The property and casualty insurance industry uses the combined ratio as a measure of underwriting profitability. On a statutory accounting basis, the combined ratio is the sum of the loss ratio (losses and loss adjustment expenses incurred as a percent of net earned premiums) plus the expense ratio (underwriting expenses, which include acquisition costs, as a percent of net written premiums). The combined ratio reflects only underwriting results, and does not include income from investments or
When reviewing reserves, we analyze historical data and estimate the impact of various loss development factors, such as our historical loss experience and that of the industry, trends in claims frequency and severity, our mix of business, our claims processing procedures, legislative enactments, judicial decisions, legal developments in imposition of damages, and changes and trends in general economic conditions, including the effects of inflation. A change in any of these factors from the
Net Realized Investment Losses. Net realized investment losses for the year ended December 31, 2002 decreased by $4.7 million to $0.3 million from $5.0 million for the year ended December 31, 2001. The 2001 net realized losses resulted primarily from the sale of certain securities which had significantly declined in credit quality from the date of purchase and from sales of securities in the ordinary course following the resetting of their carrying value under purchase accounting as of the date of the Acquisition.
Transaction Expenses. Transaction expenses increased to $9.5 million in 2001, as compared to $0.4 million in 2000. These expenses represent costs incurred in connection with the Acquisition. These costs were non-recurring in nature and did not result from ongoing insurance operations. Such costs primarily included transaction bonuses earned by employees, fees paid to Thomas Black Corporation's investment banker and legal fees.
Income Taxes. Our effective tax rate on net income before extraordinary item was 35.3% and 30.0% for the years ended December 31, 2001 and 2000, respectively. In 2001, the effective rate approximated the statutory rate of 35% due to a reduction in taxable income related to tax-exempt investment income, offset by non-deductible transaction expenses and state income tax expense. In 2000, the effective rate was lower than the statutory rate of 35% primarily due to tax-exempt interest income and the corporate dividends received deduction offset by non-deductible state income tax and employee stock ownership plan expenses. See note 13 to our consolidated financial statements.
Amounts which vary with and are primarily related to acquiring new and renewal business, principally commissions and premium taxes, are deferred and amortized ratably over the effective period of the policies. All other acquisition expenses are charged to expense as incurred. Deferred policy acquisition costs are reviewed to determine if they are recoverable from future income, and if not, are charged to expense. Future investment income attributable to related premiums is taken into account in measuring the recoverability of the carrying value of this asset. All other acquisition expenses are charged to expense as incurred.
In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 141, "Business Combinations". SFAS No. 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method. With respect to deferred credits (i.e. negative goodwill), SFAS No. 141 calls for the recognition of all existing deferred credits arising from business combinations for which the Acquisition date was after June 30, 2001 to be recognized through the income statement as an extraordinary gain. Effective with the Acquisition, the Company adopted SFAS No. 141 and accounted for the Acquisition under the purchase method. The Company recognized the resultant deferred credit of $117.5 million through earnings as an extraordinary gain in the successor period of 2001.
The Company entered into SARs agreements with executive management on October 16, 2001. Under the terms of the agreements, the Company granted 103,488 SARs on October 16, 2001 for past and future services. The agreements designated the number of "covered shares" for each executive and other employees and established the exercise price of $6.88 per share.