We provide personal and commercial property and casualty insurance primarily in Massachusetts and in other states. Our core product lines are personal automobile, homeowners and commercial automobile. We market our products exclusively through our network of independent agents in all states, except California and New York, where we use agents and brokers. Our primary business strategy is to focus on the personal automobile insurance market in Massachusetts and to grow and diversify by increasing the proportion of our business written in other states in which we currently have a significant presence, primarily from Commerce West, American Commerce and State-Wide and by expanding into the New York and New Jersey personal lines markets.
Our ability to capitalize on our business strengths and implement our strategies is subject to particular risks. For a discussion of these risks, see Item 1A, "Risk Factors," contained elsewhere in this Form 10-K.
Overview. We have been the largest writer of personal property and casualty insurance in Massachusetts in terms of market share of direct premiums written since 1990. Our estimated share of the Massachusetts personal automobile market increased to 31.6% for the year through November 30, 2007, significantly exceeding our two nearest competitors, Safety Insurance Group, Inc. and Arbella Insurance Group, who maintained an estimated 11.4% and 9.4% market shares, respectively.
In Massachusetts, private passenger automobile insurance is subject to extensive regulation. Owners of automobiles are generally required to demonstrate certain minimum automobile insurance coverages as a prerequisite to registering any automobile. With very limited exceptions, private passenger automobile insurers are required through March 31, 2008, by law to issue a policy to any applicant seeking to obtain such coverages, commonly known as the "take-all-comers" requirement. Marketing and underwriting strategies for companies operating in Massachusetts are limited by maximum premium rates and minimum agency commission levels for personal automobile insurance, both of which are mandated by the Commissioner.
The Massachusetts regulatory environment for personal automobile insurance has been characterized by the following key principles:
assigning certain agents that have not been able to obtain a voluntary contract with another insurer, known as Exclusive Representative Producers, or ERPs, to servicing carriers on the basis of market share,
On November 19, 2007, we filed our Voluntary Market Transition Rate filing with the Commissioner. On December 10, 2007, the Massachusetts Attorney General moved to initiate a hearing on the filing, alleging that the proposed rates were excessive and unfairly discriminatory. On January 9, 2008, the Commissioner held a hearing on the issues raised by the Attorney General. Specifically, the purpose of the hearing was to determine whether, as challenged by the Attorney General, the following provisions of the filing are excessive: 1) the profit provision, 2) the expense provision; 3) the acquisition provision; and 4) the loss provision. The hearing occurred on January 9 and 10, 2008. On January 25, 2008, the Commissioner issued her Opinion, Findings and Decision concluding that Commerce had met its burden of proof on the issues that were the subject of the hearing and, therefore, the filing was not disapproved. Also on January 25, 2008, the Division approved our AAA group marketing plan filings.
In addition, on December 13, 2007, the Commissioner issued a notice of a separate hearing also for January 9, 2008, regarding the rate filing to determine whether Commerce improperly factored into its proposed rates (i) reductions from rate deviations applicable to two of our group marketing plans in violation of Bulletin 2007-13, and (ii) the value of bodily injury coverage in violation of Bulletin 2007-12A. The operation of the filing was not suspended pending this hearing. On January 7, 2008, we filed with the Division a corrected filing addressing the two issues set forth in the notice of hearing. On January 23, 2008, the Commissioner issued an Order closing the proceeding. The Order states that the Division completed its review of the corrected filing and concluded that the corrected filing fully resolves the issues that were the subject of the hearing.
Changes in Premium Rates. In each of the three years 2007-2005, the Commissioner approved an average mandated Massachusetts personal automobile insurance premium rate decrease. The Commissioner approved average decreases of 11.7% for the one-year period beginning April 1, 2007 and 8.7% for the fifteen month period beginning January 1, 2006. Coinciding with the 2006 and 2005 rate decisions, the Commissioner also approved commissions agents receive for selling private passenger automobile insurance. The Commissioner approved no change in commission dollars for 2007 and a 1.5% rate increase for 2006. The following table shows the state-mandated average rate change, the actual average written premium change per exposure and our average written premium change per exposure for 2007 and for the two previous years in Massachusetts.
Affinity Group Marketing. Since 1995, we have been a leader in affinity group marketing in Massachusetts, through agreements with the three American Automobile Association Clubs operating in Massachusetts, offering discounts on private passenger automobile insurance to the clubs' members who reside in the state. A 4% discount with additional special coverages for AAA members was approved by the Commissioner for policies effective April 1, 2008. A 5% discount existed in 2007 and through April 1, 2008. Based on information provided to us by the AAA clubs operating in Massachusetts, we believe that membership in these clubs represents approximately one-third of the Massachusetts motoring public. The following table presents total direct premiums written attributable to the AAA clubs' group business in Massachusetts for the years ended December 31:
The decreasing percentages since 2005 are attributed to a higher rate of increase in non-affinity group business. Of the total Massachusetts automobile exposures written through the AAA affinity group program by us in 2007, approximately 16.0% were written through insurance agencies owned by the AAA clubs (8.1% of our total Massachusetts automobile exposures). The remaining 84.0% of the AAA group program was written through our network of independent agents.
The claim cycle begins when a claim is reported to us and claims personnel establish a "case reserve" for the estimated amount of our exposure without regard to injury causality, third party liability or potential recoveries. The amount of the reserve is primarily based upon an evaluation of the type of claim involved, the circumstances surrounding the claim and the policy provisions relating to the loss. This estimate reflects the informed judgment of such personnel based on the experience and knowledge of the claims personnel adjusting the claim. During the loss adjustment period, these case basis estimates are revised as deemed necessary by our claims department personnel based on subsequent developments and periodic reviews of the claim.
We utilize an actuarial calculation as a test of reasonableness of our financial statement loss and LAE reserves which were calculated by financial management. Our actuaries calculate their estimate of our liability for loss and LAE reserves using generally accepted actuarial reserving techniques. The reserving techniques employed by our actuaries include incurred loss development and paid loss development for all reviewed lines. For voluntary personal automobile liability, two additional methods were used - claim count times average severity and exposures times ultimate pure premium. In estimating allocated LAE ("ALAE") reserves, our actuaries used two methods - paid ALAE development and ratio of paid ALAE to paid loss development. For unallocated LAE ("ULAE") reserve, three methods were used - paid ULAE development, paid ULAE to paid loss ratio development and calendar year paid ULAE to paid loss and ALAE. An average of these methods is calculated, which is called the indicated ultimate loss. The indicated ultimate loss is then subjected to actuarial judgment which considers other factors, such as the resulting ultimate loss ratio, loss trends, changes to business and the relative value of each of the different methods. A selected ultimate loss amount is then determined. Using the criteria of Actuarial Standard of Practice No. 36, a reserve range is then calculated that the actuary judges to be reasonable based upon appropriate actuarial methods and judgment. The actuarial methods utilized are considered standard for property and casualty companies with losses settling over a relatively short period of time, usually within 0 to 3 years (short-tail liability losses). The same basic assumptions and methods were used at both December 31, 2007 and 2006. Our aggregate actuarial estimate for the loss and LAE reserves, on a consolidated basis and net of reinsurance recoverable, ranges from a low of $832,500 to a high of $957,100 as of December 31, 2007 and a low of $778,600 to a high of $893,600 at December 31, 2006.
As we base our estimate of loss and LAE reserves primarily on historical payment experience, the following sensitivity analysis assumes that our historical payment experience was impacted by the stated percentages. The factors which could cause the payment experience to change are not analyzed individually as these factors are imbedded in the historical information. Based upon historical results over the last six years, we show a redundancy for all five years, with a minimum redundancy of 6.4% and a maximum redundancy of 11.4% from the initially established reserves. See page 19 for an analysis of our historical loss and LAE reserve development.
The quarterly reports that CAR provides to us are one quarter in arrears when we calculate this component of our financial statement loss and LAE reserves, and therefore, it is necessary for us to make an estimate of the most recent quarter results for CAR. In calculating this estimate we compare the CAR loss and LAE reserve data with historical premium written and earned amounts from CAR. We then utilize the estimated written and earned premiums from CAR for the most recent quarter to calculate losses, LAE and underwriting expenses that would relate to that quarter, and then incorporate that information into our financial results.
Based on the historical data of the six most recent accident years, CAR had redundancies and deficiencies within its accident years. The deficiencies had a low of 2.8% and a high of 3.8% of the initial reserves, while the redundancies had a low of 3.4% and a high of 16.8% of the initial reserves. These are the percentages utilized in our sensitivity analysis for our loss and LAE reserves related to CAR at December 31, 2007:
We review all security holdings on a quarterly basis for potential other-than-temporary impairments due to declines in market value in accordance with GAAP. In general, unrealized losses resulting from an increase in interest rates will not necessarily lead to an other-than-temporary write-down. As part of this process, we consider any significant market decline in the context of the overall market and also in relation to the outlook for the specific issuer of the security and the issuer's industry. Each quarter, we review all securities whose market values have declined below book price. From a quantitative standpoint, we review all securities that have declined more than 20% below book price and have remained so for two consecutive quarters as potentially in need of a write-down. Any other security that we view as impaired for a significant period of time is also a candidate for a write-down, even if the percentage decline is less than 20%. In addition, we perform the following quarterly impairment review of our portfolio:
If a security is deemed other-than-temporarily impaired, we adjust the security's cost basis to market value through realized loss based on publicly available prices or, in the absence of such information, on a price supplied by a broker. There is a risk that we may assess a decline in market value as being temporary when in fact it is other-than-temporary and, consequently, not charge the impairment to our earnings, which could have a significant impact on our future earnings.
Accrued agents' profit sharing. In addition to state mandated minimum and other commissions on policies written, we pay certain of our agencies compensation in the form of profit sharing under five separate arrangements: one for Commerce and Citation for their Massachusetts agencies; another for Commerce's New Hampshire agencies; one for both American Commerce for its agencies; and, two for Commerce West for its agencies. Each of these arrangements entitles qualifying agencies to share in our results based primarily on the underwriting profits of an individual agents' business written with us. Our total obligation under these arrangements is reported on our consolidated balance sheet as "Accrued agents' profit sharing." For segment reporting, our profit sharing expenses are aligned by state; profit sharing expense for our agencies in Massachusetts is included in our Massachusetts segment's earnings; profit sharing expense for our agencies in states other than Massachusetts is included in our other than Massachusetts segment's earnings.
Approximately 97% of our total profit sharing expense in 2007 was for our Massachusetts agencies under the Commerce and Citation arrangement and, therefore the following discussion relates only to the Commerce and Citation plan in Massachusetts and excludes the other four profit sharing plans, the accounting for which we do not consider to be a critical accounting policy. The arrangement utilizes a three-year rolling plan, with one third of the agents' profit or loss for each of the current and the two prior years' calculations summed to a single amount. This amount, if positive, is multiplied by a sliding scale profit sharing commission rate and paid to the agent in the second quarter of the following year.
We estimate our current year profit sharing expense each quarter. Our expense calculation at year-end has one critical accounting estimate, as defined by the SEC, which we refer to as the discount factors. The discount factors represent our expected profit sharing payments for the second and third years following the current year's payment, net of attrition related to our agencies' profitability and profit sharing eligibility. We do not use a discount factor for the current year's payment because, subject to some final adjustments, our year-end estimate of our next payment is usually reasonably close to the actual payment amount. However, we know from experience that all of the agencies that are currently profitable, after the first and second years of each rolling three-year cycle, will not remain profitable and be entitled to all of the profit sharing earned during those years. Therefore, we apply discount factors in our accrual calculation to the estimated payment amounts for the latter two years to estimate this attrition in profit sharing eligibility.
We evaluate annually the appropriateness of these discount factors by considering our past experience and other prospective factors that may influence attrition in profit sharing eligibility, such as the pricing and regulatory environments in Massachusetts, current agency experience data, projected results of CAR, and underwriting results. Some of our prospective assumptions that underlie pricing, regulatory, CAR, and other factors are uncertain when we are performing our evaluation. Based on this evaluation, we adjusted our discount factors at the end of 2007. We reduced our second-year factor from 95% to 92% and we increased our third-year factor from 75% to 85%. These adjustments had an immaterial effect on our profit sharing expense and consolidated results for 2007.
Although the discount factors we used in our 2007 profit sharing estimate resulted from a comprehensive evaluation, our actual future payment results may not agree with these factors due to the uncertainties underlying certain assumptions we had to make. Any expense overage or shortfall will be recognized in our earnings in subsequent years along with our profit sharing estimates for those years. The following table quantifies what the financial effect would have been to our 2007 and 2006 profit sharing expense (Commerce and Citation only), consolidated net earnings (after taxes), and stockholders' equity had our discount factors been 500 basis points higher and lower.
Net investment income represents earnings on our investment portfolio less expenses. We rely on after-tax investment income as a significant source of net earnings.
The underwriting expense ratio is the percentage of underwriting expenses (including corporate expenses) incurred to net premiums written. Underwriting expenses are the aggregate of policy acquisition costs, including commissions, and the portion of administrative, general and other expenses attributable to underwriting operations. For the purposes of this calculation, underwriting expenses are adjusted for any change in deferred acquisition costs.
For a detailed breakdown on direct premiums written and earned, see Note O - Segment Information in Notes to Consolidated Financial Statements.
We experienced a decline in direct premiums written in the Massachusetts segment of 2.9%, with declines in our personal and commercial automobile business outweighing growth in homeowners business. The personal automobile business decline was a result of a 5.7% decline in written premium per vehicle compared to last year while the number of insured vehicles increased 1.7%. Commerce continues to increase its market share in the private passenger automobile market.
Our year-to-date homeowners growth was the result of a 7.7% increase in average premium per policy combined with a 3.2% increase in the number of policies written. Our year-to-date commercial automobile decline was the result of a 7.1% decrease in average premium per policy combined with a 0.5% decrease in policies written.
Earnings decreased $57,191, or 15.7%, over the prior year primarily due to the decline in revenue previously discussed combined with an increased loss ratio. The loss ratio increased due to the factors discussed for the Company as a whole.
The increase in our net investment income in 2007 was due to the combination of increased average invested assets and higher overall yields. The increase in average invested assets occurred in the first half of the year and is primarily attributable to the addition of State-Wide's portfolio and increased operating cash flows. The increase in yields corresponds with the increase in duration of our fixed maturity portfolio which rose to 5.6 years at December 31, 2007 from 5.4 years a year earlier. The increased yield is primarily attributable to the government bond and corporate bond segments, where pre-tax yields increased 70 and 100 basis points, respectively. The year end 2007 investments balance has decreased from a year earlier due primarily to the treasury stock and State-Wide purchases.
Our loss ratio increased to 64.5% for 2007 from 60.7% the prior year. The increase was the result of several factors, including:
an increase in private passenger automobile physical damage frequency partially offset by a decrease in private passenger automobile bodily injury losses.
Our underwriting ratio increased to 29.5% for 2007 from 28.5% in the prior year. One main factor was reduced ceded reinsurance commissions resulting from the termination of our other-than-automobile quota share agreement effective July 1, 2007. Ceded reinsurance commissions returned, which reduce commission expense, declined to 1.7% of direct premiums written in 2007 from 3.6% in 2006. Also contributing to the increase were increased agent commissions as a percentage of written premiums due to the April 1, 2007 Massachusetts state mandated rate decrease. These items were partially offset by a decline in agents' profit sharing expense primarily due to higher loss ratios.
Our overall effective tax rate for the year ended 2007 was 28.1% as compared to 30.0% for 2006. In both years, our effective rate was lower than the statutory rate of 35.0% primarily due to tax-exempt interest and the corporate dividends received deduction. Our effective tax rate decreased in 2007 due to a slightly higher amount of the tax exempt income received and the dividends received deduction and lower profits at the 35% rate.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements - an amendment of Accounting Research Bulletin No. 51 (SFAS 160). SFAS 160 establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent's ownership interest and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS 160 is effective as of the beginning of an entity's fiscal year that begins after December 15, 2008, and will be adopted by us on January 1, 2009. We are currently evaluating the potential impact, if any, of the adoption of SFAS 160 on our consolidated results of operations and financial condition.
In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. A business entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We do not expect the adoption of this Statement to have a material impact on our results of operations or financial position.
In July 2006, the FASB released FIN 48, Accounting for Uncertainty in Income Taxes - an interpretation of SFAS 109. This interpretation clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS 109. This interpretation prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. It also provides guidance on derecognition, classification, interest and penalties, interim periods and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006. We adopted FIN 48 as of January 1, 2007 and the adoption had a negligible impact on our results of operation and financial position.
The decrease in earnings in 2006 over 2005 resulted primarily from an increase in our combined ratio in 2006. The increase in the combined ratio can be attributed to an increase in the underwriting ratio, partially offset by a decline in the loss ratio. Also impacting 2006 net earnings was a $20,352 increase in net investment income partially offset by a $6,264 decline in net realized investment gains.
We attribute the improvement in the loss ratio to several factors:
Total direct written premiums for the other-than-Massachusetts segment declined $5,422, or 2.3%. The personal automobile decline accounted for the majority of this decrease, primarily as the result of the continued decline in premiums in Arizona due to the loss of AAA Arizona's affinity business in 2005. Direct written premiums from personal automobile policies in Arizona declined $15,633, or 62.6%, primarily due to a decline in policies. We believe Arizona business volumes have now stabilized. American Commerce and Commerce West will continue to write business in Arizona; however, ACIC no longer markets its products through AAA Arizona. Also contributing to the decline in personal automobile direct written premium were a 29.6% drop in Ohio, a 10.2% decline in Idaho and a 10.4% drop in Indiana. Partially offsetting these declines were increases in Oregon (18.9%), Washington (8.6%) and Oklahoma (7.2%). In general, we are lowering rates in states in which we write business in response to competitive pressures as a result of a soft market. Commercial automobile premiums decreased 14.4% while homeowners increased by 0.6%. Other lines increased $9,258 primarily due to $8,881 of direct premiums from ANI as a result of American Commerce becoming a direct writer of ANI business.
Earnings increased $2,986, or 0.8%, over the prior year primarily due to the increases in revenue previously discussed, partially offset by an increased combined ratio. The combined ratio increased due to the factors discussed for the Company as a whole.
As a result of changes in estimates of insured events in prior years, the provision for loss and LAE decreased $43,726 for the year ended 2006 and $61,397 for the year ended 2005. The favorable development is due primarily to lower than anticipated losses related to the personal automobile liability.
Management considers many factors, as disclosed in the Critical Accounting Policies section of this report, in establishing its best estimate for loss and LAE reserves. We believe that our loss and LAE reserve estimate is a reasonable assessment of the ultimate future payment amounts necessary to settle all of our insured losses incurred as of December 31, 2006. In addition, we believe the pro forma analysis presented under the Critical Accounting Policies is a reasonable depiction of our sensitivity related to our estimate, based on our reserving methodology and the short-tail nature of the business that we write. However, the ultimate liability may be greater or less than the established reserves for losses and LAE. If the ultimate payments are greater or less than our estimated liability for losses and LAE, we will either incur additional or less expenses, respectively, in future periods which may have a material effect on our future results of operations.
Our overall effective tax rate for the year ended 2006 was 30.0% as compared to 30.6% for 2005. In both years, our effective rate was lower than the statutory rate of 35.0% primarily due to tax-exempt interest and the corporate dividends received deduction. Our effective tax rate decreased in 2006 due to a slightly higher amount of the corporate dividends received deduction and lower profits at the 35% rate.
Total unpaid losses and LAE net of salvage and subrogation, by line of business at December 31, 2007 and 2006 follow (in millions):
Ceded unpaid losses and LAE recoverable, net of salvage and subrogation, by line of business at December 31, 2007 and 2006 follow (in millions):
Our contractual obligations and commercial commitments as of December 31, 2007 by maturity follow:
We have historically generated significant amounts of cash through operations. During the most recent three years, we have generated between $200 million and $350 million annually. Our largest non-operating cash requirement is the payment of dividends to shareholders, which totaled $76 million in 2007. Generally, we invest the remaining cash generated from operations into our investment portfolio. During 2007, we departed from this by purchasing treasury stock and State-Wide. We anticipate returning to investing our excess cash from operations into our investment portfolio.
In April 2005, Commerce Insurance became a member of the Federal Home Loan Bank (FHLB) of Boston, providing Commerce Insurance with a significant source of liquidity. The FHLB of Boston, which is one of 12 regional FHLBs, serves as a reserve or central bank for its members within its assigned region. The FHLB of Boston makes loans, which are referred to as advances, to members in accordance with policies and procedures established by its board of directors. These policies and procedures are subject to the regulation and oversight of the Federal Housing Finance Board. All advances from the FHLB of Boston to Commerce Insurance are required to be fully secured by sufficient collateral as determined by the FHLB. At Commerce Insurance, eligible collateral consist primarily of securities issued or guaranteed by the U.S. Government or any of its agencies. We estimate that FHLB membership provides Commerce Insurance with the capacity to borrow approximately $363,000 from the FHLB of Boston. To date, we have not borrowed from the FHLB.
The primary focus of our investment objectives continues to be maximizing after-tax investment income through investing primarily in high-quality diversified fixed maturity investments structured to maximize after-tax investment income while minimizing risk. We generally invest in securities with maturities intended to provide adequate cash flow to pay claims and meet other operating needs without the forced sale of investments. When the appropriate opportunity arises, we will recognize investment gains to increase after-tax total return. We held no CDOs, CBOs, SIVs, derivatives, emerging market securities or hedge funds at December 31, 2007 and 2006.
As part of our investing activities, we assume positions in fixed maturity, equity, short-term and cash equivalents markets. Therefore, we are exposed to the impacts of changes in the market value of investments resulting from fluctuations in interest rates. We estimate our exposure to interest rate changes and equity price risk using sensitivity analysis. The interest rate impact is defined as the effect of a hypothetical interest rate change of plus-or-minus 100 or 200 basis points on the market value of fixed maturities and preferred stocks.
Changes in interest rates would result in unrealized gains or losses in the market value of the fixed maturity and preferred stock portfolio due to differences between current market rates and the stated rates for these investments. The following table summarizes our interest rate risk, based on the results of the sensitivity analysis at December 31, 2007 and 2006. The table also reflects the changes in market value and stockholders' equity that would be attributable to realized investment gains (losses) that we would recognize under the equity method of accounting with respect to the change in the net asset value of the mutual funds in which we own 20% or more of the shares outstanding. See "Critical Accounting Estimates - Investments and Other-than-Temporary Impairments."
This annual report and Form 10-K may contain statements that are not historical fact and constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act. Statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These statements are often, but not always, made through the use of words or phrases such as "anticipates," "estimates," "plans," "projects," "continuing," "ongoing," "expects," "may," "will," "could," "likely," "should," "management believes," "we believe," "we intend," and similar words or phrases. These statements may address, among other things, our strategy for growth, business development, regulatory approval, market position, expenditures, financial results and reserves. Accordingly, these statements involve estimates, assumptions and uncertainties that could cause actual results to differ materially from those expressed in them. All forward-looking statements are qualified in their entirety by reference to the factors discussed throughout this annual report on Form 10-K and in our Forms 10-Q and other documents filed with the SEC. Among the key factors that could cause actual results to differ materially from forward-looking statements:
heightened competition, especially in Massachusetts if large national competitors enter the state in response to the newly implemented managed competition regulations;
the economic, market or regulatory conditions and risks associated with entry into new markets and diversification.
Our management is responsible for the consolidated financial statements and all other information presented in this Annual Report on Form 10-K. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America determined by management to be appropriate in the circumstances and include amounts based on management's informed estimates and judgments. Financial information presented elsewhere in this Annual Report on Form 10-K is consistent with the financial statements.
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1)
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). Our consolidated financial statements include the accounts of The Commerce Group, Inc. and its subsidiaries, Bay Finance Company, Inc., Clark-Prout Insurance Agency, Inc. and Commerce Holdings, Inc. (CHI). The Commerce Insurance Company (Commerce) and Citation Insurance Company (Citation) are wholly-owned subsidiaries of CHI. American Commerce Insurance Company (American Commerce), SWICO Enterprises, Ltd. (SWICO) and Commerce West Insurance Company (Commerce West) are wholly-owned subsidiaries of ACIC Holding Co., Inc. (AHC). AHC is owned jointly with AAA Southern New England (AAA SNE) with CHI maintaining a 95% common stock interest and AAA SNE maintaining a 5% common stock interest. State-Wide Insurance Company (State-Wide) is a wholly-owned subsidiary of SWICO. All inter-company transactions and balances have been eliminated in consolidation. Certain prior year account balances have been reclassified to conform to the 2007 presentations.
On April 2, 2007, AHC completed its acquisition of SWICO. The total cost of the acquisition was $55,776. The results of operations of SWICO and State-Wide are included in the consolidated financial statements only for periods subsequent to the date of acquisition.
During the second quarter of 2007, CHI transferred its ownership of Commerce West to AHC, resulting in AAA Southern New England acquiring a 5% indirect ownership in Commerce West. We recorded a gain of $1,510 in this transaction.
Carrying values of investments in fixed maturities, which include taxable and non-taxable bonds and investments in common and preferred stocks, are derived from market prices supplied by our investment custodian, or in the few cases where no price is provided by the custodian, approximately 5% of our investment portfolio,we obtain a third party valuation. We review all third party valuations for reasonableness by checking available market data for like securities and checking broker markets.
The cash and cash equivalent balances at December 31, 2007 and 2006 are grossed up by $36,548 and $41,845, respectively, which represents outstanding checks for which there was no right of offset. These amounts are included in other liabilities and accrued expenses for the respective years.
Our closed-end preferred stock mutual fund holdings at December 31, 2007 and 2006 accounted for under the equity method follow:
John Hancock Patriot Premium Dividend II Fund (PDT), John Hancock Patriot Global Dividend Fund (PGD) and John Hancock Patriot Preferred Dividend Fund (PPF). The quoted market values of these investments are less than carrying value at year end 2007 and 2006. The carrying value is the net asset value of the underlying securities, which would be the value we would receive if the fund liquidates. We intend to hold these investments to recovery.
Interest on mortgage loans is included in income as earned based upon rates applied to principal amounts outstanding. Accrual of interest on mortgage loans is discontinued either when reasonable doubt exists as to the full, timely collection of interest or principal, or when a loan becomes contractually past due more than 90 days. When a loan is placed on non-accrual status, all unpaid interest previously accrued is reversed against current period earnings. Interest on loans in a non-accrual status is recognized as received.
Mortgage principal and collateral notes receivable balances at December 31 follow:
We review all holdings with unrealized losses over $100, or a fair market value that is more than 10% below cost, for securities at a continuous loss position period of 12 to 36 months.
We will consider other-than-temporary the impairment of any security which we do not intend to hold until maturity or full recovery.
If a security is deemed other-than-temporarily impaired, we adjust the security's cost basis to market value through realized loss based on publicly available prices or, in the absence of such information, on a price supplied by a broker. Gross unrealized losses on our fixed maturity and equity securities at December 31, 2007 by duration of unrealized loss and by credit quality (for fixed maturity securities) follow:
Our unrealized losses from below investment grade fixed maturity securities at December 31, 2007 were from corporate securities and asset-backed securities with a credit quality of BB or were unrated.
Maintenance and repairs are charged to operations; betterments are capitalized. The cost of property sold or otherwise disposed and the accumulated depreciation thereon is eliminated from the related property and accumulated depreciation accounts and any resulting gain or loss is credited or charged to income. We capitalize tangible property and equipment having an economic life of more than one year with a dollar value of $2.5 or greater.
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, we estimate the ultimate net liability for losses and LAE. After taking into account all relevant factors, we believe that, based on existing information, the provision for losses and LAE at December 31, 2007 is adequate to cover the ultimate net cost of losses and claims incurred as of that date. The ultimate liability, however, may be greater or lower than established reserves. If the ultimate exposure is greater than (or less than) our estimated liability for losses and LAE, we will incur additional expense (income) which may have a material impact on our consolidated results of operations and financial position. We do not discount to present value that portion of our loss reserves expected to be paid in future periods.
Liabilities for unpaid claims and claim adjustment expenses for environmental related claims such as oil spills, mold and lead paint are included in the loss reserve methodologies described above. Reserves have been established to cover these claims for known losses. Because of our limited exposure to these types of claims, we believe they will not have a material impact on our consolidated results of operations and financial position in the future. Loss reserves on environmental related claims amounted to $5,490 and $8,611 at December 31, 2007 and 2006, respectively.
Approximately $46,792 in personal automobile liability redundancies developed for the year ended 2007, with 96% of this amount coming from the 2006, 2005 and 2004 accident years. The primary reason for the redundancies in this area is that claim severity developed better than we anticipated, coupled with significant redundancies from CAR which approximated 27% of the total automobile liability redundancy. Automobile physical damage had approximately $1,075 in redundancies primarily related to the 2006 accident year, which were partially offset by prior period deficiencies. Redundancies related to 2006 were approximately $2,813, of which all was CAR related. Commercial automobile liability had approximately $4,799 in redundancies, primarily related to the 2006 and 2005 accident years. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining net redundancy of approximately $1,955.
Approximately $43,522 in personal automobile liability redundancies developed for the year ended 2006, with 99% of this amount coming from the 2005, 2004 and 2003 accident years. The primary reason for the redundancies in this area is that claim severity developed better than we anticipated, coupled with significant redundancies from CAR which approximated 27% of the total automobile liability redundancy. Automobile physical damage had approximately $1,735 in redundancies all related to the 2005 accident year, which were offset by prior period deficiencies. Redundancies related to 2005 were approximately $4,713, of which CAR accounted for 43%. Partially offsetting these redundancies were a $1,895 deficiency in commercial automobile business, primarily related to CAR for the 2005 accident year, and a $236 deficiency in homeowners business. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining net redundancy of approximately $600.
On December 9, 2003, we issued $300,000 face value of senior unsecured and unsubordinated debt (the Senior Notes) which matures December 9, 2013. The Senior Notes were issued at 99.3% to yield 6.04% and bear a coupon interest rate of 5.95%, payable semi-annually on June 9 and December 9. Proceeds from the issuance were $297,972. Costs related to the issuance of the Senior Notes have been deferred and recorded in other assets on the balance sheet. The deferred costs and the original issue discount will be amortized into interest expense over the life of the Senior Notes. The fair market value of the Senior Notes at December 31, 2007 was estimated at $305,000.
In 2000, Commerce entered into a Limited Partnership Agreement with Conning Partners VI, L.P., a Delaware Limited Partnership. This partnership agreement required our commitment to invest up to $50,000 into the partnership. As of December 31, 2007, we have a commitment balance to the partnership of $1,440. The partnership was formed to operate as an investment fund principally for the purpose of making investments primarily in equity, equity-related and other securities issued in expansion financing, start-ups, buy-outs and recapitalization transactions relating to companies in the areas of insurance, financial services, e-commerce, healthcare, and related businesses, including, without limitation, service and technology enterprises supporting such businesses.
Employee stock options granted from 1999 through 2001 relating to a previously approved plan totaled 2,529,042, including the issuance of options previously terminated. No employee stock options were granted after 2001 under the Plan. The options entitled the recipient to purchase our common stock based upon the extent to which, if at all, the per share market value of the common stock exceeded certain thresholds set at the time the option was granted. No employee options were terminated and no employee options were outstanding at December 31, 2007.
We record our expenses related to employee and director stock options, RSUs, BVAs and IAs in three separate line items on our statement of earnings - losses and loss adjustment expenses, policy acquisition costs and net investment income. Agent options are recorded in two separate lines, losses and LAE and policy acquisition costs. The stock option, RSU, BVA and IA expenses recorded in each line item for the years ended December 31 follow:
Liabilities for the BVAs, IAs and employee and director stock option programs were $28,768 and $50,552 at December 31, 2007 and 2006, respectively.
At December 31, 2007, 5,011,400 shares of common stock may be awarded in the future under the Plan. Our Compensation Committee has not granted stock options to employees under the plan since 2001.
The American Commerce Agents' Plan. Additionally, we grant options to certain agents (ACIC agents' options) of American Commerce (the ACIC Plan). The right of the recipient to exercise these ACIC agents' options is contingent upon the average volume of other-than-Massachusetts private passenger automobile and homeowners direct written premiums placed and maintained with American Commerce for a five year period specified in the ACIC agents' option agreement. If qualified, the recipient may purchase our common stock at the exercise price for a period of five years beginning five years after the date of the grant (the confirmation date). Unexercised ACIC agents' options terminate not later than ten years after the date of the grant (the expiration date). Options cannot be exercised using cash. Options can only be exercised using a net share purchase such that the dollar value that the option is in the money is divided by the fair market value of the stock at the date of exercise to arrive at the number of shares received by the option holder. We record our expenses associated with the ACIC Plan over each award's vesting period, based on our estimate of the fair value of each award using the Black-Scholes option pricing model. Expenses related to these options were $11,287 in 2007, $6,568 in 2006 and $1,395 in 2005. The ACIC Plan has not been, and is not required to be, approved by our stockholders.
The computation of diluted EPS did not include stock options that were anti-dilutive, as their exercise price was greater than the average market price of our common stock during the year. The number of such options was 1,800,000, 2,200,000 and 800,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
Under Massachusetts law, an insurer may pay cash dividends only from earnings and statutory surplus, and the insurer's remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. Following the declaration and payment of such dividends, the insurer must file a report with the Commissioner. A Massachusetts insurance company may not pay an extraordinary dividend or distribution unless the insurer gives the Commissioner at least 30 days prior notice of the declaration and the Commissioner does not disapprove of the plan of payment prior to the date of such payment. An extraordinary dividend or distribution includes any dividend or distribution whose fair market value together with other dividends or distributions made within the preceding 12 months exceeds the greater of 10% of surplus, or net income for the 12 month period ending the 31st day of December. California and Ohio have laws similar to those in Massachusetts regulating the payment of dividends by insurance companies.
During 2008, our five insurance subsidiaries have the ability to pay $228,267 in dividends without prior regulatory approval.
The amount of consolidated retained earnings at December 31, 2007 represented by undistributed earnings of 50% or less owned investments that are accounted for using the equity method follows:
A significant portion of our Massachusetts premiums written is derived through the American Automobile Association Clubs of Massachusetts (AAA Clubs) affinity group marketing program. Direct premiums written by the AAA affinity group marketing program in Massachusetts were $643,463, or 34.6%, of our total direct premiums written in 2007, $675,904, or 36.3%, in 2006 and $725,943, or 38.7%, in 2005. Insurance agencies owned by the AAA Clubs wrote 16.0% and our network of independent agents wrote 84.0% of total AAA affinity direct written premium in 2007. During 2006, AAA Club-owned agencies wrote 17.3% and our network wrote 82.7%.
We use an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. In estimating future tax consequences, we consider all expected future events other than changes in the tax law or rates, unless enacted. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.
Realization of a deferred tax asset is dependent on generating sufficient taxable income in future years. Although realization is not assured, we believe it is more likely than not that all of the deferred tax assets will be realized. GAAP requires a valuation allowance to be recorded when it is more likely than not that some or all of the deferred tax assets will not be realized. We did not have a valuation allowance for deferred taxes at December 31, 2007 and 2006.
The total liability balance for unrecognized tax benefits (FIN 48 Liability) at December 31, 2007 is $383. Included in the FIN 48 Liability are $250 of tax positions for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility. Because of the impact of deferred tax accounting, other than interest and penalties, the change in deductibility period would not affect the annual effective tax rate, but would only accelerate the payment of cash to the taxing authority to an earlier period. Also included in the liability balance is $133 of tax positions that the deductibility is not highly certain and are not impacted by timing. The impact on the effective tax rate for this is negligible. We do not expect a material change to these amounts within the next twelve months.
It is anticipated that there will be additional assessments from time to time relating to various insolvencies. By statute, no insurer may be assessed in any year an amount greater than two percent of that insurer's direct written premiums for the calendar year preceding the assessment. MIIF assessed Commerce and Citation $1,231 and $128 for the years ended December 31, 2006 and 2005, respectively. Commerce and Citation received a net refund of $41 during 2007.
On June 9, 2006, we entered into a series of agreements with participating reinsurers that provide catastrophe reinsurance for our insurance subsidiaries' other-than-automobile property lines of business for the contract year effective July 1, 2006 through June 30, 2007 (the "Catastrophe Reinsurance Program"). This Catastrophe Reinsurance Program replaced our terminated 75% quota share program, which had covered our other-than-automobile property and liability lines of business, except for umbrella and our expiring one-year catastrophe treaty, which covered six percent of our exposure to Massachusetts FAIR Plan losses in excess of $100 million up to total Massachusetts FAIR Plan losses of $1 billion.
We will have no additional reinsurance recoveries for a single event catastrophe in excess of a total loss of $550 million, including FAIR Plan-type losses. Our average estimated combined total loss for the Commerce, Citation and ACIC insurance subsidiaries, on other-than-automobile business, was calculated using two prominent catastrophe modeling companies. The average estimated "100 year loss" is $437 million and the "250 year loss" is $792 million.
The Catastrophe Reinsurance Program will not discharge us from our primary liability to the insured for the full amount of the insured's policies, but it will make the reinsurer liable to us to the extent of the reinsured portion of any loss ultimately suffered. Each reinsurer participating in the reinsurance program will be severally (and not jointly) liable to us for its share of reinsurance coverage. We believe the reinsurers are adequately capitalized and financially able to meet their obligations under the reinsurance agreements with us, though there can be no assurance that they will be able to do so. Premiums related to the catastrophe program amounted to $29,365 for 2007.
Prior to the Catastrophe Reinsurance Program, we used a series of one-year quota share agreements. This program covered all non-automobile property and liability business, except umbrella policies. We utilized a 75% agreement for the period July 1, 2005 to June 30, 2006; and a 70% agreement for the period July 1, 2004 to June 30, 2005. Quota share reinsurance refers to a form of pro rata reinsurance arrangement where the reinsurer participates in a specified percentage of the premiums and losses on every risk within the scope of the reinsurance agreement.
Prior to 2006, Commerce and American Commerce were assuming and ceding members of ANI. Beginning in 2006, American Commerce also became a direct writing member. The total pre-tax earnings impact of all of our participation in ANI for 2007 and 2006 was approximately $1,390 and $1,499, respectively. Our maximum exposure in 2007 in the event of a catastrophic loss at an insured nuclear facility was $12,000 for domestic risks and $11,000 for foreign risks. For 2008, these exposure amounts increased to $15,000 and $15,000, respectively.
Effective January 1, 2007, we entered into a quota share agreement with an insurance company that is a wholly-owned subsidiary of AAA SNE. The underwriting results of our five insurance subsidiaries coupled with our corporate expenses that are integral to our insurance operations are ceded to AAA SNE at a quota share rate of 1.5%. The underwriting results ceded to AAA SNE include the underwriting results of all external reinsurance assumed from or ceded to us. Effective January 1, 2008, the quota share rate increased to 2.25%.
Since its inception, CAR has annually generated multi-million dollar underwriting losses, primarily in the personal automobile pool. We are required to share in the underwriting results of CAR business for our respective product lines. Under current regulations, our share of the CAR personal results is based upon our market share of automobile risks for the particular pool, adjusted by a "utilization" concept, such that, in general, we are disproportionately and adversely affected if our relative use of CAR reinsurance exceeds that of the industry, and favorably affected if our relative use of CAR reinsurance is less than that of the industry. For personal automobile writers, companies can reduce their participation ratio by writing credit eligible business voluntarily. Companies are provided credits against their participation ratio for writing those classes and territories of business that are purposefully under-priced in the Massachusetts rate setting process. Companies are also penalized for ceding certain business to CAR. Our strategy has been to maintain above average voluntary retention levels, as well as to retain private passenger automobile business voluntarily that receives credits. This favorably affects our participation ratio compared to our market share, but adversely impacts our voluntary loss ratio. Through 2005, the CAR utilization-based participation ratio calculation had remained the same for the personal automobile market. In 2005 and 2006, CAR switched to using a credit matrix approach. During 2007, 2006 and 2005, our net participation in the CAR personal automobile pool approximated 25.7%, 27.0% and 26.2%, respectively, as estimated by us for 2007 and as reported by CAR for 2006 and 2005. This is as compared to our estimated market share in those years of 31.6%, 31.2% and 29.9%, respectively. During 2007, 2006 and 2005, the amount of personal automobile exposures we reinsured through CAR approximated 3.5%, 4.6%, and 4.7%, respectively, as compared to industry averages of 4.4%, 5.1% and 5.1%, respectively.
Beginning April 1, 2008, the Commissioner will begin the implementation of the Massachusetts Automobile Insurance Plan (MAIP) to provide private passenger automobile insurance for those individuals unable to obtain insurance voluntarily. The MAIP will ultimately replace CAR for private passenger automobiles. The MAIP will assign individuals directly to an insurance company, as opposed to CAR, which is a reinsurance mechanism for under-priced risks.
Reinsurance activity with CAR for fiscal years 2007, 2006 and 2005 follows:
We pay to CAR all of the premiums generated by the policies we have ceded and CAR reimburses us for all losses incurred on ceded policies. In addition, we receive a fee for servicing ceded policies based on the expense structure established by CAR. For the years ended December 31, 2007, 2006 and 2005, these servicing fees amounted to $22,836, $23,302 and $24,102, respectively.
ESOP participants who are former employees of the Company may generally elect to withdraw from the ESOP the total amount of shares allocated to their accounts at any time. Approximately 1,094,588 shares held by the ESOP at December 31, 2007 are allocated to the ESOP accounts of these individuals.
The remaining approximately 191,915 shares held by the ESOP at December 31, 2007 are allocated to the ESOP accounts of participants who have not yet reached 100% vesting in their account balances. The fair value of the ESOP shares held by participants that are less than 100% vested at December 31, 2007 was approximately $6,905. Beginning in 2007, participants with three years of service could diversify out of our stock and into any of the investment options under the Plan's 401(k) component. We pay for administration of the ESOP.
Our 401(k) Plan is merged into the ESOP. The ESOP is administered by Fidelity Investments. The 401(k) component of the ESOP enables eligible employees to contribute up to 60% of eligible compensation on a pre-tax basis up to the annual maximum limits under federal tax law. We incur no expenses in the form of matching contributions but we pay for administration of the plan.
Direct premiums written and earned for the years ended 2007, 2006 and 2005 follow:
We have made loans to insurance agencies with which Commerce transacts business on a regular basis. At December 31, 2007, two loans with an aggregate outstanding principal balance of $213 were collateralized by the assets of the agencies. At December 31, 2006, five loans with an aggregate outstanding principal balance of $755 were collateralized by the assets of the agencies. At December 31, 2005, five loans with an aggregate outstanding balance of $1,812 were collateralized by the assets of the agencies. There were no loans to insurance agencies collateralized solely by real estate in 2007, 2006 and 2005.
In AAA Arizona, Inc. v. American Commerce Insurance Company (United States District Court for the District of Arizona), originally filed on May 16, 2005, AAA Arizona alleges, among other claims, that American Commerce has violated its contract with AAA Arizona by failing to pay profit sharing amounts that AAA Arizona claims to have earned during 2004. AAA Arizona also alleges that American Commerce is interfering with AAA Arizona's relationship with its members. AAA Arizona seeks an order from the court and an award of actual and consequential damages.
The Company is unable to predict with certainty the outcome of the CSAA proceeding; however, based upon the information available to the Company as of the date of this report, the Company does not believe that potential consequences of CSAA's claims, if proven, would have a material adverse effect on the Company's business, financial condition, liquidity or results of operations.
Member companies of CAR have joint and several liabilities for the obligations of CAR, the Massachusetts-mandated personal automobile reinsurance mechanism that enables us and other participating insurers to reinsure in CAR any risk. If one member of CAR fails to pay its assessments, the remaining members of CAR will be required to pay the pro-rata share of the member who fails to pay its obligations. As of December 31, 2007, we were not aware of any CAR member company which has failed to meet its obligations.
The insurance subsidiaries, Commerce, Citation, Commerce West, American Commerce and State-Wide, prepare statutory financial statements in accordance with accounting practices prescribed or permitted by the National Association of Insurance Commissioners and the Division of Insurance of The Commonwealth of Massachusetts, State of California, the State of Ohio and the State of New York. Statutory accounting principles differ in some respects from GAAP.
Our consolidated net income on a statutory basis for the years ended December 31, 2007, 2006 and 2005 was $232,986, $232,726 and $238,122, respectively. For 2007, statutory net income includes all twelve months of the year for State-Wide, while GAAP only includes the period subsequent to acquisition. Our statutory policyholders' surplus as reported to various state insurance departments at December 31, 2007 and 2006 was $1,527,764 and $1,536,042, respectively.
On October 30, 2007, we entered into an Agreement and Plan of Merger (the MAPFRE Merger Agreement) with MAPFRE S.A., a company organized under the laws of Spain (MAPFRE), and Magellan Acquisition Corp., a Massachusetts corporation and an indirect wholly-owned subsidiary of MAPFRE (Subsidiary). The MAPFRE Merger Agreement provides for a merger whereby Subsidiary will be merged with and into the Company, with the Company continuing as the surviving corporation and becoming an indirect wholly-owned subsidiary of MAPFRE. Pursuant to the MAPFRE Merger Agreement, each then issued and outstanding share of our common stock will be cancelled and converted into the right to receive $36.70 in cash, without interest. In addition, as permitted by the MAPFRE Merger Agreement, the Director of the Company may declare and pay regular quarterly cash dividends of $0.30 per share per quarter until the completion of the merger.
The foregoing description of the MAPFRE Merger Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the MAPFRE Merger Agreement, which has been filed with the Securities and Exchange Commission.
The terms of certain of our agreements, including various contracts and employee benefit arrangements, have provisions which could result in changes to the terms or settlement amounts of these agreements upon a change in control such as would occur upon completion of the proposed MAPFRE merger. The effects included, but are not limited to, the acceleration of the RSU vesting and related expense; the change of control provisions of IAs, which will result in a higher expense; the cash bonus payment to employees discussed in Note M; the expiration of unvested ACIC agent options; and a payment due to our investment banker contingent upon closing of the merger. The net impact of these items is estimated to be additional expense of approximately $14,000 during 2008.