*Adjusted for 2 for 1 stock dividend effective July 22, 1999 (See Note 23)
For the year 2001, the Corporation reported a net operating loss(1) of $36.4 million, or $.61 per share. Excluding a one-time after-tax charge of $26.8 million, or $.45 per share, for the transfer of the renewal obligation of New Jersey private passenger auto business, the after-tax operating loss for the twelve months ending December 31, 2001, was $9.6 million, or $.16 per share, compared with an operating loss of $77.7 million, or $1.29 per share in 2000, and operating income of $1.4 million, or $.02 per share in 1999. Also contributing to the 2001 operating loss were the effects of additions to the Group's asbestos reserves and the impact of an early retirement plan. The 2000 operating loss included the adverse effects of write-offs to the agent relationships intangible asset relating to the 1998 acquisition of the Great American Insurance Company's ("GAI") commercial lines division, the impact of inadequate pricing and the negative effects of premium cessions on experience rated reinsurance contracts. Positively impacting 2000 results was the settlement of the California Proposition 103 liability.
(1) Operating income (loss) differs from net income by the exclusion of realized investment gains (losses). It is not intended as a substitute for net income prepared in accordance with accounting principles generally accepted in the United States.
The events of September 11, 2001 had an impact on the results of operations for the year. The Group incurred before-tax losses of $3.0 million. This loss has not reached any reinsurance limits for the Group. The $3.0 million represents the Group's best estimate of total losses, which could ultimately exceed the amount estimated. Based upon year-end 2001 analysis of the financial strength of reinsurers, the Group believes any potential future increases in this estimate covered under its reinsurance programs would be collectible.
The 2000 operating loss was also impacted negatively by $23.2 million before tax for ceded premiums on certain experience rated reinsurance contracts covering losses exceeding $1.0 million. The 1999 operating income was impacted by $13.0 million before tax for similar premium cessions. The premium cessions reflect changes in estimated loss experience, and have resulted in the maximum premium cessions under these contracts for business written through year 2000.
Consolidated after-tax realized investment gains (losses) amounted to $135.0 million, or $2.25 per share in 2001, $(1.5) million, or $(.03) per share in 2000, and $104.5 million, or $1.71 per share in 1999. The 2001 realized gains included the effects of the Group's partial reallocation of its equity portfolio to fixed income holdings. Significant appreciation in the equities, as part of the reallocation, contributed to the realized gains in 2001. The 2001 realized gains included a non-recurring tax benefit of $16.1 million related to the sale of a minority interest in stock of OCNJ. Contributing to the 1999 realized investment gains were gains from a reallocation of the Group's investment portfolio during the second quarter. The Corporation completed the reallocation by selling approximately $200 million in equity securities, resulting in after-tax realized gains of approximately $94 million.
Consolidated before-tax investment income increased 3.6% to $212.4 million in 2001, compared with $205.1 million in 2000 and $184.3 million in 1999. The increases in investment income can be attributed to the equity portfolio reallocations in 1999 and 2001. The reallocations in the investment portfolio reduced equity securities and increased investment grade securities. Also contributing to the increase in before-tax investment income was the reallocation of investments from tax exempt municipal bonds to taxable bonds. After-tax investment income totaled $141.3 million in 2001, compared with $140.3 million in 2000 and $138.0 million in 1999. Before-tax and after-tax investment income comparisons are impacted by investments in municipal bonds, which provide tax- advantaged investment income.
The Group has renewed all of its reinsurance programs for 2002 with only moderate changes in the program structure and pricing. Although the terrorist events of September 11, 2001 had a significant impact on the reinsurance market, the Group's reinsurance contracts do include coverage for acts of terrorism. Instead of being unlimited as in the past, terrorism coverage in the 2002 contracts has been modified to exclude or limit coverage for certain upper layers of reinsurance. The Corporation believes that the terrorism coverage in its reinsurance programs is adequate to protect its financial health. The pricing of reinsurance in 2002 increased only moderately from prior years due to the tragic events of September 11, 2001 and from other changes in the reinsurance market.
During 1995, the Corporation's life operations were discontinued. In order to exit the life operations, the Company executed an agreement in 1995 to reinsure the existing blocks of business through a 100% coinsurance arrangement.
On December 31, 1999, the Company sold 100% of The Ohio Life Insurance Company stock, thereby transferring all remaining assets and liabilities to the buyer. The after-tax gain on this sale totaled $6.2 million, or $.11 per share.
Management uses statutory financial criteria to analyze the property and casualty results. Management analyzes statutory results through the use of insurance industry financial measures including statutory loss and loss adjustment expense ratios, statutory underwriting expense ratio, statutory combined ratio, net premiums written and net premiums earned. The statutory combined ratio is a commonly used gauge of underwriting performance measuring the percentages of premium dollars used to pay insurance losses and related expenses. A discussion of the differences between statutory accounting and accounting principles generally accepted in the United States is included in Note 17.
Statutory net premiums written decreased $33.2 million in 2001 to $1.47 billion. Net premiums written totaled $1.51 billion in 2000 and $1.59 billion in 1999. The net premiums written decrease in 2001 and 2000 can be attributed primarily to a more selective underwriting philosophy that led to the elimination and cancellation of certain business. Actions taken in 2000 to cancel the Managing General Agents and the Group's most unprofitable agents and policies represented over $150 million in annual net premiums written.
Excluding the $40.6 million, or 2.7 point impact of the New Jersey renewal obligation transfer fee, the statutory combined ratio improved 6.6 points to 112.6% in 2001, compared with 119.2% in 2000 and 112.8% in 1999. The improvement in the statutory combined ratio in 2001 over 2000 was due to improvement in the Standard Commercial Lines statutory loss ratio and all lines statutory underwriting expense ratio when excluding the $40.6 million New Jersey transfer fee. The 2001 Standard Commercial Lines statutory loss ratio improved to 64.5% from 78.6% in 2000. The 2000 statutory combined ratio was impacted adversely by increases in the loss and loss adjustment expense ratios. The 2000 loss ratio was impacted by adverse development in the workers' compensation and general liability lines of business for 1999 and prior accident years. The workers' compensation line of business added 6.8 points to the overall 2000 loss ratio.
At year-end 2000, the Group reallocated its carried bulk reserves in anticipation of Statement of Statutory Accounting Principles No. 55 under Statutory Accounting Codification, which requires that companies carry their best estimate of loss reserves for each line of business, while previous requirements focused on the overall reserves. The reallocation did not affect the all lines calendar year 2000 statutory combined ratio and did not have a material impact on most lines of business other than workers' compensation and general liability. The reallocation added 9.6 points to the workers' compensation statutory combined ratio and reduced the general liability statutory combined ratio by 4.7 points.
Statutory underwriting expenses, as a percentage of net premiums written, increased by .6 points in 2001 to 35.4%, compared with 34.8% in 2000 and 35.2% in 1999. The 2001 statutory underwriting expense ratio includes 2.7 points from the $40.6 million charge for the New Jersey transfer. Excluding the New Jersey transfer fee, the improvement in the 2001 statutory underwriting expense ratio was the result of actions to lower commissions, eliminate workers' compensation policyholder dividends and decrease the employee count. The actions to lower commissions to current market levels for selected product lines improved the 2001 underwriting expense ratio .5 points. The actions to eliminate workers' compensation policyholders dividends on new and renewal business and changes in reserves for dividends of issued policies improved the 2001 underwriting ratio .7 points. The reduction in employee count during 2001 improved the 2001 underwriting ratio by .6 points. The employee count was 3,365 as of December 31, 2001, compared with 3,470 at December 31, 2000 and 3,889 at December 31, 1999. The 2001 statutory underwriting expenses also included $.5 million of software amortization related to the limited rollout of a new internally developed software application. On a statutory accounting basis, the new application is being amortized over a five-year period in accordance with statutory accounting principles. For year 2002, the Group will continue the rollout of the new application and expects the impact to statutory expenses to be approximately $2 million to $3 million in amortization. Upon full implementation in 2003, the new application amortization should impact the statutory expenses by approximately $8 to $10 million per year through 2007. The additional cost is expected to be offset in part by reduced labor costs related to policy processing.
Standard Commercial Lines statutory combined ratio for the year 2001 decreased 13.8 points to 116.2% from 130.0% in 2000. The 1999 statutory combined ratio was 122.6%. The 2001 actual statutory combined ratio results were slightly better than the 2001 projected Standard Commercial Lines statutory combined ratio of 117.0%. Renewal price increases had a positive impact during the year. The 2001 average renewal price increase(2) was 15.2% for the Standard Commercial Lines direct premiums written, compared with a 9.9% average renewal price increase in 2000.
The workers' compensation line of business in the Standard Commercial Lines segment impacted the year's results. Although overall results improved in 2001, continued deterioration in the workers' compensation line of business in 2001 led to disappointing results for the line.
(2) When used in this report, renewal price increase means the average increase in premium for policies renewed by the Group. The average increase in premiums for each renewed policy is calculated by comparing the total expiring premium for the policy with the total renewal premium for the same policy. Renewal price increases include, among other things, the effects of rate increases and changes in the underlying insured exposures of the policy. Only policies issued by the Group in the previous policy term with the same policy identification codes are included. Therefore, renewal price increases do not include changes in premiums for newly issued policies and business assumed through reinsurance agreements, including Great American business not yet issued in the Group's systems. Renewal price increases also do not reflect the cost of any reinsurance purchased on the policies issued.
Commercial auto net premiums written increased $8.0 million, or 4.5% in 2001 to $186.7 million, compared with $178.7 million in 2000 and $175.5 million in 1999. The 2001 increase was driven by renewal price increases, averaging 15.5% on the commercial auto line of business.
The 2001 commercial auto statutory combined ratio decreased to 107.6%, from 121.5% in 2000 and 117.1% in 1999. The improvement in 2001 was largely due to better underwriting and risk selection and the effect of renewal price increases. 2000 was hindered by increased severity combined with inadequate pricing.
General liability net premiums written decreased $1.6 million, or 2.0% in 2001 to $79.0 million, compared with $80.7 million in 2000 and $82.5 million in 1999. The 2001 and 2000 decreases reflected the Group's focus on fundamental underwriting strategies.
The fidelity & surety line of business in the Specialty Commercial Lines contributed to the favorable results for the segment. Fidelity & surety net premiums written increased $1.1 million, or 3.0% in 2001 to $38.7 million, compared with $37.6 million in 2000 and $37.7 million in 1999. The statutory combined ratio was 76.8% in 2001, compared with 70.7% in 2000 and 75.9% in 1999.
Given the unfavorable regulatory environment in New Jersey and the continued unprofitability of its private passenger auto business in the state, the Group announced in the fourth quarter of 2001 the transaction to allow the Group to stop writing business in early 2002 in the private passenger auto market in New Jersey. The transaction, described in the Operating Results section, is expected to positively impact private passenger auto results beginning in 2002.
respectively. The 2001 underwriting expense ratio included $2.0 million, or 29.3 points, in expenses for fees for the removal of certain obligations related to assigned private passenger auto policies in New York.
Although the Group discontinued the private passenger auto - direct line, the Group remains committed to expanding its Internet capabilities that focus on full service options for our agents and convenience options for our policyholders.
Homeowners net premiums written fell 6.5% in 2001 to $162.0 million from $173.2 million in 2000 and $181.9 million in 1999. The Group has placed emphasis on price increases, insurance scoring and agency management. The company introduced an Insurance-To-Value program in 2000 which addressed underinsured homeowner properties and emphasized adequate replacement cost values.
The 2001 homeowners statutory combined ratio increased .9 points to 120.5%. This compares with a statutory combined ratio of 119.6% in 2000 and 124.1% in 1999. Combined ratios are heavily impacted by catastrophe losses which added 12.3 points to the combined ratio in 2001, 10.3 points in 2000 and 12.6 points in 1999.
Cash flow has also been impacted by our share repurchase program. Although the Corporation did not repurchase any shares of its common stock in 2001 or 2000, the Corporation did repurchase 2,478,000 shares for $46.1 million in 1999. Since the beginning of 1987, 31.7 million shares have been repurchased at an average cost of $14.10 per share.
The Corporation is dependent on dividend payments from its insurance subsidiaries in order to meet operating expenses, debt obligations, and to pay dividends. Insurance regulatory authorities impose various restrictions and prior approval requirements on the payment of dividends by insurance companies and holding companies. As of December 31, 2001, approximately $156.5 million of statutory surplus was not subject to restriction or prior dividend approval requirements.
As of December 31, 2001, the Corporation had $210.2 million of outstanding notes payable. Of the $210.2 million, $5.2 million is a long-term low interest loan with the state of Ohio used in conjunction with the home office purchase. The remaining $205.0 million is a current note payable under a 1997 credit facility that provided a $300.0 million revolving line of credit to the Corporation. On March 19, 2001, the Corporation elected to reduce the aggregate amount available under the revolving line of credit from $300.0 million to $250.0 million. The credit facility agreement contains financial covenants and provisions customary for such arrangements. The most restrictive covenants include a maximum permissible consolidated funded debt that cannot exceed 30% of consolidated tangible net worth (as defined in the agreement) and a minimum statutory surplus of $750.0 million. Effective March 30, 2001, the covenant was amended to require a minimum statutory surplus of $675.0 million for the quarters ending March 31, 2001 and June 30, 2001, returning to minimum statutory surplus of $750.0 million for subsequent quarters. The Corporation continues to review its financial covenants in the credit agreement in light of its operating losses. As of December 31, 2001, the Corporation was in compliance with these covenants. However, further deterioration of operating results, reductions in the equity portfolio valuation, or other changes in statutory surplus may lead to covenant violations which could ultimately result in default.
The credit agreement expires in October 2002, with any outstanding loan balance due at that time. The Corporation is evaluating its capital requirements and is exploring ways to refinance its debt and increase its financial flexibility. The Corporation has taken steps to strengthen its financial position by aggressively managing expenses and first reducing quarterly dividends to shareholders and later eliminating the current quarterly dividend in the first quarter of 2001. The Corporation will be required to obtain additional external funding, either in the form of debt or equity, in order to repay the balance of its current notes payable, which comes due October 2002. While the Corporation believes that it should be able to obtain such external funding, the ability to raise such funding cannot be assured nor can the cost of such funding be determined at this time.
Statutory surplus, a traditional insurance industry measure of strength and underwriting capacity, was $767.5 million at December 31, 2001, compared with $812.1 million at December 31, 2000 and $899.8 million at December 31, 1999. On January 1, 2001, statutory surplus was reduced by $21.7 million to $790.4 million for the cumulative effect of adopting new required statutory accounting principles. The 2001 surplus was further reduced by the $26.8 million after-tax charge associated with the New Jersey private passenger auto transfer and a decrease in the market value of the equity investment portfolio. Statutory surplus increased in 2001 due to the sale of a minority interest in the stock of a subsidiary, which caused a non- recurring tax benefit of $16.1 million. The decrease in the 2000 surplus was due primarily to poor underwriting results, dividend payments, and the statutory treatment of the final installment payment for the acquisition of the commercial lines division of GAI.
The National Association of Insurance Commissioners ("NAIC") has developed a "Risk-Based Capital" formula for property and casualty insurers and life insurers. The formula is intended to measure the adequacy of an insurer's capital given the asset structure and product mix of the company. As of December 31, 2001, all insurance companies in the Group, with the exception of OCNJ, exceed the necessary capital. The exception for OCNJ is due to a temporary difference in the recognition of deferred taxes related to the $40.6 million New Jersey transfer fee.
In 1998, the NAIC adopted the Codification of Statutory Accounting Principles guidance, which replaced the former Accounting Practices and Procedures manual as the NAIC's primary guidance on statutory accounting. The new policies provide guidance for areas where statutory accounting had been silent and changed former statutory accounting in some areas. The Group implemented the Codification guidance effective January 1, 2001. The cumulative effect of changes in accounting principles adopted to conform to the Codification guidance were reported as an adjustment to statutory policyholders' surplus as of January 1, 2001. The cumulative effect of adopting Codification reduced statutory policyholders' surplus by $21.7 million on January 1, 2001.
The Group's property per risk program covers property losses in excess of $1.0 million for a single insured, for a single event. This property per risk program covers up to $29.0 million in losses in excess of the $1.0 million retention level for a single event. The Group's casualty per occurrence program covers liability losses. Workers' compensation, umbrella and other casualty reinsurance cover losses up to $99.0 million, $49.0 million and $23.0 million, respectively, in excess of the $1.0 million retention level for a single insured event.
GAI has agreed to maintain reinsurance on the commercial lines business that the Company acquired from GAI and its affiliates in 1998. GAI is obligated to reimburse the Company if Great American's reinsurers are unable to pay claims with respect to the acquired commercial lines business.
The Group's largest liabilities are reserves for losses and loss adjustment expenses. The accounting policies related to the loss and loss adjustment expense reserves are considered critical. Loss and loss adjustment expense reserves are established for all incurred claims and are carried on an undiscounted basis before any credits for reinsurance recoverable. The establishment of loss and loss adjustment expense reserves involves the use of certain assumptions and estimates. Actual losses and loss adjustment expenses may change with further developments. These reserves amounted to $2.15 billion at December 31, 2001, $2.00 billion at December 31, 2000 and $1.91 billion at December 31, 1999.
In recent years, asbestos and environmental liability claims have expanded greatly in the insurance industry. Historically, the Group has written small commercial accounts and has not sold policies with significant manufacturing liability coverages. Within the manufacturing category, we have concentrated on the light manufacturers, which further limits exposure to environmental claims. Consequently, the Group's asbestos and environmental liability exposure is substantially below the industry average.
Estimated asbestos and environmental reserves are composed of case reserves, incurred but not reported reserves and reserves for loss adjustment expense. For 2001, 2000 and 1999, respectively, those reserves were $53.5 million, $40.4 million and $41.1 million. Asbestos reserves were $31.8 million, $13.5 million and $9.6 million and environmental reserves were $21.7 million, $26.9 million and $31.5 million for those respective years. These loss estimates are based on currently available information. However, given the expansion of coverage and liability by the courts and legislatures, there is substantial uncertainty as to the ultimate liability. The Group increased its asbestos reserves in 2001 for further development on existing claims outstanding.
The Group's fixed income portfolio has an intermediate duration and a laddered maturity structure. The Group chooses always to remain fully invested and does not try to time markets. The Group also does not invest in off-balance sheet investments or arrangements.
Tax exempt bonds decreased to 1.1% of the fixed income portfolio at year- end 2001 versus 3.2% and 19.4% for December 31, 2000 and 1999, respectively. The funds previously held in tax exempt bonds have been reallocated to investment grade taxable bonds. Due to poor underwriting results over the past few years, the Group has reduced its holdings to maximize after-tax income.
The Corporation adopted Statement of Financial Accounting Standards ("SFAS") 133 effective January 1, 2001. The adoption of SFAS 133 has had an immaterial impact on the financial results of the Corporation.
The Corporation's largest assets are its investments and, therefore, the accounting policies are considered critical. The Corporation uses certain assumptions and estimates when valuing certain investments and related income. These assumptions include estimations of cash flows and interest rates. Although the Corporation believes the values of its investments represent fair value, due to the inherent uncertainties and judgments involved with accounting measurements, certain estimates could change and lead to changes in fair values.
From time to time, the Corporation may publish forward-looking statements relating to such matters as anticipated financial performance, business prospects and plans, regulatory developments and similar matters. The statements contained in this Management's Discussion and Analysis that are not historical information, are forward-looking statements. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and The Securities Exchange Act of 1934 for forward- looking statements. In order to comply with the terms of the safe harbor, the Corporation notes that a variety of factors could cause the Corporation's actual results and experience to differ materially from the anticipated results or other expectations expressed in the Corporation's forward-looking statements.
See Item 14 for Index to Consolidated Financial Statements, including the Notes to Consolidated Financial Statements and the Report of Independent Auditors, and Schedules on page 44 of this Form 10-K.