We conduct our operations for our property and casualty - Massachusetts segment from approximately 436,000 square feet of space in several buildings that we own in Webster, Massachusetts, which is located approximately 50 miles southwest of Boston. Our data processing and operational departments are housed in modern office buildings. Our property and casualty - Other than Massachusetts segment consists primarily of the operations of Commerce West and American Commerce. Commerce West currently leases approximately 22,000 square feet of office space in Pleasanton, California. American Commerce conducts its operations from approximately 40,000 square feet of space in a building it owns located on a two acre site in Columbus, Ohio. American Commerce also leases property at three district claims offices.
We manage our business in four reportable segments: property and casualty insurance - Massachusetts; property and casualty insurance - other than Massachusetts; real estate and commercial lending; and, corporate and other.
The Massachusetts regulatory environment for personal automobile insurance is characterized by the following key principles:
apportioning losses incurred by the state-mandated residual market run by Commonwealth Automobile Reinsurers, known as CAR,
Member companies of CAR have joint and several liabilities for the obligations of CAR. If one member of CAR fails to pay its assessments, the remaining members will be required to pay the pro-rata share of the member who fails to pay its obligations. As of December 31, 2005, we were not aware of any current CAR member company which has failed to meet its obligations.
In addition to the Commissioner's order under appeal, the Massachusetts Governor has introduced legislation intended to reform CAR. Among other things, this proposed legislation would give the Commissioner the authority to create an assigned risk plan and allow for the gradual phase-in of competitively set personal automobile rates. We cannot determine at this time whether the Governor's reform proposal will be acted on by the Legislature or, if passed, how it may affect our financial condition and results of operations.
legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes and trends in general economic conditions, including the effects of inflation and recession.
We determine our net liability estimate for losses and LAE by using individual estimates of reported claims adjusted for our best estimate by line of business and a review of these results by our actuarial area using generally accepted actuarial reserving techniques. After taking into account all relevant factors, we believe that, based on existing information, the provision for losses and LAE at December 31, 2005 is adequate to cover the ultimate net cost of losses and claims incurred as of that date. The ultimate liability, however, may be greater or lower than established reserves. If the ultimate payment is greater than or less than our estimated liability for losses and LAE, we will incur additional expense or income, as appropriate, which may have a material impact on our results of operations.
We review all security holdings on a quarterly basis for potential other-than-temporary impairments due to declines in market value in accordance with GAAP. In general, unrealized losses resulting from an increase in interest rates will not necessarily lead to an other-than-temporary write-down. As part of this process, we consider any significant market declines in the context of the overall market and also in relation to the outlook for the specific issuer of the security and the issuer's industry. Each quarter, we review all securities whose market values have declined below book price. From a quantitative standpoint, we review all securities that have declined more than 20% below book price and have remained so for two consecutive quarters as potentially in need of a write-down. Any other security that we view as impaired for a significant period of time is also a candidate for a write-down, even if the percentage decline is less than 20%. In addition, we perform the following quarterly impairment review of our portfolio:
We review all holdings with an unrealized loss of over $250, or a fair market value that is more than 20% below cost.
For our investment in any closed-end preferred stock mutual fund in which we own 20% or more of the fund's shares, the equity method of accounting requires us to categorize as a realized investment gain or loss the change in the net asset value of that fund from the beginning of the current fiscal year. Our investment in these funds has had a material effect on our realized gains and losses in recent years and may have caused our net earnings to be more volatile than those of similar companies. During 2004, we decreased our ownership below 20% in all but one closed-end preferred stock mutual fund. During 2005, one additional mutual fund exceeded the 20% threshold. At December 31, 2005, we had two closed-end preferred stock mutual funds in which we owned more than 20%.
Changes in Premium Rates. For the two-year period of 2003 and 2004, average mandated Massachusetts personal automobile insurance premium rates increased an average of 2.6% per year. However, the Commissioner approved average decreases of 8.7% for 2006 and 1.7% for 2005. Coinciding with the 2006 and 2005 rate decisions, the Commissioner also approved a 1.5% and 4.8% increase, respectively, in the commission agents receive for selling private passenger automobile insurance. The following table shows the state-mandated average rate change, the actual average revenue change per exposure and our average revenue change per exposure as estimated for 2006 and for the three previous years in Massachusetts.
changes to our distribution of risks by class, territory and coverage, including changes resulting from the purchase of new, more expensive automobiles, which were not factored into the Commissioner's rate increase.
The actual state average revenue change per exposure represents the change in the average premium paid by drivers in Massachusetts, as opposed to the state mandated average rate change. As can be seen above, our 2006 average revenue change per exposure corresponds more closely to the actual state average revenue change. The primary reason for this is that both take into account newer vehicles, as compared to the state mandated average rate change, which does not.
The Commissioner approved an 8.7% decrease in state mandated average personal automobile insurance premium rate for 2006. Management estimates that this will translate into a 5.8% decline in the average revenue per exposure for the upcoming year. We estimate the 2006 net pre-tax impact of the 5.8% decrease in our 2006 average revenue per exposure, partially offset by the remaining effects of the 2005 0.4% increase in average revenue per exposure, to be approximately $27,000. The majority of the impact will occur during the last two quarters of 2006 as premiums for policies with 2006 effective dates become earned.
The decreasing percentages since 2003 are attributed to a higher rate of increase in non-affinity group business. Of the total Massachusetts automobile exposures written through the AAA affinity group program by us in 2005, approximately 14.8% were written through insurance agencies owned by the AAA clubs (8.0% of our total Massachusetts automobile exposures). The remaining 85.2% of the AAA group program was written through our network of independent agents.
Return on equity is net earnings divided by stockholders' equity at the beginning of the period.
. Direct earned premiums are the portion of direct premiums written over the preceding twelve-month period equal to the expired portion of policies and recognized as income during an accounting period.
. Net investment income represents earnings on our investment portfolio less expenses. We rely on after-tax investment income as a significant source of net earnings since we generally achieve a combined ratio (see below) of slightly less than 100%.
. The underwriting expense ratio is the percentage of underwriting expenses (including corporate expenses) incurred to net premiums written. Underwriting expenses are the aggregate of policy acquisition costs, including commissions, and the portion of administrative, general and other expenses attributable to underwriting operations. In addition, underwriting expenses are grossed-up for any change in deferred acquisition costs.
The effect of our improved loss ratio on 2005 earnings was partially offset by the increase in our underwriting ratio. This increase was driven by a significant increase in our agents' profit sharing expense in 2005 and slightly higher 2005 policy year mandated Massachusetts personal automobile commission rates, both partially offset by a decrease in our assessment from the Massachusetts Insurance Insolvency Fund. The increase in agents' profit sharing expense is the result of improved underwriting results in 2005 versus 2004.
The market price for our common stock and our financial results directly affects our expense related to stock options, book value awards (BVAs) and incentive awards (IAs), respectively. Our stock option expense primarily represents options granted to both employees and American Commerce agents. The majority of this expense is related to options granted to American Commerce agents. See Note I of Notes to Consolidated Financial Statements for further information. An increase in the market value of our stock will increase the expense we recognize for options subject to variable accounting. Similarly, an increase in our net income will increase the value of, and therefore the expense we recognize for, outstanding BVAs and IAs. We record these expenses in three separate line items on our income statement - losses and loss adjustment expenses, policy acquisition costs and net investment income. The stock option, BVA and IA expenses recorded in each line item for the years ended December 31 follow:
Total direct written premiums for the other-than-Massachusetts segment declined $15,297, or 6.0%. The personal automobile decline accounted for the majority of this decrease, primarily as the result of the decline in premiums in Arizona due to the loss of AAA Arizona's affinity business. Direct written premiums from personal automobile policies in Arizona declined $14,400, or 36.6%, and policies in force declined 65.5%.We project an additional decline of $14,000, or 56.5%, during 2006. American Commerce and Commerce West will continue to write business in Arizona; however, ACIC will no longer market its products through AAA Arizona. In general, we are lowering rates in states in which we write business in response to competitive pressures. Commercial automobile premiums increased over 9.0% while homeowners and other lines were basically unchanged. The increase in the commercial automobile category primarily resulted from an 11.9% increase in the number of policies in force at Commerce West.
Fixed maturities include mortgage-backed bonds, corporate bonds, U.S. Treasury bonds and notes and tax-exempt state and municipal bonds.
a decrease in the current year personal and commercial automobile bodily injury claim frequency.
A reconciliation of beginning and ending reserves for losses and loss adjustment expenses for the years ended December 31, net of reinsurance deductions from all reinsurers including CAR, follows:
Approximately $54,370 in personal automobile liability redundancies developed for the year ended 2005, with 92% of this amount coming from the 2004, 2003 and 2002 accident years. The primary reason for the redundancies in this area is that claim severity came in better than we anticipated, coupled with significant redundancies from CAR, which accounted for approximately 37% of the total automobile liability redundancy. Automobile physical damage had approximately $7,447 in redundancies chiefly related to the 2004 accident year, approximately 60% of which was related to CAR. In 2005, we also experienced redundancies of $1,733 for the commercial multiple peril line of business, 62% of which related to the 2004 accident year. Partially offsetting these redundancies was a $3,467 deficiency in commercial automobile business, primarily related to CAR for the 2004 accident year. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining approximately $1,314 net redundancy.
Approximately $51,027 in personal automobile liability redundancies developed for the year ended 2004, with 98.0% of this amount coming from the 2003, 2002 and 2001 accident years. The primary reason for the redundancies in this area is that claim severity came in better than we anticipated. The redundancy for personal automobile liability that related to CAR accounted for approximately 2.5% of the total. Automobile physical damage had approximately $2,334 in redundancies related to the 2003 accident year approximately 98% of which was related to CAR. In 2004, we also experienced redundancies of $2,222 for the commercial multiple peril line of business, half of which related to the 1996 accident year. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining approximately $1,448 net redundancy.
The following sensitivity analysis presents the pro forma effect of a one percentage point change in our loss and LAE reserves (prior to the effect of ceded reinsurance recoverable) at December 31, 2005:
Our underwriting ratio increased to 27.3% for 2005 from 26.2% in the prior year, primarily as a result of significantly higher accrued agents' profit sharing and slightly higher 2005 policy year mandated Massachusetts personal automobile commission rates, both partially offset by a decrease in our assessment from the Massachusetts Insurance Insolvency Fund. In addition to the increase in agents' profit sharing expense in 2005, policy acquisition cost increases are also due to our premium growth. The increase in agents' profit sharing is due to improved underwriting results versus the previous year. Premium growth results in additional expense in commission, premium tax, and other variable costs. Partially offsetting these increases was a decline in stock option, BVA and IA expense.
In September 2005, the AICPA issued a new accounting pronouncement, Statement of Position (SOP) 05-01, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts. This SOP provides guidance on accounting for deferred acquisition costs on internal replacements of
The market price for our common stock and our financial results directly affects our expense related to stock options and BVAs, respectively. Our stock option expense represents options granted to both employees and American Commerce agents. An increase in the market value of our stock will increase the expense we recognize for options subject to variable accounting. Similarly, an increase in our net income will increase the value of, and therefore the expense we recognize for, outstanding BVAs. We record these expenses in three separate line items on our income statement - losses and loss adjustment expenses, policy acquisition costs and net investment income. The stock option and BVA expenses recorded in each line item for the years ended 2004 and 2003 follow:
Direct premiums written and earned for the years ended 2004 and 2003 can be found in Note P - Segment Information in Notes to Consolidated Financial Statements.
The composition of our investment portfolio, at cost, at December 31, 2004 and 2003 follows:
Key measures of net investment income for the years ended 2004 and 2003 follow:
The increase in our net investment income in 2004 was primarily due to increased invested assets partially offset by lower overall yields, particularly lower yields on preferred stocks. The increase in invested assets is primarily attributable to proceeds from the issuance of our senior notes in December 2003 and operating cash flows. The decrease in yields is primarily due to the sale and redemption of higher yielding investment securities coupled with lower yields on new investments due primarily to tighter credit spreads. Pre-tax and after-tax yields remained consistent on a quarterly basis throughout 2004.
A reconciliation of beginning and ending reserves for losses and loss adjustment expenses for the years ended 2004 and 2003, net of reinsurance deductions from all reinsurers including CAR, follows:
developments. The amounts we will ultimately incur from loss and loss adjustment expenses could differ materially in the near term from the amounts recorded.
Interest expense and amortization of bond fees are from our senior notes which we issued in December 2003.
Our overall effective tax rate for the year ended 2004 was 29.3% as compared to 26.5% for 2003. In both years, our effective rate was lower than the statutory rate of 35.0% primarily due to tax-exempt interest and the corporate dividends
received deduction. Our effective tax rate increased in 2004 due to improved underwriting results which are taxed at 35%. Our income tax rate for 2003 was benefited 1.8% by the reversal of a $3,936 tax valuation allowance related to investments which we established in 2002.
Total unpaid losses and LAE by line of business at December 31, 2005 and 2004 follow (in millions):
Our contractual obligations and commercial commitments as of December 31, 2005 by maturity follow:
We have commitments in two venture capital fund investments. These investments are made in limited partnerships and our exposure to loss is limited to our actual investment. One limited partnership investment required a commitment by us to invest up to $50,000 into the partnership. As of December 31, 2005, we invested $34,309 into the partnership. The partnership was formed to operate as an investment fund principally for the purpose of making investments primarily in equity, equity-related and other securities issued in expansion financing, start-ups, buy-outs and recapitalization transactions relating to companies in the areas of insurance, financial services, e-commerce, healthcare, and related businesses, including, without limitation, service and technology enterprises supporting such businesses.
On June 30, 2005, our 70% one-year quota share reinsurance program expired. This program covered all non-automobile property and liability business, except umbrella policies. This program was extended another year, effective July 1, 2005, with the primary change in terms being an increase in the quota share rate to 75%. In the event of a catastrophe, recovery is limited to 75% of the loss with a maximum recovery estimated at $363,000, equating to a total loss to us of
The primary sources of our liquidity are funds generated from insurance premiums, net investment income, premium finance and service fees and the maturing and sale of investments. The primary uses of our liquidity are payment of policy claims, operating costs, interest on our senior notes, and payment of dividends to our stockholders. We believe our capital resources are sufficient toward meeting our short and long-term liquidity needs.
In conducting investing activities, we are subject to, and assume, market risk. Market risk is the risk of an adverse financial impact from changes in interest rates and market prices. The level of risk assumed by us is a function of our overall objectives, liquidity needs and market volatility.
We manage our market risk by focusing on higher quality equity and fixed income investments, by periodically monitoring the credit strength of companies in which investments are made, by limiting exposure in any one investment and by monitoring the quality of the investment portfolio taking into account, among other factors, credit ratings assigned by recognized rating organizations. Our portfolio included three corporate bonds in default with a total carrying value of $117 at December 31, 2005. Of our bonds and preferred stocks, 91% of the market value was rated in either of the two highest quality categories provided by the NAIC as of December 31, 2005, as compared to 94% at December 31, 2004. Although we have significant holdings of various closed-end preferred stock mutual funds, these funds are comprised primarily of preferred and common stocks traded on national stock exchanges, thus limiting exposure to any one obligor.
Interest Rate Sensitivity. As part of our investing activities, we assume positions in fixed maturity, equity, short-term and cash equivalents markets. Therefore, we are exposed to the impacts of interest rate changes in the market value of investments. We estimate our exposure to interest rate changes and equity price risk using sensitivity analysis. The interest rate impact is defined as the effect of a hypothetical interest rate change of plus-or-minus 200 basis points on the market value of fixed maturities and preferred stocks.
Equity Price Risk. The equity price risk is defined as a hypothetical change of plus-or-minus 10% in the carrying value of common stocks. This total includes common stocks at market value and two closed-end preferred stock mutual funds at equity value. The following table summarizes our equity price risk, based on the results of the sensitivity analysis at December 31, 2005:
We generally are unable to recover the costs of inflation in our personal automobile insurance line since the premiums charged for personal automobile insurance in Massachusetts, our principal business segment, are subject to state regulation. Additionally, the premium rates that we charge for personal automobile insurance in Massachusetts are adjusted by the Commissioner only at annual intervals. Such annual adjustments in premium rates may lag behind related cost increases. Economic recessions can have an impact upon us, primarily through the policyholder's election to decrease non-compulsory coverages afforded by the policy and decreased driving, each of which tends to decrease claims.
Inflation and recession must also be considered by us in the creation and review of loss and LAE reserves since portions of these reserves are expected to be paid over extended periods of time. The anticipated effect of economic conditions is implicitly considered when estimating liabilities for losses and LAE. The importance of continually adjusting reserves is even more pronounced in periods of changing economic circumstances.
adverse trends in claim severity or frequency and uncertainties in estimating property and casualty losses;
our concentration of business within Massachusetts and within the personal automobile line of business;
our ability to maintain favorable ratings from rating agencies, including A.M. Best, S&P, Moody's and Fitch;
our dependence on a key third party service vendor for other business in Massachusetts;
Our management's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2005 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.
We have completed integrated audits of The Commerce Group, Inc.'s December 31, 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its December 31, 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Also, in our opinion, management's assessment, included in Management's Report on Internal Control Over Financial Reporting appearing under Item 8, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management's assessment and on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
Due to the exercise of 54,221 employee stock options and 292,955 American Commerce agents' options (132,797 shares).
We account for venture capital fund investments, which is included in other investments, in which we own more than a 5% interest on the equity method. The operating results of these venture capital fund investments have been reflected in realized gains and losses.
The cash and cash equivalent balances at December 31, 2005 and 2004 are grossed up by $42,283 and $39,356, respectively, which represents outstanding checks for which there was no right of offset. These amounts are included in other liabilities and accrued expenses for the respective years.
Our closed-end preferred stock mutual fund holdings at December 31, 2005 and 2004 accounted for under the equity method follow:
John Hancock Patriot Premium Dividend II Fund (PDT) and John Hancock Patriot Global Dividend Fund (PGD). The quoted market values of these investments are less than carrying value at year end 2005 and 2004. The carrying value is the net asset value of the underlying securities, which would be the value we would receive if the fund liquidates. We intend to hold these investments to recovery.
We originate and hold real estate mortgage loans on properties located in Massachusetts and Connecticut. Mortgage loans are collateralized by the related real estate. Agency loans are generally collateralized by the assets of the agency. We control credit risk through credit approvals, credit limits and monitoring procedures. We perform in-depth credit evaluations on all new mortgage customers. We have not incurred any bad debt expense on mortgage loans during the three years ended 2005.
Interest on mortgage loans is included in income as earned based upon rates applied to principal amounts outstanding. Accrual of interest on mortgage loans is discontinued either when reasonable doubt exists as to the full, timely collection of interest or principal, or when a loan becomes contractually past due more than 90 days. When a loan is placed on non-accrual status, all unpaid interest previously accrued is reversed against current period earnings.
Fair value of our mortgage loans on real estate and collateral notes receivable is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit and for the same remaining maturities. The future cash flows associated with certain non-performing loans are estimated based on expected payments from borrowers either through work out arrangements or the disposition of collateral. The estimated fair value of mortgage loans on real estate and collateral notes receivable at December 31, 2005 and 2004, prior to the allowance for possible loan losses, was $19,029 and $16,044, respectively.
At December 31, 2005 and 2004, mortgage loans on non-accrual status totaled $149 and $357, respectively. Allowances of $13 and $37 were established in 2005 and 2004, respectively, for these non-accrual status loans. The reduction in interest income associated with non-accrual loans was $8, $15 and $36 for the years ended December 31, 2005, 2004 and 2003, respectively.
Changes in the allowance for possible loan losses for the years ended December 31 follows:
The carrying value of our fixed maturity investments which have not produced any income during 2005 was $118 at December 31, 2005.
Proceeds from investment sales, calls, maturities and paydowns for the years ended December 31 follow:
we view all securities that have declined more than 20% below book price and have remained so for two quarters as potentially in need of a write-down. Any other security that we view as impaired for a significant period of time is also a candidate for a write-down, even if the percentage decline is less than 20%. In addition, we perform the following quarterly review of our portfolio:
We review both issue specific data and general market data for all perpetual preferred stocks that have been at a continuous loss position for over 12 months.
If a security is deemed other-than-temporarily impaired, we adjust the security's cost basis to market value through realized loss based on publicly available prices or, in the absence of such information, on a price supplied by a broker. During 2005, our other-than-temporary impairment charge for our bond and preferred and common stock holdings was $4,852.
We reviewed our investment holdings at December 31, 2005 for other-than-temporary declines in market value, in accordance with our previously stated accounting policy. Based on this analysis, we determined that the impairments represented in the above gross unrealized loss table are temporary. These temporary impairments are primarily due to interest rates and general market conditions. We have the intent and ability to hold to recovery or maturity our temporarily impaired equity or fixed maturity securities, respectively.
Unrealized investment gains and losses on common and preferred stocks and fixed maturities, to the extent that there is no other-than-temporary impairment of value, are credited or charged, net of any tax effect, to a separate component of stockholders' equity, known as "net accumulated other comprehensive (loss) income," until realized.
related unearned premiums. There was no premium deficiency in 2005, 2004 and 2003. In determining whether a premium deficiency exists, we consider anticipated investment income on the unearned premium reserve.
Depreciation expense was $6,091, $5,975 and $5,893 for the years ended December 31, 2005, 2004 and 2003, respectively. Depreciation expense is allocated evenly between loss adjustment expenses and policy acquisition costs.
The change in reserves for unpaid losses and LAE, net of reinsurance deductions from all reinsurers, including CAR, for the years ended December 31 follow:
As a result of changes in estimates of insured events in prior years, the provision for loss and LAE decreased $61,397 for the year ended 2005 and $57,031 for the year ended 2004. The favorable development is due primarily to lower than anticipated losses related to the personal automobile liability, the automobile physical damage and the commercial multiple peril lines of business. Conditions and trends that have affected development in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based upon these developments. The amounts we will ultimately incur from loss and loss adjustment expenses could differ materially in the near term from the amounts recorded.
Approximately $54,370 in personal automobile liability redundancies developed for the year ended 2005, with 92% of this amount coming from the 2004, 2003 and 2002 accident years. The primary reason for the redundancies in this area is that claim severity came in better than we anticipated, coupled with significant redundancies from CAR. Automobile physical damage had approximately $7,447 in redundancies chiefly related to the 2004 accident year, approximately 60% of which related to CAR. In 2005, we also experienced redundancies of $1,733 for the commercial multiple peril line of business, 62% of which related to the 2004 accident year. Partially offsetting these redundancies was a $3,467 deficiency in
commercial automobile business, primarily related to CAR for the 2004 accident year. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining approximately $1,314 net redundancy.
On December 9, 2003, we issued $300,000 face value of senior unsecured and unsubordinated debt (the Senior Notes) which matures December 9, 2013. The Senior Notes were issued at 99.3% to yield 6.04% and bear a coupon interest rate of 5.95%, payable semi-annually on June 9 and December 9. Proceeds from the issuance were $298,000. Costs related to the issuance of the Senior Notes have been deferred and recorded in other assets on the balance sheet. The deferred costs and the original issue discount will be amortized into interest expense over the life of the Senior Notes. The fair market value of the Senior Notes at December 31, 2005 was estimated at $303,900.
Also in 2000, Commerce entered into a Limited Partnership Agreement with Distribution Partners Investment Capital, L.P. a Delaware Limited Partnership. This partnership agreement required our commitment to invest up to $3,500 into the partnership. We have not invested in the partnership since 2002. As of December 31, 2005, we have invested $2,555 into the partnership leaving a balance of $945 for funds still committed. The partnership was formed to operate as an investment fund principally for the purpose of making investments primarily in equity and equity-related securities of
The Incentive Compensation Plan. During 2002, our stockholders approved the Incentive Compensation Plan (the Plan) which provides for the award of incentive stock options, non-qualified stock options, book value awards (BVAs), stock appreciation rights, restricted stock and performance stock units. Up to 5,000,000 shares of common stock (subject to increase for anti-dilution adjustments) may be issued under the Plan, including awards of restricted stock or upon the exercise of common stock equivalent awards such as stock options and stock appreciation rights payable in the form of common stock (not in the form of cash). At the discretion of the Compensation Committee, all of our directors, officers and other senior management employees, including those of our subsidiaries, are eligible to participate in the Plan.
In May 2005, the Compensation Committee of the Board of Directors authorized, under the 2002 Incentive Compensation Plan, the grant of Incentive Awards (IAs) to officers and directors in lieu of BVAs which were granted in the past. IAs entitle officers and directors to cash payments at a specified settlement date, subject to certain specified conditions. The 2005 Incentive Award Agreement is substantially the same as the previously granted Book Value Award Agreement. The cash payment is based on cumulative net earnings per basic share of common stock over a three-year period, except for certain early retirement and change in control circumstances.
The market price for our common stock and our financial results directly affect our expense related to stock options, BVAs and IAs, respectively. Our stock option expense represents options granted to both employees and American Commerce agents. An increase in the market value of our stock will increase the expense we recognize for options subject to variable accounting. Similarly, an increase in our net income will increase the value of, and therefore the expense we recognize for, outstanding BVAs and IAs.
Liabilities for the BVAs, IAs and employee stock option programs were $48,193 and $29,654 at December 31, 2005 and 2004, respectively. Plan activity, related to employee options, for the three years ended 2005 follows:
The American Commerce Agents' Plan. Additionally, we grant options to certain agents (ACIC agents' options) of American Commerce (the ACIC Plan). The right of the recipient to exercise these ACIC agents' options is contingent upon the average volume of other-than-Massachusetts private passenger automobile and homeowners direct written premiums placed and maintained with American Commerce for a five year period specified in the ACIC agents' option agreement. If qualified, the recipient may purchase our common stock at the exercise price for a period of five years beginning five years after the date of the grant (the confirmation date). Unexercised ACIC agents' options terminate not later than ten years after the date of the grant (the expiration date). In conjunction with meeting specified premium growth levels over the term of the ACIC agents' options, we provided "put rights" to the holders of the ACIC agents' options granted in 1999. These put rights permit the agents' option holders to require us to purchase the ACIC agents' options at the difference between $40.00 less the exercise price, at any time from and after the confirmation date through and including the expiration date. Approximately 150,000 options remain outstanding from the 1999 grant. Options cannot be exercised using cash. Options can only be exercised using a net share purchase such that the dollar value that the option is in the money is divided by the fair market value of the stock at the date of exercise to arrive at the number of shares received by the option holder. We record our expenses associated with the ACIC Plan over each award's vesting period, based on our estimate of the fair value of each award. Expenses related to these options were $1,395 in 2005, $15,291 in 2004 and $9,030 in 2003. The ACIC Plan has not been, and is not required to be, approved by our stockholders.
The ACIC Plan activity for the three years ended 2005 follows:
In 2005, we issued 143,395 shares of our common stock from treasury to fund the Company's contribution to the Employee Stock Ownership Plan (ESOP). We did not acquire any of our common stock under our authorized buy-back program during 2005. At December 31, 2005, we had authority to purchase a total of 858,300 additional shares of our common stock under our buy-back program.
The aggregate amount of dividends calculated in accordance with regulations in Massachusetts, California and Ohio that could have been paid in 2005 from all of our insurance subsidiaries without prior regulatory approval was approximately $241,062, of which $68,410 was declared and paid as of December 31, 2005.
Our Board of Directors voted to declare four quarterly dividends to stockholders of record totaling $1.47 per share and $1.31 per share in 2005 and 2004, respectively. On May 20, 2005, the board voted to increase the quarterly stockholder dividend from $0.33 to $0.38 per share to stockholders of record as of May 31, 2005. Prior to that declaration, we paid quarterly dividends of $0.33 per share dating back to May 21, 2004 when the board voted to increase the dividend from $0.32 to $0.33 per share.
A significant portion of our Massachusetts premiums written is derived through the American Automobile Association Clubs of Massachusetts (AAA Clubs) affinity group marketing program. Direct premiums written by the AAA affinity group marketing program in Massachusetts were $727,206 or 38.8% of our total direct premiums written in 2005, $725,579 or 39.5% in 2004 and $691,694 or 41.7% in 2003. Insurance agencies owned by the AAA Clubs wrote 15.2 % and our network of independent agents wrote 84.8% of total AAA affinity direct written premium in 2005. During 2004, AAA Club-owned agencies wrote 14.5% and our network wrote 85.5%.
Realization of a deferred tax asset is dependent on generating sufficient taxable income in future years. Although realization is not assured, we believe it is more likely than not that all of the deferred tax assets will be realized. GAAP requires a valuation allowance to be recorded when it is more likely than not that some or all of the deferred tax assets will not be realized. We did not have a valuation allowance for deferred taxes at December 31, 2005 and 2004.
During 2004, our 2001 and 2002 federal income tax returns were audited by the IRS; there were no material findings.
All companies are also covered by similar associations in the states where they do business. These associations operate similarly to the MIIF. Commerce West, domiciled in California, is covered by the California Insurance Guarantee Association, as well as associations in Arizona and Oregon. American Commerce, domiciled in Ohio, is covered by the Ohio Guarantee Association, as well as associations in the other states in which they do business. Payments made by American Commerce, Commerce West and Commerce (for New Hampshire only) to the associations that they are covered under were $76 in 2005, $126 in 2004 and $190 in 2003. These amounts are net of credits for prior year assessments.
a form of pro rata reinsurance arrangement pursuant to which the reinsurer participates in a specified percentage of the premiums and losses on every risk that comes within the scope of the reinsurance agreement. The current program is split among American Re-Insurance Corporation, rated "A Excellent" by A.M. Best (its third highest rating), Swiss Re America Corporation, rated "A+ Superior" by A.M. Best (its second highest rating), and Transatlantic Insurance Company, rated "A+ Superior" by A.M. Best. The maximum per occurrence dollar recovery is equal to 225% of the annual net premiums ceded to the quota share arrangement in the contract year. The maximum aggregate per year dollar recovery under the quota share contract is equal to 325% of the annual net premium ceded to the quota share arrangement in the contract year. A sliding scale commission, based on loss ratio, is utilized under this program. This program provides us with sufficient protection for catastrophe coverage to enable us to forego pure catastrophe reinsurance coverage.
Under the above scenario and based on the twelve month projected premiums to be ceded under the program, we have no reinsurance recoveries for a single event catastrophe in excess of a total loss of approximately $484,000. The level of reinsurance protection increases (decreases) when we cede more (less) premium to the reinsurers.
Written premiums ceded in 2005, 2004 and 2003 under the current and prior quota share programs combined were $150,461, $133,562 and $107,313, respectively. The 12.7% increase in written premiums ceded in 2005 versus 2004 in this program was primarily the result of a $14,908, or 12.3% increase in Massachusetts homeowner direct written premium. In addition, the increase on the quota share participation rate from 70% to 75% on July 1, 2005 contributed to the increased cessions. Ceding commission income is calculated on a ceded earned premium basis.
Our insurance subsidiaries are required to participate in various Property Insurance Underwriting Associations, the most significant of which is the Fair Access to Insurance Requirements Plan (FAIR Plan) in Massachusetts. The federal government reinsures those insurers participating in FAIR Plans against losses sustained from riots and civil disorders. The Massachusetts FAIR Plan has coastal policies which could result in losses which could be material to the FAIR Plan and participating insurance companies. The Massachusetts FAIR Plan does not purchase catastrophe reinsurance; consequently, we have exposure for our proportionate share of catastrophic events occuring in the FAIR plan.
Effective July 1, 2005, we purchased a one-year Catastrophe Treaty for our exposure to FAIR Plan losses in excess of $100,000 up to a total FAIR Plan loss of $1,000,000. We purchased 6% of this treaty, which will afford us a recovery of $54,000 excess of a $6,000 retention if the FAIR Plan should suffer a $1,000,000 or greater loss. The estimated 250-year probable maximum loss for the FAIR Plan is approximately $1,000,000. This loss estimate is the average of the two catastrophe models utilized by the FAIR plan.
Casualty reinsurance, excluding umbrella policies, is written on an excess of loss basis for any one event or occurrence with a maximum recovery of $8,000 over a net retention of $2,000. This coverage is placed with Swiss Re America Corporation.
We offer an ESOP for the benefit of substantially all employees, including those of our subsidiaries. The ESOP is noncontributory on the part of participants and contributions are made at the discretion of the Board of Directors. We are under no obligation to make contributions or maintain the ESOP for any length of time and may completely discontinue or terminate the ESOP at any time without liability. Contribution expense for the ESOP for the years ended December 31, 2005, 2004 and 2003 were $10,371, $9,651 and $8,850, respectively. In 2006 and 2005, the 2005 and 2004 contributions, respectively, were funded entirely with 191,497 and 143,395 treasury stock shares, respectively. ESOP contributions in previous years were made in cash. The increase in the contribution in 2005 over 2004 and in 2004 over 2003 was primarily due to an increase in employees and wages paid to them. The ESOP held 2,871,257 and 2,819,951 shares of our common stock at December 31, 2005 and 2004, respectively.
ESOP participants who are former employees of the Company may generally elect to withdraw from the ESOP the total amount of shares allocated to their accounts at any time. Approximately 534,000 shares held by the ESOP at December 31, 2005 are allocated to the ESOP accounts of these individuals.
In 2003, our 401(k) Plan was merged into the ESOP. The ESOP is administered by Fidelity Investments. The 401(k) component of the ESOP enables eligible employees to contribute up to 60% of eligible compensation on a pre-tax basis up to the annual maximum limits under federal tax law. We incur no expenses in the form of matching contributions but we pay for administration of the plan.
During 2000, our directors approved a Directors' Retirement Compensation Plan (the Retirement Plan). The Retirement Plan becomes effective for each director upon terminating service from our Board of Directors (the Board) providing that such termination was not made under conditions adverse to our interest. Effective with the annual meeting wherein the director is not reappointed to the Board, and provided benefits are not paid until such time as the director has attained the age of 65, we will pay an annual retirement benefit equal to 50% of the average annual total compensation of the director for the highest three full years (the three year average compensation). The annual retirement benefit of 50% of the three year average compensation vests at the rate of 4.0% for each year of Board service up to a maximum of 100% vesting through termination of service. Payments continue for a maximum of ten years over the remaining life of the terminated director, or his or her then spouse, if the director pre-deceases the spouse. No payments are to be made after the death of the director and spouse. Expenses related to the Retirement Plan in 2005, 2004 and 2003 were $887, $273 and $286, respectively. We paid $78, $55 and $36 under the Retirement Plan in 2005, 2004 and 2003, respectively. The liability for the Retirement Plan, as calculated based on a discounted cash flow basis, was $3,980 and $3,093 at December 31, 2005 and 2004, respectively.
Member companies of CAR have joint and several liabilities for the obligations of CAR, the Massachusetts-mandated personal automobile reinsurance mechanism that enables us and other participating insurers to reinsure in CAR any risk. If one member of CAR fails to pay its assessments, the remaining members of CAR will be required to pay the pro-rata share of the member who fails to pay its obligations. As of December 31, 2005, we were not aware of any CAR member company which has failed to meet its obligations.
Our consolidated net income on a statutory basis for the years ended December 31, 2005, 2004 and 2003 was $238,122, $241,062 and $136,438, respectively. Our statutory policyholders' surplus as reported to various state insurance departments at December 31, 2005 and 2004 was $1,477,307 and $1,290,075, respectively.
An unaudited summary of our 2005 and 2004 quarterly performance follows:
Due to the internal reorganization in 2003, minority interest is not included in our insurance operations, but instead is included in net earnings for non-insurance companies.