We conduct our operations in approximately 86,930 square feet of leased space at 20 Custom House Street in downtown Boston, Massachusetts. Our lease expires in December 2008.
(3)The loss ratio is the ratio of losses and loss adjustment expenses to net earned premiums. The expense ratio, when calculated on a statutory accounting basis, is the ratio of underwriting expenses to net written premiums. The combined ratio is the sum of the loss ratio and the expense ratio. Our expense ratios and combined ratios shown include certain compensation and interest expenses charged to our insurance subsidiaries under our prior majority owner which are described in footnote 1 to the table shown under "Management's Discussion and Analysis of Financial Condition and Results of Operations-General-Insurance Ratios."
The following discussion should be read in conjunction with our accompanying consolidated financial statements and notes thereto, which appear elsewhere in this document.
In this discussion, "Safety" refers to Safety Insurance Group, Inc. and "our Company," "we," "us" and "our" refer to Safety Insurance Group, Inc. and its consolidated subsidiaries. The subsidiaries consist of Safety Insurance Company, Thomas Black Corporation ("TBC"), Safety Indemnity Insurance Company, Thomas Black Insurance Agency, Inc. ("TBIA") and RBS, Inc., TBIA's holding company.
As discussed below under "The Acquisition", Safety acquired (the "Acquisition") all of the issued and outstanding stock of TBC on October 16, 2001. As a result of the Acquisition, the capital structure
We are a leading provider of private passenger automobile insurance in Massachusetts. In addition to private passenger automobile insurance (which represented 81.5% of our direct written premiums in 2002), we offer a portfolio of insurance products, including commercial automobile (9.9% of 2002 direct written premiums), homeowners (7.4% of 2002 direct written premiums), dwelling fire, umbrella and business owner policies. Operating exclusively in Massachusetts through our insurance company subsidiaries, Safety Insurance Company, or Safety Insurance, and Safety Indemnity Insurance Company, we have established strong relationships with 524 independent insurance agents in 627 locations throughout Massachusetts. We have used these relationships and our extensive knowledge of the Massachusetts market to become the third largest private passenger carrier in Massachusetts, capturing an approximately 10.4% share of the Massachusetts private passenger automobile market in 2002 based on automobile exposures. These statistics total, for each vehicle insured, the number of months during the year insurance for that vehicle is in effect, to arrive at an aggregate number of car-months for each insurer; this aggregate number, divided by 12, equals the insurer's number of car-years, a measure we refer to in this discussion as automobile exposures.
In connection with management's plan for the sale of our common stock in the initial public offering ("IPO") that closed on November 27, 2002, the Board of Directors of Safety (the "Board") declared a 23.24 for 1 common stock split on November 12, 2002 in the form of a stock dividend that became effective immediately after the Company filed its amended and restated certificate of incorporation prior to the offering. In accordance with the provisions of FAS 128, Earnings Per Share, all earnings per share for the successor period presented in the consolidated financial statements of the Company have been adjusted retroactively for the stock split. The Stock Appreciation Rights ("SARs") and restricted shares referred to in Note 2 to our financial statements included in this Form 10-K have been similarly adjusted for the stock split.
Concurrent with the IPO, we incurred approximately $6.3 million of other expenses on a pre-tax basis for the year ended December 31, 2002. These expenses incurred are non-recurring in nature and are required to be expensed under GAAP.
Under purchase accounting, the fair value of our reserves for losses and loss adjustment expenses and related reinsurance recoverables was estimated based on the present value of the expected underlying cash flows of the loss reserves and reinsurance recoverables, and included a profit and risk margin. In determining the fair value estimate, management adjusted our historical GAAP undiscounted net loss reserves to present value assuming a 4.0% discount rate, which approximated the U.S. Treasury rate on the date of the Acquisition. The discounting pattern was actuarially developed from our historical loss data. A profit and risk margin of 6.0% was applied to the discounted loss reserves, to reflect management's estimate of the cost we would incur to reinsure the full amount of our net loss and loss adjustment expense reserves with a third party reinsurer. This margin was based upon management's assessment of the uncertainty inherent in the net loss reserves and their knowledge of the reinsurance marketplace.
As noted above, as part of the application of purchase accounting, equipment and leasehold improvements with a net book value of $3.3 million at October 16, 2001 were reduced to zero. In addition, the cost of all investment securities held was increased by an aggregate of $12.7 million to adjust to fair market value the cost basis of the investment securities. As a result, the amortization and accretion of bond discount and premium and the realized and unrealized gain/loss on investment securities for the successor period are different from what they would have been on an historical accounting basis. The effect of this increase in the cost basis of our investment securities will be amortized over the period we hold the respective securities. In the event that we sell any of these securities prior to maturity, the remaining amount of the premium or discount will be recognized on the date of sale.
accounting principles ("GAAP") net income available to common shareholders and exclude net realized investment gains/(losses) and certain other items that we do not believe reflect overall operating trends. The size and timing of realized investment gains/(losses) are often subject to management's discretion. The other excluded items are related to costs incurred as a result of our prior ownership structure (predecessor) and certain other items that are not expected to recur, primarily comprised of a $117.5 million extraordinary gain for the excess of fair value of acquired net assets over cost. While some of these items may be significant components of our GAAP net income, we believe that adjusted operating income is an appropriate measure that is more reflective of the net income attributable to the ongoing operations of the business.
Items are excluded from adjusted after-tax operating income based on management's judgment after a thorough review of our results of operations for the relevant period. Because discretion is exercised in compiling these amounts, adjusted operating income is an imperfect measure of operating trends, and inconsistencies may exist in the adjustments made by management. Adjusted after-tax operating income is not a substitute for net income determined in accordance with GAAP, and investors should not place undue reliance on this measure. Our adjusted after-tax operating income may be different from similarly titled measures of other companies. The following are the adjustments we made to GAAP net income to arrive at adjusted after-tax operating income.
(2)Represents interest and other expenses related to the elimination of employee stock ownership plan and supplemental executive stock ownership plan compensation expenses incurred during the predecessor period. We established these plans in 1995 under our prior majority owner. These plans represented a much larger retirement benefit than was provided prior to their implementation or that has been provided under our 401(k) plan since January 1, 2002. We do not believe that expenses of a comparable magnitude will be needed to attract and motivate our employees in the future. Accordingly, management believes that this adjustment is appropriate. 401(k) expenses incurred were $567 and $0 for the years ended
(5)Represents TJC Management fee expense. These fees are related to services that will no longer be provided after the IPO. We have agreed to terminate this aspect of our management consulting agreement with TJC Management for several reasons, including the ability of our current management to perform the equivalent functions following the IPO. We do not expect to hire additional employees or retain a new consultant on an annual or other periodic fee basis to perform these services following the IPO. We will still be required to pay fees to TJC Management in connection with consulting services they render on certain purchase, sale and financing transactions.
(6)Represents compensation expenses related to put and call options on shares held by management. These options terminated upon completion of the IPO.
We are a participant in Commonwealth Automobile Reinsurers ("CAR"), a state-established body that runs the residual market reinsurance programs for private passenger automobile insurance in Massachusetts under which premiums, expenses, losses and loss adjustment expenses on ceded business are shared by all insurers writing automobile insurance in Massachusetts. We also participate in the Massachusetts Property Insurance Underwriting Association in which premiums, expenses, losses and loss adjustment expenses on homeowners business that cannot be placed in the voluntary market are shared by all insurers writing homeowners insurance in Massachusetts.
As of December 31, 2002, we had no material amounts recoverable from any reinsurer, excluding the residual markets described above.
Proposals to change certain of CAR's rules are under consideration. In a letter to the Massachusetts Insurance Commissioner (the "Commissioner") dated June 25, 2002, the Massachusetts Attorney General reported that his office has determined that CAR's current methodology for assigning ERPs and distributing the CAR deficit is not fair and equitable. The Attorney General's letter describes several factors that he believes support his findings and which he believes should be corrected in order to comply with Massachusetts law governing CAR. The Attorney General's letter calls on the Commissioner to work with him to address these issues. The letter has engendered discussion and dialogue among various parties that could result in material changes to CAR's rules. It is uncertain
Each year, the Commissioner sets maximum premium rates that may be charged and minimum commissions that may be paid to agents for personal automobile insurance. The Commissioner approved no change in personal automobile premiums for 2002, as compared to an average rate decrease of 8.3% in 2001. During the period from 1995 through 2002 average rates decreased in five out of eight of those years. Coinciding with the 2002 rate decision, the Commissioner also approved a decrease in the commission rate agents receive for selling private passenger automobile insurance, as a percentage of premiums, from 12.3% in 2001 to 11.7% in 2002, with a further decrease to 11.0% in 2003.
Although state-mandated average maximum private passenger automobile insurance rates did not increase in 2002, our average premium per automobile exposure in the twelve months ended December 31, 2002 increased from the twelve months ended December 31, 2001 by approximately 5.2%. This increase was primarily the result of our elimination of Safe Driver Insurance Plan discounts, reduced affinity group discounts and purchases of new automobiles by our insureds. Further, beginning in late 2000, we began a new rate pursuit initiative that validated insured rating classifications and discount eligibility, and which we believe contributed to the increase in our average premiums received per automobile exposure. The table below shows average Massachusetts-mandated personal automobile premium rate changes and changes in our average premium per automobile exposure from 1991-2002.
Our statutory insurance ratios for the years ended December 31, 2002, 2001 and 2000, respectively, are outlined in the following table:
In June 2001, Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 141, "Business Combinations". SFAS No. 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method. With respect to deferred credits (i.e. negative goodwill), SFAS No. 141 calls for the recognition of all existing deferred credits arising from business combinations for which the Acquisition date was after June 30, 2001 to be recognized through the income statement as an extraordinary gain. Effective with the Acquisition, we adopted SFAS No. 141 and accounted for the Acquisition under the purchase method. We recognized the resultant deferred credit of $117.5 million through earnings as an extraordinary gain in the successor period of 2001.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure" ("SFAS No. 148") which amends SFAS Statement No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"). The objective of SFAS No. 148 is to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 does not change the provisions of SFAS No. 123 that permit entities to continue to apply the intrinsic value method of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"). In addition, 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 Company continues to maintain its accounting for stock-based compensation in accordance with APB No. 25, but has adopted the disclosure provisions of SFAS No. 148. (See Note 6 in Notes to Consolidated Financial Statements).
In accordance with industry practice, we also maintain reserves for estimated losses incurred but not yet reported. Incurred but not yet reported reserves are determined in accordance with commonly accepted actuarial reserving techniques on the basis of our historical information and experience. We review and make adjustments to incurred but not yet reported reserves quarterly.
Direct Written Premiums. Direct written premiums for the year ended December 31, 2002 increased by $44.7 million, or 9.5%, to $516.6 million from $471.9 million for the year ended December 31, 2001. This increase was primarily due to an approximate 5.2% increase in the average written premium per automobile exposure on our private passenger automobile business, a 2.2% increase in our private passenger automobile written exposures, and a 7.6% increase in our commercial automobile written exposures. We also increased our average rates on commercial automobile insurance by 7.2% effective January 1, 2002, and in addition we increased our average rates on homeowners insurance by 9.8% effective February 19, 2002.
Net Earned Premiums. Net earned premiums for the year ended December 31, 2002 increased by $42.0 million, or 9.4%, to $489.3 million from $447.3 million for the year ended December 31, 2001. This increase was primarily due to an approximately 4.4% increase in automobile exposures for which we earned premiums in our private passenger automobile business, an increase in assumed premiums from CAR, and the increased rates on our private passenger automobile, commercial automobile and homeowners lines.
Investment Income. Investment income for the year ended December 31, 2002 decreased by $1.5 million, or 5.4%, to $26.1 million from $27.6 million for the year ended December 31, 2001. An increase of $57.5 million or 11.1% in average invested securities and cash (at fair value) to $574.6 million for the year ended December 31, 2002 from $517.1 million for the year ended December 31, 2001 was more than offset by a decrease in net effective yield on our investment portfolio to 4.55% from 5.34% during the same period due to declining interest rates on our investment portfolio, as well as a change in management's investment strategy to shorten the duration of our portfolio, shift to higher rated securities, and increase our tax-exempt holdings.
(1)Obligations of U.S. Government agencies include collateralized mortgage obligations issued, guaranteed and/or insured by the following issuers: Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), and Federal National Mortgage Association (FNMA). As such, the asset-backed securities presented exclude such issuers already presented under U.S. Treasury securities and obligations of U.S. Government Agencies. As of December 31, 2002, our portfolio of fixed maturity investments was comprised entirely of investment grade corporate fixed maturities securities, U.S. government and agency securities and asset-backed securities (i.e., all our securities received a rating assigned by Moody's Investors Services, Inc. of Baa or higher, as well as a rating assigned by the Securities Valuation Office of the National Association of Insurance Commissioners of 1 or 2). In addition, all fixed maturity securities we held were publicly traded.
The unrealized losses recorded on the fixed maturity investment portfolio at December 31, 2002 resulted primarily from fluctuations in market interest rates as opposed to fundamental changes in the credit quality of the issuers of such securities. Therefore, these decreases in values are viewed as being temporary as we have the intent and ability to retain such investments for a period of time sufficient to allow for recovery in market value.
Of the approximately $0.9 million gross unrealized losses as of December 31, 2002, approximately $0.7 million relates to fixed maturity obligations of states and political subdivisions, and U.S. government agency asset-backed securities (i.e., Government National Mortgage Association, Federal Home Loan Mortgage Corporation). The remaining $0.2 million of gross unrealized losses relates to holdings of investment grade corporate fixed maturities securities in a variety of industries and sectors, including banking, finance, telecommunications, entertainment and utilities.
Finance and Other Service Income. Finance and other service income includes revenues from premium installment charges, which we recognize when earned, and other miscellaneous income and fees. Finance and other service income for the year ended December 31, 2002 increased by $2.4 million, or 20.0%, to $14.2 million from $11.8 million for the year ended December 31, 2001. These increases were due to a $1.9 million increase in premium installment billing fees due to growth in the number of policies and the fee charged per policy, as well as $0.5 million increase in miscellaneous income from CAR.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred for the year ended December 31, 2002 increased $23.3 million, or 6.6%, to $375.2 million from $351.9 million for the year ended December 31, 2001. As a percentage of premiums earned, losses and loss adjustment expenses incurred for the year ended December 31, 2002 was 76.7% compared to 78.7% for the comparable 2001 period. The ratio of net incurred losses, excluding loss adjustment expenses, to premiums earned for year ended December 31, 2002 was 68.3% compared to 67.9% for the year ended December 31, 2001. We experienced higher assumed residual market losses during the year ended December 31, 2002 than for the year ended December 31, 2001, which is the result of our increased share of 2002 CAR results, a higher CAR loss ratio and strengthening of prior year CAR reserves. Finally, in 2002 we released $2.3 million of loss reserves related to prior years, compared to $7.3 million in 2001.
Underwriting, Operating and Related Expenses. Underwriting, operating and related expenses for the year ended December 31, 2002 increased by $11.1 million, or 9.4%, to $128.9 million from $117.8 million for the comparable 2001 period. As a percentage of net written premiums, our underwriting expense ratio for the year ended December 31, 2002 was 24.9% compared to 25.3% for the comparable 2001 period.
Transaction Expenses. Transaction expenses for the year ended December 31, 2002 decreased to $0 from $9.5 million for the comparable 2001 period. The transaction expenses for the year ended December 31, 2001 represent costs incurred by the seller and paid by us in connection with the Acquisition. Such seller costs primarily included transaction expenses in the predecessor period related primarily to transaction bonuses to employees, fees paid to Thomas Black Corporation's investment banker and legal fees. These costs were non-recurring in nature and did not result from ongoing insurance operations.
Other Expenses. Other expenses for the year ended December 31, 2002 increased to $6.3 million from $0 for the year ended December 31, 2001. Other expenses are comprised of $4.0 million of TJC management termination fee expense related to services that ceased at the IPO, and $2.3 million of unamortized deferred debt issuance costs related to the Acquisition debt which were expensed upon the repayment of this debt, concurrent with the IPO.
Interest Expenses. Interest expenses for the year ended December 31, 2002 increased by $4.9 million to $7.3 million from $2.4 million for the year ended December 31, 2001. Interest expenses for 2002 were related to Acquisition debt that was extinguished at the IPO, as well as indebtedness incurred in connection with the IPO. Interest expenses for 2001 were related to the employee stock ownership plan debt that was extinguished at the Acquisition, as well as indebtedness incurred in connection with the Acquisition. Primarily as a result of the IPO, we significantly reduced our debt outstanding to $20.0 million at December 31, 2002 from $99.5 million at December 31, 2001.
Net Income Before Extraordinary Item and Preferred Stock Dividends. Net income before extraordinary item and preferred dividends for the year ended December 31, 2002 increased to $10.5 million from $0 for the comparable 2001 period. These increases were a result of the factors previously discussed above.
Net Written Premiums. Net written premiums for the year ended December 31, 2001 increased by $35.5 million, or 8.3%, to $465.5 million from $430.0 million for the year ended December 31, 2000. The increase was due primarily to increased policy growth on our direct business.
Net Earned Premiums. Net earned premiums for the year ended December 31, 2001 increased by $65.9 million, or 17.3%, to $447.3 million from $381.4 million for the year ended December 31, 2000. This increase was due primarily to increased policy growth on our direct business.
The gross unrealized appreciation (depreciation) of investments in fixed maturities securities as of December 31, 2001, were as follows:
Finance and Other Service Income. Finance and other service income for the year ended December 31, 2001 increased by $1.3 million, or 12.4%, to $11.8 million from $10.5 million for the year ended December 31, 2000. The increase was primarily due to policy growth as described above.
Loss and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred for the year ended December 31, 2001 increased $76.8 million, or 27.9%, to $351.9 million from $275.1 million for the year ended December 31, 2000. As a percentage of premiums earned, losses and loss adjustment expenses incurred for 2001 was 78.7% compared to 72.1% in 2000. The ratio of net incurred losses, excluding loss adjustment expenses, to premiums earned was 67.9% in 2001 compared to 60.7% in 2000. Poor weather in the first quarter of 2001 impacted our personal and commercial automobile loss ratios, and poor weather in the first and second quarters of 2001 impacted our homeowners loss ratio. We ceded less business to the residual market in 2001, thereby increasing our loss ratio, which was partially offset by a lower share of the residual market. We experienced higher assumed residual market losses during 2001, which were the result of a higher CAR loss ratio. Finally, in 2001 we released $7.3 million of loss reserves related to prior years, compared to $27.0 million in 2000.
Interest Expense. Interest expense for the year ended December 31, 2001 was $2.4 million compared to $1.1 million for the year ended December 31, 2000. The increase in 2001 was the result of indebtedness incurred in connection with the Acquisition, offset, in part, by a reduction in interest expense incurred in connection with the employee stock ownership plan to $0.5 million in 2001 from $1.1 million in 2000. Upon the Acquisition, our employee stock ownership plan and supplemental executive stock ownership plan were terminated.
Our Company's sources of funds primarily include premiums received, investment income and proceeds from sales and redemptions of investments. Our principal uses of cash are the payment of claims, operating expenses and taxes, the purchase of investments and payment of dividends to TBC.
For the years ended December 31, 2002 and 2001, our consolidated cash flow provided by operations was $85.4 million and $30.2 million, respectively. This $55.2 million increase was primarily a result of cash flow from growth in written premium.
For the years ended December 31, 2002 and 2001, our consolidated cash flow used for investing activities was $63.7 million and $150.9 million, respectively. The $87.2 million decrease was attributable to the increase in net bond proceeds of $51.1 million in 2002, offset by the purchase of TBC that occurred in 2001.
Financing activities have also been a source of liquidity for us. In 2002, we obtained cash to pay down our long-term debt principally from borrowings under our new credit facility, and also from issuing our common stock in our IPO that closed November 27, 2002. In 2001, we obtained cash to pay for the Acquisition and related expenses principally from borrowings under our old credit facility, the issuance of our notes, preferred stock, and common stock, each of which are described below.
subsidiaries and the capital stock of all our subsidiaries (except Safety Indemnity Insurance Company). The old credit facility contained covenants including requirements to maintain certain financial and operating ratios as well as restrictions on incurring debt or liens, paying dividends and other restricted payments and other matters. The interest rate under our old credit facility was 5.0% at the closing of the IPO. We used proceeds from our IPO, the Direct Sale and the new credit facility to repay all our borrowings under our old credit facility on that date.
Senior Subordinated Notes. Safety issued $30.0 million in 13.0% senior subordinated notes to obtain funds for the Acquisition. Interest on these notes was payable semiannually on each April 30 and October 31. The senior subordinated notes would have matured December 31, 2011. The notes could be redeemed at our option prior to maturity with no redemption premium or penalty. The notes also contained specified financial and operating covenants. We used proceeds from the IPO, the Direct Sale and the New Credit Facility to repay these notes along with approximately $0.3 million of unpaid accrued interest on that date.
As mentioned above, we used the proceeds from our IPO, the Direct Sale and our new credit facility to repay in full all outstanding principal and interest on our old credit facility, our senior subordinated notes and all outstanding dividends on our Preferred Share Exchange on that date.
Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words such as "believe," "expect," "anticipate," "intend," "plan," "estimate," "aim," "projects," or words of similar meaning and expressions that indicate future
Some other factors, such as market, operational, liquidity, interest rate, equity and other risks, are described elsewhere in this Annual Report on Form 10-K. Factors relating to the regulation and supervision of our Company are also described or incorporated in this report and our Company's prospectus in the registration statement on Form S-1 filed with the SEC on November 22, 2002. There are other factors besides those described or incorporated in this report or in the Form S-1 that could cause actual conditions, events or results to differ from those in the forward-looking statements.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, changes in shareholders' equity, comprehensive income and cash flows present fairly, in all material respects, the financial position of Safety Insurance Group, Inc. and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for the year ended December 31, 2002 and the period October 16, 2001 through December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. 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 audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed below in Note 2, the Company acquired all of the issued and outstanding stock of TBC on October 16, 2001 (the "Acquisition"). As a result of the Acquisition, the capital structure and basis of accounting of the Company differ from those of TBC prior to the Acquisition. Therefore, the financial data with respect to periods prior to the Acquisition ("predecessor" period) may not be comparable to data for periods subsequent to the Acquisition ("successor" period). In addition, the November 27, 2002 initial public offering ("IPO"), the use of IPO net proceeds, the Preferred Share Exchange (as defined below) and the Direct Sale (as defined below) have further altered the current capital structure of the Company, as discussed further in Note 2, "Acquisition and IPO".
The Company is a leading provider of personal lines property and casualty insurance focused exclusively on the Massachusetts market. Its principal product line is private passenger automobile insurance, which accounted for 81.5% of its direct written premiums in 2002. The Company operates through its insurance company subsidiaries, Safety Insurance Company and Safety Indemnity Insurance Company. TBIA is the managing agent for Safety Insurance Company and Safety Indemnity Insurance Company.
The Company was incorporated on June 25, 2001, in the State of Delaware. On October 16, 2001, the Company acquired (the "Acquisition") all of the issued and outstanding common stock of TBC and its property and casualty subsidiaries for $121.1 million. In connection with the Acquisition, an allocation of purchase price of $121.1 million was made to the estimated fair values of the assets
acquired and the liabilities assumed as of the acquisition date of October 16, 2001 as follows (in millions):
Prior to the IPO, approximately 72% of the outstanding common stock of the Company was owned by certain investors assembled by The Jordan Company, LLC, an investment firm that sponsored the Acquisition. The remaining 28% was owned by executive management. (See Note 12 regarding promissory notes received from management.) JZ Equity Partners plc, a London-based publicly traded investment trust, owned approximately 50% of the outstanding mandatorily redeemable preferred stock of the Company; the other 50% was owned by third parties. The preferred stock was cumulative, non-voting with a 6% dividend rate and was mandatorily redeemable on October 16, 2012 or upon a change in control (See Note 9).
option all at $12.00 per share. Net proceeds received were $81.8 million from these stock issuances after deducting underwriting discounts and other offering expenses. The Company also received $30.0 million from borrowings under our new credit facility. These net proceeds and borrowings were used to repay principal and interest on the outstanding debt as well as dividends on the outstanding mandatorily redeemable preferred stock. In addition, $22.4 million of common stock and additional paid in capital was recognized from the issuance of 1,866,665 common shares upon conversion of all outstanding preferred stock (the "Preferred Share Exchange"), concurrent with the IPO.
As of December 31, 2002, the Company had 15,259,991 common shares outstanding. The 5,809,992 common shares outstanding as of September 30, 2002 increased to 14,359,991 at the IPO due to the addition of the new 6,333,334 common shares sold at IPO, the 350,000 common shares sold as part of the Direct Sale, and an additional 1,866,665 common shares issued in the Preferred Share Exchange. As of December 31, 2002, the 14,359,991 shares outstanding increased to 15,259,991 common shares outstanding due to the underwriters purchase of an additional 900,000 common shares pursuant to their over-allotment option exercise on December 5, 2002.
Premiums are earned over the terms of the respective policies, which are generally under one year. Unearned premiums represent the portion of premiums written applicable to the unexpired terms of the policies.
Amounts included in accounts receivable represent premiums as well as finance charges which are billed on a monthly installment basis. A substantial majority of the Company's premiums are billed on a monthly installment basis.
Deferred income taxes are generally recognized when assets and liabilities have different values for financial statement and tax reporting purposes, and for other temporary taxable and deductible differences as defined by Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes". A valuation allowance is established where management has assessed that it is more likely than not that the Company will not be able to utilize the full deferred tax asset.
Investments in fixed maturities, which include taxable and non-taxable bonds, and equity securities available-for-sale are reported at fair value. Fair values are derived from external market quotations. Unrealized gains or losses on fixed maturity and equity securities, reported at fair value, are excluded from earnings and reported in a separate component of shareholders' equity, known as "Accumulated other comprehensive income (loss), net of federal income taxes", until realized. Realized gains or losses on the sale or maturity of investments are determined on the basis of the specific cost identification method. Fixed maturity and equity securities that experience declines in value that are other-than-temporary are written down to fair value with a corresponding charge to net realized losses on investments. As part of purchase accounting, the cost of all securities held on the date of the Acquisition was increased by $12.7 million to reset the cost to fair value. Investment income is recognized on an accrual basis of accounting. Bonds not backed by other loans are amortized using the interest method. Loan-backed bonds and structured securities are amortized using the interest method and significant changes in estimated cash flows from the original purchase assumptions are accounted for using the retrospective method.
Transaction expenses in the predecessor period represent costs incurred by the seller and paid by the Company in connection with the Acquisition. These costs were non-recurring in nature and did not result from ongoing insurance operations. Such seller costs in the predecessor period related primarily to transaction bonuses to employees, fees paid to TBC's investment banker, and legal fees.
Deferred debt issuance costs represent those costs incurred by the Company in connection with securing debt financing. These costs include closing and arranger's fees and are amortized over the life of the related loans. Included in other expenses for 2002 is $2.3 million of unamortized deferred debt acquisition costs related to the Acquisition debt which were expensed upon the repayment of this debt, concurrent with the IPO.
As described in Note 6, certain members of management were granted SARs on October 16, 2001. Prior to the IPO, the SARs were to vest 20% per annum commencing on December 31, 2002. As of the close of the IPO, the SARs became fully vested and were automatically exercised. The SARs were accounted for in accordance with the provisions of Financial Accounting Standards Board ("FASB") Interpretation No. 28 "Accounting for Stock Appreciation Rights and Other Variable Stock Options or Awards Plans" ("FIN 28"). Under FIN 28, compensation expense is accrued over the period or periods in which the employee performs the related services and is recognized to the extent that the fair market of the Company's stock exceeds the exercise price of the SARs. Changes in the fair market value of the stock in an accounting period, to the extent it still exceeds the exercise price, are recorded as compensation expense.
On June 25, 2002, the Board adopted the 2002 Management Omnibus Incentive Plan ("the Incentive Plan"). The Incentive Plan provides for a variety of awards, including incentive stock options, nonqualified stock options, SARs and restricted stock awards. The Company has granted certain stock option awards under this Incentive Plan and has adopted the accounting for these options under the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees", as allowed by SFAS No. 123, "Accounting for Stock-Based Compensation" and as amended by SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure". Disclosure of stock-based compensation determined in accordance with SFAS No. 148 is presented in Note 6.
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others", which addresses the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees. This Interpretation also clarifies the requirements related to the recognition of a liability by a guarantor at the inception of a guarantee for the obligations the guarantor has undertaken in issuing that guarantee. The provisions related to the disclosure requirements to be made by a guarantor are effective for financial statements of interim and annual reporting periods ending after December 15, 2002. The provisions related to the recognition of a liability and initial measurement shall be applied prospectively to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. The adoption of this Interpretation is not expected to have a material impact on the Company's financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure" ("SFAS No. 148") which amends SFAS Statement No. 123, "Accounting for
The cost and fair value of equity securities as of December 31, 2002 and 2001 were follows:
There were gross unrealized gains of less than $0.1 million and $0, and gross unrealized losses of less than $0.1 million and $0.2 million on stocks at December 31, 2002 and 2001, respectively.
There were no sales of stock for the year ended December 31, 2002. There were $0.9 million of gross gains and gross losses of $0.1 million on sales of stock for the period October 16, 2001 through December 31, 2001. There were no sales of stock for the period January 1, 2001 through October 15, 2001. Gross gains of less than $0.1 million and gross losses of less than $0.1 million were realized for the year ended December 31, 2000.
On October 16, 2001, the Company entered into a management subscription agreement with certain employees. The management subscription agreement contained certain Company call and employee put options that allowed the employee to put the stock owned by the employee at the time of exercise at a price based upon a formula calculation to the Company under certain circumstances outside of the Company's control and within the employee's control (e.g., employee retirement or resignation). The management subscription agreement was being accounted for as a variable plan in accordance with EITF 00-23, "Issues Related to the Accounting for Stock Compensation under APB
The Company has adopted the accounting for the Incentive Plan under the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees", and Related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and
The fair value of stock options used to compute pro forma net income and earnings per share disclosures for the year ended December 31, 2002 is the estimated fair value at grant date using the Black-Scholes option-pricing model with the following assumptions:
In 1995, upon the inception of the ESOP, as defined below, management discontinued all employer and employee contributions to its then existing qualified defined contribution profit-sharing/retirement plan (the "Retirement Plan"). As a result, the rights of each participant to his/her account on the date of the discontinuance of contributions, to the extent of the fair market value under the general investment fund, became fully vested and nonforfeitable.
Prior to the Acquisition, TBC had a leveraged employee stock ownership plan (the "ESOP") with a 30% interest in the issued and outstanding common stock of TBC (287,700 shares). The ESOP covered substantially all employees and was subject to the applicable provisions of ERISA. The ESOP was noncontributory on the part of participants and employer contributions were made at the discretion of the Board. In conjunction with the establishment of the ESOP, TBC obtained a loan of $36.0 million to finance the purchase of 30% of TBC's shares. The loan was collateralized by shares of TBC held by the ESOP but unallocated to ESOP participants. The ESOP was accounted for in accordance with Statement of Position 93-6, "Employers' Accounting for Employee Stock Ownership Plans." Compensation expense related to the ESOP was $4.7 million and $7.2 million for the period January 1, 2001 through October 15, 2001 and the year ended December 31, 2000, respectively. There was no compensation expense for the successor periods ended December 31, 2001 and December 31, 2002 related to the ESOP. The Company filed to terminate the ESOP in conjunction with the Acquisition. During 2002, a favorable determination was received from the IRS for the proposed termination date of October 16, 2001.
The Company has various noncancelable long-term operating leases. The approximate minimum annual rental payments due under these lease agreements as of December 31, 2002 are as follows:
Certain lease agreements contain renewal options and, in addition to the minimum annual rentals, generally provide for payment of a share of the real estate taxes and operating expenses in excess of a base amount. Rental expense was $2.7 million for the year ended December 31, 2002, $2.0 million for the period January 1, 2001 through October 15, 2001, $0.5 million for the period October 16, 2001 through December 31, 2001 and $2.5 million for the years ended December 31, 2000. All leases expire
Various claims, generally incidental to the conduct of normal business, are pending or alleged against the Company from time to time. In the opinion of management, based in part on the advice of legal counsel, the ultimate resolution of such claims will not have a material adverse effect on the Company's consolidated financial statements. However, liabilities related to those proceedings could be established in the near term if estimates of the ultimate resolutions of those proceedings are revised.
Massachusetts law requires that insurers licensed to do business in Massachusetts participate in the Massachusetts Insurers Insolvency Fund ("Insolvency Fund"). Members of the Insolvency Fund are assessed a proportionate share of the obligations and expenses of the Insolvency Fund in connection with an insolvent insurer. CAR also assesses its members as a result of insurer insolvencies. Because CAR is not able to recover an insolvent company's share of the net CAR losses from the Insolvency Fund, CAR must increase each of its member's share of the deficit in order to compensate for the insolvent carrier's inability to pay its deficit assessment. It is anticipated that there will be additional assessments from time to time relating to various insolvencies. In 2002, 2001 and 2000, the Company received notice of assessments from the Insolvency Fund amounting to $2.1 million, $1.4 million and $2.2 million, which it expensed for the years ended December 31, 2002, 2001 and 2000, respectively.
Debt at December 31, 2002 and 2001 consisted of the following:
At December 31, 2002, the Company had utilized advances of $20.0 million. The interest rate was 3.20% at December 31, 2002 and an average of 3.34% for the year ended December 31, 2002.
The Company incurred interest expense of $7.3 million, $1.8 million, $0.5 million, and $1.1 million for the year ended December 31, 2002, for the period October 16, 2001 through December 31, 2001, for the period January 1, 2001 through October 15, 2001, and for the year ended December 31, 2000, respectively, related to all debt outstanding during these periods.
In connection with the Acquisition (see Note 2), the Company issued 22,400 shares of the 100,000 authorized shares of 6% Series A senior preferred stock at $1,000 per share. The stock had a liquidation preference and entitled its holders to receive dividends of $60 per share per annum. To the extent that the dividends were not paid, they accrued in arrears.
The preferred stock was redeemable at any time at the option of the Company at the stock's liquidation preference plus any accrued dividends. The stock is mandatorily redeemable (at the issue price) at the earlier of October 16, 2012 or upon a change in control of the Company.
The holders of the preferred stock agreed to amend the terms of the preferred stock to cause it to automatically convert into common stock upon the closing of the IPO at the IPO price. Based upon the $12.00 per share IPO price, 1,866,665 additional common shares were issued in connection with this Preferred Share Exchange upon the close of the IPO.
As a servicing carrier for CAR, the Company has entered into service contracts with several insurance carriers under which the Company services the residual market business assigned to the carriers by CAR (the "buyout program"). Business generated through the buyout program is 100% ceded to the applicable carrier and serviced for a fee. Servicing carrier fees amounted to $0.5 million for the year ended December 31, 2002, $0.1 million for the period October 16, 2001 through December 31, 2001, $0.4 million for the period January 1, 2001 through October 15, 2001, and $0.6 million for the year ended December 31, 2000.
The Company has substantially benefited in prior years from releasing redundant reserves. Massachusetts private passenger automobile insurance pricing was very favorable in the early to mid-1990s and the reserves we established for business written during that period developed favorably, allowing us to release substantial reserves in following years. As maximum permitted rates declined in the latter part of the 1990s through 2002, and the redundancies resulting from favorable development of earlier years were released, our redundancies in subsequent years began to diminish. In the year ended December 31, 2000 we released $27.0 million in reserves relating to prior years, compared to $7.3 million in 2001. For the year ended December 31, 2002, we released loss reserves related to prior years of $2.3 million.
Upon closing of the IPO, the Company paid TJC Management Corporation, an affiliate of the Jordan Company ("TJC"), a $4.0 million termination fee related to the annual fee that ceased at the IPO, as agreed with TJC under the amended management agreement. This has been included in other expenses in the statement of operations for the year ended December 31, 2002.
During 2001, the Company entered into a ten-year management consulting agreement with TJC, an affiliate of The Jordan Company. Under the management consulting agreement, TJC renders consulting services to the Company in connection with financial and business affairs, relationships with lenders, shareholders and other third parties, and the expansion of the Company's business. The Agreement will automatically renew for successive one-year terms starting December 31, 2011 unless terminated pursuant to its provisions. Under the Agreement, the Company was required to pay an annual management fee of $1.0 million in quarterly installments.
Upon consummation of the Acquisition, the Company paid TJC a closing fee of $2.5 million in lieu of any fee otherwise payable to TJC as described above. This has been included in transaction expenses in the statement of operations for the successor period ended December 31, 2001.
Basic earnings (loss) per common share is calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Net income (loss) available to common shareholders includes preferred stock dividends for the year ended December 31, 2002 and the period October 16, 2001 through December 31, 2001.
The income tax expense (benefit) attributable to the consolidated results of operations are different from the amounts determined by multiplying income before federal income taxes by the
statutory federal income tax rate. The sources of the difference and the tax effects of each were as follows:
The Company believes, based on its recent earnings history and its future expectations, that the Company's taxable income in future years will be sufficient to realize all federal deferred tax assets. A valuation allowance has been established in 2002 in the amount of $3.1 million against state loss carryforwards. This valuation allowance is based upon management's assessment that it is more likely than not that the Company will not be able to utilize these state deferred tax assets. In determining the adequacy of future income, the Company considered the future reversal of its existing temporary differences and available tax planning strategies that could be implemented, if necessary. At December 31, 2002, there are available alternative minimum tax credit carry forwards of $0.2 million. The alternative minimum tax credit carry forwards have no expiration date.
The Company's insurance subsidiaries, domiciled in the Commonwealth of Massachusetts, prepare statutory financial statements in accordance with the accounting practices prescribed or permitted by the Division. Statutory net income of the Company's insurance subsidiaries was $21.5 million, $10.3 million, and $11.3 million for the years ended December 31, 2002, 2001 and 2000, respectively. Statutory capital and surplus of the Company's insurance subsidiaries was $234.2 and $220.1 at December 31, 2002 and 2001, respectively. In 1998, the National Association of Insurance Commissioners ("NAIC") adopted the Codification of Statutory Accounting Principles guidance, which replaces the current accounting practices and procedures manual as the NAIC's primary guidance on statutory accounting as of January 1, 2001. The codification provides guidance for areas where statutory accounting has been silent and changes current statutory accounting in some areas, e.g., deferred income taxes are recorded. The Division has adopted the codification guidance, effective January 1, 2001. The effect of adoption was an increase to the statutory capital and surplus of the Company's insurance subsidiaries of approximately $16.2 million.
The Company's insurance subsidiaries are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid to their parent without prior approval of the Division. Massachusetts' statute limits the dividends an insurer may pay in any twelve month period, without the prior permission of the Commonwealth of Massachusetts Insurance Commissioner, to the greater of (i) 10% of the insurer's surplus as of the preceding December 31 or (ii) the insurer's net income for the twelve-month period ending the preceding December 31, in each case determined in accordance with statutory accounting practices. The Company's insurance company subsidiaries may not declare an "extraordinary dividend" (defined as any dividend or distribution that, together with other distributions made within the preceding twelve months, exceeds the limits established by Massachusetts' statute) until thirty days after the Commissioner has received notice of the intended dividend and has not objected. As historically administered by the Commissioner, this provision requires the Commissioner's prior approval of an extraordinary dividend. Under Massachusetts law an insurer may pay cash dividends only from its unassigned funds, also known as earned surplus, and the insurer's remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. At year-end 2002, the statutory surplus of Safety Insurance was $234.2 million, and its net income for 2002 was $20.4 million. A maximum of $23.4 million will be available by the end of 2003 for such dividends without prior approval of the Division.
At December 31, 2002 and 2001, investments in fixed maturities had a fair value, which equaled carrying value, of $594.1 million and $507.3 million, respectively. There were no investments in fixed maturities for which a quoted market price or dealer price was not available at December 31, 2002 and 2001, respectively.
The carrying values of cash and cash equivalents and investment income accrued approximates fair value.