The data below should be read in conjunction with the consolidated financial statements, related footnotes, and other financial information included herein. All dollar amounts are in thousands, except per share data.
We provide personal and commercial property and casualty insurance primarily in Massachusetts and in other states. Our core product lines are personal automobile, homeowners, and commercial automobile. We market our products exclusively through our network of independent agents in all states, except California, where we use agents and brokers. Our primary business strategy is to focus on the personal automobile insurance market in Massachusetts and to grow and diversify by increasing the proportion of our business written in other states in which we currently have a significant presence, primarily from Commerce West and American Commerce, and by expanding into the New York and New Jersey personal lines markets through the SWICO acquisition.
A significant aspect of our automobile insurance business relates to our interaction with CAR, which enables us and the other participating servicing carriers to reinsure any automobile risk which is perceived to be under-priced. Since its inception, CAR has annually generated significant underwriting losses, primarily in the personal automobile pool. All companies writing automobile insurance in Massachusetts share in the underwriting results of CAR business for their respective product line or lines.
Member companies of CAR have joint and several liabilities for the obligations of CAR. If one member of CAR fails to pay its assessments, the remaining members will be required to pay the pro-rata share of the member who fails to pay its obligations. As of December 31, 2006, we were not aware of any current CAR member company which has failed to meet its obligations.
the change in the portion of premiums that will not be recognized as income for accounting purposes until a future period, which we refer to as unearned premiums;
estimates are revised as deemed necessary by our claims department personnel based on subsequent developments and periodic reviews of the claim.
In accordance with industry practice, we also maintain reserves for estimated IBNR, salvage and subrogation recoverable and LAE. These reserves are determined based on historical information. Imbedded within the historical information are changes in the volume of policies written, claims frequency, severity and payment patterns, the mix of business and claims processing. IBNR reserves are established for claims that have been incurred prior to year end but have not been reported to us until after year end. Our IBNR reserve is derived by analyzing the amount of losses that have been incurred subsequent to a given calendar year end. We aggregate losses incurred for each of the three years after a given calendar year end and determine the percentage of losses to earned premium for that calendar year. We calculate the IBNR reserve by multiplying the appropriate historical percentage of losses by the earned premium for the current year and each of the prior two calendar years. Our calculations are based on historical losses incurred by line of business and coverage type and are modified where appropriate for changes in premium rates. We monitor the percentages for historical patterns and adjust our IBNR reserves as appropriate.
We utilize an actuarial calculation as a test of reasonableness of our financial statement loss and LAE reserves which were calculated by financial management. Our actuaries calculate their estimate of our liability for loss and LAE reserves using generally accepted actuarial reserving techniques. The reserving techniques employed by our actuaries include incurred loss development and paid loss development for all reviewed lines. For voluntary personal automobile liability, two additional methods were used -- claim count times average severity and exposures times ultimate pure premium. In estimating allocated LAE ("ALAE") reserves, our actuaries used two methods -- paid ALAE development and ratio of paid ALAE to paid loss development. For unallocated LAE ("ULAE") reserve, three methods were used -- paid ULAE development, paid ULAE to paid loss ratio development and calendar year paid ULAE to paid loss and ALAE. An average of these methods is calculated, which is called the indicated ultimate loss. The indicated ultimate loss is then subjected to actuarial judgment which considers other factors, such as the resulting ultimate loss ratio, loss trends, changes to business and the relative value of each of the different methods. A selected ultimate loss amount is then determined. Using the criteria of Actuarial Standard
As we base our estimate of loss and LAE reserves primarily on historical payment experience, the following sensitivity analysis assumes that our historical payment experience was impacted by the stated percentages. The factors which could cause the payment experience to change are not analyzed individually as these factors are imbedded in the historical information. Based upon historical results over the last five years, we show a redundancy for all five years, with a minimum redundancy of 5.2% and a maximum redundancy of 10.2% from the initially established reserves. See page 18 for an analysis of our historical loss and LAE reserve development.
The business we assume from CAR is a significant component of our loss and LAE reserves. Our assumed CAR loss and LAE reserves amounted to approximately 13% of our loss and LAE reserves at December 31, 2006 (prior to the effect of ceded reinsurance recoverable). CAR provides information to pool participants on a quarterly basis, one quarter in arrears. CAR provides consolidated results, which consist of all companies' ceded business into the pool, as well as information specific to our company. CAR provides information by line of business on policy year and accident year bases. This information consists of premiums written, unearned premium, earned premium, paid losses, case reserves, IBNR reserves, incurred losses, incurred loss adjustment expenses and underwriting expenses. The starting point for CAR's determination of its loss and LAE reserves is the separate loss and LAE reserves that CAR member companies provide to CAR. CAR then aggregates this information, which is reviewed by CAR's loss reserve committee, comprised of actuaries from member companies. This CAR actuarial committee establishes the total loss and LAE reserves for a given period. Our share of these loss and LAE reserves is derived by multiplying our participation ratio by the total CAR loss and LAE reserves. Management utilizes the information provided by CAR to book the initial amount related to the pool. The consolidated financial results produced by CAR are audited by independent public accountants and we rely on this audit for the incorporation of their reported results into our financial statements. CAR assesses the integrity of premium and claim data submissions by member companies by periodically auditing those member companies. Our actuary also reviews the CAR actuarial committee's work along with total CAR and company loss results for reasonableness.
Accrued agents' profit sharing. In addition to state mandated minimum and other commissions on policies written, we pay certain of our agencies compensation in the form of profit sharing under five separate arrangements: one for Commerce and Citation for their Massachusetts agencies; another for Commerce's New Hampshire agencies; one for American Commerce for its agencies; and, two for Commerce West for its agencies. Each of these arrangements entitles qualifying agencies to share in our results based primarily on the underwriting profits of an individual agents' business written with us. Our total obligation under these arrangements is reported on our consolidated balance sheet as "Accrued agents' profit sharing." For segment reporting, our profit sharing expenses are aligned by state; profit sharing expense for our agencies in Massachusetts is included in our Massachusetts segment's earnings; profit sharing expense for our agencies in states other than Massachusetts is included in our Other than Massachusetts segment's earnings.
We estimate our current year profit sharing expense each quarter. Our expense calculation at year-end has one critical accounting estimate, as defined by the SEC, which we refer to as the discount factors. The discount factors represent our expected profit sharing payments for the second and third years following the current year's payment, net of attrition related to our agencies' profitability and profit sharing eligibility. We don't use a discount factor for the current year's payment because, subject to some final adjustments, our year-end estimate of our next payment is usually reasonably close to the actual payment amount. However, we know from experience that all of the agencies that are currently profitable, after the first and second years of each rolling three-year cycle, will not remain profitable and be entitled to all of the profit sharing earned during those years. Therefore, we apply discount factors in our accrual calculation to the estimated payment amounts for the latter two years to estimate this attrition in profit sharing eligibility.
Changes in Premium Rates. In each of the last three years, the Commissioner approved an average mandated Massachusetts personal automobile insurance premium rate decrease. The Commissioner approved average decreases of 11.7% for the one-year period beginning April 1, 2007 and 8.7% for the fifteen months beginning January 1, 2006. Coinciding with the 2006 and 2005 rate decisions, the Commissioner also approved commissions agents receive for selling private passenger automobile insurance. The Commissioner approved no change in commission dollars for 2007 and a 1.5% increase for 2006. The following table shows the state-mandated average rate change, the actual average written premium change per exposure and our average written premium change per exposure as estimated for 2006 and for the three previous years in Massachusetts.
Although mandated average personal automobile premium rates decreased 8.7% in 2006, our average written premium per exposure decreased only 5.6%. We believe that the smaller decrease for 2006 as compared to the Commissioner's state mandated average rate resulted primarily from:
the fact that our mix of personal automobile coverage differs from that of the industry; and
changes to our distribution of risks by class, territory and coverage, including changes resulting from the purchase of new, more expensive automobiles, which were not factored into the Commissioner's rate decrease.
The Commissioner approved an 11.7% decrease in state mandated average personal automobile insurance premium rate for the one-year period ending April 1, 2007. Management estimates that this will translate into a 6.4% decline in the average written premium per exposure for the upcoming year. We estimate the 2007 net pre-tax impact of the 6.4% decrease in our 2007 average written premium per exposure to be approximately $34,400. The majority of the impact will occur during the last quarter of 2007 and the first quarter of 2008 as premiums for policies with 2007 effective dates become earned.
Affinity Group Marketing. Since 1995, we have been a leader in affinity group marketing in Massachusetts, through agreements with the three American Automobile Association Clubs operating in Massachusetts, offering discounts on private passenger automobile insurance to the clubs' members who reside in the state. A 5% discount was approved by the Commissioner for policies effective April 1, 2007. This same discount existed in 2006 through April 1, 2007. Based on information provided to us by the AAA clubs operating in Massachusetts, we believe that membership in these clubs represents approximately one-third of the Massachusetts motoring public. The following table presents total direct premiums written attributable to the AAA clubs' group business in Massachusetts for the years ended December 31:
The decreasing percentages since 2004 are attributed to a higher rate of increase in non-affinity group business. Of the total Massachusetts automobile exposures written through the AAA affinity group program by us in 2006, approximately 15.5% were written through insurance agencies owned by the AAA clubs (8.0% of our total Massachusetts automobile exposures). The remaining 84.5% of the AAA group program was written through our network of independent agents.
. Diluted earnings per share is net earnings divided by the weighted average number of common shares outstanding adjusted by the number of additional common shares that would have been outstanding had potentially dilutive common shares been issued and reduced by the number of common shares we could have purchased from the proceeds of those potentially dilutive shares.
. Return on equity is net earnings divided by stockholders' equity at the beginning of the period.
. Direct earned premiums are the portion of direct premiums written over the preceding twelve-month period equal to the expired portion of policies and recognized as revenue during an accounting period.
The combined ratio is the sum of the loss and LAE ratio and the underwriting expense ratio and measures a company's overall underwriting profit. If the combined ratio is at or above 100%, an insurance company cannot be profitable without investment income, and may not be profitable if investment income is insufficient. We use the combined ratio in evaluating our overall underwriting profitability and for comparing our profitability to that of our competitors.
continued improvement in the results from CAR due to fewer industry-wide cessions to CAR coupled with lower loss ratio on current year CAR business;
Key measures of net investment income for the years ended December 31 follow:
Our loss ratio declined to 60.7% for 2006 from 61.4% the prior year. The improvement was the result of several factors, including:
As a result of changes in estimates of insured events in prior years, the provision for loss and LAE decreased $43,726 for the year ended 2006 and $61,397 for the year ended 2005. The favorable development is due primarily to lower than anticipated losses related to the personal automobile liability. Conditions and trends that have affected development in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based upon these developments. The amounts we will ultimately incur from loss and loss adjustment expenses could differ materially in the near term from the amounts recorded.
Approximately $43,522 in personal automobile liability redundancies developed for the year ended 2006, with 99% of this amount coming from the 2005, 2004 and 2003 accident years. The primary reason for the redundancies in this area is that claim severity developed better than we anticipated, coupled with significant redundancies from CAR, which approximated 27% of the total automobile liability redundancy. Automobile physical damage had approximately $1,735 in redundancies all related to the 2005 accident year, which were offset by prior period deficiencies. Redundancies related to 2005 were approximately $4,713, of which CAR accounted for 43%. Partially offsetting these redundancies was a $1,895 deficiency in commercial automobile business, primarily related to CAR for the 2005 accident year, and a $236 deficiency in homeowners business. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining net redundancy of approximately $600.
Management considers many factors, as disclosed in the Critical Accounting Policies section of this report, in establishing its best estimate for loss and LAE reserves. We believe that our loss and LAE reserve estimate is a reasonable assessment of the ultimate future payment amounts necessary to settle all of our insured losses incurred as of December 31, 2006. In addition, we believe the pro forma analysis presented under the Critical Accounting Policies is a reasonable depiction of our sensitivity related to our estimate, based on our reserving methodology and the short-tail nature of the
business that we write. However, the ultimate liability may be greater or less than the established reserves for losses and LAE. If the ultimate payments are greater or less than our estimated liability for losses and LAE, we will either incur additional or less expenses, respectively, in future periods which may have a material effect on our future results of operations.
The market price for our common stock and our financial results directly affects our expense related to stock options, book value awards (BVAs) and incentive awards (IAs), respectively. Our stock option expense represents options granted to both employees and American Commerce agents. The majority of this expense is related to options granted to American Commerce agents. An increase in the market value of our stock will increase the expense we recognize for options. Similarly, an increase in our net income will increase the value of, and therefore the expense we recognize for, outstanding BVAs and IAs. We record these expenses in three separate line items on our income statement -- losses and loss adjustment expenses, policy acquisition costs and net investment income. See Note I of Notes to Consolidated Financial Statements for further information. The stock option, BVA and IA expenses recorded in each line item for the years ended December 31 follow:
In September 2006, the Financial Accounting Standards Board (FASB) issued Statement No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans -- an amendment of FASB Statements No. 87, 88, 106 and 132(R). This Statement requires an employer to recognize the overfunded or underfunded status of a defined benefit plan as an asset or liability in its financial statement and to recognize changes in that funded status in the years in which the changes occur through comprehensive income. This Statement also requires measurement of funded status as of the fiscal year-end, with limited exceptions. The Statement is effective for publicly traded companies for fiscal years ending after December 15, 2006. The adoption of this Statement did not have an impact on our results of operations or financial position.
In July 2006, the FASB released FIN 48, Accounting for Uncertainty in Income Taxes -- an interpretation of SFAS 109. This interpretation clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS 109. This interpretation prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. It also provides guidance on derecognition, classification, interest and penalties, interim periods and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006. We will adopt FIN 48 as of January 1, 2007 and we expect the adoption to have a negligible impact on our results of operation and financial position.
In March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets, an amendment of Statement No. 14 (FAS 156). FAS 156 requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable, and permits an entity to subsequently measure those servicing assets and servicing liabilities at fair value. FAS 156 is effective for fiscal years beginning after September 15, 2006. We do not expect the adoption of FAS 156 to have a material impact on our results of operations or financial position.
In February 2006, the FASB issued Statement No. 155, Accounting for Certain Hybrid Financial Instruments -- an amendment of FASB Statements No. 133 and 140. The Statement permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. The new Statement also requires companies to identify interests in securitized financial assets that are freestanding derivatives or contain embedded derivatives that would have to be accounted for separately and that interest-only and principal-only strips are not subject to Statement No. 133. This new Statement is effective for fiscal years beginning after September 15, 2006 with early adoption permitted. Although we do not currently have any financial instruments subject to this new Statement, we elected to adopt this Statement effective January 1, 2006 and it had no impact on our financial statements.
In June 2005, the FASB issued Statement No. 154, Accounting Changes and Error Corrections -- A Replacement of APB Opinion No. 20 and FASB Statement No. 3 (FAS 154). The Statement applies to all voluntary changes in accounting principles and requires that such changes be applied retrospectively to prior periods unless doing so is impracticable. The Statement does not change the transition method for new accounting standards where the new pronouncements address transition provisions. The Statement was effective January 1, 2006. FAS 154 did not have an impact on our financial position or results of operations.
The FASB issued in December 2004 revised rules for accounting for stock options and other equity-based remuneration, SFAS No. 123R, Share-Based Payment. We adopted these revised rules in the first quarter of 2006 when they became effective. This change did not impact our results of operations and financial condition for the employee stock options we awarded through 2001 under the Plan because application of the revised rules is on a prospective basis, these awards were fully vested and we have not modified, repurchased or cancelled any of these stock options. The revised rules did not change our accounting for BVAs, IAs and the stock options we award under the American Commerce agents' option Plan.
assessment from the Massachusetts Insurance Insolvency Fund. The increase in agents' profit sharing expense is the result of improved underwriting results in 2005 versus 2004.
For a detailed breakdown on direct premiums written and earned, see Note P -- Segment Information in Notes to Consolidated Financial Statements.
Our year-to-date homeowners growth was from a 10.5% increase in average premium per policy partially offset by a 0.6% decrease in the number of policies written. Our year-to-date commercial automobile decline was from a 2.0% decrease in average premium per policy partially offset by a 0.7% increase in policies written. Average premium per policy has declined due to more competitive pricing in a softening market.
The composition of our investment portfolio, at cost, at December 31 follows:
Total realized gains were relatively flat from 2005 as compared to 2004. Impairment losses decreased by $10,097 but were offset by a $8,218 decline in transaction gains and a $2,600 decline in the equity in earnings of the closed-end preferred stock mutual funds. Once again in 2005, we were able to realize significant investment gains in long duration municipal bonds and asset-backed investments. We maintain the flexibility to realize capital gains when we feel it is a benefit for our long-term, after-tax return.
improved current year results and continued favorable prior years' loss development from CAR,
The market price for our common stock and our financial results directly affects our expense related to stock options, BVAs and IAs, respectively. We record these expenses in three separate line items on our income statement -- losses and loss adjustment expenses, policy acquisition costs and net investment income. The stock option, BVA and IA expenses recorded in each line item for the years ended December 31 follow:
Our financial condition improved significantly in 2006. Our stockholders' equity per share increased 16.2% from $19.39 at December 31, 2005 to $22.53 at December 31, 2006. Our ratio of total liabilities to stockholders' equity decreased 27 percentage points at December 31, 2006 from the prior year end. This decrease is due to a 15.2% increase in equity combined with a 0.6% decline in total liabilities. The increase in equity during 2006 resulted primarily from current year earnings and appreciation in value of available for sale securities, partially offset by dividends paid and common stock repurchased. Total liabilities decreased chiefly as a result of declines in unpaid losses and LAE and accrued expenses partially offset by increased accrued agents' profit sharing.
The liability for unpaid losses and LAE represents the accumulation of individual case estimates for reported losses, adjustments to this amount on a line of business basis and estimates for incurred but not reported losses and LAE, net of salvage and subrogation recoverable. The liability is intended to cover the ultimate net cost of all losses and LAE incurred through the balance sheet date. Payment amounts are estimated, based on payment patterns experienced through 2006.
Liquidity management allows us to meet our cash needs at a reasonable cost under various operating environments. Liquidity is actively managed and reviewed in order to maintain stable, cost-effective funding to meet our operating needs. Liquidity comes from a variety of sources such as cash flow from operating activities and borrowing capacity. Management believes its current liquidity exceeds its operational requirements as of December 31, 2006.
In April 2005, Commerce Insurance became a member of the Federal Home Loan Bank (FHLB) of Boston, providing Commerce Insurance with a significant source of liquidity. The FHLB of Boston, which is one of 12 regional FHLBs, serves as a reserve or central bank for its members within its assigned region. The FHLB of Boston makes loans, which are referred to as advances, to members in accordance with policies and procedures established by its board of directors. These policies and procedures are subject to the regulation and oversight of the Federal Housing Finance Board. All advances from the FHLB of Boston to Commerce Insurance are required to be fully secured by sufficient collateral as determined by the FHLB. We estimate that FHLB membership provides Commerce Insurance with the capacity to borrow approximately $380,000 from the FHLB of Boston. We have not borrowed from the FHLB.
We expect to pay significantly more for agent profit sharing in 2007 than we paid in 2006. We paid approximately $84,000 for agent profit sharing in the second quarter of 2006. Due to our improved underwriting results during 2006, we estimate paying approximately $115,000 in the second quarter of 2007.
Changes in interest rates would result in unrealized gains or losses in the market value of the fixed maturity and preferred stock portfolio due to differences between current market rates and the stated rates for these investments. The following table summarizes our interest rate risk, based on the results of the sensitivity analysis at December 31, 2006 and 2005. The table also reflects the changes in market value and stockholders' equity that would be attributable to realized investment gains (losses) that we would recognize under the equity method of accounting with respect to the change in the net asset value of the mutual funds in which we own 20% or more of the shares outstanding. See "Critical Accounting Estimates--Investments and Other-than-Temporary Impairments."
The preceding sensitivity analysis does not represent a forecast and should not be relied upon as being indicative of expected results. These hypothetical estimates are based upon numerous assumptions such as the nature and timing of interest rate levels including the yield curve shape, prepayments on loans and securities, reinvestment and replacement of asset and liability cash flows and other assumptions. While assumptions are developed based upon current economic conditions, we cannot provide any assurance as to the predictive nature of these assumptions. Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to prepayment and refinancing levels likely deviating from those assumed and other internal and external variables. Furthermore, the sensitivity analysis does not reflect actions that management might take in responding to or anticipating changes in interest rates.
market disruption in Massachusetts, if competitors exit the market or become insolvent;
our ability to retain our affinity relationships with AAA clubs, especially in Massachusetts;
our dependence on a key third party service vendor in Massachusetts;
You should not place undue reliance on any forward-looking statement. The risk factors referred to above, as well as those elsewhere in this Annual Report on Form 10-K, could cause actual results or outcomes to differ materially from those expressed in any forward-looking statement made by us or on our behalf (see Part I, Item 1, "Risks Related to Our Business" of this Form 10-K). Further, any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
Our management is responsible for the consolidated financial statements and all other information presented in this Annual Report on Form 10-K. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America determined by management to be appropriate in the circumstances and
include amounts based on management's informed estimates and judgments. Financial information presented elsewhere in this Annual Report on Form 10-K is consistent with the financial statements.
Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Securities and Exchange Act of 1934. Management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework. Based on this assessment, management concluded the Company maintained effective internal control over financial reporting as of December 31, 2006.
Our management's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2006 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.
We have completed integrated audits of The Commerce Group Inc.'s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006, 2005 and 2004, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Net other comprehensive income (loss) for the year. See Note I of Notes to Consolidated Financial Statements.
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). Our consolidated financial statements include the accounts of The Commerce Group, Inc. and its subsidiaries, Bay Finance Company, Inc., Clark-Prout Insurance Agency, Inc. and Commerce Holdings, Inc. (CHI). The Commerce Insurance Company (Commerce), Commerce West Insurance Company (Commerce West) and Citation Insurance Company (Citation) are wholly-owned subsidiaries of CHI. American Commerce Insurance Company (American Commerce) is a wholly-owned subsidiary of ACIC Holding Co., Inc. (AHC). AHC is owned jointly with AAA Southern New England (AAA SNE) with CHI maintaining a 95% common stock interest and AAA SNE maintaining a 5% common stock interest. All inter-company transactions and balances have been eliminated in consolidation. Certain prior year account balances have been reclassified to conform to the 2006 presentations.
On May 19, 2006, the Board of Directors approved a two-for-one stock split of our $0.50 par value common stock, effective June 9, 2006. As a result of the split, 40,915,773 additional shares were issued, and paid-in capital was reduced by $20,458. All references in the accompanying financial statements and notes to the number of shares and per-share amounts for prior years have been restated to reflect the stock split.
All stock option based awards accounted for under the intrinsic value method were earned as of the first quarter of 2004; therefore, no additional expense was required after that date.
Cash equivalents include short-term, liquid investments that are readily convertible to known amounts of cash and so near their maturity that they present insignificant risk of changes in value because of changes in interest rates.
The cash and cash equivalent balances at December 31, 2006 and 2005 are grossed up by $41,845 and $42,283, respectively, which represents outstanding checks for which there was no right of offset. These amounts are included in other liabilities and accrued expenses for the respective years.
Our closed-end preferred stock mutual fund holdings at December 31, 2006 and 2005 accounted for under the equity method follow:
John Hancock Patriot Premium Dividend II Fund (PDT), John Hancock Patriot Global Dividend Fund (PGD) and John Hancock Patriot Preferred Dividend Fund (PPF). The quoted market values of these investments are less than carrying value at year end 2006 and 2005. The carrying value is the net asset value of the underlying securities, which would be the value we would receive if the fund liquidates. We intend to hold these investments to recovery.
We originate and hold real estate mortgage loans on properties located in Massachusetts and Connecticut. Mortgage loans are collateralized by the related real estate. Agency loans are generally collateralized by the assets of the agency. We control credit risk through credit approvals, credit limits and monitoring procedures. We perform in-depth credit evaluations on all new mortgage customers. We have not incurred any bad debt expense on mortgage loans during the three years ended 2006.
At December 31, 2006 and 2005, mortgage loans on non-accrual status totaled $69 and $149, respectively. Allowances of $10 and $13 were established in 2006 and 2005, respectively, for these non-accrual status loans. The reduction in interest income associated with non-accrual loans was $8, $8 and $15 for the years ended December 31, 2006, 2005 and 2004, respectively.
There were no fixed maturity investments outstanding at December 31, 2006 which did not produce income during 2006.
Net realized investment gains for the years ended December 31 follow:
Net unrealized gains (losses) on available-for-sale investments, net of tax, is included in net accumulated other comprehensive income, a component of stockholders' equity.
Depreciation and amortization expense was $7,197, $6,091 and $5,975 for the years ended December 31, 2006, 2005 and 2004, respectively. Depreciation and amortization expense is allocated evenly between loss adjustment expenses and policy acquisition costs.
existing information, the provision for losses and LAE at December 31, 2006 is adequate to cover the ultimate net cost of losses and claims incurred as of that date. The ultimate liability, however, may be greater or lower than established reserves. If the ultimate exposure is greater than (or less than) our estimated liability for losses and LAE, we will incur additional expense (income) which may have a material impact on our consolidated results of operations and financial position. We do not discount to present value that portion of our loss reserves expected to be paid in future periods.
As a result of changes in estimates of insured events in prior years, the provision for loss and LAE decreased $43,726 for the year ended 2006, $61,397 for 2005 and $57,031 for 2004. The favorable development is due primarily to lower than anticipated losses related to the personal automobile liability. Conditions and trends that have affected development in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based upon these developments. The amounts we will ultimately incur from loss and loss adjustment expenses could differ materially in the near term from the amounts recorded.
Approximately $51,027 in personal automobile liability redundancies developed for the year ended 2004, with 98% of this amount coming from the 2003, 2002 and 2001 accident years. The primary reason for the redundancies in this area is that claim severity developed better than we anticipated. The redundancy for personal automobile liability that related to CAR accounted for approximately 2.5% of the total. Automobile physical damage had approximately $2,334 in redundancies related to the 2003 accident year, approximately 98% of which was related to CAR. In 2004, we also experienced redundancies of $2,222 for the commercial multiple peril line of business, half of which related to the 1996 accident year. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining net redundancy of approximately $1,448.
Our aggregate actuarial estimate for the loss and LAE reserves, on a consolidated basis and net of reinsurance recoverable, ranges from a low of $778,600 to a high of $893,600, as of December 31, 2006. Our financial statement loss and LAE reserves net of reinsurance, based on our best estimate, was established at $850,775 for that date. Financial management calculates our estimate independently from those amounts as calculated by our actuaries and, therefore, the final results are most often not the same. We estimate amounts primarily by reviewing historical loss and LAE data, focusing mainly on payment data. We also review and compare most recent loss frequency, severity and payment data to historical trends in an attempt to determine if patterns are remaining consistent or not. We attempt to establish our reserve estimate as close to the amount required for the ultimate future payments necessary to settle all losses. The accuracy of this estimate is reflected by the line noted in the above table entitled "decrease in provision for insured events of prior years."
On December 9, 2003, we issued $300,000 face value of senior unsecured and unsubordinated debt (the Senior Notes) which matures December 9, 2013. The Senior Notes were issued at 99.3% to yield 6.04% and bear a coupon interest rate of 5.95%, payable semi-annually on June 9 and December 9. Proceeds from the issuance were $297,972. Costs related to the issuance of the Senior Notes have been deferred and recorded in other assets on the balance sheet. The deferred costs and the original issue discount will be amortized into interest expense over the life of the Senior Notes. The fair market value of the Senior Notes at December 31, 2006 was estimated at $295,000.
Net accumulated other comprehensive income is a component of stockholders' equity and includes unrealized gains and losses, net of tax, on available for sale investment securities.
IAs issued relating to the Plan totaled 1,206,297 in 2006 and 1,208,631 in 2005. BVAs issued related to the Plan totaled 1,489,111 in 2004. Expenses relating to BVAs and IAs were $26,081, $29,043 and $18,904 in 2006, 2005 and 2004, respectively. The outstanding BVAs entitle the holders to cash payments based upon the extent to which, if at all, the per share book value exceeds certain thresholds set at the time the award was granted.
Employee stock options (options) granted from 1999 through 2001 relating to a previously approved plan totaled 2,529,042, including the issuance of options previously terminated. No employee stock options were granted after 2001 under the Plan. The outstanding options entitle the recipient to purchase our common stock based upon the extent to which, if at all, the per share market value of the common stock exceeds certain thresholds set at the time the option was granted. Unexercised options terminate not later than eight years after the date of grant. The average contractual life of the remaining 16,084 options outstanding at December 31, 2006 was 2.3 years.
qualified, the recipient may purchase our common stock at the exercise price for a period of five years beginning five years after the date of the grant (the confirmation date). Unexercised ACIC agents' options terminate not later than ten years after the date of the grant (the expiration date). In conjunction with meeting specified premium growth levels over the term of the ACIC agents' options, we provided "put rights" to the holders of the ACIC agents' options granted in 1999. These put rights permit the agents' option holders to require us to purchase the ACIC agents' options at the difference between $20.00 less the exercise price, at any time from and after the confirmation date through and including the expiration date. Options outstanding from the 1999 grant totaled 297,350 at December 31, 2006. Options cannot be exercised using cash. Options can only be exercised using a net share purchase such that the dollar value that the option is in the money is divided by the fair market value of the stock at the date of exercise to arrive at the number of shares received by the option holder. We record our expenses associated with the ACIC Plan over each award's vesting period, based on our estimate of the fair value of each award using the Black-Scholes option pricing model. Expenses related to these options were $6,568 in 2006, $1,395 in 2005 and $15,291 in 2004. The ACIC Plan has not been, and is not required to be, approved by our stockholders.
The ACIC Plan activity, retroactively adjusted for the June 2006 two-for-one stock split, for the three years ended 2006 follows:
There were 597,350, 308,350 and 744,260 exercisable ACIC agents' options at December 31, 2006, 2005 and 2004, respectively. The weighted average remaining contractual life of ACIC agents' options outstanding at December 31, 2006 was 6.8 years.
The weighted average exercise prices for ACIC agents' options granted in 2006, 2005, and 2004 were $37.38, $36.27 and $29.32, respectively. The estimated weighted average grant date fair values estimates of the ACIC agents' options granted during 2006, 2005 and 2004 were $4.46, $4.27 and $4.03, respectively. The ACIC agents' option liability at December 31, 2006 and 2005 was $21,236 and $17,398, respectively.
The Financial Accounting Standards Board issued in December 2004 revised rules for accounting for stock options and other equity-based remuneration, SFAS No. 123R, Share-Based Payment. SFAS No. 123R is applicable for employee options and not for non-employee options, such as ACIC agents' options. We adopted these revised rules in the first quarter
The aggregate amount of dividends calculated in accordance with regulations in Massachusetts, California and Ohio that could have been paid in 2006 from all of our insurance subsidiaries without prior regulatory approval was approximately $238,122, of which $203,410 was declared and paid as of December 31, 2006.
The amount of consolidated retained earnings at December 31, 2006 represented by undistributed earnings of 50% or less owned investments that are accounted for using the equity method follows:
Insurance premiums are recognized as income ratably over the terms of the policies. Unearned premiums are determined by prorating written premiums on a daily basis over the terms of the policies.
The method of allocation calls for current taxes to be allocated among all affiliated companies based on a written tax-sharing agreement. Under this agreement, allocation is made primarily on a separate return basis with current payment for losses and other tax items utilized in the consolidated return.
In July 2006, the FASB released FIN 48, Accounting for Uncertainty in Income Taxes - an interpretation of SFAS 109. This interpretation clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS 109. This interpretation prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. It also provides guidance on derecognition, classification, interest and penalties, interim periods and disclosure. FIN 48 is effective for fiscal years beginning after
All of the insurers writing the types of insurance covered by the Massachusetts Insurers Insolvency Fund (MIIF) are MIIF members. MIIF is obligated to pay any unpaid claim, up to $300, against an insolvent insurer if the claims existed prior to the declaration of insolvency or arose within 60 days thereafter. MIIF assesses members the amounts it deems necessary to pay both its obligations and the expenses of handling covered claims. Subject to certain limitations, assessments are made in the proportion that each member's net written premiums for the preceding calendar year for all property and casualty lines of business has to the corresponding net written premiums for all members for the same period. The statute that established MIIF also provides for the recoupment by insurers of amounts paid to MIIF. Historically, the Commissioner has allowed insurers to recoup the amounts they paid MIIF through rate adjustments.
We will have no additional reinsurance recoveries for a single event catastrophe in excess of a total loss of $600 million. Our average estimated combined total loss for the Commerce, Citation and ACIC insurance subsidiaries, on other than automobile business, was calculated in 2006 using two prominent catastrophe modeling companies. The average estimated "100 year loss" is $317 million and the "250 year loss" is $583 million.
The Catastrophe Reinsurance Program will not discharge us from our primary liability to the insured for the full amount of the insured's policies, but it will make the reinsurer liable to us to the extent of the reinsured portion of any loss ultimately suffered. Each reinsurer participating in the reinsurance program will be severally (and not jointly) liable to us for its share of reinsurance coverage. We believe the reinsurers are adequately capitalized and financially able to meet their obligations under the reinsurance agreements with us, though there can be no assurance that they will be able to do so. Premiums related to the catastrophe program amounted to $17,490 for 2006.
Prior to 2006, Commerce and American Commerce were assuming and ceding members of ANI. Beginning in 2006, American Commerce also became a direct writing member. The total pre-tax earnings impact of all of our participation in ANI for 2006 and 2005 was approximately $1,499 and $1,217, respectively. Our maximum exposure in 2006 in the event of a catastrophic loss at an insured nuclear facility was $11,000 for domestic risks and $10,000 for foreign risks. For 2007, the exposure amounts increased to $12,000 and $11,000, respectively.
Since its inception, CAR has annually generated multi-million dollar underwriting losses, primarily in the personal automobile pool. We are required to share in the underwriting results of CAR business for our respective product lines. Under current regulations, our share of the CAR personal results is based upon our market share of automobile risks for the particular pool, adjusted by a "utilization" concept, such that, in general, we are disproportionately and adversely affected if our relative use of CAR reinsurance exceeds that of the industry, and favorably affected if our relative use of CAR reinsurance is less than that of the industry. For personal automobile writers, companies can reduce their participation ratio by writing credit eligible business voluntarily. Companies are provided credits against their participation ratio for writing those classes and territories of business that are purposefully under-priced in the Massachusetts rate setting process. Companies are also penalized for ceding certain business to CAR. Our strategy has been to maintain above average voluntary retention levels, as well as to retain private passenger automobile business voluntarily that receives credits. This favorably affects our participation ratio compared to our market share, but adversely impacts our voluntary loss ratio. Through 2004, the CAR utilization-based participation ratio calculation had remained the same for the personal automobile market. In 2005 and 2006, CAR switched to using a credit matrix approach.
During 2006, 2005 and 2004, our net participation in the CAR personal automobile pool approximated 27.0%, 26.2% and 23.2%, respectively, as estimated by us for 2006 and as reported by CAR for 2005 and 2004. This is as compared to our estimated market share in those years of 31.2%, 29.9% and 29.1%, respectively. During 2006, 2005 and 2004, the amount of personal automobile exposures we reinsured through CAR approximated 4.6%, 4.7%, and 5.2%, respectively, as compared to industry averages of 5.1%, 6.2% and 6.8%, respectively. During 2006, the Commission directed CAR to redistribute personal automobile ERPs in an attempt to establish, for all Servicing Carriers, overall parity in the quantity and quality of ERP exposures.
Massachusetts has considered alternative methods to CAR for structuring the residual or involuntary market. Most recently, in December 2006, the former Commissioner approved rules which would have instituted an assigned risk plan, the Massachusetts Automobile Insurance Plan (MAIP), to provide private passenger automobile insurance for those individuals unable to obtain insurance voluntarily, in place of CAR. An assigned risk plan would place these individuals directly with an assigned insurance company. These regulations were to be effective April 1, 2007 for certain new business, July 1, 2007 for SDIP Point 10 and above new and renewal business and January 1, 2008 for all business except clean-in-three renewals. However, on January 19, 2007, the Acting Commissioner suspended these rules for up to ninety days in order to hear additional comment. A public hearing was held on February 15, 2007. In addition, a new Commissioner was named during February 2007. We are unable to predict the outcome of the hearing or what, if any, changes to the current Massachusetts residual market mechanisms may occur or determine the effect of any decision on our financial condition or results of operations.
CAR implemented a new method for handling ceded commercial automobile risks effective January 1, 2006. This new system provides for six servicing carriers, including Commerce, who were appointed after a competitive bid process for five year terms. The six appointed servicing carriers are the only carriers who can cede business to CAR, and all eligible producers are assigned to one of the servicing carriers in order to provide all producers with a market for their ceded business. As of 2006, the commercial results from all ceded commercial business is shared between all carriers, including the appointed servicing carriers, based upon each carrier's voluntary market share of commercial automobile business.
Reinsurance activity with CAR for fiscal years 2006, 2005 and 2004 follows:
We pay to CAR all of the premiums generated by the policies we have ceded and CAR reimburses us for all losses incurred on ceded policies. In addition, we receive a fee for servicing ceded policies based on the expense structure established by CAR. For the years ended December 31, 2006, 2005 and 2004, these servicing fees amounted to $23,302, $24,102 and $21,160, respectively.
We offer an ESOP for the benefit of substantially all employees, including those of our subsidiaries. The ESOP is noncontributory on the part of participants and contributions are made at the discretion of the Board of Directors. We are under no obligation to make contributions or maintain the ESOP for any length of time and may completely discontinue or terminate the ESOP at any time without liability. Contribution expense for the ESOP for the years ended December 31,
2006, 2005 and 2004 were $10,790, $10,371 and $9,651, respectively. In 2007, 2006 and 2005, the previous year's contributions were funded entirely with 367,145, 382,994 and 286,790 treasury stock shares, respectively. ESOP contributions in years prior to 2005 were made in cash. The increase in the contribution in 2006 over 2005 and in 2005 over 2004 was primarily due to an increase in employees and wages paid to them. The ESOP held 5,856,990 and 5,742,514 shares of our common stock at December 31, 2006 and 2005, respectively.
ESOP participants who are current employees and who are 100% vested in their ESOP accounts can annually elect to transfer out of the ESOP up to 100% of their allocated Company stock in the form of an eligible rollover distribution into another eligible retirement plan, such as a qualified individual retirement arrangement. Approximately 4,354,000 shares owned by participants in the ESOP at December 31, 2006 are allocated to the ESOP accounts of these individuals. Beginning January 1, 2007, ESOP accounts vest at a rate of 20% per service year beginning with a participant's second year of service.
Selected segment information for 2006, 2005 and 2004 follows. Earnings are before income taxes and change in accounting principle and include minority interest.
We have made loans to insurance agencies with which Commerce transacts business on a regular basis. At December 31, 2006, five loans with an aggregate outstanding principal balance of $755 were collateralized by the assets of the agencies. At December 31, 2005, five loans with an aggregate outstanding balance of $1,812 were collateralized by the assets of the agencies. There were no loans to insurance agencies collateralized solely by real estate in 2006 and 2005. At December 31, 2004, six loans with an aggregate outstanding balance of $2,081 were collateralized by the assets of the agencies and none collateralized solely by real estate.
The immediate family of Raymond J. Lauring, a director of the Company, owns more than a 10% equity interest in Lauring Construction Company. Mr. Lauring has no ownership interest in the construction company. Payments to Lauring Construction totaled $1,549 in 2006, $222 in 2005, and $285 in 2004. The increase in 2006 payments resulted primarily from construction projects for generators for our Webster facilities. For these projects, we paid Lauring Construction for work performed by them and by subcontractors. Lauring Construction in turn paid the subcontractors directly.
Our consolidated net income on a statutory basis for the years ended December 31, 2006, 2005 and 2004 was $233,286, $238,122 and $241,062, respectively. Our statutory policyholders' surplus as reported to various state insurance departments at December 31, 2006 and 2005 was $1,535,659 and $1,477,307, respectively.
In November 2006, Commerce entered into a quota-share agreement with an insurance company that is a wholly-owned subsidiary of AAA SNE. This agreement became effective on January 1, 2007. Beginning in the first quarter of 2007, the underwriting results of our four insurance subsidiaries coupled with our corporate expenses that are integral to our insurance operation will be ceded to AAA SNE at a quota share rate of 1.5% for 2007. The underwriting results of the insurance companies will include the underwriting results of all external reinsurance assumed from or ceded to our company subsequent to January 1, 2007.
Due to the internal reorganization in 2003, minority interest is no longer part of our insurance operation. Minority interest is included since then for comparative purposes and to reconcile to our consolidated balance sheet.