prior to the Acquisition may not be comparable with financial data for periods following the Acquisition.
(1)In this financial presentation, the financial data for 2001 has been split into a predecessor period from January 1, 2001 to October 15, 2001 and a successor period from October 16, 2001 to December 31, 2001.
(2)Our transaction expenses reflect the costs we incurred in connection with the Acquisition. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-The Acquisition."
(3)The loss ratio is the ratio of losses and loss adjustment expenses to net earned premiums. The expense ratio, when calculated on a statutory accounting basis, is the ratio of underwriting expenses to net written premiums, and when calculated on a GAAP basis is the ratio of underwriting expense to net earned premiums. The combined ratio is the sum of the loss ratio and the expense ratio. Please refer to page 35 for a discussion on the comparison of the above statutory insurance ratios to our GAAP ratios.
In this discussion, "Safety" refers to Safety Insurance Group, Inc. and "our Company," "we," "us" and "our" refer to Safety Insurance Group, Inc. and its consolidated subsidiaries. Our subsidiaries consist of Safety Insurance Company ("Safety Insurance"), Thomas Black Corporation ("TBC"), Safety Indemnity Insurance Company, Thomas Black Insurance Agency, Inc. ("TBIA") and RBS, Inc., TBIA's holding company.
As discussed below under "The Acquisition", Safety acquired all of the issued and outstanding stock of TBC on October 16, 2001 ("the Acquisition"). As a result of the Acquisition, the capital structure and basis of accounting of our Company differ from those of TBC prior to the Acquisition. Therefore, the financial data with respect to periods prior to the Acquisition ("predecessor" period) may not be comparable to data for periods subsequent to the Acquisition ("successor" period). In addition, the November 27, 2002 IPO, the use of those IPO net proceeds, the Preferred Share Exchange, as defined below, and a direct sale of 350,000 additional shares of common stock (the "Direct Sale") have further altered the current capital structure of our Company.
As discussed below, the November 27, 2002 IPO, the use of IPO net proceeds, the Preferred Share Exchange (as defined below) and the Direct Sale of 350,000 common shares altered our capital structure.
(2)The exercise price is equal to the closing price of our common stock on the grant date. The Board and the Compensation Committee intend to issue more options under the Incentive Plan in the future, not to exceed the maximum number of shares that may be granted.
On October 16, 2001, Safety acquired TBC, the holding company for our insurance and other subsidiaries, from a group of shareholders consisting primarily of TBC's founder and members of his immediate family. We accounted for the Acquisition using the purchase method of accounting, in accordance with the treatment of a business combination under Statement of Financial Accounting Standards No. 141, Business Combinations. Under purchase accounting: (i) we recorded the assets and liabilities of TBC at their estimated fair value at the date of Acquisition; (ii) we used the excess of
acquired net assets over the purchase price to reduce the estimated fair values of all non-current, non-financial assets, principally equipment and leasehold improvements; and (iii) we recorded the remaining $117,523 excess of the estimated fair value of net assets over purchase price as an extraordinary gain in the consolidated statement of operations for the period October 16, 2001 through December 31, 2001 in accordance with SFAS No. 141.
We reinsure with other insurance companies a portion of our potential liability under the policies we have underwritten, thereby protecting us against an unexpectedly large loss or a catastrophic occurrence that could produce large losses. Swiss Re, our primary reinsurer, maintains an A.M. Best rating of "A+" (Superior). All of our other reinsurers have an A.M. Best rating of "A" (Excellent) or better, except for Lloyd's of London that is rated "A-" (also Excellent). We are a participant in Commonwealth Automobile Reinsurers ("CAR"), a state-established body that runs the residual market reinsurance programs for both private passenger and commercial automobile insurance in Massachusetts under which premiums, expenses, losses and loss adjustment expenses on ceded business are shared by all insurers writing automobile insurance in Massachusetts. We also participate in the Massachusetts Property Insurance Underwriting Association in which premiums, expenses, losses and loss adjustment expenses on homeowners business that cannot be placed in the voluntary market are shared by all insurers writing homeowners insurance in Massachusetts. As of December 31, 2003, we had no material amounts recoverable from any reinsurer, excluding the residual markets described above.
We are subject to the extensive regulation of the private passenger automobile insurance industry in Massachusetts, which represented 81.0% of our direct written premiums in 2003. Owners of registered automobiles are required to maintain minimum automobile insurance coverages. Generally, we are required by law to issue a policy to any applicant who seeks it. We are also required to participate in a state-mandated reinsurance program run by CAR to which we cede certain unprofitable risks and from which we are allocated a portion of the overall losses. This program operates at an underwriting deficit. This deficit is allocated among every Massachusetts automobile insurance company, including us, based on a complex formula that takes into consideration a company's voluntary market share, the rate at which it cedes business to CAR, and the company's utilization of a credit system CAR has designed to encourage carriers to reduce their use of CAR. In addition, based on our market share, we are assigned certain licensed producers by CAR that have been unable to obtain a voluntary contract with another insurer. We call these agents Exclusive Representative Producers, or ERPs.
Proposals to materially change certain CAR rules are under consideration. In a letter to the Massachusetts Insurance Commissioner (the "Commissioner") dated June 25, 2002, the Massachusetts Attorney General reported that his office has determined that CAR's current methodology for assigning ERPs and distributing the CAR deficit must be changed to produce a fair and equitable market. The Attorney General's letter describes several factors that he believes support his findings and which he believes should be corrected in order to comply with Massachusetts law governing CAR. The Attorney General's letter calls on the Commissioner to work with him to address these issues. The letter has engendered discussion and dialogue among various parties that could result in material changes to CAR's rules. In response to the AG's letter and other factors, including a request by the Commissioner to interested parties for suggestions on reforming CAR, sixteen of the nineteen private passenger automobile insurers in Massachusetts (including Safety Insurance), representing approximately 67% of the Massachusetts private passenger automobile insurance market, has formed the "Concerned Industry Committee" for the purpose of developing a proposal for reform. This group has not yet submitted its
Each year, the Commissioner sets maximum premium rates that may be charged and minimum commissions that must be paid to agents for private passenger automobile insurance. The Commissioner announced on December 15, 2003, a 2.5% statewide average private passenger automobile insurance rate increase for 2004, as compared to a 2.7% increase for 2003 and no change for 2002. The Massachusetts Attorney General appealed the Commissioner's 2004 rate decision to the Massachusetts Supreme Judicial Court on January 5, 2004. A decision by the Court is not expected for several months and we cannot predict whether this appeal will be successful or what effect it may have on our profitability. During the period from 1996 through 2003 average rates decreased in four out of eight of those years. Coinciding with the 2004 rate decision, the Commissioner also approved a decrease to 10.5% in the commission rate agents receive for selling private passenger automobile insurance, as a percentage of premiums, as compared to a decrease from 11.7% in 2002 to 11.0% in 2003.
include acquisition costs, as a percent of net written premiums, if calculated on a statutory accounting basis, or net earned premiums, if calculated on a GAAP basis). The combined ratio reflects only underwriting results, and does not include income from investments or finance income. Underwriting profitability is subject to significant fluctuations due to competition, catastrophic events, economic and social conditions and other factors.
Our results are reported in accordance with GAAP, which differ from amounts reported in accordance with SAP as prescribed by insurance regulatory authorities. Specifically, under GAAP:
•Amounts related to ceded reinsurance are shown gross as prepaid reinsurance premiums and reinsurance recoverables, rather than netted against unearned premium reserves and loss and loss adjustment expense reserves, respectively, as required by SAP.
•The differing treatment of income and expense items results in a corresponding difference in federal income tax expense. Changes in deferred income taxes are reflected as an item of income tax benefit or expense, rather than recorded directly to surplus as regards policyholders, as required by SAP. Admittance testing may result in a charge to unassigned surplus for non-admitted portions of deferred tax assets. Under GAAP reporting, a valuation allowance may be recorded against the deferred tax asset and reflected as an expense.
When reviewing reserves, we analyze historical data and estimate the impact of various loss development factors, such as our historical loss experience and that of the industry, trends in claims frequency and severity, our mix of business, our claims processing procedures, legislative enactments, judicial decisions, legal developments in imposition of damages, and changes and trends in general economic conditions, including the effects of inflation. A change in any of these factors from the assumption implicit in our estimate can cause our actual loss experience to be better or worse than our reserves, and the difference can be material. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors. Establishment of appropriate reserves is an inherently uncertain process, and currently established reserves may not prove adequate in light of subsequent actual experience. To the extent that reserves are inadequate and are strengthened, the amount of such an increase is treated as a charge to earnings in the period that the deficiency is recognized. To the extent that reserves are redundant and are released, the amount of the release is a credit to earnings in the period the redundancy is recognized. We do not discount reserves.
In 2003, we strengthened our prior years reserves by $181. In 2002 and 2001, our reserve reviews indicated that our reserves established in prior years were slightly higher than necessary, and so in those years we released $2,262 and $7,303, respectively, of previously established reserves for losses and loss adjustment expenses. The changes we have recorded in our reserves in the past three years illustrate the uncertainty of estimating reserves. It is not appropriate to extrapolate future favorable or unfavorable development of reserves from this past experience.
In our determination of whether a decline in market value below amortized cost is an other-than-temporary impairment, we consider and evaluate several factors and circumstances including the issuer's overall financial condition, the issuer's credit and financial strength ratings, a weakening of the general market conditions in the industry or geographic region in which the issuer operates, a prolonged period (typically six months or longer) in which the fair value of an issuer's securities remains below our amortized cost and any other factors that may raise doubt about the issuer's ability to continue as a going concern.
Investment Income. Investment income for the year ended December 31, 2003 decreased to $26,086 from $26,142 for the comparable 2002 period. Average cash and investment securities (at amortized cost) increased by $79,008 or 14.1% to $638,931 for the year ended December 31, 2003 from $559,923 for the comparable 2002 period. Offsetting the effect of this increase was a decrease in net effective yield on our investment portfolio to 4.1% from 4.7% during the same period in 2003 due to declining interest rates, as well as a change in management's investment strategy to shorten the
portfolio duration, shift to higher rated securities, and increase tax-exempt holdings. Our duration decreased to 4.2 years at December 31, 2003 from 5.0 years at December 31, 2002. In addition, during the third quarter of 2003, a retrospective adjustment was made which decreased investment income by $595 due to a periodic revaluation of our asset-backed securities using revised prepayment assumptions and resulting assumed cash flows associated with the loans underlying these securities.
(1)Ratings are assigned by Moody's or the equivalent, as discussed above. Such ratings are generally assigned upon the issuance of the securities and are subject to revision on the basis of ongoing evaluations. Ratings in the table are as of the date indicated. In our determination of other-than-temporary impairments, we consider several factors and circumstances including the issuer's overall financial condition, the issuer's credit and financial strength ratings, a weakening of the general market conditions in the industry or geographic region in which the issuer operates, a prolonged period (typically six months or longer) in which the fair value of an issuer's securities remains below our amortized cost and any other factors that may raise doubt about the issuer's ability to continue as a going concern.
gross unrealized losses relates to holdings of investment grade asset-backed, corporate and other fixed maturities securities. Gross unrealized losses increased to $1,993 at December 31, 2003 from $926 at December 31, 2002.
During the last half of 2003 and 2002, there were no significant deteriorations in the credit quality of any of our holdings and no other-than-temporary impairment charges were recorded related to our portfolio of investment securities. However, during the first quarter of 2003 there was a significant deterioration in the credit quality of one of our holdings, Continental Airlines. Accordingly, during the first quarter of 2003 we recorded an other-than-temporary impairment of $837 for this security. During May 2003, this security was sold at a realized gain of $426. In comparison, during the second quarter of 2002 there was a significant deterioration in the credit quality of two of our holdings in the telecommunications sector. We recognized a realized loss of $2,020 for one of these securities, which was sold in June 2002. In addition, we recorded an other-than-temporary impairment charge of $1,043 for the other telecommunications security. During September 2002, this security was sold at a realized loss of $79.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred for the year ended December 31, 2003 increased $45,791, or 12.2%, to $420,969 from $375,178 for the comparable 2002 period. Our GAAP loss ratio for the year ended December 31, 2003 increased to 77.9% compared to 76.7% for the comparable 2002 period. Our GAAP loss ratio excluding loss adjustment expenses for the year ended December 31, 2003 increased to 70.2% compared to 68.3% for the comparable 2002 period. The 2003 increase in our GAAP loss ratio excluding loss adjustment expenses is primarily due to increased claim frequency and severity from unusually harsh winter conditions in Massachusetts during the first quarter of 2003 on our homeowners line of business.
Our GAAP expense ratio (a percentage of net premiums earned) for the year ended December 31, 2003 improved to 24.2% compared to 26.3% for the comparable 2002 period. This improvement was a result of an increase in earned premiums coupled with ongoing cost control programs, employee productivity improvements through the use of technology, and reduced expenses assumed from CAR.
Other Expenses. Other expenses for the year ended December 31, 2003 decreased to $0 from $6,250 for the comparable 2002 period. Other expenses in 2002 was comprised of $4,000 of TJC management termination fee expense related to services that ceased at the IPO, and $2,250 of
Net Earned Premiums. Net earned premiums for the year ended December 31, 2002 increased by $41,983, or 9.4%, to $489,256 from $447,273 for the comparable 2001 period. This increase was primarily due to an approximately 4.4% increase in automobile exposures for which we earned premiums in our private passenger automobile business, an increase in assumed premiums from CAR, and the increased rates on our private passenger automobile, commercial automobile and homeowners lines.
Investment Income. Investment income for the year ended December 31, 2002 decreased by $1,463, or 5.3%, to $26,142 from $27,605 for the comparable 2001 period. An increase of $47,460 or 9.3% in average invested securities and cash (at amortized cost) to $559,923 for the year ended December 31, 2002 from $512,463 for the year ended December 31, 2001 was more than offset by a decrease in net effective yield on our investment portfolio to 4.7% from 5.4% during the same period due to declining interest rates on our investment portfolio, as well as a change in management's investment strategy to shorten the duration of our portfolio, shift to higher rated securities, and increase our tax-exempt holdings.
Net Realized Losses on Investments. Net realized losses on investments for the year ended December 31, 2002 decreased by $4,773 to $277 from $5,050 for the comparable 2001 period. The 2001 net realized losses resulted primarily from the sale of certain securities that had significantly declined in credit quality from the date of purchase and from sales of securities in the ordinary course following the resetting of their carrying value under purchase accounting as of the date of the Acquisition.
The gross unrealized appreciation (depreciation) of investments in fixed maturities securities as of December 31, 2002, was as follows:
In connection with the purchase price allocation adjustments recorded effective with the Acquisition, we increased our net cost basis in investment securities held by an aggregate of approximately $12,679 to their fair market values as of October 16, 2001. None of our gross unrealized losses of $926 as of December 31, 2002 has existed for longer than six months and at a value of less than 80% of cost. As of December 31, 2001, we had gross unrealized losses of $8,083, of which approximately $7,286 related to fixed maturity obligations of the U.S. government, states, and government agency asset-backed securities. The remaining $797 of gross unrealized losses at that date related to holdings of investment grade corporate fixed maturities securities in a variety of industries and sectors, including banking, retail, finance, consumer product, telecommunications, entertainment, utilities and aerospace.
Finance and Other Service Income. Finance and other service income includes revenues from premium installment charges, which we recognize when earned, and other miscellaneous income and fees. Finance and other service income for the year ended December 31, 2002 increased by $2,362, or 20.0%, to $14,168 from $11,806 for the comparable 2001 period. These increases were due to a $1,900 increase in premium installment billing fees due to growth in the number of policies and the fee charged per policy, as well as $500 increase in miscellaneous income from CAR.
Massachusetts law requires that we participate in the Massachusetts Insurers Insolvency Fund, which pays claims up to $300 of a policyholder of an insolvent insurer if the claim existed prior to the declaration of insolvency or arose within sixty days after the declaration of insolvency. We account for allocations from the Massachusetts Insurers Insolvency Fund as underwriting expenses. Underwriting expenses in 2002 and 2001 included $2,103 and $1,398 of charges representing our allocation from the Massachusetts Insurers Insolvency Fund.
termination fee expense related to services that ceased at the IPO, and $2,250 of unamortized deferred debt issuance costs related to the Acquisition debt which were expensed upon the repayment of this debt, concurrent with the IPO.
Interest Expenses. Interest expenses for the year ended December 31, 2002 increased by $4,881 to $7,254 from $2,373 for the comparable 2001 period. Interest expenses for 2002 were related to Acquisition debt that was extinguished at the IPO, as well as indebtedness incurred in connection with the IPO. Interest expenses for 2001 were related to the employee stock ownership plan debt that was extinguished at the Acquisition, as well as indebtedness incurred in connection with the Acquisition. Primarily as a result of the IPO, we significantly reduced our debt outstanding to $19,956 at December 31, 2002 from $99,500 at December 31, 2001.
Net Income Before Extraordinary Item and Preferred Stock Dividends. Net income before extraordinary item and preferred dividends for the year ended December 31, 2002 increased to $10,461 from $22 for the comparable 2001 period.
As a holding company, Safety's assets consist primarily of the stock of our direct and indirect subsidiaries. Our principal source of funds to meet our obligations and pay dividends to shareholders, therefore, are dividends and other permitted payments from our subsidiaries, principally our indirect subsidiary, Safety Insurance. Our direct subsidiary, TBC, directly owns Safety Insurance. TBC is the borrower under our new credit facilities. As a holding company, its principal source of cash to pay amounts owed under the credit facility and its other obligations and dividends to us are dividends and other permitted payments from Safety Insurance.
Safety Insurance's sources of funds primarily include premiums received, investment income and proceeds from sales and redemptions of investments. Safety Insurance's principal uses of cash are the payment of claims, operating expenses and taxes, the purchase of investments and payment of dividends to TBC.
Net cash provided by operating activities was $85,185 and $85,379 during the years ended December 31, 2003 and 2002, respectively. Our operations typically generate substantial positive cash flows from operations as most premiums are received in advance of the time when claim and benefit payments are required. These positive operating cash flows are expected to continue to meet our liquidity requirements.
Net cash used for investing activities was $89,205 and $63,656 during the year ended December 31, 2003 and 2002, respectively, which resulted primarily from purchases of fixed maturities in excess of sales of fixed maturities.
New 2002 Credit Facility. Concurrent with the closing of our IPO and repayment of the old credit facility, TBC obtained a new $30,000 revolving credit facility. Fleet National Bank is the lender under this new credit facility. TBC borrowed the entire $30,000 under this new credit facility at the closing of the IPO and paid down the balance to $19,956 on December 5, 2002 with the approximately $10,000 net proceeds from the exercise of the underwriter's over-allotment option for 900,000 shares of our common stock. Loans under the new credit facility bear interest at our option at either (i) the LIBOR rate plus 1.50% per annum or (ii) the higher of Fleet National Bank's prime rate or 0.50% above the federal funds rate plus 1.50% per annum. The new credit facility is due and payable at maturity on November 27, 2005, which is three years from the closing of the IPO. Interest only is payable prior to maturity. The obligations of TBC under the new credit facility are secured by pledges of the assets of TBC and the capital stock of TBC's operating subsidiaries. The new credit facility is guaranteed by the non-insurance company subsidiaries of TBC. The new credit facility contains covenants including requirements to maintain minimum risk based capital ratios and statutory surplus of Safety Insurance as well as limitations or restrictions on indebtedness, liens, dividends, and other matters. As of December 31, 2003, we were in compliance with all such covenants.
Old 2001 Credit Facility. In connection with the Acquisition, TBC borrowed a total of $69,500 under our old credit facility. Fleet National Bank was the arranger under this facility, which consisted of a $55,000 term loan and a $20,000 revolving credit facility. We borrowed the entire amount of the term loan and $14,500 under the revolving credit facility to fund the Acquisition and had paid down $3,000 on the term loan prior to closing our IPO. The interest rate under our old credit facility was 5.0% at the closing of the IPO. We used proceeds from our IPO, the Direct Sale and the new credit facility to repay all our borrowings under our old credit facility on that date.
Senior Subordinated Notes. Safety issued $30,000 in 13.0% senior subordinated notes to obtain funds for the Acquisition. Interest on these notes was payable semiannually on each April 30 and October 31. The senior subordinated notes would have matured December 31, 2011. The notes could be redeemed at our option prior to maturity with no redemption premium or penalty. The notes also contained specified financial and operating covenants. We used proceeds from the IPO, the Direct Sale and the New Credit Facility to repay these notes along with approximately $0.3 million of unpaid accrued interest on that date.
Senior Redeemable Preferred Stock. Safety issued $22,400 of its senior redeemable cumulative preferred stock in connection with the Acquisition. This preferred stock was entitled to cumulative dividends at a rate of 6% per year, a liquidation preference of $22,400 and was required to be redeemed on the earlier of October 16, 2012 or the date of a change in control of our Company.
Regulatory Matters. Our insurance subsidiaries are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid to their parent without prior approval of the DOI. Massachusetts' statute limits the dividends an insurer may pay in any twelve month period, without the prior permission of the Commissioner, to the greater of (i) 10% of the insurer's surplus as of the preceding December 31 or (ii) the insurer's net income for the twelve-month period ending the preceding December 31, in each case determined in accordance with statutory accounting practices. Our insurance company subsidiaries may not declare an "extraordinary dividend" (defined as any dividend or distribution that, together with other distributions made within the preceding twelve months, exceeds the limits established by Massachusetts' statute) until thirty days after the Commissioner has received notice of the intended dividend and has not objected. As historically
administered by the Commissioner, this provision requires the Commissioner's prior approval of an extraordinary dividend. Under Massachusetts law an insurer may pay cash dividends only from its unassigned funds, also known as earned surplus, and the insurer's remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. At year-end 2003, the statutory surplus of Safety Insurance was $258,551, and its net income for 2003 was $27,007. A maximum of $27,007 is available in 2004 for such dividends without prior approval of the Commissioner. During the year ended December 31, 2003, Safety Insurance declared dividends to TBC in the amount of $6,670.
The maximum dividend permitted by law is not indicative of an insurer's actual ability to pay dividends, which may be constrained by business and regulatory considerations, such as the impact of dividends on surplus, which could affect an insurer's ratings or competitive position, the amount of premiums that can be written and the ability to pay future dividends.
We have obligation to make future payments under contracts and credit-related financial instruments and commitments. At December 31, 2003, certain long-term aggregate contractual obligations and credit-related commitments are summarized as follows:
•Projections of revenues, income, earnings per share, capital expenditures, dividends, capital structure or other financial items;
Forward-looking statements give our expectations or predictions of future conditions, events or results. They are not guarantees of future performance. By their nature, forward-looking statements are subject to risks and uncertainties. There are a number of factors-many of which are beyond our control-that could cause actual future conditions, events, results or trends to differ significantly and/or materially from historical results or those projected in the forward-looking statements. These factors include but are not limited to the competitive nature of our industry and the possible adverse effects of such competition, conditions for business operations and restrictive regulations in Massachusetts, claims related to severe weather, our possible need for and availability of additional financing, and our dependence on strategic relationships, among others, and other risks and factors identified from time to time in our reports filed with the SEC. Refer to those set forth under the caption "Risk Factors" in our prospectus in the registration statement on Form S-1 filed with the SEC on November 22, 2002.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, changes in shareholders' equity, comprehensive income and cash flows present fairly, in all material respects, the financial position of Safety Insurance Group, Inc. and its subsidiaries at December 31, 2003 and 2002, and the results of their operations and their cash flows for the years ended December 31, 2003 and 2002 and the period from October 16, 2001 through December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In connection with financing the Acquisition, the Company incurred debt of $99,500 and issued 22,400 shares of Series A senior mandatorily redeemable preferred stock at $1,000 per share. At October 16, 2001, the estimated fair value of net assets acquired approximated their carrying values, as net assets were comprised primarily of investments, cash and short-term receivables. The excess of estimated fair value of net assets over purchase price of $117,523 was recorded as an extraordinary gain in accordance with FAS 141, "Business Combinations." See Note 3 for the methodology used in determining the fair value of loss and loss adjustment expense reserves.
Prior to the IPO, approximately 72% of the outstanding common stock of the Company was owned by certain investors assembled by The Jordan Company, LLC, an investment firm that sponsored the Acquisition. The remaining 28% was owned by executive management. (See Note 12 regarding promissory notes received from management.) JZ Equity Partners plc, a London-based publicly traded investment trust, owned approximately 50% of the outstanding mandatorily redeemable preferred stock of the Company; the other 50% was owned by third parties. The preferred stock was cumulative, non-voting with a 6% dividend rate and was mandatorily redeemable on October 16, 2012 or upon a change in control. See Note 9.
The Company sold 6,333,334 common shares in its IPO, 350,000 common shares in a direct sale (the "Direct Sale") and 900,000 common shares from the exercise of the underwriters' over-allotment option all at $12.00 per share. Net proceeds received were $81,819 from these stock issuances after deducting underwriting discounts and other offering expenses. The Company also received $30,000 from borrowings under its new credit facility. These net proceeds and borrowings were used to repay principal and interest on the outstanding debt as well as dividends on the outstanding mandatorily redeemable preferred stock. In addition, $22,400 of common stock and additional paid in capital was recognized from the issuance of 1,866,665 common shares upon conversion of all outstanding preferred stock (the "Preferred Share Exchange"), concurrent with the IPO.
Amounts included in accounts receivable represent premiums as well as finance charges which are billed on a monthly installment basis. A majority of the Company's premiums are billed on a monthly installment basis. Accounts receivable are stated net of allowances for doubtful accounts. At December 31, 2003 and 2002, these allowances were $484 and $548, respectively.
acquisition. The discounting pattern was actuarially developed from the Company's historical loss data. A profit and risk margin of 6% was applied to the discounted loss and LAE reserves, to reflect management's estimate of the cost the Company would incur to reinsure the full amount of its net loss and LAE reserves with a third party reinsurer. This margin was based upon management's assessment of the uncertainty inherent in the net loss and LAE reserves and their knowledge of the reinsurance marketplace.
The Company and its subsidiaries file a consolidated United States federal income tax return. The method of allocation among members of the consolidated group is subject to a written agreement approved by the Board. The consolidated tax liability is allocated on the basis of the members' proportionate contribution to consolidated taxable income.
Basic earnings (loss) per common share ("EPS") are calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Net income (loss) available to common shareholders includes preferred stock dividends for the year ended December 31, 2002 and the period October 16, 2001 through December 31, 2001. Diluted earnings (loss) per common share are calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding and the net effect of potentially dilutive common shares. At December 31, 2003 and 2002, the Company's only potentially dilutive instruments were shares under options of 771,000 and 379,000, respectively. The Company determined that 290,500 shares of restricted stock held by management were potentially dilutive during the successor periods until the IPO when all restricted shares vested in full. For the successor period October 16, 2001 through December 31, 2001, management restricted stock was antidilutive due to the net loss before extraordinary item, and therefore was not included in the diluted earnings per common share calculation. In accordance with the provisions of FAS 128, EPS is determined based upon net income, before and after any extraordinary items, less any declared or accrued dividends on the mandatorily redeemable preferred stock. In addition, EPS is calculated for an
As described in Note 6, certain members of management were granted SARs on October 16, 2001. Prior to the IPO, the SARs were to vest 20% per annum commencing on December 31, 2002. As of the close of the IPO, the SARs became fully vested and were automatically exercised. The SARs were accounted for in accordance with the provisions of FASB Interpretation ("FIN") No. 28 "Accounting for Stock Appreciation Rights and Other Variable Stock Options or Awards Plans". Under FIN 28, compensation expense is accrued over the period or periods in which the employee performs the related services and is recognized to the extent that the fair market of the Company's stock exceeds the exercise price of the SARs. Changes in the fair market value of the stock in an accounting period, to the extent it still exceeds the exercise price, are recorded as compensation expense.
On June 25, 2002, the Board adopted the 2002 Management Omnibus Incentive Plan ("the Incentive Plan"). The Incentive Plan provides for a variety of awards, including incentive stock options, nonqualified stock options, SARs and restricted stock awards. The Company has granted certain stock option awards under this Incentive Plan and follows the accounting for these options under the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees", as allowed by FAS 123, "Accounting for Stock-Based Compensation" and as amended by FAS 148, "Accounting for Stock-Based Compensation-Transition and Disclosure".
No stock-based employee compensation cost is reflected in net income, as all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
In November 2002, the FASB issued FIN 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others", which addresses the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees. This Interpretation also clarifies the requirements related to the recognition of a liability by a guarantor at the inception of a guarantee for the obligations the guarantor has undertaken in issuing that guarantee. The provisions related to the disclosure requirements to be made by a guarantor are effective for financial statements of interim and annual reporting periods ending after December 15, 2002. The provisions related to the recognition of a liability and initial measurement shall be applied prospectively to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. The adoption of this Interpretation did not have a material impact on the Company's financial statements.
The Company comprises one business segment: property and casualty insurance operations.
(1)Obligations of U.S. Government agencies includes collateralized mortgage obligations issued, guaranteed and/or insured by the following issuers: Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC) and Federal National Mortgage Association (FNMA). The total of these fixed maturity securities was $120,928 and $93,560 at amortized cost and $121,833 and $95,946 at estimated fair value as of December 31, 2003 and 2002, respectively. As such, the asset-backed securities presented exclude such issuers already presented under U.S. Treasury securities and obligations of U.S. Government Agencies.
The amortized cost and the estimated fair value of fixed maturity securities, by maturity, at December 31, 2003 are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
obligated interest and principal payments, and the Company's intent to hold the investment for a period of time sufficient to allow for recovery of its costs.
During the year ended December 31, 2003, there was a significant deterioration in the credit quality of one of the Company's holdings, Continental Airlines. Accordingly, the Company recorded an other-than-temporary impairment of $837 for this security. During May 2003, this security was sold at a realized gain of $426. During the year ended December 31, 2002, there was a significant deterioration in the credit quality of two of the Company's holdings in the telecommunications sector. The Company recognized a realized loss of $2,020 for one of these securities which was sold in June 2002. In addition, the Company recorded an other-than-temporary impairment charge of $1,043 for the other telecommunications security. During September 2002, this security was sold at a realized loss of $79. For the periods October 16, 2001 through December 31, 2001 and January 1, 2001 through October 15, 2001, there were no significant deteriorations in the credit quality of any of the Company's holdings and the Company did not record any other-than-temporary impairment charges relating to the Company portfolio of investment securities.
As part of the application of purchase accounting, equipment and leasehold improvements with a net book value of $3,274 on the date of the Acquisition were reduced to zero. Equipment and leasehold improvements at December 31, 2003 and 2002 represent those items purchased subsequent to October 16, 2001. At December 31, 2003 and 2002, the Company held equipment and leasehold improvements with a carrying value of $1,309 and $642, which is net of accumulated depreciation of $415 and $84, respectively.
Depreciation and amortization expense for the years ended December 31, 2003 and 2002, for the period October 16, 2001 through December 31, 2001, and for the predecessor period ended October 15, 2001, was $331, $84, $0, and $1,303, respectively.
The management subscription agreements, including the Company call and employee put options, terminated upon the IPO, at which point variable plan accounting ceased and the liability accrued at the IPO date was re-classified to paid-in capital.
On October 16, 2001, the Company implemented a Restricted Stock Plan and entered into Executive Restricted Stock Award Agreements under this plan with two employees of the Company. Under these agreements, 290,500 restricted shares of common stock, the maximum number that could be granted or sold under the plan, were sold at a cost of $0.43 per share, which approximated the fair value of the shares at the date of the sale. The Restricted Stock Plan permits the Board to grant restricted shares of common stock to select employees of the Company or any of its affiliates. The Board has the right to amend or terminate the Restricted Stock Plan at any time, subject to certain limitations, but no amendment or termination may alter the rights of a participant under any awards previously granted. The restricted shares were subject to the put and call provisions of the Management Subscription Agreement, which under certain circumstances may have required the Company to purchase the restricted shares at a price based upon a formula calculation. These put and call provisions were accounted for in accordance with EITF 00-23 whereby employee compensation expense
was recorded over the period of service of the employee in accordance with FIN 28. Compensation expense related to these agreements was $0, $470 and $120 for the years ended December 31, 2003 and 2002 and the successor period ended December 31, 2001, respectively.
With the termination of the ESOP, the Company re-established the previously frozen Retirement Plan, effective January 1, 2002. The Retirement Plan is a defined contribution plan which is available to all eligible employees of the Company. An employee must be 21 years of age to be eligible to participate in the Retirement Plan, and was allowed to contribute on a pre-tax basis up to the
maximum allowed under federal law. The Retirement Plan is administered by the Company and is subject to the provisions of the Employee Retirement Income Security Act of 1974 ("ERISA"). Under the Retirement Plan, the Company shall make a matching contribution in an amount equal to 75% of the first 8% the participant contributed during the Retirement Plan year to those participants who during the Retirement Plan year have contributed from their pay to their Retirement Plan account, who started working for the Company by July 1, who worked 1,000 hours and who were employed on the last day of the Retirement Plan year. Compensation expense related to the Retirement Plan was $969 and $567 for the years ended December 31, 2003 and 2002, respectively.
On June 25, 2002, the Board adopted the 2002 Management Omnibus Incentive Plan ("the Incentive Plan"). The Incentive Plan provides for a variety of awards, including nonqualified stock options, SARs and restricted stock awards. A summary of stock options granted under the Incentive Plan as of December 31, 2003, is as follows:
(2)The exercise price is equal to the closing price of our common stock on the grant date. The Board and the Compensation Committee intend to issue more options under the Incentive Plan in the future, not to exceed the maximum number of shares to be granted. The maximum number of shares of common stock with respect to which awards may be granted under the Incentive Plan is 1,250,000. On December 31, 2003, there were 479,000 shares available for future grants.
The Company has various noncancelable long-term operating leases. The approximate minimum annual rental payments due under these lease agreements as of December 31, 2003 are as follows:
Certain lease agreements contain renewal options and, in addition to the minimum annual rentals, generally provide for payment of a share of the real estate taxes and operating expenses in excess of a base amount. Rental expense was $2,718, $2,737 for the years ended December 31, 2003 and 2002, respectively, $1,997 for the period January 1, 2001 through October 15, 2001, and $536 for the period October 16, 2001 through December 31, 2001. All leases expire prior to 2009. The Company expects that in the normal course of business, leases that expire will be renewed.
In connection with the Acquisition, the Company entered into an agreement with members of its management team to indemnity them for any tax loss they may incur in connection with the purchase of its common stock at the time the Company acquired TBC, due to a determination by the Internal Revenue Service that the value of such stock was higher than the purchase price agreed upon by the Company and its management team.
At the closing of the IPO, the Company repaid its existing credit facility and obtained a new $30,000 revolving credit facility. The purpose of the new credit facility, combined with the net proceeds of the IPO, was to repay an aggregate of $96,843 of indebtedness (including accrued interest), thereby paying off the Company's secured term loan, subordinated notes, and secured revolving credit facility. The obligations of the Company under the new credit facility are collateralized by (i) a 100% pledge of the stock of Safety Insurance Company, Inc., RBS, Inc. and TBIA, and (ii) a perfected first priority security interest, subject to permitted liens, in all of the assets, whenever acquired, of TBC, RBS, Inc. and TBIA. Loans under the new credit facility bear interest at the Company's option at either (i) the LIBOR rate plus 1.5% per annum or (ii) the higher of the bank's prime rate or 1/2% above the federal funds rate plus 1.5% per annum. The new credit facility is due and payable at the maturity date, which is November 27, 2005. Interest only is payable prior to maturity.
The Company incurred interest expense of $646, $7,254, $1,823, and $550 for the years ended December 31, 2003 and 2002, for the period October 16, 2001 through December 31, 2001, and for the period January 1, 2001 through October 15, 2001, respectively, related to all debt outstanding during these periods.
The Company cedes insurance to CAR and to other reinsurers. The Company has a property catastrophe excess of loss agreement and a casualty excess of loss agreement which qualify as reinsurance treaties and are designed to protect against large or unusual loss and LAE activity. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers and monitors economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies.
The Company is subject to concentration of credit risk with respect to reinsurance ceded to CAR. At December 31, 2003 and 2002, respectively, reinsurance receivables on paid and unpaid loss and LAE with a carrying value of $106,808 and $92,798 and prepaid reinsurance premiums of $28,859 and $26,779 were associated with CAR. The Company's participation in CAR resulted in assumed net losses of $48,367 and $38,589 for the years ended December 31, 2003 and 2002, respectively, $6,905 for the period October 16, 2001 through December 31, 2001, and $21,316 for the period January 1, 2001 through October 15, 2001.
As a servicing carrier for CAR, the Company has entered into service contracts with other insurance carriers under which the Company services the residual market business assigned to the carriers by CAR (the "buyout program"). Business generated through the buyout program is 100% ceded to the applicable carrier and serviced for a fee. Servicing carrier fees amounted to $548 and $499 for the years ended December 31, 2003 and 2002, respectively, $87 for the period October 16, 2001 through December 31, 2001, and $371 for the period January 1, 2001 through October 15, 2001.
During 2001, the Company entered into a ten-year management consulting agreement with TJC, an affiliate of The Jordan Company. Under the management consulting agreement, TJC rendered consulting services to the Company in connection with financial and business affairs, relationships with lenders, shareholders and other third parties, and the expansion of the Company's business. The Agreement was to automatically renew for successive one-year terms starting December 31, 2011 unless terminated pursuant to its provisions. Under the Agreement, the Company was required to pay an annual management fee of $1,000 in quarterly installments.
•payment by the Company of an amount equal to TJC's out-of-pocket expenses, including an allocable amount of TJC's overhead expenses attributable to services provided to the Company.
Provision for income taxes have been calculated in accordance with the provision of Statement No. 109. A summary of the income tax expense (benefit) in the Consolidated Statements of Income is shown below:
The income tax expense (benefit) attributable to the consolidated results of operations are different from the amounts determined by multiplying income before federal income taxes by the statutory federal income tax rate. The sources of the difference and the tax effects of each were as follows:
The Company uses various financial instruments in the normal course of its business. Certain insurance contracts are excluded by Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," and, therefore, are not included in the amounts discussed.
At December 31, 2003 and 2002, the carrying value of $19,956 of the secured revolving credit facility approximated its fair value as described in Note 8.
An unaudited summary of the Company's 2003 and 2002 quarterly performance is as follows: