SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For Quarterly Period Ended September 30, 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
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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 by check mark whether the registrant is an accelerated filer as
defined in Rule 12b-2 of the Exchange Act.
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 November 3, 2003
(Title of Class) 85,435,505 shares
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
21ST CENTURY INSURANCE GROUP
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, December 31,
2003 2002
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA (UNAUDITED)
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ASSETS
Fixed maturity investments available-for-sale, at fair value $ 1,119,428 $ 926,597
(amortized cost: $1,083,016 and $888,063)
Equity securities 5 --
Cash and cash equivalents 40,901 105,897
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Total investments and cash 1,160,334 1,032,494
Accrued investment income 13,948 13,230
Premiums receivable 114,008 91,029
Reinsurance receivables and recoverables 13,632 28,105
Prepaid reinsurance premiums 1,712 1,893
Deferred income taxes 70,902 88,939
Deferred policy acquisition costs 54,254 46,190
Leased property under capital lease, net of deferred gain of
$5,093 and $6,280 and net of accumulated amortization of $9,298
and $0 45,238 53,720
Property and equipment, at cost less accumulated depreciation of
$57,928 and $52,125 94,469 87,274
Other assets 39,781 27,163
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Total assets $ 1,608,278 $ 1,470,037
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LIABILITIES AND STOCKHOLDERS' EQUITY
Unpaid losses and loss adjustment expenses $ 429,050 $ 384,009
Unearned premiums 319,144 266,477
Obligation under capital lease 52,566 60,000
Claim checks payable 43,987 39,304
Reinsurance payable 1,954 4,952
Other liabilities 75,371 59,687
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Total liabilities 922,072 814,429
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Stockholders' equity:
Common stock, without par value; authorized 110,000,000
shares, outstanding 85,435,505 and 85,431,505 419,233 418,984
Retained earnings 244,797 213,067
Accumulated other comprehensive income 22,176 23,557
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Total stockholders' equity 686,206 655,608
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Total liabilities and stockholders' equity $ 1,608,278 $ 1,470,037
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See accompanying notes to consolidated financial statements.
2
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS
Unaudited
Three months ended September 30, Nine months ended September 30,
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA 2003 2002 2003 2002
-------------------------------------------------------------------------------------------------------------------
REVENUES
Net premiums earned $ 303,675 $ 234,666 $ 862,347 $ 669,968
Net investment income 11,350 11,729 34,660 34,378
Other -- -- 14,065 --
Realized investment gains 836 3,045 13,116 7,343
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Total revenues 315,861 249,440 924,188 711,689
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LOSSES AND EXPENSES
Net losses and loss adjustment expenses 240,926 239,944 722,452 618,482
Policy acquisition costs 49,857 31,517 143,767 87,836
Write-off of software -- 37,177 -- 37,177
Other operating expenses 7,234 7,395 8,567 14,363
Interest and fees expense 797 -- 2,337 --
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Total losses and expenses 298,814 316,033 877,123 757,858
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Income (loss) before federal income taxes 17,047 (66,593) 47,065 (46,169)
Federal income tax expense (benefit) 4,338 (21,358) 11,918 (19,116)
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Net income (loss) $ 12,709 $ (45,235) $ 35,147 $ (27,053)
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EARNINGS (LOSS) PER COMMON SHARE
Basic $ 0.15 $ (0.53) $ 0.41 $ (0.32)
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Diluted $ 0.15 $ (0.53) $ 0.41 $ (0.32)
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Weighted average shares outstanding-basic 85,432,838 85,439,641 85,431,949 85,408,266
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Weighted average shares outstanding-diluted 85,745,822 85,439,641 85,621,463 85,408,266
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See accompanying notes to consolidated financial statements.
3
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Unaudited
Accumulated
Other
Common Retained Comprehensive
AMOUNTS IN THOUSANDS Stock Earnings Income Total
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Balance - January 1, 2003 $418,984 $ 213,067 $ 23,557 $655,608
Comprehensive income -- 35,147 (1) (1,381)(2) 33,766
Cash dividends declared on common
stock ($0.04 per share) -- (3,417) -- (3,417)
Other 249 -- -- 249
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Balance - September 30, 2003 $419,233 $ 244,797 $ 22,176 $686,206
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(1) Net income.
(2) Net change in accumulated other comprehensive income for the nine months ended
September 30, 2003, comprises unrealized gains on available-for-sale investments of
$7,098 (net of income tax expense of $3,822) less the reclassification adjustment for
gains included in net income of $8,479 (net of income tax expense of $4,565).
See accompanying notes to consolidated financial statements.
4
21ST CENTURY INSURANCE GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited
AMOUNTS IN THOUSANDS
Nine months ended September 30, 2003 2002
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OPERATING ACTIVITIES
Net income (loss) $ 35,147 $ (27,053)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Provision for depreciation and amortization 16,435 15,113
Write-off of software -- 37,177
Amortization of restricted stock grants 247 369
Deferred federal income tax expense (benefit) 18,781 (15,660)
Realized gains on sale of investments (12,894) (7,343)
Federal income tax (expense) benefit (6,863) 4,670
Reinsurance balances 11,657 4,596
Unpaid losses and loss adjustment expenses 45,041 45,220
Unearned premiums 52,667 17,842
Claim checks payable 4,683 1,609
Premiums receivable (22,979) (13,812)
Other assets (12,341) (5,569)
Other liabilities 15,684 3,457
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Net cash provided by operating activities 145,265 60,616
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INVESTING ACTIVITIES
Fixed maturities available-for-sale:
Purchases (516,673) (466,287)
Calls or maturities 30,110 18,617
Sales 300,480 441,928
Net purchases of property and equipment (13,327) (13,212)
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Net cash used in investing activities (199,410) (18,954)
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FINANCING ACTIVITIES
Reduction of obligation under capital lease (7,434) --
Dividends paid (3,417) (13,665)
Proceeds from the exercise of stock options -- 1,485
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Net cash used in financing activities (10,851) (12,180)
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Net (decrease) increase in cash (64,996) 29,482
Cash and cash equivalents, beginning of period 105,897 28,909
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Cash and cash equivalents, end of period $ 40,901 $ 58,391
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Supplemental information:
Income taxes paid (refunded) $ 123 $ (12,920)
Interest paid $ 2,211 --
See accompanying notes to consolidated financial statements.
5
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
Unaudited
NOTE 1. BASIS OF PRESENTATION
------------------------------
The accompanying unaudited consolidated financial statements of 21st Century
Insurance Group and its 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 nine-month period ended September 30,
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.
On October 16, 2003, the board of directors voted to change 21st Century
Insurance Group's state of incorporation from California to Delaware. There will
be no change in the location of Company operations, location of employees, or in
the way the Company does business. The sole result of this action is to change
the state of legal incorporation. The reincorporation will be accomplished
through the merger of the 21st Century Insurance Group with and into a newly
formed and wholly-owned Delaware subsidiary. Shareholders holding a majority of
the voting power approved the reincorporation by written consent on October 17,
2003. The Company expects the transaction to be effective within the next 60
days.
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. During the first quarter of
2003, the Company increased its 1994 Northridge Earthquake/SB 1899 reserves by
$37.0 million, resulting in an after-tax charge of $24.1 million. Most of the
Company's remaining 1994 Earthquake claims are in litigation. During the first
quarter, several appellate court decisions were 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 Noah 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 has filed an amicus curiae brief in support
of Allstate's petition to the United States Supreme Court for review of the
Noah decision.
While the reserves now held 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. Trials for most of the cases not settled are
expected to be scheduled for May, 2004 or later. 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
6
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
Unaudited
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 losses on or after that date were ceded
to Balboa. Obligations relating to the 1994 Northridge Earthquake are not
covered by the agreement with Balboa. Under the terms of this agreement,
certain loss adjustment expenses are retained by the Company. Also, the Company
began non-renewing homeowner policies expiring on February 21, 2002 and
thereafter. Substantially all of those customers were offered homeowner
coverage through an affiliate of Countrywide. The Company has completed this
process and no longer has any homeowner policies in force.
Loss and loss adjustment expenses incurred for the homeowner and earthquake
lines in runoff for the three months and nine months ended September 30, 2003,
and 2002 were as follows:
Three Months Nine Months
Ended September 30, Ended September 30,
AMOUNTS IN THOUSANDS 2003 2002 2003 2002
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Losses and LAE incurred
Homeowner lines $ 3,245 $ -- $ 3,245 $ 6,037
Earthquake lines -- 46,863 37,000 52,640
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Total $ 3,245 $ 46,863 $ 40,245 $ 58,677
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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 extracontractual 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 of the Notes to
Consolidated Financial Statements 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
7
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
Unaudited
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 amounts 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. In the
absence of legislative relief, years of future litigation may be required to
determine the ultimate outcome. The possible losses, net of federal tax
benefit, range from close to zero to approximately
$22.0 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.
NOTE 4. STOCK - BASED COMPENSATION
-----------------------------------
Under the 1995 Stock Option Plan approved by the Company's stockholders, the
aggregate number of common shares authorized to be issued for grants of stock
options is currently limited to 10,000,000. At September 30, 2003, 2,726,214
common shares remain available for future grants and 6,797,918 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 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 September 30, 2003, ranged from
$11.68 to $29.25. The weighted-average remaining contractual life of those
options is 7.49 years.
A summary of the Company's stock option activity for the nine months ended
September 30, 2003, 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 1,802 12.03
Exercised in 2003 -- --
Forfeited in 2003 (146) 16.71
---------------------------------------------------
Options outstanding September 30, 2003 6,798 17.06
---------------------------------------------------
8
A summary of securities issuable and issued under the 1995 Stock Option Plan at
September 30, 2003, follows:
21ST CENTURY INSURANCE GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
Unaudited
1995 Stock Option
AMOUNTS IN THOUSANDS Plan
------------------------------------------------------------------------
Total securities authorized 10,000
Number of securities issued (476)
Number of securities issuable upon the exercise of all
outstanding options and rights (6,798)
Number of securities forfeited (1,382)
Number of securities forfeited and returned to plan 1,382
------------------------------------------------------------------------
Number of securities remaining available for future
grants under the plan 2,726
------------------------------------------------------------------------
Options exercisable numbered 3,600,217 and 2,520,982 as of September 30, 2003
and 2002, respectively.
For pro forma disclosure purposes, the fair value of stock options was estimated
at each date of grant using the following assumptions:
Nine Months Ended September 30, 2003 2002
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Risk-free interest rate:
Minimum 2.65% 4.61%
Maximum 3.75% 4.79%
Dividend yield 0.67% 2.50%
Volatility factor of the expected market price
of the Company's common stock:
Minimum 0.38 0.35
Maximum 0.40 0.36
Weighted-average expected life of the options 6 YEARS 8 years
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9
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 Nine Months Ended
September 30, September 30,
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA 2003 2002 2003 2002
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Net income (loss), as reported $12,709 $(45,235) $35,147 $(27,053)
Add: Stock-based employee compensation
expense included in reported net 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 1,930 1,387 5,758 4,011
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Pro forma net income (loss) $10,779 $(46,622) $29,389 $(31,064)
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Earnings (loss) per share:
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Basic- as reported $ 0.15 $ (0.53) $ 0.41 $ (0.32)
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Basic- pro forma $ 0.13 $ (0.55) $ 0.34 $ (0.36)
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Diluted- as reported $ 0.15 $ (0.53) $ 0.41 $ (0.32)
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Diluted- pro forma $ 0.13 $ (0.55) $ 0.34 $ (0.36)
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Estimated weighted-average of the fair value of
options granted -- (1) -- (1) $ 4.80 $ 6.33
-------------------------------------------------------------------------------------------------
(1) No stock options were granted in the 3rd quarters of 2003 and 2002.
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
FINANCIAL CONDITION
Investments and cash increased $35.6 million (3.2%) and $127.8 million (12.4%)
during the three months and nine months ended September 30, 2003, respectively.
This increase was primarily due to improved cash flow from operations.
Investment-grade bonds comprised substantially all of the fair value of the
fixed-maturity portfolio at September 30, 2003. The Company had less than 1% of
its investments in equity securities as of September 30, 2003 and did not have
any investments in equity securities as of December 31, 2002. Of the Company's
total investments at September 30, 2003, approximately 69.0% were invested in
tax-exempt, fixed-income securities, compared to 54.5% at December 31, 2002.
As of September 30, 2003, the pre-tax net unrealized gain on investments was
$36.4 million (unrealized gains of $39.3 million and unrealized losses of $2.9
million), compared to $38.5 million at December 31, 2002 (unrealized gains of
$41.2 million and unrealized losses 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 three months or nine months ended
September 30, 2003 or 2002.
The Company's net deferred income tax asset decreased $18.0 million (20.3%)
during the nine months ended September 30, 2003, primarily due to an increase in
taxable earnings.
Premiums receivable were $114.0 million at September 30, 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 $0.5 million and $0.3 million at September 30, 2003, and
December 31, 2002, respectively. Company policy is to write off receivable
balances when 180 days past due. At September 30, 2003, and December 31, 2002,
the allowance for doubtful accounts was $0.9 million and $0.0 million,
respectively.
Prepaid reinsurance premiums and reinsurance payables were $1.7 million and $2.0
million, respectively, at September 30, 2003, compared to $1.9 million and $5.0
million, respectively, at December 31, 2002. The decline in balances is
primarily due to the cancellation of the quota share treaty with AIG
subsidiaries effective September 1, 2002.
Increased advertising, compensation and other underwriting costs through
September 30, 2003, associated with increased customer volume, contributed to an
increase in deferred policy acquisition costs ("DPAC") of $8.1 million to $54.3
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).
The Company's loss and loss adjustment expense ("LAE") reserves, gross and net
of reinsurance, are summarized in the following table:
SEPTEMBER 30, 2003 December 31, 2002
--------------------------------------
AMOUNTS IN THOUSANDS GROSS NET Gross Net
-------------------------------------------------------------
Unpaid Losses and LAE
Personal auto lines $395,176 $387,542 $333,113 $320,031
Homeowner lines 5,306 2,718 10,952 3,683
Earthquake lines 28,568 28,568 39,944 39,944
-------------------------------------------------------------
Total $429,050 $418,828 $384,009 $363,658
-------------------------------------------------------------
11
Gross unpaid losses and LAE increased by $45.0 million during the nine months
ended September 30, 2003, primarily due to a reserve increase of $62.1 million
in the personal auto lines as a result of growth in the Company's customer base.
The homeowner and earthquake lines, which are in runoff, decreased by $17.0
million in the nine months ended September 30, 2003.
The following table summarizes losses and LAE incurred, net of reinsurance, for
the periods indicated:
Three Months Ended Nine Months Ended
September 30, September 30,
AMOUNTS IN THOUSANDS 2003 2002 2003 2002
--------------------------------------------------------------------------------------
Net losses and LAE incurred related to insured
events of:
Current year:
Personal auto lines $234,208 $191,439 $678,734 $538,231
Homeowner lines 107 -- 107 4,451
Earthquake lines -- -- -- --
--------------------------------------------------------------------------------------
Total current year 234,315 191,439 678,841 542,682
--------------------------------------------------------------------------------------
Prior years:
Personal auto lines 3,473 1,642 3,473 21,574
Homeowner lines 3,138 -- 3,138 1,586
Earthquake lines -- 46,863 37,000 52,640
--------------------------------------------------------------------------------------
Total prior years 6,611 48,505 43,611 75,800
--------------------------------------------------------------------------------------
Grand Total $240,926 $239,944 $722,452 $618,482
--------------------------------------------------------------------------------------
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 reserves after carefully
reviewing the appropriateness of the underlying assumptions.
The Company does not insure homes or other structures and consequently does not
have any homeowners claims from the October 2003 California wildfires. However,
the Company has received approximately ninety claims for damages to insured
vehicles as a result of the wildfires. These claims range from minor damage to
totally burned vehicles. A number of these claims have already been adjusted
and the Company is moving quickly to assist its policyholders on the remainder
as access is granted to the affected areas.
Stockholders' equity and book value per share increased to $686.2 million and
$8.03, respectively, at September 30, 2003, compared to $655.6 million and
$7.67, respectively, at December 31, 2002. The increase in stockholders' equity
for the nine months ended September 30, 2003, was due to net income of $35.1
million, other increases relating to common stock of $0.2 million, less a
decrease in other comprehensive income of $1.4 million and dividends to
stockholders of $3.4 million.
LIQUIDITY AND CAPITAL RESOURCES
Holding Company. The main sources of liquidity of 21st Century Insurance Group,
the holding company, historically have been dividends received from its
insurance subsidiaries and proceeds from the issuance of debt or equity
securities. The holding company currently has no indebtedness for borrowed
money, although it has guaranteed a subsidiary's capital lease obligation. The
holding company's only equity security currently outstanding is its common
stock, which has no mandatory dividend obligations.
12
Cash and investments at the holding company were $11.7 million at September 30,
2003, compared to $7.0 million at December 31, 2002. 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. 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. In addition, on June 26, 2003, the Company
declared a $1.7 million dividend to stockholders of record on July 8, 2003,
which was paid on July 25, 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
holding company without prior written approval from insurance regulatory
authorities. However, it is unlikely that the Company's insurance subsidiaries
will make any dividend payments to the holding company in 2003 due to the
current uncertainty surrounding the taxability of dividends received by holding
companies from their insurance subsidiaries (see discussion of the Ceridian case
in Note 3 of the Notes to Consolidated Financial Statements). 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% on dividends from
the insurance company subsidiaries to the holding company.
Insurance Subsidiaries. The Company has recorded underwriting profits in its
core auto insurance operations for the last seven quarters and has thereby
enhanced its liquidity. In California, a 3.9% auto premium rate increase was
implemented on March 31, 2003 and in May of 2002 there was a 5.7% rate increase.
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 occur 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 earnings, which in turn could negatively impact the Company's
liquidity.
As of September 30, 2003, the Company's insurance subsidiaries had a combined
statutory surplus of $435.2 million, compared to $397.4 million at December 31,
2002. The change in statutory surplus was primarily due to statutory net income
of $48.7 million, an increase in nonadmitted assets of $3.4 million and a
decrease in deferred income tax assets of $7.4 million. The Company's ratio of
net premiums written to statutory surplus was 2.7 for the twelve month period
ended September 30, 2003, compared to 2.4 for the year ended December 31, 2002.
At September 30, 2003, the estimated cost to complete certain software
development projects was $35.6 million. The Company expects to fund these costs
using cash flow from operations.
Obligations, Letters of Credit, and Guarantees. 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 statutory 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.
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-
13
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.
Transactions with Related Parties. Since 1995, the Company has entered into
several transactions with AIG, the Company's majority owner since 1998, or with
affiliated companies, including various reinsurance agreements which are
discussed in the Company's Annual Report on Form 10-K for the year ended
December 31, 2002. At September 30, 2003, reinsurance recoverables, net of
payables, from AIG subsidiaries were $7.8 million, compared to $18.4 million at
December 31, 2002. Other transactions with AIG or its affiliates, which are
immaterial, have resulted from competitive bidding processes for certain
corporate insurance coverages and certain software and data processing services.
Subsequent to September 30, 2003, as a result of a competitive bidding process,
the Company entered into an agreement with an AIG affiliate to provide
investment management services to the Company; the agreement was subject to
approval by the California Department of Insurance, which granted such approval
in October 2003. Apart from the foregoing, the Company has no material
transactions with related parties.
RESULTS OF OPERATIONS
Overall Results. The Company reported net income of $12.7 million, or $0.15
earnings per share (basic and diluted), on direct premiums written of $324.3
million for the quarter ended September 30, 2003, compared to a net loss of
$45.2 million, or $0.53 loss per share (basic and diluted), on direct premiums
written of $257.9 million for the same 2002 quarter. For the nine months ended
September 30, 2003, net income was $35.1 million, or $0.41 earnings per share
(basic and diluted), on direct premiums written of $918.8 million. For the nine
months ended September 30, 2002, there was a net loss of $27.1 million, or $0.32
loss per share (basic and diluted), on direct premiums written of $729.4
million. These results include: (i) after-tax charges for 1994 Northridge
Earthquake costs of $24.1 million for the nine months ended September 30, 2003
and $34.2 million for the same period in 2002; (ii) after-tax net income of
$9.1 million for the nine months ended September 30, 2003 resulting from a
nonrecurring, nonoperational item and a favorable tax settlement with the IRS;
and (iii) an after-tax charge of $24.2 million, for the three and nine months
ended September 30, 2002, relating to a write-off of software.
The following table presents the components of the Company's personal auto lines
underwriting profit and the components of the combined ratio:
Three Months Nine Months
Ended September 30, Ended September 30,
AMOUNTS IN THOUSANDS 2003 2002 2003 2002
-----------------------------------------------------------------------------------
Direct premiums written $324,190 $257,978 $918,730 $726,932
-----------------------------------------------------------------------------------
Net premiums written $322,889 $260,034 $915,112 $709,185
-----------------------------------------------------------------------------------
Net premiums earned $303,588 $234,666 $862,259 $669,968
Net losses and loss adjustment expenses 237,683 193,081 682,207 559,805
Underwriting expenses incurred 57,091 38,912 152,334 102,108
-----------------------------------------------------------------------------------
Personal auto lines underwriting profit $ 8,814 $ 2,673 $ 27,718 $ 8,055
-----------------------------------------------------------------------------------
RATIOS:
Loss and LAE ratio 78.3% 82.3% 79.1% 83.6%
Underwriting expense ratio 18.8% 16.6% 17.7% 15.2%
-----------------------------------------------------------------------------------
Combined ratio 97.1% 98.9% 96.8% 98.8%
-----------------------------------------------------------------------------------
14
The following table reconciles the Company's personal auto lines underwriting
profit to consolidated net income:
Three Months Nine Months
Ended September 30, Ended September 30,
AMOUNTS IN THOUSANDS 2003 2002 2003 2002
--------------------------------------------------------------------------------------
Personal auto lines underwriting profit $ 8,814 $ 2,673 $ 27,718 $ 8,055
Homeowner and earthquake lines, in runoff,
underwriting loss (3,156) (46,863) (40,157) (58,768)
Net investment income 11,350 11,729 34,660 34,378
Realized investment gains 836 3,045 13,116 7,343
Other revenues -- -- 14,065 --
Write-off of software -- (37,177) -- (37,177)
Interest and fees expense (797) -- (2,337) --
Federal income tax (expense) benefit (4,338) 21,358 (11,918) 19,116
--------------------------------------------------------------------------------------
Net income (loss) $12,709 $(45,235) $ 35,147 $(27,053)
--------------------------------------------------------------------------------------
Comments relating to the underwriting results of the personal auto and the
homeowner and earthquake lines in runoff are presented below, followed by
information pertaining to investment results and other revenues.
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 premiums in the three and nine months ended
September 30, 2003, and 2002. The Company currently is licensed to write
automobile insurance in 29 states, compared to 25 states at the end of 2002.
Direct premiums written in the three months ended September 30, 2003, increased
$66.2 million (25.7%) to $324.2 million, compared to $258.0 million for the same
period in 2002. Of the $66.2 million increase, $58.1 million was due to a
higher number of insured vehicles, while $8.1 million was due to rate increases.
Direct premiums written for the nine months ended September 30, 2003, increased
$191.8 million (26.4%) to $918.7 million, compared to $726.9 million for the
same period in 2002. Of the $191.8 million increase, $159.8 million was due to
a higher number of insured vehicles, while $32.0 million was due to rate
increases. Current growth is being generated through active advertising for new
customers and product innovations.
Net premiums earned increased $68.9 million (29.4%) to $303.6 million for the
three months ended September 30, 2003, compared to $234.7 million for the same
period in 2002. Net premiums earned increased $192.3 million (28.7%) to $862.3
million for the nine months ended September 30, 2003, compared to $670.0 million
for the same period in 2002.
The combined ratio was 97.1% for the three months ended September 30, 2003,
compared to 98.9% for the same period in 2002. The combined ratios for the nine
months ended September 30, 2003 and 2002 were 96.8% and 98.8%, respectively.
The improvement resulted from a reduction in the loss and LAE ratio, which was
partially offset by an increase in the underwriting expense ratio. Company
management remains focused on achieving sustainable 15% premium growth and a
combined ratio of 96.0% or better. Since 1980, the Company has simultaneously
met those benchmarks only twice (1980 and 1981).
Net losses and LAE incurred increased $44.6 million (23.1%) to $237.7 million
for the three months ended September 30, 2003, compared to $193.1 million for
the same period in 2002. For the nine months ended September 30, 2003, net
losses and LAE incurred increased $122.4 million (21.9%) to $682.2 million,
compared to $559.8 million for the same period in 2002.
15
The loss and LAE ratios were 78.3% and 82.3% for the three months ended
September 30, 2003, and 2002, respectively. For the nine months ended September
30, 2003, and 2002, the ratios were 79.1% and 83.6%, respectively. The effects
on the loss and LAE ratios of changes in estimates relating to insured events of
prior years during the third quarter were 1.1% in 2003 and 0.7% in 2002. The
effects on the loss and LAE ratios of changes in estimates relating to insured
events of prior years during the nine months ended September 30, were 0.4% in
2003 and 3.2% in 2002. These changes in estimates pertained mainly to
development in average paid loss severities beyond amounts previously
anticipated. In general, changes in estimates 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.
For the California auto lines, accident frequency (i.e., total number of claims
reported in the calendar period for all coverages divided by average vehicles in
force) decreased 5.7% in the third quarter of 2003, compared to the third
quarter of 2002, and decreased 7.4% in the first nine months of 2003, compared
to the first nine months of 2002. Loss severity increased 4.0% in the third
quarter of 2003, compared to the third quarter of 2002, and increased 4.2% in
the first nine months of 2003, compared to the first nine months of 2002. Past
frequency and severity trends are not necessarily predictive of future trends.
The ratios of net underwriting expenses to net premiums earned were 18.8% and
16.6% for the quarters ended September 30, 2003, and 2002, respectively. The
ratios of net underwriting expenses to net premiums earned were 17.7% and 15.2%
for the nine months ended September 30, 2003, and 2002, respectively. The
increases were primarily due to growth in advertising and costs associated with
increasing the number of new sales agents.
Homeowner and Earthquake Lines in Runoff. The homeowner and earthquake lines,
which are in runoff, incurred an underwriting loss of $3.2 million for the
quarter ending September 30, 2003, compared to an underwriting loss of $46.9
million for the same period a year ago. For the nine months ended September 30,
2003, and 2002, underwriting losses for those same lines were $40.2 million and
$58.8 million, respectively, of which the earthquake lines accounted for $37.0
million and $52.7 million, respectively. The earthquake underwriting losses
relate to 1994 Northridge Earthquake claims that a California statute, Senate
Bill 1899 ("SB 1899") allowed to be reopened in 2001, as is fully explained in
Note 2 of the Notes to Consolidated Financial Statements. The Company has not
written any earthquake coverage since 1994 and ceased writing new homeowner
policies in September 2001.
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 losses on or after that date were ceded
to Balboa. Under the terms of this agreement, certain loss adjustment expenses
are retained by the Company. Also, 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.
Substantially all of those customers were offered homeowner coverage through an
affiliate of Countrywide. The Company has completed this process and no longer
has any homeowner policies in force.
INVESTMENT RESULTS
The Company utilizes a conservative investment philosophy. No derivatives or
nontraditional securities are held in the Company's investment portfolio and
less than 1% of the portfolio consists of equity securities. Substantially all
of the investment portfolio is investment grade. Net investment income was $11.4
million for the quarter ended September 30, 2003, compared to $11.7 million for
the
16
same quarter in 2002. Net investment income for the nine months ended September
30, 2003 and 2002, was $34.7 million and $34.4 million, respectively. The
average annual pre-tax yields on invested assets were 4.1% and 4.4% for the
three and nine month periods ended September 30, 2003, respectively, compared to
5.1% for both the same periods in 2002. The average annual after-tax yields on
invested assets were 3.6% and 3.7% for the three and nine month periods ended
September 30, 2003, respectively, compared to 4.3% and 4.4% for the same periods
in 2002, respectively. The decrease in yields is due primarily to the fact that
the Company portfolio has a shorter duration combined with a significant
decrease in short term yields over the last twelve months.
Net realized gains on the sale of investments and fixed assets for the three and
nine months ended September 30, 2003, were $0.8 million (gross realized gains
were $0.9 million, gross realized losses were $0.1 million) and $13.1 million
(gross realized gains were $13.6 million, gross realized losses were $0.5
million), compared to $3.0 million (gross realized gains were $3.2 million,
gross realized losses were $0.2 million) and $7.3 million (gross realized gains
were $8.2 million, gross realized losses were $0.9 million) for the same periods
in 2002. At September 30, 2003, $796.3 million (69.0%) of the Company's total
investments at fair value were invested in tax-exempt bonds with the remainder,
representing 31.0% of the portfolio, invested in taxable securities, compared to
54.5% and 45.5%, respectively, at December 31, 2002.
As of September 30, 2003, the Company had a pre-tax net unrealized gain on fixed
maturity investments of $36.4 million, compared to $38.5 million at December 31,
2002.
The following table is a summary of securities sold at a loss during the three
month and nine month periods ending September 30, 2003 and 2002.
Three Months Nine Months
Ended September 30, Ended September 30,
AMOUNTS IN THOUSANDS, EXCEPT UNIT DATA 2003 2002 2003 2002
----------------------------------------------------------------------------------------------
FIXED MATURITY SECURITIES:
Realized losses on sales $ 37 $ 127 $ 356 $ 751
Fair value at the date of sale $ 4,651 $ 5,955 $ 20,999 $ 92,669
Number of securities sold 4 6 15 56
Losses realized on securities with an unrealized
loss preceding the sale for:
Less than 3 months $ 37 $ 9 $ 70 $ 65
3-6 months -- 2 100 173
6-12 months -- -- 38 139
Greater than 12 months -- 116 148 374
----------------------------------------------------------------------------------------------
OTHER REVENUES
Other revenue in the nine months ended September 30, 2003, included $9.3 million
resulting from a nonrecurring, nonoperational item from the settlement of
litigation and interest income of $4.8 million relating to a favorable
settlement with the IRS. Both items occurred in the second quarter of 2003.
17
WRITE-OFF OF SOFTWARE
In the third quarter of 2002, the Company recorded a one-time pre-tax charge to
write off $37.2 million of previously capitalized software costs for an
abandoned portion of an advanced personal lines processing system.
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 80% 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 adequate, 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 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 September 30, 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 September 30, 2003,
management has estimated that the $73.0 million carrying value and $35.6 million
estimated cost to
18
complete such software, or $108.6 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). However, although management
believes it is reasonable to assume these future cost savings, such estimates
are subject to considerable uncertainty and there can be no assurance that such
cost savings will be achieved. 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 ranging from
approximately $7.2 million to $10.9 million.
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
("NOL's"), which can be carried forward 15 years for losses incurred before 1998
and 20 years thereafter.
At September 30, 2003, the Company's DTAs were $156.4 million, and its DTLs were
$85.5 million for a net DTA of $70.9 million which represents the net deferred
tax asset reported in the consolidated balance sheet.
The Company's core business has generated an underwriting profit for the past
seven consecutive quarters. 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 September 30, 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 losses could possibly jeopardize the Company's
ability to utilize its NOL carryforwards. In the event underwriting losses due
to either SB 1899 or other causes were to occur, management might be required to
reach a different conclusion about the realization 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,
19
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 three or nine months
ending September 30, 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
September 30, 2003 and December 31, 2002, follows:
SEPTEMBER 30, December 31,
AMOUNTS IN THOUSANDS 2003 2002
------------------------------------------------------------------------------------
Noninvestment grade securities (i.e., rated below BBB):
Corning, Inc. $ -- $ 850
------------------------------------------------------------------------------------
Total noninvestment grade and unrated securities $ -- $ 850
------------------------------------------------------------------------------------
The following table sets forth securities held by the Company having an
unrealized loss of $0.1 million or more and aggregate information relating to
all other investments in unrealized loss positions as of September 30, 2003 and
December 31, 2002:
SEPTEMBER 30, 2003 December 31, 2002
---------------------------------------------------------------
AMOUNTS IN THOUSANDS, # FAIR UNREALIZED # Fair value Unrealized
EXCEPT ISSUES ISSUES VALUE LOSS issues loss
----------------------------------------------------------------------------------------------------
Fixed maturity securities with
unrealized losses:
Exceeding $0.1 million and for:
less than 6 months 2 $ 8,515 $ 663 3 $ 20,769 $ 1,601
6-12 months -- -- -- 2 7,431 530
more than 1 year -- -- -- 1 850 131
Less than $0.1 million 88 162,015 2,231 16 44,590 405
----------------------------------------------------------------------------------------------------
Total 90 $170,530 $ 2,894 22 $ 73,640 $ 2,667
----------------------------------------------------------------------------------------------------
20
A summary by contractual maturity of bonds in an unrealized loss position
follows:
SEPTEMBER 30, 2003 December 31, 2002
--------------------------------------------
AMOUNTS IN THOUSANDS AMORTIZED CARRYING AMORTIZED CARRYING
COST VALUE COST VALUE
--------------------------------------------------------------------------------------
Bond Maturities
Due in one year or less $ -- $ -- $ -- $ --
Due after one year through five years 7,416 7,291 5,415 5,076
Due after five years through ten years 39,324 38,699 30,099 28,280
Due after ten years 126,683 124,540 40,792 40,284
--------------------------------------------------------------------------------------
Total $ 173,423 $ 170,530 $ 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;
- 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 ethical code violations to an appropriate
person or personnel identified in the code; and
- accountability for adherence to the ethical 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
nine months 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,
21
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 assume 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.
Estimated Fair Value
Carrying At Adjusted Market
AMOUNTS IN MILLIONS Value Rates/Prices
-------------------------------------------------------------------------------
Fixed maturity investments available-for-sale $ 1,119.4 $ 1,041.4
Capital lease obligation 52.6 54.0
The above sensitivity analysis summarizes only the exposure to market interest
rate risk as of September 30, 2003. 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.
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 one 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 5.1 years, consistent with the
maximization of income without sacrificing investment quality and providing for
liquidity and diversification. In the current lower rate environment, the
Company is taking steps to lower duration. Financial instruments are not used
for trading purposes.
ITEM 4. DISCLOSURE, CONTROLS AND PROCEDURES
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, Chief Financial Officer, Controller and Chief
Compliance Officer.
The Disclosure Committee met specifically regarding the design and effectiveness
of the Company's disclosure controls and procedures (as defined in Exchange Act
Rule 13a-15(e)) as of September 30, 2003. The Disclosure Committee's evaluation
for the quarter ended September 30, 2003 was
22
completed on October 14, 2003. Based on the Disclosure Committee's evaluation,
the Company's certifying officers 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.
There were no changes in the Company's internal control over financial reporting
during the last fiscal quarter that have materially affected, or are reasonably
likely to materially affect, the Company's internal control over financial
reporting.
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 underwriting 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.
Dana Poss v. 21st Century Insurance Company was filed on June 13, 2003, in Los
-------------------------------------------
Angeles Superior Court. The Complaint requests injunctive and restitutionary
relief under Business and Professions Code ("B&P") Sec.17200 for alleged unfair
business practices in violation of California Insurance Code ("CIC")
Sec.1861.02(c) relating to company rating practices. The Company will
vigorously defend the action.
21st Century Insurance Group, 21st Century Casualty Company and 21st Century
----------------------------------------------------------------------------
Insurance Company v. Kai Insurance Marketing, Inc. was filed on January 31,
--------------------------------------------------
2003, in United States District Court, Central District of California, Western
Division. The Company alleges Kai violated the Lanham Act, infringed upon and
diluted trademarks, made a false designation of origin and engaged in unfair
competition. Kai has filed a Cross-Complaint, as amended against 21st Century
Insurance Group, 21st Century Casualty Company and 21st Century Insurance
Company; the remaining allegations under the Cross-Complaint are infringement,
and violation of Insurance Code Section 881.5 unfair competition under B&P
Sec.17200.
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 was filed on 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,
23
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 pled
guilty to involuntary manslaughter. In August 2003, the trial court held a bench
trial on the limited issues of promissory and equitable estoppel, and policy
forfeiture. On September 26, 2003, the trial court issued a ruling that 20th
Century cannot invoke any policy exclusions as a defense to coverage. Plaintiffs
contend that as a result of the ruling, 20th Century owes the full amount of the
wrongful death judgment, plus interest and attorneys' fees. 20th Century
contends that the court should not award damages to Aguilera as a result of his
own inequitable conduct. Both sides intend to file Summary Judgment motions on
these issues. A jury trial is set for June 1, 2004.
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.
---------------
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. Plaintiff alleges that database providers use improper methodology
to establish comparable auto values and populate their databases with biased
figures and that 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.
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.
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 Noah 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 the 9th Circuit's
decision, the Company's subsidiary, 21st Century
24
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 has
filed an amicus curiae brief in support of Allstate's petition to the United
States Supreme Court for review of the Noah decision. The Company currently
has lawsuits pending against it in connection with claims under SB 1899; many of
these lawsuits have multiple plaintiffs. Possible future judgments 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 complaint was filed on December 16, 2002, in Superior Court of California,
County of Orange and transferred to Superior Court of California, County of Los
Angeles on April 15, 2003. 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. In
the absence of legislative relief, years of future litigation may be required to
determine the ultimate outcome. The possible losses, net of federal tax
benefit, range from close to zero to approximately $22.0 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. CHANGE IN SECURITIES AND USE OF PROCEEDS
[None.]
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
[None.]
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
[None]
ITEM 5. OTHER INFORMATION
[None.]
25
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
31.1 Certification of President and Chief Executive Officer Pursuant to
Exchange Act Rule 13a-14(a).
31.2 Certification of Chief Financial Officer Pursuant to Exchange Act Rule
13a-14(a).
31.3 Certification of Principal Accounting Officer Pursuant to Exchange Act
Rule 13a-14(a).
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
The following reports on Form 8-K were filed.
DATE FILED REGARDING
July 24, 2003 2003 second quarter results.
26
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: November 5, 2003 /s/ Bruce W. Marlow
-------------------- ----------------------------------------------
BRUCE W. MARLOW
President and Chief Executive Officer
Date: November 5, 2003 /s/ Carmelo Spinella
-------------------- ----------------------------------------------
CARMELO SPINELLA
Sr. Vice President and Chief Financial Officer
Date: November 5, 2003 /s/ John M. Lorentz
-------------------- ----------------------------------------------
JOHN M. LORENTZ
Vice President, Controller and
Principal Accounting Officer
27
EXHIBIT INDEX
Exhibit No. Description
31.1 Certification of President and Chief Executive Officer Pursuant
to Exchange Act Rule 13a-14(a).
31.2 Certification of Chief Financial Officer Pursuant to Exchange Act
Rule 13a-14(a).
31.3 Certification of Principal Accounting Officer Pursuant to
Exchange Act Rule 13a-14(a).
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
28