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SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

FORM 10-K

For the transition period from                      to                     

Commission file number: 0-25508

RTW, INC.
(Exact name of registrant as specified in its charter)

8500 Normandale Lake Boulevard, Suite 1400
Bloomington, MN 55437
(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (952) 893-0403

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the 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 )

As of March 10, 2003, 5,099,746 shares of Common Stock, no par value, were outstanding after giving effect to a one-for-two reverse stock split that was effective November 22, 2002. As of March 10, 2003, assuming as fair value the last sale price of $2.15 per share on The Nasdaq Stock Market, the aggregate fair value of shares held by non-affiliates was approximately $8.2 million.

Documents incorporated by reference:

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PART I

ITEM 1. BUSINESS

Overview

     RTW, Inc. (the “Company”) provides comprehensive management products and services to insured and self-insured employers for their workers’ compensation programs in Minnesota, Wisconsin, South Dakota, Colorado, Michigan and Indiana. The Company closed its regional offices in Missouri and Massachusetts in the fourth quarter of 2001 and non-renewed substantially all policies in those regions through December 31, 2002 and will “run-off” expiring policies in those regions through February 2003. The Company has also obtained licenses but is not operating (other than previously mentioned “run-off business” and claims management associated with the “run-off business”) in Pennsylvania, Tennessee, Maryland, Arkansas, Iowa, Florida, New Jersey, Georgia, North Carolina, Texas, Missouri, Illinois, Kansas, Massachusetts, Connecticut, Rhode Island and Oklahoma. The Company believes its proprietary management approach substantially reduces wage replacement costs and medical expenses resulting from workplace injuries. The Company focuses on controlling costs by returning injured employees to work as soon as possible and by actively managing all participants in the workers’ compensation system, including employers, employees and medical care providers, as well as legal and judicial participants in the workers’ compensation system. Elements of the Company’s management approach include:

	•		thorough evaluation of potential customers;
	•		active training of customer’s management and employees in the Company’s procedures;
	•		prompt identification of potentially high-cost injuries; and
	•		rapid intervention in, and intensive management of, potentially high-cost injuries.

     The Company has developed two proprietary management systems: (i) the RTW SOLUTION®, designed to lower employers’ workers’ compensation costs and return injured employees to work as soon as possible, and (ii) the ID15® system, designed to identify those injured employees who are likely to get stuck in the workers’ compensation system. The Company also uses management techniques, including designated health care providers, medical fee schedule review, utilization review and doctor peer review, to control medical costs.

Industry

     Workers’ compensation benefits are mandated and regulated by each state. Every state requires employers to provide wage replacement and medical benefits to work accident victims regardless of fault. Virtually all employers in the United States are required to either: (a) purchase workers’ compensation insurance from a private insurance carrier; (b) obtain coverage from a state managed fund; or (c) if permitted by their state, to be self-insured. Workers’ compensation laws generally mandate two types of benefits for injured employees: (i) indemnity payments that consist of temporary wage replacement or permanent disability payments, and (ii) medical benefits that include expenses related to injury diagnosis and treatment as well as rehabilitation, if necessary. On an industry-wide basis, indemnity payments represent approximately 45% of benefits paid, while medical benefits account for the remaining 55%.

     Estimated insurance premiums totaled approximately $31.7 billion nationwide in 2002. This $31.7 billion includes: (i) the traditional or private residual market, estimated at $26.0 billion, including commercial insurers and state-operated assigned risk pools established for high risk employers, and (ii) state funds, estimated at $5.7 billion, operated in states in order to increase competition and stabilize the market.

     Indemnity payments, established by state legislative action, have risen, in part because of higher wage levels and increased state mandated benefits. Medical expenses have also increased due to the general rise in the cost of health care and the statutory requirement that employers provide coverage for all compensable medical costs, without any co-payment by the employee. The Company believes the most significant factor affecting the cost of workers’ compensation, however, results from incentives in the system for injured employees to remain away from work and to continue collecting indemnity payments and receiving medical treatment beyond the point that is necessary.

     The Company believes that traditional workers’ compensation insurance companies and workers’ compensation third party administrators are not as effective as the Company in controlling loss costs. While traditional efforts, including focusing on workplace safety and implementing certain medical cost containment measures, have reduced costs in certain areas, the Company believes these efforts have not had a significant effect on the overall system cost because they have not focused effectively on controlling indemnity payments. In the late 1990’s as well as into the 2000’s, traditional insurance companies moved toward a more comprehensive management approach including

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return-to-work initiatives. The Company believes that while traditional insurers have been somewhat successful in these initiatives, they have not achieved the cost reductions and claim closure outcomes realized by the Company.

The Company’s Management Approach

     The Company seeks to control workers’ compensation costs through a proprietary management approach that is specifically designed for the workers’ compensation system. The Company’s management strategy seeks to reduce workers’ compensation costs significantly through early intervention in each employee’s injury and intensive management of all participants in the workers’ compensation system, including employers, injured employees, medical care providers, and legal and judicial participants. Through early intervention, the Company promptly identifies cases that have the potential to result in significant expenses and acts to control these expenses before they are incurred. The Company focuses on controlling indemnity payments for lost wages, the largest component of workers’ compensation costs, by quickly and safely returning injured employees to work. As part of this strategy, the Company attempts to return an injured employee to his or her original position, if the employee is able, or to place the employee in a transitional, light-duty position until the employee is able to resume his or her former position. By promptly returning an employee to work, the Company has found that not only indemnity payments, but also medical expenses per injury, are substantially reduced. In addition, the Company uses other management techniques, including contracts with provider networks, designated health care providers, medical fee schedule review, utilization review and doctor peer review, to control medical costs.

     The Company uses five-person operating teams to implement its proprietary management approach. Each operating team handles all of the claims for a specific group of employers and is accountable within the Company for the loss experience of these employers. Each team generally consists of three nurses, a statutory claims administrator, and an assistant claims administrator / clerical support person. A team’s nurses are responsible for evaluating the medical condition of an injured employee and monitoring the employee’s medical treatment. The claims administrators are responsible for determining the eligibility of claims, paying benefits in a timely manner and following statutory requirements for administration of claims. The operating teams meet regularly to discuss strategies for managing difficult claims and to review strategies and procedures that have been particularly successful in resolving disputes.

     The following sections summarize the Company’s approach to managing the various participants in the system.

     Employers. Generally, each employer is assigned to an operating team responsible for managing the relationship. Prior to accepting an employer, members of an operating team may conduct an on-site risk assessment and explain the Company’s methods and procedures to the employer. The risk assessment forms a part of the Company’s underwriting process and includes evaluating the employer’s willingness to follow the Company’s procedures. For employers insured by the Company’s wholly-owned insurance subsidiary, American Compensation Insurance Company (“ACIC”), the employer agrees, as part of the insurance policy, to comply with the Company’s early intervention methods and to provide transitional, light-duty work for injured employees until such time as they are able to resume their normal positions. To ensure that the Company’s early intervention techniques succeed, the Company requests prompt notification from the employer of all injuries, typically 24 to 48 hours after the employer learns of the injury.

     Each operating team is responsible for managing its designated employers’ workers’ compensation program, by training the employer’s personnel in the Company’s methods and procedures and managing all reported injuries for the employer. The operating team meets with the employer, provides access to loss reports detailing current claims, conducts an annual account review and maintains active communication on open injuries. The Company’s loss control team or the operating team may make workplace safety recommendations or retain a workplace safety-engineering firm to assist its employers in remedying work conditions that the loss control team or the operating team determines constitute an inappropriate risk. In addition, the operating team may recommend to the Company’s management the cancellation or non-renewal of the policy for an employer that fails to comply with the Company’s procedures.

     Employees. The Company focuses on identifying injuries that have the greatest potential to result in significant expenses and acts quickly to control expenses resulting from these injuries. The Company has observed that approximately 15% of all injuries result in 85% of all workers’ compensation expenses and that early identification of, and intervention in, these cases can lead to significant cost savings. Within 48 hours of being notified of an injury, an operating team evaluates several factors, including the type of injury, the employee’s injury history and whether the employee is absent from work, to determine whether the injury is likely to involve significant expense. In potentially high-cost cases, a member of the operating team intervenes quickly by meeting with the injured employee to assess the injury, assisting the injured employee in obtaining medical care and rehabilitation and

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developing a plan to get the employee back to work as soon as is appropriate. If the employee cannot immediately return to his or her original position, the employer is required to provide a transitional light-duty job that is consistent with the limits defined by the employee’s medical care provider. If the employee refuses this transitional position, the Company may terminate indemnity payments, but is required to continue to provide appropriate medical benefits.

     Medical Care Providers. The operating teams actively assess each injury, monitor and manage the medical treatment and review the medical expenses of each employee’s injury. Each injury report is reviewed by one of the Company’s nurses. The nurse typically contacts the physician treating employees in cases that involve days off from work or injuries that could involve significant expense. In these cases, the physician is asked to provide his or her diagnosis, plan of treatment and assessment of the employee’s physical capabilities for transitional work. The Company has contracts with consulting physicians to assess proposed treatment plans for injured employees. These physicians also discuss injured employee treatment plans with the employee’s medical care providers. The goal is to ensure both an accurate diagnosis and treatment of the injury and an understanding of the nature and extent of the limits the diagnosis places on the employee’s ability to return to work in either the original job or a transitional, light-duty position. The operating team also monitors the health care provided to the injured employee to ensure that the employee receives proper treatment for the injury and that the employee does not receive services or procedures that are excessive, unnecessary or unrelated to the particular injury. In addition, when the operating team believes the diagnosis of an injury or the proposed rehabilitation treatment is not appropriate, the operating team will arrange for a second opinion with an independent medical examiner.

     The medical cost management team reviews all bills submitted by medical care providers to determine if the amounts charged for the treatments are appropriate according to statutory and other negotiated fee schedules.

     In many states, including Minnesota, the Company cannot require that an injured employee go to a specific physician or seek treatment from a specific provider. Nevertheless, the Company attempts to assist the injured employee in selecting appropriate medical care providers. In Colorado and Michigan (for the first ten days after the injury) the Company can require that injured employees go to a physician within a designated network of medical care providers.

     Management of Legal and Judicial Participants. The Company, through early intervention, seeks to limit the number of disputes with injured employees. As part of its early intervention process, the Company identifies injuries that are not work related and denies the claim. The Company may also deny a claim for indemnity payments when it determines that no further payments are appropriate (for example, when an employee has been offered transitional, light-duty work and has refused it). In these and other sets of circumstances, the employee may engage a lawyer to represent his or her interests. Generally, if the parties are unable to resolve the matter, the workers’ compensation law mandates arbitration, subject to judicial review. For cases that involve adversary proceedings, the Company engages one of several lawyers who are familiar with the Company’s philosophy and actively seeks to resolve the dispute with the employee’s attorney.

Customers

     The Company targets employers and associations that operate in industries with relatively high workers’ compensation costs, including manufacturing, retail, wholesale, health care and hospitality industries and employers with a history of workers’ compensation claim costs higher than average in their industry.

     The Company’s average annual premium per policy increased to $80,400 in 2002 from $56,800 in 2001 and $40,500 in 2000 due to focused aggressive re-underwriting in 2001and 2000. The Company’s ten largest customers accounted for $6.2 million or 11.4% of the Company’s premiums in force in 2002 compared to $6.6 million or 7.8% of the Company’s premiums in force in 2001 and $7.9 million or 7.9% of the Company’s premiums in force in 2000. No customer accounted for more than 5% of in force premiums in 2002, 2001 or 2000. The Company renewed 46.1% of the policies scheduled to expire in 2002, whereas 56.5% and 66.2% were renewed in 2001 and 2000, respectively. The retention rate in 2002 was decreased significantly by the closure of the Missouri and Massachusetts regions.

     Substantially all of the Company’s employers are in its Minnesota, Colorado and Michigan regions. In December 2001, the Company closed its regional offices in Missouri (covering Missouri, Illinois and Kansas) and Massachusetts (covering Massachusetts, Connecticut, New Hampshire, Rhode Island and Maine). In 2002, the Company non-renewed substantially all of its policies in its Missouri and Massachusetts regions and expects to complete run off of remaining expiring policies in these regions through February 2003. In addition to these states, the Company is also licensed in Pennsylvania, Tennessee, Maryland, Arkansas, Iowa, Florida, New Jersey, Georgia, North Carolina, Texas and Oklahoma. The Company currently has no intention to expand operations beyond the present states in which it is operating.

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Products

     Substantially all of the Company’s workers’ compensation products and services are guaranteed-cost insurance policies. Under a guaranteed-cost policy, the customer purchases an insurance policy underwritten by ACIC and pays a premium based on the employers’ aggregate payroll. The Company assumes responsibility for all the indemnity and medical costs associated with the employers’ workers’ compensation injuries and works closely with the employer in managing the employer’s entire workers’ compensation program.

     The Company determines the premium to be charged an employer based on several factors, including: (i) the expected dollar loss per $100 of payroll for the employers’ industry, (ii) the employer’s experience modifier, a measurement of the difference between the employer’s past claims experience and its industry average, (iii) an upward or downward adjustment to the premium by the Company based on its assessment of the risks associated with providing the coverage for the specific employer, and (iv) competitive market prices. An employer’s expected dollar loss and experience modifier are each determined by an independent rating agency established or adopted by its state, based on a three-year average of the claims experience of the employer and its industry.

     In addition to standard guaranteed-cost policies, the Company offers, on a limited basis, a deductible guaranteed-cost policy under which the employer is responsible for all medical and indemnity expenses up to a specific dollar amount, while the Company is responsible for medical and indemnity expenses over this level. The Company provides the same comprehensive management services for the deductible guaranteed-cost policies and the standard guaranteed-cost policies.

     In 2002, the Company began a strategic initiative to sell its workers’ compensation products and services on a fee-for-service basis. This strategic initiative extends the Company’s workers’ compensation services to self-insured employers and other alternative market non-risk products. The Company will charge a fee to these customers based on the expected number of claims managed or the time committed to the customer. This service product will provide a non-insurance revenue line for the Company. In 2002, the Company had acquired three customers totaling approximately $100,000 in annualized revenues.

Sales and Marketing

     The Company sells its workers’ compensation products and services to insured and self-insured employers through independent insurance agencies and brokers, including several large national agencies. Agencies are paid commissions which averaged 6.9% of the Company’s gross premiums earned in 2002, compared to 7.6% of the Company’s gross premiums earned in 2001 and 7.9% of gross premiums earned in 2000. The Company’s ten highest producing agencies accounted for $19.7 million or 36.3% of premiums in force in 2002, compared to $24.8 million or 29.7% of premiums in force in 2001 and $27.2 million or 27.3% of premiums in force in 2000. No agency accounted for more than 5.3% of premiums in force in 2002, compared to 6.4% of premiums in force in 2001 and 6.5% of premiums in force in 2000. The Company continually markets its products and services to its agencies to keep them aware of developments in the Company’s business. Each state’s underwriting team is responsible for establishing and maintaining agency relationships.

Reinsurance

     The Company shares the risks and benefits of the insurance it underwrites through reinsurance. The Company purchases reinsurance to protect it from potential losses in excess of the level management is willing to accept. From 1995 to 2002, the Company’s primary reinsurance was excess of loss coverage that limited its per-incident exposure.

     Under “excess of loss” policies, the Company pays the reinsurer a percentage of the Company’s gross premiums earned, and the reinsurer agrees to assume all risks relating to injuries over a specific dollar amount on a per occurrence basis. Excess of loss coverage in Minnesota is provided by a state established organization, the Minnesota Workers’ Compensation Reinsurance Association (WCRA). In non-Minnesota states, excess of loss coverage is purchased through private reinsurers.

     In 2002, 2001 and 2000, the Company selected per occurrence levels in Minnesota from the WCRA of $350,000, $330,000 and $310,000, respectively. In 2003, the selected per occurrence level excess of loss coverage under the WCRA is $360,000.

     In 2002, 2001 and 2000, the Company purchased non-Minnesota excess of loss coverage primarily through General Cologne Reinsurance Corporation, rated A++ (Superior) by A.M. Best. The excess of loss policy in effect during 2002, 2001 and 2000 provided reinsurance from $300,000 per person per any one loss and up to statutory limits per occurrence ultimate net loss for 2001, 2000 and 1999, but coverage was capped at $20.0 million per occurrence ultimate net loss for 2002.

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     In 2003, the Company’s non-Minnesota per-incident excess of loss coverage increased to $360,000, continues to be capped at $20.0 million per occurrence and further excludes claims resulting from acts of terrorism. The Company further decreased its retention in 2003 to $200,000 per-incident in 2003 by purchasing increased excess of loss reinsurance to further reduce volatility in the Company’s financial results. This coverage was purchased from three reinsurers.

     The excess of loss policy in effect during 1998 and 1997 provided reinsurance up to $9.5 million in excess of $500,000 per person per any one loss and up to $40 million in excess of $10 million per occurrence ultimate net loss for 2002. This excess of loss policy was effective January 1, 1997, and replaced excess of loss policies that were terminated on December 31, 1996. In 1996, the non-Minnesota excess of loss policies provided reinsurance up to $9.5 million in excess of $500,000 per person per any one loss and up to $49.5 million in excess of $500,000 per occurrence ultimate net loss. Transatlantic Reinsurance Company, rated A++ (Superior) by A.M. Best, is the only reinsurance company that received more than 15% of the premiums paid for reinsurance coverage under the 1996 excess of loss coverage.

     For claims occurring on or after July 1, 1998, the Company purchased excess of loss coverage through GE Reinsurance Corporation, rated A+ (Superior) by A.M. Best that provides reinsurance up to $275,000 in excess of $25,000 in all states except Minnesota. In Minnesota, the coverage is $255,000 in excess of $25,000 for 1998, $265,000 in excess of $25,000 for 1999 and $275,000 in excess of $25,000 for 2000 and 2001. This coverage was purchased to reduce risk and volatility in the Company’s operating performance. This contract was terminated effective December 31, 2000; however, the policy was effective in 2001 for policies in force at December 31, 2000 through expiration, not to exceed fifteen months after the effective termination date. Policies written or renewed in 2002 and 2001 were not covered under this lower level excess of loss reinsurance policy.

     A.M. Best determines its ratings based on a comparative analysis of the financial condition and operating performance of insurance companies. A.M. Best ratings are based upon factors of concern to insureds and are not directed toward the protection of investors. See “Competition.”

Competition

     The workers’ compensation industry is highly competitive. The Company competes with insurance companies, managed health care organizations and state sponsored insurance pools for its insured products and with Third Party Administrators for its fee-for-service business. Unlike the Company, which offers only workers’ compensation products and services, these competitors may offer additional products and services to employers, including other forms of insurance. As a consequence, these competitors may have certain advantages in pricing their workers’ compensation products. In addition, certain of these competitors are offering a management approach similar to that offered by the Company. Many of the Company’s competitors have greater financial and operating resources than the Company.

     Competitive factors in the industry include premium rates, level of service and ability to reduce claims expense. The Company believes that its workers’ compensation insurance products are competitively priced and its premium rates are typically lower than those for customers assigned to the state sponsored risk pools. The Company also believes that its level of service and its ability to reduce claims are strong competitive factors that have enabled it to retain existing customers and attract new customers.

     Insurance companies enter and exit the workers’ compensation market in different states depending on their appraisal of current market conditions. Many insurance companies stopped underwriting workers’ compensation insurance during the early 1990’s due to rising costs that were not matched by reductions in statutory benefits or higher premium rates. In the mid to late 1990’s, the Company experienced increased market pressure as new insurance companies and single line workers’ compensation insurance companies entered the market. In 2002, 2001 and 2000, many insurers withdrew from the markets in which the Company operates as premium rates were insufficient to cover the cost of benefits paid.

     Insurance companies compete primarily with the Company for insured customers that have lower past claims experience or lower experience “modifiers.” As a result, the Company experiences increased competition for the renewal of workers’ compensation policies with customers that have reduced their experience modifiers, and it expects to continue to experience this competition.

     Another competitive factor results from the fact that some insured employers will not purchase workers’ compensation products from insurance companies with an A.M. Best rating less than “A”. In addition, certain insurance companies that write umbrella policies will not provide coverage to an employer if a portion of the employer’s underlying insurance policy, such as the workers’ compensation portion, is written by an insurance

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company with a less than “A” rating. The Company believes that its B- letter rating from A.M. Best will make it difficult, in certain instances, for the Company to provide its products to certain employers. Historically, in these instances, the Company competed by writing these employers using an “A” rated insurer’s paper. This process, known as fronting, added additional cost for ACIC but allowed the Company access to markets it may have otherwise not been able to access. The Company does not currently have a fronting arrangement in effect and believes that its ability to find a fronting company at a reasonable cost in 2003 will be difficult.

     The Company’s insurance subsidiary was assigned an initial rating of B++ (Very Good) on a scale of A++ (Superior) to F (In Liquidation) on December 16, 1996. This rating was reaffirmed in April 1999 and June 2000. In June 2001, however, based on 2000 financial results, A.M. Best downgraded the Company’s rating to B+ and, based on financial results in 2001, further downgraded that rating to B- in February 2002. An A.M. Best rating is assigned after an extensive quantitative and qualitative evaluation of the Company’s financial condition and operating performance. A.M. Best ratings are based upon factors of concern to insured’s and are not directed toward the protection of investors. Furthermore, A.M. Best ratings are not ratings of the Company or any of its securities. A.M. Best ratings include Secure Ratings, consisting of A++ and A+ (Superior); A and A- (Excellent); B++ and B+ (Very Good); Vulnerable or Unsecure Ratings, consisting of B and B- (Adequate); C++ and C+ (Fair); C and C- (Marginal); D (Very Vulnerable); E (Under State Supervision); and F (In Liquidation).

Data Management

     During the period 1997 to 2002, the Company contracted with various unrelated third-parties for certain computer information systems and other software licenses. In 1996, the Company developed and implemented its own proprietary claims management and medical fee adjudicating systems to manage claims, audit medical fees, pay claims, provide reports to policyholders and analyze claims data. These systems replaced third-party contracts for claims management and medical fee adjudicating systems. In 1995, the Company developed and implemented its own proprietary policy management system to process insurance applications and issue policies and endorsements. This system replaced a third-party contract for a policy management system. In 1999, the Company developed and implemented its own proprietary billing, cash receipts, collections and agency commission systems. These systems replaced third-party software systems purchased by the Company. These systems continue to be upgraded and maintained by the Company. The Company continues to utilize third party software to maintain financial information, prepare accounting reports and financial statements and pay vendors. The Company also contracts with a third-party provider of payroll services for payroll, benefit and human resource software services. The Company utilizes other licensed software from national vendors to maintain its financial records, file statutory statements with insurance regulators and perform other general business.

Employees

     The Company had 147 full-time employees at December 31, 2002. Of the Company’s employees, approximately 78 work in the Company’s administrative and financial functions and 69 serve on, provide service to or manage approximately 12 different operating teams. None of the Company’s employees are subject to collective bargaining agreements. The Company believes its employee relations are good.

Regulation

     The Company’s insurance subsidiary is subject to substantial regulation by the governmental agencies in states in which it operates, and will be subject to such regulation in any state in which it provides workers’ compensation products and services in the future. State regulatory agencies have broad administrative power with respect to all aspects of the business of the Company, including premium rates, benefit levels, policy forms, dividend payments, capital adequacy and the amount and type of its investments. These regulations are primarily intended to protect covered employees and policyholders rather than the insurance company. Both the legislation covering insurance companies and the regulations adopted by state agencies are subject to change.

     Workers’ compensation coverage is a creation of state law, subject to change by the state legislature, and is influenced by the political processes in each state. Several states have mandated that employers receive coverage only from state operated funds. New laws affecting the workers’ compensation system in Minnesota, Colorado and Michigan and any other state where the Company may operate, including laws that require all employers to participate in state sponsored funds or that mandate premium reductions, could have a material adverse effect on the Company.

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Company Information

     The Company maintains a website at www.rtwi.com. Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and periodic reports on Form 8-K (and any amendments to these reports) will be available free of charge on the Company’s website as soon as reasonably practical but no later then September 30, 2003.

Executive Officers of the Registrant

     The following are the executive officers of the Company at March 28, 2003:

     David C. Prosser is the founder of the Company and current Chairman of the Board since December 2001. Mr. Prosser was previously Chairman of the Board through March 2000, served as President and Chief Executive Officer through January 1998, and has been a Director of the Company since its formation in 1983. From 1965 through 1985, Mr. Prosser was the owner and President of Vocational Personnel Services, Inc., which merged into the Company in 1986.

     J. Alexander Fjelstad rejoined the Company in December 2001 as President and Chief Executive Officer and Director after serving as President and Chief Executive Officer of Headwater Systems, Inc., a manufacturer of radio frequency identification devices, from March 1999 through December 2001. Mr. Fjelstad initially joined the Company in 1989 as a Vice President, served as Chief Operating Officer beginning in 1993 and became Chief Operating Officer - Marketing and Underwriting in October 1996 through his departure in 1998. Mr. Fjelstad was a Director of the Company from 1989 to February 1999. He is a member of the American Institute for Property and Liability Underwriters and holds the CPCU designation.

     Alfred L. LaTendresse rejoined the Company in December 2001 as Executive Vice President and Director after serving as Chief Operations Officer and Chief Financial Officer for Headwater Systems, Inc. from June 1999 to December 2001. Mr. LaTendresse initially joined the Company as Chief Financial Officer in 1990 and later became Secretary and Treasurer. Mr. LaTendresse departed from the Company in December 1998. Mr. LaTendresse served as a Director of the Company from July 1993 until January 1995. Mr. LaTendresse is a member of the American Institute of Certified Public Accountants and the Minnesota Society of Certified Public Accountants.

     Jeffrey B. Murphy joined the Company in October 1994 as Controller and was promoted to Chief Financial Officer in February 2000. Mr. Murphy was the Corporate Controller and held other management positions for Midcontinent Media, Inc. from 1989 to 1994. Prior to that time, Mr. Murphy served in various financial audit positions with Grant Thornton LLP from 1983 to 1989.

     Patricia M. Sheveland was appointed to Vice-President — Case and Claims Management in January 2002. Ms. Sheveland joined the Company in April 1990 and has held various management positions of increasing importance including General Manager of Operations in the Colorado regional office and Director of Operations for the Colorado, Michigan and Massachusetts regions. Prior to joining the Company, Ms. Sheveland worked as an Occupational Nurse for Kmart Corporation.

     Keith D. Krueger joined the Company in September 1998 as the Director of Underwriting and Pricing for the Company’s Minnesota regional office. He was promoted to Director of Underwriting Services for the Company’s Home Office in October 1999 and served in this capacity until being promoted to Vice President - - Underwriting and Sales in March 2002. Prior to joining the Company, Mr. Krueger was a Commercial Lines Underwriting Manager for Citizens Security Mutual Insurance from June 1997 to August 1998. From March 1995 to May 1997, Mr. Krueger was Vice President — Underwriting and Marketing for American West Insurance. He is a member of the American Institute for Property and Liability Underwriters and holds the CPCU designation.

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ITEM 2. PROPERTIES

     The following is a summary of properties leased by the Company at December 31, 2002:

ITEM 3. LEGAL PROCEEDINGS

     In the ordinary course of administering its workers’ compensation management program, the Company is routinely involved in the adjudication of claims resulting from workplace injuries. The Company is not involved in any legal or administrative claims that it believes are likely to have a material adverse effect on the Company’s operations or financial condition.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     None

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

QUARTERLY STOCK PRICE COMPARISON AND DIVIDENDS

     The Company’s shares are publicly traded on The Nasdaq Stock Market under the symbol RTWI. The Company effected a one-for-two reverse-split of its common stock on November 22, 2002. The table below sets forth the range of high and low sales prices for the Company’s stock for each quarter during the past two years. The Company had approximately 2,000 shareholders of its common stock at the close of trading on March 1, 2003.

     The Company has never paid cash dividends on its common stock. The Company currently intends to retain any and all income for use in its business and does not anticipate paying cash dividends in the foreseeable future. Any future determination as to payment of dividends will depend on the financial condition and results of operations of the Company and such other factors deemed relevant by the Board of Directors. Under the terms of its credit agreement, the Company is prohibited from making dividend payments without prior consent of the lender.

ITEM 6. SELECTED FINANCIAL DATA

     The consolidated statements of operations data set forth below for each of the three years in the period ended December 31, 2002, and the consolidated balance sheet data at December 31, 2002 and 2001 are derived from, and are qualified by reference to, the audited consolidated financial statements included elsewhere in this Form 10-K. The consolidated statements of operations data set forth below for the two years in the period ended December 31, 1999, and the consolidated balance sheet data at December 31, 2000, 1999 and 1998, are derived from audited consolidated financial statements not included herein. The information set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and

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the Company’s consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

RTW, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

The Company — RTW, Inc. (RTW) and its wholly owned insurance subsidiary, American Compensation Insurance Company (ACIC), provide disability management services to employers. Collectively, “we,” “our” and “us” refer to these entities in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

     We have developed two proprietary management systems: (i) the RTW SOLUTION®, designed to lower employers’ workers’ compensation costs and return injured employees to work as soon as possible, and (ii) the ID15® system, designed to identify those injured employees who are likely to become inappropriately dependent on the workers’ compensation system. We currently provide workers’ compensation management services to employers insured through our insurance subsidiary and to self-insured employers on a fee-for-service basis.

     During 2002, we operated primarily in Minnesota, Wisconsin, South Dakota, Colorado, Michigan and Indiana. In the fourth quarter of 2001, we closed our regional offices in Missouri (which served Missouri, Illinois and Kansas) and Massachusetts (which served Massachusetts, Connecticut, New Hampshire, Rhode Island and Maine). We did earn premiums from these regional offices in 2002. Collectively, these regional offices had remaining premiums in force totaling $1.4 million at December 31, 2002. We completed running off this business in February 2003.

     On February 28, 2002, our A.M. Best financial rating was downgraded from a Secure rating (B+) to an Unsecure rating (B-) as a result of the decrease in statutory surplus in 2001 from $29.3 million at December 31, 2000 to $19.5 million at December 31, 2001 and our adverse development in 2001 and 2000 that resulted in statutory operating losses in those years. Certain insurance carriers that write umbrella policies will not provide coverage to an employer if a portion of the employer’s underlying insurance policy, such as the workers’ compensation portion, is written by a carrier with an unsecure rating. Additionally, certain of our independent agents may be unwilling to sell our insurance as a result of the downgrade. As a result, we believe that our B- rating from A.M. Best will make it more difficult to provide our products to certain employers. While we believe that the A.M. Best downgrade will result in decreasing premiums in force, the ultimate effect of this downgrade is unknown at this time.

     Additional information about RTW is available on our website, www.rtwi.com.

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Significant Accounting Policies — Our significant accounting policies are summarized in Note 1 — “Summary of Significant Accounting Policies” to our accompanying consolidated financial statements. Our significant accounting policies include those policies related to our accounting for: (i) premiums earned, (ii) unpaid claim and claim settlement expenses, including reserves for incurred but not reported claims, (iii) policy acquisition costs, and (iv) investments. These accounting policies are further discussed in detail within each section of this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Financial Summary — This financial summary presents our discussion and analysis of the consolidated financial condition and results of operations of RTW, Inc. This review should be read in conjunction with the Consolidated Financial Statements at December 31, 2002.

The following table provides an overview of our key operating results (000’s, except per share amounts):

     RTW reported a decrease in gross premiums earned to $62.5 million in 2002 from $97.4 million in 2001. Total revenues decreased significantly in 2002 to $67.1 million from $95.7 million in 2001 due to a decrease in premiums in force related primarily to our regional office closures.

     We reported net income of $14.3 million in 2002 compared to net losses of $25.2 million and $9.7 million in 2001 and 2000, respectively. We reported basic and diluted net income per share of $2.78 in 2002 compared to basic and diluted net losses per share of $4.89 and $1.79 in 2001 and 2000, respectively. The primary factors affecting our 2002 operating results included the following:

	•		Our gross premiums earned decreased in 2002 from 2001, due primarily to a 31.6% decrease in average premiums in force to $65.1 million for 2002 from $95.2 million in 2001;
	•		Premiums earned decreased 30.0% in 2002 from 2001. Premiums earned in 2001 were reduced by premiums ceded under a lower layer excess of loss reinsurance agreement, effective for claims occurring on or after July 1, 1998, that was in runoff in 2001. Premiums ceded in 2001 included $7.9 million in premiums ceded under this lower layer excess of loss reinsurance agreement, compared to $13.4 million ceded in 2000. No premiums were ceded under this agreement in 2002. Additionally, 2002 premiums ceded were reduced by $1.4 million resulting from a change in cost related to excess of loss reinsurance in Minnesota;
	•		Claim and claim settlement expenses decreased significantly to 67.3% of premiums earned for 2002 from 93.1% for 2001. See further discussion under “Claim and Claim Settlement Expenses;”
	•		In our 2001 Report on Form 10-K/A, we revised the accounting for our contract with St. Paul Re (SPR), which was originally accounted for under reinsurance accounting standards using deposit accounting standards, and restated our 2001 financial statements. We further terminated this contract with SPR in December 2002 and were refunded $28.8 million, resulting in a $1.0 million gain recorded in December 2002. Deposit accounting for this contract required us to record a margin expense at 4.75% of premiums ceded to SPR and interest income on the fund balance at an amount equal to the quarter-end U.S. Treasury Bill rate less 25 basis points. The deposit accounting change caused a decrease in premiums ceded and an increase in investment income, claim and claim settlement expenses, policy acquisition costs and general and administrative expenses from the amounts originally reported in 2001. As a result, the accounting for this contract increased net income by $354,000 in 2002 after reducing interest income and the gain on termination by the margin expense, and an increase in the 2001 net loss by $1.5 million; and
	•		At December 31, 2001, we established a $14.5 million valuation allowance against deferred tax assets resulting in a corresponding increase in income tax expense. This valuation allowance decreased to $6.6 million at December 31, 2002. The $7.9 million decrease in the valuation allowance favorably affected our income tax expense in 2002. See further discussion under “Income Taxes.”

     We expect 2003 premiums in force to increase slightly from levels in 2002. We also anticipate that we will

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continue to operate in an environment of premium rate increases in 2003; however, these rate increases will be significantly lower than experienced in 2002, 2001 and 2000. We will focus on achieving profitability in our remaining regional markets by: (i) aggressively managing and closing claims, (ii) reviewing policy profitability at renewal and removing unprofitable accounts, and (iii) aggressively managing policy acquisition costs and general and administrative expenses.

     In the following pages, we take a look at the 2002, 2001 and 2000 operating results for items in our Consolidated Statement of Operations and also explain key balance sheet accounts in greater detail.

RESULTS OF OPERATIONS

Total revenues: Our total revenues include premiums earned, investment income, net realized investment gains (losses) and other income. The following table summarizes the components of our revenues and premiums in force (000’s):

Premiums In Force and Gross Premiums Earned: Premiums on workers’ compensation insurance policies are our largest source of revenue. Premiums earned are the gross premiums earned by us on in force workers’ compensation policies, net of the effects of ceded premiums under reinsurance agreements.

     The premium we charge a policyholder is a function of its payroll, industry and prior workers’ compensation claims experience. In underwriting a policy, we receive policyholder payroll estimates for the ensuing year. We record premiums written on an installment basis matching our billing to the policyholder and earn premiums on a daily basis over the life of each insurance policy based on the payroll estimate. We record the excess of premiums billed over premiums earned for each policy as unearned premiums on our balance sheet. When a policy expires, we audit employer payrolls for the policy period and adjust the estimated payroll and the policyholder’s premium to its actual value. The result is a “final audit” adjustment recorded to premiums earned when the adjustment becomes known. Final audit premiums recognized during the period include billed final audit premiums plus (or minus) the change in estimate for premiums on unexpired and expired unaudited policies.

     Our premiums in force decreased 35.2% to $54.2 million at December 31, 2002 from $83.7 million at December 31, 2001 due to decreases in premiums in force in all of our markets, but primarily the result of closing our Missouri and Massachusetts regional offices. Average premiums in force decreased to $65.1 million in 2002 from $95.2 million in 2001 and $90.9 million in 2000. In order to improve profitability, we aggressively targeted policies that did not meet our underwriting profit margin standards for non-renewal or re-underwriting at increased rates at policy expiration in 2002, 2001 and 2000. Our average annual premium per policy increased to $80,400 in 2002 from $56,800 in 2001 and $40,500 in 2000 as a result of the focused aggressive re-underwriting in 2001 and 2000.

     Our gross premiums earned decreased 35.8% to $62.5 million in 2002 from $97.4 million in 2001. This decrease resulted primarily from: (i) the decrease in average premiums in force, and (ii) final audit premiums which

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decreased gross premiums earned by $1.7 million in 2002 and increased gross premiums earned by $1.8 million in 2001.

     Gross premiums earned increased 1.6% to $97.4 million in 2001 from $95.9 million in 2000. This increase resulted from: (i) the increase in average premiums in force, offset by (ii) a decrease in final audit premiums that increased gross premiums earned by $1.8 million in 2001 compared to $5.5 million in 2000.

     In 2002, 2001 and 2000, we were able to increase premium rates on renewing policies an average of 9.0%, 18.5% and 11.7%, respectively. We have been able to increase premium rates in our markets due to the following:

	•		Many workers’ compensation insurers have withdrawn from the markets in which we write premiums as profitability diminished in the workers’ compensation insurance line;
	•		Reinsurance rates for workers’ compensation insurers have increased due to: (i) reductions in reinsurer’s surplus as a result of the September 11, 2001 terrorist acts against the United States, (ii) recent unprofitability resulting from highly competitive reinsurance pricing, and (iii) settlements related to certain reinsurance treaties written in the late 1990’s. These rate increases have resulted in increased costs for workers’ compensation insurers. Insurers, including RTW, have raised premium rates to offset these increases in reinsurance premiums; and
	•		A number of workers’ compensation insurers’ financial ratings have decreased due to reserve adjustments recorded in 2002, 2001 and 2000.

Premiums Ceded: Reinsurance agreements allow us to share certain risks with other insurance companies. We purchase reinsurance to protect us from potential losses in excess of the level we are willing to accept. We expect the companies to which we have ceded reinsurance to honor their obligations. In the event that these companies are unable to honor their obligations to us, we will be required to pay these obligations ourselves. We are not aware of any developments with respect to our reinsurers that would result in uncollectible reinsurance balances.

     Under our excess of loss reinsurance policies, we pay reinsurers to limit our per-incident exposure and record this cost to premiums ceded as a reduction of gross premiums earned. In Minnesota, we are required to purchase excess of loss coverage for our Minnesota policies from the Minnesota Workers’ Compensation Reinsurance Association (WCRA). In 2002, we ceded Minnesota claims in excess of $350,000 per occurrence to the WCRA; in 2001 and 2000, we ceded Minnesota claims in excess of $330,000 and $310,000, respectively to the WCRA. The per-occurrence coverage level increased to $360,000 in 2003. In our non-Minnesota states, we maintained excess of loss coverage with a per-incident exposure of $300,000 since 1999. We purchased this non-Minnesota coverage from a single reinsurer. In 2002, the non-Minnesota excess of loss coverage no longer included statutory limit coverage and was capped at $20.0 million per occurrence and further excluded claims resulting from acts of terrorism. In 2003, our non-Minnesota per-incident excess of loss coverage increased to $360,000, continues to be capped at $20.0 million per occurrence and further excludes claims resulting from acts of terrorism. We further decreased our retention to $200,000 per-incident in all our regions in 2003 by purchasing increased excess of loss reinsurance in order to further reduce volatility in our results. This coverage was purchased from three reinsurers.

     For claims occurring after June 30, 1998 through policy termination on December 31, 2000, and on a runoff basis into 2001, we further limited our per incident exposure by purchasing excess of loss coverage for losses from $25,000 to the lesser of $300,000 or the WCRA selected retention level in Minnesota and from $25,000 to $300,000 in other states from a single reinsurer. This agreement was finalized after its effective date and activity occurring from July 1, 1998 through September 30, 1998 was recorded on a retrospective basis resulting in the deferral of a gain totaling $2.0 million at December 31, 1998. We amortized $400,000 of the deferred gain as a reduction of claim and claim settlement expenses in each of 2002, 2001 and 2000 and $740,000 in 1999 resulting in an un-amortized deferred gain of $49,000 at December 31, 2002. The deferred gain is being amortized into income using the effective interest rate inherent in the amounts paid to the reinsurer and the estimated timing and amounts of recoveries from the reinsurer. Activity occurring on or after October 1, 1998 is recorded prospectively. This contract was terminated effective December 31, 2000; however the policy remained in effect in 2001 for policies in force at December 31, 2000 through expiration, not to exceed fifteen months after the effective termination date. Policies written or renewing after December 31, 2000 are not covered under this lower-level excess of loss reinsurance policy.

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     The following table summarizes the components of premiums ceded (000’s):

     Premiums ceded to reinsurers decreased to $2.2 million in 2002 from $11.4 million in 2001. The decrease in premiums ceded, resulted primarily from: (i) a $7.3 million reduction in premiums ceded under our $25,000 to $300,000 excess of loss reinsurance policy, (ii) a $1.4 million reduction in excess of loss premiums ceded resulting from a change in estimated reinsurance cost for Minnesota excess of loss reinsurance, and (iii) a decrease in gross premiums earned offset by an increase in non-Minnesota excess of loss costs in 2002.

     Premiums ceded to reinsurers decreased to $11.4 million in 2001 from $17.7 million in 2000. The decrease in premiums ceded resulted primarily from the run-off of premiums ceded under our $25,000 to $300,000 policy.

2003 Outlook: The 2003 outlook for premiums in force, gross premiums earned and premiums ceded include the following factors:

	•		We expect that our B- A.M. Best rating and the final runoff of in force premiums in our Massachusetts and Missouri regions will put downward pressure on premiums in force in 2003. Premium rates are expected to be relatively flat on new and renewing policies as we filed our rates at the high end in each region in which we operate in 2002, leaving little room to further increase rates in 2003. Premium rate increases realized in 2002 will continue to favorably affect profitability on each account in 2003 as we earn more premium on those policies. We expect to further improve our agency relationships in 2003 resulting in new business increases primarily in our Minnesota and Michigan regions. Overall, we expect premiums in force to increase only slightly;
	•		Our 2002 gross premiums earned include $7.9 million in premiums earned from our Missouri and Massachusetts regions that were in runoff in 2002. Premiums earned in these regions are expected to be less than $100,000 in 2003. Additionally, we expect our average premiums in force to decrease significantly in 2003 compared to 2002. Overall, we expect gross premiums earned to decrease significantly in 2003; and
	•		Premiums ceded under excess of loss policies will increase significantly as a percent of gross premiums earned when compared to the results attained for 2002. This increase is the result of two factors: (i) our cost for excess of loss reinsurance coverage in our non-Minnesota regions increased substantially for 2003 while our Minnesota cost decreased only slightly, and (ii) we decreased our retention to $200,000 in all our regions in 2003 by purchasing increased excess of loss coverage in order to further reduce volatility in our results.

Investment Income and Net Realized Investment Gains (Losses): Our investment income includes earnings on our investment portfolio and interest on our deposit receivable. Our net realized investment gains (losses), displayed separately on our accompanying Consolidated Statements of Operations, include gains and losses from sales of securities. Through January 2001, we invested entirely in U.S. domiciled investment-grade taxable and tax-exempt fixed maturity investments. In February 2001, we repositioned our portfolio, sold our tax-exempt securities, and purchased taxable securities to take advantage of our net operating loss carry-forward generated in 2000 and to maximize the after-tax yield of our investment portfolio. We realized investment gains totaling $1.1 million as a result of this repositioning. In February 2002, we sold certain securities within the portfolio and realized investment gains totaling $1.5 million to increase statutory surplus. In September 2002, we sold our corporate securities to further reduce risk in our portfolio and realized net investment gains of $354,000 in the third quarter of 2002. Further recognition of realized investment gains and losses will depend on sales of our investments, if any, to meet our short-term cash requirements or as we replace securities to manage our portfolio returns. We currently invest entirely in U.S. domiciled investment-grade taxable fixed maturity investments and classify our investments as available-for-sale. We intend to hold our available-for-sale investments to maturity, but may sell them before maturity in response to tax planning considerations, changes in interest rates, changes in prepayment risk and changes in funding sources or terms, or to address liquidity needs. Our primary investment objective is to maintain a

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diversified, high-quality, fixed-investment portfolio structured to maximize our after-tax investment income without taking inappropriate credit risk. For further discussion of investments, see the “Investments” section of this Management’s Discussion and Analysis.

     Investment income decreased to $5.1 million in 2002 from $6.4 million in 2001. Investment income decreased as our invested assets decreased to $81.4 million at December 31, 2002 from $89.2 million at December 31, 2001 and our investment yields decreased as we moved out of corporate securities in 2002 and reinvested in lower yielding securities due to changes in market interest rates and our desire to lower risk by buying higher rated government and mortgage-backed securities. This decrease was partially offset by an increase in interest earned on our deposit receivable to $736,000 in 2002 from $518,000 in 2001. Our invested assets decreased due to decreases in operating cash flow in 2002 and 2001, resulting primarily from: (i) reduced premiums in force and premiums written, (ii) timing differences between paying premiums ceded and recovering paid claim and claim settlement expenses, (iii) the receipt of premiums and the payment of claim and claim settlement expenses, and (iv) net cash provided by lower investment income. Investment yields decreased to 4.9% for 2002 from 6.1% for 2001. The investment yields realized in future periods will be affected by yields attained on new investments.

     Investment income increased to $6.4 million in 2001 from $5.8 million in 2000. Investment income increased as a result of repositioning our portfolio entirely into taxable securities that earn a higher pre-tax rate of return offset by a reduction in our invested assets to $89.2 million at December 31, 2001 from $96.8 million at December 31, 2000 and further includes interest on our deposit receivable totaling $518,000 for 2001. Invested assets decreased due to decreased operating cash flow, resulting primarily from: (i) the difference in timing between the receipt of premiums, the payment of premiums ceded under our reinsurance agreements, the payment of claim and claim settlement expenses and the recovery of paid claim and claim settlement expenses under our reinsurance programs, and (ii) net cash provided by investment income. Tax-adjusted investment yields were 6.1% in 2001 compared to 6.6% in 2000. The investment yields realized in future periods will be affected by yields attained on new investments.

     Net realized investment gains were $1.7 million in 2002 that resulted from sales of securities in February 2002 as well as repositioning out of corporate securities in September 2002. Net realized investment gains were $1.2 million in 2001 and resulted primarily from our portfolio repositioning out of taxable securities in February 2001. Net realized investment losses were $607,000 in 2000 and included $500,000 for the write-down of a security whose decrease in value was deemed other than temporary.

2003 Outlook: Barring significant changes in interest rates or operational cash flows, we expect that income from our investment portfolio for 2003 will be affected by the following:

	•		The increase in our funds available for investment as a result of the $28.8 million of cash received in December 2002 from terminating the St. Paul Re contract;
	•		We earned $736,000 in interest on our deposit receivable in 2002. There will be no interest earned on the deposit in 2003 due to our terminating the St. Paul Re contract;
	•		Funds from our operating cash flows and investment cash flows historically provided growth in our investment portfolio; however, these net cash flows will decrease as we focused on closing claims from prior years, years in which premiums were higher and more claims were reported, paying to close those claims. Cash flows for 2003 are expected to be adversely affected by decreases in cash flows resulting from claim payments on claims from 2002 and prior years exceeding cash flows from our premiums as we reduce our premiums earned in 2003;
	•		Further recognition of realized investment gains and losses will depend on sales of our investments, if any, to meet our short-term cash requirements or as we replace securities to manage our portfolio returns; and
	•		New and renegotiated reinsurance treaties may affect our future cash flow and future investment income.

Other Income: We recorded and received a refund totaling $2.1 million from the WCRA in 2001. The WCRA periodically reviews its surplus position and refunds excess surplus to its members. This refund represents our share of the excess surplus of the WCRA at December 31, 2000. No such refund was received in 2002. We do, however, expect that fee-for service revenues will increase substantially in 2003 from the $22,000 realized in 2002.

Total Expenses: Our expenses include claim and claim settlement expenses, policy acquisition costs, general and administrative expenses, interest expense and income taxes.

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Claim and Claim Settlement Expenses: Claim expenses refer to medical and indemnity benefits that we paid or expect to pay to claimants for events that have occurred. The costs of investigating, resolving and processing these

claims are referred to as claim settlement expenses. We record these expenses, net of amounts recoverable under reinsurance contracts, to claim and claim settlement expenses in the accompanying Consolidated Statements of Operations.

     Claim and claim settlement expenses are our largest expense and result in our largest liability. We establish reserves that reflect our estimates of the total claim and claim settlement expenses we will ultimately have to pay under our workers’ compensation insurance policies. These include claims that have been reported but not settled and claims that have been incurred but not yet reported to us. For further discussion of reserve determination, see the “Unpaid Claim and Claim Settlement Expenses and Reinsurance Recoverables” section of this Management’s Discussion and Analysis.

     We experienced a significant decrease in the estimated number of ultimate claims for 2002 compared to 2001 and 2000. The number of estimated ultimate claims by accident year decreased to approximately 11,500 in 2002 from 22,100 in 2001 and 28,300 in 2000. The net decrease correlates directly to: (i) the decrease in premiums in force, and (ii) the re-underwriting that we completed with respect to our in force policies in 2000 and 2001. The gross and net average estimated cost per claim totaled approximately $5,500 and $4,900 in 2002 compared to $4,500 and $3,400 in 2001 and $4,000 and 2,400 in 2000, respectively. The increases in gross and net average estimated cost per claim are primarily the result of increases in severity, (i.e., the average cost of a claim), caused mainly by inflationary pressures. The trend of increasing severity is attributable to a combination of factors that include increasing medical costs and increasing indemnity payments (reimbursements to injured workers for lost wages) per claim. We have also observed a decline in the number of claims being reported over the last several years. The declining frequency of claims contributes to the increasing severity trend because the frequency decline has been concentrated in less expensive claims (claims involving less time-off from work and less severe injuries).

     The number of claims reported but unpaid (open claims) and the approximate average gross and net reserves on these claims each period was: 2002 — 1,381 claims, $9,700 average gross reserve, $9,000 average net reserve; 2001 — 670 claims, $26,900 average gross reserve, $17,500 average net reserve; and 2000 - 344 claims, $46,400 average gross reserve, $9,600 average net reserve. The average gross and net reserves per claim are less in 2002 than in 2001 and 2000 as the open claims include newly reported claims from the later half of 2002, including many with much lower severity that have not had time to close, as well as new claims that are anticipated but not yet reported. The remaining open claims from 2001 and 2000 are primarily claims with significant injury characteristics resulting in the increase in outstanding average gross and net reserves per claim.

     Claim and claim settlement expenses decreased significantly to $40.5 million in 2002 from $80.1 million in 2001. As a percent of premiums earned, claim and claim settlement expenses decreased to 67.3% in 2002 from 93.1% in 2001. These changes are due to the following:

	•		Gross premiums earned decreased significantly due to: (i) decreased premiums in force, and (ii) final audit premium reductions totaling $1.7 million in 2002 compared to an increase in premiums earned due to final audits of $1.8 million in 2001, resulting in corresponding decreases in claim and claim settlement expenses and a distorted percent of gross premiums earned;
	•		The 2002 results include an $8.4 million decrease in prior years’ reserves for unpaid claim and claim settlement expenses compared to the 2001 results which include a $7.7 million increase in prior years’ reserves for unpaid claim and claim settlement expenses. Our estimate for unpaid claim and claim settlement expenses decreased in 2002 due to the following: (i) in March 2002, the Minnesota State legislature changed the way the commissioner will assess self-insured employers and insurers for estimated liabilities and administrative expenses of the State’s Special Compensation Fund (SCF). The assessment changed from being paid by the insurer on indemnity payment basis to an assessment charged on premium to the policyholder. We decreased our recorded accrual to reflect this legislative change, (ii) the frequency of claims reported in 2002 for 2001 and prior years was less than anticipated when we determined our liability in 2001, (iii) we overestimated the liability for our mandatory participation in state and national assigned risk pool operating results for states in which we operate in 2001 and reversed that excess in 2002, and (iv) our estimate of the liability for unpaid claim and claim settlement expenses is difficult and volatile due to our relatively limited historical claim data and small claim population;
	•		We recorded estimates of ceded paid and unpaid claim and claim settlement expenses under our $25,000 to $300,000 excess of loss reinsurance agreement totaling $15.2 million in 2001 resulting in a corresponding reduction in 2001 claim and claim settlement expenses. No such benefit was recorded in 2002;

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	•		We increased renewal premium rates an average of 9.0% in 2002 and 18.5% in 2001 compared to premium rates for the same periods in 2001 and 2000, respectively, reversing a trend of continued rate declines during years prior to 2000. Increases in premium rates have the effect of reducing the ratio of claim and claim settlement expenses to gross premiums earned as losses do not increase with premium rate increases; and
	•		Claim costs continued to reflect increasing medical and indemnity costs in accident year 2002 as compared to accident year 2001 resulting from inflationary pressures.

     Claim and claim settlement expenses increased to $80.1 million in 2001 from $72.4 million in 2000. As a percent of premiums earned, claim and claim settlement expenses increased slightly to 93.1% in 2001 from 92.7% in 2000. These changes are due to the following:

	•		The 2001 results include a $7.7 million increase in prior years’ reserves for unpaid claim and claim settlement expenses compared to the 2000 results which include a $15.9 million increase in prior years’ reserves for unpaid claim and claim settlement expenses. Our estimate for unpaid claim and claim settlement expenses increased in 2001 due to the following: (i) we increased the estimated liability for second injury funds and our mandatory participation in state and national assigned risk pool operating results for states in which we operate, (ii) our estimate of the liability for unpaid claim and claim settlement expenses is difficult and volatile due to our relatively limited historical claim data and small claim population, and (iii) we increased the estimated liability for claims in our closed Missouri and Massachusetts regions;
	•		We recorded estimates of ceded paid and unpaid claim and claim settlement expenses under our $25,000 to $300,000 excess of loss reinsurance agreement totaling $15.2 million in 2001 including $400,000 amortized from a deferred retrospective reinsurance gain resulting in a corresponding reduction in 2001 claim and claim settlement expenses. These amounts compare to our 2000 results which include an estimate of ceded paid and unpaid claim and claim settlement expenses totaling $21.8 million and $400,000 amortized from the deferred retrospective reinsurance gain;
	•		We increased renewal premium rates an average of 18.5% in 2001 and 11.7% in 2000 compared to premium rates for the same periods in 2000 and 1999, respectively, reversing a trend of continued rate declines during years prior to 2000. Increases in premium rates have the effect of reducing the ratio of claim and claim settlement expenses to gross premiums earned as losses do not increase with premium rate increases; and
	•		Claim costs continued to increase in 2001, 2000 and 1999 due to increasing medical and indemnity costs. These increases were offset somewhat by the effects of provider agreements that we negotiated during 1998.

2003 Outlook: We expect that claim and claim settlement expenses will be affected by the following factors:

	•		Claim costs will continue to be affected by: (i) increases in medical and indemnity costs resulting from inflationary changes, (ii) severity experienced in future periods in our policy holder base, (iii) changes resulting from increases in operating efficiency and effectiveness realized through enhancements to our internal processes and procedures, including changes to our proprietary computer systems, and (iv) legislative changes that affect benefits payable under workers’ compensation laws;
	•		Increases in premium rates, if any in 2003, will result in increasing premiums earned without a corresponding increase in claim and claim settlement expenses, ultimately decreasing claim and claim settlement expense as a percent of premiums earned. Changes in premium rates due to legislative changes in estimated loss costs, increased competition and improving customer loss experience may offset rate improvements; and
	•		Continued application of our claims management technology and methods to all open claims.

The ultimate result of the above factors on 2003 claim and claim settlement expenses as a percent of premiums earned is unknown at this time.

Policy Acquisition Costs: Policy acquisition costs are costs directly related to writing an insurance policy and consist of commissions, state premium taxes, underwriting personnel costs and expenses, sales and marketing costs and other underwriting expenses less ceding commissions from our reinsurers. Ceding commissions are amounts that reinsurers pay to us for placing reinsurance with them. Under our 1992 to 1994 quota share reinsurance agreement,

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the ceding commission is adjusted to the extent that actual claim and claim settlement expenses vary from levels specified in the agreements.

The following table summarizes policy acquisition costs (000’s):

     Policy acquisition costs decreased to $6.3 million in 2002 from $14.0 million in 2001 and $14.1 million in 2000. As a percent of gross premiums earned, policy acquisition costs decreased to 10.1% in 2002 compared to 14.4% in 2001 and 14.7% in 2000. The decrease in 2002 reflects the following:

	•		Gross premiums earned decreased significantly in 2002 compared to 2001 and 2000 resulting in corresponding decreases in policy acquisition costs;
	•		Commission expense decreased to 6.9% of gross premiums earned in 2002 from 7.6% in 2001 and 7.9% in 2000. The decreased commission percentages in 2002 and 2001 are the result of: (i) a focus on reducing commissions paid on new business in our non-Minnesota regions, and (ii) increased renewal premiums on which we pay lower commission rates in all our states. In 2002, our renewal business, on which we pay lower commission rates, significantly outpaced our new business. In all of our markets, we believe the commission rates we pay are marketplace competitive;
	•		Premium tax expense decreased slightly to 1.7% of gross premiums earned in 2002 from 1.9% of gross premiums earned in 2001 and 2.0% in 2000;
	•		Other policy acquisition costs decreased to 1.5% of gross premiums earned in 2002 compared to 4.6% in 2001 and 4.4% in 2000. Other policy acquisition costs reflect the benefit of the following: (i) improvements in our underwriting organizational structure resulting in a $1.1 million decrease in personnel costs, overhead costs and marketing costs, (ii) an $851,000 reduction in an estimated accrual for second injury funds compared to recording an adjustment for those funds in 2001, and (iii) a general decrease related to the decrease in gross premiums earned; and
	•		We incurred ceding commission expense resulting from adjustments to claim and claim settlement expense estimates for 1992 to 1994 totaling $260,000 in 2001 and $460,000 in 2000. No such expense was recorded in 2002.

2003 Outlook: We expect that policy acquisition costs in 2003 will increase as a percent of gross premiums earned to levels consistent with 2001 and 2000 as we expect no second injury fund accrual reversals in 2003.

General and Administrative Expenses: Our general and administrative expenses include personnel costs, office rent, certain state administrative charges based on premiums and other costs and expenses not specific to claim and claim settlement expenses or policy acquisition costs.

     Our general and administrative expenses decreased to $10.0 million in 2002 from $17.4 million in 2001 and $11.5 million in 2000. As a percent of gross premiums earned, general and administrative expenses decreased to 16.0% in 2002 from 17.9% in 2001 and increased from 12.0% in 2000. General and administrative expenses decreased in 2002 as follows: (i) general and administrative expenses included costs related to operating our Missouri and Massachusetts offices in 2001; no such expense was recorded in 2002, (ii) we recorded $1.4 million in margin expenses related to our St. Paul Re contract offset by a $1.0 million gain recorded on the termination of the contract in 2002 compared to $2.0 million recorded in margin expenses in 2001 on the contract, (iii) we recorded $2.0 million in restructuring charges related to closing our regional offices in Missouri and Massachusetts and closing satellite offices in Brainerd, Minnesota and Overland Park, Kansas in 2001; no such costs were recorded in 2002, (iv) assessments by state Insurance Guarantee Associations (IGA) totaling $266,000 in 2002 compared to $1.1 million in 2001 and $236,000 in 2000, (v) we incurred one-time business repositioning costs totaling $470,000 in 2001, (vi) we recorded bonuses of $864,000 in 2002 compared to $204,000 in 2001, and (vi) we expensed $270,000 in leasehold improvement write-offs related to rebuilding our Minnesota and home office leased space in

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2002. After adjusting for these items, general and administrative expenses increased as a percent of gross premiums earned to 13.1% in 2002 from 11.9% in 2001 and 11.8% in 2000. These increases reflect:

	•		General and administrative expenses increased as a percent of premiums earned, after adjusting for restructuring charges, IGA assessments and one-time charges as we had less revenue relative to our fixed operating costs and expenses. We aggressively managed personnel and other operating costs and expenses during 2002 to appropriately align operating expenses with revenues. All expenses continue to be managed aggressively and reduced where appropriate;
	•		A reduction and renegotiation of our Corporate and Minnesota office space that resulted in a decrease in related office expenses beginning in October 2002; and
	•		During the fourth quarter of 2001, we recorded pre-tax restructuring charges totaling $2.0 million to general and administrative expenses in the Consolidated Statements of Operations. These charges included costs associated with our decision to close our Missouri and Massachusetts regional offices, as well as our Brainerd, Minnesota and Overland Park, Kansas satellite offices. We anticipated that 38 employees in our regional offices, 17 employees in our satellite offices and 2 employees in our Home Office would be affected by these closures. The restructuring charge amount included $715,000 of severance pay and benefits of which $106,000 was paid in 2001 and the remainder was paid in 2002. Additionally, the restructuring charge included office and equipment lease costs totaling $684,000 of which $80,000 was paid in 2001 and an additional $195,000 was paid in 2002, and furniture and equipment disposals and other costs totaling $600,000, of which $53,000 was disposed in 2001 and the remainder was disposed in 2002. The remaining accrual balance for severance pay and benefits, office and equipment lease costs and furniture and equipment disposals and other costs was $409,000 and $1.8 million at December 31, 2002 and 2001 respectively.

2003 Outlook: We expect that general and administrative expenses will be affected by the following:

	•		We have historically managed personnel and other operating costs and expenses to keep operating expenses in line with revenues. All expenses will continue to be aggressively managed and reduced where appropriate;
	•		We have no plans to open additional state offices in 2003 and expect to further reduce overhead costs in 2003 as a result of our office closures in 2001 and runoff in 2002. We will continually monitor reported claim counts for 2003 and re-examine staffing needs as necessary; and
	•		We reduced and renegotiated lease costs for our Corporate and Minnesota office space and expect that related office expenses will decrease in 2003.

Interest Expense: We incurred interest charges on our Term Loan in 2002, 2001 and 2000.

     The Term Loan accrues interest, payable quarterly. We may elect to pay an adjusted LIBOR or bank reference rate on the Term Loan. We paid interest at rates ranging from 4.61% to 5.33% on the outstanding balance of our Term Loan in 2002 compared to 6.50% to 8.83% in 2001. Interest expense decreased to $163,000 in 2002 from $511,000 in 2001 as a result of the decrease in interest rates, $3.3 million in principal payments in 2002 and $2.5 million in principal payments in 2001.

     We paid interest at rates ranging from 6.50% to 8.83% on the outstanding balance of our Term Loan in 2001 compared to 8.68% to 9.34% in 2000. Interest expense decreased to $511,000 in 2001 from $667,000 in 2000 as a result of the change in interest rates and $2.5 million in principal payments on the note in 2001.

2003 Outlook: Interest expense is expected to decrease in 2003 as a result of the $3.3 million in principal payments made in 2002. Total interest expense is expected to decrease to approximately $55,000 in 2003 from $163,000 in 2002 as a result of principal reductions in 2002. The remaining principal is due in 2003.

     Income Taxes: We incur federal income taxes on our combined service organization (RTW) operations and insurance (ACIC) operations. We incur state income taxes on the results of our service organization’s operations and incur premium taxes in lieu of state income taxes for substantially all of our insurance operations. In certain instances, we may incur state income taxes on our insurance operations. Additionally, certain provisions of the Internal Revenue Code adversely affect our taxable income by accelerating recognition and payment of income taxes. Adjustments to book income generating current tax liabilities include limitations on the deductibility of

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unpaid claim and claim settlement expenses, limitations on the deductibility of unearned premium reserves and limitations on deductions for bad debt reserves.

     In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. We consider recent operating results, the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. At December 31, 2001, we established a $14.5 million valuation allowance (allowance) against deferred tax assets resulting in a corresponding increase in income tax expense as a result of this analysis. This allowance decreased by $7.9 million to $6.6 million at December 31, 2002 as a result of the income we earned in 2002 and federal tax refunds totaling $3.8 million resulting from a change in Federal tax law. We expect any remaining deferred tax assets, net of the allowance, at December 31, 2002, to be realized as a result of the future income and the reversal of existing taxable temporary differences. No allowance was provided against the deferred tax assets in 2000.

     Under the first provision of the Job Creation and Worker Assistance Act of 2002, signed into law in March 2002, we were allowed to carry-back our 2001 net operating loss for five years, to 1996, instead of two years under previous law. We filed our tax return in September 2002, and received a refund totaling approximately $3.3 million as a result of this Federal legislative change from carrying-back our 2001 loss. An additional $475,000 receivable was recorded that related to the carry back that resulted from revising our financial statements for 2001.

     Income tax benefit for the year ended December 31, 2002 included the following: (i) a $3.8 million benefit from carrying back our 2001 loss five years under the tax law change, (ii) a $4.0 million benefit resulting from reducing the allowance as we realized favorable claim reserve development in 2002, and (iii) a further benefit as we offset current year earnings by losses carried forward from 2000. The income tax benefit for 2002 included the items recorded in the third quarter as well as a $1.0 million benefit from reducing the allowance related to recognizing a $3.0 million benefit from the SCF. After excluding the effects of the benefits from reducing the allowance, income tax expense was $3.8 million for 2002 compared to an income tax benefit of $5.6 million for 2001. As a percent of income before income taxes, the income tax expense before any benefit from reducing the allowance was 37.1% of the income before income taxes in 2002 compared to 34.5% and 37.2% of the net loss before income taxes in 2001 and 2000, respectively.

2003 Outlook: Income tax expense will vary based on: (i) the income from operations we recognize for 2003, and (ii) the changes in our analysis of the valuation allowance necessary during 2003. The ultimate change is unknown at this time.

INVESTMENTS

Our portfolio of fixed maturity securities at December 31, 2002 included only U.S. government securities (59.0%), mortgage-backed securities (39.8%), and asset-backed securities (1.2%). Our portfolio is managed by an independent investment manager to maximize our after-tax investment income without taking inappropriate credit risk. In September 2002 we sold our corporate securities to reduce risk in our portfolio resulting in a $354,000 gain. In February 2002, we sold select securities within the portfolio and realized an additional investment gain totaling $1.5 million to increase our statutory surplus. In February 2001, we recognized gains totaling $1.1 million as we repositioned our portfolio by selling our tax-exempt securities and repurchased taxable fixed maturity investments to increase our after-tax yield. We conservatively manage our fixed maturity portfolio, investing only in investment grade (BBB or better rating from Standard and Poor’s) securities of U.S. domiciled issuers. All securities in our portfolio were rated AAA at December 31, 2002. We do not invest in derivative securities.

     Operating cash flows consist of the deficit or excess of premiums collected over claim and claim settlement expenses paid reduced by payments for reinsurance premiums as well as other operating expenses paid. Investment cash flows consist of income on existing investments and proceeds from sales and maturities of investments. Prior to 1999, we generated positive net cash flows from operations due, in part, to timing differences between the receipt of premiums and the payment of claim and claim settlement expenses. These net cash flows decreased significantly in 2001, 2000 and 1999 as we focused on closing old claims by paying earlier to close those claims. Combined with relatively flat premiums in force in 1998, 1999 and 2000 and decreasing premiums since that time, our cash flows from differences in timing have decreased. Additionally, as we lowered our reinsurance retention levels to $25,000 in mid-1998, we decreased our current period cash flows as a result of “pre-funding” quarterly reinsurance premiums under that agreement. Reinsurance reimbursements from our $25,000 to $300,000 excess of loss reinsurance agreement offset similar payments to claimants for those years in 2002. Our investment portfolio decreased $7.8 million to $81.4 million at December 31, 2002 from $89.2 million at December 31, 2001, as a result of these factors. The cash balance at December 31, 2002 included $28.8 million received from St. Paul Re from terminating the

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contract late in December 2002. We invested this cash in January 2003. We expect that cash will decrease in 2003 as we pay claims for 2002 and prior years, years in which we earned higher premiums and incurred a higher number of claims reported while 2003 premiums earned are expected to decrease.

     We record investments on our balance sheet at fair value, with the corresponding appreciation or depreciation from amortized cost recorded in shareholders’ equity as other comprehensive income, net of taxes. Because value is based on the relationship between the portfolio’s stated yields and prevailing market yields at any given time, interest rate fluctuations can have a swift and significant impact on the carrying value of these securities. As a result of classifying our securities as available-for-sale, and thus carrying them at fair value, we expect to encounter adjustments in shareholders’ equity as market interest rates and other factors change. In 2000, we recorded a $500,000 write-down of a security held in our portfolio as we deemed its decline in fair value to be other than temporary in nature. This security was sold in January 2002 and the proceeds exceeded the adjusted cost basis resulting in a net realized gain of $300,000. Prevailing market interest rates decreased since December 31, 2001, and when combined with the sale of select securities to realize gains to increase statutory surplus, resulted in a $3.4 million unrealized gain on investments in 2002 compared to a $1.4 million unrealized gain in 2001.

UNPAID CLAIM AND CLAIM SETTLEMENT EXPENSES AND REINSURANCE RECOVERABLES

At December 31, 2002, the liability for unpaid claim and claim settlement expenses totaled $181.3 million and reinsurance recoverables on unpaid claim and claim settlement expenses totaled $91.8 million, resulting in net reserves totaling $89.4 million. The net reserve at December 31, 2001 totaled $91.2 million and included the liability for unpaid claim and claim settlement expenses totaling $181.3 million net of reinsurance recoverables on unpaid claim and claim settlement expenses of $90.1 million.

     Accounting for workers’ compensation insurance operations requires us to estimate the liability for unpaid claim and claim settlement expenses (“reserves”) and the related reinsurance recoverables, (together, the “net reserves”) at each balance sheet date. Our reserves represent the estimated total unpaid cost of claim and claim settlement expenses, which cover events that occurred in 2002 and prior years. These reserves reflect our estimates of the total costs of claims that were reported, but not yet paid, and the cost of claims incurred but not yet reported (IBNR). For reported claims, we establish reserves on a “case” basis. For IBNR claims, we calculate the difference between: (i) projected ultimate claim and claim settlement expenses as determined using generally accepted actuarial standards, and (ii) case reserves and carry the difference as the IBNR reserve. By using both estimates of reported claims and IBNR claims, we estimate the ultimate net reserves for unpaid claim and claim settlement expenses.

     The amount by which estimated net reserves, measured subsequently by reference to payments and additional estimates, differ from those originally reported for a period is known as “development.” Development is unfavorable (or deficient) when losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for reserve increases on open claims. Development is favorable (redundant) when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on open claims. Favorable or unfavorable development of loss reserves is reflected in earnings in the year realized.

     Both internal and independent external actuaries review net reserves for adequacy on a periodic basis. This review assumes that past experience, adjusted for the effects of current events and anticipated trends, is an appropriate basis for predicting future events. When reviewing net reserves, actuaries analyze historical data and estimate the effect of various factors on estimated ultimate reserves including: (i) trends in general economic conditions, including the effects of inflation; (ii) estimates of trends in claims frequency and severity; (iii) our and industry historical loss experience; and (iv) legislative enactments, legal developments and changes in social and political attitudes. Variables in the reserve estimation process can be affected by both internal and external events, including changes in claims handling procedures, economic inflation, legal trends and legislative changes. Many of these items are not directly quantifiable, particularly on a prospective basis. There is no precise method for subsequently evaluating the effect of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by many factors. Additionally, there may be significant reporting lags between the occurrence of the loss and the time it is actually reported to the insurer. Due to our commencing operations in 1992, we have limited historical data to estimate our reserves for unpaid claim and claim settlement expenses and, accordingly, we supplement our experience with external industry data, as adjusted, to reflect anticipated differences between our results and the industry.

     Estimating the effect that inflation will have on the ultimate cost of claims is a major risk factor in our workers’ compensation reserve estimates. Future earnings will be affected by reserve development associated with any changes in our inflation assumptions. Estimates for the 2002 and 2001 accident years represent the majority of the uncertainty because these claims have the lowest proportionate amount of paid loss as of December 31, 2002.

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Our reserve estimates are most sensitive to changes in the assumption about inflation for the 2002 and 2001 accident years. Each one percent (1%) increase or decrease in the inflation rate for both of these accident years would increase or decrease our loss reserve estimates at December 31, 2002 and 2001 by approximately $348,000 and $290,000, respectively.

     Our independent actuary provides management with an opinion regarding the acceptable range for adequate statutory reserves based on generally accepted actuarial guidelines. We record our net reserves by considering a range of estimates bounded by the high and low point of the range. Within that range, we record our best estimate. We focus in our decision process on improving our financial strength ratings and expect to remain a market for workers’ compensation insurance in all market conditions. In 2002,we established recorded reserves in the upper half of the actuary’s range. The ultimate actual liability may be higher or lower than reserves established.

     Our reserves are primarily undiscounted; however, we discounted reserves for selected claims that have fixed and determinable future payments at rates ranging from 3.5% to 8.0% in 2002 and 2001. The discount rates in 2002 and 2001 are subject to change as market interest rates change. We use the same rates for Generally Accepted Accounting Principles as we do for Statutory Accounting in determining our liability. We also reduce the unpaid claim and claim settlement expenses for estimated amounts of subrogation.

     We continually monitor loss development trends and data to establish adequate premium rates and reasonable loss reserve estimates. Loss reserves, which are based on estimates, are inherently uncertain and represent a significant risk to the business that we attempt to mitigate by continually improving and refining our workers’ compensation claims processing practices and by employing actuarial estimation methods.

     After taking into account all relevant factors, we believe our reserves for unpaid claim and claim settlement expenses and reinsurance recoverables on unpaid claim and claim settlement expenses at December 31, 2002 are adequate to cover the ultimate net costs of claim and claim settlement expenses at that date. The ultimate cost of claim and claim settlement expenses may differ materially from the established reserves, particularly when claims may not be settled for many years. Establishing appropriate reserves is an inherently uncertain process and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience. See Notes 1 and 5 in the accompanying Consolidated Financial Statements. The following two tables reconcile the beginning and ending insurance reserves, displayed individually for each of the last three years.

The following table sets forth reserves on a gross (before reinsurance) basis (000’s):

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The following table sets forth reserves on a net (after reinsurance) basis (000’s):

     The following loss reserve development table sets forth the change, over time, of reserves established for claim and claim settlement expenses at the end of the last ten years. The following loss reserve development table is cumulative and, therefore, ending balances should not be added since the amount at the end of each calendar year includes activity for both current and prior years (000’s):

[Additional columns below]

[Continued from above table, first column(s) repeated]

				December 31,
				1996				1995				1994				1993				1992
Loss Reserve Development:
	Gross reserves for unpaid claim and claim settlement expenses			$	49,256			$	37,138			$	28,165			$	13,279			$	2,688
	Reinsurance recoverables				6,183				8,312				13,902				9,593				1,886
	Net reserves for unpaid claim and claim settlement expenses			$	43,073			$	28,826			$	14,263			$	3,686			$	802
	Paid (cumulative) as of:
		One year later		$	19,439			$	8,595			$	4,639			$	1,436			$	583
		Two years later			28,173				12,894				6,476				2,150				678
		Three years later			33,438				15,521				7,863				2,348				815
		Four years later			36,904				16,869				8,569				2,654				856
		Five years later			38,919				18,020				9,046				2,816				925
		Six years later			39,770				18,714				9,396				2,847				951
		Seven years later							19,200				9,564				2,932				920
		Eight years later											9,738				2,985				928
		Nine years later															2,972				951
		Ten years later																			885
Reserves re-estimated as of:
		End of year		$	43,073			$	28,826			$	14,263			$	3,686			$	802
		One year later			39,988				20,751				12,789				3,784				1,075
		Two years later			43,484				18,469				9,318				3,416				1,008
		Three years later			41,451				19,796				8,984				2,782				950
		Four years later			45,959				19,389				9,669				2,861				912
		Five years later			47,147				21,254				9,692				2,972				949
		Six years later			47,126				22,568				10,330				2,927				964
		Seven years later							22,388				11,675				3,106				926
		Eight years later											11,234				3,818				945
		Nine years later															3,555				951
		Ten years later																			949
Initial reserves in excess of (less than) re-estimated reserves
		Amount		$	(4,053	)		$	6,438			$	3,029			$	131			$	(147	)
		Percent			(9.4	)%			22.3	%			21.2	%			3.6	%			(18.3	)%