The following is a summary of properties leased by the Company at December 31, 2002:
The consolidated statements of operations data set forth below for each of the three years in the period ended December 31, 2002, and the consolidated balance sheet data at December 31, 2002 and 2001 are derived from, and are qualified by reference to, the audited consolidated financial statements included elsewhere in this Form 10-K. The consolidated statements of operations data set forth below for the two years in the period ended December 31, 1999, and the consolidated balance sheet data at December 31, 2000, 1999 and 1998, are derived from audited consolidated financial statements not included herein. The information set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and
We have developed two proprietary management systems: (i) the RTW SOLUTION®, designed to lower employers’ workers’ compensation costs and return injured employees to work as soon as possible, and (ii) the ID15® system, designed to identify those injured employees who are likely to become inappropriately dependent on the workers’ compensation system. We currently provide workers’ compensation management services to employers insured through our insurance subsidiary and to self-insured employers on a fee-for-service basis.
During 2002, we operated primarily in Minnesota, Wisconsin, South Dakota, Colorado, Michigan and Indiana. In the fourth quarter of 2001, we closed our regional offices in Missouri (which served Missouri, Illinois and Kansas) and Massachusetts (which served Massachusetts, Connecticut, New Hampshire, Rhode Island and Maine). We did earn premiums from these regional offices in 2002. Collectively, these regional offices had remaining premiums in force totaling $1.4 million at December 31, 2002. We completed running off this business in February 2003.
On February 28, 2002, our A.M. Best financial rating was downgraded from a Secure rating (B+) to an Unsecure rating (B-) as a result of the decrease in statutory surplus in 2001 from $29.3 million at December 31, 2000 to $19.5 million at December 31, 2001 and our adverse development in 2001 and 2000 that resulted in statutory operating losses in those years. Certain insurance carriers that write umbrella policies will not provide coverage to an employer if a portion of the employer’s underlying insurance policy, such as the workers’ compensation portion, is written by a carrier with an unsecure rating. Additionally, certain of our independent agents may be unwilling to sell our insurance as a result of the downgrade. As a result, we believe that our B- rating from A.M. Best will make it more difficult to provide our products to certain employers. While we believe that the A.M. Best downgrade will result in decreasing premiums in force, the ultimate effect of this downgrade is unknown at this time.
Financial Summary - This financial summary presents our discussion and analysis of the consolidated financial condition and results of operations of RTW, Inc. This review should be read in conjunction with the Consolidated Financial Statements at December 31, 2002.
We reported net income of $14.3 million in 2002 compared to net losses of $25.2 million and $9.7 million in 2001 and 2000, respectively. We reported basic and diluted net income per share of $2.78 in 2002 compared to basic and diluted net losses per share of $4.89 and $1.79 in 2001 and 2000, respectively. The primary factors affecting our 2002 operating results included the following:
Our gross premiums earned decreased in 2002 from 2001, due primarily to a 31.6% decrease in average premiums in force to $65.1 million for 2002 from $95.2 million in 2001;
continue to operate in an environment of premium rate increases in 2003; however, these rate increases will be significantly lower than experienced in 2002, 2001 and 2000. We will focus on achieving profitability in our remaining regional markets by: (i) aggressively managing and closing claims, (ii) reviewing policy profitability at renewal and removing unprofitable accounts, and (iii) aggressively managing policy acquisition costs and general and administrative expenses.
In the following pages, we take a look at the 2002, 2001 and 2000 operating results for items in our Consolidated Statement of Operations and also explain key balance sheet accounts in greater detail.
Our gross premiums earned decreased 35.8% to $62.5 million in 2002 from $97.4 million in 2001. This decrease resulted primarily from: (i) the decrease in average premiums in force, and (ii) final audit premiums which
decreased gross premiums earned by $1.7 million in 2002 and increased gross premiums earned by $1.8 million in 2001.
In 2002, 2001 and 2000, we were able to increase premium rates on renewing policies an average of 9.0%, 18.5% and 11.7%, respectively. We have been able to increase premium rates in our markets due to the following:
Reinsurance rates for workers’ compensation insurers have increased due to: (i) reductions in reinsurer’s surplus as a result of the September 11, 2001 terrorist acts against the United States, (ii) recent unprofitability resulting from highly competitive reinsurance pricing, and (iii) settlements related to certain reinsurance treaties written in the late 1990’s. These rate increases have resulted in increased costs for workers’ compensation insurers. Insurers, including RTW, have raised premium rates to offset these increases in reinsurance premiums; and
A number of workers’ compensation insurers’ financial ratings have decreased due to reserve adjustments recorded in 2002, 2001 and 2000.
2003 Outlook: The 2003 outlook for premiums in force, gross premiums earned and premiums ceded include the following factors:
Our 2002 gross premiums earned include $7.9 million in premiums earned from our Missouri and Massachusetts regions that were in runoff in 2002. Premiums earned in these regions are expected to be less than $100,000 in 2003. Additionally, we expect our average premiums in force to decrease significantly in 2003 compared to 2002. Overall, we expect gross premiums earned to decrease significantly in 2003; and
Investment Income and Net Realized Investment Gains (Losses): Our investment income includes earnings on our investment portfolio and interest on our deposit receivable. Our net realized investment gains (losses), displayed separately on our accompanying Consolidated Statements of Operations, include gains and losses from sales of securities. Through January 2001, we invested entirely in U.S. domiciled investment-grade taxable and tax-exempt fixed maturity investments. In February 2001, we repositioned our portfolio, sold our tax-exempt securities, and purchased taxable securities to take advantage of our net operating loss carry-forward generated in 2000 and to maximize the after-tax yield of our investment portfolio. We realized investment gains totaling $1.1 million as a result of this repositioning. In February 2002, we sold certain securities within the portfolio and realized investment gains totaling $1.5 million to increase statutory surplus. In September 2002, we sold our corporate securities to further reduce risk in our portfolio and realized net investment gains of $354,000 in the third quarter of 2002. Further recognition of realized investment gains and losses will depend on sales of our investments, if any, to meet our short-term cash requirements or as we replace securities to manage our portfolio returns. We currently invest entirely in U.S. domiciled investment-grade taxable fixed maturity investments and classify our investments as available-for-sale. We intend to hold our available-for-sale investments to maturity, but may sell them before maturity in response to tax planning considerations, changes in interest rates, changes in prepayment risk and changes in funding sources or terms, or to address liquidity needs. Our primary investment objective is to maintain a
diversified, high-quality, fixed-investment portfolio structured to maximize our after-tax investment income without taking inappropriate credit risk. For further discussion of investments, see the “Investments” section of this Management’s Discussion and Analysis.
2003 Outlook: Barring significant changes in interest rates or operational cash flows, we expect that income from our investment portfolio for 2003 will be affected by the following:
The increase in our funds available for investment as a result of the $28.8 million of cash received in December 2002 from terminating the St. Paul Re contract;
Other Income: We recorded and received a refund totaling $2.1 million from the WCRA in 2001. The WCRA periodically reviews its surplus position and refunds excess surplus to its members. This refund represents our share of the excess surplus of the WCRA at December 31, 2000. No such refund was received in 2002. We do, however, expect that fee-for service revenues will increase substantially in 2003 from the $22,000 realized in 2002.
claims are referred to as claim settlement expenses. We record these expenses, net of amounts recoverable under reinsurance contracts, to claim and claim settlement expenses in the accompanying Consolidated Statements of Operations.
Claim and claim settlement expenses are our largest expense and result in our largest liability. We establish reserves that reflect our estimates of the total claim and claim settlement expenses we will ultimately have to pay under our workers’ compensation insurance policies. These include claims that have been reported but not settled and claims that have been incurred but not yet reported to us. For further discussion of reserve determination, see the “Unpaid Claim and Claim Settlement Expenses and Reinsurance Recoverables” section of this Management’s Discussion and Analysis.
We experienced a significant decrease in the estimated number of ultimate claims for 2002 compared to 2001 and 2000. The number of estimated ultimate claims by accident year decreased to approximately 11,500 in 2002 from 22,100 in 2001 and 28,300 in 2000. The net decrease correlates directly to: (i) the decrease in premiums in force, and (ii) the re-underwriting that we completed with respect to our in force policies in 2000 and 2001. The gross and net average estimated cost per claim totaled approximately $5,500 and $4,900 in 2002 compared to $4,500 and $3,400 in 2001 and $4,000 and 2,400 in 2000, respectively. The increases in gross and net average estimated cost per claim are primarily the result of increases in severity, (i.e., the average cost of a claim), caused mainly by inflationary pressures. The trend of increasing severity is attributable to a combination of factors that include increasing medical costs and increasing indemnity payments (reimbursements to injured workers for lost wages) per claim. We have also observed a decline in the number of claims being reported over the last several years. The declining frequency of claims contributes to the increasing severity trend because the frequency decline has been concentrated in less expensive claims (claims involving less time-off from work and less severe injuries).
Gross premiums earned decreased significantly due to: (i) decreased premiums in force, and (ii) final audit premium reductions totaling $1.7 million in 2002 compared to an increase in premiums earned due to final audits of $1.8 million in 2001, resulting in corresponding decreases in claim and claim settlement expenses and a distorted percent of gross premiums earned;
The 2002 results include an $8.4 million decrease in prior years’ reserves for unpaid claim and claim settlement expenses compared to the 2001 results which include a $7.7 million increase in prior years’ reserves for unpaid claim and claim settlement expenses. Our estimate for unpaid claim and claim settlement expenses decreased in 2002 due to the following: (i) in March 2002, the Minnesota State legislature changed the way the commissioner will assess self-insured employers and insurers for estimated liabilities and administrative expenses of the State’s Special Compensation Fund (SCF). The assessment changed from being paid by the insurer on indemnity payment basis to an assessment charged on premium to the policyholder. We decreased our recorded accrual to reflect this legislative change, (ii) the frequency of claims reported in 2002 for 2001 and prior years was less than anticipated when we determined our liability in 2001, (iii) we overestimated the liability for our mandatory participation in state and national assigned risk pool operating results for states in which we operate in 2001 and reversed that excess in 2002, and (iv) our estimate of the liability for unpaid claim and claim settlement expenses is difficult and volatile due to our relatively limited historical claim data and small claim population;
Claim and claim settlement expenses increased to $80.1 million in 2001 from $72.4 million in 2000. As a percent of premiums earned, claim and claim settlement expenses increased slightly to 93.1% in 2001 from 92.7% in 2000. These changes are due to the following:
The 2001 results include a $7.7 million increase in prior years’ reserves for unpaid claim and claim settlement expenses compared to the 2000 results which include a $15.9 million increase in prior years’ reserves for unpaid claim and claim settlement expenses. Our estimate for unpaid claim and claim settlement expenses increased in 2001 due to the following: (i) we increased the estimated liability for second injury funds and our mandatory participation in state and national assigned risk pool operating results for states in which we operate, (ii) our estimate of the liability for unpaid claim and claim settlement expenses is difficult and volatile due to our relatively limited historical claim data and small claim population, and (iii) we increased the estimated liability for claims in our closed Missouri and Massachusetts regions;
Claim costs will continue to be affected by: (i) increases in medical and indemnity costs resulting from inflationary changes, (ii) severity experienced in future periods in our policy holder base, (iii) changes resulting from increases in operating efficiency and effectiveness realized through enhancements to our internal processes and procedures, including changes to our proprietary computer systems, and (iv) legislative changes that affect benefits payable under workers’ compensation laws;
Increases in premium rates, if any in 2003, will result in increasing premiums earned without a corresponding increase in claim and claim settlement expenses, ultimately decreasing claim and claim settlement expense as a percent of premiums earned. Changes in premium rates due to legislative changes in estimated loss costs, increased competition and improving customer loss experience may offset rate improvements; and
The ultimate result of the above factors on 2003 claim and claim settlement expenses as a percent of premiums earned is unknown at this time.
Policy Acquisition Costs: Policy acquisition costs are costs directly related to writing an insurance policy and consist of commissions, state premium taxes, underwriting personnel costs and expenses, sales and marketing costs and other underwriting expenses less ceding commissions from our reinsurers. Ceding commissions are amounts that reinsurers pay to us for placing reinsurance with them. Under our 1992 to 1994 quota share reinsurance agreement,
the ceding commission is adjusted to the extent that actual claim and claim settlement expenses vary from levels specified in the agreements.
Policy acquisition costs decreased to $6.3 million in 2002 from $14.0 million in 2001 and $14.1 million in 2000. As a percent of gross premiums earned, policy acquisition costs decreased to 10.1% in 2002 compared to 14.4% in 2001 and 14.7% in 2000. The decrease in 2002 reflects the following:
Commission expense decreased to 6.9% of gross premiums earned in 2002 from 7.6% in 2001 and 7.9% in 2000. The decreased commission percentages in 2002 and 2001 are the result of: (i) a focus on reducing commissions paid on new business in our non-Minnesota regions, and (ii) increased renewal premiums on which we pay lower commission rates in all our states. In 2002, our renewal business, on which we pay lower commission rates, significantly outpaced our new business. In all of our markets, we believe the commission rates we pay are marketplace competitive;
Premium tax expense decreased slightly to 1.7% of gross premiums earned in 2002 from 1.9% of gross premiums earned in 2001 and 2.0% in 2000;
Other policy acquisition costs decreased to 1.5% of gross premiums earned in 2002 compared to 4.6% in 2001 and 4.4% in 2000. Other policy acquisition costs reflect the benefit of the following: (i) improvements in our underwriting organizational structure resulting in a $1.1 million decrease in personnel costs, overhead costs and marketing costs, (ii) an $851,000 reduction in an estimated accrual for second injury funds compared to recording an adjustment for those funds in 2001, and (iii) a general decrease related to the decrease in gross premiums earned; and
Our general and administrative expenses decreased to $10.0 million in 2002 from $17.4 million in 2001 and $11.5 million in 2000. As a percent of gross premiums earned, general and administrative expenses decreased to 16.0% in 2002 from 17.9% in 2001 and increased from 12.0% in 2000. General and administrative expenses decreased in 2002 as follows: (i) general and administrative expenses included costs related to operating our Missouri and Massachusetts offices in 2001; no such expense was recorded in 2002, (ii) we recorded $1.4 million in margin expenses related to our St. Paul Re contract offset by a $1.0 million gain recorded on the termination of the contract in 2002 compared to $2.0 million recorded in margin expenses in 2001 on the contract, (iii) we recorded $2.0 million in restructuring charges related to closing our regional offices in Missouri and Massachusetts and closing satellite offices in Brainerd, Minnesota and Overland Park, Kansas in 2001; no such costs were recorded in 2002, (iv) assessments by state Insurance Guarantee Associations (IGA) totaling $266,000 in 2002 compared to $1.1 million in 2001 and $236,000 in 2000, (v) we incurred one-time business repositioning costs totaling $470,000 in 2001, (vi) we recorded bonuses of $864,000 in 2002 compared to $204,000 in 2001, and (vi) we expensed $270,000 in leasehold improvement write-offs related to rebuilding our Minnesota and home office leased space in
2002. After adjusting for these items, general and administrative expenses increased as a percent of gross premiums earned to 13.1% in 2002 from 11.9% in 2001 and 11.8% in 2000. These increases reflect:
General and administrative expenses increased as a percent of premiums earned, after adjusting for restructuring charges, IGA assessments and one-time charges as we had less revenue relative to our fixed operating costs and expenses. We aggressively managed personnel and other operating costs and expenses during 2002 to appropriately align operating expenses with revenues. All expenses continue to be managed aggressively and reduced where appropriate;
During the fourth quarter of 2001, we recorded pre-tax restructuring charges totaling $2.0 million to general and administrative expenses in the Consolidated Statements of Operations. These charges included costs associated with our decision to close our Missouri and Massachusetts regional offices, as well as our Brainerd, Minnesota and Overland Park, Kansas satellite offices. We anticipated that 38 employees in our regional offices, 17 employees in our satellite offices and 2 employees in our Home Office would be affected by these closures. The restructuring charge amount included $715,000 of severance pay and benefits of which $106,000 was paid in 2001 and the remainder was paid in 2002. Additionally, the restructuring charge included office and equipment lease costs totaling $684,000 of which $80,000 was paid in 2001 and an additional $195,000 was paid in 2002, and furniture and equipment disposals and other costs totaling $600,000, of which $53,000 was disposed in 2001 and the remainder was disposed in 2002. The remaining accrual balance for severance pay and benefits, office and equipment lease costs and furniture and equipment disposals and other costs was $409,000 and $1.8 million at December 31, 2002 and 2001 respectively.
2003 Outlook: We expect that general and administrative expenses will be affected by the following:
The Term Loan accrues interest, payable quarterly. We may elect to pay an adjusted LIBOR or bank reference rate on the Term Loan. We paid interest at rates ranging from 4.61% to 5.33% on the outstanding balance of our Term Loan in 2002 compared to 6.50% to 8.83% in 2001. Interest expense decreased to $163,000 in 2002 from $511,000 in 2001 as a result of the decrease in interest rates, $3.3 million in principal payments in 2002 and $2.5 million in principal payments in 2001.
Under the first provision of the Job Creation and Worker Assistance Act of 2002, signed into law in March 2002, we were allowed to carry-back our 2001 net operating loss for five years, to 1996, instead of two years under previous law. We filed our tax return in September 2002, and received a refund totaling approximately $3.3 million as a result of this Federal legislative change from carrying-back our 2001 loss. An additional $475,000 receivable was recorded that related to the carry back that resulted from revising our financial statements for 2001.
Income tax benefit for the year ended December 31, 2002 included the following: (i) a $3.8 million benefit from carrying back our 2001 loss five years under the tax law change, (ii) a $4.0 million benefit resulting from reducing the allowance as we realized favorable claim reserve development in 2002, and (iii) a further benefit as we offset current year earnings by losses carried forward from 2000. The income tax benefit for 2002 included the items recorded in the third quarter as well as a $1.0 million benefit from reducing the allowance related to recognizing a $3.0 million benefit from the SCF. After excluding the effects of the benefits from reducing the allowance, income tax expense was $3.8 million for 2002 compared to an income tax benefit of $5.6 million for 2001. As a percent of income before income taxes, the income tax expense before any benefit from reducing the allowance was 37.1% of the income before income taxes in 2002 compared to 34.5% and 37.2% of the net loss before income taxes in 2001 and 2000, respectively.
Our portfolio of fixed maturity securities at December 31, 2002 included only U.S. government securities (59.0%), mortgage-backed securities (39.8%), and asset-backed securities (1.2%). Our portfolio is managed by an independent investment manager to maximize our after-tax investment income without taking inappropriate credit risk. In September 2002 we sold our corporate securities to reduce risk in our portfolio resulting in a $354,000 gain. In February 2002, we sold select securities within the portfolio and realized an additional investment gain totaling $1.5 million to increase our statutory surplus. In February 2001, we recognized gains totaling $1.1 million as we repositioned our portfolio by selling our tax-exempt securities and repurchased taxable fixed maturity investments to increase our after-tax yield. We conservatively manage our fixed maturity portfolio, investing only in investment grade (BBB or better rating from Standard and Poor’s) securities of U.S. domiciled issuers. All securities in our portfolio were rated AAA at December 31, 2002. We do not invest in derivative securities.
At December 31, 2002, the liability for unpaid claim and claim settlement expenses totaled $181.3 million and reinsurance recoverables on unpaid claim and claim settlement expenses totaled $91.8 million, resulting in net reserves totaling $89.4 million. The net reserve at December 31, 2001 totaled $91.2 million and included the liability for unpaid claim and claim settlement expenses totaling $181.3 million net of reinsurance recoverables on unpaid claim and claim settlement expenses of $90.1 million.
Estimating the effect that inflation will have on the ultimate cost of claims is a major risk factor in our workers’ compensation reserve estimates. Future earnings will be affected by reserve development associated with any changes in our inflation assumptions. Estimates for the 2002 and 2001 accident years represent the majority of the uncertainty because these claims have the lowest proportionate amount of paid loss as of December 31, 2002.
Our reserve estimates are most sensitive to changes in the assumption about inflation for the 2002 and 2001 accident years. Each one percent (1%) increase or decrease in the inflation rate for both of these accident years would increase or decrease our loss reserve estimates at December 31, 2002 and 2001 by approximately $348,000 and $290,000, respectively.
Our reserves are primarily undiscounted; however, we discounted reserves for selected claims that have fixed and determinable future payments at rates ranging from 3.5% to 8.0% in 2002 and 2001. The discount rates in 2002 and 2001 are subject to change as market interest rates change. We use the same rates for Generally Accepted Accounting Principles as we do for Statutory Accounting in determining our liability. We also reduce the unpaid claim and claim settlement expenses for estimated amounts of subrogation.
We continually monitor loss development trends and data to establish adequate premium rates and reasonable loss reserve estimates. Loss reserves, which are based on estimates, are inherently uncertain and represent a significant risk to the business that we attempt to mitigate by continually improving and refining our workers’ compensation claims processing practices and by employing actuarial estimation methods.
The table above represents the development of balance sheet net reserves for 1992 through 2002. The top three rows of the table reconcile gross reserves to net reserves for unpaid claim and claim settlement expenses recorded at the balance sheet date for each of the indicated years.
The “initial reserves in excess of (less than) re-estimated reserves” rows represent the aggregate change in the estimates over all prior years. For example, the 1998 reserve developed a $2.9 million net deficiency over the course of the succeeding years. The net amount has been included in income and the changes have been recorded in the period identified. The cumulative net deficiencies in 2000 and 1999 are the result of reserve development inherent in the uncertainty in establishing reserves and anticipated loss trends. As discussed above, due to our relatively limited historical claim data and small claim population, our estimate of the liability for net reserves is difficult and volatile. As discussed further below, the reserve redundancy in 2001 is the result of accrual reversals resulting from changes in methods of assessing second injury funds, lower frequency in claims reported from the estimate at December 31, 2001, and reductions in amounts expected to be incurred for our participation in mandatory state and national assigned risk pools.
The following table is derived from the loss reserve development table and summarizes the effect of reserve re-estimates, net of reinsurance, on calendar year operations for the same ten-year period ended December 31, 2002. The total of each column details the amount of reserve re-estimates made in the indicated calendar year and shows the accident years to which the re-estimates are applicable. The amounts in the total accident year column represent the cumulative reserve re-estimates for the indicated accident year (000’s):
historical claim data and small claim population, and (iii) we increased the estimated liability for claims in our closed Missouri and Massachusetts regions;
Our primary sources of cash from operations are premiums collected and investment income. Our investment portfolio is also a source of liquidity, through the sale of readily marketable fixed maturity investments. Our primary cash requirements consist of payments for: (i) claim and claim settlement expenses, (ii) reinsurance, (iii) policy acquisition costs, (iv) general and administrative expenses, (v) capital expenditures, (vi) income taxes, and (vii) debt service or principal repayment on our Term Loan. Prior to 1999, we generated positive net cash from operations due, in part, to timing differences between the receipt of premiums and the payment of claim and claim settlement expenses. As we lowered our reinsurance retention levels to $25,000 beginning in mid-1998 through runoff in 2001, we decreased our current period cash flows as a result of “pre-funding” quarterly premiums under that agreement. In 2002, the reinsurance reimbursements from our $25,000 to $300,000 excess of loss reinsurance agreement offset similar payments to claimants for those years. This trend will continue into 2003. Cash decreased for the remainder of 2002 as: (i) we paid claims for 2002 and prior years, years in which we earned higher premiums and incurred a higher number of claims reported while 2002 premiums in force and premiums earned decreased, and (ii) amounts paid under our St. Paul Re contract resulted in net cash outflows for most of 2002 until contract termination in December 2002. In 2003, we expect that cash and investments will decrease from levels at December 31, 2002 as we pay claims for 2002 and prior years, years in which we earned higher premiums and incurred a higher number of claims reported while 2003 premiums earned are expected to decrease. Available cash is invested in either short-term cash and cash equivalents or longer-term available-for-sale securities pending future payments for such expenses as medical and indemnity benefits and other operating expenses. Cash and cash equivalents consist of cash and a money market fund that invest primarily in short-term government securities.
On September 15, 1998, our Board of Directors approved a share repurchase program authorizing us to repurchase, from time to time, up to $4,000,000 of RTW, Inc. common stock. We repurchased 41,324 shares in 2002 for approximately $78,000, 5,000 shares in 2001 for approximately $9,000 and 329,750 shares for approximately $2.7 million through 2000. We repurchased these shares on the open market or through private transactions based upon market conditions and availability. The repurchased shares will be used for employee stock option and purchase plans and other corporate purposes.
Investments held as statutory deposits and pledged as collateral do not have an adverse effect on our liquidity. We believe that cash flow generated by our operations and our cash and investment balances will be sufficient to fund continuing operations, principal and interest payments and capital expenditures for the next 12 months.
Information included in this Report on Form 10-K which can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,” “estimate,” or “continue” or the negative thereof or other variations thereon or comparable terminology constitutes forward-looking information. The following important factors, among others, in some cases have affected and in the future could affect our actual results and could cause our actual financial performance to differ materially from that expressed in any forward-looking statement: (i) our ability to retain renewing policies and write new business with a B- (Unsecure) rating from A.M. Best; (ii) our ability to continue to increase pricing in the markets in which we remain; (iii) the ability of our reinsurers to honor their obligations to us; (iv) our ability to accurately predict claim development; (v) our ability to manage both our existing claims and new claims in an effective manner; (vi) our experience with claims frequency and severity; (vii) competition and the regulatory environment in which we operate; (viii) general economic and business conditions; (ix) our ability to obtain and retain reinsurance at a reasonable cost; (x) changes in workers’ compensation regulation by states, including changes in mandated benefits or insurance company regulation; (xi) interest rate changes; and (xii) other factors as noted in our other filings with the SEC. This discussion of uncertainties is by no means exhaustive but is designed to highlight important factors that may impact our future performance.
Consolidated Statements of Operations - Years Ended December 31, 2002, 2001 and 2000
Consolidated Statements of Cash Flows - Years Ended December 31, 2002, 2001 and 2000
In our opinion, the 2002 and 2001 financial statements referred to above present fairly, in all material respects, the consolidated financial position of RTW, Inc. at December 31, 2002 and 2001, and the consolidated results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
Organization - RTW, Inc. (RTW) provides workers’ compensation products and services to employers on an insured and fee-for-service basis. Insurance policies are written for employers through RTW’s wholly owned insurance subsidiary, American Compensation Insurance Company (ACIC). Collectively, “we,” “our” and “us” will refer to these entities in these Notes to Consolidated Financial Statements.
We benefit from our ability to reduce workers’ compensation costs and provide employers the ability to control their workers’ compensation programs. Our insurance subsidiary is domiciled in Minnesota and is licensed in Minnesota, Colorado, Missouri, Michigan, Massachusetts, Illinois, Kansas, Connecticut, Wisconsin, Rhode Island, Florida, Iowa, Indiana, Arkansas, Pennsylvania, Tennessee, South Dakota, Maryland, Georgia, New Jersey, North Carolina, Texas and Oklahoma. We wrote policies primarily in Minnesota, Colorado and Michigan during 2002. In the fourth quarter of 2001, we announced that we would close our regional offices in Missouri and Massachusetts. Beginning February 2002, we began to non-renew all insurance policies in our Missouri and Massachusetts regions and will run off any remaining expiring policies in these regions through March 2003. We operate in a single business segment, workers’ compensation products and services.
Available-for-Sale Investments: Our available-for-sale investments are carried at fair value with changes in unrealized gains or losses, net of deferred taxes, reported as other comprehensive income. The fair values of our investments are determined based upon quoted market prices as obtained through commercial pricing services or brokers who provide estimated fair values.
We continually monitor the difference between investment cost and fair value for each of our securities. If any security experienced a decline in value that is determined to be other than temporary, we would reduce the security’s carrying value for the decline and record a realized loss in the Consolidated Statements of Operations. In 2000, we recorded $500,000 against a security whose decline in value was determined to be other than temporary. No securities were reduced for declines in fair value in 2002 or 2001.
Deferred Policy Acquisition Costs - The costs directly related to writing an insurance policy are referred to as policy acquisition costs and consist of commissions, state premium taxes and other direct underwriting expenses. Although these costs arise when we issue a policy, we defer certain costs, principally commissions and state premium taxes. These costs are amortized to expense as premium revenue is recognized and are reported net of ceding commissions in the Statement of Operations.
Depreciation - We depreciate furniture and equipment on a straight-line basis over the estimated useful lives of the assets (five to ten years). Accumulated depreciation was $4.0 million at December 31, 2002 and $3.7 million at December 31, 2001.
Options to purchase 1.5 million shares of common stock at prices ranging from $1.98 to $38.67 were outstanding during 2001 and options to purchase 1.2 million shares of common stock at prices ranging from $5.33 to $38.67 were outstanding in 2000 but excluded from the computation of diluted IPS due to our 2001 and 2000 net losses. Diluted weighted average shares outstanding would have increased by 4,000 shares and 8,000 shares in 2001 and 2000, respectively, had these shares not been anti-dilutive in the computation.
For claims occurring after June 30, 1998, we further limited our per incident exposure by purchasing excess of loss coverage for losses from $25,000 to the lesser of $300,000 or the WCRA selected retention level in Minnesota and from $25,000 to $300,000 in other states from a single reinsurer. This agreement was finalized after its effective date and activity occurring from July 1, 1998 through September 30, 1998 was recorded on a retrospective basis resulting in the deferral of a gain totaling $2.0 million at December 31, 1998. We amortized $400,000 of the deferred gain as a reduction of claim and claim settlement expenses in each of 2002, 2001 and 2000 and $740,000 in 1999 resulting in an un-amortized deferred gain of $49,000 at December 31, 2002. The deferred gain is being amortized into income using the effective interest rate inherent in the amounts paid to the reinsurer and the estimated timing and amounts of recoveries from the reinsurer. Activity occurring on or after October 1, 1998 is recorded prospectively. This contract was terminated effective December 31, 2000; however, the policy was effective in 2001 for policies in force at December 31, 2000 through expiration, not to exceed fifteen months after the effective termination date. Policies written or renewing after December 31, 2000 are not covered under this lower level excess of loss reinsurance policy.
The reinsurance recoverable on paid claim and claim settlement expenses consists primarily of receivables from paid claim and claim settlement expenses that were submitted to but not yet reimbursed by reinsurers at December 31, 2002 and 2001.
Our estimate for unpaid claim and claim settlement expenses decreased in 2002 due to the following: (i) in March 2002, the Minnesota State legislature changed the way the commissioner will assess self-insured employers and insurers for estimated liabilities and administrative expenses of the State’s Special Compensation Fund (SCF). The assessment changed from being paid by the insurer on indemnity payments to an assessment charged on
premium to the policyholder. We decreased our recorded accrual to reflect this legislative change, (ii) the frequency of claims reported in 2002 for 2001 and prior years was less than anticipated when we determined our liability in 2001, (iii) we overestimated the liability for our mandatory participation in state and national assigned risk pool operating results for states in which we operate in 2001 and reversed that excess in 2002, and (iv) our estimate of the liability for unpaid claim and claim settlement expenses is difficult and volatile due to our relatively limited historical claim data and small claim population.
In March 2000, we borrowed $8.0 million under a term loan agreement to fund the repurchase of common stock from certain of our shareholders. We paid $1.0 million in principal on the term loan in 2000, an additional $2.5 million in 2001 and $3.3 million in 2002. The term loan accrues interest, payable quarterly. We may elect to pay an adjusted LIBOR or bank reference rate on the term loan (adjusted LIBOR was 4.66% and 8.22% at December 31, 2002 and 2001, respectively). The remaining term loan is payable in 2003.
In assessing the realizability of deferred tax assets, we consider recent operating results, the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies. At December 31, 2001, we established a $14.5 million valuation allowance against deferred tax assets resulting in a corresponding adjustment to income tax expense as a result of this analysis. In 2002, the valuation allowance decreased to $6.6 million as we were able to carry back our 2001 operating loss five years resulting in a tax refund and the reversal of certain deferred tax items and utilization of the 2000 operating loss carry forward to offset income in 2002. We expect the remaining deferred tax asset, net of the valuation allowance, at December 31, 2002 to be realized as a result of income and the reversal of existing taxable temporary differences in the future. Deferred tax assets are included in other assets on the Consolidated Balance Sheet.
1995 Employee Stock Purchase Plan - The ESPP provides employees the opportunity to purchase shares of our stock at 85% of the fair value based on the lesser of the beginning or ending share price for each plan year as set forth in the plan. In May 1998, the shares reserved for distribution under the plan were increased from 37,500 to
100,000 shares. The ESPP terminates in ten years and will be carried out in phases, each consisting of one year or a different period of time approved by the Board of Directors. Any employee completing two weeks of service prior to commencing a phase of the plan may participate. Employees may elect to contribute from $10 to 10% of monthly salary to the plan through payroll withholdings. The following summarizes shares purchased and purchase prices for each phase in the most recent three years completed through 2002:
The eighth one-year phase began in April 2002 and expires in April 2003.
Our liability for employee contributions withheld at December 31, 2002 and 2001 for the purchase of shares in April 2003 and April 2002 under the ESPP was $51,000 and $39,000, respectively.
401(k) Retirement Component - We sponsor a defined contribution retirement component under Section 401(k) of the Internal Revenue Code for eligible employees. Our contributions are discretionary and are based on contributions made by employees. Expense recognized for 2002, 2001 and 2000 was $220,000, $316,000 and $152,000, respectively.
Employee Stock Ownership Component - We maintain an ESOP for our qualified employees. Our contributions are discretionary. We may contribute cash or shares of our common stock. No expense was recorded in 2002, 2001 or 2000.
Under Minnesota insurance law regulating the payment of dividends by ACIC, any such payments must be an amount deemed prudent by ACIC’s Board of Directors and, unless otherwise approved by the Commissioner of the Minnesota Department of Commerce (Commissioner), must be paid solely from the adjusted earned surplus of ACIC. Adjusted earned surplus means the earned surplus as determined in accordance with accounting practices (unassigned funds), less 25% of the amount of such earned surplus that is attributable to unrealized capital gains. Further, without approval of the Commissioner, ACIC may not pay a dividend in any calendar year which, when combined with dividends paid in the preceding twelve months, exceeds the greater of (i) 10% of ACIC’s statutory capital and surplus at the prior year end or (ii) 100% of ACIC’s statutory net gain from operations (not including realized capital gains) for the prior calendar year. For 2002, dividends in excess of approximately $2.7 million would require prior consent of the Commissioner.
Future minimum (base) rental payments required under the leases, as of December 31, 2002, are as follows (000’s):
Quarterly revenues are affected by (i) premiums in force at the beginning of the quarter, (ii) new policies written in the quarter, (iii) final audit premiums recognized during the quarter, and (iv) our policy renewal rate in the quarter. Historically, a majority of new policies written and policy renewals have occurred in the first, second and fourth quarters.
The following represent pre-tax adjustments recorded during each quarter of 2001 that affected reported net income: