We own two buildings (a five-story office building and an eight-story office building in which part of the first floor is leased to tenants) and related parking facilities in Cedar Rapids, Iowa, that we use as our home office. The two buildings are connected by a skywalk. We also lease additional adjacent office space in Cedar Rapids.
The selected financial data herein has been derived from the financial statements of United Fire and its subsidiaries. The data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the “Consolidated Financial Statements and Related Notes.”
Industry-wide, property and casualty net premiums written increased by approximately $38.6 billion or 10.2 percent in 2003, when compared with 2002, as estimated by A.M. Best Company, a leading insurance industry rating agency and data provider. Much of the growth in net premiums written was the result of a hard market-a market characterized by increased insurance premium rates and restrictive insurance coverage. The hard market, which began in the later part of 2001, resulted from a number of factors, including the terrorist events of September 11, 2001, the occurrence of other large catastrophes, declining interest rates, poor underwriting performance and capital losses for several years prior to 2001. Industry-wide underwriting losses from 1979 through 2000 were created by an under-pricing of many property and casualty insurance products. In 2001, as insurance profits and capital deteriorated further, it became necessary for the property and casualty insurance industry to re-price many of its products. The industry growth in net premiums written drove the growth in net premiums earned, which increased to $396.5 million in 2003, as estimated by A.M. Best Company, or 12 percent over 2002.
Improved underwriting results, modest increases in investment income, and some recovery in the equity markets contributed to an increase in the industry’s estimated statutory surplus of $330.8 billion, an increase over 2002 of 13.6 percent. These surplus results are presented on a statutory basis, as that is what is provided by A.M. Best Company. In later sections of this report, we discuss our surplus, calculated in accordance with accounting principles generally accepted in the United States.
During 2003, the depressed interest rate environment affected both the life insurance industry and the property and casualty insurance industry. While the lower returns led to very modest increases in investment income, life insurers’ unrealized gains grew. A.M. Best estimates that life insurers’ statutory surplus grew in 2003 by $28.5 billion, or 14.6 percent, over 2002, due to the growth in unrealized appreciation, a decrease between 2002 and 2003 in recorded investment impairments, improvement in net operating income and a decrease in stockholder dividends.
In addition to operating and investment challenges, we and other public companies were faced with new rules and regulations relating to corporate governance during 2003. The Sarbanes-Oxley Act of 2002 and the strengthened stock exchange listing requirements have impacted every public company in the United States, to some degree. As part of our efforts to meet the stringent internal control requirements, during 2003 we underwent a comprehensive documentation and review process of all of our internal controls and established a committee of executives charged with the task of ongoing internal control compliance and review.
In complying with the new corporate governance issues, many public companies have experienced an increase in operating costs. Financial Executives International, a professional organization serving chief financial officers, released the results of a survey on February 10, 2004 concerning the costs of Sarbanes-Oxley compliance. From the responses of 321 companies, Financial Executives International has estimated that the average cost-of-compliance per company was just under $2 million for first-year costs, with approximately 38 percent of the cost related to increased audit fees. The companies who responded were of varying sizes; 20 percent of the respondents were from companies with more than $5 billion in annual revenue, compared to 3.3 percent from companies with less than $25 million in annual revenue.
We estimate that we spent approximately $1.0 million in 2003 complying with the new corporate governance rules. We anticipate that we will have ongoing expenses associated with the activities that we must engage in to comply with the Sarbanes-Oxley Act of 2002, new SEC rules and new NASDAQ corporate governance rules.
Total revenues increased by $62.4 million to $573.3 million in 2003, when compared with 2002. Net premiums earned increased by $47.3 million to $464.6 million, an increase of 11 percent. In 2003, we recorded other-than-temporary investment impairments of $6.4 million in 2003, compared with $13.3 million in 2002. Refer to the section titled “Critical Accounting Policies” for discussion of our investment impairment policy.
The property and casualty insurance segment reported pre-tax income of $66.9 million in 2003, compared with $20.9 million in 2002. The growth in premiums earned and the decrease in losses and settlement expenses drove this increase in pre-tax income and led to improvement in our combined ratios calculated on the basis of statutory accounting principles and the basis of accounting principles generally accepted in the United States.
In 2003, premiums earned increased to $435.0 million, as compared with $389.4 million in 2002. We increased our premium rates throughout 2002 and 2003 in several lines of business and in several states, while our policy count decreased between 2002 and 2003. In 2003, we continued to de-emphasize our personal lines of business, which resulted in a reduction in personal lines premiums earned. We intend to continue concentrating on our commercial lines of business, which is where we have historically been most profitable. In 2003, premiums earned from our commercial lines of business accounted for 85 percent of net premiums earned, compared with 82 percent in 2002.
We also assume insurance business from other insurance companies. Assumed premiums written remained relatively flat between the past two years, with $12.9 million recorded in 2003 compared with $10.8 million recorded in 2002.
Losses and settlement expenses incurred in 2002 totaled $280.0 million, reflecting losses and settlement expenses of $291.1 million resulting from losses that occurred in 2002 and loss redundancy of $11.1 million on losses that occurred prior to 2002. As in 2003, our overall loss redundancy in a majority of our lines of business more than offset a loss deficiency in our other liability line of business. The deficiency recorded in 2002 in the other liability line of business of $12.8 million resulted from a number of large losses reported to us in 2002 for accident years 1997 through 2001.
Our reserving process, which contributed to favorable development of losses in 2002 and 2003, is presented under “Critical Accounting Policies” later in this discussion. Our workers’ compensation and other liability lines of business are considered long-tail lines of business due to the length of time that may elapse before claims are finally settled. Therefore, we may not know our final development on individual claims for many years. Our estimates for losses, particularly in these long-tail lines, are dependent upon many factors, such as our estimate of the severity of the claim, the legal environment, inflation and medical costs. We consider all of these factors, as well as others, in estimating our loss reserves. As conditions or trends with respect to these factors change, we change our estimate for loss reserves accordingly.
learn during the course of a claim that bodily injuries are less severe than originally believed or that damage to a structure is merely cosmetic instead of structural, as originally reported.
We define catastrophes to include events that cause $25.0 million or more in industry-wide direct insured losses to property and that affect a significant number of insureds and insurers. This is the same definition utilized by the Insurance Services Office, a supplier of property and casualty statistical data. We also include in our catastrophe totals those other events we believe are, or will be, material to our operations, either in amount or in number of claims made. We include these amounts in our catastrophe totals due to the possibility that a portion of these incurred losses may be recoverable under our catastrophe reinsurance agreements. These amounts totaled $4.0 million and $4.3 million for the years ended December 31, 2003 and 2002, respectively.
The net loss ratio in our commercial lines of business improved from 67.0 percent in 2002 to 59.6 percent in 2003. Pricing initiatives contributed to the growth in commercial lines premiums earned, which increased from $318.2 million in 2002 to $369.1 million in 2003. We continued in 2003 to obtain premium rate increases in the double digits in many of our commercial lines and in many of the states where we write commercial accounts. The most significant improvement was in fire and allied lines, where losses and expenses incurred decreased between 2002 and 2003 by $12.7 million. The loss ratio in this line improved from 62.3 percent in 2002 to 41.6 percent in 2003. We attribute this improvement to several factors. In addition to pricing initiatives, we believe that results in the commercial property lines of business were improved because we increased deductibles and improved our insurance-to-value on many of our commercial accounts. We have noted a leveling of premium rates in the property commercial lines, starting in the later part of 2003.
Commercial automobile improved slightly from a loss ratio of 68.8 percent in 2002 to a loss ratio of 65.4 percent in 2003. Premiums earned grew by 15 percent, or $11.5 million, with rate increases averaging 8 percent during 2003.
We experienced unfavorable results in our workers’ compensation line of business in 2003 and 2002. The challenges facing workers’ compensation insurance providers include some state regulatory climates that makes it difficult to obtain rate increases, inflationary medical costs and the slow economic recovery in the United States. We consider our workers’ compensation business to be a companion product; we do not write stand-alone workers’ compensation policies. Our workers’ compensation insurance covers primarily small to mid-size accounts. The loss ratio in this line deteriorated to 104.6 percent in 2003, compared with 101.4 percent in 2002. While frequency of losses has decreased, a few large losses reported to us in 2003 contributed to the continued unfavorable experience in the workers’ compensation line of business. Our experience has shown that it takes longer to obtain approval from the appropriate state insurance departments to charge higher rates for our workers’ compensation lines of business than for other lines of business that we write. The underwriting experience in this line should begin to see some pricing relief in the near future, as we receive approval for rate increases. We have adopted additional measures to improve our results in the workers’ compensation line, such as a reduction in premium volume in states where other workers’ compensation markets are available to our insureds, utilizing a tiered system of pricing and reducing or eliminating the policyholder dividends that we pay on workers’ compensation policies.
Our surety products guarantee the performance and payment of our bondholders. Our contract bonds protect owners from failure to perform on the part of our principals. Also, material suppliers and subcontractors are protected from nonpayment by our contractors. Our fidelity products generally provide coverage against loss of money or other property due to the fraud or dishonesty of employees. In 2003, we began the discontinuation of fidelity bonds, as the majority of this type of coverage has left the surety industry and is provided by the insurance industry. Our fidelity book of business had been reduced to a level where we could no longer afford to implement needed automation updates, keep trained staff and maintain current policy forms.
In 2003, our loss ratio for our fidelity and surety business was 19.8 percent, up from 8.5 percent in 2002. Premiums earned grew by 10 percent, from $21.9 million to $24.0 million. Our premium growth came mainly from our surety line; partly from existing accounts and partly from new accounts. Our growth in 2003 was spread between our Midwestern and Southern states. We do not issue bonds to companies operating in the energy trading sector.
Our underwriting expense ratio on an accounting principles generally accepted in the United States basis improved to 29.1 percent, compared with 29.9 percent in 2002. In 2003, we implemented cost savings measures that had the effect of lowering the ratio. However, offsetting these improvements were increases in commissions that we paid or will pay to our agents. In 2003 we incurred $18.7 million in contingent commissions, compared with $13.1 million incurred in 2002. Contingent commissions reward our agents for placing profitable business with us. Also offsetting cost savings measures were increases in legal and professional fees related to compliance with new corporate governance matters.
Pre-tax net income recorded by the life insurance segment for 2003 was $13.0 million compared with $5.2 million for 2002. The change in net income was attributable primarily to a decrease in net realized investment losses and growth in net investment income earned. The decrease in net realized investment losses was primarily due to investment write-downs of $5.5 million in 2003 versus investment write-downs of $11.8 million in 2002. Net investment income earned in 2003 increased by $3.4 million, or 4.0 percent, to $81.2 million.
The decrease in annuities written was due primarily to the low interest rates prevalent in the United States in 2003. Low interest rates lead to fewer dollars being invested in annuities and to difficulty finding suitable investment vehicles, in terms of duration and quality, to fit our asset-liability matching needs. During the first part of 2003, we accumulated significant amounts of cash. While this accumulation improved our liquidity, it also resulted in negative spreads on new business. From July 1, 2003 through December 31, 2003, we temporarily suspended the sale of all new fixed annuity business. Beginning in 2004, we believe that suitable investment vehicles are more readily available, leading to more appropriate opportunities to invest our cash. Effective January 1, 2004, we resumed our sale of new fixed annuity business.
Temporary unrealized losses do not impact net income and earnings per common share but do reduce comprehensive net income, stockholders’ equity and book value. Unrealized losses subsequently identified as other-than-temporary impairments are recorded as a component of net realized losses. We recorded net realized losses on securities of $1.7 million in 2003, compared with net realized losses of $13.8 million in 2002. The net realized loss that we recognized in 2003 and 2002 included other-than-temporary impairments of $6.4 million and $13.3 million, respectively. See “Critical Accounting Policies” later in this discussion for a presentation of our impairment policy. We regularly review the other-than-temporarily impaired securities for appropriate valuation. Based on the existing status and condition of these securities, we do not currently anticipate additional losses, but continued credit deterioration of some securities is possible, which may result in further write-downs.
At December 31, 2003, we had $23.5 million of net operating loss carryforwards that we acquired in the purchase of American Indemnity Financial Corporation in August 1999. The utilization of these net operating losses is limited by the Internal Revenue Code. The net operating losses began to expire prior to our purchase of American Indemnity Financial Corporation and will continue to expire in various future years through 2018. Our property and casualty insurance segment must generate sufficient taxable income to be able to use the deferred tax asset associated with the net operating loss carryforwards before their expiration.
Due to uncertainty of the realizable value of the deferred tax asset, we recorded a valuation allowance, which totaled $7.8 million at December 31, 2003. The valuation allowance recorded on our deferred tax asset decreased by $.5 million from 2002, due primarily to the utilization of net operating loss carryforwards. In the future, if we can use the net operating losses acquired in the purchase of American Indemnity Financial Corporation, the related reduction in the valuation allowance will be recorded as a reduction to our intangible asset recorded in conjunction with the purchase of American Indemnity Financial Corporation until the intangible asset has been eliminated, at which time the reduction in the allowance will reduce federal income tax expense.
At December 31, 2003, our pension plan assets exceeded the accumulated benefit obligation, and therefore no minimum pension liability adjustment was necessary. At December 31, 2002, we had recorded a minimum pension liability of $3.5 million (before tax), which represented the amount that we recognized to cover a $4.2 million deficit occurring as a result of our fair value of plan assets being less than our accumulated benefit obligation. The amount of this deficit was first offset by prepaid pension costs of $.7 million.
Net income (net operating income plus after-tax net realized gains and losses on securities) was $20.8 million, or $1.76 per share after providing for the dividend on the convertible preferred stock issued in 2002, compared with $24.1 million or $2.40 per share in 2001. Net income was reduced by pre-tax net realized investment losses of $13.8 million in 2002, compared with pre-tax net realized investment losses of $.2 million in 2001. The increase in net realized investment losses in 2002 was due to an increase in write-downs resulting from other-than-temporary impairment losses. In 2002, our largest investment write-down was WorldCom Inc., which we wrote down in the second quarter, resulting in pre-tax charges of $5.5 million. Throughout 2002, eight other securities were written down, which resulted in an additional pre-tax charge to net income of $7.8 million. We also incurred $.5 million of net realized losses on securities that we sold during 2002.
Net premiums earned increased by $45.3 million, or 12.2 percent, to $417.3 million, primarily as the result of premium rate increases in the property and casualty segment. During the 1990s and into 2000, the property and casualty insurance and reinsurance industry was characterized by excess capacity, which resulted in highly competitive market conditions as evidenced by declining premium rates. Beginning in 2000, capacity in the property and casualty market began to contract as companies withdrew from the business or ceased operations. In response to market conditions, many insurance and reinsurance companies, including our companies, began to increase prices. We continued to request approval for premium rate increases in the first quarter of 2003. We did not know when the property and casualty market would turn, leading to a leveling or decline of insurance pricing. It was our intention to continue to seek approval for premium rates that were adequate.
Losses and settlement expenses increased by $25.7 million, or 9.5 percent, to $296.0 million in 2002, due primarily to an increase in the severity of non-catastrophe losses. Although the number of non-catastrophe claims decreased by 5,723, or 12.4 percent, in 2002, the average non-catastrophe direct loss and loss adjustment expense per claim was $6,386 in 2002, compared with $4,829 in 2001. During 2002, we experienced a decrease in estimated losses for property and casualty claims that occurred in prior years, as described in the “Property and Casualty Insurance Segment” discussion on the following page.
In 2001, we incurred losses of $6.9 million related to the events of September 11, 2001. During 2002, we incurred an additional $.4 million for this loss. We had no reserves outstanding as of December 31, 2002 for the September 11 events. We consider the September 11 attacks on the World Trade Center to be one event. However, if the judicial system determines that these attacks should be considered multiple events, we estimate, based upon information currently available to us, that our pre-tax losses would increase by approximately $3.0 million.
Ceded premiums written increased from $25.2 million in 2001 to $35.3 million in 2002. To control costs resulting from higher reinsurance rates in 2002, we increased our retention levels. For our property and casualty lines of business, our retention for 2002 was $1.3 million, which means we had reinsurance for any single claim over $1.3 million. Our loss retention was $1.0 million for losses that pertained to years 1995 through 2001 and $.8 million or less for losses that pertained to years prior to 1995. We also increased our loss retention levels for the total direct loss we may incur from a single catastrophe. In 2002, we increased the total direct loss we could incur from a single catastrophe, after reinsurance, to $7.5 million plus 5 percent of losses in excess of $7.5 million. From 1993 to 2001, the limit was $5.0 million.
Beginning January 1, 2003, we increased our retention for any single claim to $1.5 million, but we did not change our catastrophe retention of $7.5 million.
In 2002, our net premiums earned grew to $389.4 million from $346.6 million in 2001. This growth was driven by the increase in our premium rates and was concentrated in our commercial liability lines, where rate increases were as high as 25 percent. Because premiums are recorded in earnings over the life of a policy, we expected the growth in net premiums written to result in continued growth in this category of net premiums earned into 2003.
Losses and settlement expenses incurred in 2002 totaled $280.0 million, reflecting losses and settlement expenses of $291.1 million resulting from losses that occurred in 2002 and favorable development of $11.1 million on losses that occurred prior to 2002. The favorable development resulted from a re-estimation of loss reserves established at December 31, 2001 in each of our lines of business except other liability. The deficiency in the other liability line of business of $12.8 million resulted from a number of large other liability losses reported to us in 2002 for accident years 1997 through 2001. The deficiency in the other liability line of business was more than offset by the redundancies in our other lines of business.
In 2002, our favorable development was attributable to savings of approximately $1.9 million from workers’ compensation medical bill reviews, compared with approximately $1.3 million in 2001; savings of approximately $2.8 million from the use of alternative dispute resolution in 2002, compared with approximately $3.9 million in 2001; recoupment of approximately $3.4 million from salvage and subrogation in 2002, compared with approximately $5.6 million in 2001 and savings of approximately $3.0 million in 2002 attributable to both the payment of claims for less than the amounts reserved and from reductions in loss reserves due to additional information on individual claims that we received after the reserves for those claims had been established, compared with approximately $36.2 million in 2001. The additional favorable information we consider is unique to each claim. Such information includes facts that reveal we have no coverage obligation for a particular claim, changes in applicable laws that reduce our liability or coverage exposure on a particular claim, facts that implicate other parties as being liable on a particular claim and favorable court rulings that decrease the likelihood that we would be liable for a particular claim. Additional information relating to severity also is unique to each claim. For example, we may learn during the course of a claim that bodily injuries are less severe than originally believed or that damage to a structure is merely cosmetic instead of structural, as originally reported.
For 2001, the development of our loss reserves in many of the categories discussed above was affected by adjustments in reserves made with respect to the book of business acquired in our purchase of American Indemnity Financial Corporation in August 1999. Following this purchase, we began a detailed review of many of the case reserves established for this business. This review was undertaken both as part of our assimilation of the case reserves into our own reserves and as a result of our belief upon completing an initial overview of reserves that many claims had insufficient reserves. We had some of our most experienced claims personnel conduct this initial review. The reserve changes made were based on the judgment of claims professionals experienced in evaluating bodily injury and property damage claims and knowledgeable about the legal environment, including trends in the geographical area involved. We also factored in our actual experience with the American Indemnity book of business as we began to settle the losses and review additional claims not a part of the initial reserve review. As a result, we increased reserves the last quarter of 1999 in this book of business by approximately $10.0 million. Through December 31, 2001, we had experienced redundancies of approximately $3.9 million relating to this reserve increase. We believe most of this redundancy had occurred due to the application of our aggressive claims handling and settlement philosophy on the assimilated claims. As of December 31, 2002, we believe the American Indemnity companies’ losses are reserved in accordance with our loss reserving philosophy, and that redundancies experienced in 2002 of $1.3 million on these claims are due to the savings factors described in the preceding paragraph.
As a measure of our underwriting profitability, we calculate a “combined ratio,” which is the sum of two ratios, the loss ratio and the expense ratio. We calculate the combined ratio on both an accounting principles generally accepted in the United States basis and a statutory basis, which is a more conservative basis of accounting and one which is required in the reports that we file with the state insurance departments in the states in which we are domiciled. We utilize the statutory basis of accounting for comparative purposes when we compare our results with those of other property and casualty insurance companies. On a statutory basis of accounting, the loss ratio is calculated by dividing net losses and net loss adjustment expenses incurred by net premiums earned, because losses occur over the life of a policy. On a statutory basis of accounting, the expense ratio is stated as a percentage of premiums written rather than premiums earned, because most underwriting expenses are paid when policies are written and are not amortized over the policy period. The statutory underwriting profit margin is the extent to which the combined ratio is less than 100 percent. In 2002, our statutory combined ratio was 101.9 percent, which compares favorably with the industry statutory combined ratio of 107.4 percent, as reported by A.M. Best Company, a leading insurance industry rating agency and data provider. Our statutory combined ratio was 104.7 percent in 2001. Without the effect of catastrophes, our statutory combined ratio was 97.3 percent in 2002 and 97.0 percent in 2001.
Under accounting principles generally accepted in the United States, the loss ratio is computed in the same manner as under the statutory basis of accounting, but the expense ratio is determined by matching underwriting expenses to the period when net premiums were earned, rather than by when net premiums were written. In 2002, our combined ratio, calculated on the basis of accounting principles generally accepted in the United States, was 101.8 percent, compared with 104.6 percent in 2001. Without the effect of catastrophes, our combined ratio calculated according to accounting principles generally accepted in the United States was 97.2 percent in 2002 and 96.8 percent in 2001.
Within the commercial lines of business, our best performing line continued to be fidelity and surety, with a loss ratio of 8.5 percent in 2002, and 17.3 percent in 2001. Our surety products provide protection against loss due to non-performance, such as a construction bond that protects owners against nonpayment by general contractors of material suppliers and subcontractors. Our fidelity products generally provide insurance against loss of money or other property due to the fraud or dishonesty of employees. Despite poor experience in the surety industry, we had continued to show profitability in this line of business. A majority of the industry losses were in the area of financial guarantees, policies which were widely written by the national surety companies throughout the 1990’s. Due to our very limited writing of financial guarantees, we had minimal losses incurred from this type of bond. Because of the industry’s poor experience, many of the national surety companies had raised their surety premium rates, while we and some other regional insurance companies had initiated more modest rate increases and term changes, which had enabled us to obtain additional, favorable surety accounts.
Typically, other liability claims have a significant amount of loss adjustment expense associated with them, and because our loss reserves in this line increased, so did our reserve for loss adjustment expenses. Due to our experience in this line in 2002, we also increased our other liability reserves for losses that had been incurred, but not yet reported to us; such reserves are estimates that are calculated using our historical experience by line of business.
the insured or uninsured or under insured motorists and the legal costs of defending the insured against lawsuits. Our policy is to write only standard automobile insurance. We do not write coverage for large fleets of automobiles. Our experience in this line had deteriorated, as measured by the increased loss ratio of 66.9 percent in 2001 to 68.8 percent in 2002, due primarily to an increase in the severity of losses.
Our commercial fire and allied line of insurance covers losses to an insured’s property, including its contents, as a result of weather, fire, theft or other causes. We provide this coverage through a variety of business policies. The loss ratio for this line of business improved to 62.3 percent in 2002, compared with 79.5 percent in 2001. The improvement in this line of business was due primarily to premium rate increases and a decrease in the frequency of non-catastrophe losses.
Workers’ compensation continues to be a poorly performing line of commercial business. The loss ratio deteriorated to 101.4 percent in 2002, from 86.1 percent in 2001. We continue to write this line of business as part of an overall commercial account. The deterioration in 2002 was primarily the result of an increase in severity of claims, coupled with modest premium rate increases. Intense competition in the workers’ compensation line, as well as state insurance department regulation of rates had resulted in lower premium rate increases in this line of business, when compared with our other commercial lines of business.
Our reinsurance line of business improved in 2002, with a net loss ratio of 81.5 percent, compared with 132.2 percent in 2001. The majority of the impact from the September 11 events was included in the 2001 results. In 2002, we incurred assumed losses and expenses of $6.9 million, compared with $26.2 million in 2001. The improvement resulted primarily from a reduced number of contracts and exposure in assumed reinsurance business. We continue to have exposure, primarily catastrophe coverages, related to the assumed reinsurance contracts written prior to 2001, as well as to the small number of assumed reinsurance contracts that we had continued to underwrite. We believe that as of December 31, 2002, our loss reserves established for the assumed reinsurance business are appropriate. We anticipate that we will decrease the assumed loss reserves each year as the non-renewed assumed reinsurance contracts continue to run off and the losses are paid out.
The expense ratio was 29.9 percent in 2002, compared with 30.7 percent in 2001. We experienced this stability in our expense ratio as a result of maintaining steady underwriting expenses while seeing growth in premiums written and earned. We anticipated that the closing of our branch office in Lincoln, Nebraska during the third quarter of 2002 would contribute to further improvement in our expense ratio.
To establish loss and loss adjustment expense reserves, we make estimates and assumptions that affect the amounts of assets, liabilities, revenues and expenses reported in our financial statements. Actual results could differ materially from those estimates. The estimate of these reserves is subjective and complex and requires us to make estimates about the future payout of claims, which is inherently uncertain. When we establish and adjust reserves, we do so based on our knowledge of the circumstances and facts of claims. Upon notice of a claim, we establish a case reserve for losses based on the claims information reported to us at that time. Subsequently, we conduct an investigation of each reported claim, which allows us to more fully understand the factors contributing to the loss and our potential exposure. This investigation may extend over a long period of time. As our investigations of claims develop and as our claims personnel identify trends in claims activity, we refine and adjust our estimates of case reserves. To evaluate and refine our overall reserving process, we track and monitor all claims until they are settled and paid in full and all salvage and subrogation claims are resolved.
At December 31, 2002, we established $1.6 million in asbestos and environmental loss reserves, compared with $1.1 million at December 31, 2001. The estimation of loss reserves for environmental claims and claims related to long-term exposure to asbestos and other substances is one of the most difficult aspects of establishing reserves, especially given the inherent uncertainties surrounding such claims. Although we record our best estimate of loss and loss adjustment expense reserves; because of the significant uncertainties involved and the likelihood that these uncertainties will not be resolved for many years, the ultimate amounts paid upon settlement of such claims may be more or less than the amount of the reserves.
Our life insurance segment’s operating earnings are derived primarily from premium revenues and investment income, reduced by interest credited, benefits to policyholders and expenses. In 2002, our life insurance segment recorded net operating income of $11.2 million, compared with net operating income of $9.9 million in 2001.
Net premiums earned by the life segment in 2002 totaled $27.9 million, compared with $25.4 million in 2001. Annuity deposits collected are not reflected in net premiums earned. Rather, revenues for annuities consist of policy surrender charges and investment income earned. In 2002, annuity deposits were $223.5 million, compared with $163.1 million in 2001. Annuity deposits are invested and recorded as liabilities, referred to as future policy benefits.
In 2002, we credited interest of $51.7 million to our fixed annuity and universal life policyholder accounts, compared with $48.2 million in 2001. We establish our interest crediting rates based upon current market conditions and maintain a “spread” by crediting rates on our policyholder account balances that are less than the ratio of net investment income to average invested assets. We decreased interest-crediting rates during 2002 and 2001 for new deposits. The increase in our expense for interest on policyholders’ accounts in 2002 was primarily a result of the interest credited on existing account balances. We do not write variable annuity products or variable insurance products. Our fixed annuity products expose us to the risk that changes in interest rates could reduce our spread and the rate of return that we are able to earn on our investments. Because of the poor performance of the market during 2002, our spread had been reduced due to the decreased rate of return earned on funds invested in 2002. We have significant amounts of annuities up for renewal beginning in 2004. Because of current market conditions, and the resulting low interest rates, there exists a risk of non-renewal of these annuities. Because of the magnitude of annuities we have at risk, our financial results could be significantly affected. However, we have historically been able to overcome various market conditions in maintaining and growing our annuity business.
Total invested assets increased $207.2 million, or 13.7 percent, to $1,722.0 million at December 31, 2002, compared with December 31, 2001. Of this growth, $35.3 million was attributable to changes in the market prices of our securities classified as available-for-sale, which are reported at fair value. The unrealized appreciation from these investments is reported net of tax as a separate component of stockholders’ equity. The fair value of securities in our investment portfolio may fluctuate depending on general economic and market conditions or events relating to a particular issuer of securities. Because the changes in the fair value of available-for-sale securities and other invested assets in our investment portfolio are reflected in our financial statements, fluctuations in fair value could result in unrealized investment losses, thereby affecting our stockholders’ equity.
At December 31, 2002, $1,348.6 million or 88 percent of our fixed maturities were classified as available-for-sale, compared with $1,142.6 million or 83 percent at December 31, 2001. During 2002, we added trading securities to our portfolio. Our trading securities consisted primarily of convertible redeemable preferred securities, which are recorded at fair value, with any changes in fair value recognized in earnings. Our remaining fixed maturities are classified as held-to-maturity and are reported at amortized cost. As of December 31, 2002, 87 percent of our fixed maturities were investment grade, as defined by the National Association of Insurance Commissioners’ Securities Valuation Office, and had ratings of Class 1 or Class 2.
(l) Available-for-sale and trading fixed maturities are carried at fair value, while held-to-maturity fixed maturities are carried at amortized cost.
We recorded net realized losses on securities of $13.8 million in 2002, compared with net realized losses of $.2 million in 2001. The 2002 net loss included other-than-temporary asset impairments of $13.3 million related to non-investment grade corporate bonds, which we recognized in 2002. See “Critical Accounting Policies” later in this discussion for a presentation of our impairment policy. We regularly review the other-than-temporarily impaired securities for appropriate valuation. Based on the existing status and condition of these securities, we do not currently anticipate additional losses, but continued credit deterioration of some securities is possible, which may result in further write-downs.
Our effective federal income tax rate of 20.2 percent was less than the applicable federal tax rate of 35 percent due primarily to our portfolio of tax-exempt securities. In 2001, our effective rate was 15.8 percent. The change between years in effective rates was driven primarily by two factors: during 2002, we held a smaller portfolio of tax-exempt securities than in 2001 and in 2001, we eliminated a deferred tax liability of $1.1 million. We had established the deferred tax liability in connection with a Revenue Agent Review and other tax contingencies related to the 1999 purchase of American Indemnity Financial Corporation. The Revenue Agent Review has been settled, and we believed that the reserve for other tax contingencies was unnecessary at December 31, 2001. The effect of the elimination was a reduction of deferred tax liabilities and a reduction in federal income tax expense of $1.1 million in 2001.
Due to uncertainty of the realizable value of the deferred tax asset, we recorded a valuation allowance of $8.4 million at December 31, 2002. The valuation allowance recorded on our deferred tax asset decreased by $.5 million from 2001, due primarily to the utilization of net operating loss carryforwards. In the future, if we can use the net operating losses acquired in the purchase of American Indemnity Financial Corporation, the related reduction in the valuation allowance will be recorded as a reduction to our intangible asset recorded in conjunction with the purchase of American Indemnity Financial Corporation, until the intangible asset has been eliminated, at which time the reduction in the allowance will reduce federal income tax expense.
At December 31, 2002, we had a recorded minimum pension liability of $3.5 million (before tax), which represents the amount that we recognized to cover a $4.2 million deficit occurring as a result of our fair value of plan assets being less than our accumulated benefit obligation. The amount of this deficit was first offset by prepaid pension cost ($.8 million) to arrive at the additional pretax minimum pension liability required to be recognized in our Consolidated Financial Statements.
The composition and related carrying value of our investment portfolio at December 31, 2003 is presented in the following table in accordance with accounting principles generally accepted in the United States:
Liquidity measures a company’s ability to generate enough cash to adequately meet its long and short-term obligations as they come due. Our operating cash needs consist primarily of paying insurance loss and loss adjustment expenses and day-to-day operating expenses. We are able to meet these cash requirements through the receipt of insurance premiums and investment income.
As of December 31, 2003, our cash and cash equivalents totaled $265.1 million, compared with $136.9 million at December 31, 2002. Several factors led to this increase. Net cash provided by operations varies with our underwriting profitability. As our profitability from insurance operations increased between 2002 and 2003, our net cash from operations has increased. The change in our investment activity between 2002 and 2003 also contributed to the increase in cash and cash equivalents. During 2003, our purchases for investment securities totaled $314.5 million, compared with $388.9 million in 2002. The unsettled investment environment experienced during 2003 made it beneficial for us to hold most of the funds generated by our operating, investment and financing activities in cash and cash equivalents rather than investing them. However, the investment environment showed signs of stabilizing during the third quarter of 2003, and we increased our investment activity accordingly.
We have significant cash flows from sales of investments and scheduled and unscheduled investment security maturities, redemptions and prepayments. These cash flows totaled $281.4 million in 2003 and $209.3 million in 2002, which were sufficient for our cash flow needs in both years. If our operating and investment cash flows had not been sufficient to support our operations, we have short-term investments that we could utilize for this purpose. We may also borrow up to $20 million on a bank line of credit. We did not utilize our line of credit during 2003 or 2002. Under the terms of our credit agreement, interest on outstanding notes is payable at the lender’s prevailing prime rate, minus 1.0 percent.
Our 2002 liquidity was enhanced by the sale of 2,760,000 shares of convertible preferred stock, which resulted in net cash of $64.9 million that was utilized to support our insurance operations. Dividends to our stockholders resulted in cash outlays of $10.0 million in both 2003 and 2002 and $7.2 million in 2001. The steady increase resulted both from the payment of preferred stock dividends beginning in the second quarter of 2002, as well as an increase in the per share dividend to common stockholders. We anticipate that cash required for dividend payments will increase slightly from that paid in 2003. However, if a significant number of preferred stock is converted (at the holders’ option), this would reduce the cash required for the payment of stock dividends.
At December 31, 2003 we have no off balance sheet arrangements. Our only long-term commitment relates to the operating leases we currently have in effect. Refer to Note 16 of the Notes to Consolidated Financial Statements for further discussion of our lease obligations.
Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties and that potentially may result in materially different results under different assumptions and conditions. Our discussion and analysis of our results of operations and financial condition are based upon our Consolidated Financial Statements, which we have prepared in accordance with accounting principles generally accepted in the United States. As we prepare these financial statements, we must make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We evaluate our estimates on an on going basis. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates. We believe that our most critical accounting policies are as follows.
All investment securities are classified upon acquisition as held-to-maturity, trading or available-for-sale. Investments in held-to-maturity fixed maturities are recorded at amortized cost. Available-for-sale fixed maturities, trading fixed maturities, equity securities and other long-term investments are recorded at fair value. Policy loans, mortgage loans and short-term investments are recorded at cost.
In most cases, quoted market prices are used in determining the fair value of fixed maturities, equity securities and short-term investments. Where quoted market prices were unavailable, the estimate is based on recent trading. Other long-term investments, consisting primarily of holdings in limited partnership funds, are valued by the various fund managers. Unrealized appreciation or depreciation of investments carried at market value is excluded from net income and credited or charged, net of applicable deferred income taxes, directly to a separate component of shareholders’ equity. The change in unrealized appreciation or depreciation during the year is reported as a component of other comprehensive income (loss).
We continually monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition requires other-than-temporary impairment charges to be recorded when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security or that the anticipated recovery in market value of the equity security will not occur in a reasonable amount of time. Impairment charges on investments are recorded based on the fair value of the investments at the measurement date and are included in net realized gains and losses. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which the fair value has been less than cost; the financial conditions and near-term prospects of the issuer; and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery. As of December 31, 2003, we had a small number of securities where fair value was less than our cost. The total temporary impairment on these securities totaled $7.9 million, compared with $45.1 million in 2002. Our rationale for not recording other-than-temporary impairments on these securities is discussed in Note 2 of the Notes to Consolidated Financial Statements.
We establish an asset for deferred policy acquisition costs such as commissions, premium taxes and other variable costs incurred in connection with writing our property and casualty lines of business. The asset is amortized over the life of the policies written. We assess the recoverability of deferred policy acquisition costs on a quarterly basis. We do not consider anticipated investment income in determining the recoverability of these costs. The loss and loss adjustment expense ratio we use to estimate the recoverability of costs is based primarily on the assumption that the future loss and loss adjustment expense ratio will approximate that of the recent past. Actual results could differ materially from our estimates, requiring adjustments to the recorded deferred policy acquisition cost asset. Such adjustments are recorded through operations in the period identified. As of December 31, 2003, we have $45.0 million in deferred policy acquisition costs, compared with $36.6 million at December 31, 2002. The increase between years was due to growth in variable operating expenses related to the underwriting of our property and casualty insurance policies.
Future Policy Benefits and Losses, Claims and Settlement Expenses - Property and Casualty Insurance Segment
• Assuming that we have liability for all claims, even though the issue of liability may in some cases be resolved in our favor;
• Focusing on loss prevention services to enhance workplace safety and to prevent accidents and illness;
• Promoting claims management services to encourage return-to-work programs, case management by nurses for serious injuries and management of medical provider services and billings; and
Future Policy Benefits and Losses, Claims and Settlement Expenses - Life Insurance Segment
The reserves reflected in our Consolidated Financial Statements are calculated in accordance with accounting principles generally accepted in the United States. We account for our annuity and universal life policy deposits in accordance with Statement of Financial Accounting Standards No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses on the Sale of Investments.” Under Statement No. 97, a benefit reserve is established at the time of policy issuance in an amount equal to the deposits received. Subsequently, the benefit reserve is adjusted for any additional deposits, interest credited and partial or complete withdrawals. Statutory reserves for the life insurance segment are based upon applicable Iowa insurance laws. Reserves determined for statutory purposes are based upon mortality rates and interest rates specified by state law. Our life insurance subsidiary’s reserves meet or exceed the minimum statutory requirements. All of our reserves are developed and analyzed annually by independent consulting actuaries. At December 31, 2003, we recorded future policy benefits of $1,210.8 million, compared with $1,128.7 million at December 31, 2002.
We are required to establish a valuation allowance for the portion of any deferred tax asset that management believes may not be realized. We have recorded a valuation allowance of $7.8 million for deferred tax assets relating to American Indemnity Financial Corporation net operating loss carryforwards that can only be used to offset future taxable income of the property and casualty insurance segment.
At December 31, 2003, we recorded liabilities for employee benefits of $12.5 million, compared with $15.9 million at December 31, 2002. In 2003 we recorded pension and retiree medical benefits expense of $4.6 million, compared with $3.3 million in 2002. A majority of the increase was driven by an increase in the service and interest cost components of our pension plan.
Our insurance companies are subject to state laws and regulations that require investment portfolio diversification and that limit the amount of investment in certain categories. Non-compliance may cause non-conforming investments to be non-admitted in measuring statutory surplus and, in some instances, may require us to sell the non-conforming securities. Our investment portfolio at December 31, 2003 was materially in compliance with the applicable state investment rules and regulations.
The National Association of Insurance Commissioners annually calculates a number of financial ratios to assist state insurance regulators in monitoring the financial condition of insurance companies. A “usual range” of results for each ratio is used as a benchmark. Departure from the “usual range” on four or more of the ratios could lead to inquiries from individual state insurance departments as to certain aspects of a company’s business. None of our insurance companies had four or more ratios outside of the “usual range” at December 31, 2003. In addition to the financial ratios, we are also required to calculate a minimum capital requirement for each of our insurance companies based on individual company insurance risk factors. These “risk-based capital” results are used to identify companies that require regulatory attention or the initiation of regulatory action. At December 31, 2003, both our life insurance segment and our property and casualty insurance segment had capital well in excess of the required levels.
Though insurance companies are subject to state regulation, some federal legislation and policies do affect the insurance industry. From time to time, federal regulation is discussed as an addition, or as an alternative, to state regulation. A recently enacted federal law, the Terrorism Act, impacts the insurance industry with its provision of a “back-stop” to property and casualty
Our financial strength is regularly reviewed by independent rating agencies who assign a rating based upon items such as results of operations, capital resources and minimum policyholders’ surplus requirements.
Concerning our property and casualty insurance segment, we believe that underwriting initiatives that we undertook in 2003 will continue to contribute to underwriting profitability. Additionally, we have taken steps to reduce our exposure to catastrophes, primarily through the monitoring of concentration and the reduction of personal lines business.
Net premiums written: Net premiums written is a statutory accounting measure representing the amount of premiums charged for policies issued during the period. Premiums are reflected as revenue as they are earned over the underlying policy period. Net premiums written applicable to the unexpired term of a policy are recorded as unearned premium. We evaluate net premiums written as a measure of business production for the period under review.
Statutory combined ratio: The combined ratio is a commonly used financial measure of underwriting performance. Generally, a combined ratio below 100 percent indicates a profitable book of business. The combined ratio is the sum of two separately calculated ratios, the loss and loss adjustment expense ratio (referred to as the “net loss ratio”) and the underwriting expense ratio (the “expense ratio”). When prepared in accordance with accounting principles generally accepted in the United States, the net loss ratio is calculated by dividing the sum of losses and loss adjustment expenses by net premium earned. The expense ratio is calculated by dividing underwriting expenses by net premiums earned. When prepared in accordance with statutory accounting principles, the net loss ratio is calculated by dividing the sum of losses and loss adjustment expenses by net premium earned. The expense ratio is calculated by dividing underwriting expenses by net premiums written.
(1) The change in net unrealized appreciation is net of reclassification adjustments and income taxes (see Note 15).
The Consolidated Financial Statements have been prepared on the basis of accounting principles generally accepted in the United States, which differ in some respects from those followed in preparing our statutory reports to insurance regulatory authorities. Our stand-alone financial statements submitted to insurance regulatory authorities are presented on the basis of accounting practices prescribed or permitted by the insurance departments of the states in which we are domiciled (“statutory accounting practices”). Effective January 1, 2001, these states have adopted the National Association of Insurance Commissioners’ codified statutory accounting practices. Refer to Note 8 for further discussion.
United Fire & Indemnity Company provides all of the statutory capital necessary for the formation of the Texas Lloyd’s plan by contributing capital to each of the trustees. The trust agreements require the trustees to become underwriters of the Lloyd’s plan, to contribute the capital to the Lloyd’s plan, to sign the articles of agreement and to appoint the attorney-in-fact. The trust agreements also require the trustees to pay to United Fire & Indemnity Company all of the profits and benefits received by the trustees as underwriters of the Lloyd’s plan, which means that United Fire & Indemnity Company has the right to receive 100 percent of the gains and profits from the Lloyd’s plan. The trustees serve at the pleasure of United Fire & Indemnity Company, which may remove a trustee and replace that trustee at any time. Termination of a trustee must be accompanied by the resignation of the trustee as an underwriter, so that the trustee can obtain the capital contribution from the Lloyd’s plan to reimburse United Fire & Indemnity Company. By retaining the ability to terminate trustees, United Fire & Indemnity Company possesses the ability to name and remove the underwriters.
Certain amounts included in the Consolidated Financial Statements for prior years have been reclassified to conform to the 2003 financial statement presentation.
The effect on the amortization of deferred policy acquisition costs for revisions to estimated gross profits is reflected in earnings in the period such estimated gross profits are revised. The effect on the deferred policy acquisition costs that would result from realization of unrealized gains (losses) is recognized with an offset to unrealized investment appreciation (depreciation) as of the balance sheet dates. As of December 31, 2003, a pre-tax adjustment to decrease deferred policy acquisition costs by $16,639,000 was made with a corresponding decrease to unrealized investment appreciation (depreciation). In 2002, the adjustment was to decrease deferred policy acquisition costs by $31,067,000.
Investments in held-to-maturity fixed maturities are recorded at amortized cost; we have the ability and positive intent to hold these investments until maturity. Available-for-sale fixed maturities, trading fixed maturities, equity securities and other long-term investments are recorded at fair value. Policy loans, mortgage loans and short-term investments are recorded at cost. Included in investments at December 31, 2003 and 2002 are securities on deposit with various regulatory authorities, as required by law, with carrying values of $1,304,679,000 and $1,181,902,000, respectively.
In 2003 and 2002, we wrote down certain holdings in our investment portfolio as a result of other-than-temporary declines in market value and recognized a total realized loss, before tax, of $6,407,000 in 2003 and $13,326,000 in 2002. We continue to review these investments, as well as all of our other investment holdings, for appropriate valuation on an ongoing basis.
Premiums earned and losses and settlement expenses incurred are reported net of reinsurance ceded and are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts.
Income taxes paid during 2003, 2002 and 2001 were $19,602,000, $7,302,000 and $4,280,000, respectively. There were no significant payments of interest in 2003, 2002 or 2001, other than interest credited to policyholders’ accounts.
Property and equipment is carried at cost less accumulated depreciation. Depreciation is computed primarily by the straight-line method over the estimated useful lives of the underlying assets. Depreciation expense totaled $3,724,000, $3,281,000 and $3,208,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
We file a consolidated federal income tax return. Deferred tax assets and liabilities are determined at the end of each period, based on differences between the financial statement bases of assets and liabilities and the tax bases of those same assets and liabilities, using the currently enacted statutory tax rates. Deferred income tax expense is measured by the year-to-year change in the net deferred tax asset or liability, except for certain changes in deferred tax amounts that affect stockholders’ equity and do not impact income tax expense.
In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 141, “Business Combinations,” which became effective January 1, 2002. Statement No. 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method. Additionally, Statement No. 141 requires an acquired intangible asset, whenever acquired, to be recognized separately from goodwill if the benefit of the intangible asset is obtained through contractual or other legal rights or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of the acquirer’s intent to do so. Recognized intangible assets (other than those with an indefinite life) must then be amortized over their estimated useful lives. We evaluated the intangible asset of $7,847,000 established in the purchase of American Indemnity Financial Corporation in 1999 in accordance with Statement No. 141, and determined that we are subject to the provision of Statement No. 141 requiring an intangible asset arising out of contractual or other legal rights to be recognized separately from goodwill and amortized over its estimated useful life. Through December 31, 2003 the basis of this intangible asset has been reduced by $4,839,000 as a result of adjustments to the deferred tax valuation allowance also established in the acquisition of American Indemnity Financial Corporation. Future adjustments to this deferred tax valuation allowance will reduce the intangible asset until its carrying value is zero. We are amortizing the remaining intangible asset to expense on a straight-line basis over a 10-year estimated useful life, which results in an annual amortization expense of $190,000 or approximately $48,000 per quarter. Accumulated amortization totaled $2,497,000 and $2,307,000 at December 31, 2003 and December 31, 2002, respectively.
In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 143, “Accounting for Asset Retirement Obligations,” which became effective for fiscal years beginning after June 15, 2002. Statement No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible, long-lived assets and the associated asset retirement costs. Because we did not retire any of our tangible, long-lived assets in 2003, the adoption of Statement No. 143 had no effect on our Consolidated Financial Statements.
In July 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” Statement No. 146 supersedes Emerging Issues Task Force 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).” Statement No. 146 requires that, in certain instances, costs associated with an exit or disposal plan be recognized when incurred rather than at the date of a commitment to an exit or disposal plan. Statement No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002.
In December 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” which amended Statement No. 123. The new standard provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. Additionally, Statement No. 148 amends the disclosure requirements of Statement No. 123 to require prominent disclosures in the annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. Statement No. 148 is effective for financial statements for fiscal years ending after December 15, 2002. In compliance with Statement No. 148, we have elected to continue to follow the intrinsic value method in accounting for our stock-based employee compensation arrangement as defined by Accounting Principles Board Opinion No. 25 and related interpretations. We have made the applicable disclosures in the “Stock-Based Compensation” section of this note.
In May 2003, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” Statement No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity and it requires that an issuer classify a financial instrument that is within its scope as a liability because the financial instrument embodies an obligation of the issuer. Statement No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective in the first interim period beginning after June 15, 2003. The adoption of Statement No. 150 did not have any impact on our Consolidated Financial Statements. Refer to Note 11 for additional information.
Statement No. 132 (revised 2003) revises existing disclosure requirements only and does not affect current measurement and recognition accounting for pension and postretirement benefits. Additional disclosures required by Statement No. 132 (revised 2003) include expanded disclosures relating to the description of plan assets including investment strategies, plan obligations, cash flows and net periodic benefit cost of defined benefit pension and other defined benefit postretirement plans. Effective December 31, 2003, we adopted the disclosure requirements of Statement No. 132 (revised 2003) as noted above. Refer to Note 10 for additional information.
Effective December 8, 2003, the “Medicare Prescription Drug, Improvement and Modernization Act of 2003” (Medicare Prescription Drug Act) was signed into law, which provides for a prescription drug benefit under Medicare (Part D) as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. Our defined benefit postretirement health care and life insurance plans do provide a prescription drug benefit.
A reconciliation of the amortized cost (cost for equity securities) to fair values of investments in held-to-maturity and available-for-sale fixed maturity and equity securities as of December 31, 2003 and 2002 is as follows.
The amortized cost and fair value of held-to-maturity, available-for-sale and trading fixed maturities at December 31, 2003, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from sales of available-for-sale securities during 2003, 2002 and 2001 were $26,367,000, $9,125,000 and $74,921,000, respectively. Gross gains of $4,855,000, $1,682,000 and $4,401,000 were realized on those sales in 2003, 2002 and 2001, respectively. Gross losses of $7,513,000, $15,040,000 and $4,948,000 were realized on those sales in 2003, 2002 and 2001, respectively.
There were no sales of held-to-maturity securities during 2003, 2002 or 2001.
We continually monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition requires other-than-temporary impairment charges to be recorded when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security or that the anticipated recovery in market value of the equity security will not occur in a reasonable amount of time. Impairment charges on investments are recorded based on the fair value of the investments at the measurement date and are included in net realized gains and losses. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which the fair value has been less than cost; the financial conditions and near-term prospects of the issuer; and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery.
Provided below is a summary of fixed maturity and equity securities that were in an unrealized loss position at December 31, 2003. We have the ability and intent to hold these securities until such time as the value recovers or the securities mature. Further, we believe the deterioration in value of our fixed maturity portfolio is primarily attributable to changes in market interest rates and not the credit quality of the issuer. Therefore, we have concluded that the unrealized losses displayed below are temporary in nature.
In most cases, quoted market prices were used in determining the fair value of fixed maturities, equity securities and short-term investments. Where quoted market prices were unavailable, the estimate was based on recent trading.
Policy loans are carried at the actual amount loaned to the policyholder. No policy loans are made for amounts in excess of the cash surrender value of the related policy. In all instances, the policy loans are fully collateralized by the related liability for future policy benefits for traditional insurance policies and by the policyholders’ account balance for interest-sensitive policies.
The estimated fair value of mortgage loans is based upon discounted cash flows at the market rate of interest for similar loans as of December 31, 2003. Other long-term investments, consisting primarily of holdings in limited partnership funds, are valued by the various fund managers. In management’s opinion, these values reflect fair value at December 31, 2003 and 2002.
Written premiums ceded were $31,380,000, $35,251,000 and $25,167,000 for the years ended December 31, 2003, 2002 and 2001, respectively. Earned premiums ceded were $34,289,000, $32,787,000 and $23,963,000 for the years ended December 31, 2003, 2002 and 2001, respectively. Ceded loss and loss adjustment expenses incurred were $440,000, $4,812,000 and $11,324,000 for the years ended December 31, 2003, 2002 and 2001, respectively. The ceding of reinsurance does not legally discharge us from primary liability under our policies, and we must pay the loss if the reinsurer fails to meet its obligations. We believe all reinsurance receivables and prepaid reinsurance premiums due from reinsurers are collectable and realizable. There are no concentrations of credit risk associated with our reinsurance.
We did not have direct exposure related to the September 11 national events. However, the 2001 results include incurred claims of $6,892,000 (before tax) related to the terrorist attacks from assumed property reinsurance. During 2003, we incurred an additional $301,000 for this loss, compared with an additional $399,000 incurred during 2002. We have recorded reserves of $160,000 at December 31, 2003 for the September 11 events.
Life reserves are stated gross of reinsurance ceded to other companies. United Life Insurance Company is contingently liable for these amounts if such companies are unable to pay their portion of the claims. United Life Insurance Company is contingently liable for ceded insurance in force of $445,985,000 and $430,682,000 at December 31, 2003 and 2002, respectively. Earned premiums ceded were $1,340,000, $1,515,000 and $1,280,000 for the years ended December 31, 2003, 2002 and 2001, respectively. Approximately 64 percent of ceded life insurance in force as of December 31, 2003 has been ceded to two reinsurers. We believe all reinsurance receivables are collectable. Ceded losses incurred were $2,110,000, $1,234,000 and $1,874,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
In 2002, the life insurance segment began assuming portions of life insurance business from other insurance companies. Assumed premiums written for the years ended December 31, 2003 and 2002 were $560,000 and $423,000, respectively. Assumed premiums earned for the years ended December 31, 2003 and 2002 were $309,000 and $87,000, respectively. Assumed losses incurred were $102,000 and $12,000 for the years ended December 31, 2003 and 2002, respectively.
We are required by the state insurance departments’ solvency regulations to calculate a minimum capital requirement based on insurance risk factors. The risk-based capital results are used by the National Association of Insurance Commissioners and state insurance departments to identify companies that merit regulatory attention or the initiation of regulatory action. At December 31, 2003, both United Life Insurance Company and United Fire had capital well in excess of their required levels.
During 2002, we contributed $30,000,000 in cash to United Life Insurance Company to improve its capital adequacy as evaluated by insurance company rating agencies.
In 2001, we eliminated a deferred tax liability of $1,143,000, which we had established in connection with a Revenue Agent Review and other tax contingencies related to our 1999 purchase of American Indemnity Financial Corporation. The effect of the elimination was a reduction of deferred tax liabilities and a reduction in current federal income tax expense of $1,143,000.
The significant components of the net deferred tax liability at December 31, 2003 and 2002, are as follows.
As of December 31, 2003, we have net operating loss carryforwards totaling $23,475,000, all of which were acquired as part of our purchase of American Indemnity Financial Corporation. These net operating loss carryforwards expire as follows: 2004 - $1,247,000; 2005 - $118,000; 2006 - $43,000; 2007 - $14,000; 2008 - $14,000; 2009 - $4,604,000; 2010 - $989,000; 2011 - $5,491,000; 2017 - $6,819,000; and 2018 - $4,136,000. We are required to establish a valuation allowance for any portion of the deferred tax asset that we believe may not be realized. At December 31, 2003, we have a valuation allowance of $7,838,000 for deferred tax assets relating to American Indemnity Financial Corporation’s net operating losses, which can only be used to offset future income of the property and casualty insurance segment. If we determine that the benefit of the American Indemnity Financial Corporation net operating losses can be realized in the future, the related reduction in the deferred tax asset valuation allowance will be recorded as a reduction to our intangible asset relating to agency relationships, until the carrying value of this intangible asset has been eliminated. The remainder will then be recognized through the income statement as a reduction to current tax expense.
We offer a noncontributory defined benefit pension plan in which all of our employees are eligible to participate after they have completed one year of service and attained twenty-one years of age. Under our pension plan, retirement benefits are primarily a function of the number of years of service and the level of compensation. Our policy is to fund this plan on a current basis to the extent that the contribution is deductible under existing tax regulations. We estimate that we will contribute $5,173,000 to the plan in 2004. At December 31, 2003, 54.4 percent of the plan assets was invested in common stock, 35.8 percent of the plan assets was invested in an annuity purchased from our life insurance company, and the remainder of the plan assets was held in cash and cash equivalents. Fourteen percent of the plan assets was invested in our own common stock. The pension plan owned 101,029 shares of United Fire common stock, with a market value of $4,078,000, as of December 31, 2003. Dividends on shares of United Fire common stock totaled approximately $78,000 during 2003. The plan has also made deposits with United Life Insurance Company totaling $10,314,000 to be used by the plan to purchase retirement annuities from that company. The annuity fund maintained by United Life Insurance Company is credited with compound interest on the average fund balance for the year. The interest rate will be equivalent to the ratio of net investment income to mean assets of United Life Insurance Company.
We offer a health and dental benefit plan to all of our eligible employees and retirees. The plan is composed of two programs: (1) the Self-Funded Retiree Health and Dental Benefit plan and (2) the Self-Funded Employee Health and Dental Benefit Plan. The plan provides health and dental benefits to our employees who are regularly scheduled to work for us for 24 or more hours per week and their covered dependents. Retired employees and their covered dependents are entitled to health and dental benefits provided the retired employees have attained at least age 55 and have continuously participated in the employee plan for at least 10 consecutive years immediately prior to retirement. The plan’s contract administrators are responsible for making medical and dental care benefit payments. The plan requires participants to submit claims for reimbursement or payment to the plan administrator within 365 days after the end of the calendar year in which the charges were incurred. The plan’s benefit obligation relates primarily to our postretirement benefit program.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make various estimates and assumptions that affect the reporting of net periodic benefit cost, plan assets, and plan obligations at the date of the financial statements. Actual results could differ from these estimates. A significant estimate relates to the calculation of the benefit plan obligations. We annually establish the discount rate used to determine the present value of the plan benefit obligations as of December 31. The discount rate utilized is based upon published investment grade, long-term corporate bond yields. The pension plan also has various investment securities. The expected long-term rate of return on the pension plan assets is another significant estimate that affects pension expense reported during a particular period. Investment securities, in general, are exposed to various risks, such as fluctuating interest rates, credit standing of the issuer of the security and overall market volatility. We annually perform an analysis of expected long-term rates of return based on the allocation of our pension plan assets and recent economic conditions.
The accumulated pension benefit obligation was $27,812,000 and $28,820,000 at December 31, 2003 and 2002, respectively.
For measurement purposes, an 11.0 percent annual rate of increase in the per capita cost of covered health care benefits is assumed for 2004. The rate is assumed to decrease gradually each year to a rate of 5.25 percent for 2010 and remain at that level thereafter. For dental claims, a 5.00 percent annual rate of increase was assumed for 2004, decreasing gradually to 4.75 percent for 2005 and thereafter.
The annual per capita contributions for the benefits provided to retired American Indemnity Financial Corporation employees are capped. As a result, increases in the assumed health care cost trend rate will have no significant effect on the accumulated postretirement benefit obligation or on the net periodic postretirement benefit cost related to these employees as of December 31, 2003.
At December 31, 2002, we recorded a minimum pension liability of $3,500,000 (before tax), which represents the amount that we recognized to cover a $4,248,000 deficit occurring as a result of our fair value of plan assets being less than our accumulated benefit obligation. The amount of this deficit was first offset by prepaid pension cost of $748,000 to arrive at the additional pretax minimum pension liability required to be recognized in our Consolidated Financial Statements. No minimum pension liability is recognized as of December 31, 2003.
We have a profit-sharing plan in which employees who meet service requirements are eligible to participate. The amount of our contribution is discretionary and is determined annually, but cannot exceed the amount deductible for federal income tax purposes. Our contribution to the plan for the years ended December 31, 2003, 2002 and 2001, was $3,545,000, $1,320,000 and $1,728,000, respectively.
We have a nonqualified employee stock option plan that authorizes the issuance of up to 500,000 shares of United Fire common stock to employees. The plan is administered by the Board of Directors. The Board has the authority to determine which employees will receive options, when options will be granted, and the terms and conditions of the options. The Board may also take any action it deems necessary and appropriate for the administration of the plan. Pursuant to the plan, the Board may, at its sole discretion, grant options to any employees of United Fire or any of its affiliated companies. These options are granted to buy shares of United Fire’s stock at the market value of the stock on the date of grant. The options vest and are exercisable in installments of 20 percent of the number of shares covered by the option award each year from the grant date. To the extent not exercised, installments shall accumulate and be exercisable by the optionee, in whole or in part, in any subsequent year included in the option period, but not later than 10 years from the grant date. Stock options are generally granted free of charge to the eligible employees of United Fire as designated by the Board of Directors.
We have elected to account for our stock options under Accounting Principles Board Opinion No. 25 and its related interpretations. As such, no compensation cost is recognized because the exercise price of United Fire’s stock options is equal to the market price of the underlying stock on the date of the grant. If the stock options had been accounted for under Statement of Financial Accounting Standard No. 123, compensation cost would have been recorded based on the grant-date fair value attributable to the number of options that eventually vest. This cost is recognized over the period in which the options vest, with the amount recognized at any date being at least equal to the value of the vested portion of the award at that date. The amount of compensation cost that would have been recognized as of December 31, 2003, 2002 and 2001 under Statement No. 123 has been determined to have an immaterial impact on the net income and earnings per share reported in our Consolidated Financial Statements.
Issuance costs in connection with our preferred stock offering totaled $4,116,000. We accrete these costs over a 12-year period. Through December 31, 2003, we have accreted $572,000 related to the preferred stock issuance costs. We review the accretion period annually to determine if we need to accelerate the accretion.
In connection with the issuance of the preferred shares, the Board of Directors reserved a number of authorized shares of common stock sufficient to permit the conversion of all of the outstanding shares of preferred stock to United Fire common stock.
We determine the dilutive effect of our convertible preferred stock using the “if-converted” method. Under this method, we add to the denominator of the earnings per share calculation a number determined by multiplying the number of convertible preferred shares by the stated conversion rate. We also add the amount of preferred dividends and accretions back to the numerator of the earnings per share equation due to the assumed conversion of all the convertible preferred stock to common stock at the beginning of the reporting period. If the effect of the if-converted method is anti-dilutive, the effect on diluted earnings per share of our convertible preferred stock is disregarded. This was the case in our diluted earnings per share calculation for each of the 2002 reporting periods in which we had preferred shares outstanding. The preferred stock had a dilutive effect on the diluted earnings per share calculation for each of the 2003 reporting periods.
We determine the dilutive effect of our stock options outstanding using the “treasury stock” method. Under this method, we assume the exercise of all of the outstanding options whose exercise price is less than the weighted-average fair market value of our stock during the period. This method also assumes that the proceeds from the hypothetical stock option exercises are used to repurchase shares of common stock at the weighted-average fair market value of the stock during the period. The net of the assumed options exercised and assumed common shares repurchased represents the number of potentially dilutive common shares, which we add to the denominator of the earnings per share calculation. The components of basic and diluted earnings per share are displayed in the following table.
Cash dividends per common share of $.77, $.73 and $.72 were declared in 2003, 2002 and 2001, respectively.
At December 31, 2003, we were obligated under noncancelable operating lease agreements principally relating to office space, vehicles, computer equipment and office equipment. Most of our leases include renewal options, purchase options or both. These provisions may be exercised by us upon the expiration of the related lease agreements. Rental expense under our operating lease agreements was $1,983,000, $2,494,000, and $2,182,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
At December 31, 2003, our future minimum rental payments are as follows (in thousands).
During the third quarter of 2001, we presented claims against an escrow account held for the deferred payment of $1.00 per share to prior shareholders of American Indemnity Financial Corporation, which we acquired in August 1999. The amount of this escrow totaled $1,990,000 and is recorded as a component of other assets on our Consolidated Balance Sheets. During 2003, we filed a lawsuit to enforce the payment to us of the amount of our claims. At December 31, 2003, the parties to the lawsuit were actively engaged in settlement negotiations. Subsequent to December 31, 2003 we achieved a favorable settlement of this lawsuit, which resulted in the payment to us of approximately $1,940,000 of the funds that were held in the escrow account.
We have audited the accompanying consolidated balance sheets of United Fire & Casualty Company and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2003. Our audits also included the 2003 and 2002 financial statement schedules listed in the Index to Supplementary Schedules at Item 8. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. The consolidated financial statements and schedules of United Fire & Casualty Company and subsidiaries for the year ended December 31, 2001, were audited by other auditors who have ceased operations and whose report, dated February 8, 2002, expressed an unqualified opinion on those statements and schedules and included an explanatory paragraph that disclosed the change in the Company’s method of accounting for derivative instruments and hedging activities, effective January 1, 1999.
Certain amounts included in this schedule for earlier years have been reclassified to conform with the 2003 financial statement presentation. Amounts included herein are net of intercompany eliminations.