We lease an aggregate of approximately 327,000 square feet of office space in numerous cities throughout the United States. Our most significant leased office spaces are located in Davie, Florida with approximately 100,000 square feet; Independence, Ohio with approximately 60,000 square feet; Anaheim, California with approximately 50,000 square feet; Phoenix, Arizona with approximately 24,000 square feet; and Centennial, Colorado with approximately 29,000 square feet. During 2004, two Ohio offices, totaling 75,000 square feet, were consolidated to a single location in Independence, Ohio.
Outsourcing service fees represent fees earned under a contract with Reliance Insurance Company for servicing policies and claims on the run-off of their non-standard automobile insurance business. We entered into this contract in connection with our acquisition of the non-standard automobile operations of Reliance Group Holdings in April 2001. These fees do not represent a recurring source of income.
Litigation expense represents expense associated with the settlements of certain class action lawsuits.
Expense ratio is the ratio, expressed as a percentage, of (i) the sum of (A) commissions and other underwriting expenses and (B) other operating and general expenses divided by (ii) the sum of (A) net premiums earned, (B) policy service fee revenues, (C) outsourcing servicing fees and (D) other income.
We provide non-standard private passenger automobile insurance and related services. Non-standard automobile insurance provides coverage to drivers who find it difficult to purchase automobile insurance from standard carriers as a result of a number of factors, including their driving record, vehicle, age, claims history, or because they have limited financial resources. Typically, these drivers purchase minimal levels of insurance coverage in order to comply with state-mandated financial responsibility laws. For comparable coverage, premiums for non-standard automobile insurance policies are generally higher than for standard or preferred automobile insurance policies.
other income, which primarily represents commission income we earn through a general agency we own in Texas.
commissions and other underwriting expenses, which consist of commissions we pay to agents and brokers, premium taxes and company expenses related to the production and underwriting of insurance policies, less ceding commissions that we receive under our reinsurance contracts;
other operating and general expenses, which include general and administrative expenses, depreciation and other expenses; and
Most companies, Bristol West included, are operating profitably at current rate levels. This contrasts with market conditions during 2001, 2002 and 2003 when most market participants were seeking rate increases to restore profitability.
California continues to be our largest state, and California, Florida and Michigan accounted for 81% of our volume for 2004. Growth rates, as enumerated above, vary significantly by state and are dependent upon a variety of factors, including competitive conditions and regulatory environments within those states, our strategies with respect to product pricing and the number and location of producers.
In California, our writings declined by 4.4% in 2004 and grew by 16.5% in 2003. In our other states, in the aggregate, our writings grew by 30.4% and 36.6% in 2004 and 2003, respectively. Our mix of premium writings is becoming more geographically diversified as we derived 56% of our written premiums from California in 2004, down from 67% in 2002.
Exclusive of the change in the provision for cancellations, we experienced a decline in direct premium written in California of 4% for the year ended December 31, 2004. In California, competitors’ filed rates remain stable, however, many have relaxed underwriting standards by not verifying mileage bands and other underwriting information, such as driving experience. This behavior results in lower policy premium for consumers, making it more difficult for companies not engaging in such practices to attract new customers. We have not relaxed our underwriting standards and do not intend to in the future, as we believe some of these competitors are underwriting these risks at an economic loss. Our direct written premium in California grew in early 2004, and then declined in the latter half of the year. By quarter, the direct written premium, excluding the change in expected policy cancellation provision, was as follows for 2004 and 2003:
In Florida, our second largest state, gross written premium grew by 38.8% for the year ended December 31, 2004 as compared to 2003. In April 2004, we introduced a new product design, with a rating structure that utilizes a significantly larger number of rating variables than did its predecessor. This product has been well received in the market, and we are pleased with the increase in new business volume. Our producer count in Florida has increased to 1,044 producers and 1,276 locations as of December 31, 2004 up from 617 producers with 806 locations as of December 31, 2003. Competition has increased in Florida, manifested by modest rate reductions, increased advertising and agent incentives. Overall, we view this market as stable and the competition we are seeing as rational.
In the aggregate, we utilized point of sale underwriting on 74% of new business applications in the fourth quarter of 2004. Policy issuance is now immediate in the states where point-of-sale underwriting technology, OneStep or OneStep-Raptor, has been deployed, compared to an average of 5 days prior to implementation of point-of-sale underwriting.
In 2004, we continued to roll out OneStep in California. As of December 31, 2004, it was deployed in all brokerage locations in California, and as of March 4, 2005 virtually all California new business applications were being processed on OneStep. We now have point-of-sale underwriting systems deployed in 12 states.
At each financial reporting date, we record our best estimate, which is a point estimate, of loss and loss adjustment expense reserves, gross and net of reinsurance. In selecting the best estimate, we utilize up to 15 different actuarial methodologies. Each of these methodologies is designed to forecast the number of claims we will be called upon to pay and the amounts we will pay on average to settle those claims. In arriving at our best estimate, our actuaries consider the likely predictive value of the various loss development methodologies employed in light of underwriting practices, premium rate changes and claim settlement practices that may have occurred, and weight the credibility of each methodology. Our actuarial methodologies take into account various factors, including, but not limited to, paid losses, liability estimates for reported losses, paid allocated loss adjustment expenses, salvage and other recoveries received, reported claim counts, open claim counts and counts for claims closed with and without payment of loss.
If our estimate of gross unpaid losses and loss adjustment expenses of $222.3 million at December 31, 2004 decreases or increases in 2005 by one percent, our net income or loss for 2005 would decrease or increase by $1.4 million after tax (assuming an effective tax rate of 35%).
performing all actuarial analyses of unpaid losses and loss adjustment expenses on a quarterly basis;
reviewing loss and loss adjustment expense reserves gross of salvage and subrogation and separately developing estimates of these items to estimate reserves net of salvage and subrogation;
increasing the number of analytical methods to include claim count analysis to develop more elaborate estimation methods; and
utilizing an automated loss and loss adjustment expense reserving process, virtually eliminating manual spreadsheets.
Based on these actions, we believe that we have addressed the issues related to unfavorable development of our loss and loss adjustment expense reserves, and that the liabilities that we have recorded for losses and loss adjustment expenses are adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date.
SFAS No. 113 also requires us to disclose the nature, purpose and effect of reinsurance transactions, including the premium amounts associated with reinsurance assumed and ceded. It also requires disclosure of concentrations of credit risk associated with reinsurance receivables and prepaid reinsurance premiums.
Gross Premiums Written. Gross premiums written increased to $752.9 million for the twelve months ended December 31, 2004, or by 16.2%, compared to $648.2 million for 2003. The increase is primarily attributable to increased market penetration evidenced by the 11.5% growth in average policies in force from 437,200 for 2003 to 487,650 for 2004. We provide for expected premature policy cancellations in order to adjust premiums written to amounts we expect to ultimately earn. During 2004, in response to improved persistency of our business, we reduced the provision by $46.3 million, which added 6.6% to the growth in our reported gross premiums written for the year.
Net Premiums Written. Net premiums written increased by 40.0% to $369.0 million from $263.0 million in 2003. The larger increase in net premiums written as compared to gross premiums written is due to a decrease in the percentage of premiums ceded under our quota share reinsurance treaty from 60% in 2003 to 50% in 2004. We have entered into a new quota share reinsurance agreement for 2005 under which we will be ceding 10% of the premiums on policies written in 2005.
Net Premiums Earned. Net premiums earned increased by 18.7% to $325.3 million in 2004 from $274.0 million in 2003. Gross earned premiums were up by 13.4% and our premium retention increased from 44.7% to 46.7% as a result of the reduction in the ceding percentage under our quota share reinsurance agreement. We had a quota share reinsurance agreement in 2004 under which we ceded 50% of 2004 policy premium; for 2005, we have a new quota share reinsurance agreement under which we will be ceding 10% of the premiums earned on policies written in 2005.
Net Investment Income and Realized Capital Gains. Net investment income was $9.0 million in 2004 compared to $6.7 million in 2003. Most of the increase is attributable to the investment of $110.0 million of the proceeds from our initial public offering, which took place in mid-February, 2004. Operating cash flows aggregated $45.9 million for the year, which also contributed to the growth in invested assets and increased net investment income. The average pre-tax equivalent investment yield on the portfolio fell from 4.57% as of December 31, 2003 to 4.30% as of year-end 2004.
Net realized gains on securities sales were insignificant for the twelve months ended December 31, 2004 compared to $1.2 million in 2003.
Policy Service Fee Revenues. Policy service fee revenues were $74.1 million for the twelve months ended December 31, 2004, an increase of $4.9 million or 7.1% compared to 2003. The growth was attributable to the growth in policies in force, since fees are charged on a per policy basis, as well as an increase in the fees we collect on each policy. The growth in policy service fees was slightly less than the growth in gross earned premiums as our premiums declined in California and grew in other states and the fees we charge related to policy premiums are, on average, higher in California than in the other states in which we operate.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses increased to $219.4 million for the year ended December 31, 2004 compared to $199.7 million for 2003. Our loss ratio (losses and loss adjustment expenses divided by net earned premiums, fee income and other income) fell to 54.6% for 2004 from 57.9% for 2003, a decline of 3.3 points. The decline in the loss ratio is primarily attributable to a reduction in adverse development on loss and loss adjustment expense reserves for prior years to $2.5 million in 2004 from $9.3 million in 2003, or 2.1 points of the improvement. Adverse development occurs when loss and loss adjustment expense reserves established for accidents that took place in years prior to the current year prove to be inadequate and management increases those reserves to reflect the revised estimate of the ultimate losses related to such accidents. Such increases result in a charge to loss and loss adjustment expenses in the current year. The remainder of the decrease in the loss ratio was due to a 1.2 point improvement in our claims experience for accident year 2004 compared to 2003.
Other Operating and General Expenses. Other operating and general expenses were $31.4 million for the twelve months ended December 31, 2004 compared to $24.2 million for the prior year, an increase of 29.8%. The costs of being a public company added approximately $4.0 million, including an increase of $1.9 million in our insurance premiums for errors and omissions and directors’ and officers’ liability coverage, depreciation increased by $1.7 million, and bank fees related principally to premium collections increased by $1.0 million.
We recorded no litigation expenses in 2004 related to the two class action lawsuits.
Interest Expense. Interest expense was $3.0 million for the twelve months ended December 31, 2004 compared to $3.2 million for the same period of 2003. Interest incurred pertains to the Company’s bank debt, which the Company refinanced on February 18, 2004. Amortization of deferred financing fees is lower under our new facility, closed in February 2004, than under the prior one.
Ratios. Our combined ratio was 76.9% for the twelve months ended December 31, 2004, compared to 79.9% for 2003, an improvement of 3 points. The reduction in adverse development accounted for 2.1 points of the improvement; the current accident year loss ratio for 2004 was 1.2 points lower than in 2003; and the overall expense ratio increased by 0.3% in 2004 compared to 2003.
Income Taxes. Income taxes for the year ended December 31, 2004 were $34.8 million, or 36.25% of income before income taxes. Our effective tax rate of 36.25% comprises 34% Federal income taxes and 2.25% state income taxes.
Net Premiums Written. Net premiums written increased by 11.3% to $263.0 million from $236.3 million in 2002. The smaller increase in net premiums written as compared to gross premiums written is due to our decision to increase the percentage of premiums ceded under our quota share reinsurance agreement from 50% in 2002 to 60% in 2003 in order to manage the net retained business in relation to our financial resources.
Net Premiums Earned. Net premiums earned increased by 13.7% to $274.0 million from $241.0 million in 2002, generally in line with the increase in net premiums written.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses were essentially unchanged from the prior year at $199.7 million for 2003 compared to $200.5 million for 2002. Our loss ratio fell to 57.9% for 2003 from 68.9% for 2002, a decline of 11 points. Most of the reduction (7 points) was due to a decrease to $9.3 million in 2003 from $28.2 million in 2002 in the adverse development of our loss and loss adjustment expense reserves for prior years. The 2003 figure comprised $4.8 million of loss reserve development and $4.5 million of loss adjustment expense reserve development. Adverse development occurs when loss and loss adjustment expense reserves established for accidents that took place in years prior to the current year prove to be inadequate and management increases those reserves to reflect the revised estimate of the ultimate losses related to such accidents. Such increases result in a charge to loss and loss adjustment expenses in the current year. The remainder of the decrease in the loss ratio was due to slightly improved loss experience on current business in 2003 compared to 2002.
Other Operating and General Expenses. Other operating and general expenses were $24.2 million for the twelve months ended December 31, 2003 compared to $19.3 million for the prior year, an increase of 25.4%. The increase was due to the expanded scope of operations to support our growing book of business. This growth, while greater than that of our net premium and fee revenue after reinsurance, was about 10 points less than the growth of our direct premiums and fees. The scale of our direct business drives our need for staff and facilities, and we evaluate our expense growth relative to that measure.
Litigation Expense. Litigation expenses related to two class action lawsuits were $17.4 million in 2003 and $14.3 million in 2002.
Ratios. Our combined ratio was 79.9% for the twelve months ended December 31, 2003, compared to 89.9% for 2002, an improvement of 10 points. The reduction in adverse development accounted for 7.0 points of the improvement; the remainder is the result of a slight improvement in current year loss experience compared to that of the prior year. Our combined ratio exclusive of the effect of adverse reserve development was 77.2% in 2003 compared to 80.3% in 2002, an improvement of 3.1 points.
In February 2004, an initial public offering of 17,250,000 shares of the Company's common stock was completed. The Company sold 6,250,000 shares providing net proceeds to the Company, after deducting issuance costs, of approximately $113.4 million. The Company contributed $110.0 million of the proceeds to its insurance subsidiaries, which increased their statutory surplus.
Our insurance subsidiaries' primary sources of funds are premiums received, investment income and proceeds from the sale and redemption of investment securities. Our non-insurance subsidiaries' primary source of funds is policy service fee revenues. Our subsidiaries use funds to pay claims and operating expenses, make payments under the tax allocation agreement, purchase investments and pay dividends to us.
After the Company’s initial public offering in February 2004, the Company began paying quarterly dividends of $0.05 per share for a total dividend payout of $4.7 million during the year ended December 31, 2004. The declaration and payment of dividends is subject to the discretion of our board of directors, and depends on, among other things, our financial condition, results of operations, capital and cash requirements, future prospects, regulatory and contractual restrictions on the payment of dividends by our subsidiaries, restrictions under our credit facility on our ability to pay dividends to our stockholders and other factors deemed relevant by the board.
Net cash provided by operating activities was $45.9 million, $17.9 million and $42.9 million for the years ended December 31, 2004, 2003 and 2002, respectively. The increase in cash flow generated from operations for 2004 compared to 2003 was due to the increased scale of our operations, a reduction in the percentage of our business ceded to our quota share reinsurers to 50% in 2004 from 60% in 2003, a reduction in paid class action litigation costs, and the tax benefit received by the Company in relation to the exercise of stock options during 2004. The net amounts paid to reinsurers were $63.5 million, $89.3 million and $29.0 million in 2004, 2003 and 2002, respectively. The cash flow generated from operations was lower in 2003 compared to 2002 as a result of the increase in the quota share ceded percentage to 60% for 2003 from 50% for 2002, and the concomitant increase in the net cash paid to our reinsurers. In addition we paid $19.8 million in litigation costs in 2003 compared to $0.7 million in 2002.
Net cash used in investment activities amounted to $157.6 million, $21.3 million and $30.7 million for the years ended December 31, 2004, 2003 and 2002, respectively, and was used principally to purchase fixed income securities. The increase in investment purchases from 2003 to 2004 was due to the investment of proceeds from the Company’s initial public offering that was completed in February 2004. The decrease in cash used in investment activities in 2003 compared to 2002 was due to the reduction in cash flow from operations as noted above. Property, software and equipment additions were $11.0 million, $6.7 million, and $5.6 million, for the years ended December 31, 2004, 2003 and 2002, respectively. Capital expenditures during 2004 were predominantly for computer equipment and software.
For the years ended December 31, 2004 and 2003, we paid $18.1 million and $12.8 million, respectively, in federal and state income taxes. We paid no federal income taxes during the year ended December 31, 2002 as a result of a $32.1 million taxable loss on our federal consolidated income tax return for the year ended December 31, 2000. The loss reported in 2000 was carried forward, applied against and completely offset our consolidated taxable income for 2002.
The Company elected to terminate and commute the 2002 to 2004 quota share reinsurance agreement on a cut-off basis effective January 1, 2005. The termination and commutation resulted in the reinsurers’ release from all future liability in return for settlement of all balances due the Company of $196.6 million, which was received on January 21, 2005. These monies have been invested in high-quality fixed income securities.
The Company ceded significant premiums and losses to its reinsurers under this agreement in 2004, 2003 and 2002, as shown in the following table.
In September 2004, the FASB staff issued clarifying guidance for comment in FASB Staff Position (“FSP”) EITF Issue No. 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1” (“FSP Issue No. 03-1-a”) and subsequently voted to delay the implementation of the impairment measurement and recognition guidance contained in paragraphs 10-20 of EITF Issue No. 03-1 in order to deliberate again certain aspects of the consensus as well as the implementation guidance included in FSP Issue No. 03-1-a. The disclosure requirements including quantitative and qualitative information regarding investments in an unrealized loss position remain effective and are included in the footnotes to the consolidated financial statments.
The following table displays our contractual obligations by the years in which payments are due as of December 31, 2004.
Our consolidated financial statements together with the report of the independent registered public accounting firm are set forth beginning on page.