The Company leases its Home Office building in Woodland Hills, California, which contains approximately 234,000 square feet of leasable office space. The lease was amended in October 1994 to extend its term until November 1999. The lease may be renewed for two consecutive five-year periods.
With its strong financial position restored, the Company has positioned itself for renewed and profitable growth. Additionally, the Company's direct exposure to future earthquake losses was completely eliminated in 1995. The Company maintains full insurance protection against its only significant remaining catastrophe exposure in the homeowner line, primarily relating to potential wild fires and fire following an earthquake event.
PRIVATE PASSENGER AUTOMOBILE. The 1997 year registered solid and profitable growth for the Company. In view of the favorable trends in loss costs and frequency in 1996 and 1997, the Company lowered overall rate levels approximately 11.5% and 3.2% in 1996 and 1997, respectively, and by an additional 3.4% in January 1998. These actions, coupled with an aggressive marketing campaign, have spurred increases in new business production and the rate of renewals, starting in the fourth quarter of 1996 (for the first time in nine quarters) and throughout 1997. Vehicles in force grew by 65,267 in 1997, compared to a decline of 49,398 in 1996, a positive swing of 114,665 vehicles. In the fourth quarter of 1997, vehicles in force grew by 10,034 compared to 4,940 for the same period in 1996. In the first two months of 1998, the voluntary vehicles in force grew at an 8.7% annual rate.
12,133, 6,847, and 8,204 as of December 31, 1997, 1996 and 1995, respectively. The overall increase in Assigned Risk units was an expected response to new legislation.
PELP. The penetration of this coverage has averaged about 1% of the vehicles in force during the three years ended December 31, 1997, which is not expected to change significantly in 1998.
Premium revenue and underwriting results for the Company's insurance programs follow, presented in conformity with generally accepted accounting principles ("GAAP"). To facilitate comparability, the effects of the earthquake and the Proposition 103 settlement have been isolated from the core business in the table below.
The auto line experienced a record high $134.1 million underwriting profit in 1997. These results compared favorably to profits in 1996 and 1995 of $81 million and $73.8 million, respectively, as adjusted for the effects of the earthquake and Proposition 103. The 1997 and 1996 increases in underwriting profit are primarily the result of favorable loss trends. For 1997, the impact of relatively dry weather, a continued strong decline in claim frequencies and severities and the attraction and retention of a higher percentage of more profitable, preferred customers all contributed to the improvement in underwriting results.
The 1997 decrease in gross premiums written reflects the 6.5% increase in insured units coupled with the effect of the 3.2% premium rate reduction implemented in 1997 and the impact of 1996 rate reductions which were fully felt in 1997. Gross premiums written in 1996 decreased 10% from 1995 reflective of the 4.6% reduction in insured units and, to a lesser extent, the effect of the three premium rate reductions implemented in 1996 (a total reduction of 11.5%).
The voluntary automobile insurance business written by the Company is comprised of "Good Drivers" as defined by California statute. While the majority of this business would have been acceptable to the Company before Proposition 103, those who had no prior insurance would have been written at a higher rate level than those who had been insured prior to being written by the Company. These drivers have produced automobile underwriting losses of $7,773,000 in 1997 compared to $15,168,000 in 1996 and $26,286,000 in 1995. The sharp decline in losses in 1997 is reflective primarily of favorable loss trends, despite the increase in vehicles in force of 14.5% over the previous year. The 1997 combined ratio for this segment of the business was 116.5% compared to 129.7% in 1996 and 143.9% in 1995. As part of the new rating plan that became effective October 1, 1997, changes were implemented that the Company expects will bring the combined ratio for this class of policyholders more into line with the rest of the Company's voluntary book of business.
Overall automobile underwriting results are also affected by Assigned Risk. Underwriting losses for Assigned Risk business were $73,000 in 1997, compared to $102,000 in 1996 and $3,082,000 in 1995. Combined ratios for this business for the same periods were 100.6%, 101.1% and 126.7%, respectively. The decrease in underwriting losses in 1997 was reflective of an improved loss ratio despite a 77.2% increase in vehicles in force since 1996, which is believed to have been fueled by strengthened legal sanctions aimed at reducing the number of uninsured motorists in California. The decrease in underwriting losses in 1996 was primarily due to a 16.5% drop in vehicles in force since 1995 coupled with the effects of a 5.2% rate increase implemented in June 1995. The future effect of the Assigned Risk plan on the Company cannot be predicted because it depends on the ability of the state-administered plan to achieve and maintain an adequate rate level.
Since July 1, 1996, the Company has maintained reinsurance programs to provide coverage for its remaining homeowner policies as discussed in Note 10 to the Consolidated Financial Statements. The Company had previously maintained separate catastrophe coverage on these lines which expired in June 1996. Written premiums ceded in 1997 totaled $24.4 million compared to $10.7 million in 1996 (excluding the $33.3 million portfolio transfer of unearned premium liabilities under the 100% quota share reinsurance agreement), and $36.3 million in 1995.
The personal excess liability program has remained stable over the three-year period ended December 31, 1997, producing approximately $2 million in gross written premiums each year. Underwriting profits can vary significantly with the number of claims which occur infrequently.
The Company's policy acquisition and general operating expense ratio continues to be among the most competitive in the industry. The ratio of underwriting expenses (excluding interest and fees) to earned premiums was 9.4% in 1997, 9.3% in 1996 and 9.0% in 1995. The increase in the expense ratios from 1995 to 1997 is mainly due to the decline in premiums earned as well as an increase in marketing expenses.
What is commonly referred to in the financial press as the "Year 2000 issue" has arisen because some computer programs were written using two digits rather than four to define the applicable year. As a result, these systems and programs may not calculate dates beyond 1999, which may cause errors or systems failures.
Net pre-tax investment income was $73,463,000 in 1997 compared to $73,178,000 in 1996 and $81,658,000 in 1995. Average invested assets decreased 2.0% in 1997, compared to decreases of 6.9% and 5.3% in 1996 and 1995, respectively. The decline in invested assets resulted from the decline in net earned premiums and the sale of investments to meet the payment requirements of both developing earthquake losses and reinsurance premiums. The average annual pre-tax yield on invested assets was 6.7% in 1997, 6.6% in 1996 and 6.8% in 1995.
As of December 31, 1997, the Company had a pre-tax unrealized gain on fixed maturity investments of $29,733,000 compared to $3,665,000 in 1996 and $50,527,000 in 1995. Interest rates fell in 1995 and 1997 which increased the fair value of the bond portfolio for those years. The decrease in unrealized gains between 1995 and 1996 resulted largely from a declining bond market coupled with an overall decline in invested assets.
At December 31, 1997, $17,427,000 of the Company's total investments at fair value was invested in tax-exempt bonds with the balance representing 98% of the portfolio, invested in taxable securities.
The Company expects to have very small cash outlays for income taxes, specifically alternative minimum tax, for the next two to three years. Until the net operating losses caused by the Northridge Earthquake are fully utilized, the Company expects that cash outlays for income taxes will be less than income tax expense recorded in accordance with generally accepted accounting principles. The net operating loss carryforwards will expire in the year 2009.
The National Association of Insurance Commissioners requires property and casualty insurance companies to calculate and report information under a Risk-Based Capital ("RBC") formula in their annual statements. The RBC requirements are intended to assist regulators in identifying inadequately capitalized companies. The RBC calculation is based on the type and mix of risks inherent in the Company's business and includes components for underwriting, asset, interest rate and other risks. The Company's insurance subsidiaries exceeded their RBC statutory surplus standards by a considerable margin as of December 31, 1997. To the extent that a subsidiary would fall below prescribed levels of surplus, it would be the parent company's intention to infuse necessary capital to support that entity.
The Company leases its Home Office building in Woodland Hills, California, which contains approximately 234,000 square feet of leasable office space. The current lease comes up for renewal in November 1999 and may be renewed for two consecutive five-year periods.
20TH CENTURY INDUSTRIES AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1997
20th Century Industries, through its wholly-owned subsidiaries, 20th Century Insurance Company and 21st Century Casualty Company (collectively, the "Company"), is engaged in the sale of private passenger automobile, homeowners and personal excess liability insurance policies in the state of California. In accordance with an order from state insurance regulators, no new homeowner and condominium policies have been written since July 23, 1994 and beginning July 24, 1996, the Company was required to begin non-renewing these policies. On February 15, 1997, pursuant to regulatory approval granted in December 1996, the Company resumed renewing its approximately 68,000 remaining homeowner policies. All condominium policies expired in July 1997.
The accompanying consolidated financial statements include the accounts and operations of 20th Century Industries and its wholly-owned subsidiaries. All material intercompany accounts and transactions have been eliminated. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles which differ from statutory accounting practices ("SAP") prescribed or permitted by insurance regulatory authorities. The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from these estimates.
The Company classifies its investment portfolio as available-for-sale and carries it at fair value with unrealized gains and losses, net of any tax effect, reported as a separate component of stockholders' equity.
The Company's 49% interest in 20th Century Insurance Company of Arizona, which is a joint venture between the Company and American International Group, Inc. ("AIG") and which began operations in August 1996, has a carrying value of $2,559,000 at December 31, 1997, and is included in other assets in the consolidated balance sheet. The Company's equity in the 1997 net loss of this venture amounted to $656,000 and is included in investment income in the consolidated statement of income.
The estimated liabilities for losses and loss adjustment expenses include the accumulation of estimates of losses for claims reported prior to the balance sheet dates, estimates (based upon actuarial analysis of historical data) of losses for claims incurred but not reported and estimates of expenses for investigating and adjusting all incurred and unadjusted claims. Amounts reported are estimates of the ultimate costs of settlement, net of estimated salvage and subrogation, which are necessarily subject to the impact of future changes in economic and social conditions. Management believes that, given the inherent variability in any such estimates, the aggregate reserves are within a reasonable and acceptable range of adequacy. The methods of making such estimates and for establishing the resulting reserves are reviewed and updated quarterly and any adjustments resulting therefrom are reflected in current earnings.
In the normal course of business, the Company seeks to reduce the loss that may arise from catastrophes and to reduce its overall risk levels by reinsuring certain areas of exposure with other insurance enterprises or reinsurers. Reinsurance premiums and reserves on reinsured business are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Amounts applicable to ceded unearned premiums and ceded claim liabilities are reported as assets in the accompanying balance sheets. The Company believes that the fair value of its reinsurance recoverables approximates their carrying amounts.
Statement of Financial Accounting Standards ("SFAS") No. 128, EARNINGS PER SHARE, became effective for periods ending after December 15, 1997. SFAS No. 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of common stock equivalents and other dilutive securities (i.e. options, warrants and convertible securities). Diluted earnings per share is very similar to the previously reported fully diluted earnings per share in that it includes the effects of all dilutive instruments meeting certain requirements. All earnings per share amounts for all prior periods have been restated to conform to the SFAS No. 128 requirements. Additional financial statement disclosures required by SFAS No. 128 are included in Note 3.
In 1997, the Financial Accounting Standards Board also issued SFAS No. 130, REPORTING COMPREHENSIVE INCOME, and No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION. The Company plans to adopt these statements effective March 31, 1998 and December 31, 1998, respectively. The Company believes that neither of these statements will require disclosure of any significant information beyond that already provided in the Company's financial statements.
The amortized cost and fair value of the Company's fixed maturity investments at December 31, 1997 are summarized, by contractual maturity, as follows:
A reconciliation of income tax computed at the federal statutory tax rate, which was 35% for 1995 through 1997, to total income tax expense follows:
Following is a summary of policy acquisition costs deferred for amortization against future income and the related amortization charged to income from operations:
In connection with an investment agreement executed in 1994 with AIG (see Note 17), each of the Company's insurance subsidiaries entered into a five-year quota share reinsurance agreement with an AIG affiliate to provide coverage for all ongoing lines of business. Under this contract, which attaches to the Company's retained risks net of all other reinsurance, 10% of each subsidiary's premiums earned and losses incurred in connection with policies incepted during the period January 1, 1995 through December 31, 1999 are ceded. The majority of the Company's reinsurance receivables are due from the AIG affiliate. At the end of the five-year period, the AIG affiliate may elect to renew the agreement annually at declining coverage percentages. Ceding commissions of 9.36%, 9.13% and 10.8% were earned by the insurance subsidiaries for 1997, 1996 and 1995,
In 1996, the Company's insurance subsidiaries entered into a 100% quota share reinsurance agreement with F&G Re and Risk Capital Re covering the homeowner and condominium lines of business. This agreement covers, for a one-year policy term, all business in force as of July 1, 1996 plus renewal business attaching between July 1, 1996 and July 23, 1996, effectively terminating with the expiration of the underlying, one-year policies. Under this contract, 100% of each subsidiary's homeowner and condominium unearned premium reserves as of June 30, 1996 were ceded 50/50 to F&G Re and Risk Capital Re, a total of $33.3 million. Additionally, 100% of written premiums and incurred losses and allocated loss adjustment expenses subsequent to June 30, 1996, on covered policies, are ceded under this contract. The Company's insurance subsidiaries earn a commission on ceded premiums based on a sliding scale dependent on the incurred loss ratio. In both 1997 and 1996, the Company earned commissions at a rate of 12.5% on this treaty. Homeowner policies renewed February 15, 1997 and subsequent are covered in full by quota share reinsurance agreements with three reinsurers, as follows: National Union Fire Insurance Co. of Pittsburgh, PA (50%), a subsidiary of AIG, F&G Re (25%) and Risk Capital Re Company (25%). The Company's insurance subsidiaries earn a commission on ceded premiums based on a sliding scale dependent on the incurred loss ratio. In 1997, the Company earned commissions at a rate of 14% on this treaty.
The Company has a quota share treaty for its Personal Excess Liability Policy line whereby it cedes 60% of premiums and losses. After the effect of the 10% quota share treaty with AIG discussed earlier, the Company effectively retains 36% of the risk for this line.
The Company leases office space in a building in Woodland Hills, California. The lease was amended in October 1994, extending the lease term until November 1999. The lease may be renewed for two consecutive five-year periods. The Company also leases office space in several other locations throughout California, primarily for claims servicing.
Rental expense charged to operations for the years ended December 31, 1997, 1996 and 1995 were $11,969,000, $11,243,000, and $12,062,000, respectively.
The Company's insurance subsidiaries are subject to restriction as to the amount of dividends which may be paid to the parent company within any one year without the approval of the California Department of Insurance ("DOI"). The California Insurance Code provides that amounts may be paid as dividends from earned surplus on an annual, noncumulative basis, without prior approval by the DOI, up to the greater of (1) net income for the preceding year, or (2) 10% of statutory surplus as regards policyholders as of the preceding December 31. Earned surplus available for dividends as of December 31, 1997 was approximately $175 million.
Surplus of the insurance subsidiaries on a statutory basis at December 31, 1997 and 1996 was $548,043,000 and $436,367,000, respectively. Statutory net income for the insurance subsidiaries was $178,727,000, $121,780,000, and $118,562,000 for the years ended December 31, 1997, 1996 and 1995, respectively.
The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related Interpretations in accounting for its stock-based compensation. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. Under APB 25, the fair value of stock grants made under the Restricted Shares Plan is amortized to expense over the vesting periods of the grants. SFAS No. 123 requires disclosure of the pro forma net income and earnings per share as if the Company had accounted for its employee stock compensation under the fair value method of that Statement.
Exercise prices for options outstanding at December 31, 1997 ranged from $12.50 to $22. The weighted average remaining contractual life of those options is 8.7 years.
common stock and subsequently amortized in equal monthly installments over the five-year vesting period of the grant. Amortization of the unearned compensation was $534,900, $365,500 and $550,000 in 1997, 1996 and 1995, respectively. This accounting treatment results in compensation expense being recorded in a manner consistent with that required under Statement 123 and, therefore, pro forma net income and earnings per share amounts would be unchanged from those reported in the financial statements.
The fourth quarter of 1996 was impacted by pre-tax charges of $40 million in additional reserves related to the 1994 Northridge Earthquake. It was also adversely affected by weather-related claims amounting to approximately $8 million.
AUTO. The $53.1 million increase in underwriting profit in 1997 compared to 1996 was largely the result of growth in the number of vehicles in force, relatively dry weather, and a continued strong decline in claim frequencies and severities. The $22.7 million decline in underwriting profit for the auto lines in 1996 compared to 1995 was caused principally by a $30 million benefit in 1995 from the reversal of amounts previously set aside for Proposition 103 rebates (see Note 15), and 1996 weather-related claims of approximately $8 million. In 1995, excluding earthquake-related claims and expenses, earthquake reinsurance reinstatements and Proposition 103 rebate adjustments, the underwriting profit for the auto lines would have been $73.8 million.