Years Ended December 31, 2001 2000 1999 1998 1997 (In thousands) ---- ---- ---- ---- ---- Income Statement Data: Direct written premiums................. $187,129 $203,268 $148,824 $153,914 $135,580 ======= ======= ======= ======= =======
Loss and loss adjustment expenses, or LAE, are based upon the accumulation of cost estimates for reported claims occurring during the period as well as an estimate for losses that have occurred but have not yet been reported. We use a variety of actuarial projection methods to make these estimates and we must use our judgment in selecting development factors and assumed trends. Workers' compensation claims can be paid out over a substantial number of years due to certain lifetime benefits. In addition, the period between when a claim is reported to us and when the injury occurred could be longer than one year and when we are no longer insuring the account. Loss and LAE reserves have a significant degree of uncertainty when related to their subsequent payments. Although our reserves are established on the basis of a reasonable estimate, it is not only possible but probable that our reserves will differ from their related subsequent developments. Underlying causes for this uncertainty include, but are not limited to, uncertainty in development patterns, unanticipated inflationary trends affecting the services covered by the insurance contract, adverse legal outcomes and new interpretations of legislation or of disputed contract provisions that result in our having to provide new or extended benefits. This uncertainty can result in both adverse as well as favorable development of actual subsequent activity when compared to the reserve established. Any subsequent change in loss and LAE reserves established in a prior year would be reflected in the current year's operating results.
Effective July 1, 1998, we entered into what we refer to as a "low level" reinsurance agreement. See Losses and Loss Adjustment Expenses below for further details on this agreement. The favorable terms of the low level reinsurance agreement provided us with an improved loss ratio, as we ceded a significant amount of losses to the reinsurer. Since the low level agreement began run-off in July 2000, the amount of premium ceded has declined and we have been receiving payments from the reinsurer over the past year which has resulted in a positive cash flow from operations during 2001.
Included in general, administrative and other expenses are other underwriting expenses of $12.3 million for the year ended December 31, 2001 compared to $12.0 million for the prior year period. Also included are policyholders' dividends of $1.5 million for the year ended December 31, 2001 compared to $2.2 million in 2000. The majority of the dividends are for Nevada participating policies and represent 0.8% of 2001 net earned premiums compared to 1.7% of 2000 net earned premiums. In addition, during 2000, we wrote-off capitalized costs of $3.0 million on an information system software project that was canceled because the vendor was unable to fulfill its contractual obligations.
Years Ended December 31, 2000 % of Total 1999 % of Total ---- ---------- ---- ---------- (dollars in millions) California........................... $155.6 76.5% $120.5 80.9% Colorado............................. 16.7 8.2 12.3 8.3 Nevada............................... 15.5 7.6 2.6 1.8 Texas................................ 7.8 3.9 7.2 4.8 Other States......................... 7.7 3.8 6.2 4.2 ----- ----- ----- ----- Total.............................. $203.3 100.0% $148.8 100.0% ===== ===== ===== =====
We had net realized losses of $620,000 for the year ended December 31, 2000 compared to net realized losses of $381,000 for the prior period. We have tried to manage our investment portfolio to minimize unplanned sales of our available-for-sale investments.
Our insurance subsidiaries are required to maintain sufficient liquid assets to pay claims and other policy obligations. Workers' compensation insurance is referred to as a "long-tail" business because of the length of time that typically occurs between when the premium is collected and when a claim is fully paid and settled due to life-time benefits that could be provided to a claimant. The excess of premiums collected over claims and expenses paid are invested until needed. State regulations dictate the kinds of investments we can have and we try to match the maturity of our investments with expected future cash needs.
In September 1991, CII Financial issued 7 1/2% Convertible Subordinated Debentures (the "old junior subordinated debentures") of which $47.1 million were outstanding at March 31, 2001. The old junior subordinated debentures were neither assumed nor guaranteed by Sierra and were subordinated to Sierra's credit facility debt. Interest on the old junior subordinated debentures was due semi-annually on March 15 and September 15, and they matured September 15, 2001. Each $1,000 in principal was convertible into 25.382 shares of common stock of Sierra at a conversion price of $39.398 per share.
Inflation can be expected to affect our operating performance and financial condition in several aspects. Inflation can reduce the market value of our investment portfolio; however, we try to manage our investment portfolio to minimize unplanned sales. Inflation can adversely affect the portion of loss and LAE reserves that relate to hospital and medical expenses, although some medical expenses are established by statute. Loss reserves related to indemnity benefits for lost wages are indirectly affected by inflation as these amounts are established by statute. In February 2002, California enacted new legislation that will increase benefits paid to injured workers starting January 1, 2003. Some benefits will be tied to the average national weekly wage. We do not believe that inflation has had a material effect on our results of operations.
To the Board of Directors and Stockholder of CII Financial, Inc.:
Deferred Policy Acquisition Costs. Policy acquisition costs consist of commissions, premium taxes and other underwriting costs, which are directly related to the production and retention of new and renewal business, and are deferred and amortized as the related premiums are earned. Should it be determined that future policy revenues and earnings on invested funds relating to existing insurance contracts will not be adequate to cover related costs and expenses, deferred costs are expensed.
Business Segment. For each of the three years in the period ended December 31, 2001, the Company operated in a single business segment, workers' compensation insurance.
The contractual maturities of held-to-maturity debt securities at December 31, 2001 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations:
Investment income, by major category of investments, is summarized as follows:
The Company holds certain mortgage notes on residential and commercial real estate. In connection with CII Financial's relocation of its principal executive offices to Pleasanton, California in July 1992, to retain key officers and other employees, the Company extended mortgage loans for the purchase of such employees' principal residences. In 1994, the terms of the loans were amended and the interest rate was reduced to a fixed rate of 3% per annum; the maturity date was fixed to March 2009; and each loan can be assumed, one time, by a qualified purchaser of the employee's residence. The interest rate, upon assumption, increases to 3.5% per annum. As of December 31, 2001 and 2000, the outstanding balances on relocation loans to active employees, which are included on the balance sheet as mortgage loans on affiliated real estate, were $992,000 and $1,257,000, respectively. Relocation loans to non-active employees are included on the balance sheet as mortgage loans on non-affiliated real estate and as of December 31, 2001 and 2000, the outstanding balances were $2,363,000 and $3,327,000, respectively.
The second commercial mortgage loan of $7.4 million was originally financed to Sierra in 2000 but was assumed by a non-affiliated buyer in conjunction with a sale-leaseback of Sierra's Las Vegas real estate portfolio. The loan to value based on the purchase price was 64%. The interest rate varies each month based on LIBOR plus a margin and the interest rate at December 31, 2001 was 5.48%. The loan was scheduled to mature on December 31, 2001; however, the buyer exercised the option to extend the maturity date for six months and paid a fee of .5% of the outstanding balance. The buyer can extend the loan for an additional six months with proper notice to California Indemnity and payment of an additional fee.
The following table provides a reconciliation of the beginning and ending reserve balances for unpaid loss and LAE. The loss estimates are subject to change in subsequent accounting periods and any change to the current reserve estimates would be accounted for in future results of operations.
A summary of the provision for income taxes for the years ended December 31, 2001, 2000 and 1999 is as follows:
If a dividend or other distribution is contemplated which, along with all other dividends or distributions made within the preceding twelve months, exceeds the greater of 10% of the insurance company's policyholders' surplus as of the end of the prior calendar year or net income for such calendar year, at least 30 days prior notice to the Commissioner must be given, and no payment of the dividend or distribution may be made unless and until (i) the Commissioner has approved it or (ii) the 30 days have elapsed and the Commissioner has not disapproved the proposed payment.
CII Financial, Inc. paid dividends of $2,637,000, in March 2000, to Sierra. California Indemnity paid dividends to CII Financial of $10,000,000 and $6,800,000, during 2001 and 2000, respectively. During 2001 and 2000, Commercial Casualty paid $3,000,000 and $1,685,000, respectively, in dividends to California Indemnity. CII Insurance Company paid $250,000 and $375,000 during 2001 and 2000, respectively, in dividends to California Indemnity. Due notice was filed with the California Department of Insurance, and all payments were made after the expiration of the required waiting period in accordance with California Insurance regulations.
The fair value of the look-back option implicit in each offering of the Purchase Plan is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 2001, 2000 and 1999, respectively: dividend yield of 0% for all years; expected volatility of 85%, 46% and 45%; risk-free interest rates of 4.36%, 5.79% and 4.66%; and expected lives of six months for all years.
March June September December 31 30 30 31 (In thousands) ----------- ------------- ----------- ---------- Year ended December 31, 2001: Net earned premiums.............................. $38,890 $ 42,484 $46,918 $44,923 Net investment income............................ 4,495 3,848 3,556 3,968 ------ ------- ------ ------ Total revenues................................... 43,385 46,332 50,474 48,891 Costs and expenses............................... 43,244 44,752 49,929 48,087 ------ ------- ------ ------ Income before income tax and extraordinary gain........................... 141 1,580 545 804 Federal income tax provision ................... 225 332 204 686 ------ ------- ------ ------ Income (loss) before extraordinary gain.......... (84) 1,248 341 118 Extraordinary gain, net of tax................... 0 463 (64) (37) ------ ------- ------ ------