We lease office space for our headquarters facilities, which are located in Woodland Hills, California. The lease term expires in February 2015 and the lease may be renewed for two consecutive five-year periods. We also lease office space in other locations, 12 of which are in California primarily for claims-related activities and for Vehicle Inspection Centers. We anticipate no difficulty in extending these leases or obtaining comparable office facilities in suitable locations and consider our facilities to be adequate for our current needs.
Our long-term financial goals include achieving a 96% or lower combined ratio, 15% annual growth in premiums written, 15% return on stockholders’ equity, and strong financial ratings. Please refer to Item 1. Business for additional information on the Company’s long-term financial goals and a discussion of insurance terminology used throughout this document.
For 2005, our net premiums earned grew 3.0% ($39.2 million) to $1,352.9 million from $1,313.7 million in 2004. California direct premiums written decreased by 2.2% to $1,262.3 million in 2005, compared to $1,290.9 million for the same period in 2004, as a result of the high level of competitor marketing activity in the state. Direct premiums written outside of California increased by 81.6% to $84.1 million in 2005, compared to $46.3 million for the same period in 2004. We plan on expanding into six additional states in 2006 to further our geographic expansion strategy.
Amount shown for 2002 would be $343,661 were it not for the sale-leaseback transaction described in Note 9 of the Notes to Consolidated Financial Statements.
Amount shown for 2002 would be 2.8:1 were it not for the sale-leaseback transaction referred to above.
The remainder of our Management’s Discussion and Analysis provides a narrative on the Company’s financial condition and performance that should be read in conjunction with the accompanying consolidated financial statements. It includes the following sections:
Stockholders’ equity and book value per share increased to $830.0 million and $9.66, respectively, at December 31, 2005, compared to $774.4 million and $9.06 at December 31, 2004. The increase for the year ended December 31, 2005, was primarily due to net income of $87.4 million and $4.7 million of proceeds from exercised stock options, offset by a decrease in accumulated other comprehensive income of $23.1 million (resulting primarily from increases in treasury yields) and dividends to stockholders of $13.7 million.
Increased advertising, sales and customer service costs through December 31, 2005, contributed to an increase in deferred policy acquisitions costs (“DPAC”) of $1.1 million to $59.9 million, compared to $58.8 million at December 31, 2004. The Company’s DPAC is estimated to be fully recoverable (see Critical Accounting Estimates - Deferred Policy Acquisition Costs).
The following table summarizes unpaid losses and loss adjustment expenses (“LAE”), gross and net of applicable reinsurance, with respect to our lines of business:
Unearned premiums decreased 3.4% to $319.7 million at the end of 2005 compared to $331.0 million at the end of 2004 primarily due to a 2.9% decrease in premiums written in the fourth quarter of 2005 as compared to the same period in 2004.
Effective December 4, 2003, we changed our state of incorporation from California to Delaware. In connection with the change, our common stock was assigned a par value of $0.001 per share, resulting in a reclassification of $419.9 million from common stock to additional paid-in capital. There was no change in the location of company operations, location of employees, or the way we do business as a result of the reincorporation.
21st Century Insurance Group. Our holding company’s main sources of liquidity historically have been dividends received from our insurance subsidiaries and proceeds from issuance of debt or equity securities. Apart from the exercise of stock options and restricted stock grants to employees, the effects of which have not been significant, we have not issued any equity securities since 1998 when AIG exercised its warrants to purchase common stock for cash of $145.6 million. Our insurance subsidiaries have not paid any dividends to our holding company since 2001 due to the previous uncertainty surrounding the taxability of dividends received by holding companies from their insurance subsidiaries in California. See further discussion in Note 5 of the Notes to Consolidated Financial Statements.
In December 2003, we completed a private offering of $100 million principal amount of 5.9 percent Senior Notes due in December 2013. The effective interest rate on the Senior Notes, when all offering costs are taken into account and amortized over the term of the Senior Notes, is approximately 6 percent per annum. Of the $99.2 million net proceeds from the offering, $85.0 million was used to increase the statutory surplus of our wholly-owned insurance subsidiary, 21st Century Insurance Company, and the balance was retained by our holding company. On July 8, 2004, the Company completed an exchange offer in which all of the private offering notes were exchanged for publicly registered notes having the same terms.
Our holding company’s significant cash obligations over the next several years, exclusive of any dividends to stockholders that our directors may declare, consist of interest payments on the Senior Notes (approximately $5.9 million annually), ongoing costs to enhance our computer software, and the repayment of the $100 million principal on the Senior Notes due in 2013.
In California, where approximately 94% of our premium is written, underwriting profit improved in 2005 without additional rate increases. Effective October 23, 2005, we implemented a class plan revision for our California business. This is a rate neutral change overall, but is intended to improve the accuracy of our pricing.
As of December 31, 2005, our insurance subsidiaries had a combined statutory surplus of $704.7 million compared to $614.9 million at December 31, 2004. The increase in statutory surplus was primarily due to statutory net income of $113.5 million offset by a decrease in net deferred tax assets of $17.2 million, an increase in nonadmitted assets of $5.4 million, and an increase in net unrealized equity investment losses of $1.6 million. The ratio of net premiums written to statutory surplus was 1.9 at December 31, 2005, compared to 2.2 at December 31, 2004.
Reinsurance agreements - The Company’s catastrophe reinsurance agreement for its personal auto lines is provided by three participating entities, two of which are AIG subsidiaries. Together they reinsure any covered event up to $45.0 million in excess of $20.0 million effective January 1, 2004 (up to $30.0 million in excess of $15.0 million in 2003). This coverage was renewed effective January 1, 2005 and 2006 (see Note 10 of the Notes to Consolidated Financial Statements). Total premiums ceded to AIG subsidiaries were $1.0 million, $1.1 million, and $1.2 million for the years ended December 31, 2005, 2004, and 2003, respectively. Total reinsurance recoverables, net of payables, from AIG subsidiaries were $0.6 million and $1.5 million as of December 31, 2005 and 2004, respectively.
The following table summarizes our significant contractual obligations and commitments at December 31, 2005 and the future periods in which such obligations are expected to be settled in cash. In addition, the table reflects the timing of principal and interest payments on outstanding senior notes.
The table above excludes periodic contributions to pension plans, which are discussed below. The capital lease obligations above resulted from the sale-leaseback transaction discussed earlier and an auto capital lease transaction (see further discussion of these items in Notes 9 and 12 of the Notes to Consolidated Financial Statements). We have no material purchase obligations or other on or off balance sheet long-term liabilities or obligations at December 31, 2005 (see discussion about variable interest entities in Note 19 of the Notes to Consolidated Financial Statements).
Our largest insurance subsidiary is responsible for making payments on both the capital lease obligations and most of the operating lease obligations.
We sponsor defined benefit pension plans that may obligate us to make contributions to the plans from time to time. Total contributions to the plans were $9.0 million, $2.7 million and $7.0 million in 2005, 2004, and 2003, respectively. For the past several years we have followed the practice of contributing sufficient amounts to the qualified defined benefit pension plan to meet or exceed statutory funding requirements, without exceeding the maximum amount that would be deductible for corporate income tax purposes, and while maintaining plan assets at a level at least equal to the actuarial present value of accumulated plan benefits. The amount and timing of future contributions to our qualified defined benefit pension plan depends on a number of unpredictable factors including statutory funding requirements, the market performance of the plan’s assets, cash requirements for benefit payments to retirees, and future changes in interest rates that affect the actuarial measurement of the plan’s obligations. Contributions to our non-qualified defined benefit pension plan generally are limited to amounts needed to make benefit payments to retirees, which are expected to total approximately $0.9 million in 2006.
The Board of our Company has made a commitment to invest a portion of policyholder surplus in economically disadvantaged communities. In connection with this commitment, the Company has guaranteed 11.1%, or $19.2 million, of a warehouse financing agreement. The Company has also committed $2.8 million for other community investment purposes. These commitments, which do not significantly impact the Company’s liquidity or capital, are further discussed in Note 19 of the Notes to Consolidated Financial Statements.
The results include net realized capital losses of $3.3 million compared to net realized capital gains of $10.8 million and $13.2 million for the same period in 2004 and 2003, respectively. The results for 2004 include a $4.9 million increase in income in the third quarter associated with the resolution of California legislation (AB 263) related to holding company taxes on dividends from insurance subsidiaries. The results for 2003 include after-tax charges of $24.1 million in the first quarter to strengthen earthquake reserves and an increase in after-tax net income of $9.6 million in the second quarter, resulting from nonrecurring, nonoperational items and a favorable tax settlement with the IRS.
We remain focused on achieving our long-term goals of a combined ratio of 96% or lower and 15% growth in direct premiums written. Direct premiums written increased 0.7% in 2005, 9.3% in 2004 and 22.8% in 2003, for a three-year compound average growth rate of 10.9%; less than our long-term goal of 15%. Market conditions in California were somewhat less favorable for growth in 2005 than in the preceding two years. In 2005 and 2004, we met our profitability goals, posting our best combined ratios since 1999 and our direct premiums written grew 9.3% despite an increasingly competitive California marketing climate. As we proceed with our multi-state expansion, we believe that achieving our long-term growth goal will steadily depend less on the California marketplace.
Net premiums earned increased 3.0% in 2005, compared to a 12.0% increase in 2004 and 26.8% in 2003. These earned premium increases are consistent with the direct premium written increases during the same years of 0.7%, 9.3% and 22.8%, respectively. The Company has undertaken several geographic expansion efforts to increase its opportunities for growth.
Net losses and LAE incurred increased 0.6% in 2005, 7.5% in 2004 and 20.0% in 2003. The loss and LAE ratios were 73.7%, 75.4%, and 78.6% for the years ended December 31, 2005, 2004 and 2003, respectively. The effects on the net loss and LAE ratios of changes in estimates relating to insured events of prior years were as follows: 2.0% favorable in 2005, 0.2% favorable in 2004; 1.0% unfavorable in 2003; and 1.8% unfavorable in 2002. For additional discussion of these estimates, please see Item 1 of this report under the heading Unpaid Losses and Loss Adjustment Expenses. In general, changes in estimates are recorded in the period in which new information becomes available indicating that a change is warranted, usually in conjunction with our quarterly actuarial review.
The following table summarizes personal auto lines losses and LAE incurred, net of applicable reinsurance, for the periods indicated:
The underwriting expense ratios to net premiums earned were 21.0%, 19.7%, and 17.9% for the years ended December 31, 2005, 2004 and 2003, respectively. The 2005 increase was primarily due to our investments in the geographic expansion strategy, costs associated with the conversion to our new technology platform, and facility and support costs. The increase in 2004 consists primarily of increased advertising costs, additional sales workforce costs, and facility and support costs to improve service and support the Texas service center. The increase in 2003 was primarily due to growth in advertising expenditures and costs associated with increasing the number of new sales agents to handle record volume of new business during 2003. Several productivity enhancement initiatives are underway aimed at reducing per unit processing costs.
Homeowner and Earthquake Lines in Runoff Results. We have not written any earthquake policies since 1994 and we ceased underwriting the homeowners coverage at the beginning of 2002. The homeowner and earthquake lines, which are in runoff, experienced adverse development of $2.3 million in 2005 on the remaining loss and LAE reserves, compared to adverse development of $2.8 million in 2004 and $40.1 million in 2003. Of these amounts, $0.4 million, $2.2 million, and $37.0 million, respectively, related to SB 1899 earthquake claims (see Note 16 of the Notes to Consolidated Financial Statements).
At December 31, 2005, $313.0 million, or 23.1%, of our total fixed maturity investments at fair value were invested in tax-exempt bonds, compared to 22.3% at December 31, 2004, with the remainder, representing 76.9% of the portfolio, invested in taxable securities, compared to 77.7% at December 31, 2004.
Other Income. Other income of $0.4 million in 2005 relates to interest income for refund claims with the taxing authorities. No other income was reported in 2004. Other income of $14.8 million in the year ended December 31, 2003, included $9.3 million resulting from a nonrecurring, nonoperational item from the settlement of litigation, interest income of $4.8 million relating to a favorable settlement with the Internal Revenue Service (“IRS”), and miscellaneous items of $0.7 million.
Pension Cost. The Company has both funded and unfunded non-contributory defined benefit pension plans, which together cover essentially all employees who have completed at least one year of service. For certain key employees designated by the Board of Directors, the Company sponsors an unfunded non-qualified supplemental executive retirement plan. Expense recognition under the pension accounting rules is based upon the attribution of plan benefits over the expected life of the Company's workforce. Pension plan costs remained relatively constant at $8.9 million and $9.0 million for the years ended 2005 and 2004, respectively. The weighted average discount rate assumption used to determine the net cost decreased to 6.0% from 6.1% for the years ended 2005 and 2004, respectively.
Based on current assumptions, the Company does not expect to be required to contribute to its qualified pension plan in 2006, but it may make additional contributions into its pension plans in fiscal 2006 and subsequent years depending on how the funded status of those plans change and also depending on the outcome of proposed changes to the funding regulations currently being considered by the United States Congress. Our nonqualified pension plan has an unfunded accumulated benefit obligation of $16.5 million. In this situation, the accounting rules require that we record an additional minimum pension liability. The additional minimum pension liability adjustment was $4.2 million and $3.3 million as of December 31, 2005 and 2004, respectively. The increase in the additional minimum pension liability in fiscal 2005 was primarily due to the decrease in the discount rate from 6.0% at December 31, 2004, to 5.7% at December 31, 2005. The accounting rules do not require that changes in the additional minimum pension liability adjustment be recorded in current period earnings, but rather they are recorded directly to equity through accumulated other comprehensive income. See Note 11 to the Consolidated Financial Statements for further discussion.
Our consolidated financial statements are prepared in accordance with GAAP. The financial information contained within these statements is, to a significant extent, financial information that is based on estimates and assumptions. Our significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements and are essential to understanding Management’s Discussion and Analysis of Financial Condition and Results of Operations. Some of our accounting policies require significant judgment to estimate values of either assets or liabilities. In addition, significant judgment may be needed to apply what often are complex accounting principles to individual transactions to determine the most appropriate treatment. We have established procedures and processes to facilitate making the judgments necessary to prepare the consolidated financial statements.
The following is a summary of the more judgmental and complex accounting estimates and principles. In each area, we have discussed the assumptions most important in the estimation process. We have used the best information available to estimate the related items involved. Actual performance that differs from our estimates and future changes in the key assumptions could change future valuations and materially impact our financial condition and results of operations.
Losses and Loss Adjustment Expenses. The estimated liabilities for losses and LAE include estimates of losses for known claims reported on or prior to the balance sheet dates, estimates of losses for claims incurred but not reported, estimates of expenses for investigating, adjusting and settling all incurred claims. Amounts reported are estimates of the ultimate costs of settlement, net of estimated salvage and subrogation. The estimated liabilities are necessarily subject to the outcome of future events, such as changes in medical and repair costs, as well as economic and social conditions that impact the settlement of claims. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of the claim, the more variable the ultimate settlement amount can be.
The methods used to determine such estimates and to establish the resulting reserves are continually reviewed and updated. Any resulting adjustments are reflected in current operating income on a dollar-for-dollar basis. For example, an upward revision of $1 million in the estimated recorded liability for unpaid losses and LAE would decrease underwriting profit, and pre-tax income, by the same $1 million amount. Conversely, a downward revision of $1 million would increase pre-tax income by the same $1 million amount.
Meetings are held with appropriate departments to discuss significant issues as a result of the review. This process culminates in a reserve meeting to review the unpaid losses and LAE. The basis for carried unpaid losses and LAE is the overall actuarial point estimate. Other relevant internal and external factors considered include a qualitative assessment of inflation and other economic conditions, changes in the legal, regulatory, judicial and social environments, underlying policy pricing, exposure and policy forms, claims handling, and geographic distribution shifts. As a result of the meeting, unpaid losses and LAE are finalized and we record quarterly changes in unpaid losses and LAE for each of our coverages. The change in unpaid losses and LAE for the quarter for each coverage is the difference between net ultimate losses and LAE and the net paid losses and LAE recorded through the end of the quarter. The overall change in our unpaid losses and LAE is based on the sum of these coverage level changes.
There is a potential for significant variation in ultimate development of unpaid losses and LAE. Most automobile claims are reported within two to three months whereas the estimate of ultimate severities exhibits greater variability at the same maturity. Generally, actual historical loss development factors are used to project future loss development, and there can be no assurance that future loss development patterns will be the same as in the past. However, we believe that our reserving methodologies are in line with other personal lines insurers and would normally expect ultimate unpaid losses and LAE development to vary approximately 5% from the carried unpaid losses and LAE.
Property and Equipment. Accounting standards require a write-off to be recognized when an asset is vacated or an asset group’s carrying value exceeds its fair value. For purposes of recognition and measurement of an impairment loss, long-lived assets are grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. Accounting standards require asset groups to be tested for possible impairment under certain conditions. There have been no events or circumstances in 2005 that would require a reassessment of the asset group for impairment.
We are required to reduce DTAs (but not DTLs) by a valuation allowance to the extent that, based on the weight of available evidence, it is “more likely than not” (i.e., a likelihood of more than 50%) that any DTAs will not be realized. Recognition of a valuation allowance would decrease reported earnings on a dollar-for-dollar basis in the year in which any such recognition were to occur. The determination of whether a valuation allowance is appropriate requires the exercise of management judgment. In making this judgment, management is required to weigh the positive and negative evidence as to the likelihood that the DTAs will be realized.
The Company’s net deferred tax assets include a net operating loss (“NOL”) carryforward for regular federal corporate tax purposes of approximately $95.9 million, representing an unrealized tax benefit of $33.6 million at December 31, 2005, compared to $75.8 million, $105.3 million and $128.6 million as of the end of the three preceding years. The steady decline in the unrealized tax benefit of the NOL since 2002 resulted from the generation of taxable underwriting and investment income in the intervening years. At the current rate of utilization, the Company’s remaining NOL excluding 21st of Southwest should be fully utilized by the end of 2007, but in any event long before its statutory expiration.
Portions of our NOL carryforward are scheduled to expire beginning in 2017, as shown in the table below (amounts in thousands):
Investments. Investment securities generally must be classified as held-to-maturity, available-for-sale or trading. The appropriate classification is based partially on our ability to hold the securities to maturity and largely on management’s intentions at inception with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on trading securities flow directly through earnings during the periods in which they arise, whereas for available-for-sale securities they are recorded as a separate component of stockholders’ equity (accumulated other comprehensive income or loss) and do not affect earnings until realized. The fair values of our investment securities are generally determined by reference to quoted market prices and reliable independent sources. The cost of investment securities sold is determined by the specific identification method.
We are obligated to assess, at each reporting date, whether there is an “other-than-temporary” impairment to our investment securities. In general, a security is considered a candidate for impairment if it meets any of the following criteria:
In the opinion of the Company’s management, it is possible that the Company may not realize a full recovery on its investment, irrespective of the occurrence of one of the foregoing events.
The determination of whether a decline in market value is “other-than-temporary” is necessarily a matter of subjective judgment. No such charges were recorded in 2005, 2004 or 2003. The timing and amount of realized losses and gains reported in income could vary if conclusions other than those made by management were to determine whether an other-than-temporary impairment exists. However, there would be no impact on equity because any unrealized losses are already included in accumulated other comprehensive income (loss).
Impact Community Capital, LLC is a limited partnership that was voluntarily established by a group of California insurers to make loans and other investments that provide housing and other services to economically disadvantaged communities.
The total net unrealized gain (loss) for these securities as of December 31, 2005 and 2004 was $27 thousand and $0 thousand, respectively. This represented less than 0.1% of total investments unrealized losses.
The following table summarizes investments held by us, having an unrealized loss of $0.1 million or more, and aggregate information relating to all other investments in unrealized loss positions:
We have completed integrated audits of 21st Century Insurance Group’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
The common stock of the Company is traded on the New York Stock Exchange under the trading symbol “TW.” Through several of its subsidiaries, American International Group, Inc. (“AIG”) currently owns approximately 62% of the Company’s outstanding common stock.
On October 16, 2003, the Board of Directors voted to change 21st Century Insurance Group’s state of incorporation from California to Delaware. There was no change in the location of Company operations, location of team members, or the way the Company does business. Shareholders holding a majority of the voting power approved the reincorporation by written consent on October 17, 2003. The reincorporation became effective December 4, 2003.
21st Century Insurance Company of the Southwest (“21st of SW”), formerly 21st Century Insurance Company of Arizona, adopted its current name on September 30, 2004, and re-domesticated from Arizona to Texas on December 31, 2004. 21st of SW was a joint venture between the Company and AIG from 1995 to 2001.
The occurrence of a discrete credit event resulting in (i) the issuer defaulting on a material outstanding obligation; or (ii) the issuer seeking protection from creditors under the bankruptcy laws or any similar laws intended for the court supervised reorganization of insolvent enterprises; or (iii) the issuer proposing a voluntary reorganization pursuant to which creditors are asked to exchange their claims for cash or securities having a fair value substantially lower than par value of their claims; or
No such charges were recorded in 2005, 2004 or 2003. The timing and amount of realized losses and gains reported in income could vary if conclusions other than those made by management were used to determine whether an other-than-temporary impairment exists. However, there would be no impact on equity because any unrealized losses are already included in accumulated other comprehensive income (loss).
Property and equipment is recorded at cost and depreciated on a straight-line basis. We capitalize certain consulting costs, payroll and payroll-related costs for employees related to computer software developed for internal use.
On an annual basis, we test this intangible asset based on the estimated fair value of the operating cash flows associated with the long-lived asset. However, we will test for impairment on a more frequent basis in cases where events and changes in circumstances would indicate that we might not recover the carrying value of the intangible asset. Our measurement of fair value is based on a discounted cash flow methodology that converts expected cash flows of our homeowner’s agency segment to present value. If the fair value is greater than the carrying value of the intangible asset, then the intangible asset is not considered impaired. The impairment test as of December 31, 2005, indicated that the asset was not impaired.
A necessarily more subjective process is used to estimate earthquake losses arising out of California Senate Bill 1899 because most of the remaining earthquake claims are in litigation. See Note 16 of the Notes to Consolidated Financial Statements for a discussion of the factors considered by management in establishing those liabilities.
In November 2005, the Company vacated approximately 2% of rentable space at its headquarters in Woodland Hills, California and plans to sublease this space. A loss on this vacated space has been recognized in accordance with SFAS No. totaling $0.4 million, as future rental costs are higher than potential market rentals.
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years the differences are expected to be recovered or settled. The Company reviews its deferred tax assets for recoverability on a quarterly basis.
SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, amends the disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation, to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. As permitted by SFAS No. 148, the Company accounts for its fixed stock options using the intrinsic-value method, prescribed in Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, which generally does not result in compensation expense recognition for stock options. Under the intrinsic-value method, compensation cost for stock options is measured at the date of grant as the excess, if any, of the quoted market price of the Company’s stock over the exercise price of the options.
For each of the three years ended December 31, 2005, 2004, and 2003, the numerator for the calculation of both basic and diluted EPS is equal to net income reported for that year. The difference between basic and diluted EPS denominators is due to dilutive common stock equivalents (stock options and restricted stock). Basic earnings per share excludes dilution and reflects net income divided by the weighted average shares of common stock outstanding during the periods presented. The denominator for the computation of basic EPS was 85,661,547 shares, 85,466,127 shares, and 85,432,838 shares for 2005, 2004 and 2003, respectively.
Diluted earnings per share is based upon the weighted average shares of common stock and dilutive common stock equivalents outstanding during the periods presented. Common stock equivalents arising from dilutive stock options and restricted common stock are computed using the treasury stock method; for the years ended December 31, 2005, 2004 and 2003, this amounted to 86,017,994 shares, 85,602,567 shares and 85,637,672 shares, respectively, which include 356,447, 136,440 and 204,834 dilutive common stock, respectively.
Options to purchase an aggregate of 5,600,376 shares, 6,156,772 shares, and 5,121,446 shares of common stock were considered anti-dilutive during 2005, 2004 and 2003, respectively, and were not included in the computation of diluted EPS because the options’ exercise prices were greater than the average market price of the common stock for each respective period. These options expire at various points in time through June 2015 (see Note 14 of the Notes to Consolidated Financial Statements).
A summary of changes in unrealized investment gains (losses) less applicable income taxes for fixed maturities and equity securities, is as follows:
The Company has no non-interest bearing fixed maturity investments, investments accounted for on a non-accrual basis or any individual securities in excess of 10% of stockholders’ equity. Fixed maturities available-for-sale, at December 31, 2005, are summarized by contractual maturity year as follows:
In the third quarter of 2004, California enacted AB 263, which allowed the Company to file certain amended California tax returns and claim a dividends-received deduction. As a result, the Company re-estimated its liability and reduced its tax provision by approximately $4.9 million in the third quarter of 2004, which reduced the effective tax rate for 2004.
Income tax payments for the year ended December 31, 2005, and December 31, 2004, totaled $26.5 million and $16.4 million, respectively. No income tax payments were required for the year ended December 31, 2003. During 2004, we received $12.5 million from the Internal Revenue Service (“IRS”) to settle the majority of the prior year receivable. As of December 31, 2005, the Company’s net federal income tax payable was $2.4 million.
The Company’s net deferred tax assets include a net operating loss (“NOL”) carryforward for regular federal corporate tax purposes of approximately $95.9 million, representing an unrealized tax benefit of $33.6 million at December 31, 2005, compared to $75.8 million as of December 31, 2004. The steady decline in the unrealized tax benefit of the NOL since 2002 resulted from the generation in the intervening years of taxable underwriting and investment income. At the current rate of utilization, the Company’s remaining NOL excluding 21st of SW should be fully utilized by the end of 2007, but in any event long before its statutory expiration.
Total advertising costs included in acquisition costs deferred during 2005, 2004 and 2003 were $70.1 million, $66.7 million, and $53.9 million, respectively.
Accounting principles require insurers to record estimates for loss and LAE in the periods in which the insured events, such as automobile accidents, occur. This estimation process requires the Company to estimate both the number of accidents that have occurred and the ultimate amount of loss and LAE related to each accident. The Company employs actuaries who are professionally trained and certified in the process of establishing estimates for frequency and severity.
As a result of this process, unpaid losses and LAE are finalized and changes are recorded for each of our coverages. The unpaid losses and LAE for each coverage is the difference between the estimated and net ultimate losses and LAE and the net paid losses and LAE recorded through the end of the period. The overall change in our unpaid losses and LAE is based on the sum of these coverage level changes.
The Senior Notes are redeemable at the Company’s option, at any time in whole, or from time to time in part, prior to maturity at a redemption price equal to the greater of (A) 100% of the principal amount of the notes or (B) the sum of the present values of the remaining scheduled payments of principal and interest thereon (exclusive of interest accrued through the date of redemption) discounted to the redemption date on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months) at the Treasury Rate, plus 25 basis points (plus in each case, accrued interest thereon to the date of redemption).
Effective January 1, 2004, the 90% quota share reinsurance treaty covering the Company’s Personal Umbrella Policies (“PUP”) was amended so that the reinsurers were as follows: Swiss RE Underwriters - 55%, Hannover Ruckversicherungs - 35%. The treaty was renewed January 1, 2005 and 2006, with the same reinsurers and related participation rates.
The accumulated benefit obligation for all defined benefit pension plans was $113.7 million and $95.3 million at December 31, 2005 and 2004, respectively, of which 90.3% and 90.7%, respectively, were vested.
The increase (decrease) in minimum liability included in accumulated other comprehensive income, net of deferred income taxes, for the years ended December 31, 2005 and 2004 was $0.2 million and $(0.5) million, respectively.
The overall expected long-term rate of return on assets is a weighted-average expectation for the return on plan assets. The Company considers historical performance and current benchmarks to arrive at expected long-term rates of return in each asset category. The Company assumed that 75% of its portfolio would be invested in equity securities, with the remainder invested in debt securities.
The Company’s pension plan weighted-average asset allocations for 2005 and 2004, and target allocation for 2006, by asset category are as follows:
The Company’s pension plan assets are managed by outside investment managers. The Company’s investment strategy is to maximize return on investments while minimizing risk. The Company believes the best way to accomplish this goal is to take a conservative approach to its investment strategy by investing in high-grade equity and debt securities.
The Company sponsors a contributory savings and security plan for eligible employees and officers. The Company provides matching contributions equal to 75% of the lesser of 6% of an employee’s compensation or the amount contributed by the employee up to the maximum allowable under IRS regulations. Company matching contributions charged against operations were $5.0 million, $4.9 million, and $4.4 million in 2005, 2004 and 2003, respectively. The plan offers a variety of investment types among which employees exercise complete discretion as to choice and investment duration.
The Company leases office space in Woodland Hills, California. The lease for the Company’s corporate office expires in February 2015 and may be renewed for two consecutive five-year periods.
The Company also leases automobiles, office and telecom equipment as well as office space in several other locations, primarily for claims services. The Company also has software license agreements with terms greater than one year. Minimum amounts due under the Company’s noncancelable commitments at December 31, 2005 are as follows:
Poss v. 21st Century Insurance Company was filed on June 13, 2003, in Los Angeles Superior Court. The complaint sought injunctive and unspecified restitutionary relief against the Company under Business and Professions Code Sec. 17200 for alleged unfair business practices in violation of California Insurance Code Sec. 1861.02(c) relating to Company rating practices. Based on California’s Proposition 64, passed in November 2004, the court granted the Company’s motion to dismiss the complaint, but allowed the addition of a second plaintiff, Leacy. The court stayed discovery in this litigation pending appellate court decisions involving similar issues by other parties. Because this matter is in the pleading stages and no discovery has taken place, no estimate of the range of potential losses in the event of a negative outcome can be made at this time.
Insurance Company cases (Ramona Goldenburg) was originally filed as Bryan Speck, individually, and on behalf of others similarly situated v. 21st Century Insurance Company, 21st Century Casualty Company, and 21st Century Insurance Group. The original action was filed on June 20, 2002, in Los Angeles Superior Court. Plaintiff seeks California class action certification, injunctive relief, and unspecified actual and punitive damages. The complaint contends that 21st Century uses “biased” software in determining the value of total-loss automobiles. Specifically, Plaintiff alleges that database providers use improper methodology to establish comparable auto values and populate their databases with biased figures and that the Company and other carriers allegedly subscribe to the programs to unfairly reduce claims costs. This case is consolidated with similar actions against other insurers for discovery and pre-trial motions. A court-ordered appraisal of Speck’s vehicle was favorable to the Company and Ramona Goldenberg was substituted as a Plaintiff, replacing Speck. The Company intends to vigorously defend the suit with other defendants in the coordinated proceedings. This matter is in the pleading stage of litigation and no reasonable estimate of potential losses in the event of a negative outcome can be made at this time.
Silvia Quintana, on her own behalf and on behalf of all others similarly situated v. 21st Century Insurance was filed on November 16, 2005. This purported class action, filed in San Diego, names the Company in four causes of action: 1) violation of B&P Section 17200, 2) conversion, 3) unjust enrichment and, 4) declaratory relief. Silvia Quintana alleges that the Company’s demand for reimbursement of the medical payments it made to her pursuant to her insurance contract violates the “made-whole rule.” The Company anticipates that if the matter survives the initial pleading stage, it will be consolidated, for discovery and pre-trial motions, with actions alleging similar facts against other insurers. This matter is in the initial stages of pleading and no reasonable estimate of potential losses in the event of a negative outcome can be made at this time.
Effective December 4, 2003, the Company changed its state of incorporation from California to Delaware. In connection with the change, the Company’s stock was assigned a par value of $0.001 per share, resulting in a reclassification of $419.9 million from common stock to additional paid-in capital. There was no impact to the Company’s financial condition or results of operations as a result of the reincorporation.
The Company is authorized to issue up to 500,000 shares of preferred stock, $1 par value, and 376,126 shares of Series A convertible preferred stock, $1 par value, none of which were outstanding at December 31, 2005 or 2004.
As of December 31, 2005 and 2004, there were 85,933,960 and 85,489,061 shares of the Company’s common stock outstanding, respectively. No shares were repurchased in 2005 or 2004.
Accumulated other comprehensive income is a component of stockholders’ equity and includes all changes in unrealized appreciation and depreciation; reclassification adjustments for investment losses and gains included in net income; and changes in minimum pension liability in excess of unamortized prior service cost.
The stockholders approved the 2004 Stock Option Plan (the “2004 Plan”) at the Annual Meeting of Shareholders on May 26, 2004. The 2004 Plan supersedes the 1995 Stock Option Plan, which will remain in effect only as to outstanding awards under it. The 2004 Plan authorizes a Committee of the Board of Directors to grant stock options in respect of 4,000,000 shares to eligible employees and nonemployee directors, subject to the terms of the 2004 Plan. Additionally, under the 2004 Plan, the Committee may grant stock options in respect of shares that were subject to outstanding awards under the 1995 Stock Option Plan to the extent such awards expire, are terminated, are cancelled, or are forfeited for any reason without shares being issued.
The weighted average fair value for options granted during 2005, 2004 and 2003 was $4.74, $5.95, and $4.80, respectively. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
Certain assets are included in the GAAP consolidated balance sheets, but are charged directly against statutory surplus under SAP. These assets consist primarily of premium receivables that are outstanding over 90 days, federal deferred tax assets in excess of statutory limitations, intercompany balances due from the parent, furniture, equipment, application computer software, leasehold improvements and prepaid expenses.
Investments, which are classified as available-for-sale, are reported at fair values, rather than at amortized cost, or the lower of amortized cost or market, depending on the specific type of security, as required by SAP. Equity securities are reported at fair values, which may differ from the NAIC market values as required by SAP.
California Senate Bill 1899 (“SB 1899”), effective from January 1, 2001 to December 31, 2001, allowed the re-opening of previously closed earthquake claims arising out of the 1994 Northridge earthquake. More than ninety-nine percent of the claims submitted and litigation brought against the Company as a result of California SB 1899 have been resolved. The Company’s loss and LAE reserve for SB 1899 claims were increased by approximately $0.4 million in the fourth quarter of 2005 based on a revised estimate of the cost of resolving the few remaining claims. The Company’s total loss and LAE reserves for SB 1899 claims as of December 31, 2005, 2004, and 2003 were $0.5 million, $4.0 million, and $14.2 million, respectively.
Third quarter 2004 results were increased by $4.9 million due to the effect of recent California legislation relating to holding company taxes on dividends from insurance subsidiaries (see additional discussion in Note 5 of the Notes to Consolidated Financial Statements).
The Company evaluates segment performance based on pre-tax underwriting profit (loss). The Company does not allocate assets, net investment income, net realized investment gains (losses), other revenues, nonrecurring items, interest and fees expense, or income taxes to operating segments. The accounting policies of the reportable segments are the same as those described in Note 2 of the Notes to Consolidated Financial Statements. All revenues are generated from external customers and the Company does not rely on any major customer.
The following table presents net premiums earned, depreciation and amortization expense, and segment profit (loss) for the Company’s segments for the years ended December 31.
Segment revenue represents premiums earned as a result of the Company’s participation in the California FAIR Plan.
In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51 (“FIN 46”), and amended it in December 2003. An entity is subject to the consolidation rules of FIN 46 and is referred to as a variable interest entity (“VIE”) if it lacks sufficient equity to finance its activities without additional financial support from other parties or if its equity holders lack adequate decision making ability based on criteria set forth in the interpretation. FIN 46 also requires disclosures about VIEs that a company is not required to consolidate, but in which a company has a significant variable interest.
The Company has decided to purchase investments that provide housing and other services to economically disadvantaged communities. To that end, the Company is a voluntary member, along with other participating insurance organizations, of Impact Community Capital, LLC (“Impact”). Impact’s charter is to make loans and other investments in such communities.
The Company is not the primary beneficiary of any of the VIEs as the Company has voting rights, beneficiary rights, obligations, and ownership in proportion to each of its Impact related investments, none of which exceeds 11.1%.
Several subsidiaries of AIG together own approximately 62% of our outstanding common stock and three of the ten members of our Board of Directors are employees of AIG. Since 1995, the Company has entered into several transactions with AIG subsidiaries, including reinsurance agreements, insurance coverage contracts, and various services.
Corporate insurance coverage - The Company has obtained the following corporate insurance policies from AIG subsidiaries: