21st Century Insurance Group 10-Q 6-30-2006
UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM
10-Q
x QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES
EXCHANGE ACT OF 1934
For
the
quarterly period ended June 30, 2006
¨
TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES
EXCHANGE ACT OF 1934
For
the
transition period from
to
Commission
File Number 0-6964
(Exact
name of registrant as specified in its charter)
|
Delaware
|
|
95-1935264
|
|
|
(State
or other jurisdiction of incorporation or organization)
|
|
(I.R.S.
Employer Identification No.)
|
|
|
|
|
|
|
|
6301
Owensmouth Avenue
|
|
|
|
|
Woodland
Hills, California
|
|
91367
|
|
|
(Address
of principal executive offices)
|
|
(Zip
Code)
|
|
|
|
|
|
|
|
(818)
704-3700
|
|
www.21st.com
|
|
|
(Registrant’s
telephone number, including area code)
|
|
(Registrant’s
web site)
|
|
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 a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “accelerated
filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
(Check one):
Large
accelerated filer ¨
|
Accelerated
filer x
|
Non-accelerated filer ¨
|
Indicate
by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes ¨
No x
The
number of shares outstanding of the issuer’s common stock as of July 13, 2006
was 86,335,335.
TABLE
OF CONTENTS
Description
|
Page
Number
|
PART
I - FINANCIAL INFORMATION
|
|
Item
1.
|
|
2
|
Item
2.
|
|
18
|
Item
3.
|
|
35
|
Item
4.
|
|
37
|
PART
II - OTHER INFORMATION
|
|
Item
1.
|
|
38
|
Item
1A.
|
|
38
|
Item
2.
|
|
38
|
Item
3.
|
|
38
|
Item
4.
|
|
38
|
Item
5.
|
|
38
|
Item
6.
|
|
38
|
|
39
|
|
40
|
31.1
|
Certification
of Principal Executive Officer Pursuant to Exchange Act Rule
13a-14(a)
|
|
31.2
|
Certification
of Principal Financial 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
|
|
PART
I - FINANCIAL INFORMATION
ITEM
1. FINANCIAL STATEMENTS
21ST
CENTURY INSURANCE GROUP
|
|
|
|
|
|
CONDENSED
CONSOLIDATED BALANCE SHEETS
|
|
|
|
|
|
Unaudited
|
|
|
|
|
|
|
|
|
|
|
|
AMOUNTS
IN THOUSANDS, EXCEPT SHARE DATA
|
|
June
30, 2006
|
December
31, 2005
|
Assets
|
|
|
|
|
|
Fixed
maturity investments available-for-sale, at fair value (amortized
cost: $1,472,300 and $1,365,948)
|
|
$
|
1,426,728
|
|
$
|
1,354,707
|
|
Equity
securities available-for-sale, at fair value (cost: $0 and
$49,210)
|
|
|
—
|
|
|
47,367
|
|
Total
investments
|
|
|
1,426,728
|
|
|
1,402,074
|
|
Cash
and cash equivalents
|
|
|
40,188
|
|
|
68,668
|
|
Accrued
investment income
|
|
|
17,304
|
|
|
16,585
|
|
Premiums
receivable
|
|
|
98,887
|
|
|
100,900
|
|
Reinsurance
receivables and recoverables
|
|
|
6,521
|
|
|
6,539
|
|
Prepaid
reinsurance premiums
|
|
|
2,072
|
|
|
1,946
|
|
Deferred
income taxes
|
|
|
57,321
|
|
|
56,209
|
|
Deferred
policy acquisition costs
|
|
|
68,248
|
|
|
59,939
|
|
Leased
property under capital lease, net of deferred gain of $1,313 and
$1,534
and net of accumulated amortization of $39,542 and $36,995
|
|
|
20,568
|
|
|
22,651
|
|
Property
and equipment, at cost less accumulated depreciation of $100,295
and
$89,595
|
|
|
148,213
|
|
|
145,811
|
|
Other
assets
|
|
|
41,323
|
|
|
38,907
|
|
Total
assets
|
|
$
|
1,927,373
|
|
$
|
1,920,229
|
|
Liabilities
and stockholders’ equity
|
|
|
|
|
|
|
|
Unpaid
losses and loss adjustment expenses
|
|
$
|
495,092
|
|
$
|
523,835
|
|
Unearned
premiums
|
|
|
321,166
|
|
|
319,676
|
|
Debt
|
|
|
121,619
|
|
|
127,972
|
|
Claims
checks payable
|
|
|
38,363
|
|
|
42,681
|
|
Reinsurance
payable
|
|
|
748
|
|
|
643
|
|
Other
liabilities
|
|
|
95,220
|
|
|
75,450
|
|
Total
liabilities
|
|
|
1,072,208
|
|
|
1,090,257
|
|
|
|
|
|
|
|
|
|
Commitments
and contingencies
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stockholders’
equity:
|
|
|
|
|
|
|
|
Common
stock, par value $0.001 per share; 110,000,000 shares authorized;
shares
issued 86,341,626 and 85,939,889
|
|
|
86
|
|
|
86
|
|
Additional
paid-in capital
|
|
|
435,894
|
|
|
425,454
|
|
Treasury
stock; at cost shares: 6,291 and 5,929
|
|
|
(89
|
)
|
|
(84
|
)
|
Retained
earnings
|
|
|
450,774
|
|
|
414,898
|
|
Accumulated
other comprehensive loss
|
|
|
(31,500
|
)
|
|
(10,382
|
)
|
Total
stockholders’ equity
|
|
|
855,165
|
|
|
829,972
|
|
Total
liabilities and stockholders’ equity
|
|
$
|
1,927,373
|
|
$
|
1,920,229
|
|
See
accompanying Notes to Condensed Consolidated Financial
Statements.
21ST
CENTURY INSURANCE GROUP
|
|
|
|
|
|
|
|
|
|
CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS
Unaudited
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three
Months Ended June30,
|
Six
Months Ended June 30,
|
AMOUNTS
IN THOUSANDS, EXCEPT SHARE DATA
|
|
2006
|
2005
|
2006
|
2005
|
Revenues
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
325,512
|
|
$
|
336,845
|
|
$
|
651,336
|
|
$
|
673,209
|
|
Net
investment income
|
|
|
17,174
|
|
|
17,006
|
|
|
34,929
|
|
|
34,043
|
|
Other
income
|
|
|
10
|
|
|
367
|
|
|
10
|
|
|
367
|
|
Net
realized investment gains (losses)
|
|
|
30
|
|
|
(1,267
|
)
|
|
(1,037
|
)
|
|
(1,727
|
)
|
Total
revenues
|
|
|
342,726
|
|
|
352,951
|
|
|
685,238
|
|
|
705,892
|
|
Losses
and expenses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
losses and loss adjustment expenses
|
|
|
223,094
|
|
|
248,284
|
|
|
459,590
|
|
|
499,315
|
|
Policy
acquisition costs
|
|
|
64,887
|
|
|
63,755
|
|
|
124,219
|
|
|
128,078
|
|
Other
underwriting expenses
|
|
|
9,504
|
|
|
8,765
|
|
|
22,104
|
|
|
16,123
|
|
Other
expense
|
|
|
923
|
|
|
—
|
|
|
923
|
|
|
—
|
|
Interest
and fees expense
|
|
|
1,854
|
|
|
2,031
|
|
|
3,752
|
|
|
4,088
|
|
Total
losses and expenses
|
|
|
300,262
|
|
|
322,835
|
|
|
610,588
|
|
|
647,604
|
|
Income
before provision for income taxes
|
|
|
42,464
|
|
|
30,116
|
|
|
74,650
|
|
|
58,288
|
|
Provision
for income taxes
|
|
|
14,143
|
|
|
9,621
|
|
|
25,011
|
|
|
18,356
|
|
Net
income
|
|
$
|
28,321
|
|
$
|
20,495
|
|
$
|
49,639
|
|
$
|
39,932
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Earnings
per common share
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
earnings per share
|
|
$
|
0.33
|
|
$
|
0.24
|
|
$
|
0.58
|
|
$
|
0.47
|
|
Diluted
earnings per share
|
|
$
|
0.33
|
|
$
|
0.24
|
|
$
|
0.57
|
|
$
|
0.47
|
|
Weighted-average
shares outstanding —
basic
|
|
|
85,968,155
|
|
|
85,704,165
|
|
|
85,918,791
|
|
|
85,613,043
|
|
Weighted-average
shares outstanding —
diluted
|
|
|
86,232,103
|
|
|
85,890,984
|
|
|
86,373,845
|
|
|
85,803,214
|
|
See
accompanying Notes to Condensed Consolidated Financial
Statements.
21ST
CENTURY INSURANCE GROUP
CONDENSED
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
Unaudited
|
|
Common
Stock
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$0.001
par value
|
|
|
|
|
|
|
|
|
|
|
AMOUNTS
IN THOUSANDS,
EXCEPT
SHARE DATA
|
|
Issued
Shares
|
Amount
|
Additional
Paid-in
Capital
|
Treasury
Stock
|
Retained
Earnings
|
Accumulated
Other Comprehensive
Loss
|
Total
|
Balance
- January 1, 2006
|
|
|
85,939,889
|
|
$
|
86
|
|
$
|
425,454
|
|
$
|
(84
|
)
|
$
|
414,898
|
|
$
|
(10,382
|
)
|
$
|
829,972
|
|
Comprehensive
income (loss)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
49,639
|
(1)
|
|
(21,118
|
)(2)
|
|
28,521
|
|
Cash
dividends declared on common stock ($0.16 per share)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(13,763
|
)
|
|
|
|
|
(13,763
|
)
|
Exercise
of stock options
|
|
|
293,187
|
|
|
|
|
|
3,844
|
|
|
|
|
|
|
|
|
|
|
|
3,844
|
|
Issuance
of restricted stock
|
|
|
108,550
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
—
|
|
Forfeiture
of 362 shares of restricted stock
|
|
|
|
|
|
|
|
|
5
|
|
|
(5
|
)
|
|
|
|
|
|
|
|
—
|
|
Stock-based
compensation cost
|
|
|
|
|
|
|
|
|
6,478
|
|
|
|
|
|
|
|
|
|
|
|
6,478
|
|
Excess
tax benefits of stock-based compensation
|
|
|
|
|
|
|
|
|
113
|
|
|
|
|
|
|
|
|
|
|
|
113
|
|
Balance
- June 30, 2006
|
|
|
86,341,626
|
|
$
|
86
|
|
$
|
435,894
|
|
$
|
(89
|
)
|
$
|
450,774
|
|
$
|
(31,500
|
)
|
$
|
855,165
|
|
(1) |
Net
income for the six months ended June 30,
2006.
|
(2)
|
Net
change in accumulated other comprehensive loss
follows:
|
|
|
Six
Months Ended
June
30, 2006
|
Unrealized
holding losses arising during the period, net of tax benefit of
$11,734
|
|
$
|
(21,792
|
)
|
Reclassification
adjustment for investment losses included in net income, net of tax
benefit of $363
|
|
|
674
|
|
Total
|
|
$
|
(21,118
|
)
|
See
accompanying Notes to Condensed Consolidated Financial
Statements.
21ST
CENTURY INSURANCE GROUP
CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited
AMOUNTS
IN THOUSANDS, EXCEPT SHARE DATA
|
|
|
|
Six
Months Ended June 30,
|
|
2006
|
2005
|
Operating
activities
|
|
|
|
|
|
Net
income
|
|
$
|
49,639
|
|
$
|
39,932
|
|
Adjustments
to reconcile net income to net cash provided by operating
activities:
|
|
|
|
|
|
|
|
Depreciation
and amortization
|
|
|
13,304
|
|
|
14,995
|
|
Net
amortization of investment premiums and discounts
|
|
|
4,496
|
|
|
4,840
|
|
Stock-based
compensation cost
|
|
|
6,478
|
|
|
138
|
|
Provision
for deferred income taxes
|
|
|
9,431
|
|
|
5,903
|
|
Net
realized investment losses
|
|
|
1,037
|
|
|
1,717
|
|
Changes
in assets and liabilities
|
|
|
|
|
|
|
|
Premiums
receivable
|
|
|
2,013
|
|
|
234
|
|
Deferred
policy acquisition costs
|
|
|
(8,309
|
)
|
|
(3,446
|
)
|
Reinsurance
receivables and recoverables
|
|
|
(3
|
)
|
|
1,377
|
|
Federal
income taxes
|
|
|
2,786
|
|
|
(69
|
)
|
Other
assets
|
|
|
(1,866
|
)
|
|
5,241
|
|
Unpaid
losses and loss adjustment expenses
|
|
|
(28,743
|
)
|
|
(20
|
)
|
Unearned
premiums
|
|
|
1,490
|
|
|
5,207
|
|
Claims
checks payable
|
|
|
(4,318
|
)
|
|
(170
|
)
|
Other
liabilities
|
|
|
16,983
|
|
|
(5,638
|
)
|
Net
cash provided by operating activities
|
|
|
64,418
|
|
|
70,241
|
|
Investing
activities
|
|
|
|
|
|
|
|
Purchases
of:
|
|
|
|
|
|
|
|
Fixed
maturity investments available-for-sale
|
|
|
(180,179
|
)
|
|
(76,575
|
)
|
Equity
securities available-for-sale
|
|
|
(35,627
|
)
|
|
(160,730
|
)
|
Property
and equipment
|
|
|
(13,346
|
)
|
|
(12,591
|
)
|
Maturities
and calls of fixed maturity investments available-for-sale
|
|
|
12,618
|
|
|
17,225
|
|
Sales
of:
|
|
|
|
|
|
|
|
Fixed
maturity investments available-for-sale
|
|
|
55,346
|
|
|
27,192
|
|
Equity
securities available-for-sale
|
|
|
84,836
|
|
|
152,688
|
|
Net
cash used in investing activities
|
|
|
(76,352
|
)
|
|
(52,791
|
)
|
Financing
activities
|
|
|
|
|
|
|
|
Repayment
of debt
|
|
|
(6,740
|
)
|
|
(5,953
|
)
|
Dividends
paid (per share: $0.16 and $0.08)
|
|
|
(13,763
|
)
|
|
(6,847
|
)
|
Proceeds
from the exercise of stock options
|
|
|
3,844
|
|
|
1,975
|
|
Excess
tax benefits from stock-based compensation
|
|
|
113
|
|
|
—
|
|
Net
cash used in financing activities
|
|
|
(16,546
|
)
|
|
(10,825
|
)
|
Net
(decrease) increase in cash and cash equivalents
|
|
|
(28,480
|
)
|
|
6,625
|
|
Cash
and cash equivalents, beginning of period
|
|
|
68,668
|
|
|
34,697
|
|
Cash
and cash equivalents, end of period
|
|
$
|
40,188
|
|
$
|
41,322
|
|
|
|
|
|
|
|
|
|
Supplemental
information:
|
|
|
|
|
|
|
|
Income
taxes paid
|
|
$
|
12,863
|
|
$
|
9,434
|
|
Interest
paid
|
|
|
3,682
|
|
|
4,017
|
|
See
accompanying Notes to Condensed Consolidated Financial
Statements.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June
30, 2006
DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
NOTE
1.
FINANCIAL STATEMENT PRESENTATION
General
21st
Century Insurance Group and subsidiaries (the “Company”) prepared the
accompanying unaudited condensed consolidated financial statements in accordance
with the rules and regulations of the Securities and Exchange Commission for
interim reporting. As permitted under those rules and regulations, certain
notes
or other information that are normally required by accounting principles
generally accepted in the United States of America (“GAAP”) have been condensed
or omitted if they substantially duplicate the disclosures contained in the
annual audited consolidated financial statements. The unaudited condensed
consolidated financial statements should be read in conjunction with the audited
consolidated financial statements and notes thereto included in the Company’s
Annual Report on Form 10-K for the year ended December 31, 2005.
These
unaudited condensed consolidated financial statements include all adjustments
(including normal, recurring accruals) that are considered necessary for the
fair presentation of our financial position and results of operations in
accordance with GAAP. Intercompany accounts and transactions have been
eliminated in consolidation. Operating results for the six-month period ended
June 30, 2006 are not necessarily indicative of results that may be expected
for
the remaining interim periods or the year as a whole.
Earnings
Per Share (“EPS”)
For
each
of the quarters ended June 30, 2006 and 2005, the numerator for the calculation
of both basic and diluted earnings per share is equal to net income reported
for
that period. The difference between basic and diluted EPS denominators is due
to
dilutive common stock equivalents (stock options and restricted stock). Basic
earnings per share excludes dilution and reflects net income divided by the
weighted-average shares of common stock outstanding during the periods
presented. The denominator for the computation of basic EPS was 85,968,155
and
85,918,791 shares for the three and six months ended June 30, 2006,
respectively, and 85,704,165 and 85,613,043 shares for the three and six months
ended June 30, 2005, respectively.
Diluted
earnings per share is based upon the weighted-average shares of common stock
and
dilutive common stock equivalents outstanding during the periods presented.
Common stock equivalents arising from dilutive stock options and restricted
common stock are computed using the treasury stock method. For the three and
six
months ended June 30, 2006, this amounted to 86,232,103 and 86,373,845 shares,
respectively, which include 263,948 and 455,054 dilutive common stock
equivalents, respectively. For the three and six months ended June 30, 2005,
this amounted to 85,890,984 and 85,803,214 shares, respectively, which include
186,819 and 190,171 dilutive common stock equivalents,
respectively.
Options
to purchase an aggregate of 6,157,293 and 5,359,356 shares of common stock
during the three and six months ended June 30, 2006, respectively, and 7,475,427
and 7,341,859 shares of common stock during the three and six months ended
June
30, 2005, respectively, were
not
included in the computation of diluted earnings per share because the options’
exercise prices were greater than the average market prices of the common stock
for each respective period. These options expire at various points in time
through 2016.
Stock-Based
Compensation
Prior
to
January 1, 2006, the Company accounted for its stock-based compensation plans
under the measurement and recognition provisions of Accounting Principles Board
Opinion No. (“APB”) 25, Accounting
for Stock Issued to Employees,
and
related Interpretations, as permitted by Statement of Financial Accounting
Standards No. (“FAS”) 123, Accounting
for Stock-Based Compensation.
Under
the intrinsic-value method prescribed by APB 25, compensation cost for stock
options was measured at the date of grant as the excess, if any, of the quoted
market price of the Company’s stock over the exercise price of the options. All
employee stock options were granted at or above the grant date market price.
Accordingly, no compensation cost was recognized for fixed stock option grants
in prior periods; however, stock-based compensation measured in accordance
with
the fair-value based method was included as a pro forma disclosure in the
consolidated financial statement footnotes.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June
30, 2006
DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
Effective
January 1, 2006, the Company adopted FAS 123 (revised 2004), Share-Based
Payment
(“FAS 123R”), which requires all stock-based payments to employees,
including grants of employee stock options, to be recognized in the statements
of operations based on their fair values. Determining the fair value of
share-based awards at the grant date requires judgment in estimating the
volatility and dividends over the expected term that the stock options will
be
outstanding prior to exercise. Judgment is also required in estimating the
amount of stock-based awards expected to be forfeited prior to vesting. If
actual results differ significantly from these estimates, stock-based
compensation expense could be materially impacted.
In
accordance with FAS 123R, the Company began recognizing the cost of all employee
stock options on a straight-line basis over their respective vesting periods,
net of estimated forfeitures, using the modified-prospective transition method.
Under this transition method, results for prior periods have not been restated
and 2006 results include:
|
·
|
Stock-based
compensation cost related to stock options granted on or prior to,
but not
vested as of, December 31, 2005, based on the grant date fair value
originally estimated for the pro forma disclosures in accordance
with the
original provisions of FAS 123; and
|
|
·
|
All
stock-based payments granted subsequent to December 31, 2005, based
on the
grant date fair value estimated in accordance with the provisions
of FAS
123R.
|
FAS
123R
also prescribes the recognition of expense using the non-substantive vesting
period approach for grants made after December 31, 2005. This expense
attribution method requires recognition of compensation expense from the date
of
grant to the earlier of the vesting date or the date retirement eligibility
is
achieved for awards with retirement eligibility options. The use of the
non-substantive vesting period approach will not affect the overall amount
of
compensation expense recognized, but could accelerate the recognition of expense
for grants made since January 1, 2006. However, the Company will continue to
follow the nominal vesting approach for the remaining portion of unvested awards
that were granted prior to January 1, 2006 and will continue to recognize
expense from the grant date to the earlier of the actual date of retirement
or
the vesting date.
Generally,
stock-based awards are forfeited when employees terminate prior to the vesting
date and any compensation cost previously recognized with respect to such
unvested stock awards is reversed in the period of forfeiture. Upon share option
exercise or restricted share unit conversion, the Company issues new shares,
unless the Company elects to use available treasury shares. The Company records
forfeitures of restricted stock as treasury share repurchases.
Prior
to
the adoption of FAS 123R, the Company previously presented all benefits of
tax
deductions resulting from the exercise of share-based compensation as operating
cash flows in the Condensed Consolidated Statements of Cash Flows. FAS 123R
requires the benefits of tax deductions in excess of the compensation cost
recognized for those options (excess tax benefits) to be classified as financing
cash flows.
Recent
Accounting Standards
In
June
2006, the Financial Accounting Standards Board (“FASB”) issued interpretation of
FASB Statement No. 109, Accounting
for Uncertainty in Income Taxes (“FIN
48”). This interpretation clarifies the accounting for uncertainty in income
taxes recognized in an enterprise’s financial statements in accordance with FASB
Statement No. 109, Accounting
for Income Taxes. FIN
48
prescribes a recognition threshold and measurement attribute for the financial
statement recognition and measurement of a tax position taken or expected to
be
taken in a tax return. This interpretation also provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure, and transition. This interpretation will be effective
January 1, 2007. The Company is currently assessing the effect of implementing
FIN 48.
Statement
of Position (“SOP”) 05-1,
Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection
with Modifications or Exchanges of Insurance Contracts, becomes
effective January 1,
2007.
SOP 05-1 provides guidance on accounting for deferred acquisition costs on
internal replacements of insurance and investment contracts other than those
specifically described in FAS 97, Accounting
and Reporting by Insurance Enterprises for Certain Long-Duration Contracts
and
for Realized Gains and Losses from the Sale of Investments.
The SOP
defines an internal replacement as a modification in product benefits, features,
rights, or coverage that occurs by the exchange of a contract for a new
contract, or by amendment, endorsement, or rider to a contract, or by the
election of a feature or coverage within a contract. The Company is currently
assessing the effect of implementing this guidance.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June
30, 2006
DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
NOTE
2.
STOCK-BASED COMPENSATION
2006
Stock-based Compensation Summary
The
effect of the adoption of FAS 123R on the condensed consolidated statements
of
operations and cash flows is as follows:
|
|
Three
Months Ended
June
30, 2006
|
|
Six
Months Ended
June
30, 2006
|
AMOUNTS
IN THOUSANDS, EXCEPT SHARE DATA
|
|
Without
FAS
123R 1
|
FAS
123R Impact
|
With
FAS 123R
|
|
Without
FAS
123R 1
|
FAS
123R Impact
|
With
FAS 123R
|
Total
revenues
|
|
$
|
342,726
|
|
$
|
—
|
|
$
|
342,726
|
|
|
$
|
685,238
|
|
$
|
—
|
|
$
|
685,238
|
|
Losses
and expenses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
losses and loss adjustment expenses
|
|
|
222,335
|
|
|
759
|
|
|
223,094
|
|
|
|
457,697
|
|
|
1,893
|
|
|
459,590
|
|
Policy
acquisition costs
|
|
|
64,439
|
|
|
448
|
|
|
64,887
|
|
|
|
123,284
|
|
|
935
|
|
|
124,219
|
|
Other
underwriting expenses
|
|
|
9,070
|
|
|
434
|
|
|
9,504
|
|
|
|
19,835
|
|
|
2,269
|
|
|
22,104
|
|
Other
expense
|
|
|
923
|
|
|
—
|
|
|
923
|
|
|
|
923
|
|
|
—
|
|
|
923
|
|
Interest
and fees expense
|
|
|
1,854
|
|
|
—
|
|
|
1,854
|
|
|
|
3,752
|
|
|
—
|
|
|
3,752
|
|
Total
losses and expenses
|
|
|
298,621
|
|
|
1,641
|
|
|
300,262
|
|
|
|
605,491
|
|
|
5,097
|
|
|
610,588
|
|
Income
before provision for income taxes
|
|
|
44,105
|
|
|
(1,641
|
)
|
|
42,464
|
|
|
|
79,747
|
|
|
(5,097
|
)
|
|
74,650
|
|
Provision
for income taxes
|
|
|
14,431
|
|
|
(288
|
)
|
|
14,143
|
|
|
|
26,056
|
|
|
(1,045
|
)
|
|
25,011
|
|
Net
income
|
|
$
|
29,674
|
|
$
|
(1,353
|
)
|
$
|
28,321
|
|
|
$
|
53,691
|
|
$
|
(4,052
|
)
|
$
|
49,639
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
earnings per share 2
|
|
$
|
0.35
|
|
$
|
(0.02
|
)
|
$
|
0.33
|
|
|
$
|
0.62
|
|
$
|
(0.05
|
)
|
$
|
0.58
|
|
Diluted
earnings per share 2
|
|
$
|
0.34
|
|
$
|
(0.02
|
)
|
$
|
0.33
|
|
|
$
|
0.62
|
|
$
|
(0.05
|
)
|
$
|
0.57
|
|
The
six
months ended June 30, 2006 results include $0.7 million and $1.4 million,
respectively, of accelerated costs incurred during the first quarter to
recognize the effect of retirement eligibility in accordance with the
non-substantive vesting period approach and actual vesting in accordance with
an
executive retention agreement, respectively. As compensation costs for certain
employees are included in deferred policy acquisition costs, pre-tax
compensation cost related to stock-based compensation of $0.9 million was
deferred, for the six months ended June 30, 2006. The remaining unrecognized
compensation cost related to unvested awards as of June 30, 2006, was $13.4
million and the weighted-average period over which this cost will be recognized
is 2.1 years. The six-month period ended June 30, 2006, results included $113
thousand of excess tax benefits as a financing cash inflow and an increase
of
additional paid-in capital.
2005
Stock-based Compensation Pro Forma Summary
Had
compensation cost for the Company’s stock-based compensation plans been
determined in the prior year based on the fair-value-based method for all
awards, net income would have been reduced by $1.3 million and $2.6 million
for
the three and six months ended June 30, 2005, respectively. The Company followed
the nominal vesting period approach, which recognizes compensation cost over
the
vesting period unless the employee retired before the end of the vesting period
at which time the Company recognizes any remaining unrecognized compensation
cost at the date of retirement. The Company did not determine the amount of
stock-based compensation cost that would have been deferred as policy
acquisition costs in its pro forma footnotes under FAS 123.
1
|
Includes
$0.3 million and $0.5 million stock-based compensation related
to
restricted shares and $0.1 million and $0.2 million associated
tax, as the
previous accounting under APB 25 was consistent with that of FAS
123, for
the three months and six months ended June 30, 2006,
respectively.
|
2 |
Earnings
per share figures may
not total due to rounding.
|
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June
30, 2006
DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
The
pro
forma net income and earnings per share amounts follow:
|
|
Three
Months Ended
|
Six
Months Ended
|
AMOUNTS
IN THOUSANDS, EXCEPT SHARE DATA
|
|
June
30, 2005
|
June
30, 2005
|
Net
income, as reported
|
|
$
|
20,495
|
|
$
|
39,932
|
|
Add:
Stock-based employee compensation expense included in reported
net income,
net of related tax effects
|
|
|
68
|
|
|
90
|
|
Deduct:
Total stock-based employee compensation expense determined under
fair-value-based method for all awards, net of related tax
effects
|
|
|
(1,298
|
)
|
|
(2,565
|
)
|
Net
income, pro forma
|
|
$
|
19,265
|
|
$
|
37,457
|
|
Basic
and diluted earnings per share
|
|
|
|
|
|
|
|
As
reported
|
|
$
|
0.24
|
|
$
|
0.47
|
|
Pro
forma
|
|
$
|
0.22
|
|
$
|
0.44
|
|
Stock
Option Plans
The
stockholders approved the 2004 Stock Option Plan (the “2004 Plan”) at the Annual
Meeting of Shareholders on May 26, 2004. The 2004 Plan supersedes the 1995
Stock
Option Plan (the “1995 Plan”), which remains in effect only as to outstanding
awards under the 1995 Plan. The 2004 Plan authorizes a Committee of the Board
of
Directors to grant stock options for up to 4,000,000 shares to eligible
employees and nonemployee directors, subject to the terms of the 2004 Plan.
Additionally, under the 2004 Plan, the Committee may grant stock options that
were subject to outstanding awards under the 1995 Plan to the extent such awards
expire, are terminated, are canceled, or are forfeited for any reason without
shares being issued.
Options
granted to employees generally have ten-year terms and vest ratably over three
years. Nonemployee director options vest over one year, provided that the
nonemployee director is in the service of the Company during that time. Options
granted to nonemployee directors expire one year after a nonemployee director
ceases service with the Company, or ten years from the date of grant, whichever
is sooner.
Issuable
and Issued Securities
A
summary
of securities issuable and issued for the Company’s stock option plans at June
30, 2006, follows:
AMOUNTS
IN THOUSANDS
|
|
1995
Stock
Option
Plan
|
2004
Stock
Option
Plan
|
Total
number of securities authorized
|
|
|
10,000
|
|
|
4,000
|
|
Number
of securities issued
|
|
|
(975
|
)
|
|
(204
|
)
|
Number
of securities issuable upon the exercise of all outstanding
options
|
|
|
(6,710
|
)
|
|
(3,617
|
)
|
Number
of securities forfeited
|
|
|
(2,600
|
)
|
|
(74
|
)
|
Number
of forfeited securities returned to plan
|
|
|
2,600
|
|
|
74
|
|
Unused
options assumed by 2004 Stock Option Plan
|
|
|
(2,315
|
)
|
|
2,315
|
|
Number
of securities available for future grants under each plan
|
|
|
—
|
|
|
2,494
|
|
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June
30, 2006
DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
Current
Activity
A
summary
of the Company’s stock option activity for the six months ended June 30, 2006
follows:
AMOUNTS
IN THOUSANDS, EXCEPT PRICE DATA
|
|
Number
of Options
|
Weighted-Average
Exercise Price
|
Options
outstanding December 31, 2005
|
|
|
8,869
|
|
$
|
16.22
|
|
Granted
in 2006
|
|
|
2,000
|
|
|
16.55
|
|
Exercised
in 2006
|
|
|
(293
|
)
|
|
13.11
|
|
Forfeited
in 2006
|
|
|
(9
|
)
|
|
14.59
|
|
Canceled
in 2006
|
|
|
(240
|
)
|
|
19.51
|
|
Options
outstanding June 30, 2006
|
|
|
10,327
|
|
|
16.30
|
|
A
summary
of the Company’s stock option activity and related information
follows:
|
|
Three
Months Ended
June30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
|
2006
|
2005
|
Fair
value of stock options granted
|
|
$
|
900
|
|
$
|
2,214
|
|
|
$
|
9,994
|
|
$
|
8,186
|
|
Intrinsic
value of options exercised
|
|
|
266
|
|
|
114
|
|
|
|
483
|
|
|
353
|
|
Grant
date fair value of options vested
|
|
|
884
|
|
|
284
|
|
|
|
7,399
|
|
|
5,241
|
|
Proceeds
from exercise of stock options
|
|
|
3,126
|
|
|
666
|
|
|
|
3,844
|
|
|
1,975
|
|
Tax
benefit realized as a result of stock option exercises
|
|
|
53
|
|
|
23
|
|
|
|
97
|
|
|
70
|
|
|
|
|
|
|
SHARE
DATA
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average
fair value per option granted
|
|
$
|
4.82
|
|
$
|
4.46
|
|
|
$
|
5.00
|
|
$
|
4.75
|
|
Black-Scholes
Assumptions
The
fair
value of each option grant was estimated on the date of grant using the
Black-Scholes option-pricing model with the following assumptions:
Six
Months Ended June 30,
|
|
2006
|
2005
Pro
Forma
|
Risk-free
interest rate:
|
|
|
|
|
|
Minimum
|
|
|
4.5
|
%
|
|
3.7
|
%
|
Maximum
|
|
|
4.8
|
%
|
|
4.3
|
%
|
Dividend
yield
|
|
|
1.9
|
%
|
|
1.1
|
%
|
Volatility
factor of the expected market price of the Company’s common
stock:
|
|
|
|
|
|
|
|
Minimum
|
|
|
29.4
|
|
|
28.6
|
|
Maximum
|
|
|
29.4
|
|
|
32.2
|
|
Expected
option term
|
|
|
6
years
|
|
|
6
years
|
|
The
expected term for options granted during the six months ended June 30, 2006,
was
calculated using the simplified method in accordance with Staff Accounting
Bulletin No. 107. The expected volatility of employee stock options was based
on
the historical volatility of key competitors in the property & casualty
insurance industry (based on six years of closing stock prices). The Company
believes that the use of historical competitor volatility better reflects
current market expectations of the Company’s stock price volatility. The
Company’s own historical stock price volatility is not representative of
expected volatility due to significant prior year events, such as the effects
of
the 1994 Northridge earthquake and SB 1899, which would not be expected to
significantly impact results in the future. The annual risk-free interest rate
is based on a traded zero-coupon U.S. Treasury bond on the grant date with
a
term equal to the option’s expected term.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June
30, 2006
DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
Outstanding
Options
The
following table summarizes information about stock options outstanding at June
30, 2006 (amounts in thousands, except price data):
|
|
Outstanding
|
|
Exercisable
|
Range
of
Exercise
Prices
|
Number
of
Options
|
Weighted-
Average
Remaining
Contractual
Term
|
Weighted-
Average
Exercise
Price
|
Aggregate
Intrinsic
Value
|
|
Number
of
Options
|
Weighted-
Average
Remaining
Contractual
Term
|
Weighted-
Average
Exercise
Price
|
Aggregate
Intrinsic
Value
|
$11.68
-$13.00
|
|
|
1,260
|
|
6.7
Years
|
$
|
11.73
|
|
$
|
3,361
|
|
|
|
1,249
|
|
6.7
Years
|
$
|
11.72
|
|
$
|
3,345
|
|
13.01
- 15.00
|
|
|
2,910
|
|
8.2
Years
|
|
14.28
|
|
|
355
|
|
|
|
1,491
|
|
8.1
Years
|
|
14.30
|
|
|
153
|
|
15.01
- 17.00
|
|
|
3,357
|
|
8.0
Years
|
|
16.38
|
|
|
—
|
|
|
|
1,490
|
|
5.8
Years
|
|
16.18
|
|
|
—
|
|
17.01
- 19.00
|
|
|
1,776
|
|
4.2
Years
|
|
18.05
|
|
|
—
|
|
|
|
1,776
|
|
4.2
Years
|
|
18.05
|
|
|
—
|
|
19.01
- 22.00
|
|
|
246
|
|
1.4
Years
|
|
20.75
|
|
|
—
|
|
|
|
246
|
|
1.4
Years
|
|
20.75
|
|
|
—
|
|
22.01
- 29.25
|
|
|
778
|
|
2.9
Years
|
|
25.43
|
|
|
—
|
|
|
|
778
|
|
2.9
Years
|
|
25.43
|
|
|
—
|
|
$11.68
-$29.25
|
|
|
10,327
|
|
6.7
Years
|
$
|
16.30
|
|
$
|
3,716
|
|
|
|
7,030
|
|
5.6
Years
|
$
|
16.65
|
|
$
|
3,498
|
|
Restricted
Shares Plan
The
Restricted Shares Plan, which was approved by the Company’s stockholders,
currently authorizes grants of up to 1,421,920 shares of common stock to be
made
available to key employees. In general, one third of the shares granted vest
on
the anniversary date of each of the three years following the year of grant.
The
Company may also grant vested shares that contain sale restrictions. The Company
becomes entitled to an income tax deduction in an amount equal to the taxable
income reported by the holders upon vesting of the restricted
shares.
Total
compensation expense relating to the Restricted Shares Plan was $0.4 million
and
$0.5 million for the three and six months ended June 30, 2006, respectively,
and
$0.1 million for the three and six months ended June 30, 2005. Unrecognized
compensation cost in connection with restricted stock grants totaled $2.2
million at June 30, 2006. The cost is expected to be recognized over a
weighted-average period of 2.4 years.
Restricted
Shares Issuable and Issued
A
summary
of securities issuable and issued for the Company’s Restricted Shares Plan at
June 30, 2006, follows:
AMOUNTS
IN THOUSANDS
|
|
Restricted
Shares
Plan
|
Total
number of securities authorized
|
|
|
1,422
|
|
Number
of securities issued
|
|
|
(1,252
|
)
|
Number
of forfeited securities returned to plan
|
|
|
162
|
|
Number
of securities remaining available for future grants under the
plan
|
|
|
332
|
|
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June
30, 2006
DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
Current
Restricted Shares Activity
The
following table summarizes activity under the Restricted Shares Plan for the
six
months ended June 30, 2006:
AMOUNTS
IN THOUSANDS, EXCEPT PRICE DATA
|
|
Number
of
Shares
|
Weighted-Average
Market Price Per Share on Date of Grant
|
Non-vested,
December 31, 2005
|
|
|
87
|
|
$
|
14.08
|
|
Vested
in 2006
|
|
|
(33)
|
|
|
14.38
|
|
Granted
in 2006
|
|
|
109
|
|
|
15.90
|
|
Non-vested,
June 30, 2006
|
|
|
163
|
|
|
15.22
|
|
A
summary
of the Restricted Shares Plan activity and related information
follows:
|
|
Three
Months Ended
June30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
|
2006
|
2005
|
Fair
value of restricted stock awards granted
|
|
$
|
80
|
|
$
|
1,267
|
|
|
$
|
1,724
|
|
$
|
1,267
|
|
Fair
value of restricted stock awards vested
|
|
|
475
|
|
|
30
|
|
|
|
475
|
|
|
183
|
|
SHARE
DATA
|
|
|
|
|
|
|
|
|
|
|
Weighted-average
fair value per share for restricted shares granted
|
|
$
|
16.01
|
|
$
|
14.10
|
|
|
$
|
15.90
|
|
$
|
14.10
|
|
NOTE
3. HOMEOWNER AND EARTHQUAKE 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. More than ninety-nine percent of the claims
submitted and litigation brought against the Company as a result of California
SB 1899 have been resolved. The Company’s total loss and loss adjustment
expenses (“LAE”) reserves for SB 1899 claims as of June 30, 2006 and December
31, 2005, were less than $0.1 million and $0.5 million,
respectively.
Loss
and
LAE incurred for the homeowner and earthquake lines in runoff were $0.3 million
for the three and six months ended June 30, 2006, compared to $0.2 million
and
$0.4 million for the same periods in 2005, respectively.
NOTE
4.
COMMITMENTS AND CONTINGENCIES
Legal
Proceedings
In
the
normal course of business, the Company is named as a defendant in lawsuits
related to claims and insurance policy issues, both on individual policy files
and by class actions seeking to attack the Company’s business practices. Many
suits seek unspecified extra-contractual and punitive damages as well as
contractual damages under the Company’s insurance policies in excess of the
Company’s estimates of its obligations under such policies. The Company cannot
estimate the amount or range of loss that could result from an unfavorable
outcome on these suits and it denies liability for any such alleged damages.
The
Company has not established reserves for potential extra-contractual or punitive
damages, or for contractual damages in excess of estimates the Company believes
are correct and reasonable under its insurance policies. Nevertheless,
extra-contractual 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 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.
In
addition, the Company denies liability and has not established a reserve for
the
matters discussed below. A range of potential losses in the event of a negative
outcome is discussed where known.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June
30, 2006
DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
Poss
v. 21st Century Insurance Company was
filed
on June 13, 2003, in Los Angeles Superior Court. The complaint sought injunctive
and unspecified restitutionary relief against the Company under Business and
Professions Code (“B&P”) Sec. 17200 for alleged unfair business practices in
violation of California Insurance Code Sec. 1861.02(c) relating to Company
rating practices. Based on California’s Proposition 64, passed in November 2004,
the court granted the Company’s motion to dismiss the complaint, but allowed the
addition of a second plaintiff, Leacy. The court stayed discovery in this
litigation pending appellate court decisions involving similar issues by other
parties. To date, these decisions have favored the Company’s position. Because
this matter is in the pleading stages and no discovery has taken place, no
estimate of the range of potential losses in the event of a negative outcome
can
be made at this time.
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 the Company’s (the Company was
formerly named 20th Century Insurance) handling of a 1994 homeowner’s claim. On
March 1, 1994, Ramon Aguilera, a homeowner policyholder, shot and killed Mr.
Gonzalez (the minor children’s father) and was later 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 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 the Company 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 the Company cannot invoke any policy exclusions as a defense to
coverage. On May 14, 2004, the court granted the Encarnacion plaintiffs’ motion
for summary adjudication, ordering that the Company must pay the full amount
of
the underlying judgment of $5.6 million, plus interest, for a total of $10.5
million. The Company disagrees with this ruling as it appears inconsistent
with
the court’s simultaneous ruling denying the Company’s motion for summary
judgment on grounds that there are triable issues of material fact as to whether
plaintiffs are precluded from recovering damages as a consequence of Aguilera’s
inequitable conduct. The Company also believes that the court’s decision was not
supported by the evidence in the case, demonstrating that no promise to settle
was ever made. The Company has appealed the judgment as to the Encarnacions.
The
trial as to Aguilera concluded on December 9, 2005, on his claims for bad faith,
emotional distress, punitive damages and attorney fees. A jury found he
sustained no damages as to these claims. The Company’s exposure in this case
includes the aforementioned $10.5 million judgment plus post-judgment interest,
which currently totals $1.8 million.
Insurance
Company cases (Ramona Goldenburg)
was
originally filed as Bryan
Speck, individually, and on behalf of others similarly situated v. 21st Century
Insurance Company, 21st Century Casualty Company, and 21st Century Insurance
Group.
The
original action was filed on June 20, 2002, in Los Angeles Superior Court.
Plaintiff seeks California class action certification, injunctive relief, and
unspecified actual and punitive damages. The complaint contends that the Company
uses “biased” software in determining the value of total-loss automobiles.
Specifically, 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 claims costs. This case is consolidated with similar
actions against other insurers for discovery and pre-trial motions. A
court-ordered appraisal of Speck’s vehicle was favorable to the Company and
Ramona Goldenberg was substituted as a Plaintiff, replacing Speck, and a new
appraisal has been ordered. The Company intends to vigorously defend the suit
with other defendants in the coordinated proceedings. This matter is in the
pleading stage of litigation and no reasonable estimate of potential losses
in
the event of a negative outcome can be made at this time.
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
California class action certification, injunctive relief, and unspecified actual
and punitive damages. The complaint contends that after insureds receive medical
treatment, the Company used a medical-review program to adjust expenses to
reasonable and necessary amounts for a given geographic area and the adjusted
amount is “predetermined” and “biased.” This case is consolidated with similar
actions against other insurers for discovery and pre-trial motions. Depositions
have recently been taken and the Company intends to vigorously defend the suit.
This matter is in the discovery stage of litigation and no reasonable estimate
of potential losses in the event of a negative outcome can be made at this
time.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June
30, 2006
DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
Silvia
Quintana, on her own behalf and on behalf of all others similarly situated
v.
21st Century Insurance
was
filed on November 16, 2005.
This
purported class action, filed in San Diego, names the Company in four causes
of
action: 1) violation of B&P Section 17200, 2) conversion, 3) unjust
enrichment and, 4) declaratory relief. Silvia Quintana alleges that the
Company’s demand for reimbursement of the medical payments it made to her
pursuant to her insurance contract violates the “made-whole rule.” The Company
anticipates that if the matter survives the initial pleading stage, it will
be
consolidated, for discovery and pre-trial motions, with actions alleging similar
facts against other insurers. This matter is in the initial stages of pleading
and no reasonable estimate of potential losses in the event of a negative
outcome can be made at this time.
NOTE
5. ACCUMULATED OTHER COMPREHENSIVE LOSS
Accumulated
other comprehensive loss is a component of stockholders’ equity and includes all
changes in unrealized gains and losses; reclassification adjustments for
investment losses and gains included in net income; and changes in minimum
pension liability in excess of unamortized prior service cost.
A
summary
of accumulated other comprehensive loss follows:
|
|
June
30,
2006
|
December
31,
2005
|
Net
unrealized losses on available-for-sale investments, net of deferred
income taxes of $15,950 and $4,579
|
|
$
|
(29,622
|
)
|
$
|
(8,504
|
)
|
Minimum
pension liability in excess of unamortized prior service cost, net
of
deferred income taxes of $1,011 and $1,011
|
|
|
(1,878
|
)
|
|
(1,878
|
)
|
Total
accumulated other comprehensive loss
|
|
$
|
(31,500
|
)
|
$
|
(10,382
|
)
|
NOTE
6.
EMPLOYEE BENEFIT PLANS
The
Company has both funded and unfunded non-contributory defined benefit pension
plans, which together cover essentially all employees who have completed at
least one year of service. For certain key employees designated by the Board
of
Directors, the Company sponsors an unfunded non-qualified supplemental executive
retirement plan. The supplemental plan benefits are based on years of service
and compensation during the three highest of the last ten years of employment
prior to retirement and are reduced by the benefit payable from the pension
plan
and 50% of the social security benefit. For other eligible employees, the
pension benefits are based on employees’ compensation during all years of
service. The Company’s funding policy for the qualified plan is to make annual
contributions as required by applicable regulations.
Components
of Net Periodic Cost
Net
pension costs for all plans were as follows:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
|
|
2006
|
2005
|
|
2006
|
2005
|
Service
cost
|
|
$
|
1,693
|
|
$
|
1,762
|
|
|
$
|
3,565
|
|
$
|
3,524
|
|
Interest
cost
|
|
|
1,898
|
|
|
1,855
|
|
|
|
3,869
|
|
|
3,710
|
|
Expected
return on plan assets
|
|
|
(2,112
|
)
|
|
(1,830
|
)
|
|
|
(4,220
|
)
|
|
(3,660
|
)
|
Amortization
of prior service cost
|
|
|
39
|
|
|
27
|
|
|
|
73
|
|
|
54
|
|
Amortization
of net loss
|
|
|
628
|
|
|
507
|
|
|
|
1,306
|
|
|
1,014
|
|
Total
|
|
$
|
2,
146
|
|
$
|
2,321
|
|
|
$
|
4,593
|
|
$
|
4,642
|
|
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June
30, 2006
DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
Pension
Plan Contributions
The
Company previously disclosed in its consolidated financial statements for the
year ended December 31, 2005, that it did not expect to contribute to its
qualified defined benefit pension plan in 2006. As of June 30, 2006, no
contributions have been made. However, the amount and timing of future
contributions to the Company’s qualified defined benefit pension plan depends on
a number of assumptions including statutory funding requirements, the market
performance of the plan’s assets and future changes in interest rates that
affect the actuarial measurement of the plan’s obligations.
Contributions
to our non-qualified defined benefit pension plan generally are limited to
amounts needed to make benefit payments to retirees, which are expected to
total
approximately $0.9 million in 2006.
Defined
Contribution Plans
The
Company sponsors a contributory savings and security plan for eligible employees
and officers. The Company provides matching contributions equal to 75% of the
lesser of 6% of an employee’s eligible compensation or the amount contributed by
the employee up to the maximum allowable under Internal Revenue Service
regulations. The plan offers a variety of investment types among which employees
exercise complete discretion as to choice and investment duration. The Company
also sponsors a 401(k) supplemental plan to provide specified benefits to a
select group of management and highly compensated employees. Company
contributions to both plans were $1.2 million and $3.1 million for the three
and
six months ended June 30, 2006, respectively, and $0.9 million and $2.3 million
for the same periods in 2005.
NOTE
7. SEGMENT INFORMATION
The
Company’s “Personal Auto Lines” reportable segment primarily markets and
underwrites personal auto, motorcycle and personal umbrella insurance. The
Company’s “Homeowner and Earthquake Lines in Runoff” reportable segment manages
the runoff of the Company’s homeowner and earthquake programs. The Company has
not written any earthquake coverage since 1994 and ceased writing homeowner
policies in February 2002.
Insurers
offering homeowner insurance in California are required to participate in the
California FAIR Plan (“FAIR Plan”). The FAIR Plan is a state administered pool
of difficult to insure homeowners’ exposures. Each participating insurer is
allocated a percentage of the total premiums written and losses and LAE incurred
by the pool according to its share of total homeowner direct premiums written
in
the state. Participation in the current year FAIR Plan operations is based
on
premiums written from two years prior. Since the Company ceased writing
homeowners business in 2002, the Company no longer receives assignments for
plan
years beyond 2004, but continues to participate in prior plan year activity,
which is in runoff.
The
Company evaluates segment performance based on pre-tax underwriting profit
or
loss. The Company does not allocate assets, net investment income, net realized
investment gains or losses, other revenues, nonrecurring items, interest and
fees expense, or income taxes to operating segments. The accounting policies
of
the reportable segments are the same as those described in Note 2 of the
Notes to Consolidated Financial Statements included in our Annual Report on
Form 10-K for the year ended December 31, 2005. All revenues are generated
from
external customers and the Company does not rely on any major
customer.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June
30, 2006
DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
The
following table presents net premiums earned, depreciation and amortization
expense, and segment profit (loss) for the Company’s segments.
|
|
Personal
Auto Lines
|
Homeowner
and Earthquake Lines in Runoff 3
|
Total
|
Three
Months Ended June 30, 2006
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
325,512
|
|
$
|
—
|
|
$
|
325,512
|
|
Depreciation
and amortization expense
|
|
|
6,642
|
|
|
1
|
|
|
6,643
|
|
Segment
profit (loss)
|
|
|
28,293
|
|
|
(266
|
)
|
|
28,027
|
|
|
|
|
|
|
|
|
|
|
|
|
Three
Months Ended June 30, 2005
|
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
336,842
|
|
$
|
3
|
|
$
|
336,845
|
|
Depreciation
and amortization expense
|
|
|
8,391
|
|
|
2
|
|
|
8,393
|
|
Segment
profit (loss)
|
|
|
16,239
|
|
|
(198
|
)
|
|
16,041
|
|
|
|
|
|
|
|
|
|
|
|
|
Six
Months Ended June 30, 2006
|
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
651,336
|
|
$
|
—
|
|
$
|
651,336
|
|
Depreciation
and amortization expense
|
|
|
13,301
|
|
|
3
|
|
|
13,304
|
|
Segment
profit (loss)
|
|
|
45,765
|
|
|
(342
|
)
|
|
45,423
|
|
|
|
|
|
|
|
|
|
|
|
|
Six
Months Ended June 30, 2005
|
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
673,203
|
|
$
|
6
|
|
$
|
673,209
|
|
Depreciation
and amortization expense
|
|
|
14,990
|
|
|
5
|
|
|
14,995
|
|
Segment
profit (loss)
|
|
|
30,063
|
|
|
(370
|
)
|
|
29,693
|
|
The
following table reconciles segment profit to consolidated income before
provision for income taxes:
|
|
Three
Months Ended
|
|
Six
Months Ended
|
|
|
June
30,
|
|
June
30,
|
|
|
2006
|
2005
|
|
2006
|
2005
|
Segment
profit
|
|
$
|
28,027
|
|
$
|
16,041
|
|
|
$
|
45,423
|
|
$
|
29,693
|
|
Net
investment income
|
|
|
17,174
|
|
|
17,006
|
|
|
|
34,929
|
|
|
34,043
|
|
Other
income
|
|
|
10
|
|
|
367
|
|
|
|
10
|
|
|
367
|
|
Net
realized investment gains (losses)
|
|
|
30
|
|
|
(1,267
|
)
|
|
|
(1,037
|
)
|
|
(1,727
|
)
|
Other
expense
|
|
|
(923
|
)
|
|
—
|
|
|
|
(923
|
)
|
|
—
|
|
Interest
and fees expense
|
|
|
(1,854
|
)
|
|
(2,031
|
)
|
|
|
(3,752
|
)
|
|
(4,088
|
)
|
Income
before provision for income taxes
|
|
$
|
42,464
|
|
$
|
30,116
|
|
|
$
|
74,650
|
|
$
|
58,288
|
|
3
Homeowner
and earthquake lines in runoff segment revenue represents premium earned
as a
result of the Company’s participation in the California FAIR Plan.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June
30, 2006
DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
NOTE
8. VARIABLE INTEREST ENTITIES
In
January 2003, the FASB issued FASB Interpretation No. 46, Consolidation
of Variable Interest Entities, an interpretation of Accounting Research Bulletin
No. 51 (“FIN
46”), and amended it in December 2003. An entity is subject to the consolidation
rules of FIN 46 and is referred to as a variable interest entity (“VIE”) if it
lacks sufficient equity to finance its activities without additional financial
support from other parties or if its equity holders lack adequate decision
making ability based on criteria set forth in the interpretation. FIN 46 also
requires disclosures about VIEs that a company is not required to consolidate,
but in which a company has a significant variable interest.
The
Company has decided to purchase investments that provide housing and other
services to economically disadvantaged communities. To that end, the Company
is
a voluntary member, along with other participating insurance organizations,
of
Impact Community Capital, LLC (“Impact”). Impact’s charter is to facilitate
loans and other investments in such communities.
The
VIE
structure provides a wider range of investment options through which insurance
companies and other institutional investors can address the investment needs
of
these communities. The Company’s maximum participation in Impact C.I.L., LLC
(“Impact C.I.L.”), a subsidiary of Impact and a VIE, is for up to 11.1% ($24.0
million) of $216.0 million of the entity’s funding activities. These commitments
consist of a $4.8 million minimum investment and a $19.2 million guarantee
of a
warehouse lending facility. Potential losses are limited to the Company’s
participation as well as associated operating fees. The Company’s pro rata share
of these advances to Impact C.I.L., which in turn makes housing investments
in
economically disadvantaged communities, was approximately 11.1%, or $4.9
million, and $5.0 million as of June 30, 2006 and December 31, 2005,
respectively. The revolving member loan and the warehouse financing agreement
do
not significantly impact the Company’s liquidity or capital.
The
Company is not the primary beneficiary of any of the VIEs as the Company has
voting rights, beneficiary rights, obligations, and ownership in proportion
to
each of its Impact related investments, none of which exceeds
11.1%.
In
addition to the above, the Company held $6.0 million and $6.2 million in other
Impact related fixed-income investments as of June 30, 2006 and December 31,
2005, respectively. The Company also held $0.3 million in other Impact related
private equity investments reclassified as other assets as of June 30, 2006.
There were no private equity investments for the same period in the prior year.
Total Impact related investment income was $0.2 million and $0.5 million for
the
three and six months ended June 30, 2006, respectively, and $0.2 million and
$0.3 million for the same periods in 2005, respectively.
The
Company does not have any other material VIEs that it needs, or will need,
to
consolidate or disclose.
NOTE
9. TRANSACTIONS WITH RELATED PARTIES
In
June
2006, the Company executed a $35 million funding commitment for a private equity
investments program. The program will be managed by AIG Global Investment Corp.
(“AIGGIC”), which provides investment management and investment accounting
services to the Company. In the event that the Company does not respond to
a
capital call during the investment term, the General Partner of the fund (“GP”)
may apply the following default provisions: withhold 50% of distributions due
to
the Company at the time of the default and 50% of future distributions due
to
the Company; hold the Company liable for fund expenses above and beyond
investments made by the Company (with the right of offset); terminate the
Company’s Limited Partner status and not allow it any further investments; or
charge interest on the defaulted capital commitment amount and fees at LIBOR
+
4% (with the right of offset). However, the GP may choose not to designate
the
Company a “defaulting limited partner” and waive the default provisions. The
investment term ends after the underlying investments are liquidated, but in
no
event later than 10 years. Multiple investments are expected to be purchased
and
liquidated over the investment term. The Company funded $9.1 million of the
commitment in July 2006.
ITEM
2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND
RESULTS OF OPERATIONS
OVERVIEW
General
21st
Century Insurance Group is an insurance holding company registered on the New
York Stock Exchange. For convenience, the terms “Company”, “21st”, “we”, “us” or
“our” are used to refer collectively to the parent company and its subsidiaries.
Management’s Discussion and Analysis of Financial Condition and Results of
Operations (“MD&A”) should be read in conjunction with the accompanying
condensed consolidated financial statements.
Founded
in 1958, we are a direct-to-consumer provider of personal auto insurance. With
$1.4 billion of revenue in 2005, we insure over 1.5 million vehicles in Arizona,
California, Florida, Georgia, Illinois, Indiana, Nevada, Ohio, Oregon,
Pennsylvania, Texas and Washington. We provide superior policy features and
customer service at a competitive price. Customers can receive a quote, purchase
a policy, service their policy, or report a claim at www.21st.com
or on
the phone with our licensed insurance professionals at 1-800-211-SAVE. Service
is offered in English and Spanish, both on the phone and on the web, 24 hours
a
day, 365 days a year. Our insurance subsidiaries, 21st Century Insurance
Company, 21st Century Casualty Company, and 21st Century Insurance Company
of
the Southwest (“21st of the Southwest”), are rated A+ by A.M. Best, Fitch
Ratings and Standard & Poor’s. The Company’s A+ rating was affirmed by A.M.
Best on June 13, 2006.
Our
long-term financial goals include achieving a 96% or lower combined ratio,
15%
annual growth in premiums written, 15% return on stockholders’ equity, and
strong financial ratings.
National
Expansion
The
Company is implementing a multi-year strategy for national expansion. In the
second quarter of 2006, the Company began operations in Florida, Georgia and
Pennsylvania, increasing the percentage of the U.S. personal auto market that
the Company operates in to 49%. The Company plans to add three additional states
in the second half of 2006. Growth in direct premiums written in non-California
markets in the second quarter of 2006 was 51.8%. The ultimate benefits of the
national expansion should include economies of scale, lower unit marketing
costs
due to the cost efficiency of buying advertising on a national basis, less
dependency on any single market and the operating flexibility to focus resources
on attractive markets and deemphasize less attractive markets.
Highlights
Financial
highlights for the second quarter ended June 30:
|
·
|
Total
direct premiums written decreased 3.6% to $316.8 million in 2006,
from
$328.7 million for same period in
2005.
|
|
·
|
California
direct premiums written decreased 7.1% to $287.4 million in 2006,
compared
to $309.2 million for the same period in 2005.
|
|
·
|
Non-California
direct premiums written increased by 51.8% to $29.4 million for the
quarter ended June 30, 2006, compared to $19.5 million for the same
period
in 2005.
|
|
·
|
Our
consolidated combined ratio of 91.4% was favorably impacted by 5.6
points
of prior accident year loss and LAE reserve decreases, versus 95.2%
for
the second quarter of 2005, which was favorably impacted by 3.5
points.
|
Financial
highlights for the six months ended June 30:
|
·
|
Total
direct premiums written declined 3.7% to $655.4 million in 2006,
from
$680.8 million for the same period in
2005.
|
|
·
|
California
direct premiums written decreased 6.6% to $599.2 million in 2006,
compared
to $641.8 million for the same period in
2005.
|
|
·
|
Non-California
direct premiums written increased by 44.1% to $56.2 million in 2006,
compared to $39.0 million for the same period in
2005.
|
|
·
|
Our
consolidated combined ratio of 93.0% was favorably impacted by 3.9
points
of prior accident year loss and LAE reserves, versus 95.6% for the
same
period in 2005, which was favorably impacted by 2.9
points.
|
For
the
three months and six months ended June 30, 2006, 21st’s insurance subsidiaries
achieved underwriting profitability, but total direct premiums written declined.
In recent quarters, the California market, which represented 90.7% of our total
direct premiums written during the second quarter, has seen stable to declining
rates from competitors and a reduced level of shopping behavior by consumers.
Both of these factors reduced our opportunities for profitable growth in this
state.
In
July
2006, the California Department of Insurance (the “CDI”) obtained approval for
changes to regulations (the “Auto Rating Factor Regulations”) relating to
automobile insurance rating factors, particularly concerning territorial rating.
Because the new Auto Rating Factor Regulations require every personal auto
insurance company operating in California to make a class plan and rate level
filing in the third quarter of 2006, competitive rate levels may change and
consumer shopping behavior may increase in the future. It is not possible at
this time to predict the ultimate timing or impact of these changes, which
could
have either a materially favorable or materially adverse impact on the Company.
See further discussion in Part II - Item 1A. Risk Factors.
Also
in
July 2006, the CDI proposed new amended rate approval regulations (the "Rate
Approval Regulations"), affecting personal auto, homeowners and most lines
of
commercial property & casualty insurance written in California. If
approved without modification, the Rate Approval Regulations could have a
materially adverse impact on the Company’s results. See further discussion
in Part
II - Item
1A. Risk Factors.
Net
income increased 38% to $28.3 million for the three months ended June 30, 2006,
or $0.33 per basic share, compared to $20.5 million, or $0.24 per basic share,
for the same period in 2005. The second quarter 2006 results include prior
year
favorable reserve development totaling $18.1 million, versus $11.9 million
in
the second quarter of 2005. Net income increased 24% to $49.6 million for the
six months ended June 30, 2006, or $0.58 per basic share, compared to $39.9
million, or $0.47 per basic share, for the same six-month period in 2005. The
six months ended June 30, 2006 include favorable prior year reserve development
totaling $25.1 million, versus $19.6 million for the same period in
2005.
The
underwriting expense to net premiums earned ratio increased to 22.9% for the
three months ended June 30, 2006 from 21.5% for the same period in 2005. For
the
six months ended June 30, 2006, the underwriting expense to net premiums earned
ratio increased to 22.4% from 21.4% for the same period in 2005. These
underwriting expense ratio increases are primarily the result of expenses
associated with the
Company’s national expansion efforts and the 2006 recognition of stock-based
compensation, which were partially offset by increases in deferred policy
acquisition costs. Underwriting expenses during the six months ended June 30,
2006, were also impacted by severance costs and corporate litigation incurred
during the first quarter.
The
recognition of stock-based compensation resulted from our adoption of Statement
of Financial Accounting Standards No. 123 (revised 2004), Share-Based
Payment
(“FAS
123R”). FAS 123R requires the recognition of compensation expense in the
Condensed Consolidated Statements of Operations based on the estimated fair
value of the employee share-based options. See Critical
Accounting Estimates - Stock-Based Compensation Expense
for
further discussion. Stock-based compensation classified as underwriting expense
for the three and six months ended June 30, 2006, was $0.9 million and $3.2
million, respectively.
Non-GAAP
Measures
Premiums
written and statutory surplus have been presented to enhance investors’
understanding of the Company’s operations. These financial measures are not
presented in accordance with accounting principles generally accepted in the
United States of America (“GAAP”). Premiums written represent the premiums
charged on policies issued during a fiscal period. The most directly comparable
GAAP measure, premiums earned, represents the portion of premiums written that
is recognized as income on a pro rata basis over the terms of the policies.
Statutory surplus represents equity as of the end of a fiscal period for the
Company’s insurance subsidiaries, determined in accordance with statutory
accounting principles prescribed by insurance regulatory authorities.
Stockholders’ equity is the most directly comparable GAAP measure to statutory
surplus. The
reconciliations of these financial measures to the most directly comparable
GAAP
measures are located in Results
of Operations
and
Liquidity
and Capital Resources,
respectively. These financial measures are not intended to replace, and should
be read in conjunction with, the GAAP financial measures.
See
Results
of Operations
for more
details as to our overall and personal auto lines results.
The
remainder of this MD&A includes the following sections:
|
·
|
Liquidity
and Capital Resources
|
|
·
|
Transactions
with Related Parties
|
|
·
|
Contractual
Obligations and Commitments
|
|
·
|
Critical
Accounting Estimates
|
|
·
|
Recent
Accounting Standards
|
|
·
|
Forward-Looking
Statements
|
RESULTS
OF OPERATIONS
Consolidated
Results
The
following table summarizes the Company’s condensed consolidated results of
operations:
|
|
Three
Months Ended
June
30,
|
|
|
|
Six
Months Ended
June
30,
|
|
|
AMOUNTS
IN THOUSANDS,
EXCEPT
SHARE DATA
|
|
2006
|
2005
|
Increase/
(Decrease)
|
|
2006
|
2005
|
Increase/
(Decrease)
|
Direct
premiums written
|
|
$
|
316,837
|
|
$
|
328,669
|
|
|
(3.6
|
)%
|
|
$
|
655,406
|
|
$
|
680,786
|
|
|
(3.7
|
)%
|
Net
premiums earned
|
|
|
325,512
|
|
|
336,845
|
|
|
(3.4
|
)
|
|
|
651,336
|
|
|
673,209
|
|
|
(3.2
|
)
|
Net
income
|
|
|
28,321
|
|
|
20,495
|
|
|
38.2
|
|
|
|
49,639
|
|
|
39,932
|
|
|
24.3
|
|
Basic
earnings per share
|
|
|
0.33
|
|
|
0.24
|
|
|
45.8
|
|
|
|
0.58
|
|
|
0.47
|
|
|
23.4
|
|
Diluted
earnings per share
|
|
|
0.33
|
|
|
0.24
|
|
|
45.8
|
|
|
|
0.57
|
|
|
0.47
|
|
|
21.3
|
|
For
the
three months ended June 30, 2005, the results include net realized capital
losses of $1.3 million. For the six months ended June 30, 2006, the results
included net realized capital losses of $1.0 million compared to net realized
capital losses of $1.7 million for the same period in 2005.
The
following table summarizes losses and loss adjustment expenses (“LAE”) incurred,
net of applicable reinsurance, for the periods indicated:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
|
2006
|
2005
|
Net
losses and LAE incurred related to insured events in:
|
|
|
|
|
|
|
|
|
|
|
Current
year personal auto lines
|
|
$
|
241,215
|
|
$
|
260,200
|
|
|
$
|
484,726
|
|
$
|
518,902
|
|
Prior
accident years:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Personal
auto lines
|
|
|
(18,387
|
)
|
|
(12,116
|
)
|
|
|
(25,479
|
)
|
|
(19,963
|
)
|
Homeowner
and earthquake lines in runoff
|
|
|
266
|
|
|
200
|
|
|
|
343
|
|
|
376
|
|
Total
prior years’ redundancy recorded in current year
|
|
|
(18,121
|
)
|
|
(11,916
|
)
|
|
|
(25,136
|
)
|
|
(19,587
|
)
|
Total
net losses and LAE incurred
|
|
$
|
223,094
|
|
$
|
248,284
|
|
|
$
|
459,590
|
|
$
|
499,315
|
|
While
we
perform quarterly reviews of the adequacy of carried unpaid losses and LAE,
these estimates depend on many assumptions about the outcome of future events.
There can be no assurance that our ultimate unpaid losses and LAE will not
develop redundancies or deficiencies and materially differ from our unpaid
losses and LAE as of June 30, 2006. In the future, if the unpaid losses and
LAE
develop redundancies or deficiencies, such redundancy or deficiency would have
a
positive or adverse impact, respectively, on future results of operations.
See
Critical
Accounting Estimates - Losses and Loss Adjustment Expenses
for
additional discussion of our reserving policy.
Personal
automobile insurance is our primary line of business. Non-California vehicles
accounted for 9.3% of our direct premiums written for the three months ended
June 30, 2006, compared to 5.9% for the same period in 2005. For the six months
ended June 30, 2006, non-California vehicles accounted for 8.6% of our direct
premiums written, compared to 5.7% for the same period in 2005. This increase
is
due to our ongoing national expansion program, which includes marketing in
non-California states. The Company is currently selling policies in 12 states
and plans to expand into three additional states during the second half of
2006
as part of its national expansion strategy.
Personal
Auto Lines Underwriting Results
The
following table presents the components of our personal auto lines underwriting
profit and the components of the combined ratio:
|
|
Three
Months Ended
June
30,
|
|
|
|
Six
Months Ended
June
30,
|
|
|
AMOUNTS
IN
THOUSANDS
|
|
2006
|
2005
|
Increase/
(Decrease)
|
|
2006
|
2005
|
Increase/
(Decrease)
|
Direct
premiums written
|
|
$
|
316,837
|
|
$
|
328,669
|
|
|
(3.6
|
)%
|
|
$
|
655,406
|
|
$
|
680,786
|
|
|
(3.7
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
premiums written
|
|
$
|
315,476
|
|
$
|
327,479
|
|
|
(3.7
|
)%
|
|
$
|
652,700
|
|
$
|
678,420
|
|
|
(3.8
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
325,512
|
|
$
|
336,842
|
|
|
(3.4
|
)%
|
|
$
|
651,336
|
|
$
|
673,203
|
|
|
(3.2
|
)%
|
Net
losses and LAE
|
|
|
222,828
|
|
|
248,083
|
|
|
(10.2
|
)
|
|
|
459,248
|
|
|
498,939
|
|
|
(8.0
|
)
|
Underwriting
expenses
|
|
|
74,391
|
|
|
72,520
|
|
|
2.6
|
|
|
|
146,323
|
|
|
144,201
|
|
|
1.5
|
|
Underwriting
profit
|
|
$
|
28,293
|
|
$
|
16,239
|
|
|
74.2
|
%
|
|
$
|
45,765
|
|
$
|
30,063
|
|
|
52.2
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ratios:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
and LAE ratio
|
|
|
68.5
|
%
|
|
73.7
|
%
|
|
(5.2
|
)%
|
|
|
70.5
|
%
|
|
74.1
|
%
|
|
(3.6
|
)%
|
Underwriting
expense ratio
|
|
|
22.9
|
|
|
21.5
|
|
|
1.4
|
|
|
|
22.5
|
|
|
21.4
|
|
|
1.1
|
|
Combined
ratio
|
|
|
91.4
|
%
|
|
95.2
|
%
|
|
(3.8
|
)%
|
|
|
93.0
|
%
|
|
95.5
|
%
|
|
(2.5
|
)%
|
The
following table reconciles our personal auto lines underwriting profit to our
consolidated net income:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
|
2006
|
2005
|
Personal
auto lines underwriting profit
|
|
$
|
28,293
|
|
$
|
16,239
|
|
|
$
|
45,765
|
|
$
|
30,063
|
|
Homeowner
and earthquake lines in runoff underwriting loss
|
|
|
(266
|
)
|
|
(198
|
)
|
|
|
(342
|
)
|
|
(370
|
)
|
Net
investment income
|
|
|
17,174
|
|
|
17,006
|
|
|
|
34,929
|
|
|
34,043
|
|
Other
income
|
|
|
10
|
|
|
367
|
|
|
|
10
|
|
|
367
|
|
Net
realized investment gains (losses)
|
|
|
30
|
|
|
(1,267
|
)
|
|
|
(1,037
|
)
|
|
(1,727
|
)
|
Other
expense
|
|
|
(923
|
)
|
|
—
|
|
|
|
(923
|
)
|
|
—
|
|
Interest
and fees expense
|
|
|
(1,854
|
)
|
|
(2,031
|
)
|
|
|
(3,752
|
)
|
|
(4,088
|
)
|
Provision
for income taxes
|
|
|
(14,143
|
)
|
|
(9,621
|
)
|
|
|
(25,011
|
)
|
|
(18,356
|
)
|
Net
income
|
|
$
|
28,321
|
|
$
|
20,495
|
|
|
$
|
49,639
|
|
$
|
39,932
|
|
The
following table reconciles our personal auto lines direct premiums written
to
net premiums earned:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
|
2006
|
2005
|
Direct
premiums written
|
|
$
|
316,837
|
|
$
|
328,669
|
|
|
$
|
655,406
|
|
$
|
680,786
|
|
Ceded
premiums written
|
|
|
(1,361
|
)
|
|
(1,190
|
)
|
|
|
(2,706
|
)
|
|
(2,366
|
)
|
Net
premiums written
|
|
|
315,476
|
|
|
327,479
|
|
|
|
652,700
|
|
|
678,420
|
|
Net
change in unearned premiums
|
|
|
10,036
|
|
|
9,363
|
|
|
|
(1,364
|
)
|
|
(5,217
|
)
|
Net
premiums earned
|
|
$
|
325,512
|
|
$
|
336,842
|
|
|
$
|
651,336
|
|
$
|
673,203
|
|
We
remain
focused on achieving our long-term goals of a combined ratio of 96% or lower
and
15% annual growth in direct premiums written.
Direct
premiums written decreased in the three months and six months ended June 30,
2006, as compared to the same period in 2005, primarily due to continued
competitiveness in the California market. As discussed in the Operating
Highlights,
in July
2006, the California Department of Insurance issued changes to regulations
relating to automobile insurance rating factors, particularly concerning
territorial rating. It is not possible at this time to predict the ultimate
timing or impact of these changes, which could have either a materially
favorable or materially adverse impact on the Company. Also in July 2006, the
CDI proposed new amended rate approval regulations, which if approved without
modification, could have a materially adverse impact on the Company’s California
results. See further discussion in Item
1A. Risk Factors.
As
the
Company proceeds with its national expansion, we believe that achieving our
long-term growth goal will steadily depend less on the California marketplace.
Net premiums earned decreased in the three months and six months ended June
30,
2006, compared to the same periods a year ago, consistent with the decline
in
direct premiums written during the same periods. The Company’s national
expansion efforts will provide us with flexibility to use combinations of local
and national marketing media, as appropriate, and the ability to focus our
marketing expenditures and company resources on attractive markets, while
minimizing costs in less attractive markets.
The
declines in the loss and LAE ratios for the three months and six months ended
June 30, 2006 of 5.2 points and 3.6 points, respectively, are partially due
to
the effect of favorable development related to prior accident years. The loss
and LAE ratios for the three months ended June 30, 2006 included 5.6 points
($18.4 million) of favorable development compared to 3.6 points ($12.1 million)
in the same period of 2005. Similarly, the six months ended June 30, 2006 loss
and LAE ratio included 3.9 points ($25.5 million) of favorable reserve
development in 2006 compared to 2.9 points ($20.0 million) in the same period
of
2005. Changes in estimates are recorded in the period in which new information
becomes available indicating that a change is warranted. The remaining decrease
in the loss and LAE ratios for both periods was primarily attributable to the
decline in frequency.
The
underwriting expense to net premiums earned ratios increased in the three months
and six months ended June 30, 2006, as compared to the same periods in the
prior
year. This was primarily due to our investments in the Company’s national
expansion efforts and the 2006 recognition of stock-based compensation partially
offset by an increase in deferred policy acquisition costs. Also, the
underwriting expense ratio for the six months ended June 30, 2006 was impacted
by severance costs and corporate litigation
incurred during the three months ended March 31, 2006.
The
combined ratio was 91.4% for the quarter ended June 30, 2006, compared to 95.2%
for the same period in 2005. The decrease was mainly due to the 5.2 point
decrease in the loss and LAE ratio partially offset by 1.4 point increase in
the
underwriting expense ratio as a result of the items discussed above. The
combined ratios for the six months ended June 30, 2006 and 2005 were 93.0%
and
95.5%, respectively. The decrease was mainly due to favorable prior accident
year loss and LAE development of $25.5 million.
Homeowner
and Earthquake Lines in Runoff
We
have
not written any earthquake policies since 1994 and exited the homeowner
insurance business in 2002. Underwriting results of the homeowner and earthquake
lines, which are in runoff, include losses and LAE incurred of $0.3 million
for
the three months ended June 30, 2006, compared to $0.2 million for the same
period a year ago. For the six months ended June 30, 2006 and 2005, losses
and
LAE for those same lines were $0.3 million and $0.4 million, respectively,
of
which the earthquake lines accounted for less than $0.1 million in loss and
LAE
during the three months and six months ended June 30, 2006.
Net
Investment Income
We
utilize a conservative investment philosophy. No derivatives or nontraditional
securities are held in our investment portfolio and there were no equity
securities at June 30, 2006. Substantially the entire fixed maturity portfolio
is investment grade (weighted-average Standard & Poor’s credit quality of
“AA”).
The
components of net investment income were as follows:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
|
2006
|
2005
|
Fixed
maturity investments available-for-sale
|
|
$
|
16,886
|
|
$
|
15,187
|
|
|
$
|
33,495
|
|
$
|
30,673
|
|
Equity
securities available-for-sale
|
|
|
—
|
|
|
1,601
|
|
|
|
811
|
|
|
2,977
|
|
Cash
and cash equivalents
|
|
|
288
|
|
|
218
|
|
|
|
623
|
|
|
393
|
|
Net
investment income
|
|
$
|
17,174
|
|
$
|
17,006
|
|
|
$
|
34,929
|
|
$
|
34,043
|
|
The
average annual yields on fixed income assets were as follows:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
|
|
2006
|
2005
|
|
2006
|
2005
|
Pre-tax
- fixed maturity securities
|
|
|
4.6
|
%
|
|
4.5
|
%
|
|
|
4.7
|
%
|
|
4.6
|
%
|
After-tax
- fixed maturity securities
|
|
|
3.3
|
|
|
3.3
|
|
|
|
3.4
|
|
|
3.3
|
|
The
fixed
maturity portfolio, which comprised 97% and 95% of the total investment
portfolio at June 30, 2006 and December 31, 2005, respectively, displayed a
10
basis point improvement, on a pre-tax basis, in both the three and six month
periods ended June 30, 2006, when compared to the same periods in 2005. This
yield improvement was due to the reinvestment of funds from investment sales
and
maturities into higher yielding fixed maturity securities during a rising rate
environment in 2006.
At
June
30, 2006, $383.0 million, or 26.9%, of our total fixed maturity investments
at
fair value were invested in tax-exempt bonds with the remainder, representing
73.1% of the portfolio, invested in taxable securities, compared to 23.1% and
76.9%, respectively, at December 31, 2005 and 21.0% and 79.0%, respectively,
at
June 30, 2005. As of June 30, 2006, no investments were rated below investment
grade.
The
net
realized gains (losses) on investments were as follows:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
|
2006
|
2005
|
Gross
realized gains1
|
|
$
|
97
|
|
$
|
1,966
|
|
|
$
|
1,549
|
|
$
|
3,304
|
|
Gross
realized losses2
|
|
|
(67
|
)
|
|
(3,233
|
)
|
|
|
(2,586
|
)
|
|
(5,031
|
)
|
Net
realized gains (losses) on investments
|
|
$
|
30
|
|
$
|
(1,267
|
)
|
|
$
|
(1,037
|
)
|
$
|
(1,727
|
)
|
Our
policy is to investigate, on a quarterly basis, all investments for possible
“other-than-temporary” impairment when the fair value of a security falls below
its amortized cost, based on all relevant facts and circumstances. No such
impairments were recorded in the three and six months ended June 30, 2006 or
2005. See discussion under Critical
Accounting Estimates - Investments
for
further information.
Other
Income and Expense
Other
income consists of interest income relating to a refund claim with the IRS.
Other expense of $0.9 million in the second quarter of 2006 relates to an
impairment charge incurred in connection with vacated space in our headquarters
in Woodland Hills, California, which will be sublet starting in the third
quarter.
FINANCIAL
CONDITION
Investments
and cash were approximately $1.5 billion at June 30, 2006 and December 31,
2005.
The Company initiated the sale of its equity securities during the first quarter
of 2006 and did not hold any equity securities as of June 30, 2006. Applicable
funds realized from the sale of equity securities were primarily reinvested
in
fixed maturity investments. However, the Company executed a $35 million funding
commitment for a private equity investment program during the second quarter
of
2006, as described in Note 9 of the Notes
to Condensed Consolidated Financial Statements.
The
Company also has unrated, community investments representing 0.2% of total
investments. These investments have been made in an effort to provide housing
and other services to economically disadvantaged communities. See Note 8 of
the
Notes
to Condensed Consolidated Financial Statements
for
additional information.
Increased
advertising, sales and customer service costs in the second quarter of 2006
contributed to an increase in deferred policy acquisition costs (“DPAC”) of $8.3
million to $68.2 million, compared to $59.9 million at December 31, 2005. Our
DPAC is estimated to be fully recoverable (see Critical
Accounting Estimates - Deferred Policy Acquisition Costs).
1 |
Gross
realized gains during the three months ended June 30, 2006 and
2005
include $64 thousand and $1.9 million, respectively, from the sale
of
equity securities. Gross realized gains during the six months ended
June
30, 2006 and 2005, include $1.2 million and $3.3 million from the
sale of
equity securities, respectively.
|
2 |
Gross
realized losses during the three months ended June 30, 2006 and
2005
include $67 thousand and $3.2 million, respectively, from the sale
of
equity securities. Gross realized losses during the six months
ended June
30, 2006 and 2005, include $2.6 million and $5.0 million from the
sale of
equity securities,
respectively.
|
The
following table summarizes unpaid losses and LAE, gross and net of applicable
reinsurance, with respect to our lines of business:
|
|
June
30, 2006
|
|
December
31, 2005
|
AMOUNTS
IN THOUSANDS
|
|
Gross
|
Net
|
|
Gross
|
Net
|
Unpaid
losses and LAE
|
|
|
|
|
|
|
|
|
|
|
Personal
auto lines
|
|
$
|
493,584
|
|
$
|
488,397
|
|
|
$
|
521,528
|
|
$
|
516,849
|
|
Homeowner
and earthquake lines in runoff
|
|
|
1,508
|
|
|
783
|
|
|
|
2,307
|
|
|
1,368
|
|
Total
|
|
$
|
495,092
|
|
$
|
489,180
|
|
|
$
|
523,835
|
|
$
|
518,217
|
|
At
June
30, 2006, gross unpaid losses and LAE decreased $28.7 million, primarily due
to
a reserve decrease of $27.9 million in the personal auto lines as a result
of
$25.5 million of favorable loss development related to prior accident years
recorded during the six months ended June 30, 2006 and fewer number of
exposures. The gross unpaid losses and LAE in the homeowner and earthquake
lines
decreased $0.8 million as the result of continued runoff activity (see
Critical
Accounting Estimates - Losses and Loss Adjustment Expenses for
a
description of the Company’s reserving process).
Debt
of
$121.6 million consists of $21.7 million of capital lease obligations and $99.9
million of Senior Notes, net of discount. The decrease in debt of $6.4 million
during the six months ended June 30, 2006 is primarily attributable to principal
payments on the capital leases.
Stockholders’
equity and book value per share increased to $855.2 million and $9.91,
respectively, at June 30, 2006, compared to $830.0 million and $9.66 at December
31, 2005, respectively. The increase in stockholders’ equity for the six months
ended June 30, 2006 was primarily due to net income of $49.6 million,
stock-based compensation cost of $6.7 million, and $3.8 million exercised stock
options. This was partially offset by dividends to stockholders of $13.8 million
and an increase in accumulated other comprehensive loss of $21.1 million
(resulting from a $32.5 million increase in net unrealized losses on the
investment portfolio due to rising market yields).
LIQUIDITY
AND CAPITAL RESOURCES
21st
Century Insurance Group
Our
holding company’s main sources of liquidity historically have been dividends
received from our insurance subsidiaries and proceeds from issuance of debt
or
equity securities. Apart from the exercise of stock options and restricted
stock
grants to employees, the effects of which have not been significant, we have
not
issued any equity securities since 1998 when American International Group,
Inc.
(“AIG”) exercised its warrants to purchase common stock for cash of $145.6
million. Our insurance subsidiaries have not paid any dividends to our holding
company since 2001. As of June 30, 2006, our insurance subsidiaries could pay
$113.0 million as dividends to the holding company without prior written
approval from insurance regulatory authorities.
Effective
December 31, 2003, the California Department of Insurance (“CDI”), approved an
intercompany lease whereby 21st Century Insurance Company leases certain
computer software from our holding company. The monthly lease payment, currently
$0.8 million, started in January 2004 and is subject to upward adjustment based
on the cost incurred by the holding company to enhance the software.
On
November 30, 2005, the CDI approved an amendment to a term loan line that
increased the available amount from $40 million to $150 million that our
insurance subsidiary, 21st Century Insurance Company, can loan to our holding
company. The outstanding balance of the term loan line as of June 30, 2006,
was
$71.0 million.
Our
holding company’s significant cash obligations over the next several years,
exclusive of any dividends to stockholders that our directors may declare,
consist of the following:
|
·
|
Ongoing
costs to enhance our computer
software;
|
|
·
|
The
repayment of the $100 million principal on the Senior Notes due in
2013;
|
|
·
|
The
repayment of $71.0 million principal on the term loan line to the
insurance subsidiary (scheduled payments include $18 million, $40
million,
and $13 million in 2007, 2008,and 2009, respectively);
and
|
|
·
|
Related
interest on the obligations above.
|
We
expect
to be able to meet those obligations from sources of cash currently available
(i.e., cash and investments at the holding company, which totaled $19.5 million
at June 30, 2006, payments received from the intercompany lease, and borrowing
from our insurance subsidiary), additional funds that may be obtainable from
the
capital markets or dividends received from our insurance subsidiaries. The
effective 2006 California state income tax rate applicable to any such dividends
paid from our subsidiaries, if taxable, is approximately 1.8%, or 1.2% net
of
federal benefit.
Insurance
Subsidiaries
We
have
achieved underwriting profits in our core auto insurance operations since 2001
and have thereby enhanced our liquidity. Our cash flows from operations and
short-term cash position generally are more than sufficient to meet 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. Our underwriting
results are impacted by rate changes. Although in the past years we have been
successful in gaining California regulatory approval for rate increases, 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.
As discussed in the Operating
Highlights,
in July
2006, the CDI issued changes to regulations relating to automobile insurance
rating factors, particularly concerning territorial rating. It is not possible
at this time to predict the ultimate timing or impact of these changes, which
could have either a materially favorable or materially adverse impact on the
Company. Also in July 2006, the CDI proposed new amended rate approval
regulations, which if approved without modification, could have a materially
adverse impact on the Company’s California results. See further discussion in
Item
1A. Risk Factors.
Also,
in
the event of adverse claims results, we could be forced 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 or cash flows, which in turn, could negatively
impact our liquidity.
As
of
June 30, 2006, our insurance subsidiaries had a combined statutory surplus
of
$755.3 million compared to $704.7 million at December 31, 2005. The increase
in
statutory surplus was primarily due to statutory net income of $59.2 million
and
an increase in net unrealized investment gains of $1.2 million, offset by a
$7.1
million increase in the deferred income tax asset and an increase in nonadmitted
assets of $2.6 million. The net premiums written to statutory surplus ratio,
which is required to be below 3.0, was 1.7 at June 30, 2006, compared to 1.9
at
December 31, 2005.
Certain
of our subsidiaries must comply with minimum capital and surplus requirements
under applicable state laws and regulations, and must have adequate reserves
for
claims. We believe that as of June 30, 2006, all of our insurance subsidiaries
met their respective regulatory requirements.
The
following is a reconciliation of our stockholders’ equity to statutory
surplus:
AMOUNTS
IN THOUSANDS
|
|
June
30,
2006
|
December
31,
2005
|
Stockholders’
equity - GAAP
|
|
$
|
855,165
|
|
$
|
829,972
|
|
Condensed
adjustments to reconcile GAAP shareholders’ equity to statutory
surplus:
|
|
|
|
|
|
|
|
Net
book value of fixed assets under capital leases
|
|
|
(21,880
|
)
|
|
(24,185
|
)
|
Deferred
gain under capital lease transactions
|
|
|
(497
|
)
|
|
(914
|
)
|
Capital
lease obligation
|
|
|
21,715
|
|
|
28,074
|
|
Nonadmitted
net deferred tax assets
|
|
|
(24,078
|
)
|
|
(34,936
|
)
|
Net
deferred tax assets related to items nonadmitted under SAP
|
|
|
24,438
|
|
|
38,544
|
|
Intercompany
receivables
|
|
|
(64,647
|
)
|
|
(57,683
|
)
|
Fixed
assets
|
|
|
(21,720
|
)
|
|
(22,492
|
)
|
Equity
in non-insurance entities
|
|
|
39,558
|
|
|
26,798
|
|
Net
unrealized losses on investments
|
|
|
44,778
|
|
|
10,788
|
|
Deferred
policy acquisition costs
|
|
|
(68,248
|
)
|
|
(59,939
|
)
|
Prepaid
pension costs and intangible pension asset
|
|
|
(18,435
|
)
|
|
(21,309
|
)
|
Other
prepaid expenses
|
|
|
(14,693
|
)
|
|
(11,049
|
)
|
Other,
net
|
|
|
3,870
|
|
|
3,002
|
|
Statutory
surplus
|
|
$
|
755,326
|
|
$
|
704,671
|
|
Operating
Cash Flows
Our
operating cash flows were as follows:
|
|
Six
Months Ended
June
30,
|
|
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
Decrease
|
Net
cash provided by operating activities
|
|
$
|
64,418
|
|
$
|
70,241
|
|
$
|
5,823
|
|
Net
cash
provided by operating activities decreased primarily due to a decline in direct
premiums collected resulting from the decline in premiums written. This was
partially offset by decreases in loss and LAE payments. Also, while underwriting
expenses and deferred policy acquisition costs increased since the prior
year, cash paid for underwriting expenses did not increase significantly due
to
the increase in other liabilities of $19.8 million, primarily as a result of
unpaid expenditures incurred towards the end of the quarter in connection with
the Company’s national expansion efforts.
Investing
Activities
Our
cash
flow from investing activities is primarily impacted by the sales, maturities
and purchases of our available-for-sale investment securities. Our investment
objective is to maintain a low level of risk and to preserve principal by
investing in high quality, investment grade securities while maintaining
liquidity in each portfolio sufficient to meet our cash flow
requirements.
Our
cash
flows from investing activities were as follows:
|
|
Six
Months Ended
June
30,
|
|
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
Increase
|
Net
cash used in investing activities
|
|
$
|
76,352
|
|
$
|
52,791
|
|
$
|
23,561
|
|
Net
cash
used in investing activities increased primarily due to payments for the
purchase of investments and purchase of property and equipment of $21.5 million
and $0.8 million, respectively, partially offset by net sales and maturities
of
investments of $44.3 million.
Financing
Activities
Our
cash
flows from investing activities were as follows:
|
|
Six
Months Ended
June
30,
|
|
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
Increase
|
Net
cash used in financing activities
|
|
$
|
16,546
|
|
$
|
10,825
|
|
$
|
5,721
|
|
Net
cash
used in financing activities increased due to the doubling of the dividend
since
the prior year from $0.04 per share to $0.08 per share, partially offset by
a
$1.0 million increase in cash receipts provided by stock option
exercises.
TRANSACTIONS
WITH RELATED PARTIES
Several
subsidiaries of AIG together own approximately 62% of our outstanding common
stock and four of the eleven members of our Board of Directors are employees
of
AIG. Since 1995, the Company has entered into transactions with AIG
subsidiaries, including reinsurance agreements, insurance coverage contracts,
and investment management and investment accounting.
Reinsurance
agreements
The
Company’s catastrophe reinsurance coverage for its personal auto lines is
provided by three participating entities, two of which are AIG subsidiaries.
Together they reinsure any covered event up to $45.0 million in excess of $20.0
million. This coverage was renewed effective January 1, 2005 and 2006. Total
premiums ceded to AIG subsidiaries were $0.3 million and $0.5 million for the
three and six months ended June 30, 2006, respectively, and $0.2 million and
$0.5 million for the three and six months ended June 30, 2005, respectively.
Total reinsurance recoverables, net of payables, from AIG subsidiaries were
$0.4
million and $0.6 million as of June 30, 2006 and December 31, 2005,
respectively.
Corporate
insurance coverage
The
Company has obtained the following corporate insurance policies from AIG
subsidiaries:
|
·
|
Workers’
compensation insurance
|
|
·
|
General
liability insurance
|
|
·
|
Umbrella
excess insurance
|
|
·
|
Fiduciary
liability insurance
|
|
·
|
Employment
practices liability insurance
|
Errors
and omissions insurance was carried with AIG through September 30,
2005.
Insurance
expense attributable to AIG corporate insurance coverages was $1.3 million
and
$2.1 million for the three and six months ended June 30, 2006, respectively,
and
$1.1 million and $2.5 million for the three and six months ended June 30, 2005,
respectively.
Investment
management and investment accounting
In
October 2003, as a result of a competitive bidding process, we entered into
an
agreement with AIG Global Investment Corp. (“AIGGIC”) to provide investment
management and investment accounting services to the Company. The fees are
determined as a percentage of the average invested asset balance and are
classified with net investment income. This agreement was approved by the CDI.
Investment management and accounting expense was $0.2 million and $0.4 million
for the three and six months ended June 30, 2006, respectively, and $0.2 million
and $0.5 million for the three and six months ended June 30, 2005,
respectively.
In
June
2006, the Company executed a $35 million funding commitment with AIGGIC for
a
program that will manage a portfolio of private equity transactions. In the
event that the Company does not respond to a capital call during the investment
term, the General Partner of the fund (“GP”) may apply the following default
provisions: withhold 50% of distributions due to the Company at the time of
the
default and 50% of future distributions due to the Company; hold the Company
liable for fund expenses above and beyond investments made by the Company (with
the right of offset); terminate the Company’s Limited Partner status and not
allow it any further investments; or charge interest on the defaulted capital
commitment amount and fees at LIBOR + 4% (with the right of offset). However,
the GP may choose not to designate the Company a "defaulting limited partner"
and waive the default provisions. The investment term ends after the underlying
investments are liquidated, but in no event later than 10 years. Typically,
multiple investments are purchased and liquidated over the investment term.
The
Company funded $9.1 million of the commitment in July 2006.
CONTRACTUAL
OBLIGATIONS AND COMMITMENTS
See
our
discussion about variable interest entities and commitments in Note 8 of the
Notes
to Condensed Consolidated Financial Statements.
There
were no material changes outside the ordinary course of our business in our
contractual obligations during the
six-month period ended June 30, 2006.
CRITICAL
ACCOUNTING ESTIMATES
Our
condensed consolidated financial statements are prepared in accordance with
GAAP. The financial information contained within these statements is, to a
significant extent, financial information that is based on estimates and
assumptions. Our significant accounting policies are essential to understanding
Management’s Discussion and Analysis of Financial Condition and Results of
Operations. Some of our accounting policies require significant judgment to
estimate values of either assets or liabilities. In addition, significant
judgment may be needed to apply what often are complex accounting principles
to
individual transactions to determine the most appropriate treatment. We have
established procedures and processes to facilitate making the judgments
necessary to prepare the condensed consolidated financial statements.
The
following is a summary of the more judgmental and complex accounting estimates
and principles. In each area, we have discussed the assumptions most important
in the estimation process. We have used the best information available to
estimate the related items involved. Actual performance that differs from our
estimates and future changes in the key assumptions could change future
valuations and materially impact our financial condition and results of
operations.
Management
has discussed our critical accounting policies and estimates, together with
any
changes therein, with the Audit Committee of our Board of Directors.
Losses
and Loss Adjustment Expenses
The
estimated liabilities for losses and LAE include estimates of losses for known
claims reported on or prior to the balance sheet dates, estimates of losses
for
claims incurred but not reported, 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.
The
methods used to determine such estimates and to establish the resulting reserves
are continually reviewed and updated. Any resulting adjustments are reflected
in
current operating income on a dollar-for-dollar basis. For example, an upward
revision of $1 million in the estimated recorded liability for unpaid losses
and
LAE 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.
It
is
management’s belief that the reserves for losses and LAE are adequate to cover
unpaid losses and LAE as of June 30, 2006. While we perform quarterly reviews
of
the adequacy of established unpaid losses and LAE reserves, there can be no
assurance that our ultimate unpaid losses and LAE will not develop redundancies
or deficiencies and possibly differ materially from our unpaid losses and LAE
as
of June 30, 2006. In the future, if the unpaid losses and LAE develop
redundancies or deficiencies, then such redundancy or deficiency would have
a
positive or adverse impact, respectively, on future results of
operations.
The
process of making changes to unpaid losses and LAE begins with the review of
the
actual claims experience, actual rate changes achieved, actual changes in
coverage, mix of business, and changes in certain other factors such as weather
and recent tort activity that may affect the loss and LAE ratio. Based on this
review, our actuaries prepare several point estimates of unpaid losses and
LAE
for each of the coverages, and they use their experience and judgment to arrive
at an overall actuarial point estimate of the unpaid losses and LAE for that
coverage.
Meetings
are held with appropriate departments to discuss significant issues as a result
of the review. This process culminates in a reserve meeting to review the unpaid
losses and LAE. The basis for carried unpaid losses and LAE is the overall
actuarial point estimate. Other relevant internal and external factors
considered include a qualitative assessment of inflation and other economic
conditions, changes in the legal, regulatory, judicial and social environments,
underlying policy pricing, exposure and policy forms, claims handling, and
geographic distribution shifts. As a result of the meeting, unpaid losses and
LAE are finalized and we record quarterly changes in unpaid losses and LAE
for
each of our coverages. The overall change in our unpaid losses and LAE is based
on the sum of these coverage level changes.
The
point
estimate methods include the use of paid loss triangles, incurred loss
triangles, claim count triangles, and severity triangles, as well as expected
loss ratio methods. Quantitative techniques frequently have to be supplemented
by subjective consideration, including managerial judgment, to assure management
satisfaction that the overall unpaid losses and LAE are adequate to meet
projected losses. For example, in property damage coverages, repair cost trends
by geographic region vary significantly. These factors are periodically reviewed
and subsequently adjusted, as appropriate, to reflect emerging trends that
are
based upon past loss experience. Thus, many factors are implicitly considered
in
estimating the loss costs recognized.
Judgment
is required in analyzing the appropriateness of the various methods and factors
to avoid overreacting to data anomalies that may distort such prior trends.
For
example, changes in limits distributions or development in the most recent
accident quarters would require more actuarial judgment. We do not believe
disclosure of specific point estimates calculated by the actuaries would be
meaningful. Any one actuarial point estimate is based on a particular series
of
judgments and assumptions of the actuary. Another actuary may make different
assumptions, and therefore reach a different point estimate.
There
is
a potential for significant variation in ultimate development of unpaid losses
and LAE. Most automobile claims are reported within two to three months whereas
the estimate of ultimate severities exhibits greater variability at the same
maturity. Generally, actual historical loss development factors are used to
project future loss development and there can be no assurance that future loss
development patterns will be the same as in the past. However, we believe that
our reserving methodologies are in line with other personal lines insurers
and
would generally expect ultimate unpaid losses and LAE development to vary
approximately 5% from the carried unpaid losses and LAE.
The
Company has experienced changes in the mix of business and policy limits. We
believe that the assumption with the highest likelihood of change that could
materially affect carried unpaid losses and LAE is the estimate of the frequency
of unpaid bodily injury claims. The Company has experienced approximately 15%
lower bodily injury claim frequency over accident years 2003 through 2005 in
California. A 5% change in the estimate of the frequency of unpaid bodily injury
claims for accident year 2005 would result in an approximate increase or
decrease in total unpaid
losses and LAE of 1.3%, or $6.2 million, at June 30, 2006.
Investments
Investment
securities generally must be classified as held-to-maturity, available-for-sale
or trading. The appropriate classification is based partially on our ability
to
hold the securities to maturity and largely on management’s intentions at
inception with respect to either holding or selling the securities. The
classification of investment securities is significant since it directly impacts
the accounting for unrealized gains and losses on securities. Unrealized gains
and losses on trading securities flow directly through earnings during the
periods in which they arise, whereas for available-for-sale securities they
are
recorded as a separate component of stockholders’ equity (accumulated other
comprehensive income or loss) and do not affect earnings until realized. The
fair values of our investment securities are generally determined by reference
to quoted market prices and reliable independent sources. The cost of investment
securities sold is determined by the specific identification
method.
We
are
obligated to assess, at each reporting date, whether there is an
“other-than-temporary” impairment to our investment securities. In general, a
security is considered a candidate for impairment if it meets any of the
following criteria:
|
·
|
Trading
at a significant (25% or more) discount to par, amortized cost (if
lower)
or cost for an extended period of time (nine months or
longer);
|
|
·
|
The
occurrence of a discrete credit event resulting in (i) the
issuer defaulting on a material outstanding obligation; or (ii) the
issuer seeking protection from creditors under the bankruptcy laws
or any
similar laws intended for the court supervised reorganization of
insolvent
enterprises; or (iii) the
issuer proposing a voluntary reorganization pursuant to which creditors
are asked to exchange their claims for cash or securities having
a fair
value substantially lower than par value of their claims;
or
|
|
·
|
In
the opinion of the Company’s management, it is possible that the Company
may not realize a full recovery on its investment, irrespective of
the
occurrence of one of the foregoing
events.
|
For
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, such as when it is
determined that an issuer is unable to repay the entire principal, a charge
is
required to be reflected in income for the difference between cost or amortized
cost and the fair value.
The
determination of whether a decline in market value is “other-than-temporary” is
necessarily a matter of subjective judgment. No such charges were recorded
in
the three or six months ended June 30, 2006 or 2005. 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 as of the periods
presented because any unrealized losses would be already included in accumulated
other comprehensive income (loss).
Substantially
the entire fixed maturity portfolio is investment grade. The following is a
summary of the Standard & Poor’s credit rating for the fixed maturity
portfolio (the weighted average is “AA”):
|
|
June
30, 2006
|
|
December
31, 2005
|
AMOUNTS
IN THOUSANDS
|
|
#
issues
|
Fair
Value
|
|
#
issues
|
Fair
Value
|
AAA
|
|
|
320
|
|
$
|
706,286
|
|
|
|
286
|
|
$
|
604,812
|
|
AA
|
|
|
114
|
|
|
174,147
|
|
|
|
116
|
|
|
169,708
|
|
A
|
|
|
118
|
|
|
428,461
|
|
|
|
118
|
|
|
486,338
|
|
BBB
|
|
|
45
|
|
|
115,092
|
|
|
|
44
|
|
|
88,918
|
|
BB
|
|
|
—
|
|
|
—
|
|
|
|
3
|
|
|
2,495
|
|
Not
Rated
|
|
|
5
|
|
|
2,742
|
|
|
|
2
|
|
|
2,436
|
|
Total
fixed maturity investments
|
|
|
602
|
|
$
|
1,426,728
|
|
|
|
569
|
|
$
|
1,354,707
|
|
The
following is a summary by issuer of non-investment grade securities and unrated
securities held (at fair value):
|
|
June
30,
|
December
31,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
Non-investment
grade equity securities:
|
|
|
|
|
|
AmerUs
Group Co.3
|
|
$
|
—
|
|
$
|
864
|
|
Non-investment
grade fixed maturity securities (i.e., rated below BBB-):
|
|
|
|
|
|
|
|
Ford
Motor Credit Company 4
|
|
|
—
|
|
|
2,495
|
|
Unrated
fixed maturity securities: 5
|
|
|
|
|
|
|
|
Impact
Community Capital, LLC
|
|
|
1,999
|
|
|
2,023
|
|
Impact
Healthcare, LLC
|
|
|
413
|
|
|
413
|
|
Impact
Childcare, LLC
|
|
|
330
|
|
|
—
|
|
Total
non-investment grade and unrated fixed maturity securities
|
|
|
2,742
|
|
|
4,931
|
|
Total
non-investment grade and unrated securities
|
|
$
|
2,742
|
|
$
|
5,795
|
|
|
|
|
|
|
|
|
|
Percentage
of total investments, at fair value
|
|
|
0.2
|
%
|
|
0.4
|
%
|
3 |
The
AmerUs Group Co. was a preferred stock holding that had an unrealized
gain
as of December 31, 2005.
|
4 |
The
Ford Motor Credit Company security matured in the first quarter
of 2006
and the Company received all amounts due, thereby incurring no
loss.
|
5 |
Impact
Community Capital is a limited partnership that was voluntarily
established by a group of California insurers to make loans and
other
investments
that provide housing and other services to economically disadvantaged
communities. See further discussion in Note 8 of the Notes
to the Condensed
Consolidated Financial
Statements.
|
The
following table summarizes investments held by us having an unrealized loss
of
$0.1 million or more and aggregate information relating to all other investments
in unrealized loss positions as of June 30, 2006 and December 31,
2005:
|
|
June
30, 2006
|
|
December
31, 2005
|
AMOUNTS
IN THOUSANDS,
EXCEPT
NUMBER OF ISSUES
|
|
#
issues
|
Fair
Value
|
Unrealized
Loss
|
|
#
issues
|
Fair
Value
|
Unrealized
Loss
|
Investments
with unrealized losses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fixed
maturity securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exceeding
$0.1 million and in a loss position for:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Less
than 6 months
|
|
|
8
|
|
$
|
47,774
|
|
$
|
1,384
|
|
|
|
16
|
|
$
|
141,034
|
|
$
|
3,074
|
|
6-12
months
|
|
|
48
|
|
|
297,042
|
|
|
15,406
|
|
|
|
16
|
|
|
129,044
|
|
|
4,072
|
|
More
than 1 year
|
|
|
75
|
|
|
500,926
|
|
|
32,761
|
|
|
|
56
|
|
|
433,368
|
|
|
16,896
|
|
Less
than $0.1 million
|
|
|
130
|
|
|
221,316
|
|
|
5,052
|
|
|
|
113
|
|
|
204,724
|
|
|
4,347
|
|
Total
fixed maturity securities with unrealized losses
|
|
|
261
|
|
|
1,067,058
|
|
|
54,603
|
|
|
|
201
|
|
|
908,170
|
|
|
28,389
|
|
Equity
securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exceeding
$0.1 million
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
|
2
|
|
|
578
|
|
|
305
|
|
Less
than $0.1 million
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
|
245
|
|
|
35,672
|
|
|
1,873
|
|
Total
equity securities with unrealized losses
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
|
247
|
|
|
36,250
|
|
|
2,178
|
|
Total
investments with unrealized losses 6
|
|
|
261
|
|
$
|
1,067,058
|
|
$
|
54,603
|
|
|
|
448
|
|
$
|
944,420
|
|
$
|
30,567
|
|
Unrealized
losses on fixed maturity investments primarily arose from rising interest rates
in the current period. If our portfolio were to be impaired by market or
issuer-specific conditions to a substantial degree, our liquidity, financial
position and financial results could be materially adversely affected. Further,
our income from these investments could be materially reduced, and write-downs
of the value of certain securities could further reduce our profitability.
In
addition, a decrease in value of our investment portfolio could put our
subsidiaries at risk of failing to satisfy regulatory capital requirements.
If
we were not at that time able to supplement our capital by issuing debt or
equity securities on acceptable terms, our ability to continue growing could
be
adversely affected. See
further discussion in
Item
3. Quantitative and Qualitative Disclosures About Market Risk.
A
summary
by contractual maturity of fixed maturity securities in an unrealized loss
position by year of maturity follows:
|
|
June
30, 2006
|
|
December
31, 2005
|
AMOUNTS
IN THOUSANDS
|
|
Amortized
Cost
|
Fair
Value
|
Unrealized
Loss
|
|
Amortized
Cost
|
Fair
Value
|
Unrealized
Loss
|
Fixed
maturity securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Due
in one year or less
|
|
$
|
2,019
|
|
$
|
1,994
|
|
$
|
25
|
|
|
$
|
5,562
|
|
$
|
5,512
|
|
$
|
50
|
|
Due
after one year through five years
|
|
|
440,835
|
|
|
421,282
|
|
|
19,553
|
|
|
|
205,363
|
|
|
200,075
|
|
|
5,288
|
|
Due
after five years through ten years
|
|
|
320,898
|
|
|
303,371
|
|
|
17,527
|
|
|
|
415,417
|
|
|
401,533
|
|
|
13,884
|
|
Due
after ten years
|
|
|
357,909
|
|
|
340,411
|
|
|
17,498
|
|
|
|
310,217
|
|
|
301,050
|
|
|
9,167
|
|
Total
fixed maturity securities with unrealized losses
|
|
$
|
1,121,661
|
|
$
|
1,067,058
|
|
$
|
54,603
|
|
|
$
|
936,559
|
|
$
|
908,170
|
|
$
|
28,389
|
|
Income
Taxes
Determining
the consolidated provision for income tax expense, deferred tax assets and
liabilities and any related valuation allowance involves judgment. GAAP 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 condensed consolidated financial statements. For
example, we have a DTA because the tax bases of our loss and LAE reserves are
smaller than their book bases. Similarly, we have a DTL because the book basis
of our 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.
6 |
Unrealized
losses represent 5.1% and 3.2% of the total carrying value of investments
with unrealized losses at June 30, 2006 and December 31, 2005,
respectively.
|
At
June
30, 2006, our DTAs totaled $127.1 million and our DTLs totaled $69.8 million.
The net of those amounts, $57.3 million, represents the net deferred tax asset
reported in the condensed consolidated balance sheets. At
December 31, 2005, our DTAs total $128.5 million and our DTLs total $72.3
million. The net of those amounts, $56.2 million, represents the net deferred
tax asset reported in the condensed consolidated balance sheets.
We
are
required to reduce DTAs (but not DTLs) by a valuation allowance to the extent
that, based on the weight of available evidence, it is “more likely than not”
(i.e., a likelihood of more than 50%) that any DTAs will not be realized.
Recognition of a valuation allowance would decrease reported earnings on a
dollar-for-dollar basis in the year in which any such recognition were to occur.
The determination of whether a valuation allowance is appropriate requires
the
exercise of management judgment. In making this judgment, management is required
to weigh the positive and negative evidence as to the likelihood that the DTAs
will be realized.
The
Company’s net deferred tax assets include a net operating loss (“NOL”)
carryforward for regular federal corporate tax purposes of approximately $27.9
million, representing an unrealized tax benefit of $9.8 million at June 30,
2006, compared to $33.6 million at December 31, 2005. The steady decline in
the
unrealized tax benefit of the NOL since 2002 resulted from the generation of
taxable underwriting and investment income in the intervening years. At the
current rate of utilization, the Company’s remaining NOL, excluding 21st of the
Southwest, should be fully utilized by the end of 2006, but in any event long
before its statutory expiration.
Portions
of our NOL carryforward are scheduled to expire beginning in 2017, as shown
in
the table below (amounts in thousands):
Year
of Expiration
|
|
NOL
Excluding 21st
of
the Southwest
|
SRLY
7
NOL of 21st
of
the Southwest
|
Consolidated
NOL
|
2017
|
|
$
|
―
|
|
$
|
1,496
|
|
$
|
1,496
|
|
2018
|
|
|
―
|
|
|
1,068
|
|
|
1,068
|
|
2019
|
|
|
―
|
|
|
1,466
|
|
|
1,466
|
|
2020
|
|
|
―
|
|
|
3,172
|
|
|
3,172
|
|
2021
|
|
|
―
|
|
|
2,180
|
|
|
2,180
|
|
2022
|
|
|
18,505
|
|
|
―
|
|
|
18,505
|
|
Total
|
|
$
|
18,505
|
|
$
|
9,382
|
|
$
|
27,887
|
|
Our
ability to fully utilize the NOL of 21st of the Southwest depends on future
taxable income either from continued operating profitability or from tax
planning strategies we could implement, such as increasing the taxable portion
of our investment portfolio. Because of the Company’s history of profitability
over the past four years, management
believes it is reasonable to expect future underwriting profits and to conclude
it is at least more likely than not that we will be able to realize the benefits
of all of our DTAs, including our NOL. Accordingly, no valuation allowance
has
been recognized as of June 30, 2006. However, generating future taxable income
is dependent on a number of factors, including regulatory and competitive
influences that may be beyond our ability to control. Future underwriting losses
could possibly jeopardize our ability to utilize our NOLs. In the event adverse
development or underwriting losses, management might be required to reach a
different conclusion about the realization of the DTAs and, if so, recognize
a
valuation allowance at that time.
In
a
December 21, 2000, court ruling, Ceridian
Corporation v. Franchise Tax Board,
a
California 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”) took the position that the discriminatory sections of the statute are
not severable and the entire statute is invalid. As a result, the FTB began
disallowing dividends-received deductions for all insurance holding companies,
regardless of domicile, for open tax years ending on or after December 1, 1997.
Although the FTB made no formal assessment, the Company anticipated a
retroactive disallowance that would result in additional tax assessments and
recorded a provision for this contingency in a prior year.
In
the
first quarter of 2005, the Company filed amended California tax returns and
paid
the State of California approximately $6.8 million to cover all issues
outstanding with the FTB, including certain matters paid under protest as to
which the Company reserved all its rights to file for refunds and appeal any
adverse rulings by the FTB to the California State Board of Equalization
(“SBE”). In September 2005, the FTB completed its audit and denied the Company’s
refund claims. In December 2005, the Company filed an appeal with the SBE.
The
Company is unable to assess the likelihood that any refunds ultimately will
be
received from the State of California.
7 |
“SRLY”
stands for Separate Return Limitation Year. Under the Federal tax
code,
only future income generated by 21st of the Southwest may be utilized
against
this portion of our NOL.
|
Deferred
Policy Acquisition Costs
Deferred
policy acquisition costs (“DPAC”) primarily include premium taxes, advertising,
and other variable costs incurred with writing business. These costs are
deferred and amortized over the 6-month policy period in which the related
premiums are earned.
Management
assesses the recoverability of deferred policy acquisition costs on a quarterly
basis. The assessment calculates the relationship of estimated costs incurred
to
premiums from contracts issued or renewed for the period. We do not consider
anticipated investment income in determining the recoverability of these costs.
Based on current indications, management believes the DPAC costs are fully
recoverable as of June 30, 2006.
The
loss
and LAE ratio used in the recoverability estimate is based primarily on expected
ultimate ratios provided by our actuaries. While management believes that is
a
reasonable assumption, actual results could differ materially from such
estimates.
Property
and Equipment
At
June
30, 2006, property and equipment included $126.8 million in software. Accounting
standards require a write-off to be recognized when an asset is vacated or
an
asset group’s carrying value exceeds its fair value. For purposes of recognition
and measurement of an impairment loss, a long-lived asset or assets are grouped
with other assets and liabilities at the lowest level for which identifiable
cash flows are largely independent of the cash flows of other assets and
liabilities. Accounting standards require asset groups to be tested for possible
impairment under certain conditions. There have been no events or circumstances
in the second quarter of 2006 that would require a reassessment of any asset
group for impairment.
Stock-Based
Compensation Expense
For
periods prior to January 1, 2006, the Company accounted for share-based payment
transactions with employees in accordance with Statement of Financial Accounting
Standard No. (“FAS”) 123, Accounting
for Stock-Based Compensation.
Under
the provisions of FAS 123, we had elected to continue using the intrinsic-value
method of accounting for stock-based awards granted to employees in accordance
with Accounting Principles Board Opinion No. 25, Accounting
for Stock Issued to Employees.
We did
not recognize in income any compensation expense for the fair value of stock
options awarded to employees as all employee stock options were granted at
or
above the grant date market price. However, stock-based employee compensation
cost relating to restricted stock was recognized in the statements of operations
for periods prior to January 1, 2006. Effective January 1, 2006, the Company
adopted the fair value recognition provisions of FAS 123 (revised 2004),
Share-Based
Payment
(“FAS
123R”). Unlike FAS 123, which was elective, FAS 123R requires that companies use
a fair value method to value share-based payments and recognize the related
compensation expense in net earnings. The Company uses the Black-Scholes
option-pricing model to calculate the fair value of the employee stock options.
The
Company adopted FAS 123R using the modified-prospective application method,
and
accordingly, financial statement amounts for the prior periods presented in
this
Form 10-Q have not been restated to reflect the fair value method of expensing
share-based compensation under FAS 123R. The modified-prospective application
method provides for the recognition of the fair value with respect to
stock-based awards granted on or after January 1, 2006 and all previously
granted, but unvested awards as of January 1, 2006.
The
adoption of FAS 123R in the first quarter of 2006 resulted in additional
stock-based compensation cost of $2.0 million and $6.0 million in the three
and
six months ended June 30, 2006, respectively, which previously would have been
only presented in a pro forma footnote disclosure. The Company expects this
cost
to approximate $10.0 million for fiscal 2006. FAS 123R also requires the Company
to estimate forfeitures in calculating the expense relating to stock-based
compensation, as opposed to recognizing these forfeitures and corresponding
reduction in expense as they occur. No cumulative adjustment was necessary
for
prior year forfeitures as these were estimated in the Company’s prior year pro
forma financial statements. In addition, FAS 123R requires the Company to
reflect the cash savings resulting from excess tax benefits (i.e., the benefit
of the tax deduction for a share-based payment that exceeds the recognized
compensation cost for that award) in its financial statements as a financing
cash flow, rather than as an operating cash flow as in prior periods. Basic
earnings per share for the three and six months ended June 30, 2006 would have
been $0.35 and $0.62, respectively, if the Company had not adopted FAS 123R,
compared to reported basic earnings per share of $0.33 and $0.58, respectively.
For
grants made on or after January 1, 2006, the Company applied the non-substantive
vesting period approach, which requires recognition of compensation expense
from
the grant date to the earlier of the vesting date or the date retirement
eligibility is achieved for awards with retirement eligibility options. The
use
of the non-substantive vesting approach will not affect the overall amount
of
compensation expense recognized, but will accelerate the recognition of expense.
This resulted in $0.7 million in accelerated vesting of awards incurred during
the first quarter of 2006. In the first quarter of 2006, the Company recognized
$1.4 million in stock-based compensation expense in connection with the
accelerated vesting of awards as part of an executive retention agreement.
For
the remaining portion of awards that were unvested and granted prior to January
1, 2006, the Company will continue to follow the nominal vesting period
approach, and accordingly recognize the expense from the grant date to the
earlier of the actual date of retirement or the vesting date.
See
additional discussion in Notes 1 and 2 of the Notes
to Condensed Consolidated Financial Statements.
RECENT
ACCOUNTING STANDARDS
In
June
2006, the Financial Accounting Standards Board (“FASB”) issued interpretation of
FASB Statement No. 109, Accounting
for Uncertainty in Income Taxes (“FIN
48”). This interpretation clarifies the accounting for uncertainty in income
taxes recognized in an enterprise’s financial statements in accordance with FASB
Statement No. 109, Accounting
for Income Taxes. FIN
48
prescribes a recognition threshold and measurement attribute for the financial
statement recognition and measurement of a tax position taken or expected to
be
taken in a tax return. This Interpretation also provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure, and transition. This interpretation will be effective
January 1, 2007. The Company is currently assessing the effect of implementing
FIN 48.
FORWARD-LOOKING
STATEMENTS
This
report contains statements that constitute forward-looking information.
Investors are cautioned that these forward-looking statements are not guarantees
of future performance or results and involve risks and uncertainties, and that
actual results or developments may differ materially from the forward-looking
statements as a result of various factors. You should not rely on
forward-looking statements in this quarterly report on Form 10-Q.
Forward-looking statements are statements not based on historical information
and which relate to future operations, strategies, financial results or other
developments. You can usually identify forward-looking statements by terminology
such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,”
“estimate,” “predict,” “intend,” “potential,” or “continue” or with the negative
of these terms or other comparable terminology.
Although
we believe that the expectations reflected in these forward-looking statements
are reasonable, we cannot guarantee our future results, level of activity,
performance or achievements. Forward-looking statements include, among other
things, discussions concerning our potential expectations, beliefs, estimates,
forecasts, projections and assumptions. Forward-looking statements may address,
among other things:
|
·
|
Our
strategy for growth;
|
|
·
|
Our
expected combined ratio and growth of written
premiums;
|
|
·
|
Litigation,
regulatory environment and
approvals;
|
It
is
possible that our actual results, actions and financial condition may differ,
possibly materially, from the anticipated results, actions and financial
condition indicated in these forward-looking statements. Other important factors
that could cause our actual results and actions to differ, possibly materially,
from those in the specific forward-looking statements include those discussed
in
this report under the heading Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
as well
as:
|
·
|
The
effects of competition and competitors’ pricing
actions;
|
|
·
|
Changes
in consumer preferences or buying
habits;
|
|
·
|
Adverse
underwriting and claims experience;
|
|
·
|
Customer
service problems;
|
|
·
|
The
impact on our operations of natural disasters, principally earthquake,
or
civil disturbance, due to the concentration of our facilities and
employees in Southern California;
|
|
·
|
Information
system problems;
|
|
·
|
Control
environment failures;
|
|
·
|
Adverse
developments in financial markets or interest rates;
|
|
·
|
Results
of legislative, regulatory or legal actions, including the inability
to
obtain approval for necessary licenses, rate increases and product
changes
and possible adverse actions taken by state regulators in market
conduct
examinations and rate proceedings;
and
|
|
·
|
Our
ability to service the Senior Notes, including our ability to receive
dividends and/or sufficient payments from our subsidiaries to service
our
obligations.
|
We
do 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, we are exposed to other risks, including
the
credit risk related to the issuers of the financial instruments in which we
invest, the underlying insurance risk related to our core business and the
exposure of the personal lines insurance business, as a regulated industry,
to
legal, legislative, judicial, political and regulatory action. Financial
instruments are not used for trading purposes. The Company also obtained
long-term fixed rate financing as a means of increasing the statutory surplus
of
the Company’s largest insurance subsidiary in 2002 and 2003. The following
disclosure reflects estimated changes in value that may result from selected
hypothetical changes in market rates and prices. Actual results may
differ.
Our
cash
flow from operations and short-term cash position generally have been more
than
sufficient to meet our projected 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. The Company primarily invests in fixed maturity
investments.
Fixed
maturity financial instruments
For
all
of our fixed maturity investments, we seek to provide for liquidity and
diversification while maximizing income without sacrificing investment quality.
The value of the fixed maturity portfolio is subject to interest rate risk
where
the value of the fixed maturity portfolio decreases as market interest rates
increase, and conversely, when market interest rates decrease, the value of
the
fixed maturity portfolio increases. Duration is a common measure of the
sensitivity of a fixed maturity security’s value to changes in interest rates.
The higher the duration, the more sensitive a fixed maturity security is to
market interest rate fluctuations. Effective duration also measures this
sensitivity, but it takes into account call terms, as well as changes in
remaining term, coupon rate, cash flow, and other items.
Since
fixed maturity investments with longer remaining terms to maturity usually
tend
to realize higher yields, the Company’s investment philosophy through 2003
typically resulted in a portfolio with an effective duration of over 6 years.
Due to the changing interest rate environment in 2004, management, in
consultation with the Investment Committee, began targeting a lower duration
for
the Company’s fixed maturity investment portfolio to reduce the negative impact
of potential increases in interest rates. As
a
result, the effective duration of the fixed maturity portfolio declined from
4.7
years as of December 31, 2005 to 4.1 years at June 30, 2006.
The
graphical depiction of the relationship between the yield on bonds of the same
credit quality with different maturities is usually referred to as a yield
curve. Because the yield on U.S. Treasury securities is the base rate (or “risk
free rate”) from which non-government bond yields are normally benchmarked, the
most commonly constructed yield curve is derived from the observation of prices
and yields in the Treasury market. An upward sloping curve, where yield rises
steadily as maturity increases, is referred to as a normal yield
curve.
The
following table shows the carrying values of our fixed maturity investments,
which are reported at fair value, and our debt, which is reported at amortized
cost. The table also presents estimated fair values at adjusted market rates
assuming a parallel 100 basis point increase in market interest rates, given
the
effective duration noted above, for the fixed maturity investment portfolio
and
a parallel 100 basis point decrease in market interest rates for the debt
determined from a present value calculation. The following sensitivity analysis
summarizes only the exposure to market interest rate risk:
DOLLAR
AMOUNTS IN MILLIONS
June
30, 2006
|
|
Carrying
Value
|
Estimated
Carrying Value at Adjusted Market Rates/Prices Indicated
Above
|
Change
in Value as a Percentage of Carrying Value
|
Fixed
maturity investments available-for-sale, at fair value
|
|
$
|
1,426.7
|
|
$
|
1,362.7
|
|
|
(4.5
|
%)
|
Debt
|
|
|
121.6
|
|
|
128.2
|
|
|
5.4
|
%
|
The
discussion above provides only a limited, point-in-time view of the market
risk
sensitivity of our fixed rate financial instruments. The actual impact of
interest rate changes on our fixed maturity investments in particular may differ
significantly from those shown, as the analysis assumes a parallel shift in
market interest rates. The analysis also does not consider any actions we could
take in response to actual and/or anticipated changes in interest rates.
Market
participants usually refer to the difference between long-term Treasury yields
and short-term Treasury yields as the “slope” of the yield curve. If the spread
between the long end of the curve, where maturities are high, and the short
end
of the curve, where maturities are low, narrows, the yield curve is said to
be
“flattening”. Conversely, if the spread between the long end of the curve and
the short end of the curve widens, the yield curve is said to be “steepening”.
If the yields on the long end of the curve fall below those of the short end
of
the curve, the yield curve is said to be “inverted.”
The
analysis above assumes a parallel shift in interest rates. However, the curve
may also steepen, flatten or become inverted. This type of behavior may affect
certain sections of the curve in disproportionate amounts. For example, if
short-term Treasury yields rise and the yield curve flattens, fixed maturity
instruments with short duration may be impacted to a greater degree than fixed
maturity instruments with longer duration. Conversely, if long-term Treasury
yields rise and the yield curve steepens, fixed maturity instruments with long
duration may be impacted to a greater degree than fixed maturity instruments
with shorter duration. The following summarizes the effective duration
distribution of our fixed maturity investments portfolio.
|
|
Effective
Duration Ranges (in years)
|
June
30, 2006
|
|
Below
1
|
1
to 3
|
3
to 5
|
5
to 7
|
7
to 10
|
10
to 20
|
Market
value percentage of fixed maturity investment portfolio
|
|
|
1.5
|
%
|
|
16.5
|
%
|
|
58.1
|
%
|
|
21.0
|
%
|
|
1.8
|
%
|
|
1.1
|
%
|
ITEM
4. CONTROLS AND PROCEDURES
Evaluation
of Disclosure Controls and Procedures
We
have
established disclosure controls and procedures to ensure that material
information relating to the Company, including its consolidated subsidiaries,
is
made known to the officers who certify the Company’s financial reports and to
other members of senior management and the Board of Directors.
Based
on
their evaluation of the effectiveness of 21st Century Insurance Group’s
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934) as of June 30, 2006, the Principal
Executive Officer and Principal Financial Officer of 21st Century Insurance
Group have concluded that such disclosure controls and procedures are effective
to ensure that the information required to be disclosed by 21st Century
Insurance Group in reports that it files or submits under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within
the
time periods specified in SEC rules and forms.
Management,
with the participation of the Principal Executive Officer and Principal
Financial Officer, has evaluated any changes in 21st Century Insurance Group’s
internal control over financial reporting that occurred during the most recent
fiscal quarter. Based on the evaluation, management, including the Principal
Executive Officer and Principal Financial Officer, have concluded that no change
in our internal control over financial reporting (as defined in Rule 13a-15(f)
under the Securities Exchange Act of 1934) occurred during the quarter ended
June 30, 2006 that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.
Inherent
Limitations on Effectiveness of Controls
A
control
system, no matter how well designed and operated, can provide only reasonable,
not absolute, assurance that the control system’s objectives will be met.
Further, no evaluation of controls can provide absolute assurance that
misstatements due to error or fraud will not occur or that all control issues
and instances of fraud, if any, have been detected. These inherent limitations
include the realities that judgments in decision-making can be faulty and that
breakdowns can occur because of simple error or mistake. Controls can also
be
circumvented by the individual acts of some persons, or by collusion of two
or
more people.
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 claims and insurance policy issues, both on individual policy files
and by class actions seeking to attack the Company’s business practices. A
description of the legal proceedings to which the Company and its subsidiaries
are a party is contained in Note 4 of the Notes
to Condensed Consolidated Financial Statements.
There
are
no material changes from the risk factors previously disclosed in Part I of
Item
1A. in our Annual Report on Form 10-K for the fiscal year ended December 31,
2005, except as follows:
In
July
of 2006, the California Department of Insurance (the “CDI”) issued changes to
regulations relating to automobile insurance rating factors, particularly
concerning territorial rating (the “Auto Rating Factor Regulations”). The
previous regulation had been validated by a court decision. The new rules
require automobile insurance companies to make a class plan and rate filing
during the third quarter to bring their automobile insurance rates in California
into compliance with the Auto Rating Factor Regulations. Litigation to enjoin
the implementation of the Auto Rating Factor Regulations and have them declared
in violation of California law has been instituted by insurance trade
organizations and other parties. If the litigation is not successful in
preliminarily enjoining implementation of the Auto Rating Factor Regulations,
the Company's class plan and rate filings will be reviewed by the CDI. The
CDI
may or may not approve the Company’s class plan and rate filings. If not
approved, further administrative and legal proceedings related specifically
to
the Company may be required to resolve any dispute. As a result of such
proceedings, the Company could ultimately be required to make changes in the
structure of its rating plans and/or the level of its overall rates that it
believes are actuarially unsound. In addition, because the new Auto Rating
Factor Regulations require every company to make a rate filing in the third
quarter of 2006, competitive rate levels may change and consumer shopping
behavior may increase in the future. It is not possible at this time to predict
the ultimate timing or impact of these proceedings and changes, which could
have
either a materially favorable or materially adverse impact on the
Company.
Also
in
July 2006, the CDI proposed new amended rate approval regulations (the “Rate
Approval Regulations”) that would determine how insurance rates for personal
auto and most other lines of personal and commercial property and casualty
lines
of business are established in California. Multiple changes from the current
regulations include capping the maximum permitted after-tax rate of return
at
11% of derived capital for all affected lines of insurance and use of a complete
formula with established generic factors to determine the maximum rates that
may
be charged. The proposed amended Rate Approval Regulations provide for several
“variances” from the rates specified by the formula. A hearing on the proposed
Rate Approval Regulations is scheduled for September 13, 2006, after which
the
CDI could propose further changes or seek to have them implemented. The Company
is currently reviewing the proposal in its entirety to determine its impact,
but
the proposed Rate Approval Regulations, if approved without modification, could
have a materially adverse impact on the Company’s results.
ITEM
2. UNREGISTERED SALES OF EQUITY 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.
See
accompanying exhibit index.
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:
|
July
26, 2006
|
|
/s/
Bruce W. Marlow
|
|
|
BRUCE
W. MARLOW
|
|
|
President
and Chief Executive Officer
|
|
|
(Principal
Executive Officer)
|
|
|
|
|
|
|
|
|
Date:
|
July
26, 2006
|
|
/s/
Steven P. Erwin
|
|
|
STEVEN
P. ERWIN
|
|
|
Senior
Vice President and Chief Financial Officer
|
|
|
(Principal
Financial Officer)
|
Exhibit
No.
|
Description
|
|
Certification
of Principal Executive Officer Pursuant to Exchange Act Rule
13a-14(a).
|
|
Certification
of Principal Financial Officer Pursuant to Exchange Act Rule
13a-14(a).
|
|
Certification
Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
906 of
the Sarbanes-Oxley Act of 2002.
|
40