The Company leases approximately 500,000 square feet for its Home Office facilities, which are located in Woodland Hills, California. The lease was amended in April 1998 to extend its term until November 2014. The lease may be renewed for two consecutive five-year periods.
In 1999, 1998 and 1997, the Company's financial statements include the effects of certain non-recurring charges of $9.2 million, $7.7 million and $1.5 million, respectively. These charges represent a non-recurring regulatory settlement with the CDOI in 1999, accelerated amortization of restricted stock grants in 1998 and Year 2000 remediation costs in 1999, 1998 and 1997. Additionally, increases in earthquake reserves in 1998 of $40 million, in 1997 of $24.75 million, in 1996 of $40 million and in 1995 of $60 million (offset partially by a $32 million reduction in the Proposition 103 liability per an order from the CDOI) are included in the financial statements. On an after-tax basis, these additional charges reduced basic earnings per share by $0.08, $0.46, $0.33, $0.51 and $0.35 for 1999, 1998, 1997, 1996 and 1995 respectively.
Units in Force Units in force for the Company's insurance programs as of December 31 were as follows:
Private Passenger Automobile. Vehicles in force grew by 54,768 in 1999, ------------------------------ compared to an increase of 53,153 in 1998. The Company's average customer retention rate was approximately 96% for both 1999 and 1998. The competition for new business intensified in 1999, particularly in California. The Company lowered overall rate levels approximately 6.8% and 3.4% in 1999 and 1998, respectively, in anticipation of continuing favorable loss trends. However, by mid-1999, past favorable trends had flattened or, in some cases turned unfavorable, which began to reduce the Company's underwriting margins in the third and fourth quarters of 1999. The Company anticipates continued pressure on its margins and expects that a price increase may become necessary during 2000.
Homeowners. The Company's position in the homeowners market is intended to - - ---------- complement its auto business and facilitate growth in that line. Units in force for the Company's homeowners program remained comparatively stable from December 31, 1998, to December 31, 1999, due to the commencement of sales of new policies in September 1999 for the first time since 1995, which substantially offset the decrease caused by customer attrition.
PUP. The penetration of this coverage has averaged about 1% of the --- vehicles in force during each of the three years ended December 31, 1999. --
Since 1996, the Company has reduced average California auto premiums by more than 25%. Although the reduction in premium revenues produced lower top-line and investment income growth, underwriting margins continued to be favorable until the third quarter of 1999, as previously discussed under "Units in Force."
From July 1, 1996, to December 31, 1999 the Company maintained a 100% quota share reinsurance program for its homeowners policies, as discussed in Note 10 of the Notes to Consolidated Financial Statements. Written premiums ceded under this program totaled $24.7 million in 1999 compared to $24.5 million in 1998 and $24.4 million in 1997.
Effective January 1, 2000, the 100% quota share reinsurance program was terminated and replaced by a more traditional catastrophe excess of loss reinsurance program. (See Note 10 of the Notes to Consolidated Financial Statements.)
The personal umbrella program has remained stable over the three-year period ended December 31, 1999, producing approximately $2 million in gross written premiums each year. Underwriting profits for this business can vary significantly with the number of claims which occur infrequently.
The Company recorded additional provisions for the 1994 Northridge Earthquake in 1998 and 1997 of $40 million and $24.75 million, respectively. No additional provision was made in 1999. Although the Company remains exposed to possible further upward development in the estimated cost to resolve certain Northridge Earthquake claims, management believes current reserves are adequate.
The Company's policy acquisition and general operating expense ratio continues to be among the most competitive in the industry. As a direct writer, the Company does not incur agent commissions and, thus, enjoys an expense advantage over most of its competitors. The ratios of underwriting expenses (excluding interest and fees) to earned premiums were 12.9% in 1999, 10.2% in 1998 and 9.4% in 1997. Excluding non-recurring charges related to the CDOI settlement, Y2K costs and the amortization of stock grants, the expense ratios would be 11.7% in 1999 and 9.2% in both 1998 and 1997. The increase in the expense ratio from 1998 to 1999 primarily results from the rate decrease taken in February 1999 and increases in advertising expense.
Net pre-tax investment income was $62.7 million in 1999 compared to $75.1 million in 1998 and $73.5 million in 1997. Average invested assets increased 0.4% in 1999 and 5.4% in 1998 compared to a decrease of 2.0% in 1997. The increase in 1998 is primarily due to additional cash received from the exercise of AIG's common stock warrants in the third quarter of 1998 as discussed in Note 12 of the Notes to Consolidated Financial Statements. The decline in invested assets for 1997 resulted from the decline in net earned premiums and the liquidation of investments to meet the payment requirements of both developing earthquake losses and reinsurance premiums. The average annual pre-tax yield on invested assets was 5.4% in 1999, 6.6% in 1998 and 6.7% in 1997. The average annual after-tax yield on invested assets was 4.3% in 1999, 4.3% in 1998 and 4.5% in 1997.
As of December 31, 1999, the Company had a pre-tax unrealized loss on fixed maturity investments of $62.3 million compared to an unrealized capital gain of $34.9 million in 1998 and $29.7 million in 1997. Interest rates rose in 1999, which decreased the fair value of our bond portfolio. Conversely, in 1998 and 1997, interest rates fell, which increased the fair value of the bond portfolio in those years.
Funds required by 21st Century Insurance Group to pay dividends and meet its debt obligations are provided by the insurance subsidiaries. Information regarding the Company's debt service requirements is included in Note 9 of the Notes to Consolidated Financial Statements. The ability of the insurance subsidiaries to pay dividends to the parent company is regulated by state law. Based upon 1999 operating results and earned surplus as of December 31, 1999, the Company believes it will not require regulatory approval in 2000 for any extraordinary dividends.
In 1997, the Company embarked on a major project to upgrade its technological infrastructure and to conform certain of its operational procedures to "industry best practices." Although the ultimate cost of this project is expected to be about $100 million, to be paid through the end of 2001, management believes cash flow from operations as well as expected improvements in operational efficiencies will be more than adequate to fund the project's implementation which is expected to be completed over the next several years.
late 1999, with the completion of construction of the new 21st Century Plaza. The leases on these Home Office facilities expire in 2014 and may be renewed for two consecutive five-year periods.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of 21st Century Insurance Group and subsidiaries at December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
21ST CENTURY INSURANCE GROUP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
21st Century Insurance Group (formerly 20th Century Industries), through its wholly owned subsidiaries, 21st Century Insurance Company and 21st Century Casualty Company (collectively, the "Company"), is engaged in the sale of private passenger automobile insurance policies in California, Nevada, Oregon and Washington and homeowners and personal umbrella insurance policies in California. At this time, almost all of the Company's business is concentrated in California. The Company also provides private passenger automobile insurance in Arizona through a joint venture with American International Group, Inc. ("AIG"), which owned a majority of the Company's outstanding common stock at December 31, 1999.
estimates of the ultimate costs of settlement, net of estimated salvage and subrogation, which are necessarily subject to the outcome of future events including the effects of changes in economic and social conditions. Management believes that, given the inherent variability in any such estimates, the aggregate reserves are within a reasonable and acceptable range of adequacy. The methods of making such estimates and for establishing the resulting reserves are reviewed and updated quarterly and any adjustments resulting therefrom are reflected in current earnings.
In the normal course of business, the Company seeks to reduce its exposure to losses that may arise from catastrophes and to reduce its overall risk levels by obtaining reinsurance from other insurance enterprises or reinsurers. Reinsurance premiums and reserves on reinsured business are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Amounts applicable to ceded unearned premiums, ceded loss payments and ceded claim liabilities are reported as assets in the accompanying balance sheets. The Company believes that the fair value of its reinsurance recoverables approximates their carrying amounts.
Expected maturities of the Company's investments may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
Company utilized net operating loss carryforwards of approximately $59,000,000 to reduce current taxable income. As of December 31, 1999, the Company has a net operating loss carryforward of approximately $97,000,000 for regular tax purposes expiring in the year 2009 and an alternative minimum tax credit carryforward of $33,029,000. Alternative minimum tax credits may be carried forward indefinitely to offset future regular tax liabilities.
Payments for income taxes were $19,500,000, $13,661,000, and $3,150,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
The Company also sponsors an unfunded supplemental executive retirement plan that covers certain key employees designated by the Board of Directors. The supplemental plan benefits are based on years of service and compensation during the last three years of employment, and are reduced by the benefit payable from the pension plan.
The net periodic pension cost for these plans was $4,357,000, $4,117,000 and $4,012,000 in 1999, 1998 and 1997, respectively. Accrued pension costs included in the consolidated balance sheets at December 31, 1999 and 1998 are $2,499,000 and $3,083,000, respectively.
The Company has entered into a revolving credit facility ("the Facility") that provides an aggregate commitment of $67.5 million at December 31, 1999. The commitment decreases by $11.25 million on the first day of each quarter until April 1, 2001. Principal repayments are required when total outstanding advances exceed the aggregate commitment. The Company may prepay principal amounts of the advances, as well as voluntarily cause the aggregate commitment to be reduced at any time during the term of the Facility.
The Company has a quota share treaty for its Personal Umbrella Policy line of business whereby it cedes 60% of premiums and losses. After the effect of the 10% quota share treaty with AIG discussed earlier, the Company effectively retains 36% of the risk for this line of business.
The Company leases office space in Woodland Hills, California. The lease expires in November 2014, and may be renewed for two consecutive five-year periods. The Company also leases office space in several other locations throughout California, primarily for claims services.
Surplus of the insurance subsidiaries on a statutory basis at December 31, 1999 and 1998, was $581,440,000 and $600,654,000, respectively. Statutory net income for the insurance subsidiaries was $100,063,000, $154,916,000, and $178,727,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25") and related Interpretations in accounting for its stock-based compensation. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. SFAS No. 123, Accounting for Stock-Based Compensation, requires disclosure of the pro forma net income and earnings per share as if the Company had accounted for its employee stock options under the fair value method of that Statement. The fair value of stock
grants made under the Restricted Shares Plan is amortized to expense under APB 25 over the vesting period of the grants. This accounting treatment results in compensation expense being recorded in a manner consistent with that required under SFAS No. 123, and, therefore, pro forma net income and earnings per share amounts for the Restricted Share Plan would be unchanged from those reported in the financial statements.
Exercise prices for options outstanding at December 31, 1999 ranged from $12.50 to $29.25. The weighted-average remaining contractual life of those options is 7.9 years.
For pro forma disclosure purposes, the fair value of stock options was estimated at each date of grant using a Black-Scholes option pricing model using the following assumptions: Risk-free interest rates of 5.48% for 1999, 5.02% to 5.65% for 1998 and 6.23% to 6.67% for 1997 ; dividend yields of 3.59% in 1999, ranging from 1.98% to 2.33% in 1998 and 1.14% to 1.44% in 1997; volatility factors of the expected market price of the Company's common stock of .23, for both 1999 and 1998 and .27 for 1997; and a weighted-average expected life of the options of 8 years in 1999, 1998 and 1997.
The Restricted Shares Plan currently provides for grants of up to 921,920 shares of common stock to be made available to key employees as determined by the Key Employee Incentive Committee of the Board of Directors. Subsequent to December 31, 1999, the Company registered 500,000 additional shares under the Restricted Shares Plan. The common shares granted are restricted. Restrictions are removed on 20% of the shares of each employee on January 1 of each of the five years following the year of grant. Upon issuance of grants of common shares under the plan, unearned compensation equivalent to the market value on the date of grant is charged to common stock and subsequently amortized in equal monthly installments over the five-year vesting period of the grant. As a consequence of AIG's acquiring a controlling interest in the Company, the previously unamortized balance of $2,280,000 as of July 27, 1998, was recognized as a charge to income. Total
amortization expense relating to the Restricted Shares Plan was $2,698,000 and $534,900 in 1998 and 1997. There was no amortization expense in 1999.
In the normal course of business, the Company is named as a defendant in lawsuits related to claim issues. Some of the actions request exemplary or punitive damages. These actions are vigorously defended unless a reasonable settlement appears appropriate.
The following table presents premium revenue and underwriting profit (loss) for the Company's insurance lines on a GAAP basis for the years ended December 31.
1999. The GAAP combined ratio for the auto line was 100.3% in the fourth quarter of 1999 and 89.6% in the third quarter of 1999, compared to 84.7% for the first half of the year and 85.4% for 1998 and 82.8% in 1997. The Company expects that it may be necessary to seek a rate increase in California during 2000 although there can be no assurance that the requisite approval will be granted by the regulator. The $21.4 million decline in underwriting profits in the auto line from 1997 to 1998 was caused mainly by the effects of an increase in claims frequency that emerged principally in the 1998 fourth quarter, and successive premium rate reductions effective October 31, 1997, and January 1, 1998, of 3.2% and 3.4%, respectively.
Homeowners. The smaller underwriting loss in the homeowners line in 1999 - - ---------- principally is due to the absence of any provision for additional earthquake reserves, which totaled $40 million in 1998 and $24.75 million in 1997. The 1999 underwriting loss includes a charge of $6.75 million taken in the second quarter in connection with a settlement of the Company reached in April 1999 with the California Department of Insurance. The settlement enabled the Company to resume sales of new homeowner policies in September 1999.