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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

VESTA INSURANCE GROUP, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

Registrant’s telephone number, including area code:
(205) 970-7000

Securities registered pursuant to Section 12(b) of the Act:

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) AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS.

YES x NO o

INDICATE BY CHECK MARK IF DISCLOSURE OF DELINQUENT FILERS PURSUANT TO ITEM 405 OF REGULATION S-K (§229,405 OF THIS CHAPTER) 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. x

INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS AN ACCELERATED FILER (AS DEFINED BY EXCHANGE ACT RULE 12b2) YES x NO o

THE AGGREGATE MARKET VALUE OF THE VOTING STOCK HELD BY NON-AFFILIATES OF THE REGISTRANT AS OF JUNE 30, 2002: $155,977,298

THE NUMBER OF SHARES OUTSTANDING OF THE REGISTRANT’S COMMON STOCK, AS OF
MARCH 20, 2003 is 35,678,060

DOCUMENTS INCORPORATED BY REFERENCE

PORTIONS OF THE VESTA INSURANCE GROUP, INC. PROXY STATEMENT FOR ITS 2003 ANNUAL MEETING OF STOCKHOLDERS
ARE INCORPORATED BY REFERENCE INTO PART III HEREOF.

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Special Note Regarding Forward-Looking Statements

Any statement contained in this report which is not a historical fact, or which might otherwise be considered an opinion or projection concerning Vesta or its business, whether expressed or implied, is meant as and should be considered a forward-looking statement as that term is defined in the Private Securities Litigation Reform Act of 1996. Forward-looking statements are based on assumptions and opinions concerning a variety of known and unknown risks, including but not necessarily limited to reinsurance recoverable, financial strength ratings, natural disasters and other catastrophic events, increased competition, changes in availability and cost of reinsurance, changes in governmental regulations, and general economic conditions, as well as other risks more completely described in Vesta’s filings with the Securities and Exchange Commission, including exhibit 99.1 to this Report on Form 10-K. If any of these assumptions or opinions proves incorrect, any forward-looking statements made on the basis of such assumptions or opinions may also prove materially incorrect in one or more respects.

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PART I

Item 1. Business

Business Overview

As used in this Annual Report, unless the context otherwise requires, the terms “Vesta,” “we,” and “our” refer to Vesta Insurance Group, Inc., a Delaware corporation, and its subsidiaries, collectively.

Vesta is a holding company whose principal assets are investments in the capital stock of a group of insurance companies that constitute the Vesta Insurance Group. Vesta was incorporated in Delaware on July 9, 1993 as the holding company for the property and casualty insurance subsidiaries of Torchmark Corporation. In November 1993, we completed an initial public offering of our common stock, with Torchmark retaining 25% of our shares. Torchmark divested its holdings of our shares in June 2000. Vesta’s common shares are traded on the New York Stock Exchange under the symbol “VTA”.

We conduct business in three areas of the personal insurance industry: (1) standard property and casualty; (2) non-standard automobile; and (3) life. We formerly participated in the commercial and reinsurance markets, but exited these business lines to pursue a strategy of diversification into various segments of the personal insurance markets. Today, our business activities are limited exclusively to various lines of personal risk insurance. The largest portion of our business is conducted through Vesta Fire Insurance Corporation, a wholly-owned subsidiary domesticated in Illinois. In 2002, Vesta’s consolidated revenue was approximately $634 million.

We report financial information according to five business segments: (1) standard property-casualty insurance; (2) nonstandard agency; (3) nonstandard underwriting; (4) life insurance; and (5) corporate and other. Since 1999, we have discontinued a number of business lines, including our recent exit of the health insurance and consulting lines in the fourth quarter of 2002. In our financial statements, we have segregated the reporting for these discontinued operations. For information concerning discontinued operations, please refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” beginning on page 28 of this report and Note R to our financial statements on page 80 of this report.

Based upon revenue generated in 2002, our largest business segment is the standard property-casualty segment, where we underwrite or sell personal automobile and residential property insurance through approximately 2,475 independent insurance sales agencies. In 2002, the standard property-casualty segment generated approximately $332 million of revenue, or approximately 52% of consolidated revenue.

In the nonstandard auto business, which targets products to higher-risk individuals, we operate as both an agency and a nonstandard underwriting insurer. In our nonstandard agency segment, our revenue consists of commissions and fees. In the nonstandard underwriting segment, our revenue consists of risk-bearing premiums. Since entering the nonstandard auto business late in 2000, our revenue in each of these segments has grown significantly. In 2002, our agency segment generated approximately $151 million of commission and fee-based revenue, or approximately 13% of consolidated revenue. In 2002, our nonstandard underwriting segment generated approximately $178 million of revenue, or approximately 28% of consolidated revenue.

With respect to both standard and nonstandard property-casualty insurance, key measures of performance are the combined and surplus leverage ratios. The combined ratio reflects the total expenses associated with property and casualty underwriting operations (including loss costs, loss adjustment expenses and other unallocated operating expenses) as a percentage of total earned premium and policy fees during the same period. The surplus leverage ratio reflects the underwriting operations’ net written premiums relative to statutory surplus at the end of the period. The following table sets forth, for the years indicated, the combined and surplus leverage ratios for our property-casualty business lines:

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Selected Operational Ratios for Property-Casualty Business

In our life insurance segment, we acquire and administer traditional life insurance products, universal life products, fixed rate annuities, pension contracts and other products. In 2002, our life insurance segment generated revenue of approximately $52 million, or approximately 8% of consolidated revenue, excluding realized gains and losses. Realized losses in 2002 include the write-off of approximately $27 million of collateral loans. As more fully described elsewhere in this document, the write-off of the collateral loans significantly reduced the statutory surplus of our life insurance subsidiary. We are actively evaluating capital alternatives for this subsidiary which (1) may enable us to continue the current growth-by-acquisition strategy for our life insurance segment; or (2) may result in our divesting our life insurance operations. For more discussion, please refer to “Business Segments – Life Insurance” on page 5 of this report, “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Life insurance segment” on page 28 of this report and Note E to our financial statements on page 60 of this report.

Our corporate and other business segment is primarily comprised of (1) net investment income related to our property-casualty operations; (2) interest expense; (3) financial results for activities not included in the other segments; and (4) unallocated overhead expenses.

A more detailed discussion of each of our business segments is included later in this report.

As a holding company for 13 insurance subsidiaries, we hold certificates of authority to write various types of personal insurance in all 50 states and the District of Columbia. All of our insurance companies are subject to regulation by governmental agencies in the states in which we conduct business. For more information, please refer to “Regulation” on page 19 of this report.

Each of the insurers we manage has been assigned a rating by the A.M. Best Company. For more information, please refer to “A.M. Best” on page 20 of this report.

Vesta maintains a website, www.vesta.com, and copies of our press releases and certain filings with the Securities and Exchange Commission are available free of charge on the investor relations section of our website, http://www.vesta.com/vta/ir vta.htm. In addition, we provide – at no charge – electronic or paper copies of our Form 10-K, Forms 10-Q and proxy statement.

Business Strategy and Recent Developments

In recent years, the domestic insurance industry has been impacted by economic distress in the U.S. economy, a general decline in interest rates, capital losses following the September 11, 2001 tragedy, the adverse impact of scandals involving major U.S. corporations and the financial collapse of numerous companies. Insurance companies have responded to these challenging issues in a number of ways, including raising premium rates, discontinuing coverage in certain lines of business and terminating business activities within various states. Although these factors have created voids in various sectors of the general insurance markets, the environment of rapid industry transformation has created opportunities for financially viable insurance companies to provide underwriting and other services in various niche markets.

Since 1998, Vesta has faced a number of challenges. In addition to the above-mentioned factors, we have been challenged by changes in key management, modifications to the financial strength ratings of various subsidiaries and extensive litigation and arbitration primarily related to actions of prior management. During this same time, we have pursued a strategy to reduce our dependence on the standard property-casualty business and participate in profitable opportunities in other industry segments. We have also endeavored to streamline operations and divest business lines that were less profitable or did not complement our strategy.

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Since 1998, we have been involved in litigation and arbitration with various parties related to a restatement of our financial results for 1997 and prior periods. Many of these matters have now been resolved, and we believe the material remaining issues can be resolved in 2003. We believe that resolution of these matters will conclude a difficult period in Vesta’s history and will enable management to focus on improving long-term profitability and capital. For more information, please refer to “Item 3, Legal Proceedings” beginning on page 22 of this report and Note G to our financial statements on page 63 of this report.

While we have experienced significant and profitable growth in various personal lines business since 2000, we have also experienced significant declines in our property and casualty subsidiaries’ statutory capital and surplus during the same period. These declines in capital and surplus are primarily attributable to lower than expected arbitration awards and changes in estimates of disputed reinsurance recoverable balances, reserve strengthening in our discontinued commercial and assumed reinsurance segments and increased policy acquisitions costs associated with significant premium growth. This decline in statutory surplus coupled with our significant growth in premium written is the primary reason that A.M. Best Company recently adjusted the financial strength ratings of our property and casualty insurance subsidiaries from B+ (Very Good) to B (Fair). In an effort to strengthen our statutory capital position, we have undertaken an evaluation of a possible sale or divestiture of a portion of our property and casualty business. For further information concerning our ratings, please refer to the discussion of “A.M. Best Ratings” on page 20 of this report.

Management is committed to strengthening Vesta’s consolidated long-term profitability and capital while maximizing shareholder value, which could involve a sale or divestiture of portions of our property and casualty business. We plan to pursue opportunities and implement measures that we believe will (1) improve the viability of our capital structure; (2) reduce the demand on our capital; and (3) provide the best operating platform to achieve our long-term financial goals. We have also recently realigned and restructured our management group, appointed a new chairman of the Board of Directors and added two independent outside directors with extensive insurance industry expertise. We believe these changes will provide the leadership and management stability necessary to accomplish our goals.

Business Segments

We report financial and other information according to five business segments: (1) standard property-casualty; (2) non-standard agency; (3) nonstandard underwriting; (4) life insurance; and (5) corporate and other. All information included in this section should be read in conjunction with “Management’s Discussion and Analysis Financial Condition and Results of Operations” and related notes to the financial statements as presented elsewhere in our Annual Report on Form 10-K for the year ended December 31, 2002.

Standard Property-Casualty Insurance Segment

Based upon revenue generated in 2002, our largest segment is the standard property-casualty segment. In this segment, we underwrite or sell standard residential property, automobile and miscellaneous insurance products to targeted markets. Our standard property-casualty products are offered through a network of 2,475 independent insurance agencies located across the U.S.

The following table presents the source of gross premium written in our standard property-casualty segment.

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In 2001 and 2002, our growth in residential property underwriting has primarily occurred in catastrophe-exposed states with capacity constraints that offer high margin potential. As a result, we have focused on increasing our presence in Florida, Texas, Hawaii, South Carolina, New Jersey and Massachusetts.

With the acquisition in 2001 of Florida Select Insurance Holdings, Inc. (“Florida Select”)(see discussion below), we acquired not only a historically profitable book of business in Florida, but also an experienced management team to conduct business in catastrophe-exposed areas. This management team is now responsible for our entire residential property line of business. Our strategy in these catastrophe-exposed states is to optimize our portfolio of business through the integration of catastrophe risk management and underwriting.

Our residential property management team utilizes a rigorous practice of continuously modeling our portfolio to maintain a geographically dispersed book of business. Using multiple catastrophe models, we strive to minimize our probable maximum loss from any one catastrophe event. When a geographic region gets out of balance from the production of new or renewal business, we seek to redistribute the risk by stopping production in over concentrated zip codes.

In states that do not have capacity constraints, we strive to build effective relationships with our independent agencies. The target market for this line of business are families (1) with multiple insurance policies; (2) who own more than one automobile; and (3) who live in a home valued between $100,000 and $250,000. Our focus for these activities is in Pennsylvania, West Virginia, Tennessee, Rhode Island, Hawaii, Connecticut and Alabama.

Residential property

Through various subsidiaries, Vesta provides residential property insurance that we generally categorize into four books of business:

•         Residential property located in Florida and Texas

•         Residential property located in Hawaii

•         Residential property located in the Northeast region of the U.S.

•         Residential property located in the Midwest and Mid-Atlantic regions of the U.S.

Florida and Texas business – In 2001, we acquired Florida Select, a historically profitable insurance provider located in Florida. Florida Select’s customer base was comprised primarily of former customers of the Florida Residential Property and Casualty Joint Underwriting Association (“JUA”), a state-sponsored insurer created by the Florida Legislature following Hurricane Andrew in 1992. Florida Select was established in response to an incentive program designed to encourage private carriers to assume policies from the JUA. Florida Select was one of the first companies to assume policies from the JUA and has operated profitably since its inception. Florida Select generates new business through a wholly-owned subsidiary, Florida Select Insurance Agency, Inc.

The Florida Select management team is also responsible for our residential property business in Texas, which is written by our subsidiary, Texas Select Lloyds Insurance Company. Since the second half of 2001, we have substantially increased our volume of insurance premiums written in Texas. The primary reason for the increase was the decision by several major insurance providers to discontinue providing new coverage in Texas because of potential exposure to claims associated with mold damage. Concurrent with Vesta’s entry into the market, a dramatic decrease in the number of providers in Texas created opportunity for us to gain new homeowners’ customers. We believe that our lack of historical business is a competitive advantage in Texas, as we have avoided current exposure to mold problems resulting from old claims. Our policies contain a mold endorsement, which limits our mold exposure only to sudden and accidental water losses that occur during the term of our policy. In 2002, we wrote approximately $186 million in net annual written premiums in Florida and Texas, compared with $53 million for the nine months we reported results for Florida Select in 2001.

In developing new homeowners’ business, we have taken measures to minimize exposure to mold claims. We implemented procedures which limit our exposure to mold claims on all new and renewal policies written in Texas unless policyholders purchase additional coverage. Effective December 1, 2002, we entered into a 50% quota share reinsurance agreement covering our residential property risks in Texas in order to reduce our overall risk with respect to this rapidly expanding portion of our business.

Hawaii business – We provide residential property-casualty insurance in Hawaii principally through The Hawaiian Insurance & Guaranty Company, Ltd., a wholly-owned subsidiary. In Hawaii, we target our products to owners of higher-value residential property. Until 2000, we primarily insured dwellings against fire and other catastrophic loss. However, in 2000, the state-sponsored insurance pool that had previously provided insurance coverage for wind and hurricane loss was disbanded and we subsequently increased the scope of our products and markets to include wind and hurricane loss. In 2002, we wrote approximately $15 million in annual residential property net written premiums in Hawaii.

Northeast U.S. business – In 1998, we acquired the Property Plus book of personal lines insurance from CIGNA, which primarily insures mid-to-high value residential property in the Northeast U.S. This book of business primarily insures older homes in densely populated areas. Our spread of geographic risk reflects the location of our agency force, and has resulted in

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a concentration of business on Long Island, New York and in the Nantuckett-Martha’s Vineyard area of Massachusetts. In 2002, we wrote approximately $48 million in annual residential property net written premium in the Northeast U.S.

Our standard residential property lines in Florida, Texas, Hawaii and the Northeast U.S. are exposed in catastrophic-prone locales. We have mitigated our risk of exposure to wind and hurricane losses by purchasing reinsurance coverage from both the traditional reinsurance markets and the capital markets. For more information, please refer to the below discussion of various reinsurance programs, “Reinsurance” on page 18 of this report and Note I to our financial statements on page 67 of this report.

Midwest and Mid-Atlantic business – We provide homeowners insurance in the Midwest and Mid-Atlantic regions of the U.S. principally through Shelby Insurance Companies, a group of wholly-owned subsidiaries we acquired in 1997. We primarily target homeowners of dwellings valued from $100,000 to $250,000. In this market we are minimally exposed to potential hurricane loss. In 2002, we wrote approximately $25 million in annual residential property net written premiums in the Midwest and Mid-Atlantic regions.

Standard personal automobile

The majority of our standard auto business is underwritten by The Shelby Insurance Company and affiliates and is sold to individuals in Pennsylvania, West Virginia, Tennessee, Rhode Island, Connecticut and Alabama. We also provide standard auto insurance in Hawaii through our local subsidiary. The target market for our standard personal auto line insurance products are drivers who are older than thirty-five years of age with above-average driving records. We underwrite standard auto policies with liability limits up to $500,000 and with personal umbrella liability coverage available up to $5 million. Most of our personal umbrella liability coverage is written with limits of $1 million to $2 million.

In early 2002, we elected to discontinue writing new business and renewing polices in seven states where we were not generating sustained profits: Arizona, Georgia, Florida, Missouri, North Carolina, Ohio and Virginia. We have adopted a regional strategy designed to focus on seven key states we believe have the best potential for sustainable profitability and growth.

Underwriting.   The target market for our underwriting activities in the standard property-casualty segment are families (1) with multiple insurance policies; (2) who own more than one automobile; and (3) who live in a home valued between $100,000 and $250,000. Our underwriters utilize standard industry computer and analytical software to assist in evaluating and selecting risks and to determine the appropriate levels of insurance to retain.

Our underwriting staff also provides support to our network of independent insurance agents. We require that independent insurance agents who sell our products and services adhere to our underwriting philosophy, discipline and objectives in developing and maintaining business.

Reinsurance – exposure to catastrophic events.   In the standard property-casualty segment, our greatest risk of loss is associated with property damage caused by catastrophic events such as hurricanes and tropical storms affecting Florida, Texas, Hawaii and the Northeast US These risks are seasonal, with the greatest risk existing generally between June and November of any given calendar year. Our exposure to loss from other catastrophic events, such as tornadoes and earthquakes is not as significant because we do not insure significant levels of property in areas traditionally affected by these types of events. Although we endeavor to reinsure a significant portion of our risk for potential catastrophic losses, there can be no assurances that losses will be maintained within the coverage limits of any reinsurance programs to which we are a party.

Our current catastrophe excess of loss reinsurance program, which covers the period July 1, 2002 to June 30, 2003, provides a maximum of $161.3 million of reinsurance for Hawaii risks and $91.3 million for nationwide risks (excluding Florida) in excess of our retention of $12.5 million. In Florida, our current program provides $170.4 million of reinsurance in excess of our retention of $12.5 million of risk. Included in the reinsurance protection for Florida is an estimated $87.9 million of coverage in excess of $28.8 million of losses, with a 10% co-insurance requirement, from The Florida Hurricane Catastrophe Fund (FHCF). This catastrophe excess of loss reinsurance program, combined with other inuring reinsurance contracts, provides reinsurance coverage sufficient to cover the probable maximum loss, or “PML,” from a 1-in-100 year weather event based on estimates of probable losses provided by Risk Management Solutions, Inc.’s RiskLink v4.2 sp1 run with demand surge, excluding storm surge. The combined PML for a 1-in-100 year event for all regions and all perils at December 31, 2002 for the group was $257.0 million.

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Reinsurance – quota share contracts.   From time to time, our property-casualty companies may obtain quota share reinsurance. A quota share reinsurance treaty is a reinsurance contract that provides protection on a proportional basis. Unlike a conventional “excess of loss” reinsurance contract, where reinsurers provide coverage for certain losses in excess of specified limits, under a quota share arrangement a reinsurer shares losses and certain allocated expenses in the same percentage as it shares in premiums.

Effective December 1, 2002, we entered into a 50% quota share reinsurance agreement covering residential property business written in Texas. Consequently, the reinsurers will share 50% of Texas Select’s premiums and losses. Catastrophe protection provided by the Texas quota share is limited to 50% of an occurrence limit not to exceed $400 million.

Reinsurance – per risk coverage.   We also maintain property “per risk” reinsurance coverage through excess of loss of reinsurance agreements, which provide coverage above a stated amount of loss on individual risks. We utilize excess of loss arrangements primarily to provide reinsurance in Florida, Texas, Hawaii and the Northeast U.S. In our property reinsurance program, our retention is $1,000,000 per loss. In our casualty excess of loss reinsurance program, our retention is $500,000 per loss occurrence.

Marketing.   Our standard property-casualty products are distributed through a network of 2,475 independent insurance agencies located in 24 states across the U.S. Key elements of our marketing strategy are developing and maintaining relationships with select independent agents located in rural or suburban areas. We believe the products we offer in the standard property-casualty lines meet the needs of a wide range of customers who are served by local independent agents. These independent agents typically maintain close relationships with their customers and usually experience a high rate of retention, which reduces our overall policy acquisition costs.

We have established compensation programs to enable independent agents to earn above-average industry pay when new policies are written through our companies, and we support the agency force through advertising and promotions designed to create a high level of awareness of the local agent and our companies. We also provide the independent agents with business-to-business technology support in order to increase productivity and reduce operating expenses.

Independent insurance agents are required to comply with strict guidelines established by Vesta and have predetermined and limited authority to bind insurance coverage on our affiliated companies. Our underwriting staff reviews all coverage implemented by the independent agents and has discretion to modify or override decisions by the agency force. Because of (1) the broad base of our independent agency force; (2) the contractual limitations on the agents’ authority to bind coverage; and (3) our disciplined underwriting review process, we believe the activities and strategy with respect to our independent agency force does not present any material risks to our overall operations.

The following table presents, for the year ending December 31, 2002, the principal geographic distribution of our gross premiums written in the standard property-casualty business for the ten states that generated the largest gross premiums.

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(1) Texas gross written premiums are subject to a 50% quota share reinsurance contract effective December 1, 2002.

Claims. Claims costs represent actual payments made and changes in estimated future payments to be made to or on behalf of our policyholders. Claims costs include expenses required to settle all claims and losses and loss estimates for future assignments and assessments.

With the exception of policies written in Texas and Florida, claims on policies written in the Northeast, Midwest and Mid-Atlantic regions are managed by a centralized claims department. When a notice of loss is received, our claims department personnel open a claim file and establish a corresponding reserve based upon standard industry specified criteria. Claims are reviewed and payments generated by employees of Vesta, with the exception of claims related to specific products adjusted by a managing general agency (“MGA”). With respect to MGA claims, our employees periodically conduct audits to insure compliance with Vesta’s policies and procedures.

We employ a centralized litigation staff to monitor all claims-related litigation. Our philosophy and practices are designed to emphasize prompt, fair and equitable settlement of meritorious claims. Our litigation staff also is responsible for insuring the adequacy of claim reserves and controlling claim adjustments and legal expenses.

Claims administration for polices written in Florida and Texas are outsourced to a third party administrator. The claims administration contract was in effect at the time of our acquisition of Florida Select, and we amended the contract in 2001 to include claims made on our policies written in Texas. We believe the third party providing these claims administration services is well-staffed and equipped with current technology to provide cost efficient and reliable claims administration for our Florida and Texas policies.

Systems. With the exception of policies written in Texas and Florida, policy issuance, billing, customer service and other facets of administration, are provided through a centralized policy management information system. In recent years, we have upgraded the core infrastructure and expanded the scope of this policy management information system. Administration for policies written in Florida and Texas is outsourced to a third party administrator.

We place a priority on e-commerce and have intensified resources in recent years to exploit internet-based technology. To assist the marketing and servicing capabilities of our independent agency force, we maintain internet-based programs to provide agents with the ability to quote, enter new business, perform endorsements and perform inquiries on policies, billing and claims. We have also established a network for exchange of intra-company information that provides independent agents with ready and convenient access to product, policy and claims information. We endeavor to utilize state-of-the-art electronic technology to allow the agency force to securely conduct transactions, access information and communicate with our insurance subsidiaries.

Non-standard agency segment

Our agency segment does not engage in underwriting activities. Rather, the primary focus of our agency segment is the distribution of non-standard auto insurance products for various insurers, including our affiliated insurers, in exchange for commissions and fees.

Our non-standard agency segment includes wholesalers and retailers. A wholesaler, also known as a managing general agency or MGA, generally provides marketing, policy issuance, underwriting, policy billings, claims management and other client services on behalf of various insurers. MGA’s utilize independent or captive retail agencies to generate customers and new business. Typically, a retail agency acquires its customers through advertisement and provides points of sale/service through convenient and sometimes extensive branch store locations. A fully integrated agency operation includes a common wholesaler with the technology and resources necessary to support an expanding and constantly changing retail branch network.

Our non-standard agencies primarily target (1) individuals specifically required by law to purchase auto insurance; (2) individuals with accidents or violations on their driving records; (3) new drivers; and (4) drivers of high-performance vehicles. Typically, non-standard auto insurance customers are considered higher-risk than standard customers, and premiums for non-standard insurance are generally more expensive. From time to time, our agency operations sell insurance policies that are underwritten by our affiliated companies. In such cases, only fees and commissions earned in connection with selling the products are reflected in financial results for the agency segment. Income earned from underwriting such policies is reported in the results for our non-standard underwriting segment. For more information, please refer to “Non-standard underwriting segment” discussion beginning on page 11 of this report.

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Structurally, all of our agency operations are conducted through Instant Insurance Holdings, Inc., a Delaware business corporation. Vesta entered the agency business in 2000 with the purchase of 52% of the stock of Instant Insurance. In December 2001, we increased our majority ownership in Instant to approximately 92%, and during 2002, we continued to acquire additional ownership in Instant through purchases of shares from third party stockholders and additional investment in Instant Insurance. As of December 31, 2002, Vesta and its affiliates owned approximately 98% of the issued and outstanding capital stock of Instant Insurance.

Since our initial investment in December 2000, Instant Insurance has acquired several wholesalers and retailers of non-standard automobile insurance products. The agencies that we acquire typically have well established name identity in the geographic areas in which they operate, and we typically continue to operate these acquired agencies under their existing brand names.

The following is a summary of our retail and wholesale agencies:

The following chart identifies the approximate volume of gross premium produced by each of these agencies, in descending order of magnitude (in thousands):

(1) The above chart indicates the volume of business, or gross premium written, produced by these agencies for all insurers, including our affiliated insurers. These gross premiums written are presented only to illustrate the volume of premium produced by our agencies. Our agencies’ revenue consists of commissions and fees.

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Agency revenue streams are generally more stable than the related underwriting income earned by insurers and reinsurers that assume the underwriting risk on the business produced by our agencies. Typically, a retail agency contract provides a fixed commission or a fixed policy fee on the business it produces. However, a wholesale agency or MGA will collect “profit sharing” commissions in excess of contractually stated minimums, depending upon losses incurred and other factors. Because the losses incurred on the policies are reported in future periods, we estimate the amount of profit sharing commissions we expect to collect when we determine that payment of such commissions is probable. Our estimates of these profit sharing commissions may change as the insurance underwriting experience is ultimately known.

In our retail operations, the major expenses we incur are for labor, advertising and rent. The primary expense of our wholesale operations is commissions to independent agents.

We have focused on integrating the various technological platforms of our retail and wholesale agencies into a common information system and administration platform capable of providing more cost efficient support for all policies distributed through our operations. We plan to continue efforts to centralize key functions of the wholesale operations in order to obtain operational synergies and control costs.

We believe that consolidation of the production and administration for smaller books of business into larger books of business subject to common agency contracts and reinsurance will increase marginal revenue and decrease marginal expenses. We also believe that such consolidation will generate increased revenue from the overlay of improved technological platforms and infrastructure and results in an overall better approach to conducting business. We also believe that the successful integration into common and more efficient systems should facilitate growth in business volumes. Increased business volume, in turn, should enable companies to gain leverage in negotiations for more favorable commissions, profit sharing and reinsurance terms.

Non-standard underwriting segment

Our nonstandard underwriting segment can be separated into two lines of business: (1) underwriting nonstandard auto insurance products sold by our affiliated agency operations and (2) underwriting nonstandard auto insurance sold by unaffiliated agencies. In each of these lines of business, we utilize quota share reinsurance to minimize our exposure to loss. Under a quota share contract, reinsurers share losses and certain allocated expenses in the same percentage as they share in premiums.

Affiliated agency business

The insurance policies sold by our affiliated agencies are typically issued by an unaffiliated insurer (sometimes known as an issuing carrier) that has agreed to issue the policies in exchange for a fee. We retain underwriting risk on these policies by agreeing to reinsure a percentage of the losses and certain allocated expenses on a quota share basis in exchange for a like percentage of the premiums. We typically act as one of several reinsurers that, collectively, reinsure most if not all of the underwriting risk from the issuing carrier.

The net premiums written on policies sold by our affiliated agencies during 2002 were approximately $154 million, or approximately 48% of the $318 million total gross premiums written on policies sold by these affiliated agencies for all insurers during 2002. The remaining underwriting risk on these policies is borne by unaffiliated third party insurers. The following chart illustrates our net written premium on policies sold by our affiliated agencies, as compared to the total gross premium on policies sold by those agencies for all carriers, and the approximate combined ratio reflecting the underwriting results of that net premium written by Vesta (in thousands):

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(1) Reflects weighted average.

As illustrated by the above chart, the largest component of our net premiums written on policies sold by our affiliated agencies were approximately $125 million in net premiums written through Insure One, our affiliated agency operation based in Chicago, Illinois. Until December 1, 2002, we bore 100% of the underwriting risk on these policies. Effective December 1, 2002, we ceded 40% of the premiums and losses on these policies to a third party reinsurer pursuant to a quota share reinsurance contract.

Unaffiliated agency business

We also act as an issuing carrier for unaffiliated agencies and reinsurers in exchange for a fee. Although our insurers actually issue these policies, we rely on the unaffiliated agencies to administer the insurance business, including collecting premium, paying claims and expenses and remitting or collecting amounts due from reinsurers. The fees we collect in exchange for issuing these policies is intended to compensate us for the use of our licenses, as well as the risk that the agency will cease to be able to effectively administer the business.

We typically cede most of the premium written in this line of business to unaffiliated reinsurers pursuant to quota share reinsurance contracts and retain relatively low levels of underwriting risk. In 2002, we acted as an issuing carrier for four unaffiliated agencies operating in California, Utah, Georgia and Alabama. The following chart illustrates our total gross premium produced by unaffiliated agencies, the amount ceded to reinsurers and our net written premium in this line of business during 2002 (in thousands):

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(1)       Reflects total expenses as a percentage of total earned premium, policy fees and issuing carrier, or fronting fees. Also, reflects weighted average.

In the event this business results in underwriting losses, we rely on the reinsurers’ ability and willingness to pay the amounts due. All of the reinsurers to which we have ceded premiums written in this line of business were rated “A–” or better by A.M. Best, and, as of December 31, 2002, we have no reason to believe that any of these reinsurers will be unable or unwilling to pay the amounts reported to them as due. For more information, please refer to “Reinsurance” on page 18 of this report, “Critical accounting policies – reinsurance recoverable on paid and accrued losses” on page 29 of this report and Note I to our financial statements on page 67 of this report.

Life Insurance Segment

We entered the life insurance business in 2000, in an effort to stabilize financial results and reduce our dependence upon the standard property-casualty business lines. Generally, losses in the property-casualty business are more difficult to estimate due to the unpredictability of potential catastrophes such as hurricanes, tornadoes and other weather-related events. Also, because of litigation and other factors, it can take years to ultimately determine property-casualty losses. In contrast, financial results and cash flows associated with the life insurance business are typically less volatile, easier to predict and the ultimate results can be determined sooner.

We provide a variety of life insurance products through American Founders Financial Corporation, a holding company for two life insurance companies domiciled in Texas. In 2000, we initially purchased a 72% interest in American Founders. On February 18, 2003, we purchased the remaining shares held by minority holders and now own 100% of American Founders. Headquartered in Scottsdale, Arizona, American Founders has an efficient and flexible operating platform to administer traditional life products, universal life products, fixed-rate annuities, pension contracts and related products.

American Founders’ growth is driven primarily by acquisition of closed blocks of life insurance products and, to a lesser extent, by marketing and distributing its fixed annuity products. Our life insurance products are sold through third party marketing firms, financial institutions and 700 independent agents located throughout 41 states and the District of Columbia. Approximately 60% of American Founders’ premiums are associated with business activities in Texas, Ohio, California and Indiana. At December 31, 2002, American Founders had in force approximately $2.5 billion in face value of life and annuity products. In addition, American Founders leverages its operating efficiency and flexibility by acting as a third party administrator for other insurance companies. In 2002, our life insurance segment generated approximately $52 million of revenue, excluding approximately $28.2 million in realized losses.

American Founders’ acquisition growth strategy is largely dependent on its ability to obtain regulatory approval of proposed acquisitions and its ability to maintain a secure rating from A.M. Best. Although it has continued to generate overall profitable underwriting results, during 2002 American Founders had approximately $27 million of loans made to borrowers in Mexico which had been non-performing since late in 2001 that were recorded as assets. In November 2002, A.M. Best reduced the

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financial strength rating for American Founders from “B+” to “B”, based largely on concerns about these loans. While we do not believe this rating adjustment will materially impact the level of existing business in force at American Founders, it indicates a capital adequacy concern that could impact American Founders’ ability to obtain regulatory approval of future acquisitions.

In the period ending December 31, 2002, we determined that these loans were impaired and we wrote off the value of the loans in our financial statements. The write-off of these loans reduced American Founders’ statutory surplus significantly. In an effort to restore American Founders’ surplus to an acceptable level, we increased the reinsurers’ coinsurance participation in certain blocks of America Founders’ business from 35% to 62.5% effective October 1, 2002, and we are actively evaluating other capital alternatives for American Founders that may enable continued growth by acquisition. Consistent with our overall corporate strategy to strengthen our consolidated long-term financial position and capital surplus, if we are unable to restore American Founders’ surplus to a level sufficient to support a continuation of its growth-by-acquisition strategy, we may also consider divesting American Founders. For more discussion, please refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on page 28 of this report and Note E to our financial statements on page 60 of this report.

During 2002, we were involved in litigation with the minority shareholders of American Founders concerning our rights and responsibilities under an Investor Rights Agreement. The primary dispute concerned the terms of sale of these minority shareholders’ interest in American Founders. Effective February 18, 2003, we acquired all of these minority shareholders’ interests in American Founders, and all litigation was dismissed with prejudice. We also named a new Chairman and Chief Executive Officer for American Founders who continues to work with existing senior management.

Marketing. Our life insurance products are marketed through third party marketing firms, financial institutions and 700 independent agents located in 41 states and the District of Columbia. Our growth in this segment has been facilitated by our use of an efficient operating and administrating system for servicing policies. We believe our flexible systems have demonstrated the ability to efficiently assimilate and promptly provide administration for newly acquired blocks of policies and results in lower administrative costs.

Claims. Our life insurance subsidiaries have a dedicated staff of claim examiners and customer service representatives to assist policyholders with questions and filing claims and to ensure that policyholders receive the benefits to which they are entitled. Life insurance claims are usually paid promptly, often within a few days. Among other responsibilities, claim examiners verify (1) beneficiaries; (2) that a policy is current and in force; and (3) that all conditions of the policy have been met. Our insurance companies may challenge or deny any claim if we believe policy provisions have been violated.

Reinsurance. In our life insurance business, we utilize reinsurance arrangements as a means of ceding risk to third party reinsurers. American Founders maintains reinsurance agreements for more than $50,000 on policies issued prior to October 24, 1990, and for more than $250,000 on policies issued subsequently. Effective October 1, 2002, we entered into a quota share reinsurance agreement with Employers Re Corporation pursuant to which we increased our ceded reinsurance from 35% to 62.5% of substantially all of our life insurance operations. We increased our ceded reinsurance to replace statutory capital lost as a result of the write off the $27 million of collateral loans held as investments by American Founders. At December 31, 2002, American Founders had statutory capital of approximately $30.6 million compared with $35 million at December 31, 2001.

There can be no assurance regarding the ability of any of our reinsurance providers to meet their future obligations. Also, there can be no assurance that we will collect 100% of the amounts we expect to receive as reimbursement by these providers, as some reinsurers may dispute our calculation of amounts recoverable. In addition, there can be no assurance that our experienced losses will be within the coverage limits of our reinsurance arrangements.

Corporate and other segment

Our corporate and other segment consists primarily of (1) net income earned on investments related to our property-casualty operations; (2) interest expenses associated with all debt; (3) financial results for a small life insurance agency; and (4) overhead expenses not directly associated with any other business segment.

Reserves

In our financial statements, we record and maintain reserves in amounts sufficient to cover the estimated ultimate liability for incurred reported and unreported loss claims for each of our companies. Our reserves are estimates based upon actuarial and

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statistical projections at a given point in time of what we expect will be the ultimate settlement and administration of claims. The establishment of appropriate reserves is an inherently uncertain process, and there can be no assurance that ultimate losses will not materially exceed our estimates. We base our reserve calculations upon (1) facts and circumstances then known; (2) estimates of future trends in claims severity; and (3) other variable factors such as inflation. To the extent established reserves are later proven to be inadequate, we are required to incur a charge to earnings in order to increase such reserves. In such case, the charge to earnings is recognized in the period the reserves are increased. These adjustments could have a material adverse effect on our results of operations and financial condition. For more information, please refer to “Critical accounting policies – loss and loss adjustment expenses” on page 29 of this report and Note F to our financial statements on page 62 of this report.

Reserves are established to insure that adequate funds are available to pay all expected losses. In order to validate that an insurance company’s investments are sufficiently liquid to pay expected losses, the Illinois Department of Insurance (the governing authority for Vesta Fire Insurance Corporation, our primary insurance subsidiary) imposes a “reserve reconciliation test”. Generally, the reserve reconciliation test requires an insurance company to maintain a specified amount of high quality liquid assets. At December 31, 2002, the qualifying assets of Vesta Fire Insurance Corporation exceeded the minimum level required pursuant to this test by approximately $71.7 million. For more information, please refer to “Liquidity and Capital Resources” beginning on page 39 of this report and Note E to our financial statements on page 60 of this report.

Reserves – standard property-casualty segment

With respect to reported claims, we establish reserves in our standard property-casualty segment based upon a case-by-case analysis. Reserve amounts are determined by taking into account the circumstances surrounding each claim and policy provision relating to the type of loss. Reserves are reviewed on a regular basis, and as new data becomes available, the reserves are adjusted appropriately to reflect estimated ultimate losses.

The insurance industry has developed a variety of methods for determining reserves associated with losses that have been incurred but not yet reported (“IBNR”). One common method of actuarial evaluation is the loss development method. This method utilizes the pattern by which losses have been reported over time and assumes that each accident year’s experience will develop in the same pattern as the historical loss development. We also rely upon industry data to provide the basis for reserve analysis on newer lines of business.

Reserves are computed using actuarial principles and procedures applicable to the various lines of business and include assumptions for estimated inflation rates. Reserves are carried in our financial statements at an estimate of the ultimate expected loss for each claim without any discount to reflect the time value of money. Reserve calculations are reviewed by management on a regular and ongoing basis and, as required by state law, we engage an independent actuary to render opinions as to the adequacy of statutory reserves we have established. The actuarial opinions are filed with the various jurisdictions in which we are licensed. Based upon the practices and procedures we employ, management believes that our reserves are adequate as of the valuation date.

The following table provides a reconciliation of beginning and ending property-casualty liability balances (presented in conformance with GAAP) for the periods indicated:

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The following table presents the reconciliation between statutory basis and GAAP basis reserves for each of the three years ending December 31:

The following table presents, on a GAAP basis, the development of reserves for unpaid losses and loss adjustment expense from 1992 through 2002 for our insurance subsidiaries, net of reinsurance recoveries or recoverables. The first line of the table presents liabilities at December 31 for each indicated year. The table reflects the estimated amounts of losses and loss adjustment expense for claims arising in that year and all prior years that are unpaid at the balance sheet date, including losses incurred but not yet reported to us. The upper portion of the table presents the cumulative amounts subsequently paid as of successive years with respect to the liability. The lower portion of the table presents the re-estimated amount of the previously recorded liability based upon experience as of the end of each succeeding year. The estimates are revised as more information becomes known about the frequency and severity of claims for individual years. A redundancy (deficiency) exists when the re-estimated liability at each December 31 is less (greater) than the prior liability estimate. The “cumulative redundancy (deficiency)” depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years.

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In the early 1980’s, we reinsured a number of casualty risks that, to the extent such liabilities were not excluded from the underlying policies, could result in claims for coverage for asbestos related and other environmental impairment liabilities. Our exposure to a significant loss from an asbestos or environmental claim has been mitigated because our participation in the reinsurance treaties relating to these risks is only at the higher levels and our percentage participation in those layers is relatively low. In addition, we carry reinsurance that would mitigate the effect of any losses under these treaties. Although the possibility exists that we could suffer material loss in the event of a high number of large losses under these treaties, management believes the occurrence of such events is unlikely.

In 2002, Vesta received arbitration rulings related to litigation with USF&G and NRMA. Both companies reinsured Vesta companies, and Vesta fully expected to recover all unpaid liabilities. However, as disclosed during the year, the impact of these cases resulted in adverse development to Vesta of $13.6 million and $23.6 million, respectively. The adjustments affect all prior accident years to some extent, but have significant impact in 1998, 1999, 2000 and 2001. Therefore, the total adverse development recognized in 2002 was $35.5 million for the cumulative prior years. In 2001, the $34.3 million in adverse development related to prior years is primarily due to a $30.0 million charge taken in our discontinued lines of business. The main contribution to the adverse development was liability exposures written in the 1980’s described above.

Vesta discontinued all commercial and assumed reinsurance lines of business in 1999 and 2000, respectively. The variability in reserves is largely due to the ultimate disposition of individual claims. The absence of other risk factors from this listing does not imply that additional factors will not be identified in the future that will have a significant influence on our reserves.

Reserves – life insurance segment

Reserves for traditional life insurance contracts are generally calculated using the net level premium method based upon assumptions as to the mortality, withdrawals, dividends and assuming investment yields of 2.5% to 6.5%. These assumptions are generally made at the time a contract is issued or at the purchase date. Our assumptions and projections are based on past experience, making allowance for possible unfavorable deviations.

Reserves for investment-type contracts are based upon (1) the contract account balance (if future benefit payments in excess of the account balance are not guaranteed); or (2) on the present value of future benefit payments (if such payments are guaranteed).

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Investments

Our consolidated investment portfolio consists primarily of investment grade fixed income securities. Using both internal and external investment managers, we manage our investment portfolio in accordance with polices and guidelines established by management and the Board of Directors. At December 31, 2002, our cash and investments totaled $1.2 billion as follows:

As part of a modified coinsurance agreement with Employers Reinsurance Corporation, our life insurance subsidiary is holding $170.0 million of invested assets for the benefit of Employers Re. Additionally, we have pledged investments having a market value of $183.6 million to the Federal Home Loan Bank.

The following table presents the value of our fixed maturities portfolio at December 31, 2002, as classified by category:

The National Association of Insurance Commissioners (“NAIC”) has established a bond rating system that assigns securities to classes referred to as “NAIC designations” that are used by insurers in preparing their annual statutory financial statements. The NAIC assigns designations to both publicly and privately traded securities. The NAIC designations range from class 1 (highest quality) to class 6. The guidelines established by our management and Board of Directors generally require that we invest in securities with a NAIC rating of class 1 or class 2. The maturity and duration of our investment portfolio are managed to match the maturity and duration of our underlying life insurance and property-casualty reserves.

Reinsurance

We routinely purchase reinsurance in order to reduce the risk associated with all of our underwriting activities. Reinsurance is a contractual arrangement under which one insurer (the ceding company) transfers to another insurer (the reinsurer) all or a portion of a risk or group of risks that the ceding company has undertaken under the insurance policy or policies it has issued. We obtain reinsurance primarily to (1) provide protection for catastrophic losses; (2) support our statutory surplus and stabilize the results of our underwriting activities; and (3) reduce our net liability for individual risks. Changes or modifications to reinsurance contracts are typically negotiated annually. The renewal dates for our various reinsurance contracts are staggered; therefore, during the year, our retention, terms and coverage limits may change materially depending upon prevailing economic conditions in the reinsurance markets.

In certain reinsurance transactions, a portion of the premiums we receive are remitted to the respective reinsurer in exchange for reinsurance coverage. Initially, we pay all claims made pursuant to our policies and then seek to recover reinsured losses from the respective reinsurer. In accordance with GAAP, the amounts we expect to recover from reinsurers are reported as

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assets in our financial statements. In 2002, gross written premiums ceded to third party reinsurers were $88.7 million, or approximately 20% of the gross premiums we wrote in the standard property-casualty segment.

Although a reinsurer is liable for losses to the extent of coverage to which it assumes, reinsurance arrangements do not legally discharge the principal insurer from primary liability for the full amount of a policy. Accordingly, we assess the credit quality of the third parties to which we cede business and seek to enter into arrangements with financially viable and reliable reinsurers. However, there can be no assurance regarding the ability of any of our reinsurance providers to meet their future obligations. Also, there can be no assurance that we will collect 100% of the amounts we expect to receive as reimbursement from these providers, as some reinsurers may dispute our calculation of amounts recoverable. In addition, there can be no assurance that our experienced losses will be within the coverage limits of our reinsurance arrangements. For more information, please refer to “Critical acounting policies – reinsurance recoverable on paid and accrued losses” on page 29 of this report and Note I to our financial statements on page 67 of this report.

Regulation

As a holding company for 13 insurance subsidiaries, Vesta holds certificates of authority to write various types of insurance in 50 states and in the District of Columbia. All of our insurance companies are subject to regulation by governmental agencies in the states in which we conduct business. The nature and extent of such regulation varies by jurisdiction, but typically involves (1) prior approval of the acquisition of control of an insurance company or any company controlling an insurance company; (2) regulation of certain transactions entered into by an insurance company with any of its affiliates; (3) approval of premium rates for many lines of insurance; (4) standards of solvency and minimum amounts of capital and surplus which must be maintained; (5) limitations on types and amounts of investments; (6) restrictions on the size of risks which may be insured by a single company; (7) licensing of insurers and agents; (8) deposits of securities for the benefit of policyholders; and (9) reports with respect to financial condition and other matters. In addition, state regulatory examiners perform periodic examinations of insurance companies. Generally, the purpose of such regulation is intended for the protection of policyholders.

In addition to the regulatory supervision of our insurance subsidiaries, we are also subject to regulation under the Illinois, Florida, Hawaii and Texas Insurance Holding Company System Regulatory Acts. These Holding Company Acts contain certain reporting requirements, including those requiring Vesta to file information relating to our capital structure, ownership and financial condition and general business operations of our insurance subsidiaries. These Holding Company Acts contain special reporting and prior approval requirements with respect to transactions among affiliates. The Illinois Holding Company Act is generally the more significant to us because Vesta Fire, our principal insurance subsidiary, is domiciled in Illinois.

State insurance regulators and the NAIC periodically re-examine existing laws and regulations and their application insurance companies. In recent years, the NAIC has approved and recommended that states adopt and implement several regulatory initiatives designed to decrease the risk of insolvency of insurance companies. These initiatives include risk-based capital requirements for determining the levels of capital and surplus an insurer must maintain in relation to its insurance and investment risks. Other NAIC regulatory initiatives impose restrictions on an insurance company’s ability to pay dividends to its stockholders. These initiatives may be adopted by the various states in which our subsidiaries are licensed, and the ultimate content and timing of any statutes and regulations adopted by the states is unknown. It is not possible to predict the future impact of changing state and federal regulation on our operations, and there can be no assurance that existing insurance related laws and regulations will not become more restrictive in the future or that laws and regulations enacted in the future will not be more restrictive.

The federal government does not directly regulate the insurance industry. However, federal legislation and administrative policies in specific areas, including pension regulation, privacy regulation, age and sex discrimination, financial services regulation and federal taxation, do affect the insurance industry. In recent years, legislation has been introduced which, if enacted, could result in the federal government assuming a more direct role in the regulation of the insurance industry.

Risk-based capital. The NAIC’s risk-based capital requirements are intended to be used as an early warning tool to help insurance regulators identify deteriorating or weakly capitalized companies in order to initiate regulatory action. Risk-based capital is a method of establishing the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. It provides an elastic means of setting the minimum capital requirement in which the degree of risk taken by the insurer is the primary determinant.

A Company’s risk-based capital is calculated by applying factors to various asset, premium and reserve items. The factor is higher for those items with greater underlying risk and lower for less risky items. The adequacy of a company’s actual

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capital may then be measured by a comparison to its risk-based capital as determined by this formula. Such requirements are not intended as a mechanism for ranking adequately capitalized companies. The formula defines a minimum capital standard that supplements the low, fixed minimum capital and surplus requirements previously implemented on a state-by-state basis.

The NAIC risk-based capital requirements mandate that insurance companies calculate and report information under a risk-based formula which attempts to measure statutory capital and surplus needs based on the risks in a company’s mix of products and investment portfolio. The formula is designed to allow state insurance regulators to identify potential weakly capitalized companies. Under the formula, a company determines its “risk-based capital” by taking into account certain risks related to the insurer’s assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer’s liabilities (including underwriting risks related to the nature and experience of its insurance business). Risk-based capital rules provide for different levels of regulatory attention depending upon the ratio of a company’s total adjusted capital to its “authorized control level” of risk-based capital.

Pursuant to the formula described above, there are no issues with respect to a company’s risk-based capital as long as risk-based capital as a percentage of authorized control level is in excess of 200%. At December 31, 2002, the total adjusted risk-based capital as a percentage of authorized control level for our principal insurance subsidiaries were as follows:

The risk-based capital percentage for Vesta Fire decreased from 550% at December 31, 2001 to 285% at December 31, 2002 due to a decrease in our statutory surplus by $35.8 million as result of arbitration losses and 93% growth in our written premiums.

Restrictions on dividends to stockholders and transactions between affiliates. Transactions between Vesta and its insurance subsidiaries, including the payment of dividends and management fees to Vesta by such subsidiaries, are subject to certain limitations under the insurance laws of the governing states. The insurance laws of Illinois, where Vesta Fire is domiciled, permit the payment of dividends out of earned surplus in any year when, together with other dividends or distributions made within the preceding 12 months, such payments do not exceed the greater of 10% of statutory surplus as of the end of the preceding year or the net income of the preceding year. Furthermore, larger dividends are payable only after receipt of prior regulatory approval. The Illinois Insurance Department has taken the position that these limitations also apply if an insurer has negative or zero “unassigned funds” on its annual for statement. Because of these limitations, Vesta Fire may not be able to declare and pay a dividend for the foreseeable future without prior approval from the Illinois Department of Insurance. For further discussion, please refer to “Management’s Discussion and Analysis of Results of Operations and Financial Condition – Liquidity and Capital Resources” beginning on page 39 of this document.

IRIS Ratios. The NAIC has developed the Insurance Regulatory Information System (“IRIS”) to assist state insurance departments in identifying significant changes in the operations of an insurance company, such as changes in product mix, large reinsurance transactions, increases or decreases in premiums received and certain other changes in operations. Such changes may not be attributable to problems with an insurance company, but may indicate changes in certain ratios that are outside predetermined “normal ranges” as defined by the NAIC. When an insurance company has four or more ratios which fall outside normal ranges, state regulators may investigate to determine the reasons for the variance and whether corrective action is warranted. In 2002, Vesta Fire had four ratios that varied unfavorably from the normal range. These variances are primarily attributable to our significantly increased premium written in our standard property and casualty (primarily Texas homeowners) and non standard underwriting segments. The Illinois Department of Insurance is aware of these variances and, as of March 25, 2003, has not suggested any corrective action. In 2002, American Founders had three ratios that varied unfavorably from the normal range.

A.M. Best Rating

The A.M. Best Company rates insurance companies based upon factors of concern to policyholders, including a company’s financial strength and ability to meet its obligations to policyholders over the long-term. Under the A.M. Best rating system, a “B+” is the minimum rating necessary to maintain classification as “secure”. Many financial institutions require insurance with companies rated at least “B” or “B+” in connection with mortgage loans, and many independent insurance agents limit their field of carriers with which they will do business to “B” or “B+” rated carriers. Because we have grown our presence in the homeowners markets significantly since 2001, these financial strength ratings have become increasingly important to our standard property casualty segment.

We recently received notification from A.M. Best Co. that it had decided to adjust the financial strength ratings of our property and casualty insurance subsidiaries from B+ (Very Good) to B (Fair). Management is unable to quantify the impact that this adjustment will have on our business; however, this adjustment could lead to significant deterioration in selected portions of our standard property and casualty premium volume and adversely impact the financial results of this segment going forward. In an effort to strengthen our statutory capital position, we have undertaken an evaluation of a possible sale or divestiture of a portion of our property and casualty business.

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In November 2002, A.M. Best reduced the financial strength rating for American Founders, our life insurance subsidiary, from “B+” to “B”, based largely on concerns about the collectability of approximately $27 million of loans held as assets by American Founders. While we do not believe that this rating adjustment will impact the level of existing business in force at American Founders, it indicates a capital adequacy concern that could impact American Founders’ ability to obtain regulatory approval of future acquisitions. Accordingly, we increased a third party reinsurer’s coinsurance participation in American Founders’ business from 35% to 62.5%, effective October 1, 2002, and we are actively evaluating other capital alternatives for American Founders which may allow continued growth-by-acquisition.

Also in November 2002, A.M. Best reduced the financial strength rating of States General Life Insurance Company, our health insurance operating subsidiary to “B” (fair). During the fourth quarter of 2002, we classified our health insurance operations as held-for-sale and the related results of operations have been presented in discontinued operations in our consolidated financial statements.

Competition

The property and casualty insurance market is highly competitive with respect to both price and service. We compete for direct business with other public companies, specialty insurance organizations, mutual insurance companies and other underwriting organizations, some of which are substantially larger and have greater financial resources. In recent years, the trend in property and casualty insurance has been toward consolidation, which could result in more competitive pricing. We also believe that, in general, the insurance industry may encounter increasing competition from banks and other financial institutions.

In recent years, large insurance companies with captive insurance agencies have made a strong push into the personal insurance lines business. These companies have competed almost exclusively by implementing aggressive pricing. While there is a segment of the population that is influenced solely by price, we believe many consumers desire the advice, counsel and relationship of a professional agent. We have pursued a business strategy that focuses on this segment of the market. Accordingly, maintaining relationships with our independent agents is critical to our ability to compete. In our day-to-day operations, we have implemented measures to develop and retain the loyalty and support of the independent agents. Such measures include providing assistance and innovative solutions to operational issues facing the independent agents, as well as responding promptly to their requests and needs.

Employees

As of March 1, 2003, we employed approximately 1,700 persons. Approximately 1,175 of our employees are involved in our agency and non-standard underwriting segments. None of our employees are represented by labor unions or subject to any collective bargaining agreements.

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Item 2. Properties

Properties

We lease approximately 115,000 square feet for our home office at 3760 River Run Drive, Birmingham, Alabama under a long-term operating lease. For our life and health insurance businesses, we lease approximately 25,000 square feet for our life insurance operations in Phoenix, Arizona, and approximately 13,000 square feet in Dallas, Texas under long-term operating leases. In our non standard auto insurance operations, we lease approximately 45,000 square feet in Addison, Texas and approximately 85,000 square feet in Bedford Park, Illinois. In addition, we lease approximately 140 retail locations primarily in the Midwest, Texas and South Carolina.

We believe our office facilities are suitable and adequate for our current and anticipated level of operations.

Item 3. Legal Proceedings

Securities Litigation

In 2001, Vesta settled a securities class action that had been pending since 1998. In connection with that settlement, we advanced approximately $5.4 million due from two issuers of directors and officers insurance policies and recorded a receivable for that amount due from those insurers. We collected that $5.4 million in cash during 2002.

Also in connection with that settlement, the issuer of our primary directors’ and officers’ insurance policy, which was intended to cover the initial $25 million of settlement costs and related expenses, denied coverage and refused to fund its share of the settlement costs. We sued that insurer in Alabama state court alleging that its action was taken in bad faith. In February 2003, we settled that claim and collected $16 million in cash.

Health insurance related lawsuits

Vesta and two former officers of Vesta are defendants in a lawsuit styled James H. Cashion, Jr. d/b/a American Health Underwriters v. Vesta Insurance Group, Inc., et al. Plaintiff, a former general agent of our subsidiary States General Life Insurance Company, which we purchased in 2001, alleges that the defendants engaged in an actionable civil conspiracy to tortiously interfere with his agency contracts. The civil conspiracy claim is premised, in part, on certain payments made to these two former officers of Vesta by another agent who replaced Mr. Cashion. Plaintiff is seeking actual and punitive damages. Vesta denies tortiously interfering with plaintiff’s agency contract, believes the claims asserted against it have no merit, and is vigorously defending this lawsuit. The case is set for trial on May 12, 2003, but is likely to be rescheduled later in 2003. In the opinion of management, resolution of this lawsuit is not expected to have a material adverse effect on our financial position.

On December 30, 2002, States General provided the contractually required notice of termination of its exclusive agency contract with Jimmy Walker, Sr., and that contract will expire in accordance with its terms on June 30, 2003. At the same time, another of our affiliates ceased loaning money to Mr. Walker and exercised its right to receive certain commissions earnings on the policies placed in force by Mr. Walker, which Mr. Walker had assigned to us as collateral for his indebtedness to us. At December 31, 2002, the outstanding balance owed by Mr. Walker was approximately $2.5 million. Mr. Walker contended that these actions constituted a premature termination of his agency contracts and threatened litigation. In the interest of resolving this issue expeditiously, we filed a lawsuit in Jefferson County, Alabama seeking a declaratory judgment that our receipt of these assigned commissions is in accordance with an enforceable collateral assignment of commissions document and otherwise lawful. We also filed for arbitration seeking a declaration that our actions were in accordance with our agency contracts with Mr. Walker and otherwise lawful. In the opinion of management, resolution of this lawsuit is not expected to have a material adverse effect on our financial position.

Life insurance related lawsuits

Our subsidiary, American Founders, is a defendant in a lawsuit brought by a judgment creditor of IFS Holdings, Inc. – the former holder of American Founders’ series A and C preferred stock – alleging that American Founders redeemed its Series A and Series C preferred stock from IFS Holdings, Inc. for less than “reasonably equivalent value,” and, therefore, engaged in a voidable fraudulent transfer. American Founders believes (i) that the redemption transaction was for reasonably

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equivalent value; and (ii) that the allegations brought against it in this lawsuit are without merit. We have vigorously defended this action. In the opinion of management, resolution of the lawsuit is not expected to have a material adverse effect on our financial position. However, depending upon the amount and timing, an unfavorable resolution of this matter could materially affect American Founders’ future operations or cash flows in a particular period.

Indemnification Agreements and Liability Insurance

Pursuant to Delaware law and our by-laws, we are obligated to indemnify our current and former officers and directors for certain liabilities arising from their employment with or services to Vesta, provided that their conduct complied with certain requirements. Pursuant to these obligations, we have been advancing costs of defense and other expenses on behalf of certain current and former officers and directors, subject to an undertaking from such individuals to repay any amounts advanced in the event a court determines that they are not entitled to indemnification.

Reinsurance Arbitration/Litigation

As discussed in previous SEC filings, in 1998 we corrected our accounting for assumed reinsurance business through restatement of our previously issued financial statements. Similar corrections were made on a statutory accounting basis through recording cumulative adjustments in Vesta Fire’s 1997 statutory financial statements. The impact of this correction has been reflected in amounts ceded under our 20 percent whole account quota share treaty which was terminated on June 30, 1998 on a run-off basis. We believe such treatment is appropriate under the terms of this treaty and have calculated the quarterly reinsurance billings presented to the three treaty participants accordingly. The aggregate amount included herein as recoverable from such reinsurers totaled $33.4 million at December 31, 2002. Additionally, we have previously collected approximately $48.5 million from the drawdown of collateral on hand. Such amount, net of related expenses, has been reflected in the 2002 financial statements.

NRMA Insurance Ltd. (“NRMA”), one of the participants in the 20 percent whole account quota share treaty, filed a lawsuit in the United States District Court for the Northern District of Alabama contesting our billings. NRMA sought rescission of the treaty and a temporary restraining order preventing us from drawing down approximately $34.5 million of collateral. We filed a demand for arbitration as provided for in the treaty and also filed a motion to compel arbitration which was granted in the United States District action. Vesta reached an agreement with NRMA to collect the $34.5 million of collateral in exchange for posting a $25 million letter of credit in favor of NRMA to fund any amounts NRMA may recover as a result of the arbitration. We also filed for arbitration against Alfa Mutual Insurance Company and Dorinco Reinsurance Company, the other two participants on the treaty. All those arbitrations are in the discovery stages. Additionally, Alfa filed a Motion for Declaratory Judgment asking the arbitration panel to order that there is no enforceable agreement between Alfa and Vesta or alternatively, that there is no coverage for developmental losses under the treaty. After a hearing in June 2002, the arbitration panel denied Alfa’s motion. The hearing on the merits of the arbitration with Alfa is scheduled for May 2003. On December 16, 2002, Dorinco filed a motion for an order that the treaty does not cover developmental losses. A decision on that motion is pending. On June 19, 2002, the panel in the NRMA arbitration issued an order to bifurcate the arbitration, and scheduled a hearing for the week of October 28, 2002 to decide the issue of coverage for developmental losses under the treaty. On September 6, 2002, the panel notified the parties that it would make such determination on this specific issue on the papers and filings submitted by the parties without the necessity of a live hearing. On November 6, 2002, the Company was notified by the panel that it ruled that the treaty does not apply to loss occurrences prior to July 1, 1997. As a result, Vesta recorded a $23.6 million pre-tax non-operating charge as a revision of our estimated reinsurance recoverable in the third quarter of 2002. This ruling does not set a binding precedent regarding Vesta’s other arbitrations and, accordingly, we have not recorded any change in our estimate of our recoverable from the other treaty participants as a result of this ruling. In February 2003, Vesta filed a petition to vacate the NRMA panel ruling in the U.S. District Court for the Northern District of Alabama. There has been no decision on this petition. While management continues to believe its interpretation of the treaty’s terms and computations based thereon are correct, these matters are in arbitration and their ultimate outcome cannot be determined at this time. If rescission on all three treaties was awarded by three separate arbitration panels, we would incur a charge of approximately $57.0 million.

We are in arbitration with CIGNA Property and Casualty Insurance Company (now ACE USA) under a personal lines insurance quota share reinsurance agreement, whereby we assumed certain risks from CIGNA. During September 2000, CIGNA filed for arbitration under the reinsurance agreement, seeking payment of the balances that CIGNA claimed were due under the terms of the treaty. At that time, the treaty was terminated on a cut-off basis. In the pending arbitration Vesta is seeking, among other things, recoupment of all believed improper claims payments and excessive expense allocations and charges from CIGNA. The arbitration was bifurcated into two phases with Phase I concentrating on the interpretation of the intent of the parties related to the expense reimbursement provisions of the treaty at the time it was entered. Phase II, which is ongoing, relates to any remaining issues between the parties, including those that exist with regard to an audit of expenses ceded to the treaty which Vesta intends to conduct. The Phase I hearing was held in February 2002 and the panel ruled that (i) the Company is responsible for the payment of ceding commissions provided for in the treaty and should pay any outstanding billings for commissions and paid claims, plus interest; (ii) the Company may proceed with an audit of expenses ceded to the treaty; and (iii) the parties should identify any further issues to be brought before the arbitration panel for phase two of the hearing. The Phase II hearing has not yet been scheduled.

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If the amounts recoverable under the relevant treaties are ultimately determined to be materially less than the amounts that we have reported as recoverable, we may incur a significant, material, and adverse impact on our financial condition and results of operations.

During 1999, F&G Re (on behalf of USF&G), filed for arbitration under two aggregate stop loss reinsurance treaties whereby F&G Re assumed certain risks from Vesta. F&G Re was seeking to cancel the treaties and avoid its obligation. Based on the terms of the two treaties, Vesta was entitled to recoveries of approximately $30.0 million as losses from prior accident years mature and we had recorded a reinsurance recoverable of $30.0 million at December 31, 2001. The hearing in this arbitration began on February 11, 2002. The hearing was adjourned on February 15, 2002 and resumed on June 11, 2002, and the panel awarded Vesta $15 million, plus interest of $1.4 million. Accordingly, we recorded a pre-tax charge of approximately $13.6 million in the second quarter of 2002. The charge related to this award was recorded in our Assumed Reinsurance segment, which is reflected herein as a discontinued operation, consistent with the manner in which premiums and losses under these contracts were originally recorded.

Muhl vs. Vesta is a case pending in the supreme Court of the State of New York, County of New York, brought by the Liquidator of Midland Insurance Company (“Midland”), claiming recoveries under two alleged retrocession agreements (Pool I and Pool III) between Midland and Interstate Fire Insurance Company, Vesta’s predecessor in interest. The Liquidator’s claims against Vesta under Pool I and Pool III have been severed.

Third party auditors hired by Vesta have identified coverage issues that cast doubt on the validity of a number of claims. In addition, there is no actual retrocessional agreement that evidences the terms and conditions of Pool III which involves 71% or more of the incurred losses at issue. Although there are other tangential documents that the Liquidator may attempt to rely on to prove liability under Pool III, we believe that the Liquidator will not be able to establish liability for any portion of the Pool III claims. We also believe that a number of the losses allegedly incurred in connection with Pool I may be avoided on specific coverage grounds. We are defending this matter vigorously and are reasonably optimistic regarding the ultimate outcome, although an adverse ruling in this case could have a material effect on our financial condition.

Nichols vs. Vesta Fire Insurance Corporation is a lawsuit brought by the Liquidator of Delta America Re Insurance Company in Kentucky state court to recover losses alleged under reinsurance contracts entered into in the 1970’s. Vesta removed the action to federal court and successfully moved to compel arbitration. Each party has selected a party arbitrator but as yet there is no neutral umpire. There has been no discovery as yet and no organizational meeting of the panel. Given the preliminary nature of these proceedings, it is too early to evaluate the likelihood of a favorable or unfavorable outcome.

Vesta vs. New Cap Re is an arbitration against an Australian reinsurer, to collect reinsurance recoverables pursuant to two accident year excess of loss ratio reinsurance agreements. In the arbitration, New Cap Re challenged Vesta’s earlier draw on a Letter of Credit for $7.5 million which was held in connection with one of the two contracts. Shortly after the arbitration commenced, New Cap Re became the subject of insolvency proceedings in Australia and an ancillary proceeding in the U.S. Bankruptcy Court in New York. The Bankruptcy Court stayed all pending litigation and arbitration against New Cap Re, and we appealed that ruling to the Southern District of New York, and ultimately to the US Court of Appeals for the Second Circuit which recently affirmed the Bankruptcy Court’s stay of the arbitration against New Cap Re. Hence, our efforts to recover losses as well as New Cap Re’s efforts to challenge the earlier draw on the $7.5 million Letter of Credit by us are stayed.

On September 5, 2002, New Cap Re served us with an Application pursuant to Section 588FF of the Australian Corporations Act seeking an order directing us to pay New Cap Re and its liquidator $1.0 million that Vesta allegedly received as an “unfair preference” and/or arising out of an “uncommercial transaction,” as those terms are defined by the Corporations Act. We filed a Notice of Appearance on October 31, 2002. While management intends to vigorously defend this matter, given the preliminary nature of these proceedings, it is too early to evaluate the likelihood of success.

Other

Vesta, through its subsidiaries, is routinely a party to pending or threatened legal proceedings and arbitration relating to the regular conduct of its insurance business. These proceedings involve alleged breaches of contract, torts, including bad faith and fraud claims and miscellaneous other specified relief. Based upon information presently available, and in light of legal and other defenses available to Vesta and its subsidiaries, management does not consider liability from any threatened or pending litigation regarding routine matters to be material.

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Item 4. Submission of Matters to a Vote of Security Holders

None.

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PART II

Item 5. Market for Registrant’s Common Equity and Related
Stockholder Matters

Price Range of Common Stock and Dividend Policy

Market Prices. Our common stock trades on the New York Stock Exchange under the symbol “VTA.”

Quarterly high and low market prices of our common stock in 2002 and 2001 were as follows:

Dividend Policy and History. The declaration and payment of dividends will be at the discretion of our Board of Directors and will depend upon many factors, including our financial condition and earnings, the capital requirements of our operating subsidiaries, legal requirements and regulatory constraints.

The dividends we paid on our common stock for the past three years were as follows (in thousands):

Illinois, Hawaii and Texas impose restrictions on the payment of dividends to us by our insurance subsidiaries under their regulatory authority in excess of certain amounts without prior regulatory approval. For more discussion, please refer to “Business—Regulation—Restrictions on Dividends to Stockholders” on page 19 of this report.

In the first quarter of 2002, we exchanged approximately 533 thousand shares of our common stock for $4.6 million principal amount of our 8.75% Senior Notes due 2025 and $.8 million of our 8.5% Deferrable Capital Securities. In the fourth quarter of 2002, we issued approximately 615 thousand shares of common stock in exchange for $3.25 million principal amount of our 8.75% Senior Notes due 2025. The transactions were not registered under the Securities Act of 1933 in reliance on the exemption afforded by Section 3(a)(9) thereof.

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Item 6. Selected Financial Data

The following information should be read in conjunction with Vesta’s Consolidated Financial Statements and related notes reported elsewhere in this Form 10-K.