The data below should be read in conjunction with the consolidated financial statements, related footnotes, and other financial information included herein. All dollar amounts in the following tables are in thousands, except per share data.
The purpose of the following discussion and analysis is to provide you with information that will assist you in understanding our financial condition and results of operations as reported in our consolidated financial statements. Therefore, the following should be read in conjunction with our consolidated financial statements in this Form 10-K.
requiring personal automobile insurers to issue a policy to any eligible applicant who seeks one, known as the "take all comers" law,
mandating that higher compulsory and optional coverages be offered to all eligible drivers, and
There have been three related initiatives in recent periods to change significantly the manner in which the Massachusetts regulation of personal automobile insurance addresses risks which the industry perceives to be under-priced in the current regulatory environment. In December 2004, the Massachusetts Insurance Commissioner adopted new regulations that, among other things, would have replaced the CAR loss-pooling residual market structure with an assigned risk plan. We appealed the Commissioner's order in January 2005, contending that the new regulations are inconsistent with existing Massachusetts insurance laws. The Superior Court ruled in June 2005 that the Commissioner did not have the statutory authority to implement an assigned risk plan. The court's ruling annulled the Commissioner's order and vacated the new regulations adopted pursuant to the order. The Commissioner appealed the Superior Court's decision to the Massachusetts Appeals Court. We and the Commissioner both petitioned for direct appellate review by the Massachusetts Supreme Judicial Court (the SJC). The SJC agreed on October 26, 2005 to hear the appeal directly. The parties have submitted briefs to the SJC and the SJC is expected to hear oral arguments in April or May, 2006. We cannot predict how the SJC will rule on the appeal, nor can we predict when this matter will be resolved. However, we believe that even if the Commissioner's appeal is upheld by the SJC, it is unlikely that the new regulations in the Commissioner's order will be implemented retroactive to January 1, 2005 in light of the recent ERP redistribution discussed below. In our 2004 Form 10-K, we provided an estimate of the impact of the December 31, 2004 Commissioner's order. However, based on the uncertainty of the resolution of the court case and the impact of the redistribution, the prior estimate is no longer valid and we are unable to provide a new estimate of the impact of the Commissioner's order.
On September 30, 2005, the Commissioner directed that CAR implement a plan to redistribute personal automobile ERPs in an attempt to establish, for all Servicing Carriers, overall parity in the quantity and quality of ERP exposures. The redistribution plan sought to achieve parity in average loss ratio by giving each Servicing Carrier a proportionate mix of the ERPs with high and low loss ratios commensurate with the Servicing Carrier's voluntary Massachusetts business. The final plan called for about 133 ERPs statewide, who are writing business only with CAR, to be redistributed among different carriers. The redistribution plan for ERPs, as adopted by the CAR Governing Committee on November 16 and December 14, 2005, was approved by the Commissioner on January 27, 2006. The plan is effective March 1, 2006 for all new business and May 1, 2006 for all renewal business with all market activity through the close of business January 26, 2006 being reflected in the redistribution. The redistribution plan called for 58 ERPs to be re-assigned from us to other carriers. These ERPs collectively had 61,674 written exposures, with loss ratios lower than the three-year average loss ratio for all ERPs statewide. Of these 58 ERPs, we offered 51 voluntary contracts, and 49 of the ERPs accepted the offer. These 49 ERPs, who are now our voluntary agents, have 52,796 written exposures. Also resulting from the redistribution plan, 27 new ERPs with loss ratios greater than the three-year average loss ratio for all ERPs, whose written exposures totaled 56,888, were re-assigned from other carriers to us.
While we believe it is premature to estimate the impact of the redistribution plan on our future financial results, we have estimated the pro-forma impact of the distribution plan on our 2005 results utilizing currently available information as if the redistribution plan became effective on January 1, 2005. Based on our analysis of the impact of the redistribution, we estimate that Commerce would have incurred additional pre-tax expense ranging between $7,600 and $10,300, depending upon the level of exposures that would be ceded to CAR. These amounts are significantly affected by the loss ratios of the ERPs assigned to us and the size of the CAR deficit, which CAR currently estimates at $155,000 for CAR policy year 2005, and we do not include the financial impact of future assignment of additional ERPs that we may have received due to providing voluntary contracts to certain low loss ratio ERPs as noted above. Lastly, offsetting the estimated increased pre-tax expense, we expect that our agent profit sharing expenses would have declined between $2,800 and $3,800, resulting in a net estimated pro-forma impact of between $4,800 and $6,500 additional pre-tax expense for the redistribution plan.
premiums that we receive from sales by our agents of property and casualty insurance policies, primarily personal automobile, homeowners and commercial automobile, which we refer to as direct premiums written, plus
premiums we receive from insurance policies that we assume, primarily from CAR, which we refer to as assumed premiums, less
incurred losses and loss adjustment expenses (which we sometimes refer to as LAE), including estimates for losses incurred during the period but not yet reported to us and changes in estimates from prior periods related to direct and assumed business, less the portion of those incurred losses and loss adjustment expenses that are ceded to other insurers; and
policy acquisition costs, including agent compensation and general and administrative costs, such as salaries and benefits, and advertising that are not deferred for accounting purposes to a future period.
Unpaid Losses and Loss Adjustment Expenses. The liability for loss and loss adjustment expenses represents our best estimate of the ultimate net cost of all loss and loss adjustment expenses incurred after reinsurance and amounts estimated to be recoverable through salvage and subrogation. The estimate for the ultimate net cost of all losses incurred through the balance sheet date includes the adjusted case estimates for losses, incurred but not reported (IBNR) losses, salvage and subrogation recoverable and a reserve for LAE. In arriving at our best estimate, we begin with the aggregate of individual case reserves and then make adjustments to these amounts on a line of business basis. These adjustments to the aggregate case reserves by line of business are made based on analyses performed by us. The entire liability for unpaid losses and LAE is also separately reviewed quarterly and annually by our actuarial department. Liability estimates are continually analyzed and updated, and therefore, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimates are included in the results of operations in the period in which the estimates are revised.
This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors, as noted above.
Our financial management personnel calculate our estimate independently from those amounts calculated by our actuaries, and therefore, the final results are usually different. We estimate our amounts primarily by reviewing historical loss and LAE data, focusing mainly on payment data. We also review and compare the most recent loss frequency, severity, and payment data to historical trends in an attempt to determine if patterns are remaining consistent or not. We attempt to establish our reserve estimate as close as possible to the amount required for the ultimate future payments necessary to settle all losses. Our aggregate actuarial estimate for the loss and LAE reserves, on a consolidated basis and net of reinsurance recoverable, ranges from a low of $764,600 to a high of $877,900, as of December 31, 2005. Our financial statement loss and LAE reserves net of reinsurance, based on our best estimate, were established at $834,699 for that date.
Overview. We have been the largest writer of personal property and casualty insurance in Massachusetts in terms of market share of direct premiums written since 1990. Our estimated share of the Massachusetts personal automobile market increased to 29.9% for the year ended December 31, 2005, significantly exceeding our two nearest competitors, Safety Insurance Group, Inc. and Arbella Insurance Group, who maintained an estimated 11.3% and 9.1% market shares, respectively.
Affinity Group Marketing. Since 1995, we have been a leader in affinity group marketing in Massachusetts, through agreements with the three American Automobile Association Clubs operating in Massachusetts, offering discounts on private passenger automobile insurance to the clubs' members who reside in the state. A 5% discount was approved by the Commissioner for policies effective January 1, 2006. This same discount existed in 2005. Based on information provided to us by the AAA clubs operating in Massachusetts, we believe that membership in these clubs represents approximately one-third of the Massachusetts motoring public. The following table presents total direct premiums written attributable to the AAA clubs' group business in Massachusetts for the years ended December 31:
Written. Direct premiums written is the sum of the total policy premiums, net of cancellations, associated with policies underwritten and issued by our insurance subsidiaries. We use direct premiums written, which includes premiums that we cede to CAR and other reinsurers, as a measure of the underlying growth of our insurance business from period to period.
. The loss and LAE ratio is the percentage of losses and loss adjustment expenses (including corporate expenses) incurred to earned premiums. We calculate this ratio net of our reinsurance recoveries. We use this ratio as a measure of the overall underwriting profitability of the insurance business we write and to assess the adequacy of our pricing.
. The combined ratio is the sum of the loss and LAE ratio and the underwriting expense ratio and measures a company's overall underwriting profit. If the combined ratio is at or above 100%, an insurance company cannot be profitable without investment income, and may not be profitable if investment income is insufficient. We use the combined ratio in evaluating our overall underwriting profitability and for comparing our profitability to that of our competitors.
Our key operating measures for the years ended December 31 follow (dollars in millions, except earnings per share):
These items were partially offset by reduced favorable voluntary loss reserve development compared to 2004.
Our net investment income for the year ended 2005 increased $7,500, or 6.5% compared to 2004. Net investment income is affected by the composition of our investment portfolio and yields on those investments.
The increase in our net investment income in 2005 was primarily due to increased invested assets partially offset by lower overall yields. The increase in invested assets is primarily attributable to increased operating cash flows. The decrease in yields corresponds with the decline in duration of our fixed maturity portfolio in which we sold higher yielding investment securities. This is particularly true in the corporate and municipal bonds segments, where pre-tax yields declined 120 to 70 basis points, respectively.
Redundancies related to prior years for CAR Private Passenger Auto Liability accounted for approximately one-half of the 2.4% decrease in the loss ratio from 2004. These items were partially offset by reduced favorable voluntary loss reserve development compared to 2004.
Management considers many factors, as disclosed in the Critical Accounting Policies section of this report, in establishing its best estimate for loss and LAE reserves. We believe that our loss and LAE reserve estimate is a true and reasonable representation of the ultimate future payment amounts necessary to settle all of our insured losses incurred as of December 31, 2005. In addition, we believe this pro forma analysis is a reasonable depiction of our sensitivity related to our estimate, based on our reserving methodology and the short-tail nature of the business that we write. However, the ultimate liability may be greater or lower than the established reserves for losses and LAE. If the ultimate payments are greater or less than our estimated liability for losses and LAE, we will either incur additional or less expenses, respectively, in future periods which may have a material effect on our future results of operations.
Our overall effective tax rate for the year ended 2005 was 30.6% as compared to 29.3% for 2004. In both years, our effective rate was lower than the statutory rate of 35.0% primarily due to tax-exempt interest and the corporate dividends received deduction. Our effective tax rate increased in 2005 due to improved underwriting results which are taxed at 35%.
The Financial Accounting Standards Board issued in December 2004 revised rules for accounting for stock options and other equity-based remuneration, SFAS No. 123R, Share-Based Payment. SFAS No. 123R is applicable for employee options and not for non-employee options, such as ACIC agents' options. We will adopt these revised rules in the first quarter of 2006 when they become effective. This change will not impact our results of operations and financial condition for the stock options we awarded through 2001 under the Plan because application of the revised rules is on a prospective basis. The revised rules will not change our accounting for BVAs, IAs and the stock options we award under the ACIC Plan.
insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards (SFAS) No. 97. Internal replacements are modifications in product benefits, features, rights, or coverages that occur by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. The provisions of this SOP are effective for internal replacements occurring in fiscal years beginning after December 15, 2006. We will adopt this SOP during the first quarter of 2007. Financial statement application of this SOP is prospective and initial application would generally occur as of the beginning of the fiscal year. We believe the adoption of this SOP will not have a material impact on our future financial statements.
In November 2005, the FASB issued Staff Position (FSP) 115-1 and 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. This FSP addresses the determination as to when an investment is impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss. The guidance in this FSP shall be applied to reporting periods beginning after December 15, 2005; however, early application is permitted. We will adopt this FSP during the first quarter of 2006. We believe the application of the provisions of this FSP will not have a material impact on our financial statements.
The significant increase in earnings and ROE in 2004 over 2003 was primarily due to the decrease in our loss ratio. We attribute the improvement in our loss ratio primarily to several factors:
Our net investment income for the year ended 2004 increased $23,528, or 25.5% compared to 2003. Net investment income is affected by the composition of our investment portfolio and yields on those investments.
As a result of changes in estimates of insured events in prior years, the provision for loss and LAE decreased $57,031 for the year ended 2004 and $25,224 for the year ended 2003. The favorable development is due primarily to lower than anticipated losses related to the personal automobile liability, the automobile physical damage and the commercial multiple peril lines of business. Conditions and trends that have affected development in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based upon these
Approximately $51,027 in personal automobile liability redundancies developed for the year ended 2004, with 98.0% of this amount coming from the 2003, 2002 and 2001 accident years. The primary reason for the redundancies in this area is that claim severity came in better than we anticipated. The redundancy for personal automobile liability that related to CAR accounted for approximately 2.5% of the total. Automobile physical damage had approximately $2,334 in redundancies related to the 2003 accident year, approximately 98% of which was related to CAR. In 2004, we also experienced redundancies of $2,222 for the commercial multiple peril line of business, half of which related to the 1996 accident year. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining approximately $1,448 net redundancy.
Total unpaid losses and LAE by line of business at December 31, 2004 and 2003 follow (in millions):
Ceded unpaid losses and LAE recoverable by line of business at December 31, 2004 and 2003 follow (in millions):
In addition to the increase in agents' profit sharing expense in 2004, policy acquisition cost increases are due to our premium growth. Increases in stock option and BVA expenses in the 2004 periods have similarly affected policy acquisition costs.
Our financial condition improved significantly in 2005. Our stockholders' equity per share increased 15.8% from $33.50 at December 31, 2004 to $38.78 at December 31, 2005. Our ratio of total liabilities to stockholders' equity decreased nearly 23 percentage points at December 31, 2005 from the prior year end, despite total liability growth of 5.0%. This decrease is primarily due to the 16.9% increase in equity from current year earnings and growth in paid-in capital from stock option exercises, partially offset by dividends paid and the change in net accumulated other comprehensive income.
Total assets increased $314,767, or 8.7%, versus the prior year end. Predictably, as they comprise 70% of total assets, investment growth presented the majority, or 75%, of the increase. Investments increased $237,596, or 9.4%, from increased operating cash flows from premium growth and retained net earnings. We continue to maintain our cash and fixed maturity investments at levels to both service our liabilities and optimize after-tax returns. Increases in premiums receivable and deferred policy acquisition costs correspond to the growth in direct written premiums, with deferred policy acquisition costs also being impacted by increased profit sharing expenses in 2005. Deferred income taxes increased primarily due to the resulting deferred tax benefit of the decline in value of available for sale securities and the application for a change in tax accounting method on file with the IRS for deferred profit sharing.
Ceded unpaid losses and LAE recoverable by line of business at December 31, 2005 and 2004 follow (in millions):
Unpaid losses and LAE reserves net of ceded reinsurance recoverable, by line of business, at December 31, 2005 and 2004, and the actuarial low and high range estimates at December 31, 2005 follow (in millions):
The liability for unpaid losses and LAE represents the accumulation of individual case estimates for reported losses, adjustments to this amount on a line of business basis and estimates for incurred but not reported losses and LAE, net of salvage and subrogation recoverable. The liability is intended to cover the ultimate net cost of all losses and LAE incurred through the balance sheet date. Payment amounts are estimated, based on payment patterns experienced through 2005.
The other limited partnership interest required a commitment by us to invest up to $3,500 into the partnership. As of December 31, 2005, we invested $2,555 into the partnership. The partnership was formed to operate as an investment fund principally for the purpose of making investments in equity and equity related securities of companies operating in the area of insurance distribution and distribution related activities.
$484,000. There are several limitations in the contract regarding losses related to nuclear, chemical, and biological terrorist events. Our maximum loss recovery in case of these types of events is estimated at $30,000. Our estimated total loss, before reinsurance, on our other than automobile business for 100 and 250-year hurricanes is approximately $340,000 and $640,000, respectively. We derived our estimates through the services of Holborn Corporation on our December 31, 2005 other-than-automobile exposures, which utilized the RMS (Risk Management Solutions) risk assessment system. We believe that most property and casualty insurance companies establish their catastrophe reinsurance programs between the 100-year and 250-year storm estimates. Note M to our consolidated financial statements provides additional information about our reinsurance.
In April 2005, Commerce Insurance became a member of the Federal Home Loan Bank (FHLB) of Boston, providing Commerce Insurance with a significant new source of liquidity. The FHLB of Boston, which is one of 12 regional FHLBs, serves as a reserve or central bank for its members within its assigned region. The FHLB of Boston makes loans, which are referred to as advances, to members in accordance with policies and procedures established by its board of directors. These policies and procedures are subject to the regulation and oversight of the Federal Housing Finance Board. All advances from the FHLB of Boston to Commerce Insurance are required to be fully secured by sufficient collateral as determined by the FHLB. We estimate that FHLB membership provides Commerce Insurance with the capacity to borrow approximately $400,000 from the FHLB of Boston. We have not borrowed from the FHLB and have no current plans to do so.
We expect to pay significantly more for agent profit sharing in 2006 than we paid in 2005. We paid approximately $47,134 for agent profit sharing in 2005. Due to our improved underwriting results during 2005, we estimate paying $87,486 in the second quarter of 2006.
The primary focus of our investment objectives continues to be maximizing after-tax investment income through investing primarily in high-quality diversified fixed income investments structured to maximize after-tax investment income while minimizing risk. We generally invest in securities with maturities intended to provide adequate cash flow to pay claims and meet other operating needs without the forced sale of investments. When the appropriate opportunity arises, we will recognize investment gains to increase after-tax total return. We held no derivatives, emerging market securities or hedge funds at December 31, 2005 and 2004.
Our fixed income portfolio's weighted average duration (which includes all fixed maturities and preferred stocks) as of December 31, 2005 and 2004 was 4.9 years and 5.6 years, respectively. The "duration" of a security is the time-weighted present value of the security's expected cash flows and is used to measure a security's price sensitivity to changes in interest rates. The duration reflects industry prepayment assumptions. The analytic systems we used to calculate the above duration data utilize optional call dates and sinking fund requirements and assume a non-static prepayment pattern in deriving these averages.
To the extent inflation and economic recession influence yields on investments, we are also affected. As each of these environments affect current market rates of return, previously committed investments may rise or decline in value depending on the type and maturity of investment.
adverse changes to the laws, regulations and rules governing CAR in Massachusetts;
fluctuations in interest rates and the performance of the financial markets in relation to the composition of our investment portfolio;
You should not place undue reliance on any forward-looking statement. The risk factors referred to above, as well as those elsewhere in the Annual Report on Form 10-K, could cause actual results or outcomes to differ materially from those expressed in any forward-looking statement made by us or on our behalf (see Part I, Item 1, "Risks Related to Our Business" of this Form 10-K). Further, any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Securities and Exchange Act of 1934. Management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2005. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control -
. Based on this assessment, management concluded the Company maintained effective internal control over financial reporting as of December 31, 2005.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of The Commerce Group, Inc. and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. 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. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Due to the exercise of 1,747,163 employee stock options and 1,500,250 American Commerce agents' options (351,888 shares).
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). Our consolidated financial statements include the accounts of The Commerce Group, Inc. and its subsidiaries, Bay Finance Company, Inc., Clark-Prout Insurance Agency, Inc. and Commerce Holdings, Inc. (CHI). The Commerce Insurance Company (Commerce), Commerce West Insurance Company (Commerce West) and Citation Insurance Company (Citation) are wholly-owned subsidiaries of CHI. American Commerce Insurance Company (American Commerce) is a wholly-owned subsidiary of ACIC Holding Co., Inc. (AHC). AHC is owned jointly with AAA Southern New England (AAA SNE) with CHI maintaining a 95% common stock interest and AAA SNE maintaining a 5% common stock interest. All inter-company transactions and balances have been eliminated in consolidation. Certain prior year account balances have been reclassified to conform to the 2005 presentations.
Carrying values of investments in fixed maturities, which include taxable and non-taxable bonds and investments in common and preferred stocks, are derived from market prices supplied by our investment custodian, or in the few cases where no price is provided by the custodian, we obtain a third party valuation.
All of our investments in fixed maturity and equity securities at December 31, 2005 and 2004 were classified as available-for-sale. Realized gains and losses on available-for-sale securities were determined by using the specific identification method. We have not invested more than 5% of fixed maturities in any one state or political subdivision.
Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. The carrying value of fixed maturities on deposit for state regulating authorities at December 31, 2005 was $8,026.
We record our equity in the change in net assets of closed-end preferred stock mutual funds for which our ownership is greater than 20% as a component of realized gains and losses. These investments are valued at original cost plus the cumulative undistributed equity in earnings and losses of the fund.
Our exposure is generally 80% or less of the appraised value of any collateralized real property at the time of the loan origination. The ability and willingness of residential and commercial borrowers to honor their repayment commitments is generally dependent upon the level of overall economic activity and real estate values. During the three years ended 2005, we did not acquire any property through foreclosure of mortgages.
We review all security holdings on a quarterly basis for potential other-than-temporary declines in market value in accordance with GAAP. In general, unrealized losses resulting from an increase in interest rates will not necessarily lead to an other-than-temporary impairment write-down. As part of this process, we consider any significant market declines in the context of the overall market and also in relation to the outlook for the specific issuer of the security and the issuer's industry. Each quarter, we review all securities whose market values have declined below book price. From a quantitative standpoint,
We consider market activity between our quarter-end date and earnings release date in our evaluation.
Gross unrealized losses on our fixed maturity and equity securities at December 31, 2005 by duration of unrealized loss and by credit quality (for fixed maturity securities) follow:
Our unrealized losses from below investment grade fixed maturity securities at December 31, 2005 were from corporate securities with a credit quality of BB.
Gross unrealized losses on our equity and fixed maturity securities at December 31, 2004, by duration of unrealized loss, follow:
Policy acquisition costs are calculated by line of business as a percentage of unearned premiums by multiplying the sum of current commission rates plus current premium tax rates plus an estimate of the percentage of other underwriting expenses incurred at policy issuance. These costs are deferred and amortized over the period in which the related premiums are earned, the amount being reduced by any potential premium deficiency. If any potential premium deficiency exists, it represents future estimated losses, loss adjustment expenses and amortization of deferred acquisition costs in excess of the
The cost of computer software developed or obtained for internal use in excess of $150 is capitalized in accordance with SOP 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Amounts below the $150 threshold are expensed in the period the costs are incurred. Capitalized costs are generally amortized on a straight-line basis over a three-year period, unless another rational basis is more representative of the software's use.
changes and trends in general economic conditions, including the effects of inflation and recession.
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, we estimate the ultimate net liability for losses and LAE. After taking into account all relevant factors, we believe that, based on existing information, the provision for losses and LAE at December 31, 2005 is adequate to cover the ultimate net cost of losses and claims incurred as of that date. The ultimate liability, however, may be greater or lower than established reserves. If the ultimate exposure is greater than (or less than) our estimated liability for losses and LAE, we will incur additional expense (income) which may have a material impact on our consolidated financial position. We do not discount to present value that portion of our loss reserves expected to be paid in future periods.
Liabilities for unpaid claims and claim adjustment expenses for environmental related claims such as oil spills, mold and lead paint are included in the loss reserve methodologies described above. Reserves have been established to cover these claims for known losses. Because of our limited exposure to these types of claims, we believe they will not have a material impact on our consolidated financial position in the future. Loss reserves on environmental related claims amounted to $7,772 and $6,646 at December 31, 2005 and 2004, respectively.
Note F - Unpaid Losses and Loss Adjustment Expenses (LAE) (Continued)
Approximately $51,027 in personal automobile liability redundancies developed for the year ended 2004, with 98% of this amount coming from the 2003, 2002 and 2001 accident years. The primary reason for the redundancies in this area is that claim severity came in better than we anticipated. The redundancy for personal automobile liability that related to CAR accounted for approximately 2.5% of the total. Automobile physical damage had approximately $2,334 in redundancies related to the 2003 accident year approximately 98% of which was related to CAR. In 2004, we also experienced redundancies of $2,222 for the commercial multiple peril line of business, half of which related to the 1996 accident year. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining approximately $1,448 net redundancy.
Our aggregate actuarial estimate for the loss and LAE reserves, on a consolidated basis and net of reinsurance recoverable, ranges from a low of $764,600 to a high of $877,900, as of December 31, 2005. Our financial statement loss and LAE reserves net of reinsurance, based on our best estimate, was established at $834,699 for that date. We calculate our estimate independently from those amounts as calculated by our actuaries and, therefore, the final results are most often not the same. We estimate amounts primarily by reviewing historical loss and LAE data, focusing mainly on payment data. We also review and compare most recent loss frequency, severity and payment data to historical trends in an attempt to determine if patterns are remaining consistent or not. We attempt to establish our reserve estimate as close to the amount required for the ultimate future payments necessary to settle all losses. The accuracy of this estimate is reflected by the line noted in the above table entitled "decrease in provision for insured events of prior years."
In 2000, Commerce entered into a Limited Partnership Agreement with Conning Partners VI, L.P., a Delaware Limited Partnership. This partnership agreement required our commitment to invest up to $50,000 into the partnership. In 2005, we received $1,245 of our principal from the partnership. In 2004 and 2003, we invested $10,688 and $5,250, respectively, into the partnership. As of December 31, 2005, we have invested $34,309 into the partnership, leaving a commitment balance to the partnership of $15,691. The partnership was formed to operate as an investment fund principally for the purpose of making investments primarily in equity, equity-related and other securities issued in expansion financing, start-ups, buy-outs and recapitalization transactions. The fund targets companies in the areas of insurance, financial services, e-commerce, healthcare, and related businesses, including, without limitation, service and technology enterprises supporting such businesses, in order to realize long-term capital returns, all as determined and managed by the General Partner for the benefit of the Partners.
companies operating in the area of insurance distribution and distribution related activities, all as determined and managed by the General Partner for the benefit of the Partners.
In addition to state mandated minimum and other commissions on policies written, we pay certain of our agencies compensation in the form of profit sharing. This is based primarily on the underwriting profits of an individual agents' business written with us. The arrangement for Massachusetts and New Hampshire business utilizes a three-year rolling plan, with one third of the agents' profit or loss for each of the current and the two prior years' calculations summed to a single amount. This amount, if positive, is multiplied by the profit sharing commission rate and paid to the agent. Outside of Massachusetts and New Hampshire, Commerce West and American Commerce each have profit sharing plans tailored to their specific markets.
The amount of consolidated retained earnings at December 31, 2005 represented by undistributed earnings of 50% or less owned investments that are accounted for using the equity method follows:
IAs issued relating to the Plan totaled 1,208,631 in 2005. BVAs issued related to the Plan totaled 1,489,111 in 2004 and 1,408,675 in 2003. Expenses relating to BVAs and IAs were $29,043, $18,904 and $11,162 in 2005, 2004 and 2003, respectively. The outstanding BVAs entitle the holders to cash payments based upon the extent to which, if at all, the per share book value exceeds certain thresholds set at the time the award was granted.
Employee stock options (options) granted from 1999 through 2001 relating to a previously approved plan totaled 2,529,042, including the issuance of options previously terminated. No employee stock options were granted after 2001 under the Plan. The outstanding options entitle the recipient to purchase our common stock based upon the extent to which, if at all, the per share market value of the common stock exceeds certain thresholds set at the time the option was granted. Unexercised options terminate not later than eight years after the date of grant. The average contractual life of the remaining 11,288 options outstanding at December 31, 2005 was 3.3 years.
We record our expenses related to stock options, BVAs and IAs in three separate line items on our income statement - losses and loss adjustment expenses, policy acquisition costs and net investment income. The stock option, BVA and IA expenses recorded in each line item for the years ended December 31 follow:
There were 154,175 and 372,130 exercisable ACIC agents' options at December 31, 2005 and 2004, respectively. None were exercisable at December 31, 2003. The weighted average remaining contractual life of ACIC agents' options outstanding at December 31, 2005 was 7.4 years.
On February 10, 2005, 700,000 of the ACIC agents' options that were outstanding at December 31, 2004 were forfeited as a result of AAA Arizona terminating its relationship with American Commerce. None of these options were exercisable at the end of 2004. Accrued expenses for these options were $3,487 at December 31, 2004. This amount was taken into income during the first quarter of 2005.
The exercise prices for ACIC agents' options granted in 2005, 2004, and 2003 were $72.53, $58.63 and $46.27, respectively. The estimated weighted average fair values per share of the ACIC agents' options were $13.80, $17.39 and $6.82 for 2005, 2004 and 2003, respectively. The ACIC agents' option liability at December 31, 2005 and 2004 was $17,398 and $19,835, respectively.
Effective July 1, 2004, Massachusetts corporate law eliminated the distinction between treasury shares and authorized but unissued shares, by providing that common shares that we acquire automatically are restored to the status of authorized but unissued shares. We have continued to reflect treasury shares on our balance sheet and in our notes to the financial statements in part because the concept of treasury shares continues to be relevant under the New York Stock Exchange Rules. Also effective July 1, 2004 Massachusetts corporate law eliminated the concept of par value. The effect of that change was to supersede the historic prohibition against issuing par value stock for less than par. There is no minimum price at which we may issue shares. We have continued to show on our balance sheet the most recent par value per share of our common stock ($0.50), as well as the aggregate amount of par value for which the shares of our common stock now outstanding were issued, because we believe that presentation facilitates an understanding of the stockholders' equity section of our consolidated balance sheet.
Basic EPS is computed based on the weighted average number of common shares outstanding. Diluted EPS is computed based on the weighted average number of common shares outstanding adjusted by the number of additional common shares that would have been outstanding had the potentially dilutive common shares been issued and reduced by the number of common shares we could have repurchased from the proceeds of the potentially dilutive shares. Our only dilutive instruments are stock options outstanding. Basic and diluted EPS are calculated for the years ended December 31, as follows:
The computation of diluted EPS did not include stock options that were anti-dilutive, as their exercise price was greater than the average market price of our common stock during the year. The number of such options was 400,000, 1,100,000 and 1,850,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
Approximately 82.8% of our direct premiums written for the year ended December 31, 2005 were generated from personal automobile insurance policies. Approximately 87.3% of our direct premiums written for the year ended December 31, 2005 were generated in Massachusetts.
All of the insurers writing the types of insurance covered by the Massachusetts Insurers Insolvency Fund (MIIF) are MIIF members. MIIF is obligated to pay any unpaid claim, up to $300, against an insolvent insurer if the claims existed prior to the declaration of insolvency or arose within 60 days thereafter. MIIF assesses members the amounts it deems necessary to pay both its obligations and the expenses of handling covered claims. Subject to certain limitations, assessments are made in the proportion that each member's net written premiums for the preceding calendar year for all property and casualty lines of business to the corresponding net written premiums for all members for the same period. The statute that established MIIF also provides for the recoupment by insurers of amounts paid to MIIF. Historically, the Commissioner has allowed insurers to recoup the amounts they paid MIIF through rate adjustments.
It is anticipated that there will be additional assessments from time to time relating to various insolvencies. By statute, no insurer may be assessed in any year an amount greater than two percent of that insurer's direct written premiums for the calendar year preceding the assessment. MIIF assessed Commerce and Citation $128, $6,304, and $8,106 for the years ended December 31, 2005, 2004 and 2003, respectively. These amounts are net of credits for prior year assessments on numerous insurer insolvencies.
On June 30, 2005, our 70% one-year quota share reinsurance program expired. This program covered all non-automobile property and liability business, except umbrella policies. This program was extended another year, effective July 1, 2005, with the primary change in terms being an increase in the quota share rate to 75%. Quota share reinsurance refers to
The table below provides information depicting the approximate recovery under the quota share contract at various loss scenarios, if a single catastrophe were to strike through June 30, 2006:
It is customary for property and casualty companies to evaluate their exposure to a weather-related catastrophe by estimating the losses that would be incurred if a storm equivalent to the most destructive storm that has occurred during a given period were to occur during a current fiscal year or reinsurance policy period. If the estimate focuses on hurricanes during the past 100 years, for example, the most destructive hurricane during that period is referred to as a "100-year hurricane." Our estimated total loss, before reinsurance, on our other-than-automobile business for 100 and 250-year hurricanes is approximately $340,000 and $640,000, respectively. Our estimates were derived through the services of Holborn Corporation on our December 31, 2005 other-than-automobile policies, which utilized the RMS (Risk Management Solutions) risk assessment system. We believe that most property and casualty insurance companies establish their catastrophe reinsurance programs between the 100-year and 250-year storm estimates.
Personal and commercial liability umbrella policies are reinsured on a 95% quota share basis in regard to limits up to $1,000 and 100% quota share basis for limits in excess of $1,000 but not exceeding $5,000 for policies with underlying automobile coverage of $250/$500 or more. We also have personal liability umbrella reinsurance coverage for policies with underlying automobile coverage of $100/$300 on a 65% quota share basis for limits up to $1,000 and 100% quota share basis for limits in excess of $1,000 but not exceeding $3,000. These coverages were placed with Employers Reinsurance Corporation, rated "A" by A.M. Best (its third highest rating), through July 31, 2005. Effective August 1, 2005, this program was placed with Swiss Re America Corporation.
We, as primary insurer, would be required to pay losses in their entirety in the event that the reinsurers were unable to discharge their obligations under the reinsurance agreements.
CAR, a state-mandated reinsurance mechanism, enables us and other servicing carriers to reinsure any automobile risk that the insurer perceives to be under-priced at the premium level permitted by the Commissioner of Insurance. Servicing carriers, which are responsible for over 99.0% of total direct premiums written for personal automobile insurance in Massachusetts, are required to offer automobile insurance coverage to all eligible applicants pursuant to "take-all-comers" regulations, but may reinsure business with CAR.
Since its inception, CAR has annually generated multi-hundred million dollar underwriting losses, primarily in the personal automobile pool. We are required to share in the underwriting results of CAR business for our respective product lines. Under current regulations, our share of the CAR personal or commercial deficit is based upon our market share of automobile risks for the particular pool, adjusted by a "utilization" concept, such that, in general, we are disproportionately and adversely affected if our relative use of CAR reinsurance exceeds that of the industry, and favorably affected if our relative use of CAR reinsurance is less than that of the industry. For personal automobile writers, companies can reduce their participation ratio by writing credit eligible business voluntarily. Companies are provided credits against their participation ratio for writing those classes and territories of business that are purposefully under-priced in the Massachusetts rate setting process. Companies are also penalized for ceding certain business to CAR. Our strategy has been to maintain above average voluntary retention levels, as well as to retain private passenger automobile business voluntarily that receives credits. This favorably affects our participation ratio compared to our market share, but adversely impacts our voluntary loss ratio. Through 2004, the CAR utilization-based participation ratio had remained the same for the personal automobile market. In 2005 and continuing into 2006, CAR began using a credit matrix which had the effect of moving our participation ratios closer to our market share. During 2005, 2004 and 2003, our net participation in the CAR personal automobile pool approximated 26.2%, 23.2% and 20.2%, respectively, as estimated by us for 2005 and as reported by CAR for 2004 and 2003. This is as compared to our estimated market share in those years of 29.9%, 29.1% and 27.7%, respectively. During 2005, 2004 and 2003, the amount of personal automobile exposure we reinsured through CAR approximated 4.7%, 5.2%, and 5.1%, respectively, as compared to industry averages of 6.2%, 6.8% and 7.0%, respectively. A CAR reform proposal approved by the Commissioner on December 31, 2004 would, if implemented, substantially change the existing CAR utilization allocation. See Note R for additional information.
Our two largest reinsurance components, quota share and CAR, settle on a quarterly basis. Quota share settles 45 days after the end of each quarter and CAR settles 90 days after the end of each quarter. There were no balances in dispute for the years ended 2005 and 2004 for either component.
Income consisting of expense reimbursements, which include servicing carrier fees from CAR on policies written for CAR, is deferred and amortized over the term of the related insurance policies.
ESOP participants who are current employees and who are 100% vested in their ESOP accounts can annually elect to transfer out of the ESOP up to 100% of their allocated Company stock in the form of an eligible rollover distribution into another eligible retirement plan, such as a qualified individual retirement arrangement. Approximately 2,177,000 shares owned by participants in the ESOP at December 31, 2005 are allocated to the ESOP accounts of these individuals. ESOP accounts vest at a rate of 20% per service year beginning with a participant's third year of service.
The remaining approximately 160,000 shares held by the ESOP at December 31, 2005 are allocated to the ESOP accounts of participants who have not yet reached 100% vesting in their account balances. The fair value of the ESOP shares held by participants that are less than 100% vested at December 31, 2005 was approximately $9,200. Disposition of these unvested shares is restricted under the ESOP. We pay for administration of the ESOP.
Selected segment information for 2005, 2004 and 2003 follows. Earnings are before income taxes and change in accounting principle and include minority interest.
Direct premiums written and earned for the years ended 2005, 2004 and 2003 follow:
The immediate family of Raymond J. Lauring, a director of the Company, owns more than a 10% equity interest in Lauring Construction Company. Mr. Lauring has no ownership interest in the construction company. During 2003, the
construction company provided construction and construction management services in connection with a contract for the estimated $13,000 renovation of a 130,000 square foot building we purchased. Terms of the contract provided for a fixed fee of $650 for supervision of management of the project. Total payments on the supervision and management services portion of the contract in 2003 were $375. Payments to the construction company in 2003 for actual materials used and construction work performed on this project were $335, and payments for other work unrelated to the project were $222 in 2005, $285 in 2004, and $45 in 2003. No payments were made to the construction company in 2004 or 2005 for the renovation project as the project was completed in 2003.
As is common with property and casualty insurance companies, we are a defendant in various legal actions arising from the normal course of our business, including claims based on the Massachusetts Unfair Claims Settlement Practices Act, or Chapter 176D and the Massachusetts Consumer Protection Act, or Chapter 93A. Similar provisions exist in other states where we do business. These proceedings are considered ordinary to operations or without foundation in fact. We are of the opinion that these actions will not have a material adverse effect on our consolidated financial position.
On January 5, 2005, we filed an action against the Insurance Commissioner in Massachusetts Superior Court appealing a December 31, 2004 order by the Commissioner adopting new regulations that, among other things, would replace the current loss-pooling residual market entity, CAR, with an assigned risk plan. We contend that the Commissioner's new regulations are inconsistent with existing Massachusetts insurance laws. Following a hearing on May 2, 2005, the Superior Court ruled, on June 20, 2005, that the Commissioner did not have the statutory authority to implement an assigned risk plan. The court's ruling annulled the Commissioner's order and vacated the new regulations adopted pursuant to the order. The Commissioner appealed the Superior Court's decision to the Massachusetts Appeals Court. We and the Commissioner both petitioned for direct appellate review by the Massachusetts Supreme Judicial Court (the SJC). The SJC agreed on October 26, 2005 to hear the appeal directly. The parties have submitted briefs to the SJC and the SJC is expected to hear oral arguments in April or May, 2006. We cannot predict how the SJC will rule on the appeal, nor can we predict when this matter will be resolved. However, we believe that even if the Commissioner's appeal is upheld by the SJC, it is unlikely that the new rules in the Commissioner's order will be implemented retroactive to January 1, 2005.