The following discussion and analysis of the results of operations for the three fiscal years ended December 31, 2003 has been derived from and should be read in conjunction with the consolidated financial statements included elsewhere in this document.
We provide non-standard private passenger automobile insurance and related services. Non-standard automobile insurance provides coverage to drivers who find it difficult to purchase standard automobile insurance as a result of a number of factors, including their driving record, vehicle, age or claims history, or because they have limited financial resources. Typically, these drivers purchase minimal levels of insurance coverage in order to comply with state-mandated financial responsibility laws. Non-standard automobile insurance policies generally require higher premiums than standard or preferred automobile insurance policies for comparable coverage.
•net premiums earned, which comprises the premiums we earn from sales of non-standard automobile insurance policies minus those premiums that we cede to our reinsurers;
•losses and loss adjustment expenses, including estimates for losses and loss adjustment expenses incurred during the period and changes in estimates from prior periods, less the portion of those insurance losses and loss adjustment expenses that we ceded to our reinsurers;
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America, or GAAP, requires us to make estimates and assumptions that affect amounts reported in our financial statements. As additional information becomes available, these estimates and assumptions are subject to change and thus impact amounts reported in the future. We have identified below three accounting policies that we consider to be critical due to the amount of judgment and uncertainty inherent in the application of these policies.
In establishing our best estimate of unpaid losses and loss adjustment expenses, we determine the number of claims that have been reported as of the financial reporting date and make an estimate of claims that have been incurred but not yet reported to us as of that date. Because our evaluations are based upon historical patterns, if the rate of claims reported to us or paid by us differs from our historical patterns, our evaluations may underestimate the number of claims that will ultimately be paid, and, therefore, the amount of unpaid losses and loss adjustment expenses recorded for the period.
Had we recognized the full 2002 impact of these and other adverse factors at December 31, 2001, we would have recorded $28.2 million of additional loss and loss adjustment expense reserves before taxes. This additional loss and loss adjustment expense would have resulted in 2001 net income decreasing by $17.5 million (assuming a 38% effective federal and state tax rate) and a loss for 2001 of approximately $10.5 million. Since we actually recorded these losses in 2002, our 2002 net income would have increased by $17.5 million to $29.0 million as a result of this change.
If our estimate of gross unpaid losses and loss adjustment expenses of $202.3 million at December 31, 2003 decreases or increases in 2004 by one percent, our net income or loss for 2004 would decrease or increase by $1.2 million after tax (assuming a state and federal effective tax rate of 38%). We determine the impact of such changes on our net income using gross rather than net unpaid losses and loss adjustment expenses since a change in ceded loss and loss adjustment expense reserves would be offset by an increase or decrease in ceded commission due from our reinsurers.
•reviewing loss and loss adjustment expense reserves gross of salvage and subrogation and separately developing estimates of these items to estimate reserves net of salvage and subrogation;
Accounting and Reporting for Reinsurance. Pursuant to SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," we are required to review the contractual terms of all our reinsurance purchases to ensure compliance with that statement. The statement establishes the conditions required for a contract with a reinsurer to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. The accounting standards depend on whether the contract is long duration or short duration and, if short duration, on whether the contract is prospective or retroactive. For all reinsurance transactions, immediate recognition of gains is precluded unless our liability to our policyholders is extinguished. Contracts that
do not result in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed generally do not meet the conditions for reinsurance accounting and must be accounted for as deposits.
Policy Service Fee Revenues. Policy service fee revenues were $69.2 million for the year ended December 31, 2003, an increase of $21.8 million or 46% compared to 2002. The growth was attributable to the growth in policies in force, since fees are charged on a per policy basis, as well as an increase in the fees we collect on each policy.
Commissions and Other Underwriting Expenses. Commissions and other underwriting expenses increased to $51.8 million for the twelve months ended December 31, 2003, compared to $42.1 million for twelve months ended December 31, 2002, an increase of $9.7 million or 23%. The increase in gross premiums drove an increase in amounts paid to agents and brokers and premium taxes. In addition, ceding commissions earned for the year ended December 31, 2003 decreased to 28.7% as a percentage of ceded earned premiums from 31.1% for 2002, which also contributed to the growth in commissions and other underwriting expenses.
an increase in the average premium charged per policy. The remaining portion of the increase was attributable to recording a full twelve months of Reliant written premiums in 2002 compared to only nine months in 2001. We believe that there were improved automobile insurance market fundamentals in 2002 compared to 2001, which we attribute to competitors retrenching or exiting the 15 states in which we operated, while other competitors, seeking to improve their financial results, increased premium rates. At the same time, due to poor financial results suffered by certain insurance carriers in the non-standard automobile insurance industry, as well as in other lines of insurance, there was diminished reinsurance capacity for non-standard automobile risks. This reduction of reinsurance capacity forced additional pricing discipline. In addition to these marketplace changes, we increased our marketing efforts by hiring two additional product managers and two additional territory marketing managers.
Net Premiums Earned. Net premiums earned for the year ended December 31, 2002 were $241.0 million, compared to $158.6 million for the year ended December 31, 2001, an increase of 52.0%. The increase in net premiums earned was primarily attributable to the growth in gross premiums written noted above.
Ratios. Our combined ratio for the year ended December 31, 2002 was 90.0%, compared to 92.7% for the year ended December 31, 2001. As explained above, our loss ratio for the year ended December 31, 2002 increased to 68.9% from 60.0% for the year ended December 31, 2001. For the year ended December 31, 2002, our expense ratio decreased to 21.1%, compared to 32.7% for the year ended December 31, 2001, primarily due to an increase in ceding commission income and the non-recurrence of expenses incurred in 2001 related to managing the run-off of the Reliant business.
Interest Expense. Interest expense for the year ended December 31, 2002 was $4.6 million, compared to $9.0 million for the year ended December 31, 2001. The decrease was the result of a decrease in average outstanding borrowings from $98.1 million to $81.1 million for the year ended December 31, 2002 compared to year ended December 31, 2001, in addition to a decrease in the applicable interest rate.
Income Taxes. Income taxes for the year ended December 31, 2002 were $5.3 million, an effective tax rate of 31.5% when measured as a percentage of income before income taxes, as compared to $3.8 million, or an effective tax rate of 35.2% for the same period in 2001. Our effective tax rate decreased in 2002 primarily as a result of a lower state tax paid due to the $14.3 million charge related to the aforementioned class action lawsuit.
In February 2004, an initial public offering of 17,250,000 shares of the Company's common stock was completed. The Company sold 6,250,000 shares providing net proceeds to the Company, after deducting issuance costs, of approximately $113.2 million. The Company contributed $110.0 million of the proceeds to its insurance subsidiaries, which increased their statutory surplus. The additional capital will permit the Company to reduce its reinsurance purchases and to retain more gross premiums
In February 2004, the Company completed a refinancing of its secured credit facility. The new bank agreement ("Bank Agreement") consists of: (1) a $50 million Secured Revolving Credit Facility, which includes up to $15 million of letters of credit, (2) a $35 million Term A Loan and (3) a $40 million Term B Loan. The Company's interest rate on borrowings under the Bank Agreement is London Interbank Offered Rate (LIBOR) plus a margin (1.0% to 2.25%), which is determined based on the Company's consolidated total debt to consolidated total capitalization ratio. The Company also pays certain commitment fees. The Bank Agreement is secured by a pledge of stock of certain of its subsidiaries.
Our insurance subsidiaries' primary sources of funds are premiums received, investment income and proceeds from the sale and redemption of investment securities. Our non-insurance subsidiaries' primary source of funds are policy service fee revenues. Our subsidiaries use funds to pay claims and operating expenses, make payments under the tax allocation agreement, purchase investments and pay dividends to us.
Net cash provided by (used in) operating activities was $17.9 million, $42.9 million, $(1.3) million for the years ended December 31, 2003, 2002, and 2001, respectively. The general increase in cash flow generated from operations from 2001 to 2003 was due to improvement in the underlying business. The cash flow generated from operations was lower in 2003 compared to 2002 as a result of the increase in the quota share ceded percentage to 60% for 2003 from 50% for 2002, and the concomitant increase in the net cash paid to our reinsurers. The net amount paid to reinsurers increased to $89.3 million in 2003 from $29.0 million in 2002, which caused our 2003 cash flow from operations to decline compared to the prior year. In addition we paid $19.8 million in litigation costs in 2003 compared to $0.7 million in 2002.
Net cash provided by (used in) investment activities amounted to $(21.3) million, $(30.7) million, and $11.4 million for the years ended December 31, 2003, 2002, and 2001, respectively, and was used principally to purchase fixed income securities. Property, plant and equipment additions were $6.7 million, $5.6 million, and $3.9 million, for the years ended December 31, 2003, 2002, and 2001. The decrease in cash (used in) investment activities in 2003 compared to 2002 was due to the reduction in cash flow from operations as noted above.
For the year ended December 31, 2003, we paid $12.8 million in federal and state income taxes. We paid no federal income taxes during the years ended December 31, 2002 and 2001 as a result of a $32.1 million loss reported on our federal consolidated income tax return for the year ended December 31, 2000. The loss reported in 2000, as allowed under the Internal Revenue Code, was carried forward, applied against and completely offset our consolidated taxable income reported for the years 2001 and 2002.
Pro-forma for the refinancing of the credit facilities which was completed in February, 2004, the schedule of contractual obligations appears as follows: