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FORM 10-K 21ST CENTURY INSURANCE GROUP
(Exact name of registrant as specified in its charter)
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2002
CALIFORNIA 95-1935264
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification number)
6301 OWENSMOUTH AVENUE
WOODLAND HILLS, CALIFORNIA 91367
(Address of principal executive offices) (Zip Code)
(818) 704-3700
(Registrant's telephone number, including area code)
WEB SITE: WWW.21ST.COM
SECURITIES REGISTERED PURSUANT TO SECTION 12 (b) OF THE ACT:
COMMON STOCK, WITHOUT PAR VALUE NEW YORK STOCK EXCHANGE
(Title of Class) (Name of each exchange
on which registered)
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 Of Regulation S-K is not contained herein,
and will not be contained, to the best of registrant's knowledge,
in definitive proxy or information statements, incorporated by
reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15 (d) of the
Securities Exchange Act of 1934 during the preceding 12 months
(or for such shorter period that the registrant was required to
file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No[ ]
The aggregate market value of the voting stock held by
non-affiliates of the registrant, based on the average high and
low prices for shares of the Company's Common Stock on June 30,
2002, as reported by the New York Stock Exchange, was
approximately $466,000,000.
On February 28, 2003, the registrant had 85,431,505 shares of
common stock outstanding, without par value, which is the
Company's only class of common stock.
DOCUMENT INCORPORATED BY REFERENCE:
Portions of the definitive proxy statement used in connection
with the annual meeting of stockholders of the registrant, to be
held on June 25, 2003, are incorporated herein by reference into
Part III hereof.
TABLE OF CONTENTS
Page
Description Number
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Part I
Item 1. Business 4
General 4
Geographic Concentration of Business 4
Types and Limits of Insurance Coverage 5
Personal Auto Product Innovations 6
Marketing 6
Consumer Advocacy 7
Customer Retention and Vehicles in Force 7
Underwriting and Pricing 8
Servicing of Business 9
Claims 9
Growth and Profitability Objectives 10
Aggregate Expense Ratio - Personal Auto Lines 10
Loss and Loss Adjustment Expense Reserves 11
Estimating the Frequency of Auto Accidents 11
Homeowner and Earthquake Frequency 12
Estimating the Severity of Auto Claims 12
Earthquake Severity 13
Loss and Reserve Development 14
Auto Lines Reserve Development 17
Homeowner and Earthquake Lines in Runoff 17
Competition 19
Reinsurance 19
State Regulation of Insurance Companies 20
Holding Company Regulation 21
Effects of Events of September 11, 2001 21
Non-Voluntary Business 21
Employees 22
Item 2. Properties 22
Item 3. Legal Proceedings 22
Item 4. Submission of Matters to a Vote of Security Holders 24
Part II 24
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters 24
Item 6. Selected Financial Data 25
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 26
Financial Condition 26
Liquidity and Capital Resources 29
Holding Company 29
Insurance Subsidiaries 29
Obligations, Letters of Credit, Guarantees and Transactions with Related
Parties 30
Results of Operations 30
Overall Results 30
Personal Auto Lines Operating Income 31
Underwriting Results 32
Personal Auto 32
Homeowner and Earthquake Lines in Runoff and All Other 33
Investment Income 35
1
Page
Description Number
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Critical Accounting Policies 35
Losses and Loss Adjustment Expenses 35
Property and Equipment 36
Deferred Income Taxes 36
Deferred Policy Acquisition Costs 38
Investments 38
Audit Committee Financial Expert 40
Policies Regarding Conflicts of Interest and Ethical Behavior 41
Forward-Looking Statements 41
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 42
Item 7B. Management's Internal Control Report 43
Item 8. Financial Statements and Supplemental Data 44
Report of Independent Accountants 44
Report of Independent Auditors 45
Consolidated Financial Statements 46
Notes to Consolidated Financial Statements 50
Note 1. Description of Business 50
Note 2. Summary of Significant Accounting Policies 50
Note 3. (Loss) Earnings per Common Share 53
Note 4. Investments 53
Note 5. Federal Income Taxes 55
Note 6. Deferred Policy Acquisition Costs 56
Note 7. Property and Equipment 57
Note 8. Unpaid Losses and Loss Adjustment Expenses 58
Note 9. Reinsurance 59
Note 10. Employee Benefit Plans 60
Note 11. Operating Lease Commitments 62
Note 12. Capital Stock 62
Note 13. Stock-Based Compensation 63
Note 14. Statutory Financial Data 65
Note 15. Litigation 66
Note 16. Northridge Earthquake 68
Note 17. Unaudited Quarterly Results of Operations 70
Note 18. Results of Operations by Line of Business 71
Note 19. 21st Century Insurance Company of Arizona 72
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 73
Part III 73
Item 10. Directors and Officers of the Registrant 73
Item 11. Executive Compensation 73
Item 12. Security Ownership of Certain Beneficial Owners and Management 73
Item 13. Certain Relationships and Related Transactions 73
Part IV 74
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 74
Schedule II - Condensed Financial Information of Registrant 75
Signatures of Officers and Board of Directors 78
Certification of President and Chief Executive Officer 80
Certification of Chief Financial Officer 81
2
Exhibits 82
3(ii) Certification of Secretary for Change to Bylaws 82
23(a) Consent of Independent Accountants 83
23(b) Consent of Independent Auditors 84
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant To
Section 906 of the Sarbanes-Oxley Act of 2002 85
3
PART I
ITEM 1. BUSINESS
GENERAL
21st Century Insurance Group is an insurance holding company founded in 1958 and
incorporated in California. The term "Company," unless the context requires
otherwise, refers to 21st Century Insurance Group and its consolidated
subsidiaries, all of which are wholly owned: 21st Century Insurance Company,
21st Century Casualty Company, 21st Century Insurance Company of Arizona(1)
("21st of Arizona"), 20th Century Insurance Services, inc., and i21 Insurance
Services. The latter two companies are not property and casualty insurance
subsidiaries, and their results are immaterial.
The common stock of the Company is traded on the New York Stock Exchange under
the trading symbol "TW." Through several of its subsidiaries, American
International Group, Inc. ("AIG"), currently owns approximately 63% of the
Company's outstanding common stock.
Founded in 1958, 21st Century Insurance Group primarily sells and underwrites
personal automobile insurance to customers in California, Arizona, Nevada,
Oregon and Washington who prefer excellent service and a high-feature product at
a competitive price. Twenty-four hours per day, 365 days a year, customers
choose to purchase insurance over the phone from the Company's centralized
licensed insurance agents at 1-800-211-SAVE or through its full service Internet
site at www.21st.com. The Company has the reputation for excellent customer
service and for being among the most efficient and lowest cost providers of
personal auto insurance in the markets it serves.
Copies of the Company's filings with the Securities and Exchange Commission on
Form 10-K, Form 10-Q, Form 8-K and proxy statements are available along with
copies of earnings releases on the Company's web site at www.21st.com. Copies
may also be obtained free of charge directly from the Company's Investor
Relations Department (6301 Owensmouth Avenue, Woodland Hills, California 91367,
phone 818-701-3595).
GEOGRAPHIC CONCENTRATION OF BUSINESS
The Company's business began in Los Angeles and historically has been
concentrated in Southern California, principally the greater Los Angeles
metropolitan area. In the mid-1980's, the Company expanded into the San Diego
area and, in the early 1990's, the Northern California area. The Company began
writing private passenger automobile insurance in Arizona in 1996, followed by
Nevada, Oregon and Washington in late 1998.
- ---------------
1 21st of Arizona was incorporated in Arizona in 1995 as a joint venture
owned 49% by the Company and 51% by AIG; the Company acquired AIG's
interest on January 1, 2002.
4
The following table presents a geographical summary of the Company's direct
premiums written for the past five years (in millions):
Years Ended December 31, 2002 2001 2000 1999 1998
- -----------------------------------------------------------------------------------
Personal auto lines(1)
California $967.3 $879.4 $861.6 $848.9 $860.8
Arizona(2) 13.0 - - - -
Nevada 8.1 8.9 7.7 2.7 -
Oregon 1.6 2.0 2.2 0.8 -
Washington 5.8 8.5 9.7 3.4 -
- -----------------------------------------------------------------------------------
Total personal auto lines 995.8 898.8 881.2 855.8 860.8
- -----------------------------------------------------------------------------------
Lines in runoff
Homeowner(3) and Earthquake(4) 2.4 30.5 29.5 24.7 24.8
- -----------------------------------------------------------------------------------
Total consolidated direct premiums written $998.2 $929.3 $910.7 $880.5 $885.6
- -----------------------------------------------------------------------------------
The following table summarizes the concentrations of the Company's California
direct in-force premiums for the voluntary personal auto lines excluding
personal umbrella and motorcycle coverages as of the end of each of the past
five years:
December 31, 2002 2001 2000 1999 1998
- ------------------------------------------------------------------------------------
Southern California excluding San Diego(5) 66.3% 73.5% 76.2% 78.8% 81.8%
San Diego(6) 10.5 10.2 9.4 9.0 8.6
Northern California(7) 23.2 16.3 14.4 12.2 9.6
- ------------------------------------------------------------------------------------
100.0% 100.0% 100.0% 100.0% 100.0%
- ------------------------------------------------------------------------------------
TYPES AND LIMITS OF INSURANCE COVERAGE
The Company's private passenger auto insurance contract generally covers: bodily
injury liability; property damage; medical payments; uninsured and underinsured
motorist; rental reimbursement; uninsured motorist property damage and collision
deductible waiver; towing; comprehensive and collision. All of the Company's
policies are written for a six-month term except for policies sold to the
involuntary market, which are for twelve months.
Minimum levels of bodily injury and property damage are required by state law
and typically cover the other party's costs when the Company's policyholder
causes an accident. Uninsured and underinsured motorist are optional coverages
and cover the Company's policyholder when the other party is at fault and has no
or insufficient liability insurance to cover the insured's injuries and loss of
income. Comprehensive and collision coverages are also optional and cover
damage to the policyholder's automobile whether or not the insured is at fault.
In some states, the
- ---------------
1 Includes motorcycle and personal umbrella coverages, which are immaterial
for all periods presented.
2 Excludes amounts not consolidated: $12.8 in 2001; $14.7 million in 2000;
$12.9 million in 1999; and $10.0 million in 1998.
3 The Company is running off approximately 5,300 California homeowner
policies remaining on its books at December 31, 2002. See further
discussion in Item 7 under the caption Underwriting Results - Homeowner
and Earthquake Lines in Runoff and All Other.
4 The Company ceased writing earthquake coverage in 1994 but remains exposed
to possible upward development in certain loss estimates relating to the
1994 Northridge Earthquake. See further discussion in Item 7 under the
captions Underwriting Results - Homeowner and Earthquake Lines in Runoff
and All Other, Critical Accounting Policies, and Note 16 of the Notes to
Consolidated Financial Statements.
5 Includes all counties not specified in footnotes 6 and 7.
6 Represents San Diego County.
7 Includes these counties: Alameda, Alpine, Amador, Butte, Calaveras, Colusa,
Contra Costa, Del Norte, El Dorado, Fresno, Glenn, Humboldt, Inyo, Kings,
Lake, Lassen, Madera, Marin, Mariposa, Mendocino, Merced, Modoc, Mono,
Monterey, Napa, Nevada, Placer, Plumas, Sacramento, San Benito, San
Francisco, San Joaquin, San Mateo, Santa Tehama, Trinity, Tulare, Yolo,
Yuba.
5
Company is required to offer personal injury protection coverage in lieu of the
medical payments coverage required in California.
Various limits of liability are underwritten with maximum limits of $500,000 per
person and $500,000 per accident. The most frequent bodily injury liability
limits purchased are $100,000 per person and $300,000 per accident. The
Company's standard coverages exclude losses from nuclear sources as well as acts
of war.
The Company's personal umbrella policy ("PUP") provides a choice of liability
coverage limits of $1.0 million, $2.0 million or $3.0 million in excess of the
underlying automobile liability coverage. The $2.0 million and $3.0 million
limits were added in May 2002. Minimum underlying automobile limits of $100,000
per person and $300,000 per accident were required for PUP policies sold prior
to May 2002, and limits of $250,000 per person and $500,000 per accident are
required thereafter. The Company must write the underlying automobile coverage.
The Company reinsures 90% of any PUP loss with unrelated reinsurers.
The homeowner program, currently in runoff, utilized an extended replacement
cost policy, thereby limiting the insured's recovery to 150% of the amount
specified in the contract for Coverage A - Dwelling and Other Building
Structures. Underwriting guidelines provided for a minimum dwelling amount of
$65,000 and a maximum dwelling amount of $750,000.
PERSONAL AUTO PRODUCT INNOVATIONS
Starting in May 2002, the Company began offering motorcycle coverage primarily
to its auto policyholders in California. In August 2002, the Company introduced
a new private passenger auto policy in California that does not have certain
standard features found in its primary policy. This limited-feature product is
similar in most respects to the product offered by many of the Company's
competitors, and is positioned as a lower-cost alternative for customers who
believe they need less coverage than provided by the Company's standard product.
In October 2002, the Company enhanced its underwriting guidelines allowing it to
provide quotes to certain customers who do not meet California's statutory "good
driver" definition but who are considered to be insurable risks within the
Company's class plan.
All of the foregoing product innovations were designed to achieve an
underwriting profit and, to date, the impact of these new products has been
immaterial.
MARKETING
While the Company offers personal auto policies in California, Arizona, Nevada,
Oregon and Washington, most of its marketing efforts are focused on the larger
urban markets in California. Beginning in late 2002, the Company restarted its
active marketing in Arizona.
The Company's marketing and underwriting strategy is to appeal to careful and
responsible drivers who desire a feature-rich product at a competitive price.
The Company uses direct mail, broadcast and print media, outdoor, community
events and the Internet to generate inbound telephone calls, which are served by
centralized licensed insurance agents. Because the Company centralizes its
sales agents, it can deliver a highly efficient and professional experience for
its California and Arizona customers 24 hours per day, 365 days per year through
a convenient, toll-free 800-211-SAVE telephone number. California and Arizona
customers may also obtain an instant auto rate quotation and purchase a policy
on the Company's Internet site at www.21st.com.
6
The following table summarizes advertising expenditures (in millions) and total
new auto policies written in California, the Company's primary market, for the
past five years:
Years Ended December 31, 2002 2001 2000 1999 1998
- ------------------------------------------------------------------------------
Total advertising
expenditures $ 43.3 $ 16.9 $ 10.1 $ 22.7 $ 10.1
New auto policies written in
California(1) 185,944 51,002 54,642 86,703 104,289
CONSUMER ADVOCACY
The Company has introduced several publications and community events designed to
assist customers and potential customers in making choices about their auto
insurance and automobile safety. The Insider's Guide to Buying California Auto
Insurance, currently available in both English and Spanish, compares coverage
and service features of products offered by the Company and its major
competitors. The comparisons are explained in understandable language to help
"demystify" the choices consumers must make in selecting their personal auto
insurance carrier.
The Company also publishes the Child Safety Seat Guide, Crash Test Ratings
Guide, and A Driving Need - A Guide for Mature Drivers and Those Who Care about
Them. All these publications are available free of charge on the Company's web
site at www.21st.com/company/getmore/safety/safety.jsp. The Company has also
distributed these publications in California movie theaters, county fairs,
direct mail promotions and other venues.
CUSTOMER RETENTION AND VEHICLES IN FORCE
Customer retention in California, measured based on the number of insured
vehicles and the number of vehicles in force, were as follows as of the end of
each of the past five years:
December 31, 2002 2001 2000 1999 1998
- -----------------------------------------------------------------------------------------------
Average customer retention -
California personal auto(2) 93% 92% 96% 97% 96%
California vehicles in force (1) 1,178,459 1,051,982 1,150,643 1,179,928 1,142,303
All other states vehicles in force 27,174 23,489 31,337 18,130 189
- -----------------------------------------------------------------------------------------------
Total auto lines exposure (1) 1,205,633 1,075,471 1,181,980 1,198,058 1,142,492
- -----------------------------------------------------------------------------------------------
California auto base rate +5.7% +4.0% +6.4% -6.9% -3.4%
changes MAY July November February January
From March 1996 to October 2000, the Company implemented six rate decreases
which resulted in a cumulative reduction in rates of nearly 23%. As a result of
this series of rate decreases, retention rates rose to Company record levels
through 2000. Growth in vehicles in force during this period was modest as the
Company's major competitors also lowered their rates. In response to rising loss
costs beginning in 1999 and continuing to date, the Company has implemented
three base rate increases as shown above for a cumulative increase of 16%, made
changes in its class plan and adopted stricter underwriting measures.
Additionally, as the Company upwardly adjusted its rates, it curtailed
advertising for new customers throughout 2000. During this same period,
competitors held rates steady or continued to take decreases. These actions
contributed to the declines in retention and vehicles in force in 2000 and 2001.
Beginning in the latter half of 2001, the Company's major California competitors
began implementing rate increases and the Company restarted active marketing and
advertising, both of which contributed to the increases in
- ---------------
1 Includes new PUP and motorcycle policies, which are insignificant for all
periods presented.
2 Represents an overall measure of customer retention, including new
customers as well as long-time customers. Retention rates for new customers
are often lower than for long-time customers.
7
the Company's retention and vehicles in force in 2002. In January 2003, the
Company received approval for a 3.9% rate increase which it expects to implement
in March 2003.
UNDERWRITING AND PRICING
The regulatory system in California requires the prior approval of insurance
rates, rules and forms. Within the regulatory framework, the Company establishes
its premium rates based primarily on actuarial analyses of its own historical
loss and expense data. This data is compiled and analyzed to establish overall
rate levels as well as classification differentials.
The Company's rates are established at levels intended to generate underwriting
profits and vary for individual policies based on a number of rating
characteristics. These rates are a blend of base rates and class plan filings
made with the California Department of Insurance ("CDI"). Base rates are the
primary amount projected to generate an adequate underwriting profit for the
Company. Class plan changes are filings that serve to modify the factors that
impact the base rates. Class plan changes are generally meant to be revenue
neutral to the Company but ultimately are done in conjunction with a base rate
filing.
California law requires that the primary rating characteristics that must be
used for automobile policies are driving record, annual mileage and number of
years the driver has been licensed. A number of other "optional" rating
factors are also permitted and used in California and include characteristics
such as automobile garaging location, make and model of car, policy limits and
deductibles, and gender and marital status.
The following table summarizes changes in the Company's base premium rates for
each of the past five years. Positive numbers represent increases; negative
numbers represent decreases.
Years Ended December 31, 2002 2001 2000 1999 1998
- ----------------------------------------------------------------------
Personal auto lines excluding PUP
California 5.7% 4.0% 6.4% (6.9)% (3.4)%
Arizona 3.7 16.5 20.0 (9.7) -
Nevada 22.0 12.6 - - N/A
Oregon 3.1 14.0 21.0 - N/A
Washington 10.7 44.9 - - N/A
Lines in runoff
Homeowner 13.2 4.0 - (7.5) -
Earthquake N/A N/A N/A N/A N/A
The Company is required to offer insurance to any California prospect that meets
the statutory definition of a "Good Driver." This definition includes all
drivers who have been licensed more than three years and have had no more than
one violation point count under criteria contained in the California Vehicle
Code. These criteria include a variety of moving violations and certain at-fault
accidents.
The Company reviews many of its policies prior to the time of renewal and as
changes occur during the policy period. Some mid-term changes may result in
premium adjustments, cancellations or non-renewals because of a substantial
increase in risk.
8
SERVICING OF BUSINESS
Computerized systems provide the information resources, telecommunications and
data processing capabilities necessary to manage the Company's business. These
systems support the activities of the Company's marketing, sales, service and
claims areas that are dedicated to serving the needs of customers. New
technology investments have been focused on making it faster and easier for
customers to transact business while ultimately lowering the cost per
transaction.
Using the Company's web site, most customers are now able to receive and accept
quotations, bind policies, pay their bills, inquire about the status of their
policies and billing information, make most common policy changes, submit first
notice of loss on a claim and access a wealth of consumer information. New
technology began to be implemented in 2001 that provides the Company's sales and
service agents with integrated knowledge about customer contacts and enables
speedier and even more convenient customer service.
CLAIMS
Claims operations include the receipt and analysis of initial loss reports,
assignment of legal counsel when necessary, and management of the settlement
process. Whenever possible, physical damage claims are handled through the use
of Company drive-in claims facilities, vehicle inspection centers and Direct
Repair Program ("DRP") providers. The claims management staff administers the
claims settlement process and oversees the work of the legal and adjuster
personnel involved in that process. Each claim is carefully analyzed to provide
for fair loss payments, compliance with the Company's contractual and regulatory
obligations and management of loss adjustment expenses. Liability and property
damage claims are handled by specialists in each area.
The Company makes extensive use of its DRP to expedite the repair process. The
program involves agreements between the Company and more than 130 independent
repair facilities. The Company agrees to accept the repair facility's damage
estimate without requiring each vehicle to be reinspected by Company adjusters.
All DRP facilities undergo a screening process before being accepted, and the
Company maintains an aggressive inspection audit program to assure quality
results. The Company's inspection teams visit all repair facilities each month
and perform a quality control inspection on approximately 40% of all repairable
vehicles in this program. The customer benefits by getting the repair process
started faster and by having the repairs guaranteed for as long as the customer
owns the vehicle. The Company benefits by not incurring the overhead expense of
a larger staff of adjusters and by negotiating repair prices it believes are
beneficial. Currently, more than 30% of all damage repairs are handled using the
DRP method.
The Company's policy with respect to vehicle repairs is not to use after market
"crash" parts. As a result, the Company believes it does not face exposure to
the types of class action suits some competitors have drawn over their use of
such parts.
The Company has established 12 claims Division Service Offices in areas of major
customer concentrations. The five Vehicle Inspection Centers, located in Los
Angeles and Orange Counties, handle total losses, thefts and vehicles that are
not driveable.
The Claims Services Division is responsible for subrogation and medical payment
claims. The Company also maintains a Special Investigations Unit as required by
the California State Insurance Code, which investigates suspected fraudulent
claims. The Company believes its efforts in this area have been responsible for
saving several million dollars annually.
9
The Company utilizes internal legal staff to handle most aspects of claims
litigation. These attorneys handle approximately 75% of all lawsuits against
its policyholders. Suits directly against the Company and those, which may
involve a conflict of interest, are assigned to outside counsel.
GROWTH AND PROFITABILITY OBJECTIVES
The Company has stated that its long-term goal is to build an organization that
consistently produces a 96% GAAP combined ratio, or better, and at least 15%
annual growth in direct written premiums. The Company has only met both of
these goals in the same year twice: 1980 and 1981. The Company came closer to
meeting both goals in the last half of 2002 for its personal automobile lines.
To achieve these goals, the Company has undertaken many steps since 1999
including:
- - Restored pricing and underwriting discipline.
- - Successfully restarted active advertising for new customers and introduced
product innovations to spur growth and profitability.
- - Launched numerous initiatives to lower per unit costs throughout the
Company's infrastructure while holding the line on fixed expenses.
Although new customers generally have higher aggregate loss ratios, their loss
experience tends to improve over time. The Company believes it can
significantly increase premium volume without incurring significantly higher
fixed costs while continuing to lower per unit costs in its variable expense
operations. Thus, assuming a responsible regulatory climate, the goal of a 96%
combined ratio should be achievable consistently despite the higher loss ratio
often associated with new customers. However, it must be noted that the
personal lines insurance business is, as a regulated industry, exposed to
legislative, judicial, political and regulatory action in addition to the normal
business forces of competition between companies and the choices of consumers.
AGGREGATE EXPENSE RATIO - PERSONAL AUTO LINES
The Company believes a competitive advantage can be achieved by operating more
efficiently than its competition. One measure of relative efficiency is the
"aggregate expense ratio" - defined as the sum of incurred loss adjustment
expenses and underwriting expenses, divided by gross premiums written. This
aggregate expense ratio removes many of the inconsistencies in how different
companies classify their expenses.
The following table presents aggregate expense ratio information extracted from
statutory filings by A.M. Best for the top ten California personal automobile
insurance companies for 1997 through 2001, the most recent data available.
Statutory Aggregate Expense Ratio
---------------------------------
Years Ended December 31, 2001 2000 1999 1998 1997
- --------------------------------------------------------------------
21ST CENTURY INSURANCE GROUP 33.5% 31.3% 30.1% 27.1% 22.8%
California State Auto Association 39.8 43.6 28.9 35.7 32.1
State Farm 38.4 41.3 40.3 38.1 34.1
Mercury 38.0 38.8 38.6 37.9 37.6
Progressive 37.1 35.4 33.4 35.0 33.7
Allstate 36.9 39.8 39.2 39.2 39.0
Farmers 35.8 35.2 33.6 35.2 34.4
Auto Club of Southern California 32.0 32.6 34.0 35.4 32.6
USAA 28.0 30.7 34.1 29.5 26.2
GEICO 24.4 27.0 29.0 27.6 24.2
The Company's aggregate expense ratio for the auto lines in 2002 was 33.2%. In
2002, the capacity of the Company's new business call center was doubled,
enabling the Company to handle a record volume of new business throughout the
year. Several productivity enhancement
10
initiatives are underway aimed at reducing per unit process costs and lowering
fixed costs in corporate support areas. The increases in the Company's ratio
from 1997 through 2001 were primarily due to the cumulative 23% decrease in rate
level in California from 1996 to 1999, and increases in data processing,
depreciation and advertising expenditures.
LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
The cost to settle a customer's claim is comprised of two major components:
losses and loss adjustment expenses.
Losses in connection with third party coverages represent damages as a result of
an insured's acts that result in property damage or bodily injury. First party
losses involve damage or injury to the insured's property or person. In either
case, the ultimate cost of the loss is not always immediately known and may
develop higher or lower than initial estimates over time. When establishing
initial and subsequent estimates, the amount of loss is reduced for salvage
(e.g., proceeds from the disposal of the wrecked automobile) and subrogation
(e.g., proceeds from another party who is fully or partially liable, such as the
insurer of the driver who caused the accident involving one of the Company's
customers).
Loss adjustment expenses ("LAE") represent the costs of adjusting, investigating
and settling the loss, most of which comprise the cost of the Company's claim
department, external inspection services, and internal and external legal
counsel. Because staff areas such as human resources, finance, and information
technology support the Company's overall operations, a portion of their
operational costs are also allocated to LAE.
Accounting for losses and LAE is highly subjective because these costs must be
estimated, often weeks, months or even years in advance of when the payments
actually are made to claimants, attorneys, claims personnel and others involved
in the claims settlement process. At the time of sale of an auto policy, for
example, the number of claims that will happen is unknown, and so is the
ultimate amount it will take to settle them.
Accounting principles require insurers to record estimates for loss and LAE in
the periods in which the insured events, such as automobile accidents, occur.
This estimation process requires the Company to estimate both the number of
accidents that may have occurred (called "frequency") and the ultimate amount of
loss and LAE (called "severity") related to each accident. The Company employs
experts called "actuaries" who are professionally trained and certified in the
process of establishing estimates for frequency and severity. From time to
time, actuarial experts from outside firms are engaged to review the work of the
Company's actuaries.
Estimating the Frequency of Auto Accidents. By studying the historical lag
between the actual date of loss and the date the accident is reported by the
customer to the claims department, the Company's actuaries can make a
reasonable, yet never perfect, estimate for the number of claims that ultimately
will be reported for a given period. This measurement is often referred to as
frequency. The difference between the estimated ultimate number of claims that
will be made and the number that have actually been reported in any given period
is often referred to as "IBNR (incurred but not reported) claims".
For example, when estimating the frequency of accidents, history has shown that
approximately 95% of property damage claims and 81% of liability claims are
reported by year-end. Accordingly, in this illustration, the Company's
actuaries add an estimated 5% to the number of property damage claims and 19% to
the number of liability claims to provide for incurred but not reported ("IBNR")
claims.
When making estimates of frequency, the Company's actuaries reviewed historical
trends, noticing that there has been a slight decrease since 1999. For example,
the Company's actuaries noted that about 11.9% of California vehicles had a
collision-related accident in 2000, which declined to approximately 11.8% in
2001 and they are estimating 11.7% will have an accident in 2002. For bodily
injury claims, the actuaries saw 3.328% in 2000, 3.168% in 2001 and are
11
estimating 3.175% in 2002. These slight declines in frequency are believed to
be attributable mainly to relatively dry weather in California beginning in 2001
and throughout 2002.
In making these estimates, a fundamental assumption is that past events are
representative indicators of future outcomes. These estimates are also highly
sensitive. For example, in the above illustration, if the actuaries had picked
11.9% for 2002 collision frequency, the Company would have reported additional
pre-tax loss expense of $3.3 million.
Homeowner and Earthquake Frequency. The Company's remaining homeowner exposures
are mainly fully reinsured although the Company has exposure on claims that
might develop from 2000 and 2001 as well as from before July of 1996. However,
the homeowner line is considered to be a relatively short-tailed line and few
IBNR claims are expected.
By contrast, general liability commercial lines claims counts may take seven,
ten or more years to fully develop, and coverages such as asbestos and
environmental liability may involve discovery periods of twenty or thirty years.
The Company does not have any such long-tailed exposures.
However, California Senate Bill 1899(1) ("SB 1899") allowed insureds in 2001 to
report 1994 Northridge Earthquake claims the Company believes were previously
barred by the statute of limitations. SB 1899 is an egregious example of an
event that no reasonable actuary or other insurance professional would have
forecast or have even considered as possible seven years earlier in 1994.
However, when the law took effect and the number of claims became reasonably
estimable, the Company recorded an estimate for these claims as if they were a
1994 event (when the earthquake occurred) rather than as a 2001 event (when the
new law was effective)(2). While the number of true "SB 1899" claims should be
a fixed number, the Company continues to receive new Northridge Earthquake
claims based on alternative legal theories. These claims are included in the
Company's reserve estimates and are handled similarly to true SB 1899 claims.
Estimating the Severity of Auto Claims. Adjusters in the Company's claim
department establish loss estimates for individual claims based upon various
factors such as the extent of the injuries, property damage sustained, and the
age of the claim. The Company's actuaries review these estimates, giving
consideration to the adjusters' historical ability to accurately estimate the
ultimate claim and length of time it will take to settle the claim. Generally,
the longer it takes to settle a claim, the higher the ultimate claim cost. The
ultimate amount of the loss is considered the "severity" of the claim. In
addition, the actuaries estimate the severity of the IBNR claims.
The severities are estimated by the Company's actuaries each quarter based on
historical studies of average claim payments and the patterns of how the claims
were paid.
Returning to the above collision example, the Company's actuaries estimate that
the average incurred claim severity for collision coverage in the 2002 accident
year was $2,467, versus $2,394 in 2001 and $2,295 in 2000. This suggests that
average collision claim costs rose about 3.0% in 2002 and 4.1% in 2001. With
actual price inflation for repairs and parts running somewhat higher than either
of those figures, the better performance by the Company reflects the care and
attention it pays to claims handling and in particular to its Direct Repair
Program (DRP) which offers superior quality to customers at a lower overall
cost, and its salvage and subrogation methods.
Average severity for the BI coverage in California was $4,416 in 2002, $4,417 in
2001 and $4,374 in 2000. While medical inflation is inherently increasing BI
severities, there is a trend
- ---------------
1 See further discussion in Item 7 under the caption Underwriting Results -
Homeowner and Earthquake Lines in Runoff and all Other.
2 After discussion with legal counsel, the Company has concluded that
providing certain details, such as the total number of SB 1899 claims and
average claim amounts, would likely prejudice the claims settlement process
to the Company's detriment.
12
where the level of loss is decreasing in California. Actuaries generally believe
the improvements in automobile safety, more rational jury awards, and
drought-like conditions are moderating the increase in BI severities.
Again, the fundamental assumption used in making these estimates is that past
events are reliable indicators of future outcomes. History, unfortunately, has
a way of thwarting even the most strongly held expectations. For example, in
the above illustration, if the actuaries would have selected a BI severity that
increased the same from 2001 to 2002 as it did from 2000 to 2001, the Company
would have reported additional pre-tax loss expense of $1.8 million in 2002.
Earthquake Severity. A necessarily more subjective process is used to estimate
earthquake losses arising out of SB 1899 due to the fact that they cannot be
determined with traditional actuarial methods that rely on credible historical
or industry data, neither of which are available in regard to this event.
Because a large number of these claims are being asserted through litigation,
the ultimate amounts will depend on many factors including whether the claim is
settled before entering the pre-trial stage, during pre-trial proceedings, or
requires a full trial to resolve. Future judicial decisions, jury verdicts and
settlements may affect the cost of resolution of remaining cases, both
positively and negatively. These and many other earthquake claim litigation
factors (see below and Note 16 of the Notes to Consolidated Financial
Statements) are difficult to predict based on past events and thus assumptions
and estimates are more likely to be subject to modification in the future.
More than two-thirds of the Company's remaining earthquake claims are in
litigation. Many suits seek extracontractual and punitive damages as well as
contractual damages far in excess of the Company's estimates. The Company
cannot estimate and, therefore, has not established a reserve for potential
extracontractual or punitive damages, or for damages in excess of estimates the
Company believes are correct and reasonable. It denies liability for any such
alleged damages. Nevertheless, extracontractual and punitive damages, if
assessed against the Company, could be material in an individual case or in the
aggregate, and damages in excess of the Company's reasonable estimates could be
material in the aggregate. The Company may choose to settle litigated cases for
amounts in excess of its own estimate of contractual damages to avoid the
expense and/or risk of litigation.
The average costs and ranges for Earthquake settlements and verdicts vary
widely. For example, the Company recently had one claim with a plaintiff's
estimate of $200,000 settle for $500 on the courthouse steps; however, before SB
1899, the Company had one earthquake trial that required more than $1 million in
defense costs. Many lawsuits contain multiple claimants that courts may or may
not sever for trial. Thus, the Company faces the prospects of mass trials as
well as numerous individual trials, each with different potential costs and
litigation risks. The Company may also seek to settle groups of litigated
claims represented by a single attorney or law firm as a means of efficiently
resolving cases without incurring substantial attorneys' fees defending multiple
lawsuits. The discovery process is not yet underway for the majority of these
cases, and it is difficult to estimate litigation costs at this stage of the
process since the level (and hence cost) of discovery is not entirely within the
Company's control and it depends on the litigation strategy plaintiffs' counsel
may employ as well as other factors (see discussion in Note 16 to the Notes to
Consolidated Financial Statements). These strategies are expected to vary by
plaintiff attorney and firm. The Company's reserve estimate for legal defense
costs assumes that the Company will be successful in settlement of the vast
majority of its earthquake litigation before trial.
Meanwhile, events such as the Company's recent fraud suit brought against a
public adjuster, Unlimited Adjusting Company (1) ("Unlimited Adjusting"), could
have a favorable impact on future settlements with claimants represented by
Unlimited Adjusting. Approximately 20% of the pending claims are or have been
represented by Unlimited Adjusting.
- ---------------
1 For more information on this suit, please see the Company's press release
dated December 17, 2002, available on the Company's web site, www.21st.com.
13
Loss and Reserve Development. Management believes that, given the inherent
variability in the estimates, the Company's reserves are within a reasonable and
acceptable range of adequacy(1). However, because reserve estimates are
necessarily subject to the outcome of future events, changes in estimates are
unavoidable in the property and casualty insurance business. These changes
sometimes are referred to as "loss development" or "reserve development."
Quarterly, the Company's actuaries prepare a new evaluation of loss and LAE
indications by accident year, and the Company assesses whether there is a need
to adjust reserve estimates pertaining to previous accounting periods. As
claims are reported and settled and as other new information becomes available,
changes in estimates are made and are included in earnings of the period of the
change.
The changes in prior accident year estimates recorded in each of the past five
years, net of applicable reinsurance, are summarized below (in thousands)(2):
For the years ended December 31, 2002 2001 2000 1999 1998
- ----------------------------------------------------------------------------------
Personal auto $16,200 $ 45,742 $42,178 $(14,239) $(39,476)
Homeowner and Earthquake 56,158 72,265 2,845 5,543 43,099
- ----------------------------------------------------------------------------------
$72,358 $118,007 $45,023 $ (8,696) $ 3,623
- ----------------------------------------------------------------------------------
To understand these changes, it is useful to put them in the context of the
cumulative reserve development experienced by the Company over a longer time
frame. The tables on the following pages present the development of loss and
LAE reserves for the personal auto lines (Table 1) and for the homeowner and
earthquake lines in runoff (Table 2), for the years 1992 through 2002. The
figures in both tables are shown gross of reinsurance.
The top line of each table shows the reserves at the balance sheet date for each
of the years indicated. The upper portion of the table indicates the cumulative
amounts paid as of subsequent year-ends with respect to that reserve liability.
The lower portion of the table indicates the re-estimated amount of the
previously recorded reserves based on experience as of the end of each
succeeding year, including cumulative payments made since the end of the
respective year. The estimates change as more information becomes known about
the frequency and severity of claims for individual years. A redundancy
(deficiency) exists when the original reserve estimate is greater (less) than
the re-estimated reserves. Each amount in the tables includes the effects of
all changes in amounts for prior periods. The tables do not present accident
year or policy year development data. Conditions and trends that have affected
the development of liabilities in the past may not necessarily occur in the
future. Therefore, it would not be appropriate to extrapolate future
deficiencies or redundancies based on the table. A detailed discussion of loss
reserve development follows the tables.
- ---------------
1 For a discussion of the reserve ranges considered by management at December
31, 2002, see discussion under Financial Condition.
2 Positive numbers represent increases in loss and LAE expense, while
negative numbers represent decreases.
14
- -----------------------------------------------------------------------------------------------------------------------------
TABLE 1 - Auto Lines as of December 31,
(Amounts in thousands, except claims) 1992 1993 1994 1995 1996 1997 1998 1999
- -----------------------------------------------------------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $515,719 $525,892 $552,872 $506,747 $468,257 $403,263 $329,021 $261,990
PAID (CUMULATIVE) AS OF:
One year later 308,211 319,938 329,305 318,273 260,287 253,528 247,317 242,579
Two years later 374,583 393,731 403,462 392,420 336,538 319,064 307,797 311,659
Three years later 395,034 410,808 429,595 416,541 354,854 333,349 324,778 324,740
Four years later 400,230 422,640 435,795 422,393 357,913 340,907 326,932
Five years later 401,590 425,021 437,041 423,429 363,068 341,446
Six years later 402,812 425,397 437,052 427,723 362,824
Seven years later 402,736 425,041 437,015 427,355
Eight years later 402,415 424,982 436,737
Nine years later 402,397 424,745
Ten years later 402,210
RESERVES RE-ESTIMATED AS OF:
One year later 470,729 451,054 465,934 440,158 365,566 359,262 313,192 309,953
Two years later 412,299 429,602 438,672 424,091 366,858 337,258 321,711 340,914
Three years later 405,696 418,576 439,125 425,404 359,925 335,246 341,695 328,190
Four years later 402,110 424,630 438,895 424,643 357,607 355,605 326,506
Five years later 401,862 425,880 436,397 422,389 377,414 340,537
Six years later 402,671 424,475 435,878 442,024 361,980
Seven years later 402,074 424,188 451,478 426,719
Eight years later 401,864 424,603 448,972
Nine years later 401,978 424,435
Ten years later 402,001
- -----------------------------------------------------------------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $113,718 $101,457 $103,900 $ 80,028 $106,277 $ 62,726 $ 2,515 $(66,200)
- -----------------------------------------------------------------------------------------------------------------------------
Supplemental Auto Claims Data:
Claims reported during the year for CA only 291,720 315,558 352,182 324,143 294,615 279,211 295,905 307,403
Claims pending at year-end for CA only 59,178 62,892 70,717 63,142 58,172 55,738 56,739 57,134
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------
TABLE 1 - Auto Lines as of December 31,
(Amounts in thousands, except claims) 2000 2001 2002
- -----------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $286,057 $301,985 $333,113
PAID (CUMULATIVE) AS OF:
One year later 268,515 239,099
Two years later 332,979
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
RESERVES RE-ESTIMATED AS OF:
One year later 352,709 323,791
Two years later 354,720
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
- ------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $(68,663) $(21,806)
- ------------------------------------------------------------------
Supplemental Auto Claims Data:
Claims reported during the year for CA only 323,395 298,417 293,955
Claims pending at year-end for CA only 54,760 50,365 51,488
- -----------------------------------------------------------------------------
See Notes 8 and 16 of the Notes to Consolidated Financial Statements
15
- ----------------------------------------------------------------------------------------------------------------------------------
TABLE 2 - Homeowner and Earthquake
Lines in Runoff as of December 31,
(Amounts in thousands) 1992 1993 1994 1995 1996 1997 1998 1999
- ----------------------------------------------------------------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $38,822 $51,598 $ 203,371 $ 78,087 $ 75,272 $ 34,624 $ 52,982 $ 14,258
PAID (CUMULATIVE) AS OF:
One year later 19,982 26,936 193,887 55,738 75,100 30,232 48,848 13,103
Two years later 29,560 34,717 236,406 119,211 100,296 74,127 58,281 37,404
Three years later 33,333 37,052 295,768 139,792 142,850 82,974 81,887 83,985
Four years later 34,629 39,504 314,225 180,799 151,342 106,274 128,266
Five years later 36,041 40,550 354,324 188,987 174,513 152,592
Six years later 36,747 41,217 362,379 211,771 220,805
Seven years later 36,928 42,318 385,161 257,839
Eight years later 37,391 42,339 431,154
Nine years later 37,399 42,455
Ten years later 37,403
RESERVES RE-ESTIMATED AS OF:
One year later 36,549 41,685 253,775 116,741 101,903 77,445 58,582 18,024
Two years later 36,401 40,189 290,526 142,071 145,635 82,716 61,393 72,546
Three years later 35,740 39,657 316,256 182,616 150,434 85,519 116,429 125,089
Four years later 35,788 41,025 355,690 186,631 153,521 140,532 169,157
Five years later 36,758 41,205 359,084 190,334 208,533 193,375
Six years later 37,044 41,586 363,260 245,267 261,389
Seven years later 37,084 42,599 418,407 298,161
Eight years later 37,556 42,450 458,640
Nine years later 37,608 42,524
Ten years later 37,446
- ----------------------------------------------------------------------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $ 1,376 $ 9,074 $(255,269) $(220,074) $(186,117) $(158,751) $(116,175) $(110,831)
- ----------------------------------------------------------------------------------------------------------------------------------
(Amounts in thousands) 2000 2001 2002
- ------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $ 12,379 $ 47,305 $50,896
PAID (CUMULATIVE) AS OF:
One year later 30,706 58,274
Two years later 78,647
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
RESERVES RE-ESTIMATED AS OF:
One year later 68,245 103,470
Two years later 121,176
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
- ---------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $(108,797) $(56,165)
- ---------------------------------------------------------------
See Notes 8 and 16 of the Notes to Consolidated Financial Statements
16
Auto Lines Reserve Development. As shown in the ten-year development table, the
Company's auto lines historically were over-reserved prior to 1999 and have
exhibited adverse development for 1999, 2000 and 2001. The period from 1993 to
1999 was quite unusual in that, during that time, the Company experienced
declining frequencies and declining severities in its auto line. As Table 1
shows, management did not immediately have confidence in these declining trends
and did not immediately lower their reserve estimates.
Much of the decline in trend occurred between 1996 and 1998 because of
moderation in health care costs due to greater use of HMO's and laws that were
enacted in California that limited the ability of uninsured motorists and drunk
drivers to collect non-economic damages. During 1999, the Company assumed that
the past trend of declining frequencies and severities would continue. However,
in retrospect, it can now be seen that the favorable decline in trends ended and
loss costs began to increase. In 2000, the Company continued to underestimate
loss severity primarily because of what then seemed to be an acceleration in the
pattern of claims payments and the uncertainty inherent in identifying a change
in multi-year patterns. In 2001, the Company experienced significant,
unexpected development in its uninsured motorist coverage while the actuarial
evaluation ranges for most prior accident years were adjusted upward as more
data became available. The changes in injury trends affected the entire
California market and occurred, to a greater or lesser degree, in virtually
every state in the country.
During 2002 and 2001, the Company improved the quality and timeliness of the
data available to make initial estimates and periodic changes in estimates and
has dedicated more resources to better understand the underlying drivers of the
changes in frequency and severity trends as they begin emerging. Management
believes the decline in the need for recognition of adverse development in 2002
due to prior accident years for the personal auto lines evidences substantial
improvement in the accuracy of its estimation processes. Historically, 21st
Century actuaries have not projected a range around the carried loss reserves.
Rather, they have used several methods and different underlying assumptions to
produce a number of point estimates for the required reserves. Management
selects the carried reserve after carefully reviewing the appropriateness of the
underlying assumptions.
Homeowner and Earthquake Lines in Runoff. In Table 2, substantially all of the
indicated development relates to the earthquake line. Changes relating to the
homeowner line, which went into runoff mode in January 2002, are not significant
for any of the years shown.
In September 2000, the State of California enacted Senate Bill 1899 ("SB 1899"),
a law that affected the entire homeowners insurance industry in California, by
allowing earthquake claims barred by contract and the statute of limitations
arising from the January 17, 1994, Northridge Earthquake to be reopened during
calendar year 2001. This statute is commonly referred to as SB 1899. The
Company considers this an unprecedented and unforeseeable violation of its
contract rights as guaranteed by Article 1 of Constitution of the United States.
In Table 2, the losses created by SB 1899 have been treated as an accident year
1994 event, since they related to the 1994 earthquake, even though the law
permitting the claims to be made was not enacted until 2000 and not effective
until January 2001. Because of this treatment, Table 2 gives the appearance
that the Company's 1994 estimates continue to be wrong. This is not the case,
because it was not possible to foresee in 1994 that an unprecedented new law
would be effective in 2001, which would reopen these claims.
SB 1899 allowed a one-year window (calendar year 2001) for claimants to bring
additional insurance claims and legal actions allegedly arising out of the
January 17, 1994, Northridge Earthquake. Prior to the enactment of this law,
such claims were considered by previously applicable law to be fully barred, or
settled and closed. Any additional legal actions with respect to such claims
were barred under the policy contracts, settlement agreements, and/or applicable
17
statutes of limitation. As a result of the enactment of this unprecedented
legislation, claimants asserted additional claims against the Company allegedly
related to damages that occurred in the 1994 earthquake but which were now being
reported seven years later in 2001. Plaintiff attorneys and public adjusters
conducted extensive advertising campaigns to solicit claimants. Hundreds of
claims were filed in the final days and hours before the December 31st deadline.
During 2001, the Company recorded an additional $70 million of pre-tax losses
related to the 1994 earthquake, including $50 million in the fourth quarter of
2001 to cover the indemnity and inspection portion of the claims. The Company
lacked sufficient information to record a reasonable estimate of the related
legal defense costs until the third quarter of 2002, at which time an additional
provision of $46.9 million was recorded. In the first two quarters of 2002, an
additional $11.9 million of legal defense costs were expensed as they were paid.
Prior to the passage of SB 1899, the Company recorded significant changes in
estimates relating to the 1994 Northridge Earthquake: $57 million in 1995, $40
million in 1996, $25 million in 1997 and $40 million in 1998. Those changes
were recorded; as new information became available indicating that previous
estimates were insufficient. Smaller earthquake provisions were recorded in
1999 and 2000 as the number of cases dropped to a few remaining lawsuits. By
the end of 2000, before SB 1899 became effective in January 2001, approximately
50 earthquake claims out of an initial 35,000 homeowner earthquake claims
remained to be resolved, and fewer than 50 were in litigation.
Management has reviewed the adequacy of the remaining SB 1899 reserves at the
end of 2002. Based on that review, no further provisions were deemed to be
required as of December 31, 2002. The Company continues to caution that the
recorded estimates for earthquake loss and loss adjustment reserves resulting
from SB 1899 are subject to a greater than normal degree of uncertainty for a
variety of reasons.
First, determining in 2001 and subsequently whether alleged damage was caused or
exacerbated by a 1994 earthquake is inherently difficult. Company experts and
experts representing claimants could have materially different views of both
causation and the necessity and cost of a particular method of repair. The
purpose of the one-year time period in the policy is precisely to avoid the
problems inherent in attempting to adjust property damage claims after
substantial time has elapsed and subsequent events have occurred, such as
additional earthquakes, normal settling and cracking, poor maintenance, etc. In
the event of a difference of opinion, an expensive mediation or litigation
process is needed to obtain resolution. Results from this process, particularly
if trial by jury is involved, are subject to a wide range of possible outcomes.
Second, Company adjusters have frequently been prevented from taking recorded
statements or examinations under oath of claimants. In many instances,
subsequent statements allow adjusters to materially reduce their estimates. It
is possible that the litigation discovery process might provide similar results
for SB 1899 claims. Similarly, the Company's actions against alleged fraudulent
claimants, adjusters, or attorneys, such as the action against Unlimited
Adjusting, could favorably impact reserves if claims are proven fraudulent.
Third, more than two-thirds of the Company's remaining earthquake claims are in
litigation. Many suits seek extracontractual and punitive damages as well as
contractual damages far in excess of the Company's estimates; the Company views
such outcomes as being remote. Therefore, a reserve for potential
extracontractual or punitive damages has not been established. Extracontractual
and punitive damages, if assessed against the Company, could be material in an
individual case or in the aggregate. In addition, the Company may choose to
settle litigated cases for amounts in excess of its own estimate of contractual
damages to avoid the expense and/or risk of litigation.
18
Fourth, additional Northridge Earthquake claims have been filed in 2002 outside
of the reporting window established by SB 1899. The Company currently has
approximately 40 such claims that are apparently based on alternative legal
theories. Thus, the Company could continue to receive additional Northridge
Earthquake claims in the future that may require additional reserves.
Finally, actual expenses for legal defense costs are susceptible to a wide range
of outcomes depending on a variety of factors including plaintiff strategies,
future judicial decisions, the percentage of cases which settle, and the period
of time cases remain outstanding before settlement. The possibility of reaching
mass settlements of cases with particular attorneys or law firms presents the
opportunity to substantially reduce estimates for legal defense costs. On the
other hand, the inability to settle a substantial majority of cases for
reasonable amounts would materially increase amounts needed for legal defense
costs.
COMPETITION
The personal automobile insurance market is highly competitive and is comprised
of a large number of well-capitalized companies, many of which operate in a
number of states and offer a wider variety of products than the Company. Several
of these competitors are larger and have greater financial resources than the
Company on a stand-alone basis. Based on direct premiums written for 2001
(latest publicly available information), the Company is the seventh largest
writer of private passenger automobile insurance in California. The Company's
main competition comes from other major writers who concentrate on the good
driver market.
Market shares in California of the top ten writers of personal automobile
insurance, based on direct premiums written per A.M. Best, for the past five
years were as follows:
December 31, 2001 2000 1999 1998 1997
- --------------------------------------------------------------------
21ST CENTURY INSURANCE GROUP 6% 6% 6% 6% 6%
State Farm 13 13 14 15 16
Farmers 12 13 14 15 15
Allstate 11 10 9 8 8
California State Auto Association 10 10 10 10 11
Auto Club of Southern California 9 9 9 8 7
Mercury 8 8 8 7 7
USAA 3 3 3 3 3
GEICO 3 3 2 2 1
Progressive 2 2 3 2 2
REINSURANCE
A reinsurance transaction occurs when an insurer transfers or cedes a portion of
its exposure to a reinsurer for a premium. The reinsurance cession does not
legally discharge the insurer from its liability for a covered loss, but
provides for reimbursement from the reinsurer for the ceded portion of the risk.
The Company periodically monitors the continuing appropriateness of its
reinsurance arrangements to determine that its retention levels are reasonable
and that its reinsurers are financially sound, able to meet their obligations
under the agreements and that the contracts are competitively priced.
The majority of the Company's cessions are with AIG subsidiaries, which have
earned A.M. Best's highest financial rating of A++. The A.M. Best financial
ratings of the Company's other reinsurers range from A- to A+. The Company's
reinsurance arrangements are discussed in more detail in Note 9 of the Notes to
Consolidated Financial Statements.
19
The Company's net retention of insurance risk after reinsurance for 2003(1) and
the preceding five years is summarized below:
Contracts Incepting During
------------------------------------------
2003 2002 2001 2000 1999 1998
- -------------------------------------------------------------------------
Auto and motorcycle lines 100% 97%(2) 94% 92% 90% 90%
Personal umbrella policies(3) 10 10 16 37 36 36
Homeowner line in runoff 0 0 94 92 0 0
The Company also has catastrophe reinsurance agreements relating to the auto
line with Endurance Specialty Insurance Ltd., Folksamerica Reinsurance Company
and Transatlantic Reinsurance Company, which reinsure any covered events up to
$30.0 million in excess of $15.0 million.
STATE REGULATION OF INSURANCE COMPANIES
Insurance companies are subject to regulation and supervision by the insurance
departments of the various states. The insurance departments have broad
regulatory, supervisory and administrative powers, such as:
- - Licensing of insurance companies, agents and customer service employees
- - Prior approval, in California and some other jurisdictions, of rates, rules
and forms
- - Establishment of capital and surplus requirements and standards of solvency
- - Nature of, and limitations on, investments insurers are allowed to hold
- - Periodic examinations of the affairs of insurers
- - Annual and other periodic reports of the financial condition and results of
operations of insurers
- - Establishment of accounting rules
- - Issuance of securities by insurers
- - Restrictions on payment of dividends
- - Restrictions on transactions with affiliates
Currently, the California Department of Insurance ("CDI") has primary regulatory
jurisdiction over the Company, including prior approval of premium rates. The
CDI typically conducts a financial examination of the Company's affairs every
three years. The most recently completed triennial examination, for the three
years ended December 31, 1999, did not require the Company to restate its 1999
statutory financial statements. In general, the current regulatory requirements
in the other states in which the Company is a licensed insurer are no more
stringent than in California.
In addition to regulation by the CDI, the Company and the personal lines
insurance business in general are also subject to legislative, judicial and
political action in addition to the normal business forces of competition
between companies and the choices of consumers.
- ---------------
1 Based on programs currently in place, the Company does not expect these
retention levels to change during 2003.
2 Effective September 1, 2002, the Company entered into an agreement to
cancel future cessions under its quota share with AIG. The treaty would
have ceded 4% of premiums for the auto and motorcycle lines to AIG in the
remainder of 2002 and would have declined to 2% in 2003. After September 1,
2002, 100% of auto and motorcycle premiums are retained by the Company.
3 Personal umbrella coverage is only available to the Company's auto
customers. Approximately 1% of the auto customers have umbrella coverage.
20
To the Company's knowledge, no new laws were enacted in 2002 by any state in
which the Company does business that are expected to have a material impact on
the auto insurance industry. However, under the preceding Insurance
Commissioner, the State of California began hearings for the purpose of
implementing generic rating factors in connection with the Commissioner's
authority to approve insurance rates, including the rating of auto insurance.
The draft regulations made public by the CDI focus on restricting an insurer's
rate of return rather than on the price charged by the insurer to the consumer.
The Company believes adverse regulations could negatively affect the Company's
profitability.
HOLDING COMPANY REGULATION
The Company's subsidiaries are also subject to regulation by the CDI pursuant to
the provisions of the California Insurance Holding Company System Regulatory Act
(the "Holding Company Act"). Many transactions defined to be of an
"extraordinary" nature may not be effected without the prior approval of the
CDI. In addition, there are limits on the subsidiaries' dividend paying
capacity. An extraordinary transaction includes a dividend which, together with
other dividends or distributions made within the preceding twelve months,
exceeds the greater of (i) 10% of the insurance company's policyholders' surplus
as of the preceding December 31 or (ii) the insurance company's statutory net
income for the preceding calendar year. The California code further provides
that property and casualty insurers may pay dividends only from unassigned
surplus.
The insurance subsidiaries currently have $21.6 million of statutory unassigned
surplus that could be paid as dividends to the parent company without prior
written approval from insurance regulatory authorities in 2003. However, given
the current uncertainty surrounding the taxability of dividends received by
holding companies from their insurance subsidiaries (see further discussion in
Item 3 of this report and Note 14 of the Notes to Consolidated Financial
Statements), it is unlikely that the Company's insurance subsidiaries will make
any dividend payments to the parent in 2003. There is no assurance that the
related tax issue will be favorably resolved in the near term, in which case the
Company faces the prospect of raising additional capital at the holding company
level, cutting or ceasing dividends to stockholders, or having to pay the
additional tax on dividends from the insurance company to the holding company.
Cash and investments at the holding company were $7.0 million at December 31,
2002, compared to $52.8 million at December 31, 2001. The decline in the
parent's cash and investments is primarily due to the payment of dividends and
the repayments of intercompany balances. On December 19, 2002, the Company
declared a $1.7 million dividend to stockholders of record on December 30, 2002,
which was paid January 17, 2003. If necessary, the Company believes it can
access the capital markets should the need arise for additional capital to
support its growth and other corporate objectives.
EFFECTS OF EVENTS OF SEPTEMBER 11, 2001
The Company has no direct exposure from the events of September 11, 2001.
However, some of the Company's reinsurers do have such exposure, which could
impact their ability to meet their obligations to the Company. Based on
information received from its reinsurers, the Company does not consider any of
its reinsurance recoverables to be of doubtful collectibility.
NON-VOLUNTARY BUSINESS
Automobile liability insurers in California are required to participate in the
California Automobile Assigned Risk Plan ("CAARP"). Drivers whose driving
records or other relevant characteristics make them difficult to insure in the
voluntary market may be eligible to apply to CAARP for placement as "assigned
risks." The number of assignments for each insurer is based on the total
applications received by the plan and the insurer's market share. As of December
31, 2002, the number of assigned risk insured vehicles was 2,436 compared to
1,750 at the end of 2001. The CAARP assignments have historically produced
underwriting losses. As of December 31, 2002,
21
this business represented less than 1% of the Company's total direct premiums
written, and the underwriting losses were $0.5 million in 2002, $0.7 million in
2001 and $0.7 million in 2000.
Insurers offering homeowner insurance in California are required to participate
in the California FAIR Plan ("FAIR Plan"). FAIR Plan is a state administered
pool of difficult to insure homeowners. Each participating insurer is allocated
a percentage of the total premiums written and losses incurred by the pool
according to its share of total homeowner direct premiums written in the state.
The Company's FAIR Plan underwriting results for 2002, 2001 and 2000 were
immaterial. However, a major shortfall in FAIR Plan operations, such as might
be caused by a catastrophe, could result in an increase in costs. Participation
in the current year FAIR Plan operations is based on the pool from two years
prior. Since the Company ceased writing direct homeowners business in 2002, the
Company will continue to receive assignments in the calendar year 2003 and 2004.
EMPLOYEES
The Company had approximately 2,600 full and part-time employees at December 31,
2002. The Company provides medical, pension and 401(k) savings plan benefits to
eligible employees, according to the provisions of each plan. The Company
believes that its relationship with its employees is good.
ITEM 2. PROPERTIES
The Company leases approximately 400,000 square feet of office space for its
headquarters facilities, which are located in Woodland Hills, California. The
lease term expires in February 2015, and the lease may be renewed for two
consecutive five-year periods.
The Company also leases office space in 14 other locations, of which 9 locations
are in California primarily for claims-related employees. The Company
anticipates no difficulty in extending these leases or obtaining comparable
office facilities in suitable locations.
On December 31, 2002, the Company entered into a sale-leaseback transaction for
$15.8 million of equipment and leasehold improvements and $44.2 million of
software. The leaseback transaction has been accounted for as a capital lease.
For a summary of the Company's lease obligations, see discussion under Item 7 of
this report and Notes 7 and 11 of the Notes to Consolidated Financial
Statements.
ITEM 3. LEGAL PROCEEDINGS
In the normal course of business, the Company is named as a defendant in
lawsuits related to claim and insurance policy issues, both on individual policy
files and by class actions seeking to attack the use of various databases,
vendors and claims practices generally. Many suits seek generally unspecified
extracontractual and punitive damages as well as contractual damages far in
excess of the Company's estimates. The Company cannot estimate the amount or
range of loss that could result from an unfavorable outcome on these suits. It
denies liability for any such alleged damages and believes that it has a number
of valid defenses to the litigation. The Company has not established reserves
for potential extracontractual or punitive damages, or for damages in excess of
estimates the Company believes are correct and reasonable. Nevertheless,
extracontractual and punitive damages, if assessed against the Company, could be
material in an individual case or in the aggregate. The Company may choose to
settle litigated cases for amounts in excess of its own estimate of contractual
damages to avoid the expense and/or risk of litigation. Other than possibly for
the contingencies discussed below, the Company does not believe the ultimate
outcome of these matters will be material to its results of operations,
financial condition or cash flows.
22
On December 9, 2002, the Company commenced an arbitration proceeding against
Computer Sciences Corporation ("CSC") arising out of CSC's obligation to provide
insurance company information technology software and other software programs to
the Company. CSC has filed a counterclaim in the proceeding. In the third
quarter of 2002, the Company wrote off $37.2 million of its investment in CSC
software. The arbitration will be conducted by the American Arbitration
Association.
Bryan Speck, individually, and on behalf of others similarly situated v. 21st
- -----------------------------------------------------------------------------
Century Insurance Company, 21st Century Casualty Company, and 21st Century
- --------------------------------------------------------------------------
Insurance Group, was filed on June 20, 2002 in Los Angeles Superior Court. The
- ---------------
plaintiff seeks national class action certification, injunctive relief, and
unspecified actual and punitive damages. The complaint contends that 21st
Century uses "biased" software in determining the value of total-loss
automobiles. The plaintiff alleges that database providers use improper
methodology to establish comparable auto values and populate their databases
with biased figures. 21st Century and other carriers allegedly subscribe to the
programs to unfairly reduce claim costs. This case is consolidated with similar
actions against other insurers for discovery and pre-trial motions. 21st
Century intends to vigorously defend the suit with other defendants in the
coordinated proceedings.
Thomas Theis, on his own behalf and on behalf of all others similarly situated
- ------------------------------------------------------------------------------
v. 21st Century Insurance, was filed on June 17, 2002 in Los Angeles Superior
- -------------------------
Court. Plaintiff seeks national class action certification, injunctive relief
and unspecified actual and punitive damages. The complaint contends that after
insureds receive medical treatment, 21st Century uses a medical-review program
to adjust expenses to reasonable and necessary amounts for a given geographic
area. The plaintiff alleges that the adjusted amount is "predetermined" and
"biased," creating an unfair pretext for reducing claim costs. This case is
consolidated with similar actions against other insurers for discovery and
pre-trial motions. 21st Century intends to vigorously defend the suit with
other defendants in the coordinated proceedings.
On October 10, 2002, a Los Angeles Superior Court granted the Company's motion
for summary judgment in the matter of 21st Century Insurance Company vs. People
of the State of California ex rel. Bill Lockyer, Attorney General et al. The
court determined that the Company's April 21, 1999, settlement with the
California Department of Insurance ("CDI") with respect to regulatory actions
arising out of the 1994 Northridge Earthquake was fully valid and enforceable.
The Court denied the Attorney General's motion seeking to have the settlement
declared void and unenforceable, a result that may have allowed the CDI to
reinstitute regulatory proceedings with respect to the Company's handling of
claims arising out of the 1994 Northridge Earthquake. The CDI has appealed the
ruling.
SB 1899, effective from January 1, 2001, to December 31, 2001, allowed the
re-opening of previously closed earthquake claims arising out of the 1994
Northridge Earthquake. The Company's first constitutional challenge to SB 1899
came to an unsuccessful result on April 29, 2002, when the United States Supreme
Court refused to hear the Company's case (see Note 16 of the Notes to
Consolidated Financial Statements). A subsidiary of the Company, 21st Century
Casualty Company, filed a new challenge to the constitutionality of SB 1899 on
February 13, 2003. The viability of this case is being reviewed as a result of a
subsequent Ninth Circuit Court of Appeals decision. The Company currently has
lawsuits pending against it in connection with claims under SB 1899; many of
these lawsuits have multiple plaintiffs. Damages in excess of the Company's
reasonable estimates for these claims could be material individually or in the
aggregate.
The Company has filed a civil complaint against California-based Unlimited
Adjusting Company ("Unlimited") and its principal Jung Ho Park ("John Park").
The suit alleges Unlimited and John Park illegally induced insureds into filing
additional unnecessary and fraudulent claims with the
23
Company stemming from the 1994 Northridge Earthquake. The Company is ultimately
seeking up to $10 million in compensatory damages.
In December of 2000, a statute that allowed a tax deduction for the dividends
received from wholly owned insurance subsidiaries was held unconstitutional on
the grounds that it discriminated against out-of-state insurance holding
companies. Subsequent to the court ruling, the staff of the California
Franchise Tax Board ("FTB") has decided to take the position that the
discriminatory sections of the statute are not severable and the entire statute
is invalid. As a result, the FTB is disallowing dividend-received deductions
for all insurance holding companies, regardless of domicile, for open tax years
ending on or after December 1, 1997. Although the FTB has not made a formal
assessment for tax years 1997 through 2000, the Company anticipates a
retroactive disallowance that would result in additional tax assessments.
The amount of any such possible assessments and the ultimate amounts, if any,
that the Company may be required to pay, are subject to a wide range of
estimates because so many ostensibly long-settled aspects of California tax law
have been thrown into disarray and uncertainty by the action of the courts. In
the absence of legislative relief, years of future litigation may be required to
determine the ultimate outcome. The range of possible loss, net of federal tax
benefit, ranges from close to zero to approximately $20.8 million depending on
which position future courts may decide to uphold or on whether the California
legislature may decide to enact corrective legislation. The Company believes it
has adequately provided for this contingency.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
(a) PRICE RANGE OF COMMON STOCK
The following table sets forth the high and low bid prices for the common stock
for the indicated periods.
2002 2001
HIGH LOW High Low
- ----------------------------------------------
Fourth Quarter $14.24 $ 9.60 $19.45 $14.43
Third Quarter 19.67 9.15 19.33 16.20
Second Quarter 21.80 17.70 18.44 15.99
First Quarter 19.50 15.82 18.66 13.26
(b) HOLDERS OF COMMON STOCK
The approximate number of holders of common stock on December 31, 2002 was 617.
(c) DIVIDENDS
Quarterly dividends of $0.16 per share were paid for the first and second
quarters of 2000. Dividends of $0.08 per share were paid from the third quarter
of 2000 through the third quarter of 2002. The dividend for the fourth quarter
of 2002 was lowered to $0.02 per share.
The Company's Board of Directors considers a variety of factors in determining
the timing and amount of dividends. Accordingly, the Company's past history of
dividend payments does not assure that future dividends will be paid.
24
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data presented below as of the end of and for each of the
years in the five-year period ended December 31, 2002, are derived from, or
supplemental to, the Company's consolidated financial statements. The
consolidated financial statements as of December 31, 2002 and 2001, and for each
of the years in the three-year period ended December 31, 2002, are included in
Item 8 of this report.
All amounts set forth in the following tables are in thousands, except for
ratios and per share data.
Years Ended December 31, 2002 2001 2000 1999 1998
- -------------------------------------------------------------------------------------
PERSONAL AUTO LINES DATA
Direct premiums written $995,794 $898,862 $881,212 $ 855,783 $ 860,811
Ceded premiums written(1) (18,902) (56,205) (72,675) (86,974) (87,453)
- -------------------------------------------------------------------------------------
Net premiums written 976,892 842,657 808,537 768,809 773,358
Net premiums earned 924,559 838,489 803,770 770,234 773,158
Loss and LAE ratio(2) 82.9% 88.1% 90.8% 77.4% 74.8%
Expense ratio - GAAP(3) 15.6 14.9 14.2 12.3 10.5
- -------------------------------------------------------------------------------------
Combined ratio(4) 98.5% 103.0% 105.0% 89.7% 85.3%
- -------------------------------------------------------------------------------------
ALL LINES DATA
Direct premiums written $998,248 $929,315 $910,720 $ 880,531 $ 885,617
Ceded premiums written(5) (32,949) (60,359) (78,592) (111,718) (111,904)
- -------------------------------------------------------------------------------------
Net premiums written 965,299 868,956 832,128 768,813 773,713
Net premiums earned 924,559 864,145 825,486 770,423 772,864
Total revenues 981,295 914,078 869,762 832,681 870,650
Loss and LAE ratio 89.4% 96.7% 90.8% 78.6% 81.0%
Expense ratio - GAAP(3) 15.5 15.0 14.4 12.9 10.2
- -------------------------------------------------------------------------------------
Combined ratio(6) 104.9% 111.7% 105.2% 91.5% 91.2%
- -------------------------------------------------------------------------------------
NET (LOSS) INCOME $(12,256) $(27,568) $ 12,945 $ 87,528 $ 101,072
(LOSS) EARNINGS PER SHARE
Basic $ (0.14) $ (0.32) $ 0.15 $ 1.00 $ 1.36
Diluted (0.14) (0.32) 0.15 1.00 1.19
DIVIDENDS DECLARED AND PAID 0.26 0.32 0.48 0.64 0.58
- ------------------------------
1 The decrease in premiums ceded from 1999 through 2002 was caused primarily
by scheduled decreases in the AIG quota share program, which was terminated
effective September 1, 2002.
2 The loss and LAE ratios for 2002 and 2001 have decreased primarily due to
increases in net premiums earned and the favorable impact on claim
frequency of drought conditions that have largely prevailed in southern
California over the past 24 months.
3 The increase in the 2002 expense ratio is primarily due to increased
acquisition costs in advertising and staffing. The increase in the expense
ratio from 1998 to 2001 reflects higher depreciation charges due to
investments in new technology and the effects of rate decreases taken in
1997 to 1999.
4 The combined ratio for the personal auto lines was impacted by the
following items: $13.6 million of costs associated with workforce
reductions and the settlement of litigation matters in 2001; Year 2000
remediation costs of $2.4 million in 1999 and $5.7 million in 1998;
acceleration of restricted stock grants of $2.0 million in 1998; and
unfavorable (favorable) prior accident year loss and LAE development of
$16.2 million, $45.7 million, $42.2 million, $(14.2) million and $(39.5)
million in 2002, 2001, 2000, 1999 and 1998, respectively.
5 In addition to the AIG cession discussed in Note 1 above, the Company's
homeowners line was 100% reinsured in 1998, 1999 and 2002.
6 In addition to the effect of the items described in footnote 2 above, the
combined ratio for all lines was impacted by underwriting losses from the
homeowner and earthquake lines, which are in runoff, of $58.8 million in
2002, $77.6 million in 2001, $2.7 million in 2000, $13.1 million in 1999
and $45.5 million in 1998.
25
DECEMBER 31, 2002 2001 2000 1999 1998
- ---------------------------------------------------------------------------------------
BALANCE SHEET DATA:
Total investments and cash $1,030,478 $ 884,633 $ 920,327 $ 988,578 $1,068,621
Total assets 1,470,037 1,354,398 1,340,916 1,383,076 1,593,156
Unpaid losses and loss
adjustment expenses 384,009 349,290 298,436 276,248 382,003
Unearned premiums 266,477 236,473 236,519 232,702 233,689
Debt(1) 60,000 - - 67,500 112,500
Total liabilities 814,429 695,092 620,355 662,239 807,554
Stockholders' equity 655,608 659,306 720,561 720,837 785,602
Book value per common
share 7.67 7.72 8.46 8.39 8.97
Statutory surplus(2) 397,381 393,119 475,640 581,440 600,654
Net premiums written to
surplus ratio(3) 2.4:1 2.2:1 1.7:1 1.3:1 1.3:1
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FINANCIAL CONDITION
Investment-grade bonds comprised 99.9% of the fair value of the fixed-maturity
portfolio at December 31, 2002. The Company has no investments in equity
securities as of December 31, 2002. Of the Company's total investments at
December 31, 2002, approximately 54.5% were invested in tax-exempt, fixed-income
securities, compared to 80.2% at December 31, 2001. The Company has begun
shifting its investment focus to investment-grade taxable bonds to accelerate
the realization of the tax benefit of its net operating loss deduction (see
Critical Accounting Policies - Deferred Income Taxes).
As of December 31, 2002, the pre-tax net unrealized gain on investments was
$38.5 million compared to a pre-tax net unrealized loss of $1.5 million at
December 31, 2001. This change is primarily due to declining market interest
rates. The Company's policy is to investigate on a quarterly basis any
investment for possible "other-than-temporary" impairment in the event the fair
value of the security falls below its amortized cost, based on all relevant
facts and circumstances (see further discussion under Critical Accounting
Policies - Investments).
Premiums receivable were $91.0 million at December 31, 2002, compared to $75.6
million at December 31, 2001, with the increase mainly attributable to growth in
the Company's customer base and higher premium rates. Company policy is to
write-off receivable balances when they become past due 180 days, and the
Company historically has not considered an allowance for doubtful accounts to be
necessary.
Prepaid reinsurance premiums and reinsurance payables were $1.9 million and $5.0
million at December 31, 2002, compared to $15.4 million and $13.0 million at
December 31, 2001, respectively. The decline in balances is primarily due to
the cancellation of the quota share treaty with AIG subsidiaries (see Note 9 to
the Notes to Consolidated Financial Statements).
Increased advertising and other costs through December 31, 2002, associated with
increased customer volume, contributed to an increase in deferred policy
acquisitions costs (DPAC) of
- ------------------------------
1 Amount shown for 2002 is a capital lease obligation (see Note 7 of the
Notes to Consolidated Financial Statements).
2 Amount shown for 2002 would be $343,661 were it not for the sale-leaseback
transaction described in Note 7 of the Notes to Consolidated Financial
Statements.
3 Amount shown for 2002 would be 2.8:1 were it not for the sale-leaseback
transaction referred to above.
26
$15.6 million compared to the balance at December 31, 2001. The Company's DPAC
is estimated to be fully recoverable (see Critical Accounting Policies -
Deferred Policy Acquisition Costs).
Leased property under capital lease and obligation under capital lease increased
$53.7 million and $60.0 million, respectively, as a result of a sale-leaseback
transaction the Company entered in December 2002 (see Note 7 to the Notes to
Consolidated Financial Statements). The purpose of the transaction was to
increase the statutory surplus of 21st Century Insurance Company, the Company's
primary wholly owned subsidiary.
Property and equipment decreased $91.4 million primarily due to the
sale-leaseback described above and the write-off of certain software in the
third quarter of 2002 (see Critical Accounting Policies - Property and Equipment
and Note 7 to the Notes to Consolidated Financial Statements). The results of
management's fourth-quarter 2002 recoverability test indicated that the
remaining carrying value of the Company's software under development is likely
to be recoverable from future operations (see Critical Accounting Policies -
Property and Equipment).
Unpaid losses and loss adjustment expenses ("LAE") increased $34.7 million for
the year ended December 31, 2002 primarily due to the increase in reserves for
SB 1899 Northridge Earthquake legal defense costs (see further discussion below
under Underwriting Results - Homeowner and Earthquake Lines in Runoff and Note
16 to the Notes to Consolidated Financial Statements) and increases in auto
reserves. As indicated in the following table, the Company's auto reserves,
gross of reinsurance, have increased $31.1 million in the year ended December
31, 2002:
AMOUNTS IN THOUSANDS 2002 2001
December 31, GROSS NET Gross Net
- ------------------------------------------------------------------
Unpaid Losses and LAE
Personal auto lines $333,113 $320,032 $301,985 $280,781
Homeowner and earthquake 50,896 43,626 47,305 44,997
- ------------------------------------------------------------------
Total $384,009 $363,658 $349,290 $325,778
- ------------------------------------------------------------------
The $ 31.1 million increase in the gross auto reserves for the year ended
December 31, 2002, comprises $4.9 million due to the consolidation of 21st of
Arizona, growth in reserves attributable to the higher number of insured
automobiles of approximately $9.0 million, approximately $7.3 million relating
to the effects of higher average loss costs and approximately $9.9 million for
strengthening of prior accident year reserves (see further discussion under
Critical Accounting Policies - Losses and Loss Adjustment Expenses).
27
The following table summarizes the provision for losses and LAE, net of
applicable reinsurance, for the periods indicated:
AMOUNTS IN THOUSANDS
YEARS ENDED DECEMBER 31, 2002 2001 2000
- -----------------------------------------------------------------------------
Net Losses and LAE incurred related to insured
events of:
Auto lines
Current year $752,077 $692,593 $687,534
Prior years 16,200 45,742 42,178
- -----------------------------------------------------------------------------
Subtotal auto lines 768,277 738,335 729,712
- -----------------------------------------------------------------------------
Homeowner lines
Current year 2,222 25,636 16,831
Prior years 3,519 1,952 (545)
- -----------------------------------------------------------------------------
Subtotal homeowner lines 5,741 27,588 16,286
- -----------------------------------------------------------------------------
Earthquake
Current year - - -
Prior years 52,639 70,313 3,390
- -----------------------------------------------------------------------------
Subtotal earthquake 52,639 70,313 3,390
- -----------------------------------------------------------------------------
All lines
Current year 754,299 718,229 704,365
Prior years 72,358 118,007 45,023
- -----------------------------------------------------------------------------
Total $826,657 $836,236 $749,388
- -----------------------------------------------------------------------------
Management believes that, given the inherent variability in the estimates, the
Company's reserves are within a reasonable and acceptable range of adequacy.
However, because reserve estimates are necessarily subject to the outcome of
future events, changes in estimates are unavoidable in the property and casualty
insurance business given that loss trends vary and timing is required for
changes in trends to be recognized and confirmed. These changes sometimes are
referred to as "loss development" or "reserve development." The changes in
estimates relating to the auto lines in 2002 were smaller than in 2001 and 2000
as the changes in loss trends were identified and reserved for. The changes in
estimates relating to auto lines in 2000 for development in prior accident years
primarily resulted from the Company's assumption that the multi-year favorable
trend would continue through 1999.
The Company's reported earnings could be significantly different if ending
reserves were based on assumptions and estimates different from those used by
management (see further discussion in Part 1 of this report under the heading
Loss and Loss Adjustment Expense Reserves). During 2002 and 2001, the Company
improved the quality and timeliness of the data available to make initial
estimates and periodic changes in estimates and has dedicated more resources to
understand better the underlying drivers of the changes in frequency and
severity trends as they begin emerging. Management believes the decline in the
need for recognition of adverse development in 2002 due to prior accident years
for the personal auto lines evidences substantial improvement in the accuracy of
its estimation processes. Historically, 21st Century actuaries have not
projected a range around the carried loss reserves. Rather, they have used
several methods and different underlying assumptions to produce a number of
point estimates for the required reserves. Management selects the carried
reserve after carefully reviewing the appropriateness of the underlying
assumptions.
28
Stockholders' equity and book value per share decreased to $655.6 million and
$7.67 at December 31, 2002, compared to $659.3 million and $7.72 at December 31,
2001. The decrease for the year ended December 31, 2002, was primarily due to a
net loss of $12.3 million and dividends to stockholders of $22.2 million, offset
in part by the increase in net unrealized investment gains of $29.9 million and
other changes in comprehensive income of $0.9 million.
LIQUIDITY AND CAPITAL RESOURCES
Holding Company. The parent company's main sources of liquidity historically
have been dividends received from its insurance subsidiaries and proceeds from
issuance of debt or equity securities. The parent company currently has no
indebtedness for borrowed money outstanding, although it has guaranteed a
subsidiary's capital lease obligation. The parent's only equity security
currently outstanding is its common stock, which has no mandatory dividend
obligations.
Cash and investments at the holding company were $7.0 million at December 31,
2002, compared to $52.8 million at December 31, 2001. The decline in the
parent's cash and investments is primarily due to the payment of dividends and
the repayments of intercompany balances. On December 19, 2002, the Company
declared a $1.7 million dividend to stockholders of record on December 30, 2002,
which was paid January 17, 2003. If necessary, the Company believes it can
access the capital markets should the need arise for additional capital to
support its growth and other corporate objectives. The Company's S&P claims
paying rating currently is A+, and its A.M. Best rating is A+.
The insurance subsidiaries currently have $21.6 million of statutory unassigned
surplus that could be paid as dividends to the parent company without prior
written approval from insurance regulatory authorities in 2003. However, given
the current uncertainty surrounding the taxability of dividends received by
holding companies from their insurance subsidiaries (see further discussion in
Item 3 of this report and Note 14 of the Notes to Consolidated Financial
Statements), it is unlikely that the Company's insurance subsidiaries will make
any dividend payments to the parent in 2003. There is no assurance that the
related tax issue will be favorably resolved in the near term, in which case the
Company faces the prospect of raising additional capital at the holding company
level, cutting or ceasing dividends to stockholders, or having to pay the
additional tax on dividends on the insurance company to the holding company.
Insurance Subsidiaries. The Company believes it has taken the proper actions to
restore underwriting profitability in its core auto insurance operations and has
thereby enhanced its liquidity. In California, the Company implemented a 5.7%
auto premium rate increase on May 6, 2002, and has received approval for a 3.9%
auto premium rate increase, which it expects to implement in March 2003.
Average loss costs in 2002 have increased at an overall rate of approximately
4.0% over 2001, although this rate may have been somewhat higher but for the
favorable impact on claim frequency of drought conditions that have largely
prevailed in southern California over the past 24 months. There can be no
assurance that insurance regulators will grant future rate increases that may be
necessary to offset possible future increases in claims cost trends. Also, the
Company remains exposed to possible upward development in previously recorded
reserves for SB 1899 claims as previously discussed. As a result of such
uncertainties, underwriting losses could recur in the future. Further, the
Company could be required to liquidate investments to pay claims, possibly
during unfavorable market conditions, which could lead to the realization of
losses on sales of investments. Adverse outcomes to any of the foregoing
uncertainties would create some degree of downward pressure on the insurance
subsidiaries, which in turn could negatively impact the Company's liquidity.
As of December 31, 2002, the Company's insurance subsidiaries had a combined
statutory surplus of $397.4 million compared to $393.1 million at December 31,
2001. Significant changes in surplus were a decrease in nonadmitted assets of
$48.8 million, primarily due to the sale-
29
leaseback of $53.7 million fixed assets discussed above. Partially offsetting
this was a statutory net loss of $39.8 million and a $7.0 million decrease in
the admitted portion of the statutory deferred tax asset. The statutory net loss
for the year ended December 31, 2001 was $53.2 million compared to statutory net
income of $11.1 million for 2000. The Company's ratio of net premiums written
to surplus was 2.4 for the twelve month period ended December 31, 2002, compared
to 2.2 and 1.7 for the years ended December 31, 2001 and 2000, respectively.
On October 23, 2002, the CDI finalized its examination report on the 1999
statutory financial statements for the Company's California-domiciled insurance
subsidiaries. The report did not require the insurance subsidiaries to restate
those financial statements.
The Company has not identified any other trends, demands, commitments, events or
uncertainties that have or are considered to have a reasonable possibility of
having a material impact on the Company's liquidity.
Obligations, Letters of Credit, Guarantees and Transactions with Related
Parties. The Company currently has a capital lease obligation resulting from the
sale-leaseback transaction discussed earlier. The lease includes a covenant
that if AIG ceases to have a majority interest in the Company, or if statutory
surplus falls below $300.0 million, or if the net premiums written to surplus
ratio is greater than 3.8:1, the Company will either deliver a letter of credit
to the lessor or pay the lessor the then outstanding balance, including a
prepayment penalty of up to 3%. The Company also has operating leases for its
office facilities.
Future cash payments required under all the Company's lease obligations are
summarized below (in millions):
Capital
Lease Operating
For the years ended December 31, Obligation Leases Total
- -----------------------------------------------------------------
2003 $ 12.8 $ 17.1 $ 29.9
2004 14.0 16.3 30.3
2005 14.0 15.7 29.7
2006 14.0 14.2 28.2
2007 14.0 12.7 26.7
2008 and thereafter - 92.9 92.9
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$ 68.8 $ 168.9 $237.7
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The Company currently has no unused letters of credit and has issued no
guarantees on behalf of others, and has no trading activities involving
non-exchange-traded contracts accounted for at fair value. The Company has
entered into no material transactions with related parties other than the
reinsurance transactions with AIG subsidiaries. At December 31, 2002 and 2001,
reinsurance recoverables, net of payables, from AIG subsidiaries were $18.4
million and $38.8 million, respectively.
The Company has no long-term debt obligations, purchase obligations or other
long-term liabilities on its balance sheet. In addition, the Company has no
retained interests in assets transferred to an unconsolidated entity, and no