We conduct our Massachusetts operations from approximately 436,000 square feet of space in several buildings that we own in Webster, Massachusetts, which is located approximately 50 miles southwest of Boston. Our data processing and operational departments are housed in modern office buildings. Commerce West currently leases approximately 22,000 square feet of office space in Pleasanton, California. American Commerce conducts its operations from approximately 40,000 square feet of space in a building it owns located on a two acre site in Columbus, Ohio. American Commerce also leases property at three district claims offices.
The data below should be read in conjunction with the consolidated financial statements, related footnotes, and other financial information included herein. The financial statements for the years ended December 31, 2004 and 2003 were audited by PricewaterhouseCoopers LLP. The financial statements for the three years ended December 31, 2002 were audited by Ernst & Young LLP. All dollar amounts in the following tables are in thousands, except per share data.
We manage our business in four reportable segments: property and casualty insurance - Massachusetts, property and casualty insurance - other than Massachusetts, real estate and commercial lending, and corporate and other.
A significant aspect of our automobile insurance business relates to our interaction with Commonwealth Automobile Reinsurers (CAR). CAR is a reinsurance mechanism mandated in Massachusetts, which enables us and the other participating servicing carriers to reinsure any automobile risk that they perceive to be under-priced. Since its inception, CAR has annually generated significant underwriting losses, primarily in the personal automobile pool. All companies writing automobile insurance in Massachusetts share in the underwriting results of CAR business for their respective product line or lines.
The transition phase of the New Rules was schedule to begin January 1, 2005 and run through 2007. The focus of the transition phase is to effect a fundamental change in the allocation of so-called "high loss ratio" exclusive representative producers or ERPs. An ERP is a Massachusetts automobile insurance agency that does not have a voluntary agency automobile insurance relationship with an insurer, and which is assigned by CAR to an insurer who is a Servicing Carrier. In general, a high loss ratio ERP is a subclass of ERPs composed of those ERPs with a loss ratio of 125% or greater.
a pool of ceded business written, excluding the impact of the net rate subsidy described in (3) below, through high loss ratio ERPs;
a pool containing ceded business, excluding the impact of the net rate subsidy described in (3) below, written through voluntary agents and ERPs that are not high loss ratio ERPs; and
CAR would apportion the underwriting results of the high loss ratio ERP pool among all insurers based on each insurer's voluntary agent market share on June 30, 2004. The CAR residual market deficit from ceded business written through voluntary agents and ERPs that are not high loss ratio ERPs would be allocated based on the market share of those agents, modified by a company's utilization of CAR. The results from the subsidy pool, which replaces the current system of CAR credits, would be allocated based on each individual company's net voluntary mix of subsidized and rate redundant business as that relates to the mix of business written by the entire market.
Although the New Rules have been stayed by the court, we have estimated their impact in the event that the stay is lifted and the New Rules are implemented retroactive to January 1, 2005. We believe that the decreased cession penalties contained within the New Rules could substantially increase the amount of business ceded to CAR. It is impossible for us to estimate, however, either the extent of the increase in the volume of business ceded to CAR or the resulting impact on the residual marketplace. Consequently, our pro forma estimate does not include this probable effect nor changes in cession behavior that could occur.
While we believe it is premature to estimate the impact of the New Rules on our future financial results, we have estimated the effect the New Rules would have had if they had been in effect for the 2003 CAR policy year, which is the most recent policy year for which substantially complete CAR data is available. Based upon our analysis of the stayed New Rules, we estimate that Commerce's increased share of the residual market deficit would amount to an additional pre-tax CAR expense between $15.2 million and $18.7 million for CAR policy year 2003, which utilizes a participation ratio for the high loss ratio pool of 25.6%. The pre-tax effect would partially impact fiscal 2003 and fully impact fiscal 2004. The ranges provided are indicative of varying CAR cession strategies that may have been utilized by us for the high loss ratio ERPs that would have been assigned to us under the reapportionment described above. Our 2005 participation ratio for the high loss ratio pool is approximately 28.7% and a proportional increase in our 2003 pro forma estimate for 2005 and beyond could be expected based on increases in our market share. Lastly, due to the estimated increased CAR expenses for policy year 2003, we expect that our agent profit sharing expenses would decline between $3.5 million and $4.3 million, which would partially impact fiscal 2003 and fully impact fiscal 2004.
On February 10, 2005, American Commerce received notification from one of its agents, AAA Arizona, Inc., that it intends to stop writing new business with American Commerce effective immediately and indicated that it intends to transfer all of its existing business from American Commerce. AAA Arizona was American Commerce's largest agent in terms of direct written premium produced, having generated $49,494 in direct written premium in 2004, representing 25.8% of American Commerce's total direct written premium and 2.7% of our consolidated total direct written premium. American Commerce will continue to write business in Arizona but will no longer market its products through AAA Arizona. Commerce West began writing business in Arizona through independent agencies in early 2005. At this time, we are not able to estimate the impact of these events on our Arizona writings.
premium finance charges and service fee income that we earn in connection with the billing and deferral of premium payments; and
Unpaid Losses and Loss Adjustment Expenses. The liability for loss and loss adjustment expenses represents our best estimate of the ultimate net cost of all loss and loss adjustment expenses incurred after reinsurance and amounts estimated to be recoverable through salvage and subrogation. The estimate for ultimate net cost of all losses incurred through the balance sheet date includes the adjusted case estimates for losses, incurred but not reported (IBNR) losses, salvage and subrogation recoverable and a reserve for LAE. In arriving at our best estimate, we begin with the aggregate of individual case reserves and then make adjustments to these amounts on a line of business basis. These adjustments to the aggregate case reserves by line of business are made based on analyses performed by us as further described below. The entire liability for unpaid losses and LAE is also separately reviewed quarterly and annually by our actuarial department. Liability estimates are continually analyzed and updated, and therefore, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimates are included in the results of operations in the period in which the estimates are revised.
In accordance with industry practice, we also maintain reserves for estimated IBNR, salvage and subrogation recoverable and LAE. These reserves are determined based on historical information and our experience. Adjustments to these reserves are made periodically to take into account changes in the volume of policies written, claims frequency, severity and payment patterns, the mix of business, claims processing and other items that can be expected to affect our liability for losses and LAE over time.
Our financial management personnel calculates our estimate independently from those amounts calculated by our actuaries, and therefore, the final results are usually different. We estimate our amounts primarily by reviewing historical loss and LAE data, focusing mainly on payment data. We also review and compare the most recent loss frequency, severity, and payment data to historical trends in an attempt to determine if patterns are remaining consistent or not. We attempt to establish our reserve estimate as close as possible to the amount required for the ultimate future payments necessary to settle all losses. Our aggregate actuarial estimate for the loss and LAE reserves, on a consolidated basis and net of reinsurance recoverable, ranges from a low of $760.9 million to a high of $875.1 million, as of December 31, 2004. Our financial statement loss and LAE reserves net of reinsurance, based on our best estimate, was established at $830.1 million for that date.
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 an other-than-temporary decline in market value as being temporary and, consequently, not charge the impairment to our earnings, which could have a significant impact on our future earnings and financial position.
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 by law to issue a policy to any applicant seeking to obtain such coverages, commonly known as the "take all comers" law. 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.
Changes in Premium Rates. During the three-year period from 2002 to 2004, average mandated Massachusetts personal automobile insurance premium rates increased an average of 1.7% per year. Coinciding with the 2005 rate decision, the Commissioner also approved a 4.8% increase in the commission agents receive for selling private passenger automobile insurance for 2005. The following table shows the state-mandated average rate change, the actual average revenue change per exposure and our average revenue change per exposure as estimated for 2005 and for the three previous years in Massachusetts.
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 5% discount was approved by the Commissioner for policies effective January 1, 2005. This same discount existed in 2004. 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 2004, 2003 and 2002:
The decreasing percentages since 2002 are attributed to a higher rate of increase in non-affinity group business and a slight decrease in AAA-Massachusetts exposures. Of the total Massachusetts automobile exposures written through the AAA affinity group program by us in 2004, approximately 14.1% were written through insurance agencies owned by the AAA clubs (7.8% of our total Massachusetts automobile exposures). The remaining 85.9% of the AAA group program were written through our network of independent agents (92.2% of our total Massachusetts automobile exposures).
Investment income represents earnings on our investment portfolio. We rely on after-tax investment income as a significant source of net earnings since we generally achieve a combined ratio (see below) of slightly less than 100%.
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. In addition, underwriting expenses are grossed-up for any change in deferred acquisition costs.
a decrease in the current year personal automobile physical damage claim frequency,
The market price for our common stock and our financial results directly affects our expense related to stock options and book value awards (BVAs), respectively. Our stock option expense represents options granted to both employees and American Commerce agents. An increase in the market value of our stock will increase the expense we recognize for options subject to variable accounting. Similarly, an increase in our net income will increase the value of, and therefore the expense we recognize for, outstanding BVAs. We record these expenses in two separate line items on our income statement - losses and loss adjustment expenses and policy acquisition costs. The stock option and BVA expenses recorded in each line item for the years ended 2004 and 2003 follow:
Fixed maturities include GNMA & FNMA mortgage-backed bonds, corporate bonds, U.S. Treasury bonds and notes and tax-exempt state and municipal bonds.
The decrease in transaction net realized gains for the year ended 2004 is primarily due to lower portfolio turnover. Portfolio turnover was relatively high in 2003 as we realigned our portfolio with the changing interest rate environment. The product of this turnover in 2003 was a significant amount of net realized gains. As part of this realignment in 2003, we sold a significant portion of our closed-end preferred stock mutual funds. The decline in interest rates during much of 2003 caused a significant increase in the net asset value of our closed-end preferred stock mutual funds and, as a direct consequence, an increase in the net realized investment gains that we recognized for those investments in 2003.
Loss and LAE reserves prior to the effect of ceded reinsurance recoverable,
The Financial Accounting Standards Board issued in December 2004 revised rules for accounting for stock options and other equity-based remuneration, Share-Based Payment. We will adopt these revised rules in the third quarter of 2005 when they become effective. This change will not impact our results of operations and financial condition for the stock options we awarded through 2001 under the Plan, because application of the revised rules is on a prospective basis. We have not granted any stock options to our employees under our Incentive Compensation Plan since 2001. The revised rules will not change our accounting for BVAs and the stock options we award under the American Commerce Plan.
Our net earnings for the year ended 2003, as compared to 2002, were favorably affected primarily by significant increases in our realized investment gains.
our decision to sell a significant portion of our securities with unrealized gains in order to implement a change in our investment view; and,
Our policy acquisition costs increased by $54.9 million, or 18.6% for the year ended 2003 compared to 2002. The increase resulted primarily from our premium growth, partially offset by a decrease in our underwriting ratio (on a statutory basis) to 22.9% for the year ended 2003 compared to 23.6% for 2002. The decrease in our underwriting ratio was primarily due to lower 2003 policy year mandated Massachusetts personal automobile commission rates. See "Policy Acquisition Costs."
agents writing more homeowner business to achieve a homeowner discount for their customer when we also insure the customer's automobile.
During 2003, we sold a significant portion of our securities with unrealized gains in order to implement a change in our investment view. Our investment strategy emphasizes investment yield while maintaining investment quality. The focus of our investment objectives continues to be maximizing after-tax investment income through investing in high quality diversified investments structured to maximize after-tax investment income while minimizing risk. A secondary objective is to achieve above average after-tax total return. Our funds are generally invested in securities with maturities intended to provide adequate funds to pay claims and meet other operating needs without the forced sale of investments. This change in view caused us to reduce the average duration of our investment portfolio during the second and third quarters, which in turn resulted in the sale of a number of securities that had increased in value significantly as overall credit spreads tightened. This caused overall portfolio turnover (e.g. volume of trades) to increase beyond that of recent years. The portfolio sales occurred in securities that had been purchased during 2003 as well as those purchased in previous years. Thus, while we did sell some higher yielding instruments, the overall after-tax yield of the portfolio did not fall significantly beyond the decline in interest rates as a whole. During the third quarter as interest rates rose, we began to invest in longer-term securities, resulting in a slightly higher duration at year end. Primarily as a result of these sales, we realized net investment gains of $56.3 million in those categories for the year ended 2003, compared to a net realized investment loss of $1.3 million on sales of securities in those categories during 2002.
Our loss and LAE ratio decreased to 74.0% for the year ended 2003 compared to 75.2% for 2002. The decrease was primarily driven by slightly more favorable experience in the current year personal automobile line of business due to increases in average earned premium revenue per automobile and more favorable loss reserve development compared to 2002.
Unpaid losses and LAE reserves prior to the effect of ceded reinsurance recoverable, by line of business, at December 31, 2003 and 2002, and the actuarial low and high range estimates at December 31, 2003 follow (in millions):
Our overall effective tax rate for the year ended 2003 was 26.5% as compared to 32.8% for 2002. 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 income tax rate for the year ended 2002 was adversely impacted by a tax valuation allowance of $3.9 million related to a deferred tax asset previously established for realized investment losses. Our income tax rate for 2003 was benefited by the reversal of the tax valuation allowance from 2002.
Due to the effect of a change in accounting principle related to goodwill, we recorded income in the first quarter of 2002, net of taxes, of $11.2 million, or $0.34 per share (diluted). This amount represented the remaining unamortized negative goodwill related to closed-end preferred stock mutual funds and the remaining excess of book value of subsidiary interest over cost relating to the 1999 acquisition of American Commerce. Negative goodwill and the excess of book value of subsidiary interest over cost were created in these acquisitions because the underlying value of the assets purchased exceeded the purchase price. The subsequent recognition of income that occurred as these items were eliminated was not a taxable event but instead became part of the basis of the acquired asset.
We have commitments in two venture capital fund investments. These investments are made in limited partnerships and our exposure to loss is limited to our actual investment. One limited partnership investment required a commitment by us to invest up to $50,000 into the partnership. As of December 31, 2004, we have invested $35,554 into the partnership. 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.
Liabilities for unpaid losses and loss adjustment expenses at December 31, 2004 and 2003 follow:
The primary sources of our liquidity are funds generated from insurance premiums, net investment income, premium finance and service fees and the maturing and sale of investments. The primary uses of our liquidity are payment of policy claims, operating costs, interest on our senior notes, and payment of dividends to our stockholders.
You should not place undue reliance on any forward-looking statement. The risk factors referred to above, as well as those elsewhere in the Annual Report and Form 10-K, could cause actual results or outcomes to differ materially from those expressed in any forward-looking statement made by us or on our behalf (see "Risks Related to Our Business" in Item 1 of this Form 10-K). Further, any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
Our management's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.
We have completed an integrated audit of The Commerce Group, Inc.'s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 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.
Due to the exercise of 1,747,163 employee stock options and 351,888 American Commerce agents' options.
We provide personal and commercial property and casualty insurance in Massachusetts and, to a lesser extent, in other states. In addition, we originate and service residential and commercial mortgages in Massachusetts and Connecticut. Our primary business is property and casualty insurance in Massachusetts.
under fair value method for awards granted in 2001, net of taxes
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, we obtain a third party valuation. For other investments, fair value equals quoted market price, if available.
The cash and cash equivalent balances at December 31, 2004 and 2003 include $39.4 million and $39.5 million, respectively, which represents outstanding checks for which there was no right of offset. These amounts are also included in other liabilities and accrued expenses for the respective years.
We record our equity in the change in net assets of one closed-end preferred stock mutual fund as a component of realized gains and losses. This investment is valued at original cost plus the cumulative undistributed equity in earnings and losses of the fund.
Our closed-end preferred stock mutual fund holding at December 31, 2004 and 2003 accounted for under the equity method follows:
Mortgage loans on real estate and collateral notes receivable are stated at the amount of unpaid principal, less an allowance for possible loan losses. The adequacy of the allowance for possible loan losses is evaluated on a regular basis. Loan losses are charged against the allowance when management believes the collectibility of the principal is unlikely and recoveries are credited to the allowance when received.
Mortgage loans on real estate and collateral notes receivable at December 31 follows:
At December 31, 2004 and 2003, mortgage loans on non-accrual status totaled $357 and $455, respectively. Allowances of $37 and $40 were established in 2004 and 2003, respectively, for non-accrual status loans. The reduction in interest income associated with non-accrual loans was $15, $36 and $44 for the years ended December 31, 2004, 2003 and 2002, respectively.
Net realized investment gains (losses) for the years ended December 31 follow:
Gross and net unrealized investment gains and losses, excluding minority interest, from fixed maturity and equity securities at December 31 follow:
We review all security holdings on a quarterly basis for potential other-than-temporary declines in market value in accordance with GAAP. As part of this process, we consider any significant market declines 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 view all securities that have declined more than 20% below book price and have remained so for two 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 review of our portfolio:
We review all holdings with an unrealized loss of over $250, or more than 20% below cost.
Generally, we consider all AAA/AA rated U.S. Government securities with market values less than cost as temporarily impaired due to our intent and ability to hold these securities to 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. During 2004, our other-than-temporary impairment charge for our bond and preferred and common stock holdings was $14,949.
Gross unrealized losses on our fixed maturity and equity securities at December 31, 2004 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, 2004 were from corporate securities with a credit quality of BB.
We reviewed our investment holdings at December 31, 2004 for other-than-temporary declines in market value, in accordance with our previously stated accounting policy. Based on this analysis, we determined that the impairments represented in the above gross unrealized loss table are temporary. These temporary impairments are primarily due to interest rates and general market conditions. We intend to hold to recovery or maturity all of our temporarily impaired equity or fixed maturity securities, respectively.
Net accumulated other comprehensive income (loss) on stocks and fixed maturity investments follows:
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 property and equipment having an economic life of more than one year and having physical substance with a unit dollar value of $1.0 or greater.
The liability for unpaid losses and LAE represents our best estimate of the ultimate net cost of all losses and LAE incurred through the balance sheet date. This estimate includes the adjusted case estimates for losses, incurred but not reported losses, salvage and subrogation recoverable and a reserve for LAE. In arriving at our best estimate, we begin with the aggregate of individual case reserves and then make adjustments to these amounts on a line of business basis. These adjustments to the aggregate case reserves by line of business are made based on our analysis as further described below. The entire liability for unpaid losses and LAE is also independently reviewed quarterly and annually by our Actuarial Department. Liability estimates are continually analyzed and updated, and therefore, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimates are included in the results of operations in the period in which the estimates are revised.
When a claim is reported to us, we establish a "case reserve" for the estimated amount of our ultimate exposure. 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 our informed judgment based on general insurance reserving practices and on our experience and knowledge. During the loss adjustment period, these estimates are revised as deemed necessary based on subsequent developments and periodic reviews of the cases.
Approximately $51,027 in personal automobile liability redundancies developed for the year ended 2004, with 98.0% of this amount coming from the 2003, 2002 and 2001 accident years. The primary reason for the redundancies in this area is that claim severity came in better than we anticipated. Automobile physical damage had approximately $2,334 in redundancies related to the 2003 accident year. In 2004, we also experienced redundancies of $2,222 for the commercial multiple peril line of business, half of which related to the 1996 accident year. Various redundancies and deficiencies for the other lines of business and accident years combined for the remaining approximately $1,448 net redundancy.
Our aggregate actuarial estimate for the loss and LAE reserves, on a consolidated basis and net of reinsurance recoverable, ranges from a low of $760.9 million to a high of $875.1 million, as of December 31, 2004. Our financial statement loss and LAE reserves net of reinsurance, based on our best estimate, was established at $830.2 million for that date. We calculate our estimate independently from those amounts as calculated by our actuaries and, therefore, the final results are most often not the same. We estimate amounts primarily by reviewing historical loss and LAE data, focusing mainly on payment data. We also review and compare most recent loss frequency, severity and payment data to historical trends in an attempt to determine if patterns are remaining consistent or not. We attempt to establish our reserve estimate as close to the amount required for the ultimate future payments necessary to settle all losses. The accuracy of this estimate is reflected by the line noted in the above table entitled "decrease in provision for insured events of prior years."
Our loss and LAE reserves reflect our share of the aggregate loss from CAR and our LAE reserves and the other writers of automobile insurance in Massachusetts that participate in CAR (Servicing Carriers).
Also in 2000, Commerce entered into a Limited Partnership Agreement with Distribution Partners Investment Capital, L.P. a Delaware Limited Partnership. This partnership agreement required our commitment to invest up to $3,500 into the partnership. In 2002, we invested $298 into the partnership. We did not invest in the partnership in 2004 and 2003. As of December 31, 2004, we have invested $2,555 into the partnership leaving a balance of $945 for funds still committed. The partnership was formed to operate as an investment fund principally for the purpose of making investments primarily in equity and equity-related securities of companies operating in the area of insurance distribution and distribution related activities, all as determined and managed by the General Partner for the benefit of the Partners.
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. This is based primarily on the underwriting profits of an individual agents' business written with us. The arrangement for Massachusetts and New Hampshire business 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 the profit sharing commission rate and paid to the agent. Outside of Massachusetts, Commerce, Commerce West and American Commerce each have profit sharing plans tailored to their specific markets.
During 2002, our stockholders approved the Incentive Compensation Plan (the Plan) which provides for the award of incentive stock options, non-qualified stock options, book value awards, stock appreciation rights, restricted stock and performance stock units. Up to 5,000,000 shares of common stock (subject to increase for anti-dilution adjustments) may be issued under the Plan, including shares that may be issued pursuant to awards of restricted stock or upon the exercise of common stock equivalent awards such as stock options and stock appreciation rights payable in the form of common stock (not in the form of cash). At the discretion of the compensation committee, all of our directors, officers and other senior management employees, including those of our subsidiaries, are eligible to participate in the Plan.
The market price for our common stock and our financial results directly affect our expense related to stock options and BVAs, respectively. Our stock option expense represents options granted to both employees and American Commerce agents. An increase in the market value of our stock will increase the expense we recognize for options subject to variable accounting. Similarly, an increase in our net income will increase the value of, and therefore the expense we recognize for, outstanding BVAs.
We record our expenses related to stock options and book value awards (BVAs) in two separate line items on our income statement - losses and loss adjustment expenses and policy acquisition costs. The stock option and BVA expenses recorded in each line item for the years ended December 31 follow:
We follow variable accounting treatment for options granted in 1999 and 2000 in accordance with APB Opinion 25 and related interpretations. Expenses in 2004, 2003 and 2002 related to options granted in 1999 and 2000 were $3,607, $2,570 and $3,306, respectively.
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). In conjunction with meeting specified premium growth levels over the term of the ACIC agents' options, we provided "put rights" to the holders of the ACIC agents' options granted in 1999. These put rights permit the agents' option holders to require us to purchase the ACIC agents' options at the difference between $40.00 less the exercise price, at any time from and after the confirmation date through and including 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. Expenses related to these options were $15,291 in 2004, $9,030 in 2003 and $1,543 in 2002. The ACIC Plan has not been, and is not required to be, approved by our stockholders.
There were 372,130 exercisable ACIC agents' options at December 31, 2004. None of the outstanding ACIC agents' options were exercisable at December 31, 2003 and 2002. The weighted average remaining contractual life of ACIC agents' options outstanding at December 31, 2004 was 7.8 years.
On February 10, 2005, 700,000 of the ACIC agents' options that were outstanding at December 31, 2004 were forfeited as a result of AAA Arizona terminating its relationship with American Commerce. None of these options were exercisable at the end of 2004. Accrued expenses for these options were $3,487 at December 31, 2004. If these options had been forfeited at December 31, 2004, the weighted average exercise price and weighted average remaining contractual life of ACIC agents' options outstanding would have been $46.82 and 7.5 years, respectively.
The exercise prices for ACIC agents' options granted in 2004, 2003, 2002, 2001, 2000 and 1999 are $58.63, $46.27, $49.50, $42.85, $34.04 and $36.32, respectively. The estimated weighted average fair values per share of the ACIC agents' options were $17.39, $6.82 and $5.03 at December 31, 2004, 2003 and 2002, respectively. The ACIC agents' option liability at December 31, 2004 and 2003 was $19.8 million and $16.7 million, respectively.
The Financial Accounting Standards Board issued in December 2004 revised rules for accounting for stock options and other equity-based remuneration, Share-Based Payment. We will adopt these revised rules in the third quarter of 2005 when they become effective. This change will not impact our results of operations and financial condition for the stock options we awarded through 2001 under the Plan, because application of the revised rules is on a prospective basis. The revised rules will not change our accounting for BVAs and the stock options we award under the ACIC Plan.
In 2004, we acquired 837,002 shares of our common stock as consideration for stock options exercised. We did not acquire any of our common stock under our authorized buy-back program during 2004. At December 31, 2004, we had authority to purchase a total of 858,300 additional shares of our common stock under our buy-back program.
The aggregate amount of dividends calculated in accordance with regulations in Massachusetts, California and Ohio that could have been paid in 2004 from all of our insurance subsidiaries without prior regulatory approval was approximately $139,957, of which $23,890 was declared and paid as of December 31, 2004.
Our Board of Directors voted to declare four quarterly dividends to stockholders of record totaling $1.31 per share and $1.27 per share in 2004 and 2003, respectively. On May 21, 2004, the board voted to increase the quarterly stockholder dividend from $0.32 to $0.33 per share to stockholders of record as of June 1, 2004. Prior to that declaration, we paid quarterly dividends of $0.32 per share dating back to May 16, 2003 when the board voted to increase the dividend from $0.31 to $0.32 per share.
Approximately 83.1% of our direct premiums written for the year ended December 31, 2004 were generated from personal automobile insurance policies. Approximately 86.2% of our direct premiums written for the year ended December 31, 2004 were generated in Massachusetts.
During 2004, our 2001 and 2002 federal income tax returns were audited by the IRS; there were no material findings. We had an accrued balance of $1,038 at December 31, 2003 for possible IRS audit adjustments which we released in 2004. We did not have a tax contingency accrual at December 31, 2004.
All of the insurers writing the types of insurance covered by the Massachusetts Insurers Insolvency Fund (MIIF) are MIIF members. MIIF is obligated to pay any unpaid claim, up to $300, against an insolvent insurer if the claims existed prior to the declaration of insolvency or arose within 60 days thereafter. MIIF assesses members the amounts it deems necessary to pay both its obligations and the expenses of handling covered claims. Subject to certain limitations, assessments are made in the proportion that each member's net written premiums for the preceding calendar year for all property and casualty lines of business bore to the corresponding net written premiums for all members for the same period. The statute that established MIIF also provides for the recoupment by insurers of amounts paid to MIIF. Historically, the Commissioner has allowed insurers to recoup the amounts they paid MIIF through rate adjustments.
The table below provides information depicting the approximate recovery under the quota share contract at various loss scenarios, if a single catastrophe were to strike through June 30, 2005:
It is customary for property and casualty companies to evaluate their exposure to a weather-related catastrophe by estimating the losses that would be incurred if a storm equivalent to the most destructive storm that has occurred during a given period were to occur during a current fiscal year or reinsurance policy period. If the estimate focuses on hurricanes during the past 100 years, for example, the most destructive hurricane during that period is referred to as a "100-year hurricane." Our estimated total loss, before reinsurance, on our other-than-automobile business for 100 and 250-year hurricanes is approximately $240,000 and $457,000, respectively. Our estimates were derived through the services of Employers Reinsurance Corporation on our December 31, 2003 other-than-automobile exposures, which utilized the RMS (Risk Management Solutions) risk assessment system. We believe that most property and casualty insurance companies establish their catastrophe reinsurance programs between the 100-year and 250-year storm estimates.
Since its inception, CAR has annually generated multi-hundred 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 or commercial deficit is based upon our market share for 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. During 2004, 2003 and 2002, our net participation in the CAR personal automobile pool approximated 23.2%, 20.2% and 18.2%, respectively, as reported by CAR, compared to our estimated market share in those years of 29.0%, 27.7% and 25.9%, respectively. The values associated with credits and penalties, under existing CAR Rules 11 and 12, are set annually, but have not been established and approved by the Commissioner for 2005.
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, 2004, 2003 and 2002, these servicing fees amounted to $21,160, $18,938 and $18,668, respectively.
Contributions are allocated among the participants' accounts in the ratio of each participant's eligible Form W-2 compensation to the total of all participants' covered compensation for the year. Dividends on ESOP shares are fully earned, and participants can elect to either receive cash or apply the dividend to their ESOP account. ESOP shares are treated as outstanding shares for the purpose of our earnings per share calculations. The fair value of the ESOP shares held by participants that are less than 100% vested at December 31, 2004 was $10,638.
ESOP participants who are current employees and who are 100% vested in their ESOP accounts can annually elect to transfer out of the ESOP up to 100% of their allocated company stock in the form of an eligible rollover distribution into another eligible retirement plan, such as a qualified individual retirement arrangement. Approximately 2,082,540 shares owned by participants in the ESOP at December 31, 2004 are allocated to the ESOP accounts of these individuals. ESOP accounts vest at a rate of 20% per service year beginning with a participant's third year of service.
During 2000, our directors approved a Directors' Retirement Compensation Plan (the Retirement Plan). The Retirement Plan becomes effective for each director upon terminating service from our Board of Directors (the Board) providing that such termination was not made under conditions adverse to our interest. Effective with the annual meeting wherein the director is not reappointed to the Board, and provided benefits are not paid until such time as the director has attained the age of 65, we will pay an annual retirement benefit equal to 50% of the average annual total compensation of the director for the immediately preceding three full years (the three year average compensation). The annual retirement benefit of 50% of the three year average compensation vests at the rate of 4.0% for each year of Board service up to a maximum of 100% vesting through termination of service. Payments continue for a maximum of ten years over the remaining life of the terminated director, or his or her then spouse, if the director pre-deceases the spouse. No payments are to be made after the death of the director and spouse. Expenses related to the Retirement Plan in 2004, 2003 and 2002 were $273, $286 and $117, respectively. We paid $55, $36 and $36 under the Retirement Plan in 2004, 2003 and 2002, respectively. The liability for the Retirement Plan, as calculated based on discounted cash flows, was $3,093 and $2,875 at December 31, 2004 and 2003, respectively.
We have four reportable segments: (1) property and casualty insurance - Massachusetts; (2) property and casualty insurance - other than Massachusetts; (3) real estate and commercial lending; and, (4) corporate and other. Our property and casualty insurance operations are written through Commerce, Citation, Commerce West, and American Commerce and are marketed to affinity groups, individuals, families and businesses through our relationships with professional independent insurance agencies. Our wholly-owned subsidiary, Bay Finance Company, Inc., originates and services residential and commercial mortgages in Massachusetts and Connecticut. The corporate and other segment represents the remainder of our activities, including those of the parent company.
We evaluate performance and allocate resources based primarily on the property and casualty insurance segments, which represents over 99% of our total revenue for the past three years. The accounting policies of the reportable segments are the same as those described in these notes to consolidated financial statements.
Selected segment information for 2004, 2003 and 2002 follows. Earnings are before income taxes and change in accounting principle and include minority interest.
Direct premiums written and earned for the years ended 2004, 2003 and 2002 follow:
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, 2004, we were not aware of any CAR member company which has failed to meet its obligations.
Following a public hearing on December 17, 2004, the Commissioner made clarifications and minor revisions to the Amended Reform Proposal (together, the Final Reform Proposal). On December 31, 2004, the Commissioner adopted the Final Reform Proposal and made it effective January 1, 2005. We filed an action in Massachusetts Superior Court on January 5, 2005 asking the Court to determine whether the Final Reform Proposal is consistent with longstanding Massachusetts laws. On February 1, 2005, based on a request of several Exclusive Representative Producers who intervened in our action, the Court stayed the implementation of the Final Reform Proposal until a court decides whether it is consistent with Massachusetts law.
Due to the effect of a change in accounting principle related to goodwill, we recorded income in the first quarter of 2002, net of taxes, of $11,237 or $0.34 per share (diluted). This amount represented the remaining unamortized negative goodwill related to preferred stock mutual funds and the remaining excess of book value of subsidiary interest over cost relating to the 1999 acquisition of American Commerce. Negative goodwill and the excess of book value of subsidiary interest over cost occurred in these acquisitions because the underlying value of the assets purchased exceeded the purchase price. The subsequent recognition of income that occurred as these items were eliminated was not a taxable event but instead became part of the basis of the acquired asset.
Due to the internal reorganization in 2003, minority interest is no longer part of our insurance operation. Minority interest is included in 2003 and 2004 for comparative purposes and to reconcile to our consolidated balance sheet.