SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For Quarter Ended March 31, 2003 Commission File Number 0-6964
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21ST CENTURY INSURANCE GROUP
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(Exact name of registrant as specified in its charter)
CALIFORNIA 95-1935264
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification number)
6301 OWENSMOUTH AVENUE
WOODLAND HILLS, CALIFORNIA 91367
(Address of principal executive offices) (Zip Code)
(818) 704-3700
(Registrant's telephone number, including area code) Web site: www.21st.com
None
--------------------------------------------------------------------------------
Former name, former address and former fiscal year, if changed since last
report.
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common Stock, Without Par Value Outstanding at May 7, 2003
(Title of Class) 85,431,505 shares
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
21ST CENTURY INSURANCE GROUP
CONSOLIDATED BALANCE SHEETS
Unaudited MARCH 31, December 31,
2003 2002
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
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ASSETS
Fixed maturity investments available-for-sale, at fair value
(amortized cost: $914,357 and $886,047) $ 951,877 $ 924,581
Cash and cash equivalents 111,738 105,897
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Total investments and cash 1,063,615 1,030,478
Accrued investment income 12,536 13,230
Premiums receivable 101,452 91,029
Reinsurance receivables and recoverables 21,455 28,105
Prepaid reinsurance premiums 1,636 1,893
Deferred income taxes 96,155 88,939
Deferred policy acquisition costs 49,895 46,190
Leased property under capital lease, net of deferred gain of
$5,971 and $6,280 50,899 53,720
Property and equipment, at cost less accumulated depreciation of
$53,517 and $52,125 88,826 87,274
Other assets 28,764 29,179
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Total assets $1,515,233 $1,470,037
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LIABILITIES AND STOCKHOLDERS' EQUITY
Unpaid losses and loss adjustment expenses $ 416,843 $384,009
Unearned premiums 287,250 266,477
Obligations under capital lease 57,953 60,000
Claim checks payable 38,649 39,304
Reinsurance payable 1,982 4,952
Other liabilities 65,964 59,687
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Total liabilities 868,641 814,429
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Stockholders' equity:
Common stock, without par value; authorized 110,000,000
shares, outstanding 85,431,505 in 2003 and 85,431,505 in 2002 419,047 418,984
Retained earnings 204,648 213,067
Accumulated other comprehensive income 22,897 23,557
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Total stockholders' equity 646,592 655,608
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Total liabilities and stockholders' equity $1,515,233 $1,470,037
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See accompanying notes to consolidated financial statements.
1
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS
Unaudited
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Three Months Ended March 31, 2003 2002
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REVENUES
Net premiums earned $ 271,441 $ 215,111
Net investment income 11,637 11,265
Realized investment gains 4,580 1,663
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Total revenues 287,658 228,039
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LOSSES AND EXPENSES
Net losses and loss adjustment expenses 253,343 188,635
Policy acquisition costs 46,144 26,558
Other operating expenses 942 3,901
Interest and fees expense 707 -
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Total losses and expenses 301,136 219,094
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(Loss) income before federal income taxes (13,478) 8,945
Federal income tax (benefit) expense (6,767) 622
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Net (loss) income $ (6,711) $ 8,323
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EARNINGS PER COMMON SHARE
Basic $ (0.08) $ 0.10
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Diluted $ (0.08) $ 0.10
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Weighted average shares outstanding - basic 85,431,505 85,364,862
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Weighted average shares outstanding - diluted 85,431,505 85,466,914
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See accompanying notes to consolidated financial statements.
2
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Unaudited
Accumulated
Other
Common Retained Comprehensive
AMOUNTS IN THOUSANDS Stock Earnings Income Total
--------------------------------------------------------------------------------------------------------- ---------
Balance - January 1, 2003 $418,984 $213,067 $23,557 $655,608
Comprehensive loss - (6,711) (1) (660) (2) (7,371)
Cash dividends declared on common stock ($0.02
per share) - (1,708) - (1,708)
Other 63 - - 63
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Balance - March 31, 2003 $419,047 $204,648 $22,897 $646,592
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(1) Net loss.
(2) Net change in accumulated other comprehensive income for the three months ended March 31, 2003, comprises
unrealized gains on available-for-sale investments of $2,667 (net of income tax benefit of $(1,436)) less the
reclassification adjustment for gains included in net income of $3,327 (net of income tax expense of $1,791).
See accompanying notes to consolidated financial statements.
3
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited
AMOUNTS IN THOUSANDS
Three Months Ended March 31, 2003 2002
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OPERATING ACTIVITIES
Net (loss) income $ (6,711) $ 8,323
Adjustments to reconcile net (loss) income to net cash
provided by operating activities:
Provision for depreciation and amortization 4,847 5,022
Amortization of restricted stock grants 92 119
Change in deferred income tax (benefit) expense (6,861) 4,289
Realized gains on sale of investments (4,580) (1,678)
Federal income tax benefit - (8,251)
Reinsurance balances 3,937 (8,197)
Unpaid losses and loss adjustment expenses 32,834 3,337
Unearned premiums 20,773 402
Claim checks payable (655) 3,248
Other assets (12,868) 827
Other liabilities 7,974 7,932
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Net cash provided by operating activities 38,782 15,373
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INVESTING ACTIVITIES
Fixed maturities available-for-sale
Purchases (168,348) (165,763)
Calls or maturities 12,937 3,213
Sales 131,330 153,329
Net purchases of property and equipment (3,396) (4,606)
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Net cash used in investing activities (27,477) (13,827)
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FINANCING ACTIVITIES
Reduction of obligation under capital lease (2,047) -
Dividends paid (3,417) (6,829)
Proceeds from the exercise of stock options - 123
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Net cash used in financing activities (5,464) (6,706)
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Net increase (decrease) in cash 5,841 (5,160)
Cash and cash equivalents, beginning of period 105,897 28,909
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Cash and cash equivalents, end of period $ 111,738 $ 23,749
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Supplemental information:
Income taxes refunded $ 123 -
Interest paid $ 280 -
See accompanying notes to consolidated financial statements.
4
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2003 (continued)
Unaudited
NOTE1. BASIS OF PRESENTATION
-----------------------------
The accompanying unaudited consolidated financial statements of 21st Century
Insurance Group and subsidiaries (the "Company") have been prepared in
accordance with accounting principles generally accepted in the United States of
America ("GAAP") for interim financial information and the instructions to Form
10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by GAAP for complete financial
statements. In the opinion of management, all adjustments (consisting of
normal, recurring accruals) considered necessary for a fair presentation have
been included. All material intercompany accounts and transactions have been
eliminated. Operating results for the three-month period ended March 31, 2003,
are not necessarily indicative of the results that may be expected for the year
ending December 31, 2003. For further information, refer to the consolidated
financial statements and notes thereto included in the Company's Annual Report
on Form 10-K for the year ended December 31, 2002.
Certain amounts in the 2002 financial statements have been reclassified to
conform to the 2003 presentation.
NOTE 2. EARTHQUAKE AND HOMEOWNER LINES IN RUNOFF
-------------------------------------------------
California Senate Bill 1899 ("SB 1899"), effective from January 1, 2001, to
December 31, 2001, allowed the re-opening of previously closed earthquake claims
arising out of the 1994 Northridge Earthquake. Based on events occurring in the
first quarter of 2003, the Company increased its 1994 Northridge Earthquake/SB
1899 reserves by $37 million, resulting in an after-tax charge of $24.1 million.
Most of the Company's remaining 1994 Earthquake claims are in litigation. The
discovery stay imposed in early 2002 was lifted in the first quarter of 2003 and
trial dates for substantially all cases have now been set. Also during the
first quarter, several appellate court decisions have been rendered on issues
affecting Northridge Earthquake cases, including a decision by the 9th Circuit
Court of Appeals involving Allstate Insurance Company, which again found SB 1899
(California Code of Civil Procedure 340.9) to be constitutional. As a result of
the 9th Circuit's decision in House et al v. Allstate Insurance Company, the
-----------------------------------------
Company's subsidiary, 21st Century Casualty Company, voluntarily dismissed the
action it initiated on February 13, 2003, seeking to have SB 1899 declared
unconstitutional. The Company continues to believe the statute violates the
federal and state constitutions and will support other companies' efforts to
have the law overturned.
All of the Company's SB 1899 claims that had been set for trial during the first
quarter, along with some other litigated Earthquake claims, have been settled.
However, as a result of the pace of settlements reached thus far, actual costs
incurred during the first quarter, and the Company's assessment of the expected
length and intensity of the litigation arising out of these claims, the Company
now has more information with which to estimate the ultimate costs of resolving
these claims. While the reserves established are the Company's current best
estimate of the cost of resolving its 1994 Earthquake claims, the reserves for
this legislatively created event continue to be highly uncertain. The estimate
currently recorded by the Company assumes that relatively few of the cases will
require a full trial to resolve, that any trial costs will approximate those
encountered by the Company in the past, and that most cases will be settled
without need for extensive pre-trial preparation. Current reserves contain no
provisions for extracontractual or punitive damages, bad faith judgments or
similar unpredictable hazards of litigation that possibly could result in the
event an adverse verdict were to be sustained against the Company. To the
extent those and other underlying assumptions prove to be
5
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2003 (continued)
Unaudited
incorrect, the ultimate amount to resolve these claims could exceed the
Company's current reserves, possibly by a material amount. The Company continues
to seek reasonable settlements of claims brought under SB 1899 and other
Northridge-Earthquake-related theories, but will vigorously defend itself
against excessive demands and fraudulent claims. The Company may, however,
settle cases in excess of its assessment of its contractual obligations in order
to reduce the future cost of litigation.
The Company has executed various transactions to exit from its homeowner line.
Under a January 1, 2002, agreement with Balboa Insurance Company ("Balboa"), a
subsidiary of Countrywide Financial Corporation ("Countrywide"), 100% of
homeowner unearned premium reserves and future related losses are reinsured by
Balboa. Obligations relating to the 1994 Northridge Earthquake are not covered
by the agreements with Balboa. The Company began non-renewing homeowner
policies expiring on February 21, 2002, and thereafter. The Company has
completed this process and no longer has homeowners policies in force or on its
paper. Substantially all of these customers were being offered homeowner
coverage through an affiliate of Countrywide.
Loss and loss adjustment expenses for the homeowner and earthquake lines in
runoff were $37.0 million for the quarter ended March 31, 2003 compared to $6.9
million for the same period in 2002.
NOTE 3. CONTINGENCIES
----------------------
Litigation. In the normal course of business, the Company is named as a
defendant in lawsuits related to claim and other insurance policy issues. Some
of the actions request extra-contractual and/or punitive damages. These actions
are vigorously defended unless a reasonable settlement appears appropriate. In
the opinion of management, except as discussed in Note 2 relating to Northridge
earthquake litigation and in Part II, Item 1, Legal Proceedings, the ultimate
outcome of such litigation is not expected to be material to the Company's
financial condition, results of operations or cash flows.
California Income Taxes. In a December 21, 2000, court ruling, Ceridian
--------
Corporation v. Franchise Tax Board, a statute that allowed a tax deduction for
----------------------------------
the dividends received from wholly owned insurance subsidiaries was held
unconstitutional on the grounds that it discriminated against out-of-state
insurance holding companies. Subsequent to the court ruling, the staff of the
California Franchise Tax Board ("FTB") has taken the position that the
discriminatory sections of the statute are not severable and the entire statute
is invalid. As a result, the FTB is disallowing dividend-received deductions
for all insurance holding companies, regardless of domicile, for open tax years
ending on or after December 1, 1997. Although the FTB has not made a formal
assessment for tax years 1997 through 2000, the Company anticipates a
retroactive disallowance that would result in additional tax assessments.
The amount of any such possible assessments and the ultimate amounts, if any,
that the Company may be required to pay, are impossible to predict because so
many ostensibly long-settled aspects of California tax law have been thrown into
disarray and uncertainty by the action of the courts that, in the absence of
legislative relief, years of future litigation may be required to determine the
ultimate outcome. Possible losses, net of federal tax benefit, range from close
to zero to approximately $20.8 million depending on which position future courts
may decide to uphold or on whether the California legislature may decide to
enact corrective legislation. The Company believes it has adequately provided
for this contingency.
6
NOTE 4. STOCK - BASED COMPENSATION
-----------------------------------
Stock-Based Compensation. Under the 1995 stock option plan the aggregate number
of common shares authorized is currently limited to 10,000,000. At March 31,
2003, 2,820,382 common shares remain available for future grants and 6,703,750
common shares are issuable upon the exercise of all outstanding options and
rights. The plan has been approved by the Company's stockholders, and all
options granted have ten-year terms. As a consequence of AIG's acquiring a
controlling interest in the Company, vesting was accelerated for all options
previously granted through July 27, 1998. Options granted after July 27, 1998,
vest over various future periods. Currently, the Company uses the intrinsic
value method to account for stock-based compensation paid to employees for their
services.
Exercise prices for options outstanding at March 31, 2003, ranged from $11.68 to
$29.25. The weighted-average remaining contractual life of those options is 7.93
years.
A summary of the Company's stock option activity and related information
follows:
Weighted-
Number of Average
AMOUNTS IN THOUSANDS, EXCEPT PRICE DATA Options Exercise Price
--------------------------------------------------------------------
Options outstanding December 31, 2002 5,142 $18.77
Granted in 2003 1,617 11.68
Exercised in 2003 - -
Forfeited in 2003 (55) 16.91
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Options outstanding March 31, 2003 6,704 17.11
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A summary of securities issuable and issued for the 1995 Stock Option Plan at
March 31, 2003, follows:
1995 Stock
AMOUNTS IN THOUSANDS Option Plan
--------------------------------------------------------------------
Total securities authorized 10,000
Number of securities issued (476)
Number of securities issuable upon the exercise of all
outstanding options and rights (6,704)
Number of securities forfeited (1,291)
Number of securities forfeited and returned to plan 1,291
--------------------------------------------------------------------
Number of securities remaining available for future
grants under each plan 2,820
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Options exercisable numbered 3,095,696 and 1,863,350 at the end of the first
quarter for the years 2003 and 2002, respectively.
SFAS No. 123, Accounting for Stock-Based Compensation, requires disclosure of
the pro forma net (loss) income and (loss) earnings per share as if the Company
had accounted for its employee stock options under the fair value method.
SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure,
provides alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based employee compensation. In
addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to
require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results.
7
For pro forma disclosure purposes, the fair value of stock options was estimated
at each date of grant using the following assumptions:
Three Months Ended March 31, 2003 2002
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Risk-free interest rate:
Minimum 3.75% 4.79%
Maximum 3.75% 4.79%
Dividend yield 0.70% 2.50%
Volatility factor of the expected market price
of the Company's common stock:
Minimum 0.38 0.36
Maximum 0.38 0.36
Weighted-average expected life of the options 6 years 8 years
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The following table illustrates the effect on net income and earnings per share
if the fair value based method, using the Black-Scholes valuation model, had
been applied to all outstanding and unvested awards:
Three Months Ended
March 31,
-----------------------------------------------------------------------
AMOUNTS IN THOUSANDS,EXCEPT SHARE DATA 2003 2002
-----------------------------------------------------------------------
Net (loss) income, as reported $(6,711) $ 8,323
Add: Stock-based employee compensation
expense included in reported net (loss) income, net
of related tax effects - -
Deduct: Total stock-based employee compensation
expense determined under fair value based for all
awards, net of related tax effects (1,836) (1,197)
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Pro forma net (loss) income (8,547) 7,126
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Earnings per share:
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Basic- as reported (0.08) 0.10
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Basic- pro forma (0.10) 0.09
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Diluted- as reported (0.08) 0.10
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Diluted- pro forma $ (0.10) $ 0.09
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Estimated weighted-average of the fair value
of options granted $ 4.67 $ 6.32
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8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FINANCIAL CONDITION
Investment-grade bonds comprised 99.9% of the fair value of the fixed-maturity
portfolio at March 31, 2003. The Company has no investments in equity securities
as of March 31, 2003. Of the Company's total investments at March 31, 2003,
approximately 63.2% were invested in tax-exempt, fixed-income securities,
compared to 54.5% at December 31, 2002.
As of March 31, 2003, the pre-tax net unrealized gain on investments was $37.5
million (unrealized gains of $39.6 million and unrealized losses of $2.1
million) compared to $38.5 million at December 31, 2002 (unrealized gain of
$41.2 million and unrealized loss of $2.7 million). The Company's policy is to
investigate, on a quarterly basis, any investment for possible
"other-than-temporary" impairment in the event the fair value of the security
falls below its amortized cost, based on all relevant facts and circumstances.
No such impairments were recorded in the quarters ended March 31, 2003 or 2002.
Premiums receivable were $101.5 million at March 31, 2003, compared to $91.0
million at December 31, 2002, with the increase mainly attributable to growth in
the Company's customer base and higher premium rates. Balances past due 90 days
or more totaled $0.4 million and $0.2 million at March 31, 2003 and 2002,
respectively. Company policy is to write-off receivable balances when they
become past due 180 days. At March 31, 2003, the Company recorded an allowance
for doubtful accounts of $0.6 million.
Prepaid reinsurance premiums and reinsurance payables were $1.6 million and $2.0
million at March 31, 2003, compared to $1.9 million and $5.0 million at December
31, 2002, respectively. The decline in balances is primarily due to the
cancellation of the quota share treaty with AIG subsidiaries.
Increased advertising and other costs through March 31, 2003, associated with
increased customer volume, contributed to an increase in deferred policy
acquisition costs ("DPAC") of $3.7 million to $49.9 million compared to $46.2
million at December 31, 2002. The Company's DPAC is estimated to be fully
recoverable (see Critical Accounting Policies - Deferred Policy Acquisition
Costs).
Property and equipment increased $1.6 million primarily due to net acquisitions
of approximately $3.1 million and an increase of accumulated depreciation in the
amount of $1.4 million.
Gross unpaid losses and loss adjustment expenses ("LAE") increased by $32.8
million in the quarter ended March 31, 2003. The increase was primarily due to
a reserve increase of $10.5 million in the auto line as a result of growth in
the Company's customer base and a net increase in reserves of $22.3 million in
the homeowner and earthquake lines (which are in runoff). The increase in
homeowner and earthquake lines is the net of a $37.0 million increase in
earthquake reserves, which was offset by a $14.7 million decrease due to the
settlement of claims in the earthquake and homeowner lines (see further
discussion under Critical Accounting Policies - Losses and LAE). The following
table summarizes unpaid losses and LAE:
MARCH 31, 2003 December 31, 2002
------------------ ------------------
AMOUNTS IN THOUSANDS Gross Net Gross Net
----------------------------------------------------------------------
Unpaid Losses and LAE
Personal auto lines $343,677 $333,553 $333,113 $320,032
Homeowner and earthquake lines 73,166 67,677 50,896 43,626
----------------------------------------------------------------------
Total $416,843 $401,230 $384,009 $363,658
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9
The following table summarizes losses and LAE incurred, net of applicable
reinsurance, for the periods indicated:
Three Months Ended
March 31,
AMOUNTS IN THOUSANDS 2003 2002
------------------------------------------------------------------
Net losses and LAE incurred related to insured
events of:
Current year $216,343 $169,185
Prior years 37,000 19,450
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Total 253,343 188,635
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Net losses and LAE incurred related to prior year events increased to $37.0
million at March 31, 2003, compared to $19.5 million at March 31, 2002. The
$37.0 million at March 31, 2003, is entirely earthquake-related. Of the $19.5
million at March 31, 2002, $1.3 million is earthquake-related. The Company's
reported earnings could be significantly different if ending reserves were based
on assumptions and estimates different from those used by management.
Historically, the Company's actuaries have not projected a range around the
carried reserves. Rather, they have used several methods and different
underlying assumptions to produce a number of point estimates for the required
reserves. Management selects the carried reserve after carefully reviewing the
appropriateness of the underlying assumptions.
Stockholders' equity and book value per share decreased to $646.6 million and
$7.57 at March 31, 2003, compared to $655.6 million and $7.67 at December 31,
2002. The decrease in stockholders' equity for the quarter ended March 31,
2003, was primarily due to a net loss of $6.7 million, dividends to stockholders
of $1.7 million, and a decrease in net unrealized investment gains of $0.7
million partially offset by other changes in comprehensive income of $0.1
million.
LIQUIDITY AND CAPITAL RESOURCES
Holding Company. The parent company's main sources of liquidity historically
have been dividends received from its insurance subsidiaries and proceeds from
issuance of debt or equity securities. The parent company currently has no
indebtedness for borrowed money, although it has guaranteed a subsidiary's
capital lease obligation. The parent's only equity security currently
outstanding is its common stock, which has no mandatory dividend obligations.
Cash and investments at the holding company were $3.8 million at March 31, 2003,
compared to $7.0 million at December 31, 2002. The decline in the parent's cash
and investments is primarily due to the payment of dividends to shareholders.
On December 19, 2002, the Company declared a $1.7 million dividend to
stockholders of record on December 30, 2002, which was paid January 17, 2003.
In addition, on February 27, 2003, the Company declared a $1.7 million dividend
to stockholders of record on March 10, 2003, which was paid March 28, 2003. If
necessary, the Company believes it can access the capital markets should the
need arise for additional capital to support its growth and other corporate
objectives. The Company's S&P claims paying rating is currently A+, and its
A.M. Best rating is A+.
The insurance subsidiaries in 2003 could pay $21.6 million as dividends to the
parent company without prior written approval from insurance regulatory
authorities. However, given the current uncertainty surrounding the taxability
of dividends received by holding companies from their insurance subsidiaries, it
is unlikely that the Company's insurance subsidiaries will make any dividend
payments to the parent in 2003. There is no assurance that this tax issue will
be favorably resolved in the near term, in which case the Company faces the
prospect of raising additional capital at the holding company level, cutting or
ceasing dividends to stockholders, or possibly having to pay the additional tax
of up to approximately 8.9 percent on dividends from the insurance company to
the holding company.
10
Insurance Subsidiaries. The Company believes it has taken the proper actions to
restore underwriting profitability in its core auto insurance operations and has
thereby enhanced its liquidity. In California, the Company implemented a 5.7%
auto premium rate increase on May 6, 2002 and a 3.9% auto premium rate increase
on March 31, 2003. There can be no assurance that insurance regulators will
grant future rate increases that may be necessary to offset possible future
increases in claims cost trends. Also, the Company remains exposed to possible
upward development in previously recorded reserves for SB 1899 claims. As a
result of such uncertainties, underwriting losses could recur in the future.
Further, the Company could be required to liquidate investments to pay claims,
possibly during unfavorable market conditions, which could lead to the
realization of losses on sales of investments. Adverse outcomes to any of the
foregoing uncertainties would create some degree of downward pressure on the
insurance subsidiaries, which in turn could negatively impact the Company's
liquidity.
As of March 31, 2003, the Company's insurance subsidiaries had a combined
statutory surplus of $385.0 million compared to $397.4 million at December 31,
2002. The change in surplus was primarily due to statutory net loss of $15.6
million during the first quarter of 2003. In addition there was an increase in
admitted assets of $3.4 million, primarily caused by an increase of $5.1 million
in the admitted portion of the deferred tax asset, partially offset by increases
in other nonadmitted assets of $1.7 million. The Company's ratio of net
premiums written to surplus was 2.7 for the twelve month period ended March 31,
2003, compared to 2.4 for the year ended December 31, 2002.
At March 31, 2003, the estimated cost to complete certain software development
projects is $39.0 million. The Company expects to fund these costs by cash flow
from operations.
Obligations, Letters of Credit, Guarantees and Transactions with Related
Parties. The Company currently has a capital lease obligation resulting from a
sale-leaseback transaction. The lease includes a covenant that if AIG ceases to
have a majority interest in the Company, or if statutory surplus falls below
$300.0 million, or if the net premiums written to surplus ratio is greater than
3.8:1, the Company will either deliver a letter of credit to the lessor or pay
the lessor the then outstanding balance, including a prepayment penalty of up to
3%. The Company also has operating leases for its office facilities.
The Company currently has no unused letters of credit, has issued no guarantees
on behalf of others, and has no trading activities involving non-exchange-traded
contracts accounted for at fair value. The Company has entered into no material
transactions with related parties other than the reinsurance transactions with
AIG subsidiaries. At March 31, 2003, reinsurance recoverables, net of payables,
from AIG subsidiaries were $13.6 million compared to $18.4 million at December
31, 2002.
Aside from the capital and operating lease obligations discussed above, the
Company has no long-term debt obligations, purchase obligations or other
long-term liabilities, whether on-balance sheet or off-balance sheet. In
addition, the Company has no retained interests in assets transferred to any
unconsolidated entities, and no obligations under derivative instruments or
obligations arising out of variable interests.
The Company has not identified any other trends, demands, commitments, events or
uncertainties that have or are considered to have a reasonable possibility of
having a material impact on the Company's liquidity.
RESULTS OF OPERATIONS
Overall Results. The Company reported net loss of $6.7 million, or $(0.8) loss
per share (basic and diluted), on direct premiums written of $293.6 million in
the quarter ended March 31, 2003, compared to net income of $8.3 million, or
$0.10 earnings per share, on direct premiums written of $233.0 million for the
same 2002 quarter. These results include after-tax charges for 1994 Northridge
earthquake costs of $24.1 million in 2003 and $0.9 million in 2002.
11
Personal Auto Lines Operating Income. Operating income, a non-GAAP financial
measure, is a key metric used by management in monitoring the operating results
of the Company's core business. Because the Company's calculation of these
measures may differ from similar measures used by other companies, investors
should be careful when comparing the Company's non-GAAP financial measures to
those of other companies.
Operating income includes (a) the underwriting revenues and expenses
attributable to the personal auto lines, personal umbrella lines, and related
vehicle lines, plus (b) net investment income excluding realized capital gains
or losses on the investment portfolio. Specifically excluded from operating
income are realized gains and losses from the investment portfolio, results of
the homeowner and earthquake lines of business, SB1899 expenses and reserve
changes, interest expense on capital leases, non-recurring items and certain
state, local and other taxes. The Company believes operating income provides
investors a valuable measure of the performance of the Company's ongoing
business because it excludes the variability created by the particular timing of
realized capital gains and losses, results of the run-off lines of business and
non-recurring items.
The following table presents the components of the Company's personal auto lines
operating income and the components of the GAAP combined ratio:
Three Months Ended
March 31,
AMOUNTS IN THOUSANDS 2003 2002
------------------------------------------------------------------------
Direct premiums written $293,616 $230,419
------------------------------------------------------------------------
Net premiums written $292,479 $220,699
------------------------------------------------------------------------
Net premiums earned $271,441 $215,111
Loss and loss adjustment expenses incurred 216,343 181,777
Underwriting expenses incurred 47,086 30,368
------------------------------------------------------------------------
Pre-tax underwriting profit on personal auto lines 8,012 2,966
Investment income 11,637 11,265
Federal income tax expense on above (4,863) (2,409)
------------------------------------------------------------------------
Personal auto lines operating income, net of tax $ 14,786 $ 11,822
------------------------------------------------------------------------
Ratios:
Loss and LAE ratio 79.7% 84.5%
Underwriting expense ratio 17.3% 14.1%
------------------------------------------------------------------------
GAAP combined ratio 97.0% 98.6%
------------------------------------------------------------------------
The following table reconciles the Company's personal auto lines operating
income to consolidated net income:
Three Months Ended
March 31,
AMOUNTS IN THOUSANDS, NET OF TAX 2003 2002
------------------------------------------------------------------------
Personal auto lines operating income $ 14,786 $11,822
Underwriting loss on homeowner and earthquake lines (24,050) (6,949)
Realized capital gains 2,977 1,081
Interest expense and fees (460)
State, local and other tax expense 36 2,369
------------------------------------------------------------------------
Net (loss) income $ (6,711) $ 8,323
------------------------------------------------------------------------
Comments relating to the underwriting results of the personal auto and the
homeowner and earthquake lines in runoff are presented below.
12
UNDERWRITING RESULTS
Personal Auto. Automobile insurance is the primary line of business written by
the Company. Vehicles insured outside of California accounted for less than 3%
of the Company's direct written premium in the first three months of 2003 and
2002. The Company currently is licensed to write automobile insurance in 29
states compared to 25 states at the end of 2002. The Company currently is
evaluating opportunities relating to expansion into new states but has not yet
adopted definitive plans. Because of the lead times involved, expansion into
new states is not expected to materially affect the Company's financial results
in 2003.
Direct premiums written in the quarter ended March 31, 2003, increased $63.2
million (27.4%) to $293.6 million compared to $230.4 for the same period in
2002. Of the $63.2 millions increase, $50.5 million was due to a higher number
of insured vehicles, while $12.7 million was due to rate increases.
Net premiums earned increased $56.3 million (26.2%) to $271.4 million for the
quarter ended March 31, 2003, compared to $215.1 million for the same period a
year ago. The increase is primarily due to the higher number of insured
vehicles and rate increases, as previously mentioned.
Net losses and LAE incurred increased $34.6 million (20.6%) to $216.3 million
for the first quarter of 2003 compared to $181.8 million for the same period
last year. The ratios of loss and LAE to net premiums earned were 79.7% and
84.5% for the quarters ended March 31, 2003 and 2002, respectively. The
effects on the loss and LAE ratios of changes in estimates relating to insured
events of prior years during the first quarter were 0.0% in 2003 and 6.8% in
2002. These changes in estimates pertained mainly to development in average
paid loss severities beyond amounts previously anticipated. In general, changes
in estimate are recorded in the period in which new information becomes
available indicating that a change is warranted, usually in conjunction with the
Company's quarterly actuarial review.
The ratios of net underwriting expenses to net premiums earned were 17.3% and
14.1% for the quarters ended March 31, 2003 and 2002, respectively. The
increase was primarily due to growth in advertising expenditures and costs
associated with increasing the number of new sales agents. Several productivity
enhancement initiatives are underway aimed at reducing per unit process costs
and lowering fixed costs in corporate support areas.
The combined ratio was 97.0% for the quarter ended March 31, 2003, compared to
98.6% for the same period a year ago. The improvement resulted mainly from the
earn-in of a 5.7% rate increase taken in May 2002. Company management remains
focused on achieving sustainable 15% growth and a combined ratio of 96%. Since
1980, the Company has simultaneously met those benchmarks only twice (1980 and
1981).
Homeowner and Earthquake Lines in Runoff. Underwriting results of the homeowner
and earthquake lines, which are in runoff, were losses of $37.0 million for the
quarter ending March 31, 2003 compared to $6.9 million for the same period a
year ago. The Company has not written any earthquake coverage since 1994 and
ceased writing new homeowner policies in September 2001.
California Senate Bill 1899 ("SB 1899"), effective from January 1, 2001, to
December 31, 2001, allowed the re-opening of previously closed earthquake claims
arising out of the 1994 Northridge Earthquake. Based on events occurring in the
first quarter of 2003, the Company increased its 1994 Northridge Earthquake/SB
1899 reserves by $37 million, resulting in an after-tax charge of $24.1 million.
Most of the Company's remaining 1994 Earthquake claims are in litigation. The
discovery stay imposed in early 2002 was lifted in the first quarter of 2003 and
trial dates for substantially all cases have now been set. Also during the
first quarter, several appellate court decisions have been rendered on issues
affecting Northridge Earthquake cases, including a decision by the 9th Circuit
Court of Appeals, involving Allstate Insurance Company, which again found SB
1899 (California Code of Civil Procedure 340.9) to be constitutional. As a
result of the 9th Circuit's decision in House et al v.
--------------
13
Allstate Insurance Company, the Company's subsidiary, 21st Century Casualty
--------------------------
Company, voluntarily dismissed the action it initiated on February 13, 2003
seeking to have SB 1899 declared unconstitutional. The Company continues to
believe the statute violates the federal and state constitutions and will
support other companies' efforts to have the law overturned.
All of the Company's SB 1899 claims that had been set for trial during the first
quarter, along with some other litigated Earthquake claims, have been settled.
However, as a result of the pace of settlements reached thus far, actual costs
incurred during the first quarter, and the Company's assessment of the expected
length and intensity of the litigation arising out of these claims, the Company
now has more information with which to estimate the ultimate costs of resolving
these claims. While the reserves established are the Company's current best
estimate of the cost of resolving its 1994 Earthquake claims, the reserves for
this legislatively created event continue to be highly uncertain. The estimate
currently recorded by the Company assumes that relatively few of the cases will
require a full trial to resolve, that any trial costs will approximate those
encountered by the Company in the past, and that most cases will be settled
without need for extensive pre-trial preparation. Current reserves contain no
provisions for extracontractual or punitive damages, bad faith judgments or
similar unpredictable hazards of litigation that possibly could result in the
event an adverse verdict were to be sustained against the Company. To the
extent those and other underlying assumptions prove to be incorrect, the
ultimate amount to resolve these claims could exceed the Company's current
reserves, possibly by a material amount. The Company continues to seek
reasonable settlements of claims brought under SB 1899 and other
Northridge-Earthquake-related theories, but will vigorously defend itself
against excessive demands and fraudulent claims. The Company may, however,
settle cases in excess of its assessment of its contractual obligations in order
to reduce the future cost of litigation.
The Company has executed various transactions to exit from its homeowner line.
Under a January 1, 2002 agreement with Balboa Insurance Company ("Balboa"), a
subsidiary of Countrywide Financial Corporation ("Countrywide"), 100% of
homeowner unearned premium reserves and subsequent related losses were reinsured
by Balboa. Obligations relating to the 1994 Northridge Earthquake are not
covered by the agreement with Balboa. The Company began non-renewing homeowner
policies expiring on February 21, 2002, and thereafter. The Company has
completed this process and no longer has homeowners policies in force or on its
paper. Substantially all of these customers were being offered homeowner
coverage through an affiliate of Countrywide.
INVESTMENT INCOME
The Company utilizes a conservative investment philosophy. No equities,
derivatives or nontraditional securities are held in the Company's investment
portfolio, substantially all of which is investment grade. Net investment income
was $11.6 million for the quarter ended March 31, 2003 compared to $11.3 million
for the same quarter in 2002. The average annual pre-tax yields on invested
assets for the three-month period ended March 31, 2003, as well as the
comparable period in 2002 were 4.6% and 5.1%, respectively. The average annual
after-tax yields on invested assets were 3.7% for the first quarter of 2003
compared to 4.4% for the same quarter in 2002.
Net realized gains on the sale of investments and fixed assets were $4.6 million
in the first quarter of 2003 (gross realized gains were $4.8 million, gross
realized losses were $0.2 million) compared to $1.7 million for the same quarter
in 2002 (gross realized gains were $2.0 million, gross realized losses were $0.3
million). At March 31, 2003, $672.0 million (63.2%) of the Company's total
investments at fair value were invested in tax-exempt bonds with the remainder,
representing 36.8% of the portfolio, invested in taxable securities, compared to
54.5% and 45.5%, respectively, at December 31, 2002.
As of March 31, 2003, the Company had a pre-tax net unrealized gain on fixed
maturity investments of $37.5 million compared to $38.5 million at December 31,
2002.
14
The following table is a summary of securities sold at a loss during the
quarters ending March 31, 2003 and 2002.
Three Months Ended
March 31,
AMOUNTS IN THOUSANDS, EXCEPT UNIT DATA 2003 2002
------------------------------------------------------------------
FIXED MATURITY SECURITIES:
Realized losses on sales $ 171 $ 189
Fair value at the date of sale 14,965 33,182
Number of securities sold 10 31
Losses realized on securities with an unrealized
loss preceding the sale for:
Less than 3 months $ 33 $ 29
3-6 months 100 126
6-12 months 38 20
Greater than 12 months - 14
------------------------------------------------------------------
CRITICAL ACCOUNTING POLICIES
The Company believes its critical accounting policies are those which require
management to make significant assumptions or estimates, and to ascertain the
appropriateness and timing of any changes in those assumptions or estimates that
can have a material effect on the Company's financial condition, results of
operations or cash flows. Specifically, the following areas require management
to make such assumptions and estimates each time the Company prepares its
financial statements: losses and LAE, particularly the liability for unpaid
losses and LAE included in the liability section of the Company's balance sheet;
the recoverability of certain property and equipment; deferred income taxes;
deferred policy acquisition costs included in the asset section of the Company's
balance sheet; and the review of the Company's investments for possible
"other-than-temporary" declines in fair value.
Management has discussed the Company's critical accounting policies and
estimates, together with any changes therein, with the Audit Committee of the
Company's Board of Directors. The Company's Disclosure Committee and Audit
Committee have reviewed the Company's disclosures in this document.
Losses and LAE. The estimated liabilities for losses and LAE include the
accumulation of estimates of losses for claims reported prior to the balance
sheet dates, estimates (based upon actuarial analysis of historical data) of
losses for claims incurred but not reported, the development of case reserves to
ultimate values and estimates of expenses for investigating, adjusting and
settling all incurred claims. Amounts reported are estimates of the ultimate
costs of settlement, net of estimated salvage and subrogation. The estimated
liabilities are necessarily subject to the outcome of future events, such as
changes in medical and repair costs, as well as economic and social conditions
that impact the settlement of claims. In addition, time can be a critical part
of reserving determinations since the longer the span between the incidence of a
loss and the payment or settlement of the claim, the more variable the ultimate
settlement amount can be. Accordingly, short-tail claims, such as property
damage claims, tend to be more reasonably predictable than long-tail liability
claims. For the Company's current mix of auto exposures, which include both
property and liability exposures, an average of approximately 63% of the
ultimate losses are settled within twelve months of the date of loss.
Given the inherent variability in the estimates, management believes the
aggregate reserves are within a reasonable and acceptable range of adequacy,
although the Company continues to caution that the reserve estimates relating to
SB 1899 are subject to a greater than normal degree of variability and
15
possible future material adjustments may become necessary as new facts become
known. The methods of making such estimates and establishing the resulting
reserves are reviewed and updated quarterly and any resulting adjustments are
reflected in current operations. Changes in the estimates for these liabilities
flow directly to the income statement on a dollar-for-dollar basis. For example,
an upward revision of $1 million in the estimated liability for unpaid losses
and loss adjustment expenses would decrease underwriting profit, and pre-tax
income, by the same $1 million amount. Conversely, a downward revision of $1
million would increase pre-tax income by the same $1 million amount.
Property and Equipment. Accounting standards require long-term assets to be
tested for possible impairment under certain conditions. At March 31, 2003,
management believes the Company's remaining capitalized costs for policy and
claims software is the only long-term asset that meets the conditions for
impairment testing. Under the applicable accounting standards, the first step
is to determine whether the carrying value and cost to complete the asset is
recoverable from future operations, based on estimates of future undiscounted
cash flows; if not, then an impairment write down would be required to be
recognized based on the fair value of the asset. At March 31, 2003, management
has estimated that the $65.4 million carrying value and $39.0 million estimated
cost to complete such software, or $104.4 million in total, is recoverable from
cost savings from future operations. This conclusion is based primarily on the
assumptions that the software can be successfully implemented and can reduce the
Company's employee count by at least 125 people (about 5% of its workforce) for
the 10 to 15 years after implementation (i.e., the current estimate of the
probable productive life of the software). Once the project has successfully
reached the stage where it is substantially complete and ready for its intended
use, the Company anticipates there will be annual depreciation charges varying
from approximately $5.8 million to $8.8 million. However, although management
believes it is reasonable to assume these future cost savings, it must be noted
that any such estimates are subject to considerable uncertainty and there can be
no assurance that such cost savings will be achieved.
Deferred Income Taxes. Generally accepted accounting principles require
deferred tax assets and liabilities ("DTAs" and "DTLs," respectively) to be
recognized for the estimated future tax effects attributed to temporary
differences and carryforwards based on provisions of the enacted tax law. The
effects of future changes in tax laws or rates are not anticipated. Temporary
differences are differences between the tax basis of an asset or liability and
its reported amount in the financial statements. For example, the Company has a
DTA because the tax basis of its loss and LAE reserves is smaller than their
book basis, and it has a DTL because the book basis of its capitalized software
exceeds its tax basis. Carryforwards include such items as alternative minimum
tax credits, which may be carried forward indefinitely, and net operating losses
(NOLs), which can be carried forward 15 years for losses incurred before 1998
and 20 years thereafter.
At March 31, 2003, the Company's DTAs total $176.4 million, and its DTLs total
$80.2 million. The net of those amounts, $96.2 million, represents the net
deferred tax asset reported in the consolidated balance sheet.
With the performance of the Company's core business in the past two quarters
running close to management's goals of 15% growth in direct written premiums and
a 96% combined ratio, management believes it is reasonable to discount the
possibility of future underwriting losses and to conclude it is at least more
likely than not that the Company will be able to realize the benefits of its
DTAs. If necessary, the Company believes it could implement tax-planning
strategies, such as investing a higher proportion of its investment portfolio in
taxable securities, in order to generate sufficient future taxable income to
utilize the NOL carryforwards prior to their expiration. Accordingly, no
valuation allowance has been recognized as of March 31, 2003. However,
generating future taxable income is dependent on a number of factors, including
regulatory and competitive influences that may be beyond the Company's ability
to control. Future underwriting
16
losses could possibly jeopardize the Company's ability to utilize its NOLs. In
the event underwriting losses due to either SB 1899 or other causes were to
persist, management might be required to reach a different conclusion about the
realizability of the DTAs and, if so, to recognize a valuation allowance at that
time.
Deferred Policy Acquisition Costs. Deferred policy acquisition costs ("DPAC")
include premium taxes, advertising, and other costs incurred in connection with
writing business. These costs are deferred and amortized over the period in
which the related premiums are earned.
Management assesses the recoverability of DPAC on a quarterly basis. The
assessment calculates the relationship of actuarially estimated costs incurred
to premiums from contracts issued or renewed for the period. The Company does
not consider anticipated investment income in determining the recoverability of
these costs. Based on current indications, no reduction in DPAC is required.
The loss and LAE ratio used in the recoverability estimate is based primarily on
the assumption that the future loss and LAE ratio will approximate that of the
recent past. While management believes that is a reasonable assumption, actual
results could differ materially from such estimates.
Investments. Impairment losses for declines in value of fixed maturity
investments below cost attributable to issuer-specific events are based upon all
relevant facts and circumstances for each investment and are recognized when
appropriate in accordance with Staff Accounting Bulletin No. 59-Noncurrent
Marketable Equity Securities, SFAS No. 115-Accounting for Certain Investments in
Debt and Equity Securities, and related guidance. For fixed maturity investments
with unrealized losses due to market conditions or industry-related events,
where the Company has the positive intent and ability to hold the investment for
a period of time sufficient to allow a market recovery or to maturity, declines
in value below cost are not assumed to be other-than-temporary. Where declines
in values of securities below cost or amortized cost are considered to be other
than temporary, a charge is required to be reflected in income for the
difference between cost or amortized cost and the fair value. No such charges
were recorded in the first quarter ending March 31, for the years 2003 and 2002.
The determination of whether a decline in market value is other than temporary
is necessarily a matter of subjective judgment. The timing and amount of
realized losses and gains reported in income could vary if conclusions other
than those made by management were to determine whether an other-than-temporary
impairment exists. However, there would be no impact on equity because any
unrealized losses are already included in comprehensive income.
A summary by issuer of noninvestment grade securities and unrated securities
held at March 31, 2003 and December 31, 2002, follows (amounts in thousands):
March 31, December 31,
2003 2002
----------------------------------------------------------------------------------
Noninvestment grade securities (i.e., rated below BBB):
Corning, Inc. $ 925 $ 850
Unrated securities:
Impact Funding, LLC 2,023 2,023
----------------------------------------------------------------------------------
Total noninvestment grade and unrated securities $ 2,948 $ 2,873
----------------------------------------------------------------------------------
17
The following table lists issuers of securities held by the Company having an
unrealized loss of $100,000 or more and aggregate information relating to all
other investments in unrealized loss positions as of March 31, 2003 and December
31, 2002:
March 31, 2003 December 31, 2002
------------------------- -------------------------
Unrealized Unrealized
Fair Value Loss Fair Value Loss
----------------------------------------------------------------------------------------------------
Fixed maturities in an unrealized loss
position less than one year:
Teco Energy, Inc. $ 5,330 $ (590) $ 5,100 $ (819)
Sears Roebuck Acceptance Corp - - 8,543 (516)
Mallinckrodt Group, Inc. - - 2,572 (317)
Duke Capital Corp. - - 7,126 (266)
Ford Motor Credit Co. 6,128 (477) 4,859 (213)
Others individually having an unrealized
loss less than $100,000 each (44
issuers and 15 issuers, respectively) 62,571 (717) 42,577 (369)
----------------------------------------------------------------------------------------------------
Subtotal 74,029 (1,784) 70,777 (2,500)
----------------------------------------------------------------------------------------------------
Fixed Maturities in an unrealized loss
position one year or more:
Corning, Inc. 925 (57) 850 (131)
Ashland, Inc. - - 2,013 (36)
General Motors Acceptance Corp. 8,847 (161) - -
Others individually having an unrealized
loss less than $100,000 each (3 issuers
at March 31, 2003) 6,104 (55) - -
----------------------------------------------------------------------------------------------------
Subtotal 15,876 (273) 2,863 (167)
----------------------------------------------------------------------------------------------------
Total $ 89,905 $ (2,057) $ 73,640 $ (2,667)
----------------------------------------------------------------------------------------------------
A summary of bond maturities in an unrealized loss position by year of maturity
follows:
March 31, 2002 December 31, 2002
--------------------- ---------------------
Amortized Carrying Amortized Carrying
Cost Value Cost Value
--------------------------------------------------------------------------------------
Bond Maturities
Due in one year or less $ - $ - $ - $ -
Due after one year through five years 5,418 5,306 5,415 5,076
Due after five years through ten years 21,064 19,818 30,099 28,280
Due after ten years 65,480 64,781 40,792 40,284
--------------------------------------------------------------------------------------
Total $ 91,962 $ 89,905 $ 76,306 $ 73,640
--------------------------------------------------------------------------------------
POLICIES REGARDING CONFLICTS OF INTEREST AND ETHICAL BEHAVIOR
The Company has adopted policies regarding conflicts of interest and ethical
behavior among its employees, particularly those with responsibilities in the
areas of accounting, financial reporting and maintaining the integrity of the
Company's internal control structure. These policies include standards that are
reasonably necessary to promote:
- honest and ethical conduct, including the ethical handling of actual or
apparent conflicts of interest between personal and professional
relationships;
18
- avoidance of conflicts of interest, including disclosure to an appropriate
person or persons of any material transaction or relationship that
reasonably could be expected to give rise to such a conflict;
- full, fair, accurate, timely and understandable disclosure in the reports
and documents that the Company files and in other public communications
made by the Company;
- compliance with applicable governmental laws, rules and regulations;
- the prompt internal reporting of code violations to an appropriate person
or personnel identified in the code; and
- accountability for adherence to the code.
The Company requires an annual attestation by applicable officers, directors and
employees that they are in compliance with these policies. The Company's Board
of Directors granted no conflict of interest waivers in 2002, nor in the first
quarter of 2003.
FORWARD-LOOKING STATEMENTS
The Company's management has made in this report, and from time to time may make
in its public filings, press releases, and oral presentations and discussions,
forward-looking statements concerning the Company's operations, economic
performance and financial condition. Forward-looking statements include, among
other things, discussions concerning the Company's potential, expectations,
beliefs, estimates, forecasts, projections and assumptions. Forward-looking
statements may address, among other things, the Company's strategy for growth,
underwriting results, product development, computer systems, regulatory
approvals, market position, financial results, dividend policy and reserves. It
is possible that the Company's actual results, actions and financial condition
may differ, possibly materially, from the anticipated results, actions and
financial condition indicated in these forward-looking statements. Important
factors that could cause the Company's actual results and actions to differ,
possibly materially, from those in the specific forward-looking statements
include the effects of competition and competitors' pricing actions; adverse
underwriting and claims experience, including revived earthquake claims under SB
1899; customer service problems; the impact on Company operations of natural
disasters, principally earthquake, or civil disturbance, due to the
concentration of Company facilities and employees in Woodland Hills, California;
information systems problems, including failures to implement information
technology projects on time and within budget; adverse developments in financial
markets or interest rates; and results of legislative, regulatory or legal
actions, including the inability to obtain approval for rate increases and
product changes and adverse actions taken by state regulators in market conduct
examinations. The Company does not undertake any obligation to update or revise
any forward-looking statements, whether as a result of new information, future
events or otherwise.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and
interest rates. In addition to market risk, the Company is exposed to other
risks, including the credit risk related to its financial instruments and the
underlying insurance risk related to its core business and the exposure of the
personal lines insurance business, as a regulated industry, to legal,
legislative, judicial, political and regulatory action. The following table
shows the financial statement carrying values of the Company's financial
instruments, which are reported at fair value. The estimated fair values at
adjusted market rates/prices assumes a 100 basis point increase in market
interest rates for the investment portfolio and a 100 basis point decrease in
market interest rates for the capital lease obligation. The following
sensitivity analysis summarizes only the exposure to market interest rate risk
as of March 31, 2003.
19
Estimated Fair Value
Carrying At Adjusted Market
AMOUNTS IN MILLIONS Value Rates/Prices
-------------------------------------------------------------------------------
Fixed maturity investments available for sale $ 952.0 $ 883.2
Capital lease obligation 58.0 59.6
The Company's cash flow from operations and short-term cash position generally
is more than sufficient to meet its obligations for claim payments, which by the
nature of the personal automobile insurance business tend to have an average
duration of less than a year. As a result, it has been unnecessary for the
Company to employ elaborate market risk management techniques involving
complicated asset and liability duration matching or hedging strategies. For
all of its financial assets and liabilities, the Company seeks to maintain
reasonable average durations, currently 6.3 years, consistent with the
maximization of income without sacrificing investment quality and providing for
liquidity and diversification. Financial instruments are not used for trading
purposes.
The sensitivity analysis provides only a limited, point-in-time view of the
market risk sensitivity of the Company's financial instruments. The actual
impact of market interest rate and price changes on the financial instruments
may differ significantly from those shown in the analysis.
ITEM 4. MANAGEMENT'S INTERNAL CONTROL REPORT
The Company's certifying officers have established and maintained disclosure
controls, internal controls and procedures to ensure the (a) reliability of
financial reporting; (b) effectiveness and efficiency of operations; and (c)
compliance with applicable laws and regulations. As part of these procedures,
the Company has established a Disclosure Committee comprised of the senior
officers responsible for the Company's operations, including the Chief Executive
Officer, General Counsel, Acting Chief Financial Officer and Controller and
Chief Internal Auditor.
The Disclosure Committee met specifically regarding the design and effectiveness
of the internal controls over financial reporting and disclosure. The
Disclosure Committee's evaluation for the quarter ended March 31, 2003 was
completed on April 4, 2003. Based on the Disclosure Committee's evaluation, the
Company's Chief Executive Officer and Acting Chief Financial Officer and
Controller reached the following conclusions:
- There were no significant deficiencies in the design or operation of
internal controls which could affect the Company's ability to record,
process, summarize and report financial data in accordance with applicable
laws and regulations;
- No material weaknesses in internal controls were noted that should be
disclosed to the Company's independent auditors, Audit Committee or Board
of Directors;
- No fraud, whether or not material, that involves management or employees
who have a significant role in the Company's internal controls, was
identified.
Subsequent to the date of the evaluation, the Disclosure Committee and
certifying officers have not become aware of any significant changes in internal
controls or in other factors that could significantly affect internal controls,
including any corrective actions with regard to significant deficiencies or
material weaknesses.
20
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In the normal course of business, the Company is named as a defendant in
lawsuits related to claim and insurance policy issues, both on individual policy
files and by class actions seeking to attack the use of various databases,
vendors and claims practices generally. Many suits seek generally unspecified
extracontractual and punitive damages as well as contractual damages far in
excess of the Company's estimates. The Company cannot estimate the amount or
range of loss that could result from an unfavorable outcome on these suits. It
denies liability for any such alleged damages and believes that it has a number
of valid defenses to the litigation. The Company has not established reserves
for potential extracontractual or punitive damages, or for damages in excess of
estimates the Company believes are correct and reasonable. Nevertheless,
extracontractual and punitive damages, if assessed against the Company, could be
material in an individual case or in the aggregate. The Company may choose to
settle litigated cases for amounts in excess of its own estimate of contractual
damages to avoid the expense and/or risk of litigation. Other than possibly for
the contingencies discussed below, the Company does not believe the ultimate
outcome of these matters will be material to its results of operations,
financial condition or cash flows.
On December 9, 2002, the Company commenced an arbitration proceeding against
Computer Sciences Corporation ("CSC") arising out of CSC's obligation to provide
insurance company information technology software and other software programs to
the Company. CSC has filed a counterclaim in the proceeding. In the third
quarter of 2002, the Company wrote off $37.2 million of its investment in
certain CSC software. The arbitration is being conducted by the American
Arbitration Association.
Cecelia Encarnacion, individually and as the Guardian Ad Litem for Nubia Cecelia
--------------------------------------------------------------------------------
Gonzalez, a Minor, Hilda Cecelia Gonzalez, a Minor, and Ramon Aguilera v. 20th
------------------------------------------------------------------------------
Century Insurance, filed July 3, 1997 in Los Angeles Superior Court. Plaintiffs
-----------------
allege bad faith, emotional distress, and estoppel involving 20th Century's
handling of a homeowner's claim. Ramon Aguilera shot Mr. Gonzalez (the minor
children's father) and was sued by Ms. Encarnacion for wrongful death. On
August 30, 1996, judgment was entered against Ramon Aguilera for $5.6 million.
The Company paid for Aguilera's defense costs through the civil trial; however,
the homeowner's policy did not provide indemnity coverage for the shooting
incident, and the Company refused to pay the judgment. After the trial,
Aguilera assigned a portion of his action against the Company to Encarnacion and
the minor children. Aguilera and the Encarnacion family then sued the Company
alleging that 20th Century had promised to pay its bodily injury policy limit if
Aguilera plead guilty to involuntary manslaughter. They further claim that the
Company is estopped to raise its policy exclusions, and that it owes the entire
judgment plus interest. A bench trial is scheduled for June 3, 2003 to resolve
the promissory estoppel issues. The Company is vigorously defending the action.
Bryan Speck, individually, and on behalf of others similarly situated v. 21st
-----------------------------------------------------------------------------
Century Insurance Company, 21st Century Casualty Company, and 21st Century
--------------------------------------------------------------------------
Insurance Group, was filed on June 20, 2002 in Los Angeles Superior Court. The
---------------
plaintiff seeks national class action certification, injunctive relief, and
unspecified actual and punitive damages. The complaint contends that 21st
Century uses "biased" software in determining the value of total-loss
automobiles. The plaintiff alleges that database providers use improper
methodology to establish comparable auto values and populate their databases
with biased figures. The Company and other carriers allegedly subscribe to the
programs to unfairly reduce claim costs. This case is consolidated with similar
actions against other insurers for discovery and pre-trial motions. The Company
intends to vigorously defend the suit with other defendants in the coordinated
proceedings.
21
Thomas Theis, on his own behalf and on behalf of all others similarly situated
------------------------------------------------------------------------------
v. 21st Century Insurance, was filed on June 17, 2002 in Los Angeles Superior
-------------------------
Court. Plaintiff seeks national class action certification, injunctive relief
and unspecified actual and punitive damages. The complaint contends that after
insureds receive medical treatment, the Company uses a medical-review program to
adjust expenses to reasonable and necessary amounts for a given geographic area.
The plaintiff alleges that the adjusted amount is "predetermined" and "biased,"
creating an unfair pretext for reducing claim costs. This case is consolidated
with similar actions against other insurers for discovery and pre-trial motions.
The Company intends to vigorously defend the suit with other defendants in the
coordinated proceedings.
On October 10, 2002, a Los Angeles Superior Court granted the Company's motion
for summary judgment in the matter of 21st Century Insurance Company vs. People
-----------------------------------------
of the State of California ex rel.Bill Lockyer, Attorney General et al. The
----------------------------------------------------------------------
court determined that the Company's April 21, 1999, settlement with the
California Department of Insurance ("CDI") with respect to regulatory actions
arising out of the 1994 Northridge Earthquake was fully valid and enforceable.
The Court denied the Attorney General's motion seeking to have the settlement
declared void and unenforceable, a result that may have allowed the CDI to
reinstitute regulatory proceedings with respect to the Company's handling of
claims arising out of the 1994 Northridge Earthquake. The CDI has appealed the
ruling.
SB 1899, effective from January 1, 2001, to December 31, 2001, allowed the
re-opening of previously closed earthquake claims arising out of the 1994
Northridge Earthquake. The Company's first constitutional challenge to SB 1899
came to an unsuccessful result on April 29, 2002, when the United States Supreme
Court refused to hear the Company's case. A subsidiary of the Company, 21st
Century Casualty Company, filed a new challenge to the constitutionality of SB
1899 on February 13, 2003. During the first quarter, several appellate court
decisions have been rendered on issues affecting Northridge Earthquake cases,
including a 9th Circuit Court of appeals decision in House et al v.
--------------
Allstate Insurance Company which again found SB 1899 (California Code of Civil
-------------------------
Procedure 340.9) to be constitutional. As a result of this 9th Circuit's
decision, the Company's subsidiary, 21st Century Casualty Company, voluntarily
dismissed the action it initiated on February 13, 2003, seeking to have SB 1899
declared unconstitutional. The Company currently has lawsuits pending against
it in connection with claims under SB 1899; many of these lawsuits have multiple
plaintiffs. Possible future judgements for damages in excess of the Company's
reasonable estimates for these claims could be material individually or in the
aggregate.
The Company has filed a civil complaint against California-based Unlimited
Adjusting Company ("Unlimited") and its principal Jung Ho Park ("John Park").
The suit alleges Unlimited and John Park illegally induced insureds into filing
additional unnecessary and fraudulent claims with the Company stemming from the
1994 Northridge Earthquake. The Company is ultimately seeking up to $10 million
in compensatory damages.
In December of 2000, a statute that allowed a tax deduction for the dividends
received from wholly owned insurance subsidiaries was held unconstitutional on
the grounds that it discriminated against out-of-state insurance holding
companies. Subsequent to the court ruling, the staff of the California
Franchise Tax Board ("FTB") has decided to take the position that the
discriminatory sections of the statute are not severable and the entire statute
is invalid. As a result, the FTB is disallowing dividend-received deductions
for all insurance holding companies, regardless of domicile, for open tax years
ending on or after December 1, 1997. Although the FTB has not made a formal
assessment for tax years 1997 through 2000, the Company anticipates a
retroactive disallowance that would result in additional tax assessments.
The amount of any such possible assessments and the ultimate amounts, if any,
that the Company may be required to pay, are subject to a wide range of
estimates because so many ostensibly long-settled aspects of California tax law
have been thrown into disarray and uncertainty by the action of the courts.
22
In the absence of legislative relief, years of future litigation may be required
to determine the ultimate outcome. The range of possible loss, net of federal
tax benefit, ranges from close to zero to approximately $20.8 million depending
on which position future courts may decide to uphold or on whether the
California legislature may decide to enact corrective legislation. The Company
believes it has adequately provided for this contingency.
ITEM 2. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 3. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to the Sarbanes- Oxley Act of 2002
(b) Reports on Form 8-K
A report on Form 8-K was filed on February 3, 2003, regarding the
resignation of Douglas K. Howell as Senior Vice President and Chief
Financial Officer effective February 7, 2003.
23
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
21ST CENTURY INSURANCE GROUP
-------------------------------------------------------
(Registrant)
Date: May 14, 2003 /s/ Bruce W. Marlow
----------------- -------------------------------------------------------
BRUCE W. MARLOW
President and Chief Executive Officer
Date: May 14, 2003 /s/ John M. Lorentz
----------------- -------------------------------------------------------
JOHN M. LORENTZ
Controller and Acting Chief Financial Officer
(Principal Accounting Officer and Acting Principal
Financial Officer)
24
CERTIFICATION OF PRESIDENT AND CHIEF EXECUTIVE OFFICER
------------------------------------------------------
I, Bruce W. Marlow, certify that:
1. I have reviewed this quarterly report on Form 10-Q of 21st Century
Insurance Group:
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: May 14, 2003 /s/ Bruce W. Marlow
--------------------- -------------------------------------------------
BRUCE W. MARLOW
President and Chief Executive Officer
25
CERTIFICATION OF CONTROLLER AND ACTING CHIEF FINANCIAL OFFICER
--------------------------------------------------------------
I, John M. Lorentz, certify that:
1. I have reviewed this quarterly report on Form 10-Q of 21st Century
Insurance Group:
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: May 14, 2003 /s/ John M. Lorentz
-------------------- ------------------------------------------------
JOHN M. LORENTZ
Controller and Acting Chief Financial Officer
(Principal Accounting Officer and Acting Principal
Financial Officer)
26
EXHIBIT INDEX
Exhibit No. Description
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
the Sarbanes-Oxley Act of 2002
27