Subsequent to December 31, 2004 we renewed our Denver office lease for an additional five years and one month.
The Consolidated Statements of Income data set forth below for each of the three years in the period ended December 31, 2004, and the Consolidated Balance Sheet data at December 31, 2004 and 2003 are derived from, and are qualified by reference to, the audited Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. The Consolidated Statements of Income data set forth below for the two years in the period ended December 31, 2001, and the Consolidated Balance Sheet data at December 31, 2002, 2001 and 2000, are derived from audited Consolidated Financial Statements not included herein. The information set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.
We developed two proprietary management systems: (i) ID15®, designed to identify early on those injured employees who are likely to become inappropriately dependent on disability system benefits, including workers’ compensation; and (ii) The RTW Solution®, designed to lower employers’ disability system costs and return injured employees to work as soon as reasonably possible. We provide disability management services, primarily workers’ compensation management services to: (i) employers insured through our insurance subsidiary; (ii) self-insured employers on a fee-for-service basis; (iii) the Minnesota Workers’ Compensation Assigned Risk Plan on a percent of premium basis; (iv) other insurance companies; and (v) on a consulting basis to agents and employers, charging hourly fees. During 2004, we operated primarily in Minnesota, Michigan and Colorado and began servicing non-insurance customers in California and Indiana.
Challenges, risks, uncertainties and trends - We derive our revenue almost entirely from workers’ compensation insurance premiums and investment income, including gains and losses from sales of securities. A small, but increasing portion of our revenue is derived from non-insurance disability management services. We are subject to the challenges, risks, uncertainties and trends that affect the workers’ compensation property and casualty insurance and the disability management services sectors of our economy including the following:
Workers’ compensation claims and related expenses can be volatile. Workers’ compensation is a long-tailed property and casualty insurance line. Claims for a given year are open on average for twelve to thirteen years and it is not unusual for workers’ compensation insurers to have some claims open for thirty or more years. We have operated ACIC since 1992 and therefore have relatively limited experience (thirteen years), and accordingly, are subject to volatility. See further discussion under “Claim and Claim Settlement Expenses”;
Workers’ compensation is subject to inflationary pressures. Worker’s compensation is subject to both medical and wage inflation. The cost of medical care has increased in excess of 10% per annum in recent years. This has resulted in reduced profitability in the workers’ compensation insurance line.
New medical procedures could evolve and new legal theories develop that could cause older claims to re-open and increase expense. See further discussion under “Claim and Claim Settlement Expenses”;
Workers’ compensation pricing is cyclical. In 2004, we were able to increase premium rates on renewing policies only by an average of 0.9%, decreasing significantly from recent years. Rates increased 1.4%, 9.0%, 18.5% and 11.7% in 2003, 2002, 2001 and 2000, respectively. These increases came after many years of rate decreases that unfavorably affected the industry in the late 1990’s. If we are unable to maintain rate increases or decrease our costs, our profit margin will be adversely affected. See further discussion under “Premiums in Force and Gross Premiums Earned”;
Profitable service revenue growth could be difficult. The national market for disability management services is highly competitive and includes national, regional and local providers of services. We do not have a national presence, limiting our ability to service national accounts. Any infrastructure changes to support growth in our non-insurance revenues could be expensive and diminish our earnings in the short-term.
Financial Summary - This financial summary presents our discussion and analysis of the consolidated financial condition and results of operations of RTW, Inc. This review should be read in conjunction with the Consolidated Financial Statements at December 31, 2004.
We reported net income of $9.9 million in 2004 compared to net income of $7.0 million in 2003 and $14.3 million in 2002. We reported diluted income per share of $1.81 in 2004 compared to diluted income per share of $1.32 in 2003 and $2.78 in 2002. The primary factors affecting our 2004 operating results included the following:
Premiums earned increased 16.0% to $53.7 million in 2004 from $46.3 million in 2003. Premiums earned in 2004 reflect the increase in gross premiums earned from 2003, and an increase in final audit premiums earned in 2004 compared to 2003, offset by an increase in premiums ceded as our cost of excess of loss reinsurance increased in 2004;
Claim and claim settlement expenses increased to 66.2% of premiums earned for 2004 from 58.8% for 2003. Favorable development for prior accident years reduced claim and claim settlement expenses by $7.0 million in 2004 compared to $6.7 million in 2003. Claim and claim settlement expenses also increased in 2004 due to the increase in gross premiums earned in 2004 compared to 2003. See further discussion under “Claim and Claim Settlement Expenses”; and
At December 31, 2004, we eliminated the valuation allowance recorded against our deferred tax asset. This allowance was originally established at December 31, 2001 at $14.5 million, and was decreased by $7.9 million in 2002, $3.0 million in 2003 and $4.0 million in 2004. The $4.0 million and $3.0 million decreases in the valuation allowance favorably affected our income tax expense in 2004 and 2003, respectively. See further discussion under “Income Taxes.”
In the following pages, we take a look at the 2004, 2003 and 2002 operating results for items in our Consolidated Statements of Income and also explain key balance sheet accounts in greater detail.
Total revenues: Our total revenues include premiums earned, investment income, net realized investment gains and service revenue. The following table summarizes the components of our revenues and premiums in force (000’s):
Gross premiums earned decreased 12.9% to $54.4 million in 2003 from $62.5 million in 2002. This decrease resulted primarily from: (i) the decrease in average premiums in force; offset by (ii) final audit premiums which increased gross premiums earned by $323,000 in 2003, compared to a $1.7 million decrease in 2002.
In 2004, 2003 and 2002, we were able to increase premium rates on renewing policies an average of 0.9%, 1.4% and 9.0%, respectively. We have been able to increase premium rates in our markets due to the following:
2005 Outlook: The 2005 outlook for premiums in force, gross premiums earned and premiums ceded include the following factors:
We expect premium rates to decrease on new and renewal policies as national and regional carriers focus on writing and retaining workers’ compensation insurance. We expect to add new agency relationships in 2005 and terminate some that are not performing well. We expect premiums in force to decrease slightly in 2005 with any growth occurring primarily in our Minnesota and Michigan regions;
Premiums ceded under excess of loss policies will increase as a percent of gross premiums earned in 2005 when compared to the results attained for 2004. We maintained a $200,000 retention in all our regions in 2005. The cost of excess of loss reinsurance has increased at all retention levels and for all regions in 2005.
We currently invest entirely in U.S. domiciled investment-grade taxable and tax-exempt fixed maturity investments and classify our investments as available-for-sale. Our primary investment objective is to maintain a diversified, high-quality, fixed-investment portfolio structured to maximize our after-tax investment income without taking inappropriate credit risk. For further discussion of investments, see the “Investments” section of this Management’s Discussion and Analysis.
We expect interest rates to increase in 2005. The timing of any such rate increases is unknown at this time. We intend to invest our excess cash into higher yielding investments in 2005 as rates increase;
Cash flows for 2005 are expected to be adversely affected by decreases in cash flows resulting from claim payments on claims from 2004 and prior years offset by cash flows from our premiums as we increase our premiums earned in 2005;
In March 2004, we were awarded a three-year contract to service 25% of the ARP. We are paid a fee based on a percent of the premium we service and began servicing new ARP business on July 1, 2004 and renewal ARP business on September 1, 2004. We believe the annual premium for the ARP to be
in excess of $100 million. We currently expect this contract to produce service revenue in excess of $4.0 million during 2005, some of which will be deferred to future periods; and
We currently have 23 additional non-insurance customers in Minnesota, Michigan, California and Indiana that will generate approximately $1.0 million of annualized service revenue over the term of their contracts. We continue to market our alternative products aggressively inside and outside the regions in which we currently operate. We expect service revenue will increase as new customers become aware of and purchase these services. The ultimate effect on service revenue is unknown at this time.
We experienced an increase in the estimated number of ultimate claims for 2004 compared to 2003 and 2002. The number of estimated ultimate claims by accident year increased to approximately 11,800 in 2004 from 9,600 in 2003 and 11,500 in 2002. The increase in 2004 correlates directly to: (i) the increase in gross earned premiums; and (ii) the re-underwriting that we completed with respect to our in force policies in 2003, 2002 and 2001. The gross and net average estimated cost per claim (which includes both claim and claim settlement expenses) totaled approximately $5,100 and $4,200 in 2004 compared to $5,000 and $4,200 in 2003 and $5,500 and $4,900 in 2002, respectively. The 2004 and 2003 decreases in gross and net average estimated cost per claim, when compared to the 2002 data, is primarily the result of our improved ability to manage cases and claims offset by increases in severity (i.e., the average cost of a claim). The trend of increasing severity is attributable to a combination of factors that include increasing medical and indemnity costs (reimbursements to injured workers for lost wages) per claim and a decline in the number of claims being reported over the last several years. The declining frequency of claims contributes to the increasing severity trend because the frequency decline has been concentrated in less expensive claims (claims involving less time-off from work and less severe injuries).
At December 31, 2004, the number of claims reported but unpaid (open claims) and the approximate average gross and net reserves on the claims occurring in the following accident years were: 2004 - 1,243 claims, $32,900 average gross reserve, $24,100 average net reserve; 2003 - 195 claims, $84,300 average gross reserve, $56,200 average net reserve; and 2002 - 139 claims, $119,400 average gross reserve, $81,600 average net reserve. The average gross and net reserves per claim are less in 2004 than in 2003 and 2002 as the open claims include newly reported claims from the later half of 2004, including many with much lower severity that have not had time to close, as well as new claims that are incurred but not yet reported. The remaining open claims from 2003 and 2002 are primarily claims with significant injury characteristics resulting in the increase in outstanding average gross and net reserves per claim.
Claim and claim settlement expenses increased in total due to the overall increase in average premiums in force and increased as a percent of premiums earned as reinsurance ceded costs increased as a percent of gross premiums earned in 2004; and
2003 Compared to 2002: Claim and claim settlement expenses decreased significantly to $27.3 million in 2003 from $40.5 million in 2002. As a percent of premiums earned, claim and claim settlement expenses decreased to 58.9% in 2003 from 67.3% in 2002. These changes are due to the following:
Claim and claims settlement expenses decreased in total due to the overall decrease in average premiums in force and decreased as a percent of gross premiums earned as premium rate increases realized in 2002 and 2003 flow through 2003 premiums earned; and
Claim costs continued to reflect increasing medical and indemnity costs in accident year 2003 as compared to accident year 2002 resulting from inflationary pressures.
Increases (decreases) in premium rates will have a direct affect on gross premiums earned without a corresponding affect on claim and claim settlement expenses, ultimately affecting claim and claim settlement expense as a percent of premiums earned. Legislative changes in estimated loss costs, increased competition and changes in customer loss experience may offset or eliminate the effect of any rate improvement; and
Policy Acquisition Costs: Policy acquisition costs are costs directly related to writing an insurance policy and include commissions, state premium taxes, underwriting personnel costs and expenses, sales and marketing costs and other underwriting expenses, less ceding commissions received from our reinsurers. Ceding commissions are amounts that reinsurers pay to us for placing reinsurance with them.
Under certain of our excess of loss reinsurance policies, the reinsurer returns a portion of the premiums we cede as ceding commissions to reimburse us for our cost of placing and managing policies. Ceding commissions received under excess of loss reinsurance policies totaled $2.4 million in 2004 compared to $1.5 million in 2003. These ceding commissions reduced our policy acquisition costs. No similar ceding commissions existed in 2002. Excluding the effect of ceding commissions, policy acquisition costs were $8.4 million in 2004, $8.4 million in 2003 and $6.3 million in 2002. As a percent of gross premiums earned, direct policy acquisition costs were 13.3% in 2004 compared to 15.4% in 2003 and 10.1% in 2002. The decrease in 2004 and increase in 2003 compared to 2002 reflect the following:
Gross premiums earned increased in 2004 compared to 2003 and 2002 resulting in corresponding increases in policy acquisition costs;
Commission expense decreased to 7.1% of gross premiums earned in 2004 from 7.3% in 2003 and increased from 6.9% in 2002. This decrease in commission rates is the result of new business growth that we experienced in the second half of 2003 on which we paid higher commission rates and the focus in 2004 on reducing the commissions we pay. In 2002, our renewal business, on which we pay lower commission rates, significantly outpaced our new business. In all of our markets, we believe the commission rates we pay are marketplace competitive;
Premium tax expense paid to states was 1.8% of gross premiums earned in 2004, 1.8% of gross premiums earned in 2003 and 1.7% in 2002; and
Other policy acquisition costs consist of various state and regulatory assessments related to second injury funds and mandatory state pools, payroll audit vendor costs, and the net effect of assigned risk plan activity in the states in which we operate. Other policy acquisition costs were affected by the following: (i) in 2004, we recorded a $478,000 increase in other policy acquisition costs reflecting a re-allocation of 2003 mandatory reinsurance pool expenses compared to a $1.5 million increase recorded in 2003; we were not assessed any re-allocation in 2002; (ii) in 2002, Michigan changed the basis of its second injury fund assessment from a claims based assessment to a premium based assessment, resulting in an $851,000 benefit in 2002 compared to no benefit received in 2004 or 2003; (iii) in 2002, we received a $541,000 favorable adjustment from a state data collection agency resulting from our significant decrease in premiums; and (iv) a general change related to the increase or decrease in gross premiums earned. Excluding the mandatory pool re-allocation, second injury fund assessment changes and refunds from data collection organizations discussed above, other policy acquisitions costs were 3.6% in 2004, 3.6% in 2003 and 3.7% in 2002.
Our general and administrative expenses decreased to $9.2 million in 2004 from $10.8 million in 2003 and $10.0 million in 2002. As a percent of gross premiums earned, general and administrative expenses decreased to 14.5% in 2004 from 19.8% in 2003 and 16.0% in 2002. General and administrative expenses decreased in 2004 from 2003 and 2002 as follows:
2005 Outlook: We expect that general and administrative expenses will be affected by the following:
General and administrative expenses, as a percentage of gross premiums earned, are expected to decrease since we will earn more premium and service revenue in 2005 and will have more premium and revenue to cover our relatively fixed costs;
Although we have no current plans to open additional offices in 2005, if service opportunities warrant opening a new office, we will evaluate the opportunities that present themselves; and
Our portfolio of fixed maturity securities included U.S. government securities (48.3%), mortgage-backed securities (27.8%), municipal securities (21.6%) and asset-backed securities (2.3%) at December 31, 2004. Our portfolio is managed by an independent investment manager to maximize our after-tax investment income without taking inappropriate credit risk. In 2004 and 2003, we sold certain securities within the portfolio to take advantage of favorable interest rates and realized net investment gains totaling $705,000 and $685,000, respectively. In 2002, we sold certain securities within the portfolio to reduce risk and realized investment gains totaling $1.7 million. We conservatively manage our fixed maturity portfolio, investing only in investment grade (BBB or better rating from Standard and Poor’s) securities of U.S. domiciled issuers. All securities in our portfolio were rated AAA or AA at December 31, 2004. We do not invest in derivative securities.
of investments. Additionally, as we lowered our reinsurance retention levels to $25,000 in mid-1998, we decreased our current period cash flows as a result of “pre-funding” quarterly reinsurance premiums under that agreement. Our investment portfolio increased $7.8 million to $87.0 million at December 31, 2004 from $79.2 million at December 31, 2003. During 2004, interest rates declined early in the year, leading to significant mortgage refinancing by consumers, resulting in significant prepayment or early redemption of our mortgage-backed securities. Cash and cash equivalents were $39.5 million at December 31, 2004 compared to $39.4 million at December 31, 2003. We expect that cash will decrease and investments will increase in 2005 and as we invest available cash into additional fixed-income securities.
The amount by which estimated net reserves, measured subsequently by reference to payments and additional estimates, differ from those originally reported for a period is known as “development.” Development is unfavorable (deficient) when losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for reserve increases on open claims. Development is favorable (redundant) when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on open claims. Favorable or unfavorable development of loss reserves is reflected in earnings in the year recognized.
Estimating the effect that inflation will have on the ultimate cost of claims is a major risk factor in our workers’ compensation reserve estimates. Future earnings will be affected by reserve development associated with any changes in our inflation assumptions. Estimates for the 2004 and 2003 accident years represent the majority (52.1% of the net reserves) of the uncertainty because these claims have the lowest proportionate amount of paid loss as of December 31, 2004. Our reserve estimates are most sensitive to changes in the assumption about inflation for the 2004 and 2003 accident years. Each one percent (1%) increase or decrease in the inflation rate for each of these accident years would increase or decrease our net loss reserve estimates at December 31, 2004 by approximately $380,000.
Our reserves are primarily undiscounted; however, we discounted reserves for selected claims that have fixed and determinable future payments at rates ranging from 3.5% to 8.0% in 2004 and 2003. The discount rates are subject to change as market interest rates change. We use the same rates for U.S. generally accepted accounting principles as we do for statutory accounting practices in determining our liability. We also reduce the unpaid claim and claim settlement expenses for estimated amounts of subrogation.
We continually monitor loss development trends and data to establish adequate premium rates and to determine reasonable reserve estimates. Reserves that are based on estimates are inherently uncertain and represent a significant risk to the business. We attempt to mitigate this risk by continually improving and refining our workers’ compensation claims processing practices and by continual monitoring through actuarial estimation methods.
and, therefore, ending balances should not be added since the amount at the end of each calendar year includes activity for both current and prior years (000’s):
The table above represents the development of balance sheet gross reserves for 1994 through 2004. The upper portion of the table shows the cumulative amount paid with respect to the previously recorded reserves as of the end of each succeeding year. The lower portion of the table shows the re-estimated amount of the previously recorded gross reserves, based on experience as of the end of each succeeding year. The estimate is either increased or decreased as more information becomes known about the frequency and severity of claims for individual years.
The “initial reserves in excess of (less than) re-estimated reserves” rows represent the aggregate change in the estimates over all prior years. For example, the 1998 reserve developed an $8.4 million net deficiency over the course of the succeeding years.
The table above represents the development of balance sheet net reserves for 1994 through 2004. The top three rows of the table reconcile gross reserves to net reserves for unpaid claim and claim settlement expenses recorded at the balance sheet date for each of the indicated years.
The lower portion of the table shows the re-estimated amount of the previously recorded net reserves, based on experience as of the end of each succeeding year. The estimate is either increased or decreased as more information becomes known about the frequency and severity of claims for individual years. For example, for the 1998 calendar year valued as of December 31, 2004, we paid $65.3 million of the currently estimated $78.9 million of claim and claim settlement expenses that were incurred through the end of 1998. Thus, the difference, an estimated $13.6 million of claim and claim settlement expenses incurred through 1998, remained unpaid as of December 31, 2004.
The “initial reserves in excess of (less than) re-estimated reserves” rows represent the aggregate change in the estimates over all prior years. For example, the 1998 reserve developed a $3.0 million net deficiency over the course of the succeeding years. The net amount has been included in income and the changes have been recorded in the period identified. The cumulative net deficiencies in 2000 and 1999 are the result of reserve development inherent in the uncertainty in establishing reserves and anticipated loss trends. As discussed above, due to our relatively limited historical claim data and small claim population, our estimate of the liability for net reserves is difficult and volatile. As discussed further below, the reserve redundancy in 2001 is the result of accrual reversals resulting from changes in methods of assessing second injury funds, lower frequency in claims reported from the estimate at December 31, 2001, and reductions in amounts expected to be incurred for our participation in mandatory state and national assigned risk pools.
The 2002 results include an $8.4 million decrease in prior years’ reserves for unpaid claim and claim settlement expenses. Our estimate for unpaid claim and claim settlement expenses decreased in 2002 due to the following: (i) in March 2002, the Minnesota State legislature changed the way the commissioner assessed self-insured employers and insurers for estimated liabilities and administrative expenses of the Minnesota Special Compensation Fund. The assessment changed from being paid by the insurer on indemnity payment basis to an assessment charged on premium to the policyholder. We decreased our recorded accrual to reflect this legislative change; (ii) the frequency of claims reported in 2002 for 2001 and prior years was less than anticipated when we determined our liability in 2001; (iii) we overestimated the liability for our mandatory participation in state and national assigned risk pool operating results for states in which we operate in 2001 and reversed that excess in 2002; and (iv) our estimate of the liability for unpaid claim and claim settlement expenses is difficult and volatile due to our relatively limited historical claim data and small claim population.
Cash provided by operating activities was $8.1 million for 2004. This is primarily a result of net income of $9.9 million, an increase of $6.1 million in unpaid claim and claim settlement expenses, a $1.0 million increase in unearned premiums, net of premiums receivable and depreciation expense of $952,000 offset by an increase in amounts due from reinsurers of $6.8 million, net realized investment gains totaling $705,000 and a net reduction in our deferred tax asset of $2.5 million. Net cash used in investing activities was $8.9 million due to $21.6 million in proceeds from sales of securities and $11.3 million in maturities of investments offset by
Our need for additional capital is primarily the result of regulations that require certain ratios of regulatory or statutory capital to premiums written in our insurance subsidiary as defined by state regulatory bodies and insurance rating agencies. Raising additional permanent capital, while difficult in the current environment in which we operate, would further reduce our ratio of premium to capital and provide a more solid base for the future growth of our insurance subsidiary. As an alternative to raising additional permanent capital, certain reinsurance contracts could be used on an interim basis that would have the effect of reducing the ratio of premiums to capital and surplus in ACIC to satisfy state regulatory requirements.
Minnesota state insurance regulations limit distributions, including dividends, from our insurance subsidiary to us. Under Minnesota insurance law regulating the payment of dividends, in any twelve month period, ACIC can pay a dividend to us from its earned surplus (unassigned surplus) not to exceed the greater of 10% of ACIC’s total surplus or ACIC’s prior years’ net income reduced for realized capital gains net of income taxes. At December 31, 2004, ACIC could pay a dividend to us totaling $3.2 million without the approval of the Minnesota Department of Commerce (See Note 9 of Notes to Consolidated Financial Statements). ACIC has never paid a dividend to us, and we intend to retain capital in the insurance subsidiary.
On September 15, 1998, our Board of Directors approved a share repurchase program authorizing us to repurchase, from time to time, up to $4,000,000 of RTW, Inc. common stock. No shares were repurchased under this program in 2004. We repurchased 18,619 shares in 2003 for approximately $37,000 and 41,324 shares in 2002 for approximately $78,000. We repurchased these shares on the open market or through private transactions based upon market conditions and availability. The repurchased shares will be used for employee stock option and purchase plans and other corporate purposes.
Our fixed maturity investments are subject to interest rate risk. Increases and decreases in prevailing interest rates generally translate into decreases and increases in the fair value of these instruments. Also, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, prepayment
Our insurance subsidiary is subject to substantial regulation by governmental agencies in the states in which we operate, and will be subject to such regulation in any state in which we provide workers’ compensation products and services in the future. State regulatory agencies have broad administrative power with respect to all aspects of our business, including premium rates, benefit levels, policy forms, dividend payments, capital adequacy and the amount and type of investments. These regulations are primarily intended to protect covered employees and policyholders rather than the insurance company. Both the legislation covering insurance companies and the regulations adopted by state agencies are subject to change. At December 31, 2004, our insurance subsidiary was licensed to do business in twenty-three states.
Consolidated Statements of Income - Years Ended December 31, 2004, 2003 and
Consolidated Statements of Shareholders’ Equity - Years Ended December 31, 2004, 2003 and 2002
Notes to Consolidated Financial Statements - Years Ended December 31, 2004, 2003 and 2002
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of RTW, Inc. at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
Organization - RTW, Inc. (RTW) provides disability management services, directed today at workers’ compensation to: (i) employers insured through our wholly-owned insurance subsidiary, American Compensation Insurance Company (ACIC); (ii) self-insured employers on a fee-for-service basis; (iii) state assigned risk plans on a percent of premium basis; (iv) other insurance companies; and (v) on a consulting basis to agents and employers, charging hourly fees through RTW and its division, Absentia. ACIC offers guaranteed cost workers’ compensation insurance to employers located primarily in Minnesota, Michigan and Colorado and is licensed in twenty-three states. Collectively, “we,” “our” and “us” refer to RTW and ACIC in these Notes to Consolidated Financial Statements.
We benefit from our ability to reduce workers’ compensation and disability system costs and provide employers the ability to control their workers’ compensation and disability programs. Our insurance subsidiary is domiciled in Minnesota and is licensed in twenty-three states. We operated primarily in Minnesota, Michigan and Colorado in 2004 and 2003 and began servicing non-insurance customers in California and Indiana in 2004. In 2002, we non-renewed all insurance policies in our Missouri and Massachusetts regions and completed our run-off of policies in these regions by February 2003. During 2004 and prior years, we operated in a single business segment, disability management products and services.
Realized Investment Gains and Losses: Net realized investment gains and losses are identified separately in our Consolidated Statements of Income. Cost of investments sold is determined by the specific identification method.
We continually monitor the difference between investment cost and fair value for each of our securities. If any security experiences a decline in value that is determined to be other than temporary, we reduce the security’s carrying value for the decline and record a realized loss in the Consolidated Statements of Income. No securities were reduced for declines in fair value in 2004, 2003 or 2002.
Fair Value of Financial Instruments - A number of our significant assets and liabilities (including reinsurance recoverables, deferred policy acquisition costs, furniture and equipment and unpaid claim and claim settlement expenses) are not considered financial instruments for disclosure purposes. Our premiums receivable and other assets and liabilities that are considered financial instruments are generally of a short-term nature. The carrying values of these instruments approximate their fair values. The carrying values and fair values of investments are disclosed in Note 3.
Depreciation - We depreciate furniture and equipment on a straight-line basis over the estimated useful life of the asset (five to ten years). Furniture and equipment are recorded at cost less accumulated depreciation of $4.7 million and $4.4 million at December 31, 2004 and 2003 respectively.
Unpaid Claim and Claim Settlement Expenses - Claim expenses refer to amounts that we paid or expect to pay to claimants for insured events that have occurred. The costs of investigating, resolving and processing claims are referred to as claim settlement expenses. We record these expenses, net of amounts recoverable under reinsurance contracts, as “Claim and claim settlement expenses” in the Consolidated Statements of Income.
Stock-Based Compensation - Had we calculated compensation expense for our option grants under the 1994 Stock Plan and stock issuances under the Employee Stock Purchase Plan (ESPP) based on the fair value method described in Statement of Financial Accounting Standard (SFAS) No. 123, “Accounting for Stock-Based Compensation,” our net income and basic and dilutive net income per share would approximate the following pro forma amounts (in 000’s, except per share data):
The weighted average fair value of options granted under the ESPP and 1994 Stock Plan during 2004, 2003 and 2002 is estimated at $2.13, $1.48 and $1.48, respectively, on the date of grant using the Black-Scholes option-pricing model with the following assumptions: no dividend yield; volatility of 41.0% to 73.8% in 2004, 115.3% to 131.5% in 2003 and 125.6% in 2002; risk-free interest rates ranging from 1.05% to 7.70%; and an expected life of 1 to 5 years.
unrealized losses for a period sufficient for recovery of such losses. In September 2004, FASB approved FASB Staff Position (“FSP”) EITF Issue 03-1-1, which delays the effective date for measurement and recognition guidance contained in paragraphs 10-20 of EITF 03-1 until certain issues are resolved. The delay of the recognition and measurement provisions is expected to be superceded concurrently with the issuance of a FSP, which will provide additional implementation guidance. We will evaluate the effect this guidance will have on our financial statements and will adopt the guidance at the time it is issued. We have previously implemented the disclosure requirements of EITF 03-1.
The gross unrealized loss in all cases is the result of a decline in interest rates and is not the result of deterioration in the credit quality of the issuers. All issues carry a credit quality of AAA or AA (Standard & Poors). We have the ability and intent to hold all of these securities to maturity or recovery. We consider all relevant facts and circumstances in evaluating whether the impairment of a security is other than temporary. Relevant facts and circumstances we consider include: (i) the length of time the fair value has been below
During 2003, we re-evaluated and lowered our estimate for excess of loss unpaid claim and claim settlement expenses by $15.1 million, which inures to the benefit of our reinsurers. Excluding the effect of this benefit, our ceded losses to reinsurers would have been $8.8 million.
The reinsurance recoverable on paid claim and claim settlement expenses consists primarily of receivables from paid claim and claim settlement expenses that were submitted but not yet reimbursed by reinsurers at December 31, 2004 and 2003.
Our estimate for unpaid claim and claim settlement expenses decreased in 2004 due to the following: (i) we improved our effectiveness in managing open claims, closing them earlier than originally anticipated; and (ii) our estimate of the liability for unpaid claim and claim settlement expenses is difficult and volatile due to our relatively limited historical claim data and small claim population.
Our estimate for reinsurance recoverables increased in 2004 due to: (i) the growth in our gross premiums earned in 2004; and (ii) payments and the related recoveries on prior year ceded claim and claim settlement expenses.
Our estimate for reinsurance recoverables decreased in 2003 due to: (i) re-evaluating and lowering our estimate for gross unpaid claim and claim settlement expenses by $15.1 million; and (ii) payments and the related recoveries on prior year ceded claim and claim settlement expenses.
differences. The tax effects of temporary differences that give rise to net deferred tax assets, included within other assets, are as follows (000’s):
1995 Employee Stock Purchase Plan - The ESPP provides employees the opportunity to purchase shares of our stock at 85% of the fair value based on the lesser of the beginning or ending share price for each plan year as set forth in the plan. In 2003, the shares reserved for distribution under the plan were increased from 100,000 to 150,000 shares. In 2004, the ESPP was amended to allow the issuance of stock within 10 years of any increase in the number of shares authorized to be issued under the plan. The ESPP terminates in 2013 and will be carried out in phases, each consisting of one year or a different period of time approved by the Board of Directors. Any employee completing two weeks of service prior to commencing a phase of the plan may participate. Employees may elect to contribute from $10 to 10% of monthly salary to the plan through payroll
The tenth one-year phase began in April 2004 and expires in April 2005.
The following table summarizes the options outstanding and exercisable at December 31, 2004:
Employee Stock Ownership Component - We maintain an ESOP for our qualified employees. Our contributions are discretionary. We may contribute cash or shares of our common stock. No contributions were made or expense recorded in 2004, 2003 or 2002.
Other Employee Benefit Plans - We maintained bonus plans in 2004, 2003 and 2002 under which all employees, including officers, were eligible for a bonus based on our operating results. These bonuses aggregated $1,295,000, $941,000 and $864,000 in 2004, 2003 and 2002, respectively.
Shareholder Rights Plan - In April 1997, we adopted a shareholder rights plan and declared a dividend of one right for each outstanding share of common stock to shareholders of record at the close of business on June 30, 1997. The rights become exercisable only after any person or group (the Acquiring Person) becomes the beneficial owner of 15% or more of the voting power of our common stock. Certain shares held by our Chairman Emeritus, David C. Prosser, and his wife are excluded from the computation for determining whether a person is an Acquiring Person. Each right entitles its registered holder to purchase from us one one-hundredth share of a new Series A Junior Participating Preferred Stock, no par value, at a price of $85 per one one-hundredth share, subject to adjustment. If any Acquiring Person acquires beneficial ownership of 15% or more of our voting power, each right will entitle its holder (other than such Acquiring Person) to purchase, at the then current purchase price of the right, that number of shares of our common stock having a market value of two times the purchase price of the right, subject to certain possible adjustments. In addition, if we are acquired in a merger or other business combination transaction, each right will entitle its holder to purchase, at the then current purchase price of the right, that number of common shares of the acquiring company having a market value of two times the purchase price of the right. Following the acquisition of a beneficial ownership of 15% or more of our outstanding common stock by any Acquiring Person and prior to an acquisition by any Acquiring Person of 50% or more of our outstanding common stock, our Board of Directors may exchange the outstanding rights (other than rights owned by such Acquiring Person), in whole or in part, at an exchange ratio of one share of common stock, or one one-hundredth share of Preferred Stock (or equivalent securities) per right, subject to adjustment. We may redeem the rights, in whole, at $.001 per right, at any time prior to an acquisition by any Acquiring Person of 15% or more of our outstanding common stock and prior to the expiration of the rights. The rights expire on April 17, 2007, unless extended or earlier redeemed by us.
Under Minnesota insurance law regulating the payment of dividends by ACIC, any such payments must be an amount deemed prudent by ACIC’s Board of Directors and, unless otherwise approved by the Commissioner of the Minnesota Department of Commerce (Commissioner), must be paid solely from the adjusted earned surplus of ACIC. Adjusted earned surplus means the earned surplus as determined in accordance with statutory accounting practices (unassigned funds), less 25% of the amount of such earned surplus that is attributable to unrealized capital gains. Further, without approval of the Commissioner, ACIC may not pay a dividend in any calendar year which, when combined with dividends paid in the preceding twelve months, exceeds the greater of: (i) 10% of ACIC’s statutory capital and surplus at the prior year end; or (ii) 100% of ACIC’s statutory net gain from operations (not including realized capital gains) for the prior calendar year. For 2005, dividends in excess of $3.9 million would require prior consent of the Commissioner.
December 31, 2004 and 2003, and statutory net income for the years ended December 31, 2004, 2003 and 2002 are as follows (000’s):
Our accumulated other comprehensive income includes only unrealized gains and losses on investments classified as available-for-sale. Changes in accumulated other comprehensive income and other comprehensive income (loss) were as follows (000’s):
During 2001, we recorded pre-tax restructuring charges totaling $2.0 million to general and administrative expenses in the Consolidated Statement of Income. These charges included costs associated with our decision to close our Missouri and Massachusetts regional offices, and our Brainerd, Minnesota and Overland Park, Kansas satellite offices. The restructuring charge included $715,000 of severance pay and benefits, of which $106,000 was paid by December 31, 2001 and the remainder of which was paid in early 2002. The restructuring charge also included office and equipment lease costs totaling $684,000 and furniture and equipment disposals and other costs totaling $600,000. At December 31, 2003, the remaining accrual totaled $248,000 and included amounts related to future lease payments. No accrual remained at December 31, 2004.
In June 2001, we entered into an agreement with St. Paul RE (SPR) effective January 1, 2001. Key provisions of this agreement included ceding 50% of the subject net earned premium to SPR in exchange for various levels of paid claim reimbursement through several loss corridors as defined in the agreement. In December 2002, we negotiated the termination of this agreement with SPR. In connection with the termination, we received $28.8 million in cash in December 2002 representing a return of all deposits made under the agreement less claim reimbursements for claims paid through December 2002. In 2002, we recorded a gain on the termination totaling $1.0 million representing the difference between the deposit receivable balance and the amount received from SPR.
The following tables present unaudited quarterly income for the eight quarters ended December 31, 2004:
The following represent pre-tax adjustments recorded during 2004 that affected reported net income: