two acre site in Columbus, Ohio. American Commerce also leases property at three district claims offices. The Company considers that its properties are in good condition, are well maintained, and are generally suitable to carry on the Company's business. For additional information, please refer to "Part II-Item 8, Notes to Financial Statements-NOTE D".
The data below should be read in conjunction with the consolidated financial statements, related footnotes, and other financial information included herein. The financial statements for the five years ended December 31, 2002 have been audited by Ernst & Young LLP. All dollar amounts set forth in the following tables are in thousands, except per share data:
The property and casualty insurance industry continues to remain highly competitive and inherently volatile in nature. Property and casualty insurance company results have traditionally been impacted by the typical forces unique to the industry, such as competition, frequency and severity of losses, the overall economy and the general regulatory environment in those states in which the insurer operates. Additional forces are impacting the industry in the form of deregulation, on-line commerce, price competition, empowered customers and technological advancement. According to A.M. Best Co. ("A.M. Best"), "the unprecedented events of September 11 have forever changed the way the insurance industry defines risk. Both property and liability lines have been exposed to catastrophic risks that cannot be priced using traditional actuarial methods". A.M. Best goes on to state, "Against the backdrop of weak financial trends, this new risk environment has accelerated the hardening of the U.S. property/casualty market". Given this increased risk environment, A.M. Best "expects to see a renewed flight to quality that will benefit financially strong insurers". The financial losses due to the events of September 11 were significant to the insurance industry, however, due to the limited exposure that The Commerce Group, Inc. (the "Company") has outside of Massachusetts, the direct financial impact to the Company was not material. Additionally, price competition remains quite heavy in many areas of the country, although it has improved in 2002 among independent agency companies in Massachusetts. Beyond Massachusetts, industry underwriting results are expected to continue to deteriorate in the near future which further emphasizes the importance of competitive advantages gained by affinity marketing and efficient operations. With these issues on the forefront, the Company continues to position itself to respond to the prevailing forces and conditions in the market. The Company has utilized its strong agency relationships, a low-cost structure, affinity group alliances and a 1999 joint-venture acquisition all in an effort to keep the Company responsive in today's competitive environment.
Additionally, the Company writes insurance in the States of California and Oregon through Commerce West Insurance Company ("Commerce West"), a wholly-owned subsidiary of Commerce, located in Pleasanton, California. The Company also writes insurance through American Commerce Insurance Company ("American Commerce"), which it acquired in January 1999. Located in Columbus, Ohio, American Commerce is a wholly-owned subsidiary of ACIC Holding Co., Inc., ("AHC") with policies in 26 states and licenses in several others. Commerce also began writing personal lines business in New Hampshire in the later part of 2001.
Effective January 1, 2002, the ownership interests in AHC were recapitalized. Prior to the recapitalization at December 31, 2001, Commerce maintained an 80% common stock interest and AAA Southern New England ("AAA SNE") maintained a 20% common stock interest in AHC. Additionally, all AHC preferred stock was owned by Commerce. The recapitalization resulted in redeeming of all the AHC preferred stock by Commerce in exchange for 3,000 additional shares of AHC common stock. This resulted in Commerce increasing its AHC common stock interest to 95% with AAA SNE maintaining a 5% AHC common stock interest with no preferred stock outstand-
Since 1995, Commerce has maintained an affinity group marketing relationship with AAA Insurance Agency, Inc., a subsidiary of AAA SNE. AAA Insurance Agency, Inc. has been a licensed insurance agent of Commerce since 1985.
As mentioned, the Company predominantly writes private passenger automobile insurance. The following tables indicate direct premiums written for private passenger automobile, commercial automobile and homeowners. Total direct premiums written increased $254,449 or 22.1% in 2002 over 2001. The 2002 increase was primarily attributable to a $172,516 or 20.1% increase in Massachusetts private passenger automobile direct premiums written. This was the result of a 13.8% increase in written exposures coupled with an increase of 5.3% in average premiums per exposure. Private passenger premiums written for all other states increased $32,725 or 26.8%, primarily attributable to an increase in American Commerce premiums of $26,633 or 31.3%, due primarily to book rollovers of business from existing agents, partially offset by decreases in states where the Company is not actively pursuing writings coupled with an increase of $3,916 or 10.5% additional premiums from Commerce West.
In Massachusetts, private passenger automobile insurance is subject to extensive regulation. Owners of registered automobiles are generally required to maintain certain minimum automobile insurance coverages. With very limited exceptions, private passenger automobile insurers are required by law to issue a policy to any applicant seeking to obtain such coverages. Companies in Massachusetts are also assigned agents, known as Exclusive Representative Producers ("ERPs"), based primarily on market share, that have been unable to obtain a voluntary contract with an insurance carrier. Marketing and underwriting strategies for companies operating in Massachusetts are limited by maximum premium rates and minimum agency commission levels for personal automobile insurance, both of which are mandated by the Massachusetts Commissioner of Insurance ("Commissioner"). In Massachusetts, accident rates, bodily injury claims, and medical care costs continue to be among the highest in the nation. According to the Automobile Insurers Bureau of Massachusetts ("AIB"), Massachusetts "has higher than average medical costs and liability claims involving attorneys". According to the AIB, Massachusetts personal automobile premium per policy, based on 2000 premium information, was the 4th highest in the nation.
During the three-year period from 2000 to 2002, average mandated Massachusetts personal automobile insurance premium rates decreased an average of 2.5% per year. The Commissioner approved an average increase of 2.7% in personal automobile premiums for 2003, as compared to no rate change in 2002. Coinciding with the 2003 rate decision, the Commissioner also approved an increase of 1.3% in the commission dollar rate agents receive for selling private passenger automobile insurance in 2002.
The actual state average rate change represents the change in the average rate paid by drivers in Massachusetts, as opposed to the state- mandated average rate change. As can be seen above, the Commerce average rate change per exposure corresponds more closely to the actual state average rate change. The reason for this is that both take into account newer vehicles, as compared to the state mandated average rate change which does not.
bile insurance in Massachusetts to reinsure any automobile risk that the insurer perceives to be under-priced at the premium level permitted by the Commissioner. All companies writing automobile insurance in Massachusetts share in the underwriting results of CAR business for their respective product line or lines. Since its inception, CAR has annually generated multi-million dollar underwriting losses in primarily the personal pool. The Company is required to share in the underwriting results of CAR business for its respective product lines. Under current regulations, the Company's share of the CAR personal or commercial deficit is based upon its market share for retained automobile risks for the particular pool, adjusted by a "utilization" concept, such that, in general, the Company is disproportionately and adversely affected if its relative use of CAR reinsurance exceeds that of the industry, and favorably affected if its 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. The Company's strategy has been to maintain above average voluntary retention levels, as well as to voluntarily retain private passenger automobile business that receives credits. This favorably impacts the Company's participation ratio compared to its market share, but also adversely impacts the Company's voluntary loss ratio.
Significant changes in the utilization of the CAR private passenger pooling mechanism are not expected under the current system. Various CAR participation formula changes have been fully implemented since 1994 with only minor changes since then. The Company's strategy has been to voluntarily retain more of the types of private passenger automobile business that generate credits, favorably impacting the utilization formula. These credits primarily result from voluntarily writing business in under-priced territories and for under-priced risks. As a result of increased voluntary retention in excess of the industry, the credits impacting the utilization formula have favorably affected the Company's participation ratio, however, at the same time, adversely affected its voluntary loss ratio. As indicated in the accompanying table, this ratio is several percentage points below the Company's estimated 25.9% share of the Massachusetts personal automobile market. The Company continues to expect the marketplace to make minor annual adjustments to find the optimum balance between voluntary and ceded writings.
The current CAR utilization-based participation ratio has been in place for the personal automobile market since 1994. During 2002, 2001 and 2000 the Company's amount of personal automobile exposures it reinsured through CAR approximated 4.9% for each year, as compared to industry averages of 7.5%, 7.7% and 8.4%, respectively.
Commerce has actively pursued affinity group marketing programs since 1995. The primary purpose of affinity group marketing programs is to provide participating groups with a convenient means of purchasing discounted private passenger automobile insurance through associations and employer groups. Emphasis is placed on writing larger affinity groups, although accounts with as few as 25 participants are considered. Affinity groups are eligible for rate discounts, which must be filed annually with the Division of Insurance. In general, the Company looks for affinity groups with mature/stable membership, favorable driving records and below average turnover ratios. Participants who leave the sponsoring group during the term of the policy are allowed to maintain the policy until expiration. At expiration, a non-discounted Commerce policy may be issued through the agency, at the insured's option.
Since the latter part of 1995, Commerce has been a leader in affinity group marketing, through agreements with the four American Automobile Association Clubs of Massachusetts ("AAA clubs"), offering discounts on private passenger automobile insurance to the clubs' members who reside in Massachusetts. A 5% discount was approved for policies effective January 1, 2003. Membership in these clubs is estimated to represent approximately one-third of the Massachusetts motoring public, and has been the primary reason for an 85.2% increase in the number of personal automobile exposures written by Commerce since year-end 1995 (the AAA affinity group program incepted in October of 1995). In 2002, total direct premiums written attributable to the AAA group business were $619,020 or 44.0% of the Company's total direct premiums written (60.0% of the Company's total Massachusetts personal automobile premium), an increase of 13.5% over 2001. Total exposures attributable to the AAA clubs group business were 625,335 or 59.8% of total Massachusetts personal automobile exposures in 2002, as compared to 581,455 or 63.3% in 2001. The decreased percentage from 2001 was attributable to a higher rate of increase in non-group business as compared to the increase in the AAA program. Of the total Massachusetts automobile exposures written through the AAA affinity group program by the Company, approximately 13.5% were written through insurance agencies owned by the AAA clubs (8.5% of total Massachusetts automobile exposures). The remaining 86.5% of the AAA group program was written through Commerce's network of independent agents (91.5% of total Massachusetts automobile exposures).
Commerce entered into an agreement on September 28, 2001, with Berkshire Mutual Insurance Company ("Berkshire") for the transfer of Massachusetts personal automobile business written by Berkshire to Commerce, effective January 1, 2002. Under terms of the agreement, Commerce offered agency contracts to independent agencies that represented Berkshire for personal automobile insurance in Massachusetts. This allowed agents of Berkshire the opportunity to offer Commerce automobile insurance policies to their customers whose policies renewed in 2002. Commerce assumed all of Berkshire's obligations for future policy years beyond 2001 under CAR, including assignment of Berkshire's involuntary agents. As consideration, the Company received a cash payment of $7,000 from Berkshire in early January, 2002.
Commerce announced the formation of a marketing alliance with Horace Mann Educators Corporation on October 18, 2001. Under the terms of an agency agreement between Commerce and Horace Mann Service Corporation ("HMSC"), a licensed brokerage agency in the Commonwealth of Massachusetts, HMSC provided its personal automobile customers with Commerce policies. New personal automobile policies sold by HMSC were insured with Commerce, beginning no later than January 1, 2002, at the policyholder's option. All personal automobile policies written by HMSC were converted to Commerce policies upon renewal in 2002.
Commerce West predominantly writes private passenger automobile insurance in California and Oregon through 808 independent insurance agencies and brokers. All business is underwritten at Commerce West's headquarters located in Pleasanton, California. Although primarily writing preferred business, Commerce West also writes non-standard personal automobile business and a small amount of lower limit commercial automobile business. American Commerce predominantly writes private passenger automobile and homeowners insurance in 26 states exclusively through 32 AAA independent insurance agencies. Products are similar to those offered by Commerce and Citation. All business is underwritten at American Commerce's headquarters located in Columbus, Ohio. Both companies primarily target preferred insurance risks.
Direct premiums written in states other than Massachusetts by Commerce West and American Commerce, increased $42,220 or 29.5%. Commerce West direct premiums written increased $7,545 or 19.5%. Personal automobile direct premiums written by Commerce West increased $3,916, or 10.5%, while commercial automobile direct premiums written increased $3,637, or 240.2%. The growth from Commerce West is primarily attributable to expansion of the commercial and preferred personal automobile programs. American Commerce direct premiums written increased $34,675 or 33.2%, primarily due to an increase in personal automobile premiums of $26,633 or 31.3%. American Commerce also experienced a 42.7% increase in homeowners premiums written, primarily as a result of book transfers from existing agents and the contraction of authority to write homeowner business by competitors. American Commerce, which writes business in 26 states, wrote greater than 90% of its business in eleven states.
Commerce West premiums and the eleven states with the highest premiums written by American Commerce are shown in the following table:
The Company has reinsurance contracts for casualty and catastrophe coverages. These reinsurance arrangements minimize the Company's losses arising from large risks and protect the Company against numerous losses from a single occurrence or event. The Company also has a quota share reinsurance contract on its other than automobile business.
Effective July 1, 2002, the Company amended its quota share reinsurance program in the event of terrorist acts. The maximum reimbursement to the Company from its quota share reinsurers will be limited to $50,000 in the event of certain defined terrorist acts. The Company believes its exposure to terrorist acts to be very limited based upon the types of coverage offered by the Company and its exposure above the limit to be extremely remote. The Company's main
Written premiums ceded in 2002, 2001 and 2000 under the above referenced program were $98.0 million, $78.6 million and $69.4 million, respectively. The 24.7% increase in written premiums ceded in 2002 versus 2001 in this program was primarily the result of a $14,380 or 19.6% increase in Massachusetts homeowner direct written premium, coupled with an $8,666 or 46.3% increase in direct homeowner writings in states other than Massachusetts, as previously mentioned. Ceding commission income is calculated on a ceded earned premium basis.
Casualty reinsurance is on an excess of loss basis for any one event or occurrence with a maximum recovery of $9.0 million over a net retention of $1.0 million. This coverage is placed with Swiss Reinsurance America Corporation (rated A++ by A.M. Best).
Effective July 1, 2002, Commerce entered into a retrocessional reinsurance agreement with one of its quota share reinsurers who maintained a one third participation in the Company's 75% quota share treaty. For a premium paid to Commerce, Commerce will indemnify the reinsurer if the reinsurer incurs a loss for a single event or occurrence over a certain threshold. Losses assumed by the reinsurer must first exceed $15,000 before a reimbursement will be made, by Commerce, to the reinsurer. Commerce's exposure to the reinsurer under this agreement is for a maximum of $35,000. The threshold translates into a $60,000 total loss event or occurrence to Commerce, $15,000 of which represents the reinsurers 25% portion of the quota share treaty, before the reinsurer would receive any benefit.
Underwriting profit margins are reflected by the extent to which the combined ratio is less than 100%. This ratio is considered the best simple index of current underwriting performance of an insurer. During the five- year period ended December 31, 2002, the property and casualty insurance industry's combined ratio, as reported by A.M. Best and weighted to reflect the Company's product mix ("weighted industry average"), has ranged from a low of 102.2% in 1998 to a high of 109.7% in both 2000 and 2001 on a statutory accounting principles basis. During this same period of time, the Company's combined ratio has consistently remained below the weighted industry average, ranging from a low of 96.8% in 2000 to a high of 98.7% in both 2001 and 2002. On an average basis, the Company's combined ratio was 98.2% for the five-year period ended December 31, 2002 compared to a weighted industry average of 106.0%.
In November 1999, the Gramm-Leach-Bliley Act was signed into law. The Act (1) repealed the Glass-Steagall Act of 1933, which had prohibited the merger of banks and securities firms, and (2) substantially modified the Bank Holding Company Act of 1956, which had the effect of separating banking and insurance underwriting business. The law contains provisions that govern competition, created safe-harbor protections for specific state laws, and established consumer protections that govern bank-insurance sales.
In order to enhance the regulation of insurer insolvency, the NAIC developed a formula and model law to provide for RBC requirements for property and casualty insurance companies. RBC requirements are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholder obligations. The RBC model for property and casualty insurance companies measures three major areas of risk facing property and casualty insurers: (i) underwriting, which encompasses the risk of adverse loss development and inadequate pricing; (ii) declines in asset values arising from credit risk; and, (iii) other business risks from investments. Insurers having less statutory surplus than required by the RBC calculation will be subject to varying degrees of regulatory action, depending on the level of capital inadequacy.
For employee stock options issued by the Company from 1999 through 2001, the Company utilized fixed accounting treatment through September 30, 2002. This accounting treatment was reviewed with the Company's independent auditors, Ernst & Young LLP, who concurred with the Company's treatment throughout this period. On January 25, 2003, a question was raised by Ernst & Young LLP as to the appropriateness of the fixed accounting treatment for some of the Company's option grants. Ernst & Young LLP advised the Company that it could no longer concur with fixed accounting for the options granted to employees in 1999 and 2000. Therefore, the Company applied variable accounting treatment in 2002 and also retroactively to 2001 and prior years. Accordingly, the Company restated its 2001 and first three quarters of 2002 results. The impact of the restatement for the year ended 2001 resulted in a decrease to net earnings of $2.8 million or $0.08 per diluted share. The year to date impact through the third quarter of 2002 resulted in an increase to net earnings of $1.2 million or $0.04 per diluted share. Although the change in accounting for employee options was also applied to 2000 and 1999, no restatements were required for those years. The impact of variable accounting for the year ended December 31, 2002 was a decrease to net earnings of $2.1 million or $0.07 per diluted share.
Year Ended December 31, 2002 compared to Year Ended December 31, 2001 (Restated)
Other states personal automobile direct premiums written increased $32,725 or 26.8%, however, an overall depressed rate environment and adverse development of prior year reserves resulted in diminished underwriting profits. The Company continues to evaluate a number of it's other than Massachusetts state rating structures, has filed for increases in several states and will seek additional rate increases where appropriate. Personal automobile direct premiums written by American Commerce increased $26,633 or 31.3% to $111,757 as compared to $85,124 due prima-
rily to book rollovers of business from existing agents, partially offset by decreases in states where the Company is not actively pursuing writings. Personal automobile direct premiums written from Commerce West increased $3,916 or 10.5% to $41,112 as compared to $37,196. Both companies primarily target preferred insurance risks and Commerce West's recent growth is attributable to preferred personal automobile business. Both American Commerce and Commerce West write predominantly personal automobile insurance. American Commerce writes personal automobile insurance in 26 states while Commerce West writes personal automobile insurance in the states of California and Oregon. Personal automobile policies for both companies are written primarily for a policy term of six months.
Direct premiums written for Massachusetts commercial automobile insurance increased by $16,791 or 28.9%, due primarily to an increase of approximately 14.0% in the number of policies written, combined with a 13.0% increase in the average commercial automobile premium per policy. The increase in premium per policy was attributable to a hardening of the commercial automobile market, as well as the Company increasing its volume of larger commercial automobile accounts. The Company experienced an increase of approximately $1,900 from policies with premiums in excess of $50. In addition, base rates for other voluntary commercial automobile policies have increased moderately, and a reduction in Individual Risk Premium Modification ("IRPM") credits has occurred, favorably impacting average premiums per policy. In addition, an approximate 3.0% increase in rates for policies written through CAR was experienced. The increased business was attributable to the Company's initiative to expand writings.
Direct premiums written for Massachusetts homeowners insurance increased by $14,380 or 19.6% due primarily to a 10.8% increase in the number of Massachusetts policies written coupled with a 7.3% increase in the average Massachusetts premium per policy. The Company's increase in Massachusetts homeowner premium is primarily related to an increased number of agents, fewer carriers writing homeowner business, the Company's pricing position in the marketplace, and agents writing more homeowner business to achieve a homeowner discount for their customers, when the Company also insures the customers' automobile. Other states homeowners insurance written by American Commerce increased $8,666 or 46.3% to $27,376 due primarily to book rollovers of business from existing agents, and the impact caused by contraction of authority to write homeowner business by competitors. Homeowner policies in all states are written primarily for a policy term of one year.
The $234,047 or 21.7% increase in net premiums written was primarily due to the growth in direct premiums written as described above offset by an increase in premiums ceded to CAR and the quota share agreement. Net premiums written for homeowner's in all other states increased $1,566, with net premiums written of $6,142 in 2002, as compared to $4,576 in 2001.
Net investment income is affected primarily by the composition of the Company's investment portfolio and yield thereon. The following table summarizes the composition of the Company's investment portfolio at cost, at December 31, 2002 and 2001:
As depicted in the accompanying table, 2002 net investment income before taxes decreased $1,097 or 1.1%, compared to 2001, principally as a result of a decrease in yield offset by an increase in average invested assets at cost. The decrease in yield is primarily due to lower short-term yields, coupled with an environment of lower long-term yields and higher yielding investment securities being called. The Company continues to monitor interest rates on medium and long-term securities and intends to maintain its relatively high cash position until such time as the Company believes medium and long-term rates have appropriately firmed. During 2002, the Company purchased approximately $142 million of FNMA securities. The Company believes these FNMAs will have a duration of less than three years. This will allow the Company to achieve higher yields until longer term investments are acquired. Net investment income as a percentage of total average investments was 6.3% in 2002, compared to 6.6% in 2001. Net investment income after-tax, as a percentage of total average investments, was 5.0% in 2002 and 5.3% in 2001.
Premium finance and service fees increased $3,679 or 20.6% during 2002, as a result of increased business and a service fee increase on Massachusetts new and renewal business from three dollars to four dollars per installment payment, for policies with effective dates of July 1 and forward.
A focus of management's judgments and estimates relating to investments involves the potential impairment of investments for other- than-temporary declines in market value. An impairment in an investment is deemed to be other-than-temporary when a security's market value has diminished to less than 75% of cost for two consecutive calendar quarters. If the contractual terms of the security are being complied with, management performs a cash flow valuation to determine the potential impairment of the security. If the security is deemed impaired, the Company adjusts the security's cost to market value through realized loss based on publicly available information or, in the absence of such, to a value based on cash flow modeling. Gross accumulated other comprehensive losses were $15,666 and $27,399 at year-end 2002 and 2001, respectively. These amounts represent securities whose market values were greater than 75%, but less than 100%, of cost. Market value declines for these securities relate primarily to interest rate changes and not to significant declines in a security's rating, financial situation or sector issues and are not considered impaired due to the Company's ability and intent to hold these securities to maturity.
Carrying values of investments in fixed maturities, which include taxable and non-taxable bonds, and investments in common and preferred stocks, are derived from market prices supplied by the Company's investment custodian. Unrealized investment gains and losses on these investments, to the extent that there is no other-than-temporary impairment of value, are credited or charged to a separate component of stockholders' equity, known as "net accumulated other comprehensive income (loss)", net of tax, until realized. Fair market value of fixed maturities and preferred and common stocks is based on quoted market prices. For other investments, fair market value equals quoted market price, if available. If a quoted market price is not available, fair market value is estimated using quoted market prices for similar securities.
When investment securities are sold, the realized gain or loss is determined on a specific identification basis.
Gross realized gains and losses for the years ended December 31, 2002 and December 31, 2001 were as follows:
Gross accumulated other comprehensive income and losses at December 31, 2002 and December 31, 2001 were as follows:
The chart above provides a detailed breakdown of the Company's net accumulated other comprehensive income, prior to minority interest and income taxes. The chart also provides an aging of the gross accumulated other comprehensive losses, along with the number of securities those losses are represented by and the cost and current market value of those securities that have losses. The percentage of fixed maturities at cost that have gross accumulated other comprehensive losses with less than an investment grade rating or no rating is 11.0% at December 31, 2002.
The $14,437 amount for 2002 indicates that Management's estimate for the year-end 2001 loss reserves was within 2.4% of the amount established at December 31, 2001. Because of the inherently difficult task of estimating the amount required to ultimately settle all losses several years into the future, it is probable that actual amounts will be either higher or lower than the
As a percentage of net premiums written, underwriting expenses for the insurance companies (on a statutory basis) decreased to 23.6% in 2002 as compared to 24.2% in 2001. The improvement was primarily due to a lower mandated Massachusetts personal automobile commission rate and lower general underwriting expenses. Another factor in the decrease resulted from business written outside of Massachusetts where the underwriting expense ratio decreased to 29.7% for 2002 as compared to 32.6% for 2001. These factors were offset by higher contingent commission expenses and higher insolvency assessments. The 2002 underwriting ratio includes a $4,496 charge versus $3,111 in 2001, representing the Company's allocation from the Massachusetts Insurers Insolvency Fund.
Due to the effect of a change in accounting principle related to Statement of Financial Accounting Standards ("SFAS") No.142, the Company recorded income in the first quarter of 2002, net of taxes, of $11,237 or $0.34 per share (diluted). This amount represented the remaining unamortized negative goodwill related to preferred stock mutual funds and the remaining excess
of book value of subsidiary interest over cost relating to the 1999 acquisition of American Commerce. Negative goodwill and the excess of book value of subsidiary interest over cost occurred in these acquisitions because the underlying value of the assets purchased exceeded the purchase price. The subsequent recognition of income that occurred as these items were eliminated was not a taxable event but instead became part of the basis of the acquired asset.
Effective January 1, 2002, the ownership interests in ACIC Holding Co., Inc. ("AHC") were recapitalized. Prior to the recapitalization at December 31, 2001, Commerce maintained an 80% common stock interest and AAA Southern New England ("AAA SNE") maintained a 20% common stock interest in AHC. Additionally, all AHC preferred stock was owned by Commerce. The recapitalization resulted in redeeming of all the AHC preferred stock by Commerce in exchange for 3,000 additional shares of AHC common stock. This resulted in Commerce increasing its AHC common stock interest to 95% with AAA SNE maintaining a 5% AHC common stock interest, with no preferred stock outstanding. The recapitalization also resulted in the creation of $4.5 million in minority interest for AAA SNE.
The following table compares direct premiums written, net premiums written and earned premiums for the years ended December 31, 2001 and 2000:
The $32,742 or 4.0% increase in Massachusetts personal automobile direct premiums written resulted primarily from increases of 5.8% and 7.1% in the number of Massachusetts personal automobile exposures for liability and physical damage coverage, respectively, offset in 2001 by decreases in rates for the coverage types noted below. The components of these changes from the previous year for 2001 and 2000 were as follows:
The above percentage changes were primarily the result of rate modifications in the individual coverage components in the 2001 state mandated rates, offset by changes in the Company's safe driver rate deviations, and changes in the distributions of the business written by the Company. The combination of these factors resulted in a 1.9% decrease in the average personal automobile premium per exposure in 2001. Despite the 2001 state mandated average rate decrease of 8.3%, the smaller Company decrease in the average personal automobile premium per exposure was primarily due to the above noted changes coupled with the fact that the announced rate decision does not estimate future purchases of new auto- mobiles in the year to which the rate decision applies and the Company's mix of personal automobile business differs from that of the industry. In 2001, the Company offered its customers safe driver deviations of 2.0% to drivers with SDIP classifications of Step 9 and 0.0% for Step 10 (6.0% for Step 9 and 2.0% for Step 10 in 2000).
The AAA affinity group discount for 2001 was established at 6.0%, which was unchanged from 2000. In 2001, for drivers who qualified, the Company's AAA affinity group discount and safe driver deviations could be combined for up to a 7.9% reduction (11.6% in 2000) from state mandated rates.
mobile insurance. American Commerce writes personal automobile insurance in 26 states while Commerce West writes personal automobile insurance in the states of California and Oregon. Personal automobile policies for both companies are written primarily for a policy term of six months. Homeowner and other policies in all states are written primarily for a policy term of one year.
Direct premiums written for Massachusetts commercial automobile insurance increased by $14,845 or 34.3%, due primarily to an increase of approximately 9.0% in the number of policies written, combined with a 23.5% increase in the average commercial automobile premium per policy. The increase in premium per policy was attributable to a hardening of the commercial automobile market, as well as the Company increasing its volume of larger commercial automobile accounts. The Company experienced an increase of approximately $3,700 from policies with premiums in excess of $50. In addition, base rates for other voluntary commercial automobile policies have increased moderately, and a reduction in IRPM credits has occurred, favorably impacting average premium per policy. In addition, an approximate 10% increase in rates for policies written through CAR was experienced. The increased business was attributable to the Company's initiative to expand writings.
The Company's investment strategy is to maximize after-tax investment income through investing in high quality securities coupled with acquiring equity investments, which may forego current investment yield in favor of potential higher yielding capital appreciation in the future.
As a result of the acquisition of American Commerce, the amount representing the excess of the fair value of the net assets acquired over the purchase price at January 29, 1999 was $16,947. This amount is being amortized into revenue on a straight-line basis over a five-year period. The amount amortized into revenue in 2001 was $3,389, compared to $3,390 in 2000.
Net realized investment losses totaled $10,633 during 2001 as compared to gains of $29,550 in 2000. Of the net realized losses during 2001, $9,071 was a result of the Company's venture capital fund investments. These investments primarily provide seed capital for start-up companies with emerging high technology initiatives in the financial services industry. These investments are made in limited partnerships and the Company's exposure to loss is limited to its actual investment. In 2001, the Company began to account for these investments on an equity basis. The equity in the operating results of these funds has been reflected in realized gains and losses. Prior to this change, the operating results were not material and were therefore reflected in accumulated other comprehensive income and loss.
Gross accumulated other comprehensive income and losses at December 31, 2001 and December 31, 2000 were as follows:
Policy acquisition costs expensed increased by $21,120 or 8.7% in 2001. As a percentage of net premiums written, the Company's statutory underwriting expense ratio for 2001 was 24.2% compared to 25.1% in 2000. The decreased 2001 underwriting expense ratio resulted primarily from a lower provision for accrued contingent commissions, lower insolvency assessments and lower expenses due to the continued effects of certain cost reduction programs. The 2000 underwriting ratio includes a $4,900 charge versus $3,111 in 2001, representing the Company's allocation from the Massachusetts Insurers Insolvency Fund. The underwriting expense ratio (on a statutory basis) for Commerce West was 32.7% for 2001 as compared to 35.8% for 2000. The underwriting expense ratio (on a statutory basis) for American Commerce, was 32.6% for 2001 compared to 29.3% for 2000.
Net earnings decreased $41,827 or 31.7% to $90,253 during 2001 as compared to $132,080 in 2000, as result of the factors previously mentioned.
Pro-forma operating earnings represent net earnings adjusted for certain items the Company believes are not indicative of operating results. Pro-forma operating earnings, which consist of net earnings exclusive of the after-tax impact of net realized investment losses, the income effect of a required change in accounting principle and the after-tax impact of employee stock option variable accounting treatment, were $98,880, or $2.93 per share (diluted), in 2001, compared to $109,631, or $3.21 per share (diluted), in 2000.
The focus of the discussion of liquidity and capital resources is on the Consolidated Balance Sheets and the Consolidated Statements of Cash Flows located in "Part II-Section 8 Financial Statement and Supplementary Data". Stockholders' equity decreased by $19,381, or 2.4%, in 2002 as compared to 2001. The decrease resulted from dividends paid to stockholders of $40,277 and Treasury Stock purchased of $48,819, offset by net earnings of $46,755, an increase in other comprehensive income, net of income taxes, on fixed maturities and preferred and common stocks of $12,870 and a $10,090 increase which resulted from the issuance of capital stock. Total assets at December 31, 2002 increased $228,057, or 10.6% to $2,382,688 as compared to total assets of
At December 31, 2002, the Company's fixed income portfolio, which represented 43.4% of the Company's total invested assets, had a weighted average stated maturity of approximately 28.9 years versus 27.3 years at December 31, 2001. The calculation of average stated maturity utilizes the dollar weighted average of the actual maturity date for a security. In contrast, the Company's weighted average duration can be significantly less. At December 31, 2002 the Company's fixed income portfolio had a weighted average duration of 4.5 years versus 5.7 years at December 31, 2001. The "duration" of a security is the time-weighted present value of the security's expected cash flows and is used to measure a security's price sensitivity to changes in interest rates. The weighted average duration is short compared to the average stated maturity because of the relatively large percentage of GNMA, FNMA and municipal housing bonds in the fixed maturity portfolio. The duration reflects industry prepayment assumptions. The municipal housing bonds are similar in nature to GNMAs in that they pay down principal during the life of the bond. For these types of bonds, investors are compensated primarily for reinvestment risk rather than credit quality risk. During periods of significant interest rate volatility, the underlying mortgages may prepay more quickly or more slowly than anticipated. If the repayment of principal occurs earlier than anticipated during periods of declining interest rates, investment income may decline due to the reinvestment of these funds at the lower current market rates. In regards to the fixed income securities, the Bloomberg Financial System, which was used to calculate the above duration data, utilizes optional call dates, sinking fund requirements and assumes a non- static prepayment pattern in deriving these averages.
The primary sources of the Company's liquidity are funds generated from insurance premiums, net investment income, premium finance and service fees and the maturing and sale of investments as reflected in the Consolidated Statements of Cash Flows. The discussion of these
items can be found under "Year Ended December 31, 2002 Compared to Year Ended December 31, 2001", herein.
For 2002, net cash flows from investing activities used cash of $127,217, as compared to net cash flows provided by investing activities of $35,199 in 2001. The majority of the difference was a $169,438 increase in the purchase of fixed maturities. The Company purchased shorter duration fixed maturities during 2002. The Company also had a $32,784 increase in the purchase of equity securities and a decline of $29,029 in the proceeds from sale of equity securities. These were offset by an increase of $37,013 in proceeds from maturity of fixed maturities, an increase of $25,046 in proceeds from sale of fixed maturities and a decline of $15,286 in the purchase of preferred stock mutual funds. The increase in fixed maturities was primarily due to the purchase of FNMA's, previously mentioned, offset by the calls and maturities of municipal bonds coupled with principle paydowns of GNMA's. The increase in preferred stocks was primarily the result of purchases in the utility and financial services sectors. Investing activities were funded by accumulated cash and cash provided by operating activities in 2002 and 2001.
any class of the insurer's own securities is to be included. No Massachusetts insurance company shall pay an extraordinary dividend or other extraordinary distribution until thirty days after the Commissioner has received notice of the intended distribution and has not objected. No extraordinary dividends were paid in 2002, 2001 or 2000. Similar laws exist in California and Ohio. No extraordinary dividend was paid by American Commerce in 2002 or 2001 and no dividends were paid by Commerce West since its acquisition.
Also, effective July 1, 2002, the Company amended its quota share reinsurance program in the event of terrorist acts. The maximum reimbursement to the Company from its quota share reinsurers will be limited to $50,000 in the event of certain defined terrorist acts. The Company believes its exposure to terrorist acts to be very limited based upon the types of coverage offered by the Company and its exposure above the limit to be extremely remote. The Company's main area of business is in the personal lines market and it has very minimal single retained exposure in excess of $1,000.
The Company evaluates performance and allocates resources based primarily on the property and casualty insurance segments, which represents over 99% of the Company's total revenue for the past three years. The accounting policies of the reportable segments are the same as those used in the notes to the financial statements.
In conducting investing activities, the Company is subject to, and assumes, market risk. Market risk is the risk of an adverse financial impact from changes in interest rates and market prices. The level of risk assumed by the Company is a function of the Company's overall objectives, liquidity needs and market volatility.
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.
In July 2001, the FASB issued Statements of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations", and No. 142, "Goodwill and Other Intangible Assets". SFAS No. 141, effective for business combinations initiated after June 30, 2001, requires that all business combinations be accounted for under a single method - the purchase method. Use of the pooling-of-interests method is no longer permitted. SFAS No. 141 also clarifies the criteria to recognize intangible assets separately from goodwill. SFAS No. 142 requires that goodwill and intangible assets deemed to have indefinite lives no longer be amortized to earnings, but instead be reviewed at least annually for impairment. Other intangible assets will continue to be amortized over their useful lives. SFAS No. 142 was effective January 1, 2002.
In accordance with industry practice, the Company also maintains reserves for estimated IBNR, salvage and subrogation recoverable and LAE. These reserves are determined on the basis of historical information and the experience of the Company. Adjustments to these reserves are made periodically to take into account changes in the volume of business written, claims frequency and severity, the mix of business, claims processing and other items that can be expected to affect the Company's liability for losses and LAE over time.
By using individual estimates of reported claims adjusted for managements' best estimate by line of business and a review of these results by the Company's actuarial area using generally accepted actuarial reserving techniques, the Company estimates the ultimate net liability for losses and LAE. After taking into account all relevant factors, management believes that, based on existing information, the provision for losses and LAE at December 31, 2002 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) management's estimated liability for losses and LAE, based on any of the factors noted previously, the Company will incur additional expense (income) which may have a material impact.
For all of the Company's insurance subsidiaries, the aggregate actuarial estimate for the loss and LAE reserves, prior to the effect of ceded reinsurance recoverable, ranges from a low of $607.3 million to a high of $700.6 million. The Company's financial statement loss and LAE reserves, based on Management's best estimate, was established at $678.3 million for year end 2002. Management calculates its estimate independently from those amounts as calculated by the Company's actuaries and, therefore, the final results are most often not the same. Management estimates its amounts primarily by reviewing historical loss and LAE data, focusing mainly on payment data. It also reviews and compares most recent loss frequency, severity and payment data to historical trends in an attempt to determine if patterns are remaining consistent or not. Management attempts to establish its 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 above entitled "decrease in provision for insured events of prior years".
As disclosed in "Part I, Item 3 - Legal Proceedings", a purported class action lawsuit, which alleges damages as a result of the alleged inherent diminished value to vehicles that are involved in accidents, is pending against Commerce. No reserve has been established for the potential liability in connection with this case because the Company is currently unable to estimate the potential exposure of this purported class action lawsuit. However, if there were a final decision certifying that a relatively large class of the Company's policyholders is entitled to recover damages based upon the inherent diminished value theory, the Company may have to increase materially its loss and loss adjustment expense reserves as a result.
The Company generally is unable to recover the costs of inflation in its personal automobile insurance line since the premiums it charges are subject to state regulation. Additionally, the premium rates charged by the Company for personal automobile insurance are adjusted by the Commissioner only at annual intervals. Such annual adjustments in premium rates may lag behind related cost increases. Economic recessions can have an impact upon the Company, primarily through the policyholder's election to decrease non-compulsory coverages afforded by the policy and decreased driving, each of which tends to decrease claims.
To the extent inflation and economic recession influence yields on investments, the Company is also affected. As each of these environments affect current market rates of return, previously committed investments may rise or decline in value depending on the type and maturity of investment.
Inflation and recession must also be considered by the Company in the creation and review of loss and LAE reserves since portions of these reserves are expected to be paid over extended periods of time. The anticipated effect of economic conditions is implicitly considered when estimating liabilities for losses and LAE. The importance of continually adjusting reserves is even more pronounced in periods of changing economic circumstances.
The Company's common stock trades on the NYSE under the symbol "CGI". The high, low and close prices for shares as quoted on Bloomberg.com of the Company's common stock for 2002 and 2001 were as follows:
As of March 1, 2003, there were 1,030 stockholders of record of the Company's Common Stock, not including stock held in "Street Name" or held in accounts for participants of the Company's ESOP.
The Board of Directors of the Company voted to declare four quarterly dividends to stockholders of record totaling $1.23 per share and $1.19 per share in 2002 and 2001, respectively. On May 17, 2002, the Board voted to increase the quarterly stockholder dividend from $0.30 to $0.31 per share to stockholders of record as of June 1, 2002. Prior to that declaration, the Company had paid quarterly dividends of $0.30 per share dating back to May 19, 2001 when the Board voted to increase the dividend from $0.29 to $0.30 per share.
A portion of the Company's cash flow consists of dividends received from CHI, which receives dividends from Commerce and Citation. The payment of any cash dividends to holders of
The management of the Company 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 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. The appropriateness of data underlying such financial information is monitored through internal accounting controls, an internal audit department, independent auditors and the Board of Directors through its audit committee.
The Company maintains a system of internal accounting controls designed to provide reasonable assurance to management and the Board of Directors that assets are safeguarded and that transactions are executed in accordance with management's authorization and recorded properly. The system of internal accounting controls is supported by the selection and training of qualified personnel combined with the appropriate division of responsibilities.
Management recognizes its responsibility for fostering a strong ethical climate so that the Company's affairs are conducted according to the highest standards of personal and corporate conduct. The Board of Directors has adopted a formal Code of Conduct and Corporate Compliance Program governing employees and directors. Management encourages open communication within the Company and requires the confidential treatment of proprietary information and compliance with all domestic laws, including those relating to financial disclosure.
The 2002 consolidated financial statements were audited by the Company's independent auditors, Ernst & Young LLP, in accordance with auditing standards generally accepted in the United States. In addition, Ernst & Young LLP performs reviews of the unaudited quarterly financial statements, prior to the announcement of quarterly earnings. Management has made available to Ernst & Young LLP all of the Company's financial records and related data, including reports prepared by the Internal Audit Department as well as the minutes of stockholders' and directors' meetings. Furthermore, management believes that all representations made to Ernst & Young LLP were valid and appropriate.
To the Board of Directors and Stockholders of The Commerce Group, Inc.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS For the years ended December 31, (Thousands of Dollars Except Per Share Data)
THE COMMERCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY For the years ended December 31, (Thousands of Dollars)
THE COMMERCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, (Thousands of Dollars)
The consolidated balance sheet, statement of earnings, statement of stockholders' equity and statement of cash flow for the year ended December 31, 2001 have been restated. This restatement was the result of applying variable accounting for employee stock options in accordance with guidance set forth in Accounting Principles Board Number 25, Accounting for Stock Issued to Employees. The Company previously applied fixed accounting to the employee stock options. The effect of accounting for employee stock options as variable decreased net income by $2.8 million in 2001 or $0.08 per diluted share. See NOTE A13, 2001 Restatement for Employee Stock Option Variable Accounting Treatment.
The insurance subsidiaries, Commerce, Citation, Commerce West and American Commerce, prepare statutory financial statements in accordance with accounting practices prescribed by the National Association of Insurance Commissioners ("NAIC"), the Commonwealth of Massachusetts, the State of California, and the State of Ohio.
The Company records their equity in the changes in net assets of closed-end preferred stock mutual funds as a component of realized gains and losses. These investments are valued at original cost plus the cumulative undistributed equity in earnings and losses of the funds and adjusted over time by the premium or discount at the time of purchase to the applicable underlying net asset value of the funds.
Mortgage loans on real estate and collateral notes receivable are stated at the amount of unpaid principal, less an allowance for possible loan losses. The adequacy of the allowance for possible loan losses is evaluated on a regular basis by management. Factors considered in evaluating the adequacy of the allowance include previous loss experience, current economic conditions and their effect on borrowers and the performance of individual loans in relation to contract terms. The provision for possible loan losses charged to operating expenses is based upon management's judgment of the amount necessary to maintain the allowance at a level adequate to
Maintenance and repairs are charged to operations; betterments are capitalized. The cost of property sold or otherwise disposed of and the accumulated depreciation thereon is eliminated from the related property and accumulated depreciation accounts and any resulting gain or loss is credited or charged to income. The Company capitalizes fixed assets. A fixed asset is classified as property, plant and equipment having an economic life of more than one year and having physical substance with a unit dollar value of $1.0 or greater.
The non-compete agreement of $2,129 represents the unamortized portion of the purchase price associated with the acquisition of American Commerce allocated to the arrangement whereby the American Automobile Association, Inc. ("AAA National") agreed not to compete with American Commerce prior to February 2009. The cost of $3,500 is being amortized on a straight-line basis over the term of the arrangement. The amount of accumulated amortization at December 31, 2002 and 2001 was $1,371 and $1,021, respectively. The Company has amortized this agreement for $350 each year since the acquisition. This will continue until the agreement is fully amortized.
The Company uses an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, the Company generally considers all expected future events other than changes in the
tax law or rates, unless enacted. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. A valuation allowance of $3,936 representing the tax effect of realized investments losses that could not be recovered was established in 2002. No valuation allowance was established in 2001 or 2000.
In addition to state-mandated minimum and other commissions on policies written, the Company pays certain of its agencies compensation in the form of profit sharing. This is based, in part, on the underwriting profits of an individual agent's business written with the Company. The arrangement for Massachusetts business utilizes a three-year rolling plan, with one third of the agent's profit or loss for each of the current and the two prior years' calculations summed to a single amount. This amount, if positive, is multiplied by the profit sharing commission rate and paid to the agent. Outside of Massachusetts, Commerce, Commerce West and American Commerce each have contingent commission plans tailored to their specific markets.
resulted in an increase to net earnings of $1.2 million or $0.04 per diluted share. Although the change in accounting for options was also applied to 2000 and 1999, no restatements were required for those years. The impact of variable accounting for the year ended December 31, 2002 was a decrease to net earnings of $2.1 million or $0.07 per diluted share.
method-the purchase method. Use of the pooling-of-interests method is no longer permitted. SFAS No. 141 also clarifies the criteria to recognize intangible assets separately from goodwill. SFAS No. 142 requires that goodwill and intangible assets deemed to have indefinite lives no longer be amortized to earnings, but instead be reviewed at least annually for impairment. Other intangible assets will continue to be amortized over their useful lives. SFAS No. 142 was effective January 1, 2002.
Effective January 1, 2002, in accordance with SFAS No. 142, the Company discontinued amortizing the balance sheet item "excess of book value of subsidiary interest over cost" which was $5.7 million and $8.4 million at year-end 2001 and 2000, respectively. The 2001 and 2000 impact of the amortization of this resulted in approximately $3.4 million or $0.10 per share for both years, of annual operating earnings. Additionally, the Company no longer amortizes the negative goodwill resulting from the purchase of preferred stock mutual funds effective January 1, 2002. The amount of unamortized negative goodwill at December 31, 2001 and 2000 was $6.4 million and $14.7 million, respectively. The 2001 and 2000 impact of the amortization of this was $3.2 million and $9.3 million or $0.10 and $0.27 per share, respectively, of earnings classified as capital gains. Both the excess of book value of subsidiary interest over cost and the negative goodwill on preferred stock mutual funds was recognized as income in the first quarter of 2002 and classified as an extraordinary item. The per share income impact of this change was $0.34 per share.
Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. The carrying value of fixed maturities on deposit for state regulating authorities is $9,950.
The difference between the carrying value at equity and the value of shares at net asset value in 2001 is negative goodwill created at the time of the purchase of the shares. On January 1, 2002 all unamortized negative goodwill was written off into income as required by SFAS 142, which amounted to $6,400. For purchases prior to July 1, 2001, that created negative goodwill, the Company amortized the negative goodwill on these securities through the end of 2001. This negative goodwill was amortized into realized gains over various periods ranging from 1.25 years to 4 years based on the turnover ratios of the funds. For purchases subsequent to June 30, 2001, the difference between the cost and net asset value at the time of purchase was recognized as a realized gain, totaling $831 and $614 for 2002 and 2001, respectively.
At December 31, 2002 and 2001, mortgage loans on real estate and collateral notes receivable consisted of the following:
non-accrual loans was $44, $99 and $118 for the years ended December 31, 2002, 2001 and 2000, respectively.
The Company originates and services residential and commercial mortgages in Massachusetts and Connecticut. The Company's exposure is generally 80% or less of the appraised value of any collateralized real property at the time of the loan origination. The ability and willingness of residential and commercial borrowers to honor their repayment commitments is generally dependent upon the level of overall economic activity and real estate values.
The following table describes mortgage principal balances by maturity, total mortgages over 90 days past due and total mortgages in foreclosure:
A summary of net accumulated other comprehensive income (loss) on stocks and fixed maturity investments at December 31, 2002, 2001 and 2000 follows:
A summary of property and equipment at December 31, is as follows:
Depreciation expense was $5,417, $4,280 and $4,270 for the years ended December 31, 2002, 2001 and 2000, respectively. Depreciation expense is allocated evenly between loss adjustment expenses and policy acquisition costs.
Liabilities for unpaid losses and LAE at December 31, consist of:
Unpaid Losses and LAE, by their nature, are inherently uncertain as to the ultimate outcome of the estimated amounts. The liability for unpaid losses and LAE represents Management's best estimate of the ultimate net cost of all losses and LAE incurred through the balance sheet date. The estimate for ultimate net cost of all losses incurred through the balance sheet date includes the adjusted case estimates for losses, incurred but not reported ("IBNR") losses, salvage and subrogation recoverable and a reserve for LAE. In arriving at its best estimate, Management begins with the aggregate of individual case reserves and then makes adjustments to these amounts on a line of business basis. These adjustments to the aggregate case reserves by line of business are made based on analysis performed by Management as further described below. The entire liability for unpaid losses and LAE is also independently reviewed quarterly and annually by the Company's Actuarial Department. Liability estimates are continually analyzed and updated, and therefore, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimates are included in the results of operations in the period in which the estimates are revised.
When reviewing the liability for unpaid losses and LAE, the Company analyzes historical data and estimates the impact of various factors such as (i) payment trends; (ii) loss expense per exposure; (iii) the historical loss experience of the Company and industry; (iv) frequency and severity trends; and, (v) legislative enactments, judicial decisions, legal developments in the imposition of damages, changes and trends in general economic conditions, including the effects of inflation and recession. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors.
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, the Company estimates the ultimate net liability for losses and LAE. After taking into account all relevant factors, management believes that, based on existing information, the provision for losses and LAE at December 31, 2002 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) Management's estimated liability for losses and LAE, based on any of the factors noted previously, the Company will incur additional expense (income) which may have a material impact. The Company does not discount to present value that portion of its loss reserves expected to be paid in future periods.
The following table sets forth a reconciliation of beginning and ending reserves for losses and loss adjustment expense, net of reinsurance deductions from all reinsurers including CAR, as shown in the Company's consolidated financial statements for the periods indicated.
The decrease in provision for insured events of prior years represents redundancies for reserves established for prior years. This decrease in provision was principally the result of re-estimation of unpaid losses and loss adjustment expenses principally on the personal automobile, commercial automobile and homeowners lines of business.
The $14,437 amount for 2002 indicates that Management's estimate for the year end 2001 loss reserves was within 2.4% of the amount established at December 31, 2001. Because of the inherently difficult task of estimating the amount required to ultimately settle all losses several years into the future, it is probable that actual amounts estimated will be either higher or lower than the originally established reserves at any given point in time. Management's intent when establishing its estimate for reserves is to be within a tolerance of plus or minus five percent of the reserve required to ultimately settle all losses. Management gauges its selected reserve estimate to the ranges as determined by the Company's actuaries in order to determine the reasonability of its estimate. To the extent that Management's selected reserve is within the range of the actuarial estimates, Management will not adjust its estimates instead; it will rely on its independently calculated reserve amounts.
$607.3 million to a high of $700.6 million. The Company's financial statement loss and LAE reserves, based on Management's best estimate, was established at $678.3 million for year end 2002. Management calculates its estimate independently from those amounts as calculated by the Company's actuaries and, therefore, the final results are most often not the same. Management estimates its amounts primarily by reviewing historical loss and LAE data, focusing mainly on payment data. It also reviews and compares most recent loss frequency, severity and payment data to historical trends in an attempt to determine if patterns are remaining consistent or not. Management attempts to establish its 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 above entitled "decrease in provision for insured events of prior years".
Effective July 1, 2002, the Company amended its quota share reinsurance program in the event of terrorist acts. The maximum reimbursement to the Company from its quota share reinsurers will be limited to $50,000 in the event of certain defined terrorist acts. The Company believes its exposure to terrorist acts to be very limited based upon the types of coverage offered by the Company and its exposure above the limit to be extremely remote. The Company's main area of business is in the personal lines market and it has very minimal single retained exposure in excess of $1,000.
Under the above scenario and based on the business subject to the quota share reinsurance contract for 2002, the Company has no reinsurance recoveries for a single event catastrophe in excess of a total loss of approximately $262.0 million. The level of reinsurance protection increases (decreases) when the company cedes more (less) premium to the reinsurers. The Company's estimated total losses on its other than automobile business for 100 and 250-year hurricanes (including American Commerce) are approximately $173.5 million and $291.2 million, respectively. The Company estimates were derived through the services of Swiss Reinsurance America Corporation (rated A++ by A.M. Best), which utilized the RMS (Risk Management Solutions) risk assessment system. Most property and casualty insurance companies establish their catastrophe reinsurance programs up to the 100 year storm estimate.
Company entered into a 95% Commercial Umbrella quota share agreement with Employers Reinsurance Corporation.
The Company, as primary insurer, would be required to pay losses in their entirety in the event that the reinsurers were unable to discharge their obligations under the reinsurance agreements.
Effective July 1, 2002, Commerce entered into a retrocessional reinsurance agreement with one of its quota share reinsurers who maintained a one third participation in Commerce's 75% quota share treaty. For a premium paid to Commerce, Commerce will indemnify the reinsurer if the reinsurer incurs a loss for a single event or occurrence over a certain threshold. Losses assumed by the reinsurer must first exceed $15,000 before a reimbursement will be made, by Commerce, to the reinsurer. Commerce's exposure to the reinsurer under this agreement is for a maximum of $35,000. The threshold translates into a $60,000 total loss event or occurrence to Commerce, $15,000 of which represents the reinsurers 25% portion of the quota share treaty, before the reinsurer would receive any benefit.
Since its inception, CAR has annually generated multi-million dollar underwriting losses, primarily in the personal automobile pool. The Company is required to share in the underwriting results of CAR business for its respective product lines. Under current regulations, the Company's share of the CAR personal or commercial deficit is based upon its market share for retained automobile risks for the particular pool, adjusted by a "utilization" concept, such that, in general, the Company is disproportionately and adversely affected if its relative use of CAR reinsurance exceeds that of the industry, and favorably affected if its relative use of CAR reinsurance is less
Written premiums, earned premiums, losses and LAE incurred, underwriting expenses incurred and the liabilities for unearned premiums, unpaid losses and LAE ceded to and assumed from CAR were as follows:
In a letter to the Massachusetts Insurance Commissioner (the "Commissioner") dated June 25, 2002, the Massachusetts Attorney General reported that, based on his examination of available information, he "believes that the CAR plan for providing access to insurance in the residual market does not comply with the CAR enabling statute, and must be changed to produce a fair and equitable market". The Attorney General's letter describes several factors that he believes support his findings and which he believes should be corrected in order to comply with Massachusetts law governing CAR. The Attorney General's letter calls on the Commissioner to work with him to address these issues. It is uncertain whether and to what extent the issues raised by the Attorney General will be addressed by the Commissioner. We cannot be certain whether changes, if any, would have a material impact on the Company.
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 Lauring Construction Company. During 2002, Lauring Construction Company provided construction and construction management services in connection with a contract for the estimated $13 million renovation of a 130,000 square foot building purchased by the Company. Terms of the contract provide for a fixed fee of $650 for supervision of management of the project. Total pay-
The Company offers an Employee Stock Ownership Plan ("ESOP") and 401(k) Plan for the benefit of substantially all employees, including those of the Company's subsidiaries. The ESOP is noncontributory on the part of Participants and contributions are made at the discretion of the Board of Directors. The Company is 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. Contributions by the Company and subsidiaries to the ESOP for the years ended December 31, 2002, 2001 and 2000 were $8,070, $7,502 and $5,702, respectively. The increase from 2002 to 2001 was primarily due to an increase in employees. The increase in the contribution in 2001 over 2000 was primarily due to the inclusion of American Commerce employees into the Plan. The ESOP held 2,921,033 and 2,989,046 shares of the Company's common stock at December 31, 2002 and 2001, respectively. ESOP Participants who are current employees of the Company or its subsidiaries 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 2,159,000 shares owned by Participants in the ESOP at December 31, 2002 are allocated to the ESOP accounts of these individuals. ESOP Participants who are former employees of the Company may generally elect to withdraw from the ESOP the total amount of shares allocated to their accounts at any time. Approximately 557,000 shares held by the ESOP at December 31, 2002 are allocated to the ESOP accounts of these individuals. The remaining approximately 205,000 shares held by the ESOP at December 31, 2002 are allocated to the ESOP accounts of Participants who have not yet reached 100% vesting in their account balances. These shares had a fair value, based on the Company's closing stock price at December 31, 2002 of $37.49 per share totaling $7,685. Disposition of these unvested shares is restricted under the ESOP. The Company pays for administration of the ESOP.
Effective June 1, 2000, the Directors of American Commerce voted to terminate the American Commerce noncontributory defined benefit pension plan (the "pension plan") and transition on January 1, 2001 to the ESOP. The payment of the termination liability to participants from previously funded assets of the pension plan amounted to $4,558 in 2000. The Company has no further obligations under this terminated pension plan.
Effective January 1, 2001, the Directors of American Commerce voted to merge the 401(k) Plan with the Company's Plan. Previously, American Commerce maintained a separate 401(k) Plan for the benefit of substantially all of its employees. American Commerce matched 50% of all
The following table shows, as of December 31, 2002 and 2001, the American Commerce post-retirement benefit plan funded status reconciled with amounts reported in the consolidated balance sheet and the assumptions used in determining the actuarial present value of the benefit obligation:
During 2002, the Company's stockholders approved the Amended and Restated Incentive Compensation Plan ("the Incentive Compensation Plan") which provides for the award of incentive stock options, non-qualified stock options, book value awards, stock appreciation rights, restricted stock and performance stock units. Up to 5,000,000 shares of common stock (subject to
THE COMMERCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2002, 2001 and 2000 (Thousands of Dollars Except for Per Share Data)
the grant ("the confirmation date"). Unexercised 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 agents' options, the Company provided "put rights" to the holders of the agents' options granted in 1999. These put rights permit the agents' option holders to require the Company to purchase the agents' options at the difference between $40.00 less the exercise price, at any time from and after the confirmation date through and including the expiration date. Expenses related to these options, determined in accordance with the fair value accounting provisions of SFAS No. 123, "Accounting for Stock-Based Compensation", amounted to $1,543 in 2002, $2,862 in 2001 and $1,307 in 2000. The American Commerce Agent's Plan has not been approved and is not required to be approved by the Company's stockholders.
The following is a summary of the changes in agents' options outstanding under the American Commerce Agents' Plan:
No agents' options were exercisable at December 31, 2002, 2001, and 2000.
The insurance companies included in the consolidated financial statements are subject to the financial capacity guidelines established by their respective state Divisions of Insurance. Every Massachusetts insurance company seeking to make any dividend or other distributions to its stockholders may, within certain limitations, pay such dividends and then file a report with the Commissioner. Dividends in excess of these limitations are called extraordinary dividends. An extraordinary dividend is any dividend or other property, whose fair value together with other dividends or distributions made within the preceding twelve months exceeds the greater of ten percent of the insurer's surplus as regards policyholders as of the end of the preceding year, or the net income of a non-life insurance company for the preceding year. No pro-rata distribution of any class of the insurer's own securities is to be included. No Massachusetts insurance company shall pay an extraordinary dividend or other extraordinary distribution until thirty days after the Commissioner has received notice of the intended distribution and has not objected. No extraordinary dividends were paid in 2002, 2001 and 2000. California and Ohio have similar regulations. No extraordinary dividend was paid by American Commerce in 2002, 2001 and 2000 and no dividends were paid by Commerce West since its acquisition.
Following is a GAAP to Statutory reconciliation for both earnings and policyholders surplus for the combined operations of Commerce, Citation, Commerce West and American Commerce:
In 2000, Commerce entered into a Limited Partnership Agreement with Conning Partners VI, L.P., a Delaware Limited Partnership. This partnership agreement required a commitment by
the Company to invest up to $50,000 into the partnership. To date the Company has invested $25,056 into the partnership, leaving a balance for funds available for commitment to the partnership of $24,944. The partnership was formed to operate as an investment fund principally for the purpose of making investments primarily in equity, equity-related and other securities issued in expansion financing, start-ups, buy-outs and recapitalization transactions relating to companies in the areas of insurance, financial services, e-commerce, healthcare, and related businesses, including, without limitation, service and technology enterprises supporting such businesses, in order to realize long-term capital returns, all as determined and managed by the General Partner for the benefit of the Partners.
As is common with property and casualty insurance companies, the Company is a defendant in various legal actions arising from the normal course of its business, including claims based on Massachusetts Chapter 176D and Chapter 93A. Similar provisions exist in other states where the Company does business. These proceedings are considered to be ordinary to operations or without foundation in fact. Management is of the opinion that these actions will not have a material adverse effect on the consolidated financial position of the Company.
The following tables depict the progress of the insurance operations of the Company over the past fifteen years. For these years of operation, net premiums written amounted to $9,572,056. During this period, the aggregate statutory financial ratios were 70.4% for losses and loss expenses and 25.9% for underwriting expenses resulting in an aggregate combined ratio of 96.3%. Total net investment income amounted to $964,849 or 10.1% of net premiums written. Net realized gains were $7,273. Stockholders' equity was $46,081 at the beginning of 1988 and $776,512, at the end of 2002, resulting in an average annual increase in excess of 22.0%, excluding dividends. This figure including dividends paid would have been 22.6%. The progress of the insurance operations during the most recent five-year period, compared to the two previous five-year periods, can best be illustrated by the following comparison:
The insurance operations of the Company include the operating results of Commerce and Citation, along with Commerce's subsidiary companies, Commerce West and American Commerce. Citation commenced business in 1981 as a wholly-owned subsidiary of Commerce. On December 31, 1989, the ownership of Citation was transferred to The Commerce Group, Inc. In September 1993, ownership of both Commerce and Citation was transferred from The Commerce Group, Inc. to CHI, a subsidiary of The Commerce Group, Inc. Results of Commerce West are included since its acquisition by Commerce on August 31, 1995. Results of American Commerce are included since its acquisition by Commerce on January 29, 1999. During 2001 certain amounts for years 1996 through 2000 were restated due to the change in accounting for closed-end preferred stock mutual funds to the equity method, reflected as realized gains or losses. During 2002, certain amounts for 2001 were restated. This restatement was the result of applying variable accounting for employee stock options that were previously accounted for on a fixed accounting basis.