Net income in 2006 includes the effect of stock-based compensation expense of $6.9 million, or $0.08 per share after tax that was not present in prior years (see further discussion in Note 14 of the Notes to Consolidated Financial Statements). The adoption of Statement 158 reduced stockholders’ equity by approximately $14.2 million as of December 31, 2006 (see Note 11 of the Notes to Consolidated Financial Statements).
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand the Company, our operations and our present business environment. MD&A should be read in conjunction with the accompanying consolidated financial statements and the accompanying notes thereto contained in Item 8 of this report. MD&A includes the following sections:
21st Century Insurance Group is an insurance holding company registered on the New York Stock Exchange. For convenience, the terms “Company”, “21st”, “we”, “us” or “our” are used to refer collectively to the parent company and its subsidiaries.
The common stock of the Company is traded on the New York Stock Exchange under the trading symbol “TW.” Through several of its subsidiaries, American International Group, Inc. (“AIG”) owned approximately 62% of the Company’s outstanding common stock as of December 31, 2006.
Non-California direct premiums written increased 77.3% to $149.1 million in 2006, compared to $84.1 million and $46.3 million in 2005 and 2004, respectively.
The loss and LAE ratios of 70.5%, 73.8%, and 75.6% for 2006, 2005, and 2004, respectively, have decreased since 2002 primarily due to favorable loss development, improvements in our pricing and underwriting methods and the favorable impact of declining frequency trends and moderate claim severity trends.
The underwriting expense to net premiums earned ratio increased to 23.2% in 2006 from 21.1% and 19.7% for 2005 and 2004, respectively. These underwriting expense ratio increases are primarily the result of expenses associated with the Company’s national expansion efforts and the 2006 recognition of stock-based compensation, which were partially offset by deferred policy acquisition costs. The increase was primarily due to our investments in the geographic expansion strategy, costs associated with the conversion to our new technology platform, and facility and support costs. The increase in 2004 consists primarily of increased advertising costs, additional sales workforce costs, and facility and support costs to improve service and support the Texas service center.
Net income increased 11.2% to $97.2 million for the year ended December 31, 2006, or $1.13 per basic share, compared to $87.4 million, or $1.02 per basic share, and $88.2 million, or $1.03 per basic share for 2005 and 2004, respectively. The 2006 results include prior year favorable reserve development totaling $51.9 million, versus $25.1 million and $0.1 million in 2005 and 2004, respectively.
The recognition of stock-based compensation resulted from our adoption of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“FAS 123R”). FAS 123R requires the recognition of compensation expense in the Consolidated Statements of Operations based on the estimated fair value of the employee share-based options. See Critical Accounting Estimates - Stock-Based Compensation Cost for further discussion. Stock-based compensation classified as underwriting expense for 2006 was $6.1 million.
In July 2006, the California Department of Insurance (the “CDI”) obtained approval for changes to regulations (the “Auto Rating Factor Regulations”) relating to automobile insurance rating factors, particularly concerning territorial rating. Because the new Auto Rating Factor Regulations require every personal auto insurance company operating in California to make a class plan and rate filing in the third quarter of 2006, competitive rate levels have changed and consumer shopping behavior may increase in the future. As of this date, the Company has filed for an overall rate decrease in California of approximately 5% of premium. The CDI approved the Company’s class plan and rate filings. The new rates took effect January 3, 2007. Most of the Company’s main competitors have also had approved overall rate decreases of varying amounts, while some have not substantially changed overall rate levels while attempting to comply with the new regulations. It is not possible at this time to predict the ultimate impact of these changes, which could have either a materially favorable or materially adverse impact on the Company. All rate changes and class plan filings must be approved by the CDI. See further discussion in Item 1A. Risk Factors.
Also in July 2006, the CDI proposed new amended rate approval regulations (the “Rate Approval Regulations”), affecting personal auto, homeowners and most lines of commercial property and casualty insurance written in California. The regulations become effective on April 3, 2007. If newly elected insurance commissioner does not modify, suspend or withdraw the regulations before they become effective, an industry lawsuit could be brought to challenge the regulations as contrary to current law. Also, the Company could consider bringing its own legal action, once the regulations are applied to it. See further discussion in Item 1A. Risk Factors.
On January 24, 2007, the majority owner, AIG, made a proposal to acquire the remaining shares of the Company common stock it does not own. The proposal is subject to several conditions, including the approval of the transaction by a Special Committee of the Company’s Board of Directors who are independent of AIG. The proposal could have a negative impact on the Company’s ability to carry out its business plans. See further discussion in Item 1A. Risk Factors and Note 19 of the Notes to the Consolidated Financial Statements.
Information concerning premiums written, underwriting profit, combined ratios, and statutory surplus have been presented to enhance readers’ understanding of the Company’s operations. These are widely used financial measures in the insurance industry that happen not to have formal definitions currently under accounting principles generally accepted in the United States of America (“GAAP”).
Premiums written represent the premiums charged on policies issued during a fiscal period. We use premiums written as a measure of the underlying growth of our insurance business from period to period. The most directly comparable GAAP measure, premiums earned, represents the portion of premiums written that is recognized as income on a pro rata basis over the terms of the policies.
See Results of Operations for more details as to our overall and personal auto lines results.
The following table reconciles our personal auto lines underwriting profit to our consolidated results of operations:
Underwriting results above include the effect of prior years’ reserve redundancy recorded in the current year. The following table summarizes losses and loss adjustment expenses (“LAE”) incurred, net of applicable reinsurance, for the periods indicated:
Personal automobile insurance is our primary line of business. Non-California vehicles accounted for 11.3%, 6.2%, and 3.5% of our direct premiums written in 2006, and 2004, respectively. This increase is due to our ongoing national expansion program, which includes marketing in non-California states. The Company currently plans to expand into additional states to further its national expansion strategy.
The following table presents the components of our personal auto lines underwriting profit and the components of the combined ratio for the past three years:
Direct premiums written decreased 2.3% in 2006, while increasing 0.7% in 2005 and 9.3% in 2004; less than our long-term goal of 15%. Market conditions in California were somewhat less favorable for growth in 2006 than in the preceding two years. Since 2004, we have met our profitability goals, posting our best combined ratios since 1999 and our direct premiums written grew 9.3% in 2004 despite an increasingly competitive California marketing climate. As discussed in the Highlights, the CDI issued changes to regulations relating to automobile insurance rating factors, particularly concerning territorial rating in July 2006. It is not possible at this time to predict the impact of these changes, which could have either a favorable or adverse impact on the Company. Also in July 2006, the CDI proposed new amended rate approval regulations, subsequently amended in October of 2006 and approved in January of 2007 with an effective date of April 3, 2007. The regulations could have a materially adverse impact on the Company’s California results. See further discussion of both regulations in Item 1A. Risk Factors.
As the Company proceeds with its national expansion, we believe that achieving our long-term growth goal will steadily depend less on the California marketplace. The Company’s national expansion efforts will provide us with flexibility to use combinations of local and national marketing media, as appropriate, and the ability to focus our marketing expenditures and Company resources on attractive markets, while minimizing costs in less attractive markets.
The declines in the loss and LAE ratios for the years ended December 31, 2006, 2005, and 2004, of 3.3 points, 1.7 points, and 3.1 points, respectively, are primarily due to the effect of favorable development related to prior accident years and lower accident frequency. The effects on the net loss and LAE ratios of changes in estimates relating to insured events of prior years were as follows: 4.0 points ($52.6 million) of favorable reserve development in 2006, 2.0 points ($27.5 million) of favorable reserve development in 2005, and 0.2 points ($2.9 million) of favorable reserve development in 2004. For additional discussion of these estimates, please see Item 1 of this report under the heading Unpaid Losses and Loss Adjustment Expenses. In general, changes in estimates are recorded in the period in which new information becomes available indicating that a change is warranted, usually in conjunction with our quarterly actuarial review.
We utilize a conservative investment philosophy. Substantially the entire fixed maturity securities portfolio is investment grade, having a weighted-average Standard & Poor’s credit quality of “AA”. No derivatives are held in our investment portfolio and there were no publicly traded equity securities at December 31, 2006. We previously held publicly traded equities, but sold them in the first quarter of 2006, lowering the risk and yield of the overall investment portfolio. The components of net investment income were as follows:
Our policy is to evaluate, on a quarterly basis, all investments for “other-than-temporary” impairment when the fair value of a security falls below its cost or amortized cost, based on all relevant facts and circumstances. No such impairments were recorded in 2006, 2005, or 2004 (see discussion under Critical Accounting Estimates - Investments).
Other income of $0.6 million and $0.4 million in 2006 and 2005, respectively, consists of interest income relating to claims with taxing authorities. Other expense of $1.8 million in 2006 consists of the following: a $0.9 million impairment charge for vacated space in our headquarters in Woodland Hills, California, and a $0.9 million write-off of software projects due to impairment. Other expense of $0.4 million in 2005 also relates to an impairment charge for vacated space in our headquarters. No other income or expense was reported in 2004.
At December 31, 2006, 26.2% of our total investments were in tax-exempt, fixed-income securities, compared to 22.3% at December 31, 2005. At December 31, 2006, investment-grade securities comprised substantially all of the fair value of our investment portfolio. As of December 31, 2006, no investments were rated below investment grade.
Increased advertising, sales and customer service costs through December 31, 2006 contributed to a $3.7 million increase in deferred policy acquisitions costs (“DPAC”) to $63.6 million, compared to $59.9 million at December 31, 2005. The Company’s DPAC is estimated to be fully recoverable (see Critical Accounting Estimates - Deferred Policy Acquisition Costs).
The following analysis provides a reconciliation of the activity in the reserve for unpaid losses and LAE:
Also, in the event of adverse claims results, we could be forced to liquidate investments to pay claims, possibly during unfavorable market conditions, which could lead to the realization of losses on sales of investments. Adverse outcomes to any of the foregoing uncertainties would create some degree of downward pressure on the insurance subsidiaries’ earnings or cash flows, which in turn, could negatively impact our liquidity.
We have various contractual obligations that are recorded as liabilities in our consolidated financial statements. Certain contractual obligations, such as operating lease obligations, are not recognized as liabilities in our consolidated financial statements, but are required to be disclosed.
The table above excludes periodic contributions to pension plans, which are discussed below, and commitments for investment purchases discussed in Transactions with Related Parties. The capital lease obligations above resulted from a sale-leaseback transaction and an auto capital lease transaction (see further discussion of these items in Notes 9 and 12 of the Notes to Consolidated Financial Statements). We have no material purchase obligations or other on or off balance sheet long-term liabilities or obligations at December 31, 2006 (see discussion about variable interest entities in Note 18 of the Notes to Consolidated Financial Statements).
We sponsor defined benefit pension plans that may obligate us to make contributions to the plans from time to time. Total contributions to the plans were $0.9 million, $10.0 million and $2.7 million in 2006, 2005, and 2004, respectively. For the past several years we have followed the practice of contributing sufficient amounts to the qualified defined benefit pension plan to meet or exceed statutory funding requirements, without exceeding the maximum amount that would be deductible for corporate income tax purposes, and while maintaining plan assets at a level at least equal to the actuarial present value of accumulated plan benefits. The amount and timing of future contributions to our qualified defined benefit pension plan depends on a number of unpredictable factors including statutory funding requirements, the market performance of the plan’s assets, cash requirements for benefit payments to retirees, and future changes in interest rates that affect the actuarial measurement of the plan’s obligations.
Our Board of Directors has made a commitment to invest a portion of policyholder surplus in economically disadvantaged communities. In connection with this commitment, the Company has guaranteed 11.1%, or $42.2 million, of a warehouse financing agreement. The Company has also committed $20.1 million for other community investment purposes. These commitments, which do not significantly impact the Company’s liquidity or capital, are further discussed in Note 18 of the Notes to Consolidated Financial Statements.
Includes amounts due under long-term software license agreements of approximately $23.8 million.
Several subsidiaries of AIG together own approximately 62% of our outstanding common stock and four of the eleven members of our Board of Directors, including our Chairman, are current or former officers and employees of AIG or its subsidiaries. Since 1995, the Company has entered into transactions with AIG subsidiaries, including reinsurance agreements, corporate insurance coverage, and investment management and investment accounting.
Total premiums ceded to AIG subsidiaries were $1.0 million, $1.0 million, and $1.1 million for the years ended December 31, 2006, 2005, and 2004, respectively. Total reinsurance recoverables, net of payables, from AIG subsidiaries were $0.4 million and $0.6 million at December 31, 2006 and 2005, respectively.
Total expense attributable to AIG corporate insurance coverages was $3.7 million, $2.9 million, and $3.5 million for the years ended December 31,2006, 2005, and 2004, respectively.
In June 2006, the Company executed a $35 million funding commitment for a private equity investment program, which is managed by AIGGIC. In the event that we do not respond to a capital call during the investment term, the General Partner of the fund (“GP”) may apply the following default provisions: withhold 50% of distributions due to us at the time of the default and 50% of future distributions due to the Company; hold the Company liable for fund expenses above and beyond investments made by us (with the right of offset); terminate our Limited Partner status and not allow it any further investments; or charge interest on the defaulted capital commitment amount and fees at LIBOR + 4% (with the right of offset). However, the GP may choose not to designate the Company a “defaulting limited partner” and waive the default provisions. The investment term ends after the underlying investments are liquidated, but in no event is longer than 10 years. Multiple investments are expected to be purchased and liquidated over the investment term. The Company funded $14.4 million of the commitment in 2006.
Through December 31, 2004, the Company utilized certain third party software and data processing monitoring tools under an agreement negotiated by AIG. Since January 1, 2005, the Company has negotiated its own contracts, and no longer incurs any software or data processing costs with AIG subsidiaries. Charges by AIG for software and data processing were $0.3 million in 2004. There was no expense in either 2005 or 2006.
Management has discussed the development and selection of our critical accounting estimate with the Audit Committee of our Board of Directors.
The methods used to determine such estimates and to establish the resulting reserves are continually monitored, reviewed, and updated. Any resulting adjustments are reflected in current operating income on a dollar-for-dollar basis. For example, an upward revision of $1 million in the estimated recorded liability for unpaid losses and LAE would decrease underwriting profit, and pre-tax income, by the same $1 million amount. Conversely, a downward revision of $1 million would increase pre-tax income by the same $1 million amount.
Because these are unknown future events, there is uncertainty in the Company’s estimates of ultimate losses and LAE. This uncertainty comes from various factors, both positive and negative, that may include changes in claims reporting and settlement patterns, changes in regulatory and legal environment, and inflation rates. The Company does not make a specific provision for these uncertainties; however, they are considered in establishing the reserves by analyzing historical patterns and trends.
The point estimate methods include the use of several commonly accepted actuarial methods utilizing paid and incurred loss histories, claim frequency and severity, and expected loss ratios.
Quantitative techniques frequently have to be supplemented by subjective consideration, including managerial judgment, to assure management satisfaction that the overall unpaid losses and LAE are adequate to meet projected losses. For example, in property damage coverages, repair cost trends by geographic region vary significantly. These factors are periodically reviewed and subsequently adjusted, as appropriate, to reflect emerging trends that are based upon past loss experience. Thus, many factors are implicitly considered in estimating the loss costs recognized.
Judgment is required in analyzing the appropriateness of the various methods and factors to avoid overreacting to data anomalies that may distort such prior trends. For example, changes in limits distributions or development in the most recent accident months would require more judgment. We do not believe disclosure of specific indicated point estimates as calculated by the various methods would be meaningful. Any one actuarial point estimate is based on a particular series of judgments and assumptions of the actuary. Another actuary may make different assumptions, and therefore reach a different point estimate.
The assumed loss development factors are also a key assumption. After evaluating the historical loss development factors from prior accident years since 1999, in Management’s judgment, it is reasonably likely that actual loss development factors will range from approximately 1.6 percent lower than those actually utilized in the year-end 2006 loss and LAE reserve analysis to approximately 0.8 percent higher than those actually utilized. If the loss development factor assumptions were reduced by 1.6 percent and increased by 0.8 percent, the loss and LAE reserves would decrease by approximately $86 million under the lower assumptions or increase by approximately $42 million under the higher assumptions. Generally, historical loss development factors are used to project future loss development. However there can be no assurance that future loss development patterns will be the same as in the past, or that they will not deviate by more than the amounts illustrated above. Thus, there is the potential for the reserves with respect to a number of accident years to be significantly affected by changes in the loss cost trends or loss development factors that were initially relied upon in setting the reserves. These changes in loss cost trends or loss development factors could be attributable to changes in inflation or in the judicial environment, or in other social or economic conditions affecting claims. Thus, there is the potential for variations greater than the amounts cited above, either negatively or positively.
The primary responsibility of an insurance company is paying claims of its policyholders in a fair and timely manner. Having adequate loss reserves, with special consideration for the upside potential of claims not yet paid is central to this responsibility. The company experienced significant losses from the Northridge earthquake and the subsequent reopening of claims resulting from SB 1899. The costs related to both the original event and SB 1899 illustrate the uncertainty that can result from estimating loss reserves. The number and severity of claims far exceeded initial estimates of losses. The two Northridge events point to the importance of the adequacy of loss reserves and the inherent estimating uncertainties of the loss reserving process.
The occurrence of a discrete credit event resulting in the debtor defaulting or seeking bankruptcy or insolvency protection or voluntary reorganization, and
The probability of non-realization of a full recovery on our investment, irrespective of the occurrence of one of the foregoing events.
The determination of whether a decline in fair value is “other-than-temporary” is necessarily a matter of subjective judgment. The Company’s intent is to hold all of its fixed securities with unrealized losses for a period of time sufficient to allow a market recovery or to maturity as long as these securities continue to be consistent with our investment strategy. If our strategy were to change and these securities were impaired, we would recognize a write down in accordance with our stated policy. Additionally, it is possible that future information will become available about our current investments that would require accounting for them as realized losses due to other-than-temporary declines in value. No such charges were recorded in 2006, 2005 or 2004. The timing and amount of realized losses and gains reported in income could vary if conclusions other than those made by management were to determine whether an other-than-temporary impairment exists. However, there would be no impact on equity at the end of the periods presented because any unrealized losses would have been already included in accumulated other comprehensive loss.
Substantially the entire fixed maturity securities portfolio is investment grade. The following is a summary of the Standard & Poor’s credit rating for the fixed maturity securities portfolio (the weighted average is “AA”):
The following is a summary by issuer of non-investment grade securities and unrated securities held:
Impact Community Capital is a limited partnership that was voluntarily established by a group of California insurers to make loans and other investments that provide housing and other services to economically disadvantaged communities. See further discussion in Note 18 of the Notes to the Consolidated Financial Statements.
AIG PEP is a private equity investment program managed by AIGGIC. See further discussion in Note 3 of the Notes to the Consolidated Financial Statements.
We have completed integrated audits of 21st Century Insurance Group’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
(2) Other comprehensive loss for the year. See Note 13 of the Notes to Consolidated Financial Statements.
The accompanying consolidated financial statements include the accounts and operations of the Company. All intercompany accounts and transactions have been eliminated. The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. Actual results could differ from these estimates.
The probability of non-realization of a full recovery on its investment, irrespective of the occurrence of one of the foregoing events.
The determination of whether a decline in fair value is “other-than-temporary” is necessarily a matter of subjective judgment. The Company’s intent is to hold all of its fixed maturity securities with unrealized losses for a period of time sufficient to allow a market recovery or to maturity as long as these securities continue to be consistent with our investment strategy. If our strategy were to change and these securities were impaired, we would recognize a write down in accordance with our stated policy. Additionally, it is possible that future information will become available about our current investments that would require accounting for them as realized losses due to other-than-temporary declines in value. No such charges were recorded in 2006, 2005 or 2004. The timing and amount of realized losses and gains reported in income could vary if conclusions other than those made by management were to determine whether an other-than-temporary impairment exists. However, there would be no impact on equity for the periods presented because any unrealized losses would have been already included in accumulated other comprehensive income (loss).
Insurance premiums written and reinsurance ceding commissions are recognized pro rata over the period of the policies. Accordingly, unearned premiums represent the portion of premium written that is applicable to the unexpired term of the policy. Installment and other fees for services are recognized in the periods the services are rendered. Premiums receivable represent premiums written and not yet collected, net of an allowance for uncollectible premiums. Generally, premiums are collected prior to providing risk coverage, minimizing the Company’s exposure to credit risk.
The loss and loss adjustment expense ratio used in the recoverability estimate is based primarily on the expected ultimate ratio provided by our actuaries. While management believes that is a reasonable assumption, actual results could differ materially from such estimates.
Leased property under capital lease is recorded as a capital asset and amortized on a straight-line basis over the shorter of the estimated useful lives of the properties, which range from 3 to 10 years, or the term of the lease. The related lease obligation is included in debt on the balance sheet.
Property and equipment is recorded at cost and depreciated on a straight-line basis. We capitalize certain consulting costs, payroll and payroll-related costs of employees who develop computer software for internal use.
The Company paid $1.5 million in 2004 to acquire the marketing name “21st Century Insurance and Financial Services,” which is used as a marketing name for 20th Century Insurance Services. The payment was capitalized as an intangible asset and is included in “Other Assets” on the accompanying balance sheets. The marketing name has an indefinite useful life and will not be amortized until its useful life is determined to no longer be indefinite.
In the normal course of business, the Company seeks to reduce its exposure to losses that may arise from catastrophes and to reduce its overall risk levels by obtaining reinsurance from other insurance enterprises or reinsurers. Reinsurance premiums and reserves on reinsured business are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts.
Reinsurance contracts do not relieve the Company from its obligations to policyholders. The Company periodically reviews the financial condition of its reinsurers to minimize its exposure to losses from reinsurer insolvencies.
Other income of $0.6 million and $0.4 million in 2006 and 2005, respectively, consists of interest income relating to refund claims with taxing authorities.
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years the differences are expected to be recovered or settled. The Company reviews its deferred tax assets for recoverability on a quarterly basis. State income taxes attributable to dividends from insurance subsidiaries are accrued in the period in which they are declared. Commencing in 2006, concurrent with the adoption of Statement of Financial Accounting Standards No. (“FAS”) 123 (revised 2004), Shared-Based Payment (“FAS 123R”), the Company follows the tax-law-ordering approach with respect to recognition of excess tax benefits relating to stock compensation. The Company had no excess tax benefits available in additional paid-in capital to offset possible future tax deficiencies relating to exercising of stock options on December 31, 2006 or at the date of adoption of FAS 123R.
The carrying value of financial assets and liabilities reported in the accompanying consolidated balance sheets for cash and cash equivalents, accrued investment income and trade accounts receivable and payable at December 31, 2006 and 2005, approximate fair value because of the short maturity of these instruments. Investments available-for-sale are carried at fair value in the accompanying balance sheets. The carrying value of the other long-term investments approximates its fair value. The fair value of investments in limited partnerships and corporations is obtained from information provided by the general partner or manager of the investments, the accounts of which generally are audited on an annual basis. The fair value of notes payable is estimated based on the quoted market prices for the same or similar issues, or on the current rates offered to us for debt with the same remaining maturities. The carrying values of our debt were $115.9 million and $128.0 million and the estimated fair values were $121.9 million and $135.0 million at December 31, 2006 and 2005, respectively.
Considerable judgment is required to develop estimates of fair value. Accordingly, the estimates are not necessarily indicative of the amounts we could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
Common stock equivalents excluded from calculation of diluted EPS because their inclusion would have been anti-dilutive (i.e., their inclusion under the treasury stock method would have increased EPS) were 5,406,095, 5,660,376, and 6,156,772 at December 31, 2006, 2005, and 2004, respectively.
In September 2006, Financial Accounting Standards Board (“FASB”) issued FAS 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an Amendment of FASB Statements No. 87, 88, 106 and 132(R) ("FAS 158"). FAS 158 requires an employer that is a business entity and sponsors one or more single employer benefit plans to (1) recognize the funded status of the defined benefit plans in its statement of financial position, (2) recognize as a component of other comprehensive income, net of tax, the actuarial gains or losses and prior service costs or credits that arise during the period, but are not recognized as components of net periodic benefit cost, (3) measure defined benefit plan assets and obligations at the date of the employer's fiscal year end statement of financial position and (4) disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs on credits, and transition asset or obligations. At December 31, 2006, the Company adopted FAS 158. The adoption of FAS 158 did not have any effect on the Company’s compliance with its financial covenants. See Note 11 of the Notes to Consolidated Financial Statements for further discussion.
In June 2006, the FASB issued Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FAS No. (“FIN 48”). This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FAS 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation will be effective January 1, 2007. We expect the adoption of FIN 48 will result in the recognition of a reduction in retained earnings of approximately $2.5 million effective January 1, 2007.
Prior to January 1, 2006, the Company accounted for its stock-based compensation plans under the measurement and recognition provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employees, and related Interpretations, as permitted by FAS 123, Accounting for Stock-Based Compensation. Under the intrinsic-value method prescribed by APB 25, compensation cost for stock options was measured at the date of grant as the excess, if any, of the quoted market price of the Company’s stock over the exercise price of the options. All employee stock options were granted at the closing market price on the grant date. Accordingly, no compensation cost was recognized for fixed stock option grants in prior periods; however, stock-based compensation measured in accordance with the fair-value based method was included as a pro forma disclosure in the consolidated financial statement footnotes.
Total insurance expense attributable to AIG corporate insurance coverages was $3.7 million, $2.9 million, and $3.5 million for 2006, 2005, and 2004, respectively.
In October 2003, as a result of a competitive bidding process, we entered into an agreement with AIG Global Investment Corp. (“AIGGIC”) to provide investment management and investment accounting services. The fees are determined as a percentage of the average invested asset balance and are classified with net investment income. This agreement was approved by the California Department of Insurance (“CDI”). Investment management and accounting expense was $1.1 million, $0.9 million, and $0.9 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Through December 31, 2004, the Company utilized certain third party software and data processing monitoring tools under an agreement negotiated by AIG. Since January 1, 2005, the Company has negotiated its own contracts, and no longer incurs any software or data processing costs with AIG subsidiaries. Charges by AIG for software and data processing were $0.3 million in 2004. There was no expense in 2006 or 2005.
A summary of changes in net unrealized investment gains and losses less applicable income taxes for fixed maturity securities and equity securities is as follows:
The Company has no non-interest bearing fixed maturity securities, investments accounted for on a non-accrual basis or any individual securities in excess of 10% of stockholders’ equity. Fixed maturity securities available-for-sale, at December 31, 2006, are summarized by contractual maturity year as follows:
Expected maturities of the Company’s investments may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties. The following table summarizes the Company’s gross unrealized losses and estimated fair values on investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.
A summary follows of the unrealized gains and losses on investments available-for-sale, net of tax, that are included in accumulated other comprehensive loss on the consolidated balance sheets:
None of the Company’s 233 investment positions with unrealized losses at December 31, 2006 were judged to have any fundamental issues that would lead the Company to believe that they were other-than-temporarily impaired. Of the 233 fixed maturity securities in an unrealized loss position, the Company had 167 investments that were in an unrealized loss position for 12 months or more. The related unrealized losses primarily arose as a result of rising interest rates. The unrealized loss for all investments in an unrealized loss position, which are all investment grade, comprised 3.3% of the related amortized cost.
The Company has the intent and ability to hold these fixed maturity securities to recovery or maturity/redemption, and will do so, as long as the security positions continue to adhere to the Company’s investment strategy. If the Company’s strategy were to change and these securities were determined to be other-than-temporarily impaired, the Company would recognize a write-down in accordance with its stated policy.
Cash and securities with fair values of $7.2 million and $7.0 million at December 31, 2006 and 2005 were on deposit with state regulatory authorities in accordance with the related statutory insurance requirements.
The significant components of deferred income tax expense attributable to income from continuing operations are as follows:
Our ability to fully utilize the NOL of 21st of the Southwest and our other DTAs depends primarily on future taxable income from operations and tax planning strategies. Because of the Company’s profitable operating history and the availability of tax planning strategies, management believes it is reasonable to conclude that it is at least more likely than not that we will be able to realize the benefits of all of our DTAs. Accordingly, no valuation allowance has been recognized at December 31, 2006 or 2005. However, generating future taxable income is dependent on a number of factors, including regulatory and competitive influences that may be beyond our ability to control. Implementation of tax planning strategies to effect realization of our remaining NOL may require regulatory approvals, which although reasonably expected cannot be assured by management. Future operating losses could possibly jeopardize our ability to realize our other DTAs. Future unfavorable regulatory actions or operating losses would lead management to reach a different conclusion about the likelihood of realizing the DTAs and, if so, to recognize a valuation allowance at that time for some or all of the DTAs.
In the first quarter of 2005, the Company filed amended California tax returns and paid the State of California approximately $6.8 million to cover all issues outstanding with the Franchise Tax Board (“FTB”), including certain matters paid under protest as to which the Company reserved all its rights to file for refunds and appeal to the California State Board of Equalization (“SBE”) any adverse rulings by the California FTB. In September 2005, the FTB completed its audit and denied our refund claims. In December 2005, the Company filed an appeal with the SBE. In the fourth quarter of 2006, the Company executed a settlement agreement with the FTB, for which the final required regulatory approval was obtained in February 2007. Accordingly, the tax refund and accrued interest totaling approximately $2.9 million ($1.9 million net of federal tax effect) was recorded as a reduction of state income tax expense effective December 31, 2006.
The Company has claimed certain items in prior years tax returns for which ultimate realization is uncertain. At December 31, 2006, due to the Company’s NOL and AMT credit carryforwards, these items have not yet reduced any taxes currently payable. Furthermore, due to the uncertainty, deferred tax assets have not been recorded with respect to these items. In the future, when these items actually reduce current tax payments, it is expected that a current liability will be recorded.
Accounting for losses and LAE is highly subjective because these costs must be estimated, often weeks, months or even years in advance of when the payments are actually made to claimants, attorneys, and others involved in the claims settlement process.
The following is a reconciliation of the activity in the reserve for unpaid losses and LAE:
Positive amounts represent deficiencies in loss and LAE reserves, while negative amounts represent redundancies.
The primary purpose of both of the Senior Notes and sale-leaseback enumerated above was to increase the statutory surplus of the Company’s largest insurance subsidiary.
On December 31, 2002, the Company entered into a sale-leaseback transaction for $15.8 million of equipment and leasehold improvements and $44.2 million of software. The transaction is accounted for as a capital lease. The lease includes a covenant that if AIG ceases to have a majority interest in the Company, or if statutory surplus falls below $300.0 million, or if the net premiums written to surplus ratio is greater than 3.8:1, or if claims paying ratings fall below BBB+ (as rated by Standard & Poor’s), Baa1 (as rated by Moody’s) or B++ (as rated by A.M. Best), the Company will either deliver a letter of credit to the lessor or pay the lessor the then outstanding balance, including a prepayment penalty of up to 3% of the outstanding balance. The lessor has been granted a security interest in the property and equipment, subject to the sale-leaseback, and also certain software in process of development. See Note 12 of the Notes to Consolidated Financial Statements for the related contractual commitment schedule.
Aggregate principal payments on debt outstanding at December 31, 2006 are $14.3 million for 2007, $0.7 million for 2008, $0.5 million for 2009, $0.4 million for 2010, and $100.0 million thereafter.
The Company has a catastrophe reinsurance agreement for auto physical damage losses incurred under the comprehensive coverage portion of its auto policies. Three participating entities, two of which are AIG subsidiaries (see further discussion in Note 3 of the Notes to Consolidated Financial Statements - Transactions with Related Parties), reinsure covered events up to $45.0 million in excess of $20.0 million. The Company has no current reinsurance on its auto lines other than the aforementioned catastrophe reinsurance agreement.
Gross losses and loss adjustment expenses have been reduced by reinsurance ceded as follows:
The Company has a qualified defined benefit pension plan, which covers essentially all employees who have completed at least one year of service. The pension benefits under the qualified plan are based on employees’ compensation during all years of service. The Company’s funding policy for the qualified plan is to make annual contributions as required by applicable regulations; employees may not make contributions to this plan. For certain key employees designated by the Board of Directors, the Company sponsors a non-qualified supplemental executive retirement plan (“SERP”). The SERP benefits are based on years of service and compensation during the three highest of the last ten years of employment prior to retirement and are reduced by the benefit payable from the pension plan and 50% of the social security benefit. Because the internal revenue code does not allow current deductions for advance funding of a non-qualified plan, the Company’s funding policy with respect to this plan is to make contributions as benefits become payable to participants.
The accumulated benefit obligation for all defined benefit pension plans was $120.6 million and $113.7 million at December 31, 2006 and 2005, respectively. Accumulated benefit obligations represent the present value of both vested and nonvested pension benefits earned at December 31, 2006 based on actual service and compensation through December 31, 2006 and taking into consideration other actuarial assumptions, such as retirement ages, termination, disability, or death.
Projected benefit obligations for defined benefit plans represent the present value of pension benefits earned at December 31, 2006 as described above plus the effects of projected future salary increases to the assumed age of retirement, termination, or death. The following table sets forth the change in the projected benefit obligation of the defined benefit pension plans, including the supplemental plan, at December 31, 2006 and 2005:
The following table sets forth the change in plan assets at December 31, 2006 and 2005:
The Company’s pension plan weighted-average asset allocations for 2006 and 2005, and target allocation for 2007, by asset category are as follows:
The weighted-average assumptions used to determine net periodic benefit cost were as follows:
The amount and timing of future contributions to the Company’s qualified defined benefit pension plan depends on a number of assumptions including statutory funding requirements, the market performance of the plan’s assets and future changes in interest rates that affect the actuarial measurement of the plan’s obligations. The Company did not make any contributions to its qualified defined benefit pension plan in 2006, contributed $9.0 million in 2005, and contributed $2.5 million in 2004. Based on current assumptions, the Company does not expect to be required to contribute to its qualified plan in 2007.
The Company contributed $0.9 million, $1.0 million, and $0.2 million to its non-qualified defined benefit pension plan in 2006, 2005, and 2004, respectively. Contributions to our non-qualified defined benefit pension plan generally are limited to amounts needed to make benefit payments to retirees, which are expected to total approximately $0.9 million in 2007.
The following table summarizes total rental and licensing expense charged to operations:
On December 31, 2002, the Company entered into a sale-leaseback transaction for $15.8 million of equipment and leasehold improvements and $44.2 million of software. The leaseback transaction has been accounted for as a capital lease.
Accumulated other comprehensive income (loss) is a component of stockholders’ equity and includes all net changes in the unrealized appreciation and depreciation in value of available-for-sale investments, changes in minimum pension liability in excess of unamortized prior service cost, and changes in unamortized prior service cost and actuarial loss of defined benefit pension plans.
In accordance with FAS 123R, the Company began recognizing the cost of all employee stock options on a straight-line basis over their respective vesting periods, net of estimated forfeitures, using the modified-prospective transition method. Under this transition method, results for prior periods have not been restated and 2006 results include:
FAS 123R also prescribes the recognition of expense using the non-substantive vesting period approach for grants made after December 31, 2005. This expense attribution method requires recognition of compensation expense from the date of grant to the earlier of the vesting date or the date retirement eligibility is achieved for awards with retirement eligibility provisions. The use of the non-substantive vesting period approach will not affect the overall amount of compensation expense recognized, but will accelerate the recognition of expense for grants made since January 1, 2006. However, the Company will continue to follow the nominal vesting approach (i.e., recognize expense from the grant date to the earlier of the actual date of retirement or the vesting date) for the remaining portion of unvested awards that were granted prior to January 1, 2006.
Generally, stock-based awards are forfeited when employees terminate prior to the vesting date, and any compensation cost previously recognized with respect to such unvested stock awards is reversed in the period of forfeiture. Upon restricted share grant or share option exercise, the Company issues new shares, unless the Company elects to use available treasury shares. The Company records forfeitures of restricted stock as treasury share repurchases.
Prior to the adoption of FAS 123R, the Company previously presented all benefits of tax deductions resulting from the exercise of share-based compensation as operating cash flows in the Consolidated Statements of Cash Flows. FAS 123R requires the benefits of tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows.
Had compensation cost for the Company’s stock-based compensation plans been determined in the prior year based on the fair-value based method for all awards, net income would have been reduced by $4.9 million and $5.5 million for the years ended 2005 and 2004, respectively. The Company followed the nominal vesting period approach, which recognizes compensation cost over the vesting period unless the employee retired before the end of the vesting period at which time the Company recognizes any remaining unrecognized compensation cost at the date of retirement. The Company did not determine the amount of stock-based compensation cost that would have been deferred as policy acquisition costs in its pro forma footnotes under FAS 123.
The pro forma net income and earnings per share amounts follow for the years ended December 31:
The stockholders approved the 2004 Stock Option Plan (the “2004 Plan”) at the Annual Meeting of Shareholders on May 26, 2004. The 2004 Plan supersedes the 1995 Stock Option Plan (the “1995 Plan”), which remains in effect only as to outstanding awards under the 1995 Plan. The 2004 Plan authorizes a Committee of the Board of Directors to grant stock options for the issuance of up to 4,000,000 shares to eligible employees and nonemployee directors, subject to the terms of the 2004 Plan. Additionally, under the 2004 Plan, the Committee may grant stock options that were subject to outstanding awards under the 1995 Plan to the extent such awards expire, are terminated, are canceled, or are forfeited for any reason without shares being issued.
A summary of the Company’s stock option activity and related information at December 31, for the years presented follows:
The weighted-average grant-date fair value for options granted during 2006, 2005 and 2004 was $4.99, $4.74, and $5.95, respectively. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
The Restricted Shares Plan, which was approved by the Company’s stockholders in 1982, currently authorizes grants of up to 1,421,920 shares of common stock to be made available to key employees. In general, one third of the shares granted vest on the anniversary date of each of the three years following the year of grant. The Company may also grant vested shares that contain sale restrictions. The Company becomes entitled to an income tax deduction in an amount equal to the taxable income reported by the holders upon vesting of the restricted shares.
Total compensation expense relating to the Restricted Shares Plan was $0.9 million, $0.3 million, and $0.6 million in 2006, 2005 and 2004, respectively. Unrecognized compensation cost in connection with restricted stock grants totaled $1.7 million, $1.0 million, and $0.1 million at December 31, 2006, and 2004, respectively. The cost is expected to be recognized over a weighted-average period of 1.9 years.
A summary of securities issuable and issued for the Company’s Restricted Shares Plan at December 31, 2006, follows:
A summary of activity under the Restricted Shares Plan for the year ended December 31, 2006 follows:
Combined Company Action Level risk-based capital for the Company's insurance subsidiaries was calculated to be $172.9 million as of December 31, 2006. These calculations were made in accordance with the guidelines issued by the National Association of Insurance Commissioners. Each of the Company’s insurance subsidiaries exceeded its respective level of minimum required capital.
On June 15, 2004, the CDI finalized its examination reports on the statutory financial statements of the Company’s two California-domiciled insurance subsidiaries for the three-year period ended December 31, 2002. The reports did not contain any findings or adjustments. The CDI and Texas Department of Insurance are currently examining the three-year period ended December 31, 2005.
The Company’s “Personal Auto Lines” reportable segment primarily markets and underwrites personal auto, motorcycle and personal umbrella insurance. The Company’s “Homeowner and Earthquake Lines in Runoff” reportable segment manages the runoff of the Company’s homeowner and earthquake programs. The Company has not written any earthquake coverage since 1994 and ceased writing voluntary homeowner policies in 2002.
In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities - an Interpretation of Accounting Research Bulletin No. 51 (“FIN 46”), and amended it in December 2003. An entity is subject to the consolidation rules of FIN 46 and is referred to as a variable interest entity (“VIE”) if it lacks sufficient equity to finance its activities without additional financial support from other parties or if its equity holders lack adequate decision making ability based on criteria set forth in the interpretation. FIN 46 also requires disclosures about VIEs that a company is not required to consolidate, but in which a company has a significant variable interest.
The Company has purchased investments that provide housing and other services to economically disadvantaged communities. To that end, the Company is a voluntary member, along with other participating insurance organizations, of Impact Community Capital, LLC (“Impact”). Impact’s charter is to facilitate loans and other investments in such communities.
On January 24, 2007, the majority owner, AIG, made a proposal to acquire the remaining shares of the Company common stock it does not own. The proposal is subject to several conditions, including the approval of the transaction by a Special Committee of the Company’s Board of Directors who are independent of AIG. Provisions in certain agreements, including the supplemental executive retirement plan and stock-based compensation plans could be triggered by an offer or acquisition, resulting in the accelerated recognition of expense that could materially impact the Company’s future results of operations. The Company’s retirement and stock option valuation assumptions have not been altered as of December 31, 2006 for the subsequent proposal made by AIG.