Unless otherwise stated, "we," "our" or "us" means The Commerce Group, Inc. and its subsidiaries. "Commerce" refers to The Commerce Insurance Company, "Commerce West" refers to Commerce West Insurance Company, "American Commerce" refers to American Commerce Insurance Company, "Citation" refers to Citation Insurance Company, and "AHC" refers to ACIC Holding Co., Inc. In addition, unless otherwise stated, all references to "years ended" are for our fiscal year which ends December 31. Dollar amounts are in thousands, except per share data.
Our ability to capitalize on our business strengths and implement our strategies is subject to particular risks. For example, because we are primarily a personal automobile insurance carrier, adverse developments in this industry could negatively affect us more than insurers that are more diversified across multiple business lines. Additionally, the concentration of our business in Massachusetts makes us more susceptible to any adverse development in the prevailing legislative, regulatory, economic, demographic, competitive and other conditions, including weather-related events, and adverse judicial decisions in Massachusetts, and could make it more costly or difficult for us to conduct our business. Our affinity group marketing programs provide members of participating groups and associations with a convenient means of purchasing discounted private passenger automobile insurance. We would lose a significant avenue for offering our existing affinity group discounts and our sales of personal automobile and homeowner insurance products in Massachusetts would likely decline if our affinity relationship with the AAA Clubs of Massachusetts is substantially changed or terminated and we are unable to devise and implement effective mitigation measures. These AAA arrangements have rolling three-year terms, and a Massachusetts AAA Club may terminate the agreement upon a minimum of two years' written notice. American Commerce has relationships with various AAA Clubs other than Massachusetts, which are not subject to any minimum advance notice to terminate. If American Commerce's relationship with one or more large AAA clubs terminates, then American Commerce would lose a substantial portion of its business, which could have a material adverse effect on our business and results of operations.
Member companies of CAR have joint and several liabilities for the obligations of CAR. If one member of CAR fails to pay its assessments, the remaining members of CAR will be required to pay the pro-rata share of the member who fails to pay its obligations. As of December 31, 2004, we were not aware of any CAR member company which has failed to meet its obligations.
The primary transition phase elements in the New Rules call for the current personal automobile residual market pool to be comprised of three components:
The New Rules would also require, for the period beginning January 1, 2005, that only companies with a September 30, 2004 market share of 2% or more will remain as a servicing carrier for the business written by ERPs. As part of these New Rules, high loss ratio and non-high loss ratio ERPs would be reapportioned amongst these servicing carriers so as to equalize the amount of ERP business written by each servicing carrier in proportion with each servicing carrier's share of the total servicing carrier market. Lastly, the New Rules would create the assigned risk plan for certain eligible business, entitled the Massachusetts Automobile Insurance Plan (the "MAIP"), beginning in 2006 for certain new business, 2007 for certain renewal business and ultimately for all business in 2008.
The New Rules approved by the Commissioner for the MAIP, along with the related Transition Rules, can be found under the section titled "Decision and Order on Changes to Rules of Operation 2, 9 through 14, and 17, and Rules 21 through 40" located at the Massachusetts Division of Insurance website address: http://www.mass.gov/doi/Legal_Hearings/Legal_Dec_decisions.html
. While the New Rules are stayed, CAR will operate under the rules that existed immediately prior to the Commissioner's adoption of the New Rules or as rule changes are permitted. A company's participation ratio in CAR's deficit is directly affected by the business it keeps voluntarily, as well as what it cedes to CAR. The values associated with credits as a result of voluntary retentions and penalties for ceding under existing CAR rules are set annually but have not yet been established and approved by the Commissioner for 2005. Until these values are known, we cannot predict the resulting impact on the CAR deficit for 2005, or the impact on our participation ratio. If significant changes are made to these values from those established for 2004, companies could cede significantly larger amounts of business to CAR, thereby increasing the overall CAR deficit and our participation ratio could also significantly increase. If this were to happen, we could be faced with significantly higher CAR costs in 2005 as compared to 2004.
We cannot predict whether the court will permit the Commissioner to implement the New Rules and, if so, whether the New Rules would become effective retroactively to January 1, 2005 as proposed, nor can we predict when this matter will be resolved. As such, we cannot predict whether the New Rules will affect our competitive position or financial performance other than as described above. We intend to review and, if necessary, revise our business strategies in response to the above information.
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We consider the following accounting policies, which are especially dependent upon our judgments and estimates, to be critical to the preparation of our financial statements.
We determine our net liability estimate for losses and LAE by using individual estimates of reported claims adjusted for our best estimate by line of business and a review of these results by our actuarial area using generally accepted actuarial reserving techniques. After taking into account all relevant factors, we believe that, based on existing information, the provision for losses and LAE at December 31, 2004 is adequate to cover the ultimate net cost of losses and claims incurred as of that date. The ultimate liability, however, may be greater or lower than established reserves. If the ultimate payment is greater than or less than our estimated liability for losses and LAE, we will incur additional expense or income, as appropriate, which may have a material impact on our results of operations.
Investments and Other-than-temporary Impairments. The carrying values of investments in fixed maturities, which include taxable and non-taxable bonds, and investments in common and preferred stocks, are derived from market prices supplied by our investment custodian, or when no price is provided by the custodian, we obtain a third party valuation. Fair market value of fixed maturities and equity securities is based on quoted market prices. For other investments, fair value equals quoted market price, if available. Unrealized investment gains and losses on common and preferred stocks and fixed maturities, to the extent that there is no other-than-temporary impairment of value, are credited or charged, net of any tax effect, to a separate component of stockholders' equity, known as "net accumulated other comprehensive income (loss)," until realized.
Our net earnings in recent years have been significantly affected by our ownership interests in several closed-end preferred stock mutual funds that we were required to account for using the equity method of accounting. For our investment in any fund in which we own 20% or more of the fund's shares, the equity method of accounting requires us to categorize as a realized investment gain or loss the change in the net asset value of that fund from the beginning of the current fiscal year. Our investment in these funds has had a material effect on our realized gains and losses in recent years and may have caused our net earnings to be more volatile than those of similar companies. During 2003, we decreased our ownership below 20% in all but one closed-end preferred stock mutual fund. At December 31, 2004, we continued to have only one closed-end preferred stock mutual fund in which we owned more than 20%.
Overview. We have been the largest writer of personal property and casualty insurance in Massachusetts in terms of market share of direct premiums written since 1990. Our estimated share of the Massachusetts personal automobile market increased to 29.0% during the eleven months ended November 30, 2004, significantly exceeding our two nearest competitors, Safety Insurance Group, Inc. and Arbella Insurance Group, who maintained an estimated 11.0% and 9.3% market share, respectively.
Although mandated average personal automobile premium rates increased 2.5% in 2004, our average revenue per exposure increased 5.8%. We believe that the relative increase for 2004 as compared to the Commissioner's state mandated average rate resulted primarily from:
We evaluate our operations by monitoring key measures of growth and profitability. We measure our growth by examining our direct premiums written as well as increases in exposures and policies. We generally measure our operating results in accordance with accounting principles generally accepted in the United States of America (GAAP) by examining our net earnings, return on equity (ROE), and our loss and LAE, underwriting expense and combined ratios on a consolidated basis. Our key measures include:
Direct premiums written is the sum of the total policy premiums, net of cancellations, associated with policies underwritten and issued by our insurance subsidiaries. We use direct premiums written, which includes premiums that we cede to CAR and other reinsurers, as a measure of the underlying growth of our insurance business from period to period.
Our key operating measures for the years ended December 31, 2004, 2003 and 2002 follow (dollars in millions, except earnings per share):
The significant increase in earnings and ROE in 2004 over 2003 was primarily due to the decrease in our loss ratio. We attribute the improvement in our loss ratio to several factors:
The effect of our improved loss ratio on 2004 earnings was partially offset by the increase in our underwriting ratio. This increase was driven by a significant increase in our agents' profit sharing expense in 2004. The increase in agents' profit sharing expense is the result of substantially better underwriting results in 2004 than in 2003. The impact of our increased agents' profit sharing expense on our underwriting ratio was partially offset by lower 2004 policy year mandated agency commission rates for Massachusetts personal automobile policies.
Direct premiums written and earned for the years ended 2004 and 2003 follow:
We experienced growth in direct premiums written in all of our insurance categories in Massachusetts, with growth in personal automobile accounting for approximately 82% of the segment's increase. Personal automobile business growth was a result of a 6.2% increase in average written premium per written exposure coupled with a 4.9% increase in the number of exposures written during 2004. Our year-to-date homeowners growth was from a 12.2% increase in average premium per policy coupled with a 1.9% increase in the number of policies. Our year-to-date commercial automobile growth was from a 3.1% increase in average premium per policy coupled with a 4.3% increase in the number of policies.
Personal automobile and homeowners growth accounted for approximately 91% of the increase in direct premiums written in states other than Massachusetts. The increase in personal automobile and homeowners business was primarily due to additional rate per policy, partially offset by a decrease in the number of policies. The policy count decrease was primarily due to increased levels of competition, our desire to maintain appropriate underwriting results and withdrawal from several states as previously reported.
Net investment income as a percentage of average net investments (at cost)
We reviewed our investment holdings at December 31, 2004 for other-than-temporary declines in market value, in accordance with our previously stated accounting policy. Based on this analysis, we determined that the impairments represented in the above gross unrealized loss table are temporary. The primary reasons for these temporary impairments are related to interest rates and general market conditions. We intend to hold to recovery or maturity all of our temporarily impaired equity or fixed maturity securities, respectively.
As a result of changes in estimates of insured events in prior years, the provision for loss and LAE decreased $57,031 for the year ended 2004 and $25,224 for the year ended 2003. The favorable development is due primarily to lower than anticipated losses related to the personal automobile liability, the automobile physical damage and the commercial multiple peril lines of business. Conditions and trends that have affected development in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based upon these developments. The amounts we will ultimately incur from loss and loss adjustment expenses could differ materially in the near term from the amounts recorded.
Unpaid losses and LAE reserves prior to the effect of ceded reinsurance recoverable, by line of business, at December 31, 2004 and 2003, and the actuarial low and high range estimates at December 31, 2004 follow (in millions):
Our overall effective tax rate for the year ended 2004 was 29.3% as compared to 26.5% for 2003. In both years, our effective rate was lower than the statutory rate of 35.0% primarily due to tax-exempt interest and the corporate dividends received deduction. Our effective tax rate increased in 2004 due to improved underwriting results which are taxed at 35%. Our income tax rate for 2003 was benefited 1.8% by the reversal of a $3.9 million tax valuation allowance related to investments which we established in 2002.
Partially offsetting the change in after-tax net investment gains (losses) was the effect of two one-time items which increased 2002 income. In 2002, we had $9.5 million of other income and $11.2 million for the after-tax cumulative effect of a change in accounting for negative goodwill. The $9.5 million of prior year other income was related to payments received from other insurance carriers under agreements to assume their Massachusetts personal automobile insurance business written in Massachusetts.
Included in losses and loss adjustment expenses and policy acquisition costs are certain corporate expenses related to stock options granted to agents of American Commerce and book value awards granted to our officers. During 2003, corporate expenses related to the American Commerce agents' options increased to $9.0 million, as compared to $1.5 million in 2002. This increase was due to an increase in the market value of our common stock, an increase in the number of stock options outstanding, an additional year of vesting of those stock options granted in prior years and changes in estimates made to certain assumptions used in our fair value estimation. The corporate expenses related to the book value awards amounted to $7.1 million in 2003, as compared to $1.0 million in 2002. The value of book value awards is primarily related to the growth in our stockholders' equity. At December 31, 2003, our stockholders' equity per share was $28.45, as compared to $24.60 at December 31, 2002.
Net investment income is affected by the composition of our investment portfolio and yields on those investments. As depicted in the following table, net investment income for the year ended 2003 decreased $6.3 million, or 6.4%, compared to 2002, principally as a result of a decrease in average yields partially offset by an increase in average invested assets at cost. The decrease in yield is primarily due to lower short-term yields coupled with an environment of lower average long-term yields and higher yielding investment securities being called. The decline in average long-term yields is illustrated by a decrease in the yield on 10-year government bonds which declined 59 basis points from an average of 4.57% at December 31, 2002 to an average of 3.98% at December 31, 2003.
Net investment income after-tax as a percentage of average net investments (at cost)
Net realized investment gains totaled $76.1 million, or $1.66 per diluted share, for the year ended 2003 as compared to net realized investment losses of $82.4 million, or $2.07 per diluted share, for 2002.
As a percentage of net premiums written, underwriting expenses for our insurance subsidiaries improved to 23.5% for the year ended 2003 as compared to 24.1% for 2002. The improvement was primarily due to lower 2003 policy year mandated Massachusetts personal automobile commission rates partially offset by a charge for an assessment from the Massachusetts Insurers Insolvency Fund (MIIF) of $8.1 million in 2003, compared to a 2002 MIIF charge of $4.5 million.
For the year ended 2003, our combined ratio was 97.5%, compared with 99.3% for 2002. The decrease in the combined ratio was primarily the result of the factors that resulted in the lower loss and underwriting ratios previously mentioned.
Our financial condition improved significantly in 2004. Our stockholders' equity per share increased 17.7% from $28.45 at December 31, 2003 to $33.50 at December 31, 2004. Our ratio of total liabilities to stockholders' equity decreased nearly 29 percentage points at December 31, 2004 from the prior year end, despite total liability growth of 8.5%. This decrease is primarily due to current year earnings and growth in paid-in capital from stock option exercises, partially offset by changes in treasury shares and net accumulated other comprehensive income. The market and equity value of our total investments increased 14.3% due to our investing cash from operating and investing activities, partially offset by unrealized losses.
Our contractual obligations and commercial commitments as of December 31, 2004 by maturity follow:
The liability for unpaid losses and LAE represents the accumulation of individual case estimates for reported losses, adjustments to this amount on a line of business basis and estimates for incurred but not reported losses and LAE, net of salvage and subrogation recoverable. The liability is intended to cover the ultimate net cost of all losses and LAE incurred through the balance sheet date. Payment amounts are estimated, based on payment patterns experienced through 2004.
The other limited partnership interest required a commitment by us to invest up to $3,500 into the partnership. As of December 31, 2004, we have invested $2,555 into the partnership. The partnership was formed to operate as an investment fund principally for the purpose of making investments in equity and equity related securities of companies operating in the area of insurance distribution and distribution related activities.
We entered into a 70% quota-share agreement for one year with modified terms. The new program became effective July 1, 2004. In the event of a catastrophe, recovery is limited to 70% of the loss with a maximum recovery estimated at $315 million, equating to a total loss to us of $450 million. There are several limitations in the contract regarding losses related to nuclear, chemical, and biological terrorist events. Our maximum loss recovery in case of these types of events is estimated at $28 million. Our estimated total loss, before reinsurance, on our other than automobile business for 100 and 250-year hurricanes is approximately $240 million and $457 million, respectively. We derived our estimates through the services of Employers Reinsurance Corporation on our December 31, 2003 other-than-automobile exposures, which utilized the RMS (Risk Management Solutions) risk assessment system. We believe that most property and casualty insurance companies establish their catastrophe reinsurance programs between the 100-year and 250-year storm estimates. Note M to our consolidated financial statements provides additional information about our reinsurance.
In November 2004, our Board of Directors approved Commerce Insurance's application to become a member of the Federal Home Loan Bank of Boston. If the application is accepted by the FHLB of Boston, Commerce Insurance will have a significant new source of liquidity. The FHLB of Boston, which is one of 12 regional FHLBs, serves as a reserve or central bank for its members within its assigned region. The FHLB of Boston makes loans, which are referred to as advances, to members in accordance with policies and procedures established by its board of directors. These policies and procedures are subject to the regulation and oversight of the Federal Housing Finance Board. All advances from the FHLB of Boston to Commerce Insurance would be required to be fully secured by sufficient collateral as determined by the FHLB. If Commerce Insurance had been a member of the FHLB of Boston as of December 31, 2004, we estimate that Commerce Insurance would have had the capacity to borrow approximately $300,000 from the FHLB of Boston.
We expect to pay significantly more for agent profit sharing in 2005 than we paid in 2004. We paid approximately $18,000 for agent profit sharing in 2004. Due to our excellent underwriting results during the current year, we estimate paying $47,134 in the second quarter of 2005.
We manage our market risk by focusing on higher quality equity and fixed income investments, by periodically monitoring the credit strength of companies in which investments are made, by limiting exposure in any one investment and by monitoring the quality of the investment portfolio by taking into account credit ratings assigned by recognized rating organizations. Our portfolio included six securities in default, three corporate bonds and three preferred stocks with a total carrying value of $175 at December 31, 2004. Of our bonds and preferred stocks, 94% of the market value was rated in either of the two highest quality categories provided by the NAIC as of December 31, 2004, as compared to 93% at December 31, 2003. Although we have significant holdings of various closed-end preferred stock mutual funds, these funds are comprised primarily of preferred and common stocks traded on national stock exchanges, thus limiting exposure to any one obligor.
As part of our investing activities, we assume positions in fixed maturity, equity, short-term and cash equivalents markets. Therefore, we are exposed to the impacts of interest rate changes in the market value of investments. At December 31, 2004, our exposure to interest rate changes and equity price risk has been estimated using sensitivity analysis. The interest rate impact is defined as the effect of a hypothetical interest rate change of plus-or-minus 200 basis points on the market value of fixed maturities and preferred stocks.
Our fixed income portfolio's weighted average duration (which includes all fixed maturities and preferred stocks) as of December 31, 2004 and 2003 was 5.6 years. The "duration" of a security is the time-weighted present value of the security's expected cash flows and is used to measure a security's price sensitivity to changes in interest rates. The duration reflects industry prepayment assumptions. The analytic systems we used to calculate the above duration data utilize optional call dates, sinking fund requirements and assume a non-static prepayment pattern in deriving these averages. As of the end of February 2005, our weighted average duration has declined to 4.5 years primarily as a result of sales of securities during the first two months of 2005.
Equity Price Risk. The equity price risk is defined as a hypothetical change of plus-or-minus 10% in the market value of common stocks. The following table summarizes our equity price risk, based on the results of the sensitivity analysis at December 31, 2004:
This annual report and Form 10-K may contain statements that are not historical fact and constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act. Statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These statements are often, but not always, made through the use of words or phrases such as "anticipates," "estimates," "plans," "projects," "continuing," "ongoing," "expects," "may," "should," "management believes," "we believe," "we intend," and similar words or phrases. These statements may address, among other things, our strategy for growth, business development, regulatory approvals, market position, expenditures, financial results and reserves. Accordingly, these statements involve estimates, assumptions and uncertainties that could cause actual results to differ materially from those expressed in them. All forward-looking statements are qualified in their entirety by reference to the factors discussed throughout this annual report and Form 10-K and in our December 2003 Form S-3, our Forms 10-Q, and other documents filed with the SEC. Among the key factors that could cause actual results to differ materially from forward-looking statements:
market disruption in Massachusetts, if competitors exited the market or become insolvent;
Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Securities and Exchange Act of 1934. Management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2004. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework. Based on this assessment, management concluded the Company maintained effective internal control over financial reporting as of December 31, 2004.
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of The Commerce Group, Inc. and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein for each of the two years in the period ended December 31, 2004 when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. The financial statements and financial statement schedules of The Commerce Group, Inc. and its subsidiaries as of December 31, 2002 and for the period ended December 31, 2002 were audited by other auditors whose report dated January 31, 2003, expressed an unqualified opinion on those financial statements.
Also, in our opinion, management's assessment, included in Management's Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management's assessment and on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
Bonds payable ($300,000 face less discounts of $1,814 and $2,016) (Note G)
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). Our consolidated financial statements include the accounts of The Commerce Group, Inc. and its subsidiaries, Bay Finance Company, Inc., Clark-Prout Insurance Agency, Inc. and Commerce Holdings, Inc. (CHI). The Commerce Insurance Company (Commerce), Commerce West Insurance Company (Commerce West) and Citation Insurance Company (Citation) are wholly-owned subsidiaries of CHI. American Commerce Insurance Company (American Commerce) is a wholly-owned subsidiary of ACIC Holding Co., Inc. (AHC). AHC is owned jointly with AAA Southern New England (AAA SNE) with CHI maintaining a 95% common stock interest and AAA SNE maintaining a 5% common stock interest. All inter-company transactions and balances have been eliminated in consolidation. Certain prior year account balances have been reclassified to conform to the 2004 presentations.
We account for venture capital fund investments in which we own more than a 5% interest on the equity method. The operating results of these venture capital fund investments have been reflected in realized gains and losses.
All of our investments in fixed maturity and equity securities at December 31, 2004 and 2003 were classified as available-for-sale. Realized gains and losses on available-for-sale securities were determined by using the specific identification method. We have not invested more than 5% of fixed maturities in any one state or political subdivision.
Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. The carrying value of fixed maturities on deposit for state regulating authorities at December 31, 2004 was $7,805.
John Hancock Patriot Premium Dividend II Fund. The quoted market value of this investment is less than its carrying value at December 31, 2004. The carrying value is the net asset value of the underlying securities, which would be the value we would receive if the fund liquidates. We intend to hold this investment to recovery.
We originate and hold real estate mortgage loans on properties located in Massachusetts and Connecticut. Mortgage loans are collateralized by the related real estate. Agency loans are generally collateralized by the assets of the agency. We control credit risk through credit approvals, credit limits and monitoring procedures. We perform in-depth credit evaluations on all new mortgage customers. We have not incurred any bad debt expense on mortgage loans during the three years ended 2004.
Interest on mortgage loans is included in income as earned based upon rates applied to principal amounts outstanding. Accrual of interest on mortgage loans is discontinued either when reasonable doubt exists as to the full, timely collection of interest or principal, or when a loan becomes contractually past due more than ninety days. When a loan is placed on non-accrual status, all unpaid interest previously accrued is reversed against current period earnings.
Fair value of our mortgage loans on real estate and collateral notes receivable is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit and for the same remaining maturities. The future cash flows associated with certain non-performing loans are estimated based on expected payments from borrowers either through work out arrangements or the disposition of collateral. The estimated fair value of mortgage loans on real estate and collateral notes receivable at December 31, 2004 and 2003, prior to the allowance for possible loan losses, was $16,044 and $17,579, respectively.
The components of net investment income for the years ended December 31 follow:
The carrying value of our fixed maturity investments which have not produced any income during 2004 was $175
We review all holdings with unrealized losses over $100, or more than 10% below cost, for securities at a continuous loss position period of 12 to 36 months.
Unrealized investment gains and losses on common and preferred stocks and fixed maturities, to the extent that there is no other-than-temporary impairment of value, are credited or charged, net of any tax effect, to a separate component of stockholders' equity, known as "net accumulated other comprehensive income (loss)," until realized.
Policy acquisition costs are calculated by line of business as a percentage of unearned premiums by multiplying the sum of current commission rates plus current premium tax rates plus an estimate of the percentage of other underwriting expenses incurred at policy issuance. These costs are deferred and amortized over the period in which the related premiums are earned, the amount being reduced by any potential premium deficiency. If any potential premium deficiency exists, it represents future estimated losses, loss adjustment expenses and amortization of deferred acquisition costs in excess of the related unearned premiums. There was no premium deficiency in 2004, 2003 and 2002. In determining whether a premium deficiency exists, we consider anticipated investment income.
Property and equipment are stated at cost and are depreciated on the straight-line method over the estimated useful lives of the assets using the following rates and lives:
Depreciation expense was $5,975, $5,893 and $5,417 for the years ended December 31, 2004, 2003 and 2002, respectively. Depreciation expense is allocated evenly between loss adjustment expenses and policy acquisition costs.
In accordance with industry practice, we also maintain reserves for estimated incurred but not reported (IBNR) and LAE net of salvage and subrogation recoverable. These reserves are determined based on historical information and experience. Adjustments to these reserves are made periodically to take into account changes in the volume of business written, claims frequency and severity, the mix of business, claims processing and other items that can be expected to affect our liability for losses and LAE.
legislative enactments, judicial decisions, legal developments in the imposition of damages; and
This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors.
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, we estimate the ultimate net liability for losses and LAE. After taking into account all relevant factors, we believe that, based on existing information, the provision for losses and LAE at December 31, 2004 is adequate to cover the ultimate net cost of losses and claims incurred as of that date. The ultimate liability, however, may be greater or lower than established reserves. If the ultimate exposure is greater than (or less than) our estimated liability for losses and LAE, we will incur additional expense (income) which may have a material impact on our consolidated financial position. We do not discount to present value that portion of our loss reserves expected to be paid in future periods.
Liabilities for unpaid claims and claim adjustment expenses for environmental related claims such as oil spills, mold and lead paint are included in the loss reserve methodologies described above. Reserves have been established to cover these claims for known losses. Because of our limited exposure to these types of claims, we believe they will not have a material impact on our consolidated financial position in the future. Loss reserves on environmental related claims amounted to $6,646 and $7,906 at December 31, 2004 and 2003, respectively.
The change in reserves for unpaid losses and LAE, net of reinsurance deductions from all reinsurers, including Commonwealth Automobile Reinsurers (CAR), for the years ended December 31 follow:
In 2000, Commerce entered into a Limited Partnership Agreement with Conning Partners VI, L.P., a Delaware Limited Partnership. This partnership agreement required our commitment to invest up to $50,000 into the partnership. In 2004, 2003 and 2002, we invested $10,688, $5,250 and $7,581, respectively, into the partnership. As of December 31, 2004, we have invested $35,554 into the partnership, leaving a commitment balance to the partnership of $14,446. The partnership was formed to operate as an investment fund principally for the purpose of making investments primarily in equity, equity-related and other securities issued in expansion financing, start-ups, buy-outs and recapitalization transactions. The fund targets companies in the areas of insurance, financial services, e-commerce, healthcare, and related businesses, including, without limitation, service and technology enterprises supporting such businesses, in order to realize long-term capital returns, all as determined and managed by the General Partner for the benefit of the Partners.
The amount of consolidated retained earnings at December 31, 2004 represented by undistributed earnings of 50% or less owned investments that are accounted for using the equity method follows:
Book value awards issued relating to the Plan totaled 1,489,111 in 2004, 1,408,675 in 2003 and 1,294,798 in 2002. Expenses relating to book value awards were $18,895, $11,203 and $1,700 in 2004, 2003 and 2002, respectively. The outstanding book value awards entitle the holders to cash payments based upon the extent to which, if at all, the per share book value exceeds certain thresholds set at the time the award was granted.
Employee stock options (options) granted through 2001 relating to the Plan totaled 2,529,042, including the issuance of options previously terminated. No employee stock options were granted after 2001 under the Plan. The outstanding options entitle the recipient to purchase our common stock based upon the extent to which, if at all, the per share market value of the common stock exceeds certain thresholds set at the time the option was granted. Unexercised options terminate not later than eight years after the date of grant. The average contractual life of the remaining 65,509 options outstanding at December 31, 2004 was 4.1 years.
At December 31, 2004, 2,557,664 shares of common stock may be awarded in the future under the Plan. Our Compensation Committee has not granted stock options under the plan since 2001.
The fair value of each of the ACIC agents' options granted under the ACIC Plan was estimated using the Black-Scholes option-pricing model, with the following weighted average assumptions:
Basic EPS is computed based on the weighted average number of common shares outstanding. Diluted EPS is computed based on the weighted average number of common shares outstanding adjusted by the number of additional common shares that would have been outstanding had the potentially dilutive common shares been issued and reduced by the number of common shares we could have repurchased from the proceeds of the potentially dilutive shares. Our only dilutive instruments are stock options outstanding. Basic and diluted EPS are calculated as follows for the years ended 2004, 2003 and 2002:
The computation of diluted EPS did not include stock options that were anti-dilutive, as their exercise price was greater than the average market price of our common stock during the year. The number of such options was 1,100,000, 1,850,000 and 750,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
Under Massachusetts law, an insurer may pay cash dividends only from earnings and statutory surplus, and the insurer's remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. Following the declaration and payment of such dividends, the insurer must file a report with the Commissioner. A Massachusetts insurance company may not pay an extraordinary dividend or distribution unless the insurer gives the Commissioner at least 30 days' prior notice of the declaration and the Commissioner does not disapprove of the plan of payment prior to the date of such payment. An extraordinary dividend or distribution includes any dividend or distribution whose fair market value together with other dividends or distributions made within the preceding 12 months exceeds the greater of 10% of surplus, or net income for the 12 month period ending the 31st day of December. California and Ohio have laws similar to those in Massachusetts regulating the payment of dividends by insurance companies.
Insurance premiums are recognized as income ratably over the terms of the policies. Unearned premiums are determined by prorating written premiums on a daily basis over the terms of the policies. A significant portion of our Massachusetts premiums written is derived through the American Automobile Association Clubs of Massachusetts (AAA Clubs) affinity group marketing program. Direct premiums written by the AAA affinity group marketing program in Massachusetts was $725,579 or 39.5% of our total direct premiums written in 2004, $691,694 or 41.7% in 2003 and $619,020 or 44.0% in 2002. Insurance agencies owned by the AAA Clubs wrote 14.5 % and our network of independent agents wrote 85.5% of these amounts in 2004.
As a member of a consolidated group for tax purposes, The Commerce Group, Inc. and its subsidiaries (Affiliated Group) elect to file a consolidated federal income tax return. As such, they are jointly and severally liable for federal income taxes of the Affiliated Group. We have entered into an agreement establishing an allocation of tax liability and for compensation of the respective members of the Affiliated Group for use of their tax losses and credits.
Our federal income tax expense (benefit) for the years ended December 31 follows:
Realization of a deferred tax asset is dependent on generating sufficient taxable income in future years. Although realization is not assured, we believe it is more likely than not that all of the deferred tax assets will be realized. GAAP requires a valuation allowance to be recorded when it is more likely than not that some or all of the deferred tax assets will not be realized. At December 31, 2002, our valuation allowance of $3,936 represented the tax effect related to realized investment losses that may not have been recoverable due to the uncertainties as to the amount of realized investment gains that may have been available in the future. We had sufficient capital gains in 2003 to reverse the 2002 year end valuation allowance in 2003. We did not have a valuation allowance for deferred taxes at December 31, 2004 and 2003.
Federal income tax on income is less than the amount computed by applying the statutory rate of 35% for the years ended 2004, 2003 and 2002 for the following reasons:
It is anticipated that there will be additional assessments from time to time relating to various insolvencies. By statute, no insurer may be assessed in any year an amount greater than two percent of that insurer's direct written premiums for the calendar year preceding the assessment. Although the timing and amounts of any such assessments are not known, based on existing knowledge, we believe that such assessments will not have a material effect on our consolidated financial position. MIIF assessed Commerce and Citation $6,304, $8,106 and $4,496 for the years ended December 31, 2004, 2003 and 2002, respectively. These amounts were net of credits for prior year assessments on numerous insurer insolvencies.
All companies are also covered by similar associations in the states where they do business. These associations operate similarly to the MIIF. Commerce West, domiciled in California, is covered by the California Insurance Guarantee Association. American Commerce, domiciled in Ohio, is covered by the Ohio Guarantee Association. Payments made by American Commerce, Commerce West and Commerce (for New Hampshire only) to the associations that they are covered under were $111 in 2004, $190 in 2003 and $107 in 2002.
We reinsure with other insurance companies on a claims incurred basis a portion of our potential exposure under the policies we have written. The objective of this reinsurance is to mitigate the adverse financial consequences of a severe loss under individual policies, or catastrophic occurrences where a number of claims can produce an extraordinary aggregate loss. Reinsurance does not legally discharge us from our primary liability to the insured for the full amount of the policies, but it does make the reinsurer liable to us to the extent of the reinsured portion of any loss ultimately suffered. We seek to utilize reinsurers that we consider adequately capitalized and financially able to meet their obligations under reinsurance agreements with us. We use a variety of reinsurance mechanisms to protect against loss.
On June 30, 2004, our 65% one-year quota share reinsurance program expired. This program covers all non-automobile property and liability business, except umbrella policies. This program was extended another year, effective July 1, 2004, with the primary change in terms being an increase in the quota share rate to 70%. Prior to July 1, 2003, we maintained a 75% quota share reinsurance program, which was incepted on July 1, 1998 and established for a five year period. Quota share reinsurance refers to a form of pro rata reinsurance arrangement pursuant to which the reinsurer participates in a specified percentage of the premiums and losses on every risk that comes within the scope of the reinsurance agreement. The current program is split among American Re-Insurance Corporation, rated "A (Excellent)" by A.M. Best (its third highest rating), Swiss Reinsurance America Corporation, rated "A+ (Superior)" by A.M. Best (its second highest rating), and Transatlantic Insurance Company, rated "A+" by A.M. Best. The maximum per occurrence dollar recovery is equal to 225% of the annual net premiums ceded to the quota share arrangement in the contract year. The maximum aggregate per year dollar recovery under the quota share contract is equal to 325% of the annual net premium ceded to the quota share arrangement in the contract year. A sliding scale commission, based on loss ratio, is utilized under this program. This program provides us with sufficient protection for catastrophe coverage to enable us to forego pure catastrophe reinsurance coverage.
Under the above scenario and based on the twelve month projected premiums to be ceded under the program, we have no reinsurance recoveries for a single event catastrophe in excess of a total loss of approximately $450 million. The level of reinsurance protection increases (decreases) when we cede more (less) premium to the reinsurers.
Written premiums ceded in 2004, 2003 and 2002 under the current and prior quota share programs combined were $133,562, $107,313 and $98,017, respectively. The 24.5% increase in written premiums ceded in 2004 versus 2003 in this program was primarily the result of a $18,271, or 17.7% increase in Massachusetts homeowner direct written premium, coupled with an $6,463, or 17.9%, increase in direct homeowner writings in states other than Massachusetts, as previously mentioned. In addition, the increase on the quota share participation rate from 65% to 70% on July 1, 2004 contributed to the increased cessions. Ceding commission income is calculated on a ceded earned premium basis.
Casualty reinsurance, excluding umbrella policies, is written on an excess of loss basis for any one event or occurrence with a maximum recovery of $8,000 over a net retention of $2,000. This coverage is placed with Swiss Reinsurance America Corporation.
Personal and commercial liability umbrella policies are reinsured on a 95% quota share basis in regard to limits up to $1,000 and 100% quota share basis for limits in excess of $1,000 but not exceeding $5,000 for policies with underlying automobile coverage of $250/$500 or more. We also have personal liability umbrella reinsurance coverage for policies with underlying automobile coverage of $100/$300 on a 65% quota share basis for limits up to $1,000 and 100% quota share basis for limits in excess of $1,000 but not exceeding $3,000. These coverages are placed with Employers Reinsurance Corporation, rated "A" by A.M. Best (its third highest rating).
Earned premiums and losses and loss adjustment expenses are stated in the accompanying consolidated financial statements after deductions for reinsurance. Those deductions for reinsurance, other than CAR, follow for the years ended December 31:
Reinsurance activity with CAR for fiscal years 2004, 2003 and 2002 follows:
Through December 31, 2004, the current CAR utilization-based participation ratio has been in place for the personal automobile market since 1994. During 2004, 2003 and 2002, the amount of personal automobile exposures we reinsured through CAR approximated 5.2%, 5.1%, and 4.9%, respectively, as compared to industry averages of 6.8%, 7.0% and 7.5%, respectively. A CAR reform proposal approved by the Commissioner on December 31, 2004 would, if implemented, substantially change the existing CAR utilization allocation. See Note R for additional information. Potential changes to CAR Rules 11 and 12 for 2005, which address credits and penalties, may significantly change our participation ratio if implemented.
Our two largest reinsurance components, quota share and CAR, settle on a quarterly basis. Quota share settles 45 days after the end of each quarter and CAR settles 90 days after the end of each quarter. There were no balances in dispute for the years ended 2004 and 2003 for either component.
We offer an Employee Stock Ownership Plan (ESOP) for the benefit of substantially all employees, including those of our subsidiaries. The ESOP is noncontributory on the part of participants and contributions are made at the discretion of the Board of Directors. We are under no obligation to make contributions or maintain the ESOP for any length of time and may completely discontinue or terminate the ESOP at any time without liability. Contribution expense for the ESOP for the years ended December 31, 2004, 2003 and 2002 were $9,651, $8,850 and $8,070, respectively. In 2005, the 2004 contribution was funded entirely with 143,395 treasury stock shares. ESOP contributions in previous years were made in cash. The increase in the contribution in 2004 over 2003 and in 2003 over 2002 was primarily due to an increase in employees. The ESOP held 2,819,951 and 2,873,856 shares of our common stock at December 31, 2004 and 2003, respectively.
ESOP participants who are former employees of the company may generally elect to withdraw from the ESOP the total amount of shares allocated to their accounts at any time. Approximately 563,126 shares held by the ESOP at December 31, 2004 are allocated to the ESOP accounts of these individuals.
The remaining approximately 174,285 shares held by the ESOP at December 31, 2004 are allocated to the ESOP accounts of participants who have not yet reached 100% vesting in their account balances. Disposition of these unvested shares is restricted under the ESOP. We pay for administration of the ESOP.
We have made loans to insurance agencies with which Commerce transacts business on a regular basis. At December 31, 2004, six loans with an aggregate outstanding principal balance of $2,081 were collateralized by the assets of the agencies. There were no loans to insurance agencies collateralized solely by real estate. At December 31, 2003, ten loans with an aggregate outstanding balance of $2,537 were collateralized by the assets of the agencies and one loan with an outstanding balance of $281 was collateralized by real estate as the primary collateral and the assets of the agency as secondary collateral. At December 31, 2002, eleven loans with an aggregate outstanding balance of $2,847 were collateralized by the assets of the agencies and one loan with an outstanding balance of $298 was collateralized by real estate as the primary collateral and the assets of the agency as second collateral.
On January 5, 2004, the Massachusetts Attorney General (AG) filed an appeal with the Supreme Judicial Court of Massachusetts arguing that the Massachusetts Division of Insurance (DOI) "wrongly imposed a 2.5% increase" in average personal automobile premiums for 2004. In November 2004, the Supreme Judicial Court of Massachusetts rejected the AG's appeal in part and instructed the DOI to revisit rates for bodily injury coverage. We cannot predict whether the remaining part of the AG's appeal will be successful and, if so, whether it will have a material impact on us.
We cannot predict whether the Commissioner's efforts to reform the residual market system without legislative action will be successful, nor can we predict when this matter will be resolved.
The insurance subsidiaries, Commerce, Citation, Commerce West and American Commerce, prepare statutory financial statements in accordance with accounting practices prescribed or permitted by the National Association of Insurance Commissioners and the Division of Insurance of The Commonwealth of Massachusetts, the State of California, and the State of Ohio. Statutory accounting principles differ in some respects from GAAP.
An unaudited summary of our 2004 and 2003 quarterly performance follows: