We conduct our operations for our property and casualty - Massachusetts segment from approximately 436,000 square feet of space in several buildings that we own in Webster, Massachusetts, which is located approximately 50 miles southwest of Boston. Our data processing and operational departments are housed in modern office buildings. Our property and casualty - Other than Massachusetts segment consists primarily of the operations of Commerce West, State-Wide and American Commerce. Commerce West currently leases approximately 22,000 square feet of office space in Pleasanton, California. American Commerce conducts its operations from approximately 40,000 square feet of space in a building it owns located on a two acre site in Columbus, Ohio. American Commerce also leases property at three district claims offices. State-Wide conducts its operations from approximately 24,000 square feet of space in a building it owns in Hempstead, New York.
requiring personal automobile insurers to issue a policy to any eligible applicant who seeks one, known as the "take-all-comers" requirement,
fixing maximum personal automobile rates, which has the effect of keeping premiums artificially low on specific high risk segments of the market, such as urban and youthful drivers, effectively imposing higher premiums on lower risk segments,
apportioning losses incurred by the state-mandated residual market run by CAR,
Since 1977, the Commissioner has chosen to fix-and-establish private passenger motor vehicle insurance rates for the entire industry on an annual basis. On July 16, 2007, the Massachusetts Division of Insurance issued its Opinion, Findings and Decision on the Operation of Competition in Private Passenger Motor Vehicle Insurance in 2008, in which it determined that competition in the Massachusetts private passenger motor vehicle insurance market was sufficient such that the Commissioner cannot fix-and-establish rates for 2008. Accordingly, effective April 1, 2008, each insurer is permitted to file and use its own rates subject to disapproval by the Commissioner.
A significant aspect of our automobile insurance business relates to our interaction with CAR. CAR enables Commerce and the other participating insurers to reinsure any personal automobile risk that the insurer perceives to be under-priced. CAR is responsible for the administration of the personal and commercial automobile reinsurance mechanisms in Massachusetts. Participating insurers, which are responsible for over 99% of total direct premiums written for personal automobile insurance in Massachusetts, are required to offer automobile insurance coverage to all eligible applicants pursuant to a "take-all-comers" requirement, but may reinsure under-priced business with CAR. In addition, participating insurers are obligated to accept private passenger ERPs from CAR and to provide a private passenger automobile insurance market in Massachusetts for those agencies. ERP assignments occur by line of business and may apply to personal automobile only, commercial automobile only or both lines.
CAR maintains separate pools for personal and commercial automobile risks. All companies writing automobile insurance in Massachusetts share in the underwriting results of CAR business for their respective product line or lines, whether or not they are servicing carriers. CAR has annually generated underwriting losses, primarily in the personal automobile pool. Accordingly, each automobile insurer attempts to develop and implement underwriting strategies that will minimize its relative share of the CAR results while maintaining acceptable loss ratios on risks not reinsured through CAR. The gap between our personal automobile market share and participation ratio has increased from 4.2% for 2006 to 5.9% for 2007.
Although mandated average personal automobile premium rates decreased 11.7% in 2007, our average written premium per exposure decreased only 5.7%. We believe that the smaller decrease for 2007 as compared to the Commissioner's state mandated average rate resulted primarily from:
the fact that our mix of personal automobile coverage differs from that of the industry;
changes to our distribution of risks by class, territory and coverage, including changes resulting from the purchase of new, more expensive automobiles, which were not factored into the Commissioner's rate decrease; and
the state mandated rate decrease was only effective for the last three quarters of 2007.
The preparation of financial statements in conformity with accounting principals generally accepted in the United States of America (GAAP) requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We consider the following accounting estimates, which are especially dependent upon our judgments and assumptions, to be critical to the preparation of our financial statements.
Salvage and subrogation reserves are established in a similar manner to IBNR except that we track actual historical salvage and subrogation receipts as a percentage of loss incurred. In addition, we establish LAE reserves by tracking historical expenses as a percentage of incurred losses.
Our financial management personnel calculate our financial statement loss and LAE reserves independently from those amounts calculated by our actuaries. Our financial management personnel establish our financial statement loss and LAE reserves primarily by reviewing historical loss and LAE data, focusing mainly on payment data. This method of using historical loss payments over discrete periods of time to estimate future losses assumes that the ratio of losses paid in one period to losses paid in an earlier period will remain consistent. This method necessarily assumes that factors that have affected paid losses in the past, such as inflation or the effects of litigation, will remain consistent in the future. Although we review trends for inflation, severity and the effects of litigation, these factors have not caused us to materially modify our loss and LAE reserves. Historical paid loss development methods do not use case reserves to estimate ultimate losses and can be more reliable than the other methods that look to case reserves (such as actuarial methods that use incurred losses) in situations where there are significant changes in how case reserves are established by a company's claims adjusters. However, historical paid loss development methods are more leveraged (meaning that small changes in payments have a larger impact on estimates of ultimate losses) than actuarial methods that use incurred losses because cumulative loss payments take much longer to equal the expected ultimate losses than cumulative incurred amounts. In addition, and for similar reasons, historical paid loss development methods are often slow to react to situations when new or different factors arise than those that have affected paid losses in the past. Because of the nature of our business and the consistent manner in claims settlement, we believe the use of historical payment patterns provides us the most appropriate method for establishing our reserve
We also review and compare the most recent loss frequency, severity, and payment data to historical trends in an attempt to determine if patterns are remaining consistent or not. We believe they remain consistent. We record our best estimate of the ultimate losses and LAE that we will incur to settle all claims and IBNR at each reporting date, but the actual amount of such losses and LAE cannot be known until all claims are settled. Our financial statement loss and LAE reserves net of reinsurance (prior to the effect of ceded insurance recoverable), based on our best estimate, were established at $904,282 for December 31, 2007.
This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no reasonably precise method, however, for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors, as noted above.
The following sensitivity analysis presents the pro forma effect of a 6.4 and 11.4 percentage point redundancy change in our loss and LAE reserves (prior to the effect of ceded reinsurance recoverable) at December 31, 2007:
The business we assume from CAR is a significant component of our loss and LAE reserves. Our assumed CAR loss and LAE reserves amounted to approximately 10% of our loss and LAE reserves at December 31, 2007 (prior to the effect of ceded reinsurance recoverable). CAR provides information to pool participants on a quarterly basis, one quarter in arrears. CAR provides consolidated results, which consist of all companies' ceded business into the pool, as well as information specific to our company. CAR provides information by line of business on policy year and accident year bases. This information consists of premiums written, unearned premium, earned premium, paid losses, case reserves, IBNR reserves, incurred losses, incurred loss adjustment expenses and underwriting expenses. The starting point for CAR's determination of its loss and LAE reserves is the separate loss and LAE reserves that CAR member companies provide to CAR. CAR then aggregates this information, which is reviewed by CAR's loss reserve committee, comprised of actuaries from member companies. This CAR actuarial committee establishes the total loss and LAE reserves for a given period. Our share of these loss and LAE reserves is derived by multiplying our participation ratio by the total CAR loss and LAE reserves. Management utilizes the information provided by CAR to book the initial amount related to the pool. The consolidated financial results produced by CAR are audited by independent public accountants and we rely on this audit for the incorporation of their reported results into our financial statements. CAR assesses the integrity of premium and claim data submissions by member companies by periodically auditing those member companies. Our actuary also reviews the CAR actuarial committee's work along with total CAR and company loss results for reasonableness.
The hypothetical changes noted above are based on historical experience. Conditions and trends that have affected development of reserves in the past may not necessarily occur in the future. Accordingly, it is not appropriate to extrapolate future development based on the preceding table. We believe that any additional payments due as a result of the inherent uncertainty of establishing loss and LAE reserves would be adequately met by our normal operating cash flow.
Investments and Other-than-Temporary Impairments. The carrying values of investments in fixed maturities, which include taxable and non-taxable bonds, and investments in common and preferred stocks, are derived from market prices supplied by our investment custodian or, when no price is provided by the custodian, from a third party valuation. Fair market value of fixed maturities and equity securities is based on quoted market prices. Unrealized investment gains and losses on common and preferred stocks and fixed maturities, to the extent that there is no other-than-temporary impairment of value, are credited or charged, net of any tax effect, to a separate component of stockholders' equity, known as "net accumulated other comprehensive income (loss)," until realized.
We review all securities that have been at a continuous loss position for 36 months or more, if the loss exceeds $30.
We will consider other-than-temporary the impairment of any security which we do not intend to hold to maturity or full recovery.
the portion of our premiums that is ceded to CAR and other reinsurers, which we refer to as ceded premiums, and
direct and assumed incurred losses and loss adjustment expenses (which we sometimes refer to as LAE), including estimates for losses incurred during the period but not yet reported to us and changes in estimates from prior periods related to direct and assumed business, less the portion of those incurred losses and loss adjustment expenses that are ceded to other insurers; and
We evaluate our operations by monitoring key measures of growth and profitability. We measure our growth by examining our direct premiums written as well as increases in exposures and policies. We generally measure our operating results in accordance with GAAP by examining our net earnings, return on equity (ROE), and our loss and LAE, underwriting expense and combined ratios on a consolidated basis. Our key measures include:
The loss and LAE ratio is the percentage of losses and loss adjustment expenses (including corporate expenses) incurred to earned premiums. We calculate this ratio net of our reinsurance recoveries. We use this ratio as a measure of the overall underwriting profitability of the insurance business we write and to assess the adequacy of our pricing for product lines and states with competitively set premiums.
The combined ratio is the sum of the loss and LAE ratio and the underwriting expense ratio and measures a company's overall underwriting profit. If the combined ratio is at or above 100%, an insurance company cannot be profitable without investment income, and may not be profitable if investment income is insufficient. We use the combined ratio in evaluating our overall underwriting profitability and for comparing our profitability to that of our competitors. We generally seek to achieve a combined ratio of less than 100%.
The decrease in earnings in 2007 over 2006 resulted primarily from an increase in our combined ratio in 2007 and net realized investment losses of $26,308 in 2007 as compared to gains of $16,643 in the prior year. The increase in the combined ratio can be attributed to increases in both the loss ratio and the underwriting ratio. Also impacting 2007 net earnings was a $16,233 increase in net investment income.
We attribute the increase in the loss ratio to several factors:
The increase in the underwriting ratio resulted primarily from reduced ceded reinsurance commissions, as a result of the termination of our other-than-automobile quota share agreement at June 30, 2006 and increased agent commissions as a percentage of written premium due to the April 1, 2007 Massachusetts state mandated rate decrease, partially offset by a decline in agents' profit sharing expense.
Total direct written premiums for the other-than-Massachusetts segment increased $41,611, or 17.9%. The personal automobile increase accounted for the majority of this change, primarily as the result of $25,432 of direct written premium generated at State-Wide, our second quarter acquisition. In addition, both ACIC and Commerce West increased personal automobile written premiums. At ACIC, private passenger written premiums increased $6,426, or 5.5%, due to a combination of increased in-force policies and increased average written premium per policy. At Commerce West, direct written premiums increased $5,707, or 10.2%, due to increased policy counts. Homeowners increased $3,133, or 7.3%, due to both increases in in-force policies and average written premium. Other lines increased $1,141 primarily due to an increase in direct premiums from ANI as a result of an increase in ACIC's participation percentage in ANI business.
Revenue decreased $25,094, or 1.5%, over the prior year primarily due to decreased net realized investment gains partially offset by increased net investment income. Net realized investment losses occurred primarily in the fourth quarter as a result of severe credit market declines, especially in the preferred stock segment. Net investment income increased as both outstanding invested assets and the yield on those assets increased.
Revenues increased $61,445, or 27.9%, over the prior year principally due to $41,902 of revenue from State-Wide, which was acquired during the second quarter of 2007. In addition, direct earned premiums at Commerce West increased $10,185 but were offset by a decline of $12,414 in direct earned premiums at ACIC. Increases in net investment income were partially offset by declines in realized investment gains.
Earnings declined $25,895, or 87.9%, over the previous year due to an increased combined ratio, resulting from the same factors for the Company as a whole. The combined ratio for this segment increased to 107.3% for 2007 from 91.1% for 2006. The increase in the combined ratio resulted primarily from the $10,300 second quarter reserve addition at State-Wide, combined with adverse weather in a number of states outside of Massachusetts.
Our net investment income for the year ended 2007 increased $16,233, or 11.3% compared to 2006. Net investment income is affected by the composition of our investment portfolio and yields on those investments.
The 2007 net realized investment losses were largely the result of other-than-temporary impairment writedowns and sales of securities that experienced declines in market value specifically in preferred stocks of entities that operate in the housing, mortgage and financial markets. During the fourth quarter of 2007, $45,241 of losses were realized from the sales or other-than-temporary impairment writedowns on several preferred stocks. In addition, losses of $9,925 for the fourth quarter and $12,872 for the year 2007 were realized for our equity in losses of our preferred stock mutual fund, which invests primarily in preferred stocks.
additional reserves of $10,300 during the second quarter of 2007 at State-Wide, our second quarter acquisition; and
As a result of changes in estimates of insured events in prior years, the provision for loss and LAE decreased $54,621 for the year ended 2007 and $43,726 for the year ended 2006. The favorable development is due primarily to lower than anticipated losses related to the personal automobile liability. Conditions and trends that have affected development in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based upon these developments. The amounts we will ultimately incur from loss and loss adjustment expenses could differ materially in the near term from the amounts recorded.
Approximately $46,792 in personal automobile liability redundancies developed for the year ended 2007, with 96% of this amount coming from the 2006, 2005 and 2004 accident years. The primary reason for the redundancies in this area is that claim severity developed better than we anticipated, coupled with significant redundancies from CAR, which approximated 27% of the total automobile liability redundancy. Automobile physical damage had approximately $1,075 in redundancies, primarily related to the 2006 accident year, which were partially offset by deficiencies in prior years. Redundancies related to 2006 were approximately $2,813, of which all was CAR related. Commercial automobile liability had approximately $4,799 in redundancies, primarily related to the 2006 and 2005 accident years. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining net redundancy of approximately $1,955.
The market price for our common stock and our financial results directly affects our expense related to stock options, non-vested equity share units (RSUs), book value awards (BVAs) and incentive awards (IAs), respectively. Our stock option expense represents options granted to employees, directors and American Commerce agents. The majority of this expense is related to options granted to American Commerce agents. An increase in the market value of our stock will increase the expense we recognize for options. Similarly, an increase in our net income will increase the value of, and therefore the expense we recognize for, outstanding BVAs and IAs. We record these expenses in three separate line items on our income statement - losses and loss adjustment expenses, policy acquisition costs and net investment income. See Note H of Notes to Consolidated Financial Statements for further information. The stock option, BVA, IA and RSU expenses recorded in each line item for the years ended December 31 follow:
In December 2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 141 (revised 2007), Business Combinations. SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. SFAS 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS 141R is effective as of the beginning of an entity's fiscal year that begins after December 15, 2008, and will be adopted by us on January 1, 2009. We are currently evaluating the potential impact, if any, of the adoption of SFAS 141R on our consolidated results of operations and financial conditions.
In September 2006, the FASB also issued Statement No. 157, Fair Value Measurements (FAS 157). The Statement defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. FAS 157 does not require any new fair value measurements but applies under other financial pronouncements that permit or require fair value measurements. FAS 157 is effective for fiscal years beginning after November 15, 2007 and early application is encouraged. We do not expect the adoption of this Statement to have a material impact on our results of operations or financial position.
In March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets, an amendment of Statement No. 14 (FAS 156). FAS 156 requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable, and permits an entity to subsequently measure those servicing assets and servicing liabilities at fair value. FAS 156 is effective for fiscal years beginning after September 15, 2006. The adoption of FAS 156 on January 1, 2007 did not have a material impact on our results of operations or financial position.
continued improvement in the results from CAR due to fewer industry-wide cessions to CAR coupled with lower loss ratio on current year CAR business; and
partially offset by reduced favorable voluntary reserve development compared to 2005.
For a detailed breakdown on direct premiums written and earned, see Note P - Segment Information in Notes to Consolidated Financial Statements.
Our net investment income for the year ended 2006 increased $20,352, or 16.5% compared to 2005. Net investment income is affected by the composition of our investment portfolio and yields on those investments.
The market price for our common stock and our financial results directly affects our expense related to stock options, book value awards (BVAs) and incentive awards (IAs), respectively. Our stock option expense represents options granted to both employees and American Commerce agents. The majority of this expense is related to options granted to American Commerce agents. An increase in the market value of our stock will increase the expense we recognize for options. Similarly, an increase in our net income will increase the value of, and therefore the expense we recognize for, outstanding BVAs and IAs. We record these expenses in three separate line items on our income statement - losses and loss adjustment expenses, policy acquisition costs and net investment income. See Note I of Notes to Consolidated Financial Statements for further information. The stock option, BVA and IA expenses recorded in each line item for the years ended December 31 follow:
Our stockholders' equity per share decreased 2.9% from $22.53 at December 31, 2006 to $21.87 at December 31, 2007. The decrease in equity resulted primarily from $223,365 of treasury stock purchases and a decline in the value of available-for-sale securities. Partially offsetting the decline in equity per share was a decline in outstanding common shares to 60.2 million from 66.7 million. Our ratio of total liabilities to stockholders' equity increased 23 percentage points at December 31, 2007 from the prior year end. This increase is due to the decrease in equity.
Total assets decreased $196,764, or 4.8%, versus the prior year end. A decline in investment securities represented the majority of the decrease. Investments and cash decreased $230,499, or 7.5%, from cash outflows resulting from treasury stock repurchases and the State-Wide purchase, in addition to the declines in market value of our available-for-sale portfolio. We continue to maintain our cash and fixed maturity investments at levels to both service our liabilities and optimize after-tax returns. Our deferred income tax asset increased primarily due to the deferred tax asset which results from the decrease in market value under the cost of available-for-sale securities.
Unpaid losses and LAE reserves net of ceded reinsurance recoverable, by line of business and the actuarial low and high range estimates at December 31, 2007 follow (in millions):
The liability for unpaid losses and LAE represents the accumulation of individual case estimates for reported losses, adjustments to this amount on a line of business basis and estimates for incurred but not reported losses and LAE, net of salvage and subrogation recoverable. The liability is intended to cover the ultimate net cost of all losses and LAE incurred through the balance sheet date. Payment amounts are estimated, based on payment patterns experienced through 2007.
We have a commitment in a venture capital fund. This investment is made in a limited partnership and our exposure to loss is limited to our actual investment. Our participation required a commitment to invest up to $50,000 into the partnership. At December 31, 2007, we have a remaining commitment of $1,440. The partnership was formed for the purpose of making investments primarily in equity, equity-related and other securities issued in expansion financing, start-ups, buy-outs and recapitalization transactions relating to companies in the areas of insurance, financial services, e-commerce, healthcare, and related businesses, including, without limitation, service and technology enterprises supporting such businesses.
Liquidity management allows us to meet our cash needs at a reasonable cost under various operating environments. Liquidity is actively managed and reviewed in order to maintain stable, cost-effective funding to meet our operating needs. Liquidity comes from a variety of sources such as cash flow from operating activities and borrowing capacity. Management believes its current liquidity exceeds its operational requirements as of December 31, 2007.
The primary source of liquidity for The Commerce Group (parent company only) is the payment of dividends from its subsidiaries. Its main subsidiary, CHI, is dependent upon dividends from our insurance subsidiaries. The payment of dividends from insurance companies is regulated and limited under the laws of Massachusetts, Ohio, California and New York. See "Payment of Dividends" within the Regulations section of Item 1. Business.
We manage our market risk by focusing on higher quality equity and fixed maturity investments, by periodically monitoring the credit strength of companies in which investments are made, by limiting exposure in any one investment and by monitoring the quality of the investment portfolio taking into account, among other factors, credit ratings assigned by recognized rating organizations. Of our bonds and preferred stocks, 94% of the market value was rated in either of the two highest quality categories provided by the NAIC as of December 31, 2007, as compared to 93% at December 31, 2006. Although we have significant holdings of a closed-end preferred stock mutual fund, this fund is comprised primarily of preferred and common stocks traded on national stock exchanges, thus limiting exposure to any one obligor.
Our fixed maturity portfolio's weighted average duration (which includes all fixed maturities and preferred stocks) as of December 31, 2007 and 2006 was 5.6 years and 5.4 years, respectively. The "duration" of a security is the time-weighted present value of the security's expected cash flows and is used to measure a security's price sensitivity to changes in interest rates. The duration reflects industry prepayment assumptions. The analytic systems we used to calculate the above duration data utilize optional call dates and sinking fund requirements and assume a non-static prepayment pattern in deriving these averages.
The equity price risk is defined as a hypothetical change of plus-or-minus 10% in the carrying value of common stocks. This total includes common stocks at market value and closed-end preferred stock mutual funds carried at equity value. The following table summarizes our equity price risk, based on the results of the sensitivity analysis at December 31, 2007 and 2006:
We generally are unable to recover the costs of inflation in our personal automobile insurance line since the premiums charged for personal automobile insurance in Massachusetts, our principal business segment, are subject to state regulation. Additionally, through March 31, 2008, the premium rates that we charge for personal automobile insurance in Massachusetts are adjusted by the Commissioner generally at annual intervals. Such annual adjustments in premium rates may lag behind related cost increases. Economic recessions can have an impact upon us, primarily through the policyholder's election to decrease non-compulsory coverages afforded by the policy and decreased driving, each of which tends to decrease claims.
the possibility of severe weather, terrorism and other adverse catastrophic experiences;
the implementation of managed competition and an Assigned Risk Plan in Massachusetts;
our ability to maintain favorable ratings from rating agencies, including A.M. Best, Fitch, Moody's and S&P;
our dependence on a key third party service vendor for our automobile business in Massachusetts;
delay of or failure to consummate the proposed MAPFRE merger; and
Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Securities and Exchange Act of 1934. Management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2007. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework. Based on this assessment, management concluded the Company maintained effective internal control over financial reporting as of December 31, 2007.
The effectiveness of the Company's internal control over financial reporting as of December 31, 2007 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.
present fairly, in all material respects, the financial position of The Commerce Group, Inc. and its subsidiaries at December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included 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. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Net other comprehensive income (loss) for the year. See Note H of Notes to Consolidated Financial Statements.
We provide personal and commercial property and casualty insurance in Massachusetts and, to a lesser extent, in other states. In addition, we service residential and commercial mortgages in Massachusetts and Connecticut. Our primary business is property and casualty insurance in Massachusetts.
All of our investments in fixed maturity and equity securities at December 31, 2007 and 2006 were classified as available-for-sale. Realized gains and losses on available-for-sale securities were determined by using a first-in, first-out methodology. Investment income from fixed maturities is recognized using the effective yield method, including estimated principal repayments, if any. The effective yield used to determine amortization subject to prepayment risk is adjusted periodically based upon actual historical and/or projected future cash flows using the prospective method. We have not invested more than 5% of fixed maturities in any one state or political subdivision.
Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. The carrying value of fixed maturities on deposit for state regulating authorities at December 31, 2007 was $9,302.
We record our equity in the change in the value of net assets of closed-end preferred stock mutual funds for which our ownership is greater than 20% as a component of realized gains and losses. These investments are accounted for under the equity method.
During 2007, four preferred stock mutual funds that we owned were merged into the PDT fund. Two of the four funds (PGD and PPF) had been accounted for under the equity method and two others (John Hancock Patriot Premium Dividend Fund I and John Hancock Patriot Select Dividend Trust) had been accounted for under the rules for available-for-sale portfolios, as our percentage of ownership was below 20%. In the merger, common shareholders of the merging funds received newly-issued shares of PDT. The aggregate net asset value of the new common shares equaled the aggregate net asset value of the common shares held immediately prior to the merger. Upon exchange of shares into PDT, we recognized a gain of $4.0 million per equity accounting rules.
We hold real estate mortgage loans on properties located in Massachusetts and Connecticut. Mortgage loans are collateralized by the related real estate. Agency loans are generally collateralized by the assets of the agency. We control credit risk through credit approvals, credit limits and monitoring procedures. During the third quarter of 2007, we announced that we would cease originating mortgage loans effective immediately. All loan commitments outstanding were fully honored. We will continue to service the existing loan portfolio.
Our exposure is generally 80% or less of the appraised value of any collateralized real property at the time of the loan origination. The ability and willingness of residential and commercial borrowers to honor their repayment commitments is generally dependent upon the level of overall economic activity and real estate values. During the three years ended 2007, we did not acquire any property through foreclosure of mortgages.
Fair value of our mortgage loans on real estate and collateral notes receivable is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit and for the same remaining maturities. The future cash flows associated with certain non-performing loans are estimated based on expected payments from borrowers either through work out arrangements or the disposition of collateral. The estimated fair value of mortgage loans on real estate and collateral notes receivable at December 31, 2007 and 2006, prior to the allowance for possible loan losses, was $18,829 and $20,176, respectively.
There were no fixed maturity investments outstanding at December 31, 2007 which did not produce income during 2007.
Net unrealized gains (losses) on available-for-sale investments, net of tax, are included in net accumulated other comprehensive income, a component of stockholders' equity.
We review all holdings with an unrealized loss of over $250, or a fair market value that is more than 20% below cost, regardless of duration.
We reviewed our investment holdings at December 31, 2007 and 2006 for other-than-temporary declines in market value, in accordance with our previously summarized accounting policy. Based on this analysis, we determined that the impairments represented in the above gross unrealized loss table are temporary. These temporary impairments are primarily due to higher interest rates and the severe credit market declines witnessed in general market conditions. Our fixed maturity investments all have final maturity dates where we believe we will be repaid the full par value of the security. More than 92% of the temporarily impaired fixed maturities are investment grade and those that are non-investment grade have not been downgraded since purchase. Since we have the intent and ability to hold these investments to maturity if necessary for full recovery, we determined their value declines to be temporary. Our temporarily impaired equity securities all have an unrealized loss duration of less than one year. The majority of these equity securities are preferred stocks, which represent over 92% of total equity securities. Preferred stocks generally react to the factors previously mentioned - interest rates and credit market declines. In the one month subsequent to year-end, improvement occurred in the market for interest-bearing securities and in our unrealized loss position. As we have the intent and ability to hold these equity securities to full recovery and believe that the near-term prospects of these issuers support such recovery, we determined their impairment to be temporary.
Gross unrealized losses on our equity and fixed maturity securities at December 31, 2006, by duration of unrealized loss and by credit quality (for fixed maturity securities), follow:
Policy acquisition costs are calculated by line of business as a percentage of unearned premiums by multiplying the sum of current commission rates plus current premium tax rates plus an estimate of the percentage of other underwriting expenses incurred at policy issuance. These costs are deferred and amortized over the period in which the related premiums are earned, the amount being reduced by any potential premium deficiency. If any potential premium deficiency exists, it represents future estimated losses, loss adjustment expenses and amortization of deferred acquisition costs in excess of the related unearned premiums. There was no premium deficiency in 2007, 2006 and 2005. In determining whether a premium deficiency exists, we consider anticipated investment income on the unearned premium reserve.
Property and equipment is carried at cost net of accumulated depreciation. Depreciation is calculated on a straight-line basis over the estimated useful lives of the assets. Depreciation and amortization expense was $7,478, $7,197 and $6,091 for the years ended December 31, 2007, 2006 and 2005, respectively. Depreciation and amortization expense is allocated evenly between loss adjustment expenses and policy acquisition costs.
Significant time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer's payment of that loss. We recognize liabilities for unpaid losses by establishing reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and LAE. We review these reserves quarterly. Regulations of the Divisions of Insurance require us to obtain a certification annually, from either a qualified actuary or an approved loss reserve specialist, that our loss and LAE reserves are reasonable.
As a result of changes in estimates of insured events in prior years, the provision for loss and LAE decreased $54,621 for the year ended 2007, $43,726 for 2006 and $61,397 for 2005. The favorable development is due primarily to lower than anticipated losses related to the personal automobile liability. Conditions and trends that have affected development in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based upon these developments. The amounts we will ultimately incur from loss and loss adjustment expenses could differ materially in the near term from the amounts recorded.
Our aggregate actuarial estimate for the loss and LAE reserves, on a consolidated basis and net of reinsurance recoverable, ranges from a low of $832,500 to a high of $957,100, as of December 31, 2007. Our financial statement loss and LAE reserves net of reinsurance, based on our best estimate, was established at $904,282 for that date. Financial management calculates our estimate independently from those amounts as calculated by our actuaries and, therefore, the final results are most often not the same. We estimate amounts primarily by reviewing historical loss and LAE data, focusing mainly on payment data. We also review and compare most recent loss frequency, severity and payment data to historical trends in an attempt to determine if patterns are remaining consistent or not. We attempt to establish our reserve estimate as close to the amount required for the ultimate future payments necessary to settle all losses. The accuracy of this estimate is reflected by the line noted in the above table entitled "decrease in provision for insured events of prior years."
The Incentive Compensation Plan. During 2002, our stockholders approved the Incentive Compensation Plan (the Plan) which provides for the award of incentive stock options, non-qualified stock options, book value awards (BVAs), stock appreciation rights, restricted stock and performance stock units. Up to 10,000,000 shares of common stock (subject to increase for anti-dilution adjustments) may be issued under the Plan, including awards of restricted stock or upon the exercise of common stock equivalent awards such as stock options and stock appreciation rights payable in the form of common stock (not in the form of cash). At the discretion of the Compensation Committee, all of our directors, officers and other senior management employees, including those of our subsidiaries, are eligible to participate in the Plan.
In May 2005, the Compensation Committee of the Board of Directors authorized, under the 2002 Incentive Compensation Plan, the grant of Incentive Awards (IAs) to officers and directors in lieu of BVAs which were granted in the past. IAs entitle officers and directors to cash payments at a specified settlement date, subject to certain specified conditions. The 2005 Incentive Award Agreement is substantially the same as the previously granted BVA Agreement. The cash payment is based on cumulative net earnings per basic share of common stock over a three-year period, except for certain early retirement and change in control circumstances. During 2006 and 2007, the Compensation Committee awarded similar IAs. Expenses relating to the IAs were $7,188, $26,081 and $29,043 in 2007, 2006 and 2005, respectively.
In February 2007, we granted 103,928 vested stock options to our Directors under our Incentive Compensation Plan. Each stock option may be exercised for one share of our common stock at $30.36. The stock options have a ten-year term. As these options were fully vested at date of grant, we recorded our expense associated with the director options on grant date based upon our estimate of the fair value of the award using the Black-Scholes option pricing model. Our expense totaled $395.
In addition, during 2007, we granted 627,327 non-vested equity share units (RSUs) to officers under our Incentive Compensation Plan. These awards provide for the right to receive one share of our common stock for each vested RSU and annual Dividend Equivalent Payments (DEPs) beginning 2008. DEPs represent amounts that would have been received had the recipient of the RSU owned the underlying Company common shares. The RSUs cliff vest in 2012. Upon vesting, our stock shall be issued for all outstanding RSUs except for those RSUs held by our named executive officers. Named executive officers shall receive their shares after leaving the Company. At settlement, the recipient will receive one share of common stock for each RSU, less an amount of shares necessary to cover income tax withholdings. Settlement is required to be done in shares of common stock only. The vesting period may be accelerated upon a change in control of the Company. Holders of the RSUs will have no voting rights or any other rights of stockholders until receipt of stock from the Company. At December 31, 2007, 613,369 RSUs remain outstanding. We record our expense for the RSUs over each award's vesting period, based upon the market value of our common stock on the date of grant. During 2007, expenses associated with the RSUs and DEPs were $2,859 and $683, respectively. The remaining unamortized expense totaled $16,041 and will be recognized over the remaining vesting period.
The market price for our common stock and our financial results directly affect our expense related to stock options and IAs, respectively. Our stock option expense represents options granted to both employees, directors and American Commerce agents. An increase in the market value of our stock will increase the expense we recognize for options subject to variable accounting. Similarly, an increase in our net income will increase the value of, and therefore the expense we recognize for, outstanding IAs.
Plan activity related to employee and director options, retroactively adjusted for the June 2006 two-for-one stock split, for the three years ended 2007 follows:
The ACIC Plan activity, retroactively adjusted for the June 2006 two-for-one stock split, for the three years ended 2007 follows:
There were 670,280, 597,350 and 308,350 exercisable ACIC agents' options at December 31, 2007, 2006 and 2005, respectively. A change of control, as defined in the agreement, will not result in an acceleration of the vesting schedule of these options. The weighted average remaining contractual life of ACIC agents' options outstanding at December 31, 2007 was 6.5 years.
The weighted average exercise prices for ACIC agents' options granted in 2007, 2006 and 2005 were $43.07, $37.38 and $36.27, respectively. The estimated weighted average grant date fair values estimates of the ACIC agents' options granted during 2007, 2006 and 2005 were $2.78, $4.46 and $4.27, respectively. The ACIC agents' option liability at December 31, 2007 and 2006 was $27,780 and $21,236, respectively.
Basic EPS is computed based on the weighted average number of common shares outstanding. Diluted EPS is computed based on the weighted average number of common shares outstanding adjusted by the number of additional common shares that would have been outstanding had the potentially dilutive common shares been issued and reduced by the number of common shares we could have repurchased from the proceeds of the potentially dilutive shares. Our dilutive instruments are outstanding stock options and RSUs. Basic and diluted EPS, retroactively adjusted for the June 2006 two-for-one stock split, are calculated for the years ended December 31, as follows:
The aggregate amount of dividends calculated in accordance with regulations in Massachusetts, California and Ohio that could have been paid in 2007 from those four insurance subsidiaries without prior regulatory approval was approximately $232,726, of which $207,870 was declared and paid as of December 31, 2007.
New York has dividend regulations differing from those of Massachusetts, California and Ohio. As a result, State-Wide dividend capacity was not included in the above calculations. State-Wide had the ability to pay $5,572 in dividends without regulatory approval, however, they did not pay any dividends during 2007.
Our Board of Directors voted to declare four quarterly dividends to stockholders of record totaling $1.20 per share and $0.975 per share in 2007 and 2006, respectively. On February 16, 2007, the board voted to increase the quarterly stockholder dividend from $0.25 to $0.30 per share to stockholders of record as of February 26, 2007. Prior to that declaration, we paid quarterly dividends of $0.25 per share dating back to May 19, 2006 when the board voted to increase the dividend from $0.225 to $0.25 per share.
Approximately 80.6% of our direct premiums written for the year ended December 31, 2007 were generated from personal automobile insurance policies. Approximately 85.2% of our direct premiums written for the year ended December 31, 2007 were generated in Massachusetts.
The method of allocation calls for current taxes to be allocated among all affiliated companies based on a written tax-sharing agreement. Under this agreement, allocation is made primarily on a separate return basis with credit for losses and other tax items utilized in the consolidated return.
Federal income tax is less than the amount computed by applying the statutory rate of 35% for the years ended December 31 for the following reasons:
Commerce and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states. The companies are not subject to U.S. federal, state or local income tax examinations in any major taxing jurisdiction for years prior to 2003. The 2004 and 2006 federal income tax returns are currently under examination. Furthermore, at the request of the Internal Revenue Service, the statute of limitations on the 2003 and 2004 federal consolidated income tax returns was extended until March 31, 2010.
All companies are also covered by similar associations in the states where they do business. These associations operate similarly to the MIIF. Commerce West, domiciled in California, is covered by the California Insurance Guarantee Association, as well as associations in Arizona and Oregon. American Commerce, domiciled in Ohio, is covered by the Ohio Guarantee Association, as well as associations in the other states in which they do business. State-Wide, domiciled in New York, is covered by Property/Casualty Insurance. Security Fund of the State of New York. (Refunds) payments made by American Commerce, Commerce West, State-Wide and Commerce (for New Hampshire only) to the associations that they are covered under were $35 in 2007, $(224) in 2006 and $76 in 2005, respectively. These amounts are net of credits for prior year assessments.
Effective July 1, 2007, we renewed our pure catastrophe reinsurance program across five layers as outlined below. The Catastrophe Program provides for reinsurance recovery of a maximum of $489 million in the event of a $550 million or greater occurrence, including all states' FAIR Plan losses. The total annual cost of the program is approximately $28.4 million and includes one reinstatement premium (pro-rated based on loss recoveries) for a maximum additional cost of approximately $28.4 million. The catastrophe program is based on $207 million of estimated subject premiums, which will vary based on actual subject premiums. This program covers all FAIR Plan-type participation in excess of reinsurance purchased by any of the Plans, but does not cover comprehensive automobile. Two-year pricing agreements were signed for approximately half of this year's placement. Based on this, the pricing for half of next year's reinsurance program (effective July 1, 2008) will be the same as this year.
Our company is a member company of American Nuclear Insurers ("ANI"). ANI is a voluntary, non-profit, unincorporated association of insurers through which members provide, on a several and not joint basis, property insurance protection and nuclear energy liability insurance protection. This protection covers hazards arising out of risks related to nuclear installations, operations or facilities. Membership is on a percentage participation basis with this percentage being applied through each pool in which the member participates. Members can increase their participation percentages at any time however this increase is only effective upon ANI Board of Directors approval. Members can also terminate or reduce their participation by giving written notice to the Association by June 30th of any calendar year with the effective date for the termination or reduction being December 31st of that year. Members may participate in the pool by being a direct writing member, a ceding member, or an assuming member or any combination of the three.
Personal and commercial liability umbrella policies are reinsured on a 95% quota share basis in regard to limits up to $1,000 and 100% quota share basis for limits in excess of $1,000 but not exceeding $5,000 for policies with underlying automobile coverage of $250/$500 or more. We also have personal liability umbrella reinsurance coverage for policies with underlying automobile coverage of $100/$300 on a 65% quota share basis for limits up to $1,000 and 100% quota share basis for limits in excess of $1,000 but not exceeding $3,000. These coverages are placed with Swiss Re America Corporation.
The reduction in written premium in 2006 primarily resulted from the termination of our quota share agreement as previously mentioned. The termination resulted in a decrease in ceded written premium of $77,708; therefore, ceded written premium for the quota share agreement for 2006 was ($4,704) as compared to $150,461 for 2005.
CAR, a state-mandated reinsurance mechanism, enables us and other servicing carriers to reinsure any automobile risk that the insurer perceives to be under-priced at the premium level permitted by the Commissioner of Insurance. Servicing carriers, which are responsible for over 99% of total direct premiums written for personal automobile insurance in Massachusetts, are required to offer automobile insurance coverage to all eligible applicants pursuant to "take-all-comers" regulations, but may reinsure business with CAR.
Two of our reinsurance components, quota share and CAR, settle on a quarterly basis. Quota share settles 45 days after the end of each quarter and CAR settles 90 days after the end of each quarter. There were no balances in dispute for the years ended 2007 and 2006 for either component.
We offer an ESOP for the benefit of substantially all employees, including those of our subsidiaries. The ESOP is noncontributory on the part of participants and contributions are made at the discretion of the Board of Directors. We are under no obligation to make contributions or maintain the ESOP for any length of time and may completely discontinue or terminate the ESOP at any time without liability. Contingent upon the close of the MAPFRE merger, the ESOP fund will terminate and all its assets will be distributed to participants as directed. If the ESOP fund is terminated, all participants in the fund will become fully vested. The Board, at its November 2007 meeting, elected not to make a contribution to the ESOP for 2007. In light of the anticipated termination of the ESOP feature, the Company elected to pay a cash bonus to employees contingent upon the closing of the merger. Contribution expense for the ESOP for the years ended December 31, 2006 and 2005 were $10,790 and $10,371, respectively. In 2007 and 2006, the previous year's contributions were funded entirely with 367,145 and 382,994 treasury stock shares, respectively. The increase in the contribution in 2006 over 2005 was primarily due to an increase in employees and wages paid to them. The ESOP held 5,646,110 and 5,856,990 shares of our common stock at December 31, 2007 and 2006, respectively.
Contributions are allocated among the participants' accounts in the ratio of each participant's eligible Form W-2 compensation to the total of all participants' covered compensation for the year. Dividends on ESOP shares are fully earned, and participants can elect to either receive cash or apply the dividend to their ESOP account. ESOP shares are treated as outstanding shares for the purpose of our earnings per share calculations.
ESOP participants who are current employees and who are 100% vested in their ESOP accounts can annually elect to transfer out of the ESOP up to 100% of their allocated Company stock in the form of an eligible rollover distribution into another eligible retirement plan, such as a qualified individual retirement arrangement. Approximately 4,359,606 shares owned by participants in the ESOP at December 31, 2007 are allocated to the ESOP accounts of these individuals. Beginning January 1, 2007, ESOP accounts vested at a rate of 20% per service year beginning with a participant's second year of service.
During 2000, our directors approved a Directors' Retirement Compensation Plan (the Retirement Plan). The Retirement Plan becomes effective for each director upon terminating service from our Board of Directors (the Board) provided that such termination was not made under conditions adverse to our interest. Effective with the annual meeting wherein the director is not reappointed to the Board, and provided benefits are not paid until such time as the director has attained the age of 65, we will pay an annual retirement benefit equal to 50% of the average annual total compensation of the director for the highest three full years (the three year average compensation). The annual retirement benefit of 50% of the three year average compensation vests at the rate of 4% for each year of Board service up to a maximum of 100% vesting through termination of service. Payments continue for a maximum of ten years over the remaining life of the terminated director, or his or her then spouse, if the director pre-deceases the spouse. No payments are to be made after the death of the director and spouse. Expenses related to the Retirement Plan in 2007, 2006 and 2005 were $2,200, $1,279 and $887, respectively. We paid $113, $78 and $78 under the Retirement Plan in 2007, 2006 and 2005, respectively. The liability for the Retirement Plan, as calculated based on a discounted cash flow basis, was $7,268 and $5,181 at December 31, 2007 and 2006, respectively.
Selected segment information for 2007, 2006 and 2005 follows. Earnings are before income taxes and include minority interest.
The immediate family of Raymond J. Lauring, a director of the Company, owns more than a 10% equity interest in Lauring Construction Company (LCC). Mr. Lauring has no ownership interest in the construction company. Payments to LCC totaled $88 in 2007, $1,549 in 2006, and $222 in 2005. The increase in 2006 payments resulted primarily from construction projects for generators for our Gore Road facilities. For these projects, we paid LCC for work performed by them and by subcontractors. LCC in turn paid the subcontractors directly.
The Court's Order does not resolve all of AAA Arizona's claims against American Commerce, the resolution of which will require a trial. The parties have submitted the case to nonbinding mediation. If the case is not resolved at mediation, we expect the Court will hold a hearing on June 6, 2008, at which time the Court is likely to set a trial date. We intend to continue to defend vigorously against AAA Arizona's claims.
On April 25, 2007, California State Automobile Inter-Insurance Bureau (CSAA) filed a lawsuit in the Superior Court of California, County of Alameda, against Commerce West, American Commerce, and CGI. In that lawsuit, styled California State Automobile Association Inter-Insurance Bureau v. The Commerce Insurance Group, Inc. et al., CSAA alleged that, through the hiring of several CSAA employees, the defendants misappropriated CSAA's trade secrets or proprietary information, intentionally interfered with a confidentiality agreement between CSAA and one of those employees, engaged in unfair business practices and unfair competition, and has been and will be unjustly enriched. CSAA cited in support of its allegations the Company's hiring of Lawrence R. Pentis, and the Company's subsequent hiring of three other former CSAA employees. Mr. Pentis is a Commerce Group Executive Vice President and the Chief Operating Officer and Executive Vice President of American Commerce and State-Wide.
Completion of the proposed MAPFRE merger is subject to various customary closing conditions including, but not limited to, insurance regulatory approval. The Company held a Special Meeting of Stockholders on February 14, 2008 and shareholders approved the October 30, 2007 MAPFRE Merger Agreement. We currently expect that the MAPFRE merger will be completed in 2008, likely late in the first quarter or early in the second quarter.