The following table summarizes our properties as of December 31, 2005:
Our newest location is a customer service, sales and claims center in Lewisville, Texas. The Company began leasing this facility in mid-2004. On September 30, 2005, the Company exercised its option under the terms of its lease agreement to purchase the land and building that house this service center. See Note 7 of the Notes to Consolidated Financial Statements for additional information.
The following selected financial data for each of the years in the five-year period ended December 31, 2005, should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes included in Item of this report. All amounts set forth in the following tables are in thousands, except for ratios and per share data.
The combined ratio for the personal auto lines was impacted by the following items: $13.6 million of costs associated with workforce reductions and the settlement of litigation matters in 2001; and (favorable) unfavorable prior accident year loss and LAE development of $(27.5) million, $(2.9) million, $11.2 million, $16.2 million, and $45.7 million in 2005, 2004, 2003, 2002, and 2001, respectively.
In addition to the effect of the items described in Footnote 13 above, the combined ratio for all lines was impacted by adverse development on remaining loss reserves from the homeowner and earthquake lines, which are in runoff, of $2.3 million in 2005, $2.8 million in 2004, $40.2 million in 2003, $58.8 million in 2002, and $77.6 million in 2001.
Founded in 1958, 21st Century Insurance Group is a direct-to-consumer provider of personal auto insurance in California, Texas, Illinois and six other states. We also provide motorcycle and personal umbrella insurance in California. We deliver superior policy features and customer service at a competitive price. We began offering personal auto insurance in Illinois, Indiana and Ohio on January 28, 2004, and in Texas on January 3, 2005.
Conversion to our new computer platforms, known as APS, occurred as planned. The APS:Claims component has a client-server architecture. The APS:Policy component has a multi-tier system architecture featuring a web client, a middle tier services layer and a real-time relational database back-end. The Claims component began taking 100% of new claims in the third quarter of 2004. Over 90% of the Company’s pending claims are now on the new system. We began writing new California 21st Century Insurance Company personal auto policies on the system in the first quarter of 2005 and completed the conversion of these in-force policies in the fourth quarter of 2005. Underwriting expenses have been higher than in prior periods due to costs associated with the conversion process, the training of service staff and the Company’s geographic expansion efforts.
Investments and cash increased $51.8 million (3.7%) since the prior year primarily due to the $160.3 million of operating cash flow offset by cash outflows of $39.1 million for property and equipment, $35.3 million for net unrealized losses due to changes in interest rates, $13.7 million in shareholder dividends, $12.6 million in debt repayments, and $7.8 million net change in various other accounts.
Of our total investments at December 31, 2005, investments in tax-exempt, fixed-income securities remained constant with December 31, 2004, at 22.3%. At December 31, 2005, investment-grade securities comprised substantially all of the fair value of our investment portfolio. As of December 31, 2005, two investments were rated below investment grade. These securities represent 0.2% of our total investments.
The Company also has unrated, community investments representing 0.2% of total investments. These investments have been made in an effort to provide housing and other services to economically disadvantaged communities. See Note 19 of the Notes to Consolidated Financial Statements for additional information.
Gross unpaid losses and LAE increased by $28.3 million in 2005 primarily due to a reserve increase of $32.1 million in the personal auto lines as a result of growth in our customer base. The increase in the personal auto lines was offset by the $3.8 million net decrease in the homeowner and earthquake lines, which are in runoff (see Critical Accounting Estimates - Losses and Loss Adjustment Expenses for a description of the Company’s reserving process).
Effective December 31, 2003, the California Department of Insurance, approved an intercompany lease whereby 21st Century Insurance Company leases certain computer software from our holding company. The monthly lease payment, currently $0.7 million, started in January 2004 and is subject to upward adjustment based on the cost incurred by the holding company to enhance the software. On November 30, 2005, the CDI permitted an amendment to a term loan line that increased the available amount from $40 million to $150 million that our insurance subsidiary, 21st Century Insurance Company, can loan to our holding company. See further information in Note B of the Notes to Condensed Financial Information of Registrant.
We expect to be able to meet those obligations from sources of cash currently available (i.e., cash and investments at the holding company, which totaled $16.9 million at December 31, 2005, payments received from the intercompany lease, and borrowing from our insurance subsidiary), additional funds obtainable from the capital markets or dividends received from our insurance subsidiaries. The effective California state income tax rate applicable to any such dividends paid from our subsidiaries, if taxable, is approximately 1.8%. Our insurance subsidiaries could pay $113.0 million in 2006 as dividends to the holding company without prior written approval from insurance regulatory authorities.
Insurance Subsidiaries. We have achieved underwriting profits in our core auto insurance operations for the last sixteen quarters and have thereby enhanced our liquidity. Our cash flow from operations and short-term cash position generally are more than sufficient to meet obligations for claim payments, which by the nature of the personal automobile insurance business, tend to have an average duration of less than a year.
Several subsidiaries of AIG together own approximately 62% of our outstanding common stock and three of the ten members of our Board of Directors are employees of AIG. Since 1995, the Company has entered into transactions with AIG subsidiaries, including reinsurance agreements, insurance coverage contracts, and various services.
Investment management and investment accounting - In October 2003, as a result of a competitive bidding process, we entered into an agreement with an AIG subsidiary to provide investment management and investment accounting services to the Company. The fees are determined as a percentage of the average invested asset balance and are classified with net investment income. This agreement was approved by the CDI. Investment management and accounting expense was $0.9 million, $0.9 million, and $0.1 million in 2005, 2004 and 2003, respectively.
Software and data processing - Through December 31, 2004, the Company utilized certain third party software and data processing monitoring tools under an agreement negotiated by AIG. Since January 1, 2005, the Company has negotiated its own contracts, and no longer incurs any software or data processing costs with AIG subsidiaries. Charges by AIG for software and data processing were $0.3 million in 2004 and 2003. There was no expense in 2005.
Includes amounts due under long-term software license agreements of approximately $21.2 million.
Consolidated Results. The following table summarizes the Company’s consolidated results of operations for the years ended 2005, 2004, and 2003.
Personal automobile insurance is our primary line of business. Vehicles insured outside of California accounted for 6.2%, 3.5%, and 2.4% of our direct premiums written in 2005, 2004 and 2003, respectively. This increase is due to our ongoing multi-state expansion program, which includes marketing in non-California states. The Company currently plans to expand into six additional states in 2006 to further its geographic expansion strategy.
The following table reconciles our personal auto lines underwriting profit to our consolidated net income:
The combined ratio was 94.7% for the year ended December 31, 2005, compared to 95.1% and 96.5% for 2004 and 2003, respectively. The decrease was mainly due to favorable prior accident year loss and LAE development of $27.5 million and $2.9 million in 2005 and 2004, respectively, and unfavorable prior accident year loss and LAE development of $11.2 million in 2003.
We have executed various transactions to exit from our homeowner line. Under a January 1, 2002 agreement with Balboa Insurance Company (“Balboa”), a subsidiary of Countrywide Financial Corporation (“Countrywide”), 100% of homeowner unearned premium reserves and losses on or after that date were ceded to Balboa. Under the terms of this agreement, we retain certain loss adjustment expenses. We began non-renewing homeowner policies expiring on February 21, 2002, and thereafter. Substantially all of these customers were offered homeowner coverage through an affiliate of Countrywide. We have completed this process and no longer have any homeowner policies in force.
The following table summarizes homeowner and earthquake lines losses and LAE incurred, net of applicable reinsurance, for the periods indicated:
Net Investment Income. We utilize a conservative investment philosophy. No derivatives or nontraditional securities are held in our investment portfolio and only 3.4% of the portfolio consists of equity securities. Substantially the entire fixed maturity portfolio is investment grade. Net investment income was $69.1 million, $58.8 million and $45.8 million for the years ended 2005, 2004, and 2003, respectively. Average invested assets increased 8.8%, 23.2% and 17.9% for the years ended 2005, 2004, and 2003, respectively.
The average annual yields on invested assets for the periods indicated were as follows:
Our policy is to evaluate, on a quarterly basis, all investments for “other-than-temporary” impairment when the fair value of a security falls below its cost or amortized cost, based on all relevant facts and circumstances. No such impairments were recorded in 2005, 2004, or 2003 (see discussion under Critical Accounting Estimates - Investments).
Other Expenses. In November 2005, the Company vacated approximately 2% of rentable space at its headquarters in Woodland Hills, California and plans to sublease this space. A loss on this vacated space has been recognized totaling $0.4 million, as future rental costs are higher than potential market rentals.
It is management’s belief that the reserves for losses and LAE are adequate to cover unpaid losses and LAE as of December 31, 2005. While we perform quarterly reviews of the adequacy of established unpaid losses and LAE reserves, there can be no assurance that our ultimate unpaid losses and LAE will not develop redundancies or deficiencies and possibly differ materially from our unpaid losses and LAE as of December 31, 2005. In the future, if the unpaid losses and LAE develop redundancies or deficiencies, such redundancy or deficiency would have a positive or adverse impact, respectively, on future results of operations.
The process of making changes to unpaid losses and LAE begins with the preparation of several point estimates, a review of the actual claims experience, actual rate changes achieved, actual changes in coverage, mix of business, and changes in certain other factors such as weather and recent tort activity that may affect the loss and LAE ratio. Our actuaries prepare several point estimates of unpaid losses and LAE for each of the coverages, and they use their experience and judgment to arrive at an overall actuarial point estimate of the unpaid losses and LAE for that coverage.
The point estimate methods include the use of paid loss triangles, incurred loss triangles, claim count triangles, and severity triangles, as well as expected loss ratio methods. Quantitative techniques frequently have to be supplemented by subjective consideration, including managerial judgment, to assure management satisfaction that the overall unpaid losses and LAE are adequate to meet projected losses. For example, in property damage coverages, repair cost trends by geographic region vary significantly. These factors are periodically reviewed and subsequently adjusted, as appropriate, to reflect emerging trends which are based upon past loss experience. Thus, many factors are implicitly considered in estimating the loss costs recognized.
The Company has experienced changes in the mix of business and policy limits. We believe that the assumption with the highest likelihood of change that could materially affect carried unpaid losses and LAE is the estimate of the frequency of unpaid bodily injury claims. The Company has experienced approximately 12% lower bodily injury claim frequency over the past 3 years in California. A 5% change in the estimate of the frequency of unpaid bodily injury claims would result in an approximate increase or decrease in total unpaid losses and LAE of 2.8%, or $14.7 million.
Income Taxes. Determining the consolidated provision for income tax expense, deferred tax assets and liabilities and any related valuation allowance involves judgment. GAAP 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 consolidated financial statements. For example, we have a DTA because the tax bases of our loss and LAE reserves are smaller than their book bases. Similarly, we have a DTL because the book basis of our 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.
Our ability to fully utilize the remaining NOL depends on future taxable income either from continued operating profitability or from tax planning strategies we could implement, such as increasing the taxable portion of our investment portfolio. Because of the Company’s history of profitability over the past three years, management believes it is reasonable to expect future underwriting profits and to conclude it is at least more likely than not that we will be able to realize the benefits of all of our DTAs, including our NOL. Accordingly, no valuation allowance has been recognized as of December 31, 2005 and 2004. However, generating future taxable income is dependent on a number of factors, including regulatory and competitive influences that may be beyond our ability to control. Future underwriting losses could possibly jeopardize our ability to utilize our NOLs. In the event adverse development or underwriting losses due to either SB 1899 matters or other causes were to occur, management might be required to reach a different conclusion about the realization of the DTAs and, if so, recognize a valuation allowance at that time.
Deferred Policy Acquisition Costs. Deferred policy acquisition costs (“DPAC”) include premium taxes, advertising, and other variable costs incurred with writing business. These costs are deferred and amortized over the 6-month policy period in which the related premiums are earned.
Management assesses the recoverability of DPAC on a quarterly basis. The assessment calculates the relationship of actuarially estimated costs incurred to premiums from contracts issued or renewed for the period. We do not consider anticipated investment income in determining the recoverability of these costs. Based on current indications, management believes that these costs are fully recoverable as of December 31, 2005.
Trading at a significant (25 percent or more) discount to par, amortized cost (if lower) or cost for an extended period of time (nine months or longer);
For investments with unrealized losses due to market conditions or industry-related events, where 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, such as when it is determined that an issuer is unable to repay the entire principal, a charge is required to be reflected in income for the difference between cost or amortized cost and the fair value.
The following is a summary by issuer of non-investment grade securities and unrated securities held (at fair value):
The investment of $4.6 million in Ford Motor Credit Company was rated BBB- by Standard & Poor’s in December 2004.
Amount represents less than 0.1%, 0.1%, and 0.0% of total fair value of investments in 2005, 2004, and 2003, respectively.
If our portfolio were to be impaired by market or issuer-specific conditions to a substantial degree, our liquidity, financial position and financial results could be materially adversely affected. Further, our income from these investments could be materially reduced, and write-downs of the value of certain securities could further reduce our profitability. In addition, a decrease in value of our investment portfolio could put our subsidiaries at risk of failing to satisfy regulatory capital requirements. If we were not at that time able to supplement our capital by issuing debt or equity securities on acceptable terms, our ability to continue growing could be adversely affected. See further discussion in
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of 21st Century Insurance Group and its subsidiaries (the “Company”) at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) 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 the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements 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.
Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
(2) Net change in accumulated other comprehensive income (loss) for the year. See Note 13 of the Notes to Consolidated Financial Statements.
21st Century Insurance Group is an insurance holding company founded in 1958 and, effective December 4, 2003, was incorporated under the laws of the State of Delaware. Previously, the Company was incorporated in California. The term “Company,” unless the context requires otherwise, refers to 21st Century Insurance Group and its consolidated subsidiaries, all of which are wholly-owned: 21st Century Insurance Company, 21st Century Casualty Company, 21st Century Insurance Company of the Southwest, 20th Century Insurance Services, Inc., and i21 Insurance Services. The latter two companies are not property and casualty insurance subsidiaries, and their results are immaterial.
Investment securities generally must be classified as held-to-maturity, available-for-sale, or trading. The appropriate classification is based partially on our ability to hold the securities to maturity and largely on management’s intentions at inception with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on trading securities flow directly through earnings during the periods in which they arise, whereas for available-for-sale securities, they are recorded as a separate component of stockholders’ equity (accumulated other comprehensive income or loss) and do not affect earnings until realized. The Company classifies its investment portfolio as available-for-sale and carries it at fair value. The fair values of our investment securities are generally determined by reference to quoted market prices and reliable independent sources. The cost of investment securities sold is determined by the specific identification method.
We are obligated to assess, at each reporting date, whether there is an “other-than-temporary” impairment in the value of any of our investment securities. The determination of whether a decline in market value is “other-than-temporary” is a matter of subjective judgment. In general, however, a security is considered a candidate for impairment if it meets any of the following criteria:
For 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 the cost or amortized cost and the fair value.
Cash and cash equivalents include cash, demand deposits and short-term investments in money market mutual funds having a maturity of three months or less at the date of purchase.
Deferred policy acquisition costs (“DPAC”) primarily include premium taxes, advertising, and other variable costs incurred with writing business. These costs are deferred and amortized over the 6-month policy period in which the related premiums are earned.
Management assesses the recoverability of deferred policy acquisition costs on a quarterly basis. The assessment calculates the relationship of actuarially estimated costs incurred to premiums from contracts issued or renewed for the period. We do not consider anticipated investment income in determining the recoverability of these costs. Based on current indications, management believes these costs are fully recoverable as of December 31, 2005.
Leased property under capital lease is recorded as a capital asset and amortized on a straight-line basis over the estimated useful lives of the properties, which range from 3 to 10 years. The related lease obligation is included in debt on the balance sheet.
The following table summarizes the estimated useful lives used for depreciation of the Company’s assets:
Management assesses the Company’s property and equipment, including software development projects in progress, for impairment. The assessment of impairment involves a two-step process, whereby an initial assessment for potential impairment is performed by comparing the carrying value plus the cost to complete, if any, to estimates of future undiscounted cash flows from operations at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. If future undiscounted cash flows are insufficient, an impairment write down is recorded for the difference between the carrying value and estimated fair value of the asset group. There have been no events or circumstances in 2005 that would require a reassessment of any asset group for impairment.
On June 24, 2004, the Company paid $1.5 million to acquire the marketing name “21st Century Insurance and Financial Services,” which will be used as a marketing name for 20th Century Insurance Services. The payment has been capitalized as an intangible asset and is included in “Other Assets” on the accompanying balance sheet. The marketing name has an indefinite useful life and will not be amortized until its useful life is determined to no longer be indefinite.
Other income of $0.4 million in 2005 relates to interest income for refund claims with the taxing authorities. No other income was reported in 2004. Other income of $14.8 million in the year ended December 31, 2003, included $9.3 million resulting from a nonrecurring, nonoperational item from the settlement of litigation, interest income of $4.8 million relating to a favorable settlement with the Internal Revenue Service (“IRS”), and miscellaneous items of $0.7 million.
Restricted shares are forfeited if officers and employees terminate prior to the expiration of restrictions. We record forfeitures of restricted stock as treasury share repurchases and any compensation cost previously recognized with respect to unvested stock awards is reversed in the period of forfeiture. This accounting treatment results in compensation expense being recorded in a manner consistent with that required under SFAS No. 123, and, therefore, pro forma net income and earnings per share amounts for the Restricted Share Plan would be unchanged from those reported in the consolidated financial statements.
Had compensation cost for the Company’s stock-based compensation plans been determined based on the estimated fair-value-based method for all awards, net income would have been reduced by $4.9 million, $5.5 million, and $4.7 million for the years ended 2005, 2004, and 2003, respectively. The pro forma net income and earnings per share amounts follow:
Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if options or other contracts to issue common stock were exercised or converted into common stock.
On September 19, 2005, FASB issued Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts. SOP 05-1 provides guidance on accounting for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. The SOP defines an internal replacement as a modification in product benefits, features, rights, or coverage that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. The effective date of the implementation guidance is January 1, 2007. The Company is currently assessing the effect of implementing this guidance.
In March 2005, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, Share-Based Payment. SAB No. 107 summarizes the views of the SEC staff regarding the interaction between SFAS No. 123 (Revised 2004), Share-Based Payment (“SFAS No. 123R”) and certain SEC rules and regulations, and is intended to assist in the initial implementation of SFAS No. 123R, which for the Company is required beginning in the first quarter of 2006. As a result of SFAS No. 123R, the Company will be required to recognize the cost of its stock options as an expense in the consolidated statement of operations. Management believes that the effect of adopting SFAS No. 123R will be material to the Company’s consolidated results of operations. Had the Company adopted SFAS No. 123R in prior periods, the impact on net income and earnings per share would have been similar to the pro forma net income and earnings per share in accordance with SFAS No. 123 as disclosed above.
Expected maturities of the Company’s investments may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
The following table summarizes the Company’s gross unrealized losses and estimated fair values on investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.
The Company held 448 investment positions with unrealized losses as of December 31, 2005. Of the 448 investment positions, 247 positions were in equity securities, which have been held for less than one year, as the Company typically holds equity securities for 90 days or less.
The remaining 201 investment positions were fixed maturity securities and all are investment grade, with the exception of the investment in Ford Motor Credit Company. The Company’s $2.5 million investment in Ford Motor Company, which matured on February 1, 2006, had an unrealized loss of $6 thousand at December 31, 2005, and was fully collected in February 2006, thus eliminating the previous unrealized loss. Unrealized losses in fixed maturity investments primarily arose from rising interest rates in the current year. None of the unrealized losses are considered credit related, except for the investment position in Ford Motor Company. The unrealized losses do not appear to represent other-than-temporary impairments based on the Company’s impairment accounting policy summarized in Note 2 of the Notes to Consolidated Financial Statements. Of the 201 fixed maturity securities in an unrealized loss position, the Company had 94 investments that were in an unrealized loss position for 12 months or more. However, the unrealized loss for such investments, which are all investment grade, comprised less than 4% of amortized cost.
Cash and securities with carrying values of $7.0 million and $7.1 million as of December 31, 2005 and 2004 were on deposit with state regulatory authorities in accordance with the related statutory insurance requirements.
The significant components of deferred income tax expense (benefit) attributable to income from continuing operations are as follows:
In a December 21, 2000, court ruling, Ceridian Corporation v. Franchise Tax Board, a California 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”) took the position that the discriminatory sections of the statute are not severable and the entire statute is invalid. As a result, the FTB began disallowing dividends-received deductions for all insurance holding companies, regardless of domicile, for open tax years ending on or after December 1, 1997. Although the FTB made no formal assessment, the Company anticipated a retroactive disallowance that would result in additional tax assessments and recorded a provision for this contingency in a prior year.
In the first quarter of 2005, the Company filed amended California tax returns and paid the State of California approximately $6.8 million to cover all issues outstanding with the FTB, including certain matters paid under protest as to which the Company reserved all its rights to file for refunds and appeal any adverse rulings by the FTB to the California State Board of Equalization (“SBE”). In September 2005, the FTB completed its audit and denied the Company’s refund claims. In December 2005, the Company filed an appeal with the SBE. The Company is unable to assess the likelihood that any refunds ultimately will be received from the State of California.
Depreciation expense for leased property under capital lease was $12.8 million, $12.4 million, and $12.4 million for the years 2005, 2004, and 2003.
During June 2004, the Company entered into a lease for a service center in Lewisville, Texas, which was set to expire in 2016. The operating lease provisions included a rent holiday through June 2005 and a $2.5 million tenant improvement allowance. On September 30, 2005, the Company purchased the land and building that house its 136 thousand square foot service center in Texas per the purchase option in our lease. As of September 29, 2005, the accrued rent obligation and tenant improvement allowance totaled $1.4 million and $2.5 million, respectively. These liabilities were offset against the facility cash purchase price of $17.6 million to arrive at a net cost of $13.7 million. The net cost consists of land, building and building equipment of $2.5 million, $9.7 million, and $1.5 million, respectively. The building and its equipment have been assigned useful lives of 39.5 years and 7 years, respectively, and will be depreciated on a straight-line basis over their respective useful lives.
The methods used to determine such estimates and to establish the resulting reserves are continually reviewed and updated. Any resulting adjustments are reflected in current operating income. It is management’s belief that the reserve for losses and LAE are adequate to cover unpaid losses and LAE as of December 31, 2005. While the Company performs quarterly reviews of the adequacy of established unpaid losses and LAE reserves, there can be no assurance that ultimate amounts will not differ materially, higher or lower, from the recorded liability for unpaid losses and LAE as of December 31, 2005. In the future, if the unpaid losses and LAE develop redundancies or deficiencies, such redundancy or deficiency would have a positive or adverse impact, respectively, on future results of operations.
The provision for losses and LAE recorded in 2003 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 adverse development in personal auto loss severity.
The Company no longer has any homeowners policies in force. The Company ceased writing earthquake coverage in 1994, but has remaining loss reserves from the 1994 Northridge earthquake.
The primary purpose of both of the senior notes and capital leases enumerated above was to increase the statutory surplus of the Company’s largest insurance subsidiary. The carrying values of our debt were $128.0 million and $138.3 million and the estimated fair values were $127.9 million and $140.9 million as of December 31, 2005 and 2004, respectively. The obligation under auto leases relates to the Company’s lease agreement with GE Fleet Services.
On April 6, 2004, pursuant to a registration rights agreement executed in connection with the offering, the Company filed a registration statement with the SEC enabling holders to exchange the private offering notes for publicly registered notes. On July 8, 2004, the Company completed an exchange offer in which all of the private offering notes were exchanged for publicly registered notes having the same terms.
Aggregate principal payments on debt outstanding at December 31, 2005 are $13.5 million for 2006, $14.1 million for 2007, $0.3 million for 2008, $0.1 million for 2009, and $100.0 million thereafter.
The Company has a catastrophe reinsurance agreement for the comprehensive coverage portion of its auto physical damage lines with AIG subsidiaries Transatlantic Reinsurance Company (20%) and National Union Reinsurance Company of Pittsburgh, PA (60%), which reinsures any covered events up to $45.0 million in excess of $20.0 million. The remaining 20% is reinsured by an unrelated entity. The agreement became effective January 1, 2004, and was renewed on January 1, 2005, and 2006 (see Note 20 of the Notes to Consolidated Financial Statements for additional information). In 2003, covered events under the catastrophe reinsurance agreement were up to $30.0 million in excess of $15.0 million and the reinsures were AIG subsidiaries Transatlantic Reinsurance Company (16.7%) and National Union Insurance Company of Pittsburgh, PA (60%). The remaining 23.3% was reinsured by an unrelated entity.
The Company has both funded and unfunded non-contributory defined benefit pension plans, which together cover essentially all employees who have completed at least one year of service. For certain key employees designated by the Board of Directors, the Company sponsors an unfunded non-qualified supplemental executive retirement plan. The supplemental plan benefits are based on years of service and compensation during the three highest of the last ten years of employment prior to retirement and are reduced by the benefit payable from the pension plan and 50% of the social security benefit. For other eligible employees, the pension benefits are based on employees’ compensation during all years of service. The Company’s funding policy is to make annual contributions as required by applicable regulations. In 2005, 2004, and 2003, the Company made additional contributions to fully fund the accumulated benefit obligation of its qualified plan.
The Company contributed $2.7 million and $7.0 million to its pension plans in 2004 and 2003, respectively. After consideration of currently available information, the Company contributed $9.0 million to its qualified defined benefit pension plan in 2005. Based on current assumptions, the Company does not expect to be required to contribute to its qualified plan in 2006. However, the amount and timing of future contributions to the Company’s qualified defined benefit pension plan depends on a number of unpredictable factors including statutory funding requirements, the market performance of the plan’s assets and future changes in interest rates that affect the actuarial measurement of the plan’s obligations. Contributions to our non-qualified defined benefit pension plan generally are limited to amounts needed to make benefit payments to retirees, which are expected to total approximately $0.9 million in 2006.
Benefit payments for the Company’s defined benefit pension plans, which reflect expected future service, are expected to be paid as follows:
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 leaseback transaction has been accounted for as a capital lease. In November 2005, the Company subleased a portion of the seventh floor of the Woodland Hills Headquarters building and recorded an impairment charge as discussed in Note 2.
In the normal course of business, the Company is named as a defendant in lawsuits related to claims and insurance policy issues, both on individual policy files and by class actions seeking to attack the Company’s business practices. Many suits seek unspecified extra-contractual and punitive damages as well as contractual damages under the Company’s insurance policies in excess of the Company’s estimates of its obligations under such policies. The Company cannot estimate the amount or range of loss that could result from an unfavorable outcome on these suits and it denies liability for any such alleged damages. The Company has not established reserves for potential extra-contractual or punitive damages, or for contractual damages in excess of estimates the Company believes are correct and reasonable under its insurance policies. Nevertheless, extra-contractual and punitive damages, if assessed against the Company, could be material in an individual case or in the aggregate. The Company may choose to settle litigated cases for amounts in excess of its own estimate of contractual damages to avoid the expense and risk of litigation. Other than possibly for the contingencies discussed below and in Note 16 of the Notes to Consolidated Financial Statements, the Company does not believe the ultimate outcome of these matters will be material to its results of operations, financial condition or cash flows. The Company denies liability and has not established a reserve for the matters discussed below. A range of potential losses in the event of a negative outcome is discussed where known.
Includes total amounts due to the Company under current sublease agreement of approximately $1.1 million.
Cecelia Encarnacion, individually and as the Guardian Ad Litem for Nubia Cecelia Gonzalez, a Minor, Hilda Cecelia Gonzalez, a Minor, and Ramon Aguilera v. 20th Century Insurance was filed on July 3, 1997, in Los Angeles Superior Court. Plaintiffs allege bad faith, emotional distress, and estoppel involving the Company’s (the Company was formerly named 20th Century Insurance) handling of a 1994 homeowner’s claim. On March 1, 1994, Ramon Aguilera, a homeowner policyholder, shot and killed Mr. Gonzalez (the minor children’s father) and was later sued by Ms. Encarnacion for wrongful death. On August 30, 1996, judgment was entered against Ramon Aguilera for $5.6 million. The Company paid for Aguilera’s defense costs through the civil trial; however, the homeowner’s policy did not provide indemnity coverage for the incident, and the Company refused to pay the judgment. After the trial, Aguilera assigned a portion of his action against the Company to Encarnacion and the minor children. Aguilera and the Encarnacion family then sued the Company alleging that the Company had promised to pay its bodily injury policy limit if Aguilera pled guilty to involuntary manslaughter. In August 2003, the trial court held a bench trial on the limited issues of promissory and equitable estoppel, and policy forfeiture. On September 26, 2003, the trial court issued a ruling that the Company cannot invoke any policy exclusions as a defense to coverage. On May 14, 2004, the court granted the Encarnacion plaintiffs’ motion for summary adjudication, ordering that the Company must pay the full amount of the underlying judgment of $5.6 million, plus interest, for a total of $10.5 million. The Company disagrees with this ruling as it appears inconsistent with the court’s simultaneous ruling denying the Company’s motion for summary judgment on grounds that there are triable issues of material fact as to whether plaintiffs are precluded from recovering damages as a consequence of Aguilera’s inequitable conduct. The Company also believes that the court’s decision was not supported by the evidence in the case, demonstrating that no promise to settle was ever made. The Company has appealed the judgment as to the Encarnacions. The trial as to Aguilera concluded on December 9, 2005, on his claims for bad faith, emotional distress, punitive damages and attorney fees. A jury found he sustained no damages as to these claims. The Company’s exposure in this case includes the aforementioned $10.5 million judgment plus post-judgment interest, which currently totals $1.5 million.
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 California class action certification, injunctive relief, and unspecified actual and punitive damages. The complaint contends that after insureds receive medical treatment, the Company used a medical-review program to adjust expenses to reasonable and necessary amounts for a given geographic area and the adjusted amount is “predetermined” and “biased.” This case is consolidated with similar actions against other insurers for discovery and pre-trial motions. Depositions have recently been taken and the Company intends to vigorously defend the suit. This matter is in the discovery stage of litigation and no reasonable estimate of potential losses in the event of a negative outcome can be made at this time.
A summary of securities issuable and issued for the Company’s stock option plans and the Restricted Shares Plan at December 31, 2005, follows:
The following table summarizes exercisable and non-vested options as of December for the years presented.
A summary of activity under the Restricted Shares Plan from 2003 through 2005 follows:
Amounts related to ceded reinsurance, such as prepaid reinsurance premiums and reinsurance recoverables, are shown gross, rather than netted against unearned premium reserves and LAE reserves, respectively, as required by SAP.
The differing treatment of income and expense items results in a corresponding difference in federal income tax expense. Both current and deferred taxes are recognized in the income statement for GAAP, while deferred taxes are posted directly to surplus for SAP.
The Company has estimated the risk-based capital requirements of each of its insurance subsidiaries as of December 31, 2005 in accordance with the guidelines issued by the National Association of Insurance Commissioners. Policyholders’ surplus for each of the Company’s insurance subsidiaries exceeded the highest level of minimum required capital.
The Company is also regulated by the provisions of the California Insurance Holding Company System Regulatory Act (the “Holding Company Act”). Many transactions that are defined to be of an “extraordinary” nature may not be effected without the prior approval of the California Department of Insurance (“CDI”). In addition, there are limits on the insurance subsidiaries’ dividend paying capacity. In 2006, the Company estimates that one of its insurance subsidiaries has capacity to pay approximately $113.0 million in dividends to its parent without prior approval of the CDI.
On June 15, 2004 the CDI finalized its examination reports on the statutory financial statements for the Company’s two California-domiciled insurance subsidiaries for the three-year period ended December 31, 2002. The reports did not contain any findings or adjustments. The CDI and Texas Department of Insurance will examine the three-year period ended December 31, 2005 during 2006.
The Company’s “Personal Auto Lines” reportable segment primarily markets and underwrites personal auto, motorcycle and personal umbrella insurance. The Company’s “Homeowner and Earthquake Lines in Runoff” reportable segment, which is in runoff, manages the wind-down of the Company’s homeowner and earthquake programs. The Company has not written any earthquake coverage since 1994 and ceased writing homeowner policies in February 2002.
Insurers offering homeowner insurance in California are required to participate in the California FAIR Plan (“FAIR Plan”). The FAIR Plan is a state administered pool of difficult to insure homeowners exposures. Each participating insurer is allocated a percentage of the total premiums written and losses and LAE incurred by the pool according to its share of total homeowner direct premiums written in the state. Participation in the current year FAIR Plan operations is based on the pool from two years prior. Since the Company ceased writing homeowners business in 2002, the Company no longer receives assignments for plan years beyond 2004, but continues to participate in prior plan year activity, which is in runoff.
Personal Auto Lines. Personal automobile insurance is our primary line of business. The growth in segment profit for the personal auto lines in 2005, 2004, and 2003 was due to an increase in the number of insured vehicles, a rate increase in 2003 and favorable claim frequency.
In addition to the above, the Company consistently held $6.2 million in other Impact related investments as of December 31, 2005 and 2004. Total Impact related investment income was $1.1 million, $0.8 million, and $0.7 million for the years ended 2005, 2004, and 2003, respectively.
Reinsurance agreements - The Company’s catastrophe reinsurance agreement for its auto lines is provided by three participating entities, two of which are AIG subsidiaries. Together they reinsure any covered event up to $45.0 million in excess of $20.0 million effective January 1, 2004 (up to $30.0 million in excess of $15.0 million in 2003). This coverage was renewed effective January 1, 2005 and 2006 (see Note of the Notes to Consolidated Financial Statements).
Total premiums ceded to AIG subsidiaries were $1.0 million, $1.1 million, and $1.2 million for the years ended December 31, 2005, 2004, and 2003, respectively. Total reinsurance recoverables, net of payables, from AIG subsidiaries were $0.6 million and $1.5 million as of December 31, 2005 and 2004, respectively.
Insurance expense attributable to AIG corporate insurance coverages was $2.9 million, $3.5 million, and $1.3 million for 2005, 2004, and 2003, respectively.
Investment management and investment accounting - In October 2003, as a result of a competitive bidding process, we entered into an agreement with an AIG subsidiary to provide investment management and investment accounting services to the Company. The fees are determined as a percentage of the average invested asset balance, and are classified with net investment income. This agreement was approved by the CDI. Investment management and accounting expense was $0.9 million, $0.9 million, and $0.1 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Software and data processing - Through December 31, 2004, the Company utilized certain third party software and data processing monitoring tools under an agreement negotiated by AIG. Since January 1, 2005, the Company has negotiated its own contracts, and no longer incurs any software or data processing costs with AIG subsidiaries. Software and data processing expense was $0.3 million and $0.3 million in 2004 and 2003, respectively. There was no expense in 2005.