Following is a discussion and analysis of the financial statements of Infinity and the financial statements of the agency business that Infinity assumed from GAI on January 1, 2003. Together, these businesses comprise Infinity's operations going forward. References in this discussion to Infinity include the NSA Group and the Assumed Agency Business unless the context indicates otherwise. This discussion should be read in conjunction with the audited financial statements beginning on page.
Infinity was incorporated in the state of Ohio in September 2002 as an indirect wholly-owned subsidiary of AFG. On December 31, 2002, AFG transferred to Infinity all of the outstanding common stock of the following personal auto insurance subsidiaries: Atlanta Casualty Company, Infinity Insurance Company, Leader Insurance Company and Windsor Insurance Company (collectively the "NSA Group").
The acquisition of the NSA Group has been accounted for, and the assumption of the Assumed Agency Business will be accounted for, at AFG's historical carrying amounts as transfers of net assets between entities under common control in accordance with Statement of Financial Accounting Standards No. 141.
Significant accounting policies are summarized in Note B to the financial statements. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change and thus impact amounts reported in the future. Management believes that the establishment of insurance reserves and the determination of "other than temporary" impairment on investments are the two areas where the degree of judgment required to determine amounts recorded in the financial statements make the accounting policies critical. These two policies are discussed below under the headings "Liquidity and Capital Resources - Investments" and "Liquidity and Capital Resources -Uncertainties."
Under the state insurance laws, dividends and capital distributions from insurance companies are subject to restrictions relating to statutory surplus and earnings. The maximum amount of dividends payable during 2003 without regulatory approval by Infinity's insurance subsidiaries is $51 million.
Infinity intends to establish a bank credit line in 2003 that will provide resources to meet liquidity requirements. However, if these funds and funds generated from operations, including dividends and tax payments from its insurance subsidiaries, are insufficient to meet fixed charges in any period, Infinity would have to generate cash through alternative methods of financing, sales of assets, or similar transactions.
QUOTA SHARE AGREEMENT Effective April 2001, Infinity's insurance subsidiaries entered into a reinsurance agreement with Inter-Ocean Reinsurance Limited, under which Infinity's subsidiaries agreed to cede 90% of its personal auto physical damage business on a funds withheld basis for policies written from April 1, 2001 to December 31, 2002. Infinity has renewed this agreement for 2003 on terms substantially equivalent to those in effect in 2002. Infinity has the flexibility in 2003 to adjust, on a quarterly basis, the percentage of business to be ceded under the reinsurance agreement. The percentage ceded may be reduced from the current level of 90% to as low as 20%. No adjustments with respect to future quarters can be predicted at this time but will be determined based on business conditions. Premiums ceded under this agreement from inception through December 31, 2001, and for the year ended December 31, 2002, were $219.5 million and $296.1 million, respectively.
The Inter-Ocean reinsurance agreement also includes coverage of GAI's personal lines business written through independent agents for policies in effect since January 1, 2002, and unearned premium at December 31, 2001 that Infinity would otherwise assume as part of the Assumed Agency Business. Accordingly, GAI's participation in the Inter-Ocean reinsurance agreement reduces the size of the Assumed Agency Business. Premiums ceded by GAI under this agreement were $78.5 million in 2002.
Approximately 91% of the fixed maturities that Infinity holds were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies at December 31, 2002. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or noninvestment grade.
The table below sets forth the scheduled maturities of fixed maturity securities at December 31, 2002 based on their market values. Securities that do not have a single maturity date are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
The table below (dollars in millions) summarizes the length of time securities have been in an unrealized gain or loss position at December 31, 2002.
- whether the unrealized loss is credit-driven or a result of changes in market interest rates,
- historical operating, balance sheet and cash flow data contained in issuer SEC filings,
- near-term prospects for improvement in the issuer and/or its industry,
- ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.
Based on its analysis of the factors enumerated above, management believes (i) Infinity will recover its cost basis in the securities with unrealized losses and (ii) that Infinity has the ability and intent to hold the securities until they mature or recover in value. Should either of these beliefs change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other than temporary impairment could be material to results of operations in a future period. Management believes it is not likely that future impairment charges will have a significant effect on Infinity's liquidity.
Increased impairment charges in recent years reflect, among other things, a rise in corporate defaults in the marketplace.
INSURANCE RESERVES Liabilities for the costs of losses and loss adjustment expenses for both reported and unreported claims are estimated based on historical trends adjusted for changes in loss cost trends, underwriting standards, policy provisions, product mix and other factors. Estimating the liability for unpaid losses and loss adjustment expense is inherently judgmental and is influenced by factors which are subject to significant variation. Through the use of analytical reserve development techniques, management monitors items such as the effect of inflation on medical, hospitalization, material repair and replacement costs, general economic trends and the legal environment. Adjustments to reserves are reflected in the results of operations in the periods in which estimates change.
EXPOSURE TO MARKET RISK Market risk represents the potential economic loss arising from adverse changes in the fair value of financial instruments. Infinity's exposures to market risk relate primarily to its investment portfolio which is exposed to interest rate risk and, to a lesser extent, equity price risk.
FIXED MATURITY PORTFOLIO The fair value of Infinity's fixed maturity portfolio is directly impacted by changes in market interest rates. Infinity's fixed maturity portfolio is comprised of substantially all fixed rate investments with primarily short-term and intermediate-term maturities. This practice allows flexibility in reacting to fluctuations of interest rates. The portfolios of Infinity's insurance companies are managed with an attempt to achieve an adequate risk-adjusted return while maintaining sufficient liquidity to meet policyholder obligations.
The following table provides information about Infinity's fixed maturity investments at December 31, 2002 and 2001, that are sensitive to interest rate risk. The table shows expected principal cash flows (in millions) and related weighted average interest rates by expected maturity date for each of the five subsequent years and collectively for all years thereafter. Callable bonds and notes are included based on call date or maturity date depending upon which date produces the most conservative yield. Mortgage-backed securities ("MBSs") and sinking fund issues are included based on maturity year adjusted for expected payment patterns. Actual cash flows may differ from those expected.
EQUITY PRICE RISK Equity price risk is the potential economic loss from adverse changes in equity security prices. Although Infinity's investment in equity securities is only 2% of total investments, it is concentrated in a relatively limited number of positions; approximately four-fifths of the total is in three investments. While this approach allows management to more closely monitor the companies and industries in which they operate, it does increase risk exposure to adverse price declines in a major position.
UNDERWRITING Infinity's insurance subsidiaries sell nonstandard, standard and preferred personal auto insurance and, to a lesser extent, nonstandard commercial auto coverage and a complement of other personal lines insurance products. Nonstandard coverage is a product designed for drivers who, due to their driving record, age or vehicle type, represent higher than normal risks and pay higher rates for comparable coverage.
Net earned premiums and combined ratios for Infinity and the Assumed Agency Business were as follows (dollars in millions):
Net earned premiums of the Assumed Agency Business decreased $43 million (28%) in 2002 reflecting the impact of the Inter-Ocean reinsurance agreement, effective January 1, 2002, under which 90% of GAI's personal automobile physical damage business written through independent agents was ceded. Excluding the effect of this agreement, net earned premiums increased $12.1 million (8%) reflecting rate increases implemented in the later part of 2001, partially offset by a reduction in volume from certain unprofitable business. The combined ratio was flat as an increase in prior year development was offset by the shift away from underperforming business and the increase in rates over the past year. Underwriting expenses fell $16.6 million in 2002 compared to 2001 reflecting GAI's $19.7 million ceding commission earned on premiums ceded under the Inter-Ocean reinsurance agreement.
2001 COMPARED TO 2000 Infinity's net earned premiums decreased $127 million (12%) in 2001 due primarily to the automobile physical damage reinsurance agreement discussed above. Excluding the effect of the agreement, net earned premiums were flat in 2001. Policies in force declined 19% as some customers decided not to renew policies at higher rates. Infinity's insurance subsidiaries increased personal auto rates approximately 15% in 2001. The 2001 combined ratio improved 5.6 points compared to 2000 as the effect of rate increases in 2001 and 2000 more than offset a $5.1 million charge to write-off policy-processing software that was not in use. Infinity's underwriting expenses decreased $27 million (12%) during 2001 as the $38 million ceding commission earned on the reinsurance agreement more than offset increased salaries and employee-related expenses.
The remaining discussion of results of operations relates to Infinity's Consolidated Statement of Operations.
The Assumed Agency Business represents a portion of GAI's personal lines business and is not a separate legal entity; accordingly, it does not have a separate investment portfolio and related investment income.
2001 COMPARED TO 2000 Net investment income increased $5.9 million in 2001 due primarily to a 12% increase in average invested assets in fixed maturity securities, partially offset by $3.1 million in interest expense on funds held from the Inter-Ocean reinsurance agreement discussed above. Average invested assets increased due primarily to a capital contribution received in the fourth quarter of 2000.
Infinity owns warrants to buy the common stock of a publicly traded company. Under generally accepted accounting principles, these investments are considered derivatives and marked to market resulting in realized gains and losses. Realized gains (losses) on investments include a loss of $281,000 in 2002 to adjust the carrying value of these warrants to their market value of $883,000 at December 31, 2002.
2001 COMPARED TO 2000 Realized gains (losses) on investments include provisions for other than temporary impairment of securities still held of $16.2 million in 2001 and $3.0 million in 2000.
2001 COMPARED TO 2000 Other operating and general expenses decreased $4.6 million (19%) due primarily to a $3.7 million reduction in corporate litigation expenses.
INCOME TAXES Infinity's effective tax rate was 35% in 2002, 38% in 2001 and 35% in 2000. See Note H to Infinity's financial statements for an analysis of items affecting the effective tax rate.
EQUITY IN AFFILIATE LOSSES Equity in net losses of affiliates for 2000 represents Infinity's proportionate share of the results of Chiquita Brands International, an affiliate of AFG during this period. Chiquita reported net losses attributable to common shareholders of $112 million in 2000.
Equity in net losses of affiliates for 2000 also includes a $14.2 million pretax charge to writedown Infinity's investment in Chiquita to quoted market value at December 31, 2000. In 2001, Infinity suspended accounting for Chiquita under the equity method due to Chiquita's pending restructuring. In March 2002, Chiquita completed its reorganization under Chapter 11 of the U.S. Bankruptcy Code. All remaining shares held by Infinity after the restructuring were sold in 2002.
RECENT ACCOUNTING STANDARDS In July 2001, the Financial Accounting Standards Board issued SFAS No. 141, "Business Combinations", and No. 142, "Goodwill and Other Intangible Assets". Under SFAS No. 141, business combinations initiated after June 30, 2001 are required to be accounted for using the purchase method of accounting. Under SFAS No. 142, goodwill is no longer amortized beginning January 1, 2002, but is subject to an impairment test at least annually. Infinity completed the transitional test for impairment in 2002 with no writedown required. Other operating and general expenses for Infinity includes goodwill amortization of $2.2 million in both 2001 and 2000. The carrying value of goodwill at December 31, 2002, was $70.3 million for Infinity and $5.0 million for the Assumed Agency Business.