SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For Quarter Ended June 30, 2003 Commission File Number 0-6964
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21ST CENTURY INSURANCE GROUP
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(Exact name of registrant as specified in its charter)
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
None
--------------------------------------------------------------------------------
Former name, former address and former fiscal year, if changed since last
report.
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act.
Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common Stock, Without Par Value Outstanding at July 18, 2003
(Title of Class) 85,431,505 shares
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
21ST CENTURY INSURANCE GROUP
CONSOLIDATED BALANCE SHEETS
Unaudited
JUNE 30, December 31,
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA 2003 2002
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ASSETS
Fixed maturity investments available-for-sale, at fair value
(amortized cost: $943,740 and $886,047) $ 994,154 $ 924,581
Cash and cash equivalents 128,543 105,897
---------------------------------------------------------------------------------------------
Total investments and cash 1,122,697 1,030,478
Accrued investment income 18,237 13,230
Premiums receivable 104,392 91,029
Reinsurance receivables and recoverables 17,981 28,105
Prepaid reinsurance premiums 1,632 1,893
Deferred income taxes 69,970 88,939
Deferred policy acquisition costs 50,959 46,190
Leased property under capital lease, net of deferred gain of
$5,489 and $6,280 and net of accumulated amortization of $6,260
and $0 48,251 53,720
Property and equipment, at cost less accumulated depreciation of
$55,801 and $52,125 91,125 87,274
Other assets 35,486 29,179
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Total assets $1,560,730 $1,470,037
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LIABILITIES AND STOCKHOLDERS' EQUITY
Unpaid losses and loss adjustment expenses $ 417,580 $ 384,009
Unearned premiums 299,758 266,477
Obligation under capital lease 55,279 60,000
Claim checks payable 42,543 39,304
Reinsurance payable 1,526 4,952
Other liabilities 61,534 59,687
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Total liabilities 878,220 814,429
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Stockholders' equity:
Common stock, without par value; authorized 110,000,000
shares, outstanding 85,431,505 in 2003 and 2002 419,139 418,984
Retained earnings 232,091 213,067
Accumulated other comprehensive income 31,280 23,557
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Total stockholders' equity 682,510 655,608
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Total liabilities and stockholders' equity $1,560,730 $1,470,037
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See accompanying notes to consolidated financial statements.
2
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS
Unaudited
Three months ended June 30, Six months ended June 30,
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA 2003 2002 2003 2002
--------------------------------------------------------------------------------------------------------
REVENUES
Net premiums earned $ 287,231 $ 220,191 $ 558,672 $ 435,302
Net investment income 11,673 11,384 23,311 22,649
Other 14,065 - 14,065 -
Realized investment gains 7,700 2,635 12,280 4,298
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Total revenues 320,669 234,210 608,328 462,249
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LOSSES AND EXPENSES
Net losses and loss adjustment expenses 228,182 189,903 481,525 378,538
Policy acquisition costs 47,766 29,762 91,209 56,320
Other operating expenses 390 3,066 4,033 6,967
Interest and fees expense 833 - 1,540 -
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Total losses and expenses 277,171 222,731 578,307 441,825
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Income before federal income taxes 43,498 11,479 30,021 20,424
Federal income tax expense 14,347 1,620 7,580 2,242
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Net income $ 29,151 $ 9,859 $ 22,441 $ 18,182
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EARNINGS PER COMMON SHARE
Basic $ 0.34 $ 0.11 $ 0.26 $ 0.21
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Diluted $ 0.34 $ 0.11 $ 0.26 $ 0.21
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Weighted average shares outstanding - basic 85,431,505 85,420,296 85,431,505 85,392,579
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Weighted average shares outstanding - diluted 85,725,925 85,933,990 85,567,620 85,731,978
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See accompanying notes to consolidated financial statements.
3
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Unaudited
Accumulated
Other
Common Retained Comprehensive
AMOUNTS IN THOUSANDS Stock Earnings Income Total
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Balance - January 1, 2003 $418,984 $213,067 $23,557 $655,608
Comprehensive gain - 22,441 (1) 7,723 (2) 30,164
Cash dividends declared on common
stock ($0.02 per share) - (3,417) - (3,417)
Other 155 - - 155
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Balance - June 30, 2003 $419,139 $232,091 $31,280 $682,510
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(1) Net income.
(2) Net change in accumulated other comprehensive income for the six months
ended June 30, 2003, comprises unrealized gains on available-for-sale
investments of $15,797 (net of income tax expense of $8,508) less the
reclassification adjustment for gains included in net income of $8,074 (net of
income tax expense of $4,348).
See accompanying notes to consolidated financial statements.
4
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited
AMOUNTS IN THOUSANDS
Six months ended June 30, 2003 2002
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OPERATING ACTIVITIES
Net income $ 22,441 $ 18,182
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for depreciation and amortization 10,465 9,728
Amortization of restricted stock grants 155 237
Change in deferred income tax expense 14,810 5,864
Realized gains on sale of investments (12,280) (4,372)
Federal income tax benefit - 4,670
Reinsurance balances 6,960 (2,488)
Unpaid losses and loss adjustment expenses 33,571 3,548
Unearned premiums 33,281 3,478
Claim checks payable 3,239 2,083
Premiums receivable (13,363) (3,550)
Other assets (15,906) 1,464
Other liabilities 1,847 4,654
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Net cash provided by operating activities 85,220 43,498
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INVESTING ACTIVITIES
Fixed maturities available-for-sale
Purchases (340,510) (329,233)
Calls or maturities 19,498 13,094
Sales 274,424 328,634
Net purchases of property and equipment (7,848) (8,891)
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Net cash (used in) provided by investing activities (54,436) 3,604
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FINANCING ACTIVITIES
Reduction of obligation under capital lease (4,721) -
Dividends paid (3,417) (13,659)
Proceeds from the exercise of stock options - 1,485
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Net cash used in financing activities (8,138) (12,174)
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Net increase in cash 22,646 34,928
Cash and cash equivalents, beginning of period 105,897 28,909
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Cash and cash equivalents, end of period $ 128,543 $ 63,837
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Supplemental information:
Income taxes paid (refunded) $ 123 $ (12,920)
Interest paid 1,407 -
See accompanying notes to consolidated financial statements.
5
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
Unaudited
NOTE 1. BASIS OF PRESENTATION
------------------------------
The accompanying unaudited consolidated financial statements of 21st Century
Insurance Group and its subsidiaries (the "Company") have been prepared in
accordance with accounting principles generally accepted in the United States of
America ("GAAP") for interim financial information and the instructions to Form
10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by GAAP for complete financial
statements. In the opinion of management, all adjustments (consisting of
normal, recurring accruals) considered necessary for a fair presentation have
been included. All material intercompany accounts and transactions have been
eliminated. Operating results for the six-month period ended June 30, 2003, are
not necessarily indicative of the results that may be expected for the year
ending December 31, 2003. For further information, refer to the consolidated
financial statements and notes thereto included in the Company's Annual Report
on Form 10-K for the year ended December 31, 2002.
Certain amounts in the 2002 financial statements have been reclassified to
conform to the 2003 presentation.
NOTE 2. EARTHQUAKE AND HOMEOWNER LINES IN RUNOFF
-------------------------------------------------
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. During the first quarter of
2003, the Company increased its 1994 Northridge Earthquake/SB 1899 reserves by
$37.0 million, resulting in an after-tax charge of $24.1 million. Most of the
Company's remaining 1994 Earthquake claims are in litigation. The discovery
stay imposed in early 2002 was lifted in the first quarter of 2003 and trial
dates for substantially all cases have now been set. Also during the first
quarter, several appellate court decisions were rendered on issues affecting
Northridge Earthquake cases, including a decision by the 9th Circuit Court of
Appeals involving Allstate Insurance Company, which again found SB 1899
(California Code of Civil Procedure 340.9) to be constitutional. As a result of
the 9th Circuit's decision in House et al v. Allstate Insurance Company, the
-----------------------------------------
Company's subsidiary, 21st Century Casualty Company, voluntarily dismissed the
action it initiated on February 13, 2003, seeking to have SB 1899 declared
unconstitutional. The Company continues to believe the statute violates the
federal and state constitutions and will support other companies' efforts to
have the law overturned.
While the reserves now held are the Company's current best estimate of the cost
of resolving its 1994 Earthquake claims, the reserves for this legislatively
created event continue to be highly uncertain. The estimate currently recorded
by the Company assumes that relatively few of the cases will require a full
trial to resolve, that any trial costs will approximate those encountered by the
Company in the past, and that most cases will be settled without need for
extensive pre-trial preparation. Current reserves contain no provisions for
extracontractual or punitive damages, bad faith judgments or similar
unpredictable hazards of litigation that possibly could result in the event an
adverse verdict were to be sustained against the Company. To the extent those
and other underlying assumptions prove to be incorrect, the ultimate amount to
resolve these claims could exceed the Company's current reserves, possibly by a
material amount. The Company continues to seek reasonable settlements of claims
brought under SB 1899 and other Northridge Earthquake-related theories, but will
vigorously defend itself against excessive demands and fraudulent claims. The
Company may, however, settle cases in excess of its assessment of its
contractual obligations in order to reduce the future cost of litigation.
6
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
Unaudited
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 future related losses are 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 those
customers were offered homeowner coverage through an affiliate of Countrywide.
The Company has completed this process and no longer has any homeowner policies
in force.
Loss and loss adjustment expenses incurred for the homeowner and earthquake
lines in runoff for the quarter and six months ended June 30, 2003, were $0 and
$37.0 million, respectively, compared to $5.0 million and $11.9 million for the
same periods in 2002.
NOTE 3. CONTINGENCIES
----------------------
Litigation. In the normal course of business, the Company is named as a
defendant in lawsuits related to claim and other insurance policy issues. Some
of the actions request extra-contractual and/or punitive damages. These actions
are vigorously defended unless a reasonable settlement appears appropriate. In
the opinion of management, except as discussed in Note 2 relating to Northridge
Earthquake litigation and in Part II, Item 1, Legal Proceedings, the ultimate
outcome of such litigation is not expected to be material to the Company's
financial condition, results of operations or cash flows.
California Income Taxes. In a December 21, 2000 court ruling, Ceridian
--------
Corporation v. Franchise Tax Board, 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 taken 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 possible losses, net of federal tax
benefit, range from close to zero to approximately $22.0 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.
7
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
Unaudited
NOTE 4. STOCK - BASED COMPENSATION
-----------------------------------
Stock-Based Compensation. Under the 1995 stock option plan the aggregate number
of common shares authorized is currently limited to 10,000,000. At June 30,
2003, 2,671,097 common shares remain available for future grants and 6,853,035
common shares are issuable upon the exercise of all outstanding options and
rights. 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. Currently, the Company uses the intrinsic
value method to account for stock-based compensation paid to employees for their
services.
Exercise prices for options outstanding at June 30, 2003, ranged from $11.68 to
$29.25. The weighted-average remaining contractual life of those options is 7.75
years.
A summary of the Company's stock option activity and related information
follows:
Weighted-
Number of Average
AMOUNTS IN THOUSANDS, EXCEPT PRICE DATA Options Exercise Price
--------------------------------------------------------------------
Options outstanding December 31, 2002 5,142 $18.77
Granted in 2003 1,802 12.03
Exercised in 2003 -
Forfeited in 2003 (91) 16.90
----------------------------------------------------
Options outstanding June 30, 2003 6,853 17.06
----------------------------------------------------
A summary of securities issuable and issued for the 1995 Stock Option Plan at
June 30, 2003 follows:
1995 Stock Option
AMOUNTS IN THOUSANDS Plan
--------------------------------------------------------------------------
Total securities authorized 10,000
Number of securities issued (476)
Number of securities issuable upon the exercise of all
outstanding options and rights (6,853)
Number of securities forfeited (1,327)
Number of securities forfeited and returned to plan 1,327
---------------------------------------------------------------------
Number of securities remaining available for future
grants under the plan 2,671
---------------------------------------------------------------------
Options exercisable numbered 3,616,154 and 2,555,847 at the end of the second
quarter for the years 2003 and 2002, respectively.
8
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2003
Unaudited
For pro forma disclosure purposes, the fair value of stock options was estimated
at each date of grant using the following assumptions:
Six Months Ended June 30, 2003 2002
-------------------------------------------------------------------
Risk-free interest rate:
Minimum 2.65% 4.61%
Maximum 3.75% 4.79%
Dividend yield 0.67% 2.50%
Volatility factor of the expected market price
of the Company's common stock:
Minimum 0.38 0.35
Maximum 0.40 0.36
Weighted-average expected life of the options 6 YEARS 8 years
-------------------------------------------------------------------
The following table illustrates the effect on net income and earnings per share
if the fair value based method, using the Black-Scholes valuation model, had
been applied to all outstanding and unvested awards:
Three Months Ended Six Months Ended
June 30, June 30,
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA 2003 2002 2003 2002
-----------------------------------------------------------------------------------------------
Net income, as reported $ 29,151 $ 9,859 $ 22,441 $ 18,182
Add: Stock-based employee compensation
expense included in reported net income, net of
related tax effects - - - -
Deduct: Total stock-based employee compensation
expense determined under fair value based for all
awards, net of related tax effects 1,992 1,428 3,828 2,625
-----------------------------------------------------------------------------------------------
Pro forma net income 27,159 8,431 18,613 15,557
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Earnings per share:
-----------------------------------------------------------------------------------------------
Basic- as reported 0.34 0.11 0.26 0.21
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Basic- pro forma 0.32 0.10 0.22 0.18
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-----------------------------------------------------------------------------------------------
Diluted- as reported 0.34 0.11 0.26 0.21
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Diluted- pro forma 0.32 0.10 0.22 0.18
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Estimated weighted-average of the fair value of
options granted $ 6.00 $ 6.53 $ 4.80 $ 6.33
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9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FINANCIAL CONDITION
Investments and cash increased $59.1 million (5.6%) and $92.2 million (8.9%)
during the quarter and six months ended June 30, 2003, respectively. This
increase was primarily due to cash flow from operations.
Investment-grade bonds comprised substantially all of the fair value of the
fixed-maturity portfolio at June 30, 2003. The Company has no investments in
equity securities as of June 30, 2003 or as of December 31, 2002. Of the
Company's total investments at June 30, 2003, approximately 66.3% were invested
in tax-exempt, fixed-income securities, compared to 54.5% at December 31, 2002.
As of June 30, 2003, the pre-tax net unrealized gain on investments was $50.4
million (unrealized gains of $51.6 million and unrealized losses of $1.2
million), compared to $38.5 million at December 31, 2002 (unrealized gains of
$41.2 million and unrealized losses of $2.7 million). 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.
No such impairments were recorded in the three months or six months ended June
30, 2003 or 2002.
Deferred income taxes decreased $19.0 million (21.3%) during the six months
ended June 30, 2003 due to an increase in taxable earnings and the
reclassification of a current tax receivable of $7.9 million relating to a
settlement with the IRS.
Premiums receivable were $104.4 million at June 30, 2003, compared to $91.0
million at December 31, 2002, with the increase mainly attributable to growth in
the Company's customer base and higher premium rates. Balances past due 90 days
or more totaled $0.5 million and $0.3 million at June 30, 2003 and December 31,
2002, respectively. Company policy is to write off receivable balances when 180
days past due. At June 30, 2003, and December 31, 2002, the allowance for
doubtful accounts was $0.6 million and $0.0 million, respectively.
Prepaid reinsurance premiums and reinsurance payables were $1.6 million and $1.5
million at June 30, 2003, compared to $1.9 million and $5.0 million at December
31, 2002, respectively. The decline in balances is primarily due to the
cancellation of the quota share treaty with AIG subsidiaries effective September
1, 2002.
Increased advertising, compensation and other operating costs through June 30,
2003, associated with increased customer volume, contributed to an increase in
deferred policy acquisition costs ("DPAC") of $4.8 million to $51.0 million,
compared to $46.2 million at December 31, 2002. The Company's DPAC is estimated
to be fully recoverable (see Critical Accounting Policies - Deferred Policy
Acquisition Costs).
The Company's loss and loss adjustment expense ("LAE") reserves are summarized
in the following table:
JUNE 30, 2003 December 31, 2002
--------------------------------------
AMOUNTS IN THOUSANDS GROSS NET Gross Net
-------------------------------------------------------------
Unpaid Losses and LAE
Personal auto lines $365,938 $356,893 $333,113 $320,031
Homeowner lines 6,706 2,117 10,952 3,683
Earthquake lines 44,936 44,936 39,944 39,944
-------------------------------------------------------------
Total $417,580 $403,946 $384,009 $363,658
-------------------------------------------------------------
10
Gross unpaid losses and LAE increased by $33.6 million during the six months
ended June 30, 2003. The increase was primarily due to a reserve increase of
$32.8 million in the personal auto lines as a result of growth in the Company's
customer base. The homeowner and earthquake lines, which are in runoff,
increased by $0.8 million in the six months ended June 30, 2003, which comprised
a $37.0 million pre-tax charge to earnings in the first quarter of 2003 in the
earthquake line (see Note 2 of the Notes to Consolidated Financial Statements),
less payments, net of applicable reinsurance, of $36.2 million ($4.2 million
relating to homeowner and $32.0 million relating to earthquake).
The following table summarizes losses and LAE incurred, net of applicable
reinsurance, for the periods indicated:
Three Months Ended Six Months Ended
June 30, June 30,
AMOUNTS IN THOUSANDS 2003 2002 2003 2002
------------------------------------------------------------------------------------------
Net losses and LAE incurred related to insured
events of:
Current year:
Personal auto lines $ 228,182 $ 180,811 $ 444,525 $ 347,476
Homeowner lines - - - 2,520
Earthquake lines - - - -
------------------------------------------------------------------------------------------
Total current year 228,182 180,811 444,525 349,996
------------------------------------------------------------------------------------------
Prior years:
Personal auto lines - 4,135 - 19,247
Homeowner lines - 500 - 3,518
Earthquake lines - 4,457 37,000 5,777
------------------------------------------------------------------------------------------
Total prior years - 9,092 37,000 28,542
------------------------------------------------------------------------------------------
Grand Total $ 228,182 $ 189,903 $ 481,525 $ 378,538
------------------------------------------------------------------------------------------
The Company's reported earnings could be significantly different if ending
reserves were based on assumptions and estimates different from those used by
management. Historically, the Company's actuaries have not projected a range
around the carried 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 reserves after carefully
reviewing the appropriateness of the underlying assumptions.
Stockholders' equity and book value per share increased to $682.5 million and
$7.99, respectively, at June 30, 2003, compared to $655.6 million and $7.67 at
December 31, 2002. The increase in stockholders' equity for the six months ended
June 30, 2003, was primarily due to net income of $22.4 million, an increase in
other comprehensive income of $7.7 million, other of $0.2 million, less
dividends to stockholders of $3.4 million.
LIQUIDITY AND CAPITAL RESOURCES
Holding Company. The main sources of liquidity of 21st Century Insurance Group,
the holding company, historically have been dividends received from its
insurance subsidiaries and proceeds from issuance of debt or equity securities.
The holding company currently has no indebtedness for borrowed money, although
it has guaranteed a subsidiary's capital lease obligation. The holding
company's only equity security currently outstanding is its common stock, which
has no mandatory dividend obligations.
11
Cash and investments at the holding company were $13.1 million at June 30, 2003,
compared to $7.0 million at December 31, 2002. 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. On February 27, 2003, the Company declared a
$1.7 million dividend to stockholders of record on March 10, 2003, which was
paid March 28, 2003. In addition, on June 26, 2003, the Company declared a $1.7
million dividend to stockholders of record on July 8, 2003, payable on July 25,
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 is currently A+,
and its A.M. Best rating is A+.
The insurance subsidiaries in 2003 could pay $21.6 million as dividends to the
holding company without prior written approval from insurance regulatory
authorities. However, given the current uncertainty surrounding the taxability
of dividends received by holding companies from their insurance subsidiaries, it
is unlikely that the Company's insurance subsidiaries will make any dividend
payments to the holding company in 2003. There is no assurance that this 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 possibly having to pay the
additional tax of up to approximately 8.9 % on dividends from the insurance
subsidiaries to the holding company.
Insurance Subsidiaries. The Company has recorded underwriting profits in its
core auto insurance operations for the last six quarters and has thereby
enhanced its liquidity. In California, a 3.9% auto premium rate increase was
implemented on March 31, 2003 and in May of 2002 there was a 5.7% rate increase.
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 a result of such
uncertainties, underwriting losses could occur 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 earnings, which in turn could negatively impact the Company's
liquidity.
As of June 30, 2003, the Company's insurance subsidiaries had a combined
statutory surplus of $422.7 million, compared to $397.4 million at December 31,
2002. The change in surplus was primarily due to statutory net income of $34.7
million during the first half of 2003. In addition there was an increase of
$2.9 million in the admitted portion of the deferred tax asset. Offsetting
these increases is an increase in nonadmitted assets of $12.3 million. The
Company's ratio of net premiums written to surplus was 2.6 for the twelve month
period ended June 30, 2003, compared to 2.4 for the year ended December 31,
2002.
At June 30, 2003, the estimated cost to complete certain software development
projects is $31.5 million. The Company expects to fund these costs by cash flow
from operations.
Obligations, Letters of Credit, Guarantees and Transactions with Related
Parties. The Company currently has a capital lease obligation resulting from a
sale-leaseback transaction. 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.
The Company currently has no unused letters of credit, 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
12
transactions with AIG subsidiaries. At June 30, 2003, reinsurance recoverables,
net of payables, from AIG subsidiaries were $10.4 million, compared to $18.4
million at December 31, 2002.
Aside from the capital and operating lease obligations discussed above, the
Company has no long-term debt obligations, purchase obligations or other
long-term liabilities, whether on-balance sheet or off-balance sheet. In
addition, the Company has no retained interests in assets transferred to any
unconsolidated entities, and no obligations under derivative instruments or
obligations arising out of variable interests.
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.
RESULTS OF OPERATIONS
Overall Results. The Company reported net income of $29.2 million, or $0.34 per
share (basic and diluted), on direct premiums written of $300.9 million for the
quarter ended June 30, 2003, compared to net income of $9.9 million, or $0.11
earnings per share (basic and diluted), on direct premiums written of $238.4
million for the same 2002 quarter. For the six months ended June 30, 2003, net
income was $22.4 million, or $0.26 earnings per share (basic and diluted), on
direct premiums written of $594.5 million. Net income for the six months ended
June 30, 2002, was $18.2 million, or $0.21 earnings per share (basic and
diluted), on direct premiums written of $471.5 million. These results include:
(i) after-tax charges for 1994 Northridge earthquake costs of $24.1 million for
the six months ended June 30, 2003 and $3.8 million for the same period in 2002;
and (ii) after-tax net income of $9.1 million for the quarter ended June 30,
2003 resulting from a non-recurring, non-operational item and a favorable tax
settlement with the IRS.
The following table presents the components of the Company's personal auto lines
underwriting profit and the components of the combined ratio:
Three Months Six Months
Ended June 30, Ended June 30,
AMOUNTS IN THOUSANDS 2003 2002 2003 2002
-----------------------------------------------------------------------------------
Direct premiums written $300,924 $238,535 $594,540 $468,954
-----------------------------------------------------------------------------------
Net premiums written $299,743 $228,452 $592,223 $449,151
-----------------------------------------------------------------------------------
Net premiums earned $287,231 $220,191 $558,672 $435,302
Net losses and loss adjustment expenses 228,182 184,947 444,525 366,724
Underwriting expenses incurred 48,156 32,828 95,242 63,196
-----------------------------------------------------------------------------------
Personal auto lines underwriting profit $ 10,893 $ 2,416 $ 18,905 $ 5,382
-----------------------------------------------------------------------------------
RATIOS:
Loss and LAE ratio 79.4% 84.0% 79.6% 84.2%
Underwriting expense ratio 16.8% 14.9% 17.0% 14.5%
-----------------------------------------------------------------------------------
Combined ratio 96.2% 98.9% 96.6% 98.7%
-----------------------------------------------------------------------------------
13
The following table reconciles the Company's personal auto lines underwriting
profit to consolidated net income:
Three Months Six Months
Ended June 30, Ended June 30,
AMOUNTS IN THOUSANDS 2003 2002 2003 2002
-------------------------------------------------------------------------------------
Personal auto lines underwriting profit $ 10,893 $ 2,416 $ 18,905 $ 5,382
Homeowner and earthquake lines, in runoff,
underwriting loss - (4,956) (37,000) (11,905)
Net investment income 11,673 11,384 23,311 22,649
Realized investment gains 7,700 2,635 12,280 4,298
Other revenues 14,065 - 14,065 -
Interest and fees expense (833) - (1,540) -
Federal income tax expense (14,347) (1,620) (7,580) (2,242)
-------------------------------------------------------------------------------------
Net income $ 29,151 $ 9,859 $ 22,441 $ 18,182
-------------------------------------------------------------------------------------
Comments relating to the underwriting results of the personal auto and the
homeowner and earthquake lines in runoff are presented below.
UNDERWRITING RESULTS
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 premiums in the three and six months ended June
30, 2003 and 2002. The Company currently is licensed to write automobile
insurance in 29 states, compared to 25 states at the end of 2002. 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 in the three months ended June 30, 2003, increased $62.4
million (26.2%) to $300.9 million, compared to $238.5 for the same period in
2002. Of the $62.4 million increase, $50.5 million was due to a higher number
of insured vehicles, while $11.9 million was due to rate increases. Direct
premiums written for the six months ended June 30, 2003, increased $125.5
million (26.8%) to $594.5 million, compared to $469.0 million for the same
period in 2002. Of the $125.5 million increase, $101.7 million was due to a
higher number of insured vehicles, while $23.8 million was due to rate
increases. Current growth is being generated through active advertising for new
customers and product innovations.
Net premiums earned increased $67.0 million (30.4%) to $287.2 million for the
three months ended June 30, 2003, compared to $220.2 million for the same period
in 2002. Net premiums earned increased $123.4 million (28.3%) to $558.7 million
for the six months ended June 30, 2003, compared to $435.3 million for the same
period in 2002. The growth rate in net premiums earned exceeds that of the
direct premiums written for these periods primarily because of the termination
of the AIG quota share reinsurance program effective September 1, 2002.
The combined ratio was 96.2% for the three months ended June 30, 2003, compared
to 98.9% for the same period in 2002. The combined ratios for the six months
ended June 30, 2003 and 2002 were 96.6% and 98.7%, respectively. The
improvement resulted from a reduction in the loss and LAE ratio, which was
partially offset by an increase in the underwriting expense ratio. Company
management remains focused on achieving sustainable 15% premium growth and a
combined ratio of 96.0% or better. Since 1980, the Company has simultaneously
met those benchmarks only twice (1980 and 1981).
14
Net losses and LAE incurred increased $43.3 million (23.4%) to $228.2 million
for the three months ended June 30, 2003, compared to $184.9 million for the
same period in 2002. For the six months ended June 30, 2003, net losses and LAE
incurred increased $77.8 million (21.2%) to $444.5 million, compared to $366.7
million for the same period in 2002.
The loss and LAE ratios were 79.4% and 84.0% for the three months ended June 30,
2003 and 2002, respectively. For the six months ended June 30, 2003 and 2002,
the ratios were 79.6% and 84.2%, respectively. The effects on the loss and LAE
ratios of changes in estimates relating to insured events of prior years during
the second quarter were 0.0% in 2003 and 1.9% in 2002. The effects on the loss
and LAE ratios of changes in estimates relating to insured events of prior years
during the six months ended June 30, were 0.0% in 2003 and 4.4% in 2002. These
changes in estimates pertained mainly to development in average paid loss
severities beyond amounts previously anticipated. 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.
For the California auto lines, accident frequency (i.e., total number of claims
reported in the calendar period for all coverages divided by average vehicles in
force) decreased 7.1% in the second quarter of 2003, compared to the second
quarter of 2002, and decreased 8.3% in the first six months of 2003, compared to
the first six months of 2002. Loss severity increased 5.6% in the second
quarter of 2003, compared to the second quarter of 2002 and increased 4.0% in
the first half of 2003, compared to the first half of 2002. Past frequency and
severity trends are not necessarily predictive of future trends.
The ratios of net underwriting expenses to net premiums earned were 16.8% and
14.9% for the quarters ended June 30, 2003 and 2002, respectively. The ratios
of net underwriting expenses to net premiums earned were 17.0% and 14.5% for the
six months ended June 30, 2003 and 2002, respectively. The increases were
primarily due to growth in advertising and costs associated with increasing the
number of new sales agents. Several productivity enhancement initiatives are
underway aimed at improving customer service, reducing per unit process costs
and lowering fixed costs in corporate support areas.
Homeowner and Earthquake Lines in Runoff. The homeowner and earthquake lines,
which are in runoff, did not show any gains or losses for the quarter ending
June 30, 2003, compared to a loss of $5.0 million for the same period a year
ago. For the six months ended June 30, 2003 and 2002, losses for those same
lines were $37.0 million and $11.9 million, respectively, of which the
earthquake lines accounted for $37.0 million and $5.8 million, respectively.
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 future related losses are 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 were offered homeowner coverage through an affiliate of Countrywide.
The Company has completed this process and no longer has homeowner policies in
force.
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. During the first quarter of
2003, the Company increased its 1994 Northridge Earthquake/SB 1899 reserves by
$37.0 million, resulting in an after-tax charge of $24.1 million. Most of the
Company's remaining 1994 Earthquake claims are in litigation. The discovery
stay imposed in early 2002 was lifted in the first quarter of 2003 and trial
dates for substantially all cases have now been set. Also during the first
quarter, several appellate court decisions were rendered on issues affecting
Northridge Earthquake cases, including a decision by the 9th Circuit Court of
Appeals involving Allstate Insurance Company, which again found SB 1899
(California Code of Civil Procedure 340.9) to
15
be constitutional. As a result of the 9th Circuit's decision in House et al v.
--------------
Allstate Insurance Company, the Company's subsidiary, 21st Century Casualty
--------------------------
Company, voluntarily dismissed the action it initiated on February 13, 2003,
seeking to have SB 1899 declared unconstitutional. The Company continues to
believe the statute violates the federal and state constitutions and will
support other companies' efforts to have the law overturned.
While the reserves now held are the Company's current best estimate of the cost
of resolving its 1994 Earthquake claims, the reserves for this legislatively
created event continue to be highly uncertain. The estimate currently recorded
by the Company assumes that relatively few of the cases will require a full
trial to resolve, that any trial costs will approximate those encountered by the
Company in the past, and that most cases will be settled without need for
extensive pre-trial preparation. Current reserves contain no provisions for
extracontractual or punitive damages, bad faith judgments or similar
unpredictable hazards of litigation that possibly could result in the event an
adverse verdict were to be sustained against the Company. To the extent those
and other underlying assumptions prove to be incorrect, the ultimate amount to
resolve these claims could exceed the Company's current reserves, possibly by a
material amount. The Company continues to seek reasonable settlements of claims
brought under SB 1899 and other Northridge Earthquake-related theories, but will
vigorously defend itself against excessive demands and fraudulent claims. The
Company may, however, settle cases in excess of its assessment of its
contractual obligations in order to reduce the future cost of litigation.
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 which is investment grade. Net investment income
was $11.7 million for the quarter ended June 30, 2003, compared to $11.4 million
for the same quarter in 2002. Net investment income for the six months ended
June 30, 2003 and 2002, was $23.3 million and $22.6 million, respectively. The
average annual pre-tax yields on invested assets were 4.5% for both the three
and six-month periods ended June 30, 2003. For the comparable periods in 2002,
the yields were 5.1% for both periods. The average annual after-tax yields on
invested assets were 3.9% and 3.8% for the quarter and six month periods ended
June 30, 2003, compared to 4.4% for both periods in 2002. The decrease in
yields is due primarily to the fact that the Company held on average almost
three times more in cash equivalents in 2003, compared to 2002 combined with a
significant decrease in short term yields over the last twelve months.
Net realized gains on the sale of investments and fixed assets for the quarter
and six months ended June 30, 2003, were $7.7 million (gross realized gains were
$7.9 million, gross realized losses were $0.2 million) and $12.3 million (gross
realized gains were $12.7 million, gross realized losses were $0.4 million),
compared to $2.6 million (gross realized gains were $3.0 million, gross realized
losses were $0.4 million) and $4.3 million (gross realized gains were $5.0
million, gross realized losses were $0.7 million) for the same periods in 2002.
At June 30, 2003, $744.7 million (66.3%) of the Company's total investments at
fair value were invested in tax-exempt bonds with the remainder, representing
33.7% of the portfolio, invested in taxable securities, compared to 54.5% and
45.5%, respectively, at December 31, 2002.
As of June 30, 2003, the Company had a pre-tax net unrealized gain on fixed
maturity investments of $50.4 million, compared to $38.5 million at December 31,
2002.
16
The following table is a summary of securities sold at a loss during the three
month and six month periods ending June 30, 2003 and 2002.
Three Months Six Months
Ended June 30, Ended June 30,
AMOUNTS IN THOUSANDS, EXCEPT UNIT DATA 2003 2002 2003 2002
-----------------------------------------------------------------------------------
FIXED MATURITY SECURITIES:
Realized losses on sales $ 148 $ 435 $ 319 $ 624
Fair value at the date of sale $1,384 $53,533 $16,348 $86,715
Number of securities sold 3 29 11 50
Losses realized on securities with an unrealized
loss preceding the sale for:
Less than 3 months $ - $ 27 $ 33 $ 56
3-6 months - 45 100 171
6-12 months - 118 38 139
Greater than 12 months 148 245 148 258
-----------------------------------------------------------------------------------
OTHER REVENUES
Other revenue in the second quarter of 2003 included $9.3 million resulting from
a nonrecurring, nonoperational item and interest income of $4.8 million relating
to a favorable settlement with the IRS.
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 LAE, particularly the liability for unpaid
losses and LAE included in the liability section of the Company's balance sheet;
the recoverability of certain property and equipment; deferred income taxes;
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 LAE. The estimated liabilities for losses and 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 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 80% of the
ultimate losses are settled within twelve months of the date of loss.
17
Given the inherent variability in the estimates, management believes the
aggregate reserves are within a reasonable and acceptable range of adequacy,
although the Company continues to caution that the reserve estimates relating to
SB 1899 are subject to a greater than normal degree of variability and possible
future material adjustments may become necessary 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. 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 June 30, 2003,
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 June 30, 2003, management
has estimated that the $70.8 million carrying value and $31.5 million estimated
cost to complete such software, or $102.3 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). However, although management
believes it is reasonable to assume these future cost savings, such estimates
are subject to considerable uncertainty and there can be no assurance that such
cost savings will be achieved. 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 ranging from
approximately $5.8 million to $8.8 million.
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 ("NOL"s),
which can be carried forward 15 years for losses incurred before 1998 and 20
years thereafter.
At June 30, 2003, the Company's DTAs were $157.4 million, and its DTLs were
$87.4 million for a net DTA of $70.0 million which represents the net deferred
tax asset reported in the consolidated balance sheet.
The Company's core business has generated an underwriting profit for the past
six consecutive quarters. 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 June 30, 2003. 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
18
Company's ability to utilize its NOL carryforwards. In the event underwriting
losses due to either SB 1899 or other causes were to occur, management might be
required to reach a different conclusion about the realization of the DTAs and,
if so, to recognize a valuation allowance at that time.
Deferred Policy Acquisition Costs. Deferred policy acquisition costs ("DPAC")
include premium taxes, advertising, and other 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 DPAC 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.
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 No. 59, Noncurrent
Marketable Equity Securities, SFAS 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 the quarter or six months
ending June 30, for the years 2003 and 2002.
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 no impact on equity because any
unrealized losses are already included in comprehensive income.
A summary by issuer of noninvestment grade securities and unrated securities
held at June 30, 2003 and December 31, 2002 follows:
JUNE 30, December 31,
AMOUNTS IN THOUSANDS 2003 2002
---------------------------------------------------------------------------------
Noninvestment grade securities (i.e., rated below BBB):
Corning, Inc. $ - $ 850
Unrated securities:
Impact Funding, LLC 2,023 2,023
---------------------------------------------------------------------------------
Total noninvestment grade and unrated securities $ 2,023 $ 2,873
---------------------------------------------------------------------------------
19
The following table sets forth 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 June 30, 2003 and December
31, 2002:
JUNE 30, 2003 December 31, 2002
---------------------------------------------------------------
AMOUNTS IN THOUSANDS, # FAIR UNREALIZED # Unrealized
EXCEPT ISSUES ISSUES VALUE LOSS issues Fair value loss
---------------------------------------------------------------------------------------------------
Fixed maturity securities with
unrealized losses:
Exceeding $0.1 million and for:
less than 6 months 1 $ 4,959 $ (145) 3 $ 20,769 $ (1,601)
6-12 months - - 2 7,431 (530)
more than 1 year - - 1 850 (131)
Less than $0.1 million 45 90,242 (1,022) 16 44,590 (405)
---------------------------------------------------------------------------------------------------
Total 46 $95,201 $ (1,167) 22 $ 73,640 $ (2,667)
---------------------------------------------------------------------------------------------------
A summary of bond maturities in an unrealized loss position by year of maturity
follows:
JUNE 30, 2003 December 31, 2002
---------------------------------------------
AMORTIZED CARRYING AMORTIZED CARRYING
AMOUNTS IN THOUSANDS COST VALUE COST VALUE
--------------------------------------------------------------------------------------
Bond Maturities
Due in one year or less $ 4,980 $ 4,977 $ - $ -
Due after one year through five years 14,553 14,417 5,415 5,076
Due after five years through ten years 26,383 25,933 30,099 28,280
Due after ten years 50,453 49,874 40,792 40,284
--------------------------------------------------------------------------------------
Total $ 96,369 $ 95,201 $ 76,306 $ 73,640
--------------------------------------------------------------------------------------
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 handling 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 ethical code violations to an appropriate
person or personnel identified in the code; and
- accountability for adherence to the ethical code.
20
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, nor in the first
six months of 2003.
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 earthquake claims under SB
1899; customer service problems; the impact on Company operations of natural
disasters, principally earthquake, or civil disturbance, due to the
concentration of Company facilities and employees in Woodland Hills, California;
information systems problems, including failures to implement information
technology projects on time and within budget; 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.
ITEM 3. 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 assume 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.
Estimated Fair Value
Carrying At Adjusted Market
AMOUNTS IN MILLIONS Value Rates/Prices
-------------------------------------------------------------------------------
Fixed maturity investments available-for-sale $ 994.2 $ 922.8
Capital lease obligation 55.3 56.8
The above sensitivity analysis summarizes only the exposure to market interest
rate risk as of June 30, 2003. 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.
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
21
insurance business tend to have an average duration of less than one 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 6.2 years,
consistent with the maximization of income without sacrificing investment
quality and providing for liquidity and diversification. In the current lower
rate environment, the Company is taking steps to lower duration. Financial
instruments are not used for trading purposes.
ITEM 4. CONTROLS AND PROCEDURES
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 Company's disclosure controls and procedures (as defined in Exchange Act
Rule 13a-15) as of June 30, 2003. The Disclosure Committee's evaluation for the
quarter ended June 30, 2003 was completed on July 16, 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.
22
PART II - OTHER INFORMATION
ITEM 1. 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 underwriting 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.
The Company resolved its arbitration action with Computer Sciences Corporation
in May of 2003. The terms of this settlement are confidential.
Dana Poss v. 21st Century Insurance Company was filed on June 13, 2003 in Los
-------------------------------------------
Angeles Superior Court. The Complaint requests injunctive and restitutionary
relief under Business and Professions Code ("B&P") Sec.17200 for alleged unfair
business practices in violation of California Insurance Code ("CIC")
Sec.1861.02(c) relating to company rating practices. The Company will
vigorously defend the action.
21st Century Insurance Group, 21st Century Casualty Company and 21st Century
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Insurance Company v. Kai Insurance Marketing, Inc. in United States District
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Court, Central District of California, Western Division. The Company alleges
Kai violated the Lanham Act, infringed upon and diluted trademarks, made a false
designation of origin and engaged in unfair competition. Kai has filed a
Cross-Complaint against 21st Century Insurance Group and 21st Century Insurance
Company alleging infringement, dilution, common law trademark rights, unfair
competition under B&P Sec.17200, and twisting under CIC Sec.781. Litigation is
in the pleading stage with the first hearing set for August 18, 2003.
Cecelia Encarnacion, individually and as the Guardian Ad Litem for Nubia Cecelia
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Gonzalez, a Minor, Hilda Cecelia Gonzalez, a Minor, and Ramon Aguilera v. 20th
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Century Insurance, filed July 3, 1997 in Los Angeles Superior Court. Plaintiffs
-----------------
allege bad faith, emotional distress, and estoppel involving 20th Century's
handling of a homeowner's claim. Ramon Aguilera shot Mr. Gonzalez (the minor
children's father) and was sued by Ms. Encarnacion for wrongful death. On
August 30, 1996, judgment was entered against Ramon Aguilera for $5.6 million.
The Company paid for Aguilera's defense costs through the civil trial; however,
the homeowner's policy did not provide indemnity coverage for the shooting
incident, and the Company refused to pay the judgment. After the trial,
Aguilera assigned a portion of his action against the Company to Encarnacion and
the minor children. Aguilera and the Encarnacion family then sued the Company
alleging that 20th Century had promised to pay its bodily injury policy limit if
Aguilera plead guilty to involuntary manslaughter. They further claim that the
Company is estopped to raise its policy exclusions, and that it owes the entire
judgment plus interest. Witness testimony was completed in June, 2003 on the
first phase concerning plaintiff's estoppel and forfeiture allegations. Final
argument is scheduled for August 1, 2003. The Company is vigorously defending
the action.
23
Bryan Speck, individually, and on behalf of others similarly situated v. 21st
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Century Insurance Company, 21st Century Casualty Company, and 21st Century
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Insurance Group, was filed on June 20, 2002 in Los Angeles Superior Court. The
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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 and that the Company 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. The
Company 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
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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, the Company 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.
The Company 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
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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. A subsidiary of the Company, 21st
Century Casualty Company, filed a new challenge to the constitutionality of SB
1899 on February 13, 2003. During the first quarter, several appellate court
decisions have been rendered on issues affecting Northridge Earthquake cases,
including a 9th Circuit Court of appeals decision in House et al v.
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Allstate Insurance Company which again found SB 1899 (California Code of Civil
--------------------------
Procedure 340.9) to be constitutional. As a result of this 9th Circuit's
decision, the Company's subsidiary, 21st Century Casualty Company, voluntarily
dismissed the action it initiated on February 13, 2003, seeking to have SB 1899
declared unconstitutional. The Company currently has lawsuits pending against
it in connection with claims under SB 1899; many of these lawsuits have multiple
plaintiffs. Possible future judgements for 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
24
Franchise Tax Board ("FTB") has taken 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 possible losses, net of federal tax
benefit, range from close to zero to approximately $22.0 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 2. CHANGE IN SECURITIES AND USE OF PROCEEDS
[None.]
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
[None.]
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The annual meeting of shareholders occurred on June 25, 2003, in which the
following individuals were elected as directors: John B. De Nault, III, R. Scott
Foster, M.D., Roxani M. Gillespie, Jeffrey L. Hayman, Bruce W. Marlow, Fred J.
Martin Jr., James P. Miscoll, Keith W. Renken, Robert M. Sandler, Gregory M.
Shepard and Howard I. Smith. The shareholders also ratified the appointment of
PricewaterhouseCoopers LLP ("PwC") as the Company's independent accountants for
2003.
The shareholders voted as follows:
Withhold or
Proposals For Against Abstain
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Election of Directors
J. De Nault, III 73,165,480 11,426,798
R. Foster, M.D. 70,988,550 13,603,728
R. Gillespie 70,666,186 13,926,092
J. Hayman 70,464,513 14,127,765
B. Marlow 72,662,003 11,930,275
F. Martin, Jr. 70,873,390 13,718,888
J. Miscoll 72,335,763 12,256,515
K. Renken 70,652,504 13,939,774
R. Sandler 77,137,643 7,454,635
G. Shepard 25,689,518 58,902,760
H. Smith 71,273,408 13,318,870
Appointment of PricewaterhouseCoopers 82,851,903 1,653,924 86,450
ITEM 5. OTHER INFORMATION
[None.]
25
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
99.1 Certification of President and Chief Executive Officer Pursuant to
Exchange Act Rule 13a-14(a).
99.2 Certification of Chief Financial Officer Pursuant to Exchange Act Rule
13a-14(a).
99.3 Certification of Principal Accounting Officer Pursuant to Exchange Act
Rule 13a-14(a).
99.4 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
The following reports on Form 8-K were filed.
DATE FILED REGARDING
May 16, 2003 2003 first quarter results.
June 26, 2003 The appointment of the Company's Chief Financial Officer,
Carmelo Spinella, effective June 23, 2003.
26
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
21ST CENTURY INSURANCE GROUP
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(Registrant)
Date: July 23, 2003 /s/ Bruce W. Marlow
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BRUCE W. MARLOW
President and Chief Executive Officer
Date: July 23, 2003 /s/ Carmelo Spinella
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CARMELO SPINELLA
Sr. Vice President and Chief Financial Officer
Date: July 23, 2003 /s/ John M. Lorentz
------------- -----------------------------------------------
JOHN M. LORENTZ
Vice President, Controller and
Principal Accounting Officer
27
EXHIBIT INDEX
Exhibit No. Description
99.1 Certification of President and Chief Executive Officer Pursuant
to Exchange Act Rule 13a-14(a).
99.2 Certification of Chief Financial Officer Pursuant to Exchange Act
Rule 13a-14(a).
99.3 Certification of Principal Accounting Officer Pursuant to
Exchange Act Rule 13a-14(a).
99.4 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
28