We lease an aggregate of approximately 306,000 square feet of office space in numerous cities throughout the United States. Our most significant leased office spaces are located in Davie, Florida with approximately 100,000 square feet; Cleveland, Ohio with approximately 31,000 square feet; Independence, Ohio with approximately 44,000 square feet; and Anaheim, California with approximately 50,000 square feet. We have leased new space in Independence, Ohio, effective September, 2004, which will permit us to consolidate our Ohio operations in approximately 15,000 fewer square feet than at present. The consolidation is planned for the fall of 2004.
The following tables present our historical financial and operating data as of the dates or for the periods indicated. We derived the data as of and for each of the five years ended December 31, 2003 from our consolidated financial statements audited by Deloitte & Touche LLP. The results of operations for past accounting periods are not necessarily indicative of the results to be expected for any future accounting periods. You should read this summary in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the financial statements and related notes appearing elsewhere in this annual report.
into this contract in connection with our acquisition in April 2001 of Reliant, the non-standard automobile operations of Reliance Group Holdings. See "
Our insurance subsidiaries offer insurance coverage exclusively through a network of approximately 5,300 independent agents and brokers, some of whom operate from multiple locations. We are licensed to provide insurance in 35 states and the District of Columbia, though we focus our resources in 17 states that we believe provide significant opportunity for profitable growth. Our non-insurance subsidiaries provide our policyholders a variety of services, including policy servicing and installment payment plans.
•policy service fee revenues, which are composed primarily of policy origination fees and installment fees to our policyholders; and
•other income, which primarily represents commission income we earn through a general agency we own in Texas.
•commissions and other underwriting expenses, which consist of commissions we pay to agents and brokers, premium taxes and company expenses related to the production and underwriting of insurance policies, less ceding commissions that we receive under our reinsurance contracts;
•other operating and general expenses, which include general and administrative expenses, depreciation and other expenses; and
In April 2001, we acquired Reliant, the non-standard automobile operations of Reliance Group Holdings, including two insurance companies, all employees, claims and processing systems, and the renewal rights to business written in 13 states. At closing, Reliant had approximately $6.1 million of loss and loss adjustment expense reserves and $17.0 million of unearned premium reserves, which were transferred to us as part of the acquisition. Through the acquisition of Reliant, we added five members to our senior management, as well as expanded the scope of our operations into 11 states in which we had not previously written business.
We received outsourcing servicing fee revenues for servicing policies and adjusting claims on the run-off of the Reliant business that we did not acquire. We performed most of these services from April 1, 2001 to November 2, 2001. Accordingly, we recorded outsourcing servicing fees of $18.6 million in 2001 and another $0.9 million in the fourth quarter of 2002 and $0.1 million in 2003. Due to the associated expenses we incurred related to the servicing of those policies, we believe this arrangement had little effect on our pre-tax income.
In 2000, we reorganized our claims department into specialized teams, resulting in multiple individuals adjudicating claims that previously would have been handled by one claims adjuster. This change slowed our claims processes and caused us to open and settle claim files slower than in the past, causing us to underestimate our projected ultimate claim counts used in estimating our projected ultimate losses and loss adjustment expenses for 2000 and 2001. In addition, this slowdown in our claims processes generally had the effect of delaying the settlement of more expensive claims, which caused us to conclude that our average cost per closed claim was decreasing. These claims were eventually settled and the ultimate cost of paying claims increased compared to historical averages because, generally, the longer claimants wait to be paid, the higher their demand and the ultimate settlement cost.
In calendar years 2001, 2002 and 2003, we experienced adverse development on loss and loss adjustment expense reserves for years prior to each of those calendar years in the amount of $17.3 million, $28.2 million and $9.3 million, respectively. The most significant factors influencing this development have been the adverse impact of the reorganization of our claims department in 2000 and the pricing and product design assumptions we utilized from 1998 through 2000. In addition, our 2002 loss and loss adjustment expense reserve increases related to 2000 were adversely impacted as a result of previously exhausting our excess of loss reinsurance coverage. Essentially, we were required to reflect 100% of our continuing 2000 adverse development in our 2002 income statement due to the exhaustion of that coverage.
From mid-1998 through 2000, we lowered premium rates and relaxed underwriting standards in California, our largest market, due to our overestimation of the profitability of our California business. We took these actions believing we could reduce our premium rates and maintain acceptable underwriting profits. This assumption proved incorrect, and as loss trends emerged, we increased our estimate of loss and loss adjustment expenses and began to tighten underwriting standards and file for premium rate increases beginning in January 2001. From January 1, 2001 through December 31, 2002, we increased our rates in California four times. In addition, we sold a poorly structured and priced product in Texas. Contrary to the product pricing assumptions, we experienced subsequent adverse loss and loss adjustment expense development as pricing assumptions ultimately proved to be wrong and the business was written at a loss. From January 1, 2001 through December 31, 2002, we increased rates in Texas 14 times. In both California and Texas, the successive rate increases were precipitated by continuing adverse development. As actual claim emergence became higher than expected, loss and loss adjustment expense reserve estimates were revised upward in 2001 and 2002.
•performing all actuarial analyses of unpaid losses and loss adjustment expenses on a quarterly basis;
•increasing the number of analytical methods to include claim count analysis to develop more elaborate estimation methods; and
•utilizing an automated loss and loss adjustment expense reserving process, virtually eliminating manual spreadsheets.
We believe we have properly accounted for all of our reinsurance contracts.
Gross Premiums Written. Gross premiums written increased to $648.2 million for the twelve months ended December 31, 2003, or by 34.5%, compared to $481.8 million for all of 2002. The increase is primarily attributable to increased market penetration evidenced by the 24.6% growth in average policies in force from 350,800 for 2002 to 437,200 for 2003 and an increase in average premium per policy of 9.9%.
Net Premiums Written. Net premiums written increased by 11.3% to $263.0 million from $236.3 million in 2002. The smaller increase in net premiums written as compared to gross premiums written is due to our decision to increase the percentage of premiums ceded under our quota share reinsurance treaty from 50% in 2002 to 60% in 2003 in order to manage the net retained business in relation to our financial resources.
For the year ended December 31, 2003, our consolidated statement of operations included a charge in the amount of $3.6 million before tax, which increased the overall charge to $17.9 million for a class action, which alleged, among other things, improper classification of our claims adjusters. $14.3 million of the overall charge related to this class action was recorded in 2002. The $3.6 million increase in our estimate was due to new facts that emerged as we processed claims forms that were submitted as required by our settlement agreement. The total amount reflected our estimate of the ultimate costs associated with this action, which include expected class member payments, plaintiff attorney fees and other related expenses. As of December 8, 2003, all claimants had settled.
Income Taxes. Income taxes for the year ended December 31, 2003 were $20.5 million, or 38% of income before income taxes. Our effective tax rate is 38% comprised of 35% Federal income taxes and 3% state income taxes.
Twelve Months Ended December 31, 2002 compared to Twelve Months Ended December 31, 2001
Gross Premiums Written. Gross premiums written for the year ended December 31, 2002 were $481.8 million, compared to $316.6 million for the year ended December 31, 2001, which represents an increase of 52.2%. The increase was primarily attributable to an increase in policies-in-force of 84,194 from 297,659 to 381,853, representing 28.3 points of the total increase, with the balance attributable to
Net Premiums Written. Net premiums written for the year ended December 31, 2002 were $236.3 million, compared to $133.3 million for the year ended December 31, 2001, a 77.3% increase. The increase was principally attributable to the growth in gross premiums written and our retention of a higher percentage of our gross premiums written.
Net Investment Income. Net investment income, excluding realized gains and losses, for the years ending December 31, 2002 and 2001, was $6.4 million. The higher level of average invested assets was offset by a decline in the weighted average pre-tax equivalent yield earned on our fixed income portfolio. The pre-tax equivalent yield on our portfolio was 5.45% at December 31, 2002, compared to 6.05% at December 31, 2001.
Policy Service Fee Revenues. Policy service fee revenues were $47.3 million for the year ended December 31, 2002, compared to $36.1 million for the year ended December 31, 2001, an increase of 31.0%. The increase in policy service fee revenues was attributable to growth in policies-in-force, as fees are charged on a per policy basis.
Commissions and Other Underwriting Expenses. Commissions and other underwriting expenses decreased to $42.1 million from $50.3 million, a 16.3% decrease, for the year ended December 31, 2002 compared to the year ended December 31, 2001. The decrease related to an increase in ceding commissions earned under our quota share reinsurance agreements due to an increase in ceded
premiums. In addition, the expenses related to outsourcing service fees earned from managing the run-off of the Reliant business during 2001 decreased as a result of terminating the contract, with the exception of the Texas business.
Other Operating and General Expenses. Other operating and general expenses were $19.3 million for the year ended December 31, 2002, compared to $19.9 million for the year ended December 31, 2001. These expenses are primarily fixed, such as rent and utilities, and do not vary with premium volumes. The minor decrease is attributable to our successfully integrating the Reliant business and offsetting the increased cost of additions to our staff by eliminating redundant positions.
Litigation Expense. At December 31, 2002, our consolidated statement of operations reflected a charge in the amount of $14.3 million on a pre-tax basis related to a class action that alleged improper classification of our claims adjusters. This amount reflected our estimate of the ultimate costs associated with this action at that time, which included expected class member payments, plaintiff attorney fees and other related expenses. No charges related to litigation outside of the normal course of business were recorded for the year ended December 31, 2001.
Goodwill Amortization. Goodwill amortization expense was zero in 2002, as a result of adopting SFAS No. 142, whereas goodwill was amortized prior to 2002 and was $2.7 million in 2001.
We are organized as a holding company with all of our operations being conducted by our insurance subsidiaries, which underwrite the risks associated with our insurance policies, and our non-insurance subsidiaries, which provide our policyholders and our insurance subsidiaries a variety of services related to the insurance policies we provide. We have continuing cash needs for the payment of principal and interest on borrowings, dividends, taxes and administrative expenses. These ongoing obligations are funded with dividends from our non-insurance subsidiaries and taxes are paid by each subsidiary through an inter-company tax allocation agreement.
written over time. The Company intends to use the remaining $3.2 million for general corporate purposes at the holding company level.
There are no restrictions on the payment of dividends by our non-insurance subsidiaries other than customary state corporation laws regarding solvency. Dividends from our insurance subsidiaries are subject to restrictions relating to statutory surplus and earnings. See "Item 1. Business-Regulatory Matters." As of December 31, 2003, our insurance subsidiaries could pay dividends of $1.1 million without seeking regulatory approval. Our insurance subsidiaries have not paid any dividends since 1999, which has not impacted our ability to meet our obligations. In addition, we do not anticipate that our insurance subsidiaries will pay dividends in the foreseeable future because we wish to reduce our reinsurance purchases in order to retain more of the gross premiums written we generate and seek stronger financial strength ratings for our insurance subsidiaries, both of which require that the capital of our insurance subsidiaries be increased. Because our non-insurance subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends, we expect to use those revenues to service all of our corporate financial obligations, such as debt service and stockholder dividends, if declared.
Net cash provided by (used in) financing activities, principally debt repayments, was $0.3 million, $(15.1) million, and $(12.2) million for the years ended December 31, 2003, 2002 and 2001, respectively.
We believe that existing cash and investment balances, together with anticipated future cash flows generated from operations will be adequate to meet our future liquidity needs.
We do not believe that inflation has had a material effect on our results of operations, except insofar as inflation may affect interest rates and claim costs. The effects of inflation are also considered in pricing and in estimating reserves for unpaid claims and claim expenses. The actual effects of inflation on our results cannot be accurately known until claims are ultimately settled. In addition to general price inflation, we are exposed to a persisting long-term upwards trend in the cost of judicial awards for damages. We make every effort to take this into account in our pricing and establishing loss and loss adjustment expense reserves.
Our consolidated financial statements together with the report of the independent auditors are set forth beginning on page.