(1) In 2002, DHC purchased 100% of ACL, 5.4% of GMS and 50% of Vessel Leasing.
(2) ACL, which was acquired on May 29, 2002, and certain of its subsidiaries, filed a petition on January 31, 2003 with the U.S. Bankruptcy Court for the Southern District of Indiana, New Albany Division to reorganize under Chapter 11 of the U.S. Bankruptcy Code. As a result of this filing, while DHC continues to exercise significant influence over the operating and financial policies of ACL, it no longer maintains control of the activities of ACL. Accordingly, DHC no longer includes ACL and its subsidiaries as consolidated subsidiaries in DHC's financial statements. DHC's investments in these entities are presented using the equity method effective as of the beginning of the year ending December 31, 2003. Other (loss) income above consists of DHC's equity in the net loss of ACL, GMS and Vessel Leasing in 2003.
(3) Does not give effect to currently exercisable options, and, in 2001, 2000 and 1999, warrants to purchase shares of Common Stock.
DHC is organized as a holding company with substantially all of its current operations conducted in the insurance services industry. DHC also has investments in companies engaged in the Marine Services industry which, beginning in 2003, are accounted for under the equity method.
In addition to the risks attendant to the operation of the Covanta energy and water businesses in the future and the integration of Covanta and its employees into DHC, the ability of DHC to utilize its NOLs to offset income generated by the Covanta operations will have a material affect on DHC's financial condition and results of operations.
DHC, on a parent-only basis, has continuing expenditures for administrative expenses and derives revenues primarily from investment returns on portfolio securities. Therefore, the analysis of DHC's financial condition is generally done on an operating subsidiary basis. As of December 31, 2003, DHC had approximately $652 million in federal tax NOLs. DHC's strategic and business plan is to acquire businesses that will allow DHC to earn an attractive return on its investments.
In May 2002, DHC acquired a 100% ownership interest in ACL thereby entering into the marine transportation, construction and related service provider businesses. On January 31, 2003, ACL and certain of its subsidiaries and its immediate direct parent entity, ACL Holdings, filed a petition with the U.S. Bankruptcy Court to reorganize under Chapter 11 of the U.S. Bankruptcy Code.
As a result of ACL's continued losses and DHC management's belief that it may recover little, if any, of its investment in ACL, DHC wrote off its remaining investment in ACL at the end of the first quarter of 2003 as an other than temporary asset impairment (see Note 20 of the Notes to Consolidated Financial Statements).
The only active insurance products currently being sold by DHC's insurance subsidiaries are in the California non-standard personal automobile insurance line. Other than run-off of other lines and insurance that NAICC is statutorily required to offer, NAICC is not actively operating any other lines of insurance business due to unfavorable loss development and capital requirements. NAICC's objective with respect to its remaining business is to underwrite business that is expected to yield an underwriting profit. As of July 7, 2003, NAICC ceased writing new policy applications for commercial automobile insurance and began the process of providing the required statutory notice of its intention not to renew existing policies. NAICC expects that by September 2004 it will have completely exited the commercial automobile marketplace.
DHC does not currently pay regular federal income tax due to its NOLs and the recognition of losses from several trusts that assumed various liabilities of certain present and former subsidiaries of DHC. It is expected that DHC's 2003 consolidated federal income tax return will report a cumulative NOL currently estimated at $652 million, which will expire in various amounts, if not used, between 2004 and 2023. Exclusive of the trusts' activities, DHC has generated cumulative taxable losses both historically and during the prior three years. Over the past several years, DHC's insurance operations have been generating losses exclusive of net investment income, net realized gains and the trusts' activities.
YEAR ENDED DECEMBER 31, 2003 COMPARED WITH YEAR ENDED DECEMBER 27, 2002
Insurance Services Year Ended December 31, 2003 Compared with Year Ended December 31, 2002
The overall decrease in net written premiums for 2003 over the comparable period in 2002 was attributable to a significant reduction in NAICC's commercial automobile line and the decision made in 2001 to exit both the workers' compensation line of business in all states and private passenger automobile outside of California. Workers' compensation net written premiums decreased by $7.3 million during 2003 over the
comparable period in 2002. The commercial automobile net written premiums decreased from $19.5 million in 2002 to $11.9 million in 2003 due to the decision to exit the line in July 2003. Net written premiums for personal automobile lines decreased by $7.4 million during 2003 primarily due to underwriting restrictions placed on the non-standard California private passenger automobile program and the decline in net written premiums outside of California.
In 2003, NAICC recognized $1.0 million in gains from fixed income securities that were maturing in 2004 as a consequence of a dynamic interest rate environment throughout the year. In 2002, a realized investment gain of $5.2 million was recognized upon conversion of the ACL notes into equity. This gain, was offset by a $5.1 million loss on non-affiliated equity securities and a $0.9 million gain on fixed maturities. Of the $5.1 million loss on equity securities, $1.0 million was recorded for other than temporary declines in fair value. NAICC had a net unrealized loss of $1.4 million on its equity portfolio at the end of December 2002 and a modest net unrealized gain at December 31, 2003.
had the most significant impact. Historically non-owner policies yield loss and ALAE ratios 10 to 30 basis points lower than owner policies.
Investment Income. Total parent company investment income decreased to $1.4 million for the year ended December 31, 2003 as compared to $9.5 million for the year ending December 27, 2002 primarily due to recognition of $8.4 million in gain on ACL bonds owned by DHC that were contributed as part of the purchase price of ACL Holdings recognized during 2002.
Administrative Expense. Parent company administrative expense decreased $0.7 million to $4.2 million for the year ended December 2003 as compared to $4.9 million for the year ended December 2002. The decrease is primarily due to a reduction of facility and payroll related costs. In 2003, DHC entered into a corporate services agreement with Equity Group Investments, L.L.C. ("EGI"). Samuel Zell, the Chairman of the Board, Chief Executive Officer and President of DHC, is also the Chairman of EGI and Philip Tinkler, Chief Financial Officer of DHC, is also an executive officer of EGI. EGI provided financial and administrative services to DHC. Subsequent to the ACL acquisition in 2002, ACL provided similar support services to DHC.
Interest Expense -- Year Ended December 31, 2003 Compared with Year Ended December 27, 2002
Interest expense decreased to $1.4 million for the year ended December 31, 2003 compared to $38.7 million during the year ended December 27, 2002. Interest expense in 2003 was due to the accrual of one month of interest on the bridge financing required for the Covanta acquisition. Interest expense in 2002 was primarily due to ACL's and GMS' interest expense after the acquisition.
Equity in Net Loss of Unconsolidated Marine Services Subsidiaries -- Year Ended December 31, 2003 Compared with Year Ended December 27, 2002
As a result of ACL's bankruptcy filing, while DHC continues to exercise influence over the operating and financial policies of ACL, it no longer maintains control of ACL. Accordingly, for the year ended December 31, 2003, DHC has accounted for its investments in ACL, GMS and Vessel Leasing using the equity method of accounting. Under the equity method of accounting, DHC reports its share of the equity investees' income or loss based on its ownership interest.
results from the date of acquisition, May 29, 2002, through December 27, 2002, but were deconsolidated in 2003 as a result of ACL's bankruptcy.)
The overall decrease in net written premiums for 2002 over the comparable period in 2001 is attributable to significant reduction in NAICC's commercial automobile line and the decision made in 2001 to exit both the workers' compensation line of business in all states and private passenger automobile outside of California. Workers' compensation net written premiums decreased by $14.1 million during 2002 over the comparable period in 2001. The commercial automobile net written premiums decreased from $38.4 million in 2001 to $19.5 million in 2002 due to curtailed underwriting activity. Net written premiums for personal automobile lines increased by $5.3 million during 2002 primarily due to premium growth in the non-standard California private passenger automobile programs in excess of the decline in net written premiums outside of California, coupled with non-renewing its 10% quota-share reinsurance agreement on the California business.
The net loss and LAE ratios were 96.3% in 2002 and 93.5% in 2001. The increase in the loss and LAE ratio during 2002 was attributable to higher than expected losses in the California private passenger automobile and commercial automobile programs totaling $2.8 million and $2.0 million, respectively. In addition, NAICC had significant adverse development in the California workers' compensation line and non-California private passenger automobile. Adverse development on prior accident years recognized for workers' compensation in 2002 was $3.6 million. The adverse development for prior accident years related to the private
passenger automobile lines placed in run-off was $2.0 million. Adverse development on prior accident years recognized for workers' compensation in 2001 totaled $4.4 million. The adverse development for prior accident years related to the private passenger automobile lines placed in run-off was $2.4 million.
As a percentage of net earned premiums, policy acquisition expenses were 22.7% in 2002 and 25.4% in 2001. The decrease in the policy acquisition expense ratio in 2002, compared to 2001, was due to a reduction of marketing costs of $1.9 million primarily as the result of the decision in 2001 to exit those lines mentioned above.
General and administrative expenses decreased in 2002 due to previously implemented cost containment efforts. General and administrative expenses in 2001 also included $0.9 million in amortization of goodwill expense. As a percentage of net earned premiums, general and administrative expenses were 9.5% in 2002 and 10.6% in 2001. The decrease in 2002 reflects decreased production in 2002 and the effect of cost saving measures implemented during 2001. The 2001 ratio included an additional $1.2 million of costs associated with the decision to contract NAICC's underwriting operations. Those costs included employee severance payments of approximately $0.5 million and a write-off of goodwill of approximately $0.7 million. These costs added 1.5% to the 2001 ratio.
Marine Services operating revenues and operating expenses in 2002 consisted of ACL, GMS and Vessel Leasing operating revenues and expenses since the date of acquisition (May 29, 2002).
Parent Company Only Investment Income and Administrative Expense -- Year Ended December 27, 2002 Compared with Year Ended December 31, 2001
Interest expense increased to $38.7 million for the year ended December 27, 2002 compared to no interest expense for the year ended December 31, 2001 primarily due to ACL's and GMS' interest expense after the acquisition.
NAICC management expects that the business environment in California non-standard personal auto to remain favorable. It appears there are fewer markets to place non-standard risks, which aided NAICC in 2002 to raise rates and renew 92.1% of its policyholders in 2003. NAICC expects a similar renewal rate for 2004. NAICC expects the hard market to continue in 2004 as new entrants are priced reasonably and ongoing
programs are tightening underwriting guidelines while a few are filing rate increases. The decision to exit the commercial auto market will negatively impact NAICC as it loses operating leverage on its general and administrative expenses and will have less earned premium during a relative hard market cycle. With the passage of AB 227 and SB 227, which was intended to serve to contain medical costs for the struggling California workers' compensation market, NAICC is anticipating these measures and future legislation will mitigate the adverse development trend previously recognized. NAICC will continue to aggressively pursue commutations on the Stuyvesant business but as there has been an influx of newly reported A&E claims over the last three years, NAICC's ability to discharge these risks will be more difficult. NAICC is evaluating other strategies to further segregate these liabilities from the active entities that could promote commutations. NAICC has come to rely upon its investment income to mitigate the shortfall on underwriting results, but as it continues to experience negative cash flow due to its operations that are in run-off and 40 year lows in interest rates, NAICC does not expect to receive the same level of investment income, as in 2002 and prior.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the same period. Actual results could differ from those estimates.
NAICC estimates reserves for unpaid losses and LAE based on reported losses and historical experience, including losses reported by other insurance companies for reinsurance assumed, and estimates of expenses for investigating and adjusting all incurred and unadjusted claims. Key assumptions used in the estimation process could have significant effects on the reserve balances. NAICC regularly evaluates their estimates and assumptions based on historical experience adjusted for current economic conditions and trends. Changes in the unpaid losses and LAE can materially effect the statement of operations. Different estimates could have been used in the current period, and changes in the accounting estimates are reasonably likely to occur from period to period based on the economic conditions. Since the loss reserving process is complex and subjective, the ultimate liability may vary significantly from our estimates.
The Insurance Services group has claims for environmental clean up against policies issued prior to 1970. The unpaid loss and LAE related to environmental cleanup has been established considering facts currently known and the current state of the law and coverage litigation.
At December 31, 2003, DHC on a parent-only basis, held cash and investments of approximately $41.0 million, including a restricted escrow account of $37.0 million. The escrow was required for the Covanta acquisition. Upon closing of the Covanta acquisition on March 8, 2004, this escrow was released and disbursed, $30.0 million in consideration of the purchase of Covanta and the remaining $7.0 million was released to DHC to pay corporate expenses and acquisition costs. Unpaid acquisition costs are currently estimated at approximately $6.6 million. Additionally, a balance of $1.0 million is due to DHC from Covanta to reimburse DHC's acquisition related expenses.
There can be no assurances as to the extent of the public participation in the planned rights offering. Management believes that even with less than full public participation, DHC will have sufficient capital resources to meet short-term and long-term liquidity needs.
Net cash used in investing activities was $6.9 million for the year ended December 31, 2001 and was comprised principally of activity in investment securities.
DHC's insurance subsidiaries require both readily liquid assets and adequate capital to meet ongoing obligations to policyholders and claimants, as well as to pay ordinary operating expenses. NAICC meets both its short-term and long-term liquidity requirements through operating cash flows that include premium
Cash used in insurance operations was $23.2 million, $23.8 million and $3.9 million in 2003, 2002 and 2001, respectively. The trend is consistent with the run-off of several lines of business and their respective run-off patterns, primarily workers' compensation and commercial auto. Such negative cash flow requires the sale of invested assets to meet obligations as they arise. Due to premium growth during the first nine months of 2001, NAICC was able to meet its short-term cash needs primarily through premium receipts.
The National Association of Insurance Commissioners provides minimum solvency standards in the form of RBC requirements. The RBC model for property and casualty insurance companies requires that companies are to report their RBC ratios based on their statutory annual statements as filed with the regulatory authorities. NAICC has calculated its RBC requirement under the RBC model and believes that it has sufficient capital for its operations. Further, the NAIC has developed the Insurance Regulatory Information System ("IRIS"). IRIS identifies twelve ratios for property/casualty insurance companies. IRIS specifies ranges of "usual values" for each ratio. Departure from the "usual value" range on four or more ratios may lead to increased regulatory oversight from individual state insurance commissioners. As a result of the losses recognized in 2003 and 2002, NAICC expects that it will fail seven of those regulatory ratios relating to loss development and surplus change. Two of the failures relate strictly to loss development and two relate to surplus changes and operating ratios caused by loss development incurred during 2003. The remaining three ratio failures relate to reduction in writings, overall investment yield and liabilities to liquid assets. The failure of such ratios subjects NAICC to increased regulatory inquiry. Based on the differential between reported surplus and the surplus level requiring further regulatory action, NAICC believes that the failure of those ratios will not have a material adverse impact on the operations of NAICC.
As noted above, ACL filed for protection under Chapter 11 of the Bankruptcy Code. As a result, it was determined for statutory insurance accounting purposes that NAICC's investment in ACL was fully impaired. At December 31, 2002, NAICC recognized a statutory charge to its surplus of $7.4 million. This charge, when combined with NAICC's underwriting results and investment losses reduced its statutory surplus level below the Company Action Level of NAICC's RBC calculation. In response to the above statutory condition, DHC repaid the $4.0 million note due May 2004 to NAICC, and further contributed $4.0 million to NAICC to increase its statutory capital during February 2003. With permission from the California Department of Insurance, these transactions were recorded at December 31, 2002. As a condition to granting permission, the Department required NAICC to obtain permission prior to entering into a loan with an affiliate. After consideration for the $8.0 million noted above, NAICC's reported capital and surplus as of December 31, 2002 was above the Company Action Level of NAICC's RBC calculation. As noted above, DHC also contributed $2.0 million to NAICC to increase its statutory capital in December 2003.
DHC's domestic insurance companies are regulated by the insurance regulatory agencies of the states in which they are authorized to do business. Many aspects of DHC's insurance business are subject to regulation. For example, minimum capitalization must be maintained; certain forms of policies must be approved before they may be offered; reserves must be established in relation to the amounts of earned premiums and losses incurred; and, in some cases, schedules of premium rates must be approved.
In compliance with state insurance laws and regulations, securities with a fair value of approximately $43.4 million, $45.0 million and $45.0 million, respectively, on each at December 31, 2003, 2002 and 2001, respectively, were on deposit with various states or governmental regulatory authorities. In addition, at December 31, 2003, 2002 and 2001, investments with a fair value of $7.2 million, $6.4 million and $6.6 million, respectively, were held in trust or as collateral under the terms of certain reinsurance treaties and letters of credit.
The following table sets forth a summary of NAICC's investment portfolio at December 31, 2003 (dollars in thousands):
Samuel Zell, the Chairman of the Board, Chief Executive Officer and President of DHC, is the Chairman of Equity Group Investments, L.L.C. ("EGI"). Commencing April 15, 2003, EGI provides administrative services for DHC. These services include financial, tax, accounting, SEC filings and related administrative costs. DHC paid EGI $0.2 million for these services in 2003. ACL was paid a fee of $0.1 million in 2003 for providing these services prior to April 15, 2003.
As described in Note 2 of the Notes to the Consolidated Financial Statements, SZ Investments, Third Avenue and Laminar provided the bridge financing required for the Covanta acquisition. See Note 2 for terms and conditions relating to this debt. Interest expense on this financing amounted to $0.4 million in 2003.
DHC used $30.0 million of the proceeds from the notes to post an escrow deposit prior to the closing of the transactions contemplated by the investment and purchase agreement. DHC amended the investment and purchase agreement as of February 23, 2004 to reduce the purchase price by $175,000 and remove $175,000 from the purchase price escrow account so that DHC could acquire an equity interest in Covanta Lake, Inc., a wholly-owned indirect subsidiary of Covanta in a transaction separate and distinct from the acquisition of Covanta out of bankruptcy. The purchase of the equity interests of Covanta was completed on March 10, 2004, at which time the escrowed purchase price funds were delivered to Covanta and used as DHC's purchase price for Covanta's equity interests. DHC has used and will use the proceeds from the sales of the bridge notes to pay transaction expenses and for general corporate purposes. In this regard, DHC has agreed to pay up to $0.9 million to the Bridge Lenders as reimbursement for expenses incurred by them in connection with the note purchase agreement.
In addition, under the note purchase agreement, Laminar has agreed to convert an amount of convertible notes to acquire up to an additional 8.75 million shares of Common Stock at $1.53 per share based upon the levels of public participation in this rights offering. Further, as discussed below, DHC has agreed, in connection with the note purchase agreement, to sell up to an additional 3 million shares of Common Stock at $1.53 per share to certain creditors of Covanta based upon the levels of public participation in this rights offering and subject to change of ownership and other limitations.
- that DHC shall comply with all applicable laws, regulations, orders and other requirements, and timely pay all taxes, pending the repayment or conversion of the outstanding convertible notes;
- that DHC shall preserve its corporate existence and all rights and franchises material to its business, pending the repayment or conversion of the outstanding convertible notes; and
- that DHC shall pay each of the Bridge Lenders a cash extension fee in the event that any of the notes are subject to ownership change rollover terms.
- pay any dividends on or repurchase any of DHC's outstanding securities, other than pursuant to employee benefit plans in the ordinary course of DHC's business, including the payment of dividends using Common Stock, other than pursuant to the planned rights offering;
- purchase or sell any material amount of assets, enter into a merger transaction, liquidate or dissolve;
- the appointment of a receiver, trustee or similar judicial officer or agent to take charge of or liquidate any of its property or assets.
- any of DHC's representations or warranties or certain of DHC's covenants contained in the note purchase agreement were untrue or incorrect in any material respect as of the date of the note purchase agreement or other specified date therein; or
- a change of control occurs, unless caused solely by the Bridge Lenders.
Pursuant to a letter agreement dated December 2, 2003, Laminar has agreed to transfer restrictions on the shares of Common Stock that Laminar holds or will acquire. In accordance with the transfer restrictions contained in Article Fifth of DHC's charter restricting the resale of Common Stock by 5% stockholders, DHC has agreed with Laminar that their ability to sell Common Stock will be limited for a period of three years to the following amounts:
- up to an additional 5% of DHC's outstanding shares, or an aggregate of 20% of DHC's outstanding shares, during the period beginning two years following March 10, 2004 and ending three years following March 10, 2004; and
- no restrictions thereafter other than restrictions included in DHC's certificate of incorporation.
Pursuant to a registration rights agreement dated as of December 2, 2003, DHC has agreed with the Bridge Lenders to file, at DHC's expense, a registration statement with the SEC to register the shares of Common Stock issued to them under the note purchase agreement not later than the earlier of (i) June 30, 2004, and (ii) ten days after closing of this rights offering. The Bridge Lenders were also granted certain "piggy-back" registration rights with respect to such shares of Common Stock.
Covanta has also entered into a domestic intercreditor agreement, with the lenders under the domestic credit facilities and the trustee under the indenture for the high yield notes discussed below, that sets forth, among other things, provisions regarding the application of payments made by Covanta among the lenders and certain matters relating to priorities upon the exercise of remedies with respect to the collateral pledged under the loan documents.
Both domestic credit facilities provide for mandatory prepayments of all or a portion of amounts funded by the lenders under letters of credit and the revolving loan upon the occurrence of specified events. These events include certain sales of assets, incurrence of additional indebtedness, availability of annual cash flow, or cash on hand above certain base amounts, and change of control transactions.
- that Covanta shall obtain ratings of the high yield bonds discussed below from Standard & Poor's Rating Group and/or Moody's Investors Service, Inc.
- incur indebtedness, or incur liens on its property, subject to specific exceptions;
- deviate from specified financial ratios and covenants, including those pertaining to consolidated net worth, adjusted EBITDA, cash flow and capital expenditures;
- sell any material amount of assets, enter into a merger transaction, liquidate or dissolve;
- a failure by Covanta to pay amounts due under the domestic credit facilities or other debt instruments;
- breaches of representations, warranties and covenants under the domestic credit facilities;
- any event that has caused a material adverse effect on Covanta;
The Covanta Power International revolving credit facility has a maturity date of three years following execution and bears interest at the rate of either (i) 7% over the Base Rate or (ii) 8% over a formula Eurodollar rate, the applicable rate to be determined by Covanta Power International (increasing by 2% over the then applicable rate in specified default situations). Covanta Power International also paid a 2% upfront fee ($200,000) upon entering into the international revolving credit facility, and will pay (i) a commitment fee equal to 0.5% per annum of the daily calculation of available credit, and (ii) an annual agency fee of $30,000.
The Covanta Power International term loan is in the original aggregate principal amount of $90 million, subject to adjustment, with a maturity date of three years following execution, and bears interest at 10.5%, 6.0% of such interest to be paid in cash and the remaining 4.5% to be paid in cash to the extent available and otherwise payable by adding it to the outstanding principal balance. The interest rate increases to 12.5% in specified default situations.
Covanta Power International has also entered into the international intercreditor agreement with the lenders under the Covanta Power International revolving credit facility and the Covanta Power International term loan and with Covanta, that sets forth, among other things, provisions regarding the application of payments made by Covanta Power International among the respective lenders and Covanta and matters relating to the exercise of remedies with respect to the collateral pledged under the loan documents, and pursuant to which Covanta will be entitled to reimbursements of operating expenses made on behalf of the Covanta Power International and payments made with respect to various parent guarantees being retained on behalf of Covanta Power International.
Covanta has issued new high yield secured notes at a discount in an aggregate principal amount of $205 million accreting 1.7% annually to an aggregate principal amount of $230 million upon maturity seven years after Covanta's emergence from bankruptcy. Interest will be paid semi-annually in arrears on the principal amount of the outstanding high yield secured notes at a rate of 8.25% per annum. The high yield secured notes will be secured by a third priority lien on Covanta's domestic assets. In addition, all or part of the high yield notes are pre-payable by Covanta at par of 100% of the accreted value during the first two years and at a premium starting at 104.625% of par and decreasing during the remainder of the term of the high yield notes. There are no mandatory sinking fund provisions. Upon the occurrence of a change of control event
and certain sales of assets, Covanta is obligated to offer to repurchase all or any part of the high yield notes at 101% of par on the accreted value.
- a failure by Covanta to pay amounts due under the high yield notes or certain other debt instruments;
- preserving its corporate existence and its material rights and franchises.
The unsecured yield notes shall become immediately due and payable in the event that Covanta or certain of its affiliates become subject to specified events of bankruptcy or insolvency, and shall become
immediately due and payable, upon action taken by the trustee under the indenture or holders of a certain specified percentage or principal under outstanding unsecured notes, in the event that any of the following occurs after expiration of applicable cure periods:
- a failure by Covanta to pay amounts due under the high yield notes or certain other debt instruments; and
- a failure by Covanta to comply with its obligations under the indenture.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150"). SFAS 150 requires that certain financial instruments, which under previous guidance were accounted for as equity, must now be accounted for as liabilities. The financial instruments affected include mandatorily redeemable stock, certain financial instruments that require or may require the issuer to buy back some of its shares in exchange for cash or other assets, and certain obligations that can be settled with shares of stock. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, otherwise it is effective July 1, 2003, the beginning of the first interim period after June 15, 2003. The provisions of this statement did not have an impact on DHC's financial statements in 2003.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
The operations of NAICC are in property and casualty insurance. NAICC writes non-standard private passenger and commercial automobile insurance in the western United States, primarily California. NAICC writes approximately 92% of its insurance in California. For the years ended December 2003, 2002 and 2001, 55%, 45% and 16%, respectively, of total direct written premiums were produced through two general agents of NAICC. In 2001, NAICC, which formerly wrote workers' compensation insurance, decided to exit the workers' compensation business in all states. In 2003, NAICC ceased writing new commercial automobile insurance and expects that by September 2004 it will have completely exited the commercial automobile insurance market.
DHC's insurance subsidiaries are referenced to herein as "Insurance Services". ACL, GMS and Vessel Leasing are together referenced to herein as "Marine Services".
In 2003, DHC changed the presentation of the parent company's accounts included in the consolidated statement of financial position from a classified to an unclassified basis. The change in classification is deemed to be more meaningful as DHC's Insurance Services' assets and liabilities have been consistently reported on an unclassified basis. Previously reported amounts have been reclassified to conform to the current classifications.
The consolidated financial statements reflect the results of operations, cash flows and financial position of DHC and its majority-owned and controlled subsidiaries as a single entity. All significant intercompany accounts and transactions have been eliminated. Investments in companies that are not majority-owned or controlled are accounted for under the equity method.
In 2002, DHC conformed its previous calendar year-end reporting basis to ACL's fiscal year-end reporting basis. Effective with the fiscal year beginning December 28, 2002, DHC is again reporting on a calendar year-end basis to conform with DIND and its consolidated subsidiaries' who have been consolidated in the accompanying consolidated financial statements using its calendar year-end reporting period in all periods presented. The transition period activity included in the consolidated financial statements for 2003 is immaterial.
Cash and cash equivalents include short-term investments with a maturity of less than three months when purchased. DHC, from time to time, has cash in banks in excess of federally insured limits. Cash and cash equivalents are stated at cost, which approximates fair value.
Debt and equity securities can be classified in one of the three categories: trading, available-for-sale, or held-to-maturity. Securities that are classified as "trading" can be classified as bought and held principally to sell in the near term. Securities which are classified as "held-to-maturity" are securities which DHC has the ability and intent to hold until maturity. All other securities, which are not classified as either trading or held- to-maturity, are classified as "available-for-sale." DHC currently classifies all of its debt and equity securities as available-for-sale.
Unpaid losses and LAE are based on estimates of reported losses and historical experience for incurred but unreported claims, including losses reported by other insurance companies for reinsurance assumed, and estimates of expenses for investigating and adjusting all incurred and unadjusted claims. Management believes that the provisions for unpaid losses and LAE are adequate to cover the cost of losses and LAE incurred to date. However, such liability is, by necessity, based upon estimates, which may change in the near term, and there can be no assurance that the ultimate liability will not exceed, or even materially exceed, such estimates. The loss and LAE is continually monitored and reviewed, and as settlements are made or reserves adjusted, differences are included in current operations.
Insurance Services accounts for its reinsurance contracts which provide indemnification by reducing earned premiums for the amounts ceded to the reinsurer and establishing recoverable amounts for paid and unpaid losses and LAE ceded to the reinsurer. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Contracts that do not result in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk generally do not meet conditions for reinsurance accounting and are accounted for as deposits. For the fiscal years 2003 and 2002, Insurance Services had no reinsurance contracts which were accounted for as deposits.
NAICC establishes an allowance for premium receivables and reinsurance recoverables through a charge to general and administrative expenses based on historical experience. After all collection efforts have been exhausted, NAICC reduces the allowance for balances that have been deemed uncollectible.
In December 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," ("SFAS 148"), which provides alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, the statement amends the disclosure requirements of SFAS 123 to require prominent disclosures about the method of accounting for stock-based employee compensation and the effect of the method used on reported financial results and requires such disclosures in interim financial information. DHC continues to account for stock-based employee compensation under APB 25 for directors and employees, but has adopted the new disclosure requirements of SFAS 148.
The following table illustrates the pro forma effect on net loss and loss per share as if the fair value recognition provisions of SFAS 123 had been applied to all stock-based compensation awards.
Per share data is based on the weighted average number of shares of common stock of DHC, par value $0.10 per share ("Common Stock"), outstanding during the relevant period. Basic earnings per share are
The following are other significant accounting policies of the previously consolidated Marine Services subsidiaries.
Accounts Receivable consist of the following as of December 27, 2002:
ACL accounts for its 50% ownership in UABL Limited and UABL Limited Terminals Ltd. (collectively, "UABL"), companies with operations in South America, by the equity method. Marine Services' share of UABL's losses included in other income, net on the consolidated statement of operations was $1,130 for 2002.
VIEs created after January 31, 2003. The provisions of this statement did not have an impact on DHC's financial statements in 2003. DHC does not expect FIN 46 will have a significant impact on its financial statements in 2004.
In June 2002, the FASB issued SFAS No. 146 "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS 146"), which addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs incurred in a Restructuring)" ("Issue 94-3"). The principal difference between SFAS 146 and Issue 94-3 relates to SFAS 146's requirements for recognition of a liability for a cost associated with an exit or disposal activity. SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost as generally defined in Issue 94-3 was recognized at the date of an entity's commitment to an exit plan. Severance pay under SFAS 146, in many cases, would be recognized over time rather than up front. Additionally, under SFAS 146, if the benefit arrangement requires employees to render future service beyond a "minimum retention period," a liability should be recognized as employees render service over the future service period even if the benefit formula used to calculate an employee's termination benefit is based on length of service. The provisions of SFAS 146, which was adopted in 2003, did not have an impact on DHC's financial statements in 2003.
On December 2, 2003, DHC executed a definitive investment and purchase agreement to acquire the energy and water businesses of Covanta Energy Corporation ("Covanta") in connection with Covanta's emergence from Chapter 11 proceedings in bankruptcy. The primary components of the transaction are: (1) the purchase by DHC of 100% of the equity of Covanta in consideration for a cash purchase price of $30,000, and (2) agreement as to new revolving credit and letter of credit facilities for Covanta's domestic and international operations, provided by some of the existing Covanta lenders and a group of additional lenders organized by DHC. DHC amended this Agreement with Covanta as of February 23, 2004 to reduce the purchase price and release $175 from an escrow account so that DHC could acquire an equity interest in Covanta Lake, Inc., a wholly-owned indirect subsidiary of Covanta, in a transaction separate and distinct from the acquisition of Covanta out of bankruptcy.
As required by the investment and purchase agreement, Covanta filed a new, alternative proposed plan of reorganization, a new, alternative proposed plan of liquidation for specified non-core businesses, and an accompanying draft disclosure statement, each reflecting the transactions contemplated under the investment and purchase agreement, with the Bankruptcy Court.
Under the terms of the investment and purchase agreement, DHC will acquire 100% of Covanta's equity in consideration for $30,000 in cash. Other assets as of December 31, 2003 include deferred acquisition costs of $979 incurred primarily for legal and consulting fees directly related to the Covanta acquisition, net of a $3,000 reimbursement of such costs from Covanta in December 2003. As part of the investment and purchase agreement, DHC arranged for a new $118,000 replacement letter of credit facility for Covanta, secured by a second lien on Covanta's domestic assets. This financing is to be provided by SZ Investments, L.L.C., a DHC shareholder ("SZ Investments"), Third Avenue Trust, on behalf of Third Avenue Value Fund Series, a DHC shareholder ("Third Avenue") and D. E. Shaw Laminar Portfolios, L.L.C., a creditor of Covanta and a DHC shareholder ("Laminar"). In addition, in connection with a note purchase agreement described below, Laminar also will arrange for a $10,000 revolving loan facility for Covanta's international operations that DHC will acquire, secured by Covanta's international assets.
DHC obtained the financing necessary for the Covanta acquisition pursuant to a note purchase agreement dated December 2, 2003, from SZ Investments, Third Avenue and Laminar (collectively, the "Bridge Lenders"). Pursuant to the note purchase agreement, the Bridge Lenders have provided DHC with $40,000 of bridge financing in exchange for notes convertible into shares of Common Stock, par value $0.10 per share ("Common Stock") at a price of $1.53 per share. These notes have a scheduled maturity date of January 2, 2005 and an extended maturity date of July 15, 2005, and bear interest at a rate of 12% per annum through July 15, 2004 and 16% per annum thereafter. In the event of a default or the failure to pay a note on its maturity, the interest rate under the note increases by 2%. DHC used $30,000 of the proceeds from the notes to post an escrow deposit prior to the closing of the transactions contemplated by the investment and purchase agreement. Upon closing, it is intended that the deposit will be used as DHC's purchase price for Covanta's equity interests. DHC will use the remainder of the proceeds to pay unreimbursed transaction expenses and for general corporate purposes. In consideration for the $40,000 of bridge financing and the agreement by the Bridge Lenders to arrange or provide for the $118,000 second lien credit facility and for Laminar to arrange or provide for the $10,000 international revolving credit facility, DHC issued to the Bridge Lenders an aggregate of 5,120,853 shares of Common Stock. At the time that DHC entered into the note purchase agreement, agreed to issue the notes convertible into shares of Common Stock and issued the equity compensation to the Bridge Lenders, the closing price of Common Stock on the day prior to the announcement of the Covanta acquisition was $1.40 on the American Stock Exchange, which was below the $1.53 per share conversion price of the notes.
On May 29, 2002, DHC completed an acquisition (the "DHC Recapitalization") of American Commercial Lines Holdings LLC ("ACL Holdings"), the parent company of ACL. Holders of ACL
On May 29, 2002, DHC also purchased a 50% equity interest in Vessel Leasing for $2,769 and a 5.4% equity interest in GMS for $1,290. Vessel Leasing leases barges to ACL's barge transportation operations and GMS owns and operates terminal and warehouse facilities.
did not meet expectations and ACL's liquidity was significantly impaired. Debt covenant violations occurred and, as a result, ACL was unable to meet its financial obligations as they became due. On January 31, 2003 (the "Petition Date"), ACL filed a petition with the U.S. Bankruptcy Court for the Southern District of Indiana, New Albany Division (the "Bankruptcy Court") to reorganize under Chapter 11 of the U.S. Bankruptcy Code (the "Bankruptcy Code" or "Chapter 11") under case number 03-90305. Included in the filing are ACL, ACL's direct parent (American Commercial Lines Holdings LLC), American Commercial Barge Line LLC, Jeffboat LLC, Louisiana Dock Company LLC and ten other U.S. subsidiaries of ACL (collectively with ACL, the "Debtors") under case numbers 03-90306 through 03-90319. These cases are jointly administered for procedural purposes before the Bankruptcy Court under case number 03-90305. The Chapter 11 petitions do not cover any of ACL's foreign subsidiaries or certain of its U.S. subsidiaries.
ACL and the other Debtors are continuing to operate their businesses as debtors-in-possession under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code and orders of the Bankruptcy Court. As debtors-in-possession, the Debtors may not engage in transactions outside of the ordinary course of business without approval, after hearing, of the Bankruptcy Court. As part of the Chapter 11 cases, the Debtors intend to develop and propose for confirmation pursuant to Chapter 11, a plan of reorganization that will restructure the operations and liabilities of the Debtors to the extent necessary to result in the continuing viability of ACL. A filing date for such a plan has not been determined; however, the Debtors have the exclusive right to file a plan of reorganization at any time on or before March 28, 2004. If the exclusive filing period were to expire, other parties, such as ACL creditors, would have the right to propose alternative plans of reorganization. During the pendency of these Chapter 11 cases, the Debtors have routinely requested extension of the exclusivity period. Such extensions have been granted with the support of the Debtors' creditors. The Debtors intend to file for an additional extension of the exclusivity period beyond the current March 28, 2004 date, as may be necessary.
The Debtors' direct and indirect foreign subsidiaries and foreign joint venture entities did not file petitions under Chapter 11 of the Bankruptcy Code and are not debtors-in-possession. DHC, GMS and Vessel Leasing also did not file petitions under Chapter 11 of the Bankruptcy Code and are not debtors-in-possession.
As a result of the Chapter 11 filings, certain events of default under ACL's Senior Credit Facilities, Senior Notes, PIK Notes and Old Senior Notes have occurred, the effects of which are stayed pursuant to certain provisions of the Bankruptcy Code.
Under Chapter 11, actions by creditors to collect claims in existence at the filing date are stayed or deferred absent specific Bankruptcy Court authorization to pay such pre-petition claims while the Debtors continue to manage their businesses as debtors-in-possession and act to develop a plan of reorganization for the purpose of emerging from these proceedings. The Debtors have received approval from the Bankruptcy Court to pay or otherwise honor certain of its pre-petition obligations, including but not limited to employee wages and certain employee benefits, certain critical vendor payments, certain insurance and claim obligations and certain tax obligations as a plan of reorganization is developed. A claims bar date of December 5, 2003 was established for all other pre-petition creditors to file a claim against the estate of the various debtors. The Debtors are currently in the process of reviewing the claims that were filed against the Debtors. The ultimate amount of claims allowed by the Court against the Debtors could be significantly different than the amount of the liabilities recorded by the Debtors.
DHC's debt as of December 31, 2003 consists of $40,000 in bridge financing relating to the acquisition of Covanta. Pursuant to the note purchase agreement, the Bridge Lenders provided DHC with bridge financing in exchange for notes convertible under certain circumstances into shares of Common Stock at a price of $1.53 per share. These notes have a scheduled maturity date of January 2, 2005 and an extended maturity date of July 15, 2005, and bear interest at a rate of 12% per annum through July 15, 2004 and 16% per annum thereafter. In the event of a default or the failure to pay a convertible note on its maturity, the interest rate under the convertible note increases by 2%.
Under the note purchase agreement, Laminar has agreed to convert an amount of convertible notes to acquire up to an additional 8.75 million shares of DHC common stock at $1.53 per share based upon the levels of public participation in a planned rights offering. DHC expects to repay the other notes through the rights offering. If DHC does not refinance all of the other outstanding notes, the remainder of the notes would be convertible, without action on the part of the Bridge Lenders, into shares of Common Stock at the rights offering price of $1.53 per share, subject to agreed upon limitations necessitated by DHC's NOLs.
In the event, that the issuance of shares of Common Stock under the convertible notes trigger certain ownership change limitations, as defined by the Internal Revenue Code of 1986, the terms of the convertible notes may be modified. In the event of a non-ownership change rollover event (as defined in the agreement), the notes will bear interest at 18% per annum, compounded quarterly on the last day of each calendar quarter. In the event of an ownership change rollover event (as defined in the agreement), amounts in excess $8.0 million shall be subject to the non-ownership change rollover terms, unless prepaid in full in cash. In the first year in which convertible notes are outstanding under the ownership change rollover terms, interest will be 12% per annum. Thereafter, interest on the notes will be 14.5% per annum, calculated quarterly and payable in arrears on the last day of each calendar quarter.
Marine Services' debt as of December 27, 2002 was as follows:
ACL's debt was adjusted to fair value as of the date of the DHC Recapitalization. The difference between the principal amount of the debt and its fair value is being accreted as interest expense over the term of the debt under the effective interest method.
Tranche A of the Term Loans matures June 30, 2005. Tranche B of the Term Loans matures June 30, 2006. Tranche C of the Term Loans matures June 30, 2007. The Term Loans bear interest at a rate equal to LIBOR plus a margin based on ACL's performance. The annual interest rates as of December 27, 2002 were: Tranche A -6.0%, Tranche B -6.25% and Tranche C -6.5%.
The Senior Credit Facilities and the indentures governing the New Senior Notes and the PIK Notes (the "Indentures") contain a number of covenants with specified financial ratios and tests including, with respect to the Senior Credit Facilities, maximum leverage ratios, rent adjusted maximum leverage ratios and interest coverage ratios. Compliance with financial ratios is measured at the end of each quarter. The Indentures also contain certain cross default provisions. ACL's ability to meet the financial ratios is affected by adverse weather conditions, seasonality and other risk factors inherent in its business. The Senior Credit Facilities also contain mandatory prepayments of the Term Loans with net proceeds from certain asset sales, equity issuances, incurrence of indebtedness and sale and leaseback transactions, as well as excess cash flow, as defined in the Senior Credit Facilities.
In late 2002, ACL obtained an amendment (the "Amendment") of certain covenants under the Senior Credit Facilities, relating to third quarter and fourth quarter 2002 covenants and a waiver of any past violations thereof. Absent the Amendment, ACL would not have been in compliance with the leverage or interest coverage ratios contained in its Senior Credit Facilities as of December 27, 2002. At the end of the first quarter of 2003, the covenant ratios revert to levels in effect before the Amendment. Although management had been working on operating and financial plans to comply with its debt covenants in 2003 and thereafter, ACL was unable to complete an out-of-court restructuring and management believed it was probable that ACL would not be in compliance with the Senior Credit Facilities covenants at the end of the first quarter 2003, absent another amendment to the Senior Credit Facilities. Accordingly, all of ACL's long-term debt was classified as current debt as of December 27, 2002.
As of December 27, 2002, GMSV had $2,850 in loans outstanding from the International Finance Corporation which bear interest at LIBOR plus a margin of 4.75% and mature May 2007. ACL currently guarantees the outstanding loan amounts. (GMSV is a group of companies in which DHC has a 57% ownership through its ownership of ACL and GMS.)
DHC does not guarantee the debt of ACL, Vessel Leasing, GMS or GMSV.
As of the year ended December 2003, General Reinsurance Corporation ("GenRe") was the only reinsurer that comprised more than 10 percent of NAICC's reinsurance recoverable on paid and unpaid claims. NAICC monitors all reinsurers, by reviewing A.M. Best reports and ratings, information obtained from reinsurance intermediaries and analyzing financial statements. As of December 31, 2003, NAICC had reinsurance recoverable on paid and unpaid balances of $13,100 from GenRe. As of the year ended December 2002, GenRe and Mitsui Sumitomo Insurance Company Ltd. (Mitsui") were the only reinsurers that comprised more than 10 percent of NAICC's reinsurance recoverable on paid and unpaid claims of $13,000 and $2,700, respectively. Both GenRe and Mitsui have an A.M. Best rating of A+ or better.
Insurance Services has claims for environmental cleanup against policies issued prior to 1985 and which are currently in run-off. The principal exposure from these claims arises from direct excess and primary policies of businesses in run-off, the obligations of which were assumed by Insurance Services. These direct excess and primary claims are relatively few in number and have policy limits of between $50 and $1,000, with reinsurance generally above $50. Insurance Services also has environmental claims primarily associated with participations in excess of loss reinsurance contracts assumed by Insurance Services. These reinsurance contracts have relatively low limits, generally less than $25, and estimates of unpaid losses are based on information provided by the primary insurance company.
The unpaid losses and LAE related to environmental cleanup is established considering facts currently known and the current state of the law and coverage litigation. Liabilities are estimated for known claims (including the cost of related litigation) when sufficient information has been developed to indicate the involvement of a specific contract of insurance or reinsurance and management can reasonably estimate its liability. Estimates for unknown claims and development of reported claims are included in Insurance Services' unpaid losses and LAE. The liability for the development of reported claims is based on estimates of the range of potential losses for reported claims in the aggregate. Estimates of liabilities are reviewed and updated continually and there is the potential that Insurance Services' exposure could be materially in excess of amounts which are currently recorded. Management does not expect that liabilities associated with these types of claims will result in a material adverse effect on the future liquidity or financial position of Insurance Services. However, claims such as these are based upon estimates and there can be no assurance that the ultimate liability will not exceed or even materially exceed such estimates. As of the years ended December 2003 and 2002, Insurance Services' net unpaid losses and LAE relating to environmental claims were approximately $8,319 and $7,344, respectively.
The CDI completed its examination of the statutory-basis financial statements of NAICC, excluding Valor, for the four years ended December 2002. The report was filed January 9, 2004. No restatement of NAICC's December 31, 2002 statutory financial statements was proposed by CDI as a result of the examination. The CDI did, however, note an increase in statutory unpaid loss and LAE by $4.1 million and a corresponding adjustment to surplus. The adjustment issued by the Department was in response to NAICC's recognition of prior years development in its June 30, 2003 quarterly filing.
In response to the above statutory condition, in 2003, DHC repaid a $4,000 note due May 2004 to NAICC, and further contributed $4,000 to NAICC to increase its statutory capital. With permission from the CDI, these transactions were recorded at December 31, 2002 in NAICC's statutory-basis annual statement. After consideration for the $8,000 noted above, NAICC's reported statutory-basis capital and surplus as of December 31, 2002 was above the Company action level of the RBC calculation. On December 30, 2003, DHC contributed $2,000 to NAICC to increase its statutory capital.
At December 27, 2002 ACL had $39,300 outstanding under its pre-petition accounts receivable securitization facility agreement and had $27,590 of net residual interest in the securitized receivables which is included in Accounts Receivable on the consolidated statement of financial position. The fair value of the net residual interest is measured at the time of the sale and is based on the sale of similar assets. In 2002, ACL received gross proceeds of $20,300 from the sale of receivables and made gross payments of $23,600 under this agreement. As described in Note 4, ACL's Pre-Petition Receivables Facility was retired with proceeds from ACL's DIP Credit Facility.
The cost or amortized cost, unrealized gains, unrealized losses and fair value of DHC's investments as of the year ended December 2003 and 2002, categorized by type of security, were as follows:
The following table sets forth a summary of NAICC's temporarily impaired investments at December 31, 2003:
Fixed maturities of DHC include mortgage-backed securities ("MBS") representing 21.9% and 31.7% of the total fixed maturities at years ended December 2003 and 2002, respectively. All MBS held by DHC are issued by the Federal National Mortgage Association ("Fannie Mae") or the Federal Home Loan Mortgage Corporation ("Freddie Mac"), both of which are rated "AAA" by Moody's Investors Services. MBS and callable bonds, in contrast to other bonds, are more sensitive to market value declines in a rising interest rate
environment than to market value increases in a declining interest rate environment. This is primarily because of payors' increased incentive and ability to prepay principal and issuers' increased incentive to call bonds in a declining interest rate environment. Management does not believe that the inherent prepayment risk in its portfolio is significant. However, management believes that the potential impact of the interest rate risk on DHC's consolidated financial statements could be significant because of the greater sensitivity of the MBS portfolio to market value declines and the classification of the entire portfolio as available-for-sale. DHC has no MBS concentrations in any geographic region.
The expected maturities of fixed maturity securities, by amortized cost and fair value, as of the year ended December 2003, are shown below. Expected maturities may differ from contractual maturities due to borrowers having the right to call or prepay their obligations with or without call or prepayment penalties. Expected maturities of MBS are estimated based upon the remaining principal balance, the projected cash flows and the anticipated prepayment rates of each security:
The components of net unrealized (loss) gain on available-for-sale securities for the years ended December 31, 2003, 2002, and 2001 consist of the following:
e. DHC's ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery in fair value.
Based upon these factors, securities that have indications of potential impairment are subject to further review. In the third quarter of 2002, DHC determined that two equity securities had declines in fair value that were "other than temporary" and DHC, accordingly, recorded a realized loss of $2,655. These securities were subsequently sold in the fourth quarter of 2002. At year end 2002, DHC determined that one equity security had a decline in fair value that was "other than temporary" and, accordingly, recorded a realized loss of $967. The net unrealized loss of DHC's equity securities was $1,373 at the end of December 2002.
During 2003, three equity securities had declines in fair value that were "other than temporary" and, accordingly, DHC recorded a realized loss of $1,890. All of these securities were sold by December 31, 2003.
Insurance Services' objective is to underwrite business that is expected to yield an underwriting profit. Insurance Services has made a determination that certain lines of insurance may not be sustainable in the current rate environment. Competitive and regulatory pressures have resulted in a general market for premium rates in these lines that is well below a level necessary in order to achieve a profit, especially in light of increasingly unfavorable loss history. Rather than continue to sustain losses, Insurance Services has exited the workers' compensation line in all states, and the non-standard private passenger automobile program written outside of California in 2001 and began exiting the commercial automobile line in all states in 2003. The last new commercial automobile policy was issued in July 2003 and the last commercial auto policy renewed was September 2003. The last workers compensation policy outside Montana was issued in July 2001 and the last Montana workers compensation policy was issued in January 2002. Costs incurred in 2003 and 2001 associated with this process totaled approximately $224 and $1,250, respectively, and are included in general and administrative expenses. The remaining line of business written by Insurance Services is non-standard private passenger automobile in the State of California.
In connection with the ACL acquisition, 339,040 shares of restricted Common Stock were issued to ACL management. These restricted shares have been valued at fair value at the date of issuance and vest one third annually over a three year period. The full value of these shares is recorded as paid in capital with an offset to unearned compensation in stockholders' equity. As employees render service over the vesting period, compensation expense is recorded and unearned compensation is reduced. During 2003, 155,506 unvested restricted shares were cancelled due to employee terminations. The remaining unearned compensation related to these cancelled shares was reduced with the offset recorded as a reduction to additional paid-in capital.
As of December 31, 2003, there were 35,793,440 shares of Common Stock issued of which 35,782,644 were outstanding; the remaining 10,796 shares of Common Stock issued but not outstanding are held as treasury stock. In connection with efforts to preserve DHC's NOLs, DHC has imposed restrictions on the ability of holders of five percent or more of Common Stock to transfer the Common Stock owned by them and to acquire additional Common Stock, as well as the ability of others to become five percent stockholders as a result of transfers of Common Stock.
The following represents shares of Common Stock reserved for future issuance as of December 31, 2003:
(A) The number of shares is based on the maximum number of shares which could be issued assuming 100% shareholder participation in the rights offering. The number of shares for the required conversion of Laminar debt and the stock purchase rights of certain creditors of Covanta are subject to the level of public participation in the rights offering (as defined in the agreements), as well as other limitations regarding the Covanta creditors' stock purchase rights.
SFAS No. 109 "Accounting for Income Taxes" ("SFAS 109") requires the establishment of a valuation allowance to reflect the likelihood of realization of deferred tax assets. Pursuant to SFAS 109, DHC makes periodic determinations of whether it is "more likely than not" that all or a portion of the DHC's deferred tax assets will be realized. In making these determinations, DHC considers all of the relevant factors, both positive and negative, which may impact upon its future taxable income including the size and operating results of its subsidiaries, the competitive environment in which these subsidiaries operate and the impact of the grantor trusts. Exclusive of the trusts' activities, DHC has generated cumulative taxable losses on a historical basis. Over the past several years, DHC's subsidiaries and holding company operations have been generating combined losses exclusive of net investment income, net realized gains and the trusts' activities.
Therefore, due to the absence of a reliable taxable income stream, DHC has recorded a valuation allowance for the amount by which its deferred tax assets exceed its deferred tax liabilities and, as a result, DHC has not recorded any liability or asset for deferred taxes.
DHC's NOLs will expire, if not used, in the following amounts in the following years:
The following reflects a reconciliation of income tax expense computed by applying the applicable Federal income tax rate of 34% to loss before provision for income taxes for the years ended December 2003, 2002 and 2001, as compared to the provision for income taxes:
The tax effects of temporary differences that give rise to the deferred tax assets and liabilities as of the years ended December 2003 and 2002, respectively, are presented as follows:
The discount rate assumption used to determine benefit obligations at December 31, 2003 and 2002 was 6.25% and 6.75%, respectively.
The Plan's fair value percentage of plan assets at December 31, 2003 and 2002 by asset category are as follows:
The primary emphasis of the management of the Plan's portfolio of assets is to establish sufficient funding for projected retirement benefits. To this end, the primary investment management objective is long-term capital appreciation. A secondary objective is to prevent erosion by inflation.
It is NAICC's intent that the portfolio be fully invested at all times. The allocation between equity securities, debt securities and cash, including any allocation between registered investment funds is left to the discretion of the plan trustee except as required by the plan administrator for pending plan disbursements.
In addition to the defined benefit pension and related plans, ACL has a defined benefit post-retirement health care plan covering most full-time employees. The plan provides medical benefits and is contributory, with retiree contributions adjusted annually, and contains other cost-sharing features such as deductibles and coinsurance. The accounting for the healthcare plan anticipates future cost-sharing changes to the written plan that are consistent with ACL's expressed intent to increase the retiree contribution rate annually.
The assumptions used to determine ACL's net periodic benefit cost for 2002 are as follows:
The following table presents the fair value percentage of ACL's plan assets in each asset category as of December 27, 2002:
The 1995 Stock and Incentive Plan (the "1995 Plan") is a qualified plan which provides for the grant of any or all of the following types of awards: stock options, including incentive stock options and non-qualified stock options; stock appreciation rights, whether in tandem with stock options or freestanding; restricted stock; incentive awards; and performance awards. The purpose of the 1995 Plan is to enable DHC to provide incentives to increase the personal financial identification of key personnel with the long-term growth of DHC and the interests of DHC's stockholders through the ownership and performance of Common Stock, to enhance DHC's ability to retain key personnel, and to attract outstanding prospective employees and Directors. The 1995 Plan became effective as of March 21, 1995.
With regard to the general terms of stock option awards, under the 1995 Plan, the exercise price for options is determined at the grant date, but cannot be less than the fair market value of a share of Common Stock on such grant date. The contractual life of the options is specified at the grant date. Options granted can vest no earlier than six months from the grant date.
On August 7, 2003, DHC granted options for 50,000 shares of Common Stock to an employee of NAICC. The options have an exercise price of $1.45 per share and expire 10 years from the grant date. 20,000 of the options vest on the first and second anniversary of the grant date and the remaining 10,000 options vest on the third anniversary of the grant date. As the market price of the Common Stock was equal to the exercise price of the options on the date of grant, no expense has been recognized in the accompanying financial statements for the options granted in 2003.
As described in Note 2, SZ Investments, Third Avenue and Laminar provided the bridge financing required for the Covanta acquisition. See Note 2 for terms and conditions relating to this debt. Interest expense on this financing amounted to $400 in 2003.
On April 14, 1999, DHC entered into a non-exclusive investment advisory agreement with EGI pursuant to which EGI agreed to provide, at the request of DHC, certain investment banking services to DHC in connection with potential transactions. For these services, in 2002, DHC paid a fee of $63 to EGI. The agreement provided that, in the event that a transaction was consummated for which the Acquisition Committee of DHC's Board of Directors determined that EGI provided material services, DHC would pay to
DHC has three reportable business segments -- insurance, marine and corporate. The Insurance Services segment writes property and casualty insurance in the western United States, primarily in California. The Marine segment includes the Barging, Construction and Terminals segments of the Marine Services businesses which are accounted for using the equity method during 2003. The corporate segment represents the operating expenses and miscellaneous income of the holding company, DHC.
The following is a reconciliation of segment (loss) earnings to consolidated totals:
As discussed in Note 3, DHC acquired ACL on May 29, 2002 and, accordingly, the operating results for 2002 include ACL beginning with the date of acquisition. As discussed in Note 1, DHC began accounting for its investment in ACL on the equity method in the first quarter of 2003 and, as discussed in Note 20, wrote off its investment in ACL in the same quarter.
A preliminary estimate of the purchase price ranges from $46,000 to $51,000 which includes the cash purchase price of $30,000, an expense estimate of approximately $6,000 for professional fees and other costs incurred in connection with the acquisition, and an estimated fair value ranging from $10,000 to $15,000 for DHC's commitment to sell up to 3 million shares of its Common Stock at $1.53 per share to certain creditors of Covanta, subject to certain limitations (see Note 2). The final purchase cost will be determined as DHC obtains additional information. The results of operations of Covanta will be consolidated with DHC commencing with the date of acquisition, March 10, 2004. A preliminary allocation of the purchase price has not been determined by DHC. Accordingly, it is not practicable at this time to disclose the amount to be assigned to each major asset and liability caption of Covanta at the acquisition date.
We have audited the accompanying consolidated statement of financial position of Danielson Holding Corporation ("DHC") as of December 31, 2003 and December 27, 2002, and the related consolidated statements of operations, stockholders' equity, and cash flows for the years then ended. Our audits also included the financial statement schedules listed in the index at Item 15(a) for the years then ended. These financial statements and schedules are the responsibility of DHC's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.