The Company - RTW, Inc. (RTW) and its wholly-owned insurance subsidiary, American Compensation Insurance Company (ACIC), provide disability management services to employers. Collectively, “we,” “our” and “us” refer to these entities in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
We have developed two proprietary management systems: (i) the RTW SOLUTION®, designed to lower employers’ workers’ compensation costs and return injured employees to work as soon as possible; and (ii) ID15®, designed to identify those injured employees who are likely to become inappropriately dependent on the workers’ compensation system. We currently provide workers’ compensation management services to employers insured through our insurance subsidiary, to self-insured employers on a fee-for-service basis and on a consulting basis charging hourly fees.
On March 9, 2004, our A.M. Best financial rating was upgraded from B (Fair, Vulnerable) to B+ (Very Good, Secure) as a result of: (i) our continued profitable operating performance in 2003; and (ii) improved capitalization in ACIC as statutory surplus increased to $33.0 million at December 31, 2003 from $26.8 million at December 31, 2002 due to our earnings in 2003. We believe that our B+ rating from A.M. Best may make it difficult to provide our products to certain employers.
challenges, risks, uncertainties and trends that affect the workers’ compensation property and casualty insurance sector of our economy including the following:
Workers’ compensation is a state regulated industry: Workers’ Compensation is governed and regulated by state governmental agencies. We are and will be subject to state regulation in any state in which we provide workers’ compensation products and services, now and in the future. State regulatory agencies have broad administrative power with respect to all aspects of our business, including premium rates, benefit levels, policy forms, dividend payments, capital adequacy and the amount and type of investments. Legislation covering insurance companies and the regulations adopted by state agencies are subject to change and any change may adversely affect our operations.
Significant Accounting Policies - Our significant accounting policies are summarized in Note 1 - “Summary of Significant Accounting Policies” to our accompanying Consolidated Financial Statements. Our significant accounting policies include those policies related to our accounting for: (i) premiums earned; (ii) unpaid claim and claim settlement expenses, including reserves for incurred but not reported claims; (iii) policy acquisition costs; (iv) deferred income taxes; and (v) investments. These accounting policies are further discussed in detail within each section of this “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.
Off-Balance Sheet Arrangements - We do not have any Off-Balance Sheet Arrangements.
RTW reported a decrease in gross premiums earned to $54.4 million in 2003 from $62.5 million in 2002. Total revenues decreased in 2003 to $51.6 million from $67.1 million in 2002 due to a decrease in premiums in force related primarily to our regional office closures and non-renewing insurance policies for Professional Employer Organizations (PEO’s) in Michigan.
We reported net income of $7.0 million in 2003 compared to net income of $14.9 million in 2002 and a net loss of $25.2 million in 2001. We reported basic and diluted income per share of $1.37 and $1.32, respectively, in 2003 compared to basic and diluted income per share of $2.78 in 2002 and basic and diluted net loss per share of $4.89 in 2001. The primary factors affecting our 2003 operating results included the following:
Gross premiums earned decreased 12.9% in 2003 from 2002 due primarily to a 17.7% decrease in average premiums in force to $53.6 million for 2003 from $65.1 million in 2002. See further discussion under “Premiums In Force and Gross Premiums Earned”;
Premiums earned decreased 23.2% in 2003 from 2002. Premiums earned in 2003 reflect: (i) the decrease in premiums in force as a result of the 2002 run-off policies in our discontinued regions and from our actions in removing unprofitable accounts; (ii) an increase in premiums ceded as our cost of excess of loss increased significantly in 2003; and (iii) additional ceded premiums as we lowered retentions in all our regions to $200,000 to reduce volatility in our operating results. Additionally, in 2003, premiums ceded increased by $92,000 resulting from a change in cost related to excess of loss reinsurance in Minnesota compared to a $1.4 million decrease in excess of loss premiums ceded in 2002;
Claim and claim settlement expenses decreased to 58.8% of premiums earned for 2003 from 67.3% for 2002. See further discussion under “Claim and Claim Settlement Expenses”; and
We expect 2004 premiums in force to increase from levels in 2003. We also anticipate that we will continue to realize slight premium rate increases in 2004, consistent with those realized in 2003 but significantly lower than experienced in 2002. We further expect to increase alternative, non-risk revenue in 2004. We will focus on achieving profitability in our markets by: (i) aggressively managing and closing claims; (ii) reviewing policy profitability at renewal and removing unprofitable accounts; and (iii) aggressively managing policy acquisition costs and general and administrative expenses.
Total revenues: Our total revenues include premiums earned, investment income, net realized investment gains and other income. The following table summarizes the components of our revenues and premiums in force (000’s):
Premiums In Force and Gross Premiums Earned: Premiums on workers’ compensation insurance policies are our largest source of revenue. Premiums earned are the gross premiums earned by us on in force workers’ compensation policies, net of the effects of ceded premiums under reinsurance agreements.
re-underwriting at increased rates at policy expiration in 2003, 2002 and 2001. Our average annual premium per policy increased to $85,400 in 2003 from $80,400 in 2002 and $56,800 in 2001 as a result of the focused aggressive re-underwriting in those years.
Gross premiums earned decreased 35.8% to $62.5 million in 2002 from $97.4 million in 2001. This decrease resulted from: (i) the decrease in average premiums in force; and (ii) final audit premiums which decreased gross premiums earned by $1.7 million in 2002 compared to a $1.8 million increase in 2001.
A number of workers’ compensation insurers’ financial ratings decreased due to reserve adjustments recorded in 2003, 2002 and 2001 resulting in a reduced capacity and creditworthiness of those insurers.
Our 2004 gross premiums earned will move in the same direction as our premiums in force, lagging slightly as premiums are earned over the term of the insurance policy; and
Investment Income and Net Realized Investment Gains: Our investment income includes earnings on our investment portfolio and, in 2002 and 2001, interest on our deposit receivable. Our net realized investment gains, displayed separately on our accompanying Consolidated Statements of Operations, include gains and losses from sales of securities. In 2003, we sold certain securities within the portfolio to take advantage of favorable interest rates and realized investment gains totaling $685,000. In 2002 and 2001, we sold certain securities within the portfolio and realized investment gains totaling $1.9 million and $1.2 million, respectively, as we repositioned the portfolio. Recognition of realized investment gains and losses in the future would depend on sales of our investments, if any, to meet our short-term cash requirements or as we replace securities to manage our portfolio returns.
At December 31, 2003 and 2002, we were invested entirely in U.S. domiciled investment-grade taxable fixed maturity investments. We also held significant cash and cash equivalents totaling $39.7 million and $36.3 million at December 31, 2003 and 2002, respectively. In December 2002, we received $28.8 million
We expect interest rates to increase in 2004. The timing of any such rate increases in unknown at this time. We intend to invest our excess cash into higher yielding investments in 2004 as the rates increase;
New and renegotiated reinsurance treaties may affect our future cash flow and future investment income.
Other Income: We recorded and received a refund totaling $2.1 million from the WCRA in 2001. The WCRA periodically reviews its surplus position and refunds excess surplus to its members. This refund represents our share of the excess surplus of the WCRA at December 31, 2000. No such refunds were received in 2002 or 2003. We do, however, expect that fee-for service revenues will increase in 2004 from the $109,000 and $22,000 realized in 2003 and 2002, respectively.
Claim costs will continue to be affected by: (i) increases in medical and indemnity costs resulting from inflationary changes; (ii) severity experienced in future periods in our policyholder base; (iii) changes resulting from increases in operating efficiency and effectiveness realized through enhancements to our internal processes and procedures, including changes to our proprietary computer systems; and (iv) legislative changes that affect benefits payable under workers’ compensation laws;
Increases in premium rates, if any in 2004, will result in increasing premiums earned without a corresponding increase in claim and claim settlement expenses, ultimately decreasing claim and claim settlement expense as a percent of premiums earned. Changes in premium rates due to legislative changes in estimated loss costs, increased competition and improving customer loss experience may offset rate improvements; and
Under certain of our excess of loss reinsurance policies, the reinsurer returns a portion of the premiums we cede as ceding commissions to reimburse us for our cost of placing and managing these policies. Ceding commissions received under these excess of loss reinsurance policies totaled $1.5 million in 2003 and reduced our policy acquisition costs. No similar ceding commissions existed in 2002 or 2001. Excluding the effect of ceding commissions, policy acquisition costs increased to $8.4 million in 2003 from $6.3 million in 2002 and decreased from $13.7 million in 2001. As a percent of gross premiums earned, policy acquisition costs increased to 15.4% in 2003 compared to 10.1% in 2002 and 14.1% in 2001. The increase in 2003 reflects the following:
Gross premiums earned decreased significantly in 2003 compared to 2002 and 2001 resulting in corresponding decreases in policy acquisition costs;
Commission expense increased to 7.3% of gross premiums earned in 2003 from 6.9% in 2002 and decreased from 7.6% in 2001. The increased commission percent in 2003 is the result of our new business growth in 2003 on which we pay higher first-year commission rates. In 2002, our renewal business, on which we pay lower commission rates, significantly outpaced our new business. In all of our markets, we believe the commission rates we pay are marketplace competitive;
Other policy acquisition costs were affected by the following: (i) in 2003, we recorded a $1.5 million increase in other policy acquisition costs reflecting a reallocation of 2002 mandatory reinsurance pool expenses; we were not assessed any reallocation in 2002; (ii) in 2002, Michigan changed the basis of its second injury fund assessment from a claims based assessment to a premium based assessment, resulting in an $851,000 benefit in 2002 compared to no benefit received in 2003; (iii) in 2002, we received a $541,000 favorable adjustment from a state data collection agency resulting from our significant decrease in premiums; and (iv) a general decrease related to the decrease in gross premiums earned.
2004 Outlook: We expect that policy acquisition costs in 2004 will remain relatively flat as a percent of gross premiums earned compared to 2003 after adjusting for the reallocation of mandatory reinsurance pool expenses.
General and administrative expenses declined significantly in 2002 from 2001 due to the following: (i) $2.0 million of restructuring charges related to office closures recorded in 2001, while no offices were closed in 2002; (ii) $400,000 of net margin expense was recorded in 2002 related to our St. Paul RE contract compared to $2.0 million in 2001; and (iii) a decrease to $266,000 of Insurance Guarantee Association (IGA) assessments in 2002 compared to $1.1 million of such IGA assessments in 2001; and
2004 Outlook: We expect that general and administrative expenses will be affected by the following:
We will continually monitor reported claim counts in 2004 and re-examine staffing needs as necessary; and
We will make appropriate investments in infrastructure to position us for the future.
The Term Loan accrued interest, payable quarterly. We paid interest at rates ranging from 4.03% to 4.66% on the outstanding balance of our Term Loan in 2003 compared to 4.61% to 5.33% in 2002. Interest expense decreased to $48,000 in 2003 from $163,000 in 2002 as a result of the decrease in interest rates, $1.3 million in principal payments in 2003 and $3.3 million in principal payments in 2002.
We paid interest at rates ranging from 4.61% to 5.33% on the outstanding balance of our Term Loan in 2002 compared to 6.50% to 8.83% in 2001. Interest expense decreased to $163,000 in 2002 from $511,000 in 2001 as a result of the change in interest rates and $3.3 million in principal payments in 2002.
2004 Outlook: We expect to incur no interest charges in 2004.
In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. We consider recent operating results, the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. At December 31, 2001, we established a $14.5 million valuation allowance (allowance) against deferred tax assets resulting in a corresponding increase in income tax expense. In 2002, the valuation allowance decreased by $7.9 million to $6.6 million as we were able to carry-back our 2001 operating loss five years resulting in a $3.8 million tax refund, the reversal of certain deferred tax items and use of the 2000 operating loss carry forward to offset income in 2002. This allowance further decreased by $3.0 million in 2003 to $3.6 million as we used the remaining 2001 operating loss carry forward to offset the income we earned in 2003 and further evaluated the asset we expect to realize based on our projected taxable income and available tax planning strategies. We expect any remaining deferred tax assets, net of the allowance, at December 31, 2003, to be realized as a result of the future income and the reversal of existing taxable temporary differences.
Income tax benefit for the year ended December 31, 2003 included a $3.0 million benefit resulting from reducing the allowance as we offset current year earnings by losses carried forward from 2001 and $384,000 in alternative minimum tax expense. Income tax benefit for the year ended December 31, 2002 included the following: (i) a $3.8 million benefit from carrying back our 2001 loss five years under the tax law change; (ii) a $4.0 million benefit resulting from reducing the allowance as we realized favorable claim reserve development in 2002; and (iii) a further benefit as we offset current year earnings by losses carried forward from 2000. After excluding the effects of the benefits from reducing the allowance, income tax expense was $2.3 million for 2003 compared to income tax expense of $3.8 million for 2002. As a percent of income before income taxes, the income tax expense before any benefit from reducing the allowance was 34.4% of the income before income taxes in 2003 compared to 37.1% in 2002 and 34.5% of the net loss before income taxes in 2001.
2004 Outlook: Income tax expense will vary based on: (i) the income from operations we earn in 2004; (ii) the amount of tax-exempt income we earn in 2004; and (iii) the changes in the valuation allowance necessary during 2004. The ultimate change is unknown at this time.
Our portfolio of fixed maturity securities included only U.S. government securities (62.1%), mortgage-backed securities (36.6%), and asset-backed securities (1.3%) at December 31, 2003. Our portfolio is managed by an independent investment manager to maximize our after-tax investment income without taking inappropriate credit risk. In 2003, we sold certain securities within the portfolio to take advantage of favorable interest rates and realized investment gains totaling $685,000. In 2002, we sold certain securities within the portfolio to reduce risk and realized investment gains totaling $1.9 million. We conservatively manage our fixed maturity portfolio, investing only in investment grade (BBB or better rating from Standard and Poor’s) securities of U.S. domiciled issuers. All securities in our portfolio were rated AAA at December 31, 2003. We do not invest in derivative securities.
Operating cash flows consist of the deficit or excess of premiums collected over claim and claim settlement expenses paid reduced by payments for reinsurance premiums as well as other operating expenses paid. Investment cash flows consist of income on existing investments and proceeds from sales and maturities of investments. Prior to 1999, we generated positive net cash flows from operations due, in part, to timing differences between the receipt of premiums and the payment of claim and claim settlement expenses. These net cash flows decreased significantly in 2001, 2000 and 1999 as we focused on closing old claims by paying earlier to close those claims. Combined with relatively flat premiums in force in 1998, 1999 and 2000 and decreasing premiums since that time, our cash flows from differences in timing have decreased. Additionally, as we lowered our reinsurance retention levels to $25,000 in mid-1998, we decreased our current period cash flows as a result of “pre-funding” quarterly reinsurance premiums under that agreement. Reinsurance reimbursements from our $25,000 to $300,000 excess of loss reinsurance agreement offset similar payments to claimants for those years in 2003. Our investment portfolio decreased $2.2 million to $79.2 million at December 31, 2003 from $81.4 million at December 31, 2002, as a result of these factors. The cash balance at December 31, 2002 included $28.8 million received from St. Paul RE (SPR) from terminating a contract late in December 2002. We invested this cash in January and February 2003. During 2003, interest rates declined, leading to significant mortgage refinancing by consumers, resulting in prepayment or early redemption of our mortgage-backed securities. At December 31, 2003 our cash balance was $39.7 million. We expect that our investments and cash and cash equivalents will decrease in 2004 as we pay claims for 2003 and prior years, years in which we earned higher premiums and incurred a higher number of claims reported.
We record investments on our balance sheet at fair value, with the corresponding appreciation or depreciation from amortized cost recorded in shareholders’ equity as other comprehensive income, net of taxes. Because value is based on the relationship between the portfolio’s stated yields and prevailing market yields at any given time, interest rate fluctuations can have a swift and significant impact on the carrying value of these securities. As a result of classifying our securities as available-for-sale, and thus carrying them at fair value, we expect to encounter adjustments in shareholders’ equity as market interest rates and other factors change. Prevailing market interest rates increased slightly since December 31, 2002, and when combined with the sale of select securities to realize gains, resulted in a $1.5 million unrealized gain on investments in 2003 compared to a $3.4 million unrealized gain in 2002.
not yet reported (IBNR). For reported claims, we establish reserves on a “case” basis. For IBNR claims, we calculate the difference between: (i) projected ultimate claim and claim settlement expenses as determined using generally accepted actuarial standards; and (ii) case reserves and carry the difference as the IBNR reserve. By using both estimates of reported claims and IBNR claims, we estimate the ultimate net reserves for unpaid claim and claim settlement expenses.
The amount by which estimated net reserves, measured subsequently by reference to payments and additional estimates, differ from those originally reported for a period is known as “development.” Development is unfavorable (or deficient) when losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for reserve increases on open claims. Development is favorable (redundant) when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on open claims. Favorable or unfavorable development of loss reserves is reflected in earnings in the year recognized.
Estimating the effect that inflation will have on the ultimate cost of claims is a major risk factor in our workers’ compensation reserve estimates. Future earnings will be affected by reserve development associated with any changes in our inflation assumptions. Estimates for the 2003 and 2002 accident years represent the majority of the uncertainty because these claims have the lowest proportionate amount of paid loss as of December 31, 2003 and represent approximately fifty-five percent (55%) of our net outstanding reserves. Our reserve estimates are most sensitive to changes in the assumption about inflation for the 2003 and 2002 accident years. Each one percent (1%) increase or decrease in the medical inflation rate for these accident years would increase or decrease our net loss reserve estimates at December 31, 2003 by approximately $390,000.
Our reserves are primarily undiscounted. We discounted reserves for selected claims that have fixed and determinable future payments, however, at rates ranging from 3.5% to 8.0% in 2003 and 2002. The discount rates in 2003 and 2002 are subject to change as market interest rates change. We use the same rates for Generally Accepted Accounting Principles as we do for Statutory Accounting Practices in determining our liability. We also reduce the unpaid claim and claim settlement expenses for estimated amounts of subrogation.
After taking into account all relevant factors, we believe our reserves for unpaid claim and claim settlement expenses and reinsurance recoverables on unpaid claim and claim settlement expenses at December 31, 2003 are adequate to cover the ultimate net costs of claim and claim settlement expenses at that date. The ultimate cost of claim and claim settlement expenses may differ materially from the established reserves, particularly when claims may not be settled for many years. Establishing appropriate reserves is an inherently uncertain process and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience. See Notes 1 and 5 in the accompanying Consolidated Financial Statements. The following two tables reconcile the beginning and ending insurance reserves, displayed individually for each of the last three years.
reserve development table is cumulative and, therefore, ending balances should not be added since the amount at the end of each calendar year includes activity for both current and prior years (000’s):
The “initial reserves in excess of (less than) re-estimated reserves” rows represent the aggregate change in the estimates over all prior years. For example, the 1998 reserve developed a $5.8 million net deficiency over the course of the succeeding years.
The lower portion of the table shows the re-estimated amount of the previously recorded net reserves, based on experience as of the end of each succeeding year. The estimate is either increased or decreased as more information becomes known about the frequency and severity of claims for individual years. For example, for the 1998 calendar year valued as of December 31, 2003, we paid $63.3 million of the currently estimated $80.5 million of claim and claim settlement expenses that were incurred through the end of 1998. Thus, the difference, an estimated $17.2 million of claim and claim settlement expenses incurred through 1998, remained unpaid as of December 31, 2003.
Liquidity refers to our ability to generate sufficient cash flows to meet the short- and long-term cash requirements of our operations. Capital resources represent those funds deployed or available to be deployed to support our business operations.
readily marketable fixed maturity investments. Our primary cash requirements consist of payments for: (i) claim and claim settlement expenses; (ii) reinsurance; (iii) policy acquisition costs; (iv) general and administrative expenses; (v) capital expenditures; and (vi) income taxes. We generate cash from or use cash in operations based on timing differences between the receipt of premiums and the payment of claim and claim settlement expenses. Selected reinsurance retention levels also use cash as a result of “pre-funding” premiums under the policies or provide cash upon reimbursement of claim payments. In 2003 and 2002, reinsurance reimbursements from our $25,000 to $300,000 excess of loss reinsurance agreement, which began in mid 1998 and ran-off in 2001, offset similar payments to claimants for those years. This trend will continue in 2004. We further expect that cash and investments will remain at levels reported at December 2003 in 2004. Available cash is invested in either short-term cash and cash equivalents or longer-term available-for-sale securities pending future payments for such expenses as medical and indemnity benefits and other operating expenses. Cash and cash equivalents consist of cash and a money market fund that invest primarily in short-term government securities.
Cash provided by operating activities was $4.4 million for 2003. This is primarily a result of net income of $7.0 million, a decrease in amounts due from reinsurers of $21.6 million, a decrease of $3.0 million in accrued expenses and other liabilities, a $2.1 million increase in unearned premiums, net of premiums receivable and depreciation expense of $1.2 million offset by a decrease of $31.2 million in unpaid claim and claim settlement expenses and net realized investment gains totaling $685,000. Net cash provided by investing activities was $212,000 due to $27.6 million in proceeds from sales of securities and $5.7 million in maturities of investments offset by $32.9 million in purchases of securities and $175,000 in purchases of fixed assets. Net cash used in financing activities was $1.2 million due primarily to principal payments on our note payable in 2003.
Our need for additional capital is primarily the result of regulations that require certain ratios of regulatory or statutory capital to premiums written in our insurance subsidiary as defined by state regulatory bodies and insurance rating agencies. Raising additional permanent capital, while difficult in the current environment in which we operate, would stabilize our ratio of premium to capital and provide a solid base for the future growth of our insurance subsidiary. As an alternative to raising additional capital, additional reinsurance would have the effect of reducing the ratio of premiums to capital and may be used to satisfy state regulatory requirements.
State insurance regulations limit distributions, including dividends, from our insurance subsidiary to us. The maximum amount of dividends that can be paid by ACIC to us in any year is equal to the greater of: (i) 10% of ACIC’s statutory surplus as of the end of the previous fiscal year; or (ii) the statutory net gain from operations (not including realized capital gains) of ACIC in its most recent fiscal year. Based on this limitation, the maximum dividend that ACIC could pay to us in 2004, without regulatory approval, is approximately $3.3 million. (See Note 9 of Notes to Consolidated Financial Statements.) ACIC has never paid a dividend to us and we intend to retain capital in our insurance subsidiary.
An increase of 100 basis points in prevailing interest rates would reduce the fair value of our interest rate sensitive instruments by approximately $3.9 million.
In March 1998, the NAIC adopted the Codification of Statutory Accounting Principles (Codification). Codification is intended to standardize regulatory accounting and reporting to state insurance departments and became effective January 1, 2001. Statutory accounting principles, however, will continue to be established by individual state laws and permitted practices. The State of Minnesota required adoption of Codification for preparing statutory financial statements for financial periods occurring on or after January 1, 2001. Adoption
of the Codification increased our statutory capital and surplus by approximately $1.9 million on January 1, 2001.
The Financial Accounting Standards Board (FASB) has issued SFAS No. 148, “Accounting for Stock-Based Compensation - an Amendment of FASB 123”; SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”; and SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. The Emerging Issues Task Force (EITF) of the FASB issued EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. After reviewing these pronouncements, we have determined that adoption of these statements is not expected to have an effect on our consolidated results of operations and financial position, except as follows:
SFAS No. 148, “Accounting for Stock-Based Compensation - an Amendment of FASB 123” requires additional disclosures in our financial statements, but does not affect our consolidated results of operation and financial position at December 31, 2003 and for the year then ended.
We benefit from our ability to reduce workers’ compensation costs and provide employers the ability to control their workers’ compensation programs. Our insurance subsidiary is domiciled in Minnesota and is licensed in twenty-three states. We wrote business primarily in Minnesota, Colorado and Michigan during 2003. In 2002, we non-renewed all insurance policies in our Missouri and Massachusetts regions and completed our run-off of all policies in these regions by February 2003. We operate in a single business segment, workers’ compensation products and services.
Investments - We invest entirely in fixed maturity investments and classify our investments as available-for-sale.
Realized Investment Gains and Losses: Net realized investment gains and losses are identified separately in our Consolidated Statements of Operations. Cost of investments sold is determined by the specific identification method.
Unpaid Claim and Claim Settlement Expenses - Claim expenses refer to amounts that we paid or expect to pay to claimants for insured events that have occurred. The costs of investigating, resolving and processing claims are referred to as claim settlement expenses. We record these expenses, net of amounts recoverable under reinsurance contracts, as “Claim and claim settlement expenses” in the Consolidated Statements of Operations.
Our “Unpaid claim and claim settlement expenses” represent reserves established for the estimated total unpaid cost of claim and claim settlement expenses for insured events that occurred on or prior to each balance sheet date. The reserves are primarily undiscounted; however, we discounted selected claims that have fixed or determinable future payments by $505,000 in 2003 and $438,000 in 2002 using discount factors ranging from 3.5% to 8.0%. These reserves reflect our estimates of the total cost of claims that were reported, but not yet paid, and the cost of claims incurred but not yet reported. Our estimates consider such variables as past loss experience, current claim trends and prevailing social, economic and legal environments. We have a limited amount of historical data to use in estimating our reserves for unpaid claim and claim settlement expenses because we commenced operations in 1992. As a result, we supplement our experience with external industry data, as adjusted to reflect anticipated differences between our results and the industry. We reduce the unpaid claim and claim settlement expenses for estimated amounts of subrogation.
Stock-Based Compensation - Had we calculated compensation expense for our option grants under the 1994 Stock Plan and stock issuances under the ESPP based on the fair value method described in SFAS No. 123, “Accounting for Stock-Based Compensation,” our net (loss) income and basic and dilutive net (loss) income per share would approximate the following pro forma amounts (in 000’s, except per share data):
Effect of Recent Accounting Pronouncements - In 2003, the Financial Accounting Standards Board (FASB) issued SFAS No. 148, “Accounting for Stock-Based Compensation - an Amendment of FASB 123”. The standard requires additional disclosures in our financial statements, but does not affect our consolidated results of operation and financial position at December 31, 2003 and for the year then ended.
The Emerging Issues Task Force (EITF) of the FASB has issued EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. The disclosure provisions of this rule, which are addressed in Note 3, require tabular presentation of certain information regarding investment securities with gross unrealized losses.
Additionally, included in investments are U.S. government securities pledged as collateral against a letter of credit provided to an insurer, with a fair value of $4.1 million and $4.3 million at December 31, 2003 and December 31, 2002.
The following table summarizes our reinsurance coverage (all losses ceded on a per occurrence basis):
For claims occurring after June 30, 1998, we further limited our per incident exposure by purchasing excess of loss coverage for losses from $25,000 to the lesser of $300,000 or the WCRA selected retention level in Minnesota and from $25,000 to $300,000 in other states from a single reinsurer. This agreement was finalized after its effective date and activity occurring from July 1, 1998 through September 30, 1998 was recorded on a retrospective basis resulting in the deferral of a gain totaling $2.0 million at December 31, 1998. We amortized $400,000 of the deferred gain as a reduction of claim and claim settlement expenses in each of 2002, 2001 and 2000 and $740,000 in 1999 resulting in an un-amortized deferred gain of $49,000 at December 31, 2003. The deferred gain is being amortized into income using the effective interest rate inherent in the amounts paid to the reinsurer and the estimated timing and amounts of recoveries from the reinsurer. Activity occurring on or after October 1, 1998 is recorded prospectively. This contract was terminated effective December 31, 2000; however, the policy was effective in 2001 for policies in force at December 31, 2000 through expiration, not to exceed fifteen months after the effective termination date. Policies written or renewing after December 31, 2000 are not covered under this lower level excess of loss reinsurance policy.
The reinsurance recoverable on paid claim and claim settlement expenses consists primarily of receivables from paid claim and claim settlement expenses that were submitted but not yet reimbursed by reinsurers at December 31, 2003 and 2002.
Changes in estimates of unpaid claim and claim settlement expenses for prior years decreased the provision for claim and claim settlement expenses by $6.7 million in 2003 and $8.4 million in 2002 and increased the provision for claim and claim settlement expenses by $7.7 million in 2001.
Our estimate for reinsurance receivables decreased in 2003 due to: (i) the re-evaluation and lowering of our estimate for gross unpaid claim and claim settlement expenses by $15.1 million; and (ii) payments and the related recoveries on prior year ceded claim and claim settlement expenses.
Differences between the tax basis of assets and liabilities and their reported amounts in the Consolidated Financial Statements that will result in taxable or deductible amounts in future years are called temporary
In assessing the realizability of deferred tax assets, we consider recent operating results, the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies. At December 31, 2001, we established a $14.5 million valuation allowance against deferred tax assets resulting in a corresponding adjustment to income tax expense. In 2002, the valuation allowance decreased by $7.9 million to $6.6 million as we were able to carry-back our 2001 operating loss five years resulting in a $3.8 million tax refund, the reversal of certain deferred tax items and use of the 2000 operating loss carry forward to offset income in 2002. This allowance further decreased by $3.0 million in 2003 to $3.6 million as we used the remaining 2001 operating loss carry forward to offset the income we earned in 2003 and further evaluated the asset we expect to realize based on our projected taxable income and available tax planning strategies. We expect the remaining deferred tax asset, net of the valuation allowance, at December 31, 2003 to be realized as a result of income and the reversal of existing taxable temporary differences in the future. Deferred tax assets are included in other assets on the Consolidated Balance Sheets.
Income taxes receivable were approximately $492,000 and $793,000 at December 31, 2003 and 2002, respectively, and are included in other assets.
1995 Employee Stock Purchase Plan - The ESPP provides employees the opportunity to purchase shares of our stock at 85% of the fair value based on the lesser of the beginning or ending share price for each plan year as set forth in the plan. In 2003, the shares reserved for distribution under the plan were increased from 100,000 to 150,000 shares. The ESPP terminates in ten years and will be carried out in phases, each consisting
of one year or a different period of time approved by the Board of Directors. Any employee completing two weeks of service prior to commencing a phase of the plan may participate. Employees may elect to contribute from $10 to 10% of monthly salary to the plan through payroll withholdings. The following summarizes shares purchased and purchase prices for each phase in the most recent three years completed through 2003:
The eighth one-year phase began in April 2003 and expires in April 2004.
1994 Stock Plan - The 1994 Stock Plan provides for awards of qualified and non-qualified stock options. In July 1998, the Board of Directors increased the shares reserved for distribution under the plan to 1,000,000. Option price, option term, vesting provisions and other limits and restrictions are determined at the time of grant by the Board of Directors or, if established, by a separate committee. The exercise price for all options granted was the market price of the common stock at the date of grant.
Each of the qualified stock options expires ten years from the date of grant and substantially all are subject to continued employment with us. Each of the non-qualified options expires ten years from the date of grant with the exception of certain options granted to the founder of the Company which expire five years from the date of grant. Certain of the options are subject to vesting provisions that restrict exercise of the option.
Employment Contracts - We entered into a one-year employment agreement with our President and Chief Executive Officer, Jeffrey B. Murphy beginning December 17, 2003. Under this agreement, Mr. Murphy receives a base salary of $250,000, subject to review annually for increase by our Board of Directors. In addition to base salary, Mr. Murphy is eligible for bonuses, expense reimbursements and health, dental, life and disability insurance consistent with that provided to other officers and employees. Additionally, Mr. Murphy was granted 100,000 non-qualified options at $6.00 per share on March 12, 2004.
401(k) Retirement Component - We sponsor a defined contribution retirement component under Section 401(k) of the Internal Revenue Code for eligible employees. Our contributions are discretionary and are based on contributions made by employees. Expense recognized for 2003, 2002 and 2001 was $204,000, $220,000 and $316,000, respectively.
Other Employee Benefit Plans - We maintained bonus plans in 2003, 2002 and 2001 under which all employees, including officers, were eligible for a bonus based on our operating results. These bonuses aggregated $941,000, $864,000 and $204,000 in 2003, 2002 and 2001, respectively.
or through private transactions depending upon market conditions and availability. Through December 31, 2003 we repurchased approximately 385,000 shares for $2.7 million. We will use the repurchased shares for employee stock option and purchase plans and other corporate purposes.
Under Minnesota insurance law regulating the payment of dividends by ACIC, any such payments must be an amount deemed prudent by ACIC’s Board of Directors and, unless otherwise approved by the Commissioner of the Minnesota Department of Commerce (Commissioner), must be paid solely from the adjusted earned surplus of ACIC. Adjusted earned surplus means the earned surplus as determined in accordance with statutory accounting practices (unassigned funds), less 25% of the amount of such earned surplus that is attributable to unrealized capital gains. Further, without approval of the Commissioner, ACIC may not pay a dividend in any calendar year which, when combined with dividends paid in the preceding twelve months, exceeds the greater of: (i) 10% of ACIC’s statutory capital and surplus at the prior year end; or (ii) 100% of ACIC’s statutory net gain from operations (not including realized capital gains) for the prior calendar year. For 2004, dividends in excess of approximately $3.3 million would require prior consent of the Commissioner.
Statutory Surplus and Statutory Net Income (Loss) - Our insurance subsidiary is required to file financial statements with state regulatory agencies. The accounting principles used to prepare the statutory financial statements follow prescribed accounting practices that differ from GAAP. Statutory capital and surplus at
December 31, 2003 and 2002, and statutory net income (loss) for the years ended December 31, 2003, 2002 and 2001 are as follows (000’s):