Net earned premiums..................... $173,215 $125,555 $ 82,955 $134,274 $129,197 Net investment income and net realized gains............... 15,867 14,454 15,395 20,229 17,361 ------- ------- ------- ------- -------
Federal income tax expense (benefit).... 1,447 (3,669) 3,602 4,166 272 ------- ------- ------- ------- -------
Extraordinary gain from debt extinguishment, net of tax.......... 362 654 111 48 2 ------- ------- ------- ------- -------
Statutory Combined Ratio: Loss and LAE ratio.................. 82.74% 91.65% 78.73% 71.03% 72.24% Underwriting expense ratio.......... 24.18 28.30 32.48 28.92 29.56 Policyholders dividends............. 1.39 .34 ------ ------ ------ ----- ------ Combined ratio...................... 108.31% 120.29% 111.21% 99.95% 101.80% ====== ====== ====== ===== ======
The following discussion and analysis provides information which management believes is relevant for an assessment and understanding of our consolidated financial condition and results of operations. The discussion should be read in conjunction with the Consolidated Financial Statements and related Notes thereto. The information contained below may be subject to risk factors. We urge you to review carefully the section "Risk Factors" in this 2001 Form 10-K for a more complete discussion of the risks associated with an investment in our securities. See "Note on Forward-Looking Statements and Risk Factors" under Item 1.
Reinsurance recoverable primarily represents the estimated amount of unpaid loss and LAE reserves that would be recovered from our reinsurers and, to a lesser extent, amounts billed to the reinsurers for their portion of paid losses and LAE claims. Reinsurance receivable for ceded paid claims is recorded in accordance with the terms of the agreements and reinsurance recoverable for unpaid losses and LAE is estimated in a manner consistent with the claim liability associated with the reinsurance policy. Any significant changes in the underlying claim liability could directly affect the amount of reinsurance recoverable. Reinsurance recoverable, including amounts related to paid and unpaid losses, are reported as assets rather than a reduction of the related liabilities. Reinsurance contracts do not relieve us from our obligations to injured workers or policyholders. If our reinsurers were to fail to honor their obligations because of insolvency or disputed contract provisions, we could incur significant losses. We evaluate the financial condition of our reinsurers to minimize our exposure to significant losses from reinsurer insolvencies.
Deferred income tax assets and liabilities result from temporary differences between the tax basis of assets and liabilities and the reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. Our temporary differences arise principally from certain net operating losses, accrued expenses, reserves that are discounted for tax return purposes and depreciation. We regularly review our deferred tax assets for recoverability based on historical taxable income, projected future taxable income and the expected timing of the reversals of the existing temporary differences. We have established a valuation allowance to reflect our inability to fully use tax benefits from certain prior operating losses currently or in the near future.
Results of Operations for the Year Ended December 31, 2001 Compared to the Year Ended December 31, 2000
Our income before taxes and extraordinary gains increased by $15.1 million for the year ended 2001 compared to 2000. The major components of the change were:
o $1.4 million increase in investment income, including net realized gains;
Our revenue is comprised of net earned premiums, net investment income and net realized gains/losses. Total revenue increased by 35% for the year ended December 31, 2001 compared to 2000. The increase was largely due to a reduction in the amounts ceded to our reinsurers offset by a decrease in written premiums. The components driving the decrease in written premiums included a 29% decrease in production growth partially offset by a 31% composite increase in premium rates for all states.
As compared to the low level reinsurance agreement that expired on June 30, 2000, the new reinsurance agreements will result in higher net earned premium revenues, as we retain more of the premium dollars, but also will lead to our keeping more of the incurred losses. This resulted in a higher loss and loss adjustment expense, or LAE, ratio as the percentage increase in the additional incurred losses was greater than the percentage increase in the additional premiums retained. The effect on the balance sheet of the new reinsurance agreements compared to the low level reinsurance agreements has resulted in a lower amount of reinsurance recoverables, and due to the length of time that it typically takes to fully pay a claim, we have already seen an increase in our operating cash flow and amounts available to be invested.
The following table shows a comparison of direct written premiums, by state, for the years ended December 31, 2001 and 2000:
As shown in the preceding table, our largest premium state, California, had the largest decrease in written premiums. The decrease was primarily due to a 28% decline in the number of inforce policies during 2001. The drop in our item count was offset by average premium rate increases on California renewing policies of approximately 38% for the year ended December 31, 2001. The market-pricing environment in California has become more favorable since 1999 in reaction to industry-wide losses in the workers' compensation line, increased reinsurance costs and from competitors exiting the market and firming their pricing. Countering the decline in California, Nevada, Colorado and Texas written premiums increased by 20%, 5%, and 23%, respectively.
The $401,000 or 3% increase, in net investment income for the year ended December 31, 2001, compared to the prior period, is a direct result of our positive cash flow offset by a decrease in our average investment yield.
We had net realized gains of $392,000 for the year ended December 31, 2001 compared to net realized losses of $620,000 in 2000. We have tried to manage our investment portfolio to minimize unplanned sales of our available-for-sale investments.
The $30.7 million increase in net losses and LAE is attributable to the following:
o In 2001, we recorded $8.7 million of net adverse loss development for prior accident years compared to net adverse loss development of $23.3 million recorded in 2000. The net adverse development recorded was largely attributable to higher costs per claim, or claim severity, in California. Higher claim severity has had a negative impact on the entire California workers' compensation industry. See our discussion above in Item 1, "Business - Losses and Loss Adjustment Expenses."
o We are establishing a higher loss and LAE ratio for the 2001 accident year, which has resulted in an increase of approximately $12.4 million. The majority of the increase is due to the termination of the low level reinsurance agreement on June 30, 2000, which results in a higher risk exposure on policies effective after that date and a higher amount of net incurred loss and LAE.
Under our low level reinsurance agreement, we reinsured 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this agreement was $17,000. This agreement covered all policies inforce at July 1, 1998 and continued until June 30, 2000 when we executed an option to extend coverage to all policies inforce as of June 30, 2000. For policies effective from July 1, 2000, we obtained excess of loss reinsurance for 100% of the losses above $250,000 and less than $500,000. This agreement terminated after one year on a cut-off basis and covered claims with dates of injury to June 30, 2001. We already had an existing excess of loss reinsurance agreement that covered 100% of the losses above $500,000. The latter reinsurance agreement is a fixed rate multi-year contract that will expire December 31, 2002. We intend to exercise an option to extend coverage for claims occurring on policies inforce at December 31, 2002.
As a percentage of net earned premiums, the loss and LAE ratio for the year ended December 31, 2001 was 81.2% compared to 87.5% for 2000. The 2001 calendar year net loss ratio was impacted by the $8.7 million net adverse development, which represents 5.0 percentage points of the loss ratio, compared to $23.3 million of net adverse development recorded during 2000, which represents 18.6 percentage points of the loss ratio. In addition, the expiration of the low level reinsurance agreement is resulting in a higher loss and LAE ratio on policies effective after June 30, 2000 as we are keeping more of the losses.
In 2001, we recorded a valuation allowance benefit of $0.4 million compared to a valuation allowance provision of $1.1 million in 2000. Under the tax sharing agreement with Sierra, valuation allowances have been established for the net deferred tax assets of CII Financial as they can only utilize these benefits to the extent they generate or realize separate return income. We believe that it is more likely than not that CII Financial will have insufficient income to fully utilize these benefits. During 2001, as a result of the gain from the debenture exchange described under "Debentures" below, CII Financial was able to realize a portion of the previously valued deferred tax assets, resulting in the valuation allowance benefit described above.
Results of Operations for the Year Ended December 31, 2000 Compared to the Year Ended December 31, 1999
As compared to the low level reinsurance agreement that expired on June 30, 2000, the new lower cost reinsurance agreements will result in higher net earned premium revenues, as we will be retaining more of the premium dollars, but also lead to our keeping more of the incurred losses. This may result in a higher loss and LAE ratio if the percentage increase in the additional incurred losses should be greater than the percentage increase in the additional premiums we retained. The effect on the balance sheet will result in a lower amount of reinsurance recoverables. However, due to the length of time that it typically takes to fully pay a claim, we should see an increase in cash flow and amounts available to be invested.
The following table shows a comparison of direct written premiums, by state, for the years ended December 31, 2000 and 1999:
Premiums inforce are an indicator of future written premium trends. Inforce premiums are the total estimated annual premiums of all policies inforce at a point in time. Total inforce premiums increased by 15% to $178.7 million at December 31, 2000 compared to the prior year. Total inforce premiums have dropped by 6% from its highest point in the last twelve months which was in August 2000. This indicates a potential slowing trend in premiums written, especially in California, due largely to business lost because of the higher premium rate increases we have been trying to obtain. The number of inforce policies at December 31, 2000 has also dropped by 6.6% from its highest point in the last twelve months, which was also August 2000.
Effective July 1, 1998, we entered into what we refer to as a "low level" reinsurance agreement. See Losses and Loss Adjustment Expenses below for further details on this agreement. The favorable terms of the low level reinsurance agreement provided us with an improved loss ratio as we reinsured a significant amount of losses to the reinsurer. However, the ceded premiums we paid the reinsurer reduced the cash available for investment and temporarily created negative cash flow for us. The $702,000 or 4% reduction in net investment income for the year ended December 31, 2000, compared to the prior period, is due to a reduction in investments primarily because of higher ceded premiums paid to reinsurers in 2000.
Under our low level reinsurance agreement, we reinsure 30% of the first $10,000 of each claim, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this agreement is $17,000. This agreement covered all policies inforce at July 1, 1998 and continued until June 30, 2000 when we executed an option to extend coverage to all policies inforce as of June 30, 2000. For policies effective from July 1, 2000, we obtained excess of loss reinsurance for 100% of the losses above $250,000 and less than $500,000. We already had an existing excess of loss reinsurance agreement that covered 100% of the losses above $500,000.
Included in general, administrative and other expenses are other underwriting expenses of $12.0 million for the year ended December 31, 2000 compared to $14.7 million for the prior year period. Also included are policyholders' dividends of $2.2 million for the year ended December 31, 2000 compared to $0.1 million in 1999. The majority of the dividends are for Nevada participating policies and represent 1.7% of 2000 net earned premiums compared to 0.1% in 1999. In addition, in 2000, we wrote-off capitalized costs of $3.0 million on an information system software project that was canceled because the vendor was unable to fulfill its contractual obligations.
The combined ratio is a measurement of underwriting profit or loss and is the sum of the loss and LAE ratio, underwriting expense ratio and policyholders' dividend ratio. A combined ratio of less than 100% indicates an underwriting profit. Our combined ratio was 115.8% for the year ended December 31, 2000 compared to 105.5% for the same period in 1999. The increase was primarily due to a higher loss and LAE ratio of 13.4 percentage points and policyholders' dividends ratio of 1.6 percentage points, offset slightly by a decrease in the underwriting expense ratio of 4.7 percentage points. The increase in the loss and LAE ratio was due to:
o Increase in net adverse loss development which represents 6.6 percentage points of the change in the loss and LAE ratio; and
o Higher loss and LAE ratio on the 2000 accident year of $8.6 million, which represents 6.8 percentage points of the change in the loss and LAE ratio.
For the year ended December 31, 2000, we recorded a tax benefit of $3.7 million compared to a tax provision of $3.6 million in 1999. The effective tax rate was 33% for the 2000 period compared to 50% for the 1999. The decrease in the effective tax rate for 2000 relates primarily to the decrease in tax preferred investments and the change in valuation allowances as a percentage of pre-tax income compared to 1999.
Our insurance subsidiaries require liquidity to pay policy claims and benefits, operating expenses, income taxes and to purchase fixed assets to maintain and enhance their operations. The source of our insurance subsidiaries' funds come from the premiums they collect, the investment income they earn and receipts from their reinsurers. The liquidity requirements of our non-insurance operations, which are essentially the holding company, CII Financial, are substantially all related to the servicing of interest payments on our debentures and the payment of our debentures at maturity.
Our net cash used in financing activities was $10.2 million in 2001 and $5.1 million in 2000. We used $21.5 million for the exchange offer on our old junior subordinated debentures described below under "Debentures" and $5.7 million for the retirement of the remaining $5.0 million of our old junior subordinated debentures and the payment of interest. We obtained loans from Sierra of $17.0 million in 2001 that were used for the exchange offer. The cash used in 2000 was for the repurchase of our old junior subordinated debentures in the open market and a dividend of $2.6 million paid to Sierra.
Our 9 1/2% senior debentures pay interest, which is due semi-annually on March 15 and September 15 of each year, commencing on September 15, 2001. The 9 1/2% senior debentures rank senior to outstanding notes payable from CII Financial to Sierra and CII Financial's guarantee of Sierra's revolving credit facility. CII Financial expects to service the 9 1/2% senior debentures from cash flows, primarily from dividends that will be paid by its insurance subsidiaries from their future earnings.
Under the terms of the revolving credit facility, capital contributions to us from Sierra in excess of $12 million that we used to repay the old junior subordinated debentures required Sierra to reduce permanently an equal amount of the outstanding balance of its credit facility commitment. Subject to normal qualifications and exceptions, Sierra has covenants that, among other things, will restrict the ability of Sierra and its subsidiaries, including CII Financial, to dispose of assets, incur indebtedness, pay dividends, make investments, loans or advances, make acquisitions, engage in mergers or consolidations, or make capital expenditures and which otherwise restrict certain corporate activities. In addition, Sierra is required to comply with specified financial ratios, as defined in the new credit agreement, including minimum interest coverage ratios and leverage ratios. Since December 15, 2000, Sierra believes it has been in compliance with the financial covenants of the new credit agreement.
CII Financial is a holding company and its only significant assets are its investment in California Indemnity Insurance Company. Of the $8.6 million in cash and cash equivalents held at December 31, 2001, approximately $8.1 million were designated for use only by the regulated insurance companies.
CII Financial has limited sources of cash and is dependent upon dividends paid by California Indemnity. Our insurance subsidiaries are restricted by state law as to the amount of dividends that can be declared and paid to us.
No prediction can be made as to whether any legislative proposals relating to dividend rules in the domiciliary states of our subsidiaries will be made or adopted in the future, whether the insurance departments of such states will impose either additional restrictions in the future or a prohibition on the ability of our regulated subsidiaries to declare and pay dividends or as to the effect of any such proposals or restrictions on our regulated subsidiaries.
(1) We are a guarantor under Sierra's revolving credit facility which facility had an outstanding balance of $89.0 million at December 31, 2001. (2) We have issued two demand notes in an aggregate amount of $17.0 million to Sierra Health Services, Inc.
In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets", or SFAS No. 142, which is effective January 1, 2002. SFAS No. 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the pronouncement includes provisions for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the identification of reporting units for purposes of assessing potential future impairments of goodwill. We do not have any recorded goodwill and do not anticipate any impact from this pronouncement.
We have audited the accompanying consolidated balance sheets of CII Financial, Inc. and its subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of operations, stockholder's equity and cash flows for each of the three years in the period ended December 31, 2001. Our audits also included the financial statement schedules listed in the Index at Item 14 (a)(2). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of CII Financial, Inc. and its subsidiaries at December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. Also, 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 therein.
CII FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 2001 and 2000 (In thousands except share data)
2001 2000 ---- ---- ASSETS Invested assets: Debt securities, available-for-sale, at fair value.............. $212,294 $177,671 Debt securities, held-to-maturity, at amortized cost ........... 13,809 21,258 Preferred stock, at fair value.................................. 5,884 5,130 Mortgage loans on non-affiliated real estate.................... 11,398 12,362 ------- ------- Total invested assets........................................... 243,385 216,421 ------- -------
Cash and cash equivalents....................................... 8,641 28,666 Reinsurance recoverable......................................... 218,079 247,205 Premiums receivable (net of allowances of $1,404 and $1,449).... 10,669 11,785 Investment income receivable.................................... 2,794 2,712 Deferred policy acquisition costs............................... 2,236 2,015 Mortgage loans on affiliated real estate........................ 992 1,257 Real estate limited partnership................................. 767 807 Note receivable affiliate....................................... 7,500 Federal income taxes receivable................................. 614 1,945 Deferred income taxes........................................... 16,305 16,251 Property and equipment, net..................................... 4,955 4,126 Other assets.................................................... 4,536 412 ------- ------- TOTAL ASSETS.................................................... $521,473 $533,602 ======= =======
CII FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, 2001, 2000 and 1999 (In thousands)
2001 2000 1999 ---- ---- ---- REVENUES Direct written premiums, gross..................... $187,129 $ 203,268 $148,824 Changes in direct unearned premiums................ (833) (193) (2,142) ------- -------- --------
Direct earned premiums, gross...................... 186,296 203,075 146,682 Add: premiums assumed............................ 299 Less: premiums ceded.............................. 13,380 77,520 63,727 ------- -------- -------
Net earned premiums................................ 173,215 125,555 82,955 Net investment income.............................. 15,475 15,074 15,776 Net realized investment gains (losses)............. 392 (620) (381) ------- -------- -------
Comprehensive income: Net income $ 3,604 3,604 3,604 Unrealized loss on available-for-sale investments, net of tax (11,746) (11,746) (11,746) Reclassification adjustment for losses included in net income 248 248 248 ------- Comprehensive income (loss) $ (7,894) --- ----- ------ ------- ======= ------ ------- BALANCE, DECEMBER 31, 1999 100 3,604 64,450 (12,200) 10,199 66,053
Comprehensive income: Net loss $(7,729) (7,729) (7,729) Unrealized gain on available-for-sale investments, net of tax 7,262 7,262 7,262 Reclassification adjustment for gains included in net loss 403 403 403 ------- Comprehensive income (loss) $ (64) ======= Dividend paid to parent (2,637) (2,637) --- ----- ------ ------- ------ ------- BALANCE, DECEMBER 31, 2000 100 3,604 64,450 (4,535) (167) 63,352
Comprehensive income: Net income $ 1,985 1,985 1,985 Unrealized gain on available-for-sale investments, net of tax 491 491 491 Reclassification adjustment for gains included in net income (392) (392) (392) ------- Comprehensive income (loss) $2,084 ===== --- ---- ------ ------- ------ ------- BALANCE, DECEMBER 31, 2001 100 $3,604 $64,450 $ (4,436) $ 1,818 $ 65,436 === ===== ====== ======= ====== =======
CII FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2001, 2000 and 1999 (In thousands)
CASH FLOWS FROM FINANCING ACTIVITIES: Repurchase of convertible subordinated debentures...................... (27,162) (2,432) (583) Dividend to Sierra..................................................... (2,637) Notes payable to Sierra................................................ 17,000 -------- -------- -------- Net cash used in financing activities................................ (10,162) (5,069) (583) -------- -------- --------
NET CHANGE IN CASH AND CASH EQUIVALENTS.................................. (20,025) 11,833 (5,281) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD......................... 28,666 16,833 22,114 -------- -------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD............................... $ 8,641 $ 28,666 $ 16,833 ======== ======== ========
The insurance subsidiaries are required by state regulatory agencies to maintain certain deposits and must also meet certain net worth and reserve requirements. The Company and its subsidiaries are in compliance with the applicable minimum regulatory and capital requirements.
The Company has an investment in a real estate limited partnership that is accounted for under the equity method. Under the equity method, original investments are recorded at cost and adjusted by the Company's share of earnings, losses and distributions of the Partnership.
Property and Equipment. Property and equipment, consisting of buildings and leasehold improvements, furniture and fixtures, data processing equipment and vehicles, is stated at cost less accumulated depreciation. Depreciation is computed on a straight-line basis over periods ranging from 5 to 10 years with leasehold improvements depreciated over the term of the lease.
Income Taxes. The Company accounts for income taxes using the liability method. Deferred income tax assets and liabilities result from temporary differences between the tax basis of assets and liabilities and the reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. The Company's temporary differences arise principally from certain net operating losses, accrued expenses, reserves for loss and LAE and depreciation. A valuation allowance is recorded for estimated deferred tax assets that cannot be fully realized in current or future periods. Federal income taxes are calculated pursuant to a tax allocation agreement between Sierra and the Company. Income taxes are allocated on a separate return basis for each company and tax benefits are recorded only to the extent that an entity could recoup taxes paid in prior years.
Concentration of Credit Risk. The Company's financial instruments that are exposed to credit risk consist primarily of investments and accounts receivable. The Company maintains cash and cash equivalents and investments with various financial institutions. These financial institutions are located in many different regions, and Company policy is designed to limit exposure with any one institution.
In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS No. 144"), which is effective for fiscal years beginning after December 15, 2001 with early adoption recommended. SFAS No. 144 requires that long-lived assets that are to be sold within one year must be separately identified and carried at the lower of carrying value or fair value less costs to sell. Long-lived assets expected to be held longer than one year are subject to depreciation and must be written down to fair value upon impairment. Long-lived assets no longer expected to be sold within one year, such as foreclosed real estate, must be written down to the lower of current fair value or fair value at the date of foreclosure adjusted to reflect depreciation since acquisition. The Company believes that the implementation of this standard will not have a material impact on its consolidated financial position, results of operations or cash flows.
Depreciation expense in 2001, 2000 and 1999 was $1,362,000, $1,368,000 and $1,075,000, respectively.
During the second quarter of 2000, the Company wrote-off capitalized costs of $3.0 million related to the application development of an information system software project that was canceled because the vendor was unable to fulfill its contractual obligations. The amounts written off include software and consulting costs of $1.6 million and capitalized internal personnel costs of $1.4 million.
The following table summarizes the Company's debt securities and preferred stock investments as of December 31, 2001:
Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value ---- ----- ------ ---------- (In thousands) Available-for-Sale: U.S. Government and its Agencies............... $186,001 $1,391 $6,271 $181,121 Municipal Obligations.......................... 3,064 42 65 3,041 Corporate Bonds................................ 30,067 116 2,051 28,132 ------- ----- ----- ------- Total Debt Securities.......................... 219,132 1,549 8,387 212,294 Preferred Stock................................ 5,871 34 21 5,884 ------- ----- ----- ------- Total Available-for-Sale.................... $225,003 $1,583 $8,408 $218,178 ======= ===== ===== =======
The following table summarizes the Company's debt securities and preferred stock investments as of December 31, 2000:
Held-to-Maturity U.S. Government and its Agencies............... $ 12,776 $278 $ 688 $ 12,366 Municipal Obligations.......................... 2,886 66 2,952 Corporate Bonds................................ 4,981 139 160 4,960 Other.......................................... 615 615 ------- --- ----- ------- Total Held-to-Maturity....................... $ 21,258 $483 $ 848 $ 20,893 ======= === ===== =======
The contractual maturities of available-for-sale debt securities at December 31, 2001 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations.
Gross realized gains on investments for the years ended December 31, 2001, 2000 and 1999 were $1,071,000, $450,000 and $261,000, respectively. Gross realized losses on investments for the years ended December 31, 2001, 2000 and 1999 were $679,000, $1,070,000 and $642,000, respectively.
Of the total debt securities and cash equivalents, $153,268,000, $161,618,000 and $171,639,000, at fair value, were on deposit with regulatory authorities in compliance with certain legal requirements related to the insurance operations at December 31, 2001, 2000 and 1999, respectively.
The Company has reinsurance agreements or treaties in effect with unrelated entities. Effective January 1, 2000, the Company entered into a reinsurance contract that provides statutory (unlimited) coverage for workers' compensation claims in excess of $500,000 per occurrence. The contract is in effect for claims occurring on or after January 1, 2000 through December 31, 2002. In 1999 and 1998, workers' compensation claims between $500,000 and $100,000,000 per occurrence were 100% reinsured. In addition, effective July 1, 1998, workers' compensation claims below $500,000 per occurrence were reinsured under quota share and excess of loss reinsurance agreements (referred to as "low level reinsurance") with an A+ rated carrier. Under this agreement, the Company reinsures 30% of the first $10,000 of each loss, 75% of the next $40,000 and 100% of the next $450,000. The maximum net loss retained on any one claim ceded under this treaty was $17,000. The Company received a 9.25% ceding commission from the reinsurer as a partial reimbursement of its operating expenses. The low level reinsurance agreement expired on June 30, 2000; however, the Company opted to continue ceding premiums and losses under the low level agreement on a run off basis for all policies inforce on June 30, 2000. On July 1, 2000, the Company entered into a reinsurance agreement that covered losses on claims in excess of $250,000 to $500,000 for policies issued after June 30, 2000. The agreement terminated after one year on a cut-off basis and covered losses with dates of injury up to June 30, 2001.
In accordance with SFAS No. 113, losses ceded under prospective reinsurance reduce direct incurred losses and amounts recoverable are reported as an asset. At December 31, 2001 and 2000, the amount of reinsurance recoverable under prospective reinsurance contracts for unpaid loss and LAE was $187,453,000 and $218,757,000, respectively. At December 31, 2001 and 2000, the amount of reinsurance recoverable under the retroactive reinsurance contract was $8,781,000 and $10,863,000, respectively. The amount of reinsurance receivable for paid loss and LAE was $21,845,000 and $17,585,000 at December 31, 2001 and 2000, respectively.
Reinsurance contracts do not relieve the Company from its obligations to injured workers or policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. All of the reinsurance recoverables are due from reinsurers rated AA and A+ by Fitch Ratings and the A.M. Best Company, respectively, and all amounts are considered to be collectible.
The following table provides workers' compensation prospective reinsurance information for the periods ended:
Change in Recoveries Recoverable on Paid or Unpaid Premiums Loss / LAE Loss / LAE Ceded ---------- ---------- ----- (In thousands) Year Ended December 31, 2001: Low level reinsurance carrier................... $80,932 $(40,430) $ 9,136 Excess of loss reinsurance carriers............. 4,407 9,125 4,244 ------ ------- ------ Total.......................................... $85,339 $(31,305) $13,380 ====== ======= ======
Year Ended December 31, 2000: Low level reinsurance carrier................... $53,408 $100,240 $74,071 Excess of loss reinsurance carriers............. 2,324 8,428 3,449 ------ ------- ------ Total.......................................... $55,732 $108,668 $77,520 ====== ======= ======
Year Ended December 31, 1999: Low level reinsurance carrier................... $21,941 $ 69,104 $60,702 Excess of loss reinsurance carriers............. 1,730 3,188 3,025 ------ ------- ------ Total.......................................... $23,671 $ 72,292 $63,727 ====== ======= ======
Net provision for insured events incurred in: Current year.............................. 131,923 86,587 51,541 Prior years............................... 8,691 23,293 9,920 ------ ------- ------- Total net provision........................... 140,614 109,880 61,461 ------- ------- -------
Gross ending loss and LAE reserve............... $385,705 $374,554 $244,394 ======= ======= =======
For claims occurring on and after July 1, 1998, the Company has reinsured a percentage of the higher claim severity under the Company's low level reinsurance agreement. The low level reinsurance agreement expired on June 30, 2000; however, the Company opted to continue ceding premiums and losses under the low level agreement on a run-off basis for all policies inforce on June 30, 2000. Effective January 1, 2000, the Company entered into a reinsurance contract that provides statutory (unlimited) coverage for workers' compensation claims in excess of $500,000 per occurrence. The contract is in effect for claims occurring on or after January 1, 2000 through December 31, 2002. On July 1, 2000, the Company entered into a reinsurance agreement that covers losses on claims in excess of $250,000 up to $500,000 for policies issued after June 30, 2000. This agreement terminated after one year on a cut-off basis and covered losses with dates of injury to June 30, 2001.
In September 1991, CII Financial issued 7 1/2% Convertible Subordinated Debentures (the "Subordinated Debentures") of which $47,059,000 were outstanding at March 31, 2001. Interest on the Subordinated Debentures was due semi-annually on March 15 and September 15, and they matured September 15, 2001. Each $1,000 in principal was convertible into 25.382 shares of common stock of Sierra at a conversion price of $39.398 per share. During 2000 and 1999, the Company repurchased $3,457,000 and $753,000 of the Subordinated Debentures in the open market resulting in an extraordinary gains of $1,007,000 and $170,000 and corresponding tax provisions of $353,000 and $59,000, respectively.
In September 2001, California Indemnity received approval from the California Department of Insurance to pay an additional $5.0 million dividend to CII Financial, which used the funds to fully pay the remaining $5.0 million in Subordinated Debentures at maturity.
In the transaction, total future cash payments (interest and principal) on the remaining Subordinated Debentures and the 9 1/2% senior debentures were less than the balance of the Subordinated Debentures at the time of the exchange less the cash consideration given in the exchange. Accordingly, a gain on restructuring was recognized for the difference and the carrying amount of the remaining Subordinated Debentures and 9 1/2% senior debentures is the total future cash payments on the debentures. Costs incurred in connection with the exchange were used to offset the gain on restructuring. All future cash payments related to the debentures are reductions of the carrying amount of the debentures; therefore, no future interest expense will be recognized for the debentures. Accordingly, the 9 1/2% senior debentures have a carrying amount of $19.2 million, which consists of principal amount of $15.0 million and future accrued interest of $4.2 million. The transaction resulted in an extraordinary gain of $557,000 and a corresponding tax provision of $195,000.
The 9 1/2% senior debentures pay interest, which is due semi-annually on March 15 and September 15 of each year, commencing on September 15, 2001. The 9 1/2% senior debentures rank senior to outstanding notes payable from CII Financial to Sierra and CII Financial's guarantee of Sierra's revolving credit facility. The 9 1/2% senior debentures may be redeemed by CII Financial at any time at premiums starting at 110% and declining to 100% for redemptions after April 1, 2004. In the event of a change in control of CII Financial, the holders of these 9 1/2% senior debentures may require that CII Financial repurchase them at the then applicable redemption price, plus accrued and unpaid interest.
Leases. The Company is the lessee under several operating leases most of which relate to office facilities and equipment. The rentals on these leases are charged to expense over the lease term and, where applicable, provide for rent escalations based on certain costs and price index factors. The Company has a sublease from Sierra for its Las Vegas, Nevada branch office through December 31, 2002. The Company has the option to renew yearly up to the term of the underlying Sierra lease, which as of December 31, 2001 had 13 more years before it expires. The following is a schedule, by year, of the future minimum lease payments under existing operating leases:
(In thousands) Years Ending December 31, 2002................................................... $2,452 2003................................................... 493 2004................................................... 140 2005................................................... 99 2006................................................... 47 Thereafter............................................. 0 ----- Total............................................. $3,231 =====
Years Ended December 31, 2001 2000 1999 (In thousands) ---- ---- ---- Provision (benefit) for income taxes: Current tax on operating results................... $1,437 $ 862 $(2,286) Deferred tax on operating results ................ 10 (4,531) 5,888 ----- ------ ------ Total tax on operating results................ 1,447 (3,669) 3,602 Current tax on extraordinary gain.................. 195 353 59 ----- ------ ------ Total......................................... $1,642 $(3,316) $ 3,661 ===== ====== ======
The following reconciles the difference between the 2001, 2000 and 1999 reported and statutory (benefit) provision for income taxes:
Statutory rate................................................ 35% (35%) 35% Tax preferred investments..................................... (6%) (3%) (6%) Change in valuation allowance................................. 10% 9% 16% Other......................................................... 6% (4%) 5% --- ---- --- Provision (benefit) for income taxes....................... 45% (33%) 50% === ==== ===
The tax effects of significant items comprising the Company's net deferred tax assets at December 31, 2001 and 2000 are as follows:
December 31, 2001 2000 (In thousands) ---- ---- Deferred tax assets: Loss and LAE reserves......................................... $ 5,409 $ 3,653 Accruals not currently deductible............................. 1,949 412 Compensation accruals......................................... 784 948 Bad debt allowances........................................... 491 507 Loss carryforwards and credits................................ 12,549 14,767 Unearned premiums............................................. 1,554 1,874 Policyholders' dividends...................................... 114 613 Depreciation and amortization................................. 0 424 Deferred reinsurance gains.................................... 2,022 1,917 Unrealized investment losses.................................. 2,389 2,442 ------- ------ Total.................................................... 27,261 27,557
Deferred tax liabilities: Deferred policy acquisition costs............................. 783 705 Depreciation and amortization................................. 256 0 Other......................................................... 321 537 ------- ------ Total.................................................... 1,360 1,242
Under California insurance company statutes and regulations, California Indemnity, Commercial Casualty and CII Insurance are restricted as to the amount of dividends they may pay on their common stock to their respective parent companies. Sierra Texas is regulated by Texas insurance statutes and regulations that are similar to California in terms of paying dividends. No dividends may be paid without at least ten business days prior notice to the Insurance Commissioner. Unless approved by the Insurance Commissioner prior to payment, dividends may be paid only out of accumulated earned surplus, excluding any earned surplus attributable to unrealized appreciation in assets or an exchange of assets.
Based on its financial position as of December 31, 2001, California Indemnity can pay $2.1 million in shareholder dividends to CII Financial during calendar year 2002 without the prior approval of the California Insurance Commissioner. Commercial Casualty, CII Insurance and Sierra Texas can pay $1,278,000, $369,000 and $194,000, respectively to California Indemnity without prior approval of the applicable state insurance commissioner.
The National Association of Insurance Commissioners ("NAIC") adopted risk-based capital guidelines for property-casualty insurance companies whereby required statutory surplus would be based, in part, on a formula based risk assessment of the individual investments held in the insurance company's portfolio. The Company's risk-based capital results for the years ended December 31, 2001, 2000 and 1999 exceeded the minimum surplus required under the regulations.
In March 1998, the NAIC adopted the Codification of Statutory Accounting Principles (the "Codification"). The Codification, which is intended to standardize regulatory accounting and reporting for the insurance industry, became effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices. The insurance subsidiaries were required to implement the Codification, with certain applicable state modifications, for the preparation of statutory financial statements effective January 1, 2001. The adoption of the Codification, as modified by the applicable state, increased the Company's insurance subsidiaries' statutory capital and surplus as of January 1, 2001, by approximately $7.0 million, which was primarily due to prescribed statutory accounting principles under the Codification regarding income taxes, earned but unbilled premiums and electronic data processing equipment.
Defined Contribution Plan. All employees who meet minimum requirements can participate in Sierra's defined contribution pension and 401(k) plan (the "Plan"). The Plan covers all employees who meet certain age and length of service requirements. For the six months ended June 30, 1999, the Company contributed a maximum of 2% of eligible employees' compensation and matched 50% of a participant's elective deferral up to a maximum of either 10% of an employee's compensation or the maximum allowable under current IRS statute. Effective July 1, 1999, the Plan was modified such that the Company matches 50%-100% of an employee's elective deferral and the maximum Company match is 6% of a participant's annual compensation, subject to Internal Revenue Service limits. The Plan does not require additional Company contributions. For the years ended December 31, 2001, 2000 and 1999, the Company expensed $585,000, $500,000 and $601,000, respectively, to this plan.
Employment Contracts. The Company currently has an employment contract with its Chief Executive Officer expiring December 2003. Minimum aggregate cash compensation obligations under this contract is $240,000, per year.
The following table reflects the activity of the stock option plans for the Company's employees:
Number of Option Weighted Shares Price Average Price ------ ----- -------------
Outstanding January 1, 1999 ................ 323,000 $ 6.31 - $24.50 $16.56
Granted................................... 163,000 4.24 - 8.93 6.72 Exercised................................. (30,000) 3.75 - 8.00 5.87 Canceled.................................. (57,000) 3.75 - 24.50 13.53 -------- Outstanding December 31, 2001............... 516,000 3.25 - 24.50 7.87 ========
Exercisable at December 31, 2001 ........... 150,000 $ 3.25 - $24.50 $10.28 ========
Weighted Average Weighted Average Range of Exercise Contractual Life Options Exercise Price Prices Remaining in Days Outstanding Exercisable Outstanding Exercisable --------------------- ----------------- ----------- ----------- ----------- -----------
$ 3.25 - $ 5.73 3,224 216,000 30,000 $ 4.58 $ 5.04 6.19 - 8.93 2,337 201,000 54,000 7.74 7.04 9.91 - 20.75 4,052 67,000 46,000 11.74 12.07 21.00 - 24.50 937 32,000 20,000 22.78 23.15
During 1999, Sierra extended by three years the expiration date for 6,000 options covering shares that would have expired in 1999 and 2000. The exercise price per share for these options ranges from $12.08 to $19.08. No expense was recognized in the consolidated statement of operations related to these options. Expense of $31,000 is included in the pro forma information presented.
Due to the fact that the Company's stock option programs vest over many years and additional awards are made each year, the above pro forma numbers are not indicative of the financial impact had the disclosure provisions of Statement of Financial Accounting Standards No. 123 been applicable to all years of previous option grants. The above numbers do not include the effect of options granted prior to 1995.
Effective January 1, 1999, Sierra and California Indemnity entered into a management agreement where Sierra would furnish services, including accounting, human resources, systems and other administrative services. The fee for the services is based on the actual direct and allocable cost. The services are subject to the ultimate control of California Indemnity Insurance Company's board of directors. The annual fees for these services were approximately $1,335,000, $1,201,000 and $1,003,000 in 2001, 2000 and 1999, respectively. The Company did not have a management agreement with Sierra prior to January 1, 1999.
The Company purchases employee health insurance from its affiliates, Health Plan of Nevada, Inc., Sierra Health and Life Insurance Company, Inc. and Texas Health Choice, L.C. The Company paid $885,000, $672,000 and $642,000 to the aforementioned affiliates for years ended December 31, 2001, 2000 and 1999, respectively. The premiums paid to its affiliates were determined on an arms-length basis.
In connection with the exchange offer for the Subordinated Debentures, (see Note 7 of these consolidated financial statements), California Indemnity loaned Sierra $7.5 million. The loan bears interest at 8.5%, which is due semi-annually on March 31 and September 30 of each year, commencing September 30, 2001. All outstanding principal and accrued interest is due on September 30, 2004. The loan is secured by the common stock of Sierra Health and Life Insurance Company ("SHL"), a wholly owned subsidiary of Sierra, equal to 120% of the principal amount outstanding. At December 31, 2001, SHL had total equity, on a statutory accounting basis of approximately $16.4 million. As an additional part of the exchange offer transaction, Sierra lent CII Financial $15.0 million as well as an additional $2.0 million to enable CII Financial to pay the accrued interest on the Subordinated Debentures due March 15, 2001 and other operating expenses. Each of the loans are demand notes payable and bear interest at 9.5%, which is due on demand or semi-annually on March 15 and September 15 of each year, commencing September 15, 2001. The notes are subordinated to the 9 1/2% senior debentures and CII Financial's guaranty of Sierra's credit facility.
In November 2001, California Indemnity acquired a newly constructed commercial building in the city of North Las Vegas and entered into a five-year lease agreement with Sierra. The monthly base rent is $13,500 and is subject to annual cost of living adjustments starting November 1, 2002 and a further market rental value adjustment on November 1, 2006. Sierra has the option to extend the terms of the lease for an additional five-year period.
Net (loss) income................................ $ (84) $ 1,711 $ 277 $ 81 ====== ======= ====== ======