The Company - RTW, Inc. (RTW) provides disability and absence management services, directed today primarily at workers’ compensation to: (i) employers insured through our wholly-owned insurance subsidiary, American Compensation Insurance Company (ACIC) and its wholly-owned insurance subsidiary, Bloomington Compensation Insurance Company (BCIC); (ii) self-insured employers on a fee-for-service basis; (iii) state-sponsored assigned risk plans on a percent of premium basis; (iv) other insurance companies; and (v) to agents and employers on a consulting basis, charging hourly fees through RTW and its Absentiasm division. ACIC offers guaranteed cost workers’ compensation insurance to employers located primarily in Minnesota, Michigan and Colorado and is licensed in twenty-three states. BCIC began underwriting business in October 2005 and offers guaranteed-cost workers’ compensation insurance to selected employers only in Minnesota. Collectively, “we,” “our” and “us” refer to RTW, ACIC, BCIC and Absentia in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
On April 14, 2005, A.M. Best Co. (Best) affirmed the financial strength rating of “B+” (Very Good, Secure) for ACIC and revised its outlook to “positive” from “stable”. The rating reflects our improved capitalization and profitability over the last three years. ACIC increased its statutory capital and surplus to $43.6 million at December 31, 2005 and $38.5 million at December 31, 2004 from $33.0 million at December 31, 2003 as a result of profitability in 2005 and 2004. We believe that our “B+” rating from A.M. Best may create a barrier in certain circumstances for us as there are agents and employers that will only do business with insurers rated “A-” or better.
Additional information about RTW is available on our website at www.rtwi.com.
of billed service revenue over earned amounts is recognized as a liability and included in “Accrued expenses and other liabilities” on our Consolidated Balance Sheet.
We reported net income of $6.0 million in 2005 compared to net income of $9.9 million in 2004 and $7.0 million in 2003. We reported diluted income per share of $1.06 in 2005 compared to diluted income per share of $1.81 in 2004 and $1.32 in 2003. The primary factors affecting our 2005 operating results included the following:
Premiums earned decreased 7.9% to $49.4 million in 2005 from $53.7 million in 2004. Premiums earned in 2005 reflect the decrease in gross premiums earned from 2004, and an increase in final audit premiums earned in 2005 compared to 2004, offset by an increase in premiums ceded as our cost of excess of loss reinsurance increased in 2005;
Total revenues included $4.6 million of net investment income and $580,000 of net realized investment gains in 2005 compared to $3.7 million of net investment income and $705,000 of net realized investment gains in 2004;
Claim and claim settlement expenses decreased to 62.3% of premiums earned for 2005 from 66.2% for 2004. We benefited from improving our claim management capabilities and closing old claims, realizing favorable development of $5.5 million in 2005 compared to $7.0 million in 2004. Claim and claim settlement expenses also decreased in 2005 due to the decrease in gross premiums earned in 2005 compared to 2004. See further discussion under “Claim and Claim Settlement Expenses”; and
Our premiums in force decreased to $52.9 million at December 31, 2005 from $62.7 million at December 31, 2004 and $58.1 million at December 31, 2003. Premiums in force in our Minnesota, Colorado and Michigan regions decreased $5.5 million, $2.3 million and $2.0 million, respectively, at the end of 2005 compared to the end of 2004. Average premiums in force decreased to $57.9 million in 2005 from $61.5 million in 2004 but increased from $53.6 million in 2003. Premiums in force decreased in 2005 as we focused on maintaining adequate pricing and declined business where we could not get a price that gave us an appropriate opportunity to earn a profit. We are in the midst of a soft cycle in the insurance market. We write to achieve an expected profit, no matter what our competitors do. In 2004 and 2003, we were able to grow our business while gaining appropriate pricing on our policies written. Our average annual premium per policy increased to $95,500 in 2005 from $94,600 in 2004 and $85,400 in 2003.
Our gross premiums earned decreased 5.5% to $59.9 million in 2005 from $63.4 million in 2004. This decrease resulted primarily from: (i) the decrease in average premiums in force, offset by; (ii) a slight increase in final audit premiums which increased gross premiums earned by $1.4 million in 2005 compared to $1.2 million in 2004.
Our gross premiums earned increased 16.5% to $63.4 million in 2004 from $54.4 million in 2003. This increase resulted primarily from: (i) the increase in average premiums in force, offset by; (ii) an increase in final audit premiums which increased gross premiums earned by $1.2 million in 2004 compared to a $323,000 increase in 2003.
Premiums ceded to reinsurers increased to $9.7 million in 2004 from $8.1 million in 2003. The increase in premiums ceded resulted primarily from: (i) our cost for excess of loss reinsurance coverage increased substantially in all regions in 2004; (ii) gross premiums earned in 2004 increased from 2003; and (iii) the 2004 results include a $129,000 decrease in excess of loss premiums ceded, resulting from a change in estimated reinsurance cost for the WCRA compared to a $92,000 increase in excess of loss premiums ceded in 2003.
2006 Outlook: The 2006 outlook for premiums in force, gross premiums earned and premiums ceded include the following factors:
Our 2006 gross premiums earned will move in the same direction as our premiums in force, lagging slightly as premiums are earned over the term of the insurance policy; and
At December 31, 2003, we were invested entirely in U.S. domiciled investment-grade taxable fixed maturity investments. We added U.S. domiciled investment-grade tax-exempt fixed maturity investments in 2004 to take advantage of the tax benefits of those securities and interest rate spreads. We held cash and cash equivalents totaling $21.9 million and $39.4 million at December 31, 2005 and 2004, respectively. In order to reduce the near term interest rate risk on the portfolio, we built our cash position throughout 2003 and 2004 by holding cash received on mortgage-backed security prepayments and through sales of securities expecting interest rates would rise in 2005. During 2005, we began to invest a portion of our cash and cash equivalents into longer maturing, fixed-rate securities. We intend to hold our available-for-sale investments to maturity.
Net investment income increased to $4.6 million in 2005 from $3.7 million in 2004. In late 2004, yields on short maturity instruments began to improve. This improvement continued throughout 2005 and resulted in a relatively “flat” yield curve. The yield curve change benefited our yields on cash and cash equivalents. Later in the year, we further enhanced our net investment income realized on cash and cash equivalents by structuring a cash ladder to improve yields without taking undue risk. Total invested assets (investments, cash and cash equivalents) increased from $126.3 million at December 31, 2004 to $129.1 million at December 31, 2005. Our book investment yield, excluding cash and cash equivalents, decreased to 3.9% at December 31, 2005 from 4.0% at December 31, 2004. As maturities occurred and pay-downs on mortgage backed securities occurred, we decreased our average maturity and duration to minimize interest rate risk. The investment yields realized in future periods will be affected by yields attained on new investments.
In 2005, 2004 and 2003, we sold certain securities within the portfolio to take advantage of favorable interest rates and realized net investment gains totaling $580,000, $705,000 and $685,000, respectively.
We expect interest rates to increase in 2006. The timing of any such rate increases is unknown at this time. We intend to invest our excess cash into higher yielding investments in 2006 as rates increase;
Recognition of realized investment gains and losses will depend on sales of our investments, if any, to meet our short-term cash requirements or as we reposition our portfolio to further manage our portfolio returns. We do not anticipate selling any securities in 2006; and
New and renegotiated reinsurance treaties may affect our future cash flow and future net investment income.
Service Revenue: Service revenue includes revenues for services that are: (i) billed as a percent of premium of insurance policies issued by non-affiliated third-party insurers; (ii) billed based on the number and type of claims serviced; (iii) billed on an hourly basis based on direct activity; or (iv) billed based on contract duration. Our customers include the Minnesota Workers’ Compensation Assigned Risk Plan (ARP), self-insured employers, other insurance companies, insurance agents and local governmental units. Service revenue grew to $4.4 million in 2005 from $633,000 in 2004 and $109,000 in 2003. Annualized service revenue was $6.6 million at December 31, 2005. Annualized service revenue represents the estimated total value of service contracts that are in place at any point in time.
Total Expenses: Our expenses include claim and claim settlement expenses, policy acquisition costs, general and administrative expenses and income taxes.
Claim and claim settlement expenses are our largest expense and result in our largest liability. We establish reserves that reflect our estimates of the total claim and claim settlement expenses we will ultimately have to pay under our workers’ compensation insurance policies. These include claims that have been reported but not yet settled and claims that have been incurred but not yet reported to us. For further discussion of reserve determination, see the “Unpaid Claim and Claim Settlement Expenses” and “Reinsurance Recoverables” sections of this Management’s Discussion and Analysis.
The decrease in gross premiums earned as discussed above under “Premiums In Force and Gross Premiums Earned;”
The 2005 results include a $5.5 million decrease in prior accident years’ reserves for unpaid claim and claim settlement expenses compared to the 2004 results, which include a $7.0 million decrease in prior accident years’ reserves. Our estimate for unpaid claim and claim settlement expenses decreased in 2005 due to the following: (i) our ability to manage and close claims has improved over our historical experience; (ii) the re-underwriting of our book of business has resulted in claims with profiles different than experienced historically; and (iii) our estimate of the liability for unpaid claim and claim settlement expenses is volatile due to our relatively limited fourteen-year historical claim data and our small claim population; and
Claim costs continued to reflect increasing medical and indemnity costs in accident year 2005 as compared to accident year 2004 resulting from inflationary pressures.
2004 Compared to 2003: Claim and claim settlement expenses increased to $35.5 million in 2004 from $27.3 million in 2003. As a percent of premiums earned, claim and claim settlement expenses increased to 66.2% in 2004 from 58.9% in 2003. These changes are due to the following:
The 2004 results include a $7.0 million decrease in prior accident years’ reserves for unpaid claim and claim settlement expenses compared to the 2003 results, which include a $6.7 million decrease in prior accident years’ reserves. Our estimate for unpaid claim and claim settlement expenses decreased in 2004 due to the following: (i) our ability to manage and close claims has improved over our historical experience; (ii) the re-underwriting of our book of business has resulted in claims with profiles different than experienced historically; and (iii) our estimate of the liability for unpaid claim and claim settlement expenses is volatile due to our relatively limited historical claim data and our small claim population; and
The ultimate effect of the above factors on claim and claim settlement expenses is unknown at this time.
Under certain of our excess of loss reinsurance policies, the reinsurer returns a portion of the premiums we cede as ceding commissions to reimburse us for our cost of placing and managing policies. Ceding commissions received under excess of loss reinsurance policies totaled $2.5 million in 2005 compared to $2.4 million in 2004 and $1.5 million in 2003. These ceding commissions reduced our policy acquisition costs. Excluding the effect of ceding commissions, policy acquisition costs were $8.0 million in 2005, $8.4 million in 2004 and $8.4 million in 2003. As a percent of gross premiums earned, direct policy acquisition costs were 13.3% in 2005 compared to 13.3% in 2004 and 15.4% in 2003. The changes in 2005, 2004 and 2003 reflect the following:
Gross premiums earned decreased in 2005 compared to 2004 resulting in a corresponding decrease in policy acquisition costs;
Premium tax expense paid to states was 1.9% of gross premiums earned in 2005, 1.8% of gross premiums earned in 2004 and 1.8% of gross premiums earned in 2003; and
General and administrative expenses increased in 2005 from 2004 levels. Significant changes include: (i) we added staff and other general and administrative expenses to deliver the services associated with the service revenue increase to $4.4 million in 2005 from $633,000 in 2004; (ii) bonus expense was $1.5 million in 2005 compared to $1.3 million in 2004; and (iii) bad debt expense was $450,000 in 2005 compared to a benefit of $108,000 in 2004, principally due to customer bankruptcies in our Michigan region; and;
General and administrative expenses decreased in 2004 from 2003 levels. Significant changes include: (i) the reversal of a previously recorded contingent reinsurance commission resulting in $375,000 in expense in 2003; (ii) bonus expense was $1.3 million in 2004 compared to $941,000 in 2003; (iii) bad debt expense was $400,000 lower in 2004; and (iv) we operated with fewer average headcount in 2004 compared to 2003.
2006 Outlook: We expect that general and administrative expenses will be affected by the following:
Our contract to manage the ARP business and continued growth in our service revenue will require staff additions and increase our general and administrative expense;
include limitations on the deductibility of unpaid claim and claim settlement expenses, limitations on the deductibility of unearned premium reserves and limitations on deductions for bad debt reserves.
Operating cash flows consist of the deficit or excess of premiums collected over claim and claim settlement expenses paid, reduced by payments for reinsurance premiums, as well as service revenue collected and other operating expenses paid. Investment cash flows consist of income on existing investments and proceeds from sales and maturities of investments. Our investment portfolio increased $20.3 million to $107.3 million at December 31, 2005 from $87.0 million at December 31, 2004. During 2003 and 2004, interest rates declined, leading to significant mortgage refinancing by consumers, resulting in significant prepayment or early redemption of our mortgage-backed securities. In order to reduce the near-term interest rate risk on the portfolio, we built our cash position throughout 2004 by holding cash received on mortgage-backed security pre-payments and through sales of securities, expecting that interest rates would rise in 2005. During 2005, we began to invest a portion of our cash and cash equivalents into longer maturing, fixed-rate securities. Cash and cash equivalents were $21.9 million at December 31, 2005 compared to $39.4 million at December 31, 2004. We expect that cash will decrease and investments will increase in 2006 as we continue to invest available cash into additional fixed-income securities.
We record investments on our balance sheet at fair value, with the corresponding appreciation or depreciation from amortized cost recorded in shareholders’ equity as accumulated other comprehensive income, net of taxes. Because value is based on the relationship between the portfolio’s stated yields and prevailing market yields at any given time, interest rate fluctuations can have a swift and significant impact on the carrying value of these securities. As a result of classifying our securities as available-for-sale, and thus carrying them at fair value, we expect to encounter adjustments in shareholders’ equity as market interest rates and other factors change. At December 31, 2005, we had a $1.8 million net unrealized loss on investments at December 31, 2005 compared to a $572,000 net unrealized gain at December 31, 2004.
At December 31, 2005, net reserves totaled $76.8 million and included the liability for unpaid claim and claim settlement expenses of $160.1 million net of reinsurance recoverables on unpaid claim and claim settlement expenses of $83.3 million. The net reserve at December 31, 2004 totaled $78.4 million and included the liability for unpaid claim and claim settlement expenses totaling $156.1 million net of reinsurance recoverables on unpaid claim and claim settlement expenses of $77.7 million.
The amount by which estimated net reserves, measured subsequently by reference to payments and additional estimates, differ from those originally reported for a period is known as “development.” Development is unfavorable (deficient) when losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for reserve increases on open claims. Development is favorable (redundant) when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on open claims. Favorable or unfavorable development of loss reserves is reflected in earnings in the year realized.
claim and claim settlement expenses. Accordingly, we supplement our experience with external industry data, as adjusted, to reflect anticipated differences between our results and the industry.
Estimating the effect that inflation will have on the ultimate cost of claims is a major risk factor in our workers’ compensation reserve estimates. Future earnings will be affected by reserve development associated with any changes in our inflation assumptions. Estimates for the 2005 and 2004 accident years represent the majority (52% of the net reserves) of the uncertainty because these claims have the lowest proportionate amount of paid loss as of December 31, 2005. Our reserve estimates are most sensitive to changes in the assumption about inflation for the 2005 and 2004 accident years. Each one percent (1%) increase or decrease in the inflation rate for each of these accident years would increase or decrease our net loss reserve estimates at December 31, 2005 by approximately $477,000.
Our reserves are primarily undiscounted; however, we discounted reserves for selected claims that have fixed and determinable future payments at rates ranging from 3.5% to 8.0% in 2005 and 2004. The discount rates are subject to change as market interest rates change. We use the same rates for U.S. generally accepted accounting principles (GAAP) as we do for statutory accounting practices (SAP) in determining our liability. We also reduce the unpaid claim and claim settlement expenses for estimated amounts of subrogation.
After taking into account all relevant factors, we believe our reserves for unpaid claim and claim settlement expenses and reinsurance recoverables on unpaid claim and claim settlement expenses at December 31, 2005 are adequate to cover the ultimate net costs of claim and claim settlement expenses at that date. The ultimate cost of claim and claim settlement expenses may differ materially from the established reserves, particularly when claims may not be settled for many years. Establishing appropriate reserves is an inherently uncertain process and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience. See Notes 1 and 5 in the accompanying Consolidated Financial Statements. The following two tables reconcile the beginning and ending insurance reserves, displayed individually for each of the last three years.
The “initial reserves in excess of (less than) re-estimated reserves” (Amount and Percent rows) represent the aggregate change in the estimates over all prior years. For example, the 1998 reserve developed a $12.9 million net deficiency over the course of the succeeding years.
may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate redundancies or deficiencies based on this table.
The table above represents the development of balance sheet net reserves for 1995 through 2005. The top three rows of the table reconcile gross reserves to net reserves for unpaid claim and claim settlement expenses recorded at the balance sheet date for each of the indicated years.
The lower portion of the table shows the re-estimated amount of the previously recorded net reserves, based on experience as of the end of each succeeding year. The estimate is either increased or decreased as
more information becomes known about the frequency and severity of claims for individual years. For example, for the 1998 calendar year valued as of December 31, 2005, we paid $66.7 million of the currently estimated $82.7 million of claim and claim settlement expenses that were incurred through the end of 1998. Thus, the difference, an estimated $15.7 million of claim and claim settlement expenses incurred through 1998, remained unpaid as of December 31, 2005.
The “initial reserves in excess of (less than) re-estimated reserves” (Amount and Percent rows) represent the aggregate change in the estimates over all prior years. For example, the 1998 reserve developed a $6.8 million net deficiency over the course of the succeeding years. The net amount has been included in income and the changes have been recorded in the period identified. The cumulative net deficiencies in 2000 and 1999 are the result of reserve development inherent in the uncertainty in establishing reserves and anticipated loss trends. As discussed above, due to our relatively limited historical claim data and small claim population, our estimate of the liability for net reserves is difficult and volatile. As discussed further below, the reserve redundancy in 2001 is the result of accrual reversals resulting from changes in methods of assessing second injury funds, lower frequency in claims reported from the estimate at December 31, 2001, and reductions in amounts expected to be incurred for our participation in mandatory state and national assigned risk pools.
The 2005 results include a $5.5 million decrease in prior years’ reserves for unpaid claim and claim settlement expenses. Our estimate for unpaid claim and claim settlement expenses decreased in 2005 due to the following: (i) our ability to manage and close claims has improved over our historical experience; (ii) the re-underwriting of our book of business has resulted in claims with profiles different than experienced historically; and (iii) our estimate of the liability for unpaid claim and claim settlement expenses is volatile due to our relatively limited fourteen-year historical claim data and our small claim population.
The 2003 results include a $6.7 million decrease in prior years’ reserves for unpaid claim and claim settlement expenses. Our estimate for unpaid claim and claim settlement expenses decreased in 2003 due to the following: (i) the frequency of claims reported in 2002 and prior years was less than anticipated when we determined our liability in 2002; and (ii) our estimate of the liability for unpaid claim and claim settlement expenses is difficult and volatile due to our relatively limited historical claim data and small claim population.
Cash provided by operating activities was $4.9 million for 2005. This is primarily a result of net income of $6.0 million and an increase of $4.0 million in unpaid claim and claim settlement expenses offset by an increase in amounts due from reinsurers of $4.9 million. Net cash used in investing activities was $23.0 million due primarily to $45.9 million in purchases of securities offset by $11.2 million in proceeds from sales of securities and $12.5 million in maturities of investments. Net cash provided by financing activities was $578,000 due to the exercise of stock options in 2005.
would have the effect of reducing the ratio of premiums to capital and surplus in ACIC to satisfy state regulatory requirements.
Minnesota state insurance regulations limit distributions, including dividends, from our insurance subsidiary to us. Under Minnesota insurance law regulating the payment of dividends, in any twelve month period, ACIC can pay a dividend to us from its earned surplus (unassigned surplus) not to exceed the greater of 10% of ACIC’s total surplus or ACIC’s prior years’ net income reduced for realized capital gains net of income taxes. At December 31, 2005, ACIC could pay a dividend to us totaling $4.1 million without the approval of the Minnesota Department of Commerce (See Note 9 of Notes to Consolidated Financial Statements). ACIC has never paid a dividend to us, and we intend to retain capital in the insurance subsidiaries.
At December 31, 2005, investments with a market value of $15.8 million were held as statutory deposits and pledged as collateral. Investments held as statutory deposits and pledged as collateral do not currently have an adverse effect on our liquidity. We believe that cash flow generated by our operations and our cash and investment balances will be sufficient to fund continuing operations and capital expenditures for the next twelve months.
Our contractual obligations consist solely of operating leases for our facilities. Future minimum (base) rental payments required under the leases, as of December 31, 2005, are as follows (000’s):
An increase of 100 basis points in prevailing interest rates would reduce the fair value of our interest rate sensitive instruments by approximately $3.3 million.
The National Association of Insurance Commissioners (NAIC) has risk-based capital standards to determine the capital requirements of a property and casualty insurance carrier based upon the risks inherent
in its operations. These standards require computing a risk-based capital amount that is compared to a carrier’s actual total adjusted capital. The computation involves applying factors to various financial data to address four primary risks: asset risk; insurance underwriting risk; credit risk; and off-balance sheet risk. These standards provide for regulatory intervention when the percent of total adjusted capital to authorized control level risk-based capital is below certain levels. Based upon the risk-based capital standards, our percent of total adjusted capital is in excess of authorized control level risk-based capital.
Our insurance subsidiaries are subject to substantial regulation by governmental agencies in the states in which we operate, and will be subject to such regulation in any state in which we provide workers’ compensation products and services in the future. State regulatory agencies have broad administrative power with respect to all aspects of our business, including premium rates, benefit levels, policy forms, dividend payments, capital adequacy and the amount and type of investments. These regulations are primarily intended to protect covered employees and policyholders rather than the insurance company. Both the legislation covering insurance companies and the regulations adopted by state agencies are subject to change. At December 31, 2005, ACIC was licensed to do business in twenty-three states while BCIC was licensed only in Minnesota.
In September 2005, the Accounting Standards Executive Committee issued Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (SOP 05-1). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in FAS 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by election of a feature or coverage within a contract. SOP 05-1 is effective for internal replacements occurring in the fiscal year beginning after December 15, 2006, with earlier adoption encouraged. The Company only issues workers’ compensation insurance policies, which are a statutory coverage and are not subject to internal
replacement or modification in product benefits, features, right or coverages. The Company does not expect the impact of adoption SOP 05-1 to have a significant effect on operations, financial condition or liquidity.
Information included in this Report on Form 10-K which can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,” “estimate,” or “continue” or the negative thereof or other variations thereon or comparable terminology constitutes “forward-looking information” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. The following important factors, among others, in some cases have affected and in the future could affect our actual results and could cause our actual financial performance to differ materially from that expressed in any forward-looking statement: (i) our ability to retain renewing policies and write new business with a B+ (Very Good, Secure) rating from A.M. Best; (ii) our ability to extend our workers’ compensation services to self-insured employers and other alternative markets and to operate profitably in providing these services; (iii) our ability to continue to maintain or increase rates on insured products in the markets in which we remain or alternatively non-renew or turn away improperly priced business; (iv) the ability of our reinsurers to honor their obligations to us; (v) our ability to accurately predict claim development; (vi) our ability to provide our proprietary products and services to customers successfully; (vii) our ability to manage both our existing claims and new claims in an effective manner; (viii) our experience with claims frequency and severity; (ix) medical inflation; (x) competition and the regulatory environment in which we operate; (xi) general economic and business conditions; (xii) our ability to obtain and retain reinsurance at a reasonable cost; (xiii) changes in workers’ compensation regulation by states, including changes in mandated benefits or insurance company regulation; (xiv) interest rate changes; and (xv) other factors as noted in our other filings with the Securities and Exchange Commission. This discussion of uncertainties is by no means exhaustive but is designed to highlight important factors that may affect our future performance.
Consolidated Statements of Shareholders’ Equity - Years Ended December 31, 2005, 2004 and 2003
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of RTW, Inc. at December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
Organization - RTW, Inc. (RTW) provides disability and absence management services, directed today primarily at workers’ compensation to: (i) employers insured through our wholly-owned insurance subsidiary, American Compensation Insurance Company (ACIC) and its wholly-owned insurance subsidiary, Bloomington Compensation Insurance Company (BCIC); (ii) self-insured employers on a fee-for-service basis; (iii) state-sponsored assigned risk plans on a percent of premium basis; (iv) other insurance companies; and (v) to agents and employers on a consulting basis, charging hourly fees through RTW and its Absentiasm division. ACIC offers guaranteed cost workers’ compensation insurance to employers located primarily in Minnesota, Michigan and Colorado and is licensed in twenty-three states. BCIC began underwriting business in October 2005 and offers guaranteed-cost workers’ compensation insurance to selected employers only in Minnesota. Collectively, “we,” “our” and “us” refer to RTW, ACIC, BCIC and Absentia in these Notes to Consolidated Financial Statements.
We benefit from our ability to reduce workers’ compensation and disability system costs and provide employers the ability to control their workers’ compensation, disability and absence programs. Our insurance subsidiaries are domiciled in Minnesota and operated primarily in Minnesota, Michigan and Colorado in 2005, 2004 and 2003. Absentia serviced customers in six states in 2004 and expanded to 18 states by December 31, 2005. In 2002, we non-renewed all insurance policies in our Missouri and Massachusetts regions and completed our run-off of policies in these regions by February 2003.
We continually monitor the difference between investment cost and fair value for each of our securities. If any security experiences a decline in value that is determined to be other than temporary, we reduce the
If deferred policy acquisition costs were to exceed the sum of unearned premiums net of reinsurance and related anticipated investment income less expected claim and claim settlement expenses, we would immediately expense the excess costs.
Depreciation - We depreciate furniture and equipment on a straight-line basis over the estimated useful life of the asset (five to ten years). Furniture and equipment are recorded at cost less accumulated depreciation of $5.1 million and $4.7 million at December 31, 2005 and 2004, respectively.
The weighted average fair value of options granted under the ESPP and 1994 Stock Plan during 2005, 2004 and 2003 is estimated at $1.84, $2.13 and $1.48, respectively, on the date of grant using the Black-Scholes option-pricing model with the following assumptions: no dividend yield; volatility of 26.1% to 33.8% in 2005, 41.0% to 73.8% in 2004 and 115.3% to 131.5% in 2003; risk-free interest rates ranging from 1.1% to 4.2%; and an expected life of 1 to 54 years.
policy on other-than-temporary impairments complies with FSP 115-1. Accordingly, the adoption of this standard has not had a material effect on the consolidated financial statements.
For claims occurring after June 30, 1998, we further limited our per incident exposure by purchasing excess of loss coverage for losses from $25,000 to the lesser of $300,000 or the WCRA selected retention level in Minnesota and from $25,000 to $300,000 in other states from a single reinsurer. This agreement was finalized after its effective date and activity occurring from July 1, 1998 through September 30, 1998 was recorded on a retrospective basis resulting in the deferral of a gain totaling $2.0 million at December 31, 1998. We amortized $400,000 of the deferred gain as a reduction of claim and claim settlement expenses in each of 2002, 2001 and 2000 and $740,000 in 1999, resulting in an un-amortized deferred gain of $49,000 at December 31, 2005. The deferred gain is being amortized into income using the effective interest rate inherent in the amounts paid to the reinsurer and the estimated timing and amounts of recoveries from the reinsurer. Activity occurring on or after October 1, 1998 is recorded prospectively. This contract was terminated effective December 31, 2000; however, the policy was effective in 2001 for policies in force at December 31, 2000 through expiration, not to exceed fifteen months after the effective termination date. Policies written or renewing after December 31, 2000 are not covered under this lower level excess of loss reinsurance policy.
Changes in estimates of unpaid claim and claim settlement expenses for prior years decreased the provision for claim and claim settlement expenses by $5.5 million, $7.0 million and $6.7 million in 2005, 2004 and 2003, respectively.
We recovered $5.0 million, $6.6 million and $15.3 million from reinsurers during 2005, 2004 and 2003 respectively.
Differences between the tax basis of assets and liabilities and their reported amounts in the Consolidated Balance Sheets that will result in taxable or deductible amounts in future years are called temporary differences. The tax effects of temporary differences that give rise to net deferred tax assets, included within other assets, are as follows (000’s):
In assessing our ability to realize the future benefit of deferred tax assets, we consider recent operating results, the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies. The valuation allowance decreased to $4.0 million in 2003 based on our projected taxable income and available tax planning strategies. In 2004, we eliminated the remaining allowance as we expect the entire deferred tax asset will be realized as a result of income and the reversal of existing taxable temporary differences in the future
Stock Based Compensation - We account for our stock-based compensation plans, the RTW, Inc. 1995 Employee Stock Purchase Plan and Trust (ESPP), the 1994 Stock Plan and the 2005 Stock Plan, using Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees,” and related Interpretations. Under APB 25, compensation cost for stock options is measured as the excess, if any, of the quoted market price of our stock at the date of the grant over the amount an employee must pay to acquire the stock.
The eleventh one-year phase began in April 2005 and expires in April 2006.
1994 Stock Plan - The 1994 Stock Plan provides for awards of incentive stock options (as defined in section 422 of the Internal Revenue code) and non-qualified stock options. In July 1998, the Board of Directors increased the shares reserved for distribution under the plan to 1,000,000. Option price, option term, vesting provisions and other limits and restrictions are determined at the time of grant by the Board of Directors or, if established, by a separate committee. The exercise price for all options granted was the market price of the common stock at the date of grant. The ability to award incentive stock options under this Plan terminated in June 2004.
Incentive stock options expire ten years from the date of grant and substantially all are subject to continued employment with us. Each of the non-qualified options expires ten years from the date of grant with the exception of certain options granted to the founder of the Company that expire five years from the date of grant. Options are generally subject to vesting provisions that restrict exercise of the option.
2005 Stock Plan - The 2005 Stock Plan was approved by the shareholders in June 2005 and provides for awards of incentive stock options (as defined in section 422 of the Internal Revenue code) and non-qualified stock options. Option price, option term, vesting provisions and other limits and restrictions are determined at the time of grant by the Board of Directors or, if established, by a separate committee. The exercise price for all options granted was the market price of the common stock at the date of grant.
Options granted, exercised, canceled and outstanding under the 2005 Stock Plan are as follows:
Employment Contracts - We entered into an employment agreement with our President and Chief Executive Officer, Jeffrey B. Murphy beginning December 17, 2003. Under the original agreement, Mr. Murphy received a base salary of $250,000, subject to review annually for increase by our Board of Directors. In addition to base salary, Mr. Murphy was eligible for bonuses, expense reimbursements and health, dental, life and disability insurance consistent with that provided to other officers and employees. Additionally, Mr. Murphy was granted 100,000 options at $6.00 per share which vest over four years on March 12, 2004. Mr. Murphy’s annual base salary was increased to $275,000 effective April 1, 2005 with the remaining terms of his agreement continuing unchanged.
401(k) Retirement Component - We sponsor a defined contribution retirement component under Section 401(k) of the Internal Revenue Code for eligible employees. Our contributions are discretionary and are based on contributions made by employees. Expense recognized for 2005, 2004 and 2003 was $224,000, $221,000 and $204,000, respectively.
Other Employee Benefit Plans - We maintained bonus plans in 2005, 2004 and 2003 under which all employees, including officers, were eligible for a bonus based on our operating results. These bonuses aggregated $1.5 million, $1.3 million and $941,000 in 2005, 2004 and 2003, respectively.
Our ability to pay cash dividends to shareholders may depend upon the amount of dividends received from our insurance subsidiary. ACIC’s ability to pay dividends is restricted by law and in certain cases may be subject to approval of the insurance regulatory authorities of Minnesota.
Under Minnesota insurance law regulating the payment of dividends by ACIC unless otherwise approved by the Commissioner of the Minnesota Department of Commerce (Commissioner), dividends must be paid solely from the adjusted earned surplus of ACIC. Adjusted earned surplus means the earned surplus as determined in accordance with statutory accounting practices (unassigned funds), less 25% of the amount of such earned surplus that is attributable to unrealized capital gains. Further, without approval of the Commissioner, ACIC may not pay a dividend in any calendar year which, when combined with dividends paid in the preceding twelve months, exceeds the greater of: (i) 10% of ACIC’s statutory capital and surplus at the prior year end; or (ii) 100% of ACIC’s statutory net gain from operations (not including realized capital gains) for the prior calendar year. For 2005, dividends in excess of $4.1 million would require prior consent of the Commissioner.
Rent expense, including contingent rentals, was $1.1 million for both 2005 and 2004 and $1.0 million for 2003.
In December 2004, Carolina Casualty agreed to pay and did pay RTW the full amount of RTW’s subrogation claim. On January 14, 2005, after a jury trial on the injured employee’s damages, the U.S. District Court in Utah entered a judgment of $1.9 million against Carolina Casualty’s insured, which was equal to the injured employee’s total damages, including $1,250,000 in general damages, less the $163,586 representing workers compensation benefits that had been paid, or accrued for future payments by RTW. Carolina Casualty subsequently settled the lawsuit with the injured worker for $1.8 million
After Carolina Casualty’s attorneys requested indemnification pursuant to this provision, RTW commenced the Declaratory Judgment suit described above. A similar Utah declaratory action initiated by Carolina Casualty and its insured has been dismissed and all matters will now proceed solely in United States District Court for the District of Minnesota.