The Company owns the 41-story office building at One East Wacker Drive, Chicago, Illinois, that houses the executive offices of Unitrin. Unitrin and one of its subsidiaries occupy approximately 45,000 square feet of the 527,000 rentable square feet in the building. In addition, Unitrin’s subsidiaries together own and occupy 7 buildings located in 5 states consisting of approximately 20,800 square feet in the aggregate. Unitrin subsidiaries hold additional properties solely for investment purposes that are not utilized by Unitrin or its subsidiaries.
Unitrin Specialty leases facilities with an aggregate square footage of approximately 150,000 at 3 locations in 3 states. The latest expiration date of the existing leases is in March 2014.
Unitrin Direct leases facilities with an aggregate square footage of approximately 190,000 at 7 locations in 6 states. The latest expiration date of the existing leases is in June 2013.
Unitrin’s Life and Health Insurance segment leases facilities with aggregate square footage of approximately 530,000 at 133 locations in 26 states. The latest expiration date of the existing leases is in January 2015.
Unitrin’s corporate data processing operation occupies a facility with an aggregate square footage of approximately 30,000 square feet under a lease that expires in December 2014.
(b) Shareholders’ Equity decreased by $ 7.3 million at December 31, 2006, as a result of the Company’s initial application of the recognition provisions of SFAS No. 158 for the Company’s postretirement benefit plans.
Net Income was $217.8 million ($3.32 per common share) for the year ended December 31, 2007, compared to $283.1 million ($4.17 per common share) for the year ended December 31, 2006. Income from Continuing Operations was $189.0 million ($2.88 per common share) in 2007, compared to $264.2 million ($3.89 per common share) for same period in 2006. Operating results in the Company’s business segments are discussed throughout this MD&A.
Automobile Finance Revenues increased by $15.2 million in 2007 due primarily to a higher level of loans outstanding, partially offset by lower interest rates.
Net Investment Income increased by $25.9 million in 2007 due in part to an increase in dividend income from the Company’s investment in Northrop preferred stock of $6.2 million due to the timing of the ex-dividend date and a special dividend of $5.2 million from the Company’s equity investment in IRI Holdings, Inc. (“IRI”). Excluding the impact of the increase in dividend income on Northrop preferred stock and the IRI dividend, Net Investment Income increased in 2007 due to higher levels of investments and, to a lesser extent, higher yields on investments.
Net Realized Investment Gains was $62.5 million in 2007, compared to $26.5 million in 2006. Net Realized Investment Gains in 2007 included pretax gains of $89.2 million from sales of equity securities and pretax losses of $33.0 million to write down certain securities. Net Realized Investment Gains in 2006 included pretax gains of $28.8 million from sales of equity securities and pretax losses of $2.8 million to write down certain securities. Net Realized Investment Gains in 2007 included pretax gains of $58.6 million from sales of Northrop common stock, compared to $5.6 million in 2006. The Company cannot anticipate when or if similar investment gains and losses may occur in the future.
Unitrin’s subsidiaries conduct their businesses in three industries: property and casualty insurance, life and health insurance and automobile finance. Accordingly, the Company is subject to several industry-specific accounting principles under accounting principles generally accepted in the United States of America (“GAAP”). The preparation of financial statements in accordance with GAAP requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The process of estimation is inherently uncertain. Accordingly, actual results could ultimately differ materially from the estimated amounts reported in a company’s financial statements. Different assumptions are likely to result in different estimates of reported amounts. The Company’s critical accounting policies most sensitive to estimates include the valuation of investments, the valuation of property and casualty insurance reserves for losses and LAE, the valuation of the reserve for loan losses, the assessment of recoverability of goodwill and the valuation of postretirement benefit obligations.
Except for the Company’s investment in the common stock of Intermec, which is accounted for under the equity method of accounting, the Company’s investments in fixed maturities, preferred stocks and common stocks are classified as available for sale and are reported at fair value under GAAP. Fair values of these investments are estimated using quoted market prices where available. For securities not actively traded, fair values are estimated using values obtained from independent pricing services or broker dealers. To estimate the value of these investments, independent pricing services and broker dealers employ various models that take into consideration such factors, among others, as the credit rating of the issuer, duration of the security, yields on comparably rated publicly traded securities and risk-free yield curves. The actual value at which such securities could actually be sold or settled with a willing buyer or seller may differ from such estimated fair values depending on a number of factors including, but not limited to, current and future economic conditions, the quantity sold or settled, the presence of an active market and the availability of a willing buyer or seller.
The Company’s Property and Casualty Insurance Reserves are reported using the Company’s estimate of its ultimate liability for losses and LAE for claims that occurred prior to the end of any given accounting period but
have not yet been paid. The Company had $1,322.9 million and $1,432.6 million of gross loss and LAE reserves at December 31, 2007 and 2006, respectively. Property and Casualty Insurance Reserves for the Company’s business segments and Unitrin Business Insurance at December 31, 2007 and 2006 were:
The Unallocated Ceded Reserves were acquired in connection with a business acquisition from SCOR in 2002 and are reinsured by an insurance subsidiary of SCOR (see Note 7, “Property and Casualty Insurance Reserves,” to the Consolidated Financial Statements). The Company does not allocate these reserves to its business segments or Unitrin Business Insurance.
The Company’s actuaries generally estimate reserves at least quarterly for most product lines and/or coverage levels using accident quarters or accident months spanning 10 or more years depending on the size of the product line and/or coverage level or emerging issues relating to them. The Company’s actuaries use a variety of generally accepted actuarial loss reserving estimation methodologies including, but not limited to, the following:
The Company’s actuaries generally review the results of at least four of these estimation methodologies, two based on paid data and two based on incurred data, to initially estimate loss and LAE reserves and to determine if a change in prior estimates is required. In some cases, the methodologies produce a cluster of estimates with a tight band of indicated possible outcomes. In other cases, however, the methodologies produce conflicting results and wider bands of indicated possible outcomes. However, such bands do not necessarily constitute a range of outcomes, nor does the Company’s management or the Company’s actuaries calculate a range of outcomes.
Changes in the judicial environment including, but not limited to, the interpretation of policy provisions, the impact of jury awards and changes in case law; and
and LAE from Hurricanes Katrina, Rita and Wilma. The recorded reserves for the Unallocated Ceded Reserves and these hurricanes were equal to the actuarial indications.
The Company’s goal is to ensure its total reserves for property and casualty insurance losses and LAE are adequate to cover all costs, while sustaining minimal variation from the time reserves for losses and LAE are initially estimated until losses and LAE are fully developed. Changes in the Company’s estimates of these losses and LAE over time, also referred to as “development,” will occur and may be material. Favorable development is recognized when the Company decreases its estimate of previously reported losses and LAE and results in an increase in net income in the period recognized, whereas adverse development is recognized when the Company increases its estimate of previously reported losses and LAE and results in a decrease in net income. The Company recognized total favorable development of $101.1 million, $91.6 million and $92.1 million before tax for the years ended December 31, 2007, 2006 and 2005, respectively. Development for each of the Company’s continuing business segments and Unitrin Business Insurance for the years ended December 31, 2007, 2006 and 2005, was:
Development in the Company’s Kemper segment comprised a substantial portion of the Company’s development reported in continuing operations. Development in Unitrin Business Insurance comprised all of the Company’s development reported in discontinued operations. Together these two operations comprised a substantial portion of the Company’s favorable development in 2007, 2006 and 2005. Additional information regarding this development follows.
In June of 2002, the Company acquired the personal lines property and casualty insurance business of KIC in a renewal rights transaction. Pursuant to the agreements among the parties, KIC retained all liabilities for policies issued by KIC prior to the closing, while the Company is entitled to premiums written for substantially all personal lines property and casualty insurance policies issued or renewed after the closing and is liable for losses and LAE incurred thereon. The Kemper segment did not complete a full calendar year underwriting cycle after the acquisition date until 2004. Accordingly, the Company’s results for 2002 and 2003 did not represent 100% of the acquired business. For example, for the 2002 calendar year, the Company’s share of earned premiums for the KIC personal lines business was approximately 20% of the entire KIC personal lines business. For the 2003 calendar year, the Company’s share of earned premiums was approximately 90% of the entire KIC personal lines business.
The Company’s actuaries use various generally accepted actuarial incurred and paid loss development methodologies to estimate unpaid losses and LAE. The key assumption in these estimation methodologies is that
patterns observed in prior periods are indicative of how losses and LAE are expected to develop in the future and that such historical data can be used to predict and estimate ultimate losses and LAE. Initially, the Company’s actuaries had to rely solely on the historical KIC Data to predict how losses for business written by the Company after the acquisition would develop. As the Company continued to renew policies, the paid loss and incurred loss data related to the Company’s share of the entire KIC personal lines business gradually increased. Immediately after the acquisition, the Company began accumulating incurred and paid loss and LAE data for the Unitrin Data. In 2003, and throughout 2004, the Company’s actuaries began to review the Unitrin Data and began comparing development factors for it with the development factors for the KIC Data. These initial reviews indicated that the Unitrin Data was producing lower development factors than the factors produced by the KIC Data. However, the amount of Unitrin Data available for analysis was still limited, and the Company’s actuaries could not be confident that the observed changes in development were anything but random fluctuations and, therefore, placed less weight on the most recent development patterns.
Increased its in-house legal expertise to better manage the litigation processes and expenses, including managing the external lawyers with whom Kemper contracts to defend claims; and,
Unitrin Business Insurance improved its claims handling procedures by placing increased emphasis on earlier identification of the full value of a claim, especially case reserves for larger claims. As part of this effort, a large loss unit was created in its home office to handle all significant claims. In addition, Unitrin Business Insurance initiated several claims handling cost cutting measures, such as using third-party analytic software for legal expense and bodily injury review, outsourcing workers compensation bill review, utilizing preferred vendors for damage repair and pursuing subrogation more aggressively. The combined effects of these claims handling initiatives were case reserves in the earlier evaluation periods that more closely matched the ultimate payments.
Although development will emerge in all of Unitrin’s personal lines’ product lines, development in Kemper’s personal automobile insurance product line could have the most significant impact. To further illustrate the sensitivity of Kemper’s reserves for automobile insurance losses and LAE to changes in the cumulative development factors, the Company’s actuaries estimated the impact of decreases in the cumulative development factors used in the incurred loss development methodology. For the most recent quarterly evaluation period, the Company assumed an average decrease of 11.2% in the cumulative development factor, gradually declining to an average decrease of 2.8% over the next 8 older evaluation quarters, gradually declining to average decrease of 0.3% over the next 15 older evaluation quarters and then gradually declining to 0% thereafter. Assuming that Kemper’s automobile insurance loss and LAE reserves were based solely on the incurred loss development methodology and such assumed decreases in the cumulative development factors, the Company estimates that Kemper’s automobile insurance loss and LAE reserves would have decreased by $72.7 million at December 31, 2007 for all accident years combined.
In addition to the factors described above, other factors may also impact loss reserve development in future periods. These factors include governmental actions, including court decisions interpreting existing laws, regulations or policy provisions, developments related to insurance policy claims and coverage issues, adverse or favorable outcomes in pending claims litigation, the number and severity of insurance claims, the impact of inflation on insurance claims and the impact of residual market assessments. Although the Company’s actuaries do not make specific numerical assumptions about these factors, changes in these factors from past patterns will impact historical loss development factors and in turn future loss reserve development. Significant positive changes in one or more factors will lead to positive future loss reserve development, which could result in the actual loss developing closer to, or even below, the lower end of the Company’s estimated reserve variability. Significant negative changes in one or more factors will lead to negative loss reserve development, which could result in the actual loss developing closer to, or even above, the higher end of the Company’s estimated reserve variability. Accordingly, due to these factors and the other factors enumerated throughout the MD&A and the
Unallocated Ceded Reserves are reinsured by an insurance subsidiary of SCOR (see Note 7, “Property and Casualty Insurance Reserves,” to the Consolidated Financial Statements). The Company does not anticipate that any variability of these reserves will have a financial impact on the Company’s reported results of operations or liquidity and, accordingly, has not estimated any potential variability to these reserves. The Company does not allocate these reserves to its business segments.
The Company’s commercial lines business is focused on the small commercial market. The Company has typically not written policies insuring large manufacturers. Accordingly, the Company’s exposure to asbestos and environmental losses is limited. Total asbestos and environmental reserves in Unitrin Business Insurance were $18 million at both December 31, 2007 and 2006.
Additional information pertaining to the estimation of and development of the Company’s Property and Casualty Insurance Reserves is contained in Item 1 of Part I of this 2007 Annual Report on Form 10-K under the heading “Property and Casualty Loss and Loss Adjustment Expense Reserves.”
The Reserve for Loan Losses is estimated using the Company’s estimate of ultimate charge-offs and recoveries of loans based on past experience adjusted for current economic conditions. Such charge-offs and recoveries emerge over a period of years. Accordingly, the Company’s actual ultimate net charge-offs could differ materially from the Company’s estimate due to a variety of factors including, but not limited to, trends and future conditions in the macroeconomic, socioeconomic and regulatory environment, the timing of charge-offs and recoveries, the value of collateral and changes in the overall credit quality of the loan portfolio. Actual net charge-off patterns may also differ materially from historical net charge-off patterns if there is a change in collection practices, the mix of loans or the credit quality of borrowers. For example, net charge-off patterns may differ in Fireside Bank’s expansion states from Fireside Bank’s historical experience. A 100-basis point increase in the Company’s estimated ultimate rate of net charge-off would increase the Company’s Reserve for Loan Losses at December 31, 2007 by $26.8 million.
The main assumptions used in the valuation of the Company’s postretirement medical benefit obligations are:
a) Estimated mortality of the employees and retirees eligible for benefits;
b) Estimated morbidity of the employees and retirees eligible for benefits;
A change in any one or more of these assumptions is likely to result in an ultimate liability different from the original actuarial estimate. Such changes in estimates may be material. For example, a one-percentage point decrease in the Company’s estimated discount rate would increase the pension obligation and the postretirement medical benefit obligation at December 31, 2007 by $57.7 million and $2.7 million, respectively, while a one-percentage point increase in the rate would decrease the pension obligation and the postretirement medical benefit obligation at December 31, 2007 by $46.4 million and $2.6 million, respectively. A one-percentage point increase in the Company’s estimated health care cost trend rate for each year would increase the postretirement medical benefit obligation at December 31, 2007 by $2.7 million. A one-percentage point decrease in the Company’s estimated health care cost trend rate for each year would decrease the postretirement medical benefit obligation at December 31, 2007 by $2.4 million. A one-percentage point decrease in the Company’s estimated long-term rate of return on plan assets would increase the pension expense for the year ended December 31, 2007 by $3.2 million, while a one-percentage point increase in the rate would decrease pension expense by $3.2 million for the same period.
The Company manages its exposure to catastrophes and other natural disasters through a combination of geographical diversification and reinsurance. To limit its exposures to catastrophic events, the Company maintains three separate primary catastrophe reinsurance programs for its property and casualty insurance businesses. Coverage for each primary catastrophe reinsurance program is provided in three layers. In addition to
these programs, the Company purchases reinsurance from the FHCF for hurricane losses in Florida at retentions lower than those described below for the Company’s primary catastrophe reinsurance programs.
Catastrophe reinsurance premiums for the Company’s primary reinsurance programs and the FHCF reduced earned premiums from continuing operations for the years ended December 31, 2007, 2006 and 2005, by the following:
The Company did not incur any catastrophe losses above any of the retention levels of its primary catastrophe reinsurance programs in 2007 and 2006. The Company incurred catastrophe losses from two catastrophes in 2005, Hurricanes Katrina and Rita, above the retention levels of its primary catastrophe reinsurance programs. The Life and Health Insurance segment’s estimated total losses from Hurricane Katrina has exceeded the maximum coverage available under its primary reinsurance program. The Company’s total incurred losses to date before reinsurance recoveries from these two hurricanes is $200.2 million. Total reinsurance recoveries under the Company’s primary catastrophe reinsurance programs for these two hurricanes is $126.7 million. The Company initially recognized a loss of $64.7 million, net of reinsurance recoveries, in 2005 for these two hurricanes and has subsequently recognized adverse development of $4.2 million in 2006 and additional adverse development of $4.6 million in 2007.
The Company’s estimates for Hurricanes Katrina and Rita include estimates for both direct losses and LAE and indirect losses from residual market assessments. The process of estimating and establishing reserves for catastrophe losses is inherently uncertain and the actual ultimate cost of a claim, net of actual reinsurance recoveries, may vary materially from the estimated amount reserved. The Company’s estimates of direct catastrophe losses are generally based on inspections by claims adjusters and historical loss development experience for areas that have not been inspected or for claims that have not yet been reported. The Company’s estimates of direct catastrophe losses are based on the coverages provided by its insurance policies. The Company’s homeowners insurance policies do not provide coverage for losses caused by floods, but generally provide coverage for physical damage caused by wind or wind-driven rain. Accordingly, the Company’s estimates of direct losses for homeowners insurance do not include losses caused by flood. Depending on the policy, automobile insurance may provide coverage for losses caused by flood. Estimates of the number of and severity of claims ultimately reported are influenced by many variables including, but not limited to, repair or
The Kemper segment is reducing its exposures to natural disasters by reducing or limiting its homeowners insurance and other property insurance business in certain coastal areas of the United States. In 2006, the Kemper segment began exiting the personal insurance market in Florida. Accordingly, the Kemper segment is no longer writing new homeowners and automobile insurance policies in the state of Florida and is not offering to renew existing policies on their anniversary dates. In addition, in certain coastal territories of Louisiana, Mississippi, New York (principally Long Island), and Texas, the Kemper segment is employing a strategy of increasing or adding hurricane deductibles to homeowners insurance policies and increasing the rates charged for homeowners insurance to cover the additional catastrophe risk and reinsurance costs inherent to homes located in these coastal areas.
Kemper plans to increase its premium volume in 2008 by continuing to implement convenience initiatives, including completing the roll-out of its Right Price Web® agency interface, appointing new agencies, increasing production from existing agents, securing books of business to write from key agents, and providing the capability to quote homeowners insurance on-line. Right Price Web® is Kemper’s new state-of-the-art internet agency interface application which has been rolled out in 29 states, representing 70% of Kemper’s business. Kemper anticipates that the roll-out will be completed in 2008. In states where Right Price Web® has been rolled out, the feedback from agents has been favorable, with an increase in production usually seen within a few months of implementation.
Operating Profit in the Kemper segment decreased by $39.5 million for the year ended December 31, 2007, compared to the same period in 2006, due primarily to higher incurred losses and LAE, partially offset by lower insurance expenses.
Insurance Expenses decreased by $11.3 million for the year ended December 31, 2007, compared to the same period in 2006, due primarily to lower commissions due to the lower earned premiums, lower premium taxes and other licensing and regulatory fees and assessments, and lower other underwriting expenses.
Operating Profit in the Kemper segment increased by $52.7 million for the year ended December 31, 2006, compared to the same period in 2005. Operating Profit increased due primarily to lower non-catastrophe incurred losses and LAE, lower catastrophe losses and LAE, net of reinsurance recoveries, and lower insurance expenses. Loss and LAE reserve development had a favorable effect of $68.2 million for the year ended December 31, 2006, compared to a favorable effect of $65.4 million in 2005. Favorable loss and LAE reserve development on automobile insurance was $49.1 million for the year ended December 31, 2006, compared to $43.7 million in 2005. Favorable loss and LAE reserve development on homeowners insurance was $14.7 million for the year ended December 31, 2006, compared to $19.0 million in 2005. Favorable loss and LAE reserve development on other personal insurance was $4.4 million for the year ended December 31, 2006, compared to $2.7 million in 2005. Non-catastrophe losses and LAE as a percentage of earned premiums decreased in part due to the effect of placing greater weight on the emerging loss development trends in the current accident year actuarial indications (see MD&A, “Critical Accounting Estimates”). Catastrophe losses and LAE (including development), net of reinsurance recoveries, were $44.2 million for the year ended December 31, 2006, compared to $63.1 million in 2005. Catastrophe losses and LAE, net of reinsurance recoveries, in 2005 included losses and LAE from Hurricanes Katrina and Rita (see MD&A, “Catastrophes”).
Net Income in the Kemper segment increased by $34.5 million for the year ended December 31, 2006, compared to the same period in 2005, due primarily to the changes in Operating Profit. The Kemper segment’s effective income tax rate differs from the federal statutory income tax rate due primarily to tax-exempt investment income and dividends received deductions. Tax-exempt investment income and dividends received deductions were $25.6 million in 2006, compared to $24.1 million in 2005.
Operating Profit in the Unitrin Specialty segment decreased by $1.3 million for the year ended December 31, 2007, compared to the same period in 2006, due primarily to higher personal automobile insurance incurred losses and LAE partially offset by lower incurred losses and LAE in both commercial automobile insurance and certain reinsurance pools that are in run-off.
Personal automobile insurance loss and LAE as a percentage of earned premiums increased for the year ended December 31, 2007, compared to the same period in 2006, due primarily to a higher frequency of claims and lower favorable loss reserve development. Personal automobile insurance loss and LAE reserve development had a favorable effect of $4.2 million in 2007, compared to a favorable effect of $6.7 million in 2006. Commercial automobile insurance incurred losses and LAE as a percentage of earned premiums decreased in 2007 due primarily to higher favorable loss and LAE reserve development and, to a lesser extent, the change in the mix of lighter weight and heavier weight commercial vehicles insured by the Unitrin Specialty segment. Commercial automobile insurance loss and LAE reserve development (which recognizes changes in estimates of prior year loss and LAE reserves in the current period) had a favorable effect of $10.1 million in 2007, compared to a favorable effect of $2.2 million in 2006. Loss and LAE reserve development on certain reinsurance pools in run-off, included in other insurance, had a favorable effect of $1.0 million in 2007, compared to no reserve development in 2006.
Net Income in the Unitrin Specialty segment decreased by $0.7 million for the year ended December 31, 2007, compared to the same period in 2006. The Unitrin Specialty segment’s effective tax rate differs from the statutory tax rate due primarily to tax-exempt investment income and dividends received deductions. Tax-exempt investment income and dividends received deductions were $11.4 million in 2007 and 2006.
exit its motorcycle insurance business, partially offset by higher volume of personal automobile insurance. Personal automobile earned premiums for the year ended December 31, 2005 included $6.1 million of motorcycle insurance premiums. Unitrin Specialty exited this line of business during 2005. Commercial automobile insurance earned premiums decreased by $3.0 million for the year ended December 31, 2006, compared to the same period in 2005, due primarily to lower volume of commercial automobile insurance and increased competition. Net Investment Income increased by $1.2 million due primarily to higher levels of investments.
In addition to the Merastar acquisition, the Unitrin Direct segment began implementing direct marketing initiatives in 2007 intended to accelerate its growth, which resulted in higher written premiums and a higher number of policies in force. Written premiums are recognized as earned premiums over the terms of the respective policies. Unitrin Direct expects that the increase in written premiums and the resulting higher number of policies in force will continue to result in higher earned premiums in future periods. Excluding policies from the Merastar acquisition, the number of policies in force increased from over 128,000 at December 31, 2006 to more than 142,000 at December 31, 2007. Direct marketing initially results in higher expenses as a percentage of earned premiums because up-front marketing costs, to the extent they are not deferrable, are expensed as incurred, generally prior to when premiums are written and subsequently earned. It takes several months for all
Earned Premiums in the Unitrin Direct segment increased by $31.7 million for the year ended December 31, 2007, compared to the same period in 2006. Earned Premiums in the Unitrin Direct segment in 2007 include earned premiums of $22.5 million from Merastar since the date of acquisition. Excluding the impact on Earned Premiums from the Merastar acquisition, Earned Premiums in the Unitrin Direct segment increased by $9.2 million for the year ended December 31, 2007, compared to the same period in 2006, due primarily to higher volume resulting from the marketing initiatives.
The Unitrin Direct segment reported an Operating Loss of $10.1 million for the year ended December 31, 2006, compared to an Operating Profit of $1.5 million for the year ended December 31, 2005. Operating results decreased due primarily to the unfavorable effects of loss and LAE reserve development and higher marketing and other policy acquisition expenses, partially offset by lower catastrophe losses and LAE. Unitrin Direct
Unitrin Direct reported a Net Loss of $4.9 million for the year ended December 31, 2006, compared to Net Income of $2.6 million for the year ended December 31, 2005. Unitrin Direct’s effective income tax rate differs from the federal statutory income tax rate due primarily to tax-exempt investment income and dividends received deductions. Tax-exempt investment income and dividends received deductions were $4.7 million in 2006, compared to $4.3 million in 2005.
Health Insurance segment’s career agents decreased by $8.6 million due primarily to lower volume related to the Company’s strategy to reduce coastal exposures and, to a lesser extent, an increase in the cost of catastrophe reinsurance. The Life and Health Insurance segment is reducing its exposures to natural disasters by suspending its new business sales and non-renewing selected property insurance business in certain coastal areas of the Gulf and southeastern United States. Prior to these actions, the affected areas comprised approximately 20% of the Life and Health Insurance segment’s property insurance business. The cost of catastrophe reinsurance coverage was $8.5 million for the year ended December 31, 2007, compared to $6.1 million for the same period in 2006 (see MD&A, “Catastrophes”).
On November 16, 2007, Unitrin signed a definitive agreement to acquire Primesco in a cash merger transaction valued at approximately $96 million, subject to certain purchase price adjustments at the time of closing. Primesco’s wholly-owned subsidiaries, Mutual Savings and Mutual Savings Fire, specialize in the sale of life, health and fire insurance products to persons of modest financial means in Alabama, Georgia, Mississippi and several other states in the Southeast. Similar to Unitrin’s Career Agency companies, Mutual Savings and Mutual Savings Fire employ a network of employee agents who call on customers in their homes to sell and service products and collect premiums. For the year ended December 31, 2006, Mutual Savings and Mutual Savings Fire had total premium revenues of approximately $53 million. The transaction is subject to approvals by Primesco’s shareholders, approvals by insurance regulators and other customary closing conditions and is expected to close in the first quarter of 2008.
Net Investment Income increased by $12.3 million for the year ended December 31, 2007, compared to the same period in 2006, due primarily to higher yields on investments and higher levels of investments. Yields on investments for the year ended December 31, 2007 included a special dividend of $5.2 million from the Company’s equity investment in IRI. The Company cannot anticipate when or if similar dividends from its equity investments in IRI may occur in the future. Net Investment Income in 2006 did not include a corresponding dividend from the Company’s equity investment in IRI.
Operating Profit in the Life and Health Insurance segment increased by $7.8 million for the year ended December 31, 2007, compared to the same period in 2006, due to lower Insurance Expenses, the higher Net Investment Income, and lower Policyholders’ Benefits and Incurred Losses and LAE, partially offset by the lower Other Income.
Insurance Expenses decreased by $16.8 million and also decreased as a percentage of earned premiums for the year ended December 31, 2007, compared to the same period in 2006, due primarily to lower commission expense and, to a lesser extent, lower administrative expenses. Commission expense was lower due primarily to lower volume, fewer active career agents, the continuing effects of changes in the Life and Health Insurance segment’s compensation plans and lower amortization of deferred policy acquisition costs, partially offset by the initial favorable impact in 2006 of the changes in the Life and Health Insurance segment’s compensation plans.
Excluding the impact of the quota share reinsurance transactions described above, Earned Premiums in the Life and Health Insurance segment decreased by $4.6 million for the year ended December 31, 2006, compared to the same period in 2005, due primarily to lower earned premiums on accident and health insurance and lower earned premiums on property insurance. Earned premiums on accident and health insurance decreased by $2.2 million in 2006, as lower volume of accident and health insurance, primarily on limited benefit medical and Medicare supplement products, contributed $8.2 million to the decrease in accident and health insurance earned premiums, while higher insurance premium rates on those same products accounted for an increase of $6.0 million. Excluding the impact of the quota share reinsurance transactions described above, earned premiums on property insurance decreased due to lower volume related to the Life and Health Insurance segment’s decision to reduce its coastal exposures and an increase in the cost of catastrophe reinsurance. The cost of catastrophe reinsurance
Other Income for the year ended December 31, 2006, includes a gain of $9.6 million, net of the initial deferred gain, and the amortization of $0.4 million of the deferred gain recognized on the sale and leaseback of Reserve National’s home office building and a gain of $1.0 million recognized on the sale of the Career Agency Companies’ Louisiana office building. Other Income for the year ended December 31, 2005, includes a gain of $2.4 million recognized on the sale of the Career Agency Companies’ St. Louis home office building, which was no longer utilized by the Career Agency Companies after it had leased a larger facility to accommodate the consolidation of its Louisiana regional office operations into its St. Louis home office. The consolidation of the Louisiana regional office operations into the St. Louis home office was completed in 2006. Other Income in 2005 also includes service fees charged for certain administrative services provided by the Career Agency Companies to ORCC, prior to the effective date of the 100% quota share agreement described above.
Net Income in the Life and Health Insurance segment increased by $39.5 million due primarily to the higher Operating Profit.
Interest, Loan Fees and Earned Discounts in the Fireside Bank segment increased by $13.9 million for the year ended December 31, 2007, compared to the same period in 2006, due primarily to higher levels of loans outstanding, partially offset by lower yield. Fireside Bank makes only loans that are secured by automobiles. Fireside Bank has no loans outstanding that are secured by real estate. Fireside Bank does not sell or securitize any portion of its loan portfolio.
In early 2008, Fireside Bank implemented an improved risk-based-pricing, credit-scoring model to aid in the underwriting process. The implementation of this model is expected to result in the prospective elimination of certain unprofitable tiers of business that comprised approximately 20% of the loans originated by Fireside Bank in 2007.
Interest Expense on Certificates of Deposits increased by $8.9 million in 2007 due to higher interest rates on Certificates of Deposits and higher levels of deposits.
Fireside Bank reported a Net Loss of $38.8 million for the year ended December 31, 2007, compared to Net Income of $26.1 million in 2006. Fireside Bank’s effective tax rate differs from the Federal statutory tax rate due primarily to state income taxes. State income taxes were a benefit of $6.7 million in 2007, compared to expense of $4.6 million in 2006.
Net Investment Income was $306.7 million, $280.8 million and $257.6 million in 2007, 2006 and 2005, respectively. Excluding the impact of the increases in dividend income from Northrop preferred stock and from IRI common stock discussed below, Net Investment Income increased in 2007 by $14.5 million, compared to the same period in 2006, due to higher levels of investments and, to a lesser extent, higher yields on investments. Net Investment Income increased by $23.2 million in 2006, compared to the same period in 2005, due to higher investment yields and, to a lesser extent, higher levels of investments. Dividend income from the Company’s investment in Northrop preferred stock increased by $6.2 million for year ended December 31, 2007, compared to the same period in 2006, due to the timing of ex-dividend dates. Dividend income from the Company’s investment in Northrop preferred stock decreased by $3.1 million for year ended December 31, 2006, compared to the same period in 2005, due to the timing of ex-dividend dates. Dividend income from other equity securities increased by $6.8 million for the year ended December 31, 2007, compared to the same period in 2006, due primarily to a special dividend of $5.2 million from the Company’s equity investment in IRI. The Company cannot anticipate when or if similar dividends from its equity investments in IRI may occur in the future. Short-term investment income increased by $6.8 million for the year ended December 31, 2007, compared to the same period in 2006, due primarily to higher levels of short-term investments. The Company invested the proceeds from the issuance of its 6.00% senior notes in short-term investments until the principal on its 5.75% senior notes was repaid in the third quarter of 2007 (see Note 8, “Notes Payable,” to the Consolidated Financial Statements. Short-term investment income increased by $13.7 million for the year ended December 31, 2006, compared to the same period in 2005, due primarily to higher yields on short-term investments and, to a lesser extent, higher levels of short-term investments. Investment income from limited partnerships and limited liability companies increased by $6.9 million for the year ended December 31, 2007, compared to the same period in 2006, and increased by $9.0 million for the year ended December 31, 2006, compared to the same period in 2005, due primarily to higher levels of investments and higher yields on investments.
The Company’s fixed maturity investment portfolio is comprised primarily of high grade municipal, corporate and agency bonds. At December 31, 2007, nearly 97% of the Company’s fixed maturity investment portfolio was rated investment grade, which is defined as a security having a rating of AAA, AA, A or BBB from Standard & Poor’s; a rating of Aaa, Aa, A or Baa from Moody’s; or a rating from the NAIC of 1 or 2. The Company has not made significant investments in securities that are directly or indirectly related to sub-prime mortgage loans including, but not limited to, collateralized debt obligations and structured investment vehicles.
The following table summarizes the credit quality of the fixed maturity investment portfolio at December 31, 2007:
The following table summarizes the underlying rating of the Company’s municipal bond portfolio at December 31, 2007:
The Company accounts for its investment in the common stock of Intermec under the equity method of accounting. Intermec is listed on the New York Stock Exchange (NYSE symbol: IN) and is subject to the reporting requirements of the federal securities laws. Intermec is held for investment purposes. The fair value of the Company’s Investment in Investee was $257.1 million at December 31, 2007, compared to an asset carrying value of $90.7 million under the equity method of accounting.
The Company accounts for its Investment in Investee under the equity method of accounting using the most recent and sufficiently timely publicly available financial reports, which results in accounting on a three-month-delay basis (see Note 2, “Summary of Accounting Policies,” to the Consolidated Financial Statements). Equity in
Dividend income from the Company’s investment in Northrop preferred stock increased by $6.2 million for year ended December 31, 2007, compared to the same period in 2006, due to the timing of ex-dividend dates. Dividend income from the Company’s investment in Northrop preferred stock decreased by $3.1 million for year ended December 31, 2006, compared to the same period in 2005, due to the timing of ex-dividend dates. Dividend income from the Company’s investment in Northrop common stock increased by $0.8 million in 2007, compared to the same period in 2006, and increased $0.6 million in 2006, compared to the same period in 2005, due primarily to an increase in the average annual dividend rate.
At December 31, 2007, there were approximately 3.4 million shares of the Company’s outstanding common stock that could be repurchased under the Company’s outstanding repurchase authorization. Common stock may be repurchased in the open market or in privately negotiated transactions from time to time subject to market conditions and other factors. The Company repurchased and retired 3,042,100 shares of its common stock in 2007 at a cost of $139.5 million. The Company repurchased and retired 2,006,500 shares of its common stock in 2006 at a cost of $89.9 million. The Company has repurchased and retired approximately 60.8 million shares of its common stock in open market transactions at an aggregate cost of approximately $1.7 billion since 1990.
The Company does not anticipate making significant changes to its capital structure during 2008. The Company’s management believes that it has sufficient resources to maintain the payment of dividends to Unitrin’s shareholders at its present level. Sources available for future shareholder dividend payments, the payment of interest on Unitrin’s senior notes and the repurchases of Unitrin’s common stock include the receipt of dividends from Unitrin’s subsidiaries, the receipt of dividends from Unitrin’s investments in Northrop, borrowings under Unitrin’s revolving credit agreement, and monetization of a portion of the Unitrin’s Northrop holdings. Various state insurance laws restrict the ability of Unitrin’s insurance subsidiaries to pay dividends without regulatory approval. Such laws generally restrict the amount of dividends paid in an annual period to the greater of statutory net income from the previous year or 10% of statutory capital and surplus. Certain risk-based capital regulations also have the effect of limiting the amount of dividends that may be paid by Fireside Bank. In 2008, Unitrin estimates that its direct insurance subsidiaries would be able to pay $162.5 million in dividends to Unitrin without prior regulatory approval. The Company does not expect Fireside Bank to pay a dividend in 2008.
On November 16, 2007, the Company entered into a definitive agreement to acquire Primesco in a cash merger transaction valued at approximately $96 million, subject to certain purchase price adjustments at the time of closing. The transaction is subject to approvals by insurance regulators and other customary closing conditions and is expected to close in the first quarter of 2008. Unitrin plans to fund this acquisition though a combination of its cash, short term investments and borrowings under its $325 million unsecured revolving credit agreement. Unitrin’s cash and short term investments totaled $67.6 million at December 31, 2007.
The primary sources of funds for Unitrin’s insurance subsidiaries are premiums and investment income. The primary uses of funds are the payment of policyholder benefits under life insurance contracts, claims under
property and casualty insurance contracts and accident and health insurance contracts, the payment of commissions and general expenses and the purchase of investments. Generally, there is a time lag between when premiums are collected and when policyholder benefits and insurance claims are paid. Accordingly, during periods of growth, insurance companies typically experience positive operating cash flows and are able to invest a portion of their operating cash flows to fund future policyholder benefits and claims. During periods in which premium revenues decline, insurance companies may experience negative cash flow from operations and may need to sell investments to fund payments to policyholders and claimants. In addition, if the Company’s property and casualty insurance subsidiaries experience several significant catastrophic events over a relatively short period of time, investments may have to be sold in advance of their maturity dates to fund payments, which could either result in investment gains or losses. Management believes that its insurance subsidiaries maintain adequate levels of liquidity and surplus capacity to manage the risks inherent with any differences between the duration of their liabilities and invested assets and to provide adequate liquidity in the event that its property and casualty insurance subsidiaries experience several catastrophic events over a relatively short period of time.
Net Cash Used by Financing Activities decreased by $24.3 million for the year ended December 31, 2007, compared to the same period in 2006. In 2007, the Company received $354.8 million in net proceeds from the issuance of the 6.00% Senior Notes. Additionally, in 2007, the Company paid $300.0 million to retire the 5.75% Senior Notes. There was no similar debt activity in 2006. Cash Provided by Financing Activities related to issuing certificates of deposits, net of withdrawals, increased by $23.2 million in 2007, compared to the same period in 2006. The Company used $139.5 million of cash in 2007 to repurchase shares of its common stock, compared to $89.9 million of cash used to repurchase shares of its common stock in the same period in 2006.
2006, compared to net cash invested in short-term investments of $166.9 million in 2005. Cash provided by the sales and maturities of fixed maturities, net of purchases, increased by $207.9 million. Cash used to purchase other equity securities exceeded cash provided from sales of other equity securities by $85.6 million in 2006, while cash provided from sales of other equity securities exceeded cash used to purchase other equity securities by $35.8 million in 2005. Cash used to acquire investments in limited liability investment companies and partnerships increased by $36.5 million in 2006.
In addition to the purchase obligations included above, the Company had certain investment commitments totaling $177 million at December 31, 2007. The funding of such investment commitments is dependent upon a number of factors, the timing of which is indeterminate.
The contractual obligations reported above also exclude the Company’s liability of $20.1 million for unrecognized tax benefits. The Company cannot make a reasonably reliable estimate of the amount and period of related future payments for such liability.
In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment. SFAS No. 123(R) replaces SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123(R) requires compensation costs related to share-based payment transactions to be recognized in the financial statements over the period that an employee provides service in exchange for the award. In 2006, the Company adopted SFAS No. 123(R) using the modified prospective method effective January 1, 2006. Under the modified prospective method, companies record prospectively the compensation cost for new and modified awards, on or after the date of adoption, over the requisite service period of such awards. In addition, companies record compensation cost prospectively for the unvested portion, at the date of adoption, of previously issued and outstanding awards over the remaining requisite service period of such awards. The Company previously adopted SFAS No. 123 in 2003. Accordingly, the incremental effect of adoption of SFAS No. 123(R) was insignificant.
Consolidated Statements of Income for the Years Ended December 31, 2007, 2006 and 2005
On December 7, 2007, the Company signed a definitive agreement to sell its Unitrin Business Insurance operations to AmTrust in a cash transaction. AmTrust will acquire the renewal rights to the Unitrin Business Insurance book of business and certain legal entities and selected other assets and workforce that the Company currently employs to write its Unitrin Business Insurance business. The transaction is subject to approvals by insurance regulators and certain federal agencies and other customary closing conditions and is expected to close in the first quarter of 2008. Under the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the 2007 results of the Unitrin Business Insurance operations are classified as discontinued operations. In accordance with SFAS No. 144, amounts reported in the Consolidated Statements of Income and related disclosures for prior periods have been reclassified to conform with the current presentation (see Note 4, “Discontinued Operations,” to the Consolidated Financial Statements).
including, but not limited to, past claims experience, current claim trends and relevant legal, economic and social conditions, in estimating reserves. A change in any one or more factors is likely to result in the ultimate net claim cost to differ from the estimated reserve. Such changes in estimates may be material.
Investment in Investee is accounted for under the equity method of accounting in the accompanying financial statements. The Company’s voting percentage and share of earnings or losses of an investee is determined using the most recent and sufficiently timely publicly available audited financial statements and subsequent unaudited interim reports, which results in accounting on a three-month-delay basis. The Company recognizes into income its equity share of changes in an investee’s reported net assets resulting from an investee’s issuance of stock that is not part of a broader corporate reorganization.
Costs directly associated with the acquisition of business, principally commissions and certain premium taxes and policy issuance costs, are deferred. Costs deferred on property and casualty insurance products and health insurance products are amortized over the term of the related policies. Costs deferred on traditional life insurance products are primarily amortized over the anticipated premium-paying period of the related policies in proportion to the ratio of the annual premiums to the total premiums anticipated, which is estimated using the same assumptions used in calculating policy reserves.
Traditional life insurance premiums are recognized as revenue when due. Policyholders’ benefits are associated with related premiums to result in recognition of profits over the periods that the benefits are provided.
Policyholders’ Benefits and Incurred Losses and Loss Adjustment Expenses include provisions for future policy benefits under life and certain accident and health insurance contracts and provisions for reported claims, estimates for claims incurred but not reported and loss adjustment expenses. Benefit payments in excess of policy account balances are expensed.
Automobile Finance Revenues primarily include interest on Automobile Loan Receivables and miscellaneous revenues related to the loans. Interest income, including amortization of unearned discount and deferred loan fees, on Automobile Loan Receivables is recorded as interest is earned, using the effective yield method over the contractual life of the loans.
Automobile Finance Expenses includes Provisions for Loan Losses and General and Administrative Expenses.
At December 31, 2007, the Company had five stock-based compensation plans, which are more fully described in Note 11, “Long Term Equity Compensation Plans,” to the Consolidated Financial Statements. Awards granted, modified or settled prior to January 1, 2003 are accounted for in the Company’s Consolidated Financial Statements for the year ended December 31, 2005 under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. Awards granted, modified or settled after January 1, 2003 are accounted for in the Company’s Consolidated Financial Statements for the year ended December 31, 2005 under the fair value recognition provisions of SFAS No. 123. Had all awards granted, modified or settled prior to January 1, 2003 been accounted for in the Company’s Consolidated Financial Statements for the year ended December 31, 2005 under the fair value recognition and measurement provisions of SFAS No. 123, net income for the year ended December 31, 2005 on a pro forma basis would have been $255.3 million, a pro forma decrease of $0.2 million from Net Income as reported. All awards are accounted for in the Company’s Consolidated Financial Statements for the years ended December 31, 2007 and 2006 under the fair value recognition provisions of SFAS No. 123(R), Share-Based Payment.
In June 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes recognized under SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and also provides guidance on various related matters such as derecognition, interest and penalties, and disclosure. On January 1, 2007, the Company adopted FIN 48. The initial application of FIN 48 to the Company’s tax positions had no effect on the Company’s Shareholders’ Equity. The Company accounts for its investment in its investee, Intermec, under the equity method of accounting on a three-month-delay basis. Accordingly, the Company recognized its pro rata share of the effect of Intermec’s adoption of FIN 48 in the
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115. SFAS No. 159 permits the choice of measuring financial instruments and certain other items at fair value. SFAS No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company has elected not to apply the provisions of SFAS No. 159 to its eligible financial assets and financial liabilities on the date of adoption. Accordingly, the initial application of SFAS No. 159 has no effect on the Company.
labeled, and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity; the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income; and changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently. SFAS No. 160 also requires that any retained noncontrolling equity investment in the former subsidiary be initially measured at fair value when a subsidiary is deconsolidated. SFAS No. 160 also sets forth the disclosure requirements to identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 applies to all entities that prepare consolidated financial statements, except not-for-profit organizations, but will affect only those entities that have an outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate a subsidiary. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. SFAS No. 160 must be applied prospectively as of the beginning of the fiscal year in which SFAS No. 160 is initially applied, except for the presentation and disclosure requirements. The presentation and disclosure requirements are applied retrospectively for all periods presented. The Company does not have a noncontrolling interest in one or more subsidiaries. Accordingly, the Company does not anticipate that the initial application of SFAS No. 160 will have an impact on the Company.
On June 29, 2007, Trinity, a subsidiary of Unitrin, acquired Merastar in a cash transaction for a total purchase price of $47.9 million, including transaction costs of $0.7 million. Beginning with the Company’s third quarter of 2007, the results of the acquisition have been included in the Company’s consolidated financial statements from the date of acquisition and are reported in the Company’s Unitrin Direct segment. Merastar provides automobile and homeowners insurance and is licensed in 48 states.
The Company accounts for its Unitrin Business Insurance operations as discontinued operations in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long Lived Assets, (see Note 1, “Basis of Presentation and Significant Estimates,” to the Consolidated Financial Statements). In accordance with SFAS
No. 144, the Company has reclassified amounts reported in the Consolidated Statements of Income and related disclosures for prior periods to conform to the current presentation. Results for discontinued operations for the years ended December 31, 2007, 2006 and 2005, are presented below:
The amortized cost and estimated fair values of the Company’s Investments in Fixed Maturities at December 31, 2007, were:
The amortized cost and estimated fair values of the Company’s Investments in Fixed Maturities at December 31, 2006, were:
The expected maturities of the Company’s Investments in Fixed Maturities may differ from the contractual maturities because debtors may have the right to call or prepay obligations with or without call or prepayment penalties. Investments in Asset-backed Securities Not Due at a Single Maturity Date were concentrated in securities issued by U.S. government agencies and authorities at December 31, 2007.
Gross unrealized gains and gross unrealized losses on the Company’s Investments in Northrop Preferred Stock, Northrop Common Stock and Other Equity Securities at December 31, 2007, were:
Gross unrealized gains and gross unrealized losses on the Company’s Investments in Northrop Preferred Stock, Northrop Common Stock and Other Equity Securities at December 31, 2006, were:
An aging of unrealized losses on the Company’s Investments in Fixed Maturities and Other Equity Securities at December 31, 2007, is presented below:
For substantially all equity securities with an unrealized loss that has continued for more than 12 months, such unrealized loss was less than 10% of the Company’s carrying value of each equity security, which the Company expects to recover. The Company considers various factors when considering if a decline in the fair value of an equity security is other than temporary including, but not limited to:
Based on evaluations of these factors at December 31, 2007 and 2006, the Company concluded that the declines in the fair values of the Company’s investments in equity securities at the respective evaluation dates are temporary.
The carrying value, fair value and approximate voting percentage for the Company’s investment in the common stock of Intermec, which is accounted for under the equity method of accounting and reported as Investment in Investee in the Company’s Consolidated Balance Sheets, at December 31, 2007 and 2006, were:
Equity in Net Income of Investee was $1.2 million, $9.2 million and $5.3 million for the years ended December 31, 2007, 2006 and 2005, respectively. Intermec recognized the financial impact of SFAS No. 158 in its financial statements at December 31, 2006. Intermec initially applied the provisions of FIN 48 on January 1, 2007. The Company accounts for its investment in Intermec under the equity method of accounting on a three-month-delay basis. Accordingly, the Company recognized a decrease of $2.3 million, which was net of a tax benefit of $1.3 million, to its Shareholders’ Equity in the first quarter of 2007 for its pro rata share of the impact of Intermec’s adoption of SFAS No. 158 and recognized a decrease of $0.9 million, which was net of a tax benefit of $0.5 million, to the Company’s Shareholders’ Equity in the second quarter of 2007 for its pro rata share of the impact of Intermec’s adoption of FIN 48.
Accordingly, the Company reduced the carrying value of its investment in Intermec to its then current estimated realizable value and allocated the reduction to the Company’s proportionate share of Intermec’s non-current assets. Accordingly, the Company’s reported equity in the net income of Intermec differs from the Company’s proportionate share of Intermec’s reported results to the extent that such results include depreciation, amortization or other charges related to such non-current assets. During the first quarter of 2005, the Company estimated that Intermec had subsequently fully recognized in its financial statements the amortization, depreciation or write-downs of such non-current assets. Accordingly, for periods beginning after the first quarter of 2005, Equity in Net Income of Investee equals the Company’s proportionate share of Intermec’s results. The fair value of the Company’s investment in Intermec subsequently recovered such that the fair value exceeded the carrying value of the Company’s investment in Intermec by $166.4 million and $214.5 million at December 31, 2007 and 2006, respectively. In accordance with applicable accounting standards, such excess is not recorded in the Consolidated Financial Statements.
The carrying values of the Company’s Other Investments at December 31, 2007 and 2006, were:
The components of Automobile Loan Receivables at December 31, 2007 and 2006, were:
Activity in the Reserve for Loan Losses for the years ended December 31, 2007, 2006 and 2005, was:
The weighted-average interest rates on Certificates of Deposits were 4.91% and 4.72% at December 31, 2007 and 2006, respectively. The range of interest rates on Certificates of Deposits was 2.35% to 5.85% at December 31, 2007 and 2.10% to 5.85% at December 31, 2006. Certificates of Deposits are generally fixed in maturity. The contractual maturities of Certificates of Deposits at December 31, 2007 and 2006, were:
Reinsurance recoverables on property and casualty insurance reserves were $84.8 million and $137.9 million at December 31, 2007 and 2006, respectively. These reinsurance recoverables are concentrated with several reinsurers, the vast majority of which are highly rated by one or more of the principal investor and/or insurance company rating agencies. While most of the reinsurance recoverables were unsecured at December 31, 2007 and 2006, the agreements with the reinsurers generally provide for some form of collateralization upon the occurrence of certain events. The largest reinsurance recoverable on property and casualty insurance is from General Security National Insurance Company (“GSNIC”), a subsidiary of SCOR. In 2002, the Company acquired two insurance companies from SCOR. Under the agreement governing the acquisition of these insurance companies, SCOR and/or GSNIC are responsible for all liabilities of these insurance companies incurred prior to the acquisition. Reinsurance recoverables at December 31, 2007 and 2006, included $45.7 million and $93.5 million, respectively, from GSNIC.
At December 31, 2007, there are approximately 3.4 million shares of the Company’s outstanding common stock that can be repurchased under the outstanding repurchase authorization of the Company’s Board of Directors. Common stock can be repurchased in the open market or in privately negotiated transactions from time to time subject to market conditions and other factors. The Company repurchased and retired 3.0 million shares of its common stock in open market transactions at an aggregate cost of $139.5 million in 2007. The Company
repurchased and retired approximately 2.0 million shares of its common stock in open market transactions at an aggregate cost of $89.9 million in 2006. Common Stock, Paid-in Capital and Retained Earnings were reduced on a pro rata basis for the cost of the repurchased shares.
vesting and expiration dates of such options. Options are non-transferable and are exercisable in installments. Prior to 2003, only non-qualified stock options had been granted. However, beginning in 2003, non-qualified stock options granted to employees were coupled with tandem stock appreciation rights (“Tandem SARs”), settled in Unitrin common stock.
Under the 1995 Director Plan, each new member of the Board of Directors who is not employed by the Company receives an initial option to purchase 4,000 shares of the Company’s common stock immediately upon becoming a director. Thereafter, on the date of each of the Company’s annual meetings of shareholders, each such eligible director automatically receives an annual grant of options to purchase 4,000 shares of common stock for so long as they remain eligible directors. Options granted under the 1995 Director Plan are exercisable one year from the date of grant at an exercise price equal to the fair market value of the Unitrin’s common stock on the date of grant and expire 10 years from the date of grant.
To encourage stock ownership, the Company’s four stock option plans include provisions, subject to certain limitations beginning in 2006 as described below, to automatically grant restorative, or reload stock options (“Restorative Options”), to replace shares of previously owned Unitrin common stock that an exercising option holder surrenders, either actually or constructively, to satisfy the exercise price and/or tax withholding obligations relating to the exercise. Restorative Options are subject to the same terms and conditions as the original options, including the expiration date, except that the exercise price is equal to the fair market value of the Unitrin’s common stock on the date of grant and cannot be exercised until six months after the date of grant. The grant of a Restorative Option does not result in an increase in the total number of shares and options held by an employee but changes the mix of the two.
For original awards granted beginning in 2006 and Restorative Options granted thereunder, Restorative Options will be granted only if, on the date of exercise of the option giving rise to the Restorative Option, the market price of the Unitrin’s common stock exceeds such option’s exercise price by 15%. Further, no Restorative Options will be granted if the option giving rise to the Restorative Option is set to expire within twelve months.
expected term of the option. The assumptions used in the Black-Scholes pricing model for options granted during the years ended December 31, 2007, 2006 and 2005, were as follows:
The weighted-average grant-date fair values of options granted during 2007, 2006 and 2005 were $6.39, $5.79 and $4.95, respectively. Total intrinsic value of stock options exercised was $7.4 million, $14.3 million and $27.2 million for the years ended December 31, 2007, 2006 and 2005, respectively. Cash received from option exercises was $5.1 million, $6.8 million and $15.7 million for the years ended December 31, 2007, 2006 and 2005, respectively. Total tax benefits realized for tax deductions from option exercises were $2.6 million, $5.2 million and $9.5 million for the years ended December 31, 2007, 2006 and 2005, respectively.
Other Comprehensive Income for the years ended December 31, 2007, 2006 and 2005, was:
The components of Accumulated Other Comprehensive Income at December 31, 2007 and 2006, were:
Net Investment Income for the years ended December 31, 2007, 2006 and 2005, was:
Dividend income from the Company’s investment in Northrop preferred stock increased by $6.2 million for year ended December 31, 2007, compared to the same period in 2006, due to the timing of ex-dividend dates. Dividend income from the Company’s investment in Northrop preferred stock decreased by $3.1 million for year ended December 31, 2006, compared to the same period in 2005, due to the timing of ex-dividend dates. Dividend income from other equity securities increased by $6.8 million for the year ended December 31, 2007, compared to the same period in 2006, due primarily to a special dividend of $5.2 million from the Company’s equity investment in IRI Holdings, Inc. Short-term investment income increased for the year ended December 31, 2007, compared to the same period in 2006, due primarily to higher levels of short-term investments. The Company invested the proceeds from the issuance of its 6.00% Senior Notes in short-term investments until the principal on its 5.75% Senior Notes was repaid in the third quarter of 2007. Short-term investment income increased for the year ended December 31, 2006, compared to the same period in 2005, due primarily to higher yields on short-term investments and, to a lesser extent, higher levels of short-term investments. Investment income from limited partnerships and limited liability companies increased for the year ended December 31, 2007, compared to the same period in 2006, and for the year ended December 31, 2006, compared to the same period in 2005, due primarily to higher levels of investments and higher yields on investments.
Net Realized Investment Gains for the years ended December 31, 2007, 2006 and 2005, include pretax losses of $33.0 million, $2.8 million and $10.3 million, respectively, from other than temporary declines in the fair values of investments. Pretax losses from write-downs of fixed maturities for the year ended December 31, 2007, included a pretax loss of $8.3 million related to an issuer that had defaulted. Pretax losses from write-downs of other equity securities for the year ended December 31, 2007, was precipitated in part to the overall decline in the stock market in the second half of 2007. The Company wrote down the value of various holdings of equity securities. The Company cannot anticipate when or if similar investment losses may occur in the future.
Insurance Expenses for the years ended December 31, 2007, 2006 and 2005, were:
The tax effects of temporary differences that give rise to significant portions of the Company’s Net Deferred Tax Liability at December 31, 2007 and 2006, were:
For the years ended December 31, 2007, 2006 and 2005, all of Unitrin’s subsidiaries are eligible to file a consolidated Federal income tax return with Unitrin. The statute of limitations related to the consolidated Federal income tax return is closed for all tax years up to and including 2003. The expiration of the statute of limitations related to the various state income tax returns that the Company and subsidiaries file, varies by state. The Company’s consolidated Federal tax return and any significant state tax returns are not currently under examination.
The Company recognizes interest and penalties, if any, related to unrecognized tax benefits in income tax expense. The liability for unrecognized tax benefits included accrued interest of $6.8 million and $7.1 million at December 31, 2007 and January 1, 2007, respectively. Tax expense for the year ended December 31, 2007 includes an interest benefit of $0.3, which is comprised of an interest benefit of $4.0 million resulting from the expiration of the statutes of limitations referred to above, and interest expense of $3.7 million on unrecognized tax benefits for prior years.
A reconciliation of the Statutory Federal Income Tax Expense and Rate to the Company’s Effective Income Tax Expense and Rate from Continuing Operations for the years ended December 31, 2007, 2006 and 2005, was:
During 2007, a benefit of $5.3 million was recorded for state income taxes related to the tax year that ended on December 31, 2002, due to the expiration of a state’s statute of limitations.
During 2005, a benefit of $14 million was recorded primarily for Federal income tax adjustments related to the tax years ended December 31, 2002 and December 31, 2001, due to the settlement of these years with the Internal Revenue Service.
Comprehensive Income Tax Expense included in the Consolidated Financial Statements for the years ended December 31, 2007, 2006 and 2005, was:
The Company sponsors two qualified defined benefit pension plans (the “Pension Plans”) covering most of its employees. Certain participation in one of the Pension Plans requires or required employee contributions of 3% of pay, as defined, per year. Benefits for the contributory plan are based on compensation during plan participation and the number of years of participation. Benefits for the non-contributory plan are based on years of service and final average pay, as defined. The Company funds the Pension Plans in accordance with the requirements of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).
The Company sponsors several other postretirement employee benefit plans (“OPEB”) that provide medical, dental and/or life insurance benefits to approximately 1,000 retired and 800 active employees (“the OPEB Plans”). The Company generally is self-insured for the benefits under the OPEB Plans. The medical plans generally provide for a limited number of years of medical insurance benefits at retirement based on the participant’s attained age at retirement and number of years of service until specified dates and are generally contributory, with most contributions adjusted annually.
A one-percentage point increase in the assumed health care cost trend rate for each year would increase the Accumulated Benefit Obligation for the OPEB Plans at December 31, 2007, by $2.7 million and 2007 OPEB expense by $0.2 million. A one-percentage point decrease in the assumed health care cost trend rate for each year would decrease the Accumulated Benefit Obligation for the OPEB Plans at December 31, 2007, by $2.4 million and 2007 OPEB expense by approximately $0.1 million.
The OPEB Plans were unfunded at December 31, 2007 and 2006. Weighted-average asset allocations for the Pension Plans at December 31, 2007 and 2006, by asset category were:
The components of Pension Expense for the years ended December 31, 2007, 2006 and 2005, were:
The actuarial assumptions used to develop the components of both Pension Expense and OPEB Expense for the years ended December 31, 2007, 2006 and 2005, were:
The Kemper segment provides preferred and standard risk personal automobile insurance, homeowners insurance and other personal insurance through independent agents. The Unitrin Specialty segment provides automobile insurance to individuals and businesses in the non-standard and specialty market through independent agents. The non-standard automobile insurance market consists of individuals and companies that have difficulty obtaining standard or preferred risk insurance, usually because of their driving records. Unitrin Direct markets personal automobile insurance through direct mail, television and the Internet through web insurance portals, click-thrus and its own website. In addition, Merastar, which is included in the Unitrin Direct segment from the date of its acquisition (see Note 3, “Acquisition of Business,” to the Consolidated Financial Statements), specializes in the sale of personal automobile and homeowners insurance through employer-sponsored voluntary benefit programs. The Life and Health Insurance segment provides individual life, accident, health and hospitalization insurance. The Company’s Life and Health Insurance employee-agents also market property insurance products under common management. The Fireside Bank segment makes sub-prime automobile loans primarily for the purchase of pre-owned automobiles and offers certificates of deposits.
Segment Revenues for the years ended December 31, 2007, 2006 and 2005, were:
Segment Operating Profit for the years ended December 31, 2007, 2006 and 2005, was:
Amortization of Deferred Policy Acquisition Costs by Operating Segment for the years ended December 31, 2007, 2006 and 2005, was:
The Company manages its exposure to catastrophes and other natural disasters through a combination of geographical diversification and reinsurance. To limit its exposures to catastrophic events, the Company maintains three separate primary catastrophe reinsurance programs for its property and casualty insurance businesses. Coverage for each primary catastrophe reinsurance program is provided in three layers. In addition to these programs, the Company purchases reinsurance from the FHCF for hurricane losses in Florida at retentions lower than those described below for the Company’s primary catastrophe reinsurance programs.
The annual program covering the Company’s Unitrin Direct and Unitrin Specialty segments and Unitrin Business Insurance provided, effective January 1, 2007, reinsurance coverage of 100% of reinsured catastrophe losses of $36 million above retention of $4 million. In 2006, the annual program covering these segments also provided reinsurance coverage of 100% of reinsured catastrophe losses of $36 million above retention of $4 million. The 2007 and 2006 annual programs covering these segments do not include Merastar. The annual program covering Merastar was effective on March 31, 2007 and provides reinsurance coverage of 97.5% of reinsured catastrophe losses of $7.25 million above retention of $0.75 million.
The Company did not incur any catastrophe losses above any of the retention levels of its primary catastrophe reinsurance programs in 2007 and 2006. The Company incurred catastrophe losses from two catastrophes in 2005, Hurricanes Katrina and Rita, above the retention levels of its primary catastrophe reinsurance programs. The Life and Health Insurance segment’s estimated total losses from Hurricane Katrina also have exceeded the maximum coverage available under its primary reinsurance program. The Company’s total incurred losses to date before reinsurance recoveries from these two hurricanes is $200.2 million. Total reinsurance recoveries under the Company’s primary catastrophe reinsurance programs for these two hurricanes is $126.7 million. The Company initially recognized a loss of $64.7 million, net of reinsurance recoveries, in 2005 for these two hurricanes and has subsequently recognized adverse development of $4.2 million in 2006 and additional adverse development of $4.6 million in 2007.
The Company’s estimates for Hurricanes Katrina and Rita include estimates for both direct losses and LAE and indirect losses from residual market assessments. The process of estimating and establishing reserves for catastrophe losses is inherently uncertain and the actual ultimate cost of a claim, net of actual reinsurance recoveries, may vary materially from the estimated amount reserved. The Company’s estimates of direct catastrophe losses are generally based on inspections by claims adjusters and historical loss development experience for areas that have not been inspected or for claims that have not yet been reported. The Company’s estimates of direct catastrophe losses are based on the coverages provided by its insurance policies. The Company’s homeowners insurance policies do not provide coverage for losses caused by floods, but generally provide coverage for physical damage caused by wind or wind-driven rain. Accordingly, the Company’s estimates of direct losses for homeowners insurance do not include losses caused by flood. Depending on the policy, automobile insurance may provide coverage for losses caused by flood. Estimates of the number of and severity of claims ultimately reported are influenced by many variables including, but not limited to, repair or reconstruction costs and determination of cause of loss, that are difficult to quantify and will influence the final amount of claim settlements. All these factors, coupled with the impact of the availability of labor and material
on costs, require significant judgment in the reserve setting process. A change in any one or more of these factors is likely to result in an ultimate net claim cost different from the estimated reserve. The Company’s estimates of indirect losses from residual market assessments are based on a variety of factors including, but not limited to, actual or estimated assessments provided by or received from the assessing entity, insurance industry estimates of losses and estimates of the Company’s market share in the assessable states. Actual assessments may differ materially from these estimated amounts.
Earned Premiums assumed and ceded on long-duration policies were not material for the years ended December 31, 2007, 2006 and 2005. Earned Premiums ceded on short-duration policies were not material for the years ended December 31, 2007, 2006 and 2005. Certain insurance subsidiaries assume business from other insurance companies and involuntary pools. Earned Premiums assumed on short-duration policies for the years ended December 31, 2007, 2006 and 2005 were:
Effective January 1, 2007, Trinity, a subsidiary of Unitrin, and Milwaukee Insurance Company (“MIC”) entered into a new quota share reinsurance agreement whereby Trinity assumes 100% of policy liabilities occurring on MIC’s direct book of business on or after January 1, 2007, which business is administered by the Unitrin Business Insurance unit and the Kemper segment. Prior to January 1, 2007, Trinity and MIC were parties to a quota share reinsurance agreement whereby Trinity assumed 95% of the business written by MIC (administered by the Unitrin Business Insurance unit and the Kemper segment) and 95% of the business that MIC assumed from First NonProfit Insurance Company (“FNP”). The new quota share reinsurance agreement amended the 95% quota share reinsurance agreement so that policy liabilities occurring on MIC’s in-force direct book of business prior to January 1, 2007 remain ceded under the 95% agreement, as do FNP policy liabilities incurred prior to January 1, 2007. In connection with the new quota share reinsurance agreement, Trinity transferred to MIC the unearned premium reserves maintained by Trinity related to the FNP business, net of a ceding commission. MIC was owned by Mutual Insurers Holding Company (“MIHC”), which in turn was owned by MIC’s policyholders. Similarly, FNP was owned by First NonProfit Mutual Holding Company (“FNMHC”), which was owned by FNP’s policyholders. In November 2007, MIHC and FNMHC merged, and, accordingly, MIC and FNP became subsidiaries of the merged company. In the past, certain employees of the Company and its subsidiaries have been members of the boards of directors of one or more of MIC, MIHC, FNP and FHMHC. Effective in November 2007 and prior to the merger, the last remaining representatives of the Company resigned such board memberships. Accordingly, the only relationship that currently exists among the Company and/or its employees and these companies is the relationship of Trinity as a reinsurer of certain business pursuant to the above mentioned quota reinsurance agreement between Trinity and MIC.
In the ordinary course of their businesses, Unitrin and its subsidiaries are involved in a number of legal proceedings including lawsuits and regulatory examinations and inquiries. Some of these proceedings include matters particular to the Company or one or more of its subsidiaries, while others pertain to business practices in the industries in which Unitrin or its subsidiaries operate. Some lawsuits seek class action status that, if granted, could expose Unitrin or its subsidiaries to potentially significant liability by virtue of the size of the putative classes. These matters can raise complicated issues and are subject to many uncertainties, including but not limited to: (i) the underlying facts of the matter; (ii) unsettled questions of law; (iii) issues unique to the jurisdiction where the matter is pending; (iv) damage claims, including claims for punitive damages, that are disproportionate to the actual economic loss incurred; and (v) the legal, regulatory and political environment faced by large corporations generally and the insurance and banking sectors specifically. Accordingly, the outcomes of these matters are difficult to predict, and the amounts or ranges of potential loss at particular points in time are in most cases difficult or impossible to ascertain with any degree of certainty.
During the course of 2007, Unitrin and certain of its subsidiaries, like many property and casualty insurers, were forced to defend a growing number of individual lawsuits, mass actions and statewide putative class actions in Louisiana and Texas arising out of Hurricanes Katrina and Rita. In these matters, the plaintiffs seek compensatory and punitive damages and equitable relief. The Company and its relevant subsidiaries believe they have meritorious defenses to these proceedings and are defending them vigorously.
The legal and regulatory environment within which Unitrin and its subsidiaries conduct their business is often unpredictable. Industry practices that were considered legally-compliant and reasonable for years may suddenly
be deemed unacceptable by virtue of an unexpected court or regulatory ruling. Anticipating such shifts in the law and the impact they may have on the Company and its operations is a difficult task.
One of Unitrin’s directors, Mr. Fayez Sarofim, is the Chairman of the Board, President and the majority shareholder of Fayez Sarofim & Co. (“FS&C”), a registered investment advisory firm. Certain of the Company’s insurance company subsidiaries and FS&C are parties to agreements under which FS&C provides investment management services to these subsidiaries. In addition, FS&C provides investment management services with respect to certain funds of the Company’s pension plans. The agreements governing those arrangements are terminable by either party at any time on 30 days advance written notice.
Under these investment advisory arrangements, FS&C is entitled to a fee calculated and payable quarterly based upon the fair market value of the assets under management. The Company and the Company’s pension plans had $226.2 million and $99.6 million, respectively, in assets with FS&C for investment management at December 31, 2007. The Company and the Company’s pension plans had $208.2 million and $92.4 million, respectively, in assets with FS&C for investment management at December 31, 2006. The Company and the Company’s pension plans paid, in the aggregate, $0.8 million and $0.7 million to FS&C in 2007 and 2006.
With respect to the Company’s 401(k) Savings Plan, one of the alternative investment choices afforded to participating employees is the Dreyfus Appreciation Fund, an open-end, diversified managed investment fund. FS&C provides investment management services to the Dreyfus Appreciation Fund as a sub-investment advisor. According to published reports filed by FS&C with the SEC, the Dreyfus Appreciation Fund pays monthly fees to FS&C according to a graduated schedule computed at an annual rate based on the value of the Dreyfus Appreciation Fund’s average daily net assets. The Company does not compensate FS&C for services rendered to the Dreyfus Appreciation Fund. Participants in the Company’s 401(k) Savings Plan had allocated $25.3 million for investment in the Dreyfus Appreciation Fund at December 31, 2007, representing 9% of the total amount invested in the Company’s 401(k) Savings Plan. Participants in the Company’s 401(k) Savings Plan had allocated $27.0 million for investment in the Dreyfus Appreciation Fund Plan at December 31, 2006, representing 10% of the total amount invested in the Company’s 401(k) Savings.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Unitrin, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity
with accounting principles generally accepted in the United States of America. In addition, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth herein. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.