The data below should be read in conjunction with the consolidated financial statements, related footnotes, and other financial information included herein. The financial statements for the year ended December 31, 2003 were audited by PricewaterhouseCoopers LLP. The financial statements for the four years ended December 31, 2002 were audited by Ernst & Young LLP. All dollar amounts in the following tables are in thousands, except per share data.
Unless otherwise stated, "we," "our" or "us" means The Commerce Group, Inc., "CGI," 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, and dollar amounts are in thousands, except per share data
The following discussion and analysis should be read in conjunction with our consolidated financial statements in this Form 10-K.
We provide personal and commercial property and casualty insurance in Massachusetts and, to a lesser extent, in other states. Casualty insurance is primarily concerned with the losses of the insured due to injuries to other persons and to the property of others, and the legal liability imposed on the insured as a consequence of such losses. Our core product lines are personal automobile, homeowners, and commercial automobile insurance. We market our products exclusively through our network of independent agents, including 650 agents in Massachusetts, 34 agents in New Hampshire, 1,096 agents in California and Oregon, and 28 agents in 16 other states, as of December 31, 2003. Our primary business strategy is to continue to focus on the personal automobile insurance market in Massachusetts and to grow by increasing the proportion of our business in other states in which we currently have a significant presence, primarily as a result of our acquisitions of Commerce West and American Commerce in 1995 and 1999, respectively.
Our ability to capitalize on our business strengths and implement our strategies entails particular risks. For example, because we are primarily a personal automobile insurance carrier, adverse developments in this industry could adversely affect us to a greater extent as compared to 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. Regulatory changes to reform the residual market and to enhance competition in Massachusetts are being considered and, if enacted, could adversely affect our market share and profitability. Also, if our affinity relationship with the AAA Clubs of Massachusetts were to be terminated, we would lose a significant avenue for offering our existing affinity group discounts and our sales of personal automobile insurance products in Massachusetts would likely decline, if we are unable to devise and implement effective mitigation measures. As the AAA arrangements have rolling three-year terms, an AAA Club may terminate upon a minimum of two years' written notice. 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. A significant decline in our sales of personal automobile insurance products in Massachusetts would have a material adverse effect on our business and results of operations.
Earned premiums constitute the portion of net premiums written that is equal to the expired portion of policies and recognized as income for accounting purposes during a given period.
Investment income relates to earnings on our investment portfolio. We rely on after-tax investment income as a significant source of net earnings since we generally seek to produce a combined ratio (see below) of slightly less than 100%.
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.
Unpaid losses and LAE, by their nature, are inherently uncertain as to the ultimate outcome of the estimated amounts. The liability for loss and loss adjustment expenses represents our best estimate of the ultimate net cost of all loss and loss adjustment expenses incurred after reinsurance and amounts estimated to be recoverable through salvage and subrogation. The estimate for ultimate net cost of all losses incurred through the balance sheet date includes the adjusted case estimates for losses, incurred but not reported ("IBNR") losses, salvage and subrogation recoverable and a reserve for LAE. In arriving at our best estimate, we begin with the aggregate of individual case reserves and then make adjustments to these amounts on a line of business basis. These adjustments to the aggregate case reserves by line of business are made based on analyses performed by us as further described below. The entire liability for unpaid losses and LAE is also separately reviewed quarterly and annually by our actuarial department. Liability estimates are continually analyzed and updated, and therefore, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimates are included in the results of operations in the period in which the estimates are revised.
A focus of our judgments and estimates relating to investments involves the potential impairment of investments for other-than-temporary declines in market values. The carrying value 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 in the few cases where 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.
We review all security holdings on a quarterly basis for potential other-than-temporary declines in market value in accordance with GAAP. As part of this process, we consider any significant market declines in the context of the overall market and also in relation to the outlook for the specific issuer of the security. Each quarter, we review all securities whose market values have declined below book price. From a quantitative standpoint, we view all securities that have declined more than 20% below book price and have remained so for two quarters as potentially in need of a write-down. In addition, any other security that we view as impaired for a significant period of time is also a candidate for a write-down, even if the percentage decline is less than 20%. In order to review these holdings, we look at any security that has been in a continuous unrealized loss position (regardless of the amount of the loss) for any period exceeding six months. In this way, we are not only looking at the amount of the unrealized loss, but also at the amount of time the loss has existed. There is a risk that we may assess an other-than-temporary decline in market value as being temporary and, consequently, not charge the impairment to our earnings, which could have a significant impact on our future earnings and financial position.
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 as compared to the end of the immediately preceding fiscal quarter. 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.
During the three-year period from 2001 to 2003, average mandated Massachusetts personal automobile insurance premium rates decreased an average of 1.9% per year, primarily due to an 8.3% decrease in 2001. Coinciding with the 2004 rate decision, the Commissioner also approved a 0.9% increase in the commission agents receive for selling private passenger automobile insurance for 2004. The following table shows the state-mandated average rate change, the actual average revenue change per exposure and our average revenue change per exposure as estimated for 2004 and for the three previous years in Massachusetts.
Although mandated average personal automobile premium rates increased 2.7% in 2003, our average revenue per exposure increased 7.9%. We believe that the relative increase for 2003 as compared to the Commissioner's state mandated average rate resulted primarily from several factors:
DOI has, without justification, ruled in favor of an increase in auto insurance rates that will hurt Massachusetts drivers." We cannot predict whether the AG's appeal will be successful, and if so, whether it will have a material impact on us.
Our performance in our personal and commercial automobile insurance lines in Massachusetts is integrally tied to our participation in CAR, the state-mandated reinsurance mechanism. CAR permits us and most other writers of automobile insurance in Massachusetts to reinsure any automobile risk that the insurer perceives to be under-priced at the premium level permitted by the Commissioner. All companies writing automobile insurance in Massachusetts share in the underwriting results of CAR business for their respective product line or lines. Since CAR's inception, it has annually generated hundreds of millions of dollars of underwriting losses, primarily in the personal pool.
The decreasing percentages since 2001 is attributed to a higher rate of increase in non-group business as compared to increases in the AAA program. Of the total Massachusetts automobile exposures written through the AAA affinity group program by us, approximately 13.6% were written through insurance agencies owned by the AAA clubs (8.4% of our total Massachusetts automobile exposures). The remaining 86.4% of the AAA group program were written through our network of independent agents (91.6% of our total Massachusetts automobile exposures).
Direct premiums written in states other than Massachusetts by American Commerce and Commerce West increased $48.1 million, or 25.9%, to $233.6 million at December 31, 2003 from $185.5 million at December 31, 2002. American Commerce's direct premiums written increased $41.3 million, or 29.7%, primarily due to an increase in personal automobile premiums of $33.2 million, or 29.7%. American Commerce also experienced a 29.7% increase in homeowners premiums written. The increase in personal automobile and homeowners was primarily due to additional rate per policy coupled with a 9.9% increase in business written, offset slightly by a decreased retention in personal automobile in-force policies. Commerce West direct premiums written increased $6.8 million, or 14.8%. The growth for Commerce West is primarily attributable to expansion of commercial and preferred personal automobile programs. Personal automobile direct premiums written by Commerce West increased $3.9 million, or 9.5% primarily from an increase in rates, while commercial automobile direct premiums written increased $2.9 million, or 56.6%, primarily due to a 49.3% increase in the number of policies.
Our net earnings for the year ended 2003, as compared to 2002, were favorably affected primarily by significant increases in our realized investment gains. We do not expect similar significant increases in our realized investment gains for 2004, nor do we expect our realized gains in 2004 to be similar to those in 2003.
The 2002 after-tax net investment losses were primarily caused by the decrease in net asset value, or NAV, of our equity investment in closed-end preferred stock mutual funds, the write-down of securities for other-than-temporary impairment of value, and the impact of the valuation allowance on deferred taxes. See "Investment Gains and Losses."
The increase in total earned premiums for 2003 was primarily attributable to increases in personal and commercial automobile business.
Premium finance and service fees increased $5.4 million, or 25.2%, during the year ended 2003, as a result of increased business and a service fee increase on Massachusetts new and renewal business from $3.00 to $4.00 per installment payment, for policies with effective dates on or after July 1, 2002.
Of the remaining $76.1 million total of net realized gains, we recognized net gains of $37.7 million for the year ended 2003 attributable to the change in the net asset value of seven closed-end preferred stock mutual funds in which we owned 20% or more through the period our ownership remained greater than 20%. During the third and fourth quarters of 2003, we dropped below the 20% ownership level and did not have the ability to exercise significant influence over operating and financial policies for six funds. Therefore, as of December 31, 2003, the investments were reported at fair market value and the unrealized gains or losses from the point our ownership fell below 20% to year end were reported as comprehensive income. See "Critical Accounting Policies -Investments." For the year ended 2003, the net realized investment gains attributable to these fund investments were $37.7 million, as compared to net realized investment losses of $45.1 million for that category of investments for 2002. Market conditions during 2003 caused a significant increase in the net asset value of those funds and, as a direct consequence, an increase in the net realized investment gains that we recognized for those investments for the year ended 2003.
None of our securities at December 31, 2003 has been in an unrealized loss position for more than 34 months. For our unrealized loss positions held between 24 and 34 months, 27%, or $12.7 million (cost), were rated AAA and were generally below amortized cost primarily due to interest rate moves. In addition, 56%, or $26.7 million, were invested in municipal bonds, all of which were rated investment grade. We do not believe any of these bonds warrant an other-than-temporary write-down as their fair values were below cost primarily due to general market conditions and not due to specific credit concerns of the obligor. The remaining 17%, or $8.2 million, consists of utility company preferred stocks rated BA2/BB+. The operating company of this utility is rated investment grade. We believe these unrealized losses are temporary in nature, that the obligor will continue to meet its obligations and we intend to hold these securities to their maturity. We will continue to monitor these holdings closely.
For our unrealized loss positions held between 6 and 12 months, approximately 74%, or $238.7 million (cost), were rated AAA and generally had market values below amortized cost due to interest rate moves. In addition, 25%, or $79.6 million, were invested in investment grade corporate and municipal bonds and preferred stocks. We view the declines in these securities as temporary, as the declines were principally due to market conditions and not due to the specific credit concerns of the obligor. Lastly, about 1.5%, or $4.5 million, were invested in utility preferred stocks that were rated below investment grade, though the respective operating companies carry investment grade ratings. We believe these unrealized losses are temporary in nature, that the obligor will continue to meet its obligations and we intend to hold these securities to their maturity. We will continue to monitor these holdings closely.
Our loss and LAE ratio (on a statutory basis) decreased to 73.4% for the year ended 2003 compared to 75.1% for 2002. The decrease was primarily driven by slightly more favorable experience in the current year personal automobile line of business due to increases in average earned premium revenue per automobile and more favorable loss reserve development compared to 2002.
As a result of changes in estimates of insured events in prior years, the provision for loss and loss adjustment expenses decreased $25,224 for the year ended 2003 and $14,437 for the year ended 2002. The favorable development is due primarily to lower than anticipated losses related to the personal automobile liability line of business, offset by worse development in automobile physical damage and commercial automobile liability. 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.
The redundancies for year end 2002 primarily related to the 2001 personal automobile liability area, as claim severity mainly came in better than anticipated and was offset by worse development for the previous accident years.
Ceded unpaid losses and LAE recoverable by line of business at December 31, 2003 and 2002 follow (in millions):
As a percentage of net premiums written, statutory underwriting expenses for our insurance subsidiaries improved to 22.9% for the year ended 2003 as compared to 23.6% 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.
Our net earnings for the year ended 2002 were adversely affected primarily by a significant increase in our net realized investment losses and, to a lesser extent, by an increase in our losses and loss adjustment expenses, which together more than offset an increase in our earned premiums.
Our after-tax net realized investment losses increased by $62.6 million for the year ended 2002 compared to the year ended 2001. The increased losses resulted primarily from:
write-downs for other-than-temporary declines in the market value of various investment securities. See "Investment Gains and Losses."
Our losses and loss adjustment expenses increased by $128.1 million, or 16.4%, in 2002 compared to 2001. The increase resulted primarily from our premium growth and an increase in our loss ratio (on a statutory basis) to 75.1% for 2002 compared to 74.5% for 2001. See "Losses and Loss Adjustment Expenses."
an increase of $102.2 million, or 13.2%, in earned premiums for personal automobile coverage in Massachusetts, primarily because of our acquisition of the personal automobile business of two companies that were exiting that market;
The following table and discussion compares direct premiums written, net premiums written and earned premiums for the years ended 2002 and 2001:
The increase in Massachusetts personal automobile direct premiums written resulted primarily from increases of 13.8% and 14.0% in the number of Massachusetts personal automobile exposures for liability and physical damage coverage, respectively, and from increases in rates for the coverage types noted below. The components of these changes for 2002 and 2001 follow:
Although direct premiums written for personal automobile insurance in states other than Massachusetts increased 26.8% in 2002, an overall depressed rate environment and adverse development of prior year reserves resulted in diminished underwriting profits. Personal automobile direct premiums written by American Commerce increased $26.6 million, or 31.3%, to $111.8 million in 2002 as compared to $85.1 million in 2001, due primarily to book rollovers of business from existing agents, partially offset by decreases in states where we are not actively pursuing writings. Personal automobile direct premiums written from Commerce West increased $3.9 million, or 10.5%, to $41.1 million in 2002 as compared to $37.2 million in 2001. Both companies primarily target preferred insurance risks and write predominantly personal automobile insurance. Commerce West's recent growth is attributable to preferred personal automobile business. Personal automobile policies for both companies are written primarily for a policy term of six months.
The increase in direct premiums written for Massachusetts commercial automobile insurance in 2002 was due primarily to an increase of approximately 14.0% in the number of policies written, combined with a 13.0% increase in the average commercial automobile premium per policy. The increase in premium per policy was attributable to demand for insurance exceeding supply in the commercial automobile market, as well as our own increase of volume of larger commercial automobile accounts. In 2002, we experienced an increase of approximately $1.9 million from policies with premiums in excess of $50. In addition, base rates for other voluntary commercial automobile policies have increased moderately, and a reduction in Individual Risk Premium Modification, or IRPM, credits has occurred, favorably affecting
The increase in direct premiums written for Massachusetts homeowners insurance in 2002 was due primarily to a 10.8% increase in the number of Massachusetts policies written coupled with a 7.3% increase in the average Massachusetts premium per policy. Our increase in Massachusetts homeowner premiums is primarily related to several factors:
The increase in total net premiums written was primarily due to the growth in direct premiums written as described above offset by an increase in premiums ceded to CAR and the quota share agreement. Net premiums written for homeowners insurance in all other states increased $1.6 million, with net premiums written of $6.1 million in 2002 as compared to $4.6 million in 2001.
The increase in total earned premiums during 2002 was primarily due to increases in written premiums as described above and 2001 written premiums being earned in 2002.
As depicted in the accompanying table, net investment income before taxes for 2002 decreased $1.1 million, or 1.1%, as compared to 2001, principally as a result of a decreased in yield partially offset by an increase in average invested assets at cost. The decrease in yield was primarily due to lower short-term yields, coupled with an environment of lower long-term yields and higher yielding investment securities being called. During 2002, we purchased approximately $142 million of Fannie Mae ("FNMA") securities. We believe these securities will have a duration of less than three years. This will allow us to achieve higher yields until longer term investments are acquired. Net investment income as a percentage of total average investments was 6.3% in 2002 compared to 6.6% in 2001. Net investment income, after-tax, as a percentage of total average investments, was 5.0% in 2002 and 5.3% in 2001.
The realized losses for 2002 also resulted from write-downs for other-than-temporary declines in the market value of certain fixed maturities, preferred and common stocks totaling $32.1 million. Our management focuses on the potential impairment of investments for other-than-temporary declines in market value. During 2002, an impairment in an investment was deemed to be other-than-temporary when a security's market value had diminished by more than 25% of cost for two consecutive calendar quarters. If the contractual terms of the security were being complied with, management performed a cash flow valuation to determine the potential impairment of the security. If the security was deemed impaired, we adjusted the security's cost to market value by recording a realized loss based on publicly available information or, in the absence of such information, to a value based on cash flow modeling. See "Critical Accounting Policies - Investments" above for more information about our current policy for determining whether an other-than-temporary decline in investment securities has occurred.
During 2002, $3.7 million in realized investment losses were also incurred related to our investments in venture capital funds. These investments primarily provide seed capital for start-up companies with emerging high technology initiatives in the financial services industry. These investments are made in limited partnerships and our exposure to loss is limited to our actual investment. Investments in these venture capital funds are accounted for on an equity basis.
compared to 32.6% for 2001. These factors were partially offset by higher contingent commission expenses and higher insolvency assessments. The 2002 underwriting ratio includes a $4.5 million charge, as compared to a $3.1 million charge in 2001, representing our allocation from the MIIF.
Our net earnings decreased $43.5 million, or 48.2%, to $46.8 million during 2002 as compared to $90.3 million in 2001, resulting primarily from an increase in our net realized investment losses of $71.8 million and an increase in our losses and loss adjustment expenses of $128.1 million, which together more than offset an increase of $166.4 million in our earned premiums, all as previously described in this section. Net earnings for 2002 included income, net of taxes, of $11.2 million due to the effect of a change in accounting principle related to SFAS No. 142.
In 2002, we restated 2001 for the effect of a change in accounting for employee stock options. For employee stock options which we issued from 1999 through 2001, we used fixed accounting treatment through September 30, 2002. At that time, we concluded that variable accounting treatment was more appropriate than fixed accounting treatment. Therefore, we applied variable accounting treatment in 2002, as well as retroactively to 2001 and prior years. Accordingly, in 2002, we restated results for 2001 and the first three quarters of 2002. The impact of the restatement for the year ended 2001 resulted in a decrease in net earnings of $2.8 million, or $0.08 per diluted share. As allowed by Statement of Financial Accounting Standards ("SFAS") No. 148, we have elected to continue to apply variable accounting for our stock options granted in 1999 and 2000. We continue to comply with Accounting Principles Board ("APB") Opinion No. 25 and related interpretations in applying fixed accounting for the employee stock options granted in 2001.
The primary sources of our liquidity are funds generated from insurance premiums, net investment income, premium finance and service fees and the maturing and sale of investments. The primary uses of our liquidity are payment of policy claims, operating costs and payment of dividends to our stockholders.
The decrease in the carrying value of the closed-end preferred stock mutual funds in 2003 was primarily the result of sales and the reclassification of six preferred stock mutual funds in which we no longer have a greater than 20% ownership position. We no longer use the equity method of accounting for these six funds, but instead mark them to market.
Cash flows provided by financing activities totaled $253.1 million during the year ended 2003 compared to $79.0 million used during 2002. The increase in cash in 2003, relative to 2002, was primarily from the net proceeds of our bond offering of $295.7 million, and from a $34.2 million reduction in treasury stock purchases. We issued $300 million face value of senior unsecured notes which mature December 9, 2013. We will pay 5.95% interest on these notes semi-annually on June 9 and December 9. We are using the proceeds for general corporate purposes, including enhancement of the capital position of our operating subsidiaries in support of recent premium growth, as well as to continue our diversification efforts outside of Massachusetts. We and our subsidiaries will be able to issue or incur additional indebtedness that is senior to the notes in the future, provided the secured portion of such debt does not exceed 15% of our consolidated tangible net worth.
Cash used in financing activities totaled $79.0 million during the year ended 2002 compared to $63.2 million during 2001. During 2002, cash flows used in financing activities consisted of $40.3 million in dividends paid to stockholders and $48.8 million used to purchase 1.3 million shares of treasury stock, partially offset by $10.1 million from the issuance of common stock pursuant to our stock option plan. During 2001, cash flows used in financing activities consisted of $40.0 million in dividends paid to stockholders and $23.3 million used to purchase approximately 623,000 shares of treasury stock.
We rely upon dividends from our operating subsidiaries for our cash requirements, including payments of interest and principal on the notes. Under Massachusetts law, if our subsidiaries wish to make any dividend or other distribution to us, they may, within certain limitations, pay such dividends and then file a report with the Commissioner. The aggregate amount of dividends calculated in accordance with regulations of Massachusetts, California and Ohio that could have been paid in 2003 from all of our insurance subsidiaries without prior regulatory approval was approximately $76.0 million, of which $66.2 million was declared and paid as of December 31, 2003.
. Our funds are generally invested in securities with maturities intended to provide adequate funds to pay claims without the forced sale of investments. The carrying value (at market and equity) of total investments, including cash and cash equivalents at December 31, 2003 was $2.2 billion. These funds provide sufficient liquidity for the payment of claims and other short-term cash needs.
Our credit quality classifications are based on Standard & Poor's ("S&P") rating agency designations. S&P's BB rating category is the highest quality tier within the below investment grade universe. Approximately 92% of the below investment grade fixed maturity securities are rated within the top two S&P tiers of the below investment grade categories.
We have commitments in two venture capital fund investments. These investments are made in limited partnerships and our exposure to loss is limited to our actual investment. One limited partnership investment required a commitment by us to invest up to $50.0 million into the partnership. As of December 31, 2003, we have invested $30.3 million into the partnership. 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 relating to companies in the areas of insurance, financial services, e-commerce, healthcare, and related businesses, including, without limitation, service and technology enterprises supporting such businesses.
The other limited partnership interest required a commitment by us to invest up to $3.5 million into the partnership. As of December 31, 2003, we have invested $2.6 million 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.
Liabilities for unpaid losses and loss adjustment expenses at December 31, 2003 and 2002 follow:
Industry and regulatory guidelines suggest that the ratio of a property and casualty insurer's annual net premiums written to statutory policyholders' surplus should not exceed 3.00 to 1.00. The following table presents, on a consolidated basis, our net premiums written to statutory surplus ratio:
In connection with the acquisition of American Commerce in January 1999, we granted stock options to agents that had been placing business with American Commerce before the acquisition. As of December 31, 2003, 1,872,380 of these options are outstanding. Each option may be exercised on or after January 29, 2004. The options will expire on January 29, 2009. Each option has two components: the right to exercise and a put option. The right to exercise permits the agents to purchase a certain amount of our common stock at an exercise price of $36.32 per share. The put option allows the agent to require us to purchase the option from the agent at a price of $3.68 per share. The agents would have an incentive to exercise their put options if the price of our common stock was below $40.00 on the exercise date. All of these options, except for 55,070 options, are vested in the put option. Our accrued liability for the exercise of these options was $14.2 million at December 31, 2003. Our total liability under the put options would be $6.7 million.
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, 2003, 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.
any mutual fund in which we own 20% or more of the shares outstanding. See "Critical Accounting Policies - Investments."
Selected information by segment for the years ended 2003, 2002 and 2001 follows:
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 recently filed registration statement on 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:
adverse changes to the laws, regulations and rules governing the residual market system in Massachusetts;
You should not place undue reliance on any forward-looking statement. The risk factors referred to above could cause actual results or outcomes to differ materially from those expressed in any forward-looking statement made by us or on our behalf. Further, any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
Property and equipment, net of accumulated depreciation (NOTES A5 and D)
Common stock, authorized 100,000,000 shares at $0.50 par value; 38,629,664 and
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 ("NAIC") and the Division of Insurance of The Commonwealth of Massachusetts, the State of California, and the State of Ohio.
All investment transactions have credit exposure to the extent that a counter party may default on an obligation to the Company. Credit risk is a consequence of carrying investment positions. To manage credit risk, the Company focuses on higher quality fixed-income securities and preferred stocks, reviews the credit strength of all companies in which it invests, limits its exposure in any one investment category and monitors the portfolio quality, taking into account credit ratings assigned by recognized statistical rating organizations.
If the security is deemed impaired, the Company adjusts the securities cost to market value through realized loss based on publicly available prices or, in the absence of such information, on a price supplied by a broker. Accumulated other comprehensive losses of less than 20% of costs that relate to interest rate changes and not to declines in a security's rating, financial situation or sector issues are not considered impaired due to the Company's ability and intent to hold these securities to maturity. During 2003, the Company wrote down $17,616 in bonds and preferred and common stocks with impairment as determined by management to be other-than-temporary. When investment securities are sold, the realized gain or loss is determined based upon specific identification. Fair market value of fixed maturities and common and preferred stocks are based on quoted market prices. For other securities held as investments, fair market value equals quoted market price, if available. If a quoted market price is not available, a price is obtained from a broker. The Company has not invested more than 5% of fixed maturities in any one state or political subdivision.
The Company accounts for venture capital fund investments in which it owns 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.
The Company records its equity in the changes in net assets of closed-end preferred stock mutual funds, in which it owns 20% or greater, as a component of realized gains and losses. These investments are valued at original cost plus the cumulative undistributed equity in earnings and losses of the funds.
Mortgage loans on real estate and collateral notes receivable are stated at the amount of unpaid principal, less an allowance for possible loan losses. The adequacy of the allowance for possible loan losses is evaluated on a regular basis by management. Loan losses are charged against the allowance when management believes the collectibility of the principal is unlikely and recoveries are credited to the allowance when received.
All of the Company's investments in fixed maturity and equity securities at December 31, 2003 and 2002 were classified as available-for-sale. Realized gains and losses on available-for-sale securities for the years ended December 31, 2003, 2002 and 2001 were determined by using the specific identification method. Fair value is based on quoted market price, when available. When quoted market prices are not available, fair value is estimated with the use of independent pricing sources.
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 2003, 2002 and 2001. In determining whether a premium deficiency exists, the Company considers anticipated investment income.
Maintenance and repairs are charged to operations; betterments are capitalized. The cost of property sold or otherwise disposed and the accumulated depreciation thereon is eliminated from the related property and accumulated depreciation accounts and any resulting gain or loss is credited or charged to income. The Company capitalizes fixed assets. A fixed asset is classified as property and equipment having an economic life of more than one year and having physical substance with a unit dollar value of $1.0 or greater.
continually reviewed and updated, and therefore, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimates are included in the results of operations in the period in which the estimates are revised.
Approximately 84% of our direct premiums written for the year ended December 31, 2003 were generated from personal automobile insurance policies. Approximately 86% of our direct premiums written for the year ended December 31, 2003 were generated in Massachusetts.
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 the Company's Massachusetts premiums written is derived through the American Automobile Association Clubs of Massachusetts ("AAA Clubs") affinity group marketing program. Of the Company's total direct premiums written, the portion attributable to the AAA affinity group marketing program in Massachusetts was $691,694 or 41.7% in 2003, $619,020 or 44.0% in 2002 and $545,496 or 47.3% in 2001. Of these amounts, 13.6% were written through insurance agencies owned by the AAA Clubs and 86.4% were written through the Company's network of independent agents in 2003.
As a member of a consolidated group for tax purposes, the Company and its subsidiaries (said parties constituting an "Affiliated Group" as defined in and for purposes of the Internal Revenue Code) are jointly and severally liable for federal income taxes of the Affiliated Group. The Company and its subsidiaries 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.
The method of allocation calls for current taxes to be allocated among all affiliated companies based on a written tax-sharing agreement. Under this agreement, allocation is made primarily on a separate return basis with current payment for losses and other tax items utilized in the consolidated return. However, to the extent that a payer member of the group has future net operating losses, which it cannot absorb in the year incurred, other members within the group will refund payments to the payer.
In addition to state mandated minimum and other commissions on policies written, the Company pays certain of its agencies compensation in the form of profit sharing. This is based, in part, on the underwriting profits of an individual agent's business written with the Company. The arrangement for Massachusetts business utilizes a three-year rolling plan, with one third of the agent's profit or loss for each of the current and the two prior years' calculations summed to a single amount. This amount, if positive, is multiplied by the profit sharing commission rate and paid to the agent. Outside of Massachusetts, Commerce, Commerce West and American Commerce each have contingent commission plans tailored to their specific markets.
Effective January 1, 2002, the ownership interests in AHC were recapitalized. Prior to the recapitalization at December 31, 2001, the Company maintained an 80% common stock interest and AAA SNE maintained a 20% common stock interest in AHC. Additionally, all AHC preferred stock was owned by the Company. The recapitalization resulted in redemption of all the AHC preferred stock by the Company in exchange for 3,000 additional shares of AHC common stock.
This resulted in the Company increasing its AHC common stock interest to 95% with AAA SNE maintaining a 5% AHC common stock interest, with no preferred stock outstanding. The recapitalization also resulted in the creation of $4.5 million in minority interest for AAA SNE. The $(294) and $555 represent AAA SNE's 5% share of the equity in (earnings) loss of AHC for 2003 and 2002, respectively. The $863 represents AAA SNE's 20% share of the equity in loss of AHC for 2001.
In November 2001, the Board of Directors of the Company authorized the repurchase of an additional 2,000,000 shares of common stock of the Company. During the period from January 1, 2003 through December 31, 2003, the Company purchased 403,572 shares of its own common stock at an average cost of $36.32. At December 31, 2003, the Company had authority to purchase a total of 574,284 additional shares of its common stock under the current buy-back program. As of December 31, 2003, the Company held a total of 6,568,964 shares of treasury stock.
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 the Company could have repurchased from the proceeds of the potentially dilutive shares. The Company's only dilutive instruments are stock options outstanding. Basic and diluted EPS are calculated as follows for the years ended 2003, 2002 and 2001:
Fair market value and amortized cost of our fixed maturity securities at December 31 follow:
During 2003, the Company's ownership interest in these funds dropped below an ownership percentage of 20%, and the Company did not have the ability to exercise significant influence over operating and financial policies. Therefore, the Company no longer accounts for its investment in those funds using the equity method of accounting. These funds are now reported at fair market value, the unrealized gains and losses are reported as comprehensive income, and they are classified under the common stock category. During 2003, a reclassification was made from preferred stock mutual funds to common stocks for each fund for the amount of the NAV at the time ownership fell below 20%. Gains or losses related to changes in NAV recorded on these funds prior to their reclassification were recorded as realized gains or losses.
Fair value of the Company's 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, 2003 and 2002, prior to the allowance for possible loan losses, was $17,579 and $28,012, respectively.
At December 31, 2003 and 2002, mortgage loans on non-accrual status totaled $455 and $388, respectively. Allowances of $40 and $53 were established in 2003 and 2002, respectively, for these loans. The reduction in interest income associated with non-accrual loans was $36, $44 and $99 for the years ended December 31, 2003, 2002 and 2001, respectively.
The Company originates and services residential and commercial mortgages in Massachusetts and Connecticut. The Company's exposure is generally 80% or less of the appraised value of any collateralized real property at the time of the loan origination. The ability and willingness of residential and commercial borrowers to honor their repayment commitments is generally dependent upon the level of overall economic activity and real estate values. During the years ended December 31, 2003, 2002 and 2001 the Company did not acquire any property through foreclosure of mortgages.
A summary of the changes in the allowance for possible loan losses for the years ended December 31 follows:
Includes $3,215 in 2001 relating to the amortization of negative goodwill, at the time of purchase of these securities.
Gross unrealized losses on our fixed maturity and equity securities at December 31, 2003 by duration of unrealized loss and by credit quality (for fixed maturity securities) follow:
None of the securities at December 31, 2003 has been in an unrealized loss position for more than 34 months. For our unrealized loss positions held between 24 and 34 months, 27%, or $12.7 million (cost), were rated AAA and were generally below amortized cost primarily due to interest rate moves. In addition, 56%, or $26.7 million, were invested in municipal bonds, all of which were rated investment grade. The Company does not believe any of these bonds warrant an other-than-temporary write-down as their fair values were below cost primarily due to general market conditions and not due to specific credit concerns of the obligor. The remaining 17%, or $8.2 million, consists of utility company preferred stocks rated BA2/BB+. The operating company of this utility is rated investment grade. The Company believes these unrealized
losses are temporary in nature, that the obligor will continue to meet its obligations and the Company intends to hold these securities to their maturity. Management will continue to monitor these holdings closely.
For the unrealized loss positions held between 12 and 24 months, 45%, or $4.8 million (cost), were rated AAA and generally had market values that were below amortized cost due to the effect of interest rate moves. In addition, 23%, or $2.5 million, were investment grade rated municipal bonds and preferred stocks which the Company believes will continue to meet their obligations. The remaining 32%, or $3.4 million, is attributable to a B rated municipal housing issuer from which the Company expects to receive full payment upon the sale of assets underlying the securities. The closing of this transaction is expected in the first quarter of 2004.
For the unrealized loss positions held between 6 and 12 months, approximately 74%, or $238.7 million (cost), were rated AAA and generally had market values below amortized cost due to interest rate moves. In addition, 25%, or $79.6 million, were invested in investment grade corporate and municipal bonds and preferred stocks. The Company views the declines in these securities as temporary, as the declines were principally due to market conditions and not due to the specific concerns of the obligor. Lastly, about 1.5%, or $4.5 million, were invested in utility preferred stocks that were rated below investment grade, though the respective operating companies carry investment grade ratings. The Company believes these unrealized losses are temporary in nature, that the obligor will continue to meet its obligations and the Company intends to hold these securities to their maturity. Management will continue to monitor these holdings closely.
Other comprehensive income (loss), less applicable income tax expense, for the years ended December 31 follow:
Property and equipment owned by the Company at December 31 follows:
In accordance with industry practice, the Company also maintains reserves for estimated IBNR and LAE net of salvage and subrogation recoverable. These reserves are determined based on historical information and the experience of the Company. 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 the Company's liability for losses and LAE over time.
When reviewing the liability for unpaid losses and LAE, the Company analyzes historical data and estimates the impact of various factors, including:
legislative enactments, judicial decisions, legal developments in the imposition of damages; and,
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, the Company estimates the ultimate net liability for losses and LAE. After taking into account all relevant factors, management believes that, based on existing information, the provision for losses and LAE at December 31, 2003 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) management's estimated liability for losses and LAE the Company will incur additional expense (income) which may have a material impact on the Company's consolidated financial position. The Company does not discount to present value that portion of its loss reserves expected to be paid in future periods.
Included in the loss reserve methodologies described above, are liabilities for unpaid claims and claim adjustment expenses for environmental related claims such as oil spills, mold and lead paint. Reserves have been established to cover these claims for known losses. Because of the Company's limited exposure to these types of claims, management believes they will not have a material impact on the consolidated financial position of the Company in the future. Loss reserves on environmental related claims amounted to $7,906 and $5,773 at December 31, 2003 and 2002, respectively.
The change in reserves for unpaid losses and loss adjustment expense, net of reinsurance deductions from all reinsurers, including CAR, for the years ended December 31 follow:
Loss and LAE reserves prior to the effect of ceded reinsurance
Approximately $35,000 in personal automobile liability redundancies developed for the year ended 2003, with two thirds of this amount coming from the 2002 and 2001 accident years. The remaining redundancy in this area came about evenly from the four accident years prior to this. The primary reason for the redundancies in this area is that claim severity came in better than the Company anticipated. The approximate $4,700 worse development in automobile physical damage occurred in the 2002 accident year offset by redundancies in the 2001 accident year. The 2002 impact was mainly from higher IBNR claims as a result of a severe winter storm during the last week of 2002, coupled with higher severity on physical damage claims. The 2001 redundancies primarily resulted from higher than anticipated subrogation. The Company also experienced deficiencies of $2,300 and $1,500 for accident years 2001 and 2002, respectively, in 2003 in the commercial automobile liability area. These deficiencies were primarily related to higher severity as compared to claims incurred in prior years. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining approximately $1,300 net deficiency.
The reserves for loss and loss adjustment expenses represent management's best estimate of the ultimate net cost of all loss and loss adjustment expenses incurred after reinsurance and for amounts estimated to be recoverable through salvage and subrogation. The Company's aggregate actuarial estimate for the loss and LAE reserves, on a consolidated basis and net of reinsurance recoverable, ranges from a low of $694.2 million to a high of $807.9 million, as of December 31, 2003. The Company's financial statement loss and LAE reserves net of reinsurance, based on management's best estimate, was established at $792.3 million for that date. Management calculates its estimate independently from those amounts as calculated by the Company's actuaries and, therefore, the final results are most often not the same. Management estimates its amounts primarily by reviewing historical loss and LAE data, focusing mainly on payment data. It also reviews and compares most recent loss frequency, severity and payment data to historical trends in an attempt to determine if patterns are remaining consistent or not. Management attempts to establish its reserve estimate as close to the amount required for the ultimate future payments necessary to settle all losses. The accuracy of this estimate is reflected by the line noted in the above table entitled "decrease in provision for insured events of prior years."
The Company's loss and LAE reserves reflect its share of the aggregate CAR loss and LAE reserves of the Company and the 34 other writers of automobile insurance in Massachusetts that participate in CAR ("Servicing Carriers").
On December 9, 2003, the Company issued $300 million face value of senior unsecured and unsubordinated debt ("the Senior Notes") which matures December 9, 2013. The Senior Notes were issued at 99.3% to yield 6.04%, and bear a coupon interest rate of 5.95%, payable semi-annually on June 9 and December 9 beginning 2004. Proceeds from the issuance were $298.0 million. Costs related to the issuance of the Senior Notes have been deferred and recorded in other assets on the balance sheet. The deferred costs and the original issue discount will be amortized into interest expense over the life of the Senior Notes. The fair market value of the Senior Notes at December 31, 2003 was $302.3 million.
The Company reinsures 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 the Company from its primary liability to the insured for the full amount of the policies, but it does make the reinsurer liable to the Company to the extent of the reinsured portion of any loss ultimately suffered. The Company seeks to utilize reinsurers that it considers adequately capitalized and financially able to meet their respective obligations under reinsurance agreements with it. The Company uses a variety of reinsurance mechanisms to protect itself against loss.
The Company entered into a new one-year 65% quota share reinsurance program to cover all non-automobile property and liability business, except umbrella policies, effective July 1, 2003. Prior to July 1,
Casualty reinsurance, excluding umbrella policies, is written on an excess of loss basis for any one event or occurrence with a maximum recovery of $8.0 million over a net retention of $2.0 million. This coverage is placed with Swiss Reinsurance America Corporation.
Earned premiums and losses and loss adjustment expenses are stated in the accompanying consolidated financial statements after deductions for ceded reinsurance. Those deductions for reinsurance, other than CAR, follow for the years ended December 31:
Effective July 1, 2002, Commerce entered into a retrocessional reinsurance agreement with one of its quota share reinsurers who maintained a one-third participation in Commerce's 75% quota share treaty. For a premium paid to Commerce, Commerce indemnified the reinsurer if the reinsurer incurred a loss for a single event or occurrence over a certain threshold. Losses assumed by the reinsurer must first exceed $15,000 before a reimbursement would have been made, by Commerce, to the reinsurer. Commerce's exposure to the reinsurer under this agreement was for a maximum of $35,000. The threshold translated into a $60,000 total loss event or occurrence to Commerce, $15,000 of which represented the reinsurers 25% portion of the quota share treaty, before the reinsurer would have received any benefit. This contract terminated on June 30, 2003 with no losses incurred by Commerce.
Since its inception, CAR has annually generated multi-million dollar underwriting losses, primarily in the personal automobile pool. The Company is required to share in the underwriting results of CAR business for its respective product lines. Under current regulations, the Company's share of the CAR personal or commercial deficit is based upon its market share for automobile risks for the particular pool, adjusted by a "utilization" concept, such that, in general, the Company is disproportionately and adversely affected if its relative use of CAR reinsurance exceeds that of the industry, and favorably affected if its relative use of CAR reinsurance is less than that of the industry. For personal automobile writers, companies can reduce their participation ratio by writing credit eligible business voluntarily. Companies are provided credits against their participation ratio for writing those classes and territories of business that are purposefully under-priced in the Massachusetts rate setting process. The Company's strategy has been to maintain above average voluntary retention levels, as well as to retain private passenger automobile business voluntarily that receives credits. This favorably affects the
Company's participation ratio compared to its market share, but adversely impacts its voluntary loss ratio. During 2003, 2002 and 2001, the Company's net participation in the CAR personal automobile pool approximated 20.2%, 18.2% and 17.3%, respectively, as reported by CAR, compared to the Company's estimated market share in those years of 27.6%, 25.9% and 23.2%.
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 their obligations. At the present time, the Company is not aware of any CAR member company who has failed to meet their obligations.
The federal income tax expense (benefit) for the years ended December 31 follows:
Federal income tax on income is less than the amount computed by applying the statutory rate of 35% for the years ended 2003, 2002 and 2001 for the following reasons:
The Company offers an Employee Stock Ownership Plan ("ESOP") for the benefit of substantially all employees, including those of the Company's subsidiaries. The ESOP is noncontributory on the part of participants and contributions are made at the discretion of the Board of Directors. The Company is 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. Contributions by the Company and subsidiaries to the ESOP for the years ended December 31, 2003, 2002 and 2001 were $8,850, $8,070 and $7,502, respectively. The increase in the contribution in 2003 over 2002 and in 2002 over 2001 was primarily due to an increase in employees. The ESOP held 2,851,748 and 2,921,033 shares of the Company's common stock at December 31, 2003 and 2002, respectively.
In 2003, the Company's 401(k) Plan was merged into the ESOP. The ESOP is administered by Fidelity Investments. The 401(k) component of the ESOP enables eligible employees to contribute up to 60% of eligible compensation on a pre-tax basis up to the annual maximum limits under federal tax law. The Company incurs no expenses in the form of matching contributions but does pay for administration of the plan.
Effective May 1, 2002, the Directors of American Commerce voted to terminate that portion of the American Commerce noncontributory post-retirement benefit plan (the "post-retirement plan") applicable to future retirees. The post-retirement plan provides benefits for retirees that include medical, dental and life insurance coverages. Retirees at May 1, 2002 and employees who retired prior to that date remained eligible for post-retirement benefits. Dental coverage ceases at
The measurement dates used to determine post-retirement benefit measurements that make up at least the majority of benefit obligations are December 31, 2003 and 2002, respectively.
The amount of consolidated retained earnings at December 31, 2003 represented by undistributed earnings of 50% or less owned investments that are accounted for using the equity method follows:
During 2002, the Company's stockholders approved the Incentive Compensation Plan which provides for the award of incentive stock options, non-qualified stock options, book value awards, stock appreciation rights ("SAR"), restricted stock and performance stock units. Up to 5,000,000 shares of common stock (subject to increase for anti-dilution adjustments) may be issued under the Incentive Compensation Plan, including shares that may be issued pursuant to awards of restricted stock or upon the exercise of common stock equivalent awards such as stock options and stock appreciation rights payable in the form of common stock (not in the form of cash). At the discretion of the compensation committee all directors, officers and other senior management employees of the Company or any of its subsidiaries are eligible to participate in this Incentive Compensation Plan.
Employee stock options ("options") granted during 2001, 2000 and 1999 relating to the Incentive Compensation Plan totaled 1,184,343, 644,520 and 700,179, respectively, including the issuance of options previously terminated. No options were granted in 2003 and 2002. The outstanding options entitle the recipient to purchase the Company's 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.
Incentive Compensation Plan activity, related to employee stock options, for the three years ended 2003 follows:
The Company follows variable accounting treatment of employee stock options granted in 1999 and 2000 in accordance with APB Opinion 25 and related interpretations. Expenses in 2003 and 2002 related to options granted in 1999 and 2000 were $2,570 and $3,306, respectively.
Additionally, the Company granted 1,100,000, 475,000 and 275,000 options to certain agents ("ACIC agents' options") of American Commerce (the "American Commerce Agents' Plan") in 2003, 2002 and 2001, respectively. The right of the recipient to exercise these ACIC agents' options is contingent upon the average volume of other-than-Massachusetts private passenger automobile and homeowners direct written premiums placed and maintained with American Commerce for a five year period specified in the ACIC agents' option agreement. If qualified, the recipient may purchase the Company's common stock at the exercise price for a period of five years beginning five years after the date of the grant ("the confirmation date"). Unexercised ACIC agents' options terminate not later than ten years after the date of the grant ("the expiration date"). In conjunction with meeting specified premium growth levels over the term of the ACIC agents' options, the Company provided "put rights" to the holders of the ACIC agents' options granted in 1999. These put rights permit the agents' option holders to require the Company to purchase the ACIC agents' options at the difference between $40.00 less the exercise price, at any time from and after the confirmation date through and including the expiration date. Options cannot be exercised using cash. Options can only be exercised using a net share purchase such that the dollar value that the option is in the money is divided by the fair market value of the stock at the date of exercise to arrive at the number of shares received by the option holder. Expenses related to these options, determined in accordance with the fair value accounting provisions of SFAS No. 123, "Accounting for Stock-Based Compensation", amounted to $9,030 in 2003, $1,543 in 2002 and $2,862 in 2001. The American Commerce Agent's Plan has not been, and is not required to be, approved by the Company's stockholders.
The fair value of each of the ACIC agents' options granted under the American Commerce Agents' Plan was estimated using the Black-Scholes option-pricing model, with the following weighted average assumptions:
The insurance companies included in the consolidated financial statements are subject to the financial capacity guidelines established by their respective state Divisions of Insurance. Every Massachusetts insurance company seeking to make any dividend or other distribution to its stockholders may, within certain limitations, pay such dividend and then file a report with the Commissioner. Dividends in excess of these limitations are called extraordinary dividends. An extraordinary dividend is any dividend or other property, whose fair value together with other dividends or distributions made within the preceding twelve months, exceeds the greater of ten percent of the insurer's surplus as regards policyholders as of the end of the preceding year, or the net income of a non-life insurance company for the preceding year. No pro-rata distribution of any class of the insurer's own securities is to be included. No Massachusetts insurance company shall pay an extraordinary dividend or other extraordinary distribution until thirty days after the Commissioner has received notice of the intended distribution and has not objected. No extraordinary dividends were paid in 2003, 2002 and 2001. California and Ohio have similar regulations. No extraordinary dividend was paid by American Commerce in 2003, 2002 and 2001 and no dividends were paid by Commerce West since its acquisition.
The Board of Directors of the Company voted to declare four quarterly dividends to stockholders of record totaling $1.27 per share and $1.23 per share in 2003 and 2002, respectively. On May 16, 2003, the Board voted to increase the quarterly stockholder dividend from $0.31 to $0.32 per share to stockholders of record as of June 4, 2003. Prior to that declaration, the Company paid quarterly dividends of $0.31 per share dating back to May 19, 2002 when the Board voted to increase the dividend from $0.30 to $0.31 per share.
The Company presents statutory financial information because it believes that these measures are useful to interested parties. Statutory measures allow readers to more easily compare our insurance operations with those of other companies, especially those whose GAAP financial statements reflect businesses more diversified than the Company's business. Statutory accounting principles vary in some respects from GAAP. Principal variations include the accounting for:
assets and liabilities related to reinsurance transactions, and commissions allowed by reinsurers on business ceded;
closed-end preferred stock mutual funds accounted for under the equity method and investments in limited partnerships.
Following is a GAAP to Statutory reconciliation for both earnings and policyholders surplus for the combined operations of our insurance subsidiaries - Commerce, Citation, Commerce West and American Commerce:
The Company evaluates performance and allocates resources based primarily on the property and casualty insurance segments, which represents over 99% of the Company's total revenue for the past three years. The accounting policies of the reportable segments are the same as those described in NOTE A - Summary of Significant Accounting Policies.
All of the insurers writing the types of insurance covered by the Massachusetts Insurers Insolvency Fund ("MIIF") are MIIF members. MIIF is obligated to pay any unpaid claim, up to $300, against an insolvent insurer if the claims existed prior to the declaration of insolvency or arose within 60 days thereafter. MIIF assesses members the amounts it deems necessary to pay both its obligations and the expenses of handling covered claims. Subject to certain limitations, assessments are made in the proportion that each member's net written premiums for the preceding calendar year for all property and casualty lines of business bore to the corresponding net written premiums for all members for the same period. The statute that established MIIF also provides for the recoupment by insurers of amounts paid to MIIF. Historically, the Commissioner has allowed insurers to recoup the amounts they paid MIIF through rate adjustments.
Credit General Insurance Company Insolvency, $1,154, Trust Insurance Company Insolvency, $1,074 and New England Fidelity Insurance Company Insolvency, $1,033. These amounts were offset by refunds for prior year assessments on numerous insurer insolvencies.
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 and, as previously mentioned, Commerce and Citation are covered by MIIF. All companies are also covered by similar associations in the states where they do business. These associations operate similarly to the MIIF described earlier. Payments made by American Commerce, Commerce West and Commerce to the associations that they are covered under were $190 in 2003 and $107 in 2002.
In 2000, Commerce entered into a Limited Partnership Agreement with Conning Partners VI, L.P., a Delaware Limited Partnership. This partnership agreement required a commitment by the Company to invest up to $50,000 into the partnership. In 2003, 2002 and 2001, the Company invested $5,250, $9,965 and $6,341, respectively, into the partnership. As of December 31, 2003, the Company has invested $30,306 into the partnership, leaving a balance for funds available for commitment to the partnership of $19,694. 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 relating to 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 Company previously disclosed that a purported class action lawsuit was pending in Massachusetts state court against Commerce. The lawsuit, titled "Elena Given, individually and as a representative of all persons similarly situated v. The Commerce Insurance Company," alleged damages as a result of the alleged inherent diminished value to vehicles that are involved in accidents. In April 2002, the trial judge in that case entered partial summary judgment for the plaintiff on the issue of whether the Massachusetts automobile policy covers her claim, ruling that the plaintiff would be entitled to reimbursement under the policy if the plaintiff were able both to prove that her vehicle suffered "inherent diminished value" in the accident and to quantify the amount of such diminution in value. During the third quarter of 2002, Commerce applied for direct appellate review of this issue by the Supreme Judicial Court of Massachusetts ("SJC"), and this application was granted. On October 7, 2003, the SJC ruled in favor of Commerce, overturning the trial court's decision that the Massachusetts automobile policy provides coverage for inherent diminished value. The plaintiff has dismissed this case. Commerce had not previously established a reserve for any contingent liability related to the Given litigation; therefore, there was no financial impact as a result of the conclusion of this litigation.
An unaudited summary of the Company's 2003 and 2002 quarterly performance follows:
The insurance operations of the Company include the operating results of Commerce, Citation, Commerce West, American Commerce and Clark-Prout. Results of Commerce West are included since its acquisition by the Company on August 31, 1995. Results of American Commerce are included since its acquisition by the Company on January 29, 1999.
Due to the internal reorganization in 2003, minority interest is not included in our insurance operations. Minority interest of $(294) in 2003 is included in net earnings for non-insurance companies.