We have developed two proprietary management systems: (i) the RTW SOLUTION®, designed to lower employers’ workers’ compensation costs and return injured employees to work as soon as possible, and (ii) the ID15® system, designed to identify those injured employees who are likely to become inappropriately dependent on the workers’ compensation system. We combine our management system with insurance products underwritten by our insurance subsidiary to offer services to customers. We currently provide workers’ compensation management services solely to employers insured through our insurance subsidiary.
On February 28, 2002, our A.M. Best financial rating was downgraded from a Secure rating (B+) to an Unsecure rating (B-) as a result of the decrease in statutory surplus in 2001 from $29.3 million at December 31, 2000 to $19.5 million at December 31, 2001 and our adverse development in 2001 and 2000 that resulted in statutory operating losses in those years. Certain insurance carriers that write umbrella policies will not provide coverage to an employer if a portion of the employer’s underlying insurance policy, such as the workers’ compensation portion, is written by a carrier with an unsecure rating. Additionally, certain of our independent agents may be unwilling to sell our insurance as a result of the downgrade. As a result, we believe that our B- rating from A.M. Best will make it difficult to provide our products to certain employers. While we believe that the A.M. Best downgrade will result in decreasing premiums in force, the ultimate effect of this downgrade is unknown at this time.
Claim and claim settlement expenses increased significantly to 130.7% of premiums earned for 2001 from 92.7% for 2000. See further discussion under “Claim and Claim Settlement Expenses.”
We expect 2002 premiums in force to decrease significantly from levels in 2001 as a result of the downgrade in our A.M. Best rating and the closure of our regional offices in Missouri and Massachusetts. We also anticipate that we will operate in an environment of continuing premium rate increases in our markets in 2002. We will focus on achieving profitability in all our remaining regional markets by (i) aggressively managing and closing claims, (ii) improving our underwriting, including reviewing policy profitability at renewal and removing unprofitable accounts, and (iii) aggressively managing policy acquisition costs and general and administrative expenses.
In the following pages, we take a look at the 2001, 2000 and 1999 operating results for items in our Consolidated Statement of Operations and also explain key balance sheet accounts in greater detail.
Total revenues: Our total revenues include premiums earned, investment income, net realized investment gains (losses) and other income. The following table summarizes the components of our revenues and premiums in force (000’s):
The premium we charge a policyholder is a function of its payroll, industry and prior workers’ compensation claims experience. In underwriting a policy, we receive policyholder payroll estimates for the ensuing year. We record premiums written on an installment basis matching our billing to the policyholder and earn premiums on a daily basis over the life of each insurance policy based on the payroll estimate. We record the excess of premiums billed over premiums earned for each policy as unearned premiums on our balance sheet. When a policy expires, we audit employer payrolls for the policy period and adjust the estimated payroll and the policyholder’s premium to its actual value. The result is a “final audit” adjustment recorded to premiums earned when the adjustment becomes known. Final audit premiums recognized during the period include billed final audit premiums plus (or minus) the change in estimate for premiums on unexpired and expired unaudited policies.
Our gross premiums earned increased 1.6% to $97.4 million in 2001 from $95.9 million in 2000. This increase resulted from the increase in average premiums in force offset by a decrease in final audit premiums earned to $1.8 million in 2001 from $5.5 million in 2000.
Premium rates on renewal policies stabilized in the latter half of 1999 and we realized only slight pricing decreases. In 2001 and 2000, we were able to increase premium rates on renewing policies an average of 18.5% and 11.7%, respectively. We have been, and expect to continue to, increase rates in our markets due to the following:
Many workers’ compensation insurers withdrew from the markets in which we write premiums due to the historical declines in premium rates in those markets;
unable to honor their obligations to us, we will be required to pay these obligations ourselves. We are not aware of any developments with respect to our reinsurers that would result in uncollectible reinsurance balances.
Under our excess of loss reinsurance policies, we pay reinsurers to limit our per-incident exposure and record this cost to premiums ceded as a reduction of gross premiums earned. In Minnesota, we are required to purchase excess of loss coverage for our Minnesota policies from the Minnesota Workers’ Compensation Reinsurance Association (WCRA). We ceded Minnesota claims in excess of $330,000, $310,000 and $290,000 per occurrence during 2001, 2000 and 1999, respectively, to the WCRA. In our non-Minnesota states, our per-incident exposure was $300,000 in 2001, 2000 and 1999. We purchased this non-Minnesota coverage from a single reinsurer. In 2002, the non-Minnesota coverage is capped at $20.0 million, no longer includes statutory limit coverage and further excludes claims resulting from acts of terrorism.
We expect that (i) the downgrade in our rating to B- from A.M. Best; (ii) closure of our regional offices in Massachusetts and Missouri, and (iii) policies targeted for non-renewal or re-underwriting during 2002 will result in a significant decrease premiums in force in 2002. Premium rate increases on new and renewing policies will partially offset these decreases. We expect that renewal premium rates will continue to
We expect to continue to cede a significant portion of our premiums under our quota share policy in 2002. Premiums ceded under the quota share policy will initially be 80% of gross premiums earned less excess of loss premiums ceded. We expect to reduce the quota share policy back to 50% sometime during the second quarter of 2002.
We expect that premiums ceded under excess of loss policies will decrease as a percent of gross premiums earned when compared to the results attained for 2001 as we will cede no premiums under our terminated $25,000 to $300,000 reinsurance agreement in 2002. This decrease will be partially offset by an increase in premiums ceded in our in our non-Minnesota markets as our excess of loss reinsurance rate in these markets increased significantly in 2002 as a result of the September 11, 2001 terrorist acts against the United States. Excess of loss reinsurance rates as a percent of premium will decrease in 2002 in Minnesota as a result of the premium rate increases we expect to realize in 2002 and realized in 2001.
Investment income increased slightly to $5.9 million in 2001 from $5.8 million in 2000. Investment income increased slightly as a result of repositioning our portfolio entirely into taxable securities that earn a higher pre-tax rate of return offset by a reduction in the funds available for investment to $89.2 million at December 31, 2001 from $96.8 million at December 31, 2000. Funds available for investment decreased due to decreased net cash provided by operating activities, resulting primarily from (i) the difference in timing between the receipt of premiums, the payment of premiums ceded under our reinsurance agreements, the payment of claim and claim settlement expenses and the recovery of paid claim and claim settlement expenses under our reinsurance programs, and (ii) net cash provided by investment income. Tax-adjusted investment yields were 6.1% in 2001 compared to 6.6% in 2000. The investment yields realized in future periods will be affected by yields attained on new investments.
Investment income decreased 11.6% to $5.8 million in 2000 from $6.5 million in 1999. Investment income decreased due to (i) reduced funds available for investment and (ii) an increase in the percent of tax-exempt securities held in our portfolio. Funds available for investment decreased to $96.8 million at December 31, 2000 from $108.1 million at December 31, 1999, due to decreased net cash provided by operating activities, resulting primarily from (i) the difference in timing between the receipt of premiums, the payment of premiums ceded under our reinsurance agreements, the payment of claim and claim settlement expenses and the recovery of paid claim and claim settlement expenses under our reinsurance programs, and (ii) net cash provided by investment income. Tax-exempt securities, which earn lower pre-tax rates than taxable securities but are comparable on a tax-adjusted basis, increased to 57.5% of our investment portfolio at year-end 2000 compared to 56.3% at year-end 1999. Tax-adjusted investment yields were 6.6% in 2000 and 1999.
2002 Outlook: Barring significant changes in interest rates or operational cash flows, we expect the 2002 pre-tax yield from our investment portfolio to be affected by the following:
Funds from our operating cash flows and investment cash flows have historically provided growth in our investment portfolio. These net cash flows decreased significantly in 2000 and 1999 as we focused on
Total Expenses: Our expenses include claim and claim settlement expenses, policy acquisition costs, general and administrative expenses, interest expense and income taxes.
The 2001 results include a $7.7 million increase in prior years’ reserves for unpaid claim and claim settlement expenses compared to the 2000 results which include an $15.9 million increase in prior years’ reserves for unpaid claim and claim settlement expenses. The 2001 reserve increase includes unfavorable development of accident year 2000 and prior year claims and adjustments for second injury funds and our mandatory participation in state and national assigned risk pools.
We recorded estimates of ceded paid and unpaid claim and claim settlement expenses under our quota share reinsurance agreement totaling $27.7 million in 2001 resulting in a corresponding reduction in 2001 claim and claim settlement expenses. This contract did not exist in 2000.
Claim and claim settlement expenses increased to $72.4 million in 2000 from $43.3 million in 1999. As a percent of premiums earned, claim and claim settlement expenses increased to 92.7% in 2000 from 60.8% in 1999. These changes are due to the following:
$300,000 excess of loss reinsurance agreement totaling $21.8 million in 2000 including $400,000 amortized from a deferred retrospective reinsurance gain resulting in a corresponding reduction in 2000 claim and claim settlement expenses. These amounts compared to our 1999 results which include an estimate of ceded paid and unpaid claim and claim settlement expenses totaling $22.0 million and $740,000 amortized from the deferred retrospective reinsurance gain;
The 2000 results include a $15.9 million increase in prior years’ reserves for unpaid claim and claim settlement expenses to reflect unfavorable development of prior period claims compared to the 1999 results which include an $8.1 million decrease in prior years’ reserves for unpaid claim and claim settlement expenses reflecting favorable development of prior period claims. Our year-end actuarial review of loss reserves in 2000 indicated an increase in the cost incurred or developing in connection with older claims, particularly in Minnesota where we have been writing policies since 1992. Given this indication, we adjusted our actuarial assumptions to reflect this change in loss experience resulting in the increase in reserves;
Claim costs continued to increase in 2000 compared to 1999 due to increasing medical and indemnity costs. This was offset somewhat by the effects of provider agreements that we negotiated during 1998.
Claim costs will continue to be affected by (i) increases in medical and indemnity costs resulting from inflationary changes, (ii) severity experienced in future periods in our policy holder base, (iii) changes resulting from increases in operating efficiency and effectiveness realized through enhancements to our internal processes and procedures, including changes to our proprietary computer systems, and (iv) legislative changes that affect benefits payable under workers’ compensation laws;
Policy Acquisition Costs: Policy acquisition costs are costs directly related to writing an insurance policy and consist of commissions, state premium taxes, underwriting personnel costs and expenses, sales and marketing costs and other underwriting expenses less ceding commissions from our reinsurers. Ceding commissions are amounts that reinsurers pay to us for placing reinsurance with them. Under our 1992 to 1994 quota share reinsurance agreement, the ceding commission is adjusted to the extent that actual claim and claim settlement expenses vary from levels specified in the agreements.
2002 Outlook: Ceding commissions received from our reinsurer under our 2001 quota-share reinsurance policy will significantly reduce policy acquisition costs again in 2002. Excluding the effects of ceding commissions, we expect that policy acquisition costs will remain consistent as a percent of gross premiums earned in 2002 as all components of acquisition costs are expected to be stable as compared to 2001.
General and administrative expenses continue to improve as a percent of premiums earned, after adjusting for restructuring charges, IGA assessments and one-time charges. We have aggressively managed personnel and other operating costs and expenses to bring operating expenses more in line with revenues. All expenses continue to be managed aggressively and reduced where appropriate.
We expect to realize additional operational efficiency during 2002 through enhancements to our internal processes and procedures, including changes to our operating structure as well as improvements to our internal proprietary computer systems.
Interest Expense: We incurred interest charges on our Term Loan in 2001 and 2000 and on our Senior Notes in 1999.
We paid interest at rates ranging from 6.50% to 8.83% on the outstanding balance of our Term Loan in 2001 compared to 8.68% to 9.34% in 2000. Interest expense decreased to $511,000 in 2001 from $667,000 in 2000 as a result of the change in the interest rate and $2.5 million in principal payments on the note in 2001.
2002 Outlook: We expect to incur interest charges in 2002 on the outstanding balance of the Term Loan totaling approximately $170,000, decreasing from $511,000 in 2001 as a result of principal payments of $2.5 million in 2001, $1.0 million in February 2002 and an additional $1.3 million through the remainder of 2002 and a decrease in the interest rate to under 5.00%.
In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. We consider recent operating results, the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. At December 31, 2001, we established a $14.1 million valuation allowance against deferred tax assets resulting in a corresponding increase in income tax expense as a result of this analysis. We expect the remaining deferred tax assets, net of the valuation allowance, at December 31, 2001 to be realized as a result of the reversal of existing taxable temporary differences in the future. No valuation allowance was provided against the deferred tax assets recorded in 2000 or 1999.
repurchasing taxable fixed maturity investments to increase our after-tax yield. We recognized gains totaling $1.1 million as a result of this repositioning. In February 2002, we sold select securities within the portfolio and realized an additional investment gain totaling $1.1 million to increase our statutory surplus. We conservatively manage our fixed maturity portfolio, investing only in investment grade (BBB or better rating from Standard and Poor’s) securities of U.S. domiciled issuers. We do not invest in derivative securities.
Funds from our operating cash flows and investment cash flows have historically provided growth in our investment portfolio. Operating cash flows consist of the excess of premiums collected over claim and claim settlement expenses reduced by payments for reinsurance premiums as well as other operating expenses paid. Investment cash flows consist of income on existing investments and proceeds from sales and maturities of investments. Prior to 1999, we generated positive net cash flows from operations due, in part, to timing differences between the receipt of premiums and the payment of claim and claim settlement expenses. These net cash flows decreased significantly in 2000 and 1999 as we focused on closing old claims, paying earlier to close those claims. Combined with relatively flat premiums in force since December 1998, our cash flows from timing on claims payments have decreased. Additionally, as we lowered our reinsurance retention levels to $25,000 in mid-1998, we decreased our current period cash flows as a result of “pre-funding” quarterly premiums under that agreement. Our investment portfolio decreased $7.6 million to $89.2 million at December 31, 2001, from $96.8 million at December 31, 2000, as a result of these factors. We expect positive quarterly cash flow from our $25,000 to $300,000 excess of loss reinsurance agreement in 2002 as we are reimbursed for loss payments to claimants under the policy. This increase in cash flow will be more than offset by (i) premiums ceded under our quota share policy and (ii) decreases in cash flows as our 2002 premiums in force and premiums earned decrease and result in the use of cash in 2002.
We record investments on our balance sheet at fair value, with the corresponding appreciation or depreciation from amortized cost recorded in shareholders’ equity, net of taxes. Because value is based on the relationship between the portfolio’s stated yields and prevailing market yields at any given time, interest rate fluctuations can have a swift and significant impact on the carrying value of these securities. As a result of classifying our securities as available-for-sale, and thus carrying them at fair value, we expect to encounter adjustments in shareholders’ equity as market interest rates and other factors change. In 2000, we recorded a $500,000 write-down of a security held in our portfolio as we deemed its decline in fair value to be other than temporary in nature. This security was sold in January 2002 and the write-down was reversed. Prevailing market interest rates decreased in 2001 and 2000 resulting in a $1.4 million unrealized gain on investments in 2001 compared to a $309,000 unrealized gain in 2000.
We believe our reserves for unpaid claim and claim settlement expenses are adequate to cover the ultimate costs of claim and claim settlement expenses. The ultimate cost of claim and claim settlement expenses may differ materially from the established reserves, particularly when claims may not be settled for many years. Reserves for unpaid claim and claim settlement expenses and assumptions used in their development are continually reviewed. We record adjustments to prior estimates of unpaid claim and claim settlement expenses to operations in the year in which the adjustments are made. See Notes 1 and 5 of Notes to Consolidated Financial Statements. The following two tables reconcile the beginning and ending insurance reserves, displayed individually for each of the last three years.
Our primary sources of cash from operations are premiums collected and investment income. Our investment portfolio is also a source of liquidity, through the sale of readily marketable fixed maturity investments. Our primary cash requirements consist of payments for (i) claim and claim settlement expenses, (ii) reinsurance, (iii) policy acquisition costs, (iv) general and administrative expenses, (v) capital expenditures, (vi) income taxes, and (vii) debt service or principal repayment on our Term Loan. Prior to 1999, we generated positive net cash from operations
due, in part, to timing differences between the receipt of premiums and the payment of claim and claim settlement expenses. As we lowered our reinsurance retention levels to $25,000 beginning in mid-1998 through runoff in 2001, we decreased our current period cash flows as a result of “pre-funding” quarterly premiums under that agreement. We expect positive quarterly cash flow from our $25,000 to $300,000 excess of loss reinsurance agreement in 2002 as we are reimbursed for loss payments to claimants under the policy. This increase in cash flow will be more than offset by (i) premiums ceded under our quota share policy and (ii) decreases in cash flows as our premiums in force and premiums earned decrease in 2002. Excess cash is either invested in short-term cash and cash equivalents or longer term available-for-sale securities pending future payments for such expenses as medical and indemnity benefits and other operating expenses. Cash and cash equivalents consist of U.S. government securities acquired under repurchase agreements and corporate securities all with maturities of 90 days or less, with the remaining balances in cash and a money market fund that invests primarily in short-term government securities.
State insurance regulations limit distributions, including dividends, from our insurance subsidiary to us. The maximum amount of dividends that can be paid by ACIC to us in any year is equal to the greater of: (i) 10% of ACIC’s statutory surplus as of the end of the previous fiscal year, or (ii) the statutory net gain from operations (not including realized capital gains) of ACIC in its most recent fiscal year. Based on this limitation, the maximum dividend that ACIC could pay to us in 2002, without regulatory approval, is approximately $1.9 million. (See Note 9 of Notes to Consolidated Financial Statements.) ACIC has never paid a dividend to us and we intend to retain capital in the insurance subsidiary.
An increase of 100 basis points in prevailing interest rates would reduce the fair value of our interest rate sensitive instruments by approximately $4.1 million.
In July 2001, the Financial Accounting Standards Board issued SFAS No. 141 “Business Combinations” and SFAS No. 142 “Goodwill and Other Intangible Assets”. SFAS No. 141 requires that all business combinations be accounted for under the purchase method only, and that certain acquired intangible assets in a business combination be recognized as assets apart from goodwill. SFAS No. 142 requires ratable amortization of goodwill be replaced with periodic tests of goodwill’s impairment and that intangible assets other than goodwill be amortized over their useful lives. Implementation of SFAS No. 141 and 142 is required for fiscal 2002. We believe that the adoption of SFAS No. 141 and 142 will not have an impact on our financial statements
Consolidated Statements of Shareholders’ Equity - Years Ended December 31, 2001, 2000 and 1999
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 2001 and 2000, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America.
Organization - RTW, Inc. (RTW) provides workers’ compensation insurance coverage to employers through its wholly owned insurance subsidiary, American Compensation Insurance Company (ACIC). Collectively, “we,” “our” and “us” will refer to these entities in these Notes to Consolidated Financial Statements.
Consolidation - Our consolidated financial statements include RTW and ACIC. We eliminate all inter-company accounts and transactions in consolidation.
Use of Estimates - We make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the financial statement date and the recorded amounts of revenues and expenses during the reporting period. Our most significant estimates are those relating to our unpaid claim and claim settlement expenses, income taxes and accrual for premium adjustments. We continually review our estimates and assumptions and make adjustments as necessary, but actual results could vary significantly from these estimates.
Fair Value of Financial Instruments - A number of our significant assets and liabilities (including deferred policy acquisition costs, reinsurance recoverables, furniture and equipment and unpaid claim and claim settlement expenses) are not considered financial instruments for disclosure purposes. Our premiums receivable and other assets and liabilities that are considered financial instruments are generally of a short-term nature. Our term loan
bears a floating interest rate. The carrying values of these instruments approximate their fair values. The carrying values and fair values of investments are disclosed in Note 3.
Depreciation - We depreciate furniture and equipment on a straight-line basis over the estimated useful lives of the assets (five to ten years). Accumulated depreciation was $3.7 million at December 31, 2001 and $5.1 million at December 31, 2000.
Our “Unpaid claim and claim settlement expenses” represent reserves established for the estimated total unpaid cost of claim and claim settlement expenses for insured events that occurred on or prior to each balance sheet date. The reserves are primarily undiscounted; however, we discounted selected claims that have fixed or determinable future payments by $482,000 in 2001 and $1.4 million in 2000 using 5.0% and 8.0% discount factors, respectively. These reserves reflect our estimates of the total cost of claims that were reported, but not yet paid, and the cost of claims incurred but not yet reported. Our estimates consider such variables as past loss experience, current claim trends and prevailing social, economic and legal environments. We have a limited amount of historical data to use in estimating our reserves for unpaid claim and claim settlement expenses because we commenced operations in 1992. As a result, we supplement our experience with external industry data, as adjusted to reflect anticipated differences between our results and the industry. We reduce the unpaid claim and claim settlement expenses for estimated amounts of subrogation.
We believe our reserves for unpaid claim and claim settlement expenses are adequate to cover the ultimate costs of claim and claim settlement expenses. The ultimate cost of claim and claim settlement expenses may differ from the established reserves, particularly when claims may not be settled for many years. Reserves for unpaid claim and claim settlement expenses and assumptions used in their development are continually reviewed. We record adjustments to prior estimates of unpaid claim and claim settlement expenses, which may be material, to operations in the year in which the adjustments are made.
We apply SFAS No. 128, “Earnings Per Share”, which requires dual presentation of a basic (loss) income per share (IPS), which excludes dilution, and a diluted IPS, which reflects the potential dilution that could occur if actions taken with respect to dilutive securities resulted in the issuance of common stock. Dilutive securities consist of stock options. Basic IPS is computed by dividing net (loss) income by the weighted average number of common shares outstanding for the period. Diluted IPS is computed by dividing net (loss) income by the weighted average number of common shares and dilutive securities outstanding for the period. Dilutive securities are considered outstanding from the date of grant, after applying the treasury stock method for determining the dilutive effect.
Additionally, included in investments are U.S. government securities pledged as collateral against a letter of credit provided to an insurer, with a fair value of $2.6 million at December 31, 2001.
Our financial statements reflect the effects of ceded reinsurance transactions. We purchase reinsurance to (i) protect us from potential losses in excess of the level we are willing to accept and (ii) to achieve premium to surplus leverage ratios that are at acceptable levels. From 1995 to 2000, our primary reinsurance was excess of loss coverage that limits our per-incident exposure. In June 2001, however, we also entered into a quota share reinsurance treaty that was effective January 1, 2001 to reduce our premiums earned and bring our premium to surplus leverage ratios in line with management targets and rating agency expectations.
We ceded Minnesota claims in excess of $330,000, $310,000 and $290,000 per occurrence during 2001, 2000 and 1999, respectively, to the Minnesota Workers’ Compensation Reinsurance Association (WCRA). In our non-Minnesota states, our per-incident exposure was $300,000 in 2001, 2000 and 1999. We purchased this non-Minnesota coverage from a single reinsurer.
For claims occurring after June 30, 1998, we further limited our per incident exposure by purchasing excess of loss coverage for losses from $25,000 to the lesser of $300,000 or the WCRA selected retention level in Minnesota and from $25,000 to $300,000 in other states from a single reinsurer. This agreement was finalized after its effective date and activity occurring from July 1, 1998 through September 30, 1998 was recorded on a retrospective basis resulting in the deferral of a gain totaling $2.0 million at December 31, 1998. We amortized $400,000 of the deferred gain as a reduction of claim and claim settlement expenses in each of 2001 and 2000 and $740,000 in 1999 resulting in an un-amortized deferred gain of $449,000 at December 31, 2001. The deferred gain is being amortized into income using the effective interest rate inherent in the amounts paid to the reinsurer and the estimated timing and amounts of recoveries from the reinsurer. Activity occurring on or after October 1, 1998 is recorded prospectively. This contract was terminated effective December 31, 2000; however, the policy was effective in 2001 for policies in force at December 31, 2000 through expiration, not to exceed fifteen months after the effective termination date. Policies written or renewing after December 31, 2000 are not covered under this lower level excess of loss reinsurance policy.
In June 2001, we entered a new 50% quota share reinsurance policy effective January 1, 2001 in order to reduce our net premium to surplus leverage ratio and maintain a secure financial strength rating for our insurance subsidiary. Due to the percentage of amounts ceded under the quota share policy and its January 1, 2001 effective date, premiums earned, claim and claim settlement expenses and policy acquisition costs were substantially reduced in 2001. We further increased the amounts ceded to 80% effective December 1, 2001 under this quota share reinsurance policy.
The reinsurance recoverable on paid claim and claim settlement expenses consists primarily of receivables from paid claim and claim settlement expenses that were submitted to but not reimbursed by reinsurers at December 31, 2001 and 2000.
Changes in estimates of unpaid claim and claim settlement expenses for prior years increased the provision for claim and claim settlement expenses by $7.7 million in 2001, increased the provision for claim and claim settlement expenses by $15.9 million in 2000 and decreased the provision for claim and claim settlement expenses by $8.1 million in 1999.
At December 31, 2001, we failed to meet certain financial covenants related to the term loan. We paid an additional $1.0 million in principal in February 2002 and the term loan agreement was amended in March 2002. Under the amendment, term loan principal payments were adjusted and covenants were amended in return for waivers of the financial covenants under the term loan agreement. We believe that we will be in compliance with the amended financial covenants throughout 2002.
The amended term loan is collateralized by the stock of ACIC and is subject to restrictive financial covenants that require maintaining minimum financial ratios, including (i) debt coverage, (ii) net worth, (iii) statutory surplus, (iv) net earnings, (v) risk based capital, (vii) A.M. Best Rating, and (viii) investment grade ratings. The agreement also restricts dividends, purchases and redemptions or retirements of common stock.
Our income tax expense (benefit) differs from the federal statutory rate as follows (000’s):
We have net operating loss carry-forwards available totaling approximately $18.8 million that expire in 2020 and 2021.
The seventh one-year phase began in April 2001 and expires in April 2002.
Our liability for employee contributions withheld at December 31, 2001 and 2000 for the purchase of shares in April 2002 and April 2001 under the ESPP was $39,000 and $72,000, respectively.
Non-Qualified Common Stock Options - Certain non-qualified options were issued prior to the onset of the 1994 Stock Plan. At January 1, 1999, 320,000 non-qualified options were outstanding at an exercise price of $2.00 per share. These options were exercised in their entirety during 1999.
401(k) Retirement Component - We sponsor a defined contribution retirement component under Section 401(k) of the Internal Revenue Code for eligible employees. Our contributions are discretionary and are based on contributions made by employees. Expense recognized for 2001, 2000 and 1999 was $316,000, $152,000 and $151,000, respectively.
Shareholder Rights Plan - In April 1997, we adopted a shareholder rights plan and declared a dividend of one right for each outstanding share of common stock to shareholders of record at the close of business on June 30, 1997. The rights become exercisable only after any person or group (the Acquiring Person) becomes the beneficial owner of 15% or more of the voting power of our common stock. Certain shares held by our Chairman, David C. Prosser, and his wife are excluded from the computation for determining whether a person is an Acquiring Person. Each right entitles its registered holder to purchase from us one one-hundredth share of a new Series A Junior Participating Preferred Stock, no par value, at a price of $85 per one one-hundredth share, subject to adjustment. If any Acquiring Person acquires beneficial ownership of 15% or more of our voting power, each right will entitle its holder (other than such Acquiring Person) to purchase, at the then current purchase price of the right, that number of shares of our common stock having a market value of two times the purchase price of the right, subject to certain possible adjustments. In addition, if we are acquired in a merger or other business combination transaction, each right will entitle its holder to purchase, at the then current purchase price of the right, that number of common shares of the acquiring company having a market value of two times the purchase price of the right. Following the acquisition of a beneficial ownership of 15% or more of our outstanding common stock by any Acquiring Person and prior to an acquisition by any Acquiring Person of 50% or more of our outstanding common stock, our Board of Directors may exchange the outstanding rights (other than rights owned by such Acquiring Person), in whole or in part, at an exchange ratio of one share of common stock, or one one-hundredth share of Preferred Stock (or equivalent
Dividend Restrictions - Dividends are paid as determined by our Board of Directors. No cash dividends have ever been paid by us.
Under Minnesota insurance law regulating the payment of dividends by ACIC, any such payments must be an amount deemed prudent by ACIC’s Board of Directors and, unless otherwise approved by the Commissioner of the Minnesota Department of Commerce (Commissioner), must be paid solely from the adjusted earned surplus of ACIC. Adjusted earned surplus means the earned surplus as determined in accordance with statutory accounting practices (unassigned funds), less 25% of the amount of such earned surplus that is attributable to unrealized capital gains. Further, without approval of the Commissioner, ACIC may not pay a dividend in any calendar year which, when combined with dividends paid in the preceding twelve months, exceeds the greater of (i) 10% of ACIC’s statutory capital and surplus at the prior year end or (ii) 100% of ACIC’s statutory net gain from operations (not including realized capital gains) for the prior calendar year. For 2002, dividends in excess of $2.0 million would require prior consent of the Commissioner.
Statutory Surplus and Statutory Net Income (Loss) - Our insurance subsidiary is required to file financial statements with state regulatory agencies. The accounting principles used to prepare the statutory financial statements follow prescribed accounting practices that differ from GAAP. Statutory policyholders’ surplus at December 31, 2001 and 2000, and statutory net (loss) income for the years ended December 31, 2001, 2000 and 1999 are as follows (000’s):
Future minimum (base) rental payments required under the leases, as of December 31, 2001, are as follows (000’s):
In the ordinary course of administering our workers’ compensation management program, we are routinely involved in the adjudication of claims resulting from workplace injuries. We are not involved in any legal or
The following tables present unaudited quarterly results of operations for the eight quarters ended December 31, 2001: