The Group has entered into a four year lease expiring on December 31, 2005 for approximately 16,000 square feet in an office building located at 45 Main Street, Brooklyn, New York. Under this lease, an additional 9,000 square feet has been leased for a two year period expiring on December 31, 2003.The Group also leases office space located in Mineola, New York and Boston, Massachusetts under leases expiring in 2007 and 2003, respectively. The Group expects to reduce the amount of office space it leases after 2003 and will seek to sublease any excess space. The rental charged to the Company for these facilities is prorated in accordance with the pooling agreement described in "Pooling Agreement" under Item 1, herein.
a) Net (Loss) Income includes net securities gains/(losses), net of applicable tax (in thousands) of $1,408, $1,870, $(213), $(1,084) and $3,951 for the years ended December 31, 2002, 2001, 2000, 1999 and 1998, respectively.
(a) Effective January 1, 1980, the Company issued a surplus note to Empire in the principal amount of $7.0 million. During 2002 and 2001, with the approval of the Superintendent of Insurance of the State of New York (the "Superintendent"), the Company paid Empire $0.2 million and $9.9 million, respectively, of interest that had been accrued on the surplus note through March 31, 2002 and September 30, 2001, respectively. For further information on the surplus note, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations, Liquidity and Capital Resources" elsewhere in this Report.
The purpose of this section is to discuss and analyze the Company's financial condition, liquidity and capital resources and results of operations. This analysis should be read in conjunction with the financial statements and related notes which appear elsewhere in this Report.
As of March 17, 2003, the Group was rated "F" (in liquidation) by A.M. Best Company ("Best"). Given the Group's decision to voluntarily liquidate all of its operations, the Best rating is not expected to have any impact on the Company's operations. As with all ratings, the Best rating is subject to change at any time.
In 2002 and 2001, net cash was used for operations principally as a result of a decrease in premiums written and the payment of claims and operating expenses. As a result of its decision to conduct an orderly voluntary liquidation of all of its operations, the Company expects to report a net use of cash from operations resulting primarily from the payment of claims and other expenses in excess of revenues generated for the foreseeable future. During 2001, the Company replaced a significant portion of its fixed maturities investment portfolio with shorter-term investments in order to shorten its duration to match its cash needs.
At December 31, 2002 and 2001, the yield of the Company's fixed maturities portfolio was 1.5% and 2.4%, respectively, with an average maturity of 0.9 years and 0.3 years, respectively. Additionally, the Company has a diversified investment portfolio of securities, 92.1% of which is rated "investment grade" by established bond rating agencies or issued or guaranteed by the U.S. Treasury or by governmental agencies. During 2001, $34.5 million of the Company's investment in a limited partnership was liquidated and distributed to the Company. The distribution proceeds were reinvested in short-term fixed maturities. The Company's remaining balance in the limited partnership at December 31, 2001 of $6.1 million consisted of short-term investments and cash equivalents. During 2002, the limited partnership reactivated its trading program and invested principally in convertible preferred stocks, convertible long-term debt securities, limited partnerships, and common stocks sold, but not yet purchased. As of December 31, 2002, the Company's investment in the limited partnership was $6.4 million.
During 2002, the Company paid to its shareholders a $0.335 per share cash dividend aggregating $2.4 million. Unless approved by the Department, New York Insurance Law prohibits New York domiciled property and casualty companies from paying dividends except out of earned surplus. At December 31, 2002, no dividends could be paid without obtaining special approval from the Department.
Liabilities for unpaid losses, which are not discounted (except for certain workers' compensation liabilities), and LAE are determined using case-basis evaluations, statistical analyses for losses incurred but not reported and estimates for salvage and subrogation recoverable, and represent estimates of the ultimate claim costs of all unpaid losses and LAE. Liabilities include a provision for losses that have occurred but have not yet been reported. These estimates are subject to the effect of trends in future claim severity and frequency experience. The Company relies upon standard actuarial ultimate loss projection techniques to obtain estimates of liabilities for losses and LAE. These projections include the extrapolation of both losses paid and incurred by business line and accident year and implicitly consider the impact of inflation and claims settlement patterns upon ultimate claim costs based upon historical patterns. In addition, methods based upon average loss costs, reported claim counts and pure premiums are reviewed in order to obtain a range of estimates for setting the reserve levels. For further input, changes in operations in pertinent areas including underwriting standards, product mix, claims management and legal climate are periodically reviewed. Adjustments to such estimates are made from time to time due to changes in such trends as well as changes in actual loss experience. These adjustments are reflected in current earnings. The liability for losses and LAE are based on estimates and assumptions and the ultimate loss may differ.
The Company uses the liability method in providing for income taxes. Under the liability method, deferred income taxes are provided at the enacted tax rates for differences between the financial statement carrying amounts and tax bases of assets and liabilities and for net operating loss carryforwards. The Company records a valuation allowance to reduce its deferred taxes to the amount that is more likely than not to be realized. If the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment would increase income in such period. Similarly, if the Company were to determine that it would not be able to realize all or part of its net deferred taxes in the future, an adjustment would be charged to income in such period. As of December 31, 2002 and 2001, the Company recorded a valuation allowance to fully reserve its deferred tax asset.
The Company's pre-tax loss was $3.7 million, $18.0 million and $17.9 million for the years ended December 31, 2002, 2001 and 2000, respectively. These amounts were negatively impacted by adverse reserve development of prior years' reserves of $3.1 million, $18.7 million and $15.9 million for 2002, 2001 and 2000, respectively. The more significant trends and events that the Company has experienced in recent years, which resulted in the recognition of the adverse reserve development, are identified below following the Company's combined ratios.
Net earned premium revenues of the Company were $4.2 million, $18.3 million and $30.9 million for the years ended December 31, 2002, 2001 and 2000, respectively. The Company's earned premiums declined in all lines of business during 2002 and 2001 as a result of actions announced during late 2000 and the first quarter of 2001. During the fourth quarter of 2000, the Group announced that it would no longer accept any new private passenger automobile policies. Existing policies of private passenger automobile insurance will be either sold, non-renewed or cancelled in accordance with New York insurance law. If the private passenger automobile book of business is not sold, it is expected that the Group will continue to issue renewal policies over the next several years as required by applicable insurance law. In March 2001, the Group announced that, effective immediately, it would no longer issue any new (as compared to renewal) insurance policies and that it filed plans of orderly withdrawal with the Department as required. All commercial lines policies have been non-renewed or canceled in accordance with New York insurance law or replaced by Tower under the 2001 Tower Agreement for the sale of the Group's renewal rights and the Company has no renewal obligations for those policies. The Group will continue to be responsible for the remaining term of its existing policies and all claims incurred prior to the expiration of these policies. Although New York insurance law required the Group to offer renewals of homeowners, dwelling fire, personal insurance coverage and personal umbrella for a three-year policy period, the Tower Agreement obligated Tower to offer its own policies as replacements for the Group's policies. As a result, all of these policies were either renewed through Tower, not renewed by the policyholder or cancelled by the Group in accordance with New York insurance law and the Group has no renewal obligations for personal lines policies, except for private passenger automobile whose in force premium volume totaled $5.3 million at December 31, 2002. As indicated above, these policies volume will continue to decline as the Group exercises its non-renewal rights under New York insurance law or policyholders choose not to renew their policies.
The NAIC has adopted model laws incorporating the concept of a "risk based capital" ("RBC") requirement for insurance companies. Generally, the RBC formula is designed to measure the adequacy of an insurer's statutory capital in relation to the risks inherent in its business. The RBC formula is used by the states as an early warning tool to identify weakly capitalized companies for the purpose of initiating regulatory action. Although New York State has not adopted the RBC requirements for property and casualty insurance companies, New York does require that property and casualty insurers file the RBC information with the Department. The NAIC also has adopted various ratios for insurance companies which, in addition to the RBC ratio, are designed to serve as a tool to assist state regulators in screening and analyzing the financial condition of insurance companies operating in their respective states. The Company and Empire had certain NAIC ratios outside of the acceptable range of results for the years ended December 31, 2002, 2001 and 2000.
In addition, the Company also increased its reserve for LAE by $3.1 million primarily as a result of a higher than expected level of payment activity during 2002, principally related to outside attorneys handling third party liability claims and the payment of internal overhead costs allocated to claims handling. During 2002, the Company reduced its accrual for certain New York workers' compensation fund assessments by approximately $2.5 million. As a result of a legislative change, these workers' compensation fund assessments are currently determined based on workers' compensation premiums writings, rather than on the basis of loss payments as had previously been the case. Due to a reduction in workers' compensation premium volume, the Company was able to reduce its accrual for these fund assessments.
During 2001, the Company recorded adverse loss reserve development of $18.7 million. During 2001, the Company increased its reserve estimates for its commercial package policies lines of business, primarily due to increases in severity of liability claims for accident years 1998 and prior. The Company has exposure for third party liability claims in many of its lines of insurance. During 2001, there were several settlements and court decisions on third party liability cases for amounts that are greater than the industry's or the Company's historical experience for similar claims, which had formed the basis for the Company's estimated loss reserves. These results signaled a change in the judicial environment in the Company's marketplace. Accordingly, in 2001, the Company increased its loss reserve estimate by $6.9 million due to an estimated increase in severity for these exposures.
Reserve increases in 2001 also resulted from unfavorable development principally in automobile lines of business for the 1998 through 2000 accident years, primarily relating to PIP coverage and in its workers' compensation lines of insurance. The Company believed that the increased loss estimates for PIP was consistent with trends in the industry during 2001, and increased loss reserves for all automobile lines by $3.3 million for 2001. In addition, the Company also increased its reserve for LAE by $7.0 million as a result of the increases to its loss reserves and an increase in the estimate of future overhead costs that will be allocated to settle claims currently incurred.
As a result of the terrorist attacks on September 11, 2001 at the World Trade Center, the Company recorded estimated incurred losses and LAE of $0.8 million for the year ended December 31, 2001, primarily relating to business interruption coverage. During 2002, the Company reestimated the incurred losses and LAE to be $0.5 million.
The reserving process relies on the basic assumption that past experience is an appropriate basis for predicting future events. The probable effects of current developments, trends and other relevant matters are also considered. Since the establishment of loss reserves is affected by many factors, some of which are outside the Company's control or are affected by future conditions, reserving for property and casualty claims is a complex and uncertain process requiring the use of informed estimates and judgments. As additional experience and other data become available and are reviewed, the Company's estimates and judgments may be revised. Any negative changes in estimates could be material to future results of operations and result in the surplus of the Company or Empire being below the minimum required level.
In management's judgment, information currently available has been appropriately considered in estimating the Company's loss reserves. The Company will continue to evaluate the adequacy of its loss reserves on a quarterly basis, incorporating any future changes in trends and actual loss experience, and record adjustments to its loss reserves as appropriate.
Net investment income for 2002 was lower than 2001 primarily due to a reduction in invested assets as a result of a decrease in premiums written, lower prevailing interest rates, the repayment of interest on the surplus note in late 2001 and payments of claims and operating expenses. The reduction in 2001 was primarily due to a reduction in investments held as a result of a decrease in premiums written and the payment of claims and operating expenses as well as a reduction in investment yields resulting from lower interest rates and the Company's decision to shorten the duration of its investment portfolio. During 2002, the Company had realized capital gains of $1.4 million primarily due to the sale of an equity security for operating cash flow needs. During 2001, the Company had realized capital gains of $1.9 million primarily due to the sale of fixed maturities to shorten the duration of the portfolio.
The combination of other underwriting expenses incurred and the amortization of deferred policy acquisition costs decreased $5.6 million or 51.8% in 2002 and approximately $5.1 million or 32.0% in 2001. The decrease in both 2002 and 2001 primarily related to the decline in premium revenue coupled with a reduction in operating expenses. The decrease in 2002 was partially offset by the write off of approximately $2.0 million of uncollectible premium receivables. In addition, during 2001, the Company expensed $2.6 million of deferred policy acquisition costs as their recoverability from premiums and related investment income was no longer anticipated.
Due to the uncertainty of future taxable income necessary for realization of the deferred tax asset, a valuation allowance has been provided as of December 31, 2002 and 2001 on the total amount of the deferred tax asset of approximately $26.7 million and $25.1 million, respectively. Current incomes taxes for 2000 reflect a benefit of $0.4 million for a change in the Company's estimated prior year's federal tax liability.
In July 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS 146"), which is effective for exit or disposal activities initiated after December 31, 2002. SFAS 146 addresses issues regarding the recognition, measurement and reporting of costs associated with exit and disposal activities, including restructuring activities. SFAS 146 requires a liability be recognized at fair value for costs associated with exit or disposal activities only when the liability is incurred as opposed to at the time the Company commits to an exit plan as permitted under Emerging Issues Task Force Issue No. 94-3. In November 2002, the FASB issued FASB Interpretation No. 45 ("FIN 45"), which requires a guarantor for certain guarantees to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of FIN 45 are applied on a prospective basis to guarantees issued or modified after December 31, 2002. In addition, FIN 45 modified the disclosure requirements for such guarantees effective for interim or annual periods ending after December 15, 2002; these disclosure requirements are not applicable to the Company. In January 2003, the FASB issued FASB Interpretation No. 46 ("FIN 46"), which addresses consolidation of variable interest entities, which are entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. FIN 46 applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. FIN 46 may be applied prospectively with a cumulative effect adjustment as of the date on which it is first applied or by restating previously issued financial statements with a cumulative effect adjustment as of the beginning of the first year restated. The Company is reviewing the impact of the implementation of SFAS 146. The Company does not currently expect that the initial recognition and measurement provisions of FIN 45, and the implementation of FIN 46 will have a material effect on the Company's consolidated results of operations or financial condition.
The factors that could cause actual results to differ materially from those suggested by any such statements include, but are not limited to, those discussed or identified from time to time in the Company's public filings, including:
o developments in claims handling, including adverse litigation developments with respect to environmental claims, including lead poisoning, and other liability claims that could adversely affect the voluntary liquidation plan of the Group;
o increased loss adjustment expenses resulting from an extended claims run-off period;
o an adverse determination by the New York State Department of Taxation and Finance on its audit of the Company's and Empire's New York State franchise tax returns for the years 1992 through 1996;
o An adverse resolution of the financial dispute with a former third party claims administrator; and