The following table sets forth our selected historical consolidated financial data as of and for each of the five years ended December 31, 2002. Prior to October 16, 2001, Thomas Black Corporation was the parent company of Safety Insurance. In the Acquisition, on October 16, 2001, Safety Insurance Group, Inc. became the parent company of Thomas Black Corporation.
The selected historical consolidated financial data for the year ended December 31, 2002 and the successor period October 16, 2001 to December 31, 2001, and as of December 31, 2002 and 2001 have been derived from the financial statements of Safety Insurance Group, Inc. included in this annual report which have been audited by PricewaterhouseCoopers LLP, independent accountants. The selected historical consolidated financial data for the predecessor period January 1, 2001 to October 15, 2001 and for the year ended December 31, 2000 have been derived from Safety Insurance Group, Inc.'s financial statements included in this annual report which have been audited by PricewaterhouseCoopers LLP. The summary historical consolidated financial data for the years ended December 31, 1999 and 1998 and as of December 31, 2000, 1999 and 1998 have been derived from Thomas Black Corporation's consolidated financial statements not included in this annual report, which have been audited by PricewaterhouseCoopers LLP. As a result of the Acquisition, financial data for periods prior to the Acquisition may not be comparable with financial data for periods following the Acquisition.
We have prepared the selected historical consolidated financial data, other than statutory data, in conformity with GAAP. We have derived the statutory data from the annual statements of our insurance subsidiaries filed with insurance regulatory authorities, which were prepared in accordance with statutory accounting practices, which vary in certain respects from GAAP.
The selected financial data presented below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated
financial statements and the accompanying notes included in this Form 10-K in order to more fully understand the historical consolidated financial data.
(2)Our transaction expenses reflect the costs we incurred in connection with the Acquisition. See "The Acquisition."
and basis of accounting of our Company differ from those of TBC prior to the Acquisition. Therefore, the financial data with respect to periods prior to the Acquisition ("predecessor" period) may not be comparable to data for periods subsequent to the Acquisition ("successor" period). In addition, the recent November 27, 2002 initial public offering ("IPO"), the use of those IPO net proceeds, the Preferred Share Exchange, as defined below, and a direct sale of 350,000 additional shares of common stock (the "Direct Sale") have further altered the current capital structure of our Company.
The holders of the preferred stock agreed to amend the terms of the preferred stock to cause it to automatically convert into common stock upon the closing of the IPO at the IPO price. Based upon the $12.00 per share IPO price, 1,866,665 additional common shares were issued in connection with the preferred share exchange (the "Preferred Share Exchange") upon the close of the IPO.
On June 25, 2002, the Board adopted the 2002 Management Omnibus Incentive Plan ("the Incentive Plan"). The Incentive Plan provides for a variety of awards, including nonqualified stock options, SARs and restricted stock awards. The maximum number of shares of common stock with respect to which awards may be granted under the Incentive Plan is 1,250,000 after adjustment for the stock dividend declared in connection with the IPO. On July 1, 2002, the Board authorized the grant of 379,000 options to purchase common stock to certain employees and one nominee for director, pursuant to the Incentive Plan. These grants were effective on the IPO date at an exercise price equal to the $12.00 per share IPO price, have a ten year term and vest in five equal annual installments beginning on the first anniversary date of these grants. The Board and the Compensation Committee intend to issue more options under the Incentive Plan in the future, not to exceed the maximum number of shares to be granted.
On October 16, 2001, Safety acquired TBC, the holding company for our insurance and other subsidiaries, from a group of shareholders consisting primarily of TBC's founder and members of his immediate family. We accounted for the Acquisition using the purchase method of accounting, in accordance with the treatment of a business combination under Statement of Financial Accounting Standards No. 141, Business Combinations. Under purchase accounting: (i) we recorded the assets and liabilities of TBC at their estimated fair value at the date of Acquisition; (ii) we used the excess of acquired net assets over the purchase price to reduce the estimated fair values of all non-current, non-financial assets, principally equipment and leasehold improvements; and (iii) we recorded the remaining $117.5 million excess of the estimated fair value of net assets over purchase price as an extraordinary gain in the consolidated statement of operations for the period October 16, 2001 through December 31, 2001 in accordance with SFAS No. 141.
Management determined that there was no material difference between the historical carrying basis of the reserves for losses and loss adjustment expenses and related reinsurance recoverables at the date of Acquisition and their fair value.
In connection with the Acquisition, we incurred approximately $9.5 million and $0.4 million of transaction-related expenses on a pre-tax basis for the years ended December 31, 2001 and December 31, 2000, respectively. These expenses incurred are non-recurring in nature and are required to be expensed under GAAP.
In managing our business, one measure we use to evaluate our performance is our adjusted after-tax operating income. In calculating these amounts, we start with our reported generally accepted
(1)Represents extraordinary gain related to the excess of the estimated fair value of net assets over the purchase price in connection with the Acquisition in accordance with FAS 141, Business Combinations.
December 31, 2002 and 2001, respectively. Further, $4,715 and $1,185 of after-tax interest expense, and $1,463 and $0 of after-tax unamortized deferred debt issuance costs expensed related to outstanding debt from the Acquisition for the years ended December 31, 2002 and 2001, respectively, have not been added back to GAAP net income available to common shareholders in determining adjusted after-tax operating income available to common shareholders.
(3)Represents salary and bonus paid to our former owner. Management believes that this adjustment is appropriate because of the limited role our former owner played in our operations, and the fact that he did not participate in day-to-day decisions following late 1998 and the appointment of David Brussard as our President and Chief Executive Officer in January 1999. In addition, no comparable expense has been incurred since the Acquisition, and no need to hire an additional person to fill this function is foreseen.
We are subject to the extensive regulation of the private passenger automobile insurance industry in Massachusetts, which represented 81.5% of our direct written premiums in 2002. Owners of registered automobiles are required to maintain minimum automobile insurance coverages. Generally, we are required by law to issue a policy to any applicant who seeks it. We are also required to participate in a state-mandated reinsurance program run by CAR to which we cede certain unprofitable risks and from which we are allocated a portion of the overall losses. This program operates at an underwriting deficit. This deficit is allocated among every Massachusetts automobile insurance company, including us, based on a complex formula that takes into consideration a company's voluntary market share, the rate at which it cedes business to CAR, and the company's utilization of a credit system CAR has designed to encourage carriers to reduce their use of CAR. In addition, based on our market share, we are assigned certain agents by CAR that have been unable to obtain a voluntary contract with another insurer. We call these agents Exclusive Representative Producers, or ERPs.
whether and to what extent the issues raised by the Attorney General will be addressed by CAR. We cannot be certain whether any changes, if adopted by CAR, would affect our profitability.
(1)Source: Division of Insurance rate decisions for 1991 - 2002. The Commissioner announced on December 13, 2002, a 2.7% statewide average private passenger rate increase for 2003, and the Commissioner also approved a decrease in the commission rate agents receive for selling private passenger automobile insurance, as a percentage of premiums, from 12.3% in 2001, to 11.7% in 2002, and a further decrease to 11.0% in 2003.
finance income. Underwriting profitability is subject to significant fluctuations due to competition, catastrophic events, economic and social conditions and other factors.
(1)The above adjusted statutory expense and combined ratios for the years 2000 and 2001 include certain expenses that management believes are not indicative of ongoing statutory underwriting performance, as described under "Management's Discussion and Analysis of Financial Condition and Results of Operation-General-Adjusted After-Tax Operating Income." These expenses consist of compensation and interest expenses related to our employee stock ownership plan and our supplemental executive stock ownership plan which were terminated effective with the Acquisition and compensation expense related to the former majority owner whom we no longer employ. If these costs were excluded from our expense ratios, our adjusted expense and combined ratios, respectively, would have been 24.8% and 103.6% for 2001, and 25.2% and 97.5% for 2000.
(2)The ratios shown for 2000 have also been adjusted from amounts previously reported to present our business assumed from CAR on a gross basis. Each insurer writing private passenger automobile insurance in Massachusetts must assume a share of premiums, losses, loss adjustment expenses and underwriting expenses from a state-mandated reinsurance pool run by CAR. Prior to 2001, we recorded our share of premiums assumed from this pool and the related losses, loss adjustment expenses and underwriting expenses by netting these items and reflecting the resulting net loss in losses and loss adjustment expenses. Effective January 1, 2001, we began recording these premiums and the related losses, loss adjustment expenses and underwriting expenses on a gross basis in our statutory financial statements. For a presentation of our statutory ratios as originally reported, see "Selected Historical Financial Data."
(3)For property and casualty industry data, the combined ratios include dividends to policyholders. Our property and casualty industry combined ratio is based on data compiled by A.M. Best. This data aggregates the performance of 2,455 national and regional property and casualty insurance companies and does not include these companies' life and other non-property and casualty insurance results. The mix of products that we offer may be different from the mix offered by these other property and casualty companies.
Loss and Loss Adjustment Expense Reserves. Significant periods of time can elapse between the occurrence of an insured loss, the reporting to us of that loss and our final payment of that loss. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities. Our reserves represent estimates of amounts needed to pay reported and unreported losses and the expenses of investigating and paying those losses, or loss adjustment expenses. Every quarter, we review our previously established reserves and adjust them, if necessary. Refer to the discussion starting on page 13 of "Part I., Item 1. Business, I. Reserves" for a more detailed discussion.
When a claim is reported, claims personnel establish a "case reserve" for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon an evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the loss. The estimate reflects informed judgment of such personnel based on general insurance reserving practices and on the experience and knowledge of the claims person. During the loss adjustment period, these estimates are revised as deemed necessary by our claims department based on subsequent developments and periodic reviews of the cases.
assumption implicit in our estimate can cause our actual loss experience to be better or worse than our reserves, and the difference can be material. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors. Establishment of appropriate reserves is an inherently uncertain process, and currently established reserves may not prove adequate in light of subsequent actual experience. To the extent that reserves are inadequate and are strengthened, the amount of such an increase is treated as a charge to earnings in the period that the deficiency is recognized. To the extent that reserves are redundant and are released, the amount of the release is a credit to earnings in the period the redundancy is recognized.
The changes we have recorded in our reserves in the past three years illustrate the uncertainty of estimating reserves. In 2002, 2001 and 2000, our reserve reviews indicated that our reserves established in prior years were slightly higher than necessary, and so in those years we released $2.3 million, $7.3 million and $27.0 million, respectively, of previously established reserves for losses and loss adjustment expenses. It is not appropriate to extrapolate future favorable or unfavorable development of reserves from this past experience.
Other-Than-Temporary Impairments. We use a systematic methodology to evaluate declines in market values below cost or amortized cost of our investments. This methodology ensures that we evaluate available evidence concerning any declines in a disciplined manner. Refer to the discussion starting on page 19 of "Part I., Item 1. Business, M. Investments" for a more detailed discussion.
In our determination of whether a decline in market value below amortized cost is an other-than-temporary impairment, we consider and evaluate several factors and circumstances including the issuer's overall financial condition, the issuer's credit and financial strength ratings, a weakening of the general market conditions in the industry or geographic region in which the issuer operates, a prolonged period (typically six months or longer) in which the fair value of an issuer's securities remains below our cost and any other factors that may raise doubt about the issuer's ability to continue as a going concern.
We record other-than-temporary impairments as a realized loss, which serves to reduce net income and earnings per share. We record temporary losses as unrealized losses, which do not impact net income and earnings per share but reduce other comprehensive net income. The risks inherent in our assessment of other-than-temporary impairments include the risk that market factors may differ from our expectations, or that the credit assessment could change in the near term, resulting in a charge to earnings.
The table below shows certain of our selected financial results for the years ended December 31, 2002, 2001 and 2000. For comparative purposes, the predecessor and successor periods have been combined under the caption "For the Year Ended December 31, 2001."
Net Written Premiums. Net written premiums for the year ended December 31, 2002 increased by $52.1 million, or 11.2%, to $517.6 million from $465.5 million for the year ended December 31, 2001. This increase was primarily due to the increase in direct written premiums, and an increase in assumed premiums from CAR.
In connection with the purchase price allocation adjustments recorded effective with the Acquisition, we increased our net cost basis in investment securities held by an aggregate of approximately $12.7 million to their fair market values as of October 16, 2001. None of our gross unrealized losses of $0.9 million as of December 31, 2002 has existed for longer than six months and at a value of less than 80% of cost. As of December 31, 2001, we had gross unrealized losses of $7.9 million, of which approximately $7.3 million related to fixed maturity obligations of the U.S. government, states, and government agency asset-backed securities. The remaining $0.6 million of gross unrealized losses at that date related to holdings of investment grade corporate fixed maturities securities in a variety of industries and sectors, including banking, retail, finance, consumer product, telecommunications, entertainment, utilities and aerospace.
Massachusetts law requires that we participate in the Massachusetts Insurers Insolvency Fund, which pays claims up to $0.3 million of a policyholder of an insolvent insurer if the claim existed prior to the declaration of insolvency or arose within sixty days after the declaration of insolvency. We account for allocations from the Massachusetts Insurers Insolvency Fund as underwriting expenses.
Underwriting expenses in 2002 and 2001 included $2.1 million and $1.4 million of charges representing our allocation from the Massachusetts Insurers Insolvency Fund. Underwriting, operating and related expenses for the year ended December 31, 2002 included $5.0 million in compensation expenses related to put and call options on shares held by management, while the comparable 2001 period included $6.9 million related to $3.5 million of expense incurred under the employee stock ownership plan and the supplemental executive stock ownership plan, both of which were terminated at the Acquisition, $2.0 million in compensation paid to our former majority owner, $1.2 million in compensation expense related to put and call options on shares held by management and $0.2 million in fees paid to TJC Management.
declined 8.3% in 2001 from 2000, our average premium per automobile exposure remained flat as a result of factors including our reduced offering of discounts, our rate pursuit initiatives and new automobile purchases by our insureds.
Investment Income. Investment income for the year ended December 31, 2001 increased by $0.7 million, or 2.6%, to $27.6 million from $26.9 million for the year ended December 31, 2000. The increase was primarily due to an increase in average invested assets to $517.1 million from $476.4 million for the year ended December 31, 2000, which was offset by a decrease in effective yield on our investment portfolio from 5.6% in 2000 to 5.3% in 2001.
Net Realized Investment Losses. Net realized investment losses for the year ended December 31, 2001 were $5.0 million and were $1.2 million for the year ended December 31, 2000. The 2001 net realized losses resulted primarily from the sale of certain securities which had significantly declined in credit quality from the date of purchase and from sales of securities in the ordinary course following the resetting of their carrying value under purchase accounting as of the date of the Acquisition.
(1)Obligations of U.S. Government agencies include collateralized mortgage obligations issued, guaranteed and/or insured by the following issuers: Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), and Federal National Mortgage Association (FNMA). As such, the asset-backed securities presented exclude such issuers already presented under U.S. Treasury securities and obligations. In connection with the purchase price allocation adjustments recorded effective with the Acquisition, we increased our net cost basis in investment securities held by an aggregate of approximately $12.7 million to their fair market values as of October 16, 2001. As of December 31, 2001, we had gross unrealized losses of $7.9 million, of which approximately $7.3 million related to fixed maturity obligations of the U.S. government, states, and government agency asset-backed securities. The remaining $0.6 million of gross unrealized losses at that date related to holdings of investment grade corporate fixed maturities securities in a variety of industries and sectors, including banking, retail, finance, consumer product, telecommunications, entertainment, utilities and aerospace.
Underwriting, Operating and Related Expenses. Underwriting, operating and related expenses for the year ended December 31, 2001 increased $4.4 million, or 3.9%, to $117.8 million from $113.4 million for the year ended December 31, 2000. As a percentage of net written premiums, our underwriting expense ratio for 2001 was 25.3% compared to 26.4% in 2000. The lower underwriting expense ratio in 2001 resulted from lower expenses primarily due to the continued effects of our technology program with respect to our agents, which allowed us to achieve economies of scale, and to a lesser extent to reductions in contingent commissions paid to our agents. Massachusetts law requires that we participate in the Massachusetts Insurers Insolvency Fund, which pays claims up to $0.3 million of a policyholder of an insolvent insurer if the claim existed prior to the declaration of insolvency or arose within sixty days after the declaration of insolvency. We account for allocations from the Massachusetts Insurers Insolvency Fund as underwriting expenses. The underwriting ratio in 2001 included a $1.4 million charge representing our allocation from the Massachusetts Insurers Insolvency Fund for the insolvencies of The Trust Insurance Company and Reliance Insurance Company. Underwriting, operating and related expenses for the year ended December 31, 2001 included $3.5 million of expense incurred under the employee stock ownership plan and the supplemental executive stock ownership plan, both of which were terminated at the Acquisition, $2.0 million in compensation paid to our former majority owner, $1.2 million in compensation expense related to put and call options on shares held by management and $0.2 million in fees paid to TJC Management. Underwriting, operating and related expenses for the year ended December 31, 2000 included $8.9 million of expense incurred under the employee stock ownership plan and the supplemental executive stock ownership plan, both of which were terminated as of the Acquisition, and $3.0 million in compensation paid to our prior majority owner.
Net Income Before Extraordinary Item and Preferred Stock Dividends. Net income before extraordinary item and preferred stock dividends decreased $19.2 million, or 100.0%, to $0 during for the year ended December 31, 2001 as compared to $19.3 million for the year ended December 31, 2000, as a result of the factors previously mentioned.
As a holding company, Safety's assets consist primarily of the stock of our Company's direct and indirect subsidiaries. Our Company's principal source of funds to meet our obligations and pay dividends to stockholders, therefore, are dividends and other permitted payments from our subsidiaries, principally our indirect subsidiary, Safety Insurance. Our Company's direct subsidiary, TBC, directly owns Safety Insurance. TBC is the borrower under both our old and new credit facilities. As a holding company, its principal source of cash to pay amounts owed under the credit facility and its other obligations and dividends to us are dividends and other permitted payments from Safety Insurance.
Old Credit Facility. In connection with the Acquisition, TBC borrowed a total of $69.5 million under our old credit facility. Fleet National Bank was the arranger under this facility, which consisted of a $55.0 million term loan and a $20.0 million revolving credit facility. We borrowed the entire amount of the term loan and $14.5 million under the revolving credit facility to fund the Acquisition and had paid down $3.0 million on the term loan prior to closing our IPO. Loans under the old credit facility accrued interest at our option at either (i) the LIBOR rate plus an applicable margin or (ii) the higher of Fleet National Bank's prime rate or 1/2% above the federal funds rate, in either case plus an applicable margin. The applicable margin for any period was based on the ratio of our consolidated debt to the combined statutory surplus of our insurance subsidiaries. The term loan was repayable in 24 increasing quarterly payments, the first three of which were due, and were paid, on April 1, July 1 and September 30, 2002, respectively. The revolving credit facility was repayable in full at maturity. We secured our obligations under our old credit facility with our assets, the assets of our non-insurance
New Credit Facility. Concurrent with the closing of our IPO and repayment of the above old credit facility, TBC obtained a new $30.0 million revolving credit facility. Fleet National Bank is the lender under this new credit facility. TBC borrowed the entire $30.0 million under this new credit facility at the closing of the IPO and paid down the balance to approximately $20.0 million on December 5, 2002 with the $10.0 million net proceeds from the exercise of the underwriter's over-allotment option for 900,000 shares of our common stock. Loans under the new credit facility bear interest at our option at either (i) the LIBOR rate plus 1.50% per annum or (ii) the higher of Fleet National Bank's prime rate or 1/2% above the federal funds rate plus 1.50% per annum. The new credit facility is due and payable at maturity on November 27, 2005, which is three years from the closing of the IPO. Interest only is payable prior to maturity. The obligations of TBC under the new credit facility are secured by pledges of the assets of TBC and the capital stock of TBC "s operating subsidiaries. The new credit facility is guaranteed by the non-insurance company subsidiaries of TBC. The new credit facility contains covenants including requirements to maintain minimum risk based capital ratios and statutory surplus of Safety Insurance as well as limitations or restrictions on indebtedness, liens, dividends, and other matters. As of December 31, 2002, the Company was in compliance with all such covenants, ratios, statutory surplus and limitations.
Senior Redeemable Preferred Stock. Safety issued $22.4 million of its senior redeemable cumulative preferred stock in connection with the Acquisition. This preferred stock was entitled to cumulative dividends at a rate of 6% per year, a liquidation preference of $22.4 million and was required to be redeemed on the earlier of October 16, 2012 or the date of a change in control of our Company.
When we completed the Preferred Share Exchange at the closing of the IPO, all of our outstanding preferred stock was converted into shares of our common stock, valued at the IPO price. Based on the IPO price of $12.00 per share, we issued an aggregate of 1,866,665 shares of common stock in the Preferred Share Exchange. We used proceeds from the IPO, The Direct Sale and the New Credit Facility to pay accrued dividends of approximately $1.5 million on the preferred shares on that date.
The Company's insurance subsidiaries are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid to their parent without prior approval of the Division. Massachusetts' statute limits the dividends an insurer may pay in any twelve month period, without the prior permission of the Commonwealth of Massachusetts Insurance Commissioner, to the greater of (i) 10% of the insurer's surplus as of the preceding December 31 or (ii) the insurer's net
income for the twelve-month period ending the preceding December 31, in each case determined in accordance with statutory accounting practices. The Company's insurance company subsidiaries may not declare an "extraordinary dividend" (defined as any dividend or distribution that, together with other distributions made within the preceding twelve months, exceeds the limits established by Massachusetts' statute) until thirty days after the Commissioner has received notice of the intended dividend and has not objected. As historically administered by the Commissioner, this provision requires the Commissioner's prior approval of an extraordinary dividend. Under Massachusetts law an insurer may pay cash dividends only from its unassigned funds, also known as earned surplus, and the insurer's remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. At year-end 2002, the statutory surplus of Safety Insurance was $234.2 million, and its net income for 2002 was $20.4 million. A maximum of $23.4 million will be available by the end of 2003 for such dividends without prior approval of the Division. At year-end 2001, the statutory surplus of Safety Insurance was $220.1 million, and its statutory net income for 2001 was $9.6 million. During 2002, Safety Insurance paid dividends to TBC in cash of $12.6 million. The maximum amount of dividends that could be paid in 2002 was $22.0 million.
events and trends, or future or conditional verbs such as "will," "would," "should," "could," or "may". All statements that address expectations or projections about the future, including statements about the Company's strategy for growth, product development, market position, expenditures and financial results, are forward-looking statements.
Forward-looking statements give the Company's expectations or predictions of future conditions, events or results. They are not guarantees of future performance. By their nature, forward-looking statements are subject to risks and uncertainties. There are a number of factors-many of which are beyond the Company's control-that could cause actual future conditions, events, results or trends to differ significantly and/or materially from historical results or those projected in the forward-looking statements. These factors include but are not limited to the competitive nature of the Company's industry and the possible adverse effects of such competition, conditions for business operations and restrictive regulations in Massachusetts, claims related to severe weather, the Company's possible need for and availability of additional financing, and the Company's dependence on strategic relationships, among others, and other risks and factors identified from time to time in the Company's reports filed with the SEC. Refer to those set forth under the caption "Risk Factors" in our prospectus in the registration statement on Form S-1 filed with the SEC on November 22, 2002.
In our opinion, the accompanying consolidated statements of operations, changes in shareholders' equity, comprehensive income and cash flows present fairly, in all material respects, the results of operations and cash flows of Safety Insurance Group, Inc. and its subsidiaries (formerly Thomas Black Corporation) for the period January 1, 2001 through October 15, 2001 and for the year ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
The consolidated financial statements have been prepared on the basis of accounting principles generally accepted in the United States of America ("GAAP"). The consolidated financial statements include Safety Insurance Group, Inc. and its subsidiaries (the "Company"). The subsidiaries consist of Safety Insurance Company, Thomas Black Corporation ("TBC"), Safety Indemnity Insurance Company, Thomas Black Insurance Agency, Inc. ("TBIA"), and RBS, Inc., TBIA's holding company. All intercompany transactions have been eliminated.
In connection with financing the Acquisition, the Company incurred debt of $99.5 million and issued 22,400 shares of Series A senior mandatorily redeemable preferred stock at $1,000 per share. At October 16, 2001, the estimated fair value of net assets acquired approximated their carrying values, as net assets were comprised primarily of investments, cash and short-term receivables. The excess of estimated fair value of net assets over purchase price of $117.5 million was recorded as an extraordinary gain in accordance with FAS 141, "Business Combinations." See Note 3 for the methodology used in determining the fair value of loss and loss adjustment expense reserves.
The holders of the preferred stock agreed to amend the terms of the preferred stock to cause it to automatically convert into common stock upon the closing of the IPO at the IPO price (the "Preferred Share Exchange"). Based upon the $12.00 per share IPO price, 1,866,665 additional common shares were issued in connection with the exchange upon the close of the IPO.
The Company sold 6,333,334 common shares in its IPO, 350,000 common shares in a direct sale (the "Direct Sale") and 900,000 common shares from the exercise of the underwriters' over-allotment
Liabilities for losses and loss adjustment expenses ("LAE") include case basis estimates for open claims reported prior to year-end and estimates of unreported claims and claim adjustment expenses. The estimates are continually reviewed and modified to reflect current conditions, and any resulting
adjustments are reflected in current operating results. Adjustments for anticipated salvage and subrogation are recorded on incurred and reported and incurred but not reported losses.
As noted in Note 2, in conjunction with the Acquisition, the assets and liabilities acquired were valued at fair market value. Accordingly, loss and loss adjustment expense reserves and related reinsurance recoverables on unpaid losses as of October 16, 2001 were recorded at estimated fair value at October 16, 2001 which approximated carrying value at that date. The fair value of the Company's reserves for losses and LAE and related reinsurance recoverables was estimated based on the present value of the expected underlying cash flows of the loss and LAE reserves and reinsurance recoverables, and included a risk premium and a profit and risk margin. In determining the fair value estimate, management adjusted the Company's historical GAAP undiscounted net loss and LAE reserves to present value assuming a 4% discount rate, which approximated the U.S. Treasury rate on the date of acquisition. The discounting pattern was actuarially developed from the Company's historical loss data. A profit and risk margin of 6% was applied to the discounted loss and LAE reserves, to reflect management's estimate of the cost the Company would incur to reinsure the full amount of its net loss and LAE reserves with a third party reinsurer. This margin was based upon management's assessment of the uncertainty inherent in the net loss and LAE reserves and their knowledge of the reinsurance marketplace.
As part of purchase accounting, the carrying value of all equipment and leasehold improvements held on the date of the Acquisition was reduced to zero. Subsequent purchases of equipment and leasehold improvements are carried at cost less accumulated depreciation. Maintenance and repairs are charged to expense as incurred; improvements are capitalized.
Equity and deposits in pools represents the net receivable cash amounts due from the residual market mechanisms for automobile, Commonwealth Automobile Reinsurers ("CAR"), and homeowner (Massachusetts Property Insurance Underwriting Association) insurance in Massachusetts. See Note 10 in Notes to Consolidated Financial Statements for a discussion of the Company's accounting for amounts assumed from residual markets.
In connection with the Acquisition, the Company obtained promissory notes from the executive management team to finance management's purchase of the Company's common stock, including the restricted stock purchased by management.
Basic earnings (loss) per common share ("EPS") is calculated by dividing net income (loss) available to common shareholders by the weighted average number of basic common shares outstanding during the period. Diluted earnings per common share is calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares and the net effect of potentially dilutive common shares. The Company's only potentially dilutive instruments at December 31, 2002 are 379,000 stock options which were granted to certain members of management concurrent with the IPO. The Company determined that 290,500 shares of restricted stock held by management were potentially dilutive during the successor periods until the IPO when all restricted shares vested in full. For the successor period October 16, 2001 through December 31, 2001, management restricted stock was antidilutive due to the net loss before extraordinary item, and therefore was not included in the diluted earnings per common share calculation. In accordance with the provisions of FAS 128, EPS is determined based upon net income, before and after any extraordinary items, less any declared or accrued dividends on the mandatorily redeemable preferred stock. In addition, EPS is calculated for an extraordinary item. EPS for the successor period has been retroactively restated for the stock split. See Note 2.
In the normal course of business, the Company enters into transactions involving various types of financial instruments, including investments in fixed maturities and equity securities. All investment transactions have credit exposure to the extent that a counter party may default on an obligation to the Company. Credit risk is a consequence of carrying, trading and investing in securities. To manage credit risk, the Company focuses on higher quality fixed income securities, reviews the credit strength of all companies in which it invests, limits its exposure in any one investment and monitors the portfolio quality, taking into account credit ratings assigned by recognized statistical rating organizations.
The Company's insurance subsidiaries, domiciled in the Commonwealth of Massachusetts, prepare statutory financial statements in accordance with the accounting practices prescribed or permitted by the Division of Insurance of the Commonwealth of Massachusetts (the "Division"). Prescribed statutory accounting practices are those practices that are incorporated directly or by reference in state laws, regulations, and general administrative rules applicable to all insurance enterprises domiciled in a particular state. Permitted statutory accounting practices include practices not prescribed by the Division, but allowed by the Division. (See Note 15 in Notes to Consolidated Financial Statements.)
Stock-Based Compensation" ("SFAS No. 123"). The objective of SFAS No. 148 is to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 does not change the provisions of SFAS No. 123 that permit entities to continue to apply the intrinsic value method of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"). In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has elected to account for stock-based compensation in accordance with APB No. 25, and has adopted the disclosure provisions of SFAS No. 148. (See Note 6 in Notes to Consolidated Financial Statements).
Gross gains of $4.0 million and gross losses of $4.3 million were realized on sales of fixed maturities for the year ended December 31, 2002. Gross gains of $0.2 million and $2.8 million and gross losses of $(5.2) million and $(3.6) million were realized on sales of fixed maturities for the period October 16, 2001 through December 31, 2001 and for the period January 1, 2001 through October 15, 2001, respectively. Gross gains of $0.8 million and gross losses of $2.0 million were realized for the year ended December 31, 2000. Proceeds from fixed maturities maturing were $71.8 million, $0, $21.6 million and $47.1 million for the year ended 2002, for the period October 16, 2001 through December 31, 2001, for the period January 1, 2001 through October 15, 2001, and for the year ended December 31, 2000, respectively.
As part of the application of purchase accounting, equipment and leasehold improvements with a net book value of $3.3 million on the date of the Acquisition were reduced to zero. Equipment and leasehold improvements at December 31, 2002 and 2001 represent those items purchased subsequent to October 16, 2001. The Company held equipment and leasehold improvements with a carrying value of $0.6 million and less than $0.1 million, which is net of less than $0.1 million of accumulated depreciation for both December 31, 2002 and 2001, respectively.
Depreciation and amortization expense for the year ended December 31, 2002, for the period October 16, 2001 through December 31, 2001, for the predecessor period ended October 15, 2001, and the year ended December 31, 2000 was $0.1 million, $0, $1.3 million, and $1.9 million, respectively.
Prior to the IPO, the SARs were to vest 20% at the end of each year commencing on December 31, 2002. As of the close of the IPO, the SARs became fully vested and were automatically exercised. Soon thereafter, the participants each received a cash payment equal to the excess of the $12.00 IPO price per common share over the exercise price of $6.88 per share.
For the successor period ended December 31, 2001, no compensation expense was recorded related to the SARs. Upon the close of the IPO, compensation expense related to the SARs of $0.5 million was recognized as a charge to earnings.
Opinion No. 25 and FASB Interpretation No. 44", whereby employee compensation expenses were being recorded over the period of service of the employee in accordance with FIN 28. Compensation expense related to the management subscription agreement totalled $4.5 million and $1.1 million for the years ended December 31, 2002 and the successor period ended December 31, 2001, respectively.
On October 16, 2001, the Company implemented a Restricted Stock Plan and entered into Executive Restricted Stock Award Agreements under this plan with two employees of the Company. Under these agreements, 290,500 restricted shares of common stock, the maximum number that could be granted or sold under the plan, were sold at a cost of $0.43 per share, which approximated the fair value of the shares at the date of the sale. The Restricted Stock Plan permits the Board to grant restricted shares of common stock to select employees of the Company or any of its affiliates. The Board has the right to amend or terminate the Restricted Stock Plan at any time, subject to certain limitations, but no amendment or termination may alter the rights of a participant under any awards previously granted.
These restricted shares vested in full and the related put and call provisions terminated upon the IPO.
On June 25, 2002, the Board adopted the 2002 Management Omnibus Incentive Plan ("the Incentive Plan"). The Incentive Plan provides for a variety of awards, including nonqualified stock options, SARs and restricted stock awards. The maximum number of shares of common stock with respect to which awards may be granted under the Incentive Plan is 1,250,000 after adjustment for the stock dividend declared in connection with the IPO. On July 1, 2002, the Board authorized the grant of 379,000 stock options to certain employees and one nominee for director, pursuant to the Incentive Plan. These grants were effective upon the IPO date at an exercise price equal to the $12.00 per share IPO price, have a ten year term and vest in five equal annual installments beginning on the first anniversary date of these grants. The Board and the Compensation Committee intend to issue more options under the Incentive Plan in the future, not to exceed the maximum number of shares to be granted.
earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, "Accounting for Stock-Based Compensation", to these stock options.
With the termination of the ESOP, as described below, the Company re-established the previously frozen Retirement Plan, effective January 1, 2002. The Retirement Plan is a defined contribution plan which is available to all eligible employees of the Company. An employee must be 21 years of age to be eligible to participate in the Retirement Plan, and is allowed to contribute up to 15% of eligible compensation. The Retirement Plan is administered by the Company and is subject to the provisions of the Employee Retirement Income Security Act of 1974 ("ERISA"). Under the Retirement Plan, the Company shall make a matching contribution on behalf of each Participant who is employed on the last day of the year in an amount equal to 50% of the first 8% of the participant's compensation contributed to the Retirement Plan. Compensation expense related to the Retirement Plan was $0.6 million for the year ended December 31, 2002.
Prior to the Acquisition, TBC also had a supplemental executive stock ownership plan (the "XSOP"). The XSOP provided certain employees not eligible to fully participate in the ESOP under the applicable provisions of the Internal Revenue Code and ERISA with benefits they would have been entitled to under the provisions of the ESOP. Total compensation expense related to the XSOP during the predecessor period ended October 15, 2001 and the year ended December 31, 2000 was ($1.1) million and $1.7 million, respectively. The net credit to compensation expense for the predecessor period ended October 15, 2001 is comprised of a credit to compensation expense of ($2.5) million resulting from the revaluation of the December 31, 2000 XSOP obligation at the 2001 fair value of TBC's shares and an expense of $1.4 million relating to the compensation earned by employees in the 2001 predecessor period. There was no compensation expense for the successor period ended December 31, 2001 and the year ended December 31, 2002 related to the XSOP. The XSOP obligation of $7.2 million at December 31, 2001 was unfunded. There was no XSOP obligation at December 31, 2002. The XSOP Plan was terminated in conjunction with the Acquisition.
At the closing of the IPO, the Company repaid its existing credit facility and obtained a new $30.0 million revolving credit facility. The purpose of the new credit facility, combined with the net proceeds of the IPO, was to repay an aggregate of $96.9 million of indebtedness (including accrued interest), thereby paying off the Company's secured term loan, subordinated notes, and secured revolving credit facility. The obligations of the Company under the new credit facility are collateralized by (i) a 100% pledge of the stock of Safety Insurance Company, Inc., RBS, Inc. and TBIA, and (ii) a perfected first priority security interest, subject to permitted liens, in all of the assets, whenever acquired, of TBC, RBS, Inc. and TBIA. Loans under the new credit facility bear interest at the Company's option at either (i) the LIBOR rate plus 1.5% per annum or (ii) the higher of the bank's
prime rate or 1/2% above the federal funds rate plus 1.5% per annum. The new credit facility is due and payable at the maturity date, which is November 27, 2005. Interest only is payable prior to maturity.
The new credit facility contains specific financial and operating covenants, including requirements to maintain minimum risk-based capital ratios and statutory surplus of Safety Insurance Company as well as limitations or restrictions on indebtedness, liens, dividends, and other matters. The Company is in compliance with these debt covenants at December 31, 2002.
As part of the funding for the Acquisition, the Company entered into a $20 million revolving credit facility and a $55 million senior secured term loan with a bank in October 2001. The obligations of the Company on these loans were collateralized by (i) a 100% pledge of the stock of Safety Insurance Company, RBS, Inc. and TBIA, and (ii) a perfected first priority security interest, subject to permitted liens, in all of the assets, whenever acquired, of TBC, RBS, Inc. and TBIA. Both loans bore interest at LIBOR plus 3.75%. The Company utilized the net proceeds from the IPO and the new secured revolving credit facility to repay $66.6 million of indebtedness (including accrued interest), thereby paying off this prior credit facility.
The Company also issued $30 million of senior subordinated notes to obtain funds for the Acquisition. Interest was payable semi-annually on each April 30 and October 31. The senior subordinated notes were to mature December 31, 2011 and could be redeemed at the option of the Company prior to maturity with no redemption premium or penalty. The senior subordinated notes bore an interest rate of 13%. The Company utilized the net proceeds from the IPO and the new secured revolving credit facility to repay $30.3 million of indebtedness (including accrued interest), thereby paying off these notes.
The preferred stock at December 31, 2001 was carried in the financial statements at its liquidation preference of $22.4 million plus accrued dividends of $0.28 million. A total of $1.5 million of dividends was accrued through the closing of the IPO and paid to the holders of the preferred stock concurrent with the Preferred Share Exchange.
The Company cedes insurance to CAR and to other reinsurers. The Company is subject to concentration of credit risk with respect to reinsurance ceded to CAR. At December 31, 2002 and 2001, respectively, reinsurance receivables on paid and unpaid loss and LAE with a carrying value of $92.8 million and $94.9 million and prepaid reinsurance premiums of $26.8 million and $19.3 million were associated with CAR. The Company's participation in CAR resulted in assumed net losses of $38.6 million for the year ended December 31, 2002, $6.9 million for the period October 16, 2001 through December 31, 2001, $21.3 million for the period January 1, 2001 through October 15, 2001, and $21.7 million for the year ended December 31, 2000.
The Company has a property catastrophe excess of loss and a casualty excess of loss reinsurance agreement which are designed to protect against large or unusual losses and LAE activity. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible. The Company evaluates the financial condition of its reinsurers and monitors economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. All of the Company's reinsurers have an A.M. Best rating of "A" or better, except for Lloyd's of London, Folksamerica Reinsurance Company, and Montpelier Reinsurance Limited that are all rated "A-." Swiss Re, the Company's primary reinsurer, maintains an A.M. Best rating of "A++" (Superior). The Company had no allowances for uncollectible reinsurance balances at December 31, 2002 or 2001.
The following table sets forth a reconciliation of beginning and ending reserves for losses and LAE, as shown, in the Company's consolidated financial statements for the periods indicated:
At the end of each period, the reserves were re-estimated for all prior accident years and were decreased by $2.3 million for the year ended December 31, 2002, $0.7 million for the period October 15, 2001 through December 31, 2001, $6.6 million for the period January 1, 2001 through October 15, 2001, and $27.0 million for the year ended December 31, 2000. Conditions and trends that have affected development of the loss and LAE reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies upon these developments.
The Company applies a consistent reserving philosophy. The reserve for loss and loss adjustment expenses represents management's best estimate of the ultimate net cost of all loss and loss adjustment expenses incurred after reinsurance. These estimates are based on actuarial studies performed by management and independent actuaries which have inherent limitations as to the accuracy of the estimates due to the fact that the ultimate liability for claims is subject to the outcome of events yet to occur. Accordingly, the amounts the Company will ultimately incur from losses and loss adjustment expenses could differ materially in the near term from the amounts recorded at December 31, 2002.
•an investment banking and sponsorship fee payable up to 2% of the aggregate consideration (i) paid by the Company for any Acquisition by the Company of all or substantially all of the outstanding capital stock, warrants or options or substantially all of the business or assets of another individual or business entity, or (ii) paid to the Company in connection with any sale by the Company of all or substantially all of its stock, warrants, options, business or assets or the stock, warrants, options, business or assets of any of its subsidiaries; •a financial consulting fee of up to 1% of the amount obtained or made available to the Company pursuant to any debt, equity or other financing by the Company with the assistance of TJC; and •payment by the Company of an amount equal to TJC's out-of-pocket expenses, including an allocable amount of TJC's overhead expenses attributable to services provided to the Company.
In connection with the Acquisition, each member of the executive management team issued a recourse promissory note to, and entered into a pledge agreement with the Company. Pursuant to the notes, the Company loaned management an aggregate of $0.7 million in order to purchase common stock in connection with the Acquisition and the Restricted Stock Plan. Pursuant to pledge agreements, the management team pledged the common stock back to the Company as security for the loans made under the promissory notes. The notes bear interest at a rate of 5% annually and are due and payable on the earlier of December 31, 2011 or 90 days after any management team member ceases to be an employee of the Company. Each member may prepay his note at any time without penalty. At December 31, 2002 and 2001, the loans are carried in the financial statements at $0.7 million which represents the outstanding principal and accrued interest on the notes. Such loans have been recorded as contra-equity in accordance with the accounting policy described in Note 3. The interest rate on the notes is below a market rate and triggers compensation expense recognition for the shares held by management, including the restricted stock, as described in Note 6.
Diluted earnings (loss) per common share is calculated by dividing net income (loss) available to common shareholders by the weighted average number of diluted shares outstanding during the period.
Gross deferred income tax assets totaled $29.8 million and $31.6 million at December 31, 2002 and 2001, respectively. Gross deferred income tax liabilities totaled $23.6 million and $13.5 million at December 31, 2002 and 2001, respectively.
At December 31, 2002 and 2001, the carrying value of $20.0 million of the new secured revolving credit facility and the carrying value of $69.5 million of the secured revolving credit facility and term loan, respectively, approximated its fair value as described in Note 8. At December 31, 2001 the carrying value of the subordinated notes approximated fair value.
At December 31, 2001, the shares of mandatorily redeemable preferred stock had a carrying value of $22.7 million, which approximated its fair value. Fair value of the preferred stock is based upon the liquidation value plus accrued dividends at December 31, 2001. There was no preferred stock outstanding at December 31, 2002.
An unaudited summary of the Company's 2002 and 2001 quarterly performance is as follows: