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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
Commission File Number 0-6964
21ST CENTURY INSURANCE GROUP
(Exact name of registrant as specified in its charter)
DELAWARE 95-1935264
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6301 OWENSMOUTH AVENUE
WOODLAND HILLS, CALIFORNIA 91367
(Address of principal executive offices) (Zip Code)
(818) 704-3700 WWW.21ST.COM
(Registrant's telephone number, including area code) (Registrant's web site)
SECURITIES REGISTERED PURSUANT TO SECTION 12 (B) OF THE ACT:
NAME OF EACH EXCHANGE ON
TITLE OF EACH CLASS WHICH REGISTERED
--------------------- ----------------
Common Stock, Par Value $0.001 New York Stock Exchange
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark 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 is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
The aggregate market value of the voting stock held by non-affiliates of 21st
Century Insurance Group, based on the average high and low prices for shares of
the registrant's Common Stock on June 30, 2003, as reported by the New York
Stock Exchange, was approximately $350,000,000.
There were 85,435,505 shares of common stock outstanding on January 30, 2004.
DOCUMENT INCORPORATED BY REFERENCE:
Part III of this Form 10-K incorporates by reference certain information from
the registrant's definitive proxy statement for the Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission within 120
days after the close of the year ended December 31, 2003.
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
Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Servicing of Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Claims. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Growth and Profitability Objectives . . . . . . . . . . . . . . . . . . . . . 10
Underwriting Expense Ratio - Personal Auto Lines. . . . . . . . . . . . . . . 10
Loss and Loss Adjustment Expense Reserves . . . . . . . . . . . . . . . . . . 11
Estimating the Frequency of Auto Accidents. . . . . . . . . . . . . . . . . 11
Estimating the Severity of Auto Claims. . . . . . . . . . . . . . . . . . . 12
Estimating Loss and LAE for Lines in Runoff . . . . . . . . . . . . . . . . 12
Loss and Reserve Development. . . . . . . . . . . . . . . . . . . . . . . . . 12
Auto Lines Reserve Development. . . . . . . . . . . . . . . . . . . . . . . 16
Homeowner and Earthquake Lines in Runoff. . . . . . . . . . . . . . . . . . 16
Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
State Regulation of Insurance Companies . . . . . . . . . . . . . . . . . . . 18
Holding Company Regulation. . . . . . . . . . . . . . . . . . . . . . . . . . 18
Non-Voluntary Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Employees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Debt Offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Item 2. Properties. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Item 4. Submission of Matters to a Vote of Security Holders . . . . . . . . . . 20
Part II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters. . 20
Item 6. Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . 21
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . 22
Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Financial Condition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Liquidity and Capital Resources . . . . . . . . . . . . . . . . . . . . . . . 24
21st Century Insurance Group. . . . . . . . . . . . . . . . . . . . . . . . 24
Insurance Subsidiaries. . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Transactions with Related Parties . . . . . . . . . . . . . . . . . . . . . 25
Contractual Obligations and Commitments . . . . . . . . . . . . . . . . . . . 25
Off Balance Sheet Arrangements. . . . . . . . . . . . . . . . . . . . . . . . 26
Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Underwriting Results. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Personal Auto . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Homeowner and Earthquake Lines in Runoff. . . . . . . . . . . . . . . . . . 28
Loss and LAE Incurred . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1
Page
Description Number
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Investment Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Other Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Write-off of Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Critical Accounting Policies. . . . . . . . . . . . . . . . . . . . . . . . . 30
Losses and Loss Adjustment Expenses . . . . . . . . . . . . . . . . . . . . 31
Property and Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Income Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Deferred Policy Acquisition Costs . . . . . . . . . . . . . . . . . . . . . 32
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Stock-Based Compensation. . . . . . . . . . . . . . . . . . . . . . . . . . 35
New Accounting Pronouncements . . . . . . . . . . . . . . . . . . . . . . . . 35
Forward-Looking Statements. . . . . . . . . . . . . . . . . . . . . . . . . . 35
Item 7A. Quantitative and Qualitative Disclosures about Market Risk . . . . . . 37
Item 8. Financial Statements and Supplementary Data. . . . . . . . . . . . . 38
Report of Independent Auditors. . . . . . . . . . . . . . . . . . . . . . . . 38
Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . 39
Notes to Consolidated Financial Statements. . . . . . . . . . . . . . . . . . 43
Note 1. Description of Business. . . . . . . . . . . . . . . . . . . . . . 43
Note 2. Summary of Significant Accounting Policies . . . . . . . . . . . . 43
Note 3. Earnings (Loss) per Common Share . . . . . . . . . . . . . . . . . 47
Note 4. Investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Note 5. Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Note 6. Deferred Policy Acquisition Costs. . . . . . . . . . . . . . . . . 50
Note 7. Property and Equipment . . . . . . . . . . . . . . . . . . . . . . 51
Note 8. Unpaid Losses and Loss Adjustment Expenses . . . . . . . . . . . . 51
Note 9. Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Note 10. Reinsurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Note 11. Employee Benefit Plans . . . . . . . . . . . . . . . . . . . . . . 56
Note 12. Commitments and Contingencies. . . . . . . . . . . . . . . . . . . 58
Note 13. Capital Stock. . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Note 14. Stock-Based Compensation . . . . . . . . . . . . . . . . . . . . . 62
Note 15. Statutory Financial Data . . . . . . . . . . . . . . . . . . . . . 64
Note 16. Northridge Earthquake. . . . . . . . . . . . . . . . . . . . . . . 65
Note 17. Unaudited Quarterly Results of Operations. . . . . . . . . . . . . 66
Note 18. Results of Operations by Line of Business. . . . . . . . . . . . . 67
Note 19. 21st Century Insurance Company of Arizona. . . . . . . . . . . . . 68
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure. . . . . . . . . . . . . . . . . . . . . . . . . 69
Item 9A. Controls and Procedures. . . . . . . . . . . . . . . . . . . . . . . . 69
Part III. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
Item 10. Directors and Executive Officers of the Registrant . . . . . . . . . 69
Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . 70
Item 12. Security Ownership of Certain Beneficial Owners and Management . . . 70
Item 13. Certain Relationships and Related Transactions . . . . . . . . . . . 70
Item 14. Principal Accountant Fees and Services . . . . . . . . . . . . . . . 70
Part IV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K. . . 70
Schedule II - Condensed Financial Information of Registrant . . . . . . . . 74
Signatures of Officers and Board of Directors . . . . . . . . . . . . . . . 78
2
Exhibits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
4.1 Indenture, dated December 9, 2003, between 21st Century Insurance
Group and The Bank of New York, as trustee.
4.2 Exchange and Registration Rights Agreement, dated December 9, 2003.
10(i) 2003 Short Term Incentive Plan.
10(l) Lease Agreements for Registrant's Principal Offices substantially in
the form of this Exhibit.
10(m) Forms of Amended and Restated Stock Option Agreements.
10(n) Form of Restricted Shares Agreement.
10(o) Retention Agreements substantially in the form of this Exhibit for
executives Richard A. Andre, Michael J. Cassanego, G. Edward Combs,
Carmelo Spinella and Dean E. Stark.
10(p) Sale and Leaseback Agreement between 21st Century Insurance Company
and General Electric Capital Corporation, for itself, and as agent for
Certain Participants, as amended, dated December 31, 2002.
14 Code of Ethics.
21 Subsidiaries of Registrant.
23 Consent of Independent Auditors.
31.1 Certification of President and Chief Executive Officer Pursuant to
Exchange Act Rule 13a-14(a).
31.2 Certification of Chief Financial Officer Pursuant to Exchange Act Rule
13a-14(a).
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
3
PART I
ITEM 1. BUSINESS
GENERAL
21st Century Insurance Group (together with its subsidiaries, referred to
hereinafter as the "Company", "we", "us" or "our") is an insurance holding
company registered on the New York Stock Exchange (NYSE: TW).
We primarily market and underwrite personal automobile, motorcycle, and umbrella
insurance in California. We also provide personal automobile insurance in four
other western states (Arizona, Nevada, Oregon and Washington) and three
midwestern states (Illinois, Indiana and Ohio). We began offering personal auto
insurance in Illinois, Indiana and Ohio on January 28, 2004(1). Twenty-four
hours per day, 365 days a year, customers have the option to purchase insurance,
service their policy or report a claim over the phone directly through our
centralized licensed insurance agents at 1-800-211-SAVE or through our full
service Internet site at www.21st.com. We believe that we have a reputation for
high quality customer service and for being among the most efficient and lowest
cost providers of personal auto insurance in the markets we serve.
The Company was founded in 1958, and until recently was incorporated in
California. Effective December 4, 2003, we were reincorporated under the laws of
the State of Delaware. Several subsidiaries of American International Group,
Inc. (hereinafter referred to as "AIG") together currently own approximately 63%
of our outstanding common stock.
Copies of our 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
We write private passenger automobile insurance primarily in California (97% of
policyholders Our remaining business is written in Arizona, Nevada, Oregon and
Washington.
- -----------
1 Results from these markets are not expected to be material in 2004.
4
The following table presents a geographical summary of our direct premiums
written for the past five years (in millions):
Direct Premiums Written
- ------------------------------------------------------------------------
Years Ended December 31, 2003 2002 2001 2000 1999
- ------------------------------------------------------------------------
Personal auto lines(1)
California $1,189.5 $967.3 $879.4 $861.6 $848.9
Arizona(2) 21.2 13.0 - - -
Nevada 6.7 8.1 8.9 7.7 2.7
Oregon 1.4 1.6 2.0 2.2 0.8
Washington 4.6 5.8 8.5 9.7 3.4
- ------------------------------------------------------------------------
Total personal auto lines 1,223.4 995.8 898.8 881.2 855.8
- ------------------------------------------------------------------------
Lines in runoff
Homeowner(3) and Earthquake(4) 0.1 2.4 30.5 29.5 24.7
- ------------------------------------------------------------------------
Total $1,223.5 $998.2 $929.3 $910.7 $880.5
- ------------------------------------------------------------------------
The table below summarizes the concentrations of our California vehicles in
force for the voluntary personal auto lines excluding personal umbrella and
motorcycle coverages as of the end of each of the past five years. Our
California market share reflects a weighted distribution that tracks the
concentration of households and population. At the end of 2003, 32% of the
vehicles insured by us were garaged in Los Angeles County. In comparison, data
from the California Department of Motor Vehicles indicates that 27% of its
registrations were for vehicles in Los Angeles County.
Concentration of
Voluntary Personal Auto Lines California Vehicles in Force
- ---------------------------------------------------------------------------
December 31, 2003 2002 2001 2000 1999
- ---------------------------------------------------------------------------
Los Angeles County 32.3% 37.2% 42.0% 43.6% 45.2%
San Diego County 13.5 13.4 13.4 12.6 12.3
Southern California excluding Los
Angeles and San Diego Counties(5) 21.4 23.5 25.9 26.5 26.8
Central and Northern California(6) 32.8 25.9 18.7 17.3 15.7
- ---------------------------------------------------------------------------
100.0% 100.0% 100.0% 100.0% 100.0%
- ---------------------------------------------------------------------------
TYPES AND LIMITS OF INSURANCE COVERAGE
Our 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 our 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 claims when our policyholder causes an
accident. Uninsured and underinsured motorist are optional coverages and cover
our 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
- ------------
1 Includes motorcycle and personal umbrella coverages, which are immaterial
for all periods presented.
2 Excludes amounts not consolidated prior to our acquisition of a majority of
the voting interests in 21st of Arizona: $12.8 million in 2001; $14.7
million in 2000; and $12.9 million in 1999.
3 We no longer have any California homeowner policies in force. See further
discussion in Item 7 under the caption Underwriting Results - Homeowner
and Earthquake Lines in Runoff.
4 We ceased writing earthquake coverage in 1994, but we have remaining loss
reserves from the 1994 Northridge Earthquake that are subject to upward
development. See further discussion in Item 7 under the captions
Underwriting Results - Homeowner and Earthquake Lines, Critical Accounting
Policies, and the Notes to Consolidated Financial Statements.
5 Includes the following counties: Imperial, Kern, Orange, Riverside, Santa
Barbara, San Bernardino and Ventura.
6 Includes all California counties other than Los Angeles County, San Diego
County, and those specified in Footnote 5.
5
coverages are also optional and cover damage to the policyholder's automobile
whether or not the insured is at fault. In some states, we are 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. Our most popular bodily injury liability
limits in force are $100,000 per person and $300,000 per accident.
Our 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 underlying
automobile liability coverage that we write. The $2.0 million and $3.0 million
limits were added in May 2002. We require minimum underlying automobile limits,
written by us, of $250,000 per person and $500,000 per accident for PUP policies
sold since May 2002 (limits of $100,000 per person and $300,000 per accident
were previously required). We reinsure 90% of any PUP loss with unrelated
reinsurers.
PERSONAL AUTO PRODUCT INNOVATIONS
Starting in May 2002, we began offering motorcycle coverage primarily to our
auto policyholders in California. In August 2002, we introduced a new private
passenger auto policy in California that does not have certain standard features
found in our primary policy. This limited-feature product is similar in most
respects to the product offered by many of our competitors, and is positioned as
a lower-cost alternative for customers who believe they need less coverage than
provided by our standard product. In October 2002, we enhanced our underwriting
guidelines allowing us to provide quotes to more customers who do not meet
California's statutory "good driver" definition, but who are considered to be
insurable risks within our class plan.
The foregoing product innovations account for approximately 9% of new auto
policies written in California in 2003. Each innovation was designed to earn an
underwriting profit equivalent to the rest of the California auto product (with
the exception of Assigned Risk program). Initial results for each product
innovation are in line with expected profit levels.
MARKETING
While we offer personal auto policies in eight states, most of our marketing
efforts are focused on the larger urban markets in California(1). Beginning in
late 2002, we resumed active marketing in Arizona.
Our marketing and underwriting strategy is to appeal to careful and responsible
drivers who desire a feature-rich product at a competitive price. We use 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 our sales agents are centralized, we can deliver a
highly efficient and professional experience for our 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 auto rate quotation and purchase a policy on our web site.
The following table summarizes advertising expenditures (in millions) and total
new auto policies written in California, our primary market, for the past five
years:
Years Ended December 31, 2003 2002 2001 2000 1999
- -----------------------------------------------------------------------------
Total advertising expenditures $ 53.9 $ 43.3 $ 16.9 $ 9.8 $ 21.3
New auto policies written in
California(2) 254,830 185,927 51,002 50,901 86,703
- ------------
1 We began offering personal auto insurance in Illinois, Indiana and Ohio on
January 28, 2004. Results from these new markets are not expected to be
material in 2004.
2 Includes new PUP and motorcycle policies, which are insignificant for all
periods presented.
6
CONSUMER ADVOCACY
We have 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.
We also publish 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 of
these publications are available free of charge on our web site at
www.21st.com/company/getmore/safety/safety.jsp. We have also distributed these
publications in California movie theaters, county fairs, direct mail promotions
and other venues.
We extended our partnership with the California Highway Patrol to address the
critical safety issues of proper child safety seat installation and distracted
driving. Working in conjunction with Highway Patrol officers we held 16 child
safety seat inspection events in under-served communities throughout California.
During these events more than 1,600 inspections were conducted, 800
unsafe/recalled seats were replaced and 1,000 new seats were donated. We also
posted billboards carrying the message "Wrap Your Most Important Package Safely"
in high visibility locations around the state. On the issue of distracted
driving we developed a handout discouraging cell phone usage by drivers in
traffic as well as a billboard campaign under the theme of "Just Drive." All of
the materials are co-branded by the Company and the Highway Patrol.
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, 2003 2002 2001 2000 1999
- -----------------------------------------------------------------------------------------
Average customer retention -
California personal auto(1) 92% 93% 92% 96% 96%
California vehicles in force 1,383,175 1,178,459 1,051,982 1,150,643 1,179,928
All other states vehicles in
force 33,332 27,174 23,489 31,337 18,130
- -----------------------------------------------------------------------------------------
Total auto lines exposure 1,416,507 1,205,633 1,075,471 1,181,980 1,198,058
- -----------------------------------------------------------------------------------------
California auto base rate +3.9% +5.7% +4.0% +6.4% -6.9%
changes APRIL May July November February
From March 1996 to February 1999, we implemented six rate decreases which
resulted in a cumulative reduction in rates of nearly 23% in our California
Personal Auto Program. As a result of this series of rate decreases, retention
rates rose to record levels for us through 2000. Growth in vehicles in force
during this period was modest as our major competitors also lowered their rates.
In the year 2000, we recognized that loss costs had stopped declining and were
again rising. While our competitors took no action or, in some cases, continued
to take rate decreases, we took decisive action to improve our results and
position us for profitable growth when the marketplace ultimately did react to
these adverse trends. In 2000, we curtailed our advertising, adopted stricter
underwriting measures, modified our class plan rating system, and increased our
California auto program base rate by 6.4%, followed by a further rate increase
of 4% in 2001. These actions contributed to the declines in retention and
vehicles in force in 2000 and 2001. Beginning in the latter half of 2001, our
major California competitors began implementing rate increases and we restarted
active marketing and advertising, both of which contributed
- ------------
1 Represents an overall measure of customer retention, including new
customers as well as long-time customers. Retention rates for new customers
are typically lower than for long-time customers.
7
to the increases in our retention and vehicles in force in 2002. In January
2003, the Company received approval for a 3.9% rate increase, which we
implemented for new and renewal policies effective March 31, 2003.
UNDERWRITING AND PRICING
The regulatory system in California requires the prior approval of insurance
rates. Within the regulatory framework, we establish our premium rates based
primarily on actuarial analyses of our own historical loss and expense data.
This data is compiled and analyzed to establish overall rate levels as well as
classification differentials.
Our 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. Class plan changes are
filings that serve to modify the factors that impact the base rates so that each
individual receives a rate that reflects their respective losses and expenses.
Class plan changes are generally meant to be revenue neutral to us, 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 (e.g., history of accidents and
moving violations), 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, which 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 our base premium rates for each of the
past five years. Positive numbers represent increases; negative numbers
represent decreases.
Changes in Our Base Premium Rates
- ---------------------------------------------------------------------
Years Ended December 31, 2003 2002 2001 2000 1999
- ---------------------------------------------------------------------
Personal auto lines excluding PUP
California 3.9% 5.7% 4.0% 6.4% (6.9)%
Arizona 3.0 3.7 16.5 20.0 (9.7)
Nevada - 22.0 12.6 - -
Oregon - 3.1 14.0 21.0 -
Washington - 10.7 44.9 - -
Lines in runoff
Homeowner N/A 13.2 4.0 - (7.5)
Earthquake N/A N/A N/A N/A N/A
We are required to offer insurance to any California applicant who meets the
statutory definition of a "Good Driver." This definition includes all drivers
licensed more than three years with 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.
We review many of our 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.
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 us. Several of these
competitors are larger and have greater financial resources than us on a
stand-alone basis. According to A.M. Best, we were the seventh largest writer of
private
8
passenger automobile insurance in California based on direct premiums written
for 2002. Our 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, according to A.M. Best, for the
past five years were as follows:
Market Share in California
Based on Direct Premiums Written
- --------------------------------------------------------------------------------
Years Ended December 31, 2002 2001 2000 1999 1998
- --------------------------------------------------------------------------------
21ST CENTURY INSURANCE GROUP 6% 6% 6% 6% 6%
State Farm Group 14 13 13 14 15
Zurich/Farmers Group 11 12 13 14 15
California State Auto Group 9 10 10 10 10
Allstate Insurance Group 9 11 10 9 8
Automobile Club of Southern California Group 9 9 9 9 8
Mercury General Group 9 8 8 8 7
USAA Group 3 3 3 3 3
Government Employees Group (GEICO) 3 3 3 2 2
Progressive Insurance Group 2 2 2 3 2
SERVICING OF BUSINESS
Computerized systems provide the information resources, telecommunications and
data processing capabilities necessary to manage our business. These systems
support the activities of our marketing, sales, service and claims people who
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 our per-transaction costs.
Using our 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 provides our 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 our contractual and regulatory
obligations and management of loss adjustment expenses. Liability and property
damage claims are handled by specialists in each area.
We make extensive use of our DRP to expedite the repair process. The program
involves agreements between us and more than 160 independent repair facilities.
We agree to accept the repair facility's damage estimate without requiring each
vehicle to be reinspected by our adjusters. All DRP facilities undergo a
screening process before being accepted, and we maintain an aggressive
inspection audit program to assure quality results. Our 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. We benefit by not
incurring the overhead expense of a larger staff of adjusters and by negotiating
repair prices we believe are beneficial. Currently, more than 30% of all damage
repairs are handled using the DRP method.
9
Our policy is to use original equipment manufacturer ("OEM") parts. As a result,
we believe we do not have exposure to the types of class action suits some
competitors have drawn over their use of after market parts.
We have established 12 claims division service offices in areas of major
customer concentrations. Our eight vehicle inspection centers, located in
Southern and Northern California, handle total losses, thefts and vehicles that
are not drivable.
The claims services division is responsible for subrogation and medical payment
claims. We also maintain a Special Investigations Unit as required by the
California State Insurance Code, which investigates suspected fraudulent claims.
We believe our efforts in this area have been responsible for saving several
million dollars annually.
We utilize internal legal staff to handle most aspects of claims litigation.
These attorneys handle approximately 75% of all lawsuits against our
policyholders. Suits directly against us and those which may involve a conflict
of interest, are assigned to outside counsel.
GROWTH AND PROFITABILITY OBJECTIVES
We have stated that our long-term goal is to build an organization that
consistently produces a 96% combined ratio prepared using accounting principles
generally accepted in the United States of America ("GAAP"), or better, and at
least 15% annual growth in direct written premiums. To achieve these goals, we
have undertaken many steps since 1999 including:
- - Restored pricing and underwriting discipline;
- - Successfully restarted active advertising for new customers;
- - Introduced product innovations to spur growth and profitability; and
- - Launched numerous initiatives to lower unit transaction costs.
UNDERWRITING EXPENSE RATIO - PERSONAL AUTO LINES
Our direct statutory underwriting expense ratio for private passenger auto
(defined as direct underwriting expenses on a statutory basis divided by direct
premiums written), was lower than seven of our nine largest competitors in the
markets in which we served for 2002.
The following table presents statutory underwriting expense ratio information
extracted from statutory filings by A.M. Best for the top ten California
personal automobile insurance companies for 1998 through 2002, the most recent
data available.
Statutory Underwriting Expense Ratio (1)
------------------------------------
Years Ended December 31, 2002 2001 2000 1999 1998
- -----------------------------------------------------------------------------------
21ST CENTURY INSURANCE GROUP 20.3%(2) 15.0% 14.1% 13.8% 10.9%
Zurich/Farmers Group 27.0% 26.2% 25.8% 26.6% 26.1%
Mercury General Group 25.1% 25.8% 25.9% 26.7% 26.3%
State Farm Group 23.0% 22.6% 23.5% 22.9% 21.6%
California State Auto Group 22.8% 23.9% 25.1% 15.7% 19.0%
Allstate Insurance Group 22.7% 23.1% 25.5% 24.1% 22.7%
Progressive Insurance Group 21.5% 22.8% 21.1% 21.8% 22.7%
Automobile Club of Southern California Group 21.2% 21.6% 22.2% 22.2% 22.1%
Government Employees Group (GEICO) 14.7% 14.2% 17.0% 18.1% 17.7%
USAA Group 12.0% 12.7% 12.3% 13.7% 11.7%
- ------------
1 There is generally a difference between underwriting expense ratios
prepared using statutory accounting principles and GAAP. In 2003, our GAAP
underwriting expense ratio was 17.9% compared to our statutory underwriting
expense ratio of 16.7%.
2 In the third quarter of 2002, we recorded a pre-tax charge to write-off
$37.2 million of previously capitalized software costs for abandoned
portions of an advanced personal lines processing system. The underwriting
expense ratio excluding such write-down would have been 16.6%.
10
Our direct statutory underwriting expense ratio for 2003 was 16.7%. Excluding
the effects of the 2002 software write-off recorded in the third quarter of 2002
our direct statutory, underwriting expense ratio increased by 0.1% from 16.6% to
16.7% in 2003 over 2002. Comparable 2003 figures for our competitors are not yet
available. In 2002, the capacity of the Company's new business call center was
doubled, enabling us to handle a record volume of new business throughout the
year. Several productivity enhancement initiatives are underway aimed at
reducing per-unit process costs. The increases in our ratio from 1998 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, over
time, may be higher or lower than initially estimated. 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 our customers).
Loss adjustment expenses ("LAE") represent the costs of adjusting, investigating
and settling claims, and are primarily comprised of the cost of our claim
department, external inspection services, and internal and external legal
counsel. Corporate support areas such as human resources, finance, and
information technology support our overall operations, and, accordingly, a
portion of their operational costs are also allocated to LAE. The LAE allocable
portion of such corporate support costs is reviewed periodically as changes
occur in our organization, and we modify the allocation percentages as
appropriate. During 2003, such changes effectively decreased our ratio of LAE to
earned premium by approximately 1.8% from 6.2% in 2002 to 4.4% in 2003.
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 us 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. We employ 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 our actuaries. Historically, our
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 reviews the
assumptions underlying the loss ratios and selects the carried reserve after
carefully reviewing the appropriateness of the underlying assumptions.
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, our 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.
11
For example, when estimating the frequency of accidents, history has shown that
approximately 99.7% of property damage claims and 89.2% of liability claims are
reported by year-end. Accordingly, in this illustration, our actuaries add an
estimated 0.3% to the number of property damage claims and 10.8% to the number
of liability claims to provide for incurred but not reported ("IBNR") claims.
In making these estimates, a fundamental assumption is that past events are
representative indicators of future outcomes.
Estimating the Severity of Auto Claims. Adjusters in our 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. Our 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, and provide for development in
the adjusters' estimates as applicable. 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 our actuaries each month based on historical
studies of average claim payments and the patterns of how the claims were paid.
Again, the fundamental assumption used in making these estimates is that past
events are reliable indicators of future outcomes.
Estimating Loss and LAE for Lines in Runoff. While the personal auto lines
represent our core business, we also have losses and LAE relating to
developments on remaining loss reserves for homeowners and earthquake lines.
These lines are said to be "in runoff" because we no longer have policies in
force. As discussed in the Notes to Consolidated Financial Statements, we have
not written any earthquake policies since 1994 and we exited the homeowners
insurance business at the beginning of 2002. Developing reserve estimates for
the earthquake line is particularly subjective because most of the remaining
earthquake claims are in litigation. Our actuaries evaluate the homeowners
reserve requirement on a quarterly basis, while personnel in our legal and
claims areas prepare monthly evaluations of the earthquake reserves.
LOSS AND RESERVE DEVELOPMENT
Management believes that our reserves are adequate and represent our best
estimate based on the information currently available. 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."
For the personal auto lines, our actuaries prepare a monthly evaluation of loss
and LAE indications by accident year, and we assesses whether there is a need to
adjust reserve estimates. Homeowners reserves are reviewed quarterly. The
adequacy of earthquake reserves is reviewed monthly by personnel in our legal
and claims areas. 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.
12
The changes in prior accident year estimates recorded in each of the past five
calendar years, net of applicable reinsurance, are summarized below (in
thousands)(1):
Changes in the Calendar Year of Prior
Accident Year Estimates, Net of Reinsurance
- ---------------------------------------------------------------------------
Years ended December 31, 2003 2002 2001 2000 1999
- ---------------------------------------------------------------------------
Personal auto $11,159 $16,200 $ 45,742 $42,178 $(14,239)
Homeowner and Earthquake(2) 40,048 56,158 72,265 2,845 5,543
- ---------------------------------------------------------------------------
$51,207 $72,358 $118,007 $45,023 $ (8,696)
- ---------------------------------------------------------------------------
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 1993 through 2003. The
figures in both tables are shown gross of reinsurance.
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.
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.
- ------------
1 Positive amounts represent deficiencies in loss and LAE expenses, while
negative amounts represent redundancies.
2 We no longer have any California homeowners policies in force. We ceased
writing earthquake coverage in 1994, but we have remaining loss reserves
from the 1994 Northridge Earthquake that are subject to upward development.
See further discussion in Item 7 under the captions Underwriting Results -
Homeowner and Earthquake Lines in Runoff, Critical Accounting Policies, and
the Notes to Consolidated Financial Statements.
13
- ------------------------------------------------------------------------------------------------------------------------------
TABLE 1 - Auto Lines as of December 31,
(Amounts in thousands, except claims) 1993 1994 1995 1996 1997 1998 1999 2000
- ------------------------------------------------------------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $525,892 $552,872 $506,747 $468,257 $403,263 $329,021 $261,990 $286,057
PAID (CUMULATIVE) AS OF:
One year later 319,938 329,305 318,273 260,287 253,528 247,317 242,579 268,515
Two years later 393,731 403,462 392,420 336,538 319,064 307,797 311,659 332,979
Three years later 410,808 429,595 416,541 354,854 333,349 324,778 324,740 352,592
Four years later 422,640 435,795 422,393 357,913 340,907 326,932 327,745
Five years later 425,021 437,041 423,429 363,068 341,446 327,418
Six years later 425,397 437,052 427,723 362,824 341,374
Seven years later 425,041 437,015 427,355 362,508
Eight years later 424,982 436,737 427,059
Nine years later 424,745 436,518
Ten years later 424,571
RESERVES RE-ESTIMATED AS OF:
One year later 451,054 465,934 440,158 365,566 359,262 313,192 309,953 352,709
Two years later 429,602 438,672 424,091 366,858 337,258 321,711 340,914 354,720
Three years later 418,576 439,125 425,404 359,925 335,246 341,695 328,190 361,264
Four years later 424,630 438,895 424,643 357,607 355,605 326,506 329,182
Five years later 425,880 436,397 422,389 377,414 340,537 326,565
Six years later 424,475 435,878 442,024 361,980 340,552
Seven years later 424,188 451,478 426,719 361,865
Eight years later 424,603 448,972 426,636
Nine years later 424,435 436,237
Ten years later 424,388
- ------------------------------------------------------------------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $101,504 $116,635 $ 80,111 $106,392 $ 62,711 $ 2,456 $(67,192) $(75,207)
- ------------------------------------------------------------------------------------------------------------------------------
Supplemental Auto Claims Data:
Claims reported during the year for CA only 315,558 352,182 324,143 294,615 279,211 295,905 307,403 323,395
Claims pending at year-end for CA only 62,892 70,717 63,142 58,172 55,738 56,739 57,134 54,760
- ------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------
TABLE 1 - Auto Lines as of December 31,
(Amounts in thousands, except claims) 2001 2002 2003
- ----------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $301,985 $333,113 $419,913
PAID (CUMULATIVE) AS OF:
One year later 239,099 249,815
Two years later 312,909
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 323,791 348,865
Two years later 338,338
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) $(36,353) $(15,752)
- ------------------------------------------------------------------
Supplemental Auto Claims Data:
Claims reported during the year for CA only 298,417 293,955 331,734
Claims pending at year-end for CA only 50,365 51,488 58,577
- ----------------------------------------------------------------------------
See Notes 8 and 16 of the Notes to Consolidated Financial Statements
14
TABLE 2 - Homeowner and Earthquake
Lines in Runoff as of December 31,
(Amounts in thousands) 1993 1994 1995 1996 1997 1998 1999
- -------------------------------------------------------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $51,598 $ 203,371 $ 78,087 $ 75,272 $ 34,624 $ 52,982 $ 14,258
PAID (CUMULATIVE) AS OF:
One year later 26,936 193,887 55,738 75,100 30,232 48,848 13,103
Two years later 34,717 236,406 119,211 100,296 74,127 58,281 37,404
Three years later 37,052 295,768 139,792 142,850 82,974 81,887 83,985
Four years later 39,504 314,225 180,799 151,342 106,274 128,266 147,856
Five years later 40,550 354,324 188,987 174,513 152,592 192,121
Six years later 41,217 362,379 211,771 220,805 216,383
Seven years later 42,318 385,161 257,839 284,455
Eight years later 42,339 431,154 321,169
Nine years later 42,455 494,260
Ten years later 42,502
RESERVES RE-ESTIMATED AS OF:
One year later 41,685 253,775 116,741 101,903 77,445 58,582 18,024
Two years later 40,189 290,526 142,071 145,635 82,716 61,393 72,546
Three years later 39,657 316,256 182,616 150,434 85,519 116,429 125,089
Four years later 41,025 355,690 186,631 153,521 140,532 169,157 163,045
Five years later 41,205 359,084 190,334 208,533 193,375 207,064
Six years later 41,586 363,260 245,267 261,389 231,217
Seven years later 42,599 418,407 298,161 299,109
Eight years later 42,450 471,330 335,657
Nine years later 42,524 508,639
Ten years later 42,579
- -------------------------------------------------------------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $ 9,019 $(305,268) $(257,570) $(223,837) $(196,593) $(154,082) $(148,787)
- -------------------------------------------------------------------------------------------------------------------------
(Amounts in thousands) 2000 2001 2002 2003
- -----------------------------------------------------------------------------------
RESERVES FOR LOSSES AND LOSS ADJUSTMENT
EXPENSES, DIRECT $ 12,379 $ 47,305 $ 50,896 $18,410
PAID (CUMULATIVE) AS OF:
One year later 30,706 58,274 71,147
Two years later 78,647 125,447
Three years later 143,564
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 89,281
Two years later 121,176 142,211
Three years later 159,331
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
- --------------------------------------------------------------------------
REDUNDANCY (DEFICIENCY) $(146,952) $(94,906) $(38,385)
- --------------------------------------------------------------------------
NOTE: Costs associated with claims that were re-opened as a result of SB 1899
are displayed in the table as a 1994 event (since they all related to the
Northridge Earthquake), even though the legislation allowing the re-opening of
related claims was not passed until almost seven years later.
See Notes 8 and 16 of the Notes to Consolidated Financial Statements
15
Auto Lines Reserve Development. As shown in the ten-year development table, our
auto lines historically developed redundancies prior to 1999 and have exhibited
adverse development for 1999 through 2002. The period from 1993 to 1999 was
quite unusual in that, during that time, we experienced declining frequencies
and declining severities in our auto line. As Table 1 shows, we did not
immediately have confidence in these declining trends and did not immediately
lower our 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, we 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, we continued to assume lower 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, we experienced significant, unexpected
development in our uninsured motorist coverage while the actuarial indications
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.
Starting in 2001, we improved the quality and timeliness of the data available
to make initial estimates and periodic changes in estimates. We have dedicated
more resources to better understand the underlying drivers of the changes in
frequency and severity trends as they begin emerging. For example, in the second
quarter of 2003 we began making accident month actuarial analyses of our
reserves for the auto lines.
Homeowner and Earthquake Lines in Runoff. In Table 2, substantially all of the
development relates to the earthquake line. A major earthquake occurred on
January 17, 1994, centered in the San Fernando Valley community of Northridge
(the "Northridge Earthquake"). Through December 31, 2003, we have settled over
46,000 Northridge Earthquake claims at a total cost (i.e., loss plus LAE) of
over $1.2 billion.
In September 2000, the State of California enacted Senate Bill 1899 ("SB 1899"),
which allowed Northridge Earthquake claims barred by contract and the statute of
limitations to be reopened during calendar year 2001. Please see Note 16 of the
Notes to Consolidated Financial Statements for additional background on the
Northridge Earthquake and SB 1899, including a discussion of factors that have
contributed to the difficulty of obtaining accurate loss and LAE estimates in
the wake of that legislation.
The loss development in Table 2 is easiest to understand by dividing it into
"pre-SB 1899" and "post-SB 1899" segments. This is because the costs relating to
the re-opened claims are displayed in the table as a 1994 event (since they all
related to the Northridge Earthquake), even though the legislation allowing the
re-opening of certain claims was not passed until almost seven years later.
Before SB 1899 was passed in late 2000, we had only approximately 50 earthquake
claims remaining to be resolved out of an initial 35,000 homeowner earthquake
claims. Although we settled 98% of the claims within a year of the quake, many
upward changes in estimates were required in 1994 and beyond as new information
emerged on the severity of the damages and as settlements of litigated claims
occurred. As a result, we recorded the following upward changes in loss
estimates after 1994, but before SB 1899 came into play: 1995 - $57 million;
1996 - $40 million; 1997 - $24.8 million; 1998 - $40 million; 1999 - $2.5
million; and 2000 - $3.5 million.
Calendar year 2001 was the one-year window SB 1899 permitted for claimants to
bring additional insurance claims and legal actions allegedly arising out of the
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 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 31, 2001 deadline.
16
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 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, we
expensed an additional $11.9 million of legal defense costs as they were paid.
Based on subsequent developments, we recorded an additional provision of $37.0
million in the first quarter of 2003.
At the end of each month, legal and claim personnel within the Company review
the adequacy of the remaining SB 1899 reserves based on the most current
information available. Based on that review, we believe our remaining earthquake
reserves are adequate as of December 31, 2003. However, we continue to caution
that these estimates are subject to a greater than normal degree of uncertainty
and possible future material adjustment as new facts become known.
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.
We periodically monitor the continuing appropriateness of our reinsurance
arrangements to determine that our retention levels are reasonable and that our
reinsurers are financially sound, able to meet their obligations under the
agreements and that the contracts are competitively priced.
The majority of our cessions are with AIG subsidiaries, which have earned A.M.
Best's highest financial rating of A++. The A.M. Best financial ratings of our
other reinsurers range from A- to A+. Our reinsurance arrangements are discussed
in more detail in Note 10 of the Notes to Consolidated Financial Statements.
Our net retention of insurance risk after reinsurance for 2004 and the preceding
five years is summarized below:
Contracts Incepting During
-----------------------------------------
Net Retention 2004 2003 2002 2001 2000 1999
- ------------------------------------------------------------------------
Auto and motorcycle lines 100% 100% 97%(1) 94% 92% 90%
Personal umbrella policies(2) 10 10 10 16 37 36
Homeowner line in runoff 0 0 0 94 92 0
We also have catastrophe reinsurance agreements relating to the auto line with
Endurance Specialty Insurance Ltd., Folksamerica Reinsurance Company and
Transatlantic Reinsurance Company (a majority held AIG subsidiary), which
reinsure any covered events up to $30.0 million in excess of $15.0 million
($45.0 million in excess of $20.0 million effective January 1, 2004).
- ------------
1 Effective September 1, 2002, we entered into an agreement to cancel future
cessions under our quota share with AIG subsidiaries. The treaty would have
ceded 4% of premiums for the auto and motorcycle lines to AIG subsidiaries
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 us.
2 Personal umbrella coverage is only available to our auto customers.
Approximately 1% of the auto customers have umbrella coverage.
17
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 premium
rates;
- - 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 statutory accounting rules;
- - Issuance of securities by insurers;
- - Restrictions on payment of dividends; and
- - Restrictions on transactions with affiliates.
Currently, the California Department of Insurance ("CDI") has primary regulatory
jurisdiction over our subsidiaries, including prior approval of premium rates.
The CDI typically conducts a financial examination of our affairs every three
years. The most recently completed triennial examination, for the three years
ended December 31, 1999, did not require us to restate our 1999 statutory
financial statements. In general, the current regulatory requirements in the
other states in which our subsidiaries are licensed insurers are no more
stringent than in California.
In addition to regulation by the CDI, we 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.
To our knowledge, no new laws were enacted in 2003 by any state in which we do
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. If implemented, we believe these draft
regulations could negatively affect our profitability.
HOLDING COMPANY REGULATION
Our 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, the Holding Company Act limits the amount of dividends our
insurance subsidiaries may pay. 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 insurance subsidiaries currently have $75.1 million of statutory unassigned
surplus that could be paid as dividends to the parent company without prior
written approval from insurance regulatory authorities in 2004. 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 15 of the Notes to Consolidated Financial
Statements), it is unlikely that our insurance subsidiaries will make any
dividend payments to us in 2004. There is no assurance that the related tax
issue will be favorably resolved in the near term, in which case we face 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.
18
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, 2003, the number of assigned risk insured vehicles was 3,678 compared to
2,436 at the end of 2002. The CAARP assignments have historically produced
underwriting losses. As of December 31, 2003, this business represented less
than 1% of our total direct premiums written, and the underwriting losses were
$0.5 million in 2003, $0.5 million in 2002 and $0.7 million in 2001.
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.
Participation in the current year FAIR Plan operations is based on the pool from
two years prior. Since we ceased writing direct homeowners business in 2002, the
Company will continue to receive assignments in the 2004 calendar year. Our FAIR
Plan underwriting results for 2003, 2002 and 2001 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.
EMPLOYEES
We had approximately 2,700 full and part-time employees at December 31, 2003. We
provide medical, pension and 401(k) savings plan benefits to eligible employees,
according to the provisions of each plan.
DEBT OFFERING
In December 2003, we completed a private offering of $100 million principal
amount of 5.9 percent Senior Notes due in December 2013. The effective interest
rate on the Senior Notes when all offering costs are taken into account and
amortized over the term of the Senior Notes is approximately 6 percent per
annum. Of the $99.2 million net proceeds from the offering, $85 million was used
to increase the statutory surplus of our wholly-owned subsidiary, 21st Century
Insurance Company, and the balance was retained by our holding company.
Under a registration rights agreement executed in connection with the offering,
we have agreed to, among other things: (i) file a registration statement on or
before April 7, 2004 enabling holders to exchange the notes for publicly
registered notes; (ii) use our reasonable best efforts to cause the
registration statement relating to the exchange offer to become or be declared
effective on or before June 6, 2004; (iii) use our reasonable best efforts to
consummate the exchange offer within 45 days after the effective date of the
registration statement. In the event such registration statement does not become
effective by June 6, 2004, the interest rate on the Senior Notes will increase
by 0.25%.
ITEM 2. PROPERTIES
We lease approximately 400,000 square feet of office space for our 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.
We also lease office space in 17 other locations, of which 9 locations are in
California primarily for claims-related employees. We anticipate 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 12 of the Notes to Consolidated Financial
Statements.
19
ITEM 3. LEGAL PROCEEDINGS
In the normal course of business, the Company is named as a defendant in
lawsuits related to claims and insurance policy issues, both on individual
policy files and by class actions seeking to attack the Company's business
practices. A description of the legal proceedings to which the Company and its
subsidiaries are a party is contained in Note 12 of the Notes to Consolidated
Financial Statements.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On October 17, 2003, the majority holder of the Company's common stock approved
by written consent (i) to change the Company's state of incorporation from
California to Delaware pursuant to a merger of the Company with and into a
wholly owned subsidiary of the Company organized under the laws of the State of
Delaware and (ii) a form of indemnity agreement for the Company's directors and
officers. The Company's Certificate of Incorporation and Bylaws, attached as
Appendices B and C, respectively, to the Information Statement filed with the
SEC on November 13, 2003, are incorporated by reference.
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 on the New York Stock
Exchange for the common stock for the indicated periods.
2003 2002
HIGH LOW High Low
- ----------------------------------------------
Fourth Quarter $14.50 $13.00 $14.24 $ 9.60
Third Quarter 16.05 13.03 19.67 9.15
Second Quarter 17.25 12.00 21.80 17.70
First Quarter 13.50 11.20 19.50 15.82
(b) HOLDERS OF COMMON STOCK
The approximate number of holders of our common stock on December 31, 2003 was
600.
(c) DIVIDENDS
We paid quarterly cash dividends of $0.08 per share from the first quarter of
2001 through the third quarter of 2002. Quarterly dividends of $0.02 per share
were paid from the fourth quarter of 2002 through the fourth quarter of 2003.
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.
(d) SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
Securities authorized for issuance under equity compensation plans at December
31, 2003 are as follows:
COLUMN (A) COLUMN (B) COLUMN (C)
WEIGHTED- NUMBER OF SECURITIES
NUMBER OF SECURITIES AVERAGE EXERCISE REMAINING AVAILABLE FOR
TO BE ISSUED UPON PRICE OF FUTURE ISSUANCE UNDER EQUITY
EXERCISE OF OUTSTANDING COMPENSATION PLANS
OUTSTANDING OPTIONS, OPTIONS, (EXCLUDING SECURITIES
WARRANTS AND RIGHTS WARRANTS AND REFLECTED IN COLUMN (A))
PLAN CATEGORY (IN THOUSANDS) RIGHTS (IN THOUSANDS)
- ------------------------------ --------------------- ----------------- -----------------------------
Equity compensation plans
approved by security holders 6,744 $ 17.05 2,780
Equity compensation plans not
approved by security holders None N/A N/A
- ------------------------------ --------------------- ----------------- -----------------------------
Total 6,744 $ 17.05 2,780
- ------------------------------ --------------------- ----------------- -----------------------------
See note 14 to the Notes to Consolidated Financial Statements for additional
information.
20
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data for each of the years in the five-year
period ended December 31, 2003 should be read in conjunction with the Company's
consolidated financial statements and the accompanying notes 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, 2003 2002 2001 2000 1999
- -----------------------------------------------------------------------------------------
PERSONAL AUTO LINES DATA
Direct premiums written $1,223,377 $995,794 $898,862 $881,212 $ 855,783
Ceded premiums written(1) (4,858) (18,902) (56,205) (72,675) (86,974)
- -----------------------------------------------------------------------------------------
Net premiums written 1,218,519 976,892 842,657 808,537 768,809
Net premiums earned 1,172,679 924,559 838,489 803,770 770,234
Loss and LAE ratio(2) 78.6% 82.9% 88.1% 90.8% 77.4%
Underwriting expense ratio(3) 17.9 15.6 14.9 14.2 12.3
- -----------------------------------------------------------------------------------------
Combined ratio(4) 96.5% 98.5% 103.0% 105.0% 89.7%
- -----------------------------------------------------------------------------------------
ALL LINES DATA
Direct premiums written $1,223,484 $998,248 $929,315 $910,720 $ 880,531
Ceded premiums written(5) (4,854) (32,949) (60,359) (78,592) (111,718)
- -----------------------------------------------------------------------------------------
Net premiums written 1,218,630 965,299 868,956 832,128 768,813
Net premiums earned 1,172,677 924,559 864,145 825,486 770,423
Total revenues 1,246,464 981,295 914,078 869,762 832,681
Loss and LAE ratio 82.0% 89.4% 96.7% 90.8% 78.6%
Expense ratio(3) 17.9 15.5 15.0 14.4 12.9
- -----------------------------------------------------------------------------------------
Combined ratio(6) 99.9% 104.9% 111.7% 105.2% 91.5%
- -----------------------------------------------------------------------------------------
NET INCOME (LOSS) $ 53,575 $(12,256) $(27,568) $ 12,945 $ 87,528
EARNINGS (LOSS) PER SHARE
Basic $ 0.63 $ (0.14) $ (0.32) $ 0.15 $ 1.00
Diluted 0.63 (0.14) (0.32) 0.15 1.00
DIVIDENDS DECLARED 0.08 0.26 0.32 0.48 0.64
- ------------
1 The decrease in premiums ceded from 1999 through 2003 was caused primarily
by scheduled decreases in the AIG subsidiaries quota share program, which
was terminated effective September 1, 2002.
2 The loss and LAE ratios have decreased since 2000 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 36 months.
3 The increase in the 2003 and 2002 expense ratios is primarily due to
increased acquisition costs in advertising and staffing. The increase in
the expense ratio from 1999 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: $37.2 million of costs related to a write-off of software
in 2002; $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 unfavorable (favorable) prior accident year
loss and LAE development of $11.2 million, $16.2 million, $45.7 million,
$42.2 million and $(14.2) million in 2003, 2002, 2001, 2000, and 1999,
respectively.
5 In addition to the AIG subsidiaries cession discussed in Note 1 above, our
homeowners line was 100% reinsured in 1998, 1999 and 2002.
6 In addition to the effect of the items described in footnote 4 above, the
combined ratio for all lines was impacted by adverse development on
remaining loss reserves from the homeowner and earthquake lines, which are
in runoff, of $40.2 million in 2003, $58.8 million in 2002, $77.6 million
in 2001, $2.7 million in 2000, and $13.1 million in 1999.
21
December 31, 2003 2002 2001 2000 1999
- ---------------------------------------------------------------------------------------
BALANCE SHEET DATA:
Total investments and cash $1,283,741 $1,030,478 $ 884,633 $ 920,327 $ 988,578
Total assets 1,737,187 1,470,037 1,354,398 1,340,916 1,383,076
Unpaid losses and loss
adjustment expenses 438,323 384,009 349,290 298,436 276,248
Unearned premiums 312,254 266,477 236,473 236,519 232,702
Debt(1) 149,686 60,000 - - 67,500
Total liabilities 1,036,497 814,429 695,092 620,355 662,239
Stockholders' equity 700,690 655,608 659,306 720,561 720,837
Book value per common
share 8.20 7.67 7.72 8.46 8.39
Statutory surplus(2) 531,658 397,381 393,119 475,640 581,440
Net premiums written to
surplus ratio(3) 2.3:1 2.4:1 2.2:1 1.7:1 1.3:1
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
We primarily market and underwrite personal automobile, motorcycle, and umbrella
insurance in California. We also provide personal automobile insurance in four
other western states (Arizona, Nevada, Oregon and Washington) and three
midwestern states (Illinois, Indiana and Ohio). We began offering personal auto
insurance in Illinois, Indiana and Ohio on January 28, 2004. We believe that we
have a reputation for high quality customer service and for being among the most
efficient and lowest cost providers of personal auto insurance in the markets we
serve.
Our primary goals include realizing 15% revenue growth and attaining a 96%
combined ratio for our personal auto lines. Our net premiums earned grew in
excess of 20%, our best growth rate since 1987, and we improved our personal
auto lines combined ratio by two points to 96.5%. For the year ended December
31, 2003, our net premiums earned increased to $1,218.5 million from $976.9
million in 2002. For the years ended December 31, 2003 and 2002, the combined
ratio for the personal auto lines was 96.5% and 98.5%, respectively.
Net income for 2003 was $53.6 million, compared to net losses in 2002 and 2001
of $12.3 million and $27.6 million, respectively. Results for the year ended
December 31, 2003 include a first quarter after-tax charge of $24.1 million to
strengthen earthquake reserves and certain nonrecurring, nonoperational items
that increased second quarter net income by $9.6 million after-tax. In 2002, the
Company's results included third quarter after-tax charges for earthquake and
software write-offs totaling $58.4 million.
For the year ended December 31, 2003, cash flow from operations was $187.5
million compared to $76.3 million for 2002. Total assets also increased to $1.7
billion at December 31, 2003 from $1.5 billion at December 31, 2002. In December
2003, the Company completed a $100 million senior debt offering and used $85
million of the proceeds to increase the statutory surplus of its principal
insurance subsidiary.
See "Results of Operations" for more details as to our overall and personal auto
lines results.
- ------------
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.
4 Results from these markets are not expected to be material in 2004.
22
The remainder of our Management's Discussion and Analysis provides a narrative
on the Company's financial condition and performance that should be read in
conjunction with the accompanying financial statements. It includes the
following sections:
- - Financial Condition
- - Liquidity and Capital Resources
- - Contractual Obligations and Commitments
- - Off Balance Sheet Arrangements
- - Results of Operations
- - Underwriting Results
- - Loss and LAE Incurred
- - Investment Income
- - Other Income
- - Write-off of Software
- - Critical Accounting Policies
- - New Accounting Pronouncements
- - Forward-Looking Statements
FINANCIAL CONDITION
Investments and cash increased $253.2 million (24.6%) since the prior year
primarily due to improved cash flow from operations of $187.5 million in 2003,
and the $100 million senior notes private offering in December 2003.
Investment-grade bonds comprised substantially all of the fair value of the
fixed-maturity portfolio at December 31, 2003. Of our total investments at
December 31, 2003, approximately 61.7% were invested in tax-exempt, fixed-income
securities, compared to 54.5% at December 31, 2002.
Increased advertising, compensation and other operating costs through December
31, 2003, associated with increased customer volume, contributed to an increase
in deferred policy acquisitions costs (DPAC) of $6.9 million to $53.1 million,
compared to $46.2 million at December 31, 2002. The Company's DPAC is estimated
to be fully recoverable (see Critical Accounting Policies - Deferred Policy
Acquisition Costs).
Our loss and LAE reserves, gross and net of reinsurance, are summarized in the
following table:
AMOUNTS IN THOUSANDS 2003 2002
December 31, GROSS NET Gross Net
- --------------------------------------------------------------
Unpaid Losses and LAE:
Personal auto lines $419,913 $413,348 $333,113 $320,032
Homeowner lines 4,172 1,774 10,952 3,682
Earthquake lines 14,238 14,237 39,944 39,944
- --------------------------------------------------------------
Total $438,323 $429,359 $384,009 $363,658
- --------------------------------------------------------------
Gross unpaid losses and LAE increased by $54.3 million since the prior year
primarily due to a reserve increase of $62.1 million in the personal auto lines
as a result of growth in our customer base. The increase in the personal auto
lines was offset by the $17.0 million net decrease in the homeowner and
earthquake lines, which are in runoff.
23
Unearned premiums increased 17.2% to $312.3 million at the end of 2003 compared
to the prior year end, due to higher volume in our personal auto lines.
Debt increased $89.7 million as a result of a private $100 million senior notes
offering executed in December 2003 (see Note 10 of the Notes to Consolidated
Financial Statements) offset by principal payments on a capital lease
obligation. The primary purpose of the 2003 debt offering was to increase the
statutory surplus of 21st Century Insurance Company, our wholly-owned
subsidiary.
Claims and other outstanding checks payable increased 14.0% at the end of 2003
from a year-ago, consistent with our increased business volume. Other
liabilities rose $30.0 million primarily because of increases relating to
various accruals for customer advances, taxes, and personnel costs.
Stockholders' equity and book value per share increased to $700.7 million and
$8.20, respectively, at December 31, 2003, compared to $655.6 million and $7.67
at December 31, 2002. The increase for the year ended December 31, 2003, was due
to net income of $53.6 million, other increases relating to common stock of $0.3
million, less a decrease in other comprehensive income of $2.0 million and
dividends to stockholders of $6.8 million.
Effective December 4, 2003, we changed our state of incorporation from
California to Delaware. In connection with the change, our common stock was
assigned a par value of $0.001 per share, resulting in a reclassification of
$419.2 million from common stock to additional paid-in capital. Delaware is the
state of incorporation for 58% of the Fortune 500 and 51% of all publicly traded
companies, and was selected by our Board of Directors after a careful study.
There was no change in the location of company operations, location of
employees, or in the way we do business.
LIQUIDITY AND CAPITAL RESOURCES
21st Century Insurance Group. Our holding company's main sources of liquidity
historically have been dividends received from our insurance subsidiaries and
proceeds from issuance of debt or equity securities. Apart from the exercise of
stock options and restricted stock grants to employees, the effects of which
have not been significant, we have not issued any equity securities since 1998
when AIG exercised its warrants to purchase common stock for cash of $145.6
million. Our insurance subsidiaries have not paid any dividends to our holding
company since 2001 due to the current uncertainty surrounding the taxability of
dividends received by holding companies from their insurance subsidiaries (see
further discussion in Note 15 of the Notes to Consolidated Financial
Statements).
In December 2003, we completed a private offering of $100 million principal
amount of 5.9 percent Senior Notes due in December 2013. The effective interest
rate on the Senior Notes when all offering costs are taken into account and
amortized over the term of the Senior Notes is approximately 6 percent per
annum. Of the $99.2 million net proceeds from the offering, $85 million was used
to increase the statutory surplus of our wholly-owned insurance subsidiary, 21st
Century Insurance Company, and the balance was retained by our holding company.
Effective December 31, 2003, the California Department of Insurance approved an
intercompany lease whereby 21st Century Insurance Company will lease certain
computer software from our holding company. The monthly lease payment, currently
$0.4 million, started in January 2004 and is subject to upward adjustment based
on the cost incurred by the holding company to complete certain enhancements to
the software.
Our holding company's significant cash obligations over the next several years
consist of interest payments on the Senior Notes (approximately $5.9 million
annually) and the estimated cost to complete certain software enhancements
(approximately $33.1 million), exclusive of any dividends to stockholders that
our directors may declare, and the repayment of the $100 million principal on
the Senior Notes due in 2013. We expect to be able to meet those obligations
from sources of cash currently available - i.e., payments received from the
intercompany lease and cash and investments currently on hand at the holding
company, which
24
totaled $24.4 million at December 31, 2003(1) - plus additional funds obtained
from the capital markets or from dividends received from our insurance
subsidiaries. Absent a favorable resolution of the state income tax issue
regarding taxability of intercompany dividends received by insurance holding
companies, we may have to pay additional state income taxes of up to
approximately 8.9% on the amount of any such dividends received.
Our insurance subsidiaries in 2004 could pay $75.1 million as dividends to us
without prior written approval from insurance regulatory authorities. We are
unlikely to have our insurance subsidiaries pay dividends to our holding company
in 2004 as long as the uncertainty persists over the taxability by the state of
intercompany dividends.
Insurance Subsidiaries. We have achieved underwriting profits in our core auto
insurance operations for the last eight quarters and have thereby enhanced our
liquidity. In California, where approximately 97.7% of our policies are written,
we implemented a 3.9% auto premium rate increase effective March 31, 2003. This
increase followed a 5.7% rate increase in May of 2002. However, 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, we
remain exposed to possible upward development in previously recorded reserves
for claims pursuant to SB 1899. As a result of such uncertainties, underwriting
losses could occur in the future. Further, we could be required to liquidate
investments to pay claims, possibly during unfavorable market conditions, which
could lead to the realization of losses on sales of investments. Adverse
outcomes to any of the foregoing uncertainties would create some degree of
downward pressure on the insurance subsidiaries' earnings, which in turn could
negatively impact our liquidity.
As of December 31, 2003, our insurance subsidiaries had a combined statutory
surplus of $531.7 million compared to $397.4 million at December 31, 2002. The
change in statutory surplus was primarily due to statutory net income of $76.1
million, a capital contribution of $37.9 million and a decrease in nonadmitted
assets of $20.9 million. Our ratio of net premiums written to statutory surplus
was 2.3 at December 31, 2003, compared to 2.4 at December 31, 2002.
The CDI is currently examining the statutory financial statements for the three
year period ended December 31, 2002. We are not aware of any proposed
adjustments to the statutory financial statements. 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.
Transactions with Related Parties. Since 1995, we have entered into several
transactions with AIG subsidiaries, including various reinsurance agreements,
which are discussed under "Item 1. Business." At December 31, 2003, reinsurance
recoverables, net of payables, from AIG subsidiaries were $5.8 million, compared
to $18.4 million at December 31, 2002. Other transactions with AIG subsidiaries,
which are immaterial, have resulted from competitive bidding processes for
certain corporate insurance coverages and certain software and data processing
services. In October 2003, as a result of a competitive bidding process, we
entered into an agreement with an AIG subsidiary to provide investment
management services to us; the agreement was subject to approval by the
California Department of Insurance, which granted such approval in October 2003.
Apart from the foregoing, we have no material transactions with related parties.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
We have various contractual obligations that are recorded as liabilities in our
consolidated financial statements. Certain contractual obligations, such as
operating lease obligations, are not recognized as liabilities in our
consolidated financial statements, but are required to be disclosed.
- ------------
1 On December 15, 2003, the Company declared a $1.7 million cash dividend to
stockholders of record on December 29, 2003, which was paid January 23,
2004.
25
The following table summarizes our significant contractual obligations and
commitments at December 31, 2003, and the future periods in which such
obligations are expected to be settled in cash. In addition, the table reflects
the timing of principal payments on outstanding senior notes.
Payments Due by Period
-----------------------------------------------
2005 2007 Remaining
through through years after
AMOUNTS IN MILLIONS TOTAL 2004 2006 2008 2008
- ------------------------------------------------------------------------------
Senior notes $159.0 $ 5.9 $ 11.8 $ 11.8 $ 129.5
Capital lease obligation 55.8 14.0 27.8 14.0 -
- ------------------------------------------------------------------------------
Debt 214.8 19.9 39.6 25.8 129.5
Operating Leases(1) 175.2 19.8 36.0 29.0 90.4
- ------------------------------------------------------------------------------
Total $390.0 $39.7 $ 75.6 $ 54.8 $ 219.9
- ------------------------------------------------------------------------------
The capital lease obligation above resulted from the sale-leaseback transaction
discussed earlier. The lease includes a covenant that if AIG ceases to have a
majority interest in us, or if statutory surplus falls below $300.0 million, or
if the net premiums written to surplus ratio is greater than 3.8:1, or if claims
paying ratings fall below BBB+ (as rated by Standard & Poor's), Baa1 (as rated
by Moody's) or B++ (as rated by A.M. Best) we 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%.
Our largest insurance subsidiary is the obligor on both the capital lease
obligation and the operating lease obligations.
We sponsor defined benefit pension plans that may obligate us to make
contributions to the plans from time to time. We do not expect to be required to
contribute to our qualified defined benefit plan in 2004, and contributions
required for 2005, if any, and future years will depend on a number of
unpredictable factors including the market performance of the plan's assets and
future changes in interest rates that affect the actuarial measurement of the
plan's obligations.
We had estimated liabilities for losses and LAE of $438.3 million at December
31, 2003, the majority of which will be required to be paid in 2004 as the
related claims are settled. We expect operating cash flow to be sufficient to
meet our obligations to pay claims and we have readily marketable investments
available for sale should operating cash flows prove to be inadequate.
We have no material purchase obligations or other on- or off-balance sheet long-
term liabilities or obligations at December 31, 2003 (see further discussion in
Note 2 of Notes to Consolidated Financial Statements).
OFF BALANCE SHEET ARRANGEMENTS
We currently have no letters of credit, have issued no guarantees on behalf of
others (other than the guarantee by 21st Century Insurance Group of the capital
lease obligation described above), have no trading activities involving
non-exchange-traded contracts accounted for at fair value, and have no
obligations under any derivative financial instruments. In addition, the Company
has no material retained interests in assets transferred to any unconsolidated
entity (see further discussion in Note 2 of Notes to Consolidated Financial
Statements).
RESULTS OF OPERATIONS
Overall Results. We reported net income of $53.6 million, or $0.63 earnings per
share (basic and diluted), on direct premiums written of $1,223.5 million for
the year ended December 31, 2003, compared to a net loss of $12.3 million, or
$0.14 loss per share, on direct premiums written of $998.2 million for the year
ended December 31, 2002. For the year ended December 31, 2001, we reported a net
loss of $27.6 million, or $0.32
- ------------
1 Includes amounts due under long-term software license agreements of
approximately $15.1 million.
26
loss per share, on direct premiums written of $929.3 million. The results for
2003, 2002 and 2001 include: (i) after-tax charges for 1994 Northridge
earthquake costs of $24.1 million, $34.2 million and $45.6 million,
respectively; (ii) after-tax net income of $9.6 million for the year ended
December 31, 2003, resulting from nonrecurring, nonoperational items and a
favorable tax settlement with the IRS; (iii) an after-tax charge of $24.2
million, for the year ended December 31, 2002, relating to a write-off of
software; and (iv) $13.6 million for the year ended December 31, 2001,
associated with workforce reductions and the settlement of litigation matters.
The following table presents the components of our personal auto lines
underwriting profit or loss and the components of the combined ratio for the
past three years:
AMOUNTS IN THOUSANDS Personal Auto Lines
---------------------------------
Years Ended December 31, 2003 2002 2001
- ---------------------------------------------------------------------------------
Direct premiums written $1,223,377 $995,794 $898,862
- ---------------------------------------------------------------------------------
Net premiums written $1,218,519 $976,892 $842,657
- ---------------------------------------------------------------------------------
Net premiums earned $1,172,679 $924,559 $838,489
Net losses and loss adjustment expenses 922,122 768,277 738,335
Underwriting expenses incurred 209,551 142,899 124,564
- ---------------------------------------------------------------------------------
Personal auto lines underwriting profit (loss) $ 41,006 $ 13,383 $(24,410)
- ---------------------------------------------------------------------------------
Ratios:
Loss and LAE ratio 78.6% 82.9% 88.1%
Underwriting expense ratio 17.9% 15.6% 14.9%
- ---------------------------------------------------------------------------------
Combined ratio 96.5% 98.5% 103.0%
- ---------------------------------------------------------------------------------
The following table reconciles our personal auto lines underwriting profit or
loss to our consolidated net income (loss):
AMOUNTS IN THOUSANDS
Years Ended December 31, 2003 2002 2001
- -------------------------------------------------------------------------------
Personal auto lines underwriting profit (loss) $ 41,006 $ 13,383 $(24,410)
Homeowner and earthquake lines in runoff,
underwriting loss (40,175) (58,768) (77,598)
Net investment income 45,833 46,345 45,930
Realized investment gains 13,177 10,391 5,001
Write-off of software - (37,177) -
Other income (expense) 14,777 - (998)
Interest and fees expense (3,471) - -
Federal income tax (expense) benefit (17,572) 13,570 24,507
- -------------------------------------------------------------------------------
Net income (loss) $ 53,575 $(12,256) $(27,568)
- -------------------------------------------------------------------------------
Comments relating to the underwriting results of the personal auto and the
homeowner and earthquake lines in runoff are presented below.
UNDERWRITING RESULTS
The tables presented in the Notes to Consolidated Financial Statements summarize
the Company's unaudited quarterly results of operations for each of the two
years in the period ended December 31, 2003, and the results of operations by
line of business for each of the three years then ended. The following
discussion of underwriting results by line of business should be read in
conjunction with the information presented in those tables and elsewhere herein.
27
Personal Auto. Personal automobile insurance is our primary line of business.
Vehicles insured outside of California accounted for less than 3% of our direct
written premium in 2003, 2002 and 2001.
Direct premiums written for the year ended December 31, 2003, increased $227.6
million (22.9%) to $1,223.4 million in 2003 compared to $995.8 million in 2002
and $898.9 million in 2001. Of the $227.6 million increase in 2003, $35.2
million was due to rate increases, while $192.4 million was due to a higher
number of insured vehicles. Of the $96.9 million increase in 2002, $36.7 million
was due to rate increases, $12.9 million was due to the effects of the
consolidation of 21st of Arizona, and $47.3 million resulted from a higher
number of insured vehicles. Current growth is being generated through active
advertising for new customers and product innovations.
California auto retention was 92% for the year ended December 31, 2003, compared
to 93% and 92% for the years ended December 31, 2002 and 2001, respectively. The
decline in 2003 is primarily due to the April 2003 rate increase and the
substantial increase in new customers, who typically have a lower retention rate
than long-time customers.
Net premiums earned increased $248.1 million (26.8%) to $1,172.7 million in
2003, compared to $924.6 million in 2002 and $838.5 million in 2001. The
increases in 2003, 2002 and 2001 are greater than the proportional increase in
the corresponding direct premiums written because of the decrease in the quota
share reinsurance arrangement with AIG subsidiaries from 6% in 2001 to 4% until
September 1, 2002, at which time we entered into an agreement to cancel future
cessions under this treaty. The cancellation resulted in a one-time pre-tax
charge of $0.9 million.
The combined ratio was 96.5% for the year ended December 31, 2003, compared to
98.5% and 103.0% for 2002 and 2001, respectively. Our management remains focused
on achieving sustainable 15% growth and a combined ratio of 96%. In 2003, we
achieved an underwriting profit in each quarter and achieved growth of 22.9%,
our best growth since 1987.
Net losses and LAE incurred increased $153.8 million (20.0%) to $922.1 million
in 2003 compared to $768.3 million and $738.3 million in 2002 and 2001,
respectively. The loss and LAE ratios were 78.6%, 82.9% and 88.1% for the years
ended December 31, 2003, 2002 and 2001, respectively. The effects on the loss
and LAE ratios of changes in estimates relating to insured events of prior years
were 1.0% in 2003, 1.8% in 2002 and 5.5% in 2001. These changes in estimates
pertained mainly to development in average paid loss severities beyond amounts
previously anticipated. For additional discussion of the factors that led to
these changes in estimates, please see Item 1 of this report under the heading
Loss and Loss Adjustment Expense Reserves. In general, changes in estimates are
recorded in the period in which new information becomes available indicating
that a change is warranted, usually in conjunction with our monthly actuarial
review.
The ratios of underwriting expenses to net premiums earned were 17.9%, 15.6% and
14.9% for the years ended December 31, 2003, 2002 and 2001, respectively. The
increase was primarily due to growth in advertising expenditures and costs
associated with increasing the number of new sales agents to handle record
volume of new business during the latter half of 2002 and all of 2003. Several
productivity enhancement initiatives are underway aimed at reducing per unit
process costs and lowering fixed costs in corporate support areas.
In the third quarter of 2002 the Company entered into a catastrophe reinsurance
agreement, which reinsures any covered events, defined as auto physical damage,
up to $30.0 million in excess of $15.0 million. This agreement expired on
December 31, 2003. Effective January 1, 2004 we entered into a new, one-year
catastrophe reinsurance agreement, which provides reinsurance on covered events
up to $45 million in excess of $20 million. The premium for this reinsurance
coverage is approximately $0.1 million per month.
Homeowner and Earthquake Lines in Runoff. The homeowner and earthquake lines,
which are in runoff, experienced adverse development on the remaining loss
reserves of $40.1 million, compared to adverse development of $56.2 million in
2002 and $72.3 million in 2001, of which development related to SB 1899
earthquake claims accounted for $36.9 million, $52.6 million, and $70.3 million,
respectively.
28
We have executed various transactions to exit from our homeowner line. Under a
January 1, 2002 agreement with Balboa Insurance Company ("Balboa"), a subsidiary
of Countrywide Financial Corporation ("Countrywide"), 100% of homeowner unearned
premium reserves and losses on or after that date were ceded to Balboa. Under
the terms of this agreement, we retain certain loss adjustment expenses. We
began non-renewing homeowner policies expiring on February 21, 2002, and
thereafter. Substantially all of these customers were offered homeowner coverage
through an affiliate of Countrywide. We have completed this process and no
longer have any homeowner policies in force.
We caution that the recorded loss and LAE estimates for our earthquake lines are
subject to a greater than normal degree of uncertainty for a variety of reasons
(see Note 16 of the Notes to Consolidated Financial Statements).
LOSS AND LAE INCURRED
The following table summarizes losses and LAE incurred, net of reinsurance, for
the periods indicated:
AMOUNTS IN THOUSANDS
Years Ended December 31, 2003 2002 2001
- ---------------------------------------------------------------------------------------
Net Losses and LAE incurred related to insured events of:
Current year:
Personal auto lines $910,963 $752,077 $692,593
Homeowner lines 141 2,222 25,636
Earthquake lines - - -
- ---------------------------------------------------------------------------------------
Total current year 911,104 754,299 718,229
- ---------------------------------------------------------------------------------------
Prior years:
Personal auto lines 11,159 16,200 45,742
Homeowner lines