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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Fiscal Year Ended December 31, 2002
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File Number 001-11462
DELPHI FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)
Delaware (302) 478-5142 13-3427277
(State or other jurisdiction of (Registrant's telephone number, (I.R.S. Employer
incorporation or organization) including area code) Identification Number)
1105 North Market Street, Suite 1230, P. O. Box 8985, Wilmington, Delaware 19899
(Address of principal executive offices) (Zip Code)
Securities registered pursuant to Section 12(b) of the Act:
Class A Common Stock, $.01 par value New York Stock Exchange
(Title of each class) (Name of each exchange
on which registered)
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to filing requirements
for the past 90 days.
Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes |X| No |_|
The aggregate market value of the voting stock held by nonaffiliates of the
Registrant as of June 30, 2002 was $741,445,612.
As of March 20, 2003, the Registrant had 17,245,268 shares of Class A Common
Stock and 3,194,905 shares of Class B Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the Registrant's 2003 Annual Meeting of
Stockholders are incorporated by reference into Part III of this Form 10-K.
This document contains certain forward-looking statements as defined in the
Securities Exchange Act of 1934, some of which may be identified by the use of
terms such as "expects," "believes," "anticipates," "intends," "judgment" or
other similar expressions. These statements are subject to various uncertainties
and contingencies, which could cause actual results to differ materially from
those expressed in such statements. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Forward-Looking Statements and
Cautionary Statements Regarding Certain Factors That May Affect Future Results."
PART I
ITEM 1. BUSINESS
Delphi Financial Group, Inc. (the "Company," which term includes the Company and
its consolidated subsidiaries unless the context indicates otherwise), organized
as a Delaware corporation in 1987, is a holding company whose subsidiaries
provide integrated employee benefit services. The Company manages all aspects of
employee absence to enhance the productivity of its clients and provides the
related insurance coverages: long-term and short-term disability, excess and
primary workers' compensation, group life and travel accident. The Company's
asset accumulation business emphasizes fixed annuity products. The Company
offers its products and services in all fifty states and the District of
Columbia. The Company's two reportable segments are group employee benefit
products and asset accumulation products. See Notes A and R to the Consolidated
Financial Statements included in this Form 10-K for additional information
regarding the Company's segments.
The Company makes available free of charge on its website at www.delphifin.com
its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports
on Form 8-K and all amendments to these reports as soon as reasonably possible,
after such material has been filed with or furnished to the Securities and
Exchange Commission.
OPERATING STRATEGY
The Company's operating strategy is to offer financial products and services
which have the potential for significant growth, which require specialized
expertise to meet the individual needs of its customers and which provide the
Company the opportunity to achieve superior operating earnings growth and
returns on its shareholders' capital.
The Company has concentrated its efforts within certain niche insurance markets,
primarily group employee benefits for small to mid-sized employers, where nearly
all of the employment growth in the American economy has occurred in recent
years. The Company also markets its group employee benefit products and services
to large employers, emphasizing unique programs that integrate both employee
benefit insurance coverages and absence management services. The Company also
operates an asset accumulation business that focuses primarily on offering fixed
annuities to individuals planning for retirement.
The Company's primary operating subsidiaries are as follows:
Reliance Standard Life Insurance Company ("RSLIC"), founded in 1907 and having
administrative offices in Philadelphia, Pennsylvania, and its subsidiary, First
Reliance Standard Life Insurance Company ("FRSLIC"), underwrite a diverse
portfolio of life, disability and accident insurance products targeted
principally to the employee benefits market. RSLIC also markets asset
accumulation products, primarily fixed annuities, to individuals and groups. The
Company, through Reliance Standard Life Insurance Company of Texas
("RSLIC-Texas"), acquired RSLIC and FRSLIC in November 1987.
Safety National Casualty Corporation ("SNCC") focuses primarily on providing
excess workers' compensation insurance to the self-insured market. Founded in
1942 and located in St. Louis, Missouri, SNCC is one of the oldest continuous
writers of excess workers' compensation insurance in the United States. The
Company, through SIG Holdings, Inc. ("SIG"), acquired SNCC in March 1996. In
2001, SNCC formed an insurance subsidiary, Safety First Insurance Company, which
also focuses on selling excess workers' compensation products to the
self-insured market.
Matrix Absence Management, Inc. ("Matrix") provides integrated disability and
absence management services to the employee benefits market across the United
States. Headquartered in San Jose, California, Matrix was acquired by the
Company in June 1998. See "Other Transactions" and Note B to the Consolidated
Financial Statements.
-1-
GROUP EMPLOYEE BENEFIT PRODUCTS
The Company is a leading provider of group life, disability and excess workers'
compensation insurance products to small and mid-sized employers, with more than
20,000 policies in force. The Company also offers travel accident, voluntary
accidental death and dismemberment and group dental insurance. The Company
markets its group products to employer-employee groups and associations in a
variety of industries. The Company insures groups ranging from 2 to more than
5,000 individuals, although the typical size of an insured group ranges from 10
to 500 individuals. The Company markets unbundled employee benefit products and
absence management services as well as an Integrated Employee Benefit program
that combines both employee benefit insurance coverages and absence management
services. The Integrated Employee Benefit program, which the Company believes
helps to differentiate itself from competitors by offering clients improved
productivity from reduced employee absence, has enhanced the Company's ability
to market its group employee benefit products to large employers. In
underwriting its group employee benefit products, the Company attempts to avoid
concentrations of business in any industry segment or geographic area.
The Company's group employee benefit products are sold to employer groups
primarily through independent brokers and agents. The Company's products are
marketed to brokers and agents by 100 sales representatives and managers, who
are located in 24 sales offices nationwide. The Company's three administrative
offices and 24 sales offices also service existing business. The Company
believes that its national sales network minimizes expenses traditionally
associated with large insurance company captive marketing systems.
The following table sets forth for the periods indicated selected financial data
concerning the Company's group employee benefit products:
Year Ended December 31,
----------------------------------
2002 2001 2000
--------- --------- ---------
(dollars in thousands)
Insurance premiums:
Core Products:
Life................................................. $ 210,030 $ 170,772 $ 156,594
Disability income.................................... 195,052 162,602 145,031
Excess workers' compensation......................... 104,170 73,404 56,015
Travel accident, dental and other.................... 49,922 45,380 42,765
--------- --------- ---------
559,174 452,158 400,405
--------- --------- ---------
Non-Core Products:
Loss portfolio transfers............................. 26,830 4,340 13,939
Reinsurance facilities............................... 771 7,872 20,885
Other................................................ 21,724 23,624 12,461
--------- --------- ---------
49,325 35,836 47,285
--------- --------- ---------
Total insurance premiums........................... $ 608,499 $ 487,994 $ 447,690
========= ========= =========
Sales (new annualized gross premiums):
Core Products:
Life................................................. $ 70,900 $ 55,606 $ 38,241
Disability income.................................... 75,996 60,628 56,251
Excess workers' compensation......................... 30,796 18,110 19,835
Travel accident, dental and other.................... 23,454 24,774 26,694
--------- --------- ---------
201,146 159,118 141,021
--------- --------- ---------
Non-Core Products:
Loss portfolio transfers............................. 26,830 4,340 14,647
Other................................................ 13,171 28,765 51,885
--------- --------- ---------
40,001 33,105 66,532
--------- --------- ---------
Total sales........................................ $ 241,147 $ 192,223 $ 207,553
========= ========= =========
-2-
The table below shows the loss and expense ratios as a percent of premium income
for the Company's group employee benefit products for the periods indicated.
Year Ended December 31,
---------------------------------
2002 2001 2000
------ ------ ------
Loss ratio .............................. 69.2% 75.0%(1) 66.0%
Expense ratio ........................... 25.4 27.0 26.3
------ ------ ------
Combined ratio ....................... 94.6% 102.0%(1) 92.3%
====== ====== ======
(1) The loss ratio and combined ratio for 2001 excluding the reserve
strengthening (as discussed in the following paragraph) are 65.9% and
92.9%, respectively.
The profitability of group employee benefit products is affected by, among other
things, differences between actual and projected claims experience, the
retention of existing customers and the ability to attract new customers, change
premium rates and contract terms and control administrative expenses. The
reserve strengthening charge in 2001 was primarily related to an unusually high
number of large losses in the Company's excess workers' compensation business.
Prior to 2001, SNCC's historical average for losses exceeding $2.0 million in
its excess workers' compensation products was one to two per year. In 2001,
however, the Company experienced seven such losses, including two losses as a
result of the terrorist attacks on the World Trade Center. The case reserves for
these seven losses totaled $15.3 million, including $6.3 million attributable to
the World Trade Center attacks. Though the Company believed that the high number
of large losses was unlikely to recur, the Company added $24.0 million to its
reserve for incurred but not reported ("IBNR") losses since its method of
estimating IBNR reserves is based on past experience. The Company experienced
only one loss in excess of $2.0 million in 2002. The Company also added $5.0
million to its long-term disability IBNR reserves in 2001 for potential mental
and nervous disabilities related to the World Trade Center attacks. The reserve
strengthening charge reduced 2001 net income by $28.8 million, or $1.40 per
share. The loss ratio for 2002 reflects the higher levels of reserves which have
been established for the Company's excess workers' compensation products due to
the high number of large losses in 2001. This loss ratio also reflects the large
amount of new business production from the Company's other group employee
benefit products, for which initial reserves have been set at higher levels
until actual loss experience emerges. The loss and expense ratios are also
affected by the level of premium from loss portfolio transfers ("LPTs") in each
year. LPTs carry a higher loss ratio and a significantly lower expense ratio as
compared to the Company's other group employee benefit products.
The Company's group life insurance products provide for the payment of a stated
amount upon the death of a member of the insured group. Policy terms are
generally one year. Accidental death and dismemberment insurance, which provides
for the payment of a stated amount upon the accidental death or dismemberment of
a member of the insured group, is frequently sold in conjunction with group life
policies and is included in premiums charged for group life insurance. The
Company reinsures risks in excess of $150,000 per individual and type of
coverage for employer-provided group life insurance policies and $100,000 per
individual for voluntary group term life policies. See "Reinsurance."
Group disability products offered by the Company, principally long-term
disability insurance, generally provide a specified level of periodic benefits
for a specified period to persons who, because of sickness or injury, are unable
to work. The Company's group long-term disability coverages are spread across
many industries. Long-term disability benefits generally are paid monthly and
typically are limited for any one employee to two-thirds of the employee's
earned income up to a specified maximum benefit. Long-term disability benefits
are usually offset by income the claimant receives from other sources, primarily
Social Security disability benefits. The Company actively manages its disability
claims, working with claimants to help them return to work as quickly as
possible. When claimants' disabilities prevent them from returning to their
original occupations, the Company, in appropriate cases, may provide assistance
in developing new productive skills for an alternative career. Premiums are
generally determined annually for disability insurance and are based upon
expected morbidity and the insured group's emerging experience, as well as
assumptions regarding operating expenses and future interest rates. The Company
reinsures risks in excess of $2,500 in long-term disability benefits per
individual per month. See "Reinsurance."
Business travel accident as well as voluntary accidental death and dismemberment
insurance policies pay a stated amount based on a predetermined schedule in the
event of the accidental death or dismemberment of a member of the insured group.
The Company reinsures risks in excess of $150,000 per individual and type of
coverage. Group dental insurance provides coverage for preventive, restorative
and specialized dentistry up to a stated maximum benefit per individual per
year. The Company has ceded 50% of its risk under dental policies with effective
dates prior to 2003 under a reinsurance arrangement and will cede 100% of its
risk under dental policies with effective dates in 2003 under such arrangement.
See "Reinsurance."
-3-
Excess workers' compensation insurance products provide coverage to employers
and groups who self-insure their workers' compensation risks. The coverage
applies to losses in excess of the applicable self-insured retentions ("SIRs" or
deductibles) of employers and groups, whose workers' compensation claims are
generally handled by third-party administrators ("TPAs"). These products are
principally targeted to mid-sized companies and association groups, particularly
small municipalities, hospitals and schools. These employers and groups are
believed to be less prone to catastrophic workers' compensation exposures and
less price sensitive than larger account business. Because excess workers'
compensation claim payments do not begin until after the self-insured's total
loss payments equal the SIR, the period from when the claim is incurred to the
time claim payments begin averages 15 years. At that point, the payments are
primarily for wage replacement, similar to the benefit provided under long-term
disability coverage, and any medical payments tend to be stable and predictable.
This family of products also includes large deductible workers' compensation
insurance, which provides coverage similar to excess workers' compensation
insurance, and a complementary product, workers' compensation self-insurance
bonds.
The pricing environment and demand for excess workers' compensation insurance
has improved since 2000 due to higher primary workers' compensation rates and
disruption in the excess workers' compensation marketplace due to difficulties
experienced by some competitors, particularly during 2000. These trends
accelerated during the second half of 2001 as sharply higher primary workers'
compensation rates and rising reinsurance costs due to the terrorist attacks on
the World Trade Center increased the demand for alternatives to primary workers'
compensation. As a result, the demand for excess workers' compensation products
and the rates for such products continued to increase. SNCC was able to obtain
significant price increases in connection with its renewals of insurance
coverage during 2002, with increases exceeding 25% on a substantial portion of
such renewals. SNCC has also been obtaining significant improvements in contract
terms, in particular higher SIR levels, in these renewals. SNCC has continued to
obtain price increases in the range of 10% to 15% on its 2003 renewals. New
business production for excess workers' compensation products increased 70% in
2002 and the retention of existing customers was consistent with SNCC's goals.
The Company reinsures excess workers' compensation risks between $3.0 million
and $50.0 million per policy per occurrence. See "Reinsurance."
As a result of the terrorist attacks on the World Trade Center, a number of the
Company's reinsurers have excluded coverage for losses resulting from terrorism.
In November 2002, the Terrorism Risk Insurance Act of 2002 (the "Terrorism Act")
was enacted. The Terrorism Act establishes a program under which the federal
government will share with the insurance industry the risk of loss from covered
acts of international terrorism. The program terminates on December 31, 2005,
and the U.S. Secretary of the Treasury (the "Secretary") has the option to
extend it through December 31, 2006. The Terrorism Act applies to all direct
lines of property and casualty insurance written by SNCC, including excess
workers' compensation. The federal government would pay 90% of each covered loss
and the insurer would pay the remaining 10%. Each insurer has a separate
deductible before federal assistance becomes available in the event of an act of
terrorism. The deductible is based on a percentage of the insurer's direct
earned premiums from the previous calendar year. The deductible is 7%, 10% and
15% of direct earned premiums in 2003, 2004 and 2005, respectively. The maximum
after-tax loss to the Company for 2003 within the Terrorism Act deductible from
property and casualty products is approximately 1% of the Company's
shareholders' equity as of December 31, 2002. Any payments made by the
government under the Terrorism Act would be subject to recoupment via surcharges
to policyholders when future premiums are billed.
The Terrorism Act also directs the Secretary to study the availability of
terrorism reinsurance for group life insurers as well as the availability of
group life insurance in the marketplace. The Secretary is empowered to include
group life insurance in the Terrorism Act program if he finds that the
availability of group life insurance in the marketplace has or is likely to be
affected by the lack of terrorism reinsurance. The Secretary has the discretion
to include group life insurance within the property and casualty program
described above, or to create a separate and distinct program for group life
insurers with separate limits and deductibles. There can be no assurance that
the Secretary will in the future include group life insurance in the Terrorism
Act program.
Non-core group employee benefit products include products that have been
discontinued, such as reinsurance facilities and excess casualty insurance,
newer products which have not demonstrated their financial potential, products
which are not expected to comprise a significant percentage of earned premiums
and products for which sales are episodic in nature, such as LPTs. Pursuant to
an LPT, the Company, in exchange for a specified one-time payment, assumes
responsibility for an existing block of disability or self-insured workers'
compensation claims. These products are typically marketed to the same types of
clients who have historically purchased the Company's disability and excess
workers' compensation products. Non-core group employee benefit products also
include primary workers' compensation for which the Company primarily receives
fee income since a significant portion of the risk is reinsured. In addition,
non-core group employee benefit products include bail bond insurance and
workers' compensation and property reinsurance.
-4-
ASSET ACCUMULATION PRODUCTS
The Company's asset accumulation products consist of fixed annuities, primarily
single premium deferred annuities ("SPDAs") and flexible premium annuities
("FPAs"). An SPDA provides for a single payment by an annuity holder to the
Company and the crediting of interest by the Company on the annuity contract at
the applicable crediting rate. An FPA provides for periodic payments by an
annuity holder to the Company, the timing and amount of which are at the
discretion of the annuity holder, and the crediting of interest by the Company
on the annuity contract at the applicable crediting rate. Interest credited on
SPDAs and FPAs is not paid currently to the annuity holder but instead
accumulates and is added to the annuity contract's account value. This
accumulation is tax deferred. The crediting rate may be increased or decreased
by the Company subject to specified guaranteed minimum crediting rates, which
currently range from 3.0% to 5.5%. For most of the Company's annuity products,
the crediting rate may be reset by the Company annually, typically on the policy
anniversary. The Company's annuity products also include multi-year interest
guarantee products, in which the crediting rate is fixed at a stated rate for a
specified period of years, such periods ranging from three to eight years. At
December 31, 2002, the weighted average crediting rate on the Company's annuity
products as a group was 5.45%. Withdrawals may be made by the annuity holder at
any time, but some withdrawals may result in the assessment of surrender
charges, taxes, and/or tax penalties on the withdrawn amount. In addition, the
accumulated value of the annuity may be increased or decreased under a market
value adjustment ("MVA") provision if it is surrendered during the surrender
charge period. The Company does not market variable annuity products.
These fixed annuity products are sold predominantly to individuals through
networks of independent agents. In 2002, the Company's SPDA products accounted
for $119.3 million of asset accumulation product deposits, of which $98.0
million was attributable to the MVA annuity product and $13.0 million was
attributable to FPA products with the MVA feature. Two networks of independent
agents accounted for approximately 42% of the deposits from these SPDA and FPA
products during 2002, with no other network of independent agents accounting for
more than 10% of these deposits. The Company believes that it has a good
relationship with these networks.
The following table sets forth for the periods indicated selected financial data
concerning the Company's asset accumulation products:
Year Ended December 31,
----------------------------------
2002 2001 2000
--------- --------- ---------
(dollars in thousands)
Asset accumulation product deposits (sales).............. $ 135,046 $ 90,159 $ 160,523
Funds under management (at period end)................... 878,820 786,214 751,311
At December 31, 2002, funds under management consisted of $803.0 million of SPDA
liabilities and $75.8 million of FPA liabilities. Of these liabilities, $587.2
million were subject to surrender charges averaging 6.75% at December 31, 2002.
Annuity liabilities not subject to surrender charges have been in force, on
average, for 20 years.
The Company prices its annuity products based on assumptions concerning
prevailing and expected interest rates and other factors to achieve a positive
spread between its expected return on investments and the crediting rate. The
Company achieves this spread by active portfolio management focusing on matching
invested assets and related liabilities to minimize the exposure to fluctuations
in market interest rates and by the adjustment of the crediting rate on its
annuity products. In response to changes in interest rates, the Company
increases or decreases the crediting rates on its annuity products.
In light of the annuity holder's ability to withdraw funds and the volatility of
market interest rates, it is difficult to predict the timing of the Company's
payment obligations under its SPDAs and FPAs. Consequently, the Company
maintains a portfolio of investments which are readily marketable and expected
to be sufficient to satisfy liquidity requirements. See "Investments."
OTHER PRODUCTS AND SERVICES
The Company provides integrated disability and absence management services on a
nationwide basis through Matrix, which was acquired in June 1998. See "Other
Transactions" and Note B to the Consolidated Financial Statements. The Company's
comprehensive disability and absence management services are designed to assist
clients in identifying and minimizing lost productivity and benefit payment
costs resulting from employee absence due to illness, injury or personal leave.
The Company offers services including event reporting, leave of absence
management, claims and case management and return to work management. These
services' goal is to enhance employee productivity and provide more
-5-
efficient benefit delivery and enhanced cost containment. The Company provides
these services on an unbundled basis or in a unique Integrated Employee Benefit
program that combines these services with various group employee benefit
insurance coverages. The Company believes that these integrated disability and
absence management services complement the Company's core group employee benefit
products, enhancing the Company's ability to market these core products and
providing the Company with a competitive advantage in the market for these
products.
In 1991, the Company introduced a variable flexible premium universal life
insurance policy under which the related assets are segregated in a separate
account not subject to claims of general creditors of the Company. Policyholders
may elect to deposit amounts in the account from time to time, subject to
underwriting limits and a minimum initial deposit of $1.0 million. Both the cash
values and death benefits of these policies fluctuate according to the
investment experience of the assets in the separate account; accordingly, the
investment risk with respect to these assets is borne by the policyholders. The
Company earns fee income from the separate account in the form of charges for
management and other administrative fees. The Company is not presently actively
marketing this product. The Company reinsures risks in excess of $200,000 per
individual under indemnity reinsurance arrangements with various reinsurance
companies. See "Reinsurance."
UNDERWRITING PROCEDURES
Premiums charged on insurance products are based in part on assumptions about
the incidence, severity and timing of insurance claims. The Company has adopted
and follows detailed underwriting procedures designed to assess and qualify
insurance risks before issuing its policies. To implement these procedures, the
Company employs a professional underwriting staff.
In underwriting group coverage, the Company focuses on the overall risk
characteristics of the group to be insured and the geographic concentration of
its new and renewal business. A prospective group client is evaluated with
particular attention paid to the claims experience of the group with prior
carriers, the occupations of the insureds, the nature of the business of the
client, the current economic outlook of the client in relation to others in its
industry and of the industry as a whole, the appropriateness of the benefits or
SIR applied for and income from other sources during disability. The Company's
products generally afford it the flexibility to adjust premiums charged annually
to its policyholders in order to reflect emerging mortality or morbidity
experience.
INVESTMENTS
The Company's management of its investment portfolio is an important component
of its profitability since a substantial portion of its operating income is
generated from the difference between the yield achieved on invested assets and,
in the case of asset accumulation products, the interest credited on
policyholder funds and, in the case of the Company's other products, the
discount rate used to calculate the related reserves. The Company's overall
investment strategy to achieve its objectives of safety and liquidity, while
seeking the best available return, focuses on, among other things, matching of
the Company's interest-sensitive assets and liabilities and seeking to minimize
the Company's exposure to fluctuations in interest rates.
In the fourth quarter of 2000, the Company liquidated a substantial majority of
the investments of its investment subsidiaries. The proceeds from these sales
were used in 2001 to repay $150.0 million of outstanding borrowings under its
revolving credit facilities, to repurchase $64.0 million liquidation amount of
the Capital Securities of its subsidiary, Delphi Funding L.L.C. (the "Capital
Securities"), and to repurchase $8.0 million principal amount of its 8% Senior
Notes due October 2003 (the "Senior Notes"). For information regarding the
composition and diversification of the Company's investment portfolio and
asset/liability management, see "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Liquidity and Capital Resources"
and Notes A, C and J to the Consolidated Financial Statements.
The following table sets forth for the periods indicated the Company's pretax
investment results:
Year Ended December 31,
----------------------------------------
2002 2001 2000
----------- ----------- -----------
(dollars in thousands)
Average invested assets (1)........................ $ 2,556,076 $ 2,312,975 $ 2,508,272
Net investment income (2).......................... 162,036 157,509 184,576
Tax equivalent weighted average annual yield (3)... 6.6% 7.0% 7.6%
-6-
(1) Average invested assets are computed by dividing the total of
invested assets as reported on the balance sheet at the beginning of
each year plus the individual quarter-end balances by five and
deducting one-half of net investment income.
(2) Consists principally of interest and dividend income less investment
expenses.
(3) The tax equivalent weighted average annual yield on the Company's
investment portfolio for each period is computed by dividing net
investment income, increased to reflect tax exempt interest income
and similar tax savings, by average invested assets for the period.
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Results of Operations."
REINSURANCE
The Company participates in various reinsurance arrangements both as the ceding
insurer and as the assuming insurer. Arrangements in which the Company is the
ceding insurer afford various levels of protection against excessive loss by
assisting the Company in diversifying its risks and by limiting its maximum loss
on risks that exceed retention limits. Under indemnity reinsurance transactions
in which the Company is the ceding insurer, the Company remains liable for
policy claims if the assuming company fails to meet its obligations. To limit
this risk, the Company monitors the financial position of its reinsurers,
including, among other things, the companies' financial ratings, and in certain
cases receives collateral security from the reinsurer. Also, certain of the
Company's reinsurance agreements require the reinsurer to set up security
arrangements for the Company's benefit in the event of certain ratings
downgrades. In addition, the U.S. federal government provides reinsurance for
insurers who issue certain property and casualty insurance coverages. See
"Business - Group Employee Benefit Products."
The Company cedes portions of the risks relating to its group employee benefit
and variable life insurance products under indemnity reinsurance agreements with
various unaffiliated reinsurers. The terms of these agreements, which are
typical for agreements of this type, provide, among other things, for the
automatic acceptance by the reinsurer of ceded risks in excess of the Company's
retention limits stated in the agreements. The Company pays reinsurance premiums
to these reinsurers which are, in general, based upon percentages of premiums
received by the Company on the business reinsured less, in certain cases, ceding
commissions and experience refunds paid by the reinsurer to the Company. These
agreements are generally terminable as to new risks by either the Company or the
reinsurer on appropriate notice; however, termination does not affect risks
ceded during the term of the agreement, which generally remain with the
reinsurer. See "Business - Group Employee Benefit Products" and Note Q to the
Consolidated Financial Statements.
In January 1998, an offering was completed whereby shareholders and
optionholders of the Company received, at no cost, rights to purchase shares of
Delphi International Ltd. ("Delphi International"), a newly-formed, independent
Bermuda insurance holding company. During 1998, the Company entered into various
reinsurance agreements with Oracle Reinsurance Company Ltd. ("Oracle Re"), a
wholly owned subsidiary of Delphi International. Pursuant to these agreements,
approximately $101.5 million of group employee benefit reserves ($35.0 million
of long-term disability insurance reserves and $66.5 million of net excess
workers' compensation and casualty insurance reserves) were ceded to Oracle Re.
The Company received collateral security from Oracle Re in an amount sufficient
to support the ceded reserves. During 2000 and 1999, Oracle Re and the Company
effected the partial recaptures of approximately $4.6 million and $10.0 million,
respectively, of the group long-term disability liabilities ceded to Oracle Re.
In October 2001, Oracle Re and the Company effected the commutation of their
reinsurance agreements, pursuant to which Oracle Re paid approximately $84.0
million to the Company (net of $11.5 million which had been held by the Company)
related to the reserves ceded to Oracle Re under such agreements. These
transactions did not have a material impact on the Company's consolidated
financial position, liquidity or net income. In furtherance of the commutation
of the reinsurance agreements, the Company agreed to waive a portion of the
amounts due to the Company under certain subordinated notes issued by Delphi
International. As a result of this waiver, the Company recognized a pre-tax loss
of $7.5 million in 2001 for the other than temporary decline in the value of
these notes. In March 2002, Delphi International repaid the adjusted amounts due
under the subordinated notes and the Company did not realize any significant
additional loss in connection with such repayment.
The Company assumes workers' compensation and property risks through
reinsurance. In these arrangements, the Company provides coverage for losses in
excess of specified amounts, subject to specified maximums. Coverage for losses
as a result of terrorism is generally excluded from these reinsurance treaties.
The attachment points for workers' compensation reinsurance range from $1
million to $100 million. Aggregate exposures assumed under individual workers'
compensation treaties generally range from $1 million to $2 million, with the
highest net exposure pursuant to any such treaty equal to $5 million. The
Company underwrites workers' compensation reinsurance assumed pursuant to
procedures similar to those utilized in connection with its excess workers'
compensation product. The majority of the Company's property reinsurance
provides coverage in the event of a catastrophe, generally excluding losses
resulting from terrorism. The Company underwrites its property reinsurance to
mitigate its risk by diversifying geographically and
-7-
limiting its exposure on any one treaty. On property reinsurance, the Company's
risk attachment points range from $0.3 million to $30 billion. The Company's
aggregate exposure on any one property treaty generally ranges from $1 million
to $2 million. The highest net exposure on a single property treaty is $2
million. The probable maximum loss on property reinsurance is estimated to be
approximately $6.1 million, net of reinstatement premium and taxes, or less than
1% of shareholders' equity.
The Company had in the past participated as an assuming insurer in a number of
reinsurance facilities. These reinsurance facilities generally are administered
by TPAs or managing underwriters who underwrite risks, coordinate premiums
charged and process claims. During 1999 and 2000, the Company terminated, on a
prospective basis, its participations in all of the reinsurance facilities in
which the Company had participated. However, the terms of such facilities
provide for the continued assumption of risks by, and payments of premiums to,
facility participants with respect to business written in the periods during
which they formerly participated in such facilities. Premium income from all
reinsurance facilities was $0.8 million, $7.9 million and $20.9 million in 2002,
2001 and 2000, respectively, and incurred losses from these facilities were $4.7
million, $10.6 million and $20.5 million in 2002, 2001 and 2000, respectively.
The reinsurance facilities did not constitute a significant part of the
Company's operations; therefore, the Company does not expect its withdrawals
from these facilities to have a material impact on its consolidated financial
position, liquidity or results of operations.
LIFE, ANNUITY, DISABILITY AND ACCIDENT RESERVES
The Company carries as liabilities actuarially determined reserves for its life,
annuity, disability and accident policy and contract obligations. These
reserves, together with premiums to be received on policies in force and
interest thereon at certain assumed rates, are calculated and established at
levels believed to be sufficient to satisfy policy and contract obligations. The
Company performs periodic studies to compare current experience for mortality,
morbidity, interest and lapse rates with the experience reflected in the reserve
assumptions to determine future policy benefit reserves for these products.
Reserves for future policy benefits and unpaid claims and claim expenses are
estimated based on individual loss data, historical loss data and industry
averages and indices and include amounts determined on the basis of individual
and actuarially determined estimates of future losses. Therefore, the ultimate
liability could deviate from the amounts currently reflected in the Consolidated
Financial Statements. Differences between actual and expected claims experience
are reflected currently in earnings for each period. The Company has not
experienced significant adverse deviations from its assumptions. In the fourth
quarter of 2001, the Company added $5.0 million to its long-term disability IBNR
reserves for potential mental and nervous disability claims related to the World
Trade Center attacks.
The life, disability and accident reserves carried in the Consolidated Financial
Statements are calculated based on accounting principles generally accepted in
the United States ("GAAP") and differ from those reported by the Company for
statutory financial statement purposes. These differences arise from the use of
different mortality and morbidity tables and interest assumptions, the
introduction of lapse assumptions into the reserve calculation and the use of
the net level method on all insurance business. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Critical Accounting
Policies" and Note A to the Consolidated Financial Statements for certain
additional information regarding reserve assumptions under GAAP.
-8-
EXCESS WORKERS' COMPENSATION INSURANCE RESERVES
The Company carries as liabilities actuarially determined reserves for
anticipated claims and claim expenses for its excess workers' compensation
insurance and other casualty insurance products. Reserves for claim expenses
represent the estimated probable costs of investigating those claims and, when
necessary, defending lawsuits in connection with those claims. Reserves for
claims and claim expenses are estimated based on individual loss data,
historical loss data and industry averages and indices and include amounts
determined on the basis of individual and actuarially determined estimates of
future losses. Therefore, the ultimate liability could deviate from the amounts
currently reflected in the Consolidated Financial Statements.
Reserving practices under GAAP allow discounting of claim reserves related to
excess workers' compensation losses to reflect the time value of money. Reserve
discounting for these types of claims is common industry practice, and the
discount factors used are less than the annual tax-equivalent investment yield
earned by the Company on its invested assets. The discount factors are based on
the expected duration and payment pattern of the claims at the time the claims
are settled and the risk-free rate of return for U.S. government securities with
a comparable duration. Reserves for claim expenses are not discounted.
The following table provides a reconciliation of beginning and ending unpaid
claims and claim expenses for the periods indicated:
Year Ended December 31,
----------------------------------
2002 2001 2000
--------- --------- ---------
(dollars in thousands)
Unpaid claims and claim expenses, net of reinsurance,
beginning of period ........................................... $ 413,950 $ 302,514 $ 307,156
Add provision for claims and claim expenses incurred, net
of reinsurance, occurring during:
Current year (1) ............................................. 82,197 73,782 41,716
Prior years (2) .............................................. 15,869 13,896 (1,584)
--------- --------- ---------
Incurred claims and claim expenses, net of reinsurance,
during the current year ............................... 98,066 87,678 40,132
--------- --------- ---------
Deduct claims and claim expenses paid, net of reinsurance,
occurring during:
Current year ................................................. 10,915 6,014 3,881
Prior years (3) .............................................. 61,954 (29,772) 40,893
--------- --------- ---------
Total paid ................................................ 72,869 (23,758) 44,774
--------- --------- ---------
Unpaid claims and claim expenses, net of reinsurance, end of period 439,147 413,950 302,514
Reinsurance receivables, end of period ............................ 95,709 92,828 144,541
--------- --------- ---------
Unpaid claims and claim expenses, gross of reinsurance,
end of period ............................................. $ 534,856 $ 506,778 $ 447,055
========= ========= =========
(1) The provision for claims and claim expenses incurred in 2001 includes a
reserve strengthening charge of $39.3 million primarily related to an
unusually high number of large losses in the Company's excess workers'
compensation business. Prior to 2001, SNCC's historical average for losses
exceeding $2.0 million in its excess workers' compensation products was
one to two per year. In 2001, however, the Company experienced seven such
losses, including two losses as a result of the terrorist attacks on the
World Trade Center. The case reserves for these seven losses totaled $15.3
million, including $6.3 million attributable to the World Trade Center
attacks. Though the Company believed that the high number of large losses
was unlikely to recur, the Company added $24.0 million to its reserve for
IBNR losses since its method of estimating IBNR reserves is based on past
experience. The Company experienced one claim in excess of $2.0 million in
2002.
(2) In 2002, the claims and claim expenses incurred related to prior years
reflect accretion of discounted reserves offset by favorable claims
development. In 2001, the claims and claim expenses incurred related to
prior years reflect the accretion of discounted reserves and unfavorable
claims development. In 2000, the claims and claim expenses incurred
reflect favorable claims development offset by the accretion of discounted
reserves.
(3) In 2001, the payments of claims and claim expenses occurring in prior
years reflect the Company's receipt of $74.3 million related to the
commutation of the reinsurance agreements with Oracle Re. See "Business -
Reinsurance."
-9-
The effects of the discount to reflect the time value of money have been removed
from the amounts set forth in the loss development table which follows in order
to present the gross loss development, net of reinsurance. During 2002, 2001 and
2000, $17.2 million, $9.5 million and $9.0 million, respectively, of discount
was amortized, and $34.6 million, $32.1 million and $23.2 million, respectively,
was accrued. The loss development table below illustrates the development of
reserves from March 5, 1996 to December 31, 2002 and is net of reinsurance.
December 31,
March 5, ---------------------------------------------------------------------------------------
1996(1) 1996 1997 1998 1999 2000 2001 2002
-------- -------- -------- -------- -------- --------- -------- --------
(dollars in thousands)
Reserve for unpaid
claims and claim
expenses, net of
reinsurance ............. $520,370 $532,923 $541,280 $422,159 $434,513 $ 444,061 $638,191 $680,835
Cumulative amount of
liability paid:
One year later ......... 23,467 28,162 98,365 40,815 40,660 (29,990)(2) 61,954
Two years later ........ 50,713 125,020 127,481 74,571 4,020(2) 26,398
Three years later ...... 140,943 152,842 156,119 33,429(2) 54,846
Four years later ....... 167,811 179,705 111,253(2) 78,981
Five years later ....... 193,363 133,228(2) 150,772
Six years later ........ 153,504(2) 170,405
Seven years later ...... 188,719
Liability reestimated as of:
One year later ......... 507,375 513,402 523,430 410,875 424,187 442,624 636,125
Two years later ........ 487,830 500,964 511,602 404,559 420,420 442,807
Three years later ...... 476,854 488,432 503,906 401,475 417,869
Four years later ....... 476,600 487,195 500,514 396,403
Five years later ....... 476,890 478,206 492,280
Six years later ........ 470,283 468,142
Seven years later ...... 460,670
Cumulative
redundancy .............. $ 59,700 $ 64,781 $ 49,000 $ 25,756 $ 16,644 $ 1,254 $ 2,066
(1) Amounts are as of or for the periods subsequent to March 5, 1996, the date
the Company acquired its workers' compensation business.
(2) The cumulative amount of liability paid through December 31, 2001 reflects
the Company's receipt of $74.3 million related to the commutation of the
reinsurance agreements with Oracle Re in 2001.
The "Reserve for unpaid claims and claim expenses, net of reinsurance" line in
the table above shows the estimated reserve for unpaid claims and claim expenses
recorded at the end of each of the periods indicated. These net liabilities
represent the estimated amount of losses and expenses for claims arising in the
current year and all prior years that are unpaid at the end of each period. The
"Cumulative amount of liability paid" lines of the table represent the
cumulative amounts paid with respect to the liability previously recorded as of
the end of each succeeding period. The "Liability reestimated" lines of the
table show the reestimated amount relating to the previously recorded liability
and is based upon experience as of the end of each succeeding period. This
estimate is either increased or decreased as additional information about the
frequency and severity of claims for each period becomes available and is
reviewed. The Company periodically reviews the estimated reserves for claims and
claim expenses and any changes are reflected currently in earnings for each
period. The Company has not experienced significant adverse deviations from its
assumptions, except for the unusually high number of large losses in the
Company's excess workers' compensation business in 2001. The "Cumulative
redundancy" line in the table represents the aggregate change in the net
estimated claim reserve liabilities from the dates indicated through December
31, 2002.
-10-
The table below illustrates the effects of the discount to reflect the time
value of money that was removed from the amounts set forth in the loss
development table above.
December 31,
March 5, --------------------------------------------------------------------------------
1996(1) 1996 1997 1998 1999 2000 2001 2002
--------- --------- --------- --------- --------- --------- --------- --------
(dollars in thousands)
Reserve for unpaid claims and
claim expenses before
discount:
Gross of reinsurance .... $ 533,871 $ 549,653 $ 564,734 $ 586,984 $ 613,693 $ 650,765 $ 731,019 $776,544
Deduct reinsurance
recoverable ........... 13,501 16,730 23,454 164,825 179,180 206,704 92,828 95,709
--------- --------- --------- --------- --------- --------- --------- --------
Net of reinsurance ...... 520,370 532,923 541,280 422,159 434,513 444,061 638,191 680,835
Deduct discount for time
value of money ............ 164,000 168,827 176,683 113,507 127,357 141,547 224,241 241,688
--------- --------- --------- --------- --------- --------- --------- --------
Unpaid claims and claim
expenses as reported
on balance sheets, net
of discount and net of
reinsurance ............... 356,370 364,096 364,597 308,652 307,156 302,514 413,950 439,147
--------- --------- --------- --------- --------- --------- --------- --------
Reestimated unpaid claims
and claim expenses, net of
discount, as of December
31, 2002:
Gross of reinsurance .... 411,713 408,938 421,008 440,110 470,924 501,926 533,523
Deduct reinsurance
recoverable ......... 35,426 36,170 42,523 112,326 138,252 167,095 103,704
--------- --------- --------- --------- --------- --------- ---------
Net of reinsurance ...... 376,287 372,768 378,485 327,784 332,672 334,831 429,819
--------- --------- --------- --------- --------- --------- ---------
Discounted cumulative
(deficiency) .............. (19,917) (8,672) (13,888) (19,132) (25,516) (32,317) (15,869)
Add accretion of discount ... 79,617 73,453 62,888 44,888 42,160 33,571 17,935
--------- --------- --------- --------- --------- --------- ---------
Cumulative redundancy
before discount ............. $ 59,700 $ 64,781 $ 49,000 $ 25,756 $ 16,644 $ 1,254 $ 2,066
========= ========= ========= ========= ========= ========= =========
(1) Amounts are as of or for the periods subsequent to March 5, 1996, the date
the Company acquired its workers' compensation business.
The excess workers' compensation insurance reserves carried in the Consolidated
Financial Statements are calculated in accordance with GAAP and, net of
reinsurance, are approximately $100.1 million less than those reported by the
Company for statutory financial statement purposes at December 31, 2002. This
difference is primarily due to the use of different discount factors as between
GAAP and statutory accounting principles and differences in the bases against
which such discount factors are applied. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Critical Accounting
Policies" and Note A to the Consolidated Financial Statements for certain
additional information regarding reserve assumptions under GAAP.
COMPETITION
The financial services industry is highly competitive. The Company competes with
numerous other insurance and financial services companies both in connection
with sales of insurance and asset accumulation products and integrated
disability and absence management services and in acquiring blocks of business
and companies. Many of these organizations have substantially greater asset
bases, higher ratings from ratings agencies, larger and more diversified
portfolios of insurance products and larger sales operations. Competition in
asset accumulation product markets is also encountered from the expanding number
of banks, securities brokerage firms and other financial intermediaries
marketing alternative savings products, such as mutual funds, traditional bank
investments and retirement funding alternatives.
The Company believes that its reputation in the marketplace, quality of service,
unique programs which integrate employee benefit products and absence management
services, and investment returns have enabled it to compete
-11-
effectively for new business in its targeted markets. The Company reacts to
changes in the marketplace generally by focusing on products with adequate
margins and attempting to avoid those with low margins. The Company believes
that its smaller size, relative to some of its competitors, enables it to more
easily tailor its products to the demands of customers.
REGULATION
The Company's insurance subsidiaries are regulated by state insurance
authorities in the states in which they are domiciled and the states in which
they conduct business. These regulations, among other things, limit the amount
of dividends and other payments that can be made by the Company's insurance
subsidiaries without prior regulatory approval and impose restrictions on the
amount and type of investments these subsidiaries may have. These regulations
also affect many other aspects of the Company's insurance subsidiaries'
business, including, for example, risk-based capital ("RBC") requirements,
various reserve requirements, the terms, conditions and manner of sale and
marketing of insurance products and the form and content of required financial
statements. These regulations are intended to protect policyholders rather than
investors. The Company's insurance subsidiaries are required under these
regulations to file detailed annual financial reports with the supervisory
agencies in the various states in which they do business, and their business and
accounts are subject to examination at any time by these agencies. To date, no
examinations have produced any significant adverse findings or adjustments. The
ability of the Company's insurance subsidiaries to continue to conduct their
businesses is dependent upon the maintenance of their licenses in these various
states.
From time to time, increased scrutiny has been placed upon the insurance
regulatory framework, and a number of state legislatures have considered or
enacted legislative measures that alter, and in many cases increase, state
authority to regulate insurance companies. In addition to legislative
initiatives of this type, the NAIC and insurance regulators are continuously
involved in a process of reexamining existing laws and regulations and their
application to insurance companies. Furthermore, while the federal government
currently does not directly regulate the insurance business, federal legislation
and administrative policies in a number of areas, such as employee benefits
regulation, age, sex and disability-based discrimination, financial services
regulation and federal taxation, can significantly affect the insurance
business. It is not possible to predict the future impact of changing regulation
on the operations of the Company and its insurance subsidiaries.
The NAIC's RBC requirements for insurance companies take into account asset
risks, insurance risks, interest rate risks and other relevant risks with
respect to the insurer's business and specify varying degrees of regulatory
action to occur to the extent that an insurer does not meet the specified RBC
thresholds, with increasing degrees of regulatory scrutiny or intervention
provided for companies in categories of lesser RBC compliance. The Company
believes that its insurance subsidiaries are adequately capitalized under the
RBC requirements and that the thresholds will not have any significant
regulatory effect on the Company. However, were the insurance subsidiaries' RBC
position to materially decline in the future, the insurance subsidiaries'
continued ability to pay dividends and the degree of regulatory supervision or
control to which they are subjected may be affected.
The Company's insurance subsidiaries can also be required, under solvency or
guaranty laws of most states in which they do business, to pay assessments to
fund policyholder losses or liabilities of insurance companies that become
insolvent. These assessments may be deferred or forgiven under most solvency or
guaranty laws if they would threaten an insurer's financial strength and, in
most instances, may be offset against future state premium taxes. SNCC
recognized expenses of $1.3 million, $1.2 million and $0.2 million in 2002, 2001
and 2000, respectively, for these types of assessments. None of the Company's
life insurance subsidiaries has ever incurred any significant costs of this
nature.
EMPLOYEES
The Company and its subsidiaries employed approximately 960 persons at December
31, 2002. The Company believes that it enjoys good relations with its employees.
-12-
OTHER SUBSIDIARIES
The Company conducts certain of its investment management activities through its
wholly-owned subsidiary, Delphi Capital Management, Inc. ("DCM"), and makes
certain investments through other wholly-owned non-insurance subsidiaries. In
the fourth quarter of 2000, the Company liquidated a substantial majority of the
investments of its investment subsidiaries. The proceeds from these sales were
used in 2001 to repay $150.0 million of outstanding borrowings under its
revolving credit facilities, to repurchase $64.0 million liquidation amount of
the Capital Securities and to repurchase $8.0 million principal amount of the
Senior Notes.
OTHER TRANSACTIONS
On June 30, 1998, the Company acquired Matrix, a provider of integrated
disability and absence management services to the employee benefits market. The
purchase price of $33.8 million consisted of 409,424 shares of the Company's
Class A Common Stock, $7.9 million of cash and $5.7 million of 8% subordinated
notes due June 2003 (the "Subordinated Notes"). Under the terms of the purchase
agreement, additional consideration of up to $5.2 million in cash was payable if
Matrix's earnings met specified targets over the four-year period subsequent to
the acquisition. Because Matrix met all of the specified targets, the Company
paid the $5.2 million of contingent consideration in two equal installments of
$2.6 million during 2000 and 2001. See Note B to the Consolidated Financial
Statements.
In April 1999, the Company completed the disposition of its Unicover Managers,
Inc. subsidiary and a related company (collectively, "Unicover"), which were
acquired in the fourth quarter of 1998, to certain of the former owners of
Unicover. In January 2000, the Company received from Unicover's pool and
facility members and the retrocessionaires of Unicover's facilities legal
releases relating to, among other things, the Company's former ownership of
Unicover. The releases were obtained in connection with a global
Unicover-related settlement involving Reliance Insurance Company, its
retrocessionaires and a group of ceding companies and brokers. The Company
contributed to this settlement by agreeing to rescind a quota share reinsurance
contract with Reliance Insurance Company.
ITEM 2. PROPERTIES
The Company leases its principal executive office at 1105 North Market Street,
Suite 1230, Wilmington, Delaware under an operating lease expiring in October
2003. RSLIC leases its administrative office at 2001 Market Street, Suite 1500,
Philadelphia, Pennsylvania, under an operating lease expiring in June 2009. SNCC
owns its home office building at 2043 Woodland Parkway, Suite 200, St. Louis,
Missouri, which consists of approximately 58,000 square feet. SNCC also owns a
neighboring office building located at 2029 Woodland Parkway, St. Louis,
Missouri. The building consists of approximately 17,000 square feet and is
intended for lease to third parties. DCM and FRSLIC lease their offices at 153
East 53rd Street, 49th Floor, New York, New York under an operating lease
expiring in July 2008. Matrix leases its principal office at 5225 Hellyer
Avenue, Suite 210, San Jose, California under an operating lease expiring in
December 2006. The Company also maintains sales and administrative offices
throughout the country to provide nationwide sales support and service existing
business.
ITEM 3. LEGAL PROCEEDINGS
In the course of its business, the Company is a party to litigation and other
proceedings, primarily involving its insurance operations. In some cases, these
proceedings entail claims against the Company for punitive damages and similar
types of relief. The ultimate disposition of such pending litigation and
proceedings is not expected to have a material adverse effect on the Company's
consolidated financial position. In addition, incident to its discontinued
products, the Company is currently a party to two separate arbitrations arising
out of two accident and health reinsurance arrangements in which it and other
companies formerly were participating reinsurers. At issue in both arbitrations,
among other things, is whether certain reinsurance risks were validly ceded to
the Company. The ultimate resolutions of these arbitrations are likely to
require extended periods of time. While management believes that in both cases
the Company has substantial legal grounds for avoiding the reinsurance risks at
issue, it is not at this time possible to predict the ultimate outcome of these
arbitrations, nor is it feasible to provide reasonable ranges of potential
losses. In the opinion of management, such arbitrations, when ultimately
resolved, will not individually or collectively have a material adverse effect
on the Company's consolidated financial position.
-13-
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 4A. EXECUTIVE OFFICERS OF THE COMPANY
The table below presents certain information concerning each of the executive
officers of the Company:
Name Age Position
---- --- --------
Robert Rosenkranz 60 Director of the Company; Chairman of the Board, President and Chief
Executive Officer of the Company; Chairman of the Board of RSLIC
Robert M. Smith, Jr. 51 Director and Executive Vice President of the Company
Chad W. Coulter 40 Vice President and General Counsel of the Company; Vice President,
General Counsel and Assistant Secretary of RSLIC
Thomas W. Burghart 44 Vice President and Treasurer of the Company and RSLIC
Lawrence E. Daurelle 51 Director of the Company and President and Chief
Executive Officer of RSLIC
Harold F. Ilg 55 Director of the Company and Chairman of the Board of SNCC
Mr. Rosenkranz has served as the President and Chief Executive Officer of the
Company since May 1987 and has served as Chairman of the Board of Directors of
the Company since April 1989. He also serves as Chairman of the Board or as a
Director of the Company's principal subsidiaries. Mr. Rosenkranz, by means of
beneficial ownership of the corporate general partner of Rosenkranz & Company
and direct or beneficial ownership, has the power to vote all of the outstanding
shares of Class B Common Stock, which represent 49.9% of the voting power of the
Company's common stock as of March 20, 2003.
Mr. Smith has served as Executive Vice President of the Company and DCM since
November 1999 and as a Director of the Company since January 1995. He has also
served as the Chief Investment Officer of RSLIC and FRSLIC since April 2001.
From July 1994 to November 1999, he served as Vice President of the Company and
DCM. Mr. Smith also serves as a Director of the Company's principal
subsidiaries.
Mr. Coulter has served as Vice President and General Counsel of the Company and
as Vice President, General Counsel and Assistant Secretary of RSLIC, FRSLIC and
RSLIC-Texas since January 1998. He also served for RSLIC in similar capacities
from February 1994 to August 1997, and in various capacities from January 1991
to February 1994. From August 1997 to December 1997, Mr. Coulter was Vice
President and General Counsel of National Life of Vermont.
Mr. Burghart has served as Vice President and Treasurer of the Company since
April 2001 and as Vice President and Treasurer of RSLIC, FRSLIC and RSLIC-Texas
since October 2000. From March 1992 to September 2000, he served as the Second
Vice President, Actuarial Statements, of RSLIC.
Mr. Daurelle has served as a Director of the Company since August 2002. He also
has served as President and Chief Executive Officer of RSLIC, FRSLIC and
RSLIC-Texas since October 2000. He served as Vice President and Treasurer of the
Company from August 1998 to April 2001. He also serves on the Board of Directors
of RSLIC, FRSLIC and RSLIC-Texas. From May 1995 to October 2000, Mr. Daurelle
was Vice President and Treasurer of RSLIC, FRSLIC and RSLIC-Texas.
Mr. Ilg has served as a Director of the Company since August 2002. He also has
served as Chairman of the Board of SNCC since January 1999. He serves on the
Board of Directors of RSLIC and FRSLIC. From April 1999 until October 2000, he
served as President and Chief Executive Officer of RSLIC, FRSLIC, and
RSLIC-Texas. Prior to January 1999, he served as Vice Chairman of the Board of
SNCC, where he has been employed in various capacities since 1978.
-14-
PART II
ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
The closing price of the Company's Class A Common Stock was $38.90 on March 20,
2003. There were approximately 2,500 holders of record of the Company's Class A
Common Stock as of March 20, 2003.
The Company's Class A Common Stock is listed on the New York Stock Exchange
under the symbol DFG. The following table sets forth the high and low sales
prices for the Company's Class A Common Stock and the cash dividends paid per
share for the Company's Class A and Class B Common Stock.
High Low Dividends
-------- -------- ---------
2002: First Quarter $ 39.67 $ 32.80 $ 0.07
Second Quarter 45.12 38.50 0.07
Third Quarter 43.50 33.86 0.07
Fourth Quarter 41.13 32.91 0.08
2001: First Quarter $ 42.25 $ 28.30 $ 0.07
Second Quarter 38.50 26.45 0.07
Third Quarter 38.40 29.92 0.07
Fourth Quarter 34.90 29.80 0.07
In 2001, the Company's Board of Directors began declaring quarterly cash
dividends of $0.07 per share, which are paid on the Company's Class A Common
Stock and Class B Common Stock. In the fourth quarter of 2002, the Company's
Board of Directors increased the cash dividend to $0.08 per share. In the first
quarter of 2003, the Company's Board of Directors declared a cash dividend of
$0.08 per share, which was paid on the Company's Class A Common Stock and Class
B Common Stock on March 6, 2003. The Company intends to continue to pay a
quarterly dividend at this level. However, the declaration and payment of such
dividends, including the amount and frequency of such dividends, is at the
discretion of the Board and depends upon many factors, including the Company's
consolidated financial position, liquidity requirements, operating results and
such other factors as the Board may deem relevant. Cash dividend payments are
permitted under the respective terms of the Company's $150.0 million revolving
credit facility and $66.5 million Senior Notes subject to certain restrictions
and covenants. See Note L to the Consolidated Financial Statements.
In addition, dividend payments by the Company's insurance subsidiaries to the
Company are subject to certain regulatory restrictions. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources" and "Business - Regulation."
-15-
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data below should be read in conjunction with
Management's Discussion and Analysis of Financial Condition and Results of
Operations and the Consolidated Financial Statements and related notes.
Year Ended December 31,
-----------------------------------------------------------------------
2002 2001 2000 1999 1998
----------- ----------- ----------- ----------- -----------
INCOME STATEMENT DATA: (dollars and shares in thousands, except per share data)
Insurance premiums and fee income:
Core group employee benefit products ........ $ 559,174 $ 452,158 $ 400,405 $ 357,541 $ 326,770
Non-core group employee benefit products(1) . 49,325 35,836 47,285 110,381 89,641
Asset accumulation products ................. 2,645 3,088 2,551 2,126 2,583
Other(2) .................................... 16,713 16,122 16,116 15,220 7,880
----------- ----------- ----------- ----------- -----------
627,857 507,204 466,357 485,268 426,874
Net investment income(3) ...................... 162,036 157,509 184,576 180,945 168,692
Net realized investment (losses) gains ........ (28,469) (70,289) (138,047) (25,720) 8,060
----------- ----------- ----------- ----------- -----------
Total revenue ............................... 761,424 594,424 512,886 640,493 603,626
Income (loss) from continuing operations(4) ... 60,868 (941) (3,293) 64,132 73,802
Net income (loss)(4)(5) ....................... 60,652 6,505 (3,293) 50,285 87,035
BASIC RESULTS PER SHARE(4)(5)(6):
Income (loss) from continuing operations ...... $ 2.93 $ (0.04) $ (0.16) $ 3.06 $ 3.50
Net income (loss) ............................. 2.92 0.32 (0.16) 2.40 4.13
Weighted average shares outstanding ........... 20,759 20,565 20,388 20,979 21,095
DILUTED RESULTS PER SHARE(4)(5)(6):
Income (loss) from continuing operations ...... $ 2.86 $ (0.04) $ (0.16) $ 2.96 $ 3.37
Net income (loss) ............................. 2.85 0.32 (0.16) 2.32 3.97
Weighted average shares outstanding ........... 21,258 20,565 20,388 21,674 21,920
CASH DIVIDENDS PAID PER SHARE(7): .............. $ 0.29 $ 0.28 $ -- $ -- $ --
OTHER DATA(8):
Operating income(9) ........................... $ 127,465 $ 81,652 $ 157,371 $ 144,995 $ 124,960
Operating earnings(9) ......................... 79,373 44,747 86,438 80,850 68,564
Diluted book value per share(10) .............. $ 32.75 $ 28.50 $ 26.87 $ 24.52 $ 26.59
Return on average shareholders' equity(11) .... 12.6% 8.0% 16.6% 15.1% 12.7%
December 31,
-----------------------------------------------------------------------
2002 2001 2000 1999 1998
----------- ----------- ----------- ----------- -----------
BALANCE SHEET DATA: (dollars in thousands)
Total investments ............................. $ 2,816,051 $ 2,427,214 $ 2,475,945 $ 2,527,763 $ 2,511,387
Total assets .................................. 3,734,942 3,336,146 3,440,010 3,395,688 3,287,057
Corporate debt(3) ............................. 118,139 125,675 267,770 283,938 265,165
Capital Securities(3) ......................... 36,050 36,050 100,000 100,000 100,000
Shareholders' equity .......................... 681,655 581,994 538,193 501,417 566,440
Debt to total capitalization ratio(12) ........ 14.1% 16.9% 29.6% 32.1% 28.5%
-16-
(1) The Company in 1999 terminated its participations in the reinsurance
facilities in which it had historically participated, resulting in lower
premiums from non-core group employee benefit products in 2000, 2001 and
2002. Premiums from non-core group employee benefit products also include
premiums from LPTs, which are episodic in nature, of $27.3 million, $44.0
million, $13.9 million, $4.3 million and $26.8 million, in 1998, 1999,
2000, 2001 and 2002, respectively. See "Business - Group Employee Benefit
Products" and "Business - Reinsurance."
(2) Reflects the acquisition of Matrix in 1998. See "Business - Other
Transactions" and Note B to the Consolidated Financial Statements.
(3) Net investment income declined in 2001 and 2002 primarily due to the
Company's liquidation during the fourth quarter of 2000 of a substantial
majority of the investments of its investment subsidiaries. In 2001, the
Company used the proceeds from these sales to repay $150.0 million of
outstanding borrowings under its revolving credit facilities, to
repurchase $64.0 million liquidation amount of the Capital Securities and
to repurchase $8.0 million principal amount of the Senior Notes. The
Company recognized an extraordinary gain of $0.36 per share, or $7.4
million, net of income tax expense of $4.0 million, in connection with
these repurchases. In the second quarter of 2002, the Company repurchased
$10.5 million aggregate principal amount of the Senior Notes and
recognized an extraordinary loss of $0.01 per share, or$0.2 million, net
of an income tax benefit of $0.1 million, in connection with this
repurchase.
(4) Results for 2001 include a charge of $1.40 per share or $28.8 million, net
of an income tax benefit of $15.5 million and reinsurance coverages of
$21.8 million, for reserve strengthening primarily related to an unusually
high number of large losses in the Company's excess workers' compensation
business. Included in this charge, on a pre-tax basis, are additions to
excess workers' compensation case reserves of $9.0 million and IBNR
reserves of $24.0 million. This charge also includes reported workers'
compensation losses of $6.3 million and a $5.0 million addition to
long-term disability IBNR reserves attributable to the terrorist attacks
on the World Trade Center. The Company experienced one large loss in its
excess workers' compensation business in 2002.
Income (loss) from continuing operations and net income (loss) include
realized investment (losses) gains, net of federal income tax (benefit)
expense, as follows:
Year Ended December 31,
------------------------------------------------------------------
2002 2001 2000 1999 1998
---------- ---------- ---------- ---------- ----------
(dollars in thousands, except per share data)
Realized investment (losses) gains, net of income tax
(benefit) expense ................................... $ (18,505) $ (45,688) $ (89,731) $ (16,718) $ 5,238
Basic per share amount ................................ (0.89) (2.22) (4.40) (0.79) 0.25
Diluted per share amount .............................. (0.87) (2.22) (4.40) (0.77) 0.24
(5) In 2002 and 2001, the Company recognized losses of $35.2 million, net of
an income tax benefit of $18.9 million, and $51.5 million, net of an
income tax benefit of $27.8 million, respectively, due to the other than
temporary declines in the market values of certain securities. In 2000,
the Company realized losses of $47.1 million, net of an income tax benefit
of $25.4 million, related to the liquidation of a substantial majority of
the investments of its investment subsidiaries and $38.0 million, net of
an income tax benefit of $20.5 million, on closed U.S. Treasury futures
and option contracts.
In 1999, the Company disposed of Unicover and recognized an after-tax loss
of $13.8 million on the disposition. After-tax income from this
discontinued operation totaled $13.2 million in 1998. See "Business -
Other Transactions."
(6) In computing the earnings per share amounts for 2001 and 2000, equivalent
shares attributable to in-the-money stock options, which totaled 0.5
million and 0.7 million for 2001 and 2000, respectively, were not
considered in the calculation of these per share amounts since the
inclusion of these equivalent shares would have diluted the loss from
continuing operations.
(7) In 2001, the Company's Board of Directors approved the initiation of a
quarterly cash dividend of $0.07 per share, payable on the Company's
outstanding Class A and Class B Common Stock. In the fourth quarter of
2002, the Company's Board of Directors increased the cash dividend to
$0.08 per share. During 2002 and 2001, the Company paid cash dividends on
its capital stock in the amount of $6.0 million and $5.7 million,
respectively. See Note L to the Consolidated Financial Statements.
(8) Management believes that it is informative to exclude discretionary or
nonrecurring income or loss items such as realized investment gains and
losses, discontinued operations and extraordinary items when analyzing the
Company's operating trends and in comparing the Company's results to those
of other companies in its industry. Investment gains and losses may be
realized based on management's decision to dispose of an investment or
management's judgment that a decline in the market value of an investment
is other than temporary. Therefore, realized investment gains and losses
do not represent elements of the Company's ongoing earnings capacity.
However, these alternative measures of the Company's performance should
not be considered a substitute for net income as an indication of the
Company's overall performance and may not be calculated in the same manner
as similarly titled captions in other companies' financial statements.
(9) Operating income is comprised of income from continuing operations
excluding realized investment gains and losses and before interest and
income tax expense or benefit. Operating earnings are comprised of net
income excluding realized investment gains and losses (net of the related
income tax expense or benefit), discontinued operations and extraordinary
items. Results for 2001 include a charge of $28.8 million, net of taxes
and reinsurance coverages, for reserve strengthening primarily related to
an unusually high number of large losses in the Company's excess workers'
compensation business. See note 4 above.
(10) Diluted book value per share is calculated by dividing shareholders'
equity, as increased by the proceeds and tax benefit from the assumed
exercise of outstanding in-the-money stock options, by total shares
outstanding, also increased by shares issued upon the assumed exercise of
the options and deferred shares.
(11) Return on average shareholders' equity is calculated by dividing operating
earnings by average shareholders' equity, as determined as of the
beginning and end of each year. Return on average shareholders' equity for
2001 excluding losses related to the reserve strengthening was 13.1%.
(12) The debt to total capitalization ratio is calculated by dividing long-term
debt by the sum of the Company's long-term debt, Capital Securities and
shareholders' equity.
-17-
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The discussion and analysis of the results of operations and financial condition
of the Company below should be read in conjunction with the Consolidated
Financial Statements and related notes.
RESULTS OF OPERATIONS
2002 COMPARED TO 2001
Premium and Fee Income. Premium and fee income in 2002 was $627.9 million as
compared to $507.2 million in 2001, an increase of 24%. Premiums from core group
employee benefit products increased 24% to $559.2 million in 2002 from $452.2
million in 2001. This increase reflects normal growth in employment and salary
levels for the Company's existing customer base, price increases, and strong
production of new business. Core group employee benefit products include group
life, disability, excess and large deductible workers' compensation, travel
accident and dental insurance and self-insurance workers' compensation bonds.
See "Business - Group Employee Benefit Products." Excess workers' compensation
premiums increased 42% to $104.2 million in 2002 from $73.4 million in 2001
primarily due to improvements in the pricing environment and demand for this
product as a result of higher primary workers' compensation rates. SNCC was able
to obtain significant price increases in connection with its renewals of
insurance coverage during 2002, with increases exceeding 25% on a substantial
portion of such renewals. SNCC has also been obtaining significant improvements
in contract terms, in particular higher SIR levels, in these renewals. SNCC has
continued to obtain price increases in the range of 10% to 15% on its 2003
renewals. New business production for excess workers' compensation products
increased 70% to $30.8 million in 2002 from $18.1 million in 2001 and the
retention of existing customers was consistent with SNCC's goals. New business
production for the Company's other core group employee benefit products
increased 21% to $170.4 million in 2002 from $141.0 million in 2001 primarily
due to the expansion of the Company's sales force during 2001 and 2002, and the
opening of three new sales offices in 2002. Retention of existing customers for
these products also improved during 2002 and price increases were implemented
for certain disability customers. Non-core group employee benefit products
include LPTs, primary workers' compensation, bail bond insurance, workers'
compensation and property reinsurance, and reinsurance facilities. See "Business
- - Group Employee Benefit Products" and "Business - Reinsurance." Premiums from
non-core group employee benefit products increased 38% to $49.3 million in 2002
from $35.8 million in 2001 primarily due to a higher level of premium from LPTs,
which are episodic in nature. Deposits from the Company's asset accumulation
products were $135.0 million in 2002 as compared to $90.2 million in 2001.
Deposits for these products, which are long-term in nature, are recorded as
liabilities rather than as premiums. The Company has maintained its disciplined
approach to setting the crediting rates offered on its asset accumulation
products since market interest rates and the resulting interest rate spreads
available to the Company on these products remained less favorable throughout
2001 and 2002. The increase in deposits from the Company's asset accumulation
products in 2002 was higher than expected due to the pullback of certain fixed
annuity providers from the wholesale distribution chain and heightened demand
for fixed annuity products as a result of adverse conditions in the equity
markets. Accordingly, the level of deposits achieved in 2002 may not be
representative of the level of deposits attainable in 2003.
Net Investment Income. Net investment income in 2002 was $162.0 million as
compared to $157.5 million in 2001, an increase of 3%. This increase primarily
reflects an increase in average invested assets in 2002, partially offset by a
decrease in the tax equivalent weighted average annual yield. The tax equivalent
weighted average annual yield on invested assets was 6.6% on average invested
assets of $2,556.1 million in 2002 and 7.0% on average invested assets of
$2,313.0 million in 2001.
Net Realized Investment Losses. Net realized investment losses were $28.5
million in 2002 as compared to $70.3 million in 2001. The Company's investment
strategy results in periodic sales of securities and, therefore, the recognition
of realized investment gains and losses. The Company monitors its investments on
an ongoing basis. When the market value of a security declines below its cost,
and such decline is determined in the judgment of management to be other than
temporary, the security is written down to fair value, and the decline is
reported as a realized investment loss. In 2002 and 2001, the Company recognized
$54.1 million and $79.3 million, respectively, of losses due to the other than
temporary declines in the market values of certain fixed maturity and equity
securities. During the same periods, the Company recognized $26.4 million and
$10.9 million, respectively, of net gains on sales of securities. Realized
investment losses, net of the related tax benefit, reduced net income by $18.5
million, or $0.87 per share, in 2002 and by $45.7 million, or $2.22 per share,
in 2001.
The losses due to the other than temporary declines in the market values of
fixed maturity and equity securities recognized during 2002, which totaled $35.2
million on an after-tax basis, resulted primarily from credit quality-related
deterioration
-18-
in the corporate debt markets, and the Company may recognize additional losses
of this type in the future. The Company anticipates that if certain other
existing declines in security values are determined to be other than temporary,
it may recognize additional investment losses in the range of $5 million to $10
million, on an after-tax basis, with respect to the relevant securities.
However, the extent of any such losses will depend on future market developments
and changes in security values, and such losses may exceed or be lower than such
range. The Company continuously monitors the affected securities pursuant to its
procedures for evaluation for other than temporary impairment in valuation. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Critical Accounting Policies" for a description of these
procedures, which take into account a number of factors. It is not possible to
predict the extent of any future changes in value, positive or negative, or the
results of the future application of these procedures, with respect to these
securities. There can be no assurance that the Company will realize investment
gains in the future in an amount sufficient to offset any such losses.
Benefits and Expenses. Policyholder benefits and expenses were $662.4 million as
compared to $583.1 million in 2001, an increase of 14%. This increase primarily
reflects the increase in premiums from the Company's group employee benefit
products discussed above. Benefits and expenses in 2001 include a pre-tax charge
of $44.3 million for reserve strengthening primarily related to an unusually
high number of large losses in the Company's excess workers' compensation
business. See "2001 Compared to 2000 - Benefits and Expenses." The combined
ratio (loss ratio plus expense ratio) for the Company's group employee benefits
segment was 94.6% in 2002 and 102.0% (92.9% excluding the reserve strengthening)
in 2001. The combined ratio in 2002 reflects the higher levels of reserves which
have been established for the Company's excess workers' compensation products
due to the high number of large losses in 2001. This combined ratio also
reflects the large amount of new business production from the Company's other
core group employee benefit products, for which initial reserves have been set
at higher levels until actual loss experience emerges. The higher level of
premium from LPTs, which carry a higher loss ratio, also contributed to the
higher combined ratio in 2002.
Interest Expense and Extraordinary (Loss) Gain. Interest expense was $12.4
million in 2002 as compared to $17.4 million in 2001, a decrease of $5.0
million. This decrease was primarily a result of the Company's repurchase of
$64.0 million liquidation amount of the Capital Securities in the open market,
which occurred on various dates during the first nine months of 2001, and a
lower weighted average borrowing rate under the Company's revolving credit
facilities. In addition, the Company had a lower amount of borrowings
outstanding during the year ended 2002 under its Senior Notes and SIG's 8.5%
Senior Notes (the "SIG Senior Notes") due May 2003. In June 2001, the Company
also repurchased $8.0 million aggregate principal amount of the Senior Notes.
The Company recognized an extraordinary gain of $7.4 million, net of income tax
expense of $4.0 million, in connection with the repurchases of the Capital
Securities and Senior Notes. In the second quarter of 2002, the Company
repurchased $10.5 million aggregate principal amount of the Senior Notes,
resulting in an extraordinary loss of $0.2 million, net of an income tax benefit
of $0.1 million.
Income Tax Expense (Benefit). Income tax expense was $25.7 million in 2002 as
compared to an income tax benefit of $5.1 million in 2001. The income tax
benefits attributable to net realized investment losses were $10.0 million and
$24.6 million in 2002 and 2001, respectively. The income tax benefit in 2001 was
also attributable to the reserve strengthening charge. The Company's effective
tax rate excluding net realized investment losses and the reserve strengthening
was 31.0% in 2002 and 32.2% in 2001.
Income before Extraordinary (Loss) Gain. Management believes the concept of
"operating earnings" is informative when analyzing the Company's operating
trends and in comparing the Company's performance with that of other companies
in its industry. Operating earnings exclude discretionary or nonrecurring income
or loss items such as realized investment gains and losses and extraordinary
items. Investment gains and losses may be realized based on management's
decision to dispose of an investment or management's judgment that a decline in
the market value of an investment is other than temporary. Therefore, realized
investment gains and losses do not represent elements of the Company's ongoing
earnings capacity. However, operating earnings should not be considered a
substitute for net income as an indication of the Company's overall performance
and may not be calculated in the same manner as similarly titled captions in
other companies' financial statements. Operating earnings for the Company,
consisting of income before extraordinary (loss) gain adjusted to exclude
realized investment losses (net of the related income tax benefit), were $79.4
million, or $3.73 per share, in 2002 as compared to $44.7 million, or $2.18 per
share, in 2001. The increase in operating earnings in the current period is
attributable to the decrease in interest expense ($3.3 million after taxes), and
charges in the 2001 period for goodwill amortization ($3.2 million after taxes)
and reserve strengthening ($28.8 million after taxes) (see "2001 Compared to
2000 - Benefits and Expenses"). Excluding the effects of the reserve
strengthening and goodwill amortization in 2001, income from group employee
benefit products increased in 2002 as compared to 2001. Equivalent shares
attributable to in-the-money stock options, which totaled 0.5 million for 2001,
were not considered in the
-19-
calculation of the per share amount since the inclusion of these equivalent
shares would have diluted the loss before extraordinary gain.
2001 COMPARED TO 2000
Premium and Fee Income. Premium and fee income in 2001 was $507.2 million as
compared to $466.4 million in 2000. Premiums from core group employee benefit
products increased 13% to $452.2 million in 2001 from $400.4 million in 2000.
This increase reflects normal growth in employment and salary levels for the
Company's existing customer base, price increases, production of new business
and improved persistency. Core group employee benefit products include group
life, disability, excess and large deductible workers' compensation, travel
accident and dental insurance and self-insurance workers' compensation bonds.
Excess workers' compensation premiums increased 31% to $73.4 million in 2001
from $56.0 million in 2000 primarily due to increases in the pricing environment
and demand for this product due to higher primary workers' compensation rates
and disruption in the workers' compensation marketplace as a result of
difficulties experienced by some competitors, particularly during 2000. These
trends accelerated during the second half of 2001 as sharply higher primary
workers' compensation rates and rising reinsurance costs due to the terrorist
attacks on the World Trade Center increased the demand for self-insurance. As a
result, the demand for excess workers' compensation products and the rates for
such products increased. New business production for the Company's other group
employee benefit products was very strong during 2001, particularly during the
fourth quarter, primarily due to a 16% increase in the Company's sales force
during 2001. Retention of existing customers for these products also improved
during 2001 and price increases were implemented for certain disability
customers. Non-core group employee benefit products include LPTs, primary
workers' compensation, bail bond insurance, workers' compensation and property
reinsurance, and reinsurance facilities. Premiums from non-core group employee
benefit products decreased to $35.8 million in 2001 from $47.3 million in 2000
primarily due to the Company's termination of its participations in the
reinsurance facilities in which it had historically participated and a lower
level of premium from LPTs, which are episodic in nature. Deposits from the
Company's asset accumulation products were $90.2 million in 2001 as compared to
$160.5 million in 2000. Deposits for these products, which are long-term in
nature, are recorded as liabilities rather than as premiums. In the first
quarter of 2001, the Company reduced the crediting rates offered on its asset
accumulation products due to the decline in market interest rates and the
resulting interest rate spreads available to the Company on these products.
Accordingly, the Company experienced a lower level of production from its asset
accumulation business in 2001 as compared to 2000.
Net Investment Income. Net investment income in 2001 was $157.5 million as
compared to $184.6 million in 2000. The tax equivalent weighted average annual
yield on invested assets was 7.0% on average invested assets of $2,313.0 million
in 2001 and 7.6% on average invested assets of $2,508.3 million in 2000. The
decrease in investment income reflects the Company's liquidation during the
fourth quarter of 2000 of a substantial majority of the investments of its
investment subsidiaries. The proceeds from these sales were used to repay $150.0
million of outstanding borrowings under the Company's revolving credit
facilities in the first half of 2001, to repurchase $64.0 million liquidation
amount of the Capital Securities during the first nine months of 2001 and to
repurchase $8.0 million principal amount of the Senior Notes in June 2001.
Net Realized Investment Losses. Net realized investment losses were $70.3
million in 2001 as compared to $138.0 million in 2000. The Company's investment
strategy results in periodic sales of securities and, therefore, the recognition
of realized investment gains and losses. The Company monitors its investments on
an ongoing basis. When the market value of a security declines below its cost,
and such decline is determined in the judgment of management to be other than
temporary, the security is written down to fair value. In 2001, the Company
recognized $79.3 million of losses due to the other than temporary declines in
the market value of certain fixed maturity and equity securities. In 2000, the
Company realized losses of $72.5 million related to the liquidation of the
investments of its investment subsidiaries and $58.5 million on closed U.S.
Treasury futures and option contracts. See Note C to the Consolidated Financial
Statements. Realized investment losses, net of the related tax benefit, reduced
net income by $45.7 million, or $2.22 per share, in 2001 and by $89.7 million,
or $4.40 per share, in 2000.
Benefits and Expenses. Policyholder benefits and expenses were $583.1 million as
compared to $493.6 million in 2000, an increase of 18%. Benefits and expenses in
2001 include a pre-tax charge of $44.3 million for reserve strengthening
primarily related to an unusually high number of large losses in the Company's
excess workers' compensation business. Prior to 2001, SNCC's historical average
for losses exceeding $2.0 million in its excess workers' compensation products
was one to two per year. In 2001, however, the Company experienced seven such
losses, including two losses as a result of the terrorist attacks on the World
Trade Center. The case reserves for these seven losses totaled $15.3 million,
including $6.3 million attributable to the World Trade Center attacks. Though
the Company believed that the high number of large losses in 2001 was unlikely
to recur, the Company added $24.0 million to its reserve for IBNR losses since
its method of estimating IBNR reserves is based on past experience. The Company
experienced only one large loss
-20-
from its excess workers' compensation business in 2002. The Company also added
$5.0 million to its long-term disability IBNR reserves for potential mental and
nervous disability claims related to the World Trade Center attacks. This
reserve strengthening charge reduced net income in 2001 by $28.8 million, or
$1.40 per share. The increase in premiums from the Company's core group employee
benefit products also contributed to the increase in benefits and expenses in
2001. The combined ratio (loss ratio plus expense ratio) for the Company's group
employee benefits segment was 102.0% (92.9% excluding the reserve strengthening)
in 2001 and 92.3% in 2000. Benefits and interest credited on asset accumulation
products increased by $3.9 million in 2001 principally due to an increase in
average funds under management from $674.5 million in 2000 to $748.6 million in
2001, partially offset by a decrease in the weighted average annual crediting
rate on asset accumulation products from 5.7% in 2000 to 5.5% in 2001.
Interest Expense and Extraordinary Gain. Interest expense was $17.4 million in
2001 as compared to $30.8 million in 2000, a decrease of $13.4 million. This
decrease was primarily a result of the Company's repayment of $150.0 million of
outstanding borrowings under its revolving credit facilities during the first
half of 2001 and the repurchase of $64.0 million liquidation amount of the
Capital Securities in the open market, which occurred on various dates during
the first nine months of 2001. In addition, the Company repurchased $8.0 million
principal amount of the Senior Notes in June 2001. The Company recognized an
extraordinary gain of $7.4 million, net of income tax expense of $4.0 million,
in connection with these repurchases.
Income Tax Benefit. The income tax benefit was $5.1 million in 2001 and $8.2
million in 2000 and was primarily attributable to the recognition of investment
losses and, in 2001, the reserve strengthening. The Company's effective tax rate
excluding net realized investment losses and the reserve strengthening was 32.2%
in 2001 and 31.7% in 2000.
Loss before Extraordinary Gain. Management believes the concept of "operating
earnings" is informative when analyzing the Company's operating trends and in
comparing the Company's performance with that of other companies in its
industry. Operating earnings exclude discretionary or nonrecurring income or
loss items such as realized investment gains and losses and extraordinary items.
Investment gains and losses may be realized based on management's decision to
dispose of an investment or management's judgment that a decline in the market
value of an investment is other than temporary. Therefore, realized investment
gains and losses do not represent elements of the Company's ongoing earnings
capacity. However, operating earnings should not be considered a substitute for
net income as an indication of the Company's overall performance and may not be
calculated in the same manner as similarly titled captions in other companies'
financial statements. Operating earnings for the Company, consisting of income
before extraordinary gain adjusted to exclude realized investment losses (net of
the related income tax benefit), were $44.7 million, or $2.18 per share, in 2001
as compared to $86.4 million, or $4.24 per share, in 2000. The decrease in
operating earnings is primarily attributable to the after-tax charge for reserve
strengthening totaling $28.8 million, or $1.40 per share (see "2001 Compared to
2000 - Benefits and Expenses"). Equivalent shares attributable to in-the-money
stock options, which totaled 0.5 million and 0.7 million for 2001 and 2000,
respectively, were not considered in the calculation of these per share amounts
since the inclusion of these equivalent shares would have diluted the loss from
continuing operations. The decrease in operating earnings is also attributable
to the liquidation during the fourth quarter of 2000 of investments of the
Company's investment subsidiaries (see "2001 Compared to 2000 - Net Investment
Income").
LIQUIDITY AND CAPITAL RESOURCES
General. The Company had approximately $40.3 million of financial resources
available at the holding company level at December 31, 2002, which was primarily
comprised of investments in the common stock of its investment subsidiaries. The
assets of the investment subsidiaries are primarily invested in fixed maturity
securities and balances with independent investment managers.
In December 2002, the Company obtained a new $150.0 million revolving credit
facility with a group of lenders comprised of major banking institutions, which
replaced the existing $140.0 million revolving credit facilities scheduled to
expire in April 2003. This facility, which expires in December 2005, is subject
to certain restrictions and financial covenants considered ordinary for this
type of credit agreement. They include, among others, the maintenance of certain
financial ratios, minimum statutory surplus and RBC requirements for RSLIC and
SNCC, and certain investment, indebtedness, dividend and stock repurchase
limitations. At December 31, 2002, the Company had $113.0 million of borrowings
available to it under its new revolving credit facility.
Other sources of liquidity at the holding company level include dividends paid
from subsidiaries, primarily generated from operating cash flows and
investments. During 2003, the Company's life insurance subsidiaries and SNCC
will be permitted, without prior regulatory approval, to make dividend payments
of $25.3 million and $21.3 million, respectively. The life insurance
subsidiaries and SNCC may also pay additional dividends with the requisite
regulatory approvals. See
-21-
"Business - Regulation." In general, dividends from the Company's non-insurance
subsidiaries are not subject to regulatory or other restrictions.
The Company's current liquidity needs, in addition to funding its operating
expenses, include principal and interest payments on outstanding borrowings
under its revolving credit facility, the Senior Notes, the SIG Senior Notes and
the Subordinated Notes and distributions on the Capital Securities. During the
second quarter of 2002, the Company repurchased $10.5 million aggregate
principal amount of the Senior Notes. The Senior Notes mature in their entirety
in October 2003 and are not subject to any sinking fund requirements nor are
they redeemable prior to maturity. A $9.0 million annual principal installment
was paid on the SIG Senior Notes in May 2002, and the remaining $9.0 million of
such notes will mature in their entirety in May 2003. The Subordinated Notes
mature in their entirety in June 2003. The junior subordinated debentures
underlying the Capital Securities are not redeemable prior to March 25, 2007.
See Note E to the Consolidated Financial Statements.
The Company's shelf registration statement for the sale, from time to time, of
securities was declared effective by the Securities and Exchange Commission on
May 6, 2002. This shelf registration increased the Company's existing $49.2
million shelf registration to an amount of up to $250.0 million of proceeds.
Subject to market conditions, the Company may refinance its revolving credit
facility and its Senior Notes prior to maturity through the issuance of debt
securities covered by the shelf registration. However, no assurance can be given
that such an offering will be commenced or completed. To mitigate the risk of
interest rates rising before such refinancing could be completed, the Company
entered into a treasury rate lock agreement, with a notional amount of $150.0
million, pursuant to which the Company will receive (or make) a single payment
at the conclusion of the agreement, depending on the extent to which the market
yield on the specified U.S. Treasury security rises (or falls) over the term of
the agreement. The agreement was entered into in September 2002 with a term of
one year. Any gains or losses on the treasury rate lock agreement would be
deferred and amortized as a component of interest expense over the term of any
debt securities issued in the refinancing, or recognized in income if, and at
the time, the Company concludes the refinancing is improbable.
Sources of liquidity available to the Company on a parent company-only basis,
including the undistributed earnings of its subsidiaries, additional borrowings
available under the Company's revolving credit facility and borrowings, if any,
available pursuant to any debt obligations issued in the future, are expected to
exceed the Company's current and long-term cash requirements. The Company from
time to time engages in discussions with respect to acquiring blocks of business
and insurance and financial services companies, any of which could, if
consummated, be material to the Company's operations.
The principal liquidity requirements of the Company's insurance subsidiaries are
their contractual obligations to policyholders and other financing sources. The
primary sources of funding for these obligations, in addition to operating
earnings, are the marketable investments included in the investment portfolios
of these subsidiaries. The Company believes that these sources of funding will
be adequate for its insurance subsidiaries to satisfy on both a short-term and
long-term basis these contractual obligations throughout their estimated or
stated period.
Cash Flows. Operating activities increased cash by $208.5 million in 2002.
Operating activities in 2001, which include $30.1 million of cash provided by
the liquidation of trading account securities and $84.0 million of funds
received from Oracle Re for the commutation of various reinsurance agreements
that the Company had entered into with Oracle Re in 1998, increased cash by
$228.7 million. See Note Q to the Consolidated Financial Statements. Operating
activities increased cash by $12.4 million in 2000 and are net of $58.1 million
of funds returned to a ceding insurer in connection with the rescission of a
reinsurance transaction, $16.0 million of cash used by trading account
activities, and a net cash payment of $19.7 million related to the cession by
the Company of group employee benefit product reserves.
Investments. The Company's overall investment strategy emphasizes safety and
liquidity, while seeking the best available return, by focusing on, among other
things, managing the Company's interest-sensitive assets and liabilities and
seeking to minimize the Company's exposure to fluctuations in interest rates.
The Company's investment portfolio, which totaled $2,816.1 million at December
31, 2002, primarily consists of investments in fixed maturity securities and
short-term investments. The market value of the Company's investment portfolio,