the Company’s consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.
Significant Accounting Policies - Our significant accounting policies are summarized in Note 1 - “Summary of Significant Accounting Policies” to our accompanying consolidated financial statements. Our significant accounting policies include those policies related to our accounting for: (i) premiums earned, (ii) unpaid claim and claim settlement expenses, including reserves for incurred but not reported claims, (iii) policy acquisition costs, and (iv) investments. These accounting policies are further discussed in detail within each section of this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
RTW reported a decrease in gross premiums earned to $62.5 million in 2002 from $97.4 million in 2001. Total revenues decreased significantly in 2002 to $67.1 million from $95.7 million in 2001 due to a decrease in premiums in force related primarily to our regional office closures.
Premiums earned decreased 30.0% in 2002 from 2001. Premiums earned in 2001 were reduced by premiums ceded under a lower layer excess of loss reinsurance agreement, effective for claims occurring on or after July 1, 1998, that was in runoff in 2001. Premiums ceded in 2001 included $7.9 million in premiums ceded under this lower layer excess of loss reinsurance agreement, compared to $13.4 million ceded in 2000. No premiums were ceded under this agreement in 2002. Additionally, 2002 premiums ceded were reduced by $1.4 million resulting from a change in cost related to excess of loss reinsurance in Minnesota;
In our 2001 Report on Form 10-K/A, we revised the accounting for our contract with St. Paul Re (SPR), which was originally accounted for under reinsurance accounting standards using deposit accounting standards, and restated our 2001 financial statements. We further terminated this contract with SPR in December 2002 and were refunded $28.8 million, resulting in a $1.0 million gain recorded in December 2002. Deposit accounting for this contract required us to record a margin expense at 4.75% of premiums ceded to SPR and interest income on the fund balance at an amount equal to the quarter-end U.S. Treasury Bill rate less 25 basis points. The deposit accounting change caused a decrease in premiums ceded and an increase in investment income, claim and claim settlement expenses, policy acquisition costs and general and administrative expenses from the amounts originally reported in 2001. As a result, the accounting for this contract increased net income by $354,000 in 2002 after reducing interest income and the gain on termination by the margin expense, and an increase in the 2001 net loss by $1.5 million; and
We expect 2003 premiums in force to increase slightly from levels in 2002. We also anticipate that we will
Our premiums in force decreased 35.2% to $54.2 million at December 31, 2002 from $83.7 million at December 31, 2001 due to decreases in premiums in force in all of our markets, but primarily the result of closing our Missouri and Massachusetts regional offices. Average premiums in force decreased to $65.1 million in 2002 from $95.2 million in 2001 and $90.9 million in 2000. In order to improve profitability, we aggressively targeted policies that did not meet our underwriting profit margin standards for non-renewal or re-underwriting at increased rates at policy expiration in 2002, 2001 and 2000. Our average annual premium per policy increased to $80,400 in 2002 from $56,800 in 2001 and $40,500 in 2000 as a result of the focused aggressive re-underwriting in 2001 and 2000.
Gross premiums earned increased 1.6% to $97.4 million in 2001 from $95.9 million in 2000. This increase resulted from: (i) the increase in average premiums in force, offset by (ii) a decrease in final audit premiums that increased gross premiums earned by $1.8 million in 2001 compared to $5.5 million in 2000.
Many workers’ compensation insurers have withdrawn from the markets in which we write premiums as profitability diminished in the workers’ compensation insurance line;
Under our excess of loss reinsurance policies, we pay reinsurers to limit our per-incident exposure and record this cost to premiums ceded as a reduction of gross premiums earned. In Minnesota, we are required to purchase excess of loss coverage for our Minnesota policies from the Minnesota Workers’ Compensation Reinsurance Association (WCRA). In 2002, we ceded Minnesota claims in excess of $350,000 per occurrence to the WCRA; in 2001 and 2000, we ceded Minnesota claims in excess of $330,000 and $310,000, respectively to the WCRA. The per-occurrence coverage level increased to $360,000 in 2003. In our non-Minnesota states, we maintained excess of loss coverage with a per-incident exposure of $300,000 since 1999. We purchased this non-Minnesota coverage from a single reinsurer. In 2002, the non-Minnesota excess of loss coverage no longer included statutory limit coverage and was capped at $20.0 million per occurrence and further excluded claims resulting from acts of terrorism. In 2003, our non-Minnesota per-incident excess of loss coverage increased to $360,000, continues to be capped at $20.0 million per occurrence and further excludes claims resulting from acts of terrorism. We further decreased our retention to $200,000 per-incident in all our regions in 2003 by purchasing increased excess of loss reinsurance in order to further reduce volatility in our results. This coverage was purchased from three reinsurers.
For claims occurring after June 30, 1998 through policy termination on December 31, 2000, and on a runoff basis into 2001, we further limited our per incident exposure by purchasing excess of loss coverage for losses from $25,000 to the lesser of $300,000 or the WCRA selected retention level in Minnesota and from $25,000 to $300,000 in other states from a single reinsurer. This agreement was finalized after its effective date and activity occurring from July 1, 1998 through September 30, 1998 was recorded on a retrospective basis resulting in the deferral of a gain totaling $2.0 million at December 31, 1998. We amortized $400,000 of the deferred gain as a reduction of claim and claim settlement expenses in each of 2002, 2001 and 2000 and $740,000 in 1999 resulting in an un-amortized deferred gain of $49,000 at December 31, 2002. The deferred gain is being amortized into income using the effective interest rate inherent in the amounts paid to the reinsurer and the estimated timing and amounts of recoveries from the reinsurer. Activity occurring on or after October 1, 1998 is recorded prospectively. This contract was terminated effective December 31, 2000; however the policy remained in effect in 2001 for policies in force at December 31, 2000 through expiration, not to exceed fifteen months after the effective termination date. Policies written or renewing after December 31, 2000 are not covered under this lower-level excess of loss reinsurance policy.
Premiums ceded to reinsurers decreased to $2.2 million in 2002 from $11.4 million in 2001. The decrease in premiums ceded, resulted primarily from: (i) a $7.3 million reduction in premiums ceded under our $25,000 to $300,000 excess of loss reinsurance policy, (ii) a $1.4 million reduction in excess of loss premiums ceded resulting from a change in estimated reinsurance cost for Minnesota excess of loss reinsurance, and (iii) a decrease in gross premiums earned offset by an increase in non-Minnesota excess of loss costs in 2002.
Premiums ceded to reinsurers decreased to $11.4 million in 2001 from $17.7 million in 2000. The decrease in premiums ceded resulted primarily from the run-off of premiums ceded under our $25,000 to $300,000 policy.
Premiums ceded under excess of loss policies will increase significantly as a percent of gross premiums earned when compared to the results attained for 2002. This increase is the result of two factors: (i) our cost for excess of loss reinsurance coverage in our non-Minnesota regions increased substantially for 2003 while our Minnesota cost decreased only slightly, and (ii) we decreased our retention to $200,000 in all our regions in 2003 by purchasing increased excess of loss coverage in order to further reduce volatility in our results.
Investment income decreased to $5.1 million in 2002 from $6.4 million in 2001. Investment income decreased as our invested assets decreased to $81.4 million at December 31, 2002 from $89.2 million at December 31, 2001 and our investment yields decreased as we moved out of corporate securities in 2002 and reinvested in lower yielding securities due to changes in market interest rates and our desire to lower risk by buying higher rated government and mortgage-backed securities. This decrease was partially offset by an increase in interest earned on our deposit receivable to $736,000 in 2002 from $518,000 in 2001. Our invested assets decreased due to decreases in operating cash flow in 2002 and 2001, resulting primarily from: (i) reduced premiums in force and premiums written, (ii) timing differences between paying premiums ceded and recovering paid claim and claim settlement expenses, (iii) the receipt of premiums and the payment of claim and claim settlement expenses, and (iv) net cash provided by lower investment income. Investment yields decreased to 4.9% for 2002 from 6.1% for 2001. The investment yields realized in future periods will be affected by yields attained on new investments.
Investment income increased to $6.4 million in 2001 from $5.8 million in 2000. Investment income increased as a result of repositioning our portfolio entirely into taxable securities that earn a higher pre-tax rate of return offset by a reduction in our invested assets to $89.2 million at December 31, 2001 from $96.8 million at December 31, 2000 and further includes interest on our deposit receivable totaling $518,000 for 2001. Invested assets decreased due to decreased operating cash flow, resulting primarily from: (i) the difference in timing between the receipt of premiums, the payment of premiums ceded under our reinsurance agreements, the payment of claim and claim settlement expenses and the recovery of paid claim and claim settlement expenses under our reinsurance programs, and (ii) net cash provided by investment income. Tax-adjusted investment yields were 6.1% in 2001 compared to 6.6% in 2000. The investment yields realized in future periods will be affected by yields attained on new investments.
We earned $736,000 in interest on our deposit receivable in 2002. There will be no interest earned on the deposit in 2003 due to our terminating the St. Paul Re contract;
Funds from our operating cash flows and investment cash flows historically provided growth in our investment portfolio; however, these net cash flows will decrease as we focused on closing claims from prior years, years in which premiums were higher and more claims were reported, paying to close those claims. Cash flows for 2003 are expected to be adversely affected by decreases in cash flows resulting from claim payments on claims from 2002 and prior years exceeding cash flows from our premiums as we reduce our premiums earned in 2003;
Further recognition of realized investment gains and losses will depend on sales of our investments, if any, to meet our short-term cash requirements or as we replace securities to manage our portfolio returns; and
Claim and Claim Settlement Expenses: Claim expenses refer to medical and indemnity benefits that we paid or expect to pay to claimants for events that have occurred. The costs of investigating, resolving and processing these
The number of claims reported but unpaid (open claims) and the approximate average gross and net reserves on these claims each period was: 2002 - 1,381 claims, $9,700 average gross reserve, $9,000 average net reserve; 2001 - 670 claims, $26,900 average gross reserve, $17,500 average net reserve; and 2000 - 344 claims, $46,400 average gross reserve, $9,600 average net reserve. The average gross and net reserves per claim are less in 2002 than in 2001 and 2000 as the open claims include newly reported claims from the later half of 2002, including many with much lower severity that have not had time to close, as well as new claims that are anticipated but not yet reported. The remaining open claims from 2001 and 2000 are primarily claims with significant injury characteristics resulting in the increase in outstanding average gross and net reserves per claim.
We recorded estimates of ceded paid and unpaid claim and claim settlement expenses under our $25,000 to $300,000 excess of loss reinsurance agreement totaling $15.2 million in 2001 including $400,000 amortized from a deferred retrospective reinsurance gain resulting in a corresponding reduction in 2001 claim and claim settlement expenses. These amounts compare to our 2000 results which include an estimate of ceded paid and unpaid claim and claim settlement expenses totaling $21.8 million and $400,000 amortized from the deferred retrospective reinsurance gain;
We increased renewal premium rates an average of 18.5% in 2001 and 11.7% in 2000 compared to premium rates for the same periods in 2000 and 1999, respectively, reversing a trend of continued rate declines during years prior to 2000. Increases in premium rates have the effect of reducing the ratio of claim and claim settlement expenses to gross premiums earned as losses do not increase with premium rate increases; and
Claim costs continued to increase in 2001, 2000 and 1999 due to increasing medical and indemnity costs. These increases were offset somewhat by the effects of provider agreements that we negotiated during 1998.
Gross premiums earned decreased significantly in 2002 compared to 2001 and 2000 resulting in corresponding decreases in policy acquisition costs;
We incurred ceding commission expense resulting from adjustments to claim and claim settlement expense estimates for 1992 to 1994 totaling $260,000 in 2001 and $460,000 in 2000. No such expense was recorded in 2002.
A reduction and renegotiation of our Corporate and Minnesota office space that resulted in a decrease in related office expenses beginning in October 2002; and
We have historically managed personnel and other operating costs and expenses to keep operating expenses in line with revenues. All expenses will continue to be aggressively managed and reduced where appropriate;
We have no plans to open additional state offices in 2003 and expect to further reduce overhead costs in 2003 as a result of our office closures in 2001 and runoff in 2002. We will continually monitor reported claim counts for 2003 and re-examine staffing needs as necessary; and
Interest Expense: We incurred interest charges on our Term Loan in 2002, 2001 and 2000.
2003 Outlook: Interest expense is expected to decrease in 2003 as a result of the $3.3 million in principal payments made in 2002. Total interest expense is expected to decrease to approximately $55,000 in 2003 from $163,000 in 2002 as a result of principal reductions in 2002. The remaining principal is due in 2003.
Income Taxes: We incur federal income taxes on our combined service organization (RTW) operations and insurance (ACIC) operations. We incur state income taxes on the results of our service organization’s operations and incur premium taxes in lieu of state income taxes for substantially all of our insurance operations. In certain instances, we may incur state income taxes on our insurance operations. Additionally, certain provisions of the Internal Revenue Code adversely affect our taxable income by accelerating recognition and payment of income taxes. Adjustments to book income generating current tax liabilities include limitations on the deductibility of
unpaid claim and claim settlement expenses, limitations on the deductibility of unearned premium reserves and limitations on deductions for bad debt reserves.
In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. We consider recent operating results, the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. At December 31, 2001, we established a $14.5 million valuation allowance (allowance) against deferred tax assets resulting in a corresponding increase in income tax expense as a result of this analysis. This allowance decreased by $7.9 million to $6.6 million at December 31, 2002 as a result of the income we earned in 2002 and federal tax refunds totaling $3.8 million resulting from a change in Federal tax law. We expect any remaining deferred tax assets, net of the allowance, at December 31, 2002, to be realized as a result of the future income and the reversal of existing taxable temporary differences. No allowance was provided against the deferred tax assets in 2000.
2003 Outlook: Income tax expense will vary based on: (i) the income from operations we recognize for 2003, and (ii) the changes in our analysis of the valuation allowance necessary during 2003. The ultimate change is unknown at this time.
contract late in December 2002. We invested this cash in January 2003. We expect that cash will decrease in 2003 as we pay claims for 2002 and prior years, years in which we earned higher premiums and incurred a higher number of claims reported while 2003 premiums earned are expected to decrease.
We record investments on our balance sheet at fair value, with the corresponding appreciation or depreciation from amortized cost recorded in shareholders’ equity as other comprehensive income, net of taxes. Because value is based on the relationship between the portfolio’s stated yields and prevailing market yields at any given time, interest rate fluctuations can have a swift and significant impact on the carrying value of these securities. As a result of classifying our securities as available-for-sale, and thus carrying them at fair value, we expect to encounter adjustments in shareholders’ equity as market interest rates and other factors change. In 2000, we recorded a $500,000 write-down of a security held in our portfolio as we deemed its decline in fair value to be other than temporary in nature. This security was sold in January 2002 and the proceeds exceeded the adjusted cost basis resulting in a net realized gain of $300,000. Prevailing market interest rates decreased since December 31, 2001, and when combined with the sale of select securities to realize gains to increase statutory surplus, resulted in a $3.4 million unrealized gain on investments in 2002 compared to a $1.4 million unrealized gain in 2001.
Accounting for workers’ compensation insurance operations requires us to estimate the liability for unpaid claim and claim settlement expenses (“reserves”) and the related reinsurance recoverables, (together, the “net reserves”) at each balance sheet date. Our reserves represent the estimated total unpaid cost of claim and claim settlement expenses, which cover events that occurred in 2002 and prior years. These reserves reflect our estimates of the total costs of claims that were reported, but not yet paid, and the cost of claims incurred but not yet reported (IBNR). For reported claims, we establish reserves on a “case” basis. For IBNR claims, we calculate the difference between: (i) projected ultimate claim and claim settlement expenses as determined using generally accepted actuarial standards, and (ii) case reserves and carry the difference as the IBNR reserve. By using both estimates of reported claims and IBNR claims, we estimate the ultimate net reserves for unpaid claim and claim settlement expenses.
The amount by which estimated net reserves, measured subsequently by reference to payments and additional estimates, differ from those originally reported for a period is known as “development.” Development is unfavorable (or deficient) when losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for reserve increases on open claims. Development is favorable (redundant) when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on open claims. Favorable or unfavorable development of loss reserves is reflected in earnings in the year realized.
After taking into account all relevant factors, we believe our reserves for unpaid claim and claim settlement expenses and reinsurance recoverables on unpaid claim and claim settlement expenses at December 31, 2002 are adequate to cover the ultimate net costs of claim and claim settlement expenses at that date. The ultimate cost of claim and claim settlement expenses may differ materially from the established reserves, particularly when claims may not be settled for many years. Establishing appropriate reserves is an inherently uncertain process and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience. See Notes 1 and 5 in the accompanying Consolidated Financial Statements. The following two tables reconcile the beginning and ending insurance reserves, displayed individually for each of the last three years.
The following loss reserve development table sets forth the change, over time, of reserves established for claim and claim settlement expenses at the end of the last ten years. The following loss reserve development table is cumulative and, therefore, ending balances should not be added since the amount at the end of each calendar year includes activity for both current and prior years (000’s):
The lower portion of the table shows the re-estimated amount of the previously recorded net reserves, based on experience as of the end of each succeeding year. The estimate is either increased or decreased as more information becomes known about the frequency and severity of claims for individual years. For example, for the 1998 calendar
year valued as of December 31, 2002, we paid $60.5 million of the currently estimated $78.8 million of claim and claim settlement expenses that were incurred through the end of 1998; thus, the difference, an estimated $18.3 million of claim and claim settlement expenses incurred through 1998, remained unpaid as of December 31, 2002.
The 2002 results include an $8.4 million decrease in prior years’ reserves for unpaid claim and claim settlement expenses compared to the 2001 results which include a $7.7 million increase in prior years’ reserves for unpaid claim and claim settlement expenses. Our estimate for unpaid claim and claim settlement expenses decreased in 2002 due to the following: (i) in March 2002, the Minnesota State legislature changed the way the commissioner will assess self-insured employers and insurers for estimated liabilities and administrative expenses of the State’s Special Compensation Fund (SCF). The assessment changed from being paid by the insurer on indemnity payment basis to an assessment charged on premium to the policyholder. We decreased our recorded accrual to reflect this legislative change, (ii) the frequency of claims reported in 2002 for 2001 and prior years was less than anticipated when we determined our liability in 2001, (iii) we overestimated the liability for our mandatory participation in state and national assigned risk pool operating results for states in which we operate in 2001 and reversed that excess in 2002, and (iv) our estimate of the liability for unpaid claim and claim settlement expenses is difficult and volatile due to our relatively limited historical claim data and small claim population.
The 2001 results include a $7.7 million increase in prior years’ reserves for unpaid claim and claim settlement expenses compared to the 2000 results which include a $15.9 million increase in prior years’ reserves for unpaid claim and claim settlement expenses. Our estimate for unpaid claim and claim settlement expenses increased in 2001 due to the following: (i) we increased the estimated liability for second injury funds and our mandatory participation in state and national assigned risk pool operating results for states in which we operate, (ii) our estimate of the liability for unpaid claim and claim settlement expenses is difficult and volatile due to our relatively limited
Cash provided by operating activities for 2002 was $25.4 million. This is primarily a result of net income of $14.3 million and a decrease in deposits receivable of $17.6 million and depreciation and amortization expense of $962,000 offset by realized capital gains totaling $1.7 million, and a decrease of $4.2 million in accrued expenses and other liabilities. Net cash provided by investing activities was $10.8 million due to $75.5 million in proceeds from sales of securities offset by $64.3 million in purchases of securities and $630,000 in purchases of fixed assets. Net cash used in financing activities was $3.3 million due to principal payments on our note payable in 2002.
Our need for additional capital is primarily the result of regulations that require certain ratios of regulatory or statutory capital to premiums written in our insurance subsidiary as defined by state regulatory bodies and insurance rating agencies. Raising additional permanent capital, while difficult in the current environment in which we operate, would stabilize our ratio of premium to capital and provide a solid base for the future growth of our insurance subsidiary. As an alternative to raising additional permanent capital, quota-share reinsurance or other additional reinsurance on an interim basis would have the effect of reducing the ratio of premiums to capital and could be used to satisfy state regulatory requirements.
An increase of 100 basis points in prevailing interest rates would reduce the fair value of our interest rate sensitive instruments by approximately $3.6 million.
Our insurance subsidiary is subject to substantial regulation by governmental agencies in the states in which we operate, and will be subject to such regulation in any state in which we provide workers’ compensation products and services in the future. State regulatory agencies have broad administrative power with respect to all aspects of our business, including premium rates, benefit levels, policy forms, dividend payments, capital adequacy and the amount and type of investments. These regulations are primarily intended to protect covered employees and policyholders rather than the insurance company. Both the legislation covering insurance companies and the regulations adopted by state agencies are subject to change. At December 31, 2002, our insurance subsidiary was licensed to do business in Minnesota, South Dakota, Wisconsin, Colorado, Missouri, Illinois, Kansas, Michigan, Indiana, Massachusetts, Connecticut, Rhode Island, Pennsylvania, Tennessee, Maryland, Arkansas, Iowa, Florida, Georgia, New Jersey, North Carolina, Texas and Oklahoma.
In March 1998, the NAIC adopted the Codification of Statutory Accounting Principles (the Codification). The Codification is intended to standardize regulatory accounting and reporting to state insurance departments and became effective January 1, 2001. Statutory accounting principles, however, will continue to be established by individual state laws and permitted practices. The State of Minnesota required adoption of the Codification for preparing statutory financial statements for financial periods occurring on or after January 1, 2001. Adoption of the Codification increased our statutory capital and surplus by approximately $1.9 million on January 1, 2001.
The Financial Accounting Standards Board (FASB) has issued SFAS No. 141, “Business Combinations”; SFAS No. 142, “Goodwill and Other Intangible Assets”; SFAS No. 143, “Accounting for Asset Retirement Obligations”; SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets”; SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statements No. 13, and Technical Correction”; and SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” since July 2001. After reviewing these pronouncements, we have determined that adoption of these statements is not expected to have an effect on our consolidated results of operations and financial position.
Consolidated Statements of Shareholders’ Equity - Years Ended December 31, 2002, 2001 and 2000
Notes to Consolidated Financial Statements - Years Ended December 31, 2002, 2001 and 2000
We have audited the accompanying consolidated balance sheets of RTW, Inc. (the Company) as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. The financial statements of the Company for the year ended December 31, 2000, were audited by other auditors whose report dated February 9, 2001 (March 28, 2001 as to Note 6) expressed an unqualified opinion on those statements and included an emphasis paragraph that stated the establishment of claim and claim settlement expense reserves is an inherently uncertain process.
We have audited the accompanying consolidated statements of operations, shareholders’ equity, and cash flows of RTW, Inc. and subsidiary (the Company) for the year ended December 31, 2000. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of the Company for the year ended December 31, 2000, in conformity with accounting principles generally accepted in the United States of America.
Use of Estimates - We make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the financial statement date and the recorded amounts of revenues and expenses during the reporting period. Our most significant estimates are those relating to our reinsurance recoverables on unpaid claim and claim settlement expenses, unpaid claim and claim settlement expenses, income taxes and accrual for premium adjustments. We continually review our estimates and assumptions and make adjustments as necessary, but actual results could vary significantly from these estimates.
Fair Value of Financial Instruments - A number of our significant assets and liabilities (including reinsurance recoverables, deferred policy acquisition costs, furniture and equipment and unpaid claim and claim settlement expenses) are not considered financial instruments for disclosure purposes. Our premiums receivable and other assets and liabilities that are considered financial instruments are generally of a short-term nature. Our term loan bears a floating interest rate. The carrying values of these instruments approximate their fair values. The carrying values and fair values of investments are disclosed in Note 3.
Our “Unpaid claim and claim settlement expenses” represent reserves established for the estimated total unpaid cost of claim and claim settlement expenses for insured events that occurred on or prior to each balance sheet date. The reserves are primarily undiscounted; however, we discounted selected claims that have fixed or determinable future payments by $438,000 in 2002 and $482,000 in 2001 using discount factors ranging from 3.5% to 8.0%. These reserves reflect our estimates of the total cost of claims that were reported, but not yet paid, and the cost of claims incurred but not yet reported. Our estimates consider such variables as past loss experience, current claim trends and prevailing social, economic and legal environments. We have a limited amount of historical data to use in estimating our reserves for unpaid claim and claim settlement expenses because we commenced operations in 1992. As a result, we supplement our experience with external industry data, as adjusted to reflect anticipated differences between our results and the industry. We reduce the unpaid claim and claim settlement expenses for estimated amounts of subrogation.
Basic income (loss) per share (IPS) is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted IPS is computed by dividing net income (loss) by the weighted average number of common shares and dilutive securities outstanding for the period. Dilutive securities consist of stock options. Dilutive securities are considered outstanding from the date of grant, after applying the treasury stock method for determining the dilutive effect.
Statutory Deposits - Included in investments are U.S. government securities on deposit with various regulatory authorities, as required by law, with a fair value of $27.7 million and $18.6 million at December 31, 2002 and 2001, respectively.
Additionally, included in investments are U.S. government securities pledged as collateral against a letter of credit provided to an insurer, with a fair value of $4.3 million and $2.6 million at December 31, 2002 and December 31, 2001.
Fixed Maturities by Maturity Date - The following table presents the amortized cost and fair value of investments by contractual maturity at December 31, 2002. Actual maturities may differ from those stated as a result of calls and prepayments (000’s):
We report reinsurance related balances on a “gross” basis on the balance sheet, resulting in reinsurance recoverable amounts on paid and on unpaid claim and claim settlement expenses recorded as assets. We estimate amounts recoverable from reinsurers in a manner consistent with the claim liability associated with the reinsured policy.
As described in Note 1, we establish unpaid claim and claim settlement expense reserves on reported and unreported claims for insured losses. The establishment of appropriate reserves is an inherently uncertain process. Furthermore, estimating ultimate reserves is difficult due to our relatively limited historical claim data and small claim population. Estimates are further complicated by the extended periods of time that elapse between the date the loss occurs and the date the loss is reported and ultimately settled. Reserve estimates are regularly reviewed and updated, using the most current information available. Any resulting adjustments, which may be material, are reflected in current operations.
Changes in estimates of unpaid claim and claim settlement expenses for prior years decreased the provision for claim and claim settlement expenses by $8.4 million in 2002 and increased the provision for claim and claim settlement expenses by $7.7 million in 2001 and by $15.9 million in 2000.
The amended term loan is collateralized by the stock of ACIC and is subject to restrictive financial covenants that require maintaining minimum financial ratios, including (i) debt coverage, (ii) net worth, (iii) statutory surplus, (iv) net earnings, (v) risk based capital and (vi) investment grade ratings. The agreement also restricts dividends, purchases and redemptions or retirements of common stock.
At December 31, 2002, we failed to meet a financial covenant of the term loan. We paid an additional $250,000 in principal in March 2003 and the covenant was waived in March 2003. Under the waiver, term loan principal payments were adjusted for a waiver of the financial covenant under the term loan agreement. The remaining term loan balance is due in 2003.
We have net operating loss carry-forwards available totaling approximately $7.6 million that expire in 2020.
Income taxes receivable were approximately $793,000 and $83,000 at December 31, 2002 and 2001, respectively, and are included in other assets.
The following table summarizes the options outstanding and exercisable at December 31, 2002:
The weighted average fair value of options granted under the ESPP and 1994 Stock Plan during 2002, 2001 and 2000 is estimated at $2.94, $2.19 and $4.48, respectively, on the date of grant using the Black-Scholes option-pricing model with the following assumptions: no dividend yield; volatility of 125.6% in 2002, 182.8% in 2001 and 64.6% in 2000; risk-free interest rates ranging from 1.66% to 7.70%; and an expected life of 1 to 5 years.
Employment Contracts - We entered into one-year employment agreements with our Chairman, David C. Prosser, President and Chief Executive Officer, J. Alexander Fjelstad III, and Executive Vice President, Alfred L. LaTendresse beginning December 13, 2001. Under these agreements, each receives a base salary, subject to review annually for increase by our Board of Directors. Mr. Prosser receives $250,000 which includes $30,000 for his services as Chairman of the Board and $220,000 in base salary. Mr. Fjelstad receives a base salary of $275,000 and Mr. LaTendresse a base salary of $200,000. In addition to base salary, each is eligible for bonuses and expense reimbursements. We also provide these individuals with health, dental, life and disability insurance consistent with that provided to other officers and employees. Additionally, Mr. Fjelstad and Mr. LaTendresse were each granted 100,000 non-qualified options at $1.98 per share on December 13, 2001. Mr. Prosser was granted 100,000 non-qualified options on February 6, 2002 at $2.42 per share.
Employment agreements with Carl B. Lehmann, our former President and Chief Executive Officer expired during 2001 and Mr. Lehmann terminated his employment with us on December 12, 2001. Under supplemental agreements with Mr. Lehmann in 2000 and 2001, we paid him “stay bonuses” of $200,000 on January 15, 2001 and $100,000 on June 30, 2001.
Other Employee Benefit Plans - We maintained bonus plans in 2002, 2001 and 2000 under which all employees, including officers, were eligible for a bonus based, in part, on our operating results. These bonuses aggregated $864,000, $204,000 and $951,000 in 2002, 2001 and 2000, respectively.
On November 7, 2002 our Board of Directors approved a one-for-two reverse stock split in order to remedy the minimum bid requirement for continued listing on the Nasdaq National Market. The reverse stock split was effective to shareholders of record on the close of business on November 22, 2002. All share and per share amounts in these financial statements have been adjusted to reflect the effect of the stock splits.
On September 15, 1998, our Board of Directors approved a share repurchase program authorizing the repurchase of up to $4.0 million of RTW, Inc. common stock. We may repurchase shares on the open market or through private transactions depending upon market conditions and availability. Through December 31, 2002 we repurchased approximately 376,000 shares for $2.7 million. We will use the repurchased shares for employee stock option and purchase plans and other corporate purposes.
On March 28, 2000, we repurchased 709,285 shares, outside the share repurchase program, from a group consisting of David C. Prosser, RTW’s founder and who at the time was a director, certain members of his family, and J. Alexander Fjelstad, who at the time was a former director and former executive of RTW (together, the Prosser Selling Group). We paid $10.38 per share, as well as legal and other costs, totaling approximately $7.7 million to repurchase the shares. After completing the transaction, the combined ownership of Mr. Prosser, members of his family and Mr. Fjelstad was reduced from approximately 52% to 46%. In December 2001, Mr. Fjelstad returned to RTW as President and Chief Executive Officer and a director (see Note 8).
In connection with the repurchase, Mr. Prosser retired from the Company, resigned as Chairman and was paid $225,000 as a termination benefit. He remained a member of our Board of Directors. In December 2001, Mr. Prosser returned to RTW as Chairman of the Board (see Note 8).
Shareholder Rights Plan - In April 1997, we adopted a shareholder rights plan and declared a dividend of one right for each outstanding share of common stock to shareholders of record at the close of business on June 30, 1997. The rights become exercisable only after any person or group (the Acquiring Person) becomes the beneficial owner of 15% or more of the voting power of our common stock. Certain shares held by our Chairman, David C. Prosser, and his wife are excluded from the computation for determining whether a person is an Acquiring Person. Each right entitles its registered holder to purchase from us one one-hundredth share of a new Series A Junior Participating Preferred Stock, no par value, at a price of $85 per one one-hundredth share, subject to adjustment. If any Acquiring Person acquires beneficial ownership of 15% or more of our voting power, each right will entitle its holder (other than such Acquiring Person) to purchase, at the then current purchase price of the right, that number of shares of our common stock having a market value of two times the purchase price of the right, subject to certain possible adjustments. In addition, if we are acquired in a merger or other business combination transaction, each right will entitle its holder to purchase, at the then current purchase price of the right, that number of common shares of the acquiring company having a market value of two times the purchase price of the right. Following the acquisition of a beneficial ownership of 15% or more of our outstanding common stock by any Acquiring Person and prior to an acquisition by any Acquiring Person of 50% or more of our outstanding common stock, our Board of Directors may exchange the outstanding rights (other than rights owned by such Acquiring Person), in whole or in part, at an exchange ratio of one share of common stock, or one one-hundredth share of Preferred Stock (or equivalent securities) per right, subject to adjustment. We may redeem the rights, in whole, at $.001 per right, at any time prior to an acquisition by any Acquiring Person of 15% or more of our outstanding common stock and prior to the expiration of the rights. The rights expire on April 17, 2007, unless extended or earlier redeemed by us.
Statutory Surplus and Statutory Net Income (Loss) - Our insurance subsidiary is required to file financial statements with state regulatory agencies. The accounting principles used to prepare the statutory financial statements follow prescribed accounting practices that differ from GAAP. Statutory policyholders’ surplus at December 31, 2002 and 2001, and statutory net income (loss) for the years ended December 31, 2002, 2001 and 2000 are as follows (000’s):
In March 1998, the National Association of Insurance Commissioners adopted the Codification of Statutory Accounting Principles (the Codification). The Codification standardized regulatory accounting and reporting to state insurance departments and became effective January 1, 2001. Statutory accounting principles, however, will continue to be established by individual state laws and permitted practices. The State of Minnesota required adoption of the Codification for preparing statutory financial statements for financial periods occurring on or after January 1, 2001. Adoption of the Codification increased our statutory capital and surplus by approximately $1.9 million at December 31, 2001.
Rent expense, including contingent rentals, was $1.3 million, $2.0 million and $2.1 million for 2002, 2001 and 2000, respectively.
Our comprehensive income (loss) includes only unrealized gains and losses on investments classified as available-for-sale. Changes in accumulated other comprehensive income (loss) and other comprehensive income (loss) were as follows (000’s):
During 2001, we recorded pre-tax restructuring charges totaling $2.0 million to general and administrative expenses in the Consolidated Statement of Operations. These charges included costs associated with our decision to close our Missouri and Massachusetts regional offices, as well as our Brainerd, Minnesota and Overland Park, Kansas satellite offices. We anticipated that 38 employees in our regional offices, 17 employees in our satellite offices and 2 employees in our Home Office would be affected by these closures. The restructuring charge included $715,000 of severance pay and benefits, of which $106,000 was paid by December 31, 2001 and the remainder of which was paid, primarily early, in 2002. Additionally, the restructuring charge included office and equipment lease costs totaling $684,000 of which $80,000 was paid by December 31, 2001 with an additional $195,000 paid in 2002 and furniture and equipment disposals and other costs totaling $600,000 of which $53,000 had been disposed of by December 31, 2001, the remainder of which was disposed of in 2002. At December 31, 2001, the remaining accrual for severance pay and benefits, office and equipment lease costs and furniture and equipment disposals and other costs was $1.8 million. The accrual decreased to $409,000 at December 31, 2002 and primarily included amounts related to future lease payments.
The following tables present unaudited quarterly results of operations for the eight quarters ended December 31, 2002: