In April 1998, the Company signed an agreement to become the primary tenant of the new 20th Century Plaza project to be completed in late 1999. As part of its goal to maintain centralized operations, five of the Company's outlying offices will be incorporated into the 20th Century Plaza. The project includes the construction of a second office building and a parking structure.
(1) For 1996, excludes $29.2 million, net of commissions, in homeowners unearned premiums ceded to reinsurers in July 1996. (2) Equity adjusted to exclude unrealized investment gains.
With its strong financial position restored, the Company has positioned itself for renewed and profitable growth. Additionally, the Company's direct exposure to future earthquake events was substantially eliminated in 1995. The Company maintains full insurance protection against its only significant remaining catastrophe exposure in the homeowners line, primarily relating to potential wild fires and fire following an earthquake event.
Units in Force Units in force for the Company's insurance programs as of December 31 were as follows (excluding 15,541, 10,853 and 3,006 in 1998, 1997 and 1996, respectively, of vehicles insured by 20th Century Insurance Company of Arizona):
PUP. The penetration of this coverage has averaged about 1% of the vehicles in force during each of the three years ended December 31, 1998.
Automobile insurance is the primary line of business written by the Company and has been consistently profitable. The majority of the Company's insured autos are located in southern California. However, the Company continues to expand its coverage throughout the state by aggressively marketing its business in northern California and San Diego County, which accounted for approximately 43% of all new business written in 1998.
The auto line experienced a $120.4 million underwriting profit in 1998 compared to $135.6 million and $81 million in 1997 and 1996, respectively, as adjusted for the effects of nonrecurring costs. These results were achieved despite increased competition and the effects of premium rate reductions of 3.2% and 3.4% effective October 31, 1997, and January 1, 1998, respectively. Favorable loss trends contributed to the solid underwriting results in all three years. However, underwriting results for 1998 fell below the 1997 level primarily due to an increase in claims frequency that emerged principally in the fourth quarter and the rate decreases mentioned previously.
The 1998 decrease in gross premiums written reflects the 5.0% increase in insured units coupled with the effect of the premium rate reductions mentioned above. The 1997 decrease in gross premiums written
Including a first quarter 1999 rate reduction of 6.8%, the Company has reduced average California auto premiums by more than 25% since 1996. Although the reduction in premium revenues produced lower top-line and investment income growth, underwriting margins continue to be favorable.
Underwriting results for this program are subject to variability caused by weather-related claims and by infrequent disasters. In 1998, 1997 and 1996, no significant losses were incurred.
The Company's policy acquisition and general operating expense ratio continues to be among the most competitive in the industry. As a direct writer, the Company does not incur agent commissions and, thus, enjoys an expense advantage over most of its competitors. The ratio of underwriting expenses (excluding interest and fees) to earned premiums was 10.2% in 1998, 9.4% in 1997 and 9.3% in 1996. Excluding non-recurring charges (accelerated amortization of restricted stock grants of $2.0 million in 1998 and "Year 2000" ("Y2K") costs of $5.7 million and $1.5 million in 1998 and 1997, respectively), the expense ratios remained relatively flat at 9.2% in 1998 and 1997 and 9.3% in 1996 despite a decline in premiums earned and an increase in marketing expenses.
The Y2K problem arose because some computer programs and hardware utilize two digits rather than four to define the applicable year. As a result, these systems, programs and hardware ("Information Technology systems" or "IT systems") may not calculate dates beyond 1999, which may cause errors or system failures. In addition, today's business environment contains many non-IT systems, ranging from elevators to automobiles, which utilize microprocessors, and these devices are also potentially susceptible to the same or similar types of date problems.
The following discussion summarizes the Company's state of readiness, costs to address its Y2K issues, the risks inherent in these issues, and the Company's contingency plans.
State of Readiness The Company has taken what it believes is a comprehensive approach to remediating its Y2K issues, as summarized in the following table:
The Company plans to complete its compliance testing of all critical components in the summer of 1999.
Y2K Remediation Costs The total Year 2000 project cost is estimated to be approximately $8.9 million, which is being expensed as incurred. Approximately one third of that amount represents the direct cost of personnel in the Company's Information Services department who have been dedicated to this project, with most of the remainder representing external consultants. Costs incurred during 1998 were approximately $5.7 million, compared to $1.5 million for 1997.
Realized capital gains on the sales of investments increased to $22.6 million for 1998 compared to $4.1 million and $7.3 million for 1997 and 1996, respectively. The 1998 increase in realized gains is primarily due to the Company's decision to begin switching its investment portfolio from taxable to nontaxable securities during 1998 in anticipation of fully utilizing its remaining net operating loss deduction in 1999. At December 31, 1998, $141.4 million of the Company's total investments at fair value was invested in tax-exempt bonds with the balance representing 86.8% of the portfolio invested in taxable securities compared to 97.7% at December 31, 1997.
As of December 31, 1998, the Company had a pre-tax unrealized gain on fixed maturity investments of $34.9 million compared to $29.7 million in 1997 and $3.7 million in 1996. Interest rates fell in 1998 and 1997 which increased the fair value of the bond portfolio for those years.
The Company has historically written its core business at an underwriting profit and thus each premium dollar generates a positive cash flow. A significant part of the decline in 1996 and subsequent increase in cash flow from operations in 1997 and 1998 is due to the fall and rise, respectively, in the size of the net book of business during these periods. In 1996, approximately $29.2 million of the $32.5 million net decrease in cash and cash equivalents was related to the portfolio transfer of unearned premiums on homeowners business.
Funds required by 20th Century Industries to pay dividends and meet its debt obligations are provided by the insurance subsidiaries. Information regarding the Company's debt service obligation is included in Note 9 of the Notes to Consolidated Financial Statements. The ability of the insurance subsidiaries to pay dividends to the parent company is regulated by state law. Based on the operating results in 1996 and the favorable ratio of premiums to surplus, the Company was able to resume normal dividends from the insurance subsidiaries in 1996 to service the parent's debt and dividend requirements. Based upon 1998 operating results and earned surplus as of December 31, 1998, the Company believes it will not require regulatory approval in 1999 for any extraordinary dividends.
In 1997, the Company embarked on a major project to upgrade its technological infrastructure and to conform certain of its procedures to "industry best practices." Although the ultimate cost of this project is not yet determinable, management believes cash flow from operations as well as expected improvements in operational efficiencies will be more than adequate to fund the project's implementation which is expected to be completed over the next several years.
The Company leases its Home Office building in Woodland Hills, California, which contains approximately 230,000 square feet of leasable office space. The current lease expires in 2014 and may be renewed for two consecutive five-year periods.
the following: (a) the intensity of competition from other companies in the insurance industry; (b) the Company's experience with respect to persistency and claims experience; (c) the Company's ability to distribute and administer competitive services in a timely, cost-effective manner; (d) the Company's visibility in the market place and its financial and claims-paying ratings; (e) the effect of changes in laws and regulations affecting the Company's business, including changes in tax laws affecting insurance products; (f) market risks related to interest rates; (g) the Company's ability to develop information technology and management information systems to support strategic goals while continuing to control costs and expenses; (h) the costs of defending litigation and the risk of unanticipated material adverse outcomes in such litigation; (i) changes in accounting and reporting practices; and (j) the Company's access to adequate financing to support its future business. The Company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. For additional information, refer to the Company's filings with the Securities and Exchange Commission.
We have audited the accompanying consolidated balance sheets of 20th Century Industries and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of 20th Century Industries and subsidiaries at December 31, 1998 and 1997, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
20TH CENTURY INDUSTRIES AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998
20th Century Industries, through its wholly owned subsidiaries, 20th Century Insurance Company and 21st Century Casualty Company (collectively, the "Company"), is engaged in the sale of private passenger automobile insurance policies in California, Nevada, Oregon and Washington and homeowners and personal umbrella insurance policies in California. At this time, almost all of the Company's business is concentrated in California. The Company also provides private passenger automobile insurance in Arizona through a joint venture with American International Group, Inc. ("AIG"), which owned a majority of the Company's outstanding common stock at December 31, 1998. An order from the California Department of Insurance ("CDOI") has prohibited the Company from writing any new homeowners policies since June 1994, and beginning in July 1996, the Company was required to begin non-renewing these policies. Effective February 15, 1997, the CDOI allowed the Company to resume renewing its remaining homeowners policies.
The Company classifies its investment portfolio as available-for-sale and carries it at fair value with unrealized gains and losses, net of any tax effect, reported as accumulated other comprehensive income in a separate component of stockholders' equity.
reasonable and acceptable range of adequacy. The methods of making such estimates and for establishing the resulting reserves are reviewed and updated quarterly and any adjustments resulting therefrom are reflected in current earnings.
Details follow concerning the change in the after-tax net unrealized gain on investments for 1998, 1997, and 1996, which is included in the accumulated other comprehensive income in the consolidated balance sheets:
The Company also sponsors an unfunded supplemental executive retirement plan which covers certain key employees designated by the Board of Directors. The supplemental plan benefits are based on years of service and compensation during the last three years of employment, and are reduced by the benefit payable from the pension plan.
The Company sponsors a contributory savings and security plan for eligible employees. The Company provides matching contributions equal to 75% of the lesser of 6% of an employee's compensation or the amount contributed by the employee. Contributions charged against operations were $2,728,000, $2,697,000 and $2,556,000 in 1998, 1997 and 1996, respectively.
The following table provides a reconciliation of the beginning and ending liability for unpaid losses and loss adjustment expenses ("LAE"):
In April 1998, the Company signed an agreement to become the primary tenant of a new office tower adjacent to its headquarters to be completed in late 1999. The new building will nearly double the size of its current facility to total almost 500,000 square feet. This lease expires in November 2014 and may be renewed for two consecutive five-year periods.
The Company's insurance subsidiaries are subject to restriction as to the amount of dividends which may be paid to the parent company within any one year without the approval of the California Department of Insurance ("CDOI"). The California Insurance Code provides that amounts may be paid as dividends from earned surplus on an annual, noncumulative basis, without prior approval by the CDOI, up to the greater of (1) net income for the preceding year, or (2) 10% of statutory surplus as regards policyholders as of the preceding December 31. Earned surplus available for dividends as of December 31, 1998 was approximately $228.7 million.
The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25") and related Interpretations in accounting for its stock-based compensation. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. Also, under APB 25, the fair value of stock grants made under the Restricted Shares Plan is amortized to expense over the vesting period of the grants. This accounting treatment results in compensation expense being recorded in a manner consistent with that required under SFAS No. 123, Accounting for Stock-Based Compensation, and, therefore, pro forma net income and earnings per share amounts would be unchanged from those reported in the financial statements. SFAS No. 123 requires disclosure of the pro forma net income and earnings per share as if the Company had accounted for its employee stock compensation under the fair value method of that Statement.
The aggregate number of common shares issued and issuable under the Plan currently is limited to 4,000,000. At December 31, 1998, 2,219,250 common shares remain available for future grants. All options granted have ten year terms. As a consequence of AIG's acquiring a controlling interest in the Company, vesting was accelerated for all options granted as of July 27, 1998. Options granted after July 27, 1998, vest over various future periods.
Exercise prices for options outstanding at December 31, 1998 ranged from $12.50 to $29.25. The weighted-average remaining contractual life of those options is 8.3 years.
The Restricted Shares Plan currently provides for grants of up to 921,920 shares of common stock to be made available to key employees as determined by the Key Employee Incentive Committee of the Board of Directors. The common shares granted are restricted. Restrictions are removed on 20% of the shares of each employee on January 1 of each of the five years following the year of grant. Upon issuance of grants of common shares under the plan, unearned compensation equivalent to the market value on the date of grant is charged to common stock and subsequently amortized in equal monthly installments over the five-year vesting period of the grant. As a consequence of AIG's acquiring a controlling interest in the Company, the previously unamortized balance of $2,280,000 was recognized as a charge to income as of July 27, 1998. Total amortization
A summary of grants under the plan from 1996 through 1998 follows:
The Northridge Earthquake, which occurred on January 17, 1994, significantly affected the operating results and the financial position of the Company. Provisions charged to income for this event amounted to $40 million, $24.75 million and $40 million in 1998, 1997 and 1996, respectively.
The quarterly earnings per share amounts do not necessarily add to annual amounts due to the changing dilutive effect of common stock equivalents as the price of the common stock fluctuates.
Additional Northridge Earthquake reserves of $40 million were recorded in the fourth quarter of 1998. The second and fourth quarters of 1997 were also impacted by additional reserves of $6.75 million and $18 million, respectively, related to the 1994 Northridge Earthquake.
AUTO. The $21.4 million decrease in underwriting profit in 1998 compared to 1997 resulted from increased competition, an increase in claims frequency that emerged principally in the 1998 fourth quarter, and premium rate reductions of 3.2% and 3.4% effective October 31, 1997, and January 1, 1998, respectively. In addition, non-recurring costs for accelerated amortization of restricted stock grants of $2.0 million were recorded in 1998 as well as Year 2000 costs of $5.7 million and $1.5 million in 1998 and 1997, respectively. The $53.1 million increase in underwriting profit in 1997 compared to 1996 was largely the result of growth in the number of vehicles in force, relatively dry weather, and a continued strong decline in claim frequencies and severities.