The following table summarizes our significant properties as of December 31, 2006:
The Company purchased a customer service, sales and claims center in Lewisville, Texas, in September 2005 after exercising its option under the terms of its lease agreement to purchase the land and building that house this service center.
The following selected financial data for each of the years in the five-year period ended December 31, 2006, should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes included in Item of this report. All amounts set forth in the following tables are in thousands, except for per share data.
The Company entered into a $60.0 million sale-leaseback transaction in 2002 and issued $100.0 million of Senior Notes in 2003 (see Note 9 of the Notes to Consolidated Financial Statements).
Founded in 1958, we are a direct-to-consumer provider of personal auto insurance. With $1.4 billion of revenue in 2006, we insure over 1.5 million vehicles in Arizona, California, Florida, Georgia, Illinois, Indiana, Nevada, New Jersey, Ohio, Oregon, Pennsylvania, Texas, Washington, Colorado, Minnesota, Missouri, and Wisconsin. We provide superior policy features and customer service at a competitive price. Customers can receive a quote, purchase a policy, service their policy, or report a claim at www.21st.com or over the phone with our licensed insurance professionals at 1-800-211-SAVE. Service is offered in English and Spanish, both over the phone and on the web, 24 hours a day, 365 days a year. Our insurance subsidiaries, 21st Century Insurance Company (our primary insurance subsidiary), 21st Century Casualty Company, and 21st Century Insurance Company of the Southwest (“21st of the Southwest”), are rated A+ by A.M. Best, Fitch Ratings and Standard & Poor’s. The Company’s A+ rating was affirmed by A.M. Best on June 13, 2006.
The Company is implementing a multi-year strategy for national expansion to realize benefits from economies of scale, lower unit marketing costs due to the cost efficiency of buying advertising on a national basis, less dependency on any single market and the operating flexibility to focus resources on attractive markets and deemphasize less attractive markets. In execution of this strategy, 21st expanded its operations into the Midwest (2004); Texas (2005); Florida, Georgia and Pennsylvania (second quarter of 2006); New Jersey (October 2006); and Colorado, Minnesota, Missouri, and Wisconsin (fourth quarter 2006). During 2006, the Company has increased the percentage of the U.S. personal auto market in which it operates from 34 percent to 60 percent. Year over year growth in direct premiums written in non-California markets in 2006 was 77.3% versus 81.6% in 2005. Non-California direct premiums written comprised 11.3% of our total direct premiums written in 2006, versus 6.2% in 2005. Continued implementation of our growth strategy could be affected by a number of factors beyond our control, such as increased competition, judicial, regulatory, or legislative developments, general economic conditions or increased operating costs.
Total direct premiums written decreased 2.3% to $1,315.1 million in 2006, from $1,346.4 million and $1,337.2 million in 2005 and 2004, respectively.
California direct premiums written decreased 7.6% to $1,166.0 million in 2006, compared to $1,262.3 million and $1,290.9 million in 2005 and 2004, respectively.
The 2006 consolidated combined ratio was 93.7%, versus 94.9% and 95.3% for 2005 and 2004, respectively. 2006 was positively impacted by 4.0 points of favorable prior accident year loss and LAE reserve development in 2006, while 2005 was favorably impacted by 1.9 points of prior accident year development. 2004 was not impacted by prior accident year development.
For 2006, 21st’s insurance subsidiaries achieved underwriting profitability, but total direct premiums written declined for the year. The California market, which represented 88.7% of our total direct premiums written during 2006, has seen stable to declining rates from competitors and a reduced level of shopping behavior by consumers, which reduced our opportunities for profitable growth in this state. However, 21st realized 77.3% of growth in non-California states during 2006 as a result of the Company’s national expansion efforts. Our non-California direct premiums written grew from 6.2% in 2005 to 11.3% of out total book of business in 2006.
Underwriting profit (loss) consists of net premiums earned less losses from claims, loss adjustment expenses and underwriting expenses. 21st believes that underwriting profit (loss) provides investors with financial information that is not only meaningful, but critically important to understanding the results of property and casualty insurance operations. The results of operations of a property and casualty insurance company include three components: underwriting profit (loss), net investment income and realized capital gains (losses). Without disclosure of underwriting profit (loss), it is difficult to determine how successful an insurance company is in its core business activity of assessing and underwriting risk, as including investment income and realized capital gains (losses) in the results of operations without disclosing underwriting profit (loss) can mask underwriting losses.
Statutory surplus represents equity as of the end of a fiscal period for the Company’s insurance subsidiaries, determined in accordance with statutory accounting principles prescribed by insurance regulatory authorities. Stockholders’ equity is the most directly comparable GAAP measure to statutory surplus.
The reconciliations of these financial measures to the most directly comparable GAAP measures are located in the following: premiums written and underwriting profit are located in the Results of Operations and statutory surplus is located in Liquidity and Capital Resources. These financial measures are not intended to replace, and should be read in conjunction with, the GAAP financial measures.
The following table reconciles our personal auto lines direct premiums written to net premiums earned:
The underwriting expense ratios to net premiums earned increased for the years ended December 31, 2006, 2005 and 2004. The 2006 increase was primarily due to our investments in the Company’s national expansion efforts and the 2006 recognition of stock-based compensation, partially offset by an increase in deferred policy acquisition costs. The increase was primarily due to our investments in the geographic expansion strategy, costs associated with the conversion to our new technology platform, and facility and support costs. The increase in 2004 consists primarily of increased advertising costs, additional sales workforce costs, and facility and support costs to improve service and support the Texas service center.
We have not written any earthquake policies since 1994 and exited the voluntary homeowner insurance business in 2002. Underwriting results of the homeowner and earthquake lines, which are in runoff, include losses and LAE incurred of $0.8 million, $2.3 million, and $2.8 million in 2006, 2005, and 2004, of which the earthquake lines accounted for $0.1 million, $0.4 million, and $2.2 million, respectively.
The fixed maturity securities portfolio comprised 99%, 97%, and 97% of the total investment portfolio at December 31, 2006, 2005, and 2004, respectively. The average annual yields on fixed maturity securities were as follows:
At December 31, 2006, $379.4 million, or 26.4%, of our total fixed maturity securities at fair value were invested in tax-exempt bonds, compared to 23.1% at December 31, 2005, with the remainder, representing 73.6% of the portfolio, invested in taxable securities, compared to 76.9% at December 31, 2005. At December 31, 2006, no investments were rated below investment grade.
Investments and cash were $1.5 billion at December 31, 2006 and December 31, 2005. The Company sold its investments in equity securities during the first quarter of 2006, with the proceeds primarily reinvested in fixed maturity securities. The Company did not hold any publicly traded equity securities at December 31, 2006. However, we executed a $35 million funding commitment for a private equity investment program during the second quarter of 2006, as described in Note 3 of the Notes to Consolidated Financial Statements. The Company funded $14.4 million of the commitment in 2006.
The following table summarizes unpaid losses and LAE, gross and net of applicable reinsurance, with respect to our lines of business:
At December 31, 2006, gross unpaid losses and LAE decreased $41.6 million, primarily due to a reserve decrease of $40.8 million in the personal auto lines as a result of $52.6 million of favorable loss development related to prior accident years recorded during the year ended December 31, 2006 and a decline in the number of insured vehicles. The gross unpaid losses and LAE in the homeowner and earthquake lines decreased $0.8 million as the result of continued runoff activity (see Critical Accounting Estimates - Losses and Loss Adjustment Expenses for a description of the Company’s reserving process).
Debt of $115.9 million at December 31, 2006, compared to $128.0 million at December 31, 2005, consists of $16.0 million of capital lease obligations and $99.9 million Senior Notes, net of discount (see Note 9 of the Notes to Consolidated Financial Statements). The decrease in debt of $12.1 million during the year ended December 31, 2006 is primarily attributable to principal payments on the capital leases.
Stockholders’ equity and book value per share increased to $898.5 million and $10.39, respectively, at December 31, 2006, compared to $830.0 million and $9.66 at December 31, 2005. The increase for the year ended December 31, 2006, was primarily due to net income of $97.2 million, stock-based compensation cost of $10.4 million, and $5.7 million of proceeds from exercised stock options. This was partially offset by dividends to stockholders of $27.6 million, a decrease of $14.2 million due to the adoption of Statement of Financial Accounting Standards No. 158, as disclosed in Recent Accounting Pronouncements, and an increase in net unrealized losses on available-for-sale investments of $3.5 million.
Our holding company’s main sources of liquidity historically have been dividends received from our insurance subsidiaries, borrowing from our primary insurance subsidiary, and proceeds from issuance of debt or equity securities. Apart from the exercise of stock options and restricted stock grants to employees, the effects of which have not been significant, we have not issued any equity securities since 1998 when AIG exercised its warrants to purchase 16 million shares of common stock for cash of $145.6 million. Our insurance subsidiaries did not pay any dividends to our holding company from 2001 to 2004 due to the previous uncertainty surrounding the taxability of dividends received by holding companies from their insurance subsidiaries in California, which was resolved in 2004. Our primary insurance subsidiary, 21st Century Insurance Company, declared and paid a $110.0 million dividend in December 2006.
On November 30, 2005, the CDI permitted an amendment to a term loan line that increased the available amount from $40 million to $150 million that our insurance subsidiary, 21st Century Insurance Company, can loan to our holding company. The term loan line had a zero balance at December 31, 2006. See further information in the Notes to Condensed Financial Information of Registrant.
Our holding company’s significant cash obligations over the next several years consist of the following:
The repayment of the $100 million principal on the Senior Notes due in 2013;
We have achieved underwriting profits in our core auto insurance operations since 2001 and have thereby enhanced our liquidity. Our cash flows from operations and short-term cash position generally are more than sufficient to meet obligations for claim payments, which by the nature of the personal automobile insurance business tend to have an average duration of less than a year. Our underwriting results are impacted by rate changes. Although in the past years we have been successful in gaining California regulatory approval for rate changes, there can be no assurance that insurance regulators will grant future rate changes that may be necessary to offset possible future increases in claims cost trends.
As discussed in the Highlights, in July 2006, the CDI issued changes to regulations relating to automobile insurance rating factors, particularly concerning territorial rating. It is not possible at this time to predict the ultimate timing or impact of these changes, which could have either a materially favorable or materially adverse impact on the Company. Also in July 2006, the CDI proposed new amended rate approval regulations, subsequently amended in October of 2006, could have a materially adverse impact on the Company’s California results. The regulations become effective April 3, 2007. If the newly elected insurance commissioner does not modify, suspend or withdraw the regulations before they become effective, an industry lawsuit could be brought to challenge the regulations as contrary to current law. Also, the Company could consider bringing its own legal action, once the regulations are applied to it. See further discussion of both regulations in Item 1A. Risk Factors.
The NAIC employs a risk-based capital formula for property and casualty insurance companies that establishes recommended minimum capital requirements. The formula was designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance having differing risk characteristics, as well as writers of similar lines where differences in risk may be related to corporate structure, investment policies, reinsurance arrangements and a number of other factors. Based on the formula adopted by the NAIC, the Company has calculated a combined Company Action Level risk-based capital requirement of $172.9 million for its insurance subsidiaries as of December 31, 2006. Each of the insurance companies’ statutory surplus exceeded their respective level of minimum required capital.
As of December 31, 2006, our insurance subsidiaries had a combined statutory surplus of $771.0 million compared to $704.7 million at December 31, 2005. The increase in statutory surplus was primarily due to statutory net income of $124.5 million and a decrease in nonadmitted assets of $64.2 million, partially offset by dividends to the Parent of $110.0 million and a $15.6 million decrease in the deferred income tax asset.
The net premiums written to statutory surplus ratio, which shows a company’s premium growth capacity and is required to be below 3.0 by the insurance regulators, was 1.7 at December 31, 2006, compared to 1.9 at December 31, 2005.
Our net increase (decrease) in cash and cash equivalents were as follows:
Net cash and cash equivalents provided by operating activities decreased primarily due to a decline in direct premiums collected resulting from the decline in premiums written and an increase in taxes paid as a result of the utilization of the carryforward of net operating losses during 2006. This was partially offset by decreases in loss and LAE payments. Also, while underwriting expenses and policy acquisition costs increased over the prior year, cash outflows for those expenses decreased slightly due to the increase in unpaid other liabilities of $14.0 million which deferred payment of expenditures incurred in connection with our national expansion efforts.
Our cash and cash equivalents used in investing activities is primarily impacted by the sales, maturities and purchases of our available-for-sale investment securities. Our investment objective is to maintain a low level of risk and to preserve principal by investing in high quality, investment grade securities while maintaining liquidity in each portfolio sufficient to meet our cash flow requirements.
Net cash and cash equivalents used in investing activities increased due to a $1.4 million decrease in net acquisitions (purchases, net of maturities, calls and sales) of investments primarily as a result of the redeployment of cash equivalents and a $5.8 million decrease in purchases of property and equipment.
The following table summarizes our significant contractual obligations and commitments at December 31, 2006 and the future periods in which such obligations are expected to be settled in cash. In addition, the table reflects the timing of principal and interest payments on outstanding Senior Notes.
Our primary insurance subsidiary is responsible for making payments on both the capital lease obligations and most of the operating lease obligations.
Contributions to our non-qualified defined benefit pension plan generally are limited to amounts needed to make benefit payments to retirees, which are expected to total approximately $0.9 million in 2007.
Purchase commitments of $0.2 million were excluded from the summary, as they are not material.
The Company has a catastrophe reinsurance agreement for the comprehensive portion of its auto physical damage lines that is provided by three participating entities, two of which are AIG subsidiaries. Together they reinsure any covered event up to $45.0 million in excess of $20.0 million. This coverage was renewed effective January 1, 2006 and 2007 (see Note 10 of the Notes to Consolidated Financial Statements).
The Company has obtained the following corporate insurance policies from AIG subsidiaries:
Errors and omissions insurance was carried with AIG through September 30, 2005.
In October 2003, as a result of a competitive bidding process, we entered into an agreement with AIG Global Investment Corp. (“AIGGIC”) to provide investment management and investment accounting services. The fees are determined as a percentage of the average invested asset balance and are classified with net investment income. This agreement was approved by the CDI. Investment management and accounting expense was $1.1 million, $0.9 million, and $0.9 million for the years ended December 31, 2006, 2005 and 2004, respectively.
The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures. Our significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements and are essential to understanding Management’s Discussion and Analysis of Financial Condition and Results of Operations. Management considers an accounting estimate to be critical if:
Change in the estimate or different estimates that could have been selected could have a material impact on the Company’s consolidated results of operations or financial condition.
The following is a summary of the more critical accounting estimates. In each area, we have discussed the assumptions most important in the estimation process. We have used the best information available to estimate the related items involved. Actual performance that differs from our estimates and future changes in the key assumptions could change future valuations and materially impact our financial condition and results of operations.
The estimated liabilities for losses and LAE include estimates of the ultimate resolution for known claims reported on or prior to the balance sheet dates, estimates of losses for claims incurred but not reported, 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. The 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. In addition, time can be a critical part of reserving determinations since the variability of the ultimate settlement amount is likely to increase as the time between the occurrence and settlement of the claim increased.
It is management’s belief that the reserves for losses and LAE are adequate to cover unpaid losses and LAE at December 31, 2006. While we perform quarterly reviews of the adequacy of established unpaid losses and LAE reserves, there can be no assurance that our ultimate unpaid losses and LAE will not develop redundancies or deficiencies and possibly differ materially from our unpaid losses and LAE recorded at December 31, 2006. In the future, if the unpaid losses and LAE develop redundancies or deficiencies, such redundancy or deficiency would have a positive or adverse impact, respectively, on future results of operations.
The process of estimating unpaid losses and LAE begins with the review of the actual claims experience, actual rate changes achieved, actual changes in coverage, mix of business, and changes in certain other factors such as weather and recent tort activity that may affect the loss and LAE ratio. Based on this review, our actuaries prepare several point estimates of unpaid losses and LAE for each of the coverages, and they use their experience and judgment to arrive at an overall actuarial point estimate of the unpaid losses and LAE for that coverage.
Meetings are held with appropriate departments to discuss significant issues as a result of the review. This process culminates in a reserve meeting to review the unpaid losses and LAE. The basis for carried unpaid losses and LAE is the overall actuarial point estimate. Other relevant internal and external factors considered include a qualitative assessment of inflation and other economic conditions, changes in the legal, regulatory, judicial and social environments, underlying policy pricing, exposure and policy forms, claims handling, and geographic distribution shifts. As a result of the meeting, unpaid losses and LAE are finalized and we record quarterly changes in unpaid losses and LAE for each of our coverages. The overall change in our unpaid losses and LAE is based on the sum of these coverage level changes.
The incurred loss development method analyzes historical case incurred loss (paid loss plus case reserves) development to estimate ultimate losses. The Company applies loss development factors against case incurred losses by accident period to calculate ultimate losses. The paid loss development method is similar to the incurred loss development method except only paid losses are used.
The claim count development method analyzes historical claim count development to estimate ultimate claim counts. The Company applies these development factors against claim counts by accident period to calculate ultimate claim counts. Severity is the amount of loss per claim. The average severity method analyzes historical severity development to calculate an ultimate average cost per claim. From this, the ultimate severity can be estimated. The claim count development method coupled with the average severity method also provides useful information regarding frequency and inflationary trends that the Company believes is useful in setting reserves.
In states with little operating history the Company’s experience is supplemented with industry statistics.
The Company uses similar methods for LAE. The Company estimates the loss IBNR reserves as the difference between its projection of ultimate losses and the sum of the payments and case reserves for losses.
There is a potential for significant variation in ultimate development of unpaid losses and LAE. Most automobile claims are reported within two to three months whereas the estimate of ultimate severities exhibits greater variability at the same maturity. Generally, actual historical loss development factors are used to project future loss development and there can be no assurance that future loss development patterns will be the same as in the past.
The Company uses numerous assumptions in determining its best estimates of reserves for losses and LAE for each coverage of the personal auto business. If actual experience differs from key assumptions used in establishing reserves, there is potential for significant variation in the development of loss and LAE reserves. Set forth below is a sensitivity analysis that estimates the effect on the loss and LAE reserve position of using alternative loss cost trend or loss development factor assumptions rather than those actually used in determining the best estimates in the year-end loss and LAE reserve analyses for 2006. The analysis addresses the personal auto business in California for which a material deviation to the Company’s overall reserve position is believed reasonably possible, and uses what the Company believes is a reasonably likely range of potential deviation. There can be no assurance, however, that actual reserve development will be consistent with either the original or the adjusted loss cost trend or loss development assumptions, or that other assumptions made in the reserving process will not materially affect reserve development for a particular coverage.
After evaluating the historical loss cost trends from prior years since 1994, in Management’s judgment, it is reasonably likely that actual loss cost trends applicable to the year-end 2006 loss and LAE reserve analysis will range from negative 13% to positive six percent, or approximately 12% lower and seven percent higher than the assumptions utilized in the year-end 2006 reserve analysis. These changes in the assumed loss cost trend would cause approximately an $84 million decrease or a $47 million increase in the loss and LAE reserves. It should be emphasized that these deviations are not considered the highest possible deviations that might be expected, but rather what is considered by the Company to reflect a reasonably likely range of potential deviation.
Trading at a significant (25 percent or more) discount to par, amortized cost (if lower) or cost for an extended period of time (nine months or longer),
For investments with unrealized losses due to market conditions or industry-related events, where we have the positive intent and ability to hold the investment for a period of time sufficient to allow a market recovery or to maturity, declines in value below cost are not assumed to be other-than-temporary. Where declines in values of securities below cost or amortized cost are considered to be other-than-temporary, such as when it is determined that an issuer is unable to repay the entire principal, a charge is required to be reflected in income for the difference between cost or amortized cost and the fair value.
The Ford Motor Credit Company security matured in the first quarter of and the Company received all amounts due, thereby incurring no loss.
The AmerUs Group Co. was a preferred stock holding that had an unrealized gain as of December 31, 2005.
The following table summarizes realized gains and losses for the past three years. Additional information has been provided with respect to how long investments that were sold at a loss in each year were in an unrealized loss position.
Amount represents 0.1%, less than 0.1%, and 0.1% of total fair value of investments in 2006, 2005, and 2004, respectively.
A summary by contractual maturity of fixed maturity securities in an unrealized loss position by year of maturity follows:
As discussed in Note 2 to the consolidated financial statements, during the year ended December 31, 2006, the Company changed its accounting for stock-based compensation costs as of January 1, 2006 and employee benefit plans as of December 31, 2006.
21st Century Insurance Group is an insurance holding company founded in 1958 and, effective December 4, 2003, was incorporated under the laws of the State of Delaware. Previously, the Company was incorporated in California. The term “Company,” unless the context requires otherwise, refers to 21st Century Insurance Group and its consolidated subsidiaries, all of which are wholly-owned: 21st Century Insurance Company (our primary insurance company), 21st Century Casualty Company, 21st Century Insurance Company of the Southwest, 20th Century Insurance Services, Inc., and i21 Insurance Services. The latter two companies are not property and casualty insurance subsidiaries, and their results are immaterial.
The common stock of the Company is traded on the New York Stock Exchange under the trading symbol “TW.” Through several of its subsidiaries, American International Group, Inc. (“AIG”) owned approximately 62% of the Company’s outstanding common stock at December 31, 2006.
Investment securities generally must be classified as held-to-maturity, available-for-sale or trading. The appropriate classification is based partially on our ability to hold the securities to maturity and largely on management’s intentions at inception with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on trading securities flow directly through earnings during the periods in which they arise, whereas for available-for-sale securities they are recorded as a separate component of stockholders’ equity (accumulated other comprehensive income or loss) and do not affect earnings until realized. The fair values of our investment securities are generally determined by reference to quoted market prices and reliable independent sources. The cost of investment securities sold is determined by the specific identification method.
We are obligated to assess, at each reporting date, whether there is an “other-than-temporary” impairment to our investment securities. In general, a security is considered a candidate for other-than-temporary impairment based upon the following criteria:
The occurrence of a discrete credit event resulting in the debtor defaulting or seeking bankruptcy or insolvency protection or voluntary reorganization; and
The Company started investing in limited partnerships and limited liability corporations during the third quarter of 2006, as further discussed in Note 3 of the Notes to Consolidated Financial Statements. Since our share of a partnership’s or corporation’s capital is greater than 3%, but less than 50%, we account for these investments using the equity method, and the carrying values of our investments, which approximates fair value, are adjusted to reflect our share of the underlying equity of the partnerships or corporations, as applicable. The change in our share of the underlying equity of the partnerships or corporations is recorded in net investment income.
Deferred policy acquisition costs (“DPAC”) primarily include premium taxes, advertising after it takes place, and other variable costs incurred with acquiring and renewing policies. These costs are deferred and amortized over the six-month policy period in which the related premiums are earned.
Management assesses the recoverability of deferred policy acquisition costs on a quarterly basis. The assessment calculates the relationship of actuarially estimated costs incurred to premiums from contracts issued or renewed for the period. We do not consider anticipated investment income in determining the recoverability of these costs. Based on current indications, management believes these costs are fully recoverable at December 31, 2006.
The following table summarizes the estimated useful lives used for calculating depreciation of the Company’s assets:
Management assesses the Company’s property and equipment, including software development projects in progress, for possible impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. The assessment of impairment involves a two-step process, whereby an initial assessment for potential impairment is performed by comparing the carrying value plus the cost to complete, if any, to estimated future undiscounted cash flows from operations at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. If future undiscounted cash flows are insufficient, an impairment write down is recorded for the difference between the carrying value and estimated fair value of the asset group. During 2006, the Company reassessed an asset group comprised of capitalized software dedicated to the administration of certain policies and concluded that such assets were impaired. An impairment of $0.9 million, classified as other expense, was recorded during the fourth quarter of 2006.
On an annual basis, we test this intangible asset based on the estimated fair value of the operating cash flows associated with the long-lived asset. However, we will test for impairment on a more frequent basis in cases where events and changes in circumstances would indicate that we might not recover the carrying value of the intangible asset. Our measurement of fair value is based on a discounted cash flow methodology that converts expected cash flows of our broker segment to present value. If the fair value is greater than the carrying value of the intangible asset, then the intangible asset is not considered impaired. The impairment test as of December 31, 2006, indicated that the asset was not impaired.
In the normal course of business, the Company is named as a defendant in lawsuits related to its insurance operations and business practices that expose it to potential losses. We recognize an estimated loss, which may represent damages, settlement costs, legal expenses or a combination of the foregoing, as appropriate, from such loss contingencies when it is both probable that a loss will be incurred and that the amount of the loss can be reasonably estimated. Our loss estimates are based in part on an analysis of potential results, the stage of the proceedings, consultation with outside counsel and any other relevant available information.
The Company vacated excess space at its Woodland Hills, California headquarters in both 2006 and 2005. Losses recognized on these vacated spaces were $0.9 million and $0.4 million in 2006 and 2005, respectively, as future rental costs are higher than potential market rentals. 2006 also includes an impairment of $0.9 million that was recognized for certain capitalized software. No other expense was reported in 2004.
The numerator for the calculation of both basic and diluted EPS is equal to net income reported for that year. The difference between basic and diluted EPS denominators is due to dilutive common stock equivalents (stock options and restricted stock). Basic EPS excludes dilution and reflects net income divided by the weighted-average shares of common stock outstanding during the periods presented. Diluted EPS is based upon the weighted-average shares of common stock and dilutive common stock equivalents outstanding during the periods presented. Common stock equivalents arising from dilutive stock options and restricted common stock were computed using the treasury stock method.
In September 2006, the FASB issued FAS 157, Fair Value Measurements (“FAS 157”). FAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be disclosed separately by level within the fair value hierarchy. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years, with early adoption permitted. We have not yet determined the effect, if any, that the implementation of FAS 157 will have on our results of operations or financial condition.
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for the Company’s fiscal year ended December 31, 2006. The adoption of SAB 108 did not have a material effect on the financial statements.
Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (“SOP 05-1”), becomes effective January 1, 2007. SOP 05-1 provides guidance on accounting for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in FAS 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. The SOP defines an internal replacement as a modification in product benefits, features, rights, or coverage that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. We are currently assessing the effect of implementing this guidance.
Effective January 1, 2006, the Company adopted FAS 123R, which requires all stock-based payments to employees, including grants of employee stock options, to be recognized in the statements of operations based on their fair values. Determining the fair value of share-based awards at the grant date requires judgment in estimating the volatility and dividends over the expected term that the stock options will be outstanding prior to exercise. Judgment is also required in estimating the amount of stock-based awards expected to be forfeited prior to vesting. If actual forfeitures differ significantly from our estimates, stock-based compensation expense could be materially impacted.
Two AIG subsidiaries are 80% participants in a catastrophe reinsurance agreement for auto physical damage losses incurred by the Company under the comprehensive coverage portion of its auto policies. The AIG subsidiaries are all rated A+ or higher. Total premiums ceded to AIG subsidiaries were $1.0 million, $1.0 million, and $1.1 million for the years ended December 31, 2006, 2005, and 2004, respectively. Total reinsurance recoverables, net of payables, from AIG subsidiaries were $0.4 million and $0.6 million at December 31, 2006 and 2005, respectively.
In June 2006, the Company executed a $35 million funding commitment for a private equity investment program, which is managed by AIGGIC. In the event that the Company does not respond to a capital call during the investment term, the General Partner of the fund (“GP”) may apply the following default provisions: withhold 50% of distributions due to the Company at the time of the default and 50% of future distributions due to the Company; hold the Company liable for fund expenses above and beyond investments made by the Company (with the right of offset); terminate the Company’s Limited Partner status and not allow it any further investments; or charge interest on the defaulted capital commitment amount and fees at LIBOR + 4% (with the right of offset). However, the GP may choose not to designate the Company a “defaulting limited partner” and waive the default provisions. The investment term ends after the underlying investments are liquidated, but in no event is longer than 10 years. Multiple investments are expected to be purchased and liquidated over the investment term. The Company funded $14.4 million of the commitment during 2006.
We are required to reduce DTAs (but not DTLs) by a valuation allowance to the extent that, based on the weight of available evidence, it is less than “more likely than not” (i.e., a likelihood of more than 50%) that any DTA will be realized. Recognition of a valuation allowance would decrease reported earnings on a dollar-for-dollar basis in the year in which any such recognition were to occur. The determination of whether a valuation allowance is appropriate requires the exercise of management judgment. In making this judgment, management is required to weigh the positive and negative evidence as to the likelihood that the DTAs will be realized.
The Company’s net deferred tax assets include a net operating loss (“NOL”) carryforward for regular federal corporate tax purposes of approximately $9.3 million, representing an unrealized tax benefit of $3.3 million at December 31, 2006, compared to $33.6 million at December 31, 2005. As a result of taxable income since 2002, our NOL has been fully utilized through December 31, 2006, except for the amount relating to 21st Century Insurance Company of the Southwest (“21st of the Southwest”) that is subject to the Internal Revenue Service (“IRS”) separate return limitation year provisions. The remaining NOL expires as follows: $1.4 million in 2017; $1.1 million in 2018; $1.5 million in 2019; $3.2 million in 2020; and $2.1 million in 2021.
During 2004, we received $12.5 million from the IRS to settle a prior year receivable. At December 31, 2006 and 2005, the Company’s net federal income tax receivable (payable) was $2.6 million and ($3.2) million, which are included in other assets and liabilities, respectively, in the accompanying consolidated balance sheets. The Company has no current liability recorded for any contingent income tax items at December 31, 2006 or 2005.
Following is a summary of policy acquisition costs deferred for amortization against future income and the related amortization charged to income from operations (policy acquisition costs are amortized over the six-month policy period):
Total advertising costs after it takes place included in policy acquisition costs deferred during 2006, 2005 and 2004 were $74.9 million, $70.1 million, and $66.7 million, respectively.
Depreciation expense for leased property under capital lease was $5.2 million, $12.8 million, and $12.4 million for the years 2006, 2005, and 2004, respectively.
The methods used to determine such estimates and to establish the resulting reserves are continually reviewed and updated. Any resulting adjustments are reflected in current operating income. It is management’s belief that the reserves for losses and LAE are adequate to cover unpaid losses and LAE at December 31, 2006. While the Company performs quarterly reviews of the adequacy of established unpaid losses and LAE reserves, there can be no assurance that ultimate amounts will not differ materially, higher or lower, from the recorded liability for unpaid losses and LAE at December 31, 2006. In the future, if the unpaid losses and LAE develop redundancies or deficiencies, such redundancy or deficiency would have a positive or adverse impact, respectively, on future results of operations.
The process of making periodic changes to unpaid losses and LAE begins with the preparation of several point estimates of unpaid losses and LAE, a review of the actual claims experience in the period, actual rate changes achieved, actual changes in coverage, mix of business, and changes in certain other factors such as weather and recent tort activity that may affect the loss ratio. Based on this review, our actuaries prepare point estimates of unpaid losses and LAE for each of the coverages, and they use their experience and judgment to arrive at an overall actuarial point estimate of the unpaid losses and LAE for that coverage.
Meetings are held with appropriate departments to discuss significant issues as a result of the review. This process culminates in a reserve meeting to review the unpaid losses and LAE. The basis for carried unpaid losses and LAE is the overall actuarial point estimate. Other relevant internal and external factors considered include a qualitative assessment of inflation and other economic conditions, changes in the legal, regulatory, judicial and social environments, underlying policy pricing, exposure and policy forms, claims handling, and geographic distribution shifts.
As a result of this process, unpaid losses and LAE are finalized and changes are recorded for each of our coverages. The unpaid losses and LAE for each coverage is the difference between the estimated net ultimate losses and LAE and the net paid losses and LAE recorded through the end of the period. The overall change in our unpaid losses and LAE is based on the sum of these coverage level changes. The favorable development in 2006 and 2005 was primarily due to favorable impact of declining frequency and moderate claim severity trends.
The Senior Notes are redeemable at the Company’s option, at any time in whole, or from time to time in part, prior to maturity at a redemption price equal to the greater of (A) 100% of the principal amount of the notes or (B) the sum of the present values of the remaining scheduled payments of principal and interest thereon (exclusive of interest accrued through the date of redemption) discounted to the redemption date on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months) at the Treasury Rate, plus 25 basis points (plus in each case, accrued interest thereon to the date of redemption). The estimated value of redemption was $105.8 million as of December 31, 2006.
The remaining capital lease obligation is for certain other longer term operating leases.
The Company reinsures 90% of its exposure to its Personal Umbrella Policies through 90% quota share reinsurance treaty policies with Swiss RE Underwriters (55%) and Hannover Ruckversicherungs (35%). All of the aforementioned reinsurers are rated A+ or higher.
December 31 is the measurement date for the plans. The discount rate can vary from year to year and is determined by developing a hypothetical portfolio of high quality bonds with cash flows matched to our projected benefit costs.
Both of the Company’s defined benefit pension plans have projected benefit obligations in excess of plan assets at December 31, 2006 and 2005, as noted under the discussion of Funded Status. The following table sets forth the projected benefit obligation and accumulated benefit obligation for the unfunded SERP, which has an accumulated benefit obligation in excess of plan assets at December 31, 2006 and 2005:
The following table sets forth the funded status of the plans at the end of the year and related amounts reported on the consolidated balance sheets:
The following table shows pension related amounts included in accumulated other comprehensive loss for the years ended December 31, 2006, 2005, and 2004:
The overall expected long-term rate of return on assets is a weighted-average expectation for the return on plan assets. The Company considers historical performance and current benchmarks to arrive at expected long-term rates of return in each asset category. The Company utilizes consulting pension actuaries to perform stochastic modeling services to assist the Company in determining the assumed expected long-term rate of return on assets, based on an assumption that 75% of the plan asset portfolio will be invested in equity securities, with the remainder invested in debt securities. Historical returns were not adjusted for purposes of performing the stochastic modeling. Neither the Company nor either of the defined benefit plans have engaged in any prohibited transactions.
The following table presents the components of net periodic benefit cost for the years ended December 31, 2006, 2005, and 2004:
The Company sponsors a qualified 401(k) contributory savings and security plan for eligible employees and officers. The Company provides matching contributions equal to 75% of the lesser of 6% of an employee’s eligible compensation or the amount contributed by the employee up to the maximum allowable under IRS regulations. The plan offers a variety of investments among which employees exercise complete discretion as to choice and investment duration. The Company also sponsors a 401(k) supplemental plan to provide specified benefits to a select group of management and highly compensated employees. Company matching contributions charged against operations were $6.0 million, $5.0 million, and $4.9 million in 2006, 2005 and 2004, respectively. The plan offers a variety of investment types among which employees exercise complete discretion as to choice and investment duration.
The Company also leases automobiles, office and telecom equipment as well as office space in several other locations, primarily for claims services. Rent expense for leases with predetermined minimum rental escalations is recognized on a straight-line basis, and the difference between the recognized rental expense and amounts payable under the leases, or deferred rent, is included in other liabilities. The deferred rent liability was $5.8 million and $4.3 million at December 31, 2006 and 2005, respectively. The Company also has software license agreements with terms greater than one year.
In the normal course of business, the Company is named as a defendant in lawsuits related to its insurance operations and business practices. Many suits seek unspecified extra-contractual and punitive damages as well as contractual damages under the Company’s insurance policies in excess of the Company’s estimates of its obligations under such policies. The Company cannot estimate the amount or range of loss that could result from an unfavorable outcome on these suits and it denies liability for any such alleged damages. The Company has not established reserves for potential extra-contractual or punitive damages, or for contractual damages in excess of estimates the Company believes are correct and reasonable under its insurance policies. Nevertheless, extra-contractual and punitive damages, if assessed against the Company, could be material in an individual case or in the aggregate. The Company may choose to settle litigated cases for amounts in excess of its own estimate of contractual damages to avoid the expense and risk of litigation. Other than the possibility of the contingencies discussed below, the Company does not believe the ultimate outcome of these matters will be material to its results of operations, financial condition or cash flows. In addition, the Company denies liability and has not established a reserve for the matters discussed below. A range of potential losses in the event of a negative outcome is discussed where known.
Poss v. 21st Century Insurance Company was filed on June 13, 2003, in Los Angeles Superior Court and Axen v. 21st Century Insurance Company was filed on April 14, 2004 in Alameda County Superior Court. Both complaints seek injunctive and unspecified restitutionary relief against the Company under Business and Professions Code (“B&P”) Sec. 17200 for alleged unfair business practices in violation of California Insurance Code Sec. 1861.02(c) relating to Company rating practices. The court in the Poss case granted the Company’s motion to dismiss the complaint, based on California’s Proposition 64, but allowed the addition of a second plaintiff, Leacy. Discovery has been stayed in both cases and, because these matters are in the pleading stages, and no discovery has taken place, no estimate of the range of potential losses in the event of a negative outcome can be made at this time. In January of 2007, a settlement agreement for an immaterial amount was reached with the Axen plaintiff, which the Company is finalizing.
Insurance Company cases (Ramona Goldenburg) was originally filed as Bryan Speck, individually, and on behalf of others similarly situated v. 21st Century Insurance Company, 21st Century Casualty Company, and 21st Century Insurance Group. The original action was filed on June 20, 2002, in Los Angeles Superior Court. Plaintiff seeks California class action certification, injunctive relief, and unspecified actual and punitive damages. The complaint contended that the Company uses “biased” software in determining the value of total-loss automobiles. Specifically, Plaintiff alleged that database providers use improper methodology to establish comparable auto values, that the providers populate their databases with biased figures, and that the Company and other carriers allegedly subscribe to the programs to unfairly reduce claims costs. This case is consolidated with similar actions against other insurers for discovery and pre-trial motions. A court-ordered appraisal of Speck’s vehicle was favorable to the Company and Ramona Goldenberg was substituted as a Plaintiff, replacing Speck, and a new appraisal was ordered. On October 13, 2006, Plaintiff’s counsel offered to dismiss this case, with prejudice, in exchange for the Company waiving its costs. The Company has accepted the offer from the Plaintiff’s counsel to dismiss the matter and will support a motion, containing the agreed terms.
Thomas Theis, on his own behalf and on behalf of all others similarly situated v. 21st Century Insurance Company was filed on June 17, 2002, in Los Angeles Superior Court. Plaintiff seeks California class action certification, injunctive relief, and unspecified actual and punitive damages. The complaint contends that after insureds receive medical treatment, the Company used a medical-review program to adjust expenses to reasonable and necessary amounts for a given geographic area and the adjusted amount is “predetermined” and “biased.” This case is consolidated with similar actions against other insurers for discovery and pre-trial motions. On January 11, 2007, Plaintiff’s motion to certify a “med-pay” class was granted. This matter is in the discovery state of litigation and no reasonable estimate of potential losses in the event of a negative outcome can be made at this time. The Company intends to vigorously defend the suit.
Silvia Quintana, on her own behalf and on behalf of all others similarly situated v. 21st Century Insurance Company was filed on November 16, 2005. This purported class action, filed in San Diego, names the Company in four causes of action: 1) violation of B&P Section 17200, 2) conversion, 3) unjust enrichment and, 4) declaratory relief. Silvia Quintana alleges that the Company’s demand for reimbursement of the medical payments it made to her pursuant to her insurance contract violates the “made-whole rule.” The Company anticipates that if the matter survives the initial pleading stage, it will be consolidated, for discovery and pre-trial motions, with actions alleging similar facts against other insurers. This matter is in the pleading stage and no reasonable estimate of potential losses in the event of a negative outcome can be made at this time. In July 2006, the trial court denied the Company’s demurrer and motion to strike and the Company has filed a writ to the Court of Appeal for review of this decision. In November 2006, the Court of Appeal ordered the trial court to show cause why the relief the Company requested should not be granted. Oral arguments have not yet been scheduled.
At December 31, 2006 and 2005, there were 86,471,754 and 85,933,960 shares of the Company’s common stock outstanding, respectively. No shares were repurchased in 2006 or 2005. However, forfeited restricted shares are deemed treasury share purchases.
Stock-based compensation cost related to stock options granted on or prior to, but not vested at December 31, 2005, based on the grant date fair value originally estimated for the pro forma disclosures in accordance with the original provisions of FAS 123; and
All stock-based payments granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of FAS 123R.
The effect of the adoption of FAS 123R on the consolidated statements of operations for the year ended December 31, 2006 is as follows:
The year ended December 31, 2006 results include $0.7 million of accelerated costs incurred during the first quarter to recognize the effect of retirement eligibility in accordance with the non-substantive vesting period approach and $1.4 million of actual vesting in accordance with an executive retention agreement. As compensation costs for certain employees are included in deferred policy acquisition costs, pre-tax compensation cost related to stock-based compensation of $0.2 million was deferred, at December 31, 2006. The remaining unrecognized compensation cost related to unvested awards at December 31, 2006, was $8.7 million and the weighted-average period over which this cost will be recognized is 1.8 years. As a result of the adoption of FAS 123R, $0.3 million of excess tax benefits in 2006 are classified as a financing cash inflow instead of as an operating inflow in the consolidated statement of cash flows.
Includes $0.9 million stock-based compensation related to restricted shares and $0.3 million associated tax, as the previous accounting under APB 25 was consistent with that of FAS 123R, for the year ended December 31, 2006.
A summary of securities issuable and issued for the Company’s stock option plans at December 31, 2006, follows:
A summary of the Company’s stock option activity and related information follows:
The expected term for options granted during the year ended December 31, 2006, was calculated using the simplified method in accordance with Staff Accounting Bulletin No. 107, Shared-Based Payment. The expected volatility of employee stock options was based on the historical volatility of key competitors in the property and casualty insurance industry (based on six years of closing stock prices). The Company believes that the use of historical competitor volatility better reflects current market expectations of the Company’s stock price volatility. The Company’s own historical stock price volatility is not representative of expected volatility due to significant prior year events, such as the effects of the 1994 Northridge earthquake and California Senate Bill 1899 (“SB 1899”), which would not be expected to significantly impact results in the future. The annual risk-free interest rate is based on a traded zero-coupon U.S. Treasury bond on the grant date with a term equal to the option’s expected term. The dividend yield is calculated based on the expected annual dividend over the closing stock price on the grant date.
The following table summarizes information about stock options outstanding and exercisable at December 31, 2006 (amounts in thousands, except price and term data):
The aggregate intrinsic value in the preceding table represents the pre-tax amount that would have been received by the option holders had all option holders exercised their options at December 31, 2006. Vested and expected-to-vest options at December 31, 2006, included in the table above, totaled 9,865,170 with a weighted-average exercise price of $16.37, a weighted-average contractual term of 6.1 years and an aggregate intrinsic value of $20.1 million.
A summary of the Restricted Shares Plan activity and related information follows for the years ended December 31:
Statutory surplus and statutory net income for the Company’s insurance subsidiaries were as follows:
The Company’s insurance subsidiaries file financial statements prepared in accordance with Statutory Accounting Principles (“SAP”) prescribed or permitted by domestic insurance regulatory agencies. The Company’s financial statements are prepared in accordance with GAAP and differ from amounts reported under SAP primarily as a result of the following:
Costs for application computer software developed or obtained for internal use are capitalized and amortized over their useful life. However, SAP requires the net book value of the assets to be nonadmitted.
The following table reconciles consolidated GAAP net income to statutory net income.
The Company is also regulated by the provisions of the California Insurance Holding Company System Regulatory Act (the “Holding Company Act”). Transactions that are defined to be of an “extraordinary” nature may not be effected without the prior approval of the CDI. There are limits on the insurance subsidiaries’ dividend paying capacity. In 2007, the Company estimates that its primary insurance subsidiary has capacity to pay approximately $124.0 million in dividends to its parent without prior approval of the CDI. The Parent received a $110 million dividend from its primary insurance subsidiary in the form of a non-cash settlement of the $86.0 million term loan due to that subsidiary and a $24.0 million cash payment in the fourth quarter of 2006.
The Company evaluates segment performance based on pre-tax underwriting profit or loss. The Company does not allocate assets, net investment income, net realized investment gains or losses, other revenues, nonrecurring items, interest and fees expense, or income taxes to operating segments. The accounting policies of the reportable segments are the same as those described in Note 2 of the Notes to Consolidated Financial Statements. All revenues are generated from external customers and the Company does not rely on any major customer.
The VIE structure provides a wider range of investment options through which insurance companies and other institutional investors can address the investment needs of these communities. The Company’s maximum participation in Impact C.I.L., LLC (“Impact C.I.L.”), a VIE and a subsidiary of Impact, is for up to 11.1% ($52.8 million) of $475.0 million of the entity’s funding activities. These commitments consist of a $10.6 million minimum investment and a $42.2 million guarantee of a warehouse lending facility. Potential losses are limited to the Company’s participation as well as associated operating fees. The Company’s pro rata share of these advances to Impact C.I.L., which in turn makes housing investments in economically disadvantaged communities, was approximately 11.1%, or $8.6 million and $5.0 million at December 31, 2006 and 2005, respectively. The revolving member loan and the warehouse financing agreement do not significantly impact the Company’s liquidity or capital.
Homeowner and earthquake segment revenue represents premiums earned as a result of the Company’s participation in the California Fair Plan.
The Company is not the primary beneficiary of any of the VIEs as the Company has a non-controlling interest with voting rights, beneficiary rights, obligations, and ownership in proportion to each of its Impact related investments.
In addition to the above, the Company held $8.2 million and $6.2 million in other Impact related fixed-income investments at December 31, 2006 and 2005, respectively. The Company also held $0.3 million in other Impact related private equity investments at December 31, 2006. There were no other Impact related private equity investments at December 31, 2005. Total Impact related investment income was $1.0 million, $1.1 million, and $0.8 million for the years ended 2006, 2005, and 2004, respectively.
Further, the Company may need to incur future costs for the retention of personnel, the proposal, and/or litigation stemming from the proposal.
Edward Bronstein v. 21st Century Insurance Group, et al and a companion case, Francis A. Sliwinski v. 21st Century Insurance Group, et al allege the Company, its directors and AIG have, or will, breach fiduciary duties as a result of AIG’s January 24, 2007 merger proposal to acquire the remaining shares of Company stock which AIG does not yet own. Both actions were filed in the Los Angeles Superior Court in January 2007 and seeks class action certification and equitable relief. The Company has formed a special committee of directors, independent of AIG, to evaluate the terms of any merger proposal. The Company believes the action is without merit.