The Company also leases office space in 14 other locations of which 13 locations are in California. The Company anticipates no difficulty in extending these leases or obtaining comparable office facilities in suitable locations.
FINANCIAL CONDITION The following table summarizes certain information pertaining to the Company's financial condition as of or for the years ended December 31,
The operating cash flow from the auto line for 2001 improved over 2000 primarily due to rate increases coupled with a decrease in the quota share cession with AIG from 8% to 6% in 2001 that offset the effects of a decline in the number of insured units. The decline in cash flow from auto line operations from 1999 to 2000 reflected increased losses and LAE and the effects of rate decreases taken in 1999.
Book value per share at the end of 2001 declined 9% from the end of 2000 primarily because of losses from the homeowner and earthquake lines, which are in runoff. See further discussion below under the caption Underwriting Results - Homeowner and Earthquake Lines in Runoff and All Other and in Note 16 of the Notes to Consolidated Financial Statements.
UNDERWRITING RESULTS The tables presented in the Notes to Consolidated Financial Statements summarize the Company's unaudited quarterly results of operations for each of the two years in the period ended December 31, 2001, and the results of operations by line of business for each of the three years then ended. The following discussion of underwriting results by line of business should be read in conjunction with the information presented in those tables and elsewhere herein.
Vehicles in force were 1,060,752, 1,166,971 and 1,184,797 as of December 31, 2001, 2000 and 1999, respectively. The decrease in 2001 and 2000 resulted from actions taken to improve underwriting results (discussed further below). The Company's retention rate was approximately 92% for 2001, 95% for 2000 and 96% for 1999.
Underwriting results were losses of $24.4 million in 2001 and $39.8 million in 2000 compared to an underwriting profit of $79.1 million in 1999. The Company had reduced its California rates by more than 25% from 1996 to 1999, and the rate decreases in 1998 and 1999 had anticipated the continuation of favorable loss trends that failed to materialize. The resultant underpricing caused the loss and LAE ratio to grow from 77.4% in 1999 to 90.8% for 2000, with the higher-than-anticipated losses first becoming evident in the third quarter of 1999. The loss and LAE ratio decreased to 88.1% in 2001 as corrective measures were implemented in late 2000 and throughout 2001. Such measures included increasing California auto rates by 6.4% in November 2000 and 4.0% in July 2001 and Oregon auto rates by 21% in November 2000. Rate increases in 2001 of 44.9%, 14.0% and 12.6% were taken in Washington, Oregon and Nevada, respectively, and a further 23.9% rate increase has been approved for 2002 in Nevada. A further 6.9% rate increase currently is pending approval of the CDOI.
The underwriting expense ratio for the auto line of business was 14.9% in 2001, 14.2% in 2000 and 12.3% in 1999. The increase in the ratios for 2001 and 2000 compared to 1999 were mainly caused by increases in occupancy costs, data processing and depreciation expense.
In the fourth quarter of 2001, a provision was recorded for the run-off of the homeowner line, primarily due to earthquake claims arising from SB 1899 (discussed further below and in Note 16 of the Notes to Consolidated Financial Statements). Total earthquake losses and expenses charged to income were $70.0 million in 2001, including $50.0 million in the fourth quarter, compared to $3.5 million in 2000 and $2.5 million in 1999.
California SB 1899, effective from January 1, 2001, to December 31, 2001, allowed the re-opening of previously closed earthquake claims arising out of the 1994 Northridge Earthquake. The Company believes this law to be unconstitutional because it impairs contract rights by extending the normal contractual limitations period by more than six years. The Company has pursued its legal rights without success in the California courts and has now submitted a writ to the United States Supreme Court. Despite the Company's challenge to the constitutionality of the law, claim reports have been accepted and losses adjusted and paid under a reservation of rights since the law took effect. The time period to make claims under SB 1899 ended on December 31, 2001. The Company is now able to make an estimate of the loss payment and inspection cost portion of the potential liability created by this law. The Company believes it is impracticable to make a reasonable estimate of the defense costs associated with settling these claims.
The Company has not written any earthquake coverage since 1994 and ceased writing new homeowner policies in September 2001 but remains exposed to possible upward development in certain loss estimates relating to the 1994 Northridge Earthquake.
This line also included $9.6 million associated with workforce reductions and the settlement of litigation matters in the fourth quarter of 2001, and a charge of $6.75 million to settle certain matters with the CDOI in 1999.
LIQUIDITY AND CAPITAL RESOURCES Liquidity. The parent company's main sources of liquidity historically have been dividends received from its insurance subsidiaries and proceeds from issuance of debt or equity securities. The parent company paid off a $67.5 million bank loan in 2000 and currently has no debt outstanding. The parent's only equity security currently outstanding is its common stock, which has no mandatory dividend obligations. The parent's significant operating expenses are all allocated to and paid for by its insurance subsidiaries. During 2002, the insurance subsidiaries have the capacity to pay dividends to the parent aggregating approximately $20 million under current insurance regulations. At December 31, 2001, the parent had $52.8 million of cash and investments on hand and a payable to one of its insurance subsidiaries amounting to approximately $28.6 million, of which $15 million was repaid in January 2002, and the balance is due on June 30, 2002.
Recent court rulings may subject certain dividends from the insurance subsidiaries to California State income tax. The Company believes the sources of funds referred to above will be adequate to meet its cash needs for dividends to shareholders or other purposes without receiving additional dividends from its insurance subsidiaries until this tax issue is resolved. If necessary, the Company believes it can access the capital markets should the need arise for additional capital to support its growth objectives, although it has no present intentions of doing so.
The Company believes it has taken the proper actions to restore underwriting profitability in its core auto insurance operations and thereby enhance its liquidity. However, there can be no assurance that California regulators will grant the rate increases recently requested by the Company. Also, the resolution of Northridge Earthquake claims pursuant to SB1899 (discussed further above under the caption Underwriting Results - Homeowner and Earthquake Lines in Runoff and All Other, also below under the caption Critical Accounting Policies, and in Note 16 of the Notes to Consolidated Financial Statements) possibly may require more outlays than the recorded estimates. As a result of such contingencies, underwriting losses could recur in the future. Further, the Company could be required to liquidate investments to pay claims, possibly during unfavorable market conditions, which could lead to the realization of losses on sales of investments. Each of the foregoing contingencies would create some degree of downward pressure on the insurance subsidiaries' statutory surplus, which in turn could negatively impact the Company's liquidity.
During the second quarter of 1999, the Company's Board of Directors authorized $50 million to purchase shares of the Company's common stock. As a result, 2,632,084 common shares were repurchased in the open market and retired through April 2000.
Off Balance Sheet Obligations, Letters of Credit, Guarantees and Transactions with Related Parties. The Company currently has no off-balance sheet obligations other than the operating leases for its office facilities, which call for minimum lease payments totaling $168.8 million as follows: $15.6 million in 2002, $14.6 million in 2003, $13.5 million in 2004, $13.5 million in 2005, $12.7 million in 2006, and $98.9 million thereafter.
The Company currently has no unused letters of credit, has issued no guarantees on behalf of others, and has no trading activities involving non-exchange-traded contracts accounted for at fair value. The Company has entered into no material transactions with related parties other than the reinsurance transactions with AIG subsidiaries that are discussed in the Notes to Consolidated Financial Statements.
In particular, the Company cautions that the earthquake loss and loss adjustment expense reserves resulting from SB 1899 cannot be estimated by conventional reserving techniques for a variety of reasons. See further discussion above under the caption Underwriting Results - Homeowner and Earthquake Lines in Runoff and All Other and in Note 16 of the Notes to the Consolidated Financial Statements.
Deferred Income Taxes. The Company is required to establish a "valuation allowance" for any portion of the deferred tax asset, which amounted to $96.2 million at December 31, 2001, that management believes will not be realized. The Company believes that because of its historically strong earnings performance and tax planning strategies available, it is more likely than not that the Company will realize the full benefit of its deferred tax assets. Accordingly, no valuation allowance has been established.
FORWARD-LOOKING STATEMENTS The Company's management has made in this report, and from time to time may make in its public filings, press releases, and oral presentations and discussions, forward-looking statements concerning the Company's operations, economic performance and financial condition. Forward-looking statements include, among other things, discussions concerning the Company's potential, expectations, beliefs, estimates, forecasts, projections and assumptions. Forward-looking statements are subject to risks and uncertainties. Actual results could differ materially from those anticipated by forward-looking statements due to a number of important factors including, but not limited to, those discussed elsewhere in this report and in the Company's other public communications, as well as the following: (a) the intensity of competition from other companies in the insurance industry; (b) the Company's experience with respect to persistency, underwriting and claims experience including revived claims under SB 1899; (c) the Company's ability to distribute and administer competitive services in a timely, cost-effective manner; (d) the Company's visibility in the marketplace and its financial and claims-paying ratings; (e) regulatory approval for rate increases and product changes; (f) the effect of changes in laws and regulations affecting the Company's business, including changes in tax laws affecting insurance products; (g) market risks related to interest rates; (h) the Company's ability to develop and deploy information technology and management information systems to support strategic goals while continuing to control costs and expenses; (i) the costs of defending litigation or regulating proceedings and the risk of unanticipated material adverse outcomes in such litigation or proceedings; (j) changes in accounting and reporting practices; and (k) the Company's access to adequate financing to support its future business. The Company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) on page 44 present fairly, in all material respects, the financial position of 21st Century Insurance Group and its subsidiaries at December 31, 2001, and the results of their operations and their cash flows for the year ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule for the year ended December 31, 2001 listed in the index appearing under Item 14(a)(2) on page 44 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit. We conducted our audit of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
We have audited the accompanying consolidated balance sheet of 21st Century Insurance Group and subsidiaries as of December 31, 2000 and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the two years in the period ended December 31, 2000. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
21ST CENTURY INSURANCE GROUP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2001 AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
21st Century Insurance Group, through its wholly owned subsidiaries, 21st Century Insurance Company and 21st Century Casualty Company (collectively, the "Company"), is engaged primarily in the sale of private passenger automobile insurance policies in California, Nevada, Oregon and Washington. Substantially all of the Company's business is concentrated in California. The Company also provides private passenger automobile insurance through 21st Century Insurance Company of Arizona ("21st of Arizona"), which was a 49% owned unconsolidated affiliate in 2001 and prior years (see Note 19). American International Group, Inc. ("AIG"), owned a majority of the Company's outstanding common stock at December 31, 2001.
INVESTMENTS The Company classifies its investment portfolio as available-for-sale and carries it at fair value. Unrealized investment gains and losses, net of any tax effect, are included as an element of accumulated other comprehensive income (loss), which is classified as a separate component of stockholders' equity.
21ST CENTURY INSURANCE COMPANY OF ARIZONA Prior to 2002, 21st of Arizona was a joint venture between the Company and AIG. On January 1, 2002, the Company acquired AIG's 51% interest in 21st of Arizona (see Note 19). This entity began operations in August 1996, has a carrying value of $3.6 million at December 31, 2001, and is included in other assets in the Consolidated Balance Sheets. The Company's equity in the net loss of this venture amounted to $1.0 million, $1.1 million, and $0.5 million in 2001, 2000 and 1999, respectively, and is included in other revenues in the Consolidated Statements of Operations.
DEFERRED POLICY ACQUISITION COSTS Deferred policy acquisition costs ("DPAC") include premium taxes and other variable costs incurred in connection with writing business. These costs are deferred and amortized over the period in which the related premiums are earned. The Company does not consider anticipated investment income in determining the recoverability of these costs. Based on current indications, management believes that these costs will be fully recoverable and, accordingly, no reduction in DPAC or premium deficiency has been recognized.
LOSSES AND LOSS ADJUSTMENT EXPENSES The estimated liabilities for losses and loss adjustment expenses ("LAE") include the accumulation of estimates of losses for claims reported prior to the balance sheet dates, estimates (based upon actuarial analysis of historical data) of losses for claims incurred but not reported and for the development of case reserves to ultimate values, and estimates of expenses for investigating, adjusting and settling all incurred claims. Amounts reported are estimates of the ultimate costs of settlement, net of estimated salvage and subrogation. These estimated liabilities are necessarily subject to the outcome of future events, such as changes in medical and repair costs as well as economic and social conditions that impact the settlement of claims. Management believes that, given the inherent variability in any such estimates, the aggregate reserves are within a reasonable and acceptable range of adequacy. The methods of making such estimates and for establishing the resulting reserves are reviewed and updated quarterly and any adjustments resulting therefrom are reflected in current operations.
The Company believes that the earthquake loss and loss adjustment expense reserves resulting from SB 1899 cannot be estimated by conventional reserving techniques. See Note 16 for a discussion of the factors considered by management in establishing those reserves.
STOCK-BASED COMPENSATION In management's opinion, existing stock option valuation models do not provide an entirely reliable measure of the fair value of non-transferable employee stock options with vesting restrictions. Accordingly, the Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related interpretations in accounting for its stock-based compensation. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. See Note 13 for disclosure of the required pro forma information as if stock option compensation expense had been determined by the alternative fair value method. The fair value of stock grants made under the Restricted Shares Plan is amortized to expense under APB 25 over the vesting period of the grants. This accounting treatment results in compensation expense being recorded in a manner consistent with that required under SFAS No. 123, and, therefore, pro forma net income and earnings per share amounts for the Restricted Share Plan would be unchanged from those reported in the financial statements.
For each of the three years in the period ending December 31, 2001, the numerator for the calculation of both basic and diluted earnings per common share is equal to net income reported for that year. The denominator for the computation of basic earnings (loss) per share was 85,340,461 shares, 85,186,084 shares and 87,144,939 shares for 2001, 2000 and 1999, respectively. The denominator for diluted earnings (loss) per share was 85,340,461 shares, 85,397,099 shares and 87,252,674 shares for 2001, 2000 and 1999, respectively. The difference between basic and diluted earnings per share denominators is due to employee restricted stock grants and stock options.
A summary of realized investment gains and losses before income taxes follows:
Fixed maturities available-for-sale at December 31, 2001, are summarized by contractual maturity year as follows:
NOTE 5. FEDERAL INCOME TAXES - ----------------------------- Federal income tax expense (benefit) consists of:
During 2001, the Company had a tax net operating loss of approximately $112 million. As of December 31, 2001, the Company has a tax net operating loss carryforward of approximately $298 million for regular tax purposes of which approximately $105 million expires in the year 2009 and $193 million expires on or after 2020; and an alternative minimum tax credit carryforward of $18 million. Alternative minimum tax credits may be carried forward indefinitely to offset future regular tax liabilities.
The Company is required to establish a "valuation allowance" for any portion of the deferred tax asset that management believes will not be realized. The Company believes that because of its historically strong earnings performance and tax planning strategies available, it is more likely than not that the Company will realize the full benefit of its deferred tax assets. Accordingly, no valuation allowance has been established.
21ST CENTURY INSURANCE GROUP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2001 (CONTINUED) AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
The following summarizes the approximate percentage of business retained and ceded under various reinsurance programs with AIG subsidiaries and unrelated insurers. Most programs provide for ceding commissions that approximate the Company's direct policy acquisition costs and other operating expenses.
The Company sponsors a contributory savings and security plan for eligible employees. The Company provides matching contributions equal to 75% of the lesser of 6% of an employee's compensation or the amount contributed by the employee. Contributions charged against operations were $4.0 million, $3.1 million and $3.0 million in 2001, 2000 and 1999, respectively. The plan offers a variety of investment types among which employees exercise complete discretion as to choice and investment duration, including any amounts the employee elects to invest in Company common stock.
2002 $ 15,641 2003 14,565 2004 13,517 2005 13,561 2006 12,692 Thereafter 98,864 ------------------ -------- $168,840 ------------------ --------
Options exercisable at the end of 2001, 2000 and 1999 numbered 1,803,917, 1,486,201 and 1,448,513, respectively.
RESTRICTED SHARES PLAN The Restricted Shares Plan, which was approved by the Company's shareholders, currently provides for grants of up to 1,421,920 shares of common stock to be made available to key employees. Twenty percent of the number of shares granted vest on January 1 of each of the five years following the year of grant. Upon issuance of grants under the plan, unearned compensation equivalent to the market value on the date of grant is charged to common stock and subsequently amortized in equal monthly installments over the five-year vesting period of the grant. Total amortization expense relating to the Restricted Shares Plan was $0.7 million, $0.2 million and $0 in 2001, 2000 and 1999, respectively. Unamortized restricted stock grants totaled $0.9 million, $3.3 million and $1.8 million at the end of 2001, 2000 and 1999, respectively.
A summary of grants under the plan from 1999 through 2001 follows:
Statutory surplus and net income (loss) for the Company's insurance subsidiaries were as follows:
Years Ended December 31, 2001 2000 1999 - ----------------------------- --------- -------- -------- Statutory surplus $393,119 $475,640 $581,440 Statutory net income (loss) (53,166) 11,071 100,063
The Company's insurance subsidiaries file financial statements prepared in accordance with SAP prescribed or permitted by domestic insurance regulatory agencies. The Company's SAP-basis financial statements differ from those prepared in accordance with GAAP primarily because certain assets recognized under GAAP are treated as nonadmitted under SAP, such as deferred policy acquisition costs, most of the Company's property and equipment and a portion of deferred income taxes. Further, under SAP, all bonds are carried at amortized cost and unpaid losses, loss adjustment expenses and unearned premium reserves are presented net of reinsurance.
Incurred loss and loss adjustment expenses related to SB 1899 totaled $4.6 million, $6.1 million, $9.3 million and $50.0 million in the first, second, third and fourth quarters of 2001, respectively.
Fourth quarter 2001 results were impacted by $50.0 million related to earthquake claims arising out of California Senate Bill 1899. In addition, the fourth quarter 2001 included $9.6 million associated with workforce reductions and the settlement of litigation matters. The impact of these items reduced net income by $0.45 per diluted share in the fourth quarter.
Under a January 1, 2002, agreement with Balboa Insurance Company ("Balboa"), a subsidiary of Countrywide Credit Industries, Inc. ("Countrywide"), 100% of homeowner unearned premium reserves and future related losses are reinsured by Balboa. Obligations relating to the 1994 Northridge Earthquake are not covered by the agreements with Balboa. The Company will begin non-renewing homeowner policies expiring on February 21, 2002, and thereafter. Substantially all of these customers are expected to be offered homeowner coverage through an affiliate of Countrywide.