The Company's assets at December 31, 2003 included $58.4 million in short-term investments which are readily convertible to cash without market penalty and an additional $99.4 million of fixed income investments maturing in less than one year. The Company believes that these liquid investments, plus the expected cash flow from current operations, are more than sufficient to provide for projected claim payments and operating cost demands. In addition, the Company's reinsurance program is structured to avoid serious cash drains that might accompany catastrophic losses. In the event competitive conditions produce inadequate premium rates and the Company chooses to restrict volume, the liquidity of its investment portfolio would permit it to continue to pay claims as settlements are reached without requiring the disposal of investments at a loss, regardless of interest rates in effect at the time.
As more fully discussed in Note F to the consolidated financial statements, at December 31, 2003, $71.5 million, or 22% of shareholders' equity, represented net assets of the Company's insurance subsidiaries which, at that time, could not be transferred in the form of dividends, loans or advances to the parent company because
Net investment income decreased $2.1 million (14%) during 2003 reflecting lower overall pre-tax yields while average invested assets increased 6 %. The average pre-tax yield on invested assets dropped to 3.3% this year from 4.1% during 2002 (18%). The largest decline in yields occurred in the bond portfolio which averaged 3.9% during 2003 compared to 5.1% last year. Yields on short-term investments also declined from 1.4% in 2002 to .8% in 2003. After tax yields declined less than pre-tax because of a reallocation of the investment portfolio whereby corporate (fully taxable) bonds were replaced with municipal (largely tax exempt) bonds. After-tax yields were 2.4% and 2.9% for 2003 and 2002, respectively. The short-term nature of the Company's bond portfolio results in a rapid recognition of changes in interest rates, either positive or negative. As interest
The loss and loss expense ratios for the Company's fleet trucking and private passenger automobile programs were fairly consistent with that experienced in 2002. Small fleet trucking experienced a 14 percentage point increase in its loss and loss expense ratio due to the increased frequency and severity of reported claims while the loss and loss expense ratio for reinsurance assumed dropped by 10 percentage points, reflecting the lack of major catastrophe activity affecting treaties in which the Company participates. The loss and loss expense ratio for the small business workers' compensation program increased to 91.4% in 2003 from 54.7% in 2002. This significant increase is due to approximately $.7 million in adjustments to prior year losses resulting from internal management review of the reserving methodologies for this product as well as increased frequency and severity of 2003 losses.
Net investment income decreased $2.7 million (15.1%) during 2002 reflecting lower overall pre-tax yields while average invested assets increased 5%. The average pre-tax yield on invested assets dropped to 4.1% this year from 5.0% during 2001. The largest decline in yields came from short-term investments which averaged 1.4% during 2002 compared to 3.7% during 2001. Average bond yields also declined from 6.0% in 2001 to 5.1% in 2002. After-tax yields were 2.9% and 3.6% for 2002 and 2001, respectively, in line with pre-tax yield changes.
Realized net capital losses were $16.4 million in 2002 compared to gains of $5.1 million for 2001. The current year's net loss consisted of losses on equity securities of $13.7 million, losses on fixed maturities of $1.9 million, and losses on other investments of $.8 million. The losses on equity securities include approximately $13.7 million of losses actually realized by disposal of securities which were considered to have little potential for near-term recovery as well as $5.8 million of gains realized on sales. In addition, unrealized losses on securities still owned which had experienced a decline in market value of more than 20% for more than six months were reclassified as realized losses during 2002 in the following amounts: equity securities, $5.8 million; fixed income securities, $.9 million and other investments $1.1 million. The losses realized during 2002 reflect the continuing bear market which has resulted from an unusual combination of factors coming together at approximately the same time. These factors included, in no particular order, the unwinding of one of the great speculative bubbles of all time (fueled largely by internet and technology stocks in which the Company had zero participation), the attack of September 11, 2001 and the significant change in security measures and attendant economic friction that resulted therefrom, an ongoing recession, a disputed U.S. Presidential election, corporate collapses and bankruptcies of historic proportion, corporate malfeasance and fraud which has resulted in massive changes in corporate governance regulations, evidence of wrongdoing on the part of major securities firms, the collapse of the merchant energy industry in the U.S. and, most recently, the imminent commencement of armed conflict with Iraq. The largest single losses realized on investments actually sold were $4.2 million realized on the sale of Vanguard Index Trust 500 Fund (S&P 500 index fund) and $1.6 million on Trenwick Group, Inc. common stock. The largest single losses reported as realized on investments still owned were $1.4 million on PICO Holdings, Inc. and $1.2 million on El Paso Corp., both common stocks.
Other operating expenses for 2002, before credits for allowances from reinsurers, increased $5.4 million (16%) to $39.8 million. Gross expenses increased at a much lower rate than the increase in premium volume because much of the Company's expense structure is fixed and does not vary directly with volume. Personnel related expenses, including amounts allocated to loss expenses and investment income, increased 7% due mainly to annual cost of living and merit wage adjustments and staffing increases necessitated by the increased premium volume. Direct commission expense increased $1.4 million (19%) primarily as the result of increased participation in voluntary reinsurance assumed treaties. Ceding commission allowances from reinsurers increased $4.8 million (37%), resulting from increased premium volume ceded under reinsurance agreements covering Protective's fleet trucking business. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 26.1% during 2002 compared to 24.3% for 2001, reflecting higher commissions including bonus commissions measured, in part, on underwriting profitability and from slightly lower rates for ceding commissions received from reinsurers. Including the agency operations, and after elimination of inter-company commissions, the ratio of other operating expenses to operating revenue was 17.8% for 2002 compared with 20.6% for 2001.
As a result of the factors mentioned above, net income for 2002 was $12.4 million compared to $5.4 million for 2001. Diluted earnings per share increased to $.84 in 2002 from $.35 in 2001. 2001 results included losses related to the events of September 11, 2001 equal to $.84 per share. Earnings per share from operations before realized gains or losses on investments was $1.57 in 2002 compared to $.14 in 2001.
Approximately 68% of the Company's assets are composed of investments at December 31, 2003. Less than .4% of these investments, consisting of limited partnership investments in real estate and venture capital assets, do not have readily determinable market values. For these investments, we estimate fair value by reference to the underlying assets of the limited partnerships. In addition, approximately $19.1 million of fixed maturity investments (3.7% of total invested assets) consists of bonds rated as less than investment grade at year end. The majority of this total is composed of shares in a widely diversified high yield municipal bond fund where exposure to default by any single issuer is extremely limited. Further, the average bond quality of assets held in this fund at year end was BBB, which would be considered investment grade. We have included the investment in this fund in the total of non-investment grade bonds since, at times, the average bond quality of the fund could fall below BBB.
Amounts recoverable under the terms of reinsurance contracts comprise approximately 24% of total Company assets as of December 31, 2003. In order to be able to provide the high limits required by the Company's trucking company insureds, we share a significant amount of the insurance risk of the underlying contracts with various insurance entities through the use of reinsurance contracts. Some reinsurance contracts provide that a loss be shared among the Company and its reinsurers on a predetermined pro-rata basis ("quota-share") while other contracts provide that the Company keep a fixed amount of the loss, similar to a deductible, with reinsurers taking all losses above this fixed amount ("excess of loss"). Some risks are covered by a combination of quota-share and excess of loss contracts. The computation of amounts due from reinsurers is based upon the terms of the various contracts and follows the underlying estimation process for loss and loss expense reserves, as described below. Accordingly, the uncertainties inherent in the loss and loss expense reserving process also affect the amounts recorded as recoverable from reinsurers. Estimation uncertainties are greatest for claims which have occurred but which have not yet been reported to the Company. Further, the high limits provided by the Company's insurance policies for trucking liability and workers' compensation, provide more variability in the estimation process than lines of business with lower coverage limits.
As with any receivable, credit risk exists in the recoverability of reinsurance. This is even more pronounced than in normal receivable situations since recoverable amounts are not generally due until the loss is settled which, in some cases, may be many years after the contract was written. If a reinsurer is unable, in the future, to meet its financial commitments under the terms of the contracts, the Company would be responsible for the
The reserving process requires us to continuously monitor and evaluate the life cycle of claims based on the class of business and the nature of claims. Our claims range from the very routine private passenger automobile "fender bender" to the highly complex and costly third party bodily injury claim involving large tractor-trailer rigs. Reserving for each class of claims requires a set of assumptions based upon historical experience, knowledge of current industry trends and seasoned judgment. The high limits provided in the Company's trucking liability policies provide for greater variation in the reserving process for more serious claims. Court rulings, tort reform (or lack thereof) and trends in jury awards also play a significant role in the estimation process of larger claims. The Company continuously reviews and evaluates loss developments subsequent to each measurement date and adjusts its reserve estimation assumptions, as necessary, in an effort to achieve the best possible estimate of the ultimate remaining loss costs at any point in time. Changes to previously established reserve amounts are charged or credited to losses and loss expenses incurred in the accounting periods in which they are determined. Note C to the consolidated financial statements includes additional information relating to loss and loss adjustment expense reserve development.
following: (i) the Company's plans, strategies, objectives, expectations and intentions are subject to change at any time at the discretion of the Company; (ii) the Company's business is highly competitive and the entrance of new competitors into or the expansion of the operations by existing competitors in the Company's markets and other changes in the market for insurance products could adversely affect the Company's plans and results of operations; and (iii) other risks and uncertainties indicated from time to time in the Company's filings with the Securities and Exchange Commission.
The liability method is used in accounting for federal income taxes. Using this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The provision for deferred federal income tax was based on items of income and expense that were reported in different years in the financial statements and tax returns and were measured at the tax rate in effect in the year the difference originated. Net deferred tax liabilities of $13.2 million and $5.8 million were recorded at December 31, 2003 and 2002, respectively. The net deferred tax liability at December 31, 2003 included $5.5 million in special tax deposits covered under Section 847 of the Internal Revenue Code, as explained in the following paragraph, which compares to $4.6 million in special tax deposits at December 31, 2002. Adjusted for the special deposits, a net deferred tax liability of $18.7 million was recorded at December 31, 2003 compared to a net deferred tax liability of $10.3 million at December 31, 2002. The increase in deferred federal taxes payable is primarily attributable to the increase in unrealized capital gains in the investment portfolio.
To the extent inflation influences yields on investments, the Company is also affected. The Company maintains a sizable portion of its investment portfolio in short-term instruments and changes in current market interest rates correspondingly affect yields on these investments. Further, as inflation affects current market rates of return, previously committed investments may rise or decline in value depending on the type and maturity of investment. (See comments under Market Risk, following.)
The most significant of the three identified market risks relates to prices in the equities market. Though not the largest category of the Company's invested assets, equity securities have the greatest potential for short-term price fluctuation. The market value of the Company's equity positions at December 31, 2003 was $130.1 million or approximately 25% of invested assets. This market valuation includes $62.2 million of appreciation on original purchase prices of the equity security investments. Funds invested in the equities market are not considered to be assets necessary for the Company to conduct its daily operations and, therefore, can be committed for extended periods of time. The long-term nature of the Company's equity investments allows it to invest in positions where ultimate value, and not short-term market fluctuations, is the primary focus.
The Company's fixed maturity portfolio totaled $321.2 million at December 31, 2003. Over two-thirds of this portfolio is made up of U. S. Government and government agency obligations and state and municipal debt securities, 95% of the portfolio matures within 5 years and the average life of the Company's fixed maturity investments is approximately 2.8 years. Although the Company is exposed to interest rate risk on its fixed maturity investments, given the anticipated duration of the Company's liabilities (principally insurance loss and loss expense reserves) relative to investment maturities, even a 100 to 200 basis point increase in interest rates would not have a significant impact on the Company's ability to conduct daily operations or to meet its obligations.
There is an inverse relationship between interest rate fluctuations and the fair value of the Company's fixed maturity investments. Additionally, the fair value of interest rate sensitive instruments may be affected by the financial strength of the issuer, prepayment options, relative values of alternative investments, liquidity of the investment and other general market conditions. The Company monitors its sensitivity to interest rate risk by measuring the change in fair value of its fixed maturity investments relative to hypothetical changes in interest rates. As previously indicated, several other factors can impact the fair values of fixed maturity investments and, therefore, significant variations in market interest rates could produce quite different results from the hypothetical estimates presented in the next paragraph.
We estimate that a 100 basis point increase in market interest rates would have resulted in a pre-tax loss in the fair value of fixed maturity investments of approximately $5.3 million at December 31, 2003. Similarly, a 100 basis point decrease in market interest rates would have resulted in an estimated pre-tax gain in the fair value of these instruments of approximately $5.4 million at December 31, 2003. Note, however, that the hypothetical loss mentioned above would only be realized if the Company was obligated to sell bonds prior to maturity, which is extremely unlikely. The aggregate value of money market and short-term investments, bonds maturing within twelve months and expected positive cash flow from operations for 2004 is equal to more than 100% of net loss and loss expense reserves at December 31, 2003.
recognize actual loss experience to date as well as projected loss experience applicable to the various contract periods. Reinstatement premiums on reinsurance assumed contracts covering catastrophic events are recorded concurrently with the related loss.
The Company recorded other than temporary writedowns of $2,394, $7,726 and $2,081 in 2003, 2002 and 2001, respectively.
The fair value and the cost or amortized cost of fixed maturity investments at December 31, 2003, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because borrowers have, in some cases, the right to call or prepay obligations with or without call or prepayment penalties.
The Company has not changed its original estimate for the loss sustained as a result of the terrorist attacks of September 11, 2001. Therefore, there is no impact on the loss developments shown in the above table except for payments against the original established reserves. The Company has paid $9.8 million to date and carries a remaining reserve of $10.2 million at December 31, 2003.
Loss reserves have been reduced by estimated salvage and subrogation recoverable of approximately $3,490 and $2,810 at December 31, 2003 and 2002, respectively.
Cash flows related to federal income taxes paid, net of refunds received, for 2003, 2002 and 2001 were $14,100, $7,250 and $5,200, respectively, including Section 847 special tax deposits. Future tax benefits on approximately $5,523 of deferred tax assets at December 31, 2003 arising from loss reserve discounting are assured based on Section 847 of the Internal Revenue Code.
Net losses and loss expenses incurred for 2003, 2002 and 2001 have been reduced by ceded reinsurance recoveries of approximately $96,812, $60,055 and $72,701, respectively. Net losses and loss expenses incurred for 2003, 2002 and 2001 include approximately $5,687, $5,165 and $24,624 relating to reinsurance assumed from non-affiliated insurance or reinsurance companies. Losses and loss expenses incurred for 2001 included $20,000 for the Company's exposure from reinsurance assumed treaties related to the events of September 11, 2001. Ceded reinsurance premiums and loss recoveries for catastrophe reinsurance contracts were not material. The Company remains liable to the extent the reinsuring companies are unable to meet their obligations under reinsurance contracts.
NOTE F - SHAREHOLDERS' EQUITY Changes in common stock outstanding and additional paid-in capital are as follows
Net income of the insurance subsidiaries, as determined in accordance with statutory accounting practices, was $22,851, $10,318 and $5,660 for 2003, 2002 and 2001, respectively. Consolidated statutory shareholder's equity for these subsidiaries was $304,651 and $269,005 at December 31, 2003 and 2002, respectively. Minimum statutory surplus necessary for the insurance subsidiaries to satisfy statutory risk based capital requirements was $62,571 at December 31, 2003.
No effect on net income was considered to result from the presumed exercise of the options used in calculating diluted earnings per share. Certain market value options, granted in 1997, were included in the computation of diluted earnings per share for 2003. These market value options were not included in the computation of diluted earnings per share for 2002 and 2001 because the exercise price during those years was greater than the average market price of the Company's stock.
For 2003, the above amounts for voluntary reinsurance assumed include certain intersegment reinsurance agreements. Intersegment premiums earned were $1,239. Intersegment losses and loss expenses incurred were $1,357.
The following tables are reconciliations of reportable segment revenues and profits to the Company's consolidated revenue and income before federal income taxes, respectively.
One customer of the fleet trucking segment represents approximately $47,693, $39,359 and $28,864 of the Company's consolidated direct and assumed premium written in 2003, 2002 and 2001, respectively.
NOTE J - STOCK PURCHASE AND OPTION PLANS In accordance with the terms of the 1981 Stock Purchase Plan (1981 Plan), the Company is obligated to repurchase shares issued under the 1981 Plan, at a price equal to 90% of the book value of the shares at the end of the quarter immediately preceding the date of repurchase. No shares have ever been repurchased under the 1981 Plan. At December 31, 2003 there were 160,849 shares (Class A) and 439,708 shares (Class B) outstanding which are eligible for repurchase by the Company.
Exercise prices for options outstanding as of December 31, 2003 were $.80, $1.00 or $20.60. The weighted-average remaining contractual lives of options exercisable at $.80 and $1.00 are 4.6 years and 9.5 years, respectively. The remaining contractual life of options exercisable at $20.60 is 4 years. No options have been granted since 1997 other than discounted options granted to directors in lieu of directors' fees. The compensation cost that has been charged against income for all stock-based compensation plans, consisting of directors' fees only, was $143, $134 and $130 for 2003, 2002 and 2001, respectively.
During 2002 and 2001, the Company offered loans to certain employees for the sole purpose of purchasing the Company's Class B common stock in the open market. $4,828 and $7,494 of such full-recourse loans were issued and outstanding at December 31, 2003 and 2002, respectively, and carry interest rates ranging from 4.75% to 6%, payable annually on the loan anniversary date. The underlying securities serve as collateral for these loans, which must be repaid no later than 10 years from the date of issue. This loan program was terminated in 2002.
NOTE L - EMPLOYEE BENEFIT PLANS The Company maintains a defined contribution 401(k) Employee Savings and Profit Sharing Plan ("the Plan") which covers all employees who have completed one year of service. The Company's contributions to the Plan for 2003, 2002 and 2001 were $978, $864 and $736, respectively.
NOTE M - CONCENTRATIONS OF CREDIT RISK The Company writes policies of excess insurance attaching above a self-insured retention ("SIR") and also writes policies that contain large, per-claim deductibles. Those losses and claims that fall within the SIR or deductible are obligations of the insured. The Company also writes surety bonds in favor of various regulatory agencies guaranteeing the insured's payment of claims within the SIR. Losses and claims under a large deductible policy are payable by the Company with reimbursement due the Company from the insured. The Company requires collateral from its insureds to serve as a source of reimbursement if the Company is obligated to pay claims within the SIR by reason of an insured's default or if the insured fails to reimburse the Company for deductible amounts paid by the Company.
NOTE O - STOCK SPLIT At its regular meeting in February, 2003, the Company's Board of Directors declared a 25% stock dividend in the form of a five-for-four stock split on the Company's Class A and Class B Common Stock. The additional shares were distributed on March 3, 2003 to shareholders of record on February 17, 2003. Fractional shares were settled in cash using the closing market value on February 17, 2003. All share and per share references within this report have been restated to reflect the stock split.