Income statement data includes the effect of amortizing the purchase accounting entries related to B.A.T's acquisition of the Company in December 1988. Major items incorporated in the purchase price of the Company include goodwill and the value of the AIF relationships of the P&C Group Companies (see Note 1). Through December 31, 2001, the amortization of these two items was being taken on a straight-line basis over forty years and reduced annual pretax income by $102.8 million in each of the years 1998 through 2001. Effective January 1, 2002, the Company adopted the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets". As a result, the Company ceased recording amortization related to goodwill and the AIF relationships.
Effective December 31, 2002, Farmers Re and a Zurich affiliate entered into a 10% All Lines Quota Share reinsurance treaty under which they assume a percentage of all lines of business written by the P&C Group of Companies, prospectively. Under this treaty, Farmers Re will assume a 2% quota share of the premiums written and the ultimate net losses sustained in all lines of business written by the P&C Group Companies after the APD reinsurance agreement is applied. Underwriting results assumed are subject to a maximum combined ratio of 112.5% and a minimum combined ratio of 93.5%. In addition, they are limited to a pro-rata share of $800.0 million in annual catastrophe losses. The reinsurance agreement, which can be terminated after 60 days notice by any of the parties beginning with the quarter ending December 31, 2003, also provides for the P&C Group
Premiums for traditional life, structured settlement contracts involving life contingencies (SSILC), and other annuity contracts with life contingencies are recognized as revenues when due from policyholders. Accident and health insurance premiums are recognized as revenue pro rata over the terms of the contract.
Revenues associated with universal life, variable universal life products and other investment type contracts consist of policy charges for the cost of insurance, policy administration fees, surrender charges, and investment income on assets allocated to support policyholder account balances on deposit. Revenues for deferred fixed and variable annuity products and structured settlement contracts not involving life contingencies (SSNILC) consist of surrender charges, investment income on assets allocated to support policyholder account balances on deposit, and administrative charges for equity-indexed annuities. Consideration received for interest-sensitive insurance, SSNILC, and annuity products are recorded as a liability when received. Policy withdrawal and other charges are recognized as revenue when assessed.
Farmers Re reinsures a percentage of the business written by the P&C Group Companies. Under the APD reinsurance agreement, Farmers Re assumes $200.0 million of annual premiums. Under the 10% All Lines Quota Share reinsurance treaty, Farmers Re assumes a 2% quota share of premiums written in all lines of business written by the P&C Group Companies after the APD contract is applied. Under the 20% Personal Lines Quota Share reinsurance treaty, Farmers Re assumes a 4% quota share of the personal lines auto business written by the P&C Group Companies after all other reinsurance treaties are applied. Premiums assumed by Farmers Re are earned ratably over the life of the underlying insurance policy.
Intangible Assets. The Company's critical accounting policies related to the valuation of intangible assets include the AIF relationships, Goodwill, VOLBA and DAC.
Effective January 1, 2002, the Company adopted the provisions of SFAS No. 142, and identified the AIF relationships as intangible assets with indefinite useful lives. Under SFAS No. 142, intangible assets with indefinite useful lives are no longer amortized, and as such, the Company no longer records $42.8 million of pretax annual amortization relating to the AIF relationships. In addition, SFAS No. 142 requires that intangible assets not subject to amortization be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company performed impairment tests of the AIF relationships balance of $1.2 billion as of January 1, 2002, as part of the implementation of SFAS No. 142, and then as of December 31, 2002, in accordance with the annual impairment test, using discounted future cash flows. Such tests did not indicate any impairment of the recorded AIF relationships.
Effective January 1, 2002, the Company adopted the provisions of SFAS No. 142. Under SFAS No. 142, goodwill is no longer amortized, and as such, the Company no longer records $60.0 million of annual amortization relating to goodwill. In addition, SFAS No. 142 requires goodwill to be tested for impairment on an annual basis and between annual tests in certain circumstances (e.g., a significant adverse change in legal factors or the business climate of the Company, an adverse action by a regulator, a loss of key personnel, etc.) using a two-step process. The first step of the goodwill impairment test identifies a potential impairment by comparing the fair value of the
intangible asset with its carrying value. The second step measures the amount of the impairment. The Company performed impairment tests of its Goodwill balance of $1.6 billion as of January 1, 2002, as part of the implementation of SFAS No. 142, and then as of December 31, 2002, in accordance with the annual impairment test, using discounted future cash flows. Such tests did not indicate any impairment of recorded goodwill.
Life DAC. Costs that vary with, and are related primarily to, the production of new business have been deferred to the extent that they are deemed recoverable. Such costs include commissions, certain costs of policy and underwriting, and certain agency expenses. For universal life insurance contracts and investment-type products, such costs are being amortized generally in proportion to the present value of expected gross profits arising principally from surrender charges and investment results, and mortality and expense margins. Interest rates are based on rates in effect during the period. The effects on the amortization of deferred policy acquisition costs of revisions to estimated gross margins and profits are reflected in earnings in the period such estimated gross margins and profits are revised.
Impairment losses were recorded for each reporting segment and, for the year ended December 31, 2002, amounted to $43.6 million, $21.9 million and $54.4 million for Farmers Management Services, Farmers Re and Farmers Life, respectively, primarily in the equity portfolios. For the year ended December 31, 2001, the Company recorded $57.2 million, $11.0 million and $82.8 million for Farmers Management Services, Farmers Re and Farmers Life, respectively, of impairment losses on investments primarily in the equity portfolios.
As of December 31, 2002, the Company held the following commitments and obligations related to the QUIPS (see Note 12) and long-term operating leases on equipment and buildings (see Note 21):
- - In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations". This Statement establishes the standard to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. The provisions of this Statement are effective for fiscal years beginning after June 15, 2002. The Company does not expect the adoption of this Statement to have a material impact on its consolidated financial statements.
- - In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections". This Statement rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt", and an amendment of that Statement, SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements". This Statement also rescinds SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers". In addition, this Statement amends SFAS No. 13, "Accounting for Leases". The provisions of this Statement are effective for fiscal years beginning after June 15, 2002. The Company does not expect the adoption of this Statement to have a material impact on its consolidated financial statements.
- - In October 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions". The Company is not impacted by the adoption of this Statement, as it is not involved in the acquisition of banking or thrift institutions.
Operating Expenses. Operating expenses decreased by 4.7% to $893.0 million in 2002, and as a percentage of operating revenues, decreased from 55.5% for the year ended December 31, 2001 to 49.6% for the year ended December 31, 2002, a decrease of 5.9 percentage points. This decrease was partially due to the fact that effective January 1, 2002, the Company ceased recording amortization related to goodwill and the AIF relationships as a result of the adoption of SFAS No. 142. For the year ended December 31, 2001, amortization related to these two items totaled $102.8 million. Partially offsetting the above decrease was a $27.5 million write-down of internally developed software in 2002 (see Note 9). Excluding the effects of the software write-down and the amortization of goodwill and the AIF relationships, operating expenses as a percentage of operating revenues decreased from 49.4% for the year ended December 31, 2001 to 48.1% for the year ended December 31, 2002, a decrease of 1.3 percentage points.
Salaries and Employee Benefits. Salaries and employee benefits increased from $417.4 million in 2001 to $443.7 million in 2002, an increase of $26.3 million, or 6.3%, due primarily to an increase in profit sharing, pension and postretirement expenses. The increase in profit sharing was due primarily to an increase in eligible salaries. For additional information regarding the Company's profit sharing and pension plans, please see Notes 13 and 20, respectively.
Buildings and Equipment Expenses. Buildings and equipment expenses increased from $102.8 million in 2001 to $115.4 million in 2002, an increase of $12.6 million, or 12.3%, due primarily to an increase in internally developed software amortization and higher hardware and software maintenance expenses.
Net Investment Income. Net investment income decreased from $80.5 million in 2001 to $68.6 million in 2002, a decrease of $11.9 million, or 14.8%. This decrease was due primarily to a change in the portfolio mix which resulted in a larger portion of invested assets held in short term securities earning lower investment yields, as well as declining market yields. Investment income earned from related parties is disclosed in Notes 10 and 15.
Net Realized Gains. Net realized gains decreased from $15.2 million in 2001 to $5.5 million in 2002, a decrease of $9.7 million, or 63.8%. This decrease was due primarily to unfavorable market conditions experienced in 2002.
Dividends on Preferred Securities of Subsidiary Trusts. Dividend expense related to the $500.0 million of QUIPS issued in 1995 was $42.1 million in each of the years ended December 31, 2002 and 2001.
As a result of the two new prospective quota share reinsurance treaties, unearned premiums totaling $160.3 million were transferred from the P&C Group Companies to Farmers Re effective December 31, 2002. However, Farmers Re's Statement of Income for the period ended December 31, 2002 was not impacted by the two new prospective quota share reinsurance treaties.
Total Revenues. Total revenues decreased from $783.7 million in 2001 to $748.2 million in 2002, a decrease of $35.5 million, or 4.5%.
Life and Annuity Premiums. Life premiums decreased from $275.5 million in 2001 to $252.7 million in 2002, a decrease of $22.8 million, or 8.3%. This decrease was primarily due to a 31.3% decrease in premiums for structured settlements involving life contingencies compared to the year ended December 31, 2001. Farmers Life had exited the business of writing structured settlements as of December 31, 2002 due to the recent change in the rating of Farmers Life (see Note 1). Excluding structured settlements, life premiums increased from $186.3 million in 2001 to $191.5 million in 2002, an increase of $5.2 million or 2.8%.
Life Policy Charges. Life policy charges increased from $218.3 million in 2001 to $223.7 million in 2002, an increase of $5.4 million, or 2.5%, reflecting 1.9% growth in universal life-type insurance in-force.
Net Investment Income. Net investment income increased from $331.4 million in 2001 to $343.3 million in 2002, an increase of $11.9 million, or 3.6%. This increase was largely due to growth in mean invested assets, principally fixed income instruments, partially offset by the decline of fixed income yields (30 basis points).
Net Realized Gains/(Losses). Net realized gains/(losses) decreased from a $41.3 million gain in 2001 to a $17.2 million loss in 2002, a decrease of $58.5 million, or 141.6%. This decrease was due primarily to losses generated from fixed income sales made for risk mitigation purposes in 2002. The most significant
Impairment Losses on Investments. Impairment losses on investments decreased from $82.8 million in 2001 to $54.3 million in 2002, a decrease of $28.5 million, or 34.4%. This decrease was primarily due to lower impairment losses recognized in the fixed income portfolio and equity portfolios in 2002. Fixed income impairments, of which $5.7 million was due to the United Airlines default, totaled $10.7 million in 2002, compared to $37.6 million in 2001. Equity impairments totaled $43.3 million, a decrease of $0.4 million from the prior year.
Total Operating Expenses. Total operating expenses decreased from $610.8 million in 2001 to $581.3 million in 2002, a decrease of $29.5 million, or 4.8%.
Life Policyholders' Benefits and Charges. Life policyholders' benefits expense and charges decreased from $459.2 million in 2001 to $448.9 million in 2002, a decrease of $10.3 million, or 2.2%.
Interest Credited to Policyholders. Interest credited to policyholders, which represents the amount credited under universal life-type contracts, deferred annuities and structured settlements not involving life contingencies to policyholder funds on deposit, decreased slightly from $178.8 million in 2001 to $178.4 million in 2002, a decrease of $0.4 million, or 0.2%. This decrease is primarily attributable to the reduction in crediting rates related to the deferred annuity and universal life products to mitigate eroding margins on these interest sensitive products caused by unfavorable market conditions, offset by 8.0% growth in policyholder funds that earn interest.
Amortization of DAC and VOLBA. Amortization expense decreased from $97.4 million in 2001 to $76.7 million in 2002, a decrease of $20.7 million, or 21.3%, reflecting a $14.1 million increase in favorable DAC asset unlocking compared to December 31, 2001. DAC asset unlocking entries are made when future profit margins are projected to be significantly different than previously estimated. In addition, realized losses and impairment losses on investments backing interest sensitive lines of business resulted in further reduction in DAC amortization of $5.7 million.
Provision for Income Taxes. Provision for income taxes increased from $56.7 million in 2001 to $57.9 million in 2002, an increase of $1.2 million, or 2.1%, due to an increase in the effective tax rate primarily attributable to the release in 2001 of a $5.9 million tax contingency reserve originally set-up during the B.A.T acquisition in 1988.
Consolidated net income of the Company increased from $580.0 million in 2001 to $683.3 million in 2002, an increase of $103.3 million, or 17.8%.
Operating Revenues. Operating revenues increased $101.5 million, or 6.4%, from $1,588.8 million for the year ended December 31, 2000 to $1,690.3 million for the year ended December 31, 2001. This growth in operating revenues was primarily attributable to higher gross premiums earned by the P&C Group Companies, which increased $1.0 billion, or 8.8%, from $11.4 billion in 2000 to $12.4 billion in 2001. The increase in gross premiums earned was driven primarily by continued growth in all lines of business, which benefited from a rising premium rate environment. Also contributing to the increase in operating revenues was the fact that revenues earned in connection with the provision of management services on the business the P&C Group Companies assumed from Foremost increased $12.0 million due to the fact that the Foremost acquisition was not completed until March 2000.
Buildings and Equipment Expenses. Buildings and equipment expenses decreased from $104.0 million in 2000 to $102.8 million in 2001, a decrease of $1.2 million, or 1.2%, due primarily to savings generated by renegotiated lease contracts. This decrease was largely offset by an increase in expenses incurred in connection with providing management services to the business assumed from Foremost.
Amortization of AIF Relationships and Goodwill. The amortization of these two items was taken on a straight-line basis over forty years and reduced pretax income by $102.8 million for each of the years ended December 31, 2001 and 2000.
Net Investment Income. Net investment income decreased from $127.1 million in 2000 to $80.5 million in 2001, a decrease of $46.6 million, or 36.7%. This decrease was due primarily to a decrease in the average invested asset base resulting from the liquidation of a sizable portion of the fixed income portfolio, which was used to help fund the payment of the $1,075.0 million special dividend paid in October 2000, and lower investment yields. Investment income earned from related parties is disclosed in Notes 10 and 15 of this Report.
Net Realized Gains. Net realized gains decreased from $68.5 million in 2000 to $15.2 million in 2001, a decrease of $53.3 million, or 77.8%. This decrease was due primarily to unfavorable market conditions experienced in 2001 as well as a loss of investment flexibility that resulted from the $1,075.0 million special dividend paid in October 2000.
Farmers Management Services. As a result of the foregoing, Farmers Management Services income decreased from $503.1 million for the year ended December 31, 2000 to $438.7 million for the year ended December 31, 2001, a decrease of $64.4 million, or 12.8%.
As a result of the APD quota share reinsurance agreement which became effective April 1, 2001, Farmers Re's assumed premiums decreased from $1,000.0 million for the year ended December 31, 2000 to $400.0 million for the year ended December 31, 2001, a decrease of $600.0 million, or 60.0%. Losses and loss adjustment expenses incurred decreased $404.9 million, or 58.9%, from $686.9 million in 2000 to $282.0 million in 2001 while non-life reinsurance commissions paid decreased $180.1 million, or 62.5%, from $288.1 million in 2000 to $108.0 million in 2001. Income before taxes decreased from $77.3 million in 2000 to $36.0 million in 2001, a decrease of $41.3 million, or 53.4%. This decrease was due primarily to the decrease in underwriting gains between years resulting from the new reinsurance agreement, a $20.9 million decrease in realized gains due to unfavorable market conditions experienced during 2001 and the $11.0 million of impairment losses on investments recorded in 2001. Farmers Re's contribution to net income was $25.1 million and $52.6 million in 2001 and 2000, respectively.
Life and Annuity Premiums. Life and annuity premiums increased from $228.7 million in 2000 to $275.5 million in 2001, an increase of $46.8 million, or 20.5%. This increase was due to 19.4% growth in
Interest Credited to Policyholders. Interest credited to policyholders increased from $162.9 million in 2000 to $178.8 million in 2001, an increase of $15.9 million, or 9.8%, reflecting growth in the universal life, structured settlements without life contingencies and fixed annuity fund balances.
General and Administrative Expenses. General and administrative expenses increased from $51.3 million in 2000 to $55.1 million in 2001, an increase of $3.8 million, or 7.4%. This increase was due primarily to business growth.
Farmers Life Income. As a result of the foregoing, Farmers Life income decreased from $169.6 million in 2000 to $116.2 million in 2001, a decrease of $53.4 million, or 31.5%.
The principal sources of funds available to Farmers Management Services are: (i) the management fees that it receives for providing management services to the P&C Group Companies, (ii) investment income and (iii) dividends from its subsidiaries. Farmers Life paid dividends to Farmers Management Services in the amounts of $112.0 million and $115.0 million, in January of 2001 and 2002, respectively. There are certain statutory limitations on the distribution of surplus. As of December 31, 2002, an aggregate of $215.9 million was available for distribution as a dividend without the approval of the state insurance departments in which the Insurance Subsidiaries are domiciled.
The principal sources of funds available to Farmers Life are premiums and amounts earned from the investment of premiums and deposits. The principal sources of funds available to Farmers Re are premiums assumed from the P&C Group Companies and investment income.
Net cash provided by operating activities of the Company increased from $987.4 million in 2001 to $1,352.9 million in 2002, an increase of $365.5 million, or 37.0%. The resulting increase in cash was partially driven by a $160.3 million increase in unearned premium liabilities held by Farmers Re, resulting from the two new Farmers Re quota share reinsurance treaties that became effective on December 31, 2002. In addition, a $144.9 million increase in cash was due to a decrease in cash used between years for non-current assets and liabilities as a result of the January 2002 settlement of a $119.0 million surplus note of the P&C Group Companies, that was redeemed in December 2001 (see Note 11). Furthermore, a $109.6 million increase in cash was due primarily to an increase in deferred taxes. Although net income increased $103.3 million between years, this was primarily a result of a $110.8 million decrease in depreciation and amortization expense in 2002 stemming from the adoption of SFAS No. 142, which had no effect on cash.
Net cash used in investing activities of the Company increased $391.0 million between years from $337.9 million in 2001 to $728.9 million in 2002. The resulting decrease in cash was due mainly to a $1,116.9 million decrease in proceeds from sales and maturities of investments available-for-sale resulting from unfavorable market conditions in 2002, which led the Company to change its investment strategy to hold on to investments or reinvest in more conservative securities. Also, a $206.5 million decrease in cash was due to a decrease between years in the proceeds received from the redemption of surplus notes of the P&C Group Companies. In addition, proceeds from the redemption of the notes receivable from affiliates decreased by $177.0 million between years. Lastly, a $100.0 million decrease in cash was due to the issuance of a promissory note to ZIC in 2002. Partially offsetting the aforementioned increase in net cash used in investing activities was a $556.5 million increase in cash resulting from a decrease between years in purchases of certificates of contribution of the P&C Group Companies and a $471.7 million increase in cash due to a decrease in the purchase of investments available-for-sale. Finally, a $100.0 million increase in cash between periods was due to the sale of a $50.0 million investment at cost, which was purchased in 2001 (see Note 15).
We have audited the accompanying consolidated statements of income, comprehensive income, stockholders' equity, and cash flows of Farmers Group, Inc. and subsidiaries (the "Company") for the year ended December 31, 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
The accompanying consolidated financial statements of Farmers Group, Inc. ("FGI") and its subsidiaries (together "the Company"; references to attorney-in - -fact ("AIF"), as applicable in context, are to FGI, dba Farmers Underwriters Association, attorney-in-fact of Farmers Insurance Exchange; or Fire Underwriters Association, attorney-in-fact of Fire Insurance Exchange; or Truck Underwriters Association, attorney-in-fact of Truck Insurance Exchange) have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). All material inter-company transactions have been eliminated. Certain amounts applicable to prior years have been reclassified to conform with the 2002 presentation. The preparation of the Company's financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
December 2002, Farmers Life exited the business of writing structured settlements. This decision to exit the structured settlement market was driven by A.M. Best's change in the rating of Farmers Life from A+ (superior) to A (excellent), as brokers often only place structured settlement business with companies rated A+ or better. As of December 31, 2002, Farmers Life is continuing to service the more than 5,200 structured settlement cases in force. For the years ended December 31, 2002, 2001 and 2000, the structured settlement business represented only 0.7%, 2.2% and 1.3% of Farmers Life's income before provision for income taxes, respectively.
The Company's critical accounting policies relate to revenue recognition, valuation of intangible assets, impairment of investments, the fair value of financial instruments and accounting for internally developed software.
The Company, through its AIF relationships with the Exchanges, is contractually permitted to receive an AIF fee based on the gross premiums earned by the P&C Group Companies. The range of fees has varied by line of business over time. During the past five years, aggregate AIF fees have averaged between 12% and 13% of gross premiums earned by the P&C Group Companies. In order to enable the P&C Group Companies to maintain appropriate capital and surplus while offering competitive insurance rates, each AIF has historically charged a lower AIF fee than the contractually permitted fee of 20% (25% in the case of the Fire Insurance Exchange). In order to ensure that its AIF fees remain competitive, the Company periodically reviews the fee it charges for the services it provides based on the level and cost of the services as well as market conditions.
AIF. Through its AIF relationships, the Company receives a substantial portion of its revenues and profits through the management services the Company provides to the P&C Group Companies. Therefore, the Company's ongoing financial performance depends on the volume of business written by and operating performance and financial strength of the P&C Group Companies. As a result, a portion of the purchase price ($1.7 billion) associated with B.A.T's acquisition of the Company in 1988 was assigned to these AIF relationships. Through December 31, 2001, the value so assigned was amortized on a straight-line basis over forty years and was regularly reviewed for indications of impairment in value, which in the view of management would be other than temporary, including unexpected or adverse changes in the following: (1) the economic or competitive environments in which the Company operates, (2) profitability analyses and (3) cash flow analyses.
implementation of SFAS No. 142, and then as of December 31, 2002, in accordance with the annual impairment test, using discounted future cash flows. Such tests did not indicate any impairment of recorded goodwill.
Management periodically updates these estimates and evaluates the recoverability of deferred policy acquisition costs. When appropriate, management revises its assumptions of the estimated gross margins or profits of these contracts, and the cumulative amortization is re-estimated and adjusted by a cumulative charge or credit to current operations.
Deferred policy acquisition costs include amounts associated with the unrealized gains and losses recorded as other comprehensive income, a component of stockholder's equity. Accordingly, deferred policy acquisition costs are increased or decreased for the impact of estimated future gross profits as if net unrealized gains or losses on securities had been realized at the balance sheet date. Net unrealized gains or losses on securities within other comprehensive income also reflect this impact.
Impairment of Investments. The Company regularly reviews its investment portfolio to determine whether declines in the value of investments are other than temporary as defined by SFAS No. 115. The Company's review for declines in value includes analyzing historical and forecasted financial information as well as reviewing the market performance of similar types of investments. As a result of the Company's review, the Company determined that some of its investments had declines in value that were other than temporary as of December 31, 2002, 2001 and 2000 due to unfavorable market and economic conditions. Accordingly, for the years ended December 31, 2002 and December 31, 2001, the Company recorded $119.9 million and $151.0 million, respectively, of impairment losses on investments primarily in the equity portfolios. For the year ended December 31, 2000, Farmers Life recorded $22.4 million of impairment losses on fixed income securities. Impairment losses were recorded for each reporting segment and, for the year ended December 31, 2002,
amounted to $43.6 million, $21.9 million and $54.4 million for Farmers Management Services, Farmers Re and Farmers Life, respectively, primarily in the equity portfolios. For the year ended December 31, 2001, the Company recorded $57.2 million, $11.0 million and $82.8 million for Farmers Management Services, Farmers Re and Farmers Life, respectively, of impairment losses on investments primarily in the equity portfolios.
Accounting for Internally Developed Software. The Company follows the provisions of Statement of Position ("SOP") No. 98-1, "Accounting for the Cost of Computer Software Developed or Obtained for Internal Use". The Company expenses costs incurred in the preliminary project stage and, thereafter, capitalizes costs incurred in developing or obtaining internal use software. Certain costs, such as maintenance and training, are expensed as incurred. Capitalized costs are amortized on a straight-line basis over the useful life of the software once it is placed into service. The Company regularly reviews its existing capitalized software assets in order to determine if any should be considered impaired or abandoned.
In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 143, "Accounting for Asset Retirement Obligations". This Statement establishes the standard to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. It also applies to legal obligations associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development and/or normal operation of a long-lived asset, except for certain obligations of lessees. The provisions of this Statement are effective for fiscal years beginning after June 15, 2002. The Company does not expect the adoption of this Statement to have a material impact on its consolidated financial statements.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". This Statement replaces Emerging Issues Task Force ("EITF") 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)". This Statement requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. The provisions of the Statement are to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The Company does not expect the adoption of this Statement to have a material impact on its consolidated financial statements.
In November 2002, the FASB issued Interpretation ("FIN") No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". This Interpretation identifies characteristics of certain guarantee contracts and requires that a liability be recognized at fair value at the inception of such guarantees for the obligations undertaken by the guarantor. Additional disclosures also are prescribed for certain guarantee contracts. The initial recognition and initial measurement provisions of this Interpretation are effective for these guarantees issued or modified after December 31, 2002. The disclosure requirements of this Interpretation are effective for the Company as of December 31, 2002. The Company does not expect the adoption of this Interpretation to have a material impact on its consolidated financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure". This Statement amends SFAS No. 123, "Accounting for Stock-Based Compensation". This Statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. Also, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of this Statement are effective for activity on or after December 15, 2003. The Company is not impacted by the adoption of this Statement, as it is not involved in stock-based employee compensation.
Following is a reconciliation of reported net income to adjusted net income to exclude the effects of amortization expenses related to goodwill and the AIF relationships:
FGI and its subsidiaries, through their AIF relationships with the Exchanges, provide non-claims related management services to the P&C Group Companies and receive management fees for the services rendered. As a result, the Company received management fees from the P&C Group Companies of $1,679.0 million, $1,582.2 million and $1,492.2 million in 2002, 2001 and 2000, respectively.
Traditional product and structured settlements involving life contingency, premiums are recognized as revenues when they become due and future benefits and expenses are matched with such premiums so that the majority of profits are recognized over the premium-paying period of the policy. This matching of revenues and expenses is accomplished through the provision for future policy benefits and the amortization of DAC.
DAC is amortized in proportion to total estimated gross profit margins. The Company regularly reviews and revises its estimate of future gross profit margins to be realized from this group of products. When future estimated gross profit margins change, the DAC amortization is adjusted retrospectively. This process is known as DAC unlocking. DAC unlocking effectively results in a change in the rate at which the deferred acquisition costs are amortized. This change is retroactive to product introduction and the resulting cumulative difference in amortization is recognized in the current period.
In 2000, Farmers Life introduced variable universal life and deferred variable annuity contracts. Revenues and expenses for variable universal life annuities are recognized in a manner similar to universal life products. Recognition of revenues and expenses for deferred variable annuities is consistent with that of deferred annuity products. However, unlike other Farmers Life products, assets and liabilities for both variable universal life and deferred variable annuity contracts are legally segregated from the general assets of the Company and are reported on the Separate Account lines on the Company's consolidated balance sheets.
In March 2000, Farmers Re and the P&C Group Companies commuted $106.4 million of losses and loss adjustment expenses associated with the 1999 accident year. As a result, in May 2000, Farmers Re paid the P&C Group Companies $106.4 million of losses and loss adjustment expenses and $9.0 million of accrued interest in settlement of this commutation.
Effective December 31, 2002, Farmers Re and a Zurich affiliate entered into a 10% All Lines Quota Share reinsurance treaty under which they assume a percentage of all lines of business written by the P&C Group of Companies, prospectively. Under this treaty, Farmers Re will assume a 2% quota share of the premiums written and the ultimate net losses sustained in all lines of business written by the P&C Group Companies after the APD reinsurance agreement is applied. Underwriting results assumed are subject to a maximum combined ratio of 112.5% and a minimum combined ratio of 93.5%. In addition, they are limited to a pro-rata share of $800.0 million in annual catastrophe losses. The reinsurance agreement, which can be terminated after 60 days notice by any of the parties beginning with the quarter ending December 31, 2003, also provides for the P&C Group Companies to receive a provisional ceding commission of 22% of premiums for acquisition expenses and 14.1% of premiums for other expenses with additional experience commissions that depend on loss experience. As a result of this new quota share reinsurance treaty, Farmers Re assumes an underwriting risk.
In addition, effective December 31, 2002, Farmers Re and a Zurich affiliate entered into a 20% Personal Lines Auto Quota Share reinsurance treaty under which they assume a percentage of the personal lines auto business written by the P&C Group of Companies, prospectively. Under this treaty, Farmers Re will assume a 4% quota share of the premiums written and the ultimate net losses sustained in the personal lines auto business written by the P&C Group Companies after all other reinsurance treaties are applied. Underwriting results assumed are subject to a maximum and minimum combined ratio of 112.5% and 97.0%, respectively, and are limited to a pro-rata share of $150.0 million in catastrophe losses. The reinsurance agreement, which can be terminated after 60 days notice by any of the parties beginning with the quarter ending December 31, 2003, also provides for the P&C Group Companies to receive a provisional ceding commission of 20% of premiums for acquisition expenses and 17.2% of premiums for other expenses with additional experience commissions that depend on loss experience. As a result of this new quota share reinsurance treaty, Farmers Re assumes an underwriting risk.
Depreciation is calculated for financial statement purposes using the straight-line method. Repairs and maintenance are charged to operations while significant renewals and betterments are capitalized. The Company's properties are depreciated over the following estimated useful lives:
Buildings and improvements 10 to 45 years Furniture and equipment 5 to 10 years Data processing equipment and software 3 to 10 years
that no longer supports the Company's strategic direction. As a result, the Company wrote-down the $27.5 million of capitalized assets, which is reflected in general and administrative expenses.
As of December 31, 2002, all members of the Company's Board of Directors were employees of the Company except for James J. Schiro, Chief Executive Officer of ZFS who was elected as Director of FGI on August 1, 2002. As a result of a restructuring of the Company's Board of Directors in April 2000, all of the members of the Company's Board of Directors were employees of the Company as of December 31, 2001 and 2000.
- $95.0 million of notes receivable from Zurich Financial Services (UKISA) Limited ("UKISA"), a subsidiary of Zurich. The Company initially purchased $1,057.0 million of notes from UKISA on September 3, 1998. Subsequently, on March 1, 2000, Eagle Star Life Assurance Company Limited ("Eagle Star"), also an affiliate of Zurich, assigned $175.0 million of matured surplus notes of the P&C Group Companies to the Company and, in return, the Company reduced the outstanding balance of the notes receivable from UKISA by $175.0 million. Additionally, on September 3, 2000, $25.0 million of the notes receivable from UKISA, were renewed for medium-term notes with a 6.80% fixed interest rate and a September 3, 2002 maturity date.
Also, on October 23, 2000, the Company sold $580.0 million of notes receivable from UKISA to ZIC for par value. In addition, on September 3, 2001, the Company received $214.6 million from UKISA in settlement of a $207.0 million note receivable and $7.6 million of accrued interest.
Finally, on September 3, 2002, $25.0 million of notes receivable from UKISA having a fixed coupon rate of 6.80% and $70.0 million of notes receivable from UKISA bearing interest at a coupon rate of 5.67% matured. These notes were renewed for short-term notes receivable from UKISA of $12.5 million, $12.5 million and $70.0 million, each with a 2.75% fixed coupon rate and a September 2, 2003 maturity date.
- A $100.0 million note receivable from ZIC, a subsidiary of Zurich. The Company loaned $100.0 million to ZIC on December 27, 2002 and, in return, received a short-term note with a 1.50% fixed interest rate that matured on February 14, 2003. Interest earned on this note for the year ended December 31, 2002 totaled $16,700. On February 14, 2003, the principal and interest were paid.
11. Certificates of contribution and surplus notes of the P&C Group Companies
At December 31, 2002, the Company held the following certificates of contribution and surplus note of the P&C Group Companies:
- $206.5 million of certificates of contribution, issued in December 2001, bearing interest at 6.00% annually and maturing in September 2006.
As of December 31, 2002 and 2001, a total of 20,000,000 shares of QUIPS were outstanding.
Statutory capital and surplus of the Insurance Subsidiaries was $1.7 billion and $1.9 billion as of December 31, 2002 and 2001, respectively. Statutory net income was $44.7 million, $55.2 million and $187.7 million for the years ended December 31, 2002, 2001 and 2000, respectively. The decrease in statutory net income in 2002 and 2001 compared to 2000 was due primarily to realized losses and impairment losses on investments.
share repurchase agreement with Endurance. In addition, as of December 31, 2002 and 2001, investments related to the grantor trusts totaled $54.6 million and $60.7 million, respectively, and were classified as trading securities under SFAS No. 115. As a result, these investments were reported on the "Other assets" line in the Farmers Management Services section of the consolidated balance sheets at market value with both realized and unrealized gains and losses included in earnings, net of tax, in the year in which they occurred.
Realized gains and losses on sales and redemptions by the Insurance Subsidiaries are determined based on either the cost of the individual securities or the amortized cost of real estate. For the year ended December 31, 2002, Farmers Life recorded realized losses totaling $43.4 million related to WorldCom, Inc., Qwest Capital Funding, Inc. and other telecommunication industry holdings. Net realized investment gains or losses for the years ended December 31 are:
Impairment losses on investments owned by the Insurance Subsidiaries are determined based on the market value of those investments on the date impairment is determined to be other than temporary. Impairment losses on investments for the years ended December 31 are:
The change in the net unrealized gains/(losses) of Farmers Management Services for the years ended December 31 are as follows:
The change in the net unrealized gains/(losses) of the Insurance Subsidiaries for the years ended December 31 are as follows:
To hedge the interest liability generated on the annuities as the index rises, the Company purchases call options on the S&P 500 Index. The Company considers such call options to be held as an economic hedge. As of December 31, 2002 and 2001, the Company had call options with contract values of approximately $123,222,000 and $117,257,000, respectively, and carrying values of approximately $1,845,000 and $12,690,000, respectively.
No S&P 500 call options were disposed of in the year ended December 31, 2002. On December 27, 2001, the Company disposed of 1,598 and 1,319 S&P 500 call option contracts acquired in January and February 2001. The Company received $518,000 in disposition proceeds, resulting in a $682,000 realized loss on disposition. This disposal was necessary as the Company purchased a larger than necessary quantity of S&P 500 call options to hedge against the equity indexed annuity product liability.
The following methods and assumptions were used to estimate the fair value of financial instruments as of December 31, 2002 and 2001:
Cash and cash equivalents and marketable securities. The carrying amounts of these items are at fair value.
Grantor trusts. The carrying amounts related to the grantor trusts are a reasonable estimate of their fair values.
Other investments. Other investments consist of Endurance common stock and miscellaneous notes and investments. The carrying amounts of the Endurance common stock (see Note 15) and the miscellaneous notes are a reasonable estimate of their fair values. The estimated fair values related to miscellaneous investments are based upon quoted market prices, current appraisals and independent pricing services.
Future policy benefits - deferred annuities. The estimated fair values of flexible premium and single premium deferred annuities are based on their cash surrender values.
Information regarding the Regular Plan's and the Restoration Plan's funded status is not developed separately for the Company and the P&C Group Companies. The funded status of the Plans for the Company and the P&C Group Companies as of December 1, 2002 and 2001 (the latest date for which information is available) was as follows:
The Company uses the projected unit credit cost actuarial method for attribution of expense for financial reporting purposes. The interest cost and the actuarial present value of benefit obligations were computed using a weighted average interest rate of 7.00% in 2002, 7.25% in 2001 and 7.75% in 2000, while the expected return on plan assets was computed using a weighted average interest rate of 9.50% in 2002, 2001 and 2000. The weighted average rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation was 4.80% in 2002 and 4.70% in 2001 and 2000.
The funded status of the entire plan, which includes the Company and the P&C Group Companies, as of December 1, 2002 and 2001 (the latest date for which information is available), was as follows:
The Company's share of the accrued postretirement benefit cost was approximately $66.5 million in 2002 and $61.5 million in 2001.
The Company is a party to lawsuits arising from its AIF relationships. The Company is also party to lawsuits arising from its other normal business activities. These actions are in various stages of discovery and development, and some seek punitive as well as compensatory damages. In the opinion of management, the Company has not engaged in any conduct which should warrant the award of any material punitive or compensatory damages. The Company intends to vigorously defend its position in each case, and management believes that, while it is not possible to predict the outcome of such matters with absolute certainty, ultimate disposition of these proceedings should not have a material adverse effect on the Company's consolidated results of operations or financial position. In addition, the Company is, from time to time, involved as a party to various governmental and administrative proceedings.
Cash payments for interest were $1.7 million, $2.2 million and $1.7 million in 2002, 2001 and 2000, respectively, while cash payments for dividends to the holders of the Company's QUIPS were $42.1 million in 2002, 2001 and 2000. Cash payments for income taxes were $419.3 million, $455.7 million and $440.0 million in 2002, 2001 and 2000, respectively.
In 2001, the Company used $207.0 million of proceeds received from the settlement of the note receivable from UKISA (see Note 10) as well as $206.5 million of proceeds received from the redemption of the surplus notes of the P&C Group Companies to substantially fund the purchase of $556.5 million of certificates of contribution of the P&C Group Companies (see Note 11).
As of December 31, 2001, the Company had a revolving credit agreement with certain financial institutions and had an aggregate borrowing facility of $500.0 million. On July 1, 2002, this revolving credit agreement expired. On September 26, 2002, the Company entered into a new one-year credit agreement with certain financial institutions. Under this agreement, the Company has an aggregate borrowing facility of $250.0 million. The proceeds of the facility are available to the Company for general corporate purposes, including loans to the P&C Group Companies. Facility fees are payable on the aggregate borrowing facility in the amount of 6 basis points per annum. In the case of a draw on the facility, the Company has the option to borrow at an annual rate equal to (i) London Interbank Offered Rate ("LIBOR") plus an Applicable Margin of 19 basis points or (ii) the Alternate Base Rate (defined as the higher of (a) the Bank of America prime rate and (b) the Federal Funds rate plus 50 basis points).
The amount of dividends paid on participating business is determined by the Farmers Life Board of Directors and is paid annually on the policyholder's anniversary date. Amounts allocable to participating policyholders are based on published dividend projections or expected dividend scales. The Company paid dividends directly to policyholders of approximately $4.1 million, $3.9 million and $2.4 million for the years ended December 31 2002, 2001 and 2000, respectively.
earned from the P&C Group Companies totaled $1,679.0 million, $1,582.2 million and $1,492.2 million for the years ended December 31, 2002, 2001 and 2000, respectively. This represented 60.7%, 54.6% and 43.3%, respectively, of the Company's consolidated operating revenues for the same periods. The Company has no ownership interest in the P&C Group Companies and, therefore, excluding the impact of the three quota share reinsurance treaties, is not directly affected by the underwriting results of the P&C Group Companies. However, as management fees comprise a significant part of the Company's revenues, the ongoing financial performance of the Company depends on the volume of business written by and the operating performance and financial strength of the P&C Group Companies. In addition, a lack of adequate surplus could impact the P&C Group Companies' ability to make interest payments and repay the principal on the certificates of contribution or the surplus notes purchased by the Company. The life insurance segment provides individual life insurance products, including universal life, term life and whole life insurance and structured settlement and annuity products, as well as variable universal life and annuity products. Finally, the reinsurance segment provides reinsurance coverage to a percentage of the business written by the P&C Group Companies.
(a) Revenues for the insurance operating segments include net investment income, net realized gains/(losses) and impairment losses on investments.
(c) Amount includes adjustment associated with the amortization of the AIF relationships ($42.7 million).
(a) Revenues for the insurance operating segments include net investment income, net realized gains and impairment losses on investments.
(c) Amount includes adjustment associated with the amortization of goodwill ($60.0 million).
(e) Amount includes adjustment related to a reclass between deferred tax asset and deferred tax liability ($193.7 million).
On October 31, 2002, the Board of Directors approved the merger into FGI of certain FGI subsidiaries (Fire Underwriters Association and Truck Underwriters Association) that act as AIF to the Exchanges. However, for the merger to become effective, it first needs to be approved by the California Department of Insurance ("DOI") and then must be filed with the appropriate Secretaries of State. The Company filed the AIF merger with the DOI on December 30, 2002 and is currently waiting approval. The AIF merger is expected to become effective in the first half of 2003.