In June of 2001, a new Corporate Strategic Plan ("Plan") was announced. The Plan introduced an organization structured around three business units: Standard Commercial Lines, Specialty Commercial Lines, and Personal Lines and established measurable financial targets for each business unit and the Group. During 2001, certain operating results of the Corporation improved. The improvements were a result of renewal price increases, more favorable underwriting results and aggressive expense management. The year also included the tragic events of September 11, 2001, which had an impact on 2001.
The Corporation reported after-tax net income of $98.6 million, or $1.64 per share for the year 2001, compared with a net loss of $79.2 million, or $1.32 per share in 2000, and net income of $114.1 million, or $1.87 per share in 1999.
In the fourth quarter of 2001, a member of the Group, Ohio Casualty of New Jersey, Inc. ("OCNJ"), entered into an agreement to transfer its obligations to renew private passenger auto business in New Jersey. The transaction will allow the Group to stop writing business in the New Jersey private passenger auto market in early 2002. In recent years, the market in New Jersey private passenger auto has become more unstable due to the inability to control either the volume of writings or the profitability. Under the terms of the transaction, the Group member, OCNJ, will pay $40.6 million to a third party to transfer its renewal obligations. The $40.6 million amount was taken as a charge in the fourth quarter of 2001 and will be paid out over the course of twelve months beginning in early 2002. OCNJ may also have a contingent liability of up to $15.6 million to be paid to the transferee company to maintain a maximum premiums-to-surplus ratio of 2.5 to 1
on the transferred business during the next three years. At December 31, 2001, it is not possible to determine the likelihood of the liability and, therefore, it has not been recognized in the financial statements. The transaction is expected to positively impact operating results beginning in 2002.
The 2001 results were also impacted by additions to the Group's asbestos reserves and an early retirement charge. During 2001, loss and loss adjustment expense reserves were strengthened by $10.5 million after-tax for asbestos related claims development. Also in 2001, the Corporation adopted an early retirement plan. Of the approximately 330 employees eligible to retire under the program, 147 accepted. The early retirement plan resulted in a one-time after-tax charge of $4.0 million for the year.
In the first quarter of 2000, the Group made the decision to discontinue its relationship with all of its Managing General Agents. The business written by the Managing General Agents was acquired in the 1998 purchase of the GAI commercial lines division. The result of the decision was a before-tax write-off of $42.2 million to the agent relationships intangible asset, which was recorded on the balance sheet in connection with the GAI purchase. The asset was also written off in 2000 by $3.8 million as a result of additional agent cancellations for a total write-off of $46.0 million for the year. In 2001, the Corporation further wrote off the agent relationships asset by $11.0 million as a result of additional agency cancellations and for certain agents determined to be impaired. The impairment analysis is a critical accounting policy and was based on updated estimated future undiscounted cash flows that were insufficient to recover the carrying amount of the asset for the agent. The determination of impairment involves the use of management estimates and assumptions. Due to the inherent uncertainties and judgments involved in making these assumptions, changes in the valuation of the agent relationship asset could again occur in the future if the underlying estimates change materially.
The Corporation's largest assets are its investments and, therefore, the related accounting policies are considered critical. See further discussion of important investment accounting policies in Note 1C. The Corporation reviews its investment portfolio quarterly to determine if any securities have sustained other than temporary decline in market value. Any loss on a security determined to be impaired is recognized as a realized loss in the current period. The after-tax realized gain (loss) was impacted by the write-down of securities for other than temporary declines in market value by $7.8 million in 2001, $10.9 million in 2000 and $5.3 million in 1999.
In 2001, the Corporation introduced into limited production a new internally developed application for issuing and maintaining insurance policies. The Corporation capitalizes costs incurred to develop certain software used in the Corporation's operations. The cost associated with this application is amortized on a straight-line basis over the estimated useful life of ten years from the date placed into service. Upon full implementation in 2003, the new application should impact results by approximately $4 to $5 million per year in amortization expense until 2012. Although management believes the asset represents its fair value, the useful life of the internally developed software was determined by using certain assumptions and estimates. Inherent changes in these assumptions could result in an immediate impairment to the asset and a corresponding charge to net income.
Net income from discontinued operations amounted to $4.3 million, or $.07 per share in 1999.
The Group's business is geographically concentrated in the Mid-West and Mid-Atlantic regions. The following table shows consolidated net premiums written for the Group's five largest states:
New Jersey is the Group's largest state with 17.4% of the total net premiums written during 2001. In recent years, New Jersey's legislative and regulatory environments have become less favorable to the Group. The state requires insurance companies to accept all risks that meet underwriting guidelines for private passenger automobile. In the fourth quarter of 2001, OCNJ entered into an agreement to transfer its New Jersey private passenger auto renewal obligations to Proformance Insurance Company. This transaction will allow the Group to stop writing business in the New Jersey private passenger auto and personal umbrella markets in early 2002. New Jersey private passenger auto and personal umbrella made up 46.9% of the Group's New Jersey net premiums written in 2001. Excluding the Group's New Jersey private passenger auto and personal umbrella net premiums written, New Jersey would have represented 10.1% of the total all lines net premiums written in 2001. The Group expects to continue writing all of its other lines of business in the state.
The 2001 all lines statutory accident year combined ratio excluding the New Jersey transfer fee was 108.8%, 3.8 points lower than the calendar year results. The loss and loss adjustment expense ("LAE") ratio component of the all lines statutory accident year combined ratio measures losses and claims expenses arising from insured events during the year. The loss and LAE ratio component of the all lines statutory calendar year combined ratio includes loss and LAE payments made during the current year and changes in the provision for future loss and LAE payments. The difference between the statutory accident year and calendar year combined ratios is concentrated in the workers' compensation, homeowners and general liability lines of business.
In June of 2001, the Corporation introduced an organizational structure around three business units: Standard Commercial Lines, Specialty Commercial Lines, and Personal Lines. The Corporation also announced projected 2001 statutory combined ratios for the three business units.
Workers' compensation statutory combined ratio decreased 27.0 points in 2001 to 138.6%, compared with 165.6% and 117.5% for 2000 and 1999, respectively. The statutory loss ratio was the main component driving the high statutory combined ratio. The 2001 statutory loss ratio was
95.8%, compared with 118.8% and 71.9% in 2000 and 1999, respectively. Deterioration in prior year losses due to an increase in claims severity contributed to the poor 2001 results. The 2001 accident year loss ratio of 81.8% was 14.0 points lower than the calendar year loss ratio. The poor results in the workers' compensation line of business in 2000 added 6.8 points to the all lines statutory loss ratio, when including the year-end reserve reallocation mentioned in the All Lines Discussion section.
In response to the deterioration of results, the Group took action in 2000 to begin non-renewing its most unprofitable workers' compensation policies. This business has a loss ratio approximately 10 points higher than the total workers' compensation line of business and is referred to as unsupported workers' compensation as it is the only product in the customer's account. As mentioned in the Operating Results section, the Group also took action to discontinue its relationship with Managing General Agents. These Managing General Agents accounted for $29.0 million in annual workers' compensation premium. These non-renewals and cancellations contributed to a 20.0%, or $37.2 million, decrease in 2001 workers' compensation net premiums written, and a 3.1%, or $5.9 million, decrease in 2000 workers' compensation net premiums written. The Group was able to achieve average renewal price increases for the workers' compensation business of 16.6% and 12.4% for 2001 and 2000, respectively. Net premiums written for 2001, 2000 and 1999 totaled $148.6 million, $185.8 million and $191.7 million, respectively.
Commercial multi-peril ("CMP"), fire & inland marine net premiums written were $275.2 million in 2001, compared with $276.5 million in 2000 and $271.1 million in 1999. The statutory combined ratio decreased to 106.4% in 2001 from 111.1% in 2000 and 127.2% in 1999. The improvement in the line has been a result of implementing renewal price increases and more selective underwriting.
The general liability statutory combined ratio decreased 6.1 points in 2001 to 120.8%, compared with 126.9% in 2000 and 130.8% in 1999. While improvement in underwriting is being shown, the higher than desired loss ratios are attributable to adverse development on prior accident years. The accident year statutory combined ratio for 2001 was 106.8%. The difference between the accident and calendar year results is primarily due to increases in asbestos reserves in 2001 for further development on existing claims outstanding.
Statutory Combined Ratios (by business unit, including selected major lines of business)
The Personal Lines statutory combined ratio for the year 2001 increased 5.7 points to 119.2% in 2001, compared with 113.5% in 2000 and 112.2% in 1999. Excluding the $40.6 million fee related to the New Jersey personal auto transaction, the 2001 statutory combined ratio was 112.9%, a decrease of .6 points from 2000. Excluding the New Jersey transfer fee, the actual 2001 statutory combined ratio was 1.4 points better than the projected 2001 statutory combined ratio of 113.7%.
Private passenger auto - agency net premiums written decreased $10.9 million, or 2.4% to $444.4 million in 2001, compared with $455.3 million in 2000 and $526.5 million in 1999. Selective underwriting and agency cancellations contributed to the decline in premiums in 2001. New Jersey's private passenger auto net premiums written represented approximately 27% of the
Group's total private passenger auto book of business in 2001. New Jersey regulation mandates private passenger automobile insurers in the state to provide insurance to all eligible consumers with limited exceptions. This "take-all-comers" regulation eliminates the Group's ability to control the volume and selection of writings in the state. The statutory combined ratio was 109.1%, excluding the fee related to the transfer of the New Jersey personal auto book in 2001, compared with 110.4% in 2000 and 106.3% in 1999. Poor underwriting results in New Jersey was the primary cause of the poor performance in 2001. The New Jersey results added 4.5 points to the 2001 private passenger auto-agency statutory loss ratio. New Jersey results were driven by regulatory restraints in the state which restrict the insurers' ability to raise rates. In addition, the New Jersey State Senate passed an auto insurance reform bill effective in 1999 that mandated a 15% rate reduction for personal auto policies. This reform bill was based on legal reform intended to provide a reduction in medical expense benefits, limitations on lawsuits and enhanced fraud protection. While the rate reduction was immediate, many of the reforms have not yet been implemented, resulting in inadequate rate levels for the Group.
The Group is implementing price increases in other states, claims management procedures and insurance scoring to improve results. The Group began to rollout insurance scoring in selected states in 2001 and expects this to help improve results by matching prices more closely with anticipated loss experience.
Net cash generated from operations was $70.2 million in 2001, compared with cash generated of $99.6 million in 2000 and cash used of $137.7 million in 1999. The 2001 cash generated reflects the operating results and the reduction in paid losses and paid loss adjustment expenses. The change in 2000 is due in part to payment received in 2000 as part of the commutation of a reinsurance treaty in the fourth quarter of 1999 and a refund of prior year taxes paid. The 1999 cash used primarily resulted from lower operating results and taxes paid. Investing activities used net cash of $57.4 million in 2001, compared with net cash used of $103.5 million in 2000 and net cash generated of $108.1 million in 1999. Total cash used for financing activities was $10.6 million in 2001, compared with $56.0 million in 2000 and total cash used of $125.5 million in 1999. Cash used for financing decreased in 2001 was a result of the elimination of shareholder dividends. Cash used from financing decreased in 2000 from 1999 as a result of the reduction in shareholder dividends and the Corporation's decision not to repurchase any of its shares. Overall, total cash generated in 2001 was $2.2 million, compared with cash used of $59.9 million in 2000 and cash used of $155.0 million in 1999.
The Corporation did not pay any shareholder dividends in 2001, compared with dividend payments of $35.4 million in 2000 and $56.0 million in 1999. The Corporation did not pay shareholder dividends in 2001 as a result of the Corporation's decision to further strengthen the Corporation's financial position.
The following table presents the Corporation's obligations (other than obligations relating to its ordinary insurance operations) to make future payments under contracts, such as debt and lease agreements:
Regularly the Group's financial strength is reviewed by independent rating agencies. These agencies may upgrade, downgrade, or affirm their previous ratings of the Group. On July 25, 2001, A.M. Best announced that its rating of the group of companies is now "A-" (Excellent) from "A" previously. The rating action reflects the sharp deterioration in the Group's earnings and the significant reduction in policyholders' surplus over recent years. A.M. Best stated the "Excellent" rating was due to solid capitalization and strategic initiatives put in place by management to improve earnings. A.M. Best has placed a silent outlook on the Group's rating. On May 7, 2001, Standard & Poor's ("S&P") Rating Services downgraded the Group's financial strength rating. The Group's S&P rating moved from "BBB+" to "BBB". S&P cited operating performance, declining capitalization, and limited financial flexibility as reasons for the rating change. S&P recognized the Group's improved strategic focus and re- underwriting actions as positive attributes. S&P has placed a negative outlook on the Group's rating. On May 2, 2001, Moody's Investors Services affirmed the Group's "A2" rating based on new executive leadership, ongoing expense reduction and re-underwriting initiatives, reduction or elimination of its shareholder dividends, and strength of its independent agency relationships. Moody's has revised the outlook for the Group's rating from negative to stable.
The ratio of premiums written to statutory surplus is one of the measures used by insurance regulators to gauge the financial strength of an insurance company and indicates the ability of the Group to grow by writing additional business. At December 31, 2001, the Group's premiums written to surplus ratio is 1.9 to 1. The ratio was 1.9 to 1 and 1.8 to 1 in 2000 and 1999, respectively.
Reinsurance is a contract by which one insurer, called a reinsurer, agrees to cover, under certain defined circumstances, a portion of the losses incurred by a primary insurer in the event a claim is made under a policy issued by the primary insurer. The Group purchases reinsurance to protect against large or catastrophic losses. There are several programs that provide reinsurance coverage.
The property catastrophe reinsurance program protects the Group against an accumulation of losses arising from one defined catastrophic occurrence or series of events. This program provides $150.0 million of coverage in excess of the Group's $25.0 million retention level. In 2001, a portion of the catastrophe program was renewed with a multi-year placement as in previous years. This provides continuity and maintains rates and each reinsurer's overall share of the program. Over the last 20 years, two events triggered coverage under the catastrophe reinsurance program. Losses and loss adjustment expenses from the Oakland fires in 1991 totaled $35.6 million and losses and loss adjustment expenses from Hurricane Andrew in 1992 totaled $29.8 million. Both of these losses exceeded the prior retention amount of $13.0 million, resulting in significant recoveries from reinsurers. Reinsurance limits are purchased to cover exposure to catastrophic events having the probability of occurring every 150-250 years.
Reinsurance contracts do not relieve the Group of their obligations to policyholders. The collectibility of reinsurance depends on the solvency of the reinsurers at the time any claims are presented. The Group monitors each reinsurer's financial health and claims settlement performance because reinsurance protection is an important component of the Corporation's financial plan. Each year, the Group reviews financial statements and calculates various ratios used to identify reinsurers who no longer meet appropriate standards of financial strength. Reinsurers who fail these tests are removed from the program at renewal. Additionally, a large base of reinsurers is utilized to mitigate concentration of risk. During the last three fiscal years, no reinsurer accounted for more than 15% of total ceded premiums. As a result of these controls, amounts of uncollectible reinsurance have not been significant.
Construction defect claims filed under general liability insurance policies involve allegations of defective work on construction projects, such as condominiums, apartment complexes, housing developments, and office buildings. These claims usually involve multiple parties and carriers.
In 1998, the Administrative Law Judge issued a proposed ruling with a rollback liability of $24.4 million plus interest. The Group established a contingent liability for the Proposition 103 rollback of $24.4 million plus simple interest at 10% from May 8, 1989. This brought the total reserve to $52.3 million at September 30, 2000. On October 25, 2000, the Group announced a settlement agreement for California Proposition 103 that was approved by the Commissioner of Insurance of the state of California. Under the terms of the settlement, the members of the Group agreed to pay $17.5 million in refund premiums to eligible 1989 California policyholders. With this development, the total reserve was decreased to $17.5 million as of December 31, 2000. This decrease in the reserve resulted in an increase in operating income and net income in 2000, but had no effect on the statutory combined ratio reported. The Group began to make payments in the first quarter of 2001. The remaining liability was $7.8 million as of December 31, 2001.
To date, the Group has paid approximately $5.7 million in legal costs related to the California withdrawal and Proposition 103.
At year-end 2001, consolidated investments had a carrying value of $3.3 billion. The excess of market value over cost was $420.9 million, compared with $629.4 million at year-end 2000 and $505.4 million at year-end 1999. The decrease in 2001 was largely due to the recognition of realized gains in connection with the sale of appreciated equity securities in the 2001 equity portfolio reallocation. The 2000 increase was due to market growth in both the fixed income and equity portfolios, while a 1999 decrease in unrealized gains was largely attributable to the Group's reallocation of its investment portfolio mentioned in the Investment Results section.
As of December 31, 2001, the Group held $1,107.8 million in mortgage-backed securities, compared with $1,124.0 million and $784.3 million at December 31, 2000 and 1999, respectively. The increase from December 31, 1999 is attributable to a redistribution of investments previously held in tax exempt bonds and the 2001 and 1999 reallocations mentioned above. The majority of
mortgage-backed security holdings are less volatile planned amortization class, sequential structures and agency pass-through securities. Of this portfolio, $10.0 million, $13.1 million and $19.3 million were invested in more volatile bond classes (e.g. interest-only, super-floaters, inverses) in 2001, 2000 and 1999, respectively.
At year-end 2001, consolidated equity investments had a market value of $489.0 million. Equity investments have decreased as a percentage of the consolidated portfolio from 22.0% in 1999 to 14.7% at year-end 2001. This decrease is attributable to the 2001 reallocation of the Group's investment portfolio.
See discussion in Note 22, New Accounting Standards, in the Notes to Consolidated Financial Statements on page 61 of this Form 10-K.
The risks and uncertainties that may affect the operations, performance, development and results of the Corporation's business, include the following: changes in property and casualty reserves; catastrophe losses; premium and investment growth; product pricing environment; availability of credit; changes in government regulation; performance of financial markets; fluctuations in interest rates; availability and pricing of reinsurance; litigation and administrative proceedings; acts of war and terrorist activities; rating agency actions; ability of Ohio Casualty to retain the business acquired from the Great American Insurance Company; ability to achieve targeted expense savings; ability to refinance indebtedness; ability to achieve premium targets and profitability goals; ability to implement major software applications; and general economic and market conditions.