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FORM 10-K 21ST CENTURY INSURANCE GROUP
(Exact name of registrant as specified in its charter)
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2002
CALIFORNIA 95-1935264
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification number)
6301 OWENSMOUTH AVENUE
WOODLAND HILLS, CALIFORNIA 91367
(Address of principal executive offices) (Zip Code)
(818) 704-3700
(Registrant's telephone number, including area code)
WEB SITE: WWW.21ST.COM
SECURITIES REGISTERED PURSUANT TO SECTION 12 (b) OF THE ACT:
COMMON STOCK, WITHOUT PAR VALUE NEW YORK STOCK EXCHANGE
(Title of Class) (Name of each exchange
on which registered)
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 Of Regulation S-K is not contained herein,
and will not be contained, to the best of registrant's knowledge,
in definitive proxy or information statements, incorporated by
reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15 (d) of the
Securities Exchange Act of 1934 during the preceding 12 months
(or for such shorter period that the registrant was required to
file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No[ ]
The aggregate market value of the voting stock held by
non-affiliates of the registrant, based on the average high and
low prices for shares of the Company's Common Stock on June 30,
2002, as reported by the New York Stock Exchange, was
approximately $466,000,000.
On February 28, 2003, the registrant had 85,431,505 shares of
common stock outstanding, without par value, which is the
Company's only class of common stock.
DOCUMENT INCORPORATED BY REFERENCE:
Portions of the definitive proxy statement used in connection
with the annual meeting of stockholders of the registrant, to be
held on June 25, 2003, are incorporated herein by reference into
Part III hereof.
TABLE OF CONTENTS
Page
Description Number
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Part I
Item 1. Business 4
General 4
Geographic Concentration of Business 4
Types and Limits of Insurance Coverage 5
Personal Auto Product Innovations 6
Marketing 6
Consumer Advocacy 7
Customer Retention and Vehicles in Force 7
Underwriting and Pricing 8
Servicing of Business 9
Claims 9
Growth and Profitability Objectives 10
Aggregate Expense Ratio - Personal Auto Lines 10
Loss and Loss Adjustment Expense Reserves 11
Estimating the Frequency of Auto Accidents 11
Homeowner and Earthquake Frequency 12
Estimating the Severity of Auto Claims 12
Earthquake Severity 13
Loss and Reserve Development 14
Auto Lines Reserve Development 17
Homeowner and Earthquake Lines in Runoff 17
Competition 19
Reinsurance 19
State Regulation of Insurance Companies 20
Holding Company Regulation 21
Effects of Events of September 11, 2001 21
Non-Voluntary Business 21
Employees 22
Item 2. Properties 22
Item 3. Legal Proceedings 22
Item 4. Submission of Matters to a Vote of Security Holders 24
Part II 24
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters 24
Item 6. Selected Financial Data 25
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 26
Financial Condition 26
Liquidity and Capital Resources 29
Holding Company 29
Insurance Subsidiaries 29
Obligations, Letters of Credit, Guarantees and Transactions with Related
Parties 30
Results of Operations 30
Overall Results 30
Personal Auto Lines Operating Income 31
Underwriting Results 32
Personal Auto 32
Homeowner and Earthquake Lines in Runoff and All Other 33
Investment Income 35
1
Page
Description Number
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Critical Accounting Policies 35
Losses and Loss Adjustment Expenses 35
Property and Equipment 36
Deferred Income Taxes 36
Deferred Policy Acquisition Costs 38
Investments 38
Audit Committee Financial Expert 40
Policies Regarding Conflicts of Interest and Ethical Behavior 41
Forward-Looking Statements 41
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 42
Item 7B. Management's Internal Control Report 43
Item 8. Financial Statements and Supplemental Data 44
Report of Independent Accountants 44
Report of Independent Auditors 45
Consolidated Financial Statements 46
Notes to Consolidated Financial Statements 50
Note 1. Description of Business 50
Note 2. Summary of Significant Accounting Policies 50
Note 3. (Loss) Earnings per Common Share 53
Note 4. Investments 53
Note 5. Federal Income Taxes 55
Note 6. Deferred Policy Acquisition Costs 56
Note 7. Property and Equipment 57
Note 8. Unpaid Losses and Loss Adjustment Expenses 58
Note 9. Reinsurance 59
Note 10. Employee Benefit Plans 60
Note 11. Operating Lease Commitments 62
Note 12. Capital Stock 62
Note 13. Stock-Based Compensation 63
Note 14. Statutory Financial Data 65
Note 15. Litigation 66
Note 16. Northridge Earthquake 68
Note 17. Unaudited Quarterly Results of Operations 70
Note 18. Results of Operations by Line of Business 71
Note 19. 21st Century Insurance Company of Arizona 72
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 73
Part III 73
Item 10. Directors and Officers of the Registrant 73
Item 11. Executive Compensation 73
Item 12. Security Ownership of Certain Beneficial Owners and Management 73
Item 13. Certain Relationships and Related Transactions 73
Part IV 74
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 74
Schedule II - Condensed Financial Information of Registrant 75
Signatures of Officers and Board of Directors 78
Certification of President and Chief Executive Officer 80
Certification of Chief Financial Officer 81
2
Exhibits 82
3(ii) Certification of Secretary for Change to Bylaws 82
23(a) Consent of Independent Accountants 83
23(b) Consent of Independent Auditors 84
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant To
Section 906 of the Sarbanes-Oxley Act of 2002 85
3
PART I
ITEM 1. BUSINESS
GENERAL
21st Century Insurance Group is an insurance holding company founded in 1958 and
incorporated in California. The term "Company," unless the context requires
otherwise, refers to 21st Century Insurance Group and its consolidated
subsidiaries, all of which are wholly owned: 21st Century Insurance Company,
21st Century Casualty Company, 21st Century Insurance Company of Arizona(1)
("21st of Arizona"), 20th Century Insurance Services, inc., and i21 Insurance
Services. The latter two companies are not property and casualty insurance
subsidiaries, and their results are immaterial.
The common stock of the Company is traded on the New York Stock Exchange under
the trading symbol "TW." Through several of its subsidiaries, American
International Group, Inc. ("AIG"), currently owns approximately 63% of the
Company's outstanding common stock.
Founded in 1958, 21st Century Insurance Group primarily sells and underwrites
personal automobile insurance to customers in California, Arizona, Nevada,
Oregon and Washington who prefer excellent service and a high-feature product at
a competitive price. Twenty-four hours per day, 365 days a year, customers
choose to purchase insurance over the phone from the Company's centralized
licensed insurance agents at 1-800-211-SAVE or through its full service Internet
site at www.21st.com. The Company has the reputation for excellent customer
service and for being among the most efficient and lowest cost providers of
personal auto insurance in the markets it serves.
Copies of the Company's filings with the Securities and Exchange Commission on
Form 10-K, Form 10-Q, Form 8-K and proxy statements are available along with
copies of earnings releases on the Company's web site at www.21st.com. Copies
may also be obtained free of charge directly from the Company's Investor
Relations Department (6301 Owensmouth Avenue, Woodland Hills, California 91367,
phone 818-701-3595).
GEOGRAPHIC CONCENTRATION OF BUSINESS
The Company's business began in Los Angeles and historically has been
concentrated in Southern California, principally the greater Los Angeles
metropolitan area. In the mid-1980's, the Company expanded into the San Diego
area and, in the early 1990's, the Northern California area. The Company began
writing private passenger automobile insurance in Arizona in 1996, followed by
Nevada, Oregon and Washington in late 1998.
- ---------------
1 21st of Arizona was incorporated in Arizona in 1995 as a joint venture
owned 49% by the Company and 51% by AIG; the Company acquired AIG's
interest on January 1, 2002.
4
The following table presents a geographical summary of the Company's direct
premiums written for the past five years (in millions):
Years Ended December 31, 2002 2001 2000 1999 1998
- -----------------------------------------------------------------------------------
Personal auto lines(1)
California $967.3 $879.4 $861.6 $848.9 $860.8
Arizona(2) 13.0 - - - -
Nevada 8.1 8.9 7.7 2.7 -
Oregon 1.6 2.0 2.2 0.8 -
Washington 5.8 8.5 9.7 3.4 -
- -----------------------------------------------------------------------------------
Total personal auto lines 995.8 898.8 881.2 855.8 860.8
- -----------------------------------------------------------------------------------
Lines in runoff
Homeowner(3) and Earthquake(4) 2.4 30.5 29.5 24.7 24.8
- -----------------------------------------------------------------------------------
Total consolidated direct premiums written $998.2 $929.3 $910.7 $880.5 $885.6
- -----------------------------------------------------------------------------------
The following table summarizes the concentrations of the Company's California
direct in-force premiums for the voluntary personal auto lines excluding
personal umbrella and motorcycle coverages as of the end of each of the past
five years:
December 31, 2002 2001 2000 1999 1998
- ------------------------------------------------------------------------------------
Southern California excluding San Diego(5) 66.3% 73.5% 76.2% 78.8% 81.8%
San Diego(6) 10.5 10.2 9.4 9.0 8.6
Northern California(7) 23.2 16.3 14.4 12.2 9.6
- ------------------------------------------------------------------------------------
100.0% 100.0% 100.0% 100.0% 100.0%
- ------------------------------------------------------------------------------------
TYPES AND LIMITS OF INSURANCE COVERAGE
The Company's private passenger auto insurance contract generally covers: bodily
injury liability; property damage; medical payments; uninsured and underinsured
motorist; rental reimbursement; uninsured motorist property damage and collision
deductible waiver; towing; comprehensive and collision. All of the Company's
policies are written for a six-month term except for policies sold to the
involuntary market, which are for twelve months.
Minimum levels of bodily injury and property damage are required by state law
and typically cover the other party's costs when the Company's policyholder
causes an accident. Uninsured and underinsured motorist are optional coverages
and cover the Company's policyholder when the other party is at fault and has no
or insufficient liability insurance to cover the insured's injuries and loss of
income. Comprehensive and collision coverages are also optional and cover
damage to the policyholder's automobile whether or not the insured is at fault.
In some states, the
- ---------------
1 Includes motorcycle and personal umbrella coverages, which are immaterial
for all periods presented.
2 Excludes amounts not consolidated: $12.8 in 2001; $14.7 million in 2000;
$12.9 million in 1999; and $10.0 million in 1998.
3 The Company is running off approximately 5,300 California homeowner
policies remaining on its books at December 31, 2002. See further
discussion in Item 7 under the caption Underwriting Results - Homeowner
and Earthquake Lines in Runoff and All Other.
4 The Company ceased writing earthquake coverage in 1994 but remains exposed
to possible upward development in certain loss estimates relating to the
1994 Northridge Earthquake. See further discussion in Item 7 under the
captions Underwriting Results - Homeowner and Earthquake Lines in Runoff
and All Other, Critical Accounting Policies, and Note 16 of the Notes to
Consolidated Financial Statements.
5 Includes all counties not specified in footnotes 6 and 7.
6 Represents San Diego County.
7 Includes these counties: Alameda, Alpine, Amador, Butte, Calaveras, Colusa,
Contra Costa, Del Norte, El Dorado, Fresno, Glenn, Humboldt, Inyo, Kings,
Lake, Lassen, Madera, Marin, Mariposa, Mendocino, Merced, Modoc, Mono,
Monterey, Napa, Nevada, Placer, Plumas, Sacramento, San Benito, San
Francisco, San Joaquin, San Mateo, Santa Tehama, Trinity, Tulare, Yolo,
Yuba.
5
Company is required to offer personal injury protection coverage in lieu of the
medical payments coverage required in California.
Various limits of liability are underwritten with maximum limits of $500,000 per
person and $500,000 per accident. The most frequent bodily injury liability
limits purchased are $100,000 per person and $300,000 per accident. The
Company's standard coverages exclude losses from nuclear sources as well as acts
of war.
The Company's personal umbrella policy ("PUP") provides a choice of liability
coverage limits of $1.0 million, $2.0 million or $3.0 million in excess of the
underlying automobile liability coverage. The $2.0 million and $3.0 million
limits were added in May 2002. Minimum underlying automobile limits of $100,000
per person and $300,000 per accident were required for PUP policies sold prior
to May 2002, and limits of $250,000 per person and $500,000 per accident are
required thereafter. The Company must write the underlying automobile coverage.
The Company reinsures 90% of any PUP loss with unrelated reinsurers.
The homeowner program, currently in runoff, utilized an extended replacement
cost policy, thereby limiting the insured's recovery to 150% of the amount
specified in the contract for Coverage A - Dwelling and Other Building
Structures. Underwriting guidelines provided for a minimum dwelling amount of
$65,000 and a maximum dwelling amount of $750,000.
PERSONAL AUTO PRODUCT INNOVATIONS
Starting in May 2002, the Company began offering motorcycle coverage primarily
to its auto policyholders in California. In August 2002, the Company introduced
a new private passenger auto policy in California that does not have certain
standard features found in its primary policy. This limited-feature product is
similar in most respects to the product offered by many of the Company's
competitors, and is positioned as a lower-cost alternative for customers who
believe they need less coverage than provided by the Company's standard product.
In October 2002, the Company enhanced its underwriting guidelines allowing it to
provide quotes to certain customers who do not meet California's statutory "good
driver" definition but who are considered to be insurable risks within the
Company's class plan.
All of the foregoing product innovations were designed to achieve an
underwriting profit and, to date, the impact of these new products has been
immaterial.
MARKETING
While the Company offers personal auto policies in California, Arizona, Nevada,
Oregon and Washington, most of its marketing efforts are focused on the larger
urban markets in California. Beginning in late 2002, the Company restarted its
active marketing in Arizona.
The Company's marketing and underwriting strategy is to appeal to careful and
responsible drivers who desire a feature-rich product at a competitive price.
The Company uses direct mail, broadcast and print media, outdoor, community
events and the Internet to generate inbound telephone calls, which are served by
centralized licensed insurance agents. Because the Company centralizes its
sales agents, it can deliver a highly efficient and professional experience for
its California and Arizona customers 24 hours per day, 365 days per year through
a convenient, toll-free 800-211-SAVE telephone number. California and Arizona
customers may also obtain an instant auto rate quotation and purchase a policy
on the Company's Internet site at www.21st.com.
6
The following table summarizes advertising expenditures (in millions) and total
new auto policies written in California, the Company's primary market, for the
past five years:
Years Ended December 31, 2002 2001 2000 1999 1998
- ------------------------------------------------------------------------------
Total advertising
expenditures $ 43.3 $ 16.9 $ 10.1 $ 22.7 $ 10.1
New auto policies written in
California(1) 185,944 51,002 54,642 86,703 104,289
CONSUMER ADVOCACY
The Company has introduced several publications and community events designed to
assist customers and potential customers in making choices about their auto
insurance and automobile safety. The Insider's Guide to Buying California Auto
Insurance, currently available in both English and Spanish, compares coverage
and service features of products offered by the Company and its major
competitors. The comparisons are explained in understandable language to help
"demystify" the choices consumers must make in selecting their personal auto
insurance carrier.
The Company also publishes the Child Safety Seat Guide, Crash Test Ratings
Guide, and A Driving Need - A Guide for Mature Drivers and Those Who Care about
Them. All these publications are available free of charge on the Company's web
site at www.21st.com/company/getmore/safety/safety.jsp. The Company has also
distributed these publications in California movie theaters, county fairs,
direct mail promotions and other venues.
CUSTOMER RETENTION AND VEHICLES IN FORCE
Customer retention in California, measured based on the number of insured
vehicles and the number of vehicles in force, were as follows as of the end of
each of the past five years:
December 31, 2002 2001 2000 1999 1998
- -----------------------------------------------------------------------------------------------
Average customer retention -
California personal auto(2) 93% 92% 96% 97% 96%
California vehicles in force (1) 1,178,459 1,051,982 1,150,643 1,179,928 1,142,303
All other states vehicles in force 27,174 23,489 31,337 18,130 189
- -----------------------------------------------------------------------------------------------
Total auto lines exposure (1) 1,205,633 1,075,471 1,181,980 1,198,058 1,142,492
- -----------------------------------------------------------------------------------------------
California auto base rate +5.7% +4.0% +6.4% -6.9% -3.4%
changes MAY July November February January
From March 1996 to October 2000, the Company implemented six rate decreases
which resulted in a cumulative reduction in rates of nearly 23%. As a result of
this series of rate decreases, retention rates rose to Company record levels
through 2000. Growth in vehicles in force during this period was modest as the
Company's major competitors also lowered their rates. In response to rising loss
costs beginning in 1999 and continuing to date, the Company has implemented
three base rate increases as shown above for a cumulative increase of 16%, made
changes in its class plan and adopted stricter underwriting measures.
Additionally, as the Company upwardly adjusted its rates, it curtailed
advertising for new customers throughout 2000. During this same period,
competitors held rates steady or continued to take decreases. These actions
contributed to the declines in retention and vehicles in force in 2000 and 2001.
Beginning in the latter half of 2001, the Company's major California competitors
began implementing rate increases and the Company restarted active marketing and
advertising, both of which contributed to the increases in
- ---------------
1 Includes new PUP and motorcycle policies, which are insignificant for all
periods presented.
2 Represents an overall measure of customer retention, including new
customers as well as long-time customers. Retention rates for new customers
are often lower than for long-time customers.
7
the Company's retention and vehicles in force in 2002. In January 2003, the
Company received approval for a 3.9% rate increase which it expects to implement
in March 2003.
UNDERWRITING AND PRICING
The regulatory system in California requires the prior approval of insurance
rates, rules and forms. Within the regulatory framework, the Company establishes
its premium rates based primarily on actuarial analyses of its own historical
loss and expense data. This data is compiled and analyzed to establish overall
rate levels as well as classification differentials.
The Company's rates are established at levels intended to generate underwriting
profits and vary for individual policies based on a number of rating
characteristics. These rates are a blend of base rates and class plan filings
made with the California Department of Insurance ("CDI"). Base rates are the
primary amount projected to generate an adequate underwriting profit for the
Company. Class plan changes are filings that serve to modify the factors that
impact the base rates. Class plan changes are generally meant to be revenue
neutral to the Company but ultimately are done in conjunction with a base rate
filing.
California law requires that the primary rating characteristics that must be
used for automobile policies are driving record, annual mileage and number of
years the driver has been licensed. A number of other "optional" rating
factors are also permitted and used in California and include characteristics
such as automobile garaging location, make and model of car, policy limits and
deductibles, and gender and marital status.
The following table summarizes changes in the Company's base premium rates for
each of the past five years. Positive numbers represent increases; negative
numbers represent decreases.
Years Ended December 31, 2002 2001 2000 1999 1998
- ----------------------------------------------------------------------
Personal auto lines excluding PUP
California 5.7% 4.0% 6.4% (6.9)% (3.4)%
Arizona 3.7 16.5 20.0 (9.7) -
Nevada 22.0 12.6 - - N/A
Oregon 3.1 14.0 21.0 - N/A
Washington 10.7 44.9 - - N/A
Lines in runoff
Homeowner 13.2 4.0 - (7.5) -
Earthquake N/A N/A N/A N/A N/A
The Company is required to offer insurance to any California prospect that meets
the statutory definition of a "Good Driver." This definition includes all
drivers who have been licensed more than three years and have had no more than
one violation point count under criteria contained in the California Vehicle
Code. These criteria include a variety of moving violations and certain at-fault
accidents.
The Company reviews many of its policies prior to the time of renewal and as
changes occur during the policy period. Some mid-term changes may result in
premium adjustments, cancellations or non-renewals because of a substantial
increase in risk.
8
SERVICING OF BUSINESS
Computerized systems provide the information resources, telecommunications and
data processing capabilities necessary to manage the Company's business. These
systems support the activities of the Company's marketing, sales, service and
claims areas that are dedicated to serving the needs of customers. New
technology investments have been focused on making it faster and easier for
customers to transact business while ultimately lowering the cost per
transaction.
Using the Company's web site, most customers are now able to receive and accept
quotations, bind policies, pay their bills, inquire about the status of their
policies and billing information, make most common policy changes, submit first
notice of loss on a claim and access a wealth of consumer information. New
technology began to be implemented in 2001 that provides the Company's sales and
service agents with integrated knowledge about customer contacts and enables
speedier and even more convenient customer service.
CLAIMS
Claims operations include the receipt and analysis of initial loss reports,
assignment of legal counsel when necessary, and management of the settlement
process. Whenever possible, physical damage claims are handled through the use
of Company drive-in claims facilities, vehicle inspection centers and Direct
Repair Program ("DRP") providers. The claims management staff administers the
claims settlement process and oversees the work of the legal and adjuster
personnel involved in that process. Each claim is carefully analyzed to provide
for fair loss payments, compliance with the Company's contractual and regulatory
obligations and management of loss adjustment expenses. Liability and property
damage claims are handled by specialists in each area.
The Company makes extensive use of its DRP to expedite the repair process. The
program involves agreements between the Company and more than 130 independent
repair facilities. The Company agrees to accept the repair facility's damage
estimate without requiring each vehicle to be reinspected by Company adjusters.
All DRP facilities undergo a screening process before being accepted, and the
Company maintains an aggressive inspection audit program to assure quality
results. The Company's inspection teams visit all repair facilities each month
and perform a quality control inspection on approximately 40% of all repairable
vehicles in this program. The customer benefits by getting the repair process
started faster and by having the repairs guaranteed for as long as the customer
owns the vehicle. The Company benefits by not incurring the overhead expense of
a larger staff of adjusters and by negotiating repair prices it believes are
beneficial. Currently, more than 30% of all damage repairs are handled using the
DRP method.
The Company's policy with respect to vehicle repairs is not to use after market
"crash" parts. As a result, the Company believes it does not face exposure to
the types of class action suits some competitors have drawn over their use of
such parts.
The Company has established 12 claims Division Service Offices in areas of major
customer concentrations. The five Vehicle Inspection Centers, located in Los
Angeles and Orange Counties, handle total losses, thefts and vehicles that are
not driveable.
The Claims Services Division is responsible for subrogation and medical payment
claims. The Company also maintains a Special Investigations Unit as required by
the California State Insurance Code, which investigates suspected fraudulent
claims. The Company believes its efforts in this area have been responsible for
saving several million dollars annually.
9
The Company utilizes internal legal staff to handle most aspects of claims
litigation. These attorneys handle approximately 75% of all lawsuits against
its policyholders. Suits directly against the Company and those, which may
involve a conflict of interest, are assigned to outside counsel.
GROWTH AND PROFITABILITY OBJECTIVES
The Company has stated that its long-term goal is to build an organization that
consistently produces a 96% GAAP combined ratio, or better, and at least 15%
annual growth in direct written premiums. The Company has only met both of
these goals in the same year twice: 1980 and 1981. The Company came closer to
meeting both goals in the last half of 2002 for its personal automobile lines.
To achieve these goals, the Company has undertaken many steps since 1999
including:
- - Restored pricing and underwriting discipline.
- - Successfully restarted active advertising for new customers and introduced
product innovations to spur growth and profitability.
- - Launched numerous initiatives to lower per unit costs throughout the
Company's infrastructure while holding the line on fixed expenses.
Although new customers generally have higher aggregate loss ratios, their loss
experience tends to improve over time. The Company believes it can
significantly increase premium volume without incurring significantly higher
fixed costs while continuing to lower per unit costs in its variable expense
operations. Thus, assuming a responsible regulatory climate, the goal of a 96%
combined ratio should be achievable consistently despite the higher loss ratio
often associated with new customers. However, it must be noted that the
personal lines insurance business is, as a regulated industry, exposed to
legislative, judicial, political and regulatory action in addition to the normal
business forces of competition between companies and the choices of consumers.
AGGREGATE EXPENSE RATIO - PERSONAL AUTO LINES
The Company believes a competitive advantage can be achieved by operating more
efficiently than its competition. One measure of relative efficiency is the
"aggregate expense ratio" - defined as the sum of incurred loss adjustment
expenses and underwriting expenses, divided by gross premiums written. This
aggregate expense ratio removes many of the inconsistencies in how different
companies classify their expenses.
The following table presents aggregate expense ratio information extracted from
statutory filings by A.M. Best for the top ten California personal automobile
insurance companies for 1997 through 2001, the most recent data available.
Statutory Aggregate Expense Ratio
---------------------------------
Years Ended December 31, 2001 2000 1999 1998 1997
- --------------------------------------------------------------------
21ST CENTURY INSURANCE GROUP 33.5% 31.3% 30.1% 27.1% 22.8%
California State Auto Association 39.8 43.6 28.9 35.7 32.1
State Farm 38.4 41.3 40.3 38.1 34.1
Mercury 38.0 38.8 38.6 37.9 37.6
Progressive 37.1 35.4 33.4 35.0 33.7
Allstate 36.9 39.8 39.2 39.2 39.0
Farmers 35.8 35.2 33.6 35.2 34.4
Auto Club of Southern California 32.0 32.6 34.0 35.4 32.6
USAA 28.0 30.7 34.1 29.5 26.2
GEICO 24.4 27.0 29.0 27.6 24.2
The Company's aggregate expense ratio for the auto lines in 2002 was 33.2%. In
2002, the capacity of the Company's new business call center was doubled,
enabling the Company to handle a record volume of new business throughout the
year. Several productivity enhancement
10
initiatives are underway aimed at reducing per unit process costs and lowering
fixed costs in corporate support areas. The increases in the Company's ratio
from 1997 through 2001 were primarily due to the cumulative 23% decrease in rate
level in California from 1996 to 1999, and increases in data processing,
depreciation and advertising expenditures.
LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
The cost to settle a customer's claim is comprised of two major components:
losses and loss adjustment expenses.
Losses in connection with third party coverages represent damages as a result of
an insured's acts that result in property damage or bodily injury. First party
losses involve damage or injury to the insured's property or person. In either
case, the ultimate cost of the loss is not always immediately known and may
develop higher or lower than initial estimates over time. When establishing
initial and subsequent estimates, the amount of loss is reduced for salvage
(e.g., proceeds from the disposal of the wrecked automobile) and subrogation
(e.g., proceeds from another party who is fully or partially liable, such as the
insurer of the driver who caused the accident involving one of the Company's
customers).
Loss adjustment expenses ("LAE") represent the costs of adjusting, investigating
and settling the loss, most of which comprise the cost of the Company's claim
department, external inspection services, and internal and external legal
counsel. Because staff areas such as human resources, finance, and information
technology support the Company's overall operations, a portion of their
operational costs are also allocated to LAE.
Accounting for losses and LAE is highly subjective because these costs must be
estimated, often weeks, months or even years in advance of when the payments
actually are made to claimants, attorneys, claims personnel and others involved
in the claims settlement process. At the time of sale of an auto policy, for
example, the number of claims that will happen is unknown, and so is the
ultimate amount it will take to settle them.
Accounting principles require insurers to record estimates for loss and LAE in
the periods in which the insured events, such as automobile accidents, occur.
This estimation process requires the Company to estimate both the number of
accidents that may have occurred (called "frequency") and the ultimate amount of
loss and LAE (called "severity") related to each accident. The Company employs
experts called "actuaries" who are professionally trained and certified in the
process of establishing estimates for frequency and severity. From time to
time, actuarial experts from outside firms are engaged to review the work of the
Company's actuaries.
Estimating the Frequency of Auto Accidents. By studying the historical lag
between the actual date of loss and the date the accident is reported by the
customer to the claims department, the Company's actuaries can make a
reasonable, yet never perfect, estimate for the number of claims that ultimately
will be reported for a given period. This measurement is often referred to as
frequency. The difference between the estimated ultimate number of claims that
will be made and the number that have actually been reported in any given period
is often referred to as "IBNR (incurred but not reported) claims".
For example, when estimating the frequency of accidents, history has shown that
approximately 95% of property damage claims and 81% of liability claims are
reported by year-end. Accordingly, in this illustration, the Company's
actuaries add an estimated 5% to the number of property damage claims and 19% to
the number of liability claims to provide for incurred but not reported ("IBNR")
claims.
When making estimates of frequency, the Company's actuaries reviewed historical
trends, noticing that there has been a slight decrease since 1999. For example,
the Company's actuaries noted that about 11.9% of California vehicles had a
collision-related accident in 2000, which declined to approximately 11.8% in
2001 and they are estimating 11.7% will have an accident in 2002. For bodily
injury claims, the actuaries saw 3.328% in 2000, 3.168% in 2001 and are
11
estimating 3.175% in 2002. These slight declines in frequency are believed to
be attributable mainly to relatively dry weather in California beginning in 2001
and throughout 2002.
In making these estimates, a fundamental assumption is that past events are
representative indicators of future outcomes. These estimates are also highly
sensitive. For example, in the above illustration, if the actuaries had picked
11.9% for 2002 collision frequency, the Company would have reported additional
pre-tax loss expense of $3.3 million.
Homeowner and Earthquake Frequency. The Company's remaining homeowner exposures
are mainly fully reinsured although the Company has exposure on claims that
might develop from 2000 and 2001 as well as from before July of 1996. However,
the homeowner line is considered to be a relatively short-tailed line and few
IBNR claims are expected.
By contrast, general liability commercial lines claims counts may take seven,
ten or more years to fully develop, and coverages such as asbestos and
environmental liability may involve discovery periods of twenty or thirty years.
The Company does not have any such long-tailed exposures.
However, California Senate Bill 1899(1) ("SB 1899") allowed insureds in 2001 to
report 1994 Northridge Earthquake claims the Company believes were previously
barred by the statute of limitations. SB 1899 is an egregious example of an
event that no reasonable actuary or other insurance professional would have
forecast or have even considered as possible seven years earlier in 1994.
However, when the law took effect and the number of claims became reasonably
estimable, the Company recorded an estimate for these claims as if they were a
1994 event (when the earthquake occurred) rather than as a 2001 event (when the
new law was effective)(2). While the number of true "SB 1899" claims should be
a fixed number, the Company continues to receive new Northridge Earthquake
claims based on alternative legal theories. These claims are included in the
Company's reserve estimates and are handled similarly to true SB 1899 claims.
Estimating the Severity of Auto Claims. Adjusters in the Company's claim
department establish loss estimates for individual claims based upon various
factors such as the extent of the injuries, property damage sustained, and the
age of the claim. The Company's actuaries review these estimates, giving
consideration to the adjusters' historical ability to accurately estimate the
ultimate claim and length of time it will take to settle the claim. Generally,
the longer it takes to settle a claim, the higher the ultimate claim cost. The
ultimate amount of the loss is considered the "severity" of the claim. In
addition, the actuaries estimate the severity of the IBNR claims.
The severities are estimated by the Company's actuaries each quarter based on
historical studies of average claim payments and the patterns of how the claims
were paid.
Returning to the above collision example, the Company's actuaries estimate that
the average incurred claim severity for collision coverage in the 2002 accident
year was $2,467, versus $2,394 in 2001 and $2,295 in 2000. This suggests that
average collision claim costs rose about 3.0% in 2002 and 4.1% in 2001. With
actual price inflation for repairs and parts running somewhat higher than either
of those figures, the better performance by the Company reflects the care and
attention it pays to claims handling and in particular to its Direct Repair
Program (DRP) which offers superior quality to customers at a lower overall
cost, and its salvage and subrogation methods.
Average severity for the BI coverage in California was $4,416 in 2002, $4,417 in
2001 and $4,374 in 2000. While medical inflation is inherently increasing BI
severities, there is a trend
- ---------------
1 See further discussion in Item 7 under the caption Underwriting Results -
Homeowner and Earthquake Lines in Runoff and all Other.
2 After discussion with legal counsel, the Company has concluded that
providing certain details, such as the total number of SB 1899 claims and
average claim amounts, would likely prejudice the claims settlement process
to the Company's detriment.
12
where the level of loss is decreasing in California. Actuaries generally believe
the improvements in automobile safety, more rational jury awards, and
drought-like conditions are moderating the increase in BI severities.
Again, the fundamental assumption used in making these estimates is that past
events are reliable indicators of future outcomes. History, unfortunately, has
a way of thwarting even the most strongly held expectations. For example, in
the above illustration, if the actuaries would have selected a BI severity that
increased the same from 2001 to 2002 as it did from 2000 to 2001, the Company
would have reported additional pre-tax loss expense of $1.8 million in 2002.
Earthquake Severity. A necessarily more subjective process is used to estimate
earthquake losses arising out of SB 1899 due to the fact that they cannot be
determined with traditional actuarial methods that rely on credible historical
or industry data, neither of which are available in regard to this event.
Because a large number of these claims are being asserted through litigation,
the ultimate amounts will depend on many factors including whether the claim is
settled before entering the pre-trial stage, during pre-trial proceedings, or
requires a full trial to resolve. Future judicial decisions, jury verdicts and
settlements may affect the cost of resolution of remaining cases, both
positively and negatively. These and many other earthquake claim litigation
factors (see below and Note 16 of the Notes to Consolidated Financial
Statements) are difficult to predict based on past events and thus assumptions
and estimates are more likely to be subject to modification in the future.
More than two-thirds of the Company's remaining earthquake claims are in
litigation. Many suits seek extracontractual and punitive damages as well as
contractual damages far in excess of the Company's estimates. The Company
cannot estimate and, therefore, has not established a reserve for potential
extracontractual or punitive damages, or for damages in excess of estimates the
Company believes are correct and reasonable. It denies liability for any such
alleged damages. Nevertheless, extracontractual and punitive damages, if
assessed against the Company, could be material in an individual case or in the
aggregate, and damages in excess of the Company's reasonable estimates could be
material in the aggregate. The Company may choose to settle litigated cases for
amounts in excess of its own estimate of contractual damages to avoid the
expense and/or risk of litigation.
The average costs and ranges for Earthquake settlements and verdicts vary
widely. For example, the Company recently had one claim with a plaintiff's
estimate of $200,000 settle for $500 on the courthouse steps; however, before SB
1899, the Company had one earthquake trial that required more than $1 million in
defense costs. Many lawsuits contain multiple claimants that courts may or may
not sever for trial. Thus, the Company faces the prospects of mass trials as
well as numerous individual trials, each with different potential costs and
litigation risks. The Company may also seek to settle groups of litigated
claims represented by a single attorney or law firm as a means of efficiently
resolving cases without incurring substantial attorneys' fees defending multiple
lawsuits. The discovery process is not yet underway for the majority of these
cases, and it is difficult to estimate litigation costs at this stage of the
process since the level (and hence cost) of discovery is not entirely within the
Company's control and it depends on the litigation strategy plaintiffs' counsel
may employ as well as other factors (see discussion in Note 16 to the Notes to
Consolidated Financial Statements). These strategies are expected to vary by
plaintiff attorney and firm. The Company's reserve estimate for legal defense
costs assumes that the Company will be successful in settlement of the vast
majority of its earthquake litigation before trial.
Meanwhile, events such as the Company's recent fraud suit brought against a
public adjuster, Unlimited Adjusting Company (1) ("Unlimited Adjusting"), could
have a favorable impact on future settlements with claimants represented by
Unlimited Adjusting. Approximately 20% of the pending claims are or have been
represented by Unlimited Adjusting.
- ---------------
1 For more information on this suit, please see the Company's press release
dated December 17, 2002, available on the Company's web site, www.21st.com.
13
Loss and Reserve Development. Management believes that, given the inherent
variability in the estimates, the Company's reserves are within a reasonable and
acceptable range of adequacy(1). However, because reserve estimates are
necessarily subject to the outcome of future events, changes in estimates are
unavoidable in the property and casualty insurance business. These changes
sometimes are referred to as "loss development" or "reserve development."
Quarterly, the Company's actuaries prepare a new evaluation of loss and LAE
indications by accident year, and the Company assesses whether there is a need
to adjust reserve estimates pertaining to previous accounting periods. As
claims are reported and settled and as other new information becomes available,
changes in estimates are made and are included in earnings of the period of the
change.
The changes in prior accident year estimates recorded in each of the past five
years, net of applicable reinsurance, are summarized below (in thousands)(2):
For the years ended December 31, 2002 2001 2000 1999 1998
- ----------------------------------------------------------------------------------
Personal auto $16,200 $ 45,742 $42,178 $(14,239) $(39,476)
Homeowner and Earthquake 56,158 72,265 2,845 5,543 43,099
- ----------------------------------------------------------------------------------
$72,358 $118,007 $45,023 $ (8,696) $ 3,623
- ----------------------------------------------------------------------------------
To understand these changes, it is useful to put them in the context of the
cumulative reserve development experienced by the Company over a longer time
frame. The tables on the following pages present the development of loss and
LAE reserves for the personal auto lines (Table 1) and for the homeowner and
earthquake lines in runoff (Table 2), for the years 1992 through 2002. The
figures in both tables are shown gross of reinsurance.
The top line of each table shows the reserves at the balance sheet date for each
of the years indicated. The upper portion of the table indicates the cumulative
amounts paid as of subsequent year-ends with respect to that reserve liability.
The lower portion of the table indicates the re-estimated amount of the
previously recorded reserves based on experience as of the end of each
succeeding year, including cumulative payments made since the end of the
respective year. The estimates change as more information becomes known about
the frequency and severity of claims for individual years. A redundancy
(deficiency) exists when the original reserve estimate is greater (less) than
the re-estimated reserves. Each amount in the tables includes the effects of
all changes in amounts for prior periods. The tables do not present accident
year or policy year development data. Conditions and trends that have affected
the development of liabilities in the past may not necessarily occur in the
future. Therefore, it would not be appropriate to extrapolate future
deficiencies or redundancies based on the table. A detailed discussion of loss
reserve development follows the tables.
- ---------------
1 For a discussion of the reserve ranges considered by management at December
31, 2002, see discussion under Financial Condition.
2 Positive numbers represent increases in loss and LAE expense, while
negative numbers represent decreases.
14
- -----------------------------------------------------------------------------------------------------------------------------
TABLE 1 - Auto Lines as of December 31,
(Amounts in thousands, except claims) 1992 1993 1994 1995 1996 1997 1998 1999
- -----------------------------------------------------------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $515,719 $525,892 $552,872 $506,747 $468,257 $403,263 $329,021 $261,990
PAID (CUMULATIVE) AS OF:
One year later 308,211 319,938 329,305 318,273 260,287 253,528 247,317 242,579
Two years later 374,583 393,731 403,462 392,420 336,538 319,064 307,797 311,659
Three years later 395,034 410,808 429,595 416,541 354,854 333,349 324,778 324,740
Four years later 400,230 422,640 435,795 422,393 357,913 340,907 326,932
Five years later 401,590 425,021 437,041 423,429 363,068 341,446
Six years later 402,812 425,397 437,052 427,723 362,824
Seven years later 402,736 425,041 437,015 427,355
Eight years later 402,415 424,982 436,737
Nine years later 402,397 424,745
Ten years later 402,210
RESERVES RE-ESTIMATED AS OF:
One year later 470,729 451,054 465,934 440,158 365,566 359,262 313,192 309,953
Two years later 412,299 429,602 438,672 424,091 366,858 337,258 321,711 340,914
Three years later 405,696 418,576 439,125 425,404 359,925 335,246 341,695 328,190
Four years later 402,110 424,630 438,895 424,643 357,607 355,605 326,506
Five years later 401,862 425,880 436,397 422,389 377,414 340,537
Six years later 402,671 424,475 435,878 442,024 361,980
Seven years later 402,074 424,188 451,478 426,719
Eight years later 401,864 424,603 448,972
Nine years later 401,978 424,435
Ten years later 402,001
- -----------------------------------------------------------------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $113,718 $101,457 $103,900 $ 80,028 $106,277 $ 62,726 $ 2,515 $(66,200)
- -----------------------------------------------------------------------------------------------------------------------------
Supplemental Auto Claims Data:
Claims reported during the year for CA only 291,720 315,558 352,182 324,143 294,615 279,211 295,905 307,403
Claims pending at year-end for CA only 59,178 62,892 70,717 63,142 58,172 55,738 56,739 57,134
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------
TABLE 1 - Auto Lines as of December 31,
(Amounts in thousands, except claims) 2000 2001 2002
- -----------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $286,057 $301,985 $333,113
PAID (CUMULATIVE) AS OF:
One year later 268,515 239,099
Two years later 332,979
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
RESERVES RE-ESTIMATED AS OF:
One year later 352,709 323,791
Two years later 354,720
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
- ------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $(68,663) $(21,806)
- ------------------------------------------------------------------
Supplemental Auto Claims Data:
Claims reported during the year for CA only 323,395 298,417 293,955
Claims pending at year-end for CA only 54,760 50,365 51,488
- -----------------------------------------------------------------------------
See Notes 8 and 16 of the Notes to Consolidated Financial Statements
15
- ----------------------------------------------------------------------------------------------------------------------------------
TABLE 2 - Homeowner and Earthquake
Lines in Runoff as of December 31,
(Amounts in thousands) 1992 1993 1994 1995 1996 1997 1998 1999
- ----------------------------------------------------------------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $38,822 $51,598 $ 203,371 $ 78,087 $ 75,272 $ 34,624 $ 52,982 $ 14,258
PAID (CUMULATIVE) AS OF:
One year later 19,982 26,936 193,887 55,738 75,100 30,232 48,848 13,103
Two years later 29,560 34,717 236,406 119,211 100,296 74,127 58,281 37,404
Three years later 33,333 37,052 295,768 139,792 142,850 82,974 81,887 83,985
Four years later 34,629 39,504 314,225 180,799 151,342 106,274 128,266
Five years later 36,041 40,550 354,324 188,987 174,513 152,592
Six years later 36,747 41,217 362,379 211,771 220,805
Seven years later 36,928 42,318 385,161 257,839
Eight years later 37,391 42,339 431,154
Nine years later 37,399 42,455
Ten years later 37,403
RESERVES RE-ESTIMATED AS OF:
One year later 36,549 41,685 253,775 116,741 101,903 77,445 58,582 18,024
Two years later 36,401 40,189 290,526 142,071 145,635 82,716 61,393 72,546
Three years later 35,740 39,657 316,256 182,616 150,434 85,519 116,429 125,089
Four years later 35,788 41,025 355,690 186,631 153,521 140,532 169,157
Five years later 36,758 41,205 359,084 190,334 208,533 193,375
Six years later 37,044 41,586 363,260 245,267 261,389
Seven years later 37,084 42,599 418,407 298,161
Eight years later 37,556 42,450 458,640
Nine years later 37,608 42,524
Ten years later 37,446
- ----------------------------------------------------------------------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $ 1,376 $ 9,074 $(255,269) $(220,074) $(186,117) $(158,751) $(116,175) $(110,831)
- ----------------------------------------------------------------------------------------------------------------------------------
(Amounts in thousands) 2000 2001 2002
- ------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $ 12,379 $ 47,305 $50,896
PAID (CUMULATIVE) AS OF:
One year later 30,706 58,274
Two years later 78,647
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
RESERVES RE-ESTIMATED AS OF:
One year later 68,245 103,470
Two years later 121,176
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
- ---------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $(108,797) $(56,165)
- ---------------------------------------------------------------
See Notes 8 and 16 of the Notes to Consolidated Financial Statements
16
Auto Lines Reserve Development. As shown in the ten-year development table, the
Company's auto lines historically were over-reserved prior to 1999 and have
exhibited adverse development for 1999, 2000 and 2001. The period from 1993 to
1999 was quite unusual in that, during that time, the Company experienced
declining frequencies and declining severities in its auto line. As Table 1
shows, management did not immediately have confidence in these declining trends
and did not immediately lower their reserve estimates.
Much of the decline in trend occurred between 1996 and 1998 because of
moderation in health care costs due to greater use of HMO's and laws that were
enacted in California that limited the ability of uninsured motorists and drunk
drivers to collect non-economic damages. During 1999, the Company assumed that
the past trend of declining frequencies and severities would continue. However,
in retrospect, it can now be seen that the favorable decline in trends ended and
loss costs began to increase. In 2000, the Company continued to underestimate
loss severity primarily because of what then seemed to be an acceleration in the
pattern of claims payments and the uncertainty inherent in identifying a change
in multi-year patterns. In 2001, the Company experienced significant,
unexpected development in its uninsured motorist coverage while the actuarial
evaluation ranges for most prior accident years were adjusted upward as more
data became available. The changes in injury trends affected the entire
California market and occurred, to a greater or lesser degree, in virtually
every state in the country.
During 2002 and 2001, the Company improved the quality and timeliness of the
data available to make initial estimates and periodic changes in estimates and
has dedicated more resources to better understand the underlying drivers of the
changes in frequency and severity trends as they begin emerging. Management
believes the decline in the need for recognition of adverse development in 2002
due to prior accident years for the personal auto lines evidences substantial
improvement in the accuracy of its estimation processes. Historically, 21st
Century actuaries have not projected a range around the carried loss reserves.
Rather, they have used several methods and different underlying assumptions to
produce a number of point estimates for the required reserves. Management
selects the carried reserve after carefully reviewing the appropriateness of the
underlying assumptions.
Homeowner and Earthquake Lines in Runoff. In Table 2, substantially all of the
indicated development relates to the earthquake line. Changes relating to the
homeowner line, which went into runoff mode in January 2002, are not significant
for any of the years shown.
In September 2000, the State of California enacted Senate Bill 1899 ("SB 1899"),
a law that affected the entire homeowners insurance industry in California, by
allowing earthquake claims barred by contract and the statute of limitations
arising from the January 17, 1994, Northridge Earthquake to be reopened during
calendar year 2001. This statute is commonly referred to as SB 1899. The
Company considers this an unprecedented and unforeseeable violation of its
contract rights as guaranteed by Article 1 of Constitution of the United States.
In Table 2, the losses created by SB 1899 have been treated as an accident year
1994 event, since they related to the 1994 earthquake, even though the law
permitting the claims to be made was not enacted until 2000 and not effective
until January 2001. Because of this treatment, Table 2 gives the appearance
that the Company's 1994 estimates continue to be wrong. This is not the case,
because it was not possible to foresee in 1994 that an unprecedented new law
would be effective in 2001, which would reopen these claims.
SB 1899 allowed a one-year window (calendar year 2001) for claimants to bring
additional insurance claims and legal actions allegedly arising out of the
January 17, 1994, Northridge Earthquake. Prior to the enactment of this law,
such claims were considered by previously applicable law to be fully barred, or
settled and closed. Any additional legal actions with respect to such claims
were barred under the policy contracts, settlement agreements, and/or applicable
17
statutes of limitation. As a result of the enactment of this unprecedented
legislation, claimants asserted additional claims against the Company allegedly
related to damages that occurred in the 1994 earthquake but which were now being
reported seven years later in 2001. Plaintiff attorneys and public adjusters
conducted extensive advertising campaigns to solicit claimants. Hundreds of
claims were filed in the final days and hours before the December 31st deadline.
During 2001, the Company recorded an additional $70 million of pre-tax losses
related to the 1994 earthquake, including $50 million in the fourth quarter of
2001 to cover the indemnity and inspection portion of the claims. The Company
lacked sufficient information to record a reasonable estimate of the related
legal defense costs until the third quarter of 2002, at which time an additional
provision of $46.9 million was recorded. In the first two quarters of 2002, an
additional $11.9 million of legal defense costs were expensed as they were paid.
Prior to the passage of SB 1899, the Company recorded significant changes in
estimates relating to the 1994 Northridge Earthquake: $57 million in 1995, $40
million in 1996, $25 million in 1997 and $40 million in 1998. Those changes
were recorded; as new information became available indicating that previous
estimates were insufficient. Smaller earthquake provisions were recorded in
1999 and 2000 as the number of cases dropped to a few remaining lawsuits. By
the end of 2000, before SB 1899 became effective in January 2001, approximately
50 earthquake claims out of an initial 35,000 homeowner earthquake claims
remained to be resolved, and fewer than 50 were in litigation.
Management has reviewed the adequacy of the remaining SB 1899 reserves at the
end of 2002. Based on that review, no further provisions were deemed to be
required as of December 31, 2002. The Company continues to caution that the
recorded estimates for earthquake loss and loss adjustment reserves resulting
from SB 1899 are subject to a greater than normal degree of uncertainty for a
variety of reasons.
First, determining in 2001 and subsequently whether alleged damage was caused or
exacerbated by a 1994 earthquake is inherently difficult. Company experts and
experts representing claimants could have materially different views of both
causation and the necessity and cost of a particular method of repair. The
purpose of the one-year time period in the policy is precisely to avoid the
problems inherent in attempting to adjust property damage claims after
substantial time has elapsed and subsequent events have occurred, such as
additional earthquakes, normal settling and cracking, poor maintenance, etc. In
the event of a difference of opinion, an expensive mediation or litigation
process is needed to obtain resolution. Results from this process, particularly
if trial by jury is involved, are subject to a wide range of possible outcomes.
Second, Company adjusters have frequently been prevented from taking recorded
statements or examinations under oath of claimants. In many instances,
subsequent statements allow adjusters to materially reduce their estimates. It
is possible that the litigation discovery process might provide similar results
for SB 1899 claims. Similarly, the Company's actions against alleged fraudulent
claimants, adjusters, or attorneys, such as the action against Unlimited
Adjusting, could favorably impact reserves if claims are proven fraudulent.
Third, more than two-thirds of the Company's remaining earthquake claims are in
litigation. Many suits seek extracontractual and punitive damages as well as
contractual damages far in excess of the Company's estimates; the Company views
such outcomes as being remote. Therefore, a reserve for potential
extracontractual or punitive damages has not been established. Extracontractual
and punitive damages, if assessed against the Company, could be material in an
individual case or in the aggregate. In addition, the Company may choose to
settle litigated cases for amounts in excess of its own estimate of contractual
damages to avoid the expense and/or risk of litigation.
18
Fourth, additional Northridge Earthquake claims have been filed in 2002 outside
of the reporting window established by SB 1899. The Company currently has
approximately 40 such claims that are apparently based on alternative legal
theories. Thus, the Company could continue to receive additional Northridge
Earthquake claims in the future that may require additional reserves.
Finally, actual expenses for legal defense costs are susceptible to a wide range
of outcomes depending on a variety of factors including plaintiff strategies,
future judicial decisions, the percentage of cases which settle, and the period
of time cases remain outstanding before settlement. The possibility of reaching
mass settlements of cases with particular attorneys or law firms presents the
opportunity to substantially reduce estimates for legal defense costs. On the
other hand, the inability to settle a substantial majority of cases for
reasonable amounts would materially increase amounts needed for legal defense
costs.
COMPETITION
The personal automobile insurance market is highly competitive and is comprised
of a large number of well-capitalized companies, many of which operate in a
number of states and offer a wider variety of products than the Company. Several
of these competitors are larger and have greater financial resources than the
Company on a stand-alone basis. Based on direct premiums written for 2001
(latest publicly available information), the Company is the seventh largest
writer of private passenger automobile insurance in California. The Company's
main competition comes from other major writers who concentrate on the good
driver market.
Market shares in California of the top ten writers of personal automobile
insurance, based on direct premiums written per A.M. Best, for the past five
years were as follows:
December 31, 2001 2000 1999 1998 1997
- --------------------------------------------------------------------
21ST CENTURY INSURANCE GROUP 6% 6% 6% 6% 6%
State Farm 13 13 14 15 16
Farmers 12 13 14 15 15
Allstate 11 10 9 8 8
California State Auto Association 10 10 10 10 11
Auto Club of Southern California 9 9 9 8 7
Mercury 8 8 8 7 7
USAA 3 3 3 3 3
GEICO 3 3 2 2 1
Progressive 2 2 3 2 2
REINSURANCE
A reinsurance transaction occurs when an insurer transfers or cedes a portion of
its exposure to a reinsurer for a premium. The reinsurance cession does not
legally discharge the insurer from its liability for a covered loss, but
provides for reimbursement from the reinsurer for the ceded portion of the risk.
The Company periodically monitors the continuing appropriateness of its
reinsurance arrangements to determine that its retention levels are reasonable
and that its reinsurers are financially sound, able to meet their obligations
under the agreements and that the contracts are competitively priced.
The majority of the Company's cessions are with AIG subsidiaries, which have
earned A.M. Best's highest financial rating of A++. The A.M. Best financial
ratings of the Company's other reinsurers range from A- to A+. The Company's
reinsurance arrangements are discussed in more detail in Note 9 of the Notes to
Consolidated Financial Statements.
19
The Company's net retention of insurance risk after reinsurance for 2003(1) and
the preceding five years is summarized below:
Contracts Incepting During
------------------------------------------
2003 2002 2001 2000 1999 1998
- -------------------------------------------------------------------------
Auto and motorcycle lines 100% 97%(2) 94% 92% 90% 90%
Personal umbrella policies(3) 10 10 16 37 36 36
Homeowner line in runoff 0 0 94 92 0 0
The Company also has catastrophe reinsurance agreements relating to the auto
line with Endurance Specialty Insurance Ltd., Folksamerica Reinsurance Company
and Transatlantic Reinsurance Company, which reinsure any covered events up to
$30.0 million in excess of $15.0 million.
STATE REGULATION OF INSURANCE COMPANIES
Insurance companies are subject to regulation and supervision by the insurance
departments of the various states. The insurance departments have broad
regulatory, supervisory and administrative powers, such as:
- - Licensing of insurance companies, agents and customer service employees
- - Prior approval, in California and some other jurisdictions, of rates, rules
and forms
- - Establishment of capital and surplus requirements and standards of solvency
- - Nature of, and limitations on, investments insurers are allowed to hold
- - Periodic examinations of the affairs of insurers
- - Annual and other periodic reports of the financial condition and results of
operations of insurers
- - Establishment of accounting rules
- - Issuance of securities by insurers
- - Restrictions on payment of dividends
- - Restrictions on transactions with affiliates
Currently, the California Department of Insurance ("CDI") has primary regulatory
jurisdiction over the Company, including prior approval of premium rates. The
CDI typically conducts a financial examination of the Company's affairs every
three years. The most recently completed triennial examination, for the three
years ended December 31, 1999, did not require the Company to restate its 1999
statutory financial statements. In general, the current regulatory requirements
in the other states in which the Company is a licensed insurer are no more
stringent than in California.
In addition to regulation by the CDI, the Company and the personal lines
insurance business in general are also subject to legislative, judicial and
political action in addition to the normal business forces of competition
between companies and the choices of consumers.
- ---------------
1 Based on programs currently in place, the Company does not expect these
retention levels to change during 2003.
2 Effective September 1, 2002, the Company entered into an agreement to
cancel future cessions under its quota share with AIG. The treaty would
have ceded 4% of premiums for the auto and motorcycle lines to AIG in the
remainder of 2002 and would have declined to 2% in 2003. After September 1,
2002, 100% of auto and motorcycle premiums are retained by the Company.
3 Personal umbrella coverage is only available to the Company's auto
customers. Approximately 1% of the auto customers have umbrella coverage.
20
To the Company's knowledge, no new laws were enacted in 2002 by any state in
which the Company does business that are expected to have a material impact on
the auto insurance industry. However, under the preceding Insurance
Commissioner, the State of California began hearings for the purpose of
implementing generic rating factors in connection with the Commissioner's
authority to approve insurance rates, including the rating of auto insurance.
The draft regulations made public by the CDI focus on restricting an insurer's
rate of return rather than on the price charged by the insurer to the consumer.
The Company believes adverse regulations could negatively affect the Company's
profitability.
HOLDING COMPANY REGULATION
The Company's subsidiaries are also subject to regulation by the CDI pursuant to
the provisions of the California Insurance Holding Company System Regulatory Act
(the "Holding Company Act"). Many transactions defined to be of an
"extraordinary" nature may not be effected without the prior approval of the
CDI. In addition, there are limits on the subsidiaries' dividend paying
capacity. An extraordinary transaction includes a dividend which, together with
other dividends or distributions made within the preceding twelve months,
exceeds the greater of (i) 10% of the insurance company's policyholders' surplus
as of the preceding December 31 or (ii) the insurance company's statutory net
income for the preceding calendar year. The California code further provides
that property and casualty insurers may pay dividends only from unassigned
surplus.
The insurance subsidiaries currently have $21.6 million of statutory unassigned
surplus that could be paid as dividends to the parent company without prior
written approval from insurance regulatory authorities in 2003. However, given
the current uncertainty surrounding the taxability of dividends received by
holding companies from their insurance subsidiaries (see further discussion in
Item 3 of this report and Note 14 of the Notes to Consolidated Financial
Statements), it is unlikely that the Company's insurance subsidiaries will make
any dividend payments to the parent in 2003. There is no assurance that the
related tax issue will be favorably resolved in the near term, in which case the
Company faces the prospect of raising additional capital at the holding company
level, cutting or ceasing dividends to stockholders, or having to pay the
additional tax on dividends from the insurance company to the holding company.
Cash and investments at the holding company were $7.0 million at December 31,
2002, compared to $52.8 million at December 31, 2001. The decline in the
parent's cash and investments is primarily due to the payment of dividends and
the repayments of intercompany balances. On December 19, 2002, the Company
declared a $1.7 million dividend to stockholders of record on December 30, 2002,
which was paid January 17, 2003. If necessary, the Company believes it can
access the capital markets should the need arise for additional capital to
support its growth and other corporate objectives.
EFFECTS OF EVENTS OF SEPTEMBER 11, 2001
The Company has no direct exposure from the events of September 11, 2001.
However, some of the Company's reinsurers do have such exposure, which could
impact their ability to meet their obligations to the Company. Based on
information received from its reinsurers, the Company does not consider any of
its reinsurance recoverables to be of doubtful collectibility.
NON-VOLUNTARY BUSINESS
Automobile liability insurers in California are required to participate in the
California Automobile Assigned Risk Plan ("CAARP"). Drivers whose driving
records or other relevant characteristics make them difficult to insure in the
voluntary market may be eligible to apply to CAARP for placement as "assigned
risks." The number of assignments for each insurer is based on the total
applications received by the plan and the insurer's market share. As of December
31, 2002, the number of assigned risk insured vehicles was 2,436 compared to
1,750 at the end of 2001. The CAARP assignments have historically produced
underwriting losses. As of December 31, 2002,
21
this business represented less than 1% of the Company's total direct premiums
written, and the underwriting losses were $0.5 million in 2002, $0.7 million in
2001 and $0.7 million in 2000.
Insurers offering homeowner insurance in California are required to participate
in the California FAIR Plan ("FAIR Plan"). FAIR Plan is a state administered
pool of difficult to insure homeowners. Each participating insurer is allocated
a percentage of the total premiums written and losses incurred by the pool
according to its share of total homeowner direct premiums written in the state.
The Company's FAIR Plan underwriting results for 2002, 2001 and 2000 were
immaterial. However, a major shortfall in FAIR Plan operations, such as might
be caused by a catastrophe, could result in an increase in costs. Participation
in the current year FAIR Plan operations is based on the pool from two years
prior. Since the Company ceased writing direct homeowners business in 2002, the
Company will continue to receive assignments in the calendar year 2003 and 2004.
EMPLOYEES
The Company had approximately 2,600 full and part-time employees at December 31,
2002. The Company provides medical, pension and 401(k) savings plan benefits to
eligible employees, according to the provisions of each plan. The Company
believes that its relationship with its employees is good.
ITEM 2. PROPERTIES
The Company leases approximately 400,000 square feet of office space for its
headquarters facilities, which are located in Woodland Hills, California. The
lease term expires in February 2015, and the lease may be renewed for two
consecutive five-year periods.
The Company also leases office space in 14 other locations, of which 9 locations
are in California primarily for claims-related employees. The Company
anticipates no difficulty in extending these leases or obtaining comparable
office facilities in suitable locations.
On December 31, 2002, the Company entered into a sale-leaseback transaction for
$15.8 million of equipment and leasehold improvements and $44.2 million of
software. The leaseback transaction has been accounted for as a capital lease.
For a summary of the Company's lease obligations, see discussion under Item 7 of
this report and Notes 7 and 11 of the Notes to Consolidated Financial
Statements.
ITEM 3. LEGAL PROCEEDINGS
In the normal course of business, the Company is named as a defendant in
lawsuits related to claim and insurance policy issues, both on individual policy
files and by class actions seeking to attack the use of various databases,
vendors and claims practices generally. Many suits seek generally unspecified
extracontractual and punitive damages as well as contractual damages far in
excess of the Company's estimates. The Company cannot estimate the amount or
range of loss that could result from an unfavorable outcome on these suits. It
denies liability for any such alleged damages and believes that it has a number
of valid defenses to the litigation. The Company has not established reserves
for potential extracontractual or punitive damages, or for damages in excess of
estimates the Company believes are correct and reasonable. Nevertheless,
extracontractual and punitive damages, if assessed against the Company, could be
material in an individual case or in the aggregate. The Company may choose to
settle litigated cases for amounts in excess of its own estimate of contractual
damages to avoid the expense and/or risk of litigation. Other than possibly for
the contingencies discussed below, the Company does not believe the ultimate
outcome of these matters will be material to its results of operations,
financial condition or cash flows.
22
On December 9, 2002, the Company commenced an arbitration proceeding against
Computer Sciences Corporation ("CSC") arising out of CSC's obligation to provide
insurance company information technology software and other software programs to
the Company. CSC has filed a counterclaim in the proceeding. In the third
quarter of 2002, the Company wrote off $37.2 million of its investment in CSC
software. The arbitration will be conducted by the American Arbitration
Association.
Bryan Speck, individually, and on behalf of others similarly situated v. 21st
- -----------------------------------------------------------------------------
Century Insurance Company, 21st Century Casualty Company, and 21st Century
- --------------------------------------------------------------------------
Insurance Group, was filed on June 20, 2002 in Los Angeles Superior Court. The
- ---------------
plaintiff seeks national class action certification, injunctive relief, and
unspecified actual and punitive damages. The complaint contends that 21st
Century uses "biased" software in determining the value of total-loss
automobiles. The plaintiff alleges that database providers use improper
methodology to establish comparable auto values and populate their databases
with biased figures. 21st Century and other carriers allegedly subscribe to the
programs to unfairly reduce claim costs. This case is consolidated with similar
actions against other insurers for discovery and pre-trial motions. 21st
Century intends to vigorously defend the suit with other defendants in the
coordinated proceedings.
Thomas Theis, on his own behalf and on behalf of all others similarly situated
- ------------------------------------------------------------------------------
v. 21st Century Insurance, was filed on June 17, 2002 in Los Angeles Superior
- -------------------------
Court. Plaintiff seeks national class action certification, injunctive relief
and unspecified actual and punitive damages. The complaint contends that after
insureds receive medical treatment, 21st Century uses a medical-review program
to adjust expenses to reasonable and necessary amounts for a given geographic
area. The plaintiff alleges that the adjusted amount is "predetermined" and
"biased," creating an unfair pretext for reducing claim costs. This case is
consolidated with similar actions against other insurers for discovery and
pre-trial motions. 21st Century intends to vigorously defend the suit with
other defendants in the coordinated proceedings.
On October 10, 2002, a Los Angeles Superior Court granted the Company's motion
for summary judgment in the matter of 21st Century Insurance Company vs. People
of the State of California ex rel. Bill Lockyer, Attorney General et al. The
court determined that the Company's April 21, 1999, settlement with the
California Department of Insurance ("CDI") with respect to regulatory actions
arising out of the 1994 Northridge Earthquake was fully valid and enforceable.
The Court denied the Attorney General's motion seeking to have the settlement
declared void and unenforceable, a result that may have allowed the CDI to
reinstitute regulatory proceedings with respect to the Company's handling of
claims arising out of the 1994 Northridge Earthquake. The CDI has appealed the
ruling.
SB 1899, effective from January 1, 2001, to December 31, 2001, allowed the
re-opening of previously closed earthquake claims arising out of the 1994
Northridge Earthquake. The Company's first constitutional challenge to SB 1899
came to an unsuccessful result on April 29, 2002, when the United States Supreme
Court refused to hear the Company's case (see Note 16 of the Notes to
Consolidated Financial Statements). A subsidiary of the Company, 21st Century
Casualty Company, filed a new challenge to the constitutionality of SB 1899 on
February 13, 2003. The viability of this case is being reviewed as a result of a
subsequent Ninth Circuit Court of Appeals decision. The Company currently has
lawsuits pending against it in connection with claims under SB 1899; many of
these lawsuits have multiple plaintiffs. Damages in excess of the Company's
reasonable estimates for these claims could be material individually or in the
aggregate.
The Company has filed a civil complaint against California-based Unlimited
Adjusting Company ("Unlimited") and its principal Jung Ho Park ("John Park").
The suit alleges Unlimited and John Park illegally induced insureds into filing
additional unnecessary and fraudulent claims with the
23
Company stemming from the 1994 Northridge Earthquake. The Company is ultimately
seeking up to $10 million in compensatory damages.
In December of 2000, a statute that allowed a tax deduction for the dividends
received from wholly owned insurance subsidiaries was held unconstitutional on
the grounds that it discriminated against out-of-state insurance holding
companies. Subsequent to the court ruling, the staff of the California
Franchise Tax Board ("FTB") has decided to take the position that the
discriminatory sections of the statute are not severable and the entire statute
is invalid. As a result, the FTB is disallowing dividend-received deductions
for all insurance holding companies, regardless of domicile, for open tax years
ending on or after December 1, 1997. Although the FTB has not made a formal
assessment for tax years 1997 through 2000, the Company anticipates a
retroactive disallowance that would result in additional tax assessments.
The amount of any such possible assessments and the ultimate amounts, if any,
that the Company may be required to pay, are subject to a wide range of
estimates because so many ostensibly long-settled aspects of California tax law
have been thrown into disarray and uncertainty by the action of the courts. In
the absence of legislative relief, years of future litigation may be required to
determine the ultimate outcome. The range of possible loss, net of federal tax
benefit, ranges from close to zero to approximately $20.8 million depending on
which position future courts may decide to uphold or on whether the California
legislature may decide to enact corrective legislation. The Company believes it
has adequately provided for this contingency.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
(a) PRICE RANGE OF COMMON STOCK
The following table sets forth the high and low bid prices for the common stock
for the indicated periods.
2002 2001
HIGH LOW High Low
- ----------------------------------------------
Fourth Quarter $14.24 $ 9.60 $19.45 $14.43
Third Quarter 19.67 9.15 19.33 16.20
Second Quarter 21.80 17.70 18.44 15.99
First Quarter 19.50 15.82 18.66 13.26
(b) HOLDERS OF COMMON STOCK
The approximate number of holders of common stock on December 31, 2002 was 617.
(c) DIVIDENDS
Quarterly dividends of $0.16 per share were paid for the first and second
quarters of 2000. Dividends of $0.08 per share were paid from the third quarter
of 2000 through the third quarter of 2002. The dividend for the fourth quarter
of 2002 was lowered to $0.02 per share.
The Company's Board of Directors considers a variety of factors in determining
the timing and amount of dividends. Accordingly, the Company's past history of
dividend payments does not assure that future dividends will be paid.
24
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data presented below as of the end of and for each of the
years in the five-year period ended December 31, 2002, are derived from, or
supplemental to, the Company's consolidated financial statements. The
consolidated financial statements as of December 31, 2002 and 2001, and for each
of the years in the three-year period ended December 31, 2002, are included in
Item 8 of this report.
All amounts set forth in the following tables are in thousands, except for
ratios and per share data.
Years Ended December 31, 2002 2001 2000 1999 1998
- -------------------------------------------------------------------------------------
PERSONAL AUTO LINES DATA
Direct premiums written $995,794 $898,862 $881,212 $ 855,783 $ 860,811
Ceded premiums written(1) (18,902) (56,205) (72,675) (86,974) (87,453)
- -------------------------------------------------------------------------------------
Net premiums written 976,892 842,657 808,537 768,809 773,358
Net premiums earned 924,559 838,489 803,770 770,234 773,158
Loss and LAE ratio(2) 82.9% 88.1% 90.8% 77.4% 74.8%
Expense ratio - GAAP(3) 15.6 14.9 14.2 12.3 10.5
- -------------------------------------------------------------------------------------
Combined ratio(4) 98.5% 103.0% 105.0% 89.7% 85.3%
- -------------------------------------------------------------------------------------
ALL LINES DATA
Direct premiums written $998,248 $929,315 $910,720 $ 880,531 $ 885,617
Ceded premiums written(5) (32,949) (60,359) (78,592) (111,718) (111,904)
- -------------------------------------------------------------------------------------
Net premiums written 965,299 868,956 832,128 768,813 773,713
Net premiums earned 924,559 864,145 825,486 770,423 772,864
Total revenues 981,295 914,078 869,762 832,681 870,650
Loss and LAE ratio 89.4% 96.7% 90.8% 78.6% 81.0%
Expense ratio - GAAP(3) 15.5 15.0 14.4 12.9 10.2
- -------------------------------------------------------------------------------------
Combined ratio(6) 104.9% 111.7% 105.2% 91.5% 91.2%
- -------------------------------------------------------------------------------------
NET (LOSS) INCOME $(12,256) $(27,568) $ 12,945 $ 87,528 $ 101,072
(LOSS) EARNINGS PER SHARE
Basic $ (0.14) $ (0.32) $ 0.15 $ 1.00 $ 1.36
Diluted (0.14) (0.32) 0.15 1.00 1.19
DIVIDENDS DECLARED AND PAID 0.26 0.32 0.48 0.64 0.58
- ------------------------------
1 The decrease in premiums ceded from 1999 through 2002 was caused primarily
by scheduled decreases in the AIG quota share program, which was terminated
effective September 1, 2002.
2 The loss and LAE ratios for 2002 and 2001 have decreased primarily due to
increases in net premiums earned and the favorable impact on claim
frequency of drought conditions that have largely prevailed in southern
California over the past 24 months.
3 The increase in the 2002 expense ratio is primarily due to increased
acquisition costs in advertising and staffing. The increase in the expense
ratio from 1998 to 2001 reflects higher depreciation charges due to
investments in new technology and the effects of rate decreases taken in
1997 to 1999.
4 The combined ratio for the personal auto lines was impacted by the
following items: $13.6 million of costs associated with workforce
reductions and the settlement of litigation matters in 2001; Year 2000
remediation costs of $2.4 million in 1999 and $5.7 million in 1998;
acceleration of restricted stock grants of $2.0 million in 1998; and
unfavorable (favorable) prior accident year loss and LAE development of
$16.2 million, $45.7 million, $42.2 million, $(14.2) million and $(39.5)
million in 2002, 2001, 2000, 1999 and 1998, respectively.
5 In addition to the AIG cession discussed in Note 1 above, the Company's
homeowners line was 100% reinsured in 1998, 1999 and 2002.
6 In addition to the effect of the items described in footnote 2 above, the
combined ratio for all lines was impacted by underwriting losses from the
homeowner and earthquake lines, which are in runoff, of $58.8 million in
2002, $77.6 million in 2001, $2.7 million in 2000, $13.1 million in 1999
and $45.5 million in 1998.
25
DECEMBER 31, 2002 2001 2000 1999 1998
- ---------------------------------------------------------------------------------------
BALANCE SHEET DATA:
Total investments and cash $1,030,478 $ 884,633 $ 920,327 $ 988,578 $1,068,621
Total assets 1,470,037 1,354,398 1,340,916 1,383,076 1,593,156
Unpaid losses and loss
adjustment expenses 384,009 349,290 298,436 276,248 382,003
Unearned premiums 266,477 236,473 236,519 232,702 233,689
Debt(1) 60,000 - - 67,500 112,500
Total liabilities 814,429 695,092 620,355 662,239 807,554
Stockholders' equity 655,608 659,306 720,561 720,837 785,602
Book value per common
share 7.67 7.72 8.46 8.39 8.97
Statutory surplus(2) 397,381 393,119 475,640 581,440 600,654
Net premiums written to
surplus ratio(3) 2.4:1 2.2:1 1.7:1 1.3:1 1.3:1
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FINANCIAL CONDITION
Investment-grade bonds comprised 99.9% of the fair value of the fixed-maturity
portfolio at December 31, 2002. The Company has no investments in equity
securities as of December 31, 2002. Of the Company's total investments at
December 31, 2002, approximately 54.5% were invested in tax-exempt, fixed-income
securities, compared to 80.2% at December 31, 2001. The Company has begun
shifting its investment focus to investment-grade taxable bonds to accelerate
the realization of the tax benefit of its net operating loss deduction (see
Critical Accounting Policies - Deferred Income Taxes).
As of December 31, 2002, the pre-tax net unrealized gain on investments was
$38.5 million compared to a pre-tax net unrealized loss of $1.5 million at
December 31, 2001. This change is primarily due to declining market interest
rates. The Company's policy is to investigate on a quarterly basis any
investment for possible "other-than-temporary" impairment in the event the fair
value of the security falls below its amortized cost, based on all relevant
facts and circumstances (see further discussion under Critical Accounting
Policies - Investments).
Premiums receivable were $91.0 million at December 31, 2002, compared to $75.6
million at December 31, 2001, with the increase mainly attributable to growth in
the Company's customer base and higher premium rates. Company policy is to
write-off receivable balances when they become past due 180 days, and the
Company historically has not considered an allowance for doubtful accounts to be
necessary.
Prepaid reinsurance premiums and reinsurance payables were $1.9 million and $5.0
million at December 31, 2002, compared to $15.4 million and $13.0 million at
December 31, 2001, respectively. The decline in balances is primarily due to
the cancellation of the quota share treaty with AIG subsidiaries (see Note 9 to
the Notes to Consolidated Financial Statements).
Increased advertising and other costs through December 31, 2002, associated with
increased customer volume, contributed to an increase in deferred policy
acquisitions costs (DPAC) of
- ------------------------------
1 Amount shown for 2002 is a capital lease obligation (see Note 7 of the
Notes to Consolidated Financial Statements).
2 Amount shown for 2002 would be $343,661 were it not for the sale-leaseback
transaction described in Note 7 of the Notes to Consolidated Financial
Statements.
3 Amount shown for 2002 would be 2.8:1 were it not for the sale-leaseback
transaction referred to above.
26
$15.6 million compared to the balance at December 31, 2001. The Company's DPAC
is estimated to be fully recoverable (see Critical Accounting Policies -
Deferred Policy Acquisition Costs).
Leased property under capital lease and obligation under capital lease increased
$53.7 million and $60.0 million, respectively, as a result of a sale-leaseback
transaction the Company entered in December 2002 (see Note 7 to the Notes to
Consolidated Financial Statements). The purpose of the transaction was to
increase the statutory surplus of 21st Century Insurance Company, the Company's
primary wholly owned subsidiary.
Property and equipment decreased $91.4 million primarily due to the
sale-leaseback described above and the write-off of certain software in the
third quarter of 2002 (see Critical Accounting Policies - Property and Equipment
and Note 7 to the Notes to Consolidated Financial Statements). The results of
management's fourth-quarter 2002 recoverability test indicated that the
remaining carrying value of the Company's software under development is likely
to be recoverable from future operations (see Critical Accounting Policies -
Property and Equipment).
Unpaid losses and loss adjustment expenses ("LAE") increased $34.7 million for
the year ended December 31, 2002 primarily due to the increase in reserves for
SB 1899 Northridge Earthquake legal defense costs (see further discussion below
under Underwriting Results - Homeowner and Earthquake Lines in Runoff and Note
16 to the Notes to Consolidated Financial Statements) and increases in auto
reserves. As indicated in the following table, the Company's auto reserves,
gross of reinsurance, have increased $31.1 million in the year ended December
31, 2002:
AMOUNTS IN THOUSANDS 2002 2001
December 31, GROSS NET Gross Net
- ------------------------------------------------------------------
Unpaid Losses and LAE
Personal auto lines $333,113 $320,032 $301,985 $280,781
Homeowner and earthquake 50,896 43,626 47,305 44,997
- ------------------------------------------------------------------
Total $384,009 $363,658 $349,290 $325,778
- ------------------------------------------------------------------
The $ 31.1 million increase in the gross auto reserves for the year ended
December 31, 2002, comprises $4.9 million due to the consolidation of 21st of
Arizona, growth in reserves attributable to the higher number of insured
automobiles of approximately $9.0 million, approximately $7.3 million relating
to the effects of higher average loss costs and approximately $9.9 million for
strengthening of prior accident year reserves (see further discussion under
Critical Accounting Policies - Losses and Loss Adjustment Expenses).
27
The following table summarizes the provision for losses and LAE, net of
applicable reinsurance, for the periods indicated:
AMOUNTS IN THOUSANDS
YEARS ENDED DECEMBER 31, 2002 2001 2000
- -----------------------------------------------------------------------------
Net Losses and LAE incurred related to insured
events of:
Auto lines
Current year $752,077 $692,593 $687,534
Prior years 16,200 45,742 42,178
- -----------------------------------------------------------------------------
Subtotal auto lines 768,277 738,335 729,712
- -----------------------------------------------------------------------------
Homeowner lines
Current year 2,222 25,636 16,831
Prior years 3,519 1,952 (545)
- -----------------------------------------------------------------------------
Subtotal homeowner lines 5,741 27,588 16,286
- -----------------------------------------------------------------------------
Earthquake
Current year - - -
Prior years 52,639 70,313 3,390
- -----------------------------------------------------------------------------
Subtotal earthquake 52,639 70,313 3,390
- -----------------------------------------------------------------------------
All lines
Current year 754,299 718,229 704,365
Prior years 72,358 118,007 45,023
- -----------------------------------------------------------------------------
Total $826,657 $836,236 $749,388
- -----------------------------------------------------------------------------
Management believes that, given the inherent variability in the estimates, the
Company's reserves are within a reasonable and acceptable range of adequacy.
However, because reserve estimates are necessarily subject to the outcome of
future events, changes in estimates are unavoidable in the property and casualty
insurance business given that loss trends vary and timing is required for
changes in trends to be recognized and confirmed. These changes sometimes are
referred to as "loss development" or "reserve development." The changes in
estimates relating to the auto lines in 2002 were smaller than in 2001 and 2000
as the changes in loss trends were identified and reserved for. The changes in
estimates relating to auto lines in 2000 for development in prior accident years
primarily resulted from the Company's assumption that the multi-year favorable
trend would continue through 1999.
The Company's reported earnings could be significantly different if ending
reserves were based on assumptions and estimates different from those used by
management (see further discussion in Part 1 of this report under the heading
Loss and Loss Adjustment Expense Reserves). During 2002 and 2001, the Company
improved the quality and timeliness of the data available to make initial
estimates and periodic changes in estimates and has dedicated more resources to
understand better the underlying drivers of the changes in frequency and
severity trends as they begin emerging. Management believes the decline in the
need for recognition of adverse development in 2002 due to prior accident years
for the personal auto lines evidences substantial improvement in the accuracy of
its estimation processes. Historically, 21st Century actuaries have not
projected a range around the carried loss reserves. Rather, they have used
several methods and different underlying assumptions to produce a number of
point estimates for the required reserves. Management selects the carried
reserve after carefully reviewing the appropriateness of the underlying
assumptions.
28
Stockholders' equity and book value per share decreased to $655.6 million and
$7.67 at December 31, 2002, compared to $659.3 million and $7.72 at December 31,
2001. The decrease for the year ended December 31, 2002, was primarily due to a
net loss of $12.3 million and dividends to stockholders of $22.2 million, offset
in part by the increase in net unrealized investment gains of $29.9 million and
other changes in comprehensive income of $0.9 million.
LIQUIDITY AND CAPITAL RESOURCES
Holding Company. The parent company's main sources of liquidity historically
have been dividends received from its insurance subsidiaries and proceeds from
issuance of debt or equity securities. The parent company currently has no
indebtedness for borrowed money outstanding, although it has guaranteed a
subsidiary's capital lease obligation. The parent's only equity security
currently outstanding is its common stock, which has no mandatory dividend
obligations.
Cash and investments at the holding company were $7.0 million at December 31,
2002, compared to $52.8 million at December 31, 2001. The decline in the
parent's cash and investments is primarily due to the payment of dividends and
the repayments of intercompany balances. On December 19, 2002, the Company
declared a $1.7 million dividend to stockholders of record on December 30, 2002,
which was paid January 17, 2003. If necessary, the Company believes it can
access the capital markets should the need arise for additional capital to
support its growth and other corporate objectives. The Company's S&P claims
paying rating currently is A+, and its A.M. Best rating is A+.
The insurance subsidiaries currently have $21.6 million of statutory unassigned
surplus that could be paid as dividends to the parent company without prior
written approval from insurance regulatory authorities in 2003. However, given
the current uncertainty surrounding the taxability of dividends received by
holding companies from their insurance subsidiaries (see further discussion in
Item 3 of this report and Note 14 of the Notes to Consolidated Financial
Statements), it is unlikely that the Company's insurance subsidiaries will make
any dividend payments to the parent in 2003. There is no assurance that the
related tax issue will be favorably resolved in the near term, in which case the
Company faces the prospect of raising additional capital at the holding company
level, cutting or ceasing dividends to stockholders, or having to pay the
additional tax on dividends on the insurance company to the holding company.
Insurance Subsidiaries. The Company believes it has taken the proper actions to
restore underwriting profitability in its core auto insurance operations and has
thereby enhanced its liquidity. In California, the Company implemented a 5.7%
auto premium rate increase on May 6, 2002, and has received approval for a 3.9%
auto premium rate increase, which it expects to implement in March 2003.
Average loss costs in 2002 have increased at an overall rate of approximately
4.0% over 2001, although this rate may have been somewhat higher but for the
favorable impact on claim frequency of drought conditions that have largely
prevailed in southern California over the past 24 months. There can be no
assurance that insurance regulators will grant future rate increases that may be
necessary to offset possible future increases in claims cost trends. Also, the
Company remains exposed to possible upward development in previously recorded
reserves for SB 1899 claims as previously discussed. As a result of such
uncertainties, underwriting losses could recur in the future. Further, the
Company could be required to liquidate investments to pay claims, possibly
during unfavorable market conditions, which could lead to the realization of
losses on sales of investments. Adverse outcomes to any of the foregoing
uncertainties would create some degree of downward pressure on the insurance
subsidiaries, which in turn could negatively impact the Company's liquidity.
As of December 31, 2002, the Company's insurance subsidiaries had a combined
statutory surplus of $397.4 million compared to $393.1 million at December 31,
2001. Significant changes in surplus were a decrease in nonadmitted assets of
$48.8 million, primarily due to the sale-
29
leaseback of $53.7 million fixed assets discussed above. Partially offsetting
this was a statutory net loss of $39.8 million and a $7.0 million decrease in
the admitted portion of the statutory deferred tax asset. The statutory net loss
for the year ended December 31, 2001 was $53.2 million compared to statutory net
income of $11.1 million for 2000. The Company's ratio of net premiums written
to surplus was 2.4 for the twelve month period ended December 31, 2002, compared
to 2.2 and 1.7 for the years ended December 31, 2001 and 2000, respectively.
On October 23, 2002, the CDI finalized its examination report on the 1999
statutory financial statements for the Company's California-domiciled insurance
subsidiaries. The report did not require the insurance subsidiaries to restate
those financial statements.
The Company has not identified any other trends, demands, commitments, events or
uncertainties that have or are considered to have a reasonable possibility of
having a material impact on the Company's liquidity.
Obligations, Letters of Credit, Guarantees and Transactions with Related
Parties. The Company currently has a capital lease obligation resulting from the
sale-leaseback transaction discussed earlier. The lease includes a covenant
that if AIG ceases to have a majority interest in the Company, or if statutory
surplus falls below $300.0 million, or if the net premiums written to surplus
ratio is greater than 3.8:1, the Company will either deliver a letter of credit
to the lessor or pay the lessor the then outstanding balance, including a
prepayment penalty of up to 3%. The Company also has operating leases for its
office facilities.
Future cash payments required under all the Company's lease obligations are
summarized below (in millions):
Capital
Lease Operating
For the years ended December 31, Obligation Leases Total
- -----------------------------------------------------------------
2003 $ 12.8 $ 17.1 $ 29.9
2004 14.0 16.3 30.3
2005 14.0 15.7 29.7
2006 14.0 14.2 28.2
2007 14.0 12.7 26.7
2008 and thereafter - 92.9 92.9
- -----------------------------------------------------------------
$ 68.8 $ 168.9 $237.7
- -----------------------------------------------------------------
The Company currently has no unused letters of credit and has issued no
guarantees on behalf of others, and has no trading activities involving
non-exchange-traded contracts accounted for at fair value. The Company has
entered into no material transactions with related parties other than the
reinsurance transactions with AIG subsidiaries. At December 31, 2002 and 2001,
reinsurance recoverables, net of payables, from AIG subsidiaries were $18.4
million and $38.8 million, respectively.
The Company has no long-term debt obligations, purchase obligations or other
long-term liabilities on its balance sheet. In addition, the Company has no
retained interests in assets transferred to an unconsolidated entity, and no
obligations under certain derivative instruments or obligations arising out of
variable interests.
RESULTS OF OPERATIONS
Overall Results. The Company reported a net loss of $12.3 million, or $0.14
loss per share, on direct premiums written of $998.2 million for the year ended
December 31, 2002, compared to a net loss of $27.6 million, or $0.32 loss per
share, on direct premiums written of $929.3 million for
30
the year ended December 31, 2001. For the year ended December 31, 2000, the
Company reported net income of $12.9 million, or $0.15 earnings per share, on
direct premiums written of $910.7 million. The results for 2002, 2001 and 2000
included pre-tax charges of $52.6 million, $70.2 million and $3.5 million,
respectively, for costs to resolve Northridge Earthquake claims. The 2002
results also include $37.2 million to write-off the costs of a software
development effort, and 2001 includes $13.6 million associated with workforce
reductions and the settlement of litigation matters.
Personal Auto Lines Operating Income, as presented in the following tables, is a
key measure used by management in monitoring the operating results of the
Company's core business. Personal auto lines operating income includes (a) the
underwriting revenues and expenses attributable to the (i) personal auto lines,
(ii) personal umbrella lines, and (iii) motorcycle lines, plus (b) investment
income excluding realized capital gains or losses on the investment portfolio;
it also excludes (c) the results of the homeowners and earthquake lines, which
are in runoff, and (d) the write-off of software discussed above.
The following table presents the components of the Company's personal auto lines
operating income:
AMOUNTS IN THOUSANDS
YEARS ENDED DECEMBER 31, 2002 2001 2000
- ------------------------------------------------------------------------------------
Direct premiums written $995,794 $898,862 $881,212
- ------------------------------------------------------------------------------------
Net premiums written $976,892 $842,657 $808,537
- ------------------------------------------------------------------------------------
Net premiums earned $924,559 $838,489 $803,770
Loss and loss adjustment expenses incurred 768,277 738,335 729,647
Underwriting expenses incurred 142,899 124,564 113,922
- ------------------------------------------------------------------------------------
Pre-tax underwriting profit (loss) on personal auto
lines 13,383 (24,410) (39,799)
Investment income 46,345 45,930 50,346
Other - (998) (1,060)
Federal income tax (expense) benefit on above (11,529) 4,233 10,009
- ------------------------------------------------------------------------------------
Personal auto lines operating income, net of tax $ 48,199 $ 24,755 $ 19,496
- ------------------------------------------------------------------------------------
The following table reconciles the Company's personal auto lines operating
income to consolidated net (loss) income:
AMOUNTS IN THOUSANDS
YEARS ENDED DECEMBER 31, 2002 2001 2000
- -----------------------------------------------------------------------------------
Personal auto lines operating income, net of tax $ 48,199 $ 24,755 $19,496
Underwriting loss on homeowner and earthquake lines (38,199) (50,439) (1,735)
Realized capital gains 6,754 3,251 3,256
Write-off of software (24,165) - -
Interest and fees - - (1,886)
State, local and other tax expense (4,845) (5,135) (6,186)
- -----------------------------------------------------------------------------------
Net (loss) income $(12,256) $(27,568) $12,945
- -----------------------------------------------------------------------------------
31
The following table presents the components of the GAAP combined ratio for the
personal auto lines:
YEARS ENDED DECEMBER 31, 2002 2001 2000
- ------------------------------------------------------------------
Personal auto lines
Loss and loss adjustment expense ratio(1) 82.9% 88.1% 90.8%
Underwriting expense ratio 15.6% 14.9% 14.2%
- ------------------------------------------------------------------
GAAP combined ratio 98.5% 103.0% 105.0%
- ------------------------------------------------------------------
Comments relating to the underwriting results of the personal auto and the
homeowner and earthquake lines in runoff are presented below.
UNDERWRITING RESULTS
The tables presented in the Notes to Consolidated Financial Statements summarize
the Company's unaudited quarterly results of operations for each of the two
years in the period ended December 31, 2002, and the results of operations by
line of business for each of the three years then ended. The following
discussion of underwriting results by line of business should be read in
conjunction with the information presented in those tables and elsewhere herein.
Personal Auto. Automobile insurance is the primary line of business written by
the Company. Vehicles insured outside of California accounted for less than 3%
of the Company's direct written premium in 2002, 2001 and 2000. At the end of
2002, the Company was licensed to write automobile insurance in 24 states
compared to 21 states at the end of 2001. The Company currently is evaluating
opportunities relating to expansion into new states but has not yet adopted
definitive plans. Because of the lead times involved, expansion into new states
is not expected to materially affect the Company's financial results in 2003.
Direct premiums written for the year ended December 31, 2002, increased $96.9
million (10.8%) to $995.8 million in 2002 compared to $898.9 million in 2001 and
$881.2 million in 2000. The increase in 2002 included rate increases ($36.7
million) and the effects of the consolidation of 21st of Arizona ($12.9
million). Also, the higher number of insured vehicles in 2002 caused premiums
to be $47.3 million higher than in 2001. The increase in 2001 was primarily due
to rate increases that more than offset the decline in the number of insured
vehicles.
California auto retention was 93% for the year ended December 31, 2002, compared
to 92% and 96% for the years ended December 31, 2001 and 2000, respectively.
The improvement in 2002 reflects improved service levels and that the Company's
major competitors have taken significant rate increases in 2002 and, therefore,
its customers are less likely to find more favorable rates elsewhere. In
response to rising loss costs beginning in November 2000 and continuing to date,
the Company has implemented three base rate increases, made changes in its class
plan and adopted stricter underwriting measures. Additionally, as the Company
upwardly adjusted its rates, it curtailed advertising for new customers
throughout 2000 and most of 2001. During this same period, competitors held
rates steady or continued to take decreases. These actions contributed to the
declines in retention in 2000 and 2001.
Net premiums earned increased $86.1 million (10.3%) to $924.6 million in 2002,
compared to $838.5 million in 2001 and $803.8 million in 2000. The increases in
2002 and 2001 are greater than the proportional increase in the corresponding
direct premiums written because of the decrease in the quota share reinsurance
arrangement with AIG subsidiaries from 6% in 2001 to
- ---------------
1 Includes changes in estimates relating to insured events of prior years as
follows: 1.8% in 2002, 5.5% in 2001, and 5.2% in 2000 and earlier.
32
4% in 2002 and from 8% in 2000 to 6% in 2001. In addition, the Company entered
into an agreement to cancel future cessions under this treaty as of September 1,
2002. The cancellation resulted in a one-time pre-tax charge of $0.9 million.
Starting in May 2002, the Company began offering motorcycle coverage primarily
to its California auto customers. In August 2002, the Company introduced a new
private passenger auto policy that does not have certain standard features found
in its primary policy. This limited-feature product is similar in most respects
to the product offered by many of the Company's competitors and is positioned as
a lower-cost alternative for customers who believe they need less coverage than
provided by the Company's standard product. In October 2002, the Company
enhanced its underwriting guidelines allowing it to provide quotes to certain
customers who do not meet California's statutory "good driver" definition but
who are considered to be insurable risks within the Company's class plan.
Through December 31, 2002, the impact of these new products on the results of
operations has been immaterial.
Net incurred losses and loss adjustment expenses increased $30.0 million (4.1%)
to $768.3 million in 2002 compared to $738.3 million and $729.6 million in 2001
and 2000, respectively. The ratios of loss and loss adjustment expenses to net
premiums earned were 82.9%, 88.1% and 90.8% for the years ended December 31,
2002, 2001 and 2000, respectively. The effects on the loss and LAE ratios of
changes in estimates relating to insured events of prior years were 1.8% in
2002, 5.5% in 2001 and 5.2% in 2000. These changes in estimates pertained
mainly to development in average paid loss severities beyond amounts previously
anticipated. For additional discussion of the factors that led to these changes
in estimates, please see Item 1 of this report under the heading Loss and Loss
Adjustment Expense Reserves. In general, changes in estimate are recorded in
the period in which new information becomes available indicating that a change
is warranted, usually in conjunction with the Company's quarterly actuarial
review.
The ratios of net underwriting expenses to net premiums earned were 15.6%, 14.9%
and 14.2% for the years ended December 31, 2002, 2001 and 2000, respectively.
The increase was primarily due to growth in advertising expenditures and costs
associated with approximately doubling the number of new sales agents, who have
been handling a record volume of new business throughout 2002. Several
productivity enhancement initiatives are underway aimed at reducing per unit
process costs and lowering fixed costs in corporate support areas.
The combined ratio was 98.5% in the year ended December 31, 2002, compared to
103.0% and 105.0% for 2001 and 2000, respectively. Company management remains
focused on achieving sustainable 15% growth and a combined ratio of 96%. Since
1980, the Company has simultaneously met those benchmarks only twice (1980 and
1981). The third and fourth quarters of 2002 both marked the first times since
1993 that the Company has achieved both an underwriting profit and growth of 15%
in direct premiums written in its auto lines.
In the third quarter of 2002 the Company entered into a catastrophe reinsurance
agreement with AIG subsidiaries, Folksamerica Reinsurance Company and
Transatlantic Reinsurance Company on its auto lines, which reinsures any covered
events up to $30.0 million in excess of $15.0 million. The premium for this
reinsurance coverage is approximately $0.1 million per month.
Homeowner and Earthquake Lines in Runoff and All Other. Underwriting results of
the homeowners and earthquake lines, which are in runoff, were losses of $58.8
million in 2002, $77.6 million in 2001 and $2.7 million in 2000. This line
included $37.2 million for the write-off of software development costs in the
third quarter of 2002.
33
The Company has not written any earthquake coverage since 1994 and ceased
writing new homeowner policies in September 2001. The Company has executed
various transactions to exit from its homeowner line. Under a January 1, 2002
agreement with Balboa Insurance Company ("Balboa"), a subsidiary of Countrywide
Financial Corporation ("Countrywide"), 100% of homeowner unearned premium
reserves and subsequent related losses were reinsured by Balboa. Obligations
relating to the 1994 Northridge Earthquake are not covered by the agreement with
Balboa. The Company began non-renewing homeowner policies expiring on February
21, 2002, and thereafter. Substantially all of these customers are being offered
homeowner coverage through an affiliate of Countrywide.
California Senate Bill 1899 ("SB 1899"), effective from January 1, 2001, to
December 31, 2001, allowed the re-opening of previously closed earthquake claims
arising out of the 1994 Northridge Earthquake. In the fourth quarter of 2001,
the Company recorded a $50.0 million pre-tax charge for loss and inspection
costs but, at that time, it was impracticable to reasonably estimate the legal
defense costs associated with previously closed earthquake claims. The
Company's constitutional challenge to SB 1899 came to an unsuccessful result on
April 29, 2002, when the United States Supreme Court refused to hear the
Company's case. Based on information subsequently available to the Company, the
Company recorded an additional $46.9 million pre-tax charge for such legal
defense costs in the third quarter of 2002.
The Company cautions that the recorded loss and LAE estimates for this event are
subject to a greater than normal degree of uncertainty for a variety of reasons
(see Note 16 of the Notes to Consolidated Financial Statements).
On October 10, 2002, a Los Angeles Superior Court granted the Company's motion
for summary judgment in the matter of 21st Century Insurance Company vs. People
of the State of California ex rel. Bill Lockyer, Attorney General et al. The
court determined that the Company's April 21, 1999, settlement with the
California Department of Insurance with respect to regulatory actions arising
out of the 1994 Northridge Earthquake was fully valid and enforceable. The
Court denied the Attorney General's motion seeking to have the settlement
declared void and unenforceable, a result that may have allowed the CDI to
reinstitute regulatory proceedings with respect to the Company's handling of
claims arising out of the 1994 Northridge Earthquake. The CDI has appealed the
ruling.
Since 1997, the Company has engaged an external software development company,
Computer Sciences Corporation ("CSC"), to develop and install an advanced
personal-lines processing system. The system has four main components: Policy,
Claims, Billing, and Customer Service. The system is still in development and
currently supports less than 2% of the Company's business. To date, the Company
has spent nearly $100 million on this project, most of which was paid directly
to CSC. In the third quarter of 2002, it became evident through a series of
tests and reviews conducted by the Company that material components of this new
system do not perform at levels necessary to support the entire operations of
the Company, and the Company recorded a one-time pre-tax charge to write-off
$37.2 million of previously capitalized software costs.
On December 9, 2002, the Company commenced an arbitration proceeding against CSC
arising out of CSC's obligation to provide insurance company information
technology software and other software programs to the Company. CSC has filed a
counterclaim in the proceeding. The arbitration will be conducted in accordance
with the rules of the American Arbitration Association.
Capital expenditures relating to this project totaled $5.1 million, $45.3
million and $20.7 million in 2002, 2001 and 2000, respectively. At December 31,
2002, management has estimated that the $64.4 million carrying value and the
$40.0 million estimated cost to
34
complete such software, or $104.4 million in total, is recoverable from cost
savings from future operations. However, if the remaining software components
cannot be successfully implemented, some or all of the remaining $64.4 million
carrying value may be written off (see Critical Accounting Policies - Property
and Equipment).
INVESTMENT INCOME
The Company utilizes a conservative investment philosophy. No equities,
derivatives or nontraditional securities are held in the Company's investment
portfolio. Substantially all of the portfolio is investment grade. Net
investment income was $46.3 million in 2002, compared to $45.9 million in 2001
and $50.3 million in 2000. Average invested assets increased 1.3% in 2002 from
the prior year and decreased 8.0% in 2001 from 2000. The decrease in 2001 was
primarily due to the sale of investments to cover incurred loss costs, the
acquisitions of property and equipment and the payment of dividends to
stockholders. The average annual pre-tax yields on invested assets were 5.1% in
2002, 5.1% in 2001 and 5.2% in 2000. The average annual after-tax yields on
invested assets were 4.3% in 2002, 4.5% in 2001 and 4.6% in 2000.
Net realized gains on the sale of investments were $10.4 million in 2002 (gross
realized gains were $13.1 million, gross realized losses were $2.2 million and
investment expenses were $0.4 million) compared to $5.0 million in 2001 and net
realized losses of $5.0 million in 2000. At December 31, 2002, $561.4 million
(54.5%) of the Company's total investments at fair value were invested in
tax-exempt bonds with the remainder, representing 45.5% of the portfolio,
invested in taxable securities, compared to 80.2% and 19.8%, respectively, at
December 31, 2001.
As of December 31, 2002, the Company had a pre-tax net unrealized gain of $38.5
million compared to a net unrealized loss on fixed maturity investments of $1.5
million in 2001 and a net unrealized gain of $3.7 million in 2000. The Company
recognized no other-than-temporary impairments in 2002, 2001 or 2000 (see
discussion under Critical Accounting Policies).
CRITICAL ACCOUNTING POLICIES
The Company believes its critical accounting policies are those which require
management to make significant assumptions or estimates, and to ascertain the
appropriateness and timing of any changes in those assumptions or estimates that
can have a material effect on the Company's financial condition, results of
operations or cash flows. Specifically, the following areas require management
to make such assumptions and estimates each time the Company prepares its
financial statements: losses and loss adjustment expenses, particularly the
liability for unpaid losses and loss adjustment expenses included in the
liability section of the Company's balance sheet; the recoverability of certain
property and equipment, deferred income taxes, and deferred policy acquisition
costs included in the asset section of the Company's balance sheet; and the
review of the Company's investments for possible "other-than-temporary" declines
in fair value.
Management has discussed the Company's critical accounting policies and
estimates, together with any changes therein, with the Audit Committee of the
Company's Board of Directors. The Company's Disclosure Committee and Audit
Committee have reviewed the Company's disclosures in this document.
Losses and Loss Adjustment Expenses. The estimated liabilities for losses and
loss adjustment expenses ("LAE") include the accumulation of estimates of losses
for claims reported prior to the balance sheet dates, estimates (based upon
actuarial analysis of historical data) of losses for claims incurred but not
reported, the development of case reserves to ultimate values and estimates of
expenses for investigating, adjusting and settling all incurred claims. Amounts
reported are estimates of the ultimate costs of settlement, net of estimated
salvage and subrogation. The estimated liabilities are necessarily subject to
the outcome of future events, such as changes in medical and repair costs, as
well as economic and social conditions that impact the
35
settlement of claims. In addition, time can be a critical part of reserving
determinations since the longer the span between the incidence of a loss and the
payment or settlement of the claim, the more variable the ultimate settlement
amount can be. Accordingly, short-tail claims, such as property damage claims,
tend to be more reasonably predictable than long-tail liability claims. For the
Company's current mix of auto exposures, which include both property and
liability exposures, an average of approximately 63% of the ultimate losses are
settled within twelve months of the date of loss.
Given the inherent variability in the estimates, management believes the
aggregate reserves are within a reasonable and acceptable range of adequacy(1),
although the Company continues to caution that the reserve estimates relating to
SB 1899(2) are subject to a greater than normal degree of variability and
possible future material adjustment as new facts become known. The methods of
making such estimates and establishing the resulting reserves are reviewed and
updated quarterly and any resulting adjustments are reflected in current
operations(3). Changes in the estimates for these liabilities flow directly to
the income statement on a dollar-for-dollar basis. For example, an upward
revision of $1 million in the estimated liability for unpaid losses and loss
adjustment expenses would decrease underwriting profit, and pre-tax income, by
the same $1 million amount. Conversely, a downward revision of $1 million would
increase pre-tax income by the same $1 million amount.
Property and Equipment. Accounting standards require long-term assets to be
tested for possible impairment under certain conditions. At December 31, 2002,
management believes the Company's remaining capitalized costs for Policy and
Claims software is the only long-term asset that meets the conditions for
impairment testing. Under the applicable accounting standards, the first step
is to determine whether the carrying value and cost to complete the asset is
recoverable from future operations, based on estimates of future undiscounted
cash flows; if not, then an impairment write down would be required to be
recognized based on the fair value of the asset. At December 31, 2002,
management has estimated that the $64.4 million carrying value and $40.0 million
estimated cost to complete such software, or $104.4 million in total, is
recoverable from cost savings from future operations. This conclusion is based
primarily on the assumptions that the software can be successfully implemented
and can reduce the Company's employee count by at least 125 people (about 5% of
its workforce) for the 10 to 15 years after implementation (i.e., the current
estimate of the probable productive life of the software). Once the project has
successfully reached the stage where it is substantially complete and ready for
its intended use, the Company anticipates there will be annual depreciation
charges varying from approximately $5.8 million to $8.8 million. However,
although management believes it is reasonable to assume these future cost
savings, it must be noted that any such estimates are subject to considerable
uncertainty and there can be no assurance that such cost savings will be
achieved.
Deferred Income Taxes. Generally accepted accounting principles require
deferred tax assets and liabilities ("DTAs" and "DTLs," respectively) to be
recognized for the estimated future tax effects attributed to temporary
differences and carryforwards based on provisions of the enacted tax law. The
effects of future changes in tax laws or rates are not anticipated. "Temporary
differences" are differences between the tax basis of an asset or liability and
its reported amount in the financial statements. For example, the Company has a
DTA because the tax basis of its loss and LAE reserves is smaller than their
book basis, and it has a DTL because the book basis of its capitalized software
exceeds its tax basis. "Carryforwards" include such items as alternative
minimum tax credits, which may be carried forward indefinitely, and net
operating losses
- ---------------
1 See further discussion in Part 1, Loss and Loss Adjustment Expenses, and in
Part 7 under Financial Condition.
2 See Note 1 above and Note 16 of the Notes to Consolidated Financial
Statements.
3 See Note 1 above.
36
(NOLs), which can be carried forward 15 years for losses incurred before 1998
and 20 years thereafter. A summary of the significant DTAs and DTLs relating to
the Company's temporary differences and carryforwards is included in Note 5 of
the Notes to Consolidated Financial Statements.
At December 31, 2002, the Company's DTAs total $163.9 million, and its DTLs
total $75.0 million. The net of those amounts, $88.9 million, represents the net
deferred tax asset reported in the consolidated balance sheet.
The Company is required to reduce DTAs (but not DTLs) by a valuation allowance
if, based on the weight of available evidence, it is "more likely than not"
(i.e., a likelihood of more than 50%) that some portion or all of the DTAs will
not be realized. Recognition of a valuation allowance would decrease reported
earnings on a dollar for dollar basis in the year in which any such recognition
were to occur.
The determination of whether a valuation allowance is appropriate requires the
exercise of management judgment. In making this judgment, management is
required to weigh the positive and negative evidence as to the likelihood that
the DTAs will be realized.
Portions of the Company's NOL carryforward are scheduled to expire beginning in
2009, as shown in the table of expirations below (amounts in millions):
YEAR OF NOL EXCLUDING SRLY(1) NOL OF CONSOLIDATED
EXPIRATION 21ST OF ARIZONA 21ST OF ARIZONA NOL
- -------------------------------------------------------------
2009 $104.6 $ - $104.6
2011 - 0.6 0.6
2012 - 2.0 2.0
2018 - 1.1 1.1
2019 - 1.5 1.5
2020 80.5 3.2 83.7
2021 134.6 2.2 136.8
2022 37.0 - 37.0
- -------------------------------------------------------------
Totals $356.7 $10.6 $367.3
- -------------------------------------------------------------
With the performance of the Company's core business in the past two quarters
running close to management's goals of 15% growth in direct written premiums and
a 96% combined ratio, management believes it is reasonable to discount the
possibility of future underwriting losses and to conclude it is at least more
likely than not that the Company will be able to realize the benefits of its
DTAs. If necessary, the Company believes it could implement tax-planning
strategies, such as investing a higher proportion of its investment portfolio in
taxable securities, in order to generate sufficient future taxable income to
utilize the NOL carryforwards prior to their expiration. Accordingly, no
valuation allowance has been recognized as of December 31, 2002. However,
generating future taxable income is dependent on a number of factors, including
regulatory and competitive influences that may be beyond the Company's ability
to control. Future underwriting losses could possibly jeopardize the Company's
ability to utilize its NOLs. In the event underwriting losses due to either SB
1899 or other causes were to persist, management might be required to reach a
different conclusion about the realizability of the DTAs and, if so, to
recognize a valuation allowance at that time.
- ---------------
1 "SRLY" stands for Separate Return Limitation Year.
37
Deferred Policy Acquisition Costs. Deferred policy acquisition costs ("DPAC")
include premium taxes and other variable costs incurred in connection with
writing business. These costs are deferred and amortized over the period in
which the related premiums are earned.
Management assesses the recoverability of deferred policy acquisition costs on a
quarterly basis. The assessment calculates the relationship of actuarially
estimated costs incurred to premiums from contracts issued or renewed for the
period. The Company does not consider anticipated investment income in
determining the recoverability of these costs. Based on current indications, no
reduction in DPAC is required unless the loss and loss adjustment expense ratio
should exceed 82.7%.
The loss and LAE ratio used in the recoverability estimate is based primarily on
the assumption that the future loss and LAE ratio will approximate that of the
recent past. While management believes that is a reasonable assumption, actual
results could differ materially from such estimates.
Investments. Impairment losses for declines in value of fixed maturity
investments below cost attributable to issuer-specific events are based upon all
relevant facts and circumstances for each investment and are recognized when
appropriate in accordance with Staff Accounting Bulletin ("SAB") 59 - Noncurrent
Marketable Equity Securities, Financial Accounting Statement ("FAS") No. 115 -
Accounting for Certain Investments in Debt and Equity Securities, and related
guidance. For fixed maturity investments with unrealized losses due to market
conditions or industry-related events, where the Company has the positive intent
and ability to hold the investment for a period of time sufficient to allow a
market recovery or to maturity, declines in value below cost are not assumed to
be other-than-temporary. Where declines in values of securities below cost or
amortized cost are considered to be other than temporary, a charge is required
to be reflected in income for the difference between cost or amortized cost and
the fair value. No such charges were recorded in 2002, 2001 or 2000.
The determination of whether a decline in market value is other than temporary
is necessarily a matter of subjective judgment. The timing and amount of
realized losses and gains reported in income could vary if conclusions other
than those made by management were to determine whether an other-than-temporary
impairment exists. However, there would be not impact on equity because any
unrealized losses are already included in comprehensive income.
38
The following table summarizes realized gains and losses for the past three
years. Additional information has been provided with respect to how long
securities sold at a loss in each year were in an unrealized loss position.
Amounts in thousands
Years Ended December 31, 2002 2001 2000
- --------------------------------------------------------------------------------------------
Realized (losses) on sales of fixed maturity securities:
Held for less than one year $ (322) $ (147) $(2,743)
- --------------------------------------------------------------------------------------------
Held one year or more
In an unrealized loss position at December 31, 2001 (83) N/A N/A
In an unrealized loss position at December 31, 2000 - - N/A
In an unrealized loss position at December 31, 1999 (196) (372) (1,123)
In an unrealized loss position at December 31, 1998 (1,567) (141) (1,512)
In an unrealized loss position at December 31, 1997 - (216) (1,183)
In an unrealized gain position at December 31, 2001 (15) N/A N/A
In an unrealized gain position at December 31, 2000 - (235) N/A
In an unrealized gain position at December 31, 1999 - - -
- --------------------------------------------------------------------------------------------
Total realized losses on sales of fixed maturity securities
held one year or more (1,861) (964) (3,818)
- --------------------------------------------------------------------------------------------
Total realized loss on sales of securities (2,183) (1,111) (6,561)
Total realized gain on sales of securities 13,053 5,912 1,685
Realized gain (loss) on disposal of property and equipment (479) 200 (134)
- --------------------------------------------------------------------------------------------
Total realized investment gains (losses) $10,391 $ 5,001 $(5,010)
- --------------------------------------------------------------------------------------------
The following table summarizes the fair values of fixed maturity securities sold
at a loss or at a gain on the date of sale (amounts in thousands):
Years Ended December 31, 2002 2001 2000
- -------------------------------------------------------------------------------------
Fair value of securities sold at a loss on date of sale $111,144 $140,334 $184,954
Fair value of securities sold at a gain on date of sale $470,043 $363,467 $110,840
A summary by issuer of noninvestment grade securities and unrated securities
held at year-end follows (amounts in thousands):
December 31, 2002 2001
- ------------------------------------------------------------------------
Noninvestment grade securities (i.e., rated below BBB):
Corning, Inc. $ 850 $ -
Unrated securities:
Impact Funding, LLC(1) 2,023 1,729
- ------------------------------------------------------------------------
Total noninvestment grade and unrated securities $2,873 $1,729
- ------------------------------------------------------------------------
- ---------------
1 Impact Funding, LLC, is a limited partnership that was established under
California's COIN program (California Organized Investment Network), a
voluntary association of California insurers providing funding for low cost
housing projects.
39
The following table lists issuers of securities held by the Company having an
unrealized loss of $100,000 or more and aggregate information relating to all
other investments in unrealized loss positions as of December 31:
2002 2001
------------------------------------------------------------------
UNREALIZED Unrealized
FAIR VALUE AT LOSS AT END OF Fair Value at Loss at End of
Years Ended December 31, END OF YEAR YEAR End of Year Year
- --------------------------------------------------------------------------------------------------------------------
Fixed maturities in an unrealized loss position
less than one year:
Teco Energy, Inc. $ 5,100 $ (819) $ - $ -
Sears Roebuck Acceptance Corp 8,543 (516) - -
Mallinckrodt Group, Inc. 2,572 (317) - -
Duke Capital Corp. 7,126 (266) - -
Ford Motor Credit Co. 4,859 (213) - -
Federal Home Loan Bank - - 7,749 (247)
Others individually having an unrealized
loss less than $100,000 each (15 issuers
in 2002 and 188 in 2001) 42,577 (369) 318,820 (5,492)
- --------------------------------------------------------------------------------------------------------------------
Subtotal 70,777 (2,500) 326,569 (5,739)
- --------------------------------------------------------------------------------------------------------------------
Fixed maturities in an unrealized loss position
one year or more:
Corning, Inc. 850 (131) 892 (86)
Ashland, Inc. 2,013 (36) 3,999 (117)
Capital One Bank - - 4,680 (423)
Computer Associates International - - 4,786 (285)
Others individually having an unrealized
loss less than $100,000 each (92 issuers
in 2001) - - 163,900 (2,127)
- --------------------------------------------------------------------------------------------------------------------
Subtotal 2,863 (167) 178,257 (3,038)
- --------------------------------------------------------------------------------------------------------------------
Total $73,640 $ (2,667) $504,826 $(8,777)
- --------------------------------------------------------------------------------------------------------------------
A summary of bond maturities in an unrealized loss position by year of maturity
follows:
2002 2001
--------------------------------------------
AMORTIZED CARRYING AMORTIZED CARRYING
December 31, COST VALUE COST VALUE
- --------------------------------------------------------------------------------------
Bond Maturities
Due in one year or less $ - $ - $ - $ -
Due after one year through five years 5,415 5,076 - -
Due after five years through ten years 30,099 28,280 38,621 37,299
Due after ten years 40,792 40,284 474,982 467,527
- --------------------------------------------------------------------------------------
$ 76,306 $ 73,640 $ 513,603 $ 504,826
- --------------------------------------------------------------------------------------
AUDIT COMMITTEE FINANCIAL EXPERT
The Board of Directors of the Company considers a financial expert to be a
person who has, through either education or experience, an understanding of
generally accepted accounting principles and financial statements, experience in
preparing or auditing financial statements comparable to the Company's, and the
application of such principles in connection with accounting for estimates,
accruals and reserves. Keith Renken is the financial expert serving on
40
the Company's audit committee; he is independent of management. Mr. Renken
retired as Senior Partner and Chairman, Executive Committee of Southern
California, of accounting firm Deloitte & Touche in 1992 after 33 years with the
firm.
POLICIES REGARDING CONFLICTS OF INTEREST AND ETHICAL BEHAVIOR
The Company has adopted policies regarding conflicts of interest and ethical
behavior among its employees, particularly those with responsibilities in the
areas of accounting, financial reporting and maintaining the integrity of the
Company's internal control structure. These policies include standards that are
reasonably necessary to promote:
- - honest and ethical conduct, including the ethical handing of actual or
apparent conflicts of interest between personal and professional
relationships;
- - avoidance of conflicts of interest, including disclosure to an appropriate
person or persons of any material transaction or relationship that
reasonably could be expected to give rise to such a conflict;
- - full, fair, accurate, timely and understandable disclosure in the reports
and documents that the Company files and in other public communications
made by the Company;
- - compliance with applicable governmental laws, rules and regulations;
- - the prompt internal reporting of code violations to an appropriate person
or personal identified in the code; and
- - accountability for adherence to the code.
The Company requires an annual attestation by applicable officers, directors and
employees that they are in compliance with these policies. The Company's Board
of Directors granted no conflict of interest waivers in 2002.
FORWARD-LOOKING STATEMENTS
The Company's management has made in this report, and from time to time may make
in its public filings, press releases, and oral presentations and discussions,
forward-looking statements concerning the Company's operations, economic
performance and financial condition. Forward-looking statements include, among
other things, discussions concerning the Company's potential, expectations,
beliefs, estimates, forecasts, projections and assumptions. Forward-looking
statements may address, among other things, the Company's strategy for growth,
underwriting results, product development, computer systems, regulatory
approvals, market position, financial results, dividend policy and reserves. It
is possible that the Company's actual results, actions and financial condition
may differ, possibly materially, from the anticipated results, actions and
financial condition indicated in these forward-looking statements. Important
factors that could cause the Company's actual results and actions to differ,
possibly materially, from those in the specific forward-looking statements
include the effects of competition and competitors' pricing actions; adverse
underwriting and claims experience, including revived claims under SB 1899;
systems and customer service problems; adverse developments in financial markets
or interest rates; and results of legislative, regulatory or legal actions,
including the inability to obtain approval for rate increases and product
changes and adverse actions taken by state regulators in market conduct
examinations. The Company does not undertake any obligation to update or revise
any forward-looking statements, whether as a result of new information, future
events or otherwise.
41
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and
interest rates. In addition to market risk, the Company is exposed to other
risks, including the credit risk related to its financial instruments and the
underlying insurance risk related to its core business and the exposure of the
personal lines insurance business, as a regulated industry, to legal,
legislative, judicial, political and regulatory action. The following table
shows the financial statement carrying values of the Company's financial
instruments, which are reported at fair value. The estimated fair values at
adjusted market rates/prices assumes a 100 basis point increase in market
interest rates for the investment portfolio and a 100 basis point decrease in
market interest rates for the capital lease obligation. The following
sensitivity analysis summarizes only the exposure to market interest rate risk
as of December 31, 2002.
Estimated Fair Value
at Adjusted Market
Carrying Rates/Prices
(Amounts in millions) Value Indicated Below
- --------------------------------------------------------------------------------
Fixed maturity investments available for sale $ 924.6 $ 859.8
Capital lease obligation 60.0 61.2
The Company's cash flow from operations and short-term cash position generally
is more than sufficient to meet its obligations for claim payments, which by the
nature of the personal automobile insurance business tend to have an average
duration of less than a year. As a result, it has been unnecessary for the
Company to employ elaborate market risk management techniques involving
complicated asset and liability duration matching or hedging strategies. For all
of its financial assets and liabilities, the Company seeks to maintain
reasonable average durations, currently 6.3 years, consistent with the
maximization of income without sacrificing investment quality and providing for
liquidity and diversification. Financial instruments are not used for trading
purposes.
The sensitivity analysis provides only a limited, point-in-time view of the
market risk sensitivity of the Company's financial instruments. The actual
impact of market interest rate and price changes on the financial instruments
may differ significantly from those shown in the analysis.
42
ITEM 7B. MANAGEMENT'S INTERNAL CONTROL REPORT
The Company's certifying officers have established and maintained disclosure
controls, internal controls and procedures to ensure the (a) reliability of
financial reporting, (b) effectiveness and efficiency of operations; and (c)
compliance with applicable laws and regulations. As part of these procedures,
the Company has established a Disclosure Committee comprised of the senior
officers responsible for the Company's operations, including the Chief Executive
Officer, General Counsel, Chief Financial Officer, Controller and Chief Internal
Auditor.
The Disclosure Committee met specifically regarding the design and effectiveness
of the internal controls over financial reporting and disclosure. The Disclosure
Committee's evaluation for the year ended December 31, 2002 was completed on or
about January 24, 2003. Based on the Disclosure Committee's evaluation, the
Company's Chief Executive Officer and Chief Financial Officer reached the
following conclusions:
- - There were no significant deficiencies in the design or operation of
internal controls which could affect the Company's ability to record,
process, summarize and report financial data in accordance with applicable
laws and regulations;
- - No material weaknesses in internal controls were noted that should be
disclosed to the Company's independent auditors, Audit Committee or Board
of Directors;
- - No fraud, whether or not material, that involves management or employees
who have a significant role in the Company's internal controls, was
identified.
Subsequent to the date of the evaluation, the Disclosure Committee and
certifying officers have not become aware of any significant changes in internal
controls or in other factors that could significantly affect internal controls,
including any corrective actions with regard to significant deficiencies or
material weaknesses.
43
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT ACCOUNTANTS
STOCKHOLDERS AND BOARD OF DIRECTORS
21ST CENTURY INSURANCE GROUP
In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a)(1) on page 74 present fairly, in all material
respects, the financial position of 21st Century Insurance Group and its
subsidiaries at December 31, 2002 and 2001, and the results of their operations
and their cash flows for each of the two years in the period ended December 31,
2002 in conformity with accounting principles generally accepted in the United
States of America. In addition, in our opinion, the financial statement schedule
for each of the two years in the period ended December 31, 2002 listed in the
index appearing under Item 14(a)(2) on page 74 presents fairly, in all material
respects, the information set forth therein when read in conjunction with the
related consolidated financial statements. These financial statements and
financial statement schedule are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with auditing standards generally accepted in the
United States of America, which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
Los Angeles, California
February 14, 2003
44
REPORT OF INDEPENDENT AUDITORS
STOCKHOLDERS AND BOARD OF DIRECTORS
21ST CENTURY INSURANCE GROUP
We have audited the accompanying consolidated statements of operations,
stockholders' equity, and cash flows of 21st Century Insurance Group and
subsidiaries for the year ended December 31, 2000. Our audit also included the
financial statement schedule listed in the Index at Item 14(a). These financial
statements and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedule based on our audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated results of operations,
stockholders' equity and cash flows of 21st Century Insurance Group and
subsidiaries for the year ended December 31, 2000, in conformity with accounting
principles generally accepted in the United States. Also, in our opinion, the
related financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material respects
the information set forth therein.
Ernst & Young LLP
Los Angeles, California
January 26, 2001
45
21ST CENTURY INSURANCE GROUP
CONSOLIDATED BALANCE SHEETS
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
December 31, 2002 2001
- -----------------------------------------------------------------------------------------------
ASSETS
Fixed maturity investments available-for-sale, at fair value
(amortized cost: $886,047 and $857,209) $ 924,581 $ 855,724
Cash and cash equivalents 105,897 28,909
- -----------------------------------------------------------------------------------------------
Total investments and cash 1,030,478 884,633
Accrued investment income 13,230 11,733
Premiums receivable 91,029 75,559
Reinsurance receivables and recoverables 28,105 40,138
Prepaid reinsurance premiums 1,893 15,444
Deferred income taxes 88,939 96,216
Deferred policy acquisition costs 46,190 30,631
Leased property under capital lease, net of deferred gain of $6,280 53,720 -
Property and equipment, at cost less accumulated depreciation of
$52,125 and $66,462 87,274 178,672
Other assets 29,179 21,372
- -----------------------------------------------------------------------------------------------
Total assets $1,470,037 $1,354,398
- -----------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Unpaid losses and loss adjustment expenses $ 384,009 $ 349,290
Unearned premiums 266,477 236,473
Obligation under capital lease 60,000 -
Claims checks payable 39,304 36,105
Reinsurance payable 4,952 12,993
Other liabilities 59,687 60,231
- -----------------------------------------------------------------------------------------------
Total liabilities 814,429 695,092
- -----------------------------------------------------------------------------------------------
Stockholders' equity:
Common stock, without par value; authorized 110,000,000 shares,
outstanding 85,431,505 in 2002 and 85,361,848 in 2001 418,984 416,991
Retained earnings 213,067 248,635
Accumulated other comprehensive income (loss) 23,557 (6,320)
- -----------------------------------------------------------------------------------------------
Total stockholders' equity 655,608 659,306
- -----------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $1,470,037 $1,354,398
- -----------------------------------------------------------------------------------------------
See accompanying Notes to Consolidated Financial Statements.
46
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Years Ended December 31, 2002 2001 2000
- ------------------------------------------------------------------------------------------
REVENUES
Net premiums earned $ 924,559 $ 864,145 $ 825,486
Net investment income 46,345 45,930 50,346
Other - (998) (1,060)
Realized investment gains (losses) 10,391 5,001 (5,010)
- ------------------------------------------------------------------------------------------
Total revenues 981,295 914,078 869,762
- ------------------------------------------------------------------------------------------
LOSSES AND EXPENSES
Net losses and loss adjustment expenses 826,657 836,236 749,388
Policy acquisition costs 123,642 102,558 91,386
Other operating expenses 19,645 27,359 27,180
Write-off of software 37,177 - -
Interest and fees expense - - 2,901
- ------------------------------------------------------------------------------------------
Total losses and expenses 1,007,121 966,153 870,855
- ------------------------------------------------------------------------------------------
Loss before federal income taxes (25,826) (52,075) (1,093)
Federal income tax benefit (13,570) (24,507) (14,038)
- ------------------------------------------------------------------------------------------
Net (loss) income $ (12,256) $ (27,568) $ 12,945
- ------------------------------------------------------------------------------------------
(LOSS) EARNINGS PER COMMON SHARE
Basic $ (0.14) $ (0.32) $ 0.15
- ------------------------------------------------------------------------------------------
Diluted $ (0.14) $ (0.32) $ 0.15
- ------------------------------------------------------------------------------------------
Weighted average shares outstanding - basic 85,414,076 85,340,461 85,186,084
- ------------------------------------------------------------------------------------------
Weighted average shares outstanding - diluted 85,414,076 85,340,461 85,397,099
- ------------------------------------------------------------------------------------------
See accompanying Notes to Consolidated Financial Statements.
47
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Accumulated
Other
Common Retained Comprehensive
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA Stock Earnings Income (Loss) Total
- ----------------------------------------------------------------------------------------------------------
Balance - January 1, 2000 $429,623 $ 331,733 $ (40,519) $720,837
Comprehensive income 12,945(1) 42,302(2) 55,247
Cash dividends paid on common stock ($0.48 per share) (40,964) (40,964)
Stock repurchased and retired (16,598) (16,598)
Other 2,039 2,039
- ----------------------------------------------------------------------------------------------------------
Balance - December 31, 2000 415,064 303,714 1,783 720,561
Comprehensive loss (27,568)(1) (8,103)(2) (35,671)
Cash dividends paid on common stock ($0.32 per share) (27,310) (27,310)
Other 1,927 (201) 1,726
- ----------------------------------------------------------------------------------------------------------
Balance - December 31, 2001 416,991 248,635 (6,320) 659,306
Comprehensive income (12,256)(1) 29,877(2) 17,621
Cash dividends paid on common stock ($0.26 per share) (22,210) (22,210)
Other 1,993 (1,102) 891
- ----------------------------------------------------------------------------------------------------------
Balance - December 31, 2002 $418,984 $ 213,067 $ 23,557 $655,608
- ----------------------------------------------------------------------------------------------------------
(1) Net income (loss) for the year.
(2) Change in accumulated other comprehensive income (loss) (see Note 4 of the
Notes to Consolidated Financial Statements).
See accompanying Notes to Consolidated Financial Statements.
48
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Years Ended December 31, 2002 2001 2000
- -------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net (loss) income $ (12,256) $ (27,568) $ 12,945
Adjustments to reconcile net (loss) income to net cash
provided by operating activities:
Provision for depreciation and amortization 20,341 21,031 14,605
Write-off of software 37,177 - -
Amortization of restricted stock grants 506 695 180
Benefit for deferred income taxes (5,370) (19,418) (3,961)
Realized (gains) losses on sale of investments (10,391) (5,001) 5,010
Federal income taxes (benefit) 4,670 5,759 (11,031)
Reinsurance balances 17,542 11,797 12,131
Unpaid losses and loss adjustment expenses 34,720 50,854 22,187
Unearned premiums 30,004 (46) 3,817
Claim checks payable 3,198 123 4,070
Other assets (38,068) (5,264) (3,697)
Other liabilities (5,781) 19,572 556
- -------------------------------------------------------------------------------------------
Net cash provided by operating activities 76,292 52,534 56,812
- -------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Fixed maturities available-for-sale
Purchases (625,690) (461,578) (208,957)
Calls or maturities 41,850 15,783 2,809
Sales 564,398 502,254 298,044
Net purchases of property and equipment (19,140) (61,247) (63,301)
- -------------------------------------------------------------------------------------------
Net cash (used in) provided by investing activities (38,582) (4,788) 28,595
- -------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Obligation under capital lease 60,000 - -
Bank loan principal repayment - - (67,500)
Dividends declared and paid (per share: $0.26; $0.32;
and $0.48) (22,210) (27,310) (40,964)
Common stock repurchased - - (16,598)
Proceeds from the exercise of stock options 1,488 1,233 1,861
- -------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities 39,278 (26,077) (123,201)
- -------------------------------------------------------------------------------------------
Net increase (decrease) in cash 76,988 21,669 (37,794)
Cash and cash equivalents, beginning of year 28,909 7,240 45,034
- -------------------------------------------------------------------------------------------
Cash and cash equivalents, end of year $ 105,897 $ 28,909 $ 7,240
- -------------------------------------------------------------------------------------------
SUPPLEMENTAL INFORMATION
Income taxes refunded $ 12,920 $ 11,435 $ 3,555
Interest paid - - (2,204)
See accompanying Notes to Consolidated Financial Statements.
49
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 1. DESCRIPTION OF BUSINESS
- --------------------------------
21st Century Insurance Group is an insurance holding company founded in 1958 and
incorporated in California. The term "Company," unless the context requires
otherwise, refers to 21st Century Insurance Group and its consolidated
subsidiaries, all of which are wholly owned: 21st Century Insurance Company,
21st Century Casualty Company, 21st Century Insurance Company of Arizona(1)
("21st of Arizona"), 20th Century Insurance Services, inc., and i21 Insurance
Services. The latter two companies are not property and casualty insurance
subsidiaries, and their results are immaterial.
The common stock of the Company is traded on the New York Stock Exchange under
the trading symbol "TW." Through several of its subsidiaries, American
International Group, Inc. ("AIG"), currently owns approximately 63% of the
Company's outstanding common stock.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
- ---------------------------------------------------
BASIS OF CONSOLIDATION AND PRESENTATION
The accompanying consolidated financial statements include the accounts and
operations of the Company. All material intercompany accounts and transactions
have been eliminated. The consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the United States
of America ("GAAP"). The preparation of the financial statements in conformity
with GAAP requires management to make estimates and assumptions that affect the
amounts reported in the financial statements. Actual results could differ from
these estimates.
INVESTMENTS
The Company classifies its investment portfolio as available-for-sale and
carries it at fair value. Fair values for fixed maturity and equity securities
are based on quoted market prices, broker quotes and other valuation techniques.
The cost of investment securities sold is determined by the specific
identification method.
Unrealized investment gains and losses, net of any tax effect, are included as
an element of accumulated other comprehensive income (loss), which is classified
as a separate component of stockholders' equity.
Impairment losses for declines in value of fixed maturity investments below
costs attributable to issuer-specific events are based upon all relevant facts
and circumstances for each investment and are recognized when appropriate in
accordance with SAB 59 - Noncurrent Marketable Equity Securities, FAS No. 115 -
Accounting for Certain Investments in Debt and Equity Securities, and related
guidance. For fixed-maturity investments with unrealized losses due to market
conditions or industry-related events, where the Company has the positive intent
and ability to hold the investment for a period of time sufficient to allow a
market recovery or to maturity, declines in value below cost are not assumed to
be other than temporary.
- ---------------
1 21st of Arizona was incorporated in Arizona in 1995 as a joint venture
owned 49% by the Company and 51% by AIG; the Company acquired AIG's
interest on January 1, 2002.
50
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Where declines in values of securities below cost or amortized cost are
considered to be other than temporary, a charge is reflected in income for the
difference between cost or amortized cost and fair value. No such charges were
recorded in 2002, 2001 or 2000.
21ST CENTURY INSURANCE COMPANY OF ARIZONA
Prior to 2002, 21st of Arizona was a joint venture between the Company and AIG.
On January 1, 2002, the Company acquired AIG's 51% interest in 21st of Arizona.
The Company's equity in the net loss of this venture amounted to $1.0 million
and $1.1 million in 2001 and 2000, respectively, and is included in other
revenues in the Consolidated Statements of Operations (see Note 19 of the Notes
to Consolidated Financial Statements).
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash, demand deposits and short-term
investments in money market mutual funds having a maturity of three months or
less at the date of purchase.
RECOGNITION OF REVENUES
Insurance premiums and reinsurance ceding commissions are recognized pro rata
over the terms of the policies. The unearned portion of premiums is included in
the Consolidated Balance Sheets as a liability for unearned premiums.
Installment and other fees for services are recognized in the periods the
services are rendered.
DEFERRED POLICY ACQUISITION COSTS
Deferred policy acquisition costs ("DPAC") include premium taxes and other
variable costs incurred in connection with writing business. These costs are
deferred and amortized over the period in which the related premiums are earned.
The Company does not consider anticipated investment income in determining the
recoverability of these costs. Based on current indications, management believes
that these costs will be fully recoverable and, accordingly, no reduction in
DPAC has been recognized.
LEASED PROPERTY UNDER CAPITAL LEASE
Leased property under capital lease is recorded as a capital asset and amortized
on a straight-line basis over the estimated useful life of the property. The
property and the related lease obligation are disclosed on the balance sheet.
PROPERTY AND EQUIPMENT
Property and equipment is recorded at cost and depreciated on a straight-line
basis. The estimated useful lives used for depreciation purposes are: furniture
and leasehold improvements - 7 years; equipment - 3 to 5 years; automobiles - 5
years; software currently in service - 3 to 10 years.
LOSSES AND LOSS ADJUSTMENT EXPENSES
The estimated liabilities for losses and loss adjustment expenses ("LAE")
include the accumulation of estimates of losses for claims reported prior to the
balance sheet dates, estimates (based upon actuarial analysis of historical
data) of losses for claims incurred but not reported and for the development of
case reserves to ultimate values, and estimates of expenses for investigating,
adjusting and settling all incurred claims. Amounts reported are estimates of
the ultimate costs of settlement, net of estimated salvage and subrogation.
These estimated liabilities are necessarily subject to the outcome of future
events, such as changes in medical and repair costs as well as economic and
social conditions that impact the settlement of claims. Management believes
that, given the inherent variability in any such estimates, the aggregate
reserves are
51
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
within a reasonable and acceptable range of adequacy. The methods of making such
estimates and for establishing the resulting reserves are reviewed and updated
quarterly and any adjustments resulting therefrom are reflected in current
operations.
A necessarily more subjective process is used to estimate earthquake losses
arising out of SB 1899 due to the fact that they cannot be determined with
traditional actuarial methods that rely on historical or industry data, neither
of which are available in regard to this event. See Note 16 of the Notes to
Consolidated Financial Statements for a discussion of the factors considered by
management in establishing those reserves.
REINSURANCE
In the normal course of business, the Company seeks to reduce its exposure to
losses that may arise from catastrophes and to reduce its overall risk levels by
obtaining reinsurance from other insurance enterprises or reinsurers.
Reinsurance premiums and reserves on reinsured business are accounted for on a
basis consistent with those used in accounting for the original policies issued
and the terms of the reinsurance contracts.
Reinsurance contracts do not relieve the Company from its obligations to
policyholders. The Company periodically reviews the financial condition of its
reinsurers to minimize its exposure to losses from reinsurer insolvencies. It is
the Company's policy to hold collateral under related reinsurance agreements in
the form of letters of credit for unpaid losses for all reinsurers not licensed
to do business in the Company's state of domicile.
Reinsurance assets include balances due from other insurance companies under the
terms of reinsurance agreements. Amounts applicable to ceded unearned premiums,
ceded loss payments and ceded claim liabilities are reported as assets in the
accompanying balance sheets. The Company believes the fair value of its
reinsurance recoverables approximates their carrying amounts.
STOCK-BASED COMPENSATION
In management's opinion, existing stock option valuation models do not provide
an entirely reliable measure of the fair value of non-transferable employee
stock options with vesting restrictions. Accordingly, the Company has elected to
follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued
to Employees ("APB 25"), and related interpretations in accounting for its
stock-based compensation. Under APB 25, because the exercise price of the
Company's employee stock options equals the market price of the underlying stock
on the date of grant, no compensation expense is recognized. See Note 13 of the
Notes to Consolidated Financial Statements for disclosure of the required pro
forma information as if stock option compensation expense had been determined by
the alternative fair value method. The fair value of stock grants made under the
Restricted Shares Plan is amortized to expense under APB 25 over the vesting
period of the grants. This accounting treatment results in compensation expense
being recorded in a manner consistent with that required under SFAS No. 123,
Accounting for Stock-Based Compensation, and, therefore, pro forma net income
and earnings per share amounts for the Restricted Share Plan would be unchanged
from those reported in the financial statements.
52
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
INCOME TAXES
Deferred income tax assets and liabilities are determined based on the
differences between the financial reporting and the tax bases of assets and
liabilities and are measured using the enacted tax rates and laws.
NEW ACCOUNTING PRONOUNCEMENTS.
FAS 148, Accounting for Stock-based Compensation, amends FAS No. 123, Accounting
for Stock-Based Compensation, to provide alternative methods of transition for
an entity that voluntarily changes to the fair value based method of accounting
for stock-based employee compensation. The effect of this change would be the
expensing of the value of the Company's stock-based compensation rather than the
current disclosure of the pro forma effect of the stock-based compensation in
the footnotes to the financial statements. The amendment is effective for
financial reports containing condensed financial statements for interim periods
beginning after December 15, 2002. The Financial Accounting Standards Board
("FASB") Interpretation No. 45 elaborates on the disclosures to be made by a
guarantor in its interim and annual financial statements about its obligations
under certain guarantees that it has issued. The Company has no guarantees of
this nature.
FASB Interpretation No. 46 clarifies the application of Accounting Research
Bulletin No. 51 Consolidated Financial Statements regarding variable interest
entities. The Company does not have investments in such entities.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the current year
presentation.
NOTE 3. (LOSS) EARNINGS PER COMMON SHARE
- -----------------------------------------
For each of the three years in the period ended December 31, 2002, the numerator
for the calculation of both basic and diluted (loss) earnings per common share
is equal to net (loss) income reported for that year. The denominator for the
computation of basic (loss) earnings per share was 85,414,076 shares, 85,340,461
shares and 85,186,084 shares for 2002, 2001 and 2000, respectively. The
denominator for diluted (loss) earnings per share was 85,414,076 shares,
85,340,461 shares and 85,397,099 shares for 2002, 2001 and 2000, respectively.
The difference between basic and diluted (loss) earnings per share denominators
is due to employee restricted stock grants and stock options.
NOTE 4. INVESTMENTS
- --------------------
Cash and securities with carrying values of $6.8 million and $12.4 million were
deposited by the Company's subsidiaries under requirements of regulatory
authorities as of December 31, 2002 and 2001.
A summary of net investment income follows:
Years Ended December 31, 2002 2001 2000
- ----------------------------------------------------------
Interest on fixed maturities $45,777 $44,722 $48,411
Interest on cash equivalents 922 1,602 2,265
Investment expense (354) (394) (330)
- ----------------------------------------------------------
Net investment income $46,345 $45,930 $50,346
- ----------------------------------------------------------
53
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
A summary of realized investment gains (losses) follows:
Years Ended December 31, 2002 2001 2000
- -----------------------------------------------------------------------------------------
Realized (losses) on sales of fixed maturity securities $(2,183) $(1,111) $(6,561)
Realized gain on sales of securities 13,053 5,912 1,685
Realized gain (loss) on disposal of property and equipment (479) 200 (134)
- -----------------------------------------------------------------------------------------
Total realized investment gains (losses) $10,391 $ 5,001 $(5,010)
- -----------------------------------------------------------------------------------------
A summary of fixed maturity investments follows:
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
- -------------------------------------------------------------------------------------------------
DECEMBER 31, 2002
U.S. Treasury securities and obligations of U.S.
government corporations and agencies $ 95,268 $ 4,764 $ - $100,032
Obligations of states and political subdivisions 548,919 26,053 (207) 574,765
Corporate securities 241,860 10,384 (2,460) 249,784
- -------------------------------------------------------------------------------------------------
Total fixed maturity investments $ 886,047 $ 41,201 $ (2,667) $924,581
- -------------------------------------------------------------------------------------------------
December 31, 2001
U.S. Treasury securities and obligations of U.S.
government corporations and agencies $ 40,363 $ 461 $ (91) $ 40,733
Obligations of states and political subdivisions 719,411 6,209 (7,016) 718,604
Corporate securities 97,435 623 (1,671) 96,387
- -------------------------------------------------------------------------------------------------
Total fixed maturity investments $ 857,209 $ 7,293 $ (8,778) $855,724
- -------------------------------------------------------------------------------------------------
The Company has no non-interest bearing investments, non-accrued investment
income or any individual securities in excess of 10% of equity. Fixed
maturities available-for-sale at December 31, 2002, are summarized by
contractual maturity year as follows:
Amortized Fair
Cost Value
- --------------------------------------------
Fixed maturities due:
2003 $ 4,022 $ 4,098
2004-2007 33,213 35,516
2008-2012 311,671 326,543
2013 and thereafter 537,141 558,424
- -------------------------------------------
Total $ 886,047 $924,581
- -------------------------------------------
Expected maturities of the Company's investments may differ from contractual
maturities because certain borrowers have the right to call or prepay
obligations with or without call or prepayment penalties.
54
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Details follow concerning the changes in the after-tax items included in
"Accumulated other comprehensive income (loss)" in the Consolidated Statements
of Stockholders' Equity for 2002, 2001 and 2000.
Years Ended December 31, 2002 2001 2000
- -------------------------------------------------------------------------------------------
Unrealized gain (loss) on available-for-sale investments, net
of tax expense (benefit) of $17,811, $(152) and $21,608,
respectively $33,078 $ (282) $40,128
Less reclassification adjustment for investment gains (losses)
included in net income, net of tax expense (benefit) of
$3,805, $1,784 and $(1,627), respectively 7,065 3,314 (3,022)
Minimum pension liability in excess of unamortized prior
service cost, net of deferred income tax (benefit) expense
of $(2,081), $2,427, and $457, respectively 3,864 (4,507) (848)
- -------------------------------------------------------------------------------------------
$29,877 $(8,103) $42,302
- -------------------------------------------------------------------------------------------
A summary of accumulated other comprehensive income (loss) follows:
December 31, 2002 2001
- -------------------------------------------------------------------------------------------
Unrealized gains (losses), net of deferred income tax expense (benefit)
of $13,487 and of $(520), respectively $25,047 $ (965)
Minimum pension liability in excess of unamortized prior service cost,
net of deferred income tax benefit of $802 and $2,883, respectively (1,490) (5,355)
- -------------------------------------------------------------------------------------------
$23,557 $(6,320)
- -------------------------------------------------------------------------------------------
NOTE 5. FEDERAL INCOME TAXES
- -----------------------------
Federal income tax benefit consists of:
Years Ended December 31, 2002 2001 2000
- ---------------------------------------------------------
Current tax benefit $ (8,200) $ (5,089) $(10,077)
Deferred tax benefit (5,370) (19,418) (3,961)
- ---------------------------------------------------------
$(13,570) $(24,507) $(14,038)
- ---------------------------------------------------------
A reconciliation of income tax computed at the federal statutory tax rate of 35%
to total income tax expense follows:
Years Ended December 31, 2002 2001 2000
- ------------------------------------------------------------------------------
Federal income tax benefit at statutory rate $ (9,039) $(18,227) $ (382)
Tax-exempt income, net (9,377) (11,067) (12,546)
State and local taxes, net of federal benefit 5,151 4,706 -
Research and experimentation tax credit (1,040) - (1,193)
Nondeductible political contributions 766 81 101
Other - net (31) - (18)
- ------------------------------------------------------------------------------
Federal income tax benefit $(13,570) $(24,507) $(14,038)
- ------------------------------------------------------------------------------
There were no income tax payments required for the years ended December 31,
2002, 2001 and 2000. As of December 31, 2002, the Company had no federal income
tax refund receivable.
55
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
The Company's net deferred tax asset is comprised of:
December 31, 2002 2001
- ----------------------------------------------------------------
Deferred tax assets:
Net operating loss carryforward $128,581 $104,137
Alternative minimum tax credit 9,451 17,701
Unearned premiums 19,156 16,047
Unpaid losses and loss adjustment expenses 6,793 9,218
Employee benefits - 5,146
Unrealized investment losses - 3,512
- ----------------------------------------------------------------
163,981 155,761
- ----------------------------------------------------------------
Deferred tax liabilities:
EDP software development costs 36,262 46,833
Deferred policy acquisition costs 16,166 9,465
Unrealized investment gains 12,685 -
Employee benefits 1,276 -
Other 8,653 3,247
- ----------------------------------------------------------------
75,042 59,545
- ----------------------------------------------------------------
Net deferred tax asset $ 88,939 $ 96,216
- ----------------------------------------------------------------
During 2002, the Company had a tax net operating loss of approximately $37.0
million. As of December 31, 2002, the Company has a tax net operating loss
carryforward of approximately $367.3 million for regular tax purposes of which
approximately $104.6 million expires in the year 2009 and $262.7 million expires
on or after 2011; and an alternative minimum tax credit carryforward of $9.5
million. Alternative minimum tax credits may be carried forward indefinitely to
offset future regular tax liabilities.
The Company is required to establish a "valuation allowance" for any portion
of the deferred tax asset that management believes will not be realized. The
Company believes that because of tax planning strategies available, it is more
likely than not that the Company will realize the full benefit of its deferred
tax assets. Accordingly, no valuation allowance has been established.
NOTE 6. DEFERRED POLICY ACQUISITION COSTS
- -----------------------------------------
Following is a summary of policy acquisition costs deferred for amortization
against future income and the related amortization charged to income from
operations:
Years Ended December 31, 2002 2001 2000
- ---------------------------------------------------------------------------------------
Deferred policy acquisition costs, beginning of year $ 30,631 $ 25,228 $ 25,900
Acquisition costs deferred 139,201 107,961 90,714
Acquisition costs amortized and charged to income
during the year (123,642) (102,558) (91,386)
- ---------------------------------------------------------------------------------------
Deferred policy acquisition costs, end of year $ 46,190 $ 30,631 $ 25,228
- ---------------------------------------------------------------------------------------
Total advertising costs included in deferred acquisition costs in 2002, 2001 and
2000 were $43.3 million, $18.7 million and $9.7 million, respectively.
56
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 7. PROPERTY AND EQUIPMENT
- -------------------------------
A summary of property and equipment follows:
December 31, 2002 2001
- --------------------------------------------------------------------------------------
Furniture and equipment $ 34,936 $ 57,324
Automobiles 2,855 3,593
Leasehold improvements 9,716 17,780
Software currently in service 25,144 69,589
Software development projects in progress 66,748 96,848
- --------------------------------------------------------------------------------------
Subtotal 139,399 245,134
Less accumulated depreciation, including $14,927 and $19,827 for
software currently in service (52,125) (66,462)
- --------------------------------------------------------------------------------------
$ 87,274 $178,672
- --------------------------------------------------------------------------------------
Depreciation expense on software currently in service was $9.6 million, $10.4
million and $4.1 million in 2002, 2001 and 2000, respectively. Substantially
all software development projects in progress are expected to be completed by
2004.
On December 31, 2002, the Company entered into a sale-leaseback transaction for
$15.8 million of equipment and leasehold improvements and $44.2 million of
software. The transaction is accounted for as a capital lease under FAS 13 -
Accounting for Leases, as amended by FAS 28 - Accounting for Sales with
Leasebacks. The agreement calls for an interest-only payment on February 14,
2003, of $0.3 million and, commencing at the same date, 59 monthly payments of
approximately $1.2 million with a bargain purchase option at the end of the
term. At December 31, 2002, the remaining minimum lease payments were $ 68.8
million.
A summary of future minimum lease payments under the capital lease follows:
2003 $12,799
2004 13,962
2005 13,962
2006 13,962
2007 13,962
------------------------------------------------
Net minimum lease payments 68,647
Less: amount representing interest 8,647
------------------------------------------------
Present value of minimum lease payments $60,000
------------------------------------------------
The lease includes a covenant that if statutory surplus falls below $300.0
million, or if the net premiums written to surplus ratio is greater than 3.8:1,
or if AIG is no longer a majority stockholder, the Company will either deliver a
letter of credit to the lessor or pay the lessor all rent and other sums due and
unpaid as of the first rent payment date following the occurrence of one of the
above.
57
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 8. UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
- ---------------------------------------------------
The following analysis provides a reconciliation of the activity in the reserve
for unpaid losses and loss adjustment expenses:
Years Ended December 31, 2002 2001 2000
- -----------------------------------------------------------------------------------
At beginning of year:
Reserve for losses and LAE, gross of reinsurance $349,290 $298,436 $276,248
Reinsurance recoverable (23,512) (31,483) (32,850)
Acquisition of 21st of Arizona 6,749 - -
- -----------------------------------------------------------------------------------
Reserve for losses and LAE, net of reinsurance 332,527 266,953 243,398
- -----------------------------------------------------------------------------------
Losses and LAE incurred, net of reinsurance:
Current year 754,299 718,229 704,365
Prior years 72,358 118,007 45,023
- -----------------------------------------------------------------------------------
Total 826,657 836,236 749,388
- -----------------------------------------------------------------------------------
Losses and LAE paid, net of reinsurance:
Current year 513,738 506,294 498,602
Prior years 281,788 271,117 227,231
- -----------------------------------------------------------------------------------
Total 795,526 777,411 725,833
- -----------------------------------------------------------------------------------
At end of year:
Reserve for losses and LAE, net of reinsurance 363,658 325,778 266,953
Reinsurance recoverable 20,351 23,512 31,483
- -----------------------------------------------------------------------------------
Reserve for losses and LAE, gross of reinsurance $384,009 $349,290 $298,436
- -----------------------------------------------------------------------------------
The provision for losses and LAE recorded in 2002 and 2001 for insured events of
prior years primarily resulted from the Company's recognition of earthquake
losses under SB 1899, as discussed in Note 16 of the Notes to Consolidated
Financial Statements, and from the Company's under-estimate of changes in
personal auto loss severity trends that became apparent in 2001. The loss and
LAE provision recorded in 2000 for insured events of prior years primarily
resulted from the Company's over-estimate in 1999 of the beneficial effect on
loss costs of laws passed in prior years that limited the ability of uninsured
motorists and drunk drivers to collect non-economic damages.
Accounting for losses and LAE is highly subjective because these costs must be
estimated, often weeks, months or even years in advance of when the payments
actually are made to claimants, attorneys, claims personnel and others involved
in the claims settlement process. At the time of sale of an auto policy, for
example, the number of claims that will happen is unknown, and so is the
ultimate amount it will take to settle them.
Accounting principles require insurers to record estimates for loss and LAE in
the periods in which the insured events, such as automobile accidents, occur.
This estimation process requires the Company to estimate both the number of
accidents that may have occurred (called "frequency") and the ultimate amount of
loss and LAE (called "severity") related to each accident. The Company employs
experts called "actuaries" who are professionally trained and certified in the
process of establishing estimates for frequency and severity. From time to
time, external actuarial experts are engaged from consulting firms to review the
work of the Company's actuaries.
58
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Management believes that, given the inherent variability in the estimates, the
Company's reserves are within a reasonable and acceptable range of adequacy.
However, because reserve estimates are necessarily subject to the outcome of
future events, changes in estimates are unavoidable in the property and casualty
insurance business. These changes sometimes are referred to as "loss
development" or "reserve development."
Quarterly, the Company's actuaries prepare a new evaluation of loss and LAE
indications by accident year, and the Company assesses whether there is a need
to adjust reserve estimates pertaining to previous accounting periods. As
claims are reported and settled and as other new information becomes available,
changes in estimates are made and are included in earnings of the period of the
change.
The increases in prior accident year estimates recorded in each of the past
three years, net of applicable reinsurance, are summarized below:
For the years ended December 31, 2002 2001 2000
- ------------------------------------------------------------
Personal auto $16,200 $ 45,742 $42,178
Homeowner and Earthquake 56,158 72,265 2,845
- ------------------------------------------------------------
$72,358 $118,007 $45,023
- ------------------------------------------------------------
The following table shows unpaid losses and LAE on a gross and net basis:
2002 2001
------------------ ------------------
December 31, GROSS NET Gross Net
- ------------------------------------------------------------------
Unpaid Losses and LAE
Personal auto lines $333,113 $320,032 $301,985 $280,781
Homeowner and earthquake 50,896 43,626 47,305 44,997
- ------------------------------------------------------------------
Total $384,009 $363,658 $349,290 $325,778
- ------------------------------------------------------------------
The $31.1 million increase in the gross auto reserves for the year ended
December 31, 2002, is comprised of $4.9 million due to the consolidation of 21st
of Arizona, growth in reserves attributable to the higher number of insured
automobiles of approximately $9.0 million, approximately $7.3 million relating
to the effects of higher average loss costs and approximately $9.9 million for
strengthening of prior accident year reserves.
NOTE 9. REINSURANCE
- --------------------
In the third quarter of 2002, the Company entered into a catastrophe reinsurance
agreement on its auto lines with AIG subsidiaries, Folksamerica Reinsurance
Company and Transatlantic Reinsurance Company, which reinsures any covered
events up to $30.0 million in excess of $15.0 million.
Effective September 1, 2002, the Company entered into an agreement to cancel
future cessions under its quota share reinsurance treaty with AIG subsidiaries
resulting in a one time pre-tax charge of $0.9 million. The treaty would have
ceded 4% of premiums to AIG subsidiaries in the remainder of 2002 and 2% in
2003. The majority of the Company's reinsurance receivables are due from AIG
subsidiaries.
59
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
The following summarizes the approximate percentage of business retained and
ceded under various reinsurance programs with AIG subsidiaries and unrelated
insurers. Most programs provide for ceding commissions that approximate the
Company's direct policy acquisition costs and other operating expenses.
Contracts Incepting During
---------------------------
2002 2001 2000
- -----------------------------------------------------------------------
AUTO POLICIES
Retained 97% 94% 92%
Ceded 3% 6% 8%
Catastrophe cover excess $15 million $30,000 - -
HOMEOWNER POLICIES(1)
Retained - 94% 92%
Ceded 100% 6% 8%
Catastrophe cover excess $10 million(2) - $75,000 $65,000
PUP POLICIES
Retained 10% 16% 37%
Ceded 90% 84% 63%
Reinsurance coverages related to historical earthquake losses have been
exhausted.
The effect of reinsurance on premiums written and earned is as follows:
2002 2001 2000
----------------------------------------------------------------
Years Ended December 31, WRITTEN EARNED Written Earned Written Earned
- ------------------------------------------------------------------------------------------
Gross $998,248 $971,059 $929,315 $929,361 $910,720 $906,903
Ceded (32,949) (46,500) (60,360) (65,216) (78,593) (81,417)
- ------------------------------------------------------------------------------------------
Net $965,299 $924,559 $868,955 $864,145 $832,127 $825,486
- ------------------------------------------------------------------------------------------
Gross losses and loss adjustment expenses have been reduced by reinsurance ceded
as follows:
Years Ended December 31, 2002 2001 2000
- -----------------------------------------------------------------------------------
Gross losses and loss adjustment expenses incurred $870,402 $893,139 $824,714
Ceded losses and loss adjustment expenses incurred (43,745) (56,903) (75,326)
- -----------------------------------------------------------------------------------
Net losses and loss adjustment expenses incurred $826,657 $836,236 $749,388
- -----------------------------------------------------------------------------------
At December 31, 2002 and 2001, the Company's reinsurance recoverables, net of
payables, from AIG subsidiaries were $18.4 million and $38.8 million,
respectively.
NOTE 10. EMPLOYEE BENEFIT PLANS
- --------------------------------
The Company sponsors a contributory savings and security plan for eligible
employees. The Company provides matching contributions equal to 75% of the
lesser of 6% of an employee's compensation or the amount contributed by the
employee. Contributions charged against operations were $4.2 million, $4.0
million and $3.1 million in 2002, 2001 and 2000, respectively. The plan offers a
variety of investment types among which employees exercise complete
- ---------------
1 The Company's homeowner policies do not include any earthquake coverage.
2 This catastrophe coverage does provide protection from the potential for
fire following an earthquake and other catastrophes.
60
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
discretion as to choice and investment duration, including any amounts the
employee elects to invest in Company common stock.
The Company sponsors non-contributory defined benefit pension plans, which cover
essentially all employees who have completed at least one year of service. For
certain key employees designated by the Board of Directors, the Company sponsors
an unfunded supplemental executive retirement plan. The supplemental plan
benefits are based on years of service and compensation during the three highest
of the last ten years of employment prior to retirement and are reduced by the
benefit payable from the pension plan. For other eligible employees, the pension
benefits are based on employees' compensation during all years of service. The
Company's funding policy is to make annual contributions as required by
applicable regulations. At December 31, 2002, the pension plans' assets were
comprised of 21% fixed income securities, 58.9% stock index mutual funds and
20.1% cash. Other information regarding the Company's defined benefit pension
plans follows:
Years Ended December 31, 2002 2001
- -------------------------------------------------------------------------------------------
Change in benefit obligation:
Benefit obligation at beginning of year $ 68,943 $ 58,257
Service cost 3,788 3,508
Interest cost 5,008 4,554
Plan amendments 553 -
Actuarial loss 2,523 5,254
Benefits paid (2,131) (2,630)
- -------------------------------------------------------------------------------------------
Benefit obligation at end of year 78,684 68,943
- -------------------------------------------------------------------------------------------
Change in plan assets:
Fair value of plan assets at beginning of year 45,544 43,011
Actual return on plan assets net of expenses (6,661) (1,245)
Employer contributions 21,524 6,408
Benefits paid (2,131) (2,630)
- -------------------------------------------------------------------------------------------
Fair value of plan assets at end of year 58,276 45,544
- -------------------------------------------------------------------------------------------
Reconciliation of funded status:
Funded status (20,408) (23,399)
Unrecognized net loss 33,074 20,707
Unrecognized transition obligation - 182
Unrecognized prior service cost 807 670
- -------------------------------------------------------------------------------------------
Net pension asset (liability) recognized at year end 13,473 (1,840)
- -------------------------------------------------------------------------------------------
Amounts recognized in the statement of financial position consist of:
Prepaid pension cost - qualified plan 18,449 1,167
Accrued benefit liability - nonqualified plan (4,976) (3,007)
Additional minimum liability - nonqualified plan (3,058) (9,090)
Intangible asset 766 852
Accumulated other comprehensive income, pre-tax 2,292 8,238
- -------------------------------------------------------------------------------------------
Net pension asset (liability) recognized at year end $ 13,473 $ (1,840)
- -------------------------------------------------------------------------------------------
61
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Years Ended December 31, 2002 2001
- ------------------------------------------------------------------
Weighted-average assumptions used in determining the
amounts above:
Discount rate 6.75% 7.00%
Expected return on plan assets 8.50% 8.50%
Rate of compensation increase 5.60% 5.60%
- ------------------------------------------------------------------
Net pension costs were comprised of the following:
Years Ended December 31, 2002 2001 2000
- --------------------------------------------------------------------------------
Service cost $ 3,788 $ 3,509 $ 2,966
Interest cost 5,008 4,554 4,135
Expected return on plan assets (4,193) (3,737) (3,672)
Amortization of unrecognized transition obligation 181 181 181
Amortization of prior service cost 105 233 338
Amortization of net loss 1,012 394 138
- --------------------------------------------------------------------------------
$ 5,901 $ 5,134 $ 4,086
- --------------------------------------------------------------------------------
NOTE 11. OPERATING LEASE COMMITMENTS
- -------------------------------------
The Company leases office space in Woodland Hills, California. The lease expires
in February 2015 and may be renewed for two consecutive five-year periods. The
Company also leases automobiles and office equipment as well as office space in
several other locations throughout California, primarily for claims services.
Minimum rental commitments under the Company's lease obligations are as follows:
2003 $ 17,079
2004 16,287
2005 15,718
2006 14,201
2007 12,731
Thereafter 92,895
--------------------
$168,911
--------------------
Rental expense charged to operations for the years ended December 31, 2002, 2001
and 2000 was $16.4 million, $15.6 million and $15.5 million, respectively.
NOTE 12. CAPITAL STOCK
- -----------------------
The Company is authorized to issue up to 500,000 shares of preferred stock, $1
par value, and 376,126 shares of Series A convertible preferred stock, $1 par
value, none of which were outstanding at December 31, 2002 or 2001.
Shares of common stock issued pursuant to the exercise of employee stock options
and restricted stock grants were 69,657 in 2002, 39,893 in 2001 and 234,300 in
2000. Shares of common stock repurchased by the Company in 2000 numbered
883,400. No shares were repurchased in 2002 or 2001.
62
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 13. STOCK-BASED COMPENSATION
- ----------------------------------
1995 STOCK OPTION PLAN
The aggregate number of common shares authorized under the plan currently is
limited to 10,000,000. At December 31, 2002, 4,382,232 common shares remain
available for future grants. The plan has been approved by the Company's
stockholders, and all options granted have ten-year terms. As a consequence of
AIG's acquiring a controlling interest in the Company, vesting was accelerated
for all options previously granted through July 27, 1998. Options granted after
July 27, 1998, vest over various future periods.
Exercise prices for options outstanding at December 31, 2002, ranged from $12.41
to $29.25. The weighted-average remaining contractual life of those options is
7.59 years.
A summary of the Company's stock option activity and related information
follows:
Weighted-
Number of Average
Options Exercise Price
- -----------------------------------------------------------------
Options outstanding January 1, 2000 2,048,063 21.24
Granted in 2000 1,034,925 19.97
Exercised in 2000 (100,682) 16.73
Forfeited in 2000 (135,582) 22.43
- -----------------------------------------------------------------
Options outstanding December 31, 2000 2,846,724 20.88
Granted in 2001 1,854,079 18.09
Exercised in 2001 (79,901) 15.60
Forfeited in 2001 (620,964) 20.51
- -----------------------------------------------------------------
Options outstanding December 31, 2001 3,999,938 19.75
Granted in 2002 1,523,708 16.09
Exercised in 2002 (86,881) 16.46
Forfeited in 2002 (294,865) 18.93
- -----------------------------------------------------------------
Options outstanding December 31, 2002 5,141,900 18.77
- -----------------------------------------------------------------
Options exercisable numbered 2,574,577 at the end of 2002, 1,803,917 at the end
of 2001 and 1,486,201 at the end of 2000.
SFAS No. 123, Accounting for Stock-Based Compensation, requires disclosure of
the pro forma net (loss) income and (loss) earnings per share as if the Company
had accounted for its employee stock options under the fair value method. The
Company's pro forma information using the Black-Scholes valuation model follows:
Years Ended December 31, 2002 2001 2000
- --------------------------------------------------------------------------------------
Estimated weighted-average of the fair value
of options granted $ 6.33 $ 6.36 $ 6.72
Pro forma net (loss) income (17,654) (30,738) 11,902
Pro forma (loss) earnings per share - basic and diluted (0.21) (0.36) 0.14
63
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
For pro forma disclosure purposes, the fair value of stock options was estimated
at each date of grant using the following assumptions:
Years Ended December 31, 2002 2001 2000
- ----------------------------------------------------------------------------
Risk-free interest rate:
Minimum 3.75% 4.73% 5.93%
Maximum 4.79% 5.28% 6.82%
Dividend yield 2.49% 2.50% 2.50%
Volatility factor of the expected market price
of the Company's common stock:
Minimum 0.35 0.33 0.20
Maximum 0.38 0.34 0.32
Weighted-average expected life of the options 8 YEARS 8 years 8 years
RESTRICTED SHARES PLAN
The Restricted Shares Plan, which was approved by the Company's stockholders,
currently provides for grants of up to 1,421,920 shares of common stock to be
made available to key employees. Twenty percent of the number of shares granted
vest on the anniversary date of each of the five years following the year of
grant. Upon issuance of grants under the plan, unearned compensation equivalent
to the market value on the date of grant is charged to common stock and
subsequently amortized in equal monthly installments over the five-year vesting
period of the grant. Total amortization expense relating to the Restricted
Shares Plan was $0.5 million, $0.7 million and $0.2 million in 2002, 2001 and
2000, respectively. Unamortized restricted stock grants totaled $1.0 million,
$1.8 million and $3.3 million at the end of 2002, 2001 and 2000, respectively.
A summary of grants under the plan from 2000 through 2002 follows:
Common Market Price Per
Shares Share on Date of Grant
- -----------------------------------------------------------------
Outstanding, January 1, 2000 49,275
Granted in 2000 160,175 $18.67
Vested and distributed in 2000 (9,855)
Canceled or forfeited (23,457)
- ----------------------------------------
Outstanding, December 31, 2000 176,138
Granted in 2001 -
Vested and distributed in 2001 (33,039)
Canceled or forfeited (40,008)
- ----------------------------------------
Outstanding, December 31, 2001 103,091
Granted in 2002 -
Vested and distributed in 2002 (25,629)
Canceled or forfeited (17,224)
- ----------------------------------------
Outstanding, December 31, 2002 60,238
- ----------------------------------------
64
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
A summary of securities issuable and issued for both the 1995 Stock Option Plan
and the Restricted Shares Plan at December 31, 2002, follows:
1995 Stock Restricted
AMOUNTS IN THOUSANDS Option Plan Shares Plan
- ----------------------------------------------------------------------------------
Total securities authorized 10,000 1,422
Number of securities issued (476) (128)
Number of securities issuable upon the exercise of all
outstanding options and rights (5,142) -
Number of securities forfeited (1,236) (64)
Number of securities forfeited and returned to plan 1,236 -
- ----------------------------------------------------------------------------------
Number of securities remaining available for future
grants under each plan 4,382 1,230
- ----------------------------------------------------------------------------------
NOTE 14. STATUTORY FINANCIAL DATA
- ----------------------------------
Statutory surplus and statutory net (loss) income for the Company's insurance
subsidiaries were as follows:
Years Ended December 31, 2002 2001 2000
- -----------------------------------------------------------
Statutory surplus $397,381 $393,119 $475,640
Statutory net (loss) income (39,771) (53,157) 11,069
The Company's insurance subsidiaries file financial statements prepared in
accordance with Statutory Accounting Principles ("SAP") prescribed or permitted
by domestic insurance regulatory agencies. The Company's SAP-basis financial
statements differ from those prepared in accordance with GAAP primarily because
certain assets recognized under GAAP are treated as nonadmitted under SAP, such
as deferred policy acquisition costs, most of the Company's property and
equipment and a portion of deferred income taxes. Further, under SAP, all bonds
are carried at amortized cost and unpaid losses, loss adjustment expenses and
unearned premium reserves are presented net of reinsurance. The following table
reconciles consolidated GAAP net (loss) income to statutory net (loss) income.
Years Ended December 31, 2002 2001 2000
- -----------------------------------------------------------------------------
Net (loss) income - GAAP basis $(12,256) $(27,568) $12,945
Deferred federal income tax benefit (10,816) (19,418) (3,962)
Change in deferred policy acquisition costs (19,032) (1,816) (2,921)
Net (loss) income from non-insurance entities 4,319 (4,355) 5,007
Other, net (1,986) - -
- -----------------------------------------------------------------------------
Net (loss) income - SAP basis $(39,771) $(53,157) $11,069
- -----------------------------------------------------------------------------
65
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
The following table reconciles consolidated GAAP stockholders' equity to
statutory surplus.
Years Ended December 31, 2002 2001
- --------------------------------------------------------------------------------------------
Stockholders' equity - GAAP $ 655,608 $ 659,306
Assets/gains (liabilities/losses) recognized under GAAP but not
under SAP:
Non admitted deferred tax assets (125,088) (116,057)
Deferred tax liabilities relating to items nonadmitted under SAP 55,483 74,683
Intercompany receivables (13,500) -
Fixed assets (16,797) (100,775)
Deferred policy acquisition costs (46,190) (30,631)
Prepaid pension costs and intangible pension asset (19,215) -
Unrealized (losses) gains on bonds (38,582) (3,411)
Other prepaid expenses (7,478) (6,425)
Equity in non-insurance entities (45,117) (84,260)
Salvage and subrogation receivable (1,030) -
Other, net (713) 689
- --------------------------------------------------------------------------------------------
Statutory Surplus $ 397,381 $ 393,119
- --------------------------------------------------------------------------------------------
The Company is also regulated by the provisions of the California Insurance
Holding Company System Regulatory Act (the "Holding Company Act"). Many
transactions that are defined to be of an "extraordinary" nature may not be
effected without the prior approval of the CDI. In addition, there are limits on
the insurance subsidiaries' dividend paying capacity. In 2003, the Company
estimates that its insurance subsidiaries have capacity to pay approximately
$21.6 million in dividends to their parent without prior approval of the CDI.
Effective January 1, 2001, the State of California required that domiciliary
insurance companies prepare their statutory-basis financial statements in
accordance with the NAIC Accounting Practices and Procedures Manual
(Codification). As a result of adopting the Codification, the Company's
statutory capital and surplus increased by approximately $35 million in 2001,
mainly due to the treatment accorded previously nonadmitted deferred tax assets.
NOTE 15. LITIGATION
- --------------------
In the normal course of business, the Company is named as a defendant in
lawsuits related to claim and insurance policy issues, both on individual policy
files and by class actions seeking to attack the use of various databases,
vendors and claims practices generally. Many suits seek generally unspecified
extracontractual and punitive damages as well as contractual damages far in
excess of the Company's estimates. The Company cannot estimate the amount or
range of loss that could result from an unfavorable outcome on these suits. It
denies liability for any such alleged damages and believes that it has a number
of valid defenses to the litigation. The Company has not established reserves
for potential extracontractual or punitive damages, or for damages in excess of
estimates the Company believes are correct and reasonable. Nevertheless,
extracontractual and punitive damages, if assessed against the Company, could be
material in an individual case or in the aggregate. The Company may choose to
settle litigated cases for amounts in excess of its own estimate of contractual
damages to avoid the expense and/or risk of litigation.
66
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Other than possibly for the contingencies discussed
below, the Company does not believe the ultimate outcome of these matters will
be material to its results of operations, financial condition or cash flows.
On December 9, 2002, the Company commenced an arbitration proceeding against
Computer Sciences Corporation ("CSC") arising out of CSC's obligation to provide
insurance company information technology software and other software programs to
the Company. CSC has filed a counterclaim in the proceeding. In the third
quarter of 2002, the Company wrote off $37.2 million of its investment in CSC
software. The arbitration will be conducted in accordance with the rules of the
American Arbitration Association.
On October 10, 2002, a Los Angeles Superior Court granted the Company's motion
for summary judgment in the matter of 21st Century Insurance Company vs. People
of the State of California ex rel. Bill Lockyer, Attorney General et al. The
court determined that the Company's April 21, 1999, settlement with the
California Department of Insurance ("CDI") with respect to regulatory actions
arising out of the 1994 Northridge Earthquake was fully valid and enforceable.
The Court denied the Attorney General's motion seeking to have the settlement
declared void and unenforceable, a result that may have allowed the CDI to
reinstitute regulatory proceedings with respect to the Company's handling of
claims arising out of the 1994 Northridge Earthquake. The CDI has appealed the
ruling.
Bryan Speck, individually, and on behalf of others similarly situated v. 21st
- -----------------------------------------------------------------------------
Century Insurance Company, 21st Century Casualty Company, and 21st Century
- --------------------------------------------------------------------------
Insurance Group, was filed on June 20, 2002 in Los Angeles Superior Court. The
- ---------------
plaintiff seeks national class action certification, injunctive relief, and
unspecified actual and punitive damages. The complaint contends that 21st
Century uses "biased" software in determining the value of total-loss
automobiles. The plaintiff alleges that database providers use improper
methodology to establish comparable auto values and populate their databases
with biased figures. 21st Century and other carriers allegedly subscribe to the
programs to unfairly reduce claim costs. This case is consolidated with similar
actions against other insurers for discovery and pre-trial motions. 21st
Century intends to vigorously defend the suit with other defendants in the
coordinated proceedings.
Thomas Theis, on his own behalf and on behalf of all others similarly situated
- ------------------------------------------------------------------------------
v. 21st Century Insurance, was filed on June 17, 2002 in Los Angeles Superior
- -------------------------
Court. Plaintiff seeks national class action certification, injunctive relief
and unspecified actual and punitive damages. The complaint contends that after
insureds receive medical treatment, 21st Century uses a medical-review program
to adjust expenses to reasonable and necessary amounts for a given geographic
area. The plaintiff alleges that the adjusted amount is "predetermined" and
"biased," creating an unfair pretext for reducing claim costs. This case is
consolidated with similar actions against other insurers for discovery and
pre-trial motions. 21st Century intends to vigorously defend the suit with
other defendants in the coordinated proceedings.
SB 1899, effective from January 1, 2001, to December 31, 2001, allowed the
re-opening of previously closed earthquake claims arising out of the 1994
Northridge Earthquake. The Company's first constitutional challenge to SB 1899
came to an unsuccessful result on April 29, 2002, when the United States Supreme
Court refused to hear the Company's case (see Note 16 of the Notes to
Consolidated Financial Statements). A subsidiary of the Company, 21st Century
Casualty Company, filed a new challenge to the constitutionality of SB 1899 on
February 13, 2003. The viability of this case is being reviewed as a result of a
subsequent Ninth Circuit Court
67
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
of Appeals decision. The Company currently has lawsuits pending against it in
connection with claims under SB 1899; many of these lawsuits have multiple
plaintiffs. Damages in excess of the Company's reasonable estimates for these
claims could be material individually or in the aggregate.
The Company has filed a civil complaint against California-based Unlimited
Adjusting Company ("Unlimited") and its principal Jung Ho Park ("John Park").
The suit alleges Unlimited and John Park illegally induced insureds into filing
additional unnecessary and fraudulent claims with the Company stemming from the
1994 Northridge Earthquake. The Company is ultimately seeking up to $10 million
in compensatory damages.
In December of 2000, a statute that allowed a tax deduction for the dividends
received from wholly owned insurance subsidiaries was held unconstitutional on
the grounds that it discriminated against out-of-state insurance holding
companies. Subsequent to the court ruling, the staff of the California
Franchise Tax Board ("FTB") has decided to take the position that the
discriminatory sections of the statute are not severable and the entire statute
is invalid. As a result, the FTB is disallowing dividend-received deductions
for all insurance holding companies, regardless of domicile, for open tax years
ending on or after December 1, 1997. Although the FTB has not made a formal
assessment for tax years 1997 through 2000, the Company anticipates a
retroactive disallowance that would result in additional tax assessments.
The amount of any such possible assessments and the ultimate amounts, if any,
that the Company may be required to pay, are subject to a wide range of
estimates because so many ostensibly long-settled aspects of California tax law
have been thrown into disarray and uncertainty by the action of the courts. In
the absence of legislative relief, years of future litigation may be required to
determine the ultimate outcome. The range of possible loss, net of federal tax
benefit, ranges from close to zero to approximately $20.8 million depending on
which position future courts may decide to uphold or on whether the California
legislature may decide to enact corrective legislation. The Company believes it
has adequately provided for this contingency.
In December 2001, the Company settled, subject to court approval, for a maximum
of $4.2 million, all matters related to various overtime pay lawsuits that were
filed in the third quarter of 2001. The $4.2 million settlement was charged to
operations in the fourth quarter of 2001.
NOTE 16. NORTHRIDGE EARTHQUAKE
- -------------------------------
California Senate Bill 1899 ("SB 1899"), effective from January 1, 2001, to
December 31, 2001, allowed the re-opening of previously closed earthquake claims
arising out of the 1994 Northridge Earthquake. The Company's constitutional
challenge to SB 1899 came to an unsuccessful result on April 29, 2002, when the
United States Supreme Court refused to hear the Company's case. In the fourth
quarter of 2001, the Company recorded a $50.0 million pre-tax charge for loss
and inspection costs but, at that time, it was impracticable to reasonably
estimate the legal defense costs associated with previously closed earthquake
claims. Based on information available to the Company, the Company recorded an
additional $46.9 million pre-tax charge for such legal defense costs in the
third quarter of 2002. Earthquake reserves at December 31, 2002, were $39.9
million.
The Company cautions that the recorded estimates for this event are subject to a
greater than normal degree of uncertainty for a variety of reasons.
68
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
First, determining in 2001 and subsequently whether alleged damage was caused or
exacerbated by a 1994 earthquake is inherently difficult. Company experts and
experts representing claimants could have materially different views of both
causation and the necessity and cost of a particular method of repair. The
purpose of the one-year time period in the policy is precisely to avoid the
problems inherent in attempting to adjust stale claims. In the event of a
difference of opinion, an expensive mediation or litigation process is needed to
obtain resolution. Results from this process, particularly the jury process, are
not predictable with precision.
Second, Company adjusters have frequently been prevented from taking recorded
statements or examinations under oath of claimants. In many instances,
subsequent statements allow adjusters to materially reduce their estimates. It
is possible that the litigation discovery process might provide similar results
for SB 1899 claims. Similarly, the Company's actions against alleged fraudulent
claimants, adjusters, or attorneys, such as the action against Unlimited
Adjusting, could favorably impact reserves if claims are proven fraudulent.
Third, more than two-thirds of the Company's remaining earthquake claims are in
litigation. Many suits seek extracontractual and punitive damages as well as
contractual damages far in excess of the Company's estimates; the Company views
such outcomes as being remote. Therefore, a reserve for potential
extracontractual or punitive damages has not been established. Extracontractual
and punitive damages, if assessed against the Company, could be material in an
individual case or in the aggregate. In addition, the Company may choose to
settle litigated cases for amounts in excess of its own estimate of contractual
damages to avoid the expense and/or risk of litigation.
Fourth, additional Northridge Earthquake claims have been filed in 2002 outside
of the reporting window established by SB 1899. The Company currently has
approximately 40 such claims that are apparently based on alternative legal
theories. Thus, the Company could continue to receive additional Northridge
Earthquake claims in the future that may require additional reserves.
Finally, actual expenses for legal defense costs are susceptible to a wide range
of outcomes depending on a variety of factors including plaintiff strategies,
future judicial decisions, the percentage of cases which settle, and the period
of time cases remain outstanding before settlement. The possibility of reaching
mass settlements of cases with particular attorneys or law firms presents the
opportunity to substantially reduce estimates for legal defense costs. On the
other hand, the inability to settle a substantial majority of cases for
reasonable amounts would materially increase amounts needed for legal defense
costs.
Although approximately one-third of the SB 1899 claims are settled, more than
two-thirds of the remaining claims are in litigation and thus may prove more
difficult to settle.
69
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 17. UNAUDITED QUARTERLY RESULTS OF OPERATIONS
- ---------------------------------------------------
The summarized unaudited quarterly results of operations were as follows:
Quarters Ended March 31, June 30, September 30, December 31,
- -------------------------------------------------------------------------------------------
2002
Net premiums earned $ 215,111 $ 220,191 $ 234,666 $ 254,591
Net investment income 11,265 11,384 11,729 11,967
Realized investment gains 1,663 2,635 3,045 3,048
Net income (loss) 8,323 9,859 (45,235) 14,797
Earnings (loss) per common share(1) $ 0.10 $ 0.11 $ (0.53) $ 0.17
2001
Net premiums earned $ 214,611 $ 217,366 $ 216,631 $ 215,537
Net investment income 11,805 11,561 11,395 11,169
Realized investment gains 1,116 434 962 2,489
Net income (loss) 4,922 5,797 2,679 (40,966)
Earnings (loss) per common share(1) $ 0.06 $ 0.07 $ 0.03 $ (0.48)
Third quarter 2002 and fourth quarter 2001 results were impacted by $46.9 and
$50.0 million, respectively, related to earthquake claims arising out of
California Senate Bill 1899. In addition, the third quarter of 2002 included a
charge of $37.2 million for the write-off of software development costs, and the
fourth quarter of 2001 included a charge of $9.6 million associated with
workforce reductions and the settlement of litigation matters.
- ---------------
1 Basic and diluted amounts are the same for all periods presented.
70
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 18. RESULTS OF OPERATIONS BY LINE OF BUSINESS
- ---------------------------------------------------
The following table presents premium revenue and underwriting profit (loss) for
the Company's insurance lines on a GAAP basis for the years ended December 31.
Homeowner and
Earthquake
Personal Lines in Runoff
2002 Auto Lines and All Other Total
- -----------------------------------------------------------------------
Direct premiums written $ 995,794 $ 2,454 $ 998,248
Net premiums earned 924,559 - 924,559
Underwriting profit (loss) 13,383 (58,768) (45,385)
Loss and LAE ratio 82.9% N/M(1) 89.4%
Underwriting ratio 15.6% N/M 15.5%
Combined ratio 98.5% N/M 104.9%
2001
- -----------------------------------------------------------------------
Direct premiums written $ 898,862 $ 30,453 $ 929,315
Net premiums earned 838,489 25,656 864,145
Underwriting loss (24,410) (77,598) (102,008)
Loss and LAE ratio 88.1% 381.6% 96.7%
Underwriting ratio 14.9% 20.9% 15.0%
Combined ratio 103.0% 402.5% 111.7%
2000
- -----------------------------------------------------------------------
Direct premiums written $ 881,212 $ 29,508 $ 910,720
Net premiums earned 803,770 21,716 825,486
Underwriting loss (39,799) (2,669) (42,468)
Loss and LAE ratio 90.8% 90.9% 90.8%
Underwriting ratio 14.2% 21.4% 14.4%
Combined ratio 105.0% 112.3% 105.2%
Personal Auto Lines. The underwriting gain for the personal auto lines was due
to a 12.1% increase in the number of insured vehicles, rate increases and the
favorable impact on claim frequency of drought conditions that have largely
prevailed in Southern California during the past year. The underwriting loss for
the personal auto lines decreased by $15.4 million in 2001 compared to 2000 as
the effects of rate increases more than offset the effects of a decline in the
number of insured vehicles.
Homeowner and Earthquake Lines in Runoff and All Other. The underwriting loss
for the homeowner and earthquake lines decreased by $18.8 million in 2002
compared to 2001 and increased $74.9 million in 2001 compared to 2000 due to
losses and loss adjustment expenses related to SB 1899. See Notes 8 and 16 of
the Notes to Consolidated Financial Statements.
- ---------------
1 The ratio cannot be calculated, as the denominator is zero.
71
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 (CONTINUED)
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 19. 21ST CENTURY INSURANCE COMPANY OF ARIZONA
- ---------------------------------------------------
Effective January 1, 2002, the Company acquired AIG's 51% interest in 21st
Insurance Company of Arizona (21st of Arizona). The Company previously held a
49% interest in 21st of Arizona, which writes personal auto exclusively in
Arizona. The Company's primary purpose in acquiring 21st of Arizona was to
provide an additional entity to facilitate the Company's planned expansion into
other states.
The purchase price was $4.4 million, which approximated 51% of 21st of Arizona's
GAAP book value. No research and development assets were acquired, and no
goodwill was recorded.
The purchase agreement included a one-year contingency for subsequent loss and
LAE reserve development for 2001 and prior accident years. Under its terms, at
December 31, 2002, 33% of any additional loss and LAE development would be
reimbursed to the Company by AIG, while a reduction in the loss and LAE
development would be paid to AIG. Based on the 2002 year-end results, the
amount receivable from AIG is $.05 million.
The following is a summarized balance sheet of 21st of Arizona as of December
31, 2001.
Investments and cash $14,193
Deferred income taxes 3,887
Other assets 1,455
-------------------------------------------------
Total assets 19,535
-------------------------------------------------
Unpaid loss and loss adjustment expenses 6,749
Unearned premiums 2,815
Other liabilities 1,244
-------------------------------------------------
Total liabilities 10,808
-------------------------------------------------
Total equity $ 8,727
-------------------------------------------------
The following table summarizes actual results of the Company and pro forma
results as if 21st of Arizona had been consolidated with the Company for the
year ended December 31, 2001.
Consolidated Results
As Reported Pro Forma
------------------------------------------
Revenue $ 914,078 $ 929,576
Net loss (27,568) (28,607)
Loss per share (0.32) (0.34)
72
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Effective April 23, 2001, Ernst & Young LLP ("E&Y") was dismissed as the
Company's independent auditors. E&Y's reports on the audited financial
statements for the year ended December 31, 2000, did not contain adverse,
qualified or modified opinions. The change in accountants was recommended by the
board of directors. There were no disagreements with E&Y. At the June 6, 2001,
stockholder meeting, the stockholders ratified the appointment of
PricewaterhouseCoopers LLP as the Company's independent accountants.
PART III
ITEM 10. DIRECTORS AND OFFICERS OF THE REGISTRANT
Information in response to Item 10 is incorporated by reference from the
Company's definitive proxy statement used in connection with the Company's 2003
Annual Meeting of Stockholders pursuant to Instruction G(3) of Form 10-K.
ITEM 11. EXECUTIVE COMPENSATION
Information in response to Item 11 is incorporated by reference from the
Company's definitive proxy statement used in connection with the Company's 2003
Annual Meeting of Stockholders pursuant to Instruction G(3) of Form 10-K.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information in response to Item 12 is incorporated by reference from the
Company's definitive proxy statement used in connection with the Company's 2003
Annual Meeting of Stockholders pursuant to Instruction G(3) of Form 10-K.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Certain Information in response to Item 13 is incorporated by reference from the
Company's definitive proxy statement used in connection with the Company's 2003
Annual Meeting of Stockholders pursuant to Instruction G(3) of Form 10-K. All
related party transactions, which require disclosure, are included in the
Management's Discussion and Analysis or the Notes to Consolidated Financial
Statements.
73
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) DOCUMENTS FILED WITH THIS REPORT
(1) FINANCIAL STATEMENTS
The following consolidated financial statements of the Company are filed as
a part of this report:
PAGE
(i) Report of independent accountants (2002 and 2001); 44
(ii) Report of independent auditors (2000); 45
(iii) Consolidated balance sheets - December 31, 2002 and 2001; 46
(iv) Consolidated statements of operations - Years ended December 31,
2002, 2001 and 2000; 47
(v) Consolidated statements of stockholders' equity - Years ended
December 31, 2002, 2001 and 2000; 48
(vi) Consolidated statements of cash flows - Years ended December 31,
2002, 2001 and 2000; 49
(vii) Notes to consolidated financial statements 50
(2) SCHEDULES
The following financial statement schedule required to be filed by Item 8
and by paragraph (d) of Item 14 of Form 10-K is submitted as a separate
section of this report.
Schedule II - Condensed Financial Information of Registrant 75
Schedules I, III, IV, V and VI have been omitted as all required data is
included in the Notes to Consolidated Financial Statements.
All other schedules for which provision is made in the applicable
accounting regulations of the Securities and Exchange Commission are not
required under the related instructions or are inapplicable and, therefore,
have been omitted.
(3) EXHIBITS REQUIRED
The following exhibits required by Item 601 of Regulation S-K and by
paragraph (c) of Item 14 of Form 10-K are listed by number corresponding to
the Exhibit Table of Item 601 of Regulation S-K and are filed herewith:
3(ii) Bylaws, as amended 82
23(a) Consent of Independent Accountants, filed herewith 83
23(b) Consent of Independent Auditors, filed herewith 84
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 85
(b) REPORTS ON FORM 8-K.
The Company filed a Form 8-K on December 31, 2002, announcing the expansion of
the Company's Board of Directors from nine to eleven members. Three new
directors were named and one former director resigned.
74
SCHEDULE II
21ST CENTURY INSURANCE GROUP (PARENT COMPANY)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
December 31, 2002 2001
- ----------------------------------------------------------------------------------------------
ASSETS
Cash $ 5,946 $ 8,142
Fixed maturities available-for-sale, at fair value 1,031 44,705
Investment in unconsolidated insurance subsidiaries and affiliates, at
equity 610,693 575,047
Other assets 64,151 84,692
- ----------------------------------------------------------------------------------------------
Total assets $681,821 $712,586
- ----------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Dividends payable $ 1,708 $ -
Accounts payable and accrued expenses 687 24,705
Deferred tax liabilities 10,542 -
Accounts payable to subsidiaries and affiliates, net of receivables 13,276 28,575
- ----------------------------------------------------------------------------------------------
Total liabilities 26,213 53,280
- ----------------------------------------------------------------------------------------------
Stockholders' equity:
Common stock, without par value; authorized 110,000,000
shares, outstanding 85,431,505 in 2002 and 85,361,848 in 2001 418,984 416,991
Retained earnings 213,067 248,635
Accumulated other comprehensive income (loss) 23,557 (6,320)
- ----------------------------------------------------------------------------------------------
Total stockholders' equity 655,608 659,306
- ----------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $681,821 $712,586
- ----------------------------------------------------------------------------------------------
75
SCHEDULE II
21ST CENTURY INSURANCE GROUP (PARENT COMPANY)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF OPERATIONS
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Years Ended December 31, 2002 2001 2000
- ---------------------------------------------------------------------------------------------
REVENUES
Dividends received from subsidiaries(1) $ - $ 3,076 $ 181,924
Realized investment gains 289 706 -
Interest 1,100 4,644 807
- ---------------------------------------------------------------------------------------------
Total revenues 1,389 8,426 182,731
- ---------------------------------------------------------------------------------------------
EXPENSES
Loan interest and fees - - 2,900
General and administrative 72 10 77
- ---------------------------------------------------------------------------------------------
Total losses and expenses 72 10 2,977
- ---------------------------------------------------------------------------------------------
Income before federal income taxes 1,317 8,416 179,754
Federal income tax (expense) benefit (5,436) (529) 414
- ---------------------------------------------------------------------------------------------
Net (loss) income before equity in undistributed loss of
subsidiaries (4,119) 7,887 180,168
Equity in undistributed loss of subsidiaries (8,137) (35,455) (167,223)
- ---------------------------------------------------------------------------------------------
Net (loss) income $(12,256) $(27,568) $ 12,945
- ---------------------------------------------------------------------------------------------
(1) Excludes accrued dividends of $3.1 million at December 31, 2000.
76
SCHEDULE II
21ST CENTURY INSURANCE GROUP (PARENT COMPANY)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF CASH FLOWS
AMOUNTS IN THOUSANDS
Years Ended December 31, 2002 2001 2000
- --------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net (loss) income $(12,256) $(27,568) $ 12,945
Adjustments to reconcile net (loss) income to net cash
provided by operating activities:
Provision for depreciation and amortization 2,823 3,350 4,483
Amortization of restricted stock grants 506 695 178
Benefit for deferred income taxes (8,730) (5,700) (23,794)
Dividends received from subsidiaries - - 95,000
Realized gains on sale of investments (538) (709) -
Federal income taxes 10,542 - -
Other assets 19,914 (14,051) 117,249
Other liabilities (37,406) 6,959 2,464
- --------------------------------------------------------------------------------------------
NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES (25,145) (37,024) 208,525
- --------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Capital contributed to subsidiaries (1,000) - -
Net proceeds (purchases) of investments available for sale 43,962 53,864 (94,054)
Net proceeds (purchases) of property and equipment 709 17,475 (33,352)
- --------------------------------------------------------------------------------------------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES 43,671 71,339 (127,406)
- --------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Repurchase of common stock, net of options exercised - - (16,598)
Proceeds from exercise of options 1,488 1,233 1,861
Bank loan principal repayment - - (67,500)
Dividends paid (22,210) (27,310) (40,964)
- --------------------------------------------------------------------------------------------
NET CASH USED IN FINANCING ACTIVITIES (20,722) (26,077) (123,201)
- --------------------------------------------------------------------------------------------
Net (decrease) increase in cash (2,196) 8,238 (42,082)
Cash and cash equivalents, beginning of year 8,142 (96) 41,986
- --------------------------------------------------------------------------------------------
Cash and cash equivalents, end of year $ 5,946 $ 8,142 $ (96)
- --------------------------------------------------------------------------------------------
77
SIGNATURES OF OFFICERS AND BOARD OF DIRECTORS
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
Date: March 18, 2003 21ST CENTURY INSURANCE GROUP
(Registrant)
By: /s/ Bruce W. Marlow
-----------------------
Bruce W. Marlow
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated on the 18th of March, 2003.
SIGNATURE TITLE
/s/ Bruce W. Marlow President and Chief Executive Officer and Director
- ------------------------- (Principal Executive Officer)
Bruce W. Marlow
/s/ John M. Lorentz Controller and Acting Chief Financial Officer
- ------------------------- (Principal Accounting Officer and Acting Principal
John M. Lorentz Financial Officer)
/s/ Robert M. Sandler
- -------------------------
Robert M. Sandler Chairman of the Board
/s/ John B. DeNault, III
- -------------------------
John B. DeNault, III Director
/s/ R. Scott Foster, M.D.
- -------------------------
R. Scott Foster, M.D. Director
/s/ Roxani M. Gillespie
- -------------------------
Roxani M. Gillespie Director
/s/ Jeffrey L. Hayman
- -------------------------
Jeffrey L. Hayman Director
/s/ Fred Martin, Jr.
- -------------------------
Fred Martin, Jr. Director
/s/ James P. Miscoll
- -------------------------
James P. Miscoll Director
/s/ Keith W.Renken
- -------------------------
Keith W. Renken Director
78
/s/ Gregory M. Shepard
- -------------------------
Gregory M. Shepard Director
/s/ Howard I. Smith
- -------------------------
Howard I. Smith Director
79
CERTIFICATION OF PRESIDENT AND CHIEF EXECUTIVE OFFICER
- ------------------------------------------------------
I, Bruce W. Marlow, certify that:
1. I have reviewed this annual report on Form 10-K of 21st Century Insurance
Group:
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: March 18, 2003 /s/ Bruce W. Marlow
-------------- -------------------------------------
Bruce W. Marlow
President and Chief Executive Officer
80
CERTIFICATION OF CHIEF FINANCIAL OFFICER
- ----------------------------------------
I, John M. Lorentz, certify that:
1. I have reviewed this annual report on Form 10-K of 21st Century Insurance
Group:
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: March 18, 2003 /s/ John M. Lorentz
-------------- ---------------------------------------------
John M. Lorentz
Controller and Acting Chief Financial Officer
(Principal Accounting Officer
and Acting Principal Financial Officer)
81
EXHIBIT 3(II)
CERTIFICATION
I, Michael J. Cassanego, do hereby certify that:
1. I am the duly elected and acting Secretary of 21st Century Insurance Group,
21st Century Insurance Company and 21st Century Casualty Company, each a
California corporation;
2. That at a meeting of the Board of Directors of said corporations, held on
the 30th of December, 2002, the following resolutions were adopted:
RESOLVED, THAT ARTICLE III, SECTION 3.02 OF THE BYLAWS OF 21ST CENTURY
INSURANCE GROUP, 21ST CENTURY INSURANCE COMPANY AND 21ST CENTURY
CASUALTY COMPANY BE AMENDED TO READ AS FOLLOWS:
"SECTION 3.02 NUMBER OF DIRECTORS. THE AUTHORIZED NUMBER OF DIRECTORS
OF THE CORPORATION SHALL BE ELEVEN."
WITNESS my hand and corporate seal this 25th day of February 2003, at Woodland
Hills, California.
21st Century Insurance Group
21st Century Insurance Company
21st Century Casualty Company
February 25, 2003 /s/ Michael J. Cassanego
----------------------------------
Michael J. Cassanego
Secretary
82