American Indemnity Company, a subsidiary of American Indemnity Financial Corporation, owns two adjacent and connected buildings in Galveston, Texas. One building is seven stories and the other is three stories. Two floors of the seven-story building serve as American Indemnity Company’s home office, while the remainder is available for lease. As of December 31, 2003, American Indemnity Company leases a small amount of the available office space to tenants.
This discussion may contain forward-looking statements about our operations, anticipated performance and other similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Act of 1934 for forward-looking statements. The forward-looking statements are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. Such forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry in which we operate, management’s beliefs and assumptions made by management. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “continues,” “seeks,” “estimates,” “predicts,” “should,” “could,” “may,” “will continue,” “might”, “hope” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed in such forward-looking statements. Among the factors that could cause our actual outcomes and results to differ are the following: inherent uncertainties with respect to loss reserving; the occurrence of catastrophic events or other insured or reinsured events with a frequency or severity exceeding our estimates; the actual amount of new and renewal business and demand for our products and services; the competitive environment in which we operate, including price, product and service competition; developments in domestic and global financial markets that could affect our investment portfolio and financing plans; impact of regulatory actions on our Consolidated Financial Statements; uncertainties relating to government and regulatory policies; additional government and stock exchange policies relating to corporate governance, and the cost to comply; legal developments; changing rates of inflation, interest rates and other economic conditions; a continuation or worsening of global economic conditions; a slow recovery from the United States recession; our relationship with our agencies; the valuation of invested assets; the recovery of deferred acquisition costs; or our relationship with our reinsurers. These are representative of the risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from what is expressed in forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
The property and casualty insurance industry experienced good financial performance in 2003. The improvement came after a number of years of industry-wide underwriting losses and capital erosion. In 2003, rising insurance premiums and underwriting discipline were essential elements of the insurance industry’s recovery.
The statutory combined ratio is a common measure of underwriting profitability used in the property and casualty insurance industry. It is determined by adding (a) net incurred losses and net loss adjustment expenses expressed as a percentage of net premiums earned and (b) underwriting expenses expressed as a percentage of net premiums written. Generally speaking, a 100 percent statutory combined ratio is a break-even point for underwriting profitability. The combined ratio is also calculated on the basis of accounting principles generally accepted in the United States. The combined ratio presented in the following paragraph is calculated on a statutory basis because A.M. Best Company reports actual and estimated combined ratios for the industry on a statutory basis. We believe it is useful to compare our results on a statutory basis with those reported or estimated for the entire property and casualty industry. Later in this report, we include a discussion of our combined ratio determined in accordance with accounting principles generally accepted in the United States.
For 2003, the statutory combined ratio is estimated by A.M. Best Company to be 101.1 percent for the property and casualty industry. This is compared with an actual statutory combined ratio of 107.4 percent in 2002 and 115.9 percent in 2001. The improvement was driven primarily by premium growth and improved underwriting standards.
While the results for 2003 in the property and casualty industry were favorable overall, 2003 was not a year without challenges. Many insurers concluded that they were deficient in their loss reserves for events that occurred in prior years, and increased their liabilities for reserves in 2003. Many of the reserve deficiencies were concentrated in asbestos and environmental exposures. Despite industry reserve strengthening, A.M. Best Company estimates that “the industry is under-funded by $11.6 billion for asbestos exposures through year-end.”
In addition to problems associated with reserving, reinsurance has presented challenges to the property and casualty industry, with pricing increasing and terms becoming more restrictive.
Finding and making appropriate investments continued to challenge the property and casualty insurance industry in 2003. Despite interest rates on bonds edging towards record lows, improvement in underwriting results led to an increase in the amount of funds that insurers were investing and to a modest increase in investment income. A.M. Best estimates the entire property and casualty industry had $42.3 billion in investment income in 2003, compared with $40.1 billion in 2002. Estimated realized capital losses were $6.5 billion in 2003, compared with realized capital gains of $2.8 billion in 2002.
In 2003, we reported record net income of $55.6 million, or $5.06 per share (after providing for the dividend on convertible preferred stock), which included net realized investment losses (before tax) of $1.7 million. Net income in 2002 was $20.8 million, or $1.76 per share (after providing for the dividend on convertible preferred stock), which included net realized investment losses (before tax) of $13.8 million. Diluted earnings were $4.72 per share and $1.76 per share for 2003 and 2002, respectively.
The improvement in results was driven primarily by growth in property and casualty premiums earned. Also contributing to the increase in net income between years was a reduction in losses and settlement expenses, and a decrease in other-than-temporary investment impairments recorded between years.
Losses and settlement expenses decreased by $7.3, million or 2 percent, between 2002 and 2003. While losses and settlement expenses increased between years in some of our lines of business, significant improvement in our fire and allied lines business led to the overall improvement between years. Good weather in 2003 contributed to this improvement, as did a number of underwriting initiatives that we undertook during the year.
We conduct our operations through two distinct segments, property and casualty insurance and life insurance. These segments are managed separately because they generally do not share the same customer base, and they each have different pricing and expense structures. We evaluate segment profit based on operating and investment results. Segment profit or loss as described in the following sections of the Management’s Discussion and Analysis is pre-tax. Detailed segment information is presented in Note 12 to the Consolidated Financial Statements.
Our property and casualty insurance segment compared favorably with the property and casualty industry. Our statutory combined ratio was 93.1 percent in 2003, compared with 101.9 percent in 2002. Like the industry as a whole, our underwriting profitability benefited from the premium rate increases that began in 2001, and continued in 2002 and 2003. We attribute the reduction in losses and settlement expenses, which was concentrated in our fire and allied lines of business, to a decrease in loss frequency and continued adherence to firm underwriting standards.
Net premiums written grew to $450.5 million in 2003, compared with $418.3 million in 2002. Premiums written on a direct basis constitutes the most significant portion of premiums written. In 2003, direct premiums written were $469.0 million, compared with $442.8 million in 2002. For the past three years, Texas has been our largest state in terms of direct premium volume, with Iowa being a close second. The following states provided more than 60 percent of the total direct premium written in the property and casualty insurance segment in 2003: Texas (13.7%), Iowa (12.8%), Louisiana (11.3%), Missouri (8.1%), Illinois (7.9%) and Colorado (7.9%).
To reduce our exposure to large losses and to catastrophic losses, we cede a portion of our business to other insurance companies. In 2003, we recorded ceded premiums written of $31.4 million compared with $35.2 million in 2002. To reduce the cost of reinsurance, we increased our retention levels in both 2002 and 2003. For our property and casualty lines of business, our retention for 2003 was $1.5 million, which means that we had reinsurance for any single claim over $1.5 million. Our loss retention was $1.3 million for losses that occurred in 2002, $1.0 million for losses that occurred in years 1995 through 2001 and $.8 million for losses that occurred in years prior to 1995. Our catastrophe retention level is $7.5 million. This means that the total direct loss that we could incur from a single catastrophe, after reinsurance is $7.5 million, plus five percent of losses in excess of $7.5 million. From 1993 to 2001, our catastrophe retention was $5.0 million.
We increased our retention again, effective January 1, 2004 to $2.0 million for any single claim, and we increased our catastrophe retention to $10.0 million, plus five percent of losses in excess of $10.0 million.
Our reinsurance contracts limit or exclude coverage for losses sustained as a result of terrorist activities. The Terrorism Risk Insurance Act of 2002 was passed by Congress and signed into law by the President on November 26, 2002. The Act defines a “certified” act of terrorism as “an act that is certified by the Secretary of the Treasury as resulting in aggregate losses in excess of $5.0 million, is a violent act or dangerous to human life, property or infrastructure, and is committed by an individual(s) acting on behalf of any foreign person or interest as part of an effort to coerce the civilian population of the United States or to influence the policy or affect the conduct of the United States Government by coercion.” The Act requires us to offer coverage for certified acts of terrorism on all polices issued or renewed through December 31, 2004.
In 2003, we incurred losses and settlement expenses of $271.6 million, of which $283.9 million was attributable to losses that occurred in 2003. In 2003 we recorded a $12.3 million offset to losses incurred related to the net savings realized in 2003 on the settlement of losses that occurred prior to 2003. The net savings, also referred to as loss redundancy, resulted from settling or re-estimating claims for less than reserved at December 31, 2002. We experienced loss redundancy in each of our lines of business, with the exception of other liability and workers’ compensation.
In 2003, our $12.3 million net loss redundancy was attributable to savings of approximately $1.1 million from workers’ compensation medical bill reviews, compared with approximately $1.9 million in 2002; savings of approximately $7.3 million from the use of alternative dispute resolution in 2003, compared with approximately $2.8 million in 2002; recoupment of approximately $5.8 million from salvage and subrogation in 2003, compared with approximately $3.4 million in 2002 and a small deficiency offset of approximately $1.9 million in 2003 attributable to both the payment of claims in amounts other than the amounts reserved and from changes in loss reserves due to additional information on individual claims that we received after the reserves for those claims had been established, compared with a savings of approximately $3.0 million in 2002. The additional information we consider is unique to each claim. Such information includes facts that reveal we have no coverage obligation for a particular claim, changes in applicable laws that reduce our liability or coverage exposure on a particular claim, facts that implicate other parties as being liable on a particular claim and favorable court rulings that decrease the likelihood that we would be liable for a particular claim. Also, additional information relating to severity is unique to each claim. For example, we may
In 2003, we recorded $17.6 million in catastrophe losses, compared with $18.0 million in 2002. Our most significant catastrophes in 2003 included a hailstorm that passed through Texas in April, resulting in losses of $3.6 million, and a series of severe storms that struck the Midwest and South from May 2 through May 11, resulting in losses of $7.5 million.
We review our net loss ratio to measure our profitability by line and make pricing and underwriting decisions based upon these results. Our net loss ratio was 62.4 percent in 2003, 71.9 percent in 2002 and 73.9 percent in 2001. In the following table, we present the net loss ratio for each of the last three years for each of our lines of business. The information in the table below is presented in accordance with accounting principles generally accepted in the United States.
Our second largest commercial line of business, measured by premiums earned, is other liability. This line showed slight improvement in the loss ratio, decreasing from 73.9 percent in 2002 to 71.8 percent in 2003. Pricing activities drove an increase of $13.0 million, or 16.0 percent, in the premiums earned in this line of business. Losses and loss adjustment expenses incurred were up $7.6 million. New construction defect claims and higher-than-anticipated legal costs deterred better improvement in this line of business. From a pricing standpoint, we believe that prices will remain firm, and that we will be able to continue to pursue adequate pricing in our commercial liability lines of business. To control claims activity, we are being more selective in the general contractors that we insure because construction defect claims against general contractors generally tend to be associated with elevated legal costs.
Surety losses incurred more than doubled in 2003, increasing from $1.9 million in 2002 to $4.8 million in 2003. Typically, the surety business is characterized by infrequent but potentially high severity losses. When losses occur, our loss is determined by estimating the cost to complete the remaining work and pay the contractor’s unpaid bills, offset by contract funds due to the contractor, reinsurance and the value of any collateral we may have access to. The increase in losses incurred between 2002 and 2003 resulted from an increase in the frequency of claims reported to us. We attribute this change to the slow economic recovery in the United States, which has greatly reduced the amount of public construction projects. Our exposure comes from a small number of accounts that are currently experiencing cash flow problems or that are in various stages of bankruptcy proceedings. We have responded to this condition by conducting a more thorough underwriting process, which involves more fact gathering, as we make our risk selections.
We continued to improve personal lines profitability in 2003, through both rate increases and modification of policy terms and conditions that take effect as policies renew or as new business is written. The decrease in total premiums earned in our personal lines of $5.8 million, or 9 percent, was the result of our efforts to de-emphasize our personal lines of business. During 2003, we continued to decrease our number of exposures, particularly in areas where the personal lines business was least profitable. These actions contributed to an increase in profitability, as measured by the loss ratio, which decreased to 75.8 percent in 2003, down from 95.4 percent in 2002. The improvement was concentrated in our personal property lines of business, where losses incurred in fire and allied lines (including homeowners policies) decreased between 2002 and 2003 by $13.4 million, or 44 percent. Catastrophe losses decreased in these lines by $3.5 million between the two years.
In our assumed reinsurance line of business, we recorded a loss ratio of 95.4 percent in 2003, compared with 81.5 percent in 2002. Our assumed premiums earned were significantly reduced between 2001 and 2003, due to the run-off of several assumed reinsurance contracts. This lower premium volume, coupled with losses incurred related to the run-off contracts, has contributed to the deterioration. We continue to have exposure, primarily catastrophe coverages, related to the assumed reinsurance contracts written prior to 2001, as well as to the small number of assumed reinsurance contracts that we have continued to underwrite. We believe that as of December 31, 2003, our loss reserves established for the assumed reinsurance business are appropriate. We anticipate that we will decrease the assumed loss reserves each year as the non-renewed assumed reinsurance contracts continue to run off and the losses are paid out.
In 2003, we credited interest of $56.5 million to our fixed annuity and universal life policyholder accounts, compared with $51.7 million in 2002. We establish our interest crediting rates based upon current market conditions and maintain a “spread” by crediting rates on our policyholder account balances that are less than the ratio of net investment income to average invested assets. We decreased interest-crediting rates during 2003 and 2002 for new deposits. The increase in our expense for interest on policyholders’ accounts in 2003 was primarily a result of the interest credited on existing account balances. Our fixed annuity products expose us to the risk that changes in interest rates could reduce our spread and the rate of return that we are able to earn on our investments. Because of the poor performance of the market during 2003, our spread has been reduced due to the decreased rate of return earned on funds invested in 2003. We have significant amounts of annuities up for renewal beginning in 2004. Because of current market conditions and the resulting low interest rates, many of these annuities may not be renewed. Because there are significant annuities at risk for non-renewal, our financial results could be significantly and negatively affected. We will endeavor to overcome these market conditions to maintain and increase our annuity business.
As of December 31, 2003, we have recorded net unrealized gains, after-tax, of $90.6 million compared with net unrealized gains, after-tax, of $52.7 million at December 31, 2002. The growth was driven by the low interest rate environment and increases in the market values of equity securities that we hold. Included within the 2003 net unrealized gain were unrealized losses of $6.8 million on our fixed maturity portfolio and $1.1 million on our equity portfolio. We believe that the unrealized losses related to our fixed maturity portfolio resulted primarily from changes in interest rates, not from changes in the credit quality of the issuers of these securities. We consider the unrealized losses to be temporary, and we have the intent and ability to hold our fixed maturity securities for a period of time that is sufficient to allow for the recovery in fair value that we expect to occur. We also believe that the unrealized losses on our equity portfolio are temporary. As of December 31, 2003, the largest unrealized loss, after-tax, on any single investment security was $1.0 million.
Our effective federal income tax rate of 30.3 percent was less than the applicable federal tax rate of 35.0 percent due primarily to our portfolio of tax-exempt securities. Our effective rate was 20.2 percent in 2002. The increasing effective rate was driven primarily by an increase in taxable income.
Net operating income, which excludes net realized gains and losses, for the year ending December 31, 2002, increased by $5.5 million to $29.8 million, compared with $24.2 million in 2001. This was $2.66 per share, after providing for the dividend on the convertible preferred stock, compared with $2.41 per share in 2001. Factors contributing significantly to the change in net operating income included a decrease in the property and casualty segment’s combined ratio (calculated in accordance with accounting principles generally accepted in the United States) to 101.8 percent in 2002, compared with 104.6 percent in 2001, and improvement in the life segments’ operating results.
Pre-tax catastrophe losses decreased from $27.0 million in 2001 to $18.0 million in 2002. We had exposure to 25 catastrophes that occurred in 2002 and 23 that occurred in 2001. Our largest catastrophe loss in 2002 was Hurricane Lili, which occurred on October 3, 2002 and resulted in pre-tax direct losses and loss adjustment expenses of $9.8 million in 2002. Because our catastrophe reinsurance retention in 2002 was $7.5 million plus 5 percent of losses in excess of $7.5 million for a catastrophic event, our net exposure to Hurricane Lili was $7.6 million. Incurred losses related to Hurricane Isidore, which occurred on September 26, 2002, were $.5 million in 2002. We attempt to reduce our potential impact of future catastrophes through geographic distribution of risks, reduction of our exposure in catastrophe-prone areas and utilization of reinsurance. We define catastrophes to include events that cause $25.0 million or more in industry-wide direct insured losses to property and that affect a significant number of insureds and insurers. This is the same definition utilized by the Insurance Services Office, a supplier of property and casualty statistical data. At United Fire, we also include in our catastrophe totals, those events we believe are, or will be, material to our operations, either in amount, or in number of claim counts. Because the occurrence and severity of catastrophes are inherently unpredictable, historical results of operations may not be indicative of future results of operations. Claims from catastrophic events could reduce our net income, cause substantial volatility in our financial results for any fiscal quarter or year or otherwise adversely affect our financial condition or results of operations.
Net investment income increased by $6.6 million, or 6.7 percent, to $105.6 million between 2001 and 2002. Despite the depressed interest rate environment that existed in the United States throughout 2002, annuity deposits and premium receipts had led to growth in our investment portfolio, thus leading to the increase in investment income.
Net income in the property and casualty insurance segment was $17.5 million in 2002, compared with $15.6 million in 2001. The segment’s net income benefited from an increase in net premiums earned driven by an increase in premium rates, improvement in the accounting principles generally accepted in the United States loss and expense ratios, and decreased catastrophe losses.
Net written premiums increased by 14.3 percent, from $366.1 million in 2001 to $418.3 million in 2002. We were focusing our growth efforts on our commercial lines of business, where we are most profitable. Net premiums written increased in the commercial lines by $61.2 million, or 21.3 percent, in 2002, and decreased in the personal lines by $3.3 million, or 5.2 percent, in 2002. During 2002, we implemented rate increases of up to 25 percent in many of our commercial lines of business. We also implemented rate increases in many of our personal lines of business, but we reduced the number of personal lines policies in force.
Direct premiums written were $442.8 million in 2002, compared with $375.6 million in 2001. Texas was our largest state in terms of direct premium volume, with direct premiums written of $64.0 million. Iowa was our second largest state, with direct premiums written of $57.9 million. Our assumed premiums written decreased between 2001 and 2002 from $15.7 million to $10.8 million due to the run-off of several assumed reinsurance contracts.
Our reserving process, which contributed to the favorable development in 2002 and 2001, is presented under “Reserves,” later in this discussion. Our liability lines of business are considered long-tail lines of business due to the length of time that may elapse before claims are finally settled. Therefore, we may not know our final development on individual claims for many years. Our estimates for losses, particularly in these long-tail lines, are dependent upon many factors, such as our estimate of the severity of the claim, the legal environment, inflation and medical costs. We consider all of these factors, as well as others, in estimating our loss reserves. As conditions or trends with respect to these factors change, we change our estimate for loss reserves accordingly.
Conditions and trends that have historically affected the prior years’ loss development of reserves may not necessarily occur in the future. Despite our history of favorable development on prior years’ reserves, our current reserves for claims may prove to be inadequate, which could have a material impact on our net income and stockholders’ equity.
We review the net loss ratio to measure our profitability by line and make pricing and underwriting decisions based upon these results. The net loss ratio was 71.9 percent in 2002, 74.4 percent in 2001 and 74.2 percent in 2000. In the following table, we present the net loss ratio for each of the last three years for each of our lines of business. The information in the table below is presented in accordance with accounting principles generally accepted in the United States.
Our other liability line of insurance covers businesses for any liability for bodily injury and property damage arising from general business operations, accidents on their premises and products manufactured or sold. The 2002 loss ratio for this line of business was 73.9 percent, compared with 55.6 percent in 2001. The deterioration between years was due to a number of large losses reported to us in 2002. Many of these losses related to prior accident years. A small portion of these losses were the result of construction defect claims, primarily for residential general and subcontractors. This particular type of claim involves allegations of defective work on construction projects. The claims typically involve numerous parties and insurers. Our reserves for construction defect claims are based upon information that is currently available to us, as well as our past loss experience, and the current legal environment. Future judicial and regulatory actions concerning construction defect liability creates uncertainty as to our ultimate liability for these types of claims.
Our commercial automobile insurance covers physical damage to an insured’s vehicle as well as liabilities to third parties. Automobile physical damage insurance covers loss or damage to vehicles from collision, vandalism, fire, theft, flood or other causes. Automobile liability insurance covers bodily injury, damage to property resulting from automobile accidents caused by
The deterioration in the loss ratio for our personal lines of business was the result of an increase in the severity of both catastrophe and non-catastrophe losses. Through selective underwriting, we had reduced our number of personal lines policies in force by 22,984 or 18 percent in 2002. In 2002, our personal lines represented 16.3 percent of our direct property and casualty premiums written, compared with 17.9 percent in 2001.
Net income recorded by the life segment for 2002 was $3.3 million compared with $8.5 million for 2001. The change in net income was attributable primarily to growth in net investment income, offset by an increase in net realized investment losses. Net investment income earned increased by $7.1 million, or 10.1 percent, in 2002 to $77.8 million. Despite depressed interest rates, annuity deposits increased our life segment’s investment portfolio, leading to the increase in investment earnings. The increase in net realized investment losses was primarily due to investment write-downs of $11.8 million in 2002 versus investment write-downs of $3.5 million in 2001.
Net investment income increased by $6.6 million, or 6.7 percent, to $105.6 million between 2001 and 2002. More than 95 percent of our investment income originated from interest on fixed maturities. Our remaining investment income is derived from dividends on equity securities, interest on other long-term investments, interest on mortgage loans, interest on policy loans and rent earned from tenants in our home office. The average investment yield, which is investment income divided by average invested assets, was 6.4 percent in 2002, compared with 6.7 percent in 2001. We attributed the decrease between years to the reinvestment of proceeds from maturing fixed maturities and the investment of new funds at lower investment yields during 2002 due to market conditions.
At December 31, 2002, we had $25.0 million of net operating loss carryforwards acquired in the purchase of American Indemnity Financial Corporation in August 1999. The utilization of these net operating losses is limited by the Internal Revenue Code. The net operating losses began to expire prior to our purchase of American Indemnity Financial Corporation and will continue to expire in various future years through 2019. Our property and casualty insurance segment must generate sufficient taxable income to be able to use the deferred tax asset associated with the net operating loss carryforwards before their expiration.
Our main objectives in managing our investment portfolio are to maximize after-tax investment income and total investment returns. We develop our investment strategies based on a number of factors, including estimated duration of reserve liabilities, short- and long-term liquidity needs, projected tax status, general economic conditions, expected rates of inflation and regulatory requirements. We manage our portfolio based on investment guidelines approved by our management.
At December 31, 2003, $1,519.4 million or 92 percent of our fixed maturities were classified as available-for-sale, compared with $1,398.6 million, or 88.0 percent, at December 31, 2002. Our trading securities consist primarily of convertible redeemable preferred securities, which are recorded at fair value, with any changes in fair value recognized in earnings. Our remaining fixed maturities are classified as held-to-maturity and are reported at amortized cost. As of December 31, 2003, 88.2 percent of our fixed maturities were investment grade, as defined by the National Association of Insurance Commissioners’ Securities Valuation Office, and had ratings of Class 1 or Class 2.
(1) Available-for-sale and trading fixed maturities are carried at fair value, while held-to-maturity fixed maturities are carried at amortized cost.
Offsetting the operating and investing increases to cash was a reduction in cash provided by financing activities. We generate cash from the sale, less withdrawals, of our fixed annuities and universal life contracts. In 2003, net cash from these activities decreased to $65.3 million, compared with $160.7 million in 2002. This is described in the life insurance segment discussion. Our re-entry into the fixed annuities market in 2004 will cause our net cash from operations to increase when compared with 2003, but we do not anticipate that the 2004 sale of fixed annuities will reach the level of sales in 2002.
We invest funds available for short-term cash needs primarily in money market accounts, which are classified as cash equivalents. At December 31, 2003, our cash and cash equivalents included $91.7 million related to these money market accounts, compared with $28.8 million at December 31, 2002.
Under the insurance laws of the states and jurisdictions where our insurance subsidiaries and affiliate are domiciled, an insurer is restricted with respect to the timing or the amount of dividends it may pay without prior approval by regulatory authorities. In 2003 and 2002, United Fire did not receive dividends from its insurance subsidiaries and affiliate.
Stockholders’ equity increased from $290.4 million at December 31, 2002 to $373.9 million at December 31, 2003, an increase of 28.8 percent. Increases to stockholders’ equity included net income of $55.6 million and an increase in net unrealized investment appreciation of $37.9 million, after tax. The elimination of a minimum pension liability increased stockholders’ equity by $2.3 million after tax. We issued 5,100 shares of common stock as the result of the exercise of stock options, which increased stockholders’ equity by $.1 million. Common and preferred stockholder dividends and preferred stock accretion of $12.4 million decreased stockholders’ equity. Book value per share at December 31, 2003 was $37.23, compared with $28.94 at December 31, 2002. As of December 31, 2003, we had authorization granted by the board of directors to repurchase 89,210 shares of our common stock. In 2003, we repurchased 550 shares of our common stock, all of which were distributed to employees as awards. We did not retire any shares of our common stock in 2003.
We also defer and amortize policy acquisition costs related to investment contracts and universal life contracts; we amortize these policy acquisition costs in proportion to the present value of expected gross profits from investment, mortality and expense margins and surrender charges. Actual gross profits can vary from our estimates, resulting in increases or decreases in the rate of amortization. We periodically review these estimates and evaluate the recoverability of the deferred acquisition cost asset. When appropriate, we revise our assumptions on the estimated gross profits of these contracts, and we re-estimate and adjust cumulative amortization for our books of business by a cumulative charge or credit to income.
At December 31, 2003, we have $41.3 million in deferred policy acquisition costs related to our life insurance segment, as compared with $53.8 million at December 31, 2002. The deferred policy acquisition costs with respect to our fixed annuities and universal life products are adjusted with respect to estimated gross profits as a result of changes in the net unrealized gains or losses on fixed maturity and equity securities available-for-sale. That is, because fixed maturity and equity securities available-for-sale are carried at aggregate fair value, an adjustment is made to deferred policy acquisition costs equal to the change in amortization that would have been recorded if such securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. The change in this adjustment, net of tax, is included with the change in net unrealized gains and losses on fixed maturity securities and equity securities available-for-sale that is credited or charged directly to comprehensive income. Deferred policy acquisition costs have decreased by $46.2 million at December 31, 2003, compared with $29.6 million at December 31, 2002. This variance between years was driven by the low interest rate environment, and the resulting increase in unrealized gains related to the fair value of available-for-sale fixed maturity securities.
Over the course of the last 10 accident years, our net reserves for losses and loss adjustment expenses have exceeded our net incurred losses and loss adjustment expenses. Because establishing reserves is inherently uncertain, an analysis of factors affecting reserves can produce a range of reasonable estimates. Our philosophy is to establish reserves that are appropriate and reasonable, but assume a pessimistic view of potential outcomes. Generally, our best estimate of reserves is slightly above the mid-point of a range of reasonable estimates. We believe that in determining reserves, it is appropriate and reasonable to establish a best estimate within a range of reasonable estimates. We believe the use of a range of reasonable reserves is especially effective when we are reserving for claims for bodily injury, disabilities and similar claims, for which settlements and verdicts can vary widely. Our reserving philosophy may result in favorable development in future years that will decrease loss and loss adjustment expenses for prior year claims in the year of adjustment. While we realize that this philosophy, coupled with what we believe to be aggressive and successful claims management and settlement practices, has resulted in year-to-year redundancies in reserves, we believe our approach is better than experiencing year-to-year uncertainty as to the adequacy of our reserves.
• Establishing reserves that are appropriate and reasonable, but assume a pessimistic view of potential outcomes;
The estimation of assumed and ceded reinsurance loss and loss adjustment expense reserves is subject to the same factors as the estimation of insurance loss and loss adjustment expense reserves. In addition to those factors which give rise to inherent uncertainties in establishing insurance loss and loss adjustment expense reserves, there exists a delay in our receipt of reported claims due to the procedure of having claims first reported through one or more intermediary insurers or reinsurers.
At December 31, 2003 our reserves for gross losses and settlement expenses increased by $34.4 million to $427.0 million, from $392.6 million at December 31, 2002. We increased our gross loss and settlement reserves for the other liability line of business by $35.1 million, and we increased our gross reserves for our workers’ compensation business by $12.3 million. In all of our other lines of business, we decreased our gross reserves for losses and loss adjustment expenses. Other liability and workers’ compensation lines of business are considered long-tail lines of business due to the length of time that may elapse before claims are finally settled. Therefore, we may not know our final development on individual claims for many years. Our estimates for losses, particularly in these long-tail lines, are dependent upon many factors, such as our estimate of the severity of the claim, the legal environment, inflation and medical costs. We consider all of these and other factors in estimating our loss reserves. As conditions or trends with respect to these factors change, we change our estimate for loss reserves accordingly.
Included in the other liability line of business are gross reserves for asbestos and other environmental losses and settlement expenses. At December 31, 2003, we established $3.3 million in asbestos and environmental loss reserves, compared with $1.6 million at December 31, 2002. The estimation of loss reserves for environmental claims and claims related to long-term exposure to asbestos and other substances is one of the most difficult aspects of establishing reserves, especially given the inherent uncertainties surrounding such claims. Although we record our best estimate of loss and loss adjustment expense reserves, because of the significant uncertainties involved and the likelihood that these uncertainties will not be resolved for many years, the ultimate amounts paid upon settlement of such claims may be more or less than the amount of the reserves.
We have elected to account for our stock options under Accounting Principles Board Opinion No. 25 in accounting for our stock option plan. Under Accounting Principles Board Opinion No. 25, no compensation expense is recognized for grants of options to employees and directors at an exercise price equal to or greater than the market price of the stock on the date of grant. Accordingly, based on our grants to employees in 2003 and 2002, no compensation expense has been recognized.
We annually determine the assumptions used to calculate our benefit plan obligations. We establish the discount rate based upon published investment grade, long-term corporate bond yields. In 2003, we lowered the discount rate to 6.5 percent (from 6.75 percent in 2002, and 7.25 percent in 2001.)
A hypothetical 1 percent increase in the discount rate would result in a decrease in pension and retiree medical projected benefit obligations of approximately $2.1 million and $1.7 million, respectively. A hypothetical 1 percent decrease in the discount rate would result in an increase in pension and retiree medical projected benefit obligations of approximately $2.5 million and $2.2 million, respectively.
The estimated long-term rate of return that is assumed on pension plan assets affects our pension expense during a particular period. Because our retiree medical plan is unfunded, it is unaffected by changes in the rate of return assumption. We perform an analysis of expected long-term rates of return based on the allocation of our pension plan assets and recent economic conditions to develop an expected long-term rate of return. For 2003, we utilized an expected rate of return of 8.25 percent on our pension assets in arriving at these costs. At December 31, 2003, 54.4 percent of the plan assets was invested in common stock, 35.8 percent of the plan assets was invested in an annuity purchased from our life insurance company, and the remainder of the plan assets was held in cash and cash equivalents. Fourteen percent of the plan assets was invested in our own common stock. A hypothetical 1 percent increase or decrease in the expected long-term rate of return would result in a pretax change in our pension expense (or income) for 2004 of approximately $.4 million.
Net premiums written consists of direct premiums written plus assumed premiums less ceded premiums. All three components of net premiums written are recognized as revenue over the period that coverage is provided. When premium rates increase, the effect of those increases will not immediately affect earned premium. Rather, those increases will be recognized ratably over the period of coverage. Unearned premiums and prepaid reinsurance premiums, which are recorded on the Consolidated Balance Sheets, represent that portion of premiums written that are applicable to the unexpired terms of policies in force.
Despite strict oversight by state insurance regulators, insurance companies occasionally become insolvent. Each of our insurance companies is required to participate in state guaranty fund associations, the purpose of which is to protect the policyholders of insolvent insurance companies. The guaranty fund associations assess solvent insurers to pay the claims of insolvent insurers. The assessments are based proportionately upon each solvent insurance company’s share of written premiums in the applicable state. Most of the state guaranty fund associations allow solvent insurers to recoup the assessments paid via the utilization of rate increases, surcharges or premium tax credits. However, there is no assurance that we will ultimately recover these assessments. At December 31, 2003, we have accrued $.1 million for state guaranty fund assessments.
insurers in the event of future terrorist acts perpetrated by foreign agents or interests. The law limits the industry’s aggregate liability by requiring the federal government to share 90 percent of certified losses once a company meets a specific retention or deductible as determined by its prior year’s direct written premiums and limits the aggregate liability to be paid by the government and industry, without further action by Congress, to $100 billion. In exchange for this “back-stop”, primary insurers are required to make coverage available to commercial insureds for losses from acts of non-domestic terrorism as specified in the Terrorism Act. We are complying with the requirements of the Terrorism Act in order to ensure our ability to be reimbursed by the federal government for any losses we may incur as a result of future terrorist acts.
Our family of property and casualty insurers has received a group rating of “A” (Excellent) from A.M. Best Company. Within the group, all of our property and casualty insurers have an “A” (Excellent) rating, except two insurance subsidiaries that are in a run-off status, which A.M. Best has designated as NR-3 (Rating Procedure Inapplicable).
See Note 1 of the Notes to Consolidated Financial Statements for a description of recently issued accounting pronouncements. We believe that the new accounting pronouncements will not materially affect our financial condition or results of operations.
From a pricing perspective, despite what the industry does, our philosophy remains consistent - we will seek to charge adequate prices for our property and casualty insurance products. We do not intend to under-price our products to gain market share, as we believe this strategy leads to long-term underwriting losses and capital erosion. We are convinced that our historical results, as compared with those of the property and casualty industry, and as measured by the statutory combined ratio, support this underwriting philosophy.
We are hopeful that the investment markets will recover, thus leading to improvement in our investment results. A recovery would contribute profitability in both of our insurance segments. However, improvements in the interest rate environment would negatively impact our stockholders’ equity, as higher rates would lead to a decrease in the fair value of our fixed maturity securities and the related unrealized appreciation recognized in stockholders’ equity.
Contingent on improvements in the interest rate environment, we expect our life insurance segment to experience an increase in our fixed annuity sales in 2004. We have been able to maintain our very important relationships with our life insurance agents throughout the six-month suspension of fixed annuity sales that existed from July 1, 2003 through December 31, 2003. The decision to suspend annuity sales was a difficult decision to make, but we remain convinced that it was the best decision in order for us to continue to meet the long-term needs of our agents and policyholders.
We continually review our operations, looking for opportunities to increase our efficiency, thus reducing operating costs, and we will continue to do so. Despite the improvements that we make, we anticipate that we will incur increased costs in the area of legal, auditing and other professional fees due to the necessity to meet more stringent corporate governance regulations.
We utilize certain non-GAAP financial measures to monitor and evaluate our ongoing insurance operating results and trends. Management believes that investor understanding of our financial performance is enhanced by disclosure of these non-GAAP measures because they provide supplemental information that facilitates comparison with our prior periods, and with other companies within our industry. The non-GAAP financial measures we utilize are written premium, catastrophe losses and statutory combined ratio. Written premium, catastrophe losses and statutory combined ratio are statutory financial measures prepared in accordance with statutory accounting rules as prescribed by the National Association of Insurance Commissioners’ Accounting Practices and Procedures Manual.
Catastrophe losses: A catastrophe loss is a single incident or series of closely related incidents causing severe insured losses. Catastrophes are by their nature unpredictable. The frequency and severity of catastrophic losses we experience in any year impacts our results of operations and financial position. In analyzing the underwriting performance of our property and casualty insurance segment, we evaluate performance both including and excluding catastrophe losses. We define catastrophes to include events that cause $25.0 million or more in industry-wide direct insured losses to property and that affect a significant number of insureds and insurers. This is the same definition utilized by the Insurance Services Office, a supplier of property and casualty statistical data. We also include in our catastrophe totals those events we believe are, or will be, material to our operations, either in amount or in number of claims made.
(2) The adjustment of minimum pension liability is net of income taxes (see Note 15).
The accompanying Consolidated Financial Statements include United Fire & Casualty Company and its wholly owned subsidiaries: United Life Insurance Company, Lafayette Insurance Company, Addison Insurance Company, American Indemnity Financial Corporation, American Indemnity Company, United Fire & Indemnity Company and Texas General Indemnity Company. United Fire Lloyd’s, an affiliate of United Fire, has also been included in consolidation. All intercompany balances have been eliminated in consolidation.
United Fire Lloyd’s is organized as a Texas Lloyd’s plan, which is an aggregation of underwriters who, under a common name, engage in the business of insurance through a corporate attorney-in-fact. United Fire Lloyd’s is financially and operationally controlled by United Fire & Indemnity Company, its corporate attorney-in-fact, pursuant to three types of agreements: trust agreements between United Fire & Indemnity Company and certain individuals who agree to serve as trustees; articles of agreement among the trustees who agree to act as underwriters to establish how the Lloyd’s plan will be operated; and powers of attorney from each of the underwriters appointing a corporate attorney-in-fact, who is authorized to operate the Lloyd’s plan. Because United Fire & Indemnity Company can name the trustees, the Lloyd’s plan is perpetual, subject only to United Fire & Indemnity Company’s desire to terminate it.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management 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. The financial statement captions that are most dependent on management estimates and assumptions include investments, deferred policy acquisition costs and future policy benefits and losses, claims and settlement expenses.
To establish loss and loss adjustment expense reserves, we make estimates and assumptions that affect the amounts of assets, liabilities, revenues and expenses reported in our financial statements. Actual results could differ materially from those estimates. The estimate of these reserves is subjective and complex and requires us to make estimates about the future payout of claims. Such estimates are inherently uncertain. When we establish and adjust reserves, we do so given our knowledge of the circumstances and claim facts. To the extent that we have over- or under-estimated our loss and loss adjustment expense reserves, we adjust the reserves in the period the over- or under-estimate is determined.
On whole life and term insurance (traditional business), premiums are reported as earned when due, and benefits and expenses are associated with premium income in order to result in the recognition of profits over the lives of the related contracts. On universal life and annuity policies (nontraditional business), income and expenses are reported as charged and credited to policyholder account balances in order to result in the recognition of profits over the lives of the related contracts, which is accomplished by means of a provision for future policy benefits and the deferral and subsequent amortization of life policy acquisition costs. We do not write variable annuities or variable insurance products.
The costs of acquiring new life business, principally commissions and certain variable underwriting, agency and policy issue expenses, have been deferred. These costs are being amortized to income over the premium paying period of the related traditional policies in proportion to the ratio of the expected annual premium revenue to the expected total premium revenue, and over the anticipated lives of nontraditional policies in proportion to the ratio of the expected annual gross profits to the expected total gross profits. The expected premium revenue and gross profit are based upon the same mortality and withdrawal assumptions used in determining future policy benefits. For nontraditional policies, changes in the amount or timing of expected gross profit will result in adjustments to the cumulative amortization of these costs.
Liabilities for future policy benefits for traditional products are computed by the net level premium method using interest assumptions ranging from 4.5 percent to 8.0 percent and withdrawal, mortality and morbidity assumptions appropriate at the time the policies were issued. Accident and health reserves are stated at amounts determined by estimates on individual cases and estimates of unreported claims based on past experience. Liabilities for universal life and investment contracts are stated at policyholder account values before surrender charges. Liabilities for traditional immediate annuities are based primarily upon future anticipated cash flows using statutory mortality and interest rates, which produce results that are not materially different from accounting principles generally accepted in the United States. Deferred annuity reserves are carried at the account value.
Our accounting policy for impairment recognition requires other-than-temporary impairment charges to be recorded when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security or that the anticipated recovery in market value of the equity security will not occur in a reasonable amount of time. Impairment charges on investments are recorded based on the fair value of the investments at the measurement date and are included in net realized gains and losses. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which the fair value has been less than cost; the financial conditions and near-term prospects of the issuer; and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery.
For purposes of reporting cash flows, cash and cash equivalents include cash, non-negotiable certificates of deposit with original maturities of three months or less and money market accounts. Negative cash balances are included in accrued expenses and other liabilities.
Our intangibles are comprised entirely of agency relationships, which are being amortized by the straight-line method over periods of up to 10 years. The carrying value of our intangibles is reviewed regularly for impairment in the recoverability of the underlying asset. Any impairment would be charged to operations in the period that the impairment was recognized. We did not recognize an impairment write-down to the carrying value of our intangibles in 2003, 2002 or 2001.
We have a stock-based compensation plan, which is described more fully in Note 10. Pursuant to Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation,” we elected to apply Accounting Principles Board Opinion No. 25 and related interpretations in accounting for our stock options, which prescribe the use of the intrinsic value method of accounting for employee and director stock-based compensation awards. Accordingly, we have not recognized compensation expense for stock options issued to our employees and directors. We have determined the amount of compensation cost that would have been recognized as of December 31, 2003, 2002 and 2001 under the fair value method of accounting prescribed by Statement No. 123 has an immaterial impact on the net income and earnings per share reported in our Consolidated Financial Statements.
In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 142 “Goodwill and Other Intangible Assets,” which became effective January 1, 2002. Statement No. 142 eliminates the amortization of goodwill over its estimated useful life, but requires goodwill to be subject to at least an annual assessment for impairment by applying a fair-value-based test. Pursuant to the adoption of Statement No. 141, we do not have any unamortized goodwill reported at January 1, 2002. The adoption of Statement No. 142 had no effect on our Consolidated Financial Statements.
In October 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which became effective for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. Statement No. 144 revises and clarifies the existing professional guidance addressing: (a) recognition and measurement of the impairment of long-lived assets to be held and used; (b) the measurement of long-lived assets to be disposed of by sale; and (c) the reporting of discontinued operations and components of an entity that either has been disposed of (by sale, by abandonment, or in a distribution to owners) or is classified as held for sale. The adoption of Statement No. 144 had no effect on our Consolidated Financial Statements.
In April 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 145, “Rescission of Financial Accounting Standards Board Statements No. 4, 44 and 64, Amendment of Financial Accounting Standards Board Statement No. 13, and Technical Corrections,” which became effective for fiscal years beginning after May 15, 2002. The rescission of Statement of Financial Accounting Standard No. 4, “Reporting Gains and Losses from Extinguishment of Debt,” and Statement of Financial Accounting Standard No. 64, “Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements,” which had amended Statement No. 4, will affect income statement classification of gains and losses from extinguishment of debt. Statement No. 4 required material gains and losses from extinguishment of debt to be classified as extraordinary items. Under Statement No. 145, extinguishment of debt is now considered a risk management strategy by the reporting enterprise, and the Financial Accounting Standards Board does not believe it should be considered extraordinary under the criteria in Accounting Principles Board Opinion No. 30, “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” unless the debt extinguishment meets the unusual-in-nature and infrequency-of-occurrence criteria in Accounting Principles Board Opinion No. 30. Because we did not extinguish debt in 2003, the adoption of Statement No. 145 had no effect on our Consolidated Financial Statements.
In October 2002, the Financial Accounting Standards Board issued Statement No. 147, “Acquisitions of Certain Financial Institutions,” which clarifies the accounting treatment for acquisitions of financial institutions. In addition, Statement No. 147 amends Statement No. 144 to include in its scope long-term customer-relationship intangible assets of financial institutions such as depositor- and borrower-relationship intangible assets and credit cardholder intangible assets. Statement No. 147 is effective on October 1, 2002. Our adoption of Statement No. 147 will have no effect on our Consolidated Financial Statements.
In April 2003, the Financial Accounting Standards Board issued Statement No. 149, “Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities.” Statement No. 149 improves financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, this new standard (a) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative discussed in paragraph 6(b) of Statement No. 133, (b) clarifies when a derivative contains a financing component, (c) amends the definition of an underlying variable to conform it to language used in Financial Accounting Standards Board Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” and (d) amends certain other existing pronouncements. These changes will result in more consistent reporting of contracts as either derivatives or hybrid instruments. Statement No. 149 is to be applied prospectively to contracts entered into or modified after September 30, 2003. We will evaluate our reporting for all contracts to which Statement No. 149 applies; however, we do not believe that the adoption of Statement No. 149 will have any impact on our Consolidated Financial Statements.
In November 2003, the Emerging Issues Task Force reached a consensus on certain additional quantitative and qualitative disclosure requirements in connection with its deliberations of Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The new pronouncement requires that in addition to the disclosures already required by Statement of Financial Accounting Standard No. 115 and Statement of Financial Accounting Standard No. 124, the aggregate amount of unrealized losses, aggregate related fair value of investments with unrealized loss and certain qualitative disclosures must also be disclosed. This pronouncement was required to be applied to financial statements for fiscal years ending after December 15, 2003. We have adopted this pronouncement. Refer to Note 2 for the presentation of the disclosures prescribed by this pronouncement.
On December 23, 2003, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 132 (revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits - an amendment of Statements No. 87, 88 and 106.” Statement No. 132 (revised 2003) disclosure requirements are effective for fiscal years ending and interim periods beginning after December 15, 2003. Required disclosures related to estimated benefit payments will be effective for fiscal years ending after June 15, 2004.
For companies electing the one-time deferral, such deferral remains in effect until authoritative guidance on the accounting for the federal subsidy is issued, or until certain other events, such as a plan amendment, settlement or curtailment, occur. We are currently evaluating the effects of the Medicare Prescription Drug Act on our other postretirement benefit plan and its participants, and have elected the one-time deferral. Our accumulated postretirement obligation or net periodic postretirement benefit cost for 2003 does not reflect the effects of the Act on our other postretirement plan. Additionally, once the specific authoritative guidance on the accounting for the federal subsidy is issued, it could result in a change to previously reported information.
Proceeds from the sale of trading securities were $3,261,000 and $2,604,000 in 2003 and 2002, respectively. Gross gains of $192,000 and $9,000 were realized on these sales in 2003 and 2002, respectively. Gross losses of $447,000 and $306,000 were realized on these sales in 2003 and 2002, respectively. An additional gross gain of $639,000, which was attributable to the change in fair value of these securities, was realized during 2003, compared to an additional gross loss of $227,000 realized during 2002.
A summary of realized investment gains (losses) resulting from sales, calls, maturities, and other-than-temporary impairments and a summary of net changes in unrealized investment appreciation (depreciation), less applicable income taxes, is as follows.
Net investment income for the years ended December 31, 2003, 2002 and 2001 is comprised of the following.
Our investment portfolio includes trading securities with embedded derivatives, primarily convertible debt and equity instruments. These securities are recorded at fair value. Any income or loss, including the change in the fair value of these trading securities, is recognized currently in earnings as a component of realized investment losses. Our trading portfolio of fixed maturity securities had a market value of $8,099,000 at December 31, 2003, compared with $4,117,000 at December 31, 2002.
A summary of the carrying value and estimated fair value of assets and liabilities meeting the definition of financial instruments at December 31, 2003 and 2002 is as follows.
Reinsurance is a contract by which one insurer, called the reinsurer, agrees to cover, under certain defined circumstances, a portion of the losses incurred by a primary insurer if a claim is made under a policy issued by the primary insurer. For business written during 2003, we have several programs that provide reinsurance coverage. This reinsurance coverage limits the risk of loss that we retain by reinsuring direct risks in excess of our retention limits. For our property and casualty lines of business, our retention for 2003 was $1,500,000, which means we have reinsurance for any single claim over $1,500,000 in 2003. Our loss retention is $1,500,000 for losses that pertain to 2003, $1,250,000 for losses that pertain to 2002, $1,000,000 for losses that pertain to years 1995 through 2001 and $750,000 or less for losses that pertain to years prior to 1995. In addition, we reinsure personal and commercial umbrella policy losses in excess of $1,000,000 up to $5,000,000, and we reinsure surety policy losses in excess of $1,250,000 up to $5,000,000, 90 percent of losses from $5,000,000 up to $15,000,000 and 80 percent of losses from $15,000,000 up to $20,000,000. We also have reinsurance that limits the total direct loss we may incur from a single catastrophe. The catastrophic program provides coverage of 95 percent of $70,000,000 for losses in excess of our retention of $7,500,000 for a catastrophic event. We have additional coverage for 95 percent of $30,000,000 for catastrophic events occurring in the states of Arkansas, Florida, Louisiana, Mississippi and Texas.
Our property and casualty companies also assume portions of their insurance business from other insurance companies. Written premiums assumed for the years ended December 31, 2003, 2002 and 2001 were $12,860,000, $10,766,000 and $15,708,000, respectively. Assumed premiums earned for the years ended December 31, 2003, 2002 and 2001 were $12,822,000, $11,024,000 and $19,171,000, respectively. Assumed loss and loss adjustment expenses incurred were $12,238,000, $6,818,000 and $26,266,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
As of December 31, 2003, our life insurance segment has purchased reinsurance to limit the dollar amount of any one risk of loss. On standard individual life cases where the insured is age 65 or less, our retention is $200,000. On standard individual life cases where the insured is age 66 or older, our retention is $80,000. Our accidental death benefit rider on an individual policy is reinsured at 100 percent up to a maximum benefit of $250,000. Our group coverage, both life and accidental death and dismemberment, is reinsured at 50 percent. Catastrophe excess coverage applies when three or more insureds die in a “catastrophic accident.” For catastrophe excess claims, we retain the first $1,000,000 of ultimate net loss, and the reinsurer agrees to indemnify us for the excess up to a maximum of $5,000,000. We plan to supplement this coverage when appropriate with “known concentration” coverage.
The table below provides an analysis of changes in our property and casualty loss and loss adjustment expense reserves for 2003, 2002 and 2001 (net of reinsurance amounts). Changes in reserves are reflected in the statement of income for the year when the changes are made. The favorable development resulted from a re-estimation of loss reserves established at December 31 of the prior year.
Conditions and trends that have affected the reserve development reflected in the table may change. Such development can not be used to extrapolate future reserve redundancies or deficiencies.
Statutory policyholders’ surplus at December 31, 2003, 2002 and 2001 and net income for the years then ended are as follows.
(1) Because of United Fire & Casualty Company’s ownership of United Life Insurance Company, the property and casualty surplus includes life, accident and health surplus, and therefore represents our total consolidated statutory policyholders’ surplus.
The State of Iowa Insurance Department governs the amount of dividends we may pay to stockholders without prior approval by the department. Based on these restrictions, we are allowed to make a maximum of $30,311,000 in dividend distributions to stockholders in 2004 without prior approval. Dividend payments by the insurance subsidiaries to United Fire are subject to similar restrictions in the states in which they are domiciled. We received no dividends from our subsidiaries in 2003 or 2002, as compared to $275,000 in 2001.
A reconciliation of income tax expense (computed at the applicable federal tax rate of 35 percent in 2003, 2002 and 2001, respectively) to the amount recorded in the Consolidated Financial Statements is as follows.
Under prior federal income tax law, one-half of the excess of a life insurance company’s income from operations over its taxable investment income was not taxed, but was set aside in a special tax account designated as “Policyholders’ Surplus.” At December 31, 2003, we had approximately $2,121,000 of untaxed “Policyholders’ Surplus” on which no payment of federal income taxes will be required unless it is distributed as a dividend, or under other specified conditions. Barring the enactment of new tax legislation, we do not believe that any significant portion of the account will be taxed in the near future; therefore, no deferred tax liability has been recognized relating to the Policyholders’ Surplus balance. If the entire Policyholders’ Surplus balance became taxable at the current federal rate, the tax would be approximately $742,000.
The following actuarial assumptions were used at December 31 in determining the reported plan benefit obligations:
The following actuarial assumptions were used at January 1 in determining our reported net periodic benefit costs:
The following table provides a reconciliation of the changes in both plans’ benefit obligations and fair value of plan assets and a statement of the plan’s funded status for 2003 and 2002.
The unrecognized prior service cost and the unrecognized actuarial loss are being amortized on a straight-line basis over an average period of approximately eleven years. This period represents the average remaining employee service period until the date of full eligibility.
The following table sets forth the activity of our stock option plan for the years ended December 31, 2003, 2002, and 2001.
On May 6, 2002, we issued 2,760,000 shares of 6.375 percent convertible preferred stock, Series A at $25 per share. In connection with the preferred stock issuance, we collected net proceeds of $64,884,000. The preferred shares are non-voting. Dividends on the preferred stock are cumulative from the date of original issuance and are payable on March 15, June 15, September 15 and December 15 of each year, beginning on June 15, 2002. During 2003 and 2002, we paid and accrued dividends of $4,399,000 and $2,871,000, respectively, on our preferred stock. The preferred stock has a liquidation preference and redemption price of $25 per share.
The preferred stock is convertible at the option of the holder at any time, unless previously redeemed, into shares of common stock at an initial conversion price of $40.26 per share of common stock, which is equivalent to .621 shares of common stock for each share of preferred stock converted. The conversion price is subject to adjustment upon the occurrence of certain events.
We may redeem all or any shares of preferred stock on or after May 15, 2005. The preferred stock will be subject to mandatory redemption on May 15, 2014.
The property and casualty insurance segment markets most forms of commercial and personal property and casualty insurance products, including fidelity and surety bonds and reinsurance. The business is generated through approximately 1,030 independent agencies and brokers in 41 states. The following states provided more than 60 percent of the direct premium volume in this segment in 2003: Texas (13.7%), Iowa (12.8%), Louisiana (11.3%), Missouri (8.1%), Illinois (7.9%) and Colorado (7.9%).
United Life Insurance Company underwrites and markets ordinary life (primarily universal life), annuities (primarily single premium) and credit life products to individuals and groups through approximately 1,390 independent agencies in 27 states. The following states provided more than 70 percent of the direct premium volume in this segment in 2003: Iowa (38.0%), Minnesota (10.0%), Illinois (8.6%), Nebraska (7.9%) and Wisconsin (7.3%).
Total revenue by segment includes sales to both outside customers and inter-segment sales that are eliminated to arrive at the total revenues as reported in our Consolidated Statements of Income. We account for inter-segment sales on the same basis as sales to outside customers. The table on the following page sets forth certain data for each of our business segments. Depreciation expense and property and equipment acquisitions for the years ended December 31, 2003, 2002 and 2001, are reflected in the property and casualty insurance segment.
The primary components of our comprehensive income are net income, net unrealized appreciation and depreciation on available-for-sale securities and minimum pension liability adjustments. The following table sets forth the components of other comprehensive income, and the related tax effects, for the years ended December 31, 2003, 2002 and 2001.
In our opinion, the 2003 and 2002 financial statements referred to above present fairly, in all material respects, the consolidated financial position of United Fire & Casualty Company and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the two years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related 2003 and 2002 financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
The following is a copy of Arthur Andersen LLP’s previously issued report. Arthur Andersen LLP has ceased practicing before the Commission and is therefore unable to reissue this report.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of United Fire & Casualty Company and Subsidiaries as of December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States.
(1) Annuity deposits are included in future policy benefits, losses, claims, and loss expenses.
(2) Recorded in connection with purchase of American Indemnity Financial Corporation.