1998 1999 2000 2001 2002 Earnings Per Common Share 2.28 1.53 1.55 2.40 1.76 Cash Dividends Declared 0.67 0.68 0.71 0.72 0.73
Losses and settlement expenses increased by $25,651,000, or 9.5 percent, to $295,980,000 in 2002, due primarily to an increase in the severity of non-catastrophe losses. Although the number of non-catastrophe claims decreased by 5,723, or 12.4 percent, in 2002, the average non-catastrophe direct loss and loss adjustment expense per claim was $6,386 in 2002, compared to $4,829 in 2001. During 2002, we experienced a decrease in estimated losses for property and casualty claims that occurred in prior years, as described in "Property and Casualty Insurance Segment" below.
In 2001, we incurred losses of $6,892,000 related to the events of September 11, 2001. During 2002, we incurred an additional $399,000 for this loss. We have no reserves outstanding as of December 31, 2002 for the September 11 events. We consider the September 11 attacks on the World Trade Center to be one event. However, if the judicial system determines that these attacks should be considered multiple events, we estimate, based upon information currently available to us, that our pre-tax losses would increase by approximately $3,000,000.
Other underwriting expenses and amortization together increased in 2002 by $10,857,000, or 9.0 percent, to $131,401,000, primarily as the result of the growth in net premiums written.
Net investment income increased by $6,644,000, or 6.7 percent, to $105,553,000 between 2001 and 2002. Despite the depressed interest rate environment that existed in the United States throughout 2002, annuity deposits and premium receipts have led to growth in our investment portfolio, thus leading to the increase in investment income.
Interest on policyholder accounts increased to $51,735,000 in 2002, compared to $48,213,000 in 2001. We lowered interest-crediting rates on new deposits throughout 2002. Much of the growth in interest credited was primarily a result of the interest credited on existing account balances, where the interest crediting rates are higher than the current rates.
Losses and settlement expenses incurred in 2002 totaled $280,021,000, reflecting losses and settlement expenses of $291,077,000 resulting from losses that occurred in 2002 and favorable development of $11,056,000 on losses that occurred prior to 2002. The favorable development resulted from a re-estimation of loss reserves established at December 31, 2001 in each of our lines of business except other liability. The deficiency in the other liability line of business of $12,788,000 resulted from a number of large other liability losses reported to us in 2002 for accident years 1997 through 2001. The deficiency in the other liability line of business was more than offset by the redundancies in our other lines of business.
Losses and settlement expenses incurred in 2001 totaled $256,145,000, reflecting $303,182,000 of losses that occurred in 2001 and $47,037,000 of favorable development on losses that occurred prior to 2001. In 2001, the favorable development was concentrated in our commercial automobile liability and other liability lines of business for accidents occurring in years 1998 through 2000.
In 2002, our favorable development was attributable to savings of approximately $1,858,000 from workers' compensation medical bill reviews, compared to approximately $1,290,000 in 2001; savings of approximately $2,795,000 from the use of alternative dispute resolution in 2002, compared to approximately $3,930,000 in 2001; recoupment of approximately $3,358,000 from salvage and subrogation in 2002, compared to approximately $5,643,000 in 2001 and savings of approximately $3,045,000 in 2002 attributable to both the payment of claims for less than the amounts reserved and from reductions in loss reserves due to additional information on individual claims that we received after the reserves for those claims had been established, compared to approximately $36,174,000 in 2001. The additional favorable information we consider is unique to each claim. Such information includes facts that reveal we have no coverage obligation for a particular claim, changes in applicable laws that reduce our liability or coverage exposure on a particular claim, facts that implicate other parties as being liable on a particular claim and favorable court rulings that decrease the likelihood that we would be liable for a particular claim. Additional information relating to severity also is unique to each claim. For example, we may learn during the course of a claim that bodily injuries are less severe than originally believed or that damage to a structure is merely cosmetic instead of structural, as originally reported.
For 2001, the development of our loss reserves in many of the categories discussed above was affected by adjustments in reserves made with respect to the book of business acquired in our purchase of American Indemnity Financial Corporation in August 1999. Following this purchase, we began a detailed review of many of the case reserves established for this business. This review was undertaken both as part of our assimilation of the case reserves into our own reserves and as a result of our belief upon completing an initial overview of reserves that many claims had insufficient reserves. We had some of our most experienced claims personnel conduct this initial review. The reserve changes made were based on the judgment of claims professionals experienced in evaluating bodily injury and property damage claims and knowledgeable about the legal environment, including
Conditions and trends that have historically affected the prior years' loss development of reserves may not necessarily occur in the future. Despite our history of favorable development on prior years' reserves, our current reserves for claims may prove to be inadequate, which could have a material impact on our net income and stockholders' equity.
Within the commercial lines of business, our best performing line continues to be fidelity and surety, with a loss ratio of 8.5 percent in 2002, and 17.3 percent in 2001. Our surety products provide protection against loss due to non-performance, such as a construction bond that protects owners against nonpayment by general contractors of material suppliers and subcontractors. Our fidelity products generally provide insurance against loss of money or other property due to the fraud or dishonesty of employees. Despite poor experience in the surety industry, we have continued to show profitability in this line of business. A majority of the industry losses have been in the area of financial guarantees, policies which were widely written by the national surety companies throughout the 1990's. Due to our very limited writing of financial guarantees, we have had minimal losses incurred from this type of bond. Because of the industry's poor experience, many of the national surety companies have raised their surety premium rates, while we and some other regional insurance companies have initiated more modest rate increases and term changes, which has enabled us to obtain additional, favorable surety accounts.
Our other liability line of insurance covers businesses for any liability for bodily injury and property damage arising from general business operations, accidents on their premises and products manufactured or sold. The 2002 loss ratio for this line of business was 73.9 percent, compared to 55.6 percent in 2001. The deterioration between years was due to a number of large losses reported to us in 2002. Many of these losses related to prior accident years. A small portion of these losses were the result of construction defect claims, primarily for residential general and subcontractors. This particular type of claim involves allegations of defective work on construction projects. The claims typically involve numerous parties and insurers. Our reserves for construction defect claims are based upon information that is currently available to us, as well as our past loss experience, and the current legal environment. Future judicial and regulatory actions concerning construction defect liability creates uncertainty as to our ultimate liability for these types of claims.
Workers' compensation continues to be a poorly performing line of commercial business. The loss ratio deteriorated to 101.4 percent in 2002, from 86.1 percent in 2001. We continue to write this line of business as part of an overall commercial account. The deterioration in 2002 was primarily the result of an increase in severity of claims, coupled with modest premium rate increases. Intense competition in the workers' compensation line, as well as state insurance department regulation of rates have resulted in lower premium rate increases in this line of business, when compared to our other commercial lines of business.
The expense ratio was 29.9 percent in 2002, compared to 30.7 percent in 2001. We experienced this stability in our expense ratio as a result of maintaining steady underwriting expenses while seeing growth in premiums written and earned. We anticipate that the closing of our branch office in Lincoln, Nebraska during the third quarter of 2002 will contribute to further improvement in our expense ratio.
Losses and loss adjustment expenses incurred represent actual payments made and changes in estimated future payments to be made, including expenses required to settle both reported and unreported losses. For reported losses, we establish reserves based upon policy provisions, accident facts, injury or damage exposure, trends in the legal system, historical results and other factors. For unreported losses, we establish reserves for each line of business based on the probable number and nature of losses, determined on the basis of historical and statistical information. Once we have established reserves, we closely monitor and adjust them as losses develop. We regularly review our reserve calculations and, as required by state law, we engage an independent actuary to render opinions as to the adequacy of the statutory reserves we establish. We file the actuarial opinions in those states where we are licensed. There are no material differences between our statutory reserves and those established under accounting principles generally accepted in the United States.
Over the course of the last ten accident years, our reserves for losses and loss adjustment expenses have exceeded our incurred losses and loss adjustment expenses. Because establishing reserves is inherently uncertain, an analysis of factors affecting reserves can produce a range of reasonable estimates. Our philosophy is to establish reserves that are appropriate and reasonable, but assume a pessimistic view of potential outcomes. Generally, our best estimate of reserves is slightly above the mid-point of a range of reasonable estimates. We believe that it is appropriate and reasonable to establish a best estimate within a range of reasonable estimates for use in determining reserves. We believe the use of a range of reasonable reserves is especially effective when we are reserving for claims for bodily injury, disabilities and similar claims, for which settlements and verdicts can vary widely. Our reserving philosophy may result in favorable development in succeeding years that will decrease loss and loss adjustment expenses for prior year claims in the year of adjustment. While we realize that this philosophy, coupled with what we believe to be aggressive and successful claims management and settlement practices, has resulted in year-to-year redundancies in reserves, we believe our approach is better than experiencing year-to-year uncertainty as to the adequacy of our reserves.
. Our philosophy is to establish reserves that are appropriate and reasonable, but assume a pessimistic view of potential outcomes; . We use claims negotiation to control the size of settlements; . We assume that we have liability for all claims, even though the issue of liability may in some cases be resolved in our favor; . We focus on loss prevention services to enhance workplace safety and to prevent accidents and illness; . We promote claims management services to encourage return-to-work programs, case management by nurses for serious injuries and management of medical provider services and billings; and . We use programs and services to help prevent fraud and to assist in favorably resolving cases.
Net income recorded by the life segment for 2002 was $3,313,000 compared to $8,534,000 for 2001. The change in net income was attributable primarily to growth in net investment income, offset by an increase in net realized investment losses. Net investment income earned increased by $7,127,000, or 10.1 percent, in 2002 to $77,809,000. Despite depressed interest rates, annuity deposits increased our life segment's investment portfolio, leading to the increase in investment earnings. The increase in net realized investment losses was primarily due to investment write-downs of $11,836,000 in 2002 versus investment write-downs of $3,503,000 in 2001.
Net premiums earned by the life segment in 2002 totaled $27,873,000, compared to $25,437,000 in 2001. Annuity deposits collected are not reflected in net premiums earned. Rather, revenues for annuities consist of policy surrender charges and investment income earned. In 2002, annuity deposits were $223,452,000, compared to $163,115,000 in 2001. Annuity deposits are invested and recorded as liabilities, referred to as future policy benefits.
At December 31, 2002, $1,398,636,000 or 88 percent of our fixed maturities were classified as available-for-sale, compared to $1,142,614,000 or 83 percent at December 31, 2001. During 2002, we added trading securities to our portfolio. Our trading securities consist primarily of convertible redeemable preferred securities, which are recorded at fair value, with any changes in fair value recognized in earnings. Our remaining fixed maturities are classified as held-to-maturity and are reported at amortized cost. As of December 31, 2002, 87 percent of our fixed maturities were investment grade, as defined by the National Association of Insurance Commissioners' Securities Valuation Office, and had ratings of Class 1 or Class 2.
Net investment income increased by $6,644,000, or 6.7 percent, to $105,553,000 between 2001 and 2002. More than 95 percent of our investment income originates from interest on fixed maturities. Our remaining investment income is derived from dividends on equity securities, interest on other long-term investments, interest on mortgage loans, interest on policy loans and rent earned from tenants in our home office. The average investment yield, which is investment income divided by average invested assets, was 6.4 percent in 2002, compared to 6.7 percent in 2001. We attribute the decrease between years to the reinvestment of proceeds from maturing fixed maturities and the investment of new funds at lower investment yields during 2002 due to market conditions.
At December 31, 2002, we have a recorded minimum pension liability of $3,500,000 (before tax), which represents the amount that we recognized to cover a $4,248,000 deficit occurring as a result of our fair value of plan assets being less than our accumulated benefit obligation. The amount of this deficit is first offset by any prepaid pension cost ($748,000) to arrive at the additional pretax minimum pension liability required to be recognized in our Consolidated Financial Statements.
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2001 and 2000
For the year ended December 31, 2001, our consolidated net operating income, which excludes net realized gains and losses on securities, was $24,214,000, or $2.41 per share, compared to $16,713,000, or $1.67 per share, for the year ended December 31, 2000. The most significant factors contributing to the increase were growth in net premiums earned, growth in net investment income and favorable development in our property and casualty loss reserves.
Net premiums earned increased by $38,654,000, or 12 percent, to $372,019,000, due primarily to premium rate increases in our property and casualty insurance segment. Net investment income increased by $12,042,000, or 14 percent, to $98,909,000, with more than $9,000,000 of the increase contributed by our life insurance segment. Annuity deposits increased our life insurance segment's investment portfolio, leading to higher investment earnings. During 2001, we experienced a decrease in estimated losses for property and casualty claims that occurred in prior years, as described in the "Property and Casualty Insurance Segment," on the following page.
In 2001, losses and settlement expenses increased by $33,522,000, or 14 percent, to $270,329,000, due primarily to an increase in severity in our fire and allied lines and workers' compensation lines of business. This increased severity more than offset the decrease in prior year estimated property and casualty claim losses. The combination of amortization of deferred policy acquisition costs and other underwriting expenses reflected a moderate increase of $2,772,000, or 2 percent, which primarily resulted from the continued increase in business written across our various property and casualty lines of business, both on a new and renewal basis. Interest on policyholders' accounts increased by $5,803,000, or 14 percent, to $48,213,000, due primarily to interest credited on existing annuity account balances; we decreased interest-crediting rates for new annuity deposits received during 2001.
On a consolidated basis, net income, which is net operating income plus after-tax net realized gains and losses on securities, was $24,093,000, or $2.40 per share in 2001, compared to $15,527,000, or $1.55 per share, in 2000. We recorded net realized after-tax losses of $121,000 in 2001 and $1,186,000 in 2000. In both years, other-than-temporary impairments on a small number of fixed maturities contributed to realized losses.
In 2001, favorable development was concentrated in our commercial automobile liability and other liability lines of business. For both lines of business, favorable development was concentrated with respect to accidents occurring in years 1998 through 2000. Offsetting favorable development were incurred losses totaling $303,182,000 for accidents occurring in 2001. In 2000, favorable development was concentrated in our workers' compensation and personal automobile liability lines of business, primarily for accidents occurring in 1998 through 2000. Claims for accidents occurring in 2000 resulted in incurred losses of $263,099,000 in 2000.
In 2001, improvement in our commercial automobile business more than offset deterioration in our personal automobile business. In our commercial automobile business, we imposed stricter underwriting guidelines and aggressively pursued rate increases. We also continued to increase rates and tighten eligibilities for our personal automobile business.
Other liability insurance covers businesses for liability for bodily injury and property damage arising from general business operations, accidents on their premises and products manufactured or sold. Our loss ratio in the other liability line of business was favorable when compared with our other lines of business. Our loss ratio was 55.6 percent in 2001 and 61.7 percent in 2000. Appropriate pricing, and restrictive underwriting guidelines contributed to the favorable results in the other liability line of business.
The loss ratio for our workers' compensation line of business deteriorated to 86.1 percent in 2001, from 65.1 percent in 2000. Results in 2000 were unusually favorable because we settled many workers' compensation cases favorably, which led to lower payments than were reserved. In 2001, the frequency and severity of the claims reported to us increased, and many of our workers' compensation cases had not settled favorably. We carefully continued to underwrite this line of business and further tightened our eligibility guidelines.
Our fidelity and surety bond business had some deterioration in 2001 when compared to 2000. The loss ratio was 17.3 percent in 2001 and 14.8 percent in 2000. This line continued to be our most profitable. However, for the past several years a soft surety insurance market and competitive pressures had contributed to depressed rates for this line of business. In 2001, we initiated rate increases and stricter underwriting guidelines to address the conditions in this line.
Net premiums earned by the life segment in 2001 totaled $25,437,000, compared to $26,094,000 in 2000. In 2001, annuity deposits were $163,115,000, compared to $165,181,000 in 2000.
In 2001, we credited interest of $48,213,000 to annuity and universal life policyholder accounts, compared to $42,410,000 in 2000. We decreased interest-crediting rates during 2001 for new deposits. The increase in our expense for interest on policyholders' accounts for the year was primarily a result of the interest credited on existing account balances.
The composition of our investment portfolio at December 31, 2001 is presented in the following table in accordance with accounting principles generally accepted in the United States:
In 2001, we eliminated a deferred tax liability of $1,143,000, which we had established in connection with a Revenue Agent Review and other tax contingencies related to the 1999 purchase of American Indemnity Financial Corporation. The Revenue Agent Review had been settled, and we believe that the reserve for other tax contingencies was unnecessary at December 31, 2001. The effect of the elimination was a reduction of deferred tax liabilities and a reduction in federal income tax expense of $1,143,000.
Due to uncertainty of the realizable value of the deferred tax asset, we recorded a valuation allowance of $8,934,000. The valuation allowance recorded on our deferred tax asset decreased $2,436,000 from 2000, due primarily to the utilization of net operating loss carryforwards. In the future, if we can use the net operating losses acquired in the purchase of American Indemnity Financial Corporation, the related reduction in the valuation allowance will be recorded as a reduction to our intangible asset until the intangible asset has been eliminated, at which point the reduction in the allowance will reduce federal income tax expense.
We invest funds available for short-term cash needs, primarily in money market accounts, which are classified as cash equivalents. At December 31, 2002, our cash and cash equivalents included $28,837,000 related to these money market accounts, compared to $46,113,000 at December 31, 2001.
Redeemable preferred stock totaling $65,113,000 consists of 2,760,000 shares of 6.375 percent Convertible Preferred Stock, Series A, issued at $25 per share in May of 2002. Dividends paid and accrued on our preferred stock in 2002 totaled $2,871,000. Our preferred stock is discussed further in Note 11 of the Notes to Consolidated Financial Statements
A material adverse deviation in certain critical assumptions, including surrender rates, mortality experience, or investment performance, would negatively affect our reported deferred policy acquisition cost asset, earnings and stockholders' equity.
Stock-Based Compensation We have elected to account for our stock options under Accounting Principles Board Opinion No. 25 in accounting for our stock option plan. Under Accounting Principles Board Opinion No. 25, no compensation expense is recognized for grants of options to employees and directors at an exercise price equal to or greater than the market price of the stock on the date of grant. Accordingly, based on our grants to employees in 2002 and 2001, no compensation expense has been recognized.
Pension Expense and Liabilities We use an outside actuarial service to provide a calculation to determine our pension liability, which we include in our Consolidated Balance Sheet in a liability line labeled "Accrued expenses and other liabilities". We provide assumptions to our actuaries for the expected long-term rate of return and the discount rate. The expected long term rate of return on pension plan assets considers expected capital market returns over a long term horizon, inflation rate assumptions and actual returns on plan assets. Lower market interest rates and plan asset returns have resulted in declines in pension plan asset performance and funded status. As a result, the expected return on plan assets was reduced to 8.0 percent (from 8.25 percent for 2002 expense recognition) and the discount rate was reduced to 6.75 percent (from 7.25 percent at the previous measurement date). Both the expected rate of return and the discount rate impact our current and future pension expense and pension liability. The decrease in the expected rate of return and the discount rate will increase pension expense in 2003. We do not know what the expected long-term rate of return will be in the future; it will depend upon market interest rates. If our current assumptions for the expected long term rate of return and the discount rate prove to be too high, our future expenses and liabilities related to our pension plan will increase.
Postretirement Benefit Expense and Liabilities The expense and liabilities related to postretirement benefits are calculated based upon a number of actuarial assumptions, the most significant of which are the discount rate and the expected long term health care trend rate. The discount rate we utilize for determining postretirement benefit expense and liability is the same as that used for our pension plan. When we estimate the expected long term health care trend rate, we consider industry trends, our actual healthcare cost experience and our future benefit structure. For measurement purposes, a 12.0 percent annual rate of increase in the per capita cost of covered health care benefits is assumed for 2003. The rate is assumed to decrease gradually each year to a rate of 5.25 percent for 2010 and remain at that level thereafter. For dental claims, a 5.25 percent annual rate of increase was assumed for 2002, decreasing gradually to 4.75 percent for 2005 and thereafter. If either current assumptions for either the discount rate prove to be too high, and/or the expected long term health care trend rates prove to be too low, our future expenses and liabilities related to our postretirement benefit plan will increase.
The insurance industry is governed by the individual state insurance departments. All of the insurance departments of the states in which we are domiciled have adopted the codification of insurance statutory accounting principles, effective January 1, 2001. Previously, these principles were prescribed in a variety of publications, as well as state laws, regulations and general administrative rules. The effect on our statutory financial statements as of January 1, 2001 was an increase to statutory policyholders' surplus of $10,300,000. This change does not affect the financial statements in this report that are based on accounting principles generally accepted in the United States. Although, pursuant to codification rules, we may use permitted statutory practices with approval from the insurance departments in our states of domicile, we do not use any statutory permitted practices.
To comply with solvency regulations of the individual state insurance departments, we are required to calculate a minimum capital requirement based on insurance risk factors. The risk-based capital results are used to identify companies that require regulatory attention or the initiation of regulatory action. At December 31, 2002, both our life insurance segment and our property and casualty insurance segment had capital well in excess of the required levels.
We are not aware of any other current recommendations by the National Association of Insurance Commissioners or other regulatory authorities in the states in which we conduct business that, if or when implemented, would have a material effect on our liquidity, capital resources or operations.
Our financial strength is regularly reviewed by independent rating agencies, who assign a rating based upon items such as results of operations, capital resources and minimum policyholders' surplus requirements.
Company. According to A.M. Best Company, companies rated "A" and "A-" have, "an excellent ability to meet their ongoing obligations to policyholders." A.M. Best Company assigned a "bbb" rating to our convertible preferred stock issue.
See Note 1 of the Notes to Consolidated Financial Statements for a description of recently issued accounting pronouncements. We believe that the impact of adopting new accounting pronouncements will not materially affect our financial condition or results of operations.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Consolidated Balance Sheets December 31, 2002 and 2001
Consolidated Statements of Income Years Ended December 31, 2002, 2001 and 2000
Consolidated Statements of Stockholders' Equity Years Ended December 31, 2002, 2001 and 2000
The Consolidated Financial Statements have been prepared on the basis of accounting principles generally accepted in the United States, which differ in some respects from those followed in preparing our statutory reports to insurance regulatory authorities. Our stand-alone financial statements submitted to insurance regulatory authorities are presented on the basis of accounting practices prescribed or permitted by the insurance departments of the states in which we are domiciled ("statutory accounting practices"). Effective January 1, 2001, these states have adopted the National Association of Insurance Commissioners' codified statutory accounting practices. Refer to Note 8 for further discussion.
The accompanying Consolidated Financial Statements include United Fire & Casualty Company and its wholly owned subsidiaries: United Life Insurance Company, Lafayette Insurance Company, Insurance Brokers & Managers, Inc., Addison Insurance Company, American Indemnity Financial Corporation, American Indemnity Company, United Fire & Indemnity Company and Texas General Indemnity Company. United Fire Lloyd's, an affiliate of United Fire, has also been included in consolidation. All intercompany balances have been eliminated in consolidation.
United Fire Lloyd's is organized as a Texas Lloyd's plan, which is an aggregation of underwriters who, under a common name, engage in the business of insurance through a corporate attorney-in-fact. United Fire Lloyd's is financially and operationally controlled by United Fire & Indemnity Company, its corporate attorney-in-fact, pursuant to three types of agreements: trust agreements between United Fire & Indemnity Company and certain individuals who agree to serve as trustees; articles of agreement among the trustees who agree to act as underwriters to establish how the Lloyd's plan will be operated; and powers of attorney from each of the underwriters appointing a corporate attorney-in-fact, who is authorized to operate the Lloyd's plan. Because United Fire & Indemnity Company can name the trustees, the Lloyd's plan is perpetual, subject only to United Fire & Indemnity Company's desire to terminate it.
On whole life and term insurance (traditional business), premiums are reported as earned when due, and benefits and expenses are associated with premium income in order to result in the recognition of profits over the lives of the related contracts. On universal life and annuity policies (nontraditional business), income and expenses are reported as charged and credited to policyholder account balances through the use of the retrospective deposit method. This method results in the recognition of profits over the lives of the related contracts, which is accomplished by means of a provision for future policy benefits and the deferral and subsequent amortization of life policy acquisition costs. We do not write variable annuities or variable insurance products.
The costs of acquiring new life business, principally commissions and certain variable underwriting, agency and policy issue expenses, have been deferred. These costs are being amortized to income over the premium paying period of the related traditional policies in proportion to the ratio of the expected annual premium revenue to the expected total premium revenue, and over the anticipated lives of nontraditional policies in proportion to the ratio of the expected annual gross profit to the expected total gross profit. The expected premium revenue and gross profit are based upon the same mortality and withdrawal assumptions used in determining future policy benefits. For nontraditional policies, changes in the amount or timing of expected gross profit will result in adjustments to the cumulative amortization of these costs.
Investments in held-to-maturity fixed maturities are recorded at amortized cost; we have the ability and positive intent to hold these investments until maturity. Available-for-sale fixed maturities, trading fixed maturities, equity securities and other long-term investments are recorded at fair value. Policy loans, mortgage loans and short-term investments are recorded at cost. Included in investments at December 31, 2002 and 2001, are securities on deposit with various regulatory authorities, as required by law, with carrying values of $1,181,902,000 and $1,042,341,000, respectively.
Realized gains or losses on disposition of investments are included in the computation of net income. Cost of investments sold is determined by the specific identification method. Changes in unrealized appreciation and depreciation with respect to available-for-sale fixed maturities and equity securities are reported as direct increases or decreases in stockholders' equity, less applicable income taxes.
In 2002 and 2001, we wrote down certain holdings in our fixed income portfolio as a result of other-than-temporary declines in market value and recognized a net realized loss, before tax, of $13,326,000 in 2002 and $3,841,000 in 2001. We continue to review these investments, as well as all of our other investment holdings, for appropriate valuation on an ongoing basis.
Income taxes paid during 2002, 2001 and 2000 were $7,302,000, $4,280,000 and $2,088,000, respectively. In 2000, tax and interest payments received in connection with the settlement of a federal income tax Revenue Agent Review were $1,160,000 and $889,000, respectively. There were no significant payments of interest in 2002, 2001 or 2000, other than interest credited to policyholders' accounts.
Property and equipment is carried at cost less accumulated depreciation. Depreciation is computed primarily by the straight-line method over the estimated useful lives of the underlying assets. Depreciation expense totaled $3,281,000, $3,208,000, and $3,512,000 for the years ended December 31, 2002, 2001 and 2000, respectively.
Amortization expense totaled $470,000, $845,000, and $940,000 for the years ended December 31, 2002, 2001 and 2000, respectively. We reduced agency relationships by $548,000 and $2,437,000 in 2002 and 2001, respectively, as a result of an adjustment to the deferred tax asset valuation allowance related to the acquisition of American Indemnity Financial Corporation. Refer to Note 9 for further discussion.
In June 2000, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities -- an amendment of Financial Accounting Standards Board Statement No. 133," which because of our early adoption of Statement of Financial Accounting Standard No. 133, was effective for all fiscal quarters beginning after June 15, 2000. This statement amends the accounting and reporting standards of Statement of Financial Accounting Standard No. 133 for certain derivative instruments and certain hedging activities. Because we have limited involvement with derivative financial instruments and do not engage in the derivative market for hedging purposes, the adoption of Statement of Financial Accounting Standard No. 138 did not have a material effect on our Consolidated Financial Statements.
Effective July 1, 2000, we adopted Financial Accounting Standards Board Interpretation No. 44, "Accounting for Certain Transactions Including Stock Compensation (an Interpretation of Accounting Principles Board Opinion No. 25)." Financial Accounting Standards Board Interpretation No. 44 clarifies the application of Accounting Principles Board Opinion No. 25 for only certain issues, such as: (a) the definition of employee for purposes of applying Accounting Principles Board Opinion No. 25; (b) the criteria for determining whether a plan qualifies as a noncompensatory plan; (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award; and (d) the accounting for an exchange of stock compensation awards in a business combination. The adoption of Financial Accounting Standards Board Interpretation No. 44 did not have a material effect on our Consolidated Financial Statements.
Effective December 31, 2000, we adopted Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements." The Staff Accounting Bulletin summarizes the SEC staff's views on applying accounting principles generally accepted in the United States to the recognition of revenue in financial statements. The adoption of Staff Accounting Bulletin No. 101 had no effect on our Consolidated Financial Statements.
In July 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No.146, "Accounting for Costs Associated with Exit or Disposal Activities." Statement of Financial Accounting Standard No. 146 supersedes Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." Statement of Financial Accounting Standard No. 146 requires that, in certain instances, costs associated with an exit or disposal plan be recognized when incurred rather than at the date of a commitment to an exit or disposal plan. Statement of Financial Accounting Standard No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. We have not yet determined the impact that the adoption of this statement will have on our Consolidated Financial Statements.
There were no sales of held-to-maturity securities during 2002, 2001 or 2000.
In most cases, quoted market prices were used in determining the fair value of fixed maturities, equity securities and short-term investments. Where quoted market prices were unavailable, the estimate was based on recent trading. Other long-term investments, consisting primarily of holdings in limited partnership funds, are valued by the various fund managers. In management's opinion, these values reflect fair value at December 31, 2002 and 2001.
The estimated fair value of mortgage loans is based upon discounted cash flows at the market rate of interest for similar loans as of December 31, 2002.
The fair value of the liabilities for annuity products that are in a benefit payment phase, guaranteed investment contracts and structured settlements is based on a discount rate of 6.25 percent at December 31, 2002 and 2001. The fair value of annuities currently in an accumulation phase is based on the net cash surrender value.
Reinsurance is a contract by which one insurer, called the reinsurer, agrees to cover, under certain defined circumstances, a portion of the losses incurred by a primary insurer if a claim is made under a policy issued by the primary insurers. As of December 31, 2002, we have several programs that provide reinsurance coverage. Our property program is reinsured on a per risk basis and covers property losses in excess of $1,250,000 up to $10,000,000. Our casualty program is reinsured on a per occurrence basis and covers casualty losses in excess of $1,250,000 up to $12,000,000. In addition, we have a program that reinsures personal and commercial umbrella policy losses in excess of $1,000,000 up to $5,000,000 and surety policy losses in excess of $1,250,000 up to $5,000,000, 90 percent of losses from $5,000,000 up to $12,000,000 and 80 percent of losses from $12,000,000 up to $18,000,000. Our property catastrophe program reinsures us against an accumulation of losses arising from a single defined catastrophic occurrence or series of catastrophic events. The catastrophic program provides coverage of 95 percent of $70,000,000 for losses in excess of our retention of $7,500,000 for a catastrophic event. We have additional coverage for 95 percent of $30,000,000 for catastrophic events occurring in the states of Arkansas, Florida, Louisiana, Mississippi and Texas.
We did not have direct exposure related to the September 11 national events. However, the 2001 results include claims of $6,892,000 (before tax) related to the terrorist attacks from assumed property reinsurance. During 2002, we incurred an additional $399,000 for this loss. We have no reserves outstanding as of December 31, 2002 for the September 11 events.
Life reserves are stated gross of reinsurance ceded to other companies. United Life Insurance Company is contingently liable for these amounts if such companies are unable to pay their portion of the claims. United Life Insurance Company is contingently liable for ceded insurance in force of $430,682,000 and $414,496,000 at December 31, 2002 and 2001, respectively. Approximately 64 percent of ceded life insurance in force as of December 31, 2002, has been ceded to two reinsurers. We believe all reinsurance receivables are collectable.
The insurance industry is governed by the National Association of Insurance Commissioners and individual state insurance departments. All of the insurance departments of the states in which we are domiciled have adopted codification of insurance statutory accounting practices effective January 1, 2001. Previously, these principles were prescribed in a variety of publications, as well as state laws, regulations and general administrative rules. Due to the adoption of codification, the effect on the statutory financial statements as of January 1, 2001 was an increase to statutory policyholders' surplus of approximately $10,300,000. This change does not affect the accompanying financial statements, which are based on accounting principles generally accepted in the United States. Pursuant to codification rules, permitted statutory accounting practices may be utilized with approval from an insurer's state of domicile insurance department; however, we do not use any statutory permitted practices.
We are required by the National Association of Insurance Commissioners and state insurance departments' solvency regulations to calculate a minimum capital requirement based on insurance risk factors. The risk-based capital results are used by the National Association of Insurance Commissioners and state insurance departments to identify companies that merit regulatory attention or the initiation of regulatory action. At December 31, 2002, both the life segment and the property and casualty companies had capital well in excess of their required levels.
Our effective income tax rates were 20 percent, 16 percent and 11 percent in 2002, 2001 and 2000, respectively. These rates were lower than the applicable federal tax rates of 35 percent, due primarily to our portfolio of tax-exempt securities and a reduction in the contingent tax liability in 2001.
As of December 31, 2002, we have tax net operating loss carryforwards totaling $25,040,000, all of which were acquired as part of our purchase of American Indemnity Financial Corporation. These net operating loss carryforwards expire as follows: 2003, $1,565,000; 2004, $1,247,000; 2005, $118,000; 2006, $43,000; 2007, $14,000; 2008, $14,000; 2009, $4,604,000; 2010, $989,000; 2011, $5,491,000; 2017, $6,819,000; and 2018, $4,136,000. We are required to establish a valuation allowance for any portion of the deferred tax asset that we believe may not be realized. At December 31, 2002, we have a valuation allowance of $8,386,000 for deferred tax assets relating to American Indemnity Financial Corporation's net operating losses, which can only be used to offset future income of the property and casualty insurance segment. If we determine that the benefit of the American Indemnity Financial Corporation net operating losses can be realized in the future, the related reduction in the deferred tax asset valuation allowance will be recorded as a reduction to agency relationships, until agency relationships has been eliminated. The remainder will then be recognized through the income statement. We also have alternative minimum tax credit carryforwards of $1,628,000, which do not expire.
Under prior federal income tax law, one-half of the excess of a life insurance company's income from operations over its taxable investment income was not taxed, but was set aside in a special tax account designated as "Policyholders' Surplus." At December 31, 2002, we had approximately $2,121,000 of untaxed "Policyholders' Surplus" on which no payment of federal income taxes will be required unless it is distributed as a dividend, or under other specified conditions. Barring the enactment of new tax legislation, we do not believe that any significant portion of the account will be taxed in the near future; therefore, no deferred tax liability has been recognized relating to the Policyholders' Surplus balance. If the entire Policyholders' Surplus balance became taxable at the current federal rate, the tax would be approximately $742,000.
The following table provides the components of net periodic benefit cost for the plans for 2002, 2001 and 2000.
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A 1.0 percent change in assumed health care cost trend rates would have the following effects.
The annual per capita contributions for the benefits provided to retired American Indemnity Financial Corporation employees are capped. As a result, increases in the assumed health care cost trend rate will have no significant effect on the accumulated postretirement benefit obligation or on the net periodic postretirement benefit cost as of December 31, 2002.
We also have an Employee Stock Ownership Plan for the benefit of eligible employees and their beneficiaries. All employees are eligible to participate in the plan upon completion of one year of service, meeting the hourly requirements with United Fire and attaining age 21. Contributions to this plan are made at our discretion. These contributions are based upon a percentage of total payroll and are allocated to participants on the basis of compensation. We make contributions in stock or cash, which the Trustee uses to acquire shares of United Fire stock to allocate to participants' accounts. As of December 31, 2002, 2001 and 2000, the Employee Stock Ownership Plan owned 126,216, 127,190 and 127,386 shares of United Fire stock, respectively. Shares owned by the Employee Stock Ownership Plan are included in shares issued and outstanding for purposes of calculating earnings per share, and dividends paid on the shares are charged to retained earnings. We made contributions to the plan of $90,000, $60,000 and $50,000 in 2002, 2001 and 2000 respectively.
We have a nonqualified employee stock option plan that authorizes the issuance of up to 500,000 shares of United Fire common stock to employees. The plan is administered by the Board of Directors. The Board has the authority to determine which employees will receive options, when options will be granted, and the terms and conditions of the options. The Board may also take any action it deems necessary and appropriate for the administration of the plan. Pursuant to the plan, the Board may, at its sole discretion, grant options to any employees of United Fire or any of its affiliated companies, including any director. These options are granted to buy shares of United Fire's stock at the market value of the stock on the date of grant. The options vest and are exercisable in installments of 20 percent of the number of shares covered by the option award each year from the grant date. To the extent not exercised, installments shall accumulate and be exercisable by the optionee, in whole or in part, in any subsequent year included in the option period, but not later than 10 years from the grant date. Stock options are generally granted free of charge to the eligible employees of United Fire as designated by the Board of Directors.
The following table sets forth the activity of our stock option plan for the years ended December 31, 2002, 2001, and 2000.
(1) There were no options forfeited or expired during 2002, 2001, and 2000.
The weighted-average grant date fair value of the options granted under the plan has been estimated using the Black-Scholes option pricing model with the following weighted average assumptions:
The following table summarizes information regarding the stock options outstanding at December 31, 2002.
On May 6, 2002, we issued 2,760,000 shares of 6.375 percent convertible preferred stock, Series A at $25 per share. In connection with the preferred stock issuance, we collected net proceeds of $64,884,000. The preferred shares are non-voting. Dividends on the preferred stock are cumulative from the date of original issuance and are payable on March 15, June 15, September 15 and December 15 of each year, beginning on June 15, 2002. Through December 31, 2002, we paid and accrued dividends of $2,871,000 on our preferred stock. The preferred stock has a liquidation preference and redemption price of $25 per share.
United Life Insurance Company underwrites and markets ordinary life (primarily universal life), annuities (primarily single premium) and credit life products to individuals and groups through approximately 1,330 independent agencies in 26 states. Of these states, Iowa, Minnesota, Wisconsin, Nebraska and Illinois accounted for approximately 72.5 percent of our direct life insurance premiums written in 2002.
(1) "Fire and allied lines" in this table includes fire, allied lines, homeowners, commercial multiple peril and inland marine. (2) "Other liability" is business insurance covering bodily injury and property damage arising from general business operations, accidents on the insured's premises and products manufactured or sold.
We compute earnings per share in accordance with Statement of Financial Accounting Standard No. 128, "Earnings per Share." Accordingly, we compute basic earnings per share by dividing net income or loss available to common shareholders (net income or loss less dividends to preferred shareholders and accretions of preferred stock issuance costs) by the weighted-average number of common shares outstanding during the period. Diluted earnings per share gives effect to all potentially dilutive common shares outstanding during the period. The potentially dilutive shares we consider in our diluted earnings per share calculation relate to our convertible preferred stock outstanding as well as our outstanding stock options.
We determine the dilutive effect of our convertible preferred stock using the "if-converted" method. Under this method, we add to the denominator of the earnings per share calculation a number determined by multiplying the number of convertible preferred shares by the stated conversion rate. We also add the amount of preferred dividends and accretions back to the numerator of the earnings per share equation due to the assumed conversion of all the convertible preferred stock to common stock. If the effect of the if-converted method is anti-dilutive, the effect on diluted earnings per share of our convertible preferred stock is disregarded. This was the case in our diluted earnings per share calculation for each of the 2002 reporting periods in which we had preferred shares outstanding.
Cash dividends per common share of $.73 and $.72 were declared in 2002 and 2001, respectively.
- ------------------------------------------------------------------------ 2003 $1,894 2004 572 2005 184 2006 146 2007 144 Thereafter 1,392 - ------------------------------------------------------------------------ Total $4,332 ========================================================================
During the third quarter of 2001, we presented a claim against an escrow account held for the deferred payment of $1.00 per share to prior shareholders of American Indemnity Financial Corporation, which was acquired by us in August 1999. The amount of this escrow totaled $1,990,000 and is recorded as a part of other assets on our Consolidated Balance Sheet. Representatives of American Indemnity Financial Corporation have responded to our claim. We anticipate further correspondence with American Indemnity Financial Corporation's stockholder representatives prior to the resolution of the escrow claim.
In our opinion, the 2002 financial statements referred to above present fairly, in all material respects, the consolidated financial position of United Fire & Casualty Company and subsidiaries at December 31, 2002, and the consolidated results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related 2002 financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
_________ (1) Reversal of allowance due to subsequent collections in 2001. (2) Recorded in connection with purchase of American Indemnity Financial Corporation. (3) A liability for employee termination benefits and future contractual lease payments related to abandoned facilities in connection with the purchase of American Indemnity Financial Corporation.