FINANCIAL CONDITION Investment-grade bonds comprised 99.9% of the fair value of the fixed-maturity portfolio at December 31, 2002. The Company has no investments in equity securities as of December 31, 2002. Of the Company's total investments at December 31, 2002, approximately 54.5% were invested in tax-exempt, fixed-income securities, compared to 80.2% at December 31, 2001. The Company has begun shifting its investment focus to investment-grade taxable bonds to accelerate the realization of the tax benefit of its net operating loss deduction (see Critical Accounting Policies - Deferred Income Taxes).
Premiums receivable were $91.0 million at December 31, 2002, compared to $75.6 million at December 31, 2001, with the increase mainly attributable to growth in the Company's customer base and higher premium rates. Company policy is to write-off receivable balances when they become past due 180 days, and the Company historically has not considered an allowance for doubtful accounts to be necessary.
Prepaid reinsurance premiums and reinsurance payables were $1.9 million and $5.0 million at December 31, 2002, compared to $15.4 million and $13.0 million at December 31, 2001, respectively. The decline in balances is primarily due to the cancellation of the quota share treaty with AIG subsidiaries (see Note 9 to the Notes to Consolidated Financial Statements).
- ------------------------------ 1 Amount shown for 2002 is a capital lease obligation (see Note 7 of the Notes to Consolidated Financial Statements). 2 Amount shown for 2002 would be $343,661 were it not for the sale-leaseback transaction described in Note 7 of the Notes to Consolidated Financial Statements. 3 Amount shown for 2002 would be 2.8:1 were it not for the sale-leaseback transaction referred to above.
Property and equipment decreased $91.4 million primarily due to the sale-leaseback described above and the write-off of certain software in the third quarter of 2002 (see Critical Accounting Policies - Property and Equipment and Note 7 to the Notes to Consolidated Financial Statements). The results of management's fourth-quarter 2002 recoverability test indicated that the remaining carrying value of the Company's software under development is likely to be recoverable from future operations (see Critical Accounting Policies - Property and Equipment).
AMOUNTS IN THOUSANDS 2002 2001 December 31, GROSS NET Gross Net - ------------------------------------------------------------------ Unpaid Losses and LAE Personal auto lines $333,113 $320,032 $301,985 $280,781 Homeowner and earthquake 50,896 43,626 47,305 44,997 - ------------------------------------------------------------------ Total $384,009 $363,658 $349,290 $325,778 - ------------------------------------------------------------------
Management believes that, given the inherent variability in the estimates, the Company's reserves are within a reasonable and acceptable range of adequacy. However, because reserve estimates are necessarily subject to the outcome of future events, changes in estimates are unavoidable in the property and casualty insurance business given that loss trends vary and timing is required for changes in trends to be recognized and confirmed. These changes sometimes are referred to as "loss development" or "reserve development." The changes in estimates relating to the auto lines in 2002 were smaller than in 2001 and 2000 as the changes in loss trends were identified and reserved for. The changes in estimates relating to auto lines in 2000 for development in prior accident years primarily resulted from the Company's assumption that the multi-year favorable trend would continue through 1999.
The insurance subsidiaries currently have $21.6 million of statutory unassigned surplus that could be paid as dividends to the parent company without prior written approval from insurance regulatory authorities in 2003. However, given the current uncertainty surrounding the taxability of dividends received by holding companies from their insurance subsidiaries (see further discussion in Item 3 of this report and Note 14 of the Notes to Consolidated Financial Statements), it is unlikely that the Company's insurance subsidiaries will make any dividend payments to the parent in 2003. There is no assurance that the related tax issue will be favorably resolved in the near term, in which case the Company faces the prospect of raising additional capital at the holding company level, cutting or ceasing dividends to stockholders, or having to pay the additional tax on dividends on the insurance company to the holding company.
Insurance Subsidiaries. The Company believes it has taken the proper actions to restore underwriting profitability in its core auto insurance operations and has thereby enhanced its liquidity. In California, the Company implemented a 5.7% auto premium rate increase on May 6, 2002, and has received approval for a 3.9% auto premium rate increase, which it expects to implement in March 2003. Average loss costs in 2002 have increased at an overall rate of approximately 4.0% over 2001, although this rate may have been somewhat higher but for the favorable impact on claim frequency of drought conditions that have largely prevailed in southern California over the past 24 months. There can be no assurance that insurance regulators will grant future rate increases that may be necessary to offset possible future increases in claims cost trends. Also, the Company remains exposed to possible upward development in previously recorded reserves for SB 1899 claims as previously discussed. As a result of such uncertainties, 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. Adverse outcomes to any of the foregoing uncertainties would create some degree of downward pressure on the insurance subsidiaries, which in turn could negatively impact the Company's liquidity.
leaseback of $53.7 million fixed assets discussed above. Partially offsetting this was a statutory net loss of $39.8 million and a $7.0 million decrease in the admitted portion of the statutory deferred tax asset. The statutory net loss for the year ended December 31, 2001 was $53.2 million compared to statutory net income of $11.1 million for 2000. The Company's ratio of net premiums written to surplus was 2.4 for the twelve month period ended December 31, 2002, compared to 2.2 and 1.7 for the years ended December 31, 2001 and 2000, respectively.
The Company currently has no unused letters of credit and 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. At December 31, 2002 and 2001, reinsurance recoverables, net of payables, from AIG subsidiaries were $18.4 million and $38.8 million, respectively.
The following table presents the components of the Company's personal auto lines operating income:
The following table reconciles the Company's personal auto lines operating income to consolidated net (loss) income:
The following table presents the components of the GAAP combined ratio for the personal auto lines:
YEARS ENDED DECEMBER 31, 2002 2001 2000 - ------------------------------------------------------------------ Personal auto lines Loss and loss adjustment expense ratio(1) 82.9% 88.1% 90.8% Underwriting expense ratio 15.6% 14.9% 14.2% - ------------------------------------------------------------------ GAAP combined ratio 98.5% 103.0% 105.0% - ------------------------------------------------------------------
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, 2002, 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.
Personal Auto. Automobile insurance is the primary line of business written by the Company. Vehicles insured outside of California accounted for less than 3% of the Company's direct written premium in 2002, 2001 and 2000. At the end of 2002, the Company was licensed to write automobile insurance in 24 states compared to 21 states at the end of 2001. The Company currently is evaluating opportunities relating to expansion into new states but has not yet adopted definitive plans. Because of the lead times involved, expansion into new states is not expected to materially affect the Company's financial results in 2003.
- --------------- 1 Includes changes in estimates relating to insured events of prior years as follows: 1.8% in 2002, 5.5% in 2001, and 5.2% in 2000 and earlier.
The ratios of net underwriting expenses to net premiums earned were 15.6%, 14.9% and 14.2% for the years ended December 31, 2002, 2001 and 2000, respectively. The increase was primarily due to growth in advertising expenditures and costs associated with approximately doubling the number of new sales agents, who have been handling a record volume of new business throughout 2002. Several productivity enhancement initiatives are underway aimed at reducing per unit process costs and lowering fixed costs in corporate support areas.
The Company cautions that the recorded loss and LAE estimates for this event are subject to a greater than normal degree of uncertainty for a variety of reasons (see Note 16 of the Notes to Consolidated Financial Statements).
Capital expenditures relating to this project totaled $5.1 million, $45.3 million and $20.7 million in 2002, 2001 and 2000, respectively. At December 31, 2002, management has estimated that the $64.4 million carrying value and the $40.0 million estimated cost to
INVESTMENT INCOME The Company utilizes a conservative investment philosophy. No equities, derivatives or nontraditional securities are held in the Company's investment portfolio. Substantially all of the portfolio is investment grade. Net investment income was $46.3 million in 2002, compared to $45.9 million in 2001 and $50.3 million in 2000. Average invested assets increased 1.3% in 2002 from the prior year and decreased 8.0% in 2001 from 2000. The decrease in 2001 was primarily due to the sale of investments to cover incurred loss costs, the acquisitions of property and equipment and the payment of dividends to stockholders. The average annual pre-tax yields on invested assets were 5.1% in 2002, 5.1% in 2001 and 5.2% in 2000. The average annual after-tax yields on invested assets were 4.3% in 2002, 4.5% in 2001 and 4.6% in 2000.
Management has discussed the Company's critical accounting policies and estimates, together with any changes therein, with the Audit Committee of the Company's Board of Directors. The Company's Disclosure Committee and Audit Committee have reviewed the Company's disclosures in this document.
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, 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. 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
Property and Equipment. Accounting standards require long-term assets to be tested for possible impairment under certain conditions. At December 31, 2002, management believes the Company's remaining capitalized costs for Policy and Claims software is the only long-term asset that meets the conditions for impairment testing. Under the applicable accounting standards, the first step is to determine whether the carrying value and cost to complete the asset is recoverable from future operations, based on estimates of future undiscounted cash flows; if not, then an impairment write down would be required to be recognized based on the fair value of the asset. At December 31, 2002, management has estimated that the $64.4 million carrying value and $40.0 million estimated cost to complete such software, or $104.4 million in total, is recoverable from cost savings from future operations. This conclusion is based primarily on the assumptions that the software can be successfully implemented and can reduce the Company's employee count by at least 125 people (about 5% of its workforce) for the 10 to 15 years after implementation (i.e., the current estimate of the probable productive life of the software). Once the project has successfully reached the stage where it is substantially complete and ready for its intended use, the Company anticipates there will be annual depreciation charges varying from approximately $5.8 million to $8.8 million. However, although management believes it is reasonable to assume these future cost savings, it must be noted that any such estimates are subject to considerable uncertainty and there can be no assurance that such cost savings will be achieved.
Deferred Income Taxes. Generally accepted accounting principles require deferred tax assets and liabilities ("DTAs" and "DTLs," respectively) to be recognized for the estimated future tax effects attributed to temporary differences and carryforwards based on provisions of the enacted tax law. The effects of future changes in tax laws or rates are not anticipated. "Temporary differences" are differences between the tax basis of an asset or liability and its reported amount in the financial statements. For example, the Company has a DTA because the tax basis of its loss and LAE reserves is smaller than their book basis, and it has a DTL because the book basis of its capitalized software exceeds its tax basis. "Carryforwards" include such items as alternative minimum tax credits, which may be carried forward indefinitely, and net operating losses
(NOLs), which can be carried forward 15 years for losses incurred before 1998 and 20 years thereafter. A summary of the significant DTAs and DTLs relating to the Company's temporary differences and carryforwards is included in Note 5 of the Notes to Consolidated Financial Statements.
The Company is required to reduce DTAs (but not DTLs) by a valuation allowance if, based on the weight of available evidence, it is "more likely than not" (i.e., a likelihood of more than 50%) that some portion or all of the DTAs will not 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.
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. The Company does not consider anticipated investment income in determining the recoverability of these costs. Based on current indications, no reduction in DPAC is required unless the loss and loss adjustment expense ratio should exceed 82.7%.
Investments. Impairment losses for declines in value of fixed maturity investments below cost attributable to issuer-specific events are based upon all relevant facts and circumstances for each investment and are recognized when appropriate in accordance with Staff Accounting Bulletin ("SAB") 59 - Noncurrent Marketable Equity Securities, Financial Accounting Statement ("FAS") No. 115 - Accounting for Certain Investments in Debt and Equity Securities, and related guidance. For fixed maturity investments with unrealized losses due to market conditions or industry-related events, where the Company has 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, a charge is required to be reflected in income for the difference between cost or amortized cost and the fair value. No such charges were recorded in 2002, 2001 or 2000.
A summary by issuer of noninvestment grade securities and unrated securities held at year-end follows (amounts in thousands):
A summary of bond maturities in an unrealized loss position by year of maturity follows:
AUDIT COMMITTEE FINANCIAL EXPERT The Board of Directors of the Company considers a financial expert to be a person who has, through either education or experience, an understanding of generally accepted accounting principles and financial statements, experience in preparing or auditing financial statements comparable to the Company's, and the application of such principles in connection with accounting for estimates, accruals and reserves. Keith Renken is the financial expert serving on
POLICIES REGARDING CONFLICTS OF INTEREST AND ETHICAL BEHAVIOR The Company has adopted policies regarding conflicts of interest and ethical behavior among its employees, particularly those with responsibilities in the areas of accounting, financial reporting and maintaining the integrity of the Company's internal control structure. These policies include standards that are reasonably necessary to promote:
- - avoidance of conflicts of interest, including disclosure to an appropriate person or persons of any material transaction or relationship that reasonably could be expected to give rise to such a conflict;
- - full, fair, accurate, timely and understandable disclosure in the reports and documents that the Company files and in other public communications made by the Company;
- - the prompt internal reporting of code violations to an appropriate person or personal identified in the code; and
In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) on page 74 present fairly, in all material respects, the financial position of 21st Century Insurance Group and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule for each of the two years in the period ended December 31, 2002 listed in the index appearing under Item 14(a)(2) on page 74 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 audits. We conducted our audits 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 audits provide a reasonable basis for our opinion.
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"), currently owns approximately 63% of the Company's outstanding common stock.
Impairment losses for declines in value of fixed maturity investments below costs attributable to issuer-specific events are based upon all relevant facts and circumstances for each investment and are recognized when appropriate in accordance with SAB 59 - Noncurrent Marketable Equity Securities, FAS No. 115 - Accounting for Certain Investments in Debt and Equity Securities, and related guidance. For fixed-maturity investments with unrealized losses due to market conditions or industry-related events, where the Company has 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.
- --------------- 1 21st of Arizona was incorporated in Arizona in 1995 as a joint venture owned 49% by the Company and 51% by AIG; the Company acquired AIG's interest on January 1, 2002.
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. The Company's equity in the net loss of this venture amounted to $1.0 million and $1.1 million in 2001 and 2000, respectively, and is included in other revenues in the Consolidated Statements of Operations (see Note 19 of the Notes to Consolidated Financial Statements).
LEASED PROPERTY UNDER CAPITAL LEASE Leased property under capital lease is recorded as a capital asset and amortized on a straight-line basis over the estimated useful life of the property. The property and the related lease obligation are disclosed on the balance sheet.
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 of the Notes to Consolidated Financial Statements 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, Accounting for Stock-Based Compensation, 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.
FASB Interpretation No. 46 clarifies the application of Accounting Research Bulletin No. 51 Consolidated Financial Statements regarding variable interest entities. The Company does not have investments in such entities.
The Company has no non-interest bearing investments, non-accrued investment income or any individual securities in excess of 10% of equity. Fixed maturities available-for-sale at December 31, 2002, are summarized by contractual maturity year as follows:
Details follow concerning the changes in the after-tax items included in "Accumulated other comprehensive income (loss)" in the Consolidated Statements of Stockholders' Equity for 2002, 2001 and 2000.
There were no income tax payments required for the years ended December 31, 2002, 2001 and 2000. As of December 31, 2002, the Company had no federal income tax refund receivable.
During 2002, the Company had a tax net operating loss of approximately $37.0 million. As of December 31, 2002, the Company has a tax net operating loss carryforward of approximately $367.3 million for regular tax purposes of which approximately $104.6 million expires in the year 2009 and $262.7 million expires on or after 2011; and an alternative minimum tax credit carryforward of $9.5 million. Alternative minimum tax credits may be carried forward indefinitely to offset future regular tax liabilities.
Total advertising costs included in deferred acquisition costs in 2002, 2001 and 2000 were $43.3 million, $18.7 million and $9.7 million, respectively.
On December 31, 2002, the Company entered into a sale-leaseback transaction for $15.8 million of equipment and leasehold improvements and $44.2 million of software. The transaction is accounted for as a capital lease under FAS 13 - Accounting for Leases, as amended by FAS 28 - Accounting for Sales with Leasebacks. The agreement calls for an interest-only payment on February 14, 2003, of $0.3 million and, commencing at the same date, 59 monthly payments of approximately $1.2 million with a bargain purchase option at the end of the term. At December 31, 2002, the remaining minimum lease payments were $ 68.8 million.
The lease includes a covenant that if statutory surplus falls below $300.0 million, or if the net premiums written to surplus ratio is greater than 3.8:1, or if AIG is no longer a majority stockholder, the Company will either deliver a letter of credit to the lessor or pay the lessor all rent and other sums due and unpaid as of the first rent payment date following the occurrence of one of the above.
The following analysis provides a reconciliation of the activity in the reserve for unpaid losses and loss adjustment expenses:
The provision for losses and LAE recorded in 2002 and 2001 for insured events of prior years primarily resulted from the Company's recognition of earthquake losses under SB 1899, as discussed in Note 16 of the Notes to Consolidated Financial Statements, and from the Company's under-estimate of changes in personal auto loss severity trends that became apparent in 2001. The loss and LAE provision recorded in 2000 for insured events of prior years primarily resulted from the Company's over-estimate in 1999 of the beneficial effect on loss costs of laws passed in prior years that limited the ability of uninsured motorists and drunk drivers to collect non-economic damages.
Accounting for losses and LAE is highly subjective because these costs must be estimated, often weeks, months or even years in advance of when the payments actually are made to claimants, attorneys, claims personnel and others involved in the claims settlement process. At the time of sale of an auto policy, for example, the number of claims that will happen is unknown, and so is the ultimate amount it will take to settle them.
Management believes that, given the inherent variability in the estimates, the Company's reserves are within a reasonable and acceptable range of adequacy. However, because reserve estimates are necessarily subject to the outcome of future events, changes in estimates are unavoidable in the property and casualty insurance business. These changes sometimes are referred to as "loss development" or "reserve development."
The $31.1 million increase in the gross auto reserves for the year ended December 31, 2002, is comprised of $4.9 million due to the consolidation of 21st of Arizona, growth in reserves attributable to the higher number of insured automobiles of approximately $9.0 million, approximately $7.3 million relating to the effects of higher average loss costs and approximately $9.9 million for strengthening of prior accident year reserves.
In the third quarter of 2002, the Company entered into a catastrophe reinsurance agreement on its auto lines with AIG subsidiaries, Folksamerica Reinsurance Company and Transatlantic Reinsurance Company, which reinsures any covered events up to $30.0 million in excess of $15.0 million.
Effective September 1, 2002, the Company entered into an agreement to cancel future cessions under its quota share reinsurance treaty with AIG subsidiaries resulting in a one time pre-tax charge of $0.9 million. The treaty would have ceded 4% of premiums to AIG subsidiaries in the remainder of 2002 and 2% in 2003. The majority of the Company's reinsurance receivables are due from AIG subsidiaries.
2003 $ 17,079 2004 16,287 2005 15,718 2006 14,201 2007 12,731 Thereafter 92,895 -------------------- $168,911 --------------------
Exercise prices for options outstanding at December 31, 2002, ranged from $12.41 to $29.25. The weighted-average remaining contractual life of those options is 7.59 years.
Options exercisable numbered 2,574,577 at the end of 2002, 1,803,917 at the end of 2001 and 1,486,201 at the end of 2000.
A summary of securities issuable and issued for both the 1995 Stock Option Plan and the Restricted Shares Plan at December 31, 2002, 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 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. The following table reconciles consolidated GAAP net (loss) income to statutory net (loss) income.
Other than possibly for 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.
On December 9, 2002, the Company commenced an arbitration proceeding against Computer Sciences Corporation ("CSC") arising out of CSC's obligation to provide insurance company information technology software and other software programs to the Company. CSC has filed a counterclaim in the proceeding. In the third quarter of 2002, the Company wrote off $37.2 million of its investment in CSC software. The arbitration will be conducted in accordance with the rules of the American Arbitration Association.
Thomas Theis, on his own behalf and on behalf of all others similarly situated - ------------------------------------------------------------------------------ v. 21st Century Insurance, was filed on June 17, 2002 in Los Angeles Superior - ------------------------- Court. Plaintiff seeks national class action certification, injunctive relief and unspecified actual and punitive damages. The complaint contends that after insureds receive medical treatment, 21st Century uses a medical-review program to adjust expenses to reasonable and necessary amounts for a given geographic area. The plaintiff alleges that the adjusted amount is "predetermined" and "biased," creating an unfair pretext for reducing claim costs. This case is consolidated with similar actions against other insurers for discovery and pre-trial motions. 21st Century intends to vigorously defend the suit with other defendants in the coordinated proceedings.
In December of 2000, a statute that allowed a tax deduction for the dividends received from wholly owned insurance subsidiaries was held unconstitutional on the grounds that it discriminated against out-of-state insurance holding companies. Subsequent to the court ruling, the staff of the California Franchise Tax Board ("FTB") has decided to take the position that the discriminatory sections of the statute are not severable and the entire statute is invalid. As a result, the FTB is disallowing dividend-received deductions for all insurance holding companies, regardless of domicile, for open tax years ending on or after December 1, 1997. Although the FTB has not made a formal assessment for tax years 1997 through 2000, the Company anticipates a retroactive disallowance that would result in additional tax assessments.
The amount of any such possible assessments and the ultimate amounts, if any, that the Company may be required to pay, are subject to a wide range of estimates because so many ostensibly long-settled aspects of California tax law have been thrown into disarray and uncertainty by the action of the courts. In the absence of legislative relief, years of future litigation may be required to determine the ultimate outcome. The range of possible loss, net of federal tax benefit, ranges from close to zero to approximately $20.8 million depending on which position future courts may decide to uphold or on whether the California legislature may decide to enact corrective legislation. The Company believes it has adequately provided for this contingency.
In December 2001, the Company settled, subject to court approval, for a maximum of $4.2 million, all matters related to various overtime pay lawsuits that were filed in the third quarter of 2001. The $4.2 million settlement was charged to operations in the fourth quarter of 2001.
California Senate Bill 1899 ("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's constitutional challenge to SB 1899 came to an unsuccessful result on April 29, 2002, when the United States Supreme Court refused to hear the Company's case. In the fourth quarter of 2001, the Company recorded a $50.0 million pre-tax charge for loss and inspection costs but, at that time, it was impracticable to reasonably estimate the legal defense costs associated with previously closed earthquake claims. Based on information available to the Company, the Company recorded an additional $46.9 million pre-tax charge for such legal defense costs in the third quarter of 2002. Earthquake reserves at December 31, 2002, were $39.9 million.
Second, Company adjusters have frequently been prevented from taking recorded statements or examinations under oath of claimants. In many instances, subsequent statements allow adjusters to materially reduce their estimates. It is possible that the litigation discovery process might provide similar results for SB 1899 claims. Similarly, the Company's actions against alleged fraudulent claimants, adjusters, or attorneys, such as the action against Unlimited Adjusting, could favorably impact reserves if claims are proven fraudulent.
Third, more than two-thirds of the Company's remaining earthquake claims are in litigation. Many suits seek extracontractual and punitive damages as well as contractual damages far in excess of the Company's estimates; the Company views such outcomes as being remote. Therefore, a reserve for potential extracontractual or punitive damages has not been established. Extracontractual and punitive damages, if assessed against the Company, could be material in an individual case or in the aggregate. In addition, the Company may choose to settle litigated cases for amounts in excess of its own estimate of contractual damages to avoid the expense and/or risk of litigation.
Finally, actual expenses for legal defense costs are susceptible to a wide range of outcomes depending on a variety of factors including plaintiff strategies, future judicial decisions, the percentage of cases which settle, and the period of time cases remain outstanding before settlement. The possibility of reaching mass settlements of cases with particular attorneys or law firms presents the opportunity to substantially reduce estimates for legal defense costs. On the other hand, the inability to settle a substantial majority of cases for reasonable amounts would materially increase amounts needed for legal defense costs.
The purchase agreement included a one-year contingency for subsequent loss and LAE reserve development for 2001 and prior accident years. Under its terms, at December 31, 2002, 33% of any additional loss and LAE development would be reimbursed to the Company by AIG, while a reduction in the loss and LAE development would be paid to AIG. Based on the 2002 year-end results, the amount receivable from AIG is $.05 million.
Investments and cash $14,193 Deferred income taxes 3,887 Other assets 1,455 ------------------------------------------------- Total assets 19,535 ------------------------------------------------- Unpaid loss and loss adjustment expenses 6,749 Unearned premiums 2,815 Other liabilities 1,244 ------------------------------------------------- Total liabilities 10,808 ------------------------------------------------- Total equity $ 8,727 -------------------------------------------------
Consolidated Results As Reported Pro Forma ------------------------------------------ Revenue $ 914,078 $ 929,576 Net loss (27,568) (28,607) Loss per share (0.32) (0.34)