premiums we receive from insurance policies that we assume, primarily from Commonwealth Automobile Reinsurers, or CAR, which we refer to as assumed premiums, less
We evaluate our operations by monitoring key measures of growth and profitability. We measure our growth by examining our direct premiums written as well as increases in exposures and policies. We generally measure our operating results by examining our net income, return on equity, and our loss and LAE, underwriting expense and combined ratios. The following provides further explanation of the key measures that we use to evaluate our results:
Net premiums written is the sum of direct premiums written for a given period, less premiums ceded to CAR and other reinsurers during such period, plus premiums assumed during such period.
The loss and LAE ratio is the ratio of losses and loss adjustment expenses incurred to premiums earned, expressed as a percentage, and measures the underwriting profitability of a company's insurance business. This ratio is measured 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. For our insurance subsidiaries, this ratio is generally calculated using statutory accounting principles which for this purpose are essentially the same as accounting principles generally accepted in the United States of America ("GAAP"). Occasionally we will use the term "pure loss ratio" which refers to the ratio (expressed as a percentage) of incurred losses, excluding LAE, to earned premiums.
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 statutory combined ratio in evaluating our overall underwriting profitability and as a measure for comparison of our profitability relative to the profitability of our competitors.
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the
When reviewing the liability for unpaid losses and LAE, we analyze historical data and estimate the impact of various factors such as:
By using individual estimates of reported claims adjusted for our best estimate by line of business and a review of these results by our actuarial area using generally accepted actuarial reserving techniques, we arrive at our final estimate of our 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, 2003 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 payment is greater than or less than our estimated liability for losses and LAE, we will incur additional expense or income, as appropriate, which may have a material impact on our results of operations.
We calculate our estimate independently from those amounts calculated by our actuaries, and therefore, the final results are most often not the same. 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 $694.2 million to a high of $807.9 million, as of December 31, 2003. Our financial statement loss and LAE reserves net of reinsurance, based on our best estimate, was established at $792.3 million for that date.
In conjunction with reviewing the amount a security has declined, we also assess the aging of all unrealized losses on a particular security on a quarterly basis. That is, we look at how long a security has been at an unrealized loss position by classifying it within the following categories: under 6 months, 6 to 12 months, 12 to 24 months, 24 to 34 months and greater than 34 months.
In Massachusetts, private passenger automobile insurance is subject to extensive regulation. Owners of automobiles are generally required to demonstrate certain minimum automobile insurance coverages as a prerequisite to registering any automobile. With very limited exceptions, private passenger automobile insurers are required by law to issue a policy to any applicant seeking to obtain such coverages, commonly known as the "take all comers" law. Based on their market shares, insurers in Massachusetts are also assigned agents, known as ERPs, which have been unable to obtain a voluntary contract with an insurance carrier. Marketing and underwriting strategies for companies operating in Massachusetts are limited by maximum premium rates and minimum agency commission levels for personal automobile insurance, both of which are mandated by the Commissioner. In Massachusetts, accident rates, bodily injury claims, and medical care costs continue to be among the highest in the nation. According to the Automobile Insurers Bureau of Massachusetts, or AIB, Massachusetts "has higher than average medical costs and liability claims involving attorneys." According to the NAIC State Average Expenditure Report, Massachusetts' personal automobile premium per exposure, based on 2001 premium information, was the fourth highest in the nation.
Estimated for actual state and Commerce average revenue change per exposure.
the fact that our mix of personal automobile coverage differs from that of the industry; and,
On January 5, 2004, the Massachusetts Attorney General (the "AG") filed an appeal with the Supreme Judicial Court of Massachusetts arguing that the Massachusetts Division of Insurance (the "DOI") "wrongly imposed a 2.5% increase" in average personal automobile premiums for 2004. According to the AG, "for the second consecutive year, the
We are required to share in CAR's underwriting results. Under current regulations, our share of the CAR personal or commercial deficit is based upon our market share for 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.
Since 1995, we have been a leader in affinity group marketing in Massachusetts, through agreements with the four American Automobile Association Clubs operating in Massachusetts, offering discounts on private passenger automobile insurance to the clubs' members who reside in Massachusetts. A 5% discount was approved by the Commissioner for policies effective January 1, 2004. 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, and has been the primary reason for a 97.9% increase in the number of personal automobile exposures written by us since year-end 1995. The following table presents total direct premiums written attributable to the AAA clubs' group business in Massachusetts for the years ended 2003, 2002 and 2001:
the favorable impact on the net asset value of closed-end preferred stock mutual funds due to market conditions as well as significant sales of these funds during the year.
Our losses and loss adjustment expenses increased by $160.4 million, or 17.6%, for the year ended 2003 compared to 2002. The increase resulted primarily from our premium growth partially offset by a decrease in our loss ratio (on a statutory basis) to 73.4% from 75.1% in 2002. The decrease was primarily driven by slightly more favorable experience in the current year personal automobile line of business due to increases in average earned premium revenue per automobile and more favorable loss reserve development compared to 2002.
Certain corporate expenses included in our loss adjustment expenses and policy acquisition costs do not impact the statutory loss and LAE ratio or the statutory underwriting ratio because they are not expenses borne by our insurance subsidiaries. These expenses are primarily related to stock options granted to agents of American Commerce and book value awards granted to our officers. During 2003, corporate expenses related to the American Commerce agents' options increased to $9.0 million, as compared to $1.5 million in 2002. This increase was due to an increase in the market value of our common stock, an increase in the number of stock options outstanding, an additional year of vesting of those stock options granted in prior years and changes in estimates made to certain assumptions used in our fair value estimation. The corporate expenses related to the book value awards amounted to $7.1 million in 2003, as compared to $1.0 million in 2002. The value of book value awards is primarily related to the growth in our stockholders' equity. At December 31, 2003, our stockholders' equity per share was $28.45, as compared to $24.60 at December 31, 2002.
The following table and discussion compares direct premiums written, net premiums written and earned premiums for the years ended 2003 and 2002.
The increase in Massachusetts personal automobile direct premiums written during 2003 resulted primarily from a 7.9% increase in average written premium per written exposure coupled with a 6.9% increase in the number of exposures written. We attribute the growth in exposures to increased penetration of our independent agents' books of business as the overall number of exposures in Massachusetts has had less than 1% growth during the period. The increase in other than Massachusetts personal automobile and homeowners business was primarily due to additional rate per policy coupled with an approximate 10% increase in business written, offset slightly by a decreased retention in personal automobile in-force policies.
Our increase in Massachusetts commercial automobile premiums is directly related to our effort to increase writings in this line of business and from increases in the average rate per policy. Our increase in Massachusetts homeowner premiums is primarily related to:
increases in policy count due to an increased number of agents;
We use the aging table below in our analysis of our exposure to potential other-than-temporary impairment. Gross unrealized losses on our fixed maturity and equity securities at December 31, 2003 by duration of unrealized loss and by credit quality (for fixed maturity securities) follow (dollars in thousands):
For our unrealized loss positions held between 12 and 24 months, 45%, or $4.8 million (cost), were rated AAA and generally had market values that were below amortized cost due to the effect of interest rate moves. In addition, 23%, or $2.5 million, were investment grade rated municipal bonds and preferred stocks which we feel will continue to meet their obligations. The remaining 32%, or $3.4 million, is attributable to a B rated municipal housing issuer from which we expect
to receive full payment upon the sale of assets underlying the securities. The closing of this transaction is expected in the first quarter of 2004.
Unrealized losses from our below investment grade fixed maturity securities by credit quality at December 31, 2003 follow:
A reconciliation of beginning and ending reserves for losses and loss adjustment expenses for the years ended 2003 and 2002, net of reinsurance deductions from all reinsurers including CAR, follows:
Loss and LAE reserves prior to the effect of ceded reinsurance recoverable, beginning
Approximately $35,000 in personal automobile liability redundancies developed for the year ended 2003, with two thirds of this amount coming from the 2002 and 2001 accident years. The remaining redundancy in this area came about evenly from the four accident years prior to this. The primary reason for the redundancies in this area is that claim severity came in better than we anticipated. The approximate $4,700 worse development in automobile physical damage occurred in the 2002 accident year offset by redundancies in the 2001 accident year. The 2002 impact was mainly from higher IBNR claims as a result of a severe winter storm during the last week of 2002, coupled with higher severity on physical damage claims. The 2001 redundancies primarily resulted from higher than anticipated subrogation. We also experienced deficiencies of $2,300 and $1,500 for accident years 2001 and 2002, respectively, in 2003 in our commercial automobile liability area. These deficiencies were primarily related to higher severity as compared to claims incurred in prior years. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining approximately $1,300 net deficiency.
For the year ended 2003, our statutory combined ratio was 96.3%, compared with 98.7% for 2002. The decrease in the combined ratio was primarily the result of the factors that resulted in the lower loss and underwriting ratios previously mentioned.
Year Ended December 31, 2002 compared to Year Ended December 31, 2001
the unfavorable impact of the decline in utility common stocks on the net values of various closed-end preferred stock mutual funds that we must reflect in our net realized investment losses using the equity method of accounting; and,
an increase of $29.9 million, or 25.7%, in earned premiums for personal automobile coverage outside of Massachusetts; and,
an increase of $12.7 million, or 29.6%, in earned premiums for commercial automobile coverage in Massachusetts. See "Premiums" on the following page.
Represents change in our average rate per exposure from our prior year average rate for Massachusetts private passenger automobile premiums.
The total rate change depicted is the result of the weighted average of premiums written for all coverages divided by liability exposures only, because all exposures are required to carry liability coverage.
The above percentage changes were primarily the result of rate modifications in the individual coverage components in the 2002 state mandated rates, changes in our safe driver rate deviations, and changes in the distribution of our business by class and territory. The combination of these factors resulted in a 5.3% increase in the average personal automobile premium per exposure in 2002. Despite no change from the previous year for the 2002 state mandated average rates, our increase in the average personal automobile premium per exposure was primarily due to the above-noted changes. Also having an impact, was the fact that the announced rate decision did not include the effect of future purchases of new automobiles in the year to which the rate decision applied. In addition, our mix of personal automobile business differs from that of the industry. In 2002, we did not offer our customers safe driver deviations.
Included in the premium increase for Massachusetts personal automobile direct premiums written are premiums that were the result of appointments of new agents. During 2002, we had 127 new appointments, of which 89 were from voluntary agents resulting in an additional $50.5 million in premiums. These new appointments were primarily the result of our agreements to acquire the Massachusetts personal automobile business from Berkshire Mutual Insurance Company and MassWest Insurance Company. See Item 1, "Agreements for the Transfer of Massachusetts Business from Other Companies in 2002." The remainder of the new appointments resulted from ERPs. Business obtained from new ERPs amounted to $17.0 million during 2002.
The AAA affinity group discount for 2002 was established at 6.0%, which was unchanged from 2001. In 2001, for drivers who qualified, our AAA affinity group discount and safe driver deviations could be combined for up to a 7.9% reduction from state-mandated rates. In 2002, we did not offer a safe driver discount.
average premiums per policy. In addition, we experienced approximately a 3.0% increase in rates for policies written through CAR. The increased business was attributable to our initiative to expand writings.
the bundling of homeowners insurance with automobile insurance, which provides a homeowner discount to customers.
Homeowners insurance written by American Commerce in other states increased 46.3% to $27.4 million in 2002 due primarily to book rollovers of business from existing agents and the impact caused by contraction of authority to write homeowner business by competitors. Homeowner policies in all states are written primarily for a policy term of one year.
Premium finance and service fees increased $3.7 million, or 20.6%, during 2002, as a result of increased business and a service fee increase on Massachusetts new and renewal business from $3.00 to $4.00 per installment payment, for policies with effective dates on or after July 1, 2002.
Net realized investment losses totaled $82.4 million during 2002 as compared to $10.6 million in 2001. Net realized investment losses during 2002 were primarily centered in two areas: closed-end preferred stock mutual funds and other-than-temporary impairments. Declines in the market values of utility stocks held by various closed-end preferred stock mutual funds totaling $44.6 million were the primary reasons for these losses. We reflect these declines through realized losses
because our significant level of ownership requires the use of the equity method of accounting for these funds. See "Critical Accounting Policies - Investments" above for more information on our use of the equity method of accounting for these funds.
Our loss and LAE ratio (on a statutory basis) increased to 75.1% in 2002 as compared to 74.5% in 2001. The primary reasons for this increase were higher private passenger automobile losses from CAR as a result of increased participation in CAR and higher CAR loss ratios, coupled with an increase in the frequency of personal automobile bodily injury claims compared to last year. Another factor in the increase resulted from business written outside of Massachusetts for which the loss ratio increased to 86.4% during 2002 as compared to 84.6% for 2001. These factors were somewhat offset by a lower physical damage claim frequency and a lower loss ratio in the Massachusetts commercial automobile line.
Losses and loss adjustment expenses attributable to insured events of the current year
Unpaid losses and loss adjustment expense reserves at the end of year per financial
As a percentage of net premiums written, our statutory underwriting expenses decreased to 23.6% in 2002 as compared to 24.2% in 2001. The improvement was primarily due to a lower mandated Massachusetts personal automobile commission rate in 2002 as compared to 2001, and to lower general underwriting expenses. Another factor in the decrease resulted from business written outside of Massachusetts where the underwriting expense ratio decreased to 29.7% for 2002 as
Our statutory combined ratio was 98.7% for both 2002 and 2001. This resulted in an underwriting profit of 1.3% for both 2002 and 2001. This was the result of the factors mentioned above.
Our effective tax rate was 32.8% and 17.1% for the years ended December 31, 2002 and 2001, respectively. In 2002, the effective tax rate was affected by the write-off of deferred tax assets of $14.8 million. This amount was comprised of $10.9 million from the write-off of a deferred tax asset associated with realized losses on our closed-end preferred stock mutual funds that were ineligible for a tax benefit and $3.9 million of valuation allowance associated with our inability to claim a portion of our realized losses against prior years' realized gains. In 2001, the effective rate was lower than the statutory rate of 35% primarily due to tax-exempt interest income and the corporate dividends received deduction.
Effective January 1, 2002, the ownership interests in ACIC Holding Co., Inc. were recapitalized. Prior to the recapitalization at December 31, 2001, we maintained an 80% common stock interest and AAA Southern New England, or AAA SNE, maintained a 20% common stock interest in ACIC Holding. Additionally, all ACIC Holding preferred stock was owned by us. The recapitalization resulted in the redemption of our ACIC Holding preferred stock in exchange for 3,000 additional shares of ACIC Holding common stock. This resulted in an increase in our ACIC Holding common stock interest to 95% with AAA SNE maintaining a 5% ACIC Holding common stock interest, with no preferred stock outstanding.
See item as previously stated in this report in our comparison of 2003 to 2002.
2001 Restatement for Employee Stock Option Variable Accounting Treatment Made in 2002
Our operating activities provided cash of $260.1 million in the year ended 2003 as compared to $231.4 million during 2002, representing an increase of $28.7 million, or 12.4%. Premiums collected less loss and policy acquisition cost payments were $53.8 million higher for the year ended 2003 compared to 2002. The primary reason for this increase is that
the increase in premiums collected outpaced the increase in losses and LAE paid and the policy acquisition costs paid. This occurs when we have significant increases in business, as claims paid tend to lag behind premiums collected. Net investment income received continued to decline, and was approximately $10 million less than prior year, due primarily to decreased investment yields and higher yielding securities being called.
For the years ended 2003 and 2002, net cash flows from investing activities used cash of $504.0 million and $127.2 million, respectively. The majority of the difference was a $1.6 billion increase in purchases of fixed securities and equity securities, partially offset by an increase in the proceeds from the sales and maturities of fixed maturities, equities and closed-end preferred stock mutual funds totaling $1.2 billion. This resulted from our decision to sell a significant portion of our securities with unrealized gains in order to implement a change in our investment view. This change in view caused us to reduce the average duration of our investment portfolio during the second and third quarters, which in turn resulted in the sale of a number of securities that had increased in value significantly as overall credit spreads tightened. This caused overall portfolio turnover (e.g. volume of trades) to increase beyond that of recent years. The portfolio sales occurred in securities that had been purchased during 2003 as well as those purchased in previous years. Thus, while we did sell some higher yielding instruments, the overall after-tax yield of the portfolio did not fall significantly beyond the decline in interest rates as a whole. During the third quarter as interest rates rose, we began to invest in longer-term securities, resulting in a slightly higher duration at year end. Investing activities were funded by the accumulation of cash and cash provided by operating activities.
We purchased a 130,000 square foot building in 2001 and renovated it during 2002. Expenditures in 2003, 2002 and 2001 were $2.0 million, $13.1 million and $4.9 million, respectively. The project was complete as of December 31, 2003.
Our fixed maturity and equity security portfolio at fair and equity values at December 31, 2003 and 2002 follows:
Our fixed maturity security portfolio by investment type and credit quality as of December 31, 2003 follows:
Our below investment grade fixed maturity securities at fair value by credit quality at December 31, 2003 follow:
Our contractual obligations and commercial commitments as of December 31, 2003 by maturity follow:
Our liabilities increased 38.3% at December 31, 2003 from December 31, 2002. The liability for losses and loss adjustment expenses represented 22.8% of the total liability increase, primarily as a result of increased business. The unearned premiums increase represented 19.8% of the total liability increase due primarily to increases in our business. The bond payable represented 47.9% of the total liability increase.
We have negotiated a 65% quota-share agreement for one year with modified terms. The new program became effective July 1, 2003. In the event of a catastrophe, recovery is limited to 65% of the loss with a maximum recovery estimated at $233 million, equating to a total loss to us of $359 million. Several limitations were added to the new 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 $26 million. Our estimated total loss, before reinsurance, on our other than automobile business for 100 and 250-year hurricanes is approximately $200 million and $322 million, respectively. We derived our estimates through the services of Employers Reinsurance Corporation on our December 31, 2002 other-than-automobile exposures, which utilized the RMS (Risk Management Solutions) risk assessment system, and are based on increases in policies written in 2003 that are subject to the quota share treaty. We believe that most property and casualty insurance companies establish their catastrophe reinsurance programs between the 100-year and 250-year storm estimates.
Our investment strategy emphasizes investment yield while maintaining investment quality. The focus of our investment objectives continues to be maximizing after-tax investment income through investing in high quality diversified investments structured to maximize after-tax investment income while minimizing risk. A secondary objective is to achieve above average after-tax total return. Our funds are generally invested in securities with maturities intended to provide adequate funds to pay claims and meet other operating needs without the forced sale of investments. During 2003, we sold a significant portion of our securities with unrealized gains in order to implement a change in our investment view. This change in view caused us to reduce the average duration of our investment portfolio during the second and third quarters and included the sale of a number of securities which had increased in value significantly as overall credit spreads tightened. This caused overall portfolio turnover (e.g. volume of trades) to increase beyond that of recent years. The portfolio sales occurred in securities that had been purchased during 2003 as well as those purchased in previous years. Thus, while we did sell some higher yielding instruments, the overall after tax yield of the portfolio did not fall significantly beyond the decline in interest rates as a whole. During the third quarter as interest rates rose, we began to invest in longer-term securities, resulting in a slightly higher duration at year end 2003.
We manage our market risk by focusing on higher quality equity and fixed income investments, by periodically monitoring the credit strength of companies in which investments are made, by limiting exposure in any one investment and by monitoring the quality of the investment portfolio by taking into account credit ratings assigned by recognized rating organizations. Our portfolio includes six securities in default, three corporate bonds, two preferred stocks and one municipal bond with a total carrying value of $4.0 million at December 31, 2003. Of our bonds and preferred stocks, 93% were rated in either of the two highest quality categories provided by the NAIC as of December 31, 2003, as compared to 96.5% at December 31, 2002. This decrease primarily resulted from an increase in the market value of securities that are not rated in either of the two highest categories. Although we have significant holdings of various closed-end preferred stock mutual funds, these funds are comprised primarily of preferred and common stocks traded on national stock exchanges, thus limiting exposure to any one investment.
Changes in interest rates would result in unrealized gains or losses in the market value of the fixed maturity and preferred stock portfolio due to differences between current market rates and the stated rates for these investments. The following table summarizes our interest rate risk, based on the results of the sensitivity analysis at December 31, 2003. The table also reflects the changes in market value and stockholders' equity that would be attributable to realized investment gains (losses) that we would recognize under the equity method of accounting with respect to the change in the net asset value of
We evaluate performance and allocate resources based primarily on the property and casualty insurance segments, which represent over 99% of our total revenue for the past three years. The accounting policies of the reportable segments are the same as those used in the notes to the financial statements.
Our management is responsible for the consolidated financial statements and all other information presented in this Annual Report on Form 10-K. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America determined by management to be appropriate in the circumstances and include amounts based on management's informed estimates and judgments. Financial information presented elsewhere in this Annual Report on Form 10-K is consistent with the financial statements. The appropriateness of data underlying such financial information is monitored through internal accounting controls, an internal audit department, independent auditors and the Board of Directors through its audit committee.
We maintain a system of internal accounting controls designed to provide reasonable assurance to management and the Board of Directors that assets are safeguarded and that transactions are executed in accordance with management's authorization and recorded properly. The system of internal accounting controls is supported by the selection and training of qualified personnel combined with the appropriate division of responsibilities.
Management recognizes its responsibility for fostering a strong ethical climate so that our affairs are conducted according to the highest standards of personal and corporate conduct. The Board of Directors has adopted a formal Code of Ethics and Corporate Compliance Program governing employees and directors. Management encourages open communication within the company and requires the confidential treatment of proprietary information and compliance with all domestic laws, including those relating to financial disclosure.
The 2003 consolidated financial statements were audited by our independent auditors, PricewaterhouseCoopers LLP, in accordance with auditing standards generally accepted in the United States of America. Management has made available to PricewaterhouseCoopers LLP all of our financial records and related data, including reports prepared by the Internal Audit Department as well as the minutes of stockholders' and directors' meetings. Furthermore, management believes that all representations made to PricewaterhouseCoopers LLP were valid and appropriate.
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 Subsidiaries at December 31, 2003 and the results of their operations and their cash flows for the year then ended 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 appearing 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 audit. We conducted our audit of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit 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 audit provides a reasonable basis for our opinion. The financial statements and financial statement schedules of the Company as of December 31, 2002 and 2001 and for each of the two years in the period ended December 31, 2002 were audited by other auditors whose report dated January 31, 2003, expressed an unqualified opinion on those financial statements and included an explanatory paragraph that described the restatement of the 2001 consolidated financial statements due to a change in accounting for stock options discussed in Note A to the financial statements and the adoption in 2002 of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets.
Premiums receivable (less allowance for doubtful receivables of $2,254 and $1,661)
Unpaid losses and loss adjustment expenses (NOTES A7, E and G)
Net accumulated other comprehensive income, net of income taxes of $15,664
Reconciliation of Net Earnings to Net Cash Provided by Operating Activities
The Commerce Group, Inc. (the "Company") provides personal and commercial property and casualty insurance in Massachusetts and, to a lesser extent, in other states. In addition, the Company originates and services residential and commercial mortgages in Massachusetts and Connecticut. The Company's primary business is Massachusetts property and casualty insurance.
The consolidated financial statements include The Commerce Group, Inc. and its wholly-owned 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 Commerce maintaining a 95% common stock interest and AAA SNE maintaining a 5% common stock interest (see NOTE A14).
All inter-company transactions and balances have been eliminated in consolidation. Certain prior year account balances have been reclassified to conform to the 2003 presentation.
A focus of management's judgments and estimates relating to investments involves the potential impairment of investments for other-than-temporary declines in market values. 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 the Company's investment custodian, or in the few cases where no price is provided by the custodian, we obtain a third party valuation. For other investments, fair value equals quoted market price, if available. Unrealized investment gains and losses on common and preferred stocks and fixed maturities, to the extent that there is no other-than-temporary impairment of value, are credited or charged, net of any tax effect, to a separate component of stockholders' equity, known as "net accumulated other comprehensive income (loss)," until realized.
The Company reviews all security holdings on a quarterly basis for potential other-than-temporary declines in market value in accordance with GAAP. As part of this process, the Company considers any significant market declines in the context of the overall market and in relation to the outlook for the specific issuer of the security. Each quarter, the Company reviews all securities whose market values have declined below book price. From a quantitative standpoint, the Company views all securities that have declined more than 20% below book price and have remained so for two quarters as
potentially in need of a write-down. In addition, any other security that is viewed as impaired for a significant period is also a candidate for a write-down, even if the percentage decline is less than 20%. In order to review these holdings, the Company looks at any security that has been in a continuous unrealized loss position (regardless of the amount of the loss) for any period exceeding six months. In this way, the Company not only looks at the amount of the unrealized loss, but also at the amount of time the loss has existed. There is a risk that the Company may assess an other-than-temporary decline in market value as being temporary and, consequently, not charge the impairment to our earnings, which could have a significant impact on its future earnings and financial position.
The Company originates and holds mortgage loans on real estate on properties located in Massachusetts and Connecticut. Mortgage loans are collateralized by the related real estate. Agency loans are generally collateralized by the assets of the agency. The Company controls credit risk through credit approvals, credit limits and monitoring procedures. The Company performs in-depth credit evaluations on all new mortgage customers. The company has not incurred any bad debt expense on mortgage loans during the three years ended 2003.
Loss and loss adjustment expense ("LAE") reserves by their nature are inherently uncertain as to the ultimate outcome of the estimated amounts. 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 ("IBNR") losses and LAE net of, salvage and subrogation recoverable. The liability for losses and LAE is intended to cover the ultimate net cost of all losses and LAE incurred through the balance sheet date. Liability estimates are
The Company uses an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, the Company generally considers all expected future events other than changes in the tax law or rates, unless enacted. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.
Income consisting of expense reimbursements, which include servicing carrier fees from Commonwealth Automobile Reinsurers ("CAR"), a state-mandated reinsurance mechanism, on policies written for CAR, are deferred and amortized over the term of the related insurance policies (see NOTE G).
Due to the effect of a change in accounting principle related to Statement of Financial Accounting Standards ("SFAS") No.142, the Company recorded income in the first quarter of 2002, net of taxes, of $11,237 or $0.34 per share (diluted). This amount represented the remaining unamortized negative goodwill related to preferred stock mutual funds and the remaining excess of book value of subsidiary interest over cost relating to the 1999 acquisition of American Commerce. Negative goodwill and the excess of book value of subsidiary interest over cost occurred in these acquisitions because the underlying value of the assets purchased exceeded the purchase price. The subsequent recognition of income that occurred as these items were eliminated was not a taxable event but instead became part of the basis of the acquired asset.
Pro forma net earnings and earnings per share as if the Company had applied the fair value method of accounting for its stock-based compensation plans accounted for under the intrinsic value method for the years ended December 31 follow:
The fair value of employee options granted in 2001 was estimated on the date of grant, using the Black-Scholes option-pricing model. No options were granted in 2003 and 2002. The weighted average fair value and related assumptions of the 2001 options were:
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 the Company's common stock during the year. The number of such options was 1,850,000, 750,000 and 2,147,380 for the years ended December 31, 2003, 2002 and 2001, respectively.
The amortized cost and approximate fair market value of fixed maturities, by contractual maturity, at December 31 follow:
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 is $7,304.
The Company's holdings in closed-end preferred stock mutual funds at December 31, 2003 and 2002 accounted for under the equity method follow:
John Hancock Patriot Global Dividend Fund ("PGD"), John Hancock Patriot Preferred Dividend Fund ("PPF"), John Hancock Patriot Premium Dividend I Fund ("PDF"), John Hancock Patriot Premium Dividend II Fund ("PDT"), John Hancock Patriot Select Dividend Fund ("DIV"), Preferred Income Fund ("PFD"), Preferred Income Opportunity Fund ("PFO").
Unrealized losses from below investment grade fixed maturity securities by credit quality at December 31, 2003 follow:
Depreciation expense was $5,893, $5,417 and $4,280 for the years ended December 31, 2003, 2002 and 2001, respectively. Depreciation expense is allocated evenly between loss adjustment expenses and policy acquisition costs.
Unpaid Losses and LAE, by their nature, are inherently uncertain as to the ultimate outcome of the estimated amounts. The liability for unpaid losses and LAE represents management's best estimate of the ultimate net cost of all losses and LAE incurred through the balance sheet date. The estimate for ultimate net cost of all losses incurred through the balance sheet date includes the adjusted case estimates for losses, incurred but not reported losses, salvage and subrogation recoverable and a reserve for LAE. In arriving at its best estimate, management begins with the aggregate of individual case reserves and then makes 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 analysis performed by management as further described below. The entire liability for unpaid losses and LAE is also independently reviewed quarterly and annually by the Company's 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.
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer's payment of that loss. To recognize liabilities for unpaid losses, insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and LAE. Quarterly, the Company reviews these reserves internally. Regulations of the Division of Insurance require the Company to obtain a certification annually from either a qualified actuary or an approved loss reserve specialist that its loss and LAE reserves are reasonable.
When a claim is reported to the Company, claims personnel establish a "case reserve" for the estimated amount of the ultimate exposure to the Company. The amount of the reserve is primarily based upon an evaluation of the type of claim involved, the circumstances surrounding the claim and the policy provisions relating to the loss. This estimate reflects the informed judgment of such personnel based on general insurance reserving practices and on the experience and knowledge of the claims personnel adjusting the claim. During the loss adjustment period, these estimates are revised as deemed necessary by the Company's claims department personnel based on subsequent developments and periodic reviews of the cases.
NOTE E - Unpaid Losses and Loss Adjustment Expenses (LAE) (continued)
Losses and LAE attributable to insured events of the current year
NOTE E - Unpaid losses and Loss Adjustment Expenses (LAE) (continued)
The Company is a defendant in various legal actions arising from the normal course of its business. These proceedings are considered to be ordinary to operations or without foundation in fact. Management is of the opinion that these actions will not have a materially adverse effect on the consolidated financial statements of the Company.
2003, the Company maintained a 75% quota share reinsurance program, which was incepted on July 1, 1998 and established for a five year period. Quota share reinsurance refers to a form of pro rata reinsurance arrangement pursuant to which the reinsurer participates in a specified percentage of the premiums and losses on every risk that comes within the scope of the reinsurance agreement. The current program is split among American Re-Insurance Corporation, rated "A+(Superior)" by A.M. Best (its second highest rating), Employers Reinsurance Corporation, rated "A (Excellent)" by A.M. Best (its third highest rating), Swiss Reinsurance America Corporation, rated "A+ (Superior)" by A.M. Best, and Transatlantic Insurance Company, rated "A++ (Superior)" by A.M. Best (its top rating). The maximum per occurrence dollar recovery is equal to 225% of the annual net premiums ceded to the quota share arrangement in the contract year. The maximum aggregate per year dollar recovery under the quota share contract is equal to 325% of the annual net premium ceded to the quota share arrangement in the contract year. A sliding scale commission, based on loss ratio, is utilized under this program. Several limitations were added to the new quota share program regarding losses related to nuclear, chemical and biological terrorist events. The Company's maximum loss recovery in case of these types of events is estimated at $26 million. This program provides the Company with sufficient protection for catastrophe coverage to enable it to forego pure catastrophe reinsurance coverage.
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, 2004:
Under the above scenario and based on the twelve month projected premiums to be ceded under the program, we have no reinsurance recoveries for a single event catastrophe in excess of a total loss of approximately $359 million. The level of reinsurance protection increases (decreases) when the Company cedes more (less) premium to the reinsurers.
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 $200 million and $322 million, respectively. Our estimates were derived through the services of Employers Reinsurance Corporation on our December 31, 2002 other-than-automobile exposures, which utilized the RMS (Risk Management Solutions) risk assessment system, and are based on increases in policies written in 2003 that are subject to the quota share treaty. We believe that most property and casualty insurance companies establish their catastrophe reinsurance programs between the 100-year and 250-year storm estimates.
Written premiums ceded in 2003, 2002 and 2001 under the current and prior quota share programs combined were $107.3 million, $98.0 million and $78.6 million, respectively. The 9.5% increase in written premiums ceded in 2003 versus 2002 in this program was primarily the result of a $19.3 million, or 23.1% increase in Massachusetts homeowner direct written premium, coupled with an $8.7 million, or 31.9%, increase in direct homeowner writings in states other than Massachusetts, as previously mentioned. The impact of these increases was offset by the reduction on the quota share participation rate from 75 % to 65 % on July 1, 2003. Ceding commission income is calculated on a ceded earned premium basis.
Personal and commercial liability umbrella policies are reinsured on a 95% quota share basis in regard to limits up to $1.0 million and 100% quota share basis for limits in excess of $1.0 million but not exceeding $5.0 million 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 $1.0 million and 100% quota share basis for limits in excess of $1.0 million but not exceeding $3.0 million. The personal liability coverage was placed with American Re-Insurance through year end 2002. Effective January 1, 2003, we entered into a 95% personal umbrella quota share agreement with Employers Reinsurance Corporation, rated "A (Excellent)" by A.M. Best (its third highest rating). Through July 15, 2002, our commercial liability umbrella policies were placed with American Re-Insurance Company. Subsequent to July 15, 2002, we entered into a 95% commercial umbrella quota share agreement with Employers Reinsurance Corporation.
Reinsurance activity with CAR for fiscal years 2003, 2002 and 2001 follows:
The Company pays to CAR all of the premiums generated by the policies it has ceded and CAR reimburses the Company for all losses incurred on account of ceded policies. In addition, the Company receives a fee for servicing ceded policies based on the expense structure established by CAR. For the years ended December 31, 2003, 2002 and 2001, these servicing fees amounted to $18,938, $18,668 and $17,161, respectively.
The Company's 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 2003 and 2002 for both components.
Realization of a deferred tax asset is dependent on generating sufficient taxable income in future years. Although realization is not assured, management believes it is more likely than not that all of the deferred tax assets will be realized. SFAS No. 109 requires a valuation allowance to be recorded when it is more likely than not that some or all of the deferred tax assets will not be realized. At December 31, 2002, the Company's valuation allowance of $3,936 represented the tax effect related to realized investment losses that may not have been recoverable due to the uncertainties as to the amount of realized investment gains that may have been available in the future. The Company had sufficient capital gains in 2003 to reverse the 2002 year end valuation allowance in 2003.
The Company has made loans to insurance agencies with which Commerce transacts business on a regular basis. At December 31, 2003, ten loans with an aggregate outstanding principal balance of $2,537 were collateralized by the assets of the agencies and one loan with an outstanding balance of $281 was collateralized by real estate as the primary collateral and the assets of the agency as secondary collateral. There were no loans to insurance agencies collateralized solely by real estate. At December 31, 2002, eleven loans with an aggregate outstanding balance of $2,847 were collateralized by the assets of the agencies and one loan with an outstanding balance of $298 was collateralized by real estate as the primary collateral and the assets of the agency as secondary collateral.
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 Lauring Construction Company. During 2003 and 2002, Lauring Construction Company provided construction and construction management services in connection with a contract for the estimated $13 million renovation of a 130,000 square foot building purchased by the Company. 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 and 2002 were $375 and $275, respectively. Payments to Lauring Construction Company in 2003 and 2002 for actual materials used and construction work performed on this project were $335 and $2,308, respectively, and payments for other work unrelated to the project were $45 in 2003 and $33 in 2002.
ESOP participants who are current employees of the Company or its subsidiaries 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 2,096,000 shares owned by participants in the ESOP at December 31, 2003 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.
ESOP participants who are former employees of the Company may generally elect to withdraw from the ESOP the total amount of shares allocated to their accounts at any time. Approximately 561,000 shares held by the ESOP at December 31, 2003 are allocated to the ESOP accounts of these individuals.
The remaining approximately 194,000 shares held by the ESOP at December 31, 2003 are allocated to the ESOP accounts of participants who have not yet reached 100% vesting in their account balances. Disposition of these unvested shares is restricted under the ESOP. The Company pays for administration of the ESOP.
age 65 and life insurance coverage decreases based upon the age of the participant until the attainment of age 70 and thereafter. Participants' spouses are also covered under the post-retirement plan. The cost of post-retirement medical, dental and life insurance benefits was accrued over the active service periods of employees to the date they attained full eligibility for such benefits. It is the policy of American Commerce to pay for post-retirement benefits as incurred.
The post-retirement benefit plan's funded status reconciled with amounts reported in the consolidated balance sheet and the assumptions used in determining the actuarial present value of the benefit obligation at year end follows:
Net periodic cost of the post-retirement plan for the periods ended December 31, 2003, 2002 and 2001 follows:
The assumed health care cost trend rate for 2003 was 7.5% and 6.75% for medical and dental, respectively. These rates grade down until the final trend rates of 6.0% and 5.0% for medical and dental, respectively, are reached in 2010. A one percentage point increase in the assumed health and dental cost trend rates increases the sum of the service and interest costs components of the 2003, 2002 and 2001 periodic post-retirement benefit cost by 11.3%, 16.9% and 16.3% respectively, and the accumulated post-retirement benefit obligation as of December 31, 2003, 2002 and 2001 by 10.5%, 10.9% and 16.6%, respectively.
During 2000, the Company's Directors approved a Directors' Retirement Compensation Plan (the "Retirement Plan"). The Retirement Plan becomes effective for each Company Director upon terminating service on the Company's Board of Directors (the "Board") providing that such termination was not made under conditions adverse to the Company's interest. Effective with the annual meeting wherein the Director is not reappointed to the Board, and provided benefits are not paid until such time as the Director has attained the age of 65, the Company will pay an annual retirement benefit equal to 50% of the average annual total compensation of the Director for the immediately preceding three full years ("the three year average compensation"). The annual retirement benefit of 50% of the three year average compensation vests at the rate of 4.0% for each year of Board service up to a maximum of 100% vesting through termination of service. Payments continue for a maximum of ten years over the remaining life of the terminated Director, or his or her then spouse, if the Director pre-deceases the spouse. No payments are to be made after the death of the Director and spouse. Expenses related to the Retirement Plan in 2003, 2002 and 2001 amounted to $286, $117 and $178, respectively. The Company paid $36, $36 and $19 under the Retirement Plan in 2003, 2002 and 2001, respectively. The liability for the Retirement Plan, as calculated based on discounted cash flows, was $2,875 and $2,624 at December 31, 2003 and 2002, respectively.
Book value awards issued relating to the Incentive Compensation Plan totaled 1,408,675, 1,268,784 and 474,541 in 2003, 2002 and 2001, respectively. Expenses relating to book value awards were $11,203, $1,700 and $1,577 in 2003, 2002 and 2001, respectively. The outstanding book value awards 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.
Liabilities for the book value awards and employee stock option programs were $17,512 and $10,926 at December 31, 2003 and 2002, respectively.
At December 31, 2003, 2,557,664 shares of common stock may be awarded in the future under the Incentive Compensation Plan.
None of the outstanding ACIC agents' options was exercisable at December 31, 2003, 2002 and 2001.
The exercise prices for ACIC agents' options granted in 2003, 2002, 2001, 2000 and 1999 are $46.27, $49.50, $42.85, $34.04 and $36.32, respectively. The estimated weighted average fair value per share of the ACIC agents' options under the American Commerce Agents' Plan was $6.82, $5.03 and $5.63 at December 31, 2003, 2002 and 2001, respectively. The ACIC agents' option liability at December 31, 2003 and 2002 was $16.7 million and $7.6 million, respectively.
The aggregate amount of dividends calculated in accordance with regulations in Massachusetts, California and Ohio that could have been paid in 2003 from all of the Company's insurance subsidiaries without prior regulatory approval was approximately $76.0 million, of which $66.2 million was declared and paid as of December 31, 2003.
furniture and equipment, prepaid commissions, and other assets not specifically identified as an admitted asset;
The Company has four reportable segments: (1) property and casualty insurance - Massachusetts; (2) property and casualty insurance - other than Massachusetts; (3) real estate and commercial lending; and, (4) corporate and other. The Company's property and casualty insurance operations are written through Commerce, Citation, Commerce West, and American Commerce and are marketed to affinity groups, individuals, families and businesses through the Company's relationships with professional independent insurance agencies. The Company's real estate and commercial lending operations are a result of insurance companies having the authority to invest in mortgages. The Company's wholly-owned subsidiary, Bay Finance Company, Inc., originates and services residential and commercial mortgages in Massachusetts and Connecticut. The corporate and other segment represents the remainder of the Company's activities, including those of the parent company.
From MIIF's inception on August 2, 1972 through December 31, 2003, the MIIF has approved assessments totaling $286,016, of which the share for Commerce and Citation was approximately $28,288. 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. Although the timing and amounts of any such assessments are not known, based on existing knowledge, management is of the opinion that such assessments will not have a material effect on the consolidated financial position of the Company. MIIF assessed Commerce and Citation $8,106, $4,496 and $3,111 for the years ended December 31, 2003, 2002 and 2001, respectively. The assessment for 2003 was the result of 20 insolvencies. It was primarily the result of the insolvencies of Reliance Insurance Company and Legion Insurance Company for $2,570 each, and the insolvency of Midland Insurance Company for $2,185. The assessment for 2002 was primarily the result of six insolvencies. It was primarily the result of the
Also in 2000, Commerce entered into a Limited Partnership Agreement with Distribution Partners Investment Capital, L.P. a Delaware Limited Partnership. This partnership agreement required a commitment by the Company to invest up to $3,500 into the partnership. In 2002 and 2001, the Company invested $298 and $1,733, respectively, into the partnership. The Company did not invest in the partnership in 2003. As of December 31, 2003, the Company has invested $2,555 into the partnership leaving a balance of $945 for funds still committed. The partnership was formed to operate as an investment fund principally for the purpose of making investments primarily in equity and equity-related securities of 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. See Note F for the Company's indebtedness commitment.
As is common with property and casualty insurance companies, the Company is a defendant in various legal actions arising from the normal course of its 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 the Company does business. These proceedings are considered ordinary to operations or without foundation in fact. Management is of the opinion that these actions will not have a material adverse effect on the consolidated financial position of the Company.
The following tables depict the progress of the insurance operations of the Company over the past fifteen years. For these years of operation, net premiums written amounted to $11.0 billion. During this period, the aggregate statutory financial ratios were 70.8% for losses and loss expenses and 25.5% for underwriting expenses resulting in an aggregate combined ratio of 96.3 %. Total net investment income amounted to $1.0 billion or 9.4% of net premiums written. Net realized gains were $92.0 million. Stockholders' equity was $67.2 million at the beginning of 1989 and $1.2 billion, at the end of 2003, resulting in an average annual increase in excess of 22.5%, excluding dividends. This figure, including dividends paid, would have been 22.7%. The progress of the insurance operations during the most recent five year period, compared to the two previous five year periods, can best be illustrated by the following comparison:
Due to the internal reorganization in 2003, minority interest is no longer part of our insurance operation. Minority interest is included in 2003 for comparative purposes and to reconcile to our consolidated balance sheet.