed. The residual market receivable increased $32,806 or 21.9% over
2001 due to the increased assumed business from CAR previously mentioned.
The Company's investment portfolio, at market and equity, is shown on
the following table as of December 31, 2002 and 2001:
December 31,
----------------------------------------------
% of % of
Investments, at market and equity 2002 Invest. 2001 Invest.
- ----------------------------------------------------------------------------------------
GNMA & FNMA mortgage-backed bonds $ 212,615 13.5% $ 98,985 6.6%
Corporate bonds 126,067 8.0 136,506 9.1
U.S. Treasury bonds and notes 228 - 105 -
Tax exempt state and municipal bonds 344,901 21.9 390,886 26.1
--------------------------------------------
Total fixed maturities 683,811 43.4 626,482 41.8
--------------------------------------------
Preferred stocks 305,057 19.3 248,101 16.6
--------------------------------------------
Common stocks 99,818 6.3 107,458 7.2
--------------------------------------------
Closed-end preferred stock mutual funds
at equity 270,616 17.2 309,282 20.6
--------------------------------------------
Mortgages and collateral loans (net of
allowance for possible loan losses) 26,754 1.7 39,505 2.6
Cash and cash equivalents 169,946 10.8 148,630 9.9
Other investments 21,068 1.3 18,743 1.3
--------------------------------------------
Total investments $1,577,070 100.0% $1,498,201 100.0%
============================================
Comparison of Cost/Market Value of Fixed Maturities as of December
31, 2002 and 2001:
2002 % of Total
---------------------------------- Based on
Market Cost Difference Cost
------------------------------------------------
GNMA & FNMA mortgage-backed bonds $212,615 $208,260 $ 4,355 31.2%
Corporate bonds 126,067 119,698 6,369 18.0
U.S. Treasury bonds and notes 228 222 6 -
Tax exempt state and municipal bonds 344,901 338,730 6,171 50.8
---------------------------------------------
Total fixed maturities $683,811 $666,910 $16,901 100.0%
=============================================
2001 % of Total
---------------------------------- Based on
Market Cost Difference Cost
------------------------------------------------
GNMA & FNMA mortgage-backed bonds $ 98,985 $ 98,198 $ 787 15.9%
Corporate bonds 136,506 133,506 3,000 21.6
U.S. Treasury bonds and notes 105 104 1 -
Tax exempt state and municipal bonds 390,886 386,967 3,919 62.5
---------------------------------------------
Total fixed maturities $626,482 $618,775 $ 7,707 100.0%
=============================================
66
The table below sets forth as of December 31, 2002 the composition of
the Company's fixed maturity investments, excluding short-term investments,
at market, by time to maturity at the dates indicated:
Percent of
Fixed
Maturity
Amount Portfolio
----------------------
Period from December 31, 2002 to maturity:
One year or less $ 103 -%
More than one year to five years 726 0.1
More than five years to ten years 14,069 2.1
More than ten years 668,913 97.8
-------------------
$683,811 100.0%
===================
At December 31, 2002, the Company's fixed income portfolio, which
represented 43.4% of the Company's total invested assets, had a weighted
average stated maturity of approximately 28.9 years versus 27.3 years at
December 31, 2001. The calculation of average stated maturity utilizes the
dollar weighted average of the actual maturity date for a security. In
contrast, the Company's weighted average duration can be significantly
less. At December 31, 2002 the Company's fixed income portfolio had a
weighted average duration of 4.5 years versus 5.7 years at December 31,
2001. The "duration" of a security is the time-weighted present value of
the security's expected cash flows and is used to measure a security's
price sensitivity to changes in interest rates. The weighted average
duration is short compared to the average stated maturity because of the
relatively large percentage of GNMA, FNMA and municipal housing bonds in
the fixed maturity portfolio. The duration reflects industry prepayment
assumptions. The municipal housing bonds are similar in nature to GNMAs in
that they pay down principal during the life of the bond. For these types
of bonds, investors are compensated primarily for reinvestment risk rather
than credit quality risk. During periods of significant interest rate
volatility, the underlying mortgages may prepay more quickly or more slowly
than anticipated. If the repayment of principal occurs earlier than
anticipated during periods of declining interest rates, investment income
may decline due to the reinvestment of these funds at the lower current
market rates. In regards to the fixed income securities, the Bloomberg
Financial System, which was used to calculate the above duration data,
utilizes optional call dates, sinking fund requirements and assumes a non-
static prepayment pattern in deriving these averages.
Of the Company's bonds, 96.5% and 97.9% were rated in either of the
two highest quality categories provided by the NAIC for 2002 and 2001,
respectively. Of all the Company's other Securities, 8 with a cost of $16.3
million and a market value of $18.0 million, are private placement securities
and, therefore are not rated by a rating agency.
67
Comparison of Carrying Value as of December 31, 2002 and 2001:
December 31, December 31,
2002 2001
Market/Equity Market/Equity Increase/ %
Value Value (Decrease) Change
------------------------------------------------------
Fixed maturities $ 683,811 $ 626,482 $ 57,329 9.2%
Preferred stocks 305,057 248,101 56,956 23.0%
Common stocks 99,818 107,458 (7,640) (7.1)%
Closed-end preferred stock mutual funds
at equity 270,616 309,282 (38,666) (12.5)%
Mortgages and collateral loans (net of
allowance for possible loan losses) 26,754 39,505 (12,751) (32.3)%
Cash and cash equivalents 169,946 148,630 21,316 14.3%
Other investments 21,068 18,743 2,325 12.4%
---------------------------------------------------
Total investments $1,577,070 $1,498,201 $ 78,869 5.3%
===================================================
The decrease in closed-end preferred stock mutual funds was primarily
the result of decreases in the net asset value of the preferred stock
mutual funds held by the Company. The decrease in net asset value was the
result of the impact of utility common stocks held by the preferred stock
mutual funds. The Company's strategy continues to focus on maximizing
after-tax investment income through investing in high quality securities
coupled with acquiring equity investments, which may forego current
investment yield in favor of potential higher yielding capital appreciation
in the future. The Company continues to monitor interest rates on medium
and long-term securities and intends to maintain its relatively high cash
position until such time as the Company believes the medium and long-term
rates have appropriately firmed.
The Company's liabilities increased $243,332 or 18.1% to $1,588,530
at December 31, 2002 as compared to $1,345,198 at December 31, 2001. Loss
and loss adjustment expense reserves comprised 51.3% of the Company's
liabilities at December 31, 2002 compared with 51.7% at December 31, 2001.
Unearned premiums comprised 43.3% of the Company's liabilities at December
31, 2002 compared with 41.9% at December 31, 2001. All other liabilities
comprised 5.4% of the Company's liabilities at December 31, 2002, compared
with 6.4% at December 31, 2001. Loss and loss adjustment expense reserves
increased $120,434 or 17.3%. Unearned premiums increased $123,692 or
22.0%, due primarily to increased business in 2002.
Liabilities for unpaid losses and loss adjustment expenses at
December 31, 2002 and 2001 consist of:
2002 2001
-----------------------
(Restated)
Net voluntary unpaid loss and LAE reserves $650,892 $562,456
Voluntary salvage and subrogation recoverable (88,108) (73,393)
Assumed unpaid loss and LAE reserves from CAR 138,355 125,787
Assumed salvage and subrogation recoverable from CAR (22,790) (20,695)
----------------------
Total voluntary and assumed unpaid loss and LAE reserves 678,349 594,155
Adjustment for ceded unpaid loss and LAE reserves 146,277 110,037
Adjustment for ceded salvage and subrogation recoverable (9,000) (9,000)
----------------------
Total unpaid loss and LAE reserves $815,626 $695,192
======================
The primary sources of the Company's liquidity are funds generated
from insurance premiums, net investment income, premium finance and service
fees and the maturing and sale of investments as reflected in the
Consolidated Statements of Cash Flows. The discussion of these
68
items can be found under "Year Ended December 31, 2002 Compared to Year
Ended December 31, 2001", herein.
The Company's operating activities provided cash of $227,539 in 2002,
as compared to $106,172 in 2001, representing an increase of $112,367 or
114.3% in 2002. The primary reason for this increase is that the increase
in premiums collected outpaced the increase in losses and LAE paid and
policy acquisition cost paid. This often occurs in a year when a company
has significant increases in business as claims paid tend to lag premiums
collected. It is anticipated that loss payments will increase at a faster
pace than premiums collected next year as a result of the "lag" catching
up. Additionally, premium finance and service fees collected increased
$3,679 or 20.6% primarily as the result of increased business and a service
fee increase on Massachusetts new and renewal business from three dollars
to four dollars per installment payment, for policies with effective dates
of July 1, 2002 and forward.
For 2002, net cash flows from investing activities used cash of
$127,217, as compared to net cash flows provided by investing activities of
$35,199 in 2001. The majority of the difference was a $169,438 increase in
the purchase of fixed maturities. The Company purchased shorter duration
fixed maturities during 2002. The Company also had a $32,784 increase in
the purchase of equity securities and a decline of $29,029 in the proceeds
from sale of equity securities. These were offset by an increase of
$37,013 in proceeds from maturity of fixed maturities, an increase of
$25,046 in proceeds from sale of fixed maturities and a decline of $15,286
in the purchase of preferred stock mutual funds. The increase in fixed
maturities was primarily due to the purchase of FNMA's, previously
mentioned, offset by the calls and maturities of municipal bonds coupled
with principle paydowns of GNMA's. The increase in preferred stocks was
primarily the result of purchases in the utility and financial services
sectors. Investing activities were funded by accumulated cash and cash
provided by operating activities in 2002 and 2001.
Commerce purchased a 130,000 square foot building in 2001 and
renovated it during 2002. Expenditures in 2002 and 2001 for the land and
building were $13,148 and $4,932 respectively. The project was
substantially complete as of December 31, 2002.
Cash flows used in financing activities totaled $79,006 during 2002
compared to $63,262 during 2001. The 2002 cash flows used in financing
activities consisted of $40,277 in dividends paid to stockholders and
$48,819 used to purchase 1,295,844 shares of Treasury Stock, offset by cash
provided by capital stock issued of $10,090 (as a result of employee stock
option exercises). The 2001 cash flows used in financing activities
consisted of $39,951 in dividends paid to stockholders and $23,311 used to
purchase 622,900 shares of Treasury Stock.
The Company's funds are generally invested in securities with
maturities intended to provide adequate funds to pay claims without the
forced sale of investments. The carrying value (at market and equity) of
total investments at December 31, 2002 was $1,577,070. At December 31,
2002, the Company held cash and cash equivalents of $169,946. These funds
provide sufficient liquidity for the payment of claims and other short-term
cash needs. The Company continues to monitor interest rates on medium and
long-term securities and intends to maintain its relatively high cash
position until such time as the Company believes medium and long-term rates
have appropriately firmed.
The Company also relies upon dividends from its subsidiaries for its
cash requirements. Every Massachusetts insurance company seeking to make
any dividend or other distributions to its stockholders may, within certain
limitations, pay such dividends and then file a report with the
Commissioner. Dividends in excess of these limitations are called
extraordinary dividends. An extraordinary dividend is any dividend or
other property, whose fair value together with other dividends or
distributions made within the preceding twelve months exceeds the greater
of ten percent of the insurer's surplus as regards to policyholders as of
the end of the preceding year, or the net income of a non-life insurance
company for the preceding year. No pro-rata distribution of
69
any class of the insurer's own securities is to be included. No
Massachusetts insurance company shall pay an extraordinary dividend or
other extraordinary distribution until thirty days after the Commissioner
has received notice of the intended distribution and has not objected. No
extraordinary dividends were paid in 2002, 2001 or 2000. Similar laws
exist in California and Ohio. No extraordinary dividend was paid by
American Commerce in 2002 or 2001 and no dividends were paid by Commerce
West since its acquisition.
Periodically, sales have occasionally been made from the Company's
fixed maturity investment portfolio to actively manage portfolio risks,
including credit-related concerns, to optimize tax planning and to realize
gains. This practice may continue in the future.
Effective July 1, 2002, the Company entered into a retrocessional
reinsurance agreement with one of its quota share reinsurers who maintains
a one-third participation in the Company's 75% quota share treaty. For a
premium paid to the Company, the Company will indemnify the reinsurer if
the reinsurer incurs a loss for a single event or occurrence over a certain
threshold. Losses assumed by the reinsurer must first exceed $15,000
before a reimbursement will be made, by the Company, to the reinsurer. The
Company's exposure to the reinsurer under this agreement is for a maximum
of $35,000. The threshold translates into a $60,000 total loss event or
occurrence to the Company, $15,000 of which represents the reinsurers 25%
portion of the quota share treaty, before the reinsurer would receive any
benefit.
Also, effective July 1, 2002, the Company amended its quota share
reinsurance program in the event of terrorist acts. The maximum
reimbursement to the Company from its quota share reinsurers will be
limited to $50,000 in the event of certain defined terrorist acts. The
Company believes its exposure to terrorist acts to be very limited based
upon the types of coverage offered by the Company and its exposure above
the limit to be extremely remote. The Company's main area of business is
in the personal lines market and it has very minimal single retained
exposure in excess of $1,000.
Industry and regulatory guidelines suggest that the ratio of a
property and casualty insurer's annual net premiums written to statutory
policyholders' surplus should not exceed 3.00 to 1.00. The Company's
statutory premiums to surplus ratio was 1.98 to 1.00, 1.51 to 1.00, and
1.53 to 1.00 for the years ended December 31, 2002, 2001 and 2000,
respectively.
Commerce has commitments in two venture capital fund investments.
These investments are made in limited partnerships and the Company's
exposure to loss is limited to its actual investment. In 2000, Commerce
entered into a Limited Partnership Agreement with Conning Partners VI,
L.P., a Delaware Limited Partnership. This partnership agreement required
a commitment by the Company to invest up to $50,000 into the partnership.
To date the Company has invested $25,056 into the partnership, leaving a
balance for funds available for commitment to the partnership of $24,944.
The partnership was formed to operate as an investment fund principally for
the purpose of making investments primarily in equity, equity-related and
other securities issued in expansion financing, start-ups, buy-outs and
recapitalization transactions relating to companies in the areas of
insurance, financial services, e-commerce, healthcare, and related
businesses, including, without limitation, service and technology
enterprises supporting such businesses, in order to realize long-term
capital returns, all as determined and managed by the General Partner for
the benefit of the Partners.
Also in 2000, Commerce entered into a Limited Partnership Agreement
with Distribution Partners Investment Capital, L.P. a Delaware Limited
Partnership. This partnership agreement required a commitment by the
Company to invest up to $3,500 into the partnership. To date the Company
has invested $2,555 into the partnership leaving a balance of $945 for
funds still committed. The partnership was formed to operate as an
investment fund principally for the purpose of making investments primarily
in equity and equity-related securities of companies operating in
70
the area of insurance distribution and distribution related activities, all
as determined and managed by the General Partner for the benefit of the
Partners.
Segment Information
The Company has four reportable segments: (1) property and casualty
insurance-Massachusetts; (2) property and casualty insurance-other than
Massachusetts; (3) real estate and commercial lending; and, (4) corporate
and other. The Company's property and casualty insurance operations are
written through Commerce, Citation, Commerce West, and American Commerce
and are marketed to affinity groups, individuals, families and businesses
through the Company's relationships with professional independent insurance
agencies. The Company's real estate and commercial lending operations are
a result of insurance companies having the authority to invest in
mortgages. The Company's wholly-owned subsidiary, Bay Finance Company,
Inc., originates and services residential and commercial mortgages in
Massachusetts and Connecticut. The corporate and other segment represents
the remainder of the Company's activities, including those of the parent
company.
The Company evaluates performance and allocates resources based
primarily on the property and casualty insurance segments, which represents
over 99% of the Company's total revenue for the past three years. The
accounting policies of the reportable segments are the same as those used
in the notes to the financial statements.
Selected information by industry segment for 2002, 2001 and 2000 is
summarized as follows:
Earnings (Losses)
Before Income Taxes,
Change in Accounting
Principle, and Identifiable
Revenue Minority Interest Assets
--------------------------------------------------
2002
Property and casualty insurance
Massachusetts $1,092,396 $ 72,903 $2,073,853
Other than Massachusetts 161,962 (17,034) 269,091
Real estate and commercial lending 2,737 2,737 27,554
Corporate and other 24 (6,580) 12,190
-------------------------------------------------
Consolidated $1,257,119 $ 52,026 $2,382,688
=================================================
2001-(Restated)
Property and casualty insurance
Massachusetts $1,011,318 $118,657 $1,857,921
Other than Massachusetts 135,483 (6,730) 245,397
Real estate and commercial lending 3,592 3,592 40,483
Corporate and other 3,397 (7,737) 10,830
-------------------------------------------------
Consolidated $1,153,790 $107,782 $2,154,631
=================================================
2000
Property and casualty insurance
Massachusetts $ 969,624 $164,237 $1,780,724
Other than Massachusetts 121,028 7,115 236,240
Real estate and commercial lending 5,407 5,407 52,327
Corporate and other 3,421 (6,693) 6,323
-------------------------------------------------
Consolidated $1,099,480 $170,066 $2,075,614
=================================================
71
Market Risk: Interest Rate Sensitivity and Equity Price Risk
The Company's investment strategy emphasizes investment yield while
maintaining investment quality. The Company's investment objective
continues to focus on maximizing after-tax investment income through
investing in high quality diversified investments structured to maximize
after-tax investment income while minimizing risk. The Company's funds are
generally invested in securities with maturities intended to provide
adequate funds to pay claims and meet other operating needs without the
forced sale of investments. Periodically, sales have occasionally been
made from the Company's fixed maturity portfolio to actively manage
portfolio risks, including credit-related concerns, to optimize tax
planning and to realize gains. This practice may continue in the future.
In conducting investing activities, the Company is subject to, and
assumes, market risk. Market risk is the risk of an adverse financial
impact from changes in interest rates and market prices. The level of risk
assumed by the Company is a function of the Company's overall objectives,
liquidity needs and market volatility.
The Company manages its market risk by focusing on higher quality
equity and fixed income investments, by periodically monitoring the credit
strength of companies in which investments are made, by limiting exposure
in any one investment and by monitoring the quality of the investment
portfolio by taking into account credit ratings assigned by recognized
rating organizations. The Company's portfolio consists of four securities
in default, one corporate bond and three preferred stocks, with an
aggregate cost at December 31, 2002 of $14,203. Of the Company's bonds,
96.5% and 97.9% were rated in either of the two highest qualities
categories provided by the NAIC for 2002 and 2001, respectively. Although
the Company has significant holdings of various closed-end preferred stock
mutual funds, these funds are comprised primarily of preferred and common
stocks traded on national stock exchanges, thus limiting exposure to any
one investment.
As part of its investing activities, the Company assumes positions in
fixed maturity, equity, short-term and cash equivalents markets. The
Company is, therefore, exposed to the impacts of interest rate changes in
the market value of investments. At December 31, 2002, the Company's
exposure to interest rate changes and equity price risk has been estimated
using sensitivity analysis. The interest rate impact is defined as the
effect of a hypothetical interest rate change of plus-or-minus 200 basis
points on the market value of fixed maturities and preferred stocks. The
equity price risk is defined as a hypothetical change of plus-or-minus 10%
in the fair value of common stocks. Changes in interest rates would result
in unrealized gains or losses in the market value of the fixed maturity and
preferred stock portfolio due to differences between current market rates
and the stated rates for these investments. Based on the results of the
sensitivity analysis at December 31, 2002, the Company's estimated market
exposure for a 200-basis point increase (decrease) in interest rates was
calculated. A 200 basis point increase results in a theoretical $78,464
decrease in the market value of the fixed maturities and preferred stocks.
A 200 basis point decrease results in a theoretical $44,995 increase in the
market value of the same securities. The equity price risk impact at
December 31, 2002, based upon a 10% increase in the fair value of common
stocks and preferred stock mutual funds, would be an increase of $9,982 and
$27,062, respectively. Based upon a 10% decrease, common stocks and
preferred stock mutual funds would decrease $9,982 and $27,062,
respectively. Long-term interest rates (30-year Treasury Bond) decreased
to 4.74% at December 31, 2002 from 5.47% at December 31, 2001. The
preceding sensitivity analysis does not represent a forecast and should not
be relied upon as being indicative of expected operating results. These
hypothetical estimates are based upon numerous assumptions such as the
nature and timing of interest rate levels including the yield curve shape,
prepayments on loans and securities, reinvestment and replacement of asset
and liability cash flows and others. While assumptions are developed based
upon current economic conditions, the Company cannot provide any assurance
as to the predictive nature of these assumptions. Also, as market
conditions vary from those assumed in the sensitivity analysis, actual
results will also differ due to
72
prepayment and refinancing levels likely deviating from those assumed and
other internal and external variables. Furthermore, the sensitivity
analysis does not reflect actions that management might take in responding
to or anticipating changes in interest rates.
Recent Relevant Accounting Developments
In July 2001, the FASB issued Statements of Financial Accounting
Standards ("SFAS") No. 141, "Business Combinations", and No. 142, "Goodwill
and Other Intangible Assets". SFAS No. 141, effective for business
combinations initiated after June 30, 2001, requires that all business
combinations be accounted for under a single method - the purchase method.
Use of the pooling-of-interests method is no longer permitted. SFAS No.
141 also clarifies the criteria to recognize intangible assets separately
from goodwill. SFAS No. 142 requires that goodwill and intangible assets
deemed to have indefinite lives no longer be amortized to earnings, but
instead be reviewed at least annually for impairment. Other intangible
assets will continue to be amortized over their useful lives. SFAS No. 142
was effective January 1, 2002.
Effective January 1, 2002, in accordance with SFAS No. 142, the
Company discontinued amortizing the balance sheet item "excess of book
value of subsidiary interest over cost" which was $5.7 million and $8.4
million at year end 2001 and 2000, respectively. The 2001 and 2000 impact
of the amortization of this resulted in approximately $3.4 million or $0.10
per share for both years, of annual operating earnings. Additionally, the
Company no longer amortizes the negative goodwill resulting from the
purchase of preferred stock mutual funds effective January 1, 2002. The
amount of unamortized negative goodwill at December 31, 2001 and 2000 was
$6.4 million and $14.7 million, respectively. The 2001 and 2000 impact of
the amortization of this was $3.2 million and $9.3 million or $0.10 and
$0.27 per share, respectively, of earnings classified as capital gains.
Both the excess of book value of subsidiary interest over cost and the
negative goodwill on preferred stock mutual funds was recognized as income
in the first quarter of 2002 and classified as an extraordinary item. The
per share income impact of this change was $0.34 per share.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation-Transition and Disclosure-an amendment of FASB
Statement No. 123." This Statement amends SFAS No. 123, Accounting for
Stock-Based Compensation, to provide alternative methods of transition for
a voluntary change to the fair value based method of accounting for stock-
based employee compensation. In addition, this Statement amends the
disclosure requirements of SFAS 123 to require prominent disclosures in
both annual and interim financial statements about the method of accounting
for stock-based employee compensation and the effect of the method used on
reported results. The Company has adopted the disclosure-only provisions
of SFAS 148 as of December 31, 2002.
Critical Accounting Policies
The preparation of financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates. The following accounting
policies, which are derived based on management's judgments and estimates,
are considered critical to the preparation of the Company's financial
statements.
1. Investments
A focus of management's judgments and estimates relating to
investments involves the potential impairment of investments for other-
than-temporary declines in market values. The carrying value of
investments in fixed maturities, which include taxable and non-taxable
bonds,
73
and investments in common and preferred stocks, are derived from market
prices supplied by the Company's investment custodian. Unrealized
investment gains and losses on common and preferred stocks and fixed
maturities, to the extent that there is no other-than-temporary impairment
of value, are credited or charged to a separate component of stockholders'
equity, known as "net accumulated other comprehensive income (loss)", until
realized, net of any tax effect. An impairment in an investment is deemed
to be other-than-temporary, when a security's market value has diminished
to less than 75% of cost for two consecutive calendar quarters. An
impairment can also occur when a security is in default or has had a
significant deterioration in its financial condition. If the security is
deemed impaired, the Company adjusts the security's cost to market value
through realized loss based on publicly available information or, in the
absence of such, to a value based on cash flow modeling. During 2002, the
Company wrote down $32,114 in bonds, preferred and common stocks with
impairment as determined by management to be other-than-temporary.
2. Unpaid Losses and Loss Adjustment Expenses ("LAE")
Unpaid Losses and LAE, by their nature, are inherently uncertain as
to the ultimate outcome of the estimated amounts. The liability for unpaid
losses and LAE represents Management's best estimate of the ultimate net
cost of all losses and LAE incurred through the balance sheet date. The
estimate for ultimate net cost of all losses incurred through the balance
sheet date includes the adjusted case estimates for losses, incurred but
not reported ("IBNR") losses, salvage and subrogation recoverable and a
reserve for LAE. In arriving at its best estimate, management begins with
the aggregate of individual case reserves and then makes adjustments to
these amounts on a line of business basis. These adjustments to the
aggregate case reserves by line of business are made based on analysis
performed by Management as further described below. The entire liability
for unpaid losses and LAE is also independently reviewed quarterly and
annually by the Company's Actuarial Department. Liability estimates are
continually analyzed and updated, and therefore, the ultimate liability may
be more or less than the current estimate. The effects of changes in the
estimates are included in the results of operations in the period in which
the estimates are revised.
The claim cycle begins when a claim is reported to the Company and
claims personnel establish a "case reserve" for the estimated amount of the
Company's exposure, without regard to injury causality, third party
liability or potential recoveries. The amount of the reserve is primarily
based upon an evaluation of the type of claim involved, the circumstances
surrounding the claim and the policy provisions relating to the loss. This
estimate reflects the informed judgment of such personnel based on the
experience and knowledge of the claims personnel adjusting the claim.
During the loss adjustment period, these case basis estimates are revised
as deemed necessary by the Company's claims department personnel based on
subsequent developments and periodic reviews of the claim.
In accordance with industry practice, the Company also maintains
reserves for estimated IBNR, salvage and subrogation recoverable and LAE.
These reserves are determined on the basis of historical information and
the experience of the Company. Adjustments to these reserves are made
periodically to take into account changes in the volume of business
written, claims frequency and severity, the mix of business, claims
processing and other items that can be expected to affect the Company's
liability for losses and LAE over time.
When reviewing the liability for unpaid losses and LAE, the Company
analyzes historical data and estimates the impact of various factors such
as: (i) payment trends; (ii) loss expense per exposure; (iii) the
historical loss experience of the Company and industry; (iv) frequency and
severity trends; and, (v) legislative enactments, judicial decisions, legal
developments in the imposition of damages, changes and trends in general
economic conditions, including the effects of inflation and recession.
This process assumes that past experience, adjusted for the effects of
current developments and anticipated trends, is an appropriate basis for
predicting future events. There is no precise method, however, for
subsequently evaluating the impact of any specific factor
74
on the adequacy of reserves, because the eventual development of reserves
is affected by many factors.
By using individual estimates of reported claims adjusted for
managements' best estimate by line of business and a review of these
results by the Company's actuarial area using generally accepted actuarial
reserving techniques, the Company estimates the ultimate net liability for
losses and LAE. After taking into account all relevant factors, management
believes that, based on existing information, the provision for losses and
LAE at December 31, 2002 is adequate to cover the ultimate net cost of
losses and claims incurred as of that date. The ultimate liability,
however, may be greater or lower than established reserves. If the
ultimate exposure is greater than (or less than) management's estimated
liability for losses and LAE, based on any of the factors noted previously,
the Company will incur additional expense (income) which may have a
material impact.
For all of the Company's insurance subsidiaries, the aggregate
actuarial estimate for the loss and LAE reserves, prior to the effect of
ceded reinsurance recoverable, ranges from a low of $607.3 million to a
high of $700.6 million. The Company's financial statement loss and LAE
reserves, based on Management's best estimate, was established at $678.3
million for year end 2002. Management calculates its estimate
independently from those amounts as calculated by the Company's actuaries
and, therefore, the final results are most often not the same. Management
estimates its amounts primarily by reviewing historical loss and LAE data,
focusing mainly on payment data. It also reviews and compares most recent
loss frequency, severity and payment data to historical trends in an
attempt to determine if patterns are remaining consistent or not.
Management attempts to establish its reserve estimate as close to the
amount required for the ultimate future payments necessary to settle all
losses. The accuracy of this estimate is reflected by the line noted above
entitled "decrease in provision for insured events of prior years".
As disclosed in "Part I, Item 3-Legal Proceedings", a purported class
action lawsuit, which alleges damages as a result of the alleged inherent
diminished value to vehicles that are involved in accidents, is pending
against Commerce. No reserve has been established for the potential
liability in connection with this case because the Company is currently
unable to estimate the potential exposure of this purported class action
lawsuit. However, if there were a final decision certifying that a
relatively large class of the Company's policyholders is entitled to
recover damages based upon the inherent diminished value theory, the
Company may have to increase materially its loss and loss adjustment
expense reserves as a result.
Forward-Looking Statements
This annual report and Form 10-K contains some statements that are
not historical facts and are considered "forward-looking statements" as
defined in the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements involve opinions, assumptions and predictions,
and no assurance can be given that the future results will be achieved
since events or results may differ materially as a result of risks facing
the Company. These include, but are not limited to, those risks and
uncertainties in our business, some of which are beyond the control of the
Company, that are described in the Company's Forms 10-K and 10-Q, Schedules
13D and 13G, and other documents filed with the SEC, including the
possibility of adverse catastrophe experience and severe weather, adverse
trends in claim severity or frequency, adverse state and federal regulation
and legislation, changes to CAR's operation rules and regulations, adverse
state judicial decisions, litigation risks, interest rate risk, rate making
decisions for private passenger automobile policies in Massachusetts,
potential rate filings outside of Massachusetts, adverse impacts related to
consolidation activities, heightened competition, as well as the economic,
market or regulatory conditions and risks associated with entry into new
markets and diversification.
75
Effects of Inflation and Recession
The Company generally is unable to recover the costs of inflation in
its personal automobile insurance line since the premiums it charges are
subject to state regulation. Additionally, the premium rates charged by
the Company for personal automobile insurance are adjusted by the
Commissioner only at annual intervals. Such annual adjustments in premium
rates may lag behind related cost increases. Economic recessions can have
an impact upon the Company, primarily through the policyholder's election
to decrease non-compulsory coverages afforded by the policy and decreased
driving, each of which tends to decrease claims.
To the extent inflation and economic recession influence yields on
investments, the Company is also affected. As each of these environments
affect current market rates of return, previously committed investments may
rise or decline in value depending on the type and maturity of investment.
Inflation and recession must also be considered by the Company in the
creation and review of loss and LAE reserves since portions of these
reserves are expected to be paid over extended periods of time. The
anticipated effect of economic conditions is implicitly considered when
estimating liabilities for losses and LAE. The importance of continually
adjusting reserves is even more pronounced in periods of changing economic
circumstances.
Common Stock Price and Dividend Information
The Company's common stock trades on the NYSE under the symbol "CGI".
The high, low and close prices for shares as quoted on Bloomberg.com of the
Company's common stock for 2002 and 2001 were as follows:
2002 2001
--------------------------------------------------------
High Low Close High Low Close
--------------------------------------------------------
First Quarter $39.80 $33.52 $38.70 $32.10 $24.55 $32.00
Second Quarter 42.11 38.25 39.55 36.99 30.75 36.79
Third Quarter 40.49 31.20 32.36 38.35 33.55 38.00
Fourth Quarter 39.00 29.45 37.49 40.35 35.80 37.69
As of March 1, 2003, there were 1,030 stockholders of record of the
Company's Common Stock, not including stock held in "Street Name" or held
in accounts for participants of the Company's ESOP.
The Board of Directors of the Company voted to declare four quarterly
dividends to stockholders of record totaling $1.23 per share and $1.19 per
share in 2002 and 2001, respectively. On May 17, 2002, the Board voted to
increase the quarterly stockholder dividend from $0.30 to $0.31 per share
to stockholders of record as of June 1, 2002. Prior to that declaration,
the Company had paid quarterly dividends of $0.30 per share dating back to
May 19, 2001 when the Board voted to increase the dividend from $0.29 to
$0.30 per share.
In November 2001, the Board of Directors of the Company authorized a
stock buy-back program to purchase shares of common stock of the Company.
During the period from January 1, 2002 through December 31, 2002, the
Company purchased 1,295,844 shares of its own common stock at an average
cost of $37.67. At December 31, 2002, the Company had authority to
purchase a total of 977,856 additional shares of its common stock under the
current buy-back program. As of December 31, 2002, the Company held a
total of 6,165,392 shares of treasury stock.
A portion of the Company's cash flow consists of dividends received
from CHI, which receives dividends from Commerce and Citation. The payment
of any cash dividends to holders of
76
common stock by the Company therefore depends on the receipt of dividend
payments from CHI. To the extent Commerce and Citation are restricted from
paying dividends, CHI, will be limited in its ability to pay dividends to
the Company. The payment of dividends by Commerce and Citation is subject
to limitations imposed by Massachusetts law, as discussed in "Part I, Item
1-J Regulation" of this report.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
For the information required by this Item, please refer to "Part II,
Item 7-Market Risk: Interest Rate Sensitivity and Equity Price Risk"
section (MD&A).
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF MANAGEMENT
The management of the Company is responsible for the consolidated
financial statements and all other information presented in this Annual
Report on Form 10-K. The financial statements have been prepared in
conformity with accounting principles generally accepted in the United
States determined by management to be appropriate in the circumstances and
include amounts based on management's informed estimates and judgments.
Financial information presented elsewhere in this Annual Report on Form 10-
K is consistent with the financial statements. The appropriateness of data
underlying such financial information is monitored through internal
accounting controls, an internal audit department, independent auditors and
the Board of Directors through its audit committee.
The Company maintains a system of internal accounting controls
designed to provide reasonable assurance to management and the Board of
Directors that assets are safeguarded and that transactions are executed in
accordance with management's authorization and recorded properly. The
system of internal accounting controls is supported by the selection and
training of qualified personnel combined with the appropriate division of
responsibilities.
Management recognizes its responsibility for fostering a strong
ethical climate so that the Company's affairs are conducted according to
the highest standards of personal and corporate conduct. The Board of
Directors has adopted a formal Code of Conduct and Corporate Compliance
Program governing employees and directors. Management encourages open
communication within the Company and requires the confidential treatment of
proprietary information and compliance with all domestic laws, including
those relating to financial disclosure.
The 2002 consolidated financial statements were audited by the
Company's independent auditors, Ernst & Young LLP, in accordance with
auditing standards generally accepted in the United States. In addition,
Ernst & Young LLP performs reviews of the unaudited quarterly financial
statements, prior to the announcement of quarterly earnings. Management
has made available to Ernst & Young LLP all of the Company's financial
records and related data, including reports prepared by the Internal Audit
Department as well as the minutes of stockholders' and directors' meetings.
Furthermore, management believes that all representations made to Ernst &
Young LLP were valid and appropriate.
77
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders of
The Commerce Group, Inc.
We have audited the accompanying consolidated balance sheets of The
Commerce Group, Inc. and Subsidiaries as of December 31, 2002 and 2001, and
the related consolidated statements of earnings, stockholders' equity and
cash flows for each of the three years in the period ended December 31,
2002. Our audits also included the financial statement schedules listed in
the Index at Item 15. These financial statements and schedules are the
responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements and schedules based on our
audits.
We conducted our audits in accordance with auditing standards
generally accepted in the United States. Those standards 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. An audit also includes assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
The Commerce Group, Inc. and Subsidiaries at December 31, 2002 and 2001,
and the consolidated results of their operations and their cash flows for
each of the three years in the period ended December 31, 2002, in
conformity with accounting principles generally accepted in the United
States. Also, in our opinion, the related financial statement schedules,
when considered in relation to the basic financial statements taken as a
whole, present fairly in all material respects the information set forth
therein.
As discussed in Note A, the 2001 consolidated financial statements
have been restated due to a change in accounting for stock options.
As discussed in Note A, in 2002 the Company adopted Statement of
Financial Accounting Standards No. 142, Goodwill and Other Intangible
Assets.
ERNST & YOUNG LLP
Hartford, Connecticut
January 31, 2003
78
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31,
(Thousands of Dollars)
2002 2001
---------------------------
(Restated)
ASSETS
Investments (NOTES A2, A3, and B)
Fixed maturities, at market (cost: $666,910 in 2002 and $618,775
in 2001) $ 683,811 $ 626,482
Preferred stocks, at market (cost: $301,141 in 2002 and $256,582
in 2001) 305,057 248,101
Common stocks, at market (cost: $81,602 in 2002 and $87,704
in 2001) 99,818 107,458
Preferred stock mutual funds, at equity (cost: $294,192 in 2002
and $294,948 in 2001) 270,616 309,282
Mortgage loans on real estate and collateral notes receivable (less
allowance for possible loan losses of $418 in 2002 and $660 in 2001) 26,754 39,505
Cash and cash equivalents 169,946 148,630
Other investments (cost: $35,015 in 2002
and $28,291 in 2001) 21,068 18,743
--------------------------
Total investments 1,577,070 1,498,201
Accrued investment income 13,959 15,539
Premiums receivable (less allowance for doubtful receivables of
$1,661 in 2002 and $1,565 in 2001) 297,610 246,221
Deferred policy acquisition costs (NOTES A4 and C) 138,241 116,557
Property and equipment, net of accumulated depreciation
(NOTES A5 and D) 51,509 40,014
Residual market receivable (NOTE F)
Losses and loss adjustment expenses 112,102 87,271
Unearned premiums 52,374 44,399
Due from reinsurers (NOTE F) 98,403 74,359
Current income taxes (NOTES A9 and G) 662 -
Deferred income taxes (NOTES A9 and G) 30,728 21,795
Receivable for investments sold 366 838
Non-compete agreement, net of accumulated amortization (NOTE A6) 2,129 2,479
Other assets 7,535 6,958
--------------------------
Total assets $ 2,382,688 $ 2,154,631
==========================
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Unpaid losses and loss adjustment expenses (NOTES A7, E and F) $ 815,626 $ 695,192
Unearned premiums (NOTE A8) 687,148 563,456
Current income taxes (NOTES A9 and G) - 2,735
Deferred income (NOTES A10 and F) 8,421 7,015
Contingent commissions accrued (NOTE A11) 32,550 29,724
Excess of book value of subsidiary interest over cost (NOTE A12) - 5,719
Other liabilities and accrued expenses 44,785 41,357
--------------------------
Total liabilities 1,588,530 1,345,198
--------------------------
Minority interest (NOTE A14) 4,106 -
--------------------------
Stockholders' Equity (NOTES B, L, M and N)
Preferred stock, authorized 5,000,000 shares at $1.00 par value;
none issued in 2002 and 2001 - -
Common stock, authorized 100,000,000 shares at $.50 par value;
38,281,627 shares issued in 2002 and 38,000,000 shares in 2001 19,141 19,000
Paid-in capital 39,570 29,621
Net accumulated other comprehensive income, net of income
taxes of $13,603 in 2002 and $6,674 in 2001 25,264 12,394
Retained earnings 877,308 870,830
--------------------------
961,283 931,845
Treasury stock, 6,165,392 shares in 2002 and 4,869,548 shares in
2001, at cost (NOTE A15) (171,231) (122,412)
--------------------------
Total stockholders' equity 790,052 809,433
--------------------------
Total liabilities, minority interest and stockholders' equity $ 2,382,688 $ 2,154,631
==========================
The accompanying notes are an integral part of these consolidated financial
statements.
79
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
For the years ended December 31,
(Thousands of Dollars Except Per Share Data)
2002 2001 2000
-----------------------------------------
(Restated)
Revenues
Earned premiums (NOTES A8 and F) $ 1,210,040 $ 1,043,652 $ 954,483
Net investment income (NOTE B) 98,466 99,563 96,830
Premium finance and service fees 21,498 17,819 15,227
Amortization of excess of book value of subsidiary
interest over cost (NOTE A12) - 3,389 3,390
Net realized investment gains (losses) (NOTE B) (82,385) (10,633) 29,550
Other income 9,500 - -
-----------------------------------------
Total revenues 1,257,119 1,153,790 1,099,480
-----------------------------------------
Expenses
Losses and loss adjustment expenses
(NOTES A7, E and F) 909,769 781,631 686,157
Policy acquisition costs (NOTES A4 and C) 295,324 264,377 243,257
-----------------------------------------
Total expenses 1,205,093 1,046,008 929,414
-----------------------------------------
Earnings before income taxes, change in
accounting principle and minority interest 52,026 107,782 170,066
Income taxes (NOTES A9 and G) 17,063 18,392 38,306
Change in accounting principle, net of taxes
(NOTE A12) 11,237 - -
-----------------------------------------
Net earnings before minority interest in
subsidiary 46,200 89,390 131,760
Minority interest in net loss of subsidiary (NOTE A14) 555 863 320
-----------------------------------------
NET EARNINGS $ 46,755 $ 90,253 $ 132,080
=========================================
COMPREHENSIVE INCOME $ 59,625 $ 90,814 $ 168,570
=========================================
NET EARNINGS PER COMMON SHARE:
(NOTE A16)
BASIC $ 1.43 $ 2.69 $ 3.87
=========================================
DILUTED $ 1.42 $ 2.67 $ 3.87
=========================================
CASH DIVIDENDS PAID PER SHARE $ 1.23 $ 1.19 $ 1.15
=========================================
WEIGHTED AVERAGE NUMBER OF COMMON
SHARES OUTSTANDING:
BASIC 32,773,519 33,608,804 34,121,047
=========================================
DILUTED 33,028,081 33,794,938 34,121,047
=========================================
The accompanying notes are an integral part of these consolidated financial
statements.
80
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
For the years ended December 31,
(Thousands of Dollars)
Net
Accumulated
Other
Common Paid-in Comprehensive Retained Treasury
Stock Capital Income/(Loss) Earnings Stock Total
-------------------------------------------------------------------------
Balance, January 1, 2000 $19,000 $29,621 $(24,657) $727,649 $ (83,608) $668,005
--------
Net earnings 132,080 132,080
--------
Other comprehensive income:
Unrealized holding gains
arising during the period,
net of taxes of $18,218 33,833 33,833
Reclassification adjust-
ment, net of taxes
of $1,431 2,657 2,657
-------- --------
Other comprehensive
income 36,490 36,490
-------- --------
Comprehensive income 168,570
--------
Stockholder dividends (39,201) (39,201)
Treasury stock purchased (15,493) (15,493)
-------------------------------------------------------------------------
Balance, December 31, 2000 19,000 29,621 11,833 820,528 (99,101) 781,881
--------
Net earnings (Restated) 90,253 90,253
--------
Other comprehensive
income (loss):
Unrealized holding losses
arising during the period,
net of tax benefits of
$(634) (1,178) (1,178)
Reclassification adjust-
ment, net of taxes
of $936 1,739 1,739
-------- --------
Other comprehensive
income 561 561
-------- --------
Comprehensive income 90,814
--------
Stockholder dividends (39,951) (39,951)
Treasury stock purchased (23,311) (23,311)
-------------------------------------------------------------------------
Balance, December 31, 2001
(Restated) 19,000 29,621 12,394 870,830 (122,412) 809,433
--------
Net earnings 46,755 46,755
--------
Other comprehensive income
Unrealized holding gains
arising during the period,
net of taxes of $6,496 12,064 12,064
Reclassification adjust-
ment, net of taxes of $434 806 806
-------- --------
Other comprehensive
income 12,870 12,870
-------- --------
Comprehensive income 59,625
--------
Stockholder dividends (40,277) (40,277)
Capital stock issued (1) 141 9,949 10,090
Treasury stock purchased (48,819) (48,819)
-------------------------------------------------------------------------
Balance, December 31, 2002 $19,141 $39,570 $ 25,264 $877,308 $(171,231) $790,052
=========================================================================
- --------------------
This was the result of the exercise of 281,627 employee stock
options.
The accompanying notes are an integral part of these consolidated financial
statements.
81
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended December 31,
(Thousands of Dollars)
2002 2001 2000
---------------------------------------
(Restated)
Cash flows from operating activities
Premiums collected $1,263,130 $1,066,544 $ 977,413
Net investment income received 97,487 101,168 92,962
Premium finance and service fees received 21,498 17,819 15,227
Losses and loss adjustment expenses paid (820,867) (769,197) (660,665)
Policy acquisition costs paid (306,888) (270,459) (247,767)
Federal income tax payments (36,321) (39,703) (29,264)
Other income 9,500 - -
---------------------------------------
Net cash provided by operating activities 227,539 106,172 147,906
---------------------------------------
Cash flows from investing activities
Proceeds from maturity of fixed maturities 62,792 25,779 20,805
Proceeds from sale of fixed maturities 114,758 89,712 97,180
Proceeds from sale of equity securities 21,739 50,768 45,604
Proceeds from sale of preferred stock mutual funds 6,362 2,945 -
Proceeds from sale of other investments 1,902 5,735 -
Proceeds from sale of mortgages - - 20,042
Purchase of fixed maturities (241,140) (71,702) (125,844)
Purchase of equity securities (75,558) (42,774) (29,987)
Purchase of preferred stock mutual funds (5,914) (21,200) (60,024)
Purchase of other investments (7,879) (8,074) (11,885)
Payments received on mortgage loans and collateral
notes receivable 15,521 14,506 9,141
Mortgage loans and collateral notes originated (2,521) (2,152) (7,896)
Purchase of property and equipment (17,914) (10,206) (3,416)
Other proceeds from investing activities 635 1,862 1,054
---------------------------------------
Net cash (used in) provided by investing activities (127,217) 35,199 (45,226)
---------------------------------------
Cash flows from financing activities
Dividends paid to stockholders (40,277) (39,951) (39,201)
Purchase of treasury stock (48,819) (23,311) (15,493)
Capital stock issued 10,090 - -
---------------------------------------
Net cash used in financing activities (79,006) (63,262) (54,694)
---------------------------------------
Increase in cash and cash equivalents 21,316 78,109 47,986
Cash and cash equivalents at beginning of year 148,630 70,521 22,535
---------------------------------------
Cash and cash equivalents at end of year $ 169,946 $ 148,630 $ 70,521
=======================================
The accompanying notes are an integral part of these consolidated financial
statements.
82
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Reconciliation of Net Earnings to Net Cash Provided by Operating Activities
For the years ended December 31,
(Thousands of Dollars)
2002 2001 2000
-------------------------------------
(Restated)