We lease approximately 406,000 square feet of office space for our headquarters facilities, which are located in Woodland Hills, California. The lease term expires in February 2015, and the lease may be renewed for two consecutive five-year periods.
We also lease office space in 15 other locations, of which 12 locations are in California primarily for claims-related employees. We anticipate no difficulty in extending these leases or obtaining comparable office facilities in suitable locations.
The decrease in premiums ceded from 2000 through 2004 was caused primarily by scheduled decreases in the AIG subsidiaries quota share program, which was terminated effective September 1, 2002.
The loss and LAE ratios have decreased since 2000 primarily due to increases in net premiums earned and the favorable impact on claim frequency of drought conditions that have largely prevailed in southern California.
The increase in the 2002 to 2004 expense ratios is primarily due to increased advertising expenditures, increased costs for improving customer service and opening a call center in Texas. The increase in the expense ratio from 2000 to 2001 reflects higher depreciation charges due to investments in new technology.
The combined ratio for the personal auto lines was impacted by the following items: $13.6 million of costs associated with workforce reductions and the settlement of litigation matters in 2001; Year 2000 remediation costs of $2.4 million in 1999; and (favorable) unfavorable prior accident year loss and LAE development of $(2.9) million, $11.2 million, $16.2 million, $45.7 million, and $42.2 million in 2004, 2003, 2002, 2001, and 2000, respectively.
In addition to the effect of the items described in footnote 4 above, the combined ratio for all lines was impacted by adverse development on remaining loss reserves from the homeowner and earthquake lines, which are in runoff, of $2.8 million in 2004, $40.2 million in 2003, $58.8 million in 2002, $77.6 million in 2001, and $2.7 million in 2000.
Our primary goals include achieving and sustaining 15% annual growth in premiums written and a 96% (or better) combined ratio in our personal auto lines. For 2004, our net premiums earned for personal auto grew 12% ($140.9 million) to $1,313.6 million from $1,172.7 million in 2003. The combined ratio for personal auto improved 1.4% to 95.1% in 2004 compared to 96.5% in 2003.
Amount shown for 2002 is a capital lease obligation (see Note 9 of the Notes to Consolidated Financial Statements).
The Company's investment portfolio of $1,384.2 million contained $42.0 million of equity securities, which are a new investment vehicle for the Company.
Gross unpaid losses and LAE increased by $57.2 million in 2004 primarily due to a reserve increase of $69.5 million in the personal auto lines as a result of growth in our customer base. The increase in the personal auto lines was offset by the $12.3 million net decrease in the homeowner and earthquake lines, which are in runoff (see Results of Operations - Loss and LAE Incurred for a description of the Company's reserving process).
Unearned premiums increased 6.0% to $331.0 million at the end of 2004 compared to $312.3 million at the end of 2003 due to higher volume in our personal auto lines.
Debt consists of a $38.4 million capital lease obligation with GE Capital Corporation and the $99.9 million senior note offering issued in December 2003, aggregating $138.3 million (see Note 9 of the Notes to Consolidated Financial Statements). The primary purpose of both borrowings was to increase the statutory surplus of 21st Century Insurance Company, our wholly-owned subsidiary, which had significant adverse earthquake and auto reserve development in 2000, 2001, and 2002. The decrease in debt of $11.4 million from the prior year is attributable to principal payments on the capital lease.
Effective December 31, 2003, the California Department of Insurance approved an intercompany lease whereby 21st Century Insurance Company leases certain computer software from our holding company. The monthly lease payment, currently $0.6 million, started in January 2004 and is subject to upward adjustment based on the cost incurred by the holding company to complete certain enhancements to the software.
Our holding company's significant cash obligations over the next several years consist of interest payments on the Senior Notes ($5.9 million annually) and the estimated cost of $22.0 million to implement our California policy servicing system in 2005, exclusive of any dividends to stockholders that the holding company may declare, and the repayment of the $100 million principal on the Senior Notes due in 2013. The holding company expects to be able to meet those obligations from sources of cash currently available (i.e., payments received from the intercompany lease and cash and investments at the holding company. Total cash and investments at the holding company were $16.2 million at December 31, 2004.), additional funds obtainable from the capital markets or from dividends received from its insurance subsidiaries. California currently levies state income taxes of approximately 1.8% on the amount of any such dividends received.
Our insurance subsidiaries could pay $109.8 million in 2005 as dividends to the holding company without prior written approval from insurance regulatory authorities.
Although in the past years we have been successful in gaining regulatory approval for rate increase, there can be no assurance that insurance regulators will grant future rate increases that may be necessary to offset possible future increases in claims cost trends. Also, we remain exposed to possible upward development in previously recorded reserves for claims pursuant to SB 1899. As a result of such uncertainties, underwriting losses could occur in the future. Further, we could be required to liquidate investments to pay claims, possibly during unfavorable market conditions, which could lead to the realization of losses on sales of investments. Adverse outcomes to any of the foregoing uncertainties would create some degree of downward pressure on the insurance subsidiaries' earnings or cash flows, which in turn could negatively impact our liquidity.
On June 15, 2004, the CDI finalized its examination reports on the statutory financial statements for the Company's California-domiciled insurance subsidiaries for the three-year period ended December 31, 2002. The reports did not contain any findings or adjustments.
Transactions with Related Parties. Since 1995, we have entered into several transactions with AIG subsidiaries, including various reinsurance agreements, which are discussed under Item 1. Business. At December 31, 2004, reinsurance recoverables, net of payables, from AIG subsidiaries were $1.4 million, compared to $5.8 million at December 31, 2003. Other transactions with AIG subsidiaries, which are immaterial, have resulted from competitive bidding processes for certain corporate insurance coverages and certain software and data processing services. In October 2003, as a result of a competitive bidding process, we entered into an agreement with an AIG subsidiary to provide investment management services to us; the agreement was approved by the California Department of Insurance.
We had estimated liabilities for losses and LAE of $495.5 million at December 31, 2004, the majority of which will be required to be paid in 2005 as the related claims are settled. We expect operating cash flow to be sufficient to meet our obligations to pay claims and we have readily marketable investments available for sale should operating cash flows prove to be inadequate.
Overall Results. We reported an increase of 64.7% in net income to $88.2 million, or $1.03 earnings per share, on direct premiums written of $1,337.2 million for the year ended December 31, 2004, compared to a net income of $53.6 million, or $0.63 earnings per share, on direct premiums written of $1,223.5 million for the year ended December 31, 2003. For the year ended December 31, 2002, we reported a net loss of $12.3 million, or $0.14 loss per share, on direct premiums written of $998.2 million. The results for 2003 and 2002 include: (i) after-tax charges of $24.1 million in the first quarter of 2003 and $34.2 million in the third quarter of 2002 to strengthen earthquake reserves; (ii) after-tax net income of $9.6 million for the year ended December 31, 2003, resulting from nonrecurring, nonoperational items and a favorable tax settlement with the IRS; and (iii) an after-tax charge of $24.2 million, for the year ended December 31, 2002, relating to a write-off of software.
The following table reconciles our personal auto lines underwriting profit to our consolidated net income (loss):
The tables presented in the Notes to Consolidated Financial Statements summarize the Company's unaudited quarterly results of operations for each of the two years in the period ended December 31, 2004. The following discussion of underwriting results by line of business should be read in conjunction with the information presented in those tables and elsewhere herein.
Direct premiums written grew 9.3% in 2004, 22.8% in 2003 and 10.8% in 2002, for a three-year compound average growth rate of 14.1%, or slightly less than our long-term goal of 15%. Market conditions in California were somewhat less favorable for growth in 2004 than in the preceding two years; for example, some major competitors sought rate decreases in 2004 in contrast with the market-wide rate increases, which helped to spur consumers' shopping activity in 2003 and 2002. As we proceed with our multi-state expansion, we believe that achieving our long-term growth goal will steadily depend less on the California marketplace.
Net premiums earned increased $140.9 million (12.0%) to $1,313.6 million in 2004, compared to $1,172.7 million in 2003 and $924.6 million in 2002. The combined ratio was 95.1% for the year ended December 31, 2004, compared to 96.5% and 98.5% for 2003 and 2002, respectively.
We have executed various transactions to exit from our homeowner line. Under a January 1, 2002 agreement with Balboa Insurance Company ("Balboa"), a subsidiary of Countrywide Financial Corporation ("Countrywide"), 100% of homeowner unearned premium reserves and losses on or after that date were ceded to Balboa. Under the terms of this agreement, we retain certain loss adjustment expenses. We began non-renewing homeowner policies expiring on February 21, 2002, and thereafter. Substantially all of these customers were offered homeowner coverage through an affiliate of Countrywide. We have completed this process and no longer have any homeowner policies in force.
The process of making changes to unpaid losses and LAE begins with the preparation of several point estimates of unpaid losses and LAE, a review of the actual claims experience in the quarter, actual rate changes achieved, actual changes in coverage, mix of business, and changes in certain other factors such as weather and recent tort activity that may affect the loss ratio. Our actuaries prepare several point estimates of unpaid losses and LAE for each of the coverages, and they use their experience and judgment to arrive at an overall actuarial point estimate of the unpaid losses and LAE for that coverage. Meetings are held with appropriate departments to discuss significant issues as a result of the review. This process culminates in a reserve meeting to review the unpaid losses and LAE. Other relevant internal and external factors considered include a qualitative assessment of inflation and other economic conditions, changes in the legal, regulatory, judicial and social environments, underlying policy pricing, exposure and policy forms, claims handling, and geographic distribution shifts. As a result of the meeting, unpaid losses and LAE are finalized and we record quarterly changes in unpaid losses and LAE for each of our coverages. The change in unpaid losses and LAE for the quarter for each coverage is the difference between net ultimate losses and LAE and the net paid losses and LAE recorded through the end of the quarter. The overall change in our unpaid losses and LAE is based on the sum of these coverage level changes.
Judgment is required in analyzing the appropriateness of the various methods and factors to avoid overreacting to data anomalies that may distort such prior trends. For example, changes in limits distributions or development in the most recent accident quarters would require more actuarial judgment. We do not believe disclosure of specific point estimates calculated by the actuaries would be meaningful. Any one actuarial point estimate is based on a particular series of judgments and assumptions of the actuary. Another actuary may make different assumptions, and therefore reach a different point estimate.
As a result of the significant growth in the non-Los Angeles County regions, the Company has experienced changes in the mix of business relative to geography and policy limits. We believe that the assumption with the highest likelihood of change that could materially affect carried unpaid losses and LAE is property damage and collision severity in the San Francisco and Bay Area regions, which have significantly different repair costs and have exhibited significant policy growth. A 5% change in the severity assumption for these regions would result in an increase or decrease in total unpaid losses and LAE of 0.14%, or $1.8 million.
Net realized gains on the sale of investments1 were $10.8 million in 2004 (gross realized gains were $14.1 million and gross realized losses were $3.3 million), compared to net realized gains of $13.2 million in 2003 (gross realized gains were $13.7 million and gross realized losses were $0.5 million), and net realized gains of $10.4 million in 2002 (gross realized gains were $13.1 million and gross realized losses were $2.7 million). At December 31, 2004, $308.0 million (22.3%) of our total fixed maturity investments at fair value were invested in tax-exempt bonds, compared to 64.9% at December 31, 2003 and 60.7% at December 31, 2002, with the remainder, representing 77.7% of the portfolio, invested in taxable securities, compared to 35.1% at December 31, 2003 and 39.3% at December 31, 2002. The shift to taxable securities in 2004 was made to reduce the average duration of the portfolio and to accelerate the realization of the Company's NOL carryforward.
We recognized no other-than-temporary impairments in 2004, 2003, or 2002 (see discussion under Critical Accounting Estimates).
Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within those statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Our significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements and are essential to understanding Management's Discussion and Analysis of Financial Condition and Results of Operations. Some of our accounting policies require significant judgment to estimate values of either assets or liabilities. In addition, significant judgment may be needed to apply what often are complex accounting principles to individual transactions to determine the most appropriate treatment. We have established procedures and processes to facilitate making the judgments necessary to prepare the financial statements.
Losses and Loss Adjustment Expenses. The estimated liabilities for losses and loss adjustment expenses ("LAE") include the accumulation of estimates of losses for claims reported on or prior to the balance sheet dates, estimates (based upon actuarial analysis of historical data) of losses for claims incurred but not reported, the development of case reserves to ultimate values and estimates of expenses for investigating, adjusting and settling all incurred claims. Amounts reported are estimates of the ultimate costs of settlement, net of estimated salvage and subrogation. The estimated liabilities are necessarily subject to the outcome of future events, such as changes in medical and repair costs, as well as economic and social conditions that impact the settlement of claims. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than relatively longer-tail liability claims. For our current mix of auto exposures, which include both property and liability exposures, an average of approximately 80% of the ultimate losses are settled within twelve months of the date of loss. Given the inherent variability in the estimates, management believes the aggregate reserves are adequate, although we continue to caution that the reserve estimates relating to SB 1899 are subject to a greater than normal degree of variability and possible future material adjustment as new facts become known. The methods of making such estimates and establishing the resulting reserves are reviewed and updated monthly and any resulting adjustments are reflected in current operations. Changes in these recorded liabilities flow directly to the income statement on a dollar-for-dollar basis. For example, an upward revision of $1 million in the estimated recorded liability for unpaid losses and LAE would decrease underwriting profit, and pre-tax income, by the same $1 million amount. Conversely, a downward revision of $1 million would increase pre-tax income by the same $1 million amount.
Property and Equipment. Accounting standards require a write-off to be recognized when an asset is abandoned or an asset group's carrying value exceeds its fair value. For purposes of recognition and measurement of an impairment loss, a long-lived asset or assets are grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. Accounting standards require asset groups to be tested for possible impairment under certain conditions. In the third quarter of 2002, we recorded a pre-tax charge to write off $37.2 million of previously capitalized software costs for abandoned portions of an advanced personal lines processing system. As such, in 2002, we assessed the asset group that included the advanced personal lines processing system for impairment. However, an impairment was not triggered by the abandonment as we determined that the impairment recognition criterion had not been met. Future cash flows expected to be generated by the asset group exceeded its carrying amount. There have been no events or circumstances in 2004 that would require a reassessment of the asset group for impairment.
Income Taxes. Determining the consolidated provision for income tax expense, deferred tax assets and liabilities and any related valuation allowance involves judgment. Generally accepted accounting principles require deferred tax assets and liabilities ("DTAs" and "DTLs," respectively) to be recognized for the estimated future tax effects attributed to temporary differences and carryforwards based on provisions of the enacted tax law. The effects of future changes in tax laws or rates are not anticipated. Temporary differences are differences between the tax basis of an asset or liability and its reported amount in the financial statements. For example, we have a DTA because the tax bases of our loss and LAE reserves are smaller than their book bases. Similarly, we have a DTL because the book basis of our capitalized software exceeds its tax basis. Carryforwards include such items as alternative minimum tax credits, which may be carried forward indefinitely, and net operating losses ("NOLs"), which can be carried forward 15 years for losses incurred before 1998 and 20 years thereafter. A summary of the significant DTAs and DTLs relating to the Company's temporary differences and carryforwards is included in Note 5 of the Notes to Consolidated Financial Statements.
At December 31, 2004, our DTAs total $136.7 million, and our DTLs total $80.6 million. The net of those amounts, $56.1 million, represents the net deferred tax asset reported in the consolidated balance sheet.
Portions of our NOL carryforward are scheduled to expire beginning in 2017, as shown in the table below (amounts in millions):
“SRLY” stands for Separate Return Limitation Year. Under the Federal tax code, only future income generated by 21st of Southwest (formerly 21st of Arizona) may be utilized against this portion of our NOL.
Deferred Policy Acquisition Costs. Deferred policy acquisition costs ("DPAC") include premium taxes and other variable costs incurred with writing business. These costs are deferred and amortized over the 6-month policy period in which the related premiums are earned.
Investments. Temporary unrealized investment gains and losses, net of applicable tax effects, are included as an element of accumulated other comprehensive income (loss), which is classified as a separate component of stockholders' equity. For investments with unrealized losses due to market conditions or industry-related events, where the Company has the positive intent and ability to hold the investment for a period of time sufficient to allow a market recovery or to maturity, declines in value below cost are not assumed to be other-than-temporary.
Where declines in values of securities below cost or amortized cost are considered to be other-than-temporary, a charge is required to be reflected in income for the difference between cost or amortized cost and the fair value. The determination of whether a decline in market value is "other-than-temporary" is necessarily a matter of subjective judgment. No such charges were recorded in 2004, 2003 or 2002. The timing and amount of realized losses and gains reported in income could vary if conclusions other than those made by management were to determine whether an other-than-temporary impairment exists. However, there would be no impact on equity because any unrealized losses are already included in accumulated other comprehensive income.
Impact Community Capital LLC, is a limited partnership that was established under California’s COIN program (California Organized Investment Network), a voluntary association of California insurers providing funding for low cost housing projects.
The total net unrealized gain (loss) for these securities as of December 31, 2004 and 2003 was $0.4 million and $0, respectively.
The following table summarizes the fair values of investments sold at a loss or at a gain on the date of sale:
Unrealized losses represent less than 0.5% of the total carrying value of investments.
Stock-based compensation. Under the provisions of Statement of Financial Accounting Standard ("SFAS") No. 123, Accounting for Stock-Based Compensation, we have elected to continue using the intrinsic-value method of accounting for stock-based awards granted to employees in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. Accordingly, we have not recognized in income any compensation expense for the fair value of stock options awarded to employees. Companies electing to continue to follow the intrinsic-value method must make pro forma disclosures, as if the fair value based method of accounting had been applied. A summary of the expense that would have been recorded, together with the underlying assumptions, had we recognized for the fair value of stock-based awards, is included in Notes 2 and 14 of the Notes to Consolidated Financial Statements.
In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulleting No. 51, and amended it in December 2003 ("FIN 46R"). An entity is subject to the consolidation rules of FIN 46R and is referred to as a variable interest entity ("VIE") if it lacks sufficient equity to finance its activities without additional financial support from other parties or if its equity holders lack adequate decision making ability based on criteria set forth in the interpretation. FIN 46R requires an investor with a majority of the variable interests in a VIE to consolidate the entity.
Although we believe that the expectations reflected in these forward-looking statements are reasonable, we cannot guarantee our future results, level of activity, performance or achievements. Forward-looking statements include, among other things, discussions concerning our potential expectations, beliefs, estimates, forecasts, projections and assumptions. Forward-looking statements may address, among other things:
Adverse underwriting and claims experience, including as a result of revived earthquake claims under SB 1899;
Results of legislative, regulatory or legal actions, including the inability to obtain approval for rate increases and product changes and adverse actions taken by state regulators in market conduct examinations; and
Our ability to service the senior notes, including our ability to receive dividends and/or sufficient payments from our subsidiaries to service our obligations.
We have completed an integrated audit of 21st Century Insurance Group's 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004, and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
On October 16, 2003, the board of directors voted to change 21st Century Insurance Group's state of incorporation from California to Delaware. There was no change in the location of Company operations, location of employees, or the way the Company does business. Shareholders holding a majority of the voting power approved the reincorporation by written consent on October 17, 2003. The reincorporation became effective December 4, 2003.
21st Century Insurance Company of Arizona ("21st of Arizona") changed its name to 21st Century Insurance Company of the Southwest on September 30, 2004, and re-domesticated from Arizona to Texas on December 31, 2004. 21st of Arizona was a joint venture between the Company and AIG from 1995 to 2001. On January 1, 2002, the Company acquired AIG's 51% interest in 21st of Arizona for $4.4 million.
Since 1995, the Company has entered into several transactions with AIG subsidiaries, including various reinsurance agreements, which are discussed in Note 10 of the Notes to Consolidated Financial Statements. At December 31, 2004, reinsurance recoverables, net of payables, from AIG subsidiaries were $1.4 million, compared to $5.8 million at December 31, 2003. Other transactions with AIG subsidiaries have resulted from competitive bidding processes for certain corporate insurance coverages and certain software and data processing services. In October 2003, as a result of a competitive bidding process, the Company entered into an agreement with an AIG subsidiary whereby AIG provides the Company with investment management services; the agreement was approved by the California Department of Insurance.
Management assesses the recoverability of deferred policy acquisition costs on a quarterly basis. The assessment calculates the relationship of actuarially estimated costs incurred to premiums from contracts issued or renewed for the period. We do not consider anticipated investment income in determining the recoverability of these costs. Based on current indications, no reduction in DPAC is required. The loss and loss adjustment expense ratio used in the recoverability estimate is the expected ultimate ratio provided by our actuaries. While management believes that is a reasonable assumption, actual results could differ materially from such estimate.
Leased property under capital lease is recorded as a capital asset and amortized on a straight-line basis over the estimated useful lives of the property, which range from 3 to 10 years. The related lease obligation is included in debt on the balance sheet.
The business name has an indefinite useful life, and in accordance with SFAS No. 142 will not be amortized until its useful life is determined to no longer be indefinite. Under SFAS No. 142, an intangible asset is to be carried at fair value and has to be tested for impairment on an annual basis. The impairment test as of December 31, 2004 indicated that the asset was not impaired.
The estimated liabilities for losses and loss adjustment expenses ("LAE") include the accumulation of estimates of losses for claims reported prior to the balance sheet dates, estimates (based upon actuarial analysis of historical data) of losses for claims incurred but not reported, the development of case reserves to ultimate values, and estimates of expenses for investigating, adjusting and settling all incurred claims. Amounts reported are estimates of the ultimate costs of settlement, net of estimated salvage and subrogation. These estimated liabilities are necessarily subject to the outcome of future events, such as changes in medical and repair costs as well as economic and social conditions that impact the settlement of claims. Management believes that the aggregate reserves are adequate and represent our best estimate based on the information currently available. The methods of making such estimates and for establishing the resulting reserves are reviewed and updated as applicable, and any adjustments resulting therefrom are reflected in current operations.
Reinsurance receivables and recoverables include balances due from other insurance companies for paid losses and LAE as well as ceded unpaid losses and LAE under the terms of reinsurance agreements. Amounts applicable to ceded unearned premiums are reported as prepaid reinsurance premiums in the accompanying balance sheets. The Company believes the fair value of its reinsurance recoverables approximates their carrying amounts.
Had compensation cost for the Company's stock-based compensation plans been determined based on the estimated fair value at the grant dates of stock-based compensation, net income and earnings per share would have been reduced to the pro forma amounts indicated below:
In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulleting No. 51, and amended it in December 2003 ("FIN 46R). An entity is subject to the consolidation rules of FIN 46R and is referred to as a variable interest entity ("VIE") if it lacks sufficient equity to finance its activities without additional financial support from other parties or if its equity holders lack adequate decision making ability based on criteria set forth in the interpretation. FIN 46R requires an investor with a majority of the variable interests in a VIE to consolidate the entity.
Impact C.I.L. is a subsidiary of Impact Community Capital, LLC ("Impact"), whose charter is to provide real estate loans in economically disadvantaged areas. At present, the Company has a $2.0 million note receivable from Impact in addition to the $5.1 million investment noted above. If the mortgages purchased with these funds are not securitized, the note receivable will be liquidated in 10 years from the initial date of the agreement. The Company has voting rights and ownership of Impact in proportion to its investment (approximately 10%).
For each of the three years ended December 31, 2004, 2003, and 2002, the numerator for the calculation of both basic and diluted EPS is equal to net income (loss) reported for that year. The difference between basic and diluted EPS denominators is due to dilutive stock options. The denominator for the computation of basic EPS was 85,466,127 shares, 85,432,838 shares, and 85,414,076 shares for 2004, 2003 and 2002, respectively. The denominator for diluted EPS was 85,602,567 shares, 85,637,672 shares, and 85,414,076 shares for 2004, 2003 and 2002, respectively.
Options to purchase an aggregate of 6,156,772 shares, 5,121,446 shares, and 5,010,411 shares of common stock were considered anti-dilutive during 2004, 2003 and 2002, respectively, and were not included in the computation of diluted EPS because the options' exercise prices were greater than the average market price of the common stock for each respective period. These options expire at various points in time through December 2014 (see Note 14 of the Notes to Consolidated Financial Statements).
The following table summarizes the Company's gross unrealized losses and estimated fair values on investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position.
The Company held 179 investment positions with unrealized losses as of December 31, 2004. Of the 179 investment positions, 64 positions were in equity securities, which have been held for less than one year, as the Company typically holds equity securities for 90 days or less. The remaining 115 investment positions were fixed maturity securities and are all investment grade; none of the unrealized losses are considered credit related and given the length of time in an unrealized loss position do not appear to represent other-than-temporary impairment. Of the 115 fixed maturity securities in an unrealized loss position, the Company had 8 investments that were in an unrealized loss position for 12 months or more, however, the unrealized loss for such investments, which are all investment grade, comprised less than 5% of amortized cost.
Cash and securities with carrying values of $7.1 million and $6.7 million as of December 31, 2004 and 2003 were on deposit with state regulatory authorities in accordance with the related statutory insurance requirements.
Income tax payments for the year ended December 31, 2004 totaled $16.4 million. No income tax payments were required in the years ended December 31, 2003 and 2002. During 2004, we received $12.5 million from the IRS to settle the majority of the prior year receivable. As of December 31, 2004, the Company's federal income tax refund receivable was $2.8 million.
Our core business has generated an underwriting profit for the past three years. Management believes it is reasonable to expect future underwriting profits and to conclude it is at least more likely than not that we will be able to realize the benefits of our DTAs. If necessary, we believe we could implement tax-planning strategies to generate sufficient future taxable income to utilize the NOL carryforwards prior to their expiration. Accordingly, no valuation allowance has been recognized as of December 31, 2004. However, generating future taxable income is dependent on a number of factors, including regulatory and competitive influences that may be beyond our ability to control. Future underwriting losses could possibly jeopardize our ability to utilize our NOLs. If so, management might be required to reach a different conclusion about the realization of the DTAs and recognize a valuation allowance at that time.
Following is a summary of policy acquisition costs deferred for amortization against future income and the related amortization charged to income from operations (policy acquisition costs are amortized over the 6-month policy period):
Depreciation expense on software currently in service was $7.0 million, $4.2 million, and $9.6 million in 2004, 2003 and 2002, respectively. In the third quarter of 2002, we recorded a pre-tax charge to write off $37.2 million of previously capitalized software costs for abandoned portions of an advanced personal lines processing system. Substantially all software development projects in progress, which primarily relate to the advanced personal lines processing system, are expected to be implemented during 2005.
The methods used to determine such estimates and to establish the resulting reserves are continually reviewed and updated. Any adjustments resulting therefrom are reflected in current operating income. It is management's belief that the unpaid losses and LAE are adequate to cover unpaid losses and LAE as of December 31, 2004. While the Company performs quarterly reviews of the adequacy of established unpaid losses and LAE, there can be no assurance that ultimate amounts will not differ materially, higher or lower, from the recorded liability for unpaid losses and LAE as of December 31, 2004. In the future, if the unpaid losses and LAE develop redundancies or deficiencies, such redundancy or deficiency would have a positive or adverse impact, respectively, on future results of operations.
The Company no longer has any California homeowners policies in force. The Company ceased writing earthquake coverage in 1994, but has remaining loss reserves from the 1994 Northridge Earthquake that are subject to adverse development.
The $69.5 million increase in the gross auto reserves for the year ended December 31, 2004, is comprised of growth in reserves attributable to the higher number of insured automobiles of approximately $36.8 million, the effects of higher average loss costs of approximately $35.6 million and the favorable development in prior accident year reserves of approximately $2.9 million.
The primary purpose of both of the borrowings enumerated above was to increase the statutory surplus of the Company's largest insurance subsidiary.
In December 2003, the Company completed a private offering of $100 million principal amount of 5.9 percent Senior Notes due in December 2013 at a discount of $0.8 million. The effective interest rate on the Senior Notes, when all offering costs are taken into account and amortized over the term of the Senior Notes, is approximately 6 percent per annum. Of the $99.2 million in net proceeds from the Senior Notes, $85.0 million was used to increase the statutory surplus of 21st Century Insurance Company, a wholly-owned subsidiary of the Company, and the balance was retained by the holding company.
The Senior Notes are redeemable at the Company's option, at any time in whole, or from time to time in part, prior to maturity at a redemption price equal to the greater of (A) 100% of the principal amount of the notes or (B) the sum of the present values of the remaining scheduled payments of principal and interest thereon (exclusive of interest accrued through the date of redemption) discounted to the redemption date on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months) at the Treasury Rate, plus 25 basis points (plus in each case, accrued interest thereon to the date of redemption).
Effective September 1, 2002, the Company entered into an agreement to cancel future cessions under its quota share reinsurance treaty with AIG subsidiaries resulting in a pre-tax charge of $0.9 million. The treaty would have ceded 4% of premiums and losses and LAE to AIG subsidiaries in the remainder of 2002 and 2% in 2003.
The Company has a catastrophe reinsurance agreement for its auto lines with Endurance Specialty Insurance Ltd. (20%) and AIG subsidiaries Transatlantic Reinsurance Company (20%) and National Union Insurance Company of Pittsburg, PA (60%), which reinsures any covered events up to $45.0 million in excess of $20.0 million effective January 1, 2004. In 2003 and 2002, covered events were up to $30.0 million in excess of $15.0 million and the reinsurers were Folksamerica Reinsurance Company (6.7%), Endurance Specialty Insurance Ltd. (16.7%), Transatlantic Reinsurance Company (16.7%) and National Union Insurance Company of Pittsburg, PA (60%).
Effective January 1, 2004, the 90% quota share reinsurance treaty covering the Company's Personal Umbrella Policies ("PUP") was amended so that the reinsurers are as follows: Swiss RE Underwriters - 55%, Hannover Ruckversicherungs - 35%.
1 The Company’s homeowner policies did not include any earthquake coverage.
Information for the unfunded supplemental executive retirement plan, which has an accumulated benefit obligation in excess of plan assets, is as follows:
The (decrease) increase in minimum liability included in accumulated other comprehensive income, net of deferred income taxes, for the years ended December 31, 2004 and 2003 was $(0.2) and $0.5 million, respectively.
December 31 is the measurement date for the plans. The discount rate can vary from year to year and is determined by developing a hypothetical bond portfolio matched to our projected benefit costs.
The Company's pension plan weighted-average asset allocations for 2004 and 2003, and target allocation for 2005, by asset category are as follows:
The Company's pension plan assets are managed by outside investment managers. The Company's investment strategy is to maximize return on investments while minimizing risk. The Company believes the best way to accomplish this goal is to take a conservative approach to its investment strategy by investing in high-grade equity and debt securities.
During 2004, the Company contributed $2.7 million to its pension plans. Based on current assumptions, the Company does not expect to be required to contribute to its qualified plan in 2005. However, the amount and timing of future contributions to our qualified defined benefit pension plan depends on a number of unpredictable factors including statutory funding requirements, the market performance of the plan's assets, cash requirements for benefit payments to retirees, and future changes in interest rates that affect the actuarial measurement of the plan's obligations. Contributions to our non-qualified defined benefit pension plan generally are limited to amounts needed to make benefit payments to retirees, which are expected to total approximately $1.1 million in 2005.
The Company sponsors a contributory savings and security plan for eligible employees and officers. The Company provides matching contributions equal to 75% of the lesser of 6% of an employee's compensation or the amount contributed by the employee up to the maximum allowable under IRS regulations. Company matching contributions charged against operations were $4.9 million, $4.4 million, and $4.2 million in 2004, 2003 and 2002, respectively. The plan offers a variety of investment types among which employees exercise complete discretion as to choice and investment duration, including any amounts the employee elects to invest in Company common stock.
Total rental expense charged to operations for the years ended December 31, 2004, 2003 and 2002 was $24.4 million, $17.5 million, and $16.4 million, respectively.
The Company owns an 11.11% interest in Impact, an entity whose purpose is to provide real estate loans in economically disadvantaged areas. Through one of Impact's subsidiaries, Impact C.I.L., the Company has a commitment to fund up to an additional $24.0 million in loans over the next ten years.
Cecelia Encarnacion, individually and as the Guardian Ad Litem for Nubia Cecelia Gonzalez, a Minor, Hilda Cecelia Gonzalez, a Minor, and Ramon Aguilera v. 20th Century Insurance was filed on July 3, 1997, in Los Angeles Superior Court. Plaintiffs allege bad faith, emotional distress, and estoppel involving the Company's (the Company was formerly named 20th Century Insurance) handling of a 1994 homeowner's claim. On March 1, 1994, Ramon Aguilera shot and killed Mr. Gonzalez (the minor children's father) and was later sued by Ms. Encarnacion for wrongful death. On August 30, 1996, judgment was entered against Ramon Aguilera for $5.6 million. The Company paid for Aguilera's defense costs through the civil trial; however, the homeowner's policy did not provide indemnity coverage for the shooting incident, and the Company refused to pay the judgment. After the trial, Aguilera assigned a portion of his action against the Company to Encarnacion and the minor children. Aguilera and the Encarnacion family then sued the Company alleging that the Company had promised to pay its bodily injury policy limit if Aguilera pled guilty to involuntary manslaughter. In August 2003, the trial court held a bench trial on the limited issues of promissory and equitable estoppel, and policy forfeiture. On September 26, 2003, the trial court issued a ruling that the Company cannot invoke any policy exclusions as a defense to coverage. On May 14, 2004, the court granted the Encarnacion plaintiffs' motion for summary adjudication, ordering that the Company must pay the full amount of the underlying judgment of $5.6 million, plus interest, for a total of $10.5 million. The Company disagrees with this ruling as it appears inconsistent with the court's simultaneous ruling denying the Company's motion for summary judgment on grounds that there are triable issues of material fact as to whether plaintiffs are precluded from recovering damages as a consequence of Aguilera's inequitable conduct. The Company also believes that the court's decision was not supported by the evidence in the case demonstrating that no promise to settle was ever made. The Company has appealed the judgment as to the Encarnacions. The trial as to Aguilera is set for May 2005 on his claims for bad faith, emotional distress, punitive damages and attorney fees. The Company believes it has meritorious defenses to these additional claims, but expects plaintiff's attorney fee claim alone to approach $4.0 million.
Bryan Speck, individually, and on behalf of others similarly situated v. 21st Century Insurance Company, 21st Century Casualty Company, and 21st Century Insurance Group, was filed on June 20, 2002, in Los Angeles Superior Court. Plaintiff seeks California class action certification, injunctive relief, and unspecified actual and punitive damages. The complaint contends that 21st Century uses "biased" software in determining the value of total-loss automobiles. Plaintiff alleges that database providers use improper methodology to establish comparable auto values and populate their databases with biased figures and that the Company and other carriers allegedly subscribe to the programs to unfairly reduce claims costs. This case is consolidated with similar actions against other insurers for discovery and pre-trial motions. The Company intends to vigorously defend the suit with other defendants in the coordinated proceedings. This matter is in the discovery stage of litigation and no reasonable estimate of potential losses in the event of a negative outcome can be made at this time.
Shares of common stock issued pursuant to the exercise of employee stock options and restricted stock grants were 53,556 in 2004, 4,000 in 2003, and 69,657 in 2002. No shares were repurchased in 2004 or 2003.
The stockholders approved the 2004 Stock Option Plan (the "2004 Plan") at the Annual Meeting of Shareholders on May 26, 2004. The 2004 Plan supersedes the 1995 Stock Option Plan, which will remain in effect only as to outstanding awards under it. The 2004 Plan authorizes a Committee of the Board of Directors to grant stock options in respect of 4,000,000 shares to eligible employees and nonemployee directors, subject to the terms of the 2004 Plan. Additionally, under the 2004 Plan, the Committee may grant stock options in respect of shares that were subject to outstanding awards under the 1995 Stock Option Plan to the extent such awards expire, are terminated, are cancelled, or are forfeited for any reason without shares being issued.
A summary of securities issuable and issued for the Company's stock option plans and the Restricted Shares Plan at December 31, 2004, follows:
Certain assets are included in the GAAP consolidated balance sheets, but are charged directly against statutory surplus under SAP. These assets consist primarily of premium receivables that are outstanding over 90 days, federal deferred tax assets in excess of statutory limitations, furniture, equipment, application computer software, leasehold improvements and prepaid expenses.
Amounts related to ceded reinsurance, such as prepaid reinsurance premiums and reinsurance recoverables, are shown gross, rather than netted against unearned premium reserves and loss and loss adjustment expense reserves, respectively, as required by SAP.
On October 10, 2002, a Los Angeles Superior Court granted the Company's motion for summary judgment in the matter of 21st Century Insurance Company vs. People of the State of California ex rel.Bill Lockyer, Attorney General et al. The court determined that the Company's April 21, 1999, settlement with the California Department of Insurance ("CDI") with respect to regulatory actions arising out of the 1994 Northridge Earthquake was fully valid and enforceable. The Court denied the Attorney General's motion seeking to have the settlement declared void and unenforceable, a result that may have allowed the CDI to reinstitute regulatory proceedings with respect to the Company's handling of claims arising out of the 1994 Northridge Earthquake. The CDI appealed the ruling. On October 28, 2004, the California Court of Appeal unanimously upheld the decision of the Superior Court. The CDI did not seek review by the California Supreme Court and this matter has now been finally resolved in favor of the Company.
Third quarter 2004 results were increased by $4.9 million due to the effect of recent California legislation relating to holding company taxes on dividends from insurance subsidiaries (see additional discussion in Note 5 of the Notes to Consolidated Financial Statements). First quarter 2003 results were impacted by adverse development related to SB 1899 reserves of $37.0 million (pre-tax). Second quarter 2003 results include nonrecurring, nonoperational income of $9.3 million (pre-tax) resulting from the settlement of litigation and interest income of $4.8 million relating to a favorable settlement with the Internal Revenue Service.
The Company's "Personal Auto Lines" reportable segment primarily markets and underwrites personal automobile, motorcycle and umbrella insurance. The Company's "Homeowner and Earthquake Lines in Runoff" reportable segment, which is in runoff, manages the wind-down of the Company's homeowner and earthquake programs. The Company has not written any earthquake coverage since 1994 and ceased writing homeowner policies in February 2002.
1 Basic and diluted amounts are the same for all periods presented.
Insurers offering homeowner insurance in California are required to participate in the California FAIR Plan ("FAIR Plan"). FAIR Plan is a state administered pool of difficult to insure homeowners. Each participating insurer is allocated a percentage of the total premiums written and losses and LAE incurred by the pool according to its share of total homeowner direct premiums written in the state. Participation in the current year FAIR Plan operations is based on the pool from two years prior. Since the Company ceased writing homeowners business in 2002, the Company will continue to receive assignments in the 2005 calendar year.
The following table presents net premiums earned, depreciation and amortization expense, and segment profit (loss) for the Company's segments for the years ended December 31.
Personal Auto Lines. The growth in segment profit for the personal auto lines in 2004, 2003, and 2002 was due to an increase in the number of insured vehicles, rate increases and favorable claim frequency.