This overview discusses some of the relevant factors that management considers in evaluating the Company's performance, prospects and risks. It is not all-inclusive and is meant to be read in conjunction with the entirety of the management discussion and analysis, the Company's financial statements and notes thereto and all other items contained within the report on this Annual Report on Form 10-K.
Revenue and Income Generation - ----------------------------- The Company receives its revenue primarily from earned premium derived from the insurance company operations, commission and fee income generated from the insurance agency operations, finance charges and fee income from the premium finance operations, and investment income from cash generated primarily from the insurance operation. The insurance company operation generates approximately 82% of the Company's total revenue. The Company's remaining operations constitute a variety of specialty insurance services, each with unique characteristics and individually not material to consolidated revenues.
Insurance Company Operation - --------------------------- The property and casualty insurance industry is highly competitive and includes many insurers, ranging from large companies offering a wide variety of products worldwide to smaller, specialized companies in a single state or region offering only a single product. Many of the Company's existing or potential competitors have considerably greater financial and other resources, have a higher rating assigned by independent rating organizations such as A.M. Best Company, have greater experience in the insurance industry and offer a broader line of insurance products than the Company. Currently, Crusader is writing primarily Commercial Multiple Peril business only in the state of California and is rated B+ (Very Good) by A.M. Best Company.
Over the past two years, the insurance industry has seen some difficult times as a result of September 11, industry-wide underwriting losses, decreases in investment yield, and increases in reinsurance cost that have all contributed to the change from a "soft market" to a "hard market. The Company believes that a "hard market" cycle currently exists in the insurance marketplace. The Company has experienced beneficial market changes in its primary line of business and is benefiting from the fact that some of its competitors have gone out of business and others have recently raised rates or adopted more restrictive rules. Although the Company has increased its rates and adopted more restrictive underwriting guidelines, the beneficial market changes have contributed to a 40% increase in direct written premiums in 2003, a 21% increase in direct written premiums in 2002, and an increase in the number of policies issued in both 2003 and 2002. The Company cannot determine how long the existing market conditions will continue, nor in which direction they might change. The Company's future writings and growth are dependent on, among other things, market conditions, competition, and the Company's ability to introduce new and profitable products.
Unifax primarily sells and services insurance policies for Crusader. The commissions paid by Crusader to Unifax are eliminated as intercompany transactions and are not reflected as income in the financial statements. As a result of the increase in policies sold by Unifax and the increase in the service fee from $100 to $165 in August 2002, service fee income increased 54% in 2003 compared to 2002.
AIB sells and services health insurance policies for individual/family and small business groups primarily for CIGNA HealthCare and receives commission and fee income based on the premiums that it writes. Commission and fee income in this program increased 21% in the year ended December 31, 2003, compared to 2002, as a result of increased premiums written in this program. However CIGNA HealthCare is discontinuing its individual/family health insurance program over the period from November 1, 2003 through October 1, 2004. AIB has been assisting existing CIGNA policyholders to find health coverage with other insurance carriers that AIB represents. The Company is unsure of the number of terminated CIGNA policyholders it may ultimately assist with the purchase of new health coverage. In addition, CIGNA small business group has decreased due to intense competition in both rates and benefits offered.
In accordance with Statement of Financial Accounting Standard No. 115, Accounting for Certain Investments in Debt and Equity Securities, the Company is required to classify its investment securities into one of three categories: held-to-maturity, available-for-sale or trading securities. Although all of the Company's investments are classified as available-for-sale and the Company may sell investment securities from time to time in response to economic and market conditions, its investment guidelines place primary emphasis on buying and holding high-quality investments to maturity.
The Company's investment policy limits investments in any one company to $2,000,000 and any one U.S. government agency to $3,000,000. This limitation excludes bond premiums paid in excess of par value and U.S. government or U.S. government guaranteed issues. The Company's investment guidelines on equity securities limit investments in equity securities to an aggregate maximum of $2,000,000. As of December 31, 2003, all of the Company's fixed maturity investments were investment grade, the Company held no non-traded fixed maturity or equity securities, all state and municipal tax exempt fixed maturity investments were pre-refunded issues, and all certificates of deposit were FDIC insured.
In 2003, Unico made capital contributions totaling $3,000,000 to its Crusader subsidiary. The contributions were made to ensure that Crusader's capital remained above $25,000,000. The funding of Unico's capital contribution to Crusader was derived from available cash from the Company's other operations and the proceeds of two notes. On September 29, 2003, the Company borrowed $1,000,000 from Erwin Cheldin, a director and the Company's principal shareholder, president and chief executive officer, and $500,000 from The Cary and Danielle Cheldin Family Trust. Cary L. Cheldin is a director and the Company's executive vice president. The notes are due and payable upon demand of lender (on no less than fourteen days' notice) and, if no demand is made, then the notes are payable in full on September 28, 2007. The notes may be prepaid at any time without penalty. The notes are unsecured and bear interest as follows: Interest on the $1,000,000 note is 5% and is adjustable in April 1, 2004,
and every third month thereafter by adding a margin of one percentage point to the prime rate; interest on the $500,000 note is 7% per annum. Interest is payable monthly on both notes.
The Company has previously announced that its Board of Directors had authorized the repurchase in the open market from time to time of up to an aggregate of 945,000 shares of the common stock of the Company (see Note 17 of Notes to Consolidated Financial Statements). During the year ended December 31, 2003, the Company did not repurchase any shares of the Company's common stock. As of December 31, 2003, the Company has purchased and retired under the Board of Directors authorization an aggregate of 868,958 shares of its common stock at a cost of $5,517,465.
The Company is following the progress of current legislation that would address the unconstitutionality of the California statue by restructuring the rate at which California taxes dividends for in and out of state insurance holding companies. The legislation would also resolve the issue regarding the retroactive assessments due to the disallowance of the deduction. If the legislation were enacted, it would result in the Company paying a relatively small amount of California franchise taxes on dividends received from its insurance company subsidiary. Without a legislative solution, the Company anticipates the ultimate outcome of the dividend received deduction will be settled by future litigation.
Crusader's primary line of business is commercial multiple peril business package policies. This line of business represented approximately 97% of Crusader's total written premium for the years ended December 31, 2003 and 2002, and 96% for the year ended December 31, 2001.
As of December 31, 2003, Crusader was licensed as an admitted insurance company in the states of Arizona, California, Colorado, Idaho, Montana, Nevada, Ohio, Oregon, and Washington and is approved as a non-admitted surplus lines writer in other states.
2003 $64,047,717 21,425 $2,989 2002 $45,622,280 18,603 $2,452 2001 $37,637,396 18,114 $2,078
As discussed above, the fact that some of the Company's competitors have gone out of business and others have recently raised rates or adopted more restrictive rules resulted in a 15% increase in the number of policies issued by the Company in 2003 as compared to 2002. The number of policies issued in 2002 increased 3% over 2001.
Crusader's direct earned premium, earned ceded premium, and ceding commission are as follows:
Year ended December 31 ---------------------- 2003 2002 2001 ---- ---- ---- Loss ratio 85.5% 98.1% 139.4% Expense ratio 21.4% 27.8% 29.1% ----- ----- ----- Combined ratio 106.9% 125.9% 168.5% ===== ===== =====
Reserves for losses and loss adjustment expenses before reinsurance were $78,139,090 at December 31, 2003, compared to $74,905,284 at December 31, 2002, and to $60,534,295 at December 31, 2001. The increase in loss and loss adjustment expense reserves in 2003 is primarily a result of increased IBNR reserves as a result of the 32% increase in earned premium in the year ended December 31, 2003 as discussed above. The increase in reserves at December 31, 2002 and 2001 reflects both an increase in claim severities and adverse development of prior years in the Company's Commercial Multiple Peril (CMP) and Other Liability lines of business.
2002 losses and loss adjustment expenses - ---------------------------------------- The adverse development in the year ending December 31, 2002, of $7,790,851 was primarily the result of liquor and premises liability outside of California for the accident years 1999 through 2001 and higher than anticipated costs of construction defect and apartment house habitability claims for accident years prior to 1998. The liquor liability claims arose from the liability of tavern owners related to the sale of alcoholic beverages. Based on the development in 2002 of the liquor and premises liability claims the Company increased its estimate of ultimate losses for 1999 and subsequent years.
Adverse (favorable) development of prior years losses in 2002 by line of business is as follows:
In light of the adverse development in 2001, the Company increased the frequency and scope of its reserve studies. The continued adverse development in 2002, discussed above, was first observed in June 2002 when the Company determined that losses for accident years 2002 and 2001 were developing higher than anticipated and the underwriting actions had not mitigated loss exposure to the extent previously estimated. Of the total adverse development in 2002 of $7,790,851, $6,332,812 was reflected as of June 30, 2002. Adverse development of prior years losses in 2002 represented 15.6% of net reserves as of December 31, 2001.
Crusader incurred underwriting losses in 2000, 2001, and 2002. As a result of these underwriting losses, Crusader's management analyzed and acted upon the following components of its underwriting activity:
1. Business Outside of California 2. Habitability Exposure 3. Construction Defect Exposure 4. Special Risk Class of Business 5. Increased Cost of Settling Claims, Indemnity and Expense 6. Increased Cost of Reinsurance 7. Mold Exposure 8. Terrorism Exposure 9. Market Conditions and Competition
1. Business Outside of California: As reflected on the table below, collectively, the insurance underwritten by the Company outside of California has been very unprofitable, particularly with respect to the Liquor and Premises types of liability coverage. The Company adopted substantial rate increases and coverage restrictions beginning in June of 2001 for all Liquor Liability written outside of California and Nevada. The rate increases caused a dramatic decline in sales, causing the Company to be concerned about adverse selection. The Company determined that under current market conditions, it could not sell its policies at an adequate rate outside of California and ceased writing in those states. Direct written premium outside California decreased from $5,263,039 in 2001, to $3,031,606 in 2002, to $18,224 in 2003.
2. Habitability Exposure: In 2000 and 2001, the Company began experiencing adverse development on its apartment house business, due primarily to the effect of settlements on habitability claims. Those settlements were substantially influenced by a statute that provides for the payment of plaintiff attorney fees without regard to policy limits, and by the Montrose Chemical Corp. v. Admiral Insurance Company decision of 1995.
Since 2002, no additional claims of any significance have been reported to Crusader. The Company believes that the combination of improved underwriting and policy language limiting supplemental payments have substantially reduced the exposure.
3. Construction Defect Exposure: The Company continuously modifies its underwriting practice with respect to subcontractors in an effort to improve loss experience. For example, subcontractors performing "waterproofing, weather-coating, or decking" were deemed ineligible by the Company in 1995; and, to minimize the adverse effects of the Montrose decision of 1995, the Company changed its coverage forms in 1996; and, the Company adopted numerous, program-specific questions to its applications, inspections, and survey forms. Although the Company believes that the ultimate results of its post-1996 underwriting of this class of business will prove to be profitable, the results will not be known until the 10 year statute runs. Therefore, on April 18, 2002, the Company sought regulatory approval for a change in or discontinuation of its experience rating plan. When the regulator disapproved that filing, on June 18, 2002, the Company imposed
a moratorium on all new offers of artisan contractors' insurance. In January 2003 Crusader received regulatory approval of its plan to discontinue experience rating, which translates into a 21% rate increase for all coverages offered to artisan contractors. However, because the Company is cautious about underwriting this type of business, it has not lifted the underwriting moratorium that started on June 18, 2002. Since that date, attrition was significant, reducing the number of policies in force. Until such time that the Company can change this program to make underwriting more predictable, the moratorium will not be lifted.
7. Mold Exposure: The Company has not seen any significant mold-based claim and all of its policies are now being endorsed with a "Mold Exclusion." In addition, numerous articles from respected medical authorities were recently published, making plaintiffs task of proving mold-based injuries much more difficult.
9. Market Conditions, Competition: The Company continues to benefit from the "hard market conditions." Although some new competitors have entered the marketplace, their pricing seems to be reasonable and therefore the Company's products continue to remain competitive.
AIB markets health and life insurance in California through non-affiliated insurance companies for individuals and groups. In January 2003, NIB assigned all its contracts and commissions to AIB, and NIB is now inactive.
Due to CIGNA's discontinuation of its individual and family health insurance program, some policyholders have decided to terminate their policy prior to the date issued by CIGNA. As of December 31, 2003, approximately 1,800 policyholders have terminated their CIGNA policies. Of this amount, the Company has placed approximately 600 policyholders with other carriers. The Company cannot determine the percentage of affected policyholders that will leave through normal attrition or that will not be accepted by the Company's other insurance carriers due to pre-existing health conditions.
Revenues for the year ended December 31, 2002, increased $159,382 (6%) compared to the year ended December 31, 2001. The increase in commission income in the health and life insurance programs is primarily due to an increase in premiums written in the CIGNA HealthCare programs.
Year ended December 31 ---------------------- 2003 2002 2001 ---- ---- ---- Service fee income $3,458,559 $2,241,883 $1,726,811 Policies written 21,425 18,603 18,114
Association Operation --------------------- Membership and fee income from the association program of AAQHC is as follows:
Membership and fee income for the year ended December 31, 2003, increased $56,582 (13%), compared to the year ended December 31, 2002. This increase in membership and fee income is primarily a result of increased marketing efforts and the fact that in November 2002 CIGNA terminated its contract with another administrator
Revenue for 2002 and 2001 were relatively unchanged as the membership base remained constant.
Year ended December 31 ---------------------- 2003 2002 2001 ---- ---- ---- Earthquake program commission income $40,015 $51,576 $51,029 Workers' compensation program commission income 1,042 12,258 19,730 Commercial liability program commission and fee income - (741) 62,839 Miscellaneous fee income 70 109 161 ------ ------ ------- Total other commission and fee income $41,127 $63,202 $133,759 ====== ====== =======
Year ended December 31 ---------------------- 2003 2002 2001 ---- ---- ---- Premium finance charges and fees earned $952,543 $878,316 $868,496 New loans 6,216 6,340 7,148
Revenue for the year ended December 31, 2002, increased $9,820 (1%) compared to the year ended December 31, 2001. The number of new loans decreased by 808 (11%) in the year ending December 31, 2002, compared to the prior year. The increase in revenues despite the decrease in the number of new loans in 2002 is primarily due to the fact that the average policy loan being financed is approximately 22% greater than the prior year.
Year ended December 31 ---------------------- 2003 2002 2001 ---- ---- ---- Interest income Insurance Company operations $4,801,133 $5,401,870 $5,647,026 Other operations 47,010 56,176 156,387 --------- --------- --------- Total interest income 4,848,143 5,458,046 5,803,413
In the year ended December 31, 2003, while the Company's average invested assets (at amortized value) increased $11,939,605 (12%) compared to the year ended December 31, 2002, investment income earned (excluding net realized gains) decreased $609,903 (11%) compared to the year ended December 31, 2002. The decrease in investment income is primarily the result of a continued decline in the average return on invested assets in the Company's investment portfolio due to both a general decline in short and long-term yield in the marketplace and a shorter weighted average maturity of the portfolio. Due to the current interest rate environment, management believes it prudent to purchase fixed maturity investments with shorter maturities and therefore, the weighted average maturity of the Company's fixed maturity investments has decreased from 2.4 years as of December 31, 2002, to 1.9 years as of December 31, 2003. In the year ended December 31, 2003, the Company's average yield on invested assets (at amortized value) was 4.38% compared to 5.53% at the year ended December 31, 2002. The Company's average invested assets increased in the year ending December 31, 2003, primarily as a result of increased cash flows from operations. The mix of taxable and tax-exempt securities in the portfolio affects the investment income return percentage. Tax-exempt securities generally carry a lower yield than taxable securities. These securities (at amortized value) decreased to $2,029,891 (2% of total investments) at December 31, 2003, compared to $2,731,060 (3% of total investments) at December 31, 2002.
At December 31, 2003, the Company held securities with unrealized appreciation of $3,236,623 and securities with unrealized depreciation of $38,169. The securities with unrealized depreciation consisted of six fixed maturity investments with a total par value of $9,990,000. Only one of the fixed maturity investments with a par value of $15,000 and unrealized depreciation of $355 has been in a continuous unrealized depreciation position over 12 months. The Company does not deem the unrealized depreciation to be significant or indicative of an other-than-temporary decline, either individually or in the aggregate. Out of the six fixed maturity investments with unrealized depreciation, three are U.S. treasury notes with a total par value of $6,100,000 with a total of $6,485 of unrealized depreciation as of December 31, 2003, and one fixed maturity is a U.S. agency with a par value of $3,000,000, with an unrealized depreciation in the amount of $24,360 as of December 31, 2003.
The Company continually evaluates the recoverability of its investment holdings. All securities held by the Company are rated. When a decline in value of fixed maturities or equity securities is considered other than temporary, a loss is recognized in the consolidated statements of operations. In 2003, there were no other than temporary declines in the value of fixed maturity or equity securities recognized in the consolidated statements of operations. During 2002, the Company realized a loss of $216 on one equity security where a decline in market value was considered other than temporary. The Company had recognized a loss on this equity security of $25,704 in 2001 and $138,250 in 2000. No securities were sold at a loss during 2003, 2002 or 2001.
Year ended December 31 ---------------------- 2003 2002 2001 ---- ---- ---- Policy acquisition costs $7,941,199 $9,274,263 $8,695,037 Ratio to net earned premium (GAAP ratio) 21% 28% 29%
Commissions to Agents/Brokers (not including commissions on Crusader policies that are reflected in policy acquisition costs) are generally related to gross commission income from the health and life insurance program, the daily automobile rental insurance program, the earthquake program, and the commercial liability program. Commissions to agents and brokers increased $241,374 (20%) for the year ended December 31, 2003, compared to the year ended December 31, 2002. Commissions to agents and brokers decreased $40,749 (3%) for the year ended December 31, 2002, compared to the year ended December 31, 2001.
Other Operating Expenses generally do not change significantly with changes in production. This is true for both increases and decreases in production. Operating expenses decreased $350,341 (11%) for the year ended December 31, 2003, compared to the year ended December 31, 2002. The decrease is primarily the result of the settlement of litigation with the Company's former stock transfer agent that resulted in the receipt of $527,500 to reimburse damages and legal expenses that were incurred from 2001 through 2003.
Year ended December 31 ---------------------- 2003 2002 2001 ---- ---- ---- Other operating expenses $2,897,886 $3,248,227 $2,886,266
Income Taxes - ------------ The income tax expense for the year ended December 31, 2003, was $1,080,721 compared to an income tax benefit of $1,589,370 for the year ended December 31, 2002. The effective combined income tax rates for 2003 and 2002 were 50% and 33%, respectively. The pre-tax income increased $6,963,430 for the year ended December 31, 2003, compared to the year ended December 31, 2002, which resulted in an increased income tax expense in 2003. Also contributing to the income tax expense in 2003 was the recognition of an assessment of $287,000 for the years 1999 and 2000 from the California Franchise Tax Board. A recent court ruling in Ceridian vs. Franchise Tax Board held that the California statute permitting the tax deductibility of dividends received from a wholly owned insurance subsidiary was unconstitutional because it discriminated against out-of-state holding companies and thus was in violation of the interstate commerce clause of the United States Constitution. The
On September 29, 2003, the Company borrowed $1,000,000 from Erwin Cheldin, a director and the Company's principal shareholder, president and chief executive officer, and $500,000 from The Cary and Danielle Cheldin Family Trust. Cary L. Cheldin is a director and the Company's executive vice president. The notes are due and payable upon demand of lender (on no less than fourteen days' notice) and, if no demand is made, then the notes are payable in full on September 28, 2007. The notes may be prepaid at any time without penalty. The notes are unsecured and bear interest as follows: interest on the $1,000,000 note is 5% and is adjustable in April1, 2004, and every third month thereafter by adding a margin of one percentage point to the prime rate; interest on the $500,000 note is 7% per annum. Interest is payable monthly on both notes.
Forward Looking Statements - -------------------------- Certain statements contained herein, including the Sections entitled "Business," "Legal Proceedings" and "Management's Discussion and Analysis of Financial Condition and Results of Operations," that are not historical facts are forward looking. These statements, which may be identified by forward looking words or phrases such as "anticipate," "appears," "believe," "estimates," "expect," "intend," "may," "should," and "would," involve risks and uncertainties, many of which are beyond the control of the Company. Such risks and uncertainties could cause actual results to differ materially from these forward looking statements. Factors which could cause actual results to differ materially include those described under Item 1 - Business - Competition; premium rate adequacy relating to competition or regulation; actual versus estimated claim experience; success of the Company's underwriting and pricing actions that it believes addresses the adverse development on its construction defect, apartment house habitability, special risk class of business, and non-California liquor liability claims; the outcome of existing and planned filings with regulatory authorities seeking rate increases; acceptance by insureds of rate increases; adequacy of rate increases; possible reductions in Crusader's A.M. Best rating; regulatory changes or developments; the outcome of regulatory proceedings; unforeseen calamities; general market conditions; and the Company's ability to introduce new profitable products.
Consolidated Balance Sheets as of December 31, 2003, and December 31, 2002 37
Consolidated Statements of Operations for the years ended December 31, 2003, December 31, 2002, and December 31, 2001 38
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Unico American Corporation and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.
Investments - ----------- All of the Company's fixed maturity investments are classified as available-for-sale and are stated at market value. Although all of the Company's investments are classified as available-for-sale and the Company may sell investment securities from time to time in response to economic and market conditions, its investment guidelines place primary emphasis on buying and holding high-quality investments to maturity. Short-term investments are carried at cost, which approximates market value. Investments in equity securities are carried at market value. The unrealized gains or losses from fixed maturities and equity securities are reported as accumulated other comprehensive income (loss), which is a separate component of stockholders' equity, net of any deferred tax effect. When a decline in value of a fixed maturity or equity security is considered other than temporary, a loss is recognized in the consolidated statements of operations. Realized gains and losses are included in the consolidated statements of operations based on the specific identification method.
Earnings Per Share - ------------------ Basic earnings per share exclude the impact of common share equivalents and are based upon the weighted average common shares outstanding. Diluted earnings per share utilize the average market price per share when applying the treasury stock method in determining common share dilution. When dilutive, outstanding stock options are treated as common share equivalents for purposes of computing diluted earnings per share and represent the difference between basic and diluted weighted average shares outstanding. In loss periods, options are excluded from the calculation of diluted earnings per share, as the inclusion of such options would have antidilutive effect.
(2) Included in short-term investments are two deposits assigned and held by Travis County and the Los Angeles Superior courts. These deposits are filed with the superior courts in lieu of a bond, in order to stay execution of judgments and allow the Company to appeal the judgment in these matters. . (3) Included in fixed maturity investments are statutory deposits assigned to and held by the California State Treasurer and the Insurance Commissioner of the State of Nevada. These deposits are required for writing certain lines of business in California and for admission in states other than California.
The insurance company operation is conducted through the Company's wholly owned subsidiary Crusader Insurance Company, (Crusader) which as of December 31, 2003, was licensed as an admitted insurance carrier in the states of Arizona, California, Colorado, Idaho, Montana, Nevada, Ohio, Oregon, and Washington. Crusader is a multiple-line property and casualty insurance company, which began transacting business on January 1, 1985.
As of December 31, 2003, 97% of Crusader's business was commercial multiple peril business package insurance policies. Commercial multiple peril policies provide a combination of property and liability coverage for businesses. Commercial property coverages insure against loss or damage to buildings, inventory and equipment from natural disasters, including hurricanes, windstorms, hail, water, explosions, severe winter weather and other events such as theft and vandalism, fires and storms and financial loss due to business interruption resulting from covered property damage. Commercial liability coverages insure against third party liability from accidents occurring on the insured's premises or arising out of its operations, such as injuries sustained from products sold or operation of the insured premises. In addition to commercial multiple peril policies, Crusader also writes separate policies to insure commercial property and commercial liability risks on a mono-line basis.
Concentration of Risks - ---------------------- In 2003 approximately 100% of Crusader's gross premium written was derived from California. In 2003, approximately 92% of the $3,681,513 commission income from the Company's health and life insurance program was from CIGNA HealthCare medical and dental plan programs.
Stock-Based Compensation - ------------------------ The Company applies the intrinsic-value based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation, an interpretation of APB Opinion No. 25, to account for its fixed-plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. FASB Statement No. 123, Accounting for Stock-Based Compensation and FASB Statement No. 148, Accounting for Stock Based Compensation - Transition and Disclosure, an amendment of FASB Statement No. 123, established accounting and disclosure requirements using a fair-value based method of accounting for stock-based employee compensation plans. As permitted by existing accounting standards, the Company has elected to continue to apply the intrinsic-value based method of accounting described above and has adopted only the disclosure requirements of Statement 123, as amended. Had compensation cost for the Company's stock-based compensation plan been reflected in the accompanying consolidated financial statements based on the fair value at the grant dates for option awards consistent with the method of SFAS 123, the Company's net income would have been reduced to the pro forma amounts indicated below:
redeemable financial instruments, 2) obligations to repurchase the issuer's equity shares by transferring assets, and 3) obligations to issue a variable number of shares. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The implementation of SFAS No. 150 did not have an impact on the Company's consolidated financial statements.
Year ended December 31 ---------------------- 2003 2002 2001 ---- ---- ----
Gross realized gains on fixed maturities: - $3,906 $35,276 Gross realized (losses) on equity securities: - (216) (25,704) ----- ------ Net realized investment gains (losses) - $3,690 $9,572 ===== =====
The following table illustrates the gross unrealized losses included in the Company's investment portfolio and the fair value of those securities, aggregated by investment category. The table also illustrates the length of time that they have been in a continuous unrealized loss position as of December 31, 2003.
* Deposited with Superior courts to stay execution of judgments pending appeal of two Crusader Claims.
NOTE 4 - PROPERTY AND EQUIPMENT (NET OF ACCUMULATED DEPRECIATION) - ----------------------------------------------------------------
Year ended December 31 ---------------------- 2003 2002 ---- ---- Note payable - Erwin Cheldin $1,000,000 $500,000 Note payable - The Cary and Danielle Cheldin Family Trust 500,000 250,000 --------- ------- Notes payable - related parties $1,500,000 $750,000 ========= =======
Losses and loss adjustment expenses were $31,720,533, for the year ended December 31, 2003, compared to $32,727,023 for the year ended December 31, 2002. The decrease in losses and loss adjustment expenses for the year ended December 31, 2003, is primarily the result of a decrease in the adverse development of prior year losses in 2003 compared to 2002. The adverse loss development in 2003 was $2,751,586 compared to $7,790,851 in 2002. The adverse development in 2003 was primarily the result of an adverse binding arbitration decision on a 1993 claim that exceeded Crusader's reinsurance coverage. As a result of this decision the Company incurred adverse development on this claim, net of reinsurance of approximately $2,000,000. The other adverse development in 2003 was a result of continued losses due to the impact of changes in California case law that expanded coverage and increased loss exposure primarily on construction defect claims for claims occurring in or prior to the Company's revision of its policy forms in 1995.
Losses and loss adjustment expenses were $32,727,023, for the year ended December 31, 2002, compared to $41,677,016 for the year ended December 31, 2001. The decrease in losses for the year ended December 31, 2002, is primarily the result of a decrease in the adverse development of prior year losses in 2002 compared to 2001. The adverse loss development in 2002 was $7,790,851 compared to $19,326,349 in 2001. The adverse development in the year ending December 31, 2002, of $7,790,851 was primarily the result of liquor and premises liability outside of California for the accident years 1999 through 2001 and higher than anticipated costs of construction defect and apartment house habitability claims for accident years prior to 1998. The liquor liability claims arose from the liability of tavern owners related to the sale of alcoholic beverages. Based on the development in 2002 of the liquor and premises liability claims, the Company increased its estimate of ultimate losses for 1999 and subsequent years.
NOTE 8 - DEFERRED POLICY ACQUISITION COSTS - ------------------------------------------ Deferred policy acquisition costs consist of commissions (net of ceding commission), premium taxes, inspection fees, and certain other underwriting costs, which are related to and vary with the production of Crusader policies.
Premium payable $4,241,811 $4,708,648 Unearned claim administration income 100,000 300,000 Profit sharing contributions 477,000 291,144 Accrued salaries 250,803 451,347 Security purchases payable - 2,000,000 Assessments due California Insurance Guarantee Association 650,448 - Other 1,255,226 882,337 --------- --------- Total accrued expenses and other liabilities $6,975,288 $8,633,476 ========= =========
The Company intends to pay the NPA to stop the interest from accruing and to file a protective claim for refund to protect its interest when or if legislation or litigation resolves the issue. The full amount of the NPA has been accrued in the financial statement as of December 31, 2003. After the federal tax benefit of deducting the state taxes and interest related to the NPA, the effect on net income in the quarter ended December 31, 2003, is approximately $242,000. An unsatisfactory conclusion to the inter-company dividend issue could affect Unico's future dividend policy to its shareholders.
NOTE 12 - REINSURANCE - --------------------- A reinsurance transaction occurs when an insurance company transfers (cedes) a portion of its exposure on business written by it to a reinsurer that assumes that risk for a premium (ceded premium). Reinsurance does not legally discharge the Company from primary liability under its policies. If the reinsurer fails to meet its obligations, the Company must nonetheless pay its policy obligations. In 2003, Crusader's primary excess of loss reinsurance agreements are with Hannover Ruckversicherungs (A.M. Best Rating A+), Platinum Reinsurance (A.M. Best Rating A), QBE Reinsurance Corporation (A.M. Best Rating A), and General Reinsurance Corporation (A.M. Best Rating A+). From 2000 to 2002, Crusader had its primary excess of loss reinsurance agreements with Partners Reinsurance Company of the U.S. (A.M Best Rating A+). In 1999, Crusader had its primary excess of loss reinsurance agreements with General Reinsurance Corporation. Crusader also has catastrophe reinsurance from various highly rated California admitted and Bermuda reinsurance companies. These reinsurance agreements help protect Crusader against liabilities in excess of certain retentions, including major or catastrophic losses that may occur from any one or more of the property and/or casualty risks which Crusader insures. The Company has no reinsurance recoverable balances in dispute.
On most of the premium that Crusader cedes to the reinsurer, the reinsurer pays a commission to Crusader, which includes a reimbursement of the cost of acquiring the portion of the premium, which is ceded. Crusader does not currently assume any reinsurance. The Company intends to continue obtaining reinsurance although the availability and cost may vary from time to time. The unpaid losses ceded to the reinsurer are recorded as an asset on the balance sheet.
The increase in earned ceded premiums in 2003 and 2002 were primarily the result of rate increases by the Company's reinsurers and the increase in the related direct earned premiums on which those rates were based. The rate increases are primarily due to the Company's ceded loss experience and the hardening of the reinsurance marketplace.
Employer contributions to the plan were as follows: Year ended December 31, 2003 $674,977 Year ended December 31, 2002 $434,789 Year ended December 31, 2001 $554,111
The insurance department has completed its financial examination of Crusader's December 31, 2001, statutory financial statements. The report of examination that was filed with the insurance department on May 30, 2003, reported no adjustments to Crusader's statutory financial statements.
Crusader is restricted in the amount of dividends it may pay to its parent in any twelve (12) month period without prior approval of the California Department of Insurance. Presently, without prior approval, Crusader may pay a dividend in any twelve (12) month period to its parent equal to the greater of (a) 10% of Crusader's statutory policyholders' surplus or (b) Crusader's statutory net income for the preceding calendar year. There were no dividends paid by Crusader to Unico in 2003, 2002, or in 2001. Based on Crusader's statutory surplus as regards policyholders as of December 31, 2003, the maximum dividend that could be made by Crusader to Unico without prior regulatory approval in 2004 is $2,610,344.
In December 1993, the National Association of Insurance Commissioners (NAIC) adopted a Risk-Based Capital (RBC) Model Law for property and casualty companies. The RBC Model Law is intended to provide standards for calculating a variable regulatory capital requirement related to a company's current operations and its risk exposures (asset risk, underwriting risk, credit risk and off-balance sheet risk). These standards are intended to serve as a diagnostic solvency tool for regulators that establishes uniform capital levels and specific authority levels for regulatory intervention when an insurer falls below minimum capital levels. The RBC Model Law specifies four distinct action levels at which a regulator can intervene with increasing degrees of authority over a domestic insurer if its RBC is equal to or less than 200% of its computed authorized control level RBC. A company's RBC is required to be disclosed in its statutory annual statement. The RBC is not intended to be used as a rating or ranking tool nor is it to be used in premium rate making or approval. Crusader's adjusted capital at December 31, 2003, was 298% of authorized control level risk-based capital.
On December 18, 2002, the Company granted an additional 182,000 incentive stock options under the Company's 1999 Omnibus Stock Plan. All of these options were outstanding as of December 31, 2003. These options expire 10 years from the date of the grant and are not exercisable prior to January 1, 2004. Options become exercisable as follows:
Options exercisable were 95,000 at December 31, 2003, at a weighted average exercise price of $9.25; 92,500 at December 31, 2002, at a weighted average exercise price of $9.25; 81,145 at December 31, 2001, at a weighted average exercise price of $8.44.
Year ended December 31 ---------------------- 2003 2002 2001 ---- ---- ---- Current provision: Federal $703,663 $(1,599,760) $(5,375,381) State 572,822 160,626 24,935 --------- --------- --------- Total federal and state 1,276,485 (1,439,134) (5,350,446) Deferred (195,764 (150,236) (502,645) --------- --------- --------- Provision for taxes $1,080,721 $(1,589,370) $(5,853,091) ========= ========= =========
On March 9, 2002, the Job Creation and Workers Assistance Act of 2002 was signed into law. This act was effective for tax years ending in 2001 and provided that a net operating loss for tax years ending in 2001 or 2002 is carried back five years, rather than the previously allowed two years. This act allowed the Company to carryback its entire 2002 net operating loss. The carryback of the 2002 Federal tax benefit was allocated as follows:
Tax year ended Amount Applied - -------------- -------------- December 31, 1998 $(1,548,427) --------- Total Federal income tax carryback (1,548,427) Adjustment to 2001 tax provision ( 51,333) --------- 2002 Federal income tax provision $(1,599,760) =========
Although realization is not assured, management believes it is more likely than not that all of the deferred tax assets will be realized. The amount of the deferred tax assets considered realizable could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced.
The Company and its wholly owned subsidiaries file consolidated federal and combined California income tax returns. Pursuant to the a tax allocation agreement, Crusader and American Acceptance Corporation are allocated taxes or (in the case of losses) tax credits at current corporate rates based on their own taxable income or loss.
A recent court ruling in Ceridian vs. Franchise Tax Board held that the California statute permitting the tax deductibility of dividends received from a wholly owned insurance subsidiary was unconstitutional because it discriminated against out-of-state holding companies and thus was in violation of the interstate commerce clause of the United States Constitution. The ruling concluded that the discriminatory sections of the statute are not severable and the entire statute is invalid and unenforceable. California law provides that the proper remedy in such circumstances is to disallow the deduction to those taxpayers that benefited from the deduction. As a result of the court ruling, in February 2003, the Franchise Tax Board (FTB) notified the Company that it would issue a Notice of Proposed Assessment (NPA) for tax years 1999 and 2000 of approximately $287,000 representing California state franchise taxes plus related interest of approximately $80,000.
*In loss periods, options are excluded from the calculation of diluted EPS, as the inclusion of such options would have an antidilutive effect. Therefore, 1,428 options were excluded from the calculation of diluted EPS for the years ended December 31, 2002 and 26,725 options were excluded for the year ended December 31, 2001.