Our principal executive offices and the Las Vegas, Nevada branch office are comprised of 41,005 square feet of office space subleased from Sierra through December 31, 2002. We have the option to renew yearly up to the term of the underlying Sierra lease which as of December 31, 2001 had 13 more years before it expires. Our Northern California branch office, comprised of approximately 34,975 square feet of office space leased through October 31, 2002, is located in Pleasanton, California. Our Southern California branch office, comprised of 23,250 square feet of office space leased through September 30, 2003, is located in Burbank, California. We also lease space in other locations where we have operations and believe our facilities are adequate for our current needs.
Net written premiums.................... $174,048 $125,748 $ 85,097 $134,147 $130,597 ======= ======= ======= ======= =======
Total costs and expenses................ 186,012 152,061 91,255 136,625 135,745 ------- ------- ------- ------- -------
Income (loss) before federal income taxes and extraordinary gain............... 3,070 (12,052) 7,095 17,878 10,813
Net income (loss)....................... $ 1,985 $ (7,729) $ 3,604 $ 13,760 $ 10,543 ======= ======= ======= ======= =======
December 31, 2001 2000 1999 1998 1997 (In thousands) ---- ---- ---- ---- ---- Balance Sheet Data: Total cash, cash equivalents and invested assets..................... $261,285 $247,151 $226,572 $283,509 $278,479 Total assets.......................... 521,473 533,602 404,338 379,880 343,022 Total debt............................ 19,187 47,059 50,498 51,251 54,467 Total liabilities..................... 456,037 470,250 338,285 305,933 285,452 Total stockholder's equity............ 65,436 63,352 66,053 73,947 57,570 Dividends paid........................ None 2,637 None None None
Our operating results are primarily the results of our workers' compensation insurance subsidiaries and consist of underwriting profit/loss, net investment income, net realized gains/losses, other income/expense, interest expense on the old junior subordinated debentures and intercompany debt, and income taxes.
Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing these financial statements, we are required to make judgments, assumptions and estimates, which we believe are reasonable and prudent based on the available facts and circumstances. These judgments, assumptions and estimates affect certain of our revenues and expenses and their related balance sheet accounts and the disclosure of our contingent assets and liabilities. We base our assumptions and estimates primarily on past historical experience and factor in known and projected trends. On an on-going basis, we re-evaluate our selection of assumptions and the method of calculating our estimates. Actual results, however, may differ from our calculated estimates and this difference would be reported in our current operations. The following discusses our most critical accounting policies and estimates.
In addition to the most critical accounting policies and estimates discussed above, other areas requiring us to use judgment, assumptions and estimates include, but are not limited to, earned but unbilled premiums, allowances for doubtful receivables, litigation and legal settlement costs and accruals, other accrued liabilities, accrued payroll and taxes, unearned premium revenue, policyholders' dividends and retrospective rated premium accruals and contingent assets and liabilities.
For a more extensive discussion of our accounting policies, see Note 2 "Summary of Significant Accounting Policies", in the Notes to the Consolidated Financial Statements.
o $30.7 million increase in net loss and loss adjustment expenses;
Net earned premiums are the end result of direct written premiums, plus the change in unearned premiums, plus premiums assumed, less premiums ceded to reinsurers. Our direct written premiums decreased by 7.9% due primarily to the decline in production growth in California, which is attributable to our rising premium rates. Offsetting the decrease in direct written premiums was an 82.7% decrease in premiums ceded to our reinsurers, which was due primarily to the expiration of our low level reinsurance agreement on June 30, 2000 and new lower cost reinsurance agreements, all of which reduced the percentage of premiums being ceded.
Years Ended December 31, 2001 % of Total 2000 % of Total ---- ---------- ---- ---------- (dollars in millions) California........................... $134.8 72.1% $155.6 76.5% Colorado............................. 17.5 9.4 16.7 8.2 Nevada............................... 18.6 9.9 15.5 7.6 Texas................................ 9.6 5.1 7.8 3.9 Other States......................... 6.6 3.5 7.7 3.8 ----- ----- ----- ----- Total.............................. $187.1 100.0% $203.3 100.0% ===== ===== ===== =====
o Approximately $32.9 million in additional loss and LAE is related to the increase in net earned premiums in 2001 compared to 2000.
Underwriting expenses consist of policy acquisition costs and other underwriting costs. Policy acquisition costs are those expenses that are directly related to, and vary with, written premiums. Examples of policy acquisition costs are commissions and allowances paid to agents and brokers, premium taxes, boards and bureau fees and certain operating expenses primarily related to our underwriting and marketing departments. The increase in policy acquisition costs of $7.9 million for the year ended December 31, 2001 compared to 2000 is primarily attributable to reductions in ceded commissions received relating to the low level reinsurance agreement. As a percentage of net earned premiums, the underwriting expense ratio, including policyholders' dividends, was 24.9% in 2001 compared to 28.3% in 2000. The improvement in the expense ratio was due in part to higher net earned premiums, which provides a larger base to spread our fixed costs, smaller growth in personnel expenses and lower agents' commissions and allowances.
The combined ratio is a measurement of underwriting profit or loss and is the sum of the loss and LAE ratio, underwriting expense ratio and policyholders' dividend ratio. A combined ratio of less than 100% indicates an underwriting profit. Our combined ratio was 106.1% for the year ended December 31, 2001 compared to 115.8% for the same period in 2000. The decrease was primarily due to a lower loss and LAE ratio of 6.3 percentage points, a lower underwriting expense ratio of 2.5 percentage points, and a lower policyholders' dividend ratio of 0.9 percentage points.
For the year ended December 31, 2001, we recorded a tax provision of $1.5 million compared to a tax benefit of $3.7 million in 2000. The effective tax rate was 45% for 2001 compared to 33% for 2000. The effective tax rate differs from the statutory tax rate primarily as a result of tax preferred investments and the valuation allowance.
Our income before taxes and extraordinary gains decreased by $19.1 million for the year ended 2000 compared to 1999. The major components of the change were:
Our revenue is comprised of net earned premiums, net investment income and net realized gains/losses. Total revenue increased by 42% for the year ended December 31, 2000 compared to 1999. The increase was largely due to a larger amount of written premiums. The components increasing written premiums included a 18% composite increase in premium rates for all states and a 24% increase in production growth.
Net earned premiums are the end result of direct written premiums, plus the change in unearned premiums, less premiums ceded to reinsurers. Our direct written premiums increased by 37% due primarily to growth in California and Nevada. Partially offsetting the growth in direct written premiums was an increase in premiums ceded to reinsurers, which increased by 22%. The growth in ceded reinsurance premiums was lower than the growth in direct written premiums primarily due to the expiration of our low level reinsurance agreement on June 30, 2000 and new lower cost reinsurance agreements, all of which reduced the percentage of premiums being ceded.
The $48.4 million increase in losses and LAE is attributable to the following:
o Approximately $26.4 million of the increase is related to our premium growth.
o For the year ended December 31, 2000 compared to 1999, we recorded an increase of $13.4 million in net adverse loss development for prior accident years. For the year ended December 31, 2000, we recorded $23.3 million of net adverse loss development, primarily for 1996 to 1999 accident years, compared to net adverse loss development of $9.9 million recorded in 1999, primarily for 1996 to 1998 accident years. The net adverse development recorded in 1999 and 2000 for the prior accident years was largely attributable to higher costs per claim, or claim severity, in California. Higher claim severity has had a negative impact on the entire California workers' compensation industry. See our discussion above in Item 1, "Business - Losses and Loss Adjustment Expenses."
o We established a higher loss and LAE ratio for the 2000 accident year, which has resulted in a year over year increase in loss and LAE of approximately $8.6 million. The majority of the increase is due to the termination of the low level reinsurance agreement on June 30, 2000, which results in a higher risk exposure on policies effective after that date and a higher amount of net incurred loss and LAE. In addition, in light of the net adverse loss development we recorded in the fourth quarter of 1999 of $9.9 million, the lower premium rates on policies written in 1999 and trends in health care costs, we believed it prudent to establish the 2000 accident year reserves at a higher rate.
Underwriting expenses consist of policy acquisition costs and other underwriting costs. Policy acquisition costs are those expenses that are directly related to, and vary with, written premiums. Examples of policy acquisition costs are commissions and allowances paid to agents and brokers, premium taxes, boards and bureau fees and certain operating expenses primarily related to our underwriting and marketing departments. The increase in policy acquisition costs of $10.1 million for the year ended December 31, 2000 compared to 1999 is primarily attributable to the increase in net earned premiums. Included in the 2000 expenses are the effects of the run-off of the low level reinsurance agreement and its related reduction in ceding commissions, which has resulted in an increase in policy acquisition costs of $3.2 million in 2000. Other underwriting expenses decreased by $2.7 million for the year ended December 31, 2000 compared to 1999 due to cost containment measures that we initiated. As a percentage of net earned premiums, the underwriting expense ratio, including policyholders' dividends, was 28.3% in 2000 compared to 31.5% in 1999. The improvement in the expense ratio was due in part to higher net earned premiums, which provides a larger base to spread our fixed costs, smaller growth in personnel expenses and lower agents' commissions and allowances.
For the years ended December 31, 2000 and 1999, we recorded valuation allowances of $1.1 million and $1.2 million, respectively. Under the tax sharing agreement with Sierra, valuation allowances have been established for the net deferred tax asset of CII Financial as they can only utilize these benefits to the extent they generate or realize separate return income. We believe that it is more likely than not that CII Financial will have insufficient future income to fully utilize these tax benefits.
We had positive cash flows from operating activities of $27.6 million and $16.2 million for the years ended December 31, 2001 and 2000, respectively. The primary source of cash for 2001 was due to the decrease in the balance of our reinsurance recoverable on paid and unpaid losses of $29.1 million and $11.2 million from an increase in loss and LAE reserves. This was offset by a use of cash of $11.1 million due to the decrease in the ceded reinsurance premium payable. The decrease in reinsurance recoverable and ceded reinsurance premiums payable is due to the expiration of the low level reinsurance agreement. Our positive cash flow for 2000 was largely due to an increase in loss and LAE reserves of $130.2 million plus an increase of $4.5 million for depreciation, amortization and asset impairment, which were partially offset by a net loss of $7.7 million and an increase in reinsurance recoverable on paid and unpaid losses of $115.3 million.
Our net cash used in investing activities was $37.5 million for the year ended December 31, 2001 compared to net cash provided by investing activities of $700,000 for 2000. Net capital expenditures in 2001 were $2.2 million and $839,000 in 2000. We anticipate our capital expenditures to approximate $2 million to $4 million per year over the next several years. Net cash used for the purchase of investments was $27.8 million during 2001.
CII Financial anticipated that it would not have readily available sources of cash to pay the old junior subordinated debentures when they were scheduled to mature in September 2001 and initiated a proposed exchange offer in December 2000. To facilitate the exchange, CII Financial received loans of $17.0 million from Sierra and California Indemnity Insurance Company, a wholly owned subsidiary of CII Financial, and obtained approval from the California Department of Insurance to pay a dividend of $5.0 million to CII Financial. On May 7, 2001, CII Financial closed its exchange offer for $42.1 million of its outstanding old junior subordinated debentures. CII Financial purchased $27.1 million in principal amount of old junior subordinated debentures for $20.0 million in cash and issued $15.0 million in our 9 1/2% senior debentures, due September 15, 2004, in exchange for $15.0 million in old junior subordinated debentures. The transaction resulted in an extraordinary gain of $557,000 and a corresponding tax provision of $195,000. See Note 7 of the Notes to Consolidated Financial Statements for an explanation of the accounting treatment of the transaction.
In September 2001, California Indemnity Insurance Company, or California Indemnity, received approval from the California Department of Insurance to pay an additional $5.0 million dividend to CII Financial, which used these funds to fully pay the remaining $5.0 million in old junior subordinated debentures that matured on September 15, 2001.
Sierra has a bank credit facility and, at June 30, 2000, was in breach of certain of its financial covenants (leverage ratio, consolidated net worth and fixed charges coverage ratio). In consideration of the banks granting a waiver of compliance, in August 2000, CII Financial became a guarantor of the Sierra credit facility debt. The guaranty of the bank debt ranked senior to the old junior subordinated debentures. The waivers expired on October 31, 2000 and Sierra received a notice of default from the banks on November 8, 2000. The credit facility was amended and restated on December 15, 2000. In May 2001, to facilitate the exchange offer, the credit facility was amended to subordinate the credit facility debt to our 9 1/2% senior debentures.
Moreover, insurance companies domiciled in California and Texas generally may not pay extraordinary dividends without providing the state insurance commissioner with 30 days' prior notice, during which time the commissioner may disapprove the payment. An "extraordinary dividend" is generally defined as a dividend whose fair market value together with that of other dividends or distributions made within the preceding 12 months exceeds the greater of ten percent of the insurer's surplus as of the preceding December 31 or the income of such insurer for the 12-month period ending on the preceding December 31.
In addition, our insurance subsidiaries may not pay a dividend without the prior approval of the state insurance commissioner to the extent the cumulative amount of dividends or distributions paid or proposed to be paid in any year exceeds the amount shown as unassigned funds (reduced by any unrealized gains included in such amount) on the insurer's statutory statement as of the previous December 31. California Indemnity, which is our only direct subsidiary, can pay dividends to us in calendar year 2002 of up to $2.1 million without the prior approval of the California Department of Insurance. On February 22, 2001 and September 6, 2001, the California Department of Insurance approved the payment of dividends of $5.0 million each by California Indemnity to us to finance a portion of our debenture exchange offer and bond retirement. We are not in a position to assess the likelihood of obtaining future approval for the payment of dividends other than those specifically allowed by law in each of our subsidiaries' state of domicile.
Since our acquisition by Sierra in October 1995, we have paid dividends to Sierra totaling $2.6 million. Since the acquisition, Sierra has contributed $3.7 million to us by purchasing in the open market old junior subordinated debentures and contributing them to us for retirement.
The following schedule represents our obligations and commitments for long-term debt and operating leases. We do not have any capital leases outstanding. The amounts below represent the entire payment, principal and interest, on our outstanding obligations.
Long-Term Operating Debt (1) Leases Total -------- ------ ----- (In thousands) Payments due on demand (2)............................. $17,000 $17,000 Payments due in less than 1 year....................... 1,421 $2,452 3,873 Payments due in 1 to 3 years........................... 17,766 633 18,399 Payments due in 4 to 5 years........................... 146 146 Payments due after 5 years............................. ------ ----- ------ Total............................................. $36,187 $3,231 $39,418 ====== ===== ======
In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", or SFAS No. 144, which is effective for fiscal years beginning after December 15, 2001 with early adoption recommended. SFAS No. 144 requires that long-lived assets that are to be sold within one year must be separately identified and carried at the lower of carrying value or fair value less costs to sell. Long-lived assets expected to be held longer than one year are subject to depreciation and must be written down to fair value upon impairment. Long-lived assets no longer expected to be sold within one year, such as foreclosed real estate, must be written down to the lower of current fair value or fair value at the date of foreclosure adjusted to reflect depreciation since acquisition. We believe that the implementation of this standard will not have a material impact on our consolidated financial position, results of operations or cash flows.
Management Report on Consolidated Financial Statements............................................... 33 Independent Auditors' Report......................................................................... 34 Consolidated Financial Statements as of December 31, 2001 and 2000 and for each of the three years in the period ended December 31, 2001: Consolidated Balance Sheets.......................................................................... 35 Consolidated Statements of Operations................................................................ 36 Consolidated Statements of Stockholder's Equity...................................................... 37 Consolidated Statements of Cash Flows................................................................ 38 Notes to Consolidated Financial Statements........................................................... 39
The management of CII Financial, Inc. is responsible for the integrity and objectivity of the accompanying consolidated financial statements. The statements have been prepared in conformity with accounting principles generally accepted in the United States of America applied on a consistent basis and are not misstated due to fraud or material error. The statements include some amounts that are based upon the Company's best estimates and judgment.
LIABILITIES Reserve for loss and loss adjustment expenses................... $385,705 $374,554 Unearned premiums............................................... 14,327 13,493 Ceded reinsurance premiums payable.............................. 11,073 Senior Debentures............................................... 19,187 Convertible subordinated debentures............................. 47,059 Accounts payable and other accrued expenses..................... 15,284 19,708 Notes payable affiliate......................................... 17,000 Payable to affiliates........................................... 3,018 1,708 Income tax payable.............................................. 156 1,413 Deferred tax liability.......................................... 1,360 1,242 ------- ------- TOTAL LIABILITIES............................................... 456,037 470,250 ------- -------
STOCKHOLDER'S EQUITY Common stock, no par value, 1,000 shares authorized; 100 shares issued and outstanding................... 3,604 3,604 Additional paid-in capital...................................... 64,450 64,450 Accumulated other comprehensive loss: Unrealized holding loss on available-for-sale investments.. (4,436) (4,535) Retained earnings (accumulated deficit)......................... 1,818 (167) ------- ------- TOTAL STOCKHOLDER'S EQUITY...................................... 65,436 63,352 ------- -------
COSTS AND EXPENSES Loss and loss adjustment expenses.................. 194,648 274,280 157,424 Reinsurance recoveries............................. (54,034) (164,400) (95,963) ------- -------- -------
Net loss and loss adjustment expenses.............. 140,614 109,880 61,461 Policy acquisition costs........................... 29,272 21,386 11,260 General, administrative and other.................. 13,816 14,196 14,828 Asset impairment................................... 3,000 Interest expense................................... 2,310 3,599 3,706 ------- -------- -------
INCOME (LOSS) BEFORE FEDERAL INCOME TAX EXPENSE (BENEFIT) AND EXTRAORDINARY GAIN................................... 3,070 (12,052) 7,095
Federal income tax expense (benefit)................. 1,447 (3,669) 3,602 ------- --------- -------
Extraordinary gain from debt extinguishment (net of income tax of $195, $353 and $59).......... 362 654 111 ------- -------- -------
NET INCOME (LOSS).................................... $ 1,985 $ (7,729) $ 3,604 ======= ======== =======
CII FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY For the Years Ended December 31, 2001, 2000 and 1999 (In thousands except share data)
BALANCE, JANUARY 1, 1999 100 $3,604 $64,450 $ (702) $ 6,595 $ 73,947
2001 2000 1999 ---- ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)...................................................... $ 1,985 $ (7,729) $ 3,604 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Extraordinary gain................................................... (557) (1,007) (170) Depreciation and amortization........................................ 1,330 1,514 1,220 Provision for asset impairment....................................... 3,000 Provision for losses on premiums..................................... (144) Change in assets and liabilities: Premiums receivable............................................... 236 (2,393) 1,365 Investment income receivable...................................... (82) 74 (3) Deferred policy acquisition costs................................. (221) 363 (574) Payable to affiliates............................................. 2,374 (360) 662 Reinsurance recoverable........................................... 29,126 (115,343) (73,438) Federal income taxes receivable................................... (1,311) 236 (4,404) Deferred income taxes............................................. 1,396 (403) 5,887 Reserve for loss and loss adjustment expense...................... 11,151 130,160 32,130 Unearned premiums................................................. 834 193 2,142 Accounts payable and other accrued expenses....................... (4,712) 4,443 (3,523) Ceded reinsurance premiums payable................................ (11,073) 1,752 582 Other assets...................................................... (2,870) 1,703 5,142 -------- -------- -------- Net cash provided by (used in) operating activities.................. 27,606 16,203 (29,522) -------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures, Net.............................................. (2,193) (839) (4,176) Note receivable from Sierra............................................ (7,500) Purchase of available-for-sale investments ............................ (718,432) (171,369) (291,863) Proceeds from sales/maturities of available-for-sale investments....... 683,336 169,103 291,919 Purchase of held-to-maturity investments............................... (1,265) (1,662) (7,133) Proceeds from maturities of held-to-maturity investments............... 8,585 5,466 36,077 -------- -------- -------- Net cash (used in) provided by investing activities.................. (37,469) 699 24,824 -------- -------- --------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW DATA Cash paid during the year for interest (net of amount capitalized)..... $ 3,303 $ 3,713 $ 3,724 Cash paid during the year for income taxes............................. 7 1,834 Non-cash Financing Activities: Debentures exchanged................................................... 19,692
CII FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 2001, 2000 and 1999
CII Financial, Inc. ("CII Financial") was incorporated in the State of California on September 15, 1988. On October 31, 1995, Sierra Health Services, Inc. ("Sierra") acquired CII Financial for approximately $76.3 million of common stock in a transaction accounted for as a pooling of interests. CII Financial is a holding company primarily engaging in writing workers' compensation insurance through its wholly-owned subsidiaries, California Indemnity Insurance Company ("California Indemnity"), Commercial Casualty Insurance Company ("Commercial Casualty"), CII Insurance Company ("CII Insurance") and Sierra Insurance Company of Texas ("Sierra Texas").
Principles of Consolidation. All significant intercompany transactions and balances have been eliminated. The consolidated financial statements of CII Financial, Inc. include the accounts of all of its wholly-owned subsidiaries, California Indemnity, Commercial Casualty, Sierra Texas, CII Insurance and Financial Assurance Company, Ltd. CII Leasing, Inc. and CII Premium Finance Company were liquidated in previous years and in 2001, Financial Assurance Company, Ltd., was liquidated.
Premium Revenues. Revenue from workers' compensation premiums are calculated by formula such that the premium written is earned pro rata over the term of the policy. Premiums written in excess of premiums earned are recorded as unearned premium revenue. The premium for workers' compensation insurance is calculated as a factor of an insured's payroll dollars during the period of coverage. At the inception of the policy, annual payroll dollars are estimated and the policy is issued with estimated annual premiums which are billed based on this estimate. Actual premiums for past interim coverage periods are periodically determined through payroll reporting and interim premium audits. The final actual premium is not determined until a final premium audit is performed, which occurs after the policy has expired. Direct premiums earned but not billed at the end of each accounting period are estimated and accrued, based on historical premium audit trends. Differences between such estimates and final billings are included in current operations. Accrued earned but unbilled premiums are included with premiums receivable. The number and dollar amount of issued workers' compensation insurance policies that are subject to retrospective adjustments based on incurred or paid claims or experienced rated premiums are not significant.
General and Administrative Expenses. Policyholder's dividends and management fees are included in general and administrative expenses.
Cash and Cash Equivalents. The Company considers cash and cash equivalents as all highly liquid instruments with an original maturity of three months or less at the time of purchase. The carrying amount of cash and cash equivalents approximates fair value because of the short maturity of these instruments.
Investments. Available-for-sale debt securities and preferred stocks are stated at fair value with unrealized gains and losses recorded as a separate component of other comprehensive income (loss), net of deferred income taxes. Held-to-maturity debt securities are carried at amortized cost.
Investment income is recognized when earned. Gains and losses on disposition are based on net proceeds and the adjusted carrying amount of the securities sold, using the specific identification method.
Reinsurance. In the normal course of business, insurance companies seek to reduce the effects of events that may cause unfavorable underwriting results by reinsuring certain levels of risk in various levels of exposure with reinsurers. Amounts recoverable from the reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance receivables, including amounts related to paid and unpaid losses, are reported as assets rather than a reduction of the related liabilities.
Recently Issued Accounting Standards. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS No. 142"), which is effective January 1, 2002. SFAS No. 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the pronouncement includes provisions for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the identification of reporting units for purposes of assessing potential future impairments of goodwill. The Company does not have any recorded goodwill and does not anticipate any impact from this pronouncement.
Use of Estimates in the Preparation of Financial Statements. The preparation of the Company's financial statements requires management to make estimates and assumptions that affect the amounts of reported assets and liabilities, particularly loss and LAE reserves and incurred loss and LAE reported in the financial statements. Loss and LAE reserves have a significant degree of uncertainty when related to their subsequent payments. Although reserves are established on the basis of a reasonable estimate, it is not only possible but probable that reserves will differ from their related subsequent developments. Underlying causes for this uncertainty include, but are not limited to, uncertainty in development patterns and unanticipated inflationary trends affecting the services provided by the insurance contract. This uncertainty can result in both adverse as well as favorable development of actual subsequent activity when compared to the reserve established. Any subsequent change in loss and LAE reserves established in a prior year would be reflected in the current year's operating results.
2001 2000 (In thousands) ---- ---- Land............................................ $ 116 Buildings and leasehold improvements............ 2,350 $ 974 Furniture, fixtures and equipment............... 2,620 3,071 Data processing equipment and software.......... 5,345 3,920 Construction in progress........................ 93 1,544 Less: accumulated depreciation................. (5,569) (5,383) ------ ------ Net property and equipment.................... $ 4,955 $ 4,126 ====== ======
Held-to-Maturity U.S. Government and its Agencies............... $ 6,234 $ 24 $ 258 $ 6,000 Municipal Obligations.......................... 964 44 920 Corporate Bonds................................ 6,611 239 6,850 ------- ----- ----- ------- Total Held-to-Maturity....................... $ 13,809 $ 263 $ 302 $ 13,770 ======= ===== ===== =======
Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value ---- ----- ------ ---------- (In thousands) Available-for-Sale: U.S. Government and its Agencies............... $134,143 $313 $5,393 $129,063 Municipal Obligations.......................... 13,510 44 280 13,274 Corporate Bonds................................ 36,874 70 1,664 35,280 Other.......................................... 54 54 ------- --- ----- ------- Total Debt Securities.......................... 184,581 427 7,337 177,671 Preferred Stock................................ 5,212 82 5,130 ------- --- ----- ------- Total Available-for-Sale..................... $189,793 $427 $7,419 $182,801 ======= === ===== =======
Amortized Estimated Cost Fair Value ---- ---------- (In thousands) Due in one year or less.................................... $ 6,291 $ 6,299 Due after one year through five years...................... 19,863 20,254 Due after five years through ten years..................... 27,715 27,703 Due after ten years through fifteen years.................. 16,908 16,885 Due after fifteen years.................................... 148,355 141,153 ------- ------- Total.................................................. $219,132 $212,294 ======= =======
Amortized Estimated Cost Fair Value ---- ---------- (In thousands) Due in one year or less.................................... $ 4,065 $ 4,111 Due after one year through five years...................... 3,171 3,389 Due after five years through ten years..................... Due after ten years through fifteen years.................. Due after fifteen years.................................... 6,573 6,270 ------ ------ Total.................................................. $13,809 $13,770 ====== ======
Years Ended December 31, 2001 2000 1999 ---- ---- ---- (In thousands) Interest from debt securities...................... $14,051 $14,035 $14,387 Dividend income from preferred stock............... 507 335 411 Mortgage interest.................................. 1,169 842 1,130 Other.............................................. 45 ------ ------ ------ Total investment income.......................... 15,727 15,257 15,928 Less investment expenses........................... 252 183 152 ------ ------ ------ Net investment income............................ $15,475 $15,074 $15,776 ====== ====== ======
The Company also holds two non-affiliated commercial mortgage loans. One of the commercial mortgage loans is currently in default; the principal balance outstanding was $1,635,000 at December 31, 2001. The property has been appraised at a value that exceeds book value. The interest rate is at the default rate of 16.25%; however, no interest income has been accrued since the default date. The Company has asserted the priority of its lien on the property and is currently in the process of selling the underlying real estate.
Years Ended December 31, 2001 2000 1999 ---- ---- ---- (In thousands) Net beginning loss and LAE reserve.............. $155,797 $134,305 $174,467
Net payments for loss and LAE Attributable to insured events incurred in: Current year.............................. 28,560 26,867 21,207 Prior years............................... 69,599 61,521 80,416 ------ ------- ------- Total net payments............................ 98,159 88,388 101,623 ------ ------- -------
Net ending loss and LAE reserve................. 198,252 155,797 134,305 Reinsurance recoverable......................... 187,453 218,757 110,089 ------- ------- -------
During the years ended December 31, 2001 and 2000, the Company experienced prior year net adverse loss development of $8.7 million and $23.3 million, respectively. In 2000, estimated losses and LAE incurred in accident years 1996 to 1999 have developed significantly due to the continuation of increasing claim severity patterns on the Company's California book of business. This trend continued into 2001 where estimated losses and LAE incurred on accident years 1995 to 1998 adversely developed. Many workers' compensation insurance carriers in California are also experiencing high claim severity. Factors influencing the higher claim severity include rising average temporary disability costs, the increase in the number of major permanent disability claims, medical inflation and adverse court decisions related to medical control of a claimant's treatment. In February 2002, new legislation was enacted in California that will largely negate the adverse court decisions related to medical control.
For the year ended December 31, 1999, the Company recorded net adverse loss development on prior accident years of $9.9 million, primarily for accident years 1996 to 1998. This adverse development was largely due to the higher average California claim severity patterns that the Company experienced in the last half of 1999.
The exchange offer contained concessions by the holders of the Subordinated Debentures, including extending the maturity and accepting an interest rate that may have been lower than what CII Financial could have obtained from other lenders. In accordance with accounting principles generally accepted in the United States of America, the exchange of the 9 1/2% senior debentures for the Subordinated Debentures was treated as a restructuring of debt. Additionally, the Subordinated Debentures were considered to represent one payable, even though there were many debenture holders. Although some of the debenture holders exchanged the Subordinated Debentures for cash, some exchanged them for new 9 1/2% senior debentures and others a combination of the two, this did not change the substance of the transaction for CII Financial; accordingly, the exchange was considered to be a single transaction.
Rent expense totaled $2,986,000, $2,867,000 and $2,602,000 in 2001, 2000 and 1999, respectively.
Guaranty of Sierra's Credit Facility Debt. At June 30, 2000, Sierra was not in compliance with certain financial covenants relating to its line of credit. The lenders provided Sierra with waivers effective June 30, 2000 and expiring October 31, 2000. In consideration for the banks granting one of the waivers, in August 2000, CII Financial became a guarantor of Sierra's credit facility debt. The waivers expired on October 31, 2000 and Sierra received a Notice of Default from the banks on November 8, 2000. No demand was made by the banks to perform on the guaranty and Sierra was able to amend its credit facility agreement on December 15, 2000. The new Sierra credit facility agreement expires on September 30, 2003. In the amended agreement, CII Financial continues to provide a guaranty of the debt in the event of a default by Sierra. However, the 9 1/2% senior debentures rank senior to CII Financial's guarantee of Sierra's revolving credit facility.
Litigation and Legal Matters. The Company is subject to various claims and other litigation in the ordinary course of business. Such litigation includes claims for workers' compensation and claims by providers for payment for medical services rendered to injured workers. In the opinion of the Company's management, the ultimate resolution of pending legal proceedings should not have a material adverse effect on the Company's financial condition.
Under the tax sharing agreement with Sierra, the amount and expiration dates of CII Financial's net operating losses as of December 31, 2001 are as follows:
Year Generated Amount Expires --------- ------ ------- 1993 $ 4,966,000 2007 1994 4,419,000 2008 1995 2,356,000 2009 1995 1,930,000 2010 1996 3,338,000 2011 1997 4,114,000 2012 1998 3,685,000 2018 1999 3,250,000 2019 2000 2,931,000 2020 ---------- $30,989,000 ==========
Net deferred tax asset before valuation allowance................. 25,901 26,315 Valuation allowance............................................... (10,956) (11,306) ------- -------
In accordance with Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" ("SFAS No. 109"), the Company has established a valuation allowance for the net deferred tax asset of CII Financial. Under the tax sharing agreement with Sierra, CII Financial can only utilize these deferred tax benefits to the extent of separate return income. With the exception of 2001, CII Financial, on a stand alone basis, has historically had significant net operating losses each year. During 2001, CII Financial had taxable income as a result of the refinancing of its Subordinated Debentures. As a result, for the year ended December 31, 2001, the Company decreased the valuation allowance by $350,000 as compared to an increase of $1,079,000 for the year ended December 31, 2000.
In lieu of state franchise and corporate income taxes, California Indemnity, Commercial Casualty, CII Insurance and Sierra Texas pay premium taxes based upon direct written premiums to the states in which they write business. Premium tax expense of $5,437,000, $5,441,000 and $4,078,000 is included in policy acquisition costs in the Consolidated Statements of Operations for the years ended December 31, 2001, 2000 and 1999, respectively.
Current tax receivable balances were $614,000 and $1,945,000 as of December 31, 2001 and 2000, respectively. These amounts are due from Sierra as the administrative agent under the tax sharing agreement.
Net income and capital and surplus (equity) of domestic insurance subsidiaries, as filed with regulatory authorities on the basis of statutory accounting practices, are summarized as follows:
Years Ended December 31, 2001 2000 1999 ---- ---- ---- (In thousands) Statutory net income (loss) for the years ended......... $ 2,427 $ (6,108) $ 12,283 Statutory capital and surplus at year end................ 106,781 108,178 118,278
Executive Retirement Plans. The Company offered key employees and officers a Supplemental Executive Retirement Plan and Supplemental Senior Executive Retirement Plan. Eligibility for participation in both plans was limited to officers and key employees selected and approved by the Board of Directors. These plans were terminated effective October 31, 1995, and there have been no further contributions. Pursuant to contractual obligations under the plans, the Company paid $258,000, $250,000 and $250,000 to former plan participants in the years ended December 31, 2001, 2000 and 1999, respectively.
Employee Stock Purchase Plan. The Company offers employee stock purchase plans through Sierra (the "Purchase Plan") whereby employees may purchase newly issued shares of Sierra stock through payroll deductions at 85% of the fair market value of such shares on specified dates as defined in the Purchase Plan.
Stock Option Plans. The Company offers several plans, through Sierra, that provide common stock-based awards to employees and to non-employee directors. The plans provide for the granting of Sierra options, stock, and other stock-based awards. Awards are granted by a committee appointed by the Sierra Board of Directors and no specific amount has been reserved for the Company's employees. Options become exercisable at such times and in such installments as set by the committee. The exercise price of each option equals the market price of Sierra stock on the date of grant. Stock options generally vest at a rate of 20% - 33% per year. Options generally expire from one to seven years after the end of the vesting period.
Granted.................................. 152,000 6.69 - 21.00 8.87 Exercised................................ (1,000) 6.31 - 11.71 7.81 Canceled................................. (19,000) 11.71 - 24.50 13.87 -------- Outstanding December 31, 1999............... 455,000 6.31 - 24.50 14.12
Granted.................................. 149,000 3.25 - 6.19 3.97 Canceled................................. (164,000) 3.25 - 24.50 19.43 -------- Outstanding December 31, 2000............... 440,000 3.25 - 24.50 8.89
Accounting for Stock-Based Compensation. The Company uses the intrinsic value method in accounting for its stock-based compensation plans. Accordingly, no compensation cost has been recognized for its employee stock option plans nor the Purchase Plan. Had compensation cost for the Company's stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans, the Company's net income for the years ended December 31 would have been reduced to the pro forma amounts indicated below:
Years Ended December 31, 2001 2000 1999 ---- ---- ---- (In thousands) Net Income (Loss): As reported............ $1,985 $(7,729) $3,604 Pro forma.............. 1,522 (8,049) 3,188
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 2001, 2000 and 1999, respectively: dividend yield of 0% for all years; expected volatility of 82%, 52% and 43%; risk-free interest rates of 4.34%, 6.72% and 5.86%; and expected lives of three to five years. The weighted average fair value of options granted in 2001, 2000 and 1999 was $5.70, $2.76 and $3.82, respectively.
Effective January 1, 1999, the Company entered into an investment services agreement with Sierra. Under this agreement, Sierra manages the investments of the Company. Sierra is, however, subject to the Company's investment guidelines and the ultimate control of each insurer's board of directors. The management fee is a percentage of the total amount under management. The annual investment fees paid by the Company in 2001, 2000 and 1999 were approximately $265,000, $400,000 and $335,000, respectively.
At January 1, 1999, California Indemnity and Commercial Casualty invested in a real estate limited partnership of which Sierra is the general partner. California Indemnity agreed to adjust its partnership interest to approximate its occupancy. Together, the two insurance subsidiaries own limited partner interests totaling approximately 27% of the limited partnership. These transactions were done to enable both companies to qualify for certain premium tax credits in the state of Nevada and were approved by the California Department of Insurance. California Indemnity also had a rental agreement with the related partnership under which California Indemnity leased a portion of the transferred real estate. Rental expense under this agreement was approximately $1,267,000 and $1,168,000 for the years ended December 31, 2000 and 1999 , respectively. In December 2000, in conjunction with a sale-leaseback transaction of Sierra's Las Vegas real estate portfolio, the limited partnership sold the real estate to an unrelated third party and the rental agreement was canceled. Sierra entered into a 15-year master lease with the third party purchaser of this real estate. Effective January 1, 2001, Sierra and California Indemnity have entered into a one-year sublease for the space occupied by California Indemnity. The sublease is subject to the provisions of Sierra's master lease and automatically renews from year to year unless California Indemnity gives notice prior to December 1 of each year. Rental expense under this agreement was approximately $1,176,000 for the year ended December 31, 2001.
In March 2000, California Indemnity financed a $7,400,000 five-year mortgage note to Sierra. The note was secured by a first deed of trust and earned quarterly interest payments at 8.75% per annum beginning April 1, 2000 until April 1, 2005, when the unpaid principal balance was due and payable in full. The note was callable in April 2001. In December 2000, in conjunction with a sale-leaseback of Sierra's Las Vegas real estate portfolio, the mortgage note was assumed by the buyer. The loan to value based on the purchase price was 64%. The interest rate was increased to 30-day LIBOR plus a margin and the maturity date was set at December 31, 2001. The loan was scheduled to mature on December 31, 2001; however, the buyer exercised the option to extend the maturity date for six months and paid a fee of .5% of the outstanding balance. The buyer can extend the loan for an additional six months with proper notice to California Indemnity and payment of an additional fee.
In order to make the September 15, 2000 interest payment on the junior subordinated debentures, Sierra advanced $365,000 to CII Financial, Inc.
In May 2001, Sierra purchased $1.0 million of the 9 1/2% senior debentures from a non-affiliated debenture holder. These debentures are still outstanding and Sierra received $35,000 in interest payments in 2001.
California Indemnity has cost sharing agreements with two of its affiliates, SHL and Nevada Administrators, Inc. ("NVA"). In its agreement with SHL, the Company purchases the use of SHL's Health Care Organization ("HCO") and other managed care services. The services are provided at cost. During 2001, the Company paid $5.0 million to SHL under the terms of this agreement. In its agreement with NVA, the Company receives reimbursement for certain services provided by the Company at cost. During 2001, the Company received $57,000 from NVA under the terms of this agreement.
The following table sets forth the unaudited data regarding operations for each quarter of the years ended December 31, 2001 and 2000. In the opinion of management, such unaudited data includes all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the information presented. The Company's operating results for any quarter are not necessarily indicative of the operating results for any future period.
Year ended December 31, 2000: Net earned premiums.............................. $25,344 $ 27,344 $38,263 $34,604 Net investment income............................ 3,369 3,571 3,817 3,697 ------ ------- ------ ------ Total revenues................................... 28,713 30,915 42,080 38,301 Costs and expenses............................... 25,926 48,957 40,832 36,346 ------ ------- ------ ------ Income (loss) before income tax and extraordinary gain........................... 2,787 (18,042) 1,248 1,955 Federal income tax provision (benefit)........... 1,153 (6,492) 437 1,233 ------ ------- ------ ------ Income (loss) before extraordinary gain.......... 1,634 (11,550) 811 722 Extraordinary gain, net of tax................... 76 485 93 0 ------ ------- ------ ------
Net income (loss) ............................... $ 1,710 $(11,065) $ 904 $ 722 ====== ======= ====== ======