21st Century Insurance 10-Q 9-30-2006
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 September 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 October 23, 2006
was 86,377,135.
Description |
Page
Number
|
PART
I - FINANCIAL INFORMATION
|
|
Item
1.
|
|
2
|
Item
2.
|
|
19
|
Item
3.
|
|
36
|
Item
4.
|
|
37
|
PART
II - OTHER INFORMATION
|
|
Item
1.
|
|
38
|
Item
1A.
|
|
38
|
Item
6.
|
|
38
|
|
39
|
|
40
|
31.1
|
Certification
of principal executive officer pursuant to Rule 13a-14(a)
under the Securities Exchange Act of 1934
|
|
31.2 |
Certification
of principal financial officer pursuant to Rule 13a-14(a) under the
Securities Exchange Act of 1934
|
|
32
|
Certification
Pursuant to 18 U.S.C. Section 1350
|
|
PART
I - FINANCIAL INFORMATION
ITEM
1. FINANCIAL STATEMENTS
21ST
CENTURY INSURANCE GROUP
|
|
|
|
|
|
CONDENSED
CONSOLIDATED BALANCE SHEETS
|
|
|
|
|
|
Unaudited
|
|
|
|
|
|
AMOUNTS
IN THOUSANDS, EXCEPT SHARE DATA
|
|
September
30,
2006
|
December
31,
2005
|
Assets
|
|
|
|
|
|
Investments
available for sale
|
|
|
|
|
|
Fixed
maturity securities, at fair value (amortized cost: $1,487,873 and
$1,365,948)
|
|
$
|
1,470,385
|
|
$
|
1,354,707
|
|
Equity
securities, at fair value (cost: $0 and $49,210)
|
|
|
—
|
|
|
47,367
|
|
Other
long-term investments, equity method
|
|
|
9,443
|
|
|
—
|
|
Total
investments
|
|
|
1,479,828
|
|
|
1,402,074
|
|
Cash
and cash equivalents
|
|
|
19,497
|
|
|
68,668
|
|
Accrued
investment income
|
|
|
17,006
|
|
|
16,585
|
|
Premiums
receivable
|
|
|
115,513
|
|
|
100,900
|
|
Reinsurance
receivables and recoverables
|
|
|
6,550
|
|
|
6,539
|
|
Prepaid
reinsurance premiums
|
|
|
2,141
|
|
|
1,946
|
|
Deferred
income taxes
|
|
|
42,566
|
|
|
56,209
|
|
Deferred
policy acquisition costs
|
|
|
67,592
|
|
|
59,939
|
|
Leased
property under capital leases, net of deferred gain of $1,203 and
$1,534
and net of accumulated amortization of $40,853 and $36,995
|
|
|
19,998
|
|
|
22,651
|
|
Property
and equipment, at cost less accumulated depreciation of $105,780
and
$89,595
|
|
|
152,480
|
|
|
145,811
|
|
Other
assets
|
|
|
40,277
|
|
|
38,907
|
|
Total
assets
|
|
$
|
1,963,448
|
|
$
|
1,920,229
|
|
Liabilities
and stockholders’ equity
|
|
|
|
|
|
|
|
Unpaid
losses and loss adjustment expenses
|
|
$
|
484,258
|
|
$
|
523,835
|
|
Unearned
premiums
|
|
|
329,719
|
|
|
319,676
|
|
Debt
|
|
|
118,853
|
|
|
127,972
|
|
Claims
checks payable
|
|
|
39,697
|
|
|
42,681
|
|
Reinsurance
payable
|
|
|
769
|
|
|
643
|
|
Other
liabilities
|
|
|
92,529
|
|
|
75,450
|
|
Total
liabilities
|
|
|
1,065,825
|
|
|
1,090,257
|
|
|
|
|
|
|
|
|
|
Commitments
and contingencies
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stockholders’
equity:
|
|
|
|
|
|
|
|
Common
stock, par value $0.001 per share; 110,000,000 shares authorized;
shares
issued 86,381,472 and 85,939,889
|
|
|
86
|
|
|
86
|
|
Additional
paid-in capital
|
|
|
438,618
|
|
|
425,454
|
|
Treasury
stock; at cost shares: 8,804 and 5,929
|
|
|
(106
|
)
|
|
(84
|
)
|
Retained
earnings
|
|
|
472,271
|
|
|
414,898
|
|
Accumulated
other comprehensive loss
|
|
|
(13,246
|
)
|
|
(10,382
|
)
|
Total
stockholders’ equity
|
|
|
897,623
|
|
|
829,972
|
|
Total
liabilities and stockholders’ equity
|
|
$
|
1,963,448
|
|
$
|
1,920,229
|
|
See
accompanying Notes to Condensed Consolidated Financial
Statements.
21ST
CENTURY INSURANCE GROUP
|
|
|
|
|
|
|
|
CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS
Unaudited
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three
Months Ended
September
30,
|
Nine
Months Ended
September
30,
|
AMOUNTS
IN THOUSANDS, EXCEPT SHARE DATA
|
|
2006
|
2005
|
2006
|
2005
|
Revenues
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
327,325
|
|
$
|
344,102
|
|
$
|
978,661
|
|
$
|
1,017,311
|
|
Net
investment income
|
|
|
16,897
|
|
|
17,042
|
|
|
51,827
|
|
|
51,085
|
|
Other
income (loss)
|
|
|
58
|
|
|
(3
|
)
|
|
68
|
|
|
364
|
|
Net
realized investment gains (losses)
|
|
|
159
|
|
|
(939
|
)
|
|
(878
|
)
|
|
(2,666
|
)
|
Total
revenues
|
|
|
344,439
|
|
|
360,202
|
|
|
1,029,678
|
|
|
1,066,094
|
|
Losses
and expenses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
losses and loss adjustment expenses
|
|
|
222,550
|
|
|
258,105
|
|
|
682,140
|
|
|
757,420
|
|
Policy
acquisition costs
|
|
|
64,803
|
|
|
60,852
|
|
|
189,022
|
|
|
188,931
|
|
Other
underwriting expenses
|
|
|
12,715
|
|
|
8,786
|
|
|
34,819
|
|
|
24,908
|
|
Other
expense
|
|
|
—
|
|
|
—
|
|
|
924
|
|
|
—
|
|
Interest
and fees expense
|
|
|
1,820
|
|
|
1,988
|
|
|
5,572
|
|
|
6,076
|
|
Total
losses and expenses
|
|
|
301,888
|
|
|
329,731
|
|
|
912,477
|
|
|
977,335
|
|
Income
before provision for income taxes
|
|
|
42,551
|
|
|
30,471
|
|
|
117,201
|
|
|
88,759
|
|
Provision
for income taxes
|
|
|
14,144
|
|
|
9,369
|
|
|
39,155
|
|
|
27,725
|
|
Net
income
|
|
$
|
28,407
|
|
$
|
21,102
|
|
$
|
78,046
|
|
$
|
61,034
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Earnings
per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
0.33
|
|
$
|
0.25
|
|
$
|
0.91
|
|
$
|
0.71
|
|
Diluted
|
|
$
|
0.33
|
|
$
|
0.24
|
|
$
|
0.90
|
|
$
|
0.71
|
|
Cash
dividends declared per share
|
|
$
|
0.08
|
|
$
|
0.04
|
|
$
|
0.24
|
|
$
|
0.12
|
|
Weighted-average
shares outstanding:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
86,192,395
|
|
|
85,793,904
|
|
|
86,010,994
|
|
|
85,672,993
|
|
Additional
common shares assumed issued under treasury stock method
|
|
|
262,114
|
|
|
411,695
|
|
|
390,035
|
|
|
264,823
|
|
Diluted
|
|
|
86,454,509
|
|
|
86,205,599
|
|
|
86,401,029
|
|
|
85,937,816
|
|
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)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
78,046
|
(1)
|
|
(2,864
|
)(2)
|
|
75,182
|
|
Cash
dividends declared on common stock
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(20,673
|
)
|
|
|
|
|
(20,673
|
)
|
Exercise
of stock options
|
|
|
325,033
|
|
|
|
|
|
4,250
|
|
|
|
|
|
|
|
|
|
|
|
4,250
|
|
Issuance
of restricted stock
|
|
|
116,550
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
—
|
|
Forfeiture
of 2,875 shares of restricted stock
|
|
|
|
|
|
|
|
|
22
|
|
|
(22
|
)
|
|
|
|
|
|
|
|
—
|
|
Stock-based
compensation cost
|
|
|
|
|
|
|
|
|
8,752
|
|
|
|
|
|
|
|
|
|
|
|
8,752
|
|
Excess
tax benefits of stock-based compensation
|
|
|
|
|
|
|
|
|
140
|
|
|
|
|
|
|
|
|
|
|
|
140
|
|
Balance
- September 30, 2006
|
|
|
86,381,472
|
|
$
|
86
|
|
$
|
438,618
|
|
$
|
(106
|
)
|
$
|
472,271
|
|
$
|
(13,246
|
)
|
$
|
897,623
|
|
(1) |
Net
income for the nine months ended September 30,
2006.
|
(2)
|
Net
change in accumulated other comprehensive loss
follows:
|
|
|
Nine
Months Ended
September
30, 2006
|
Unrealized
holding losses arising during the period, net of tax benefit of
$1,844
|
|
$
|
(3,423
|
)
|
Reclassification
adjustment for investment losses included in net income, net of
tax
benefit of $301
|
|
|
559
|
|
Total
|
|
$
|
(2,864
|
)
|
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
|
|
|
|
Nine
Months Ended September 30,
|
|
2006
|
2005
|
Operating
activities
|
|
|
|
|
|
Net
income
|
|
$
|
78,046
|
|
$
|
61,034
|
|
Adjustments
to reconcile net income to net cash provided by operating
activities:
|
|
|
|
|
|
|
|
Depreciation
and amortization
|
|
|
20,393
|
|
|
24,502
|
|
Net
amortization of investment premiums and discounts
|
|
|
7,318
|
|
|
7,205
|
|
Stock-based
compensation cost
|
|
|
8,752
|
|
|
238
|
|
Provision
for deferred income taxes
|
|
|
15,185
|
|
|
10,687
|
|
Net
realized investment losses
|
|
|
878
|
|
|
2,779
|
|
Changes
in assets and liabilities
|
|
|
|
|
|
|
|
Premiums
receivable
|
|
|
(14,613
|
)
|
|
(11,166
|
)
|
Deferred
policy acquisition costs
|
|
|
(7,653
|
)
|
|
(5,001
|
)
|
Reinsurance
receivables and recoverables
|
|
|
(80
|
)
|
|
1,193
|
|
Federal
income taxes
|
|
|
(5,540
|
)
|
|
(1,088
|
)
|
Other
assets
|
|
|
1,531
|
|
|
6,723
|
|
Unpaid
losses and loss adjustment expenses
|
|
|
(39,577
|
)
|
|
22,072
|
|
Unearned
premiums
|
|
|
10,043
|
|
|
9,019
|
|
Claims
checks payable
|
|
|
(2,984
|
)
|
|
1,974
|
|
Other
liabilities
|
|
|
12,551
|
|
|
(7,802
|
)
|
Net
cash provided by operating activities
|
|
|
84,250
|
|
|
122,369
|
|
Investing
activities
|
|
|
|
|
|
|
|
Purchases
of:
|
|
|
|
|
|
|
|
Fixed
maturity securities available-for-sale
|
|
|
(228,027
|
)
|
|
(94,020
|
)
|
Equity
securities available-for-sale
|
|
|
(35,627
|
)
|
|
(239,493
|
)
|
Other
long-term investments, equity method
|
|
|
(9,123
|
)
|
|
—
|
|
Property
and equipment
|
|
|
(23,315
|
)
|
|
(32,539
|
)
|
Maturities
and calls of fixed maturity securitites available-for-sale
|
|
|
23,726
|
|
|
24,461
|
|
Sales
of:
|
|
|
|
|
|
|
|
Fixed
maturity securities available-for-sale
|
|
|
73,765
|
|
|
28,943
|
|
Equity
securities available-for-sale
|
|
|
84,836
|
|
|
233,884
|
|
Net
cash used in investing activities
|
|
|
(113,765
|
)
|
|
(78,764
|
)
|
Financing
activities
|
|
|
|
|
|
|
|
Repayment
of debt
|
|
|
(10,283
|
)
|
|
(9,343
|
)
|
Dividends
paid (per share: $0.16 and $0.08)
|
|
|
(13,763
|
)
|
|
(6,850
|
)
|
Proceeds
from the exercise of stock options
|
|
|
4,250
|
|
|
3,155
|
|
Excess
tax benefit from stock-based compensation
|
|
|
198
|
|
|
—
|
|
Excess
tax liability from stock-based compensation
|
|
|
(58
|
)
|
|
—
|
|
Net
cash used in financing activities
|
|
|
(19,656
|
)
|
|
(13,038
|
)
|
Net
(decrease) increase in cash and cash equivalents
|
|
|
(49,171
|
)
|
|
30,567
|
|
Cash
and cash equivalents, beginning of period
|
|
|
68,668
|
|
|
34,697
|
|
Cash
and cash equivalents, end of period
|
|
$
|
19,497
|
|
$
|
65,264
|
|
|
|
|
|
|
|
|
|
Supplemental
information:
|
|
|
|
|
|
|
|
Income
taxes paid
|
|
$
|
29,580
|
|
$
|
19,281
|
|
Interest
paid
|
|
|
3,991
|
|
|
4,495
|
|
See
accompanying Notes to Condensed Consolidated Financial
Statements.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
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 nine-month period ended
September 30, 2006 are not necessarily indicative of results that may be
expected for the remaining interim period or the year as a whole.
Other
long-term investments, equity method
The
Company started investing in limited partnerships and limited liability
corporations during the third quarter of 2006, as further discussed in Note
9 of
the Notes
to Condensed Consolidated Financial Statements.
Since
our share of a partnership’s or corporation’s capital is greater than 3%, but
less than 50%, we account for these investments on the equity method, and the
carrying values of our investments are adjusted to reflect our share of the
underlying equity of the partnerships or corporations, as applicable.
Earnings
Per Share (“EPS”)
The
numerator for the calculation of both basic and diluted EPS 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 EPS excludes dilution and reflects net income divided
by the weighted-average shares of common stock outstanding during the periods
presented. Diluted EPS 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 were computed using the treasury stock method.
The
following shares attributable to outstanding stock options and restricted shares
were excluded from the calculation of diluted earnings per share because their
inclusion would have been anti-dilutive (i.e., their inclusion under the
treasury stock method would have increased EPS):
|
|
Three
Months Ended
September
30,
|
Nine
Months Ended
September
30,
|
|
|
2006
|
2005
|
2006
|
2005
|
Common
stock equivalents excluded from calculation of diluted EPS
|
|
|
6,149,111
|
|
|
4,501,547
|
|
|
5,625,501
|
|
|
6,395,088
|
|
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
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. 25 (“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 the closing market price on the grant
date. 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 condensed consolidated financial statement
footnotes.
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 forfeitures differ significantly from our 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 provisions. The use of the
non-substantive vesting period approach will not affect the overall amount
of
compensation expense recognized, but will accelerate the recognition of expense
for grants made since January 1, 2006. However, the Company will continue to
follow the nominal vesting approach (i.e., recognize expense from the grant
date
to the earlier of the actual date of retirement or the vesting date) for the
remaining portion of unvested awards that were granted prior to January 1,
2006.
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 restricted
share grant or share option exercise, 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.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
Recent
Accounting Pronouncements
In
September 2006, Financial
Accounting Standards Board (“FASB”)
issued
FAS 158,
Employers’
Accounting for Defined Benefit Pension and Other Postretirement Plans - an
Amendment of FASB Statements No. 87, 88, 106 and 132(R)
("FAS
158"). FAS 158 requires an employer that is a business entity and sponsors
one
or more single employer benefit plans to (1) recognize the funded
status of the benefit in its statement of financial position, (2) recognize
as a
component of other comprehensive income, net of tax, the gains or
losses
and prior service costs or credits that arise during the period, but are not
recognized as components of net periodic benefit cost, (3) measure defined
benefit plan assets and obligations as of the date of the employer's fiscal
year
end statement of financial position and (4) disclose in the notes to
financial statements additional information about certain effects on net
periodic benefit cost for the next fiscal year that arise from
delayed recognition
of the gains or losses, prior service costs on credits, and transition asset
or
obligations. Under
FAS
158, the Company will be required to recognize the funded status of its defined
benefit plans and to provide the required disclosures as of December 31,
2006.
However,
had we been required to adopt the provisions of FAS 158 as of September 30,
2006, the estimated cumulative impact on the Company’s condensed consolidated
financial statements as a result of the adoption of this standard would have
resulted in an approximate $17
million net after-tax reduction in equity with a corresponding reduction
of $7.8 million in total assets, and an increase of $9.3 million in total
liabilities. Because our net pension liabilities are dependent
upon future events and circumstances, the impact at the time of adoption of
FAS
158 may differ from these amounts. Adoption of FAS 158 will not
have
any effect on the Company's compliance with its financial
covenants.
In
September 2006, the FASB issued FAS 157, Fair
Value Measurements
(“FAS
157”). FAS 157 clarifies the principle that fair value should be based on the
assumptions market participants would use when pricing an asset or liability
and
establishes a fair value hierarchy that prioritizes the information used to
develop those assumptions. Under the standard, fair value measurements would
be
separately disclosed by level within the fair value hierarchy. FAS 157 is
effective for financial statements issued for fiscal years beginning
after November 15, 2007 and interim periods within those fiscal years, with
early adoption permitted. The Company has not yet determined the effect, if
any,
that the implementation of FAS 157 will have on our results of operations or
financial condition.
In
September 2006, the Securities and Exchange Commission (“SEC”) issued Staff
Accounting Bulletin No. 108, Considering
the Effects of Prior Year Misstatements when Quantifying Misstatements in
Current Year Financial Statements
(“SAB
108”). SAB 108 provides interpretive guidance on how the effects of the
carryover or reversal of prior year misstatements should be considered in
quantifying a current year misstatement. The SEC staff believes that registrants
should quantify errors using both a balance sheet and an income statement
approach and evaluate whether either approach results in quantifying a
misstatement that, when all relevant quantitative and qualitative factors are
considered, is material. SAB 108 is effective for the Company’s fiscal year
ending December 31, 2006. We do not expect SAB 108 to have a material impact
on
our consolidated financial statements.
FASB
Financial Interpretation No. 48, Accounting
for Uncertainty in Income Taxes - an Interpretation of FAS No. 109
(“FIN
48”), becomes effective January 1, 2007. This interpretation clarifies the
accounting for uncertainty in income taxes recognized in an enterprise’s
financial statements in accordance with FAS 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. The Company is currently assessing the
effect of implementing FIN 48.
Statement
of Position 05-1,
Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection
with Modifications or Exchanges of Insurance Contracts
(“SOP
05-1”),
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 No. 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)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
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 is as follows:
|
|
Three
Months Ended
September
30, 2006
|
|
Nine
Months Ended
September
30, 2006
|
AMOUNTS
IN THOUSANDS, EXCEPT PER SHARE DATA
|
|
Without
FAS
123R
|
FAS
123R
Impact
|
With
FAS
123R
|
|
Without
FAS
123R
|
FAS
123R
Impact
|
With
FAS
123R
|
Total
revenues
|
|
$
|
344,439
|
|
$
|
—
|
|
$
|
344,439
|
|
|
$
|
1,029,678
|
|
$
|
—
|
|
$
|
1,029,678
|
|
Losses
and expenses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
losses and loss adjustment expenses
|
|
|
221,767
|
|
|
783
|
|
|
222,550
|
|
|
|
679,464
|
|
|
2,676
|
|
|
682,140
|
|
Policy
acquisition costs
|
|
|
63,893
|
|
|
910
|
|
|
64,803
|
|
|
|
187,177
|
|
|
1,845
|
|
|
189,022
|
|
Other
underwriting expenses
|
|
|
12,184
|
|
|
531
|
|
|
12,715
|
|
|
|
32,019
|
|
|
2,800
|
|
|
34,819
|
|
Other
expense
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
|
924
|
|
|
—
|
|
|
924
|
|
Interest
and fees expense
|
|
|
1,820
|
|
|
—
|
|
|
1,820
|
|
|
|
5,572
|
|
|
—
|
|
|
5,572
|
|
Total
losses and expenses
|
|
|
299,664
|
|
|
2,224
|
|
|
301,888
|
|
|
|
905,156
|
|
|
7,321
|
|
|
912,477
|
|
Income
before provision for income taxes
|
|
|
44,775
|
|
|
(2,224
|
)
|
|
42,551
|
|
|
|
124,522
|
|
|
(7,321
|
)
|
|
117,201
|
|
Provision
for income taxes
|
|
|
14,876
|
|
|
(732
|
)
|
|
14,144
|
|
|
|
40,932
|
|
|
(1,777
|
)
|
|
39,155
|
|
Net
income
|
|
$
|
29,899
|
1 |
$
|
(1,492
|
)
|
$
|
28,407
|
|
|
$
|
83,590
|
1 |
$
|
(5,544
|
)
|
$
|
78,046
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
earnings per share 2
|
|
$
|
0.35
|
|
$
|
(0.02
|
)
|
$
|
0.33
|
|
|
$
|
0.97
|
|
$
|
(0.06
|
)
|
$
|
0.91
|
|
Diluted
earnings per share 2
|
|
$
|
0.35
|
|
$
|
(0.02
|
)
|
$
|
0.33
|
|
|
$
|
0.97
|
|
$
|
(0.06
|
)
|
$
|
0.90
|
|
The
nine
months ended September 30, 2006 results include $0.7 million 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
$1.4 million of actual vesting in accordance with an executive retention
agreement. As compensation costs for certain employees are included in deferred
policy acquisition costs, pre-tax compensation cost related to stock-based
compensation of $0.8 million was deferred, for the nine months ended September
30, 2006. The remaining unrecognized compensation cost related to unvested
awards as of September 30,
2006,
was $11.3 million and the weighted-average period over which this cost will
be
recognized is 1.9 years. Results for the nine-month period ended September
30,
2006 included $140 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 $1.2 million and $3.7
million for
the
three and nine months ended September 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
$0.2 million and $0.7 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
nine months ended September 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)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
The
pro
forma net income and earnings per share amounts follow:
AMOUNTS
IN THOUSANDS, EXCEPT SHARE DATA
|
|
Three
Months Ended
September
30, 2005
|
Nine
Months Ended
September
30, 2005
|
Net
income, as reported
|
|
$
|
21,102
|
|
$
|
61,034
|
|
Add:
Stock-based employee compensation expense included in reported
net income,
net of related tax effects
|
|
|
65
|
|
|
155
|
|
Deduct:
Total stock-based employee compensation expense determined under
fair-value based method for all awards, net of related tax
effects
|
|
|
(1,278
|
)
|
|
(3,844
|
)
|
Net
income, pro forma
|
|
$
|
19,889
|
|
$
|
57,345
|
|
Basic
earnings per share:
|
|
|
|
|
|
|
|
As
reported
|
|
$
|
0.25
|
|
$
|
0.71
|
|
Pro
forma
|
|
$
|
0.23
|
|
$
|
0.67
|
|
Diluted
earnings per share:
|
|
|
|
|
|
|
|
As
reported
|
|
$
|
0.24
|
|
$
|
0.71
|
|
Pro
forma
|
|
$
|
0.23
|
|
$
|
0.67
|
|
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
September 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
|
|
|
(1,001
|
)
|
|
(210
|
)
|
Number
of securities issuable upon the exercise of all outstanding
options
|
|
|
(6,683
|
)
|
|
(3,545
|
)
|
Number
of securities forfeited
|
|
|
(2,601
|
)
|
|
(151
|
)
|
Number
of forfeited securities returned to plan
|
|
|
2,601
|
|
|
151
|
|
Unused
options assumed by 2004 Stock Option Plan
|
|
|
(2,316
|
)
|
|
2,316
|
|
Number
of securities available for future grants under each plan
|
|
|
—
|
|
|
2,561
|
|
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
Current
Activity
A
summary
of the Company’s stock option activity for the nine months ended September 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
|
|
|
2,012
|
|
|
16.54
|
|
Exercised
in 2006
|
|
|
(325
|
)
|
|
13.08
|
|
Forfeited
in 2006
|
|
|
(88
|
)
|
|
14.38
|
|
Canceled
in 2006
|
|
|
(240
|
)
|
|
19.49
|
|
Options
outstanding September 30, 2006
|
|
|
10,228
|
|
|
16.32
|
|
A
summary
of the Company’s stock option activity and related information for the nine
months ended September 30, follows:
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
Fair
value of stock options granted
|
|
$
|
10,040
|
|
$
|
8,186
|
|
Intrinsic
value of options exercised
|
|
|
566
|
|
|
590
|
|
Grant
date fair value of options vested
|
|
|
7,428
|
|
|
5,288
|
|
Proceeds
from exercise of stock options
|
|
|
4,250
|
|
|
3,155
|
|
Tax
benefit realized as a result of stock option exercises
|
|
|
198
|
|
|
247
|
|
Black-Scholes
Fair Values
The
weighted-average fair value per option granted during the nine months ended
September 30, 2006 and 2005, was $4.99 and $4.75, respectively. 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:
Nine
Months Ended September 30,
|
|
2006
|
2005
Pro
Forma
|
Risk-free
interest rate:
|
|
|
|
|
|
Minimum
|
|
|
4.5
|
%
|
|
3.7
|
%
|
Maximum
|
|
|
5.0
|
%
|
|
4.3
|
%
|
Dividend
yield
|
|
|
1.9
|
%
|
|
1.1
|
%
|
Volatility
factor of the expected market price of the Company’s common
stock:
|
|
|
|
|
|
|
|
Minimum
|
|
|
0.29
|
|
|
0.29
|
|
Maximum
|
|
|
0.29
|
|
|
0.32
|
|
Expected
option term
|
|
|
6
years
|
|
|
6
years
|
|
The
expected term for options granted during the nine months ended September 30,
2006, was calculated using the simplified method in accordance with Staff
Accounting Bulletin No. 107, Shared-Based
Payment.
The
expected volatility of employee stock options was based on the historical
volatility of key competitors in the property and 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
California Senate Bill 1899 (“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)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
Outstanding
Options
The
following table summarizes information about stock options outstanding at
September 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
|
|
|
1,240
|
|
|
6.5
Years
|
|
$
|
11.73
|
|
$
|
3,991
|
|
|
|
1,235
|
|
|
6.5
Years
|
|
$
|
11.73
|
|
$
|
3,980
|
|
13.01
- 15.00
|
|
|
2,839
|
|
|
7.5
Years
|
|
|
14.28
|
|
|
1,894
|
|
|
|
1,409
|
|
|
7.5
Years
|
|
|
14.31
|
|
|
907
|
|
15.01
- 17.00
|
|
|
3,349
|
|
|
7.8
Years
|
|
|
16.38
|
|
|
—
|
|
|
|
1,489
|
|
|
6.1
Years
|
|
|
16.18
|
|
|
—
|
|
17.01
- 19.00
|
|
|
1,776
|
|
|
4.0
Years
|
|
|
18.05
|
|
|
—
|
|
|
|
1,776
|
|
|
4.0
Years
|
|
|
18.05
|
|
|
—
|
|
19.01
- 22.00
|
|
|
131
|
|
|
1.5
Years
|
|
|
19.65
|
|
|
—
|
|
|
|
131
|
|
|
1.5
Years
|
|
|
19.65
|
|
|
—
|
|
22.01
- 29.25
|
|
|
893
|
|
|
1.9
Years
|
|
|
24.99
|
|
|
—
|
|
|
|
893
|
|
|
1.9
Years
|
|
|
24.99
|
|
|
—
|
|
$
11.68 - 29.25
|
|
|
10,228
|
|
|
6.3
Years
|
|
|
16.32
|
|
$
|
5,885
|
|
|
|
6,933
|
|
|
5.3
Years
|
|
|
16.69
|
|
$
|
4,887
|
|
The
aggregate intrinsic value in the preceding table represents the pre-tax amount
that would have been received by the option holders had all option holders
exercised their options as of September 30, 2006. Vested and expected-to-vest
options as of September 30, 2006, included in the table above, totaled
10,147,276 with a weighted-average exercise price of $16.33, a weighted-average
contractual life of 6.2 years and an aggregate intrinsic value of $5.9
million.
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 $0.2 million
and
$0.7 million for the three and nine months ended September 30, 2006,
respectively, and $0.1 million and $0.2 million for the three and nine months
ended September 30, 2005. Unrecognized compensation cost in connection with
restricted stock grants totaled $1.9 million at September 30, 2006. The cost
is
expected to be recognized over a weighted-average period of 2.2
years.
Restricted
Shares Issuable and Issued
A
summary
of securities issuable and issued for the Company’s Restricted Shares Plan at
September 30, 2006, follows:
AMOUNTS
IN THOUSANDS
|
|
Restricted
Shares
Plan
|
Total
number of securities authorized
|
|
|
1,422
|
|
Number
of securities issued
|
|
|
(1,260
|
)
|
Number
of forfeited securities returned to plan
|
|
|
164
|
|
Number
of securities remaining available for future grants under the
plan
|
|
|
326
|
|
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
Current
Restricted Shares Activity
The
following table summarizes activity under the Restricted Shares Plan for the
nine months ended September 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
|
|
|
117
|
|
|
15.83
|
|
Forfeited
in 2006
|
|
|
(3
|
)
|
|
15.65
|
|
Non-vested,
September 30, 2006
|
|
|
168
|
|
|
15.22
|
|
A
summary
of the Restricted Shares Plan activity and related information
follows:
|
|
Three
Months Ended
September
30,
|
Nine
Months Ended
September
30,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
2006
|
2005
|
Fair
value of restricted stock awards granted
|
|
$
|
121
|
|
$
|
—
|
|
$
|
1,845
|
|
$
|
1,267
|
|
Fair
value of restricted stock awards vested
|
|
|
—
|
|
|
29
|
|
|
475
|
|
|
212
|
|
SHARE
DATA
|
|
|
|
|
|
|
|
|
|
Weighted-average
fair value per share for restricted shares granted
|
|
$
|
15.11
|
|
$
|
—
|
|
$
|
15.83
|
|
$
|
14.09
|
|
NOTE
3. HOMEOWNER AND EARTHQUAKE LINES IN RUNOFF
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 SB 1899 have been resolved. The
Company’s total reserves for losses and loss adjustment expenses (“LAE”) for SB
1899 claims as of September 30, 2006 and December 31, 2005, were less than
$0.1
million and $0.5 million, respectively.
Losses
and LAE incurred for the homeowner and earthquake lines in runoff were $0.2
million and $0.5 million for the three and nine months ended September 30,
2006,
compared to $0.6 million and $1.0 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 its insurance operations and 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 the possibility of 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.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
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.
Poss
v. 21st Century Insurance Company was
filed
on June 13, 2003, in Los Angeles Superior Court and Axen
v. 21st Century Insurance Company
was
filed on April 14, 2004 in Alameda County Superior Court. Both complaints seek
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. The court in the Poss
case
granted the Company’s motion to dismiss the complaint, based on California’s
Proposition 64, but allowed the addition of a second plaintiff, Leacy. Discovery
has been stayed in both cases and, because these matters are 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 $2.1 million.
This matter is now subject to three separate appeals by the parties. The Company
moved to consolidate the three appeals on October 18, 2006.
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 contended that the
Company uses “biased” software in determining the value of total-loss
automobiles. Specifically, Plaintiff alleged 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 was ordered. On October 13, 2006, Plaintiff’s counsel
offered to dismiss this case, with prejudice, in exchange for the Company
waiving its costs. The Company has accepted Plaintiff’s counsel’s offer to
dismiss the matter and will support a motion, containing the agreed terms,
for
the court to dismiss the action.
Thomas
Theis, on his own behalf and on behalf of all others similarly situated v.
21st
Century Insurance Company
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.
A motion for certification of a class in this action is currently
pending.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
Silvia
Quintana, on her own behalf and on behalf of all others similarly situated
v.
21st Century Insurance Company
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 pleading stage and no
reasonable estimate of potential losses in the event of a negative outcome
can
be made at this time. In July 2006, the trial court denied the Company’s
demurrer and motion to strike and the Company has filed a writ to the Court
of
Appeal for review of this decision.
Ronald
A.Katz Technology Licensing, L.P. vs. American International Group, Inc. et
al was
filed
on September 1, 2006, in the United States District Court for the District
of
Delaware. The defendants include American International Group, Inc., its
subsidiaries and affiliates, including 21st Century Insurance Group, 21st
Century Insurance Company, and 21st Century Casualty Company. The complaint
alleges infringement of various patents relating to automated call processing
applications. The matter is in the initial pleading stage 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
after-tax changes in unrealized gains and losses and changes in minimum pension
liability in excess of unamortized prior service cost.
A
summary
of accumulated other comprehensive loss follows:
|
|
September
30,
2006
|
December
31,
2005
|
Net
unrealized losses on available-for-sale investments, net of deferred
income taxes of $6,120 and $4,579
|
|
$
|
(11,368
|
)
|
$
|
(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
|
|
$
|
(13,246
|
)
|
$
|
(10,382
|
)
|
NOTE
6.
EMPLOYEE BENEFIT PLANS
The
Company has a qualified defined benefit pension plan, which covers essentially
all employees who have completed at least one year of service. The pension
benefits under the qualified plan 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; employees
may
not make contributions to this plan. 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.
Components
of Net Periodic Cost
Net
pension costs for all plans were as follows:
|
|
Three
Months Ended
September
30,
|
Nine
Months Ended
September
30,
|
|
|
2006
|
2005
|
2006
|
2005
|
Service
cost
|
|
$
|
1,782
|
|
$
|
1,620
|
|
$
|
5,347
|
|
$
|
5,145
|
|
Interest
cost
|
|
|
1,935
|
|
|
1,763
|
|
|
5,804
|
|
|
5,473
|
|
Expected
return on plan assets
|
|
|
(2,110
|
)
|
|
(1,827
|
)
|
|
(6,330
|
)
|
|
(5,487
|
)
|
Amortization
of prior service cost
|
|
|
36
|
|
|
78
|
|
|
109
|
|
|
131
|
|
Amortization
of net loss
|
|
|
653
|
|
|
428
|
|
|
1,959
|
|
|
1,442
|
|
Total
|
|
$
|
2,296
|
|
$
|
2,062
|
|
$
|
6,889
|
|
$
|
6,704
|
|
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
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 September 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 $1.1 million in 2006.
Defined
Contribution Plans
The
Company sponsors a qualified 401(k) 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 investments 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. The charges to expenses equal to Company contributions to both plans
were $1.5 million and $4.6 million for the three and nine months ended September
30, 2006, respectively, and $1.4 million and $3.7 million for the same periods
in 2005, respectively.
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 voluntary
homeowner policies in 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)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
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 September 30, 2006
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
327,325
|
|
$
|
—
|
|
$
|
327,325
|
|
Depreciation
and amortization expense
|
|
|
7,088
|
|
|
1
|
|
|
7,089
|
|
Segment
profit (loss)
|
|
|
27,447
|
|
|
(190
|
)
|
|
27,257
|
|
|
|
|
|
|
|
|
|
|
|
|
Three
Months Ended September 30, 2005
|
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
344,099
|
|
$
|
3
|
|
$
|
344,102
|
|
Depreciation
and amortization expense
|
|
|
9,504
|
|
|
3
|
|
|
9,507
|
|
Segment
profit (loss)
|
|
|
16,972
|
|
|
(613
|
)
|
|
16,359
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine
Months Ended September 30, 2006
|
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
978,661
|
|
$
|
—
|
|
$
|
978,661
|
|
Depreciation
and amortization expense
|
|
|
20,389
|
|
|
4
|
|
|
20,393
|
|
Segment
profit (loss)
|
|
|
73,213
|
|
|
(533
|
)
|
|
72,680
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine
Months Ended September 30, 2005
|
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
1,017,302
|
|
$
|
9
|
|
$
|
1,017,311
|
|
Depreciation
and amortization expense
|
|
|
24,495
|
|
|
7
|
|
|
24,502
|
|
Segment
profit (loss)
|
|
|
47,035
|
|
|
(983
|
)
|
|
46,052
|
|
The
following table reconciles segment profit to consolidated income before
provision for income taxes:
|
|
Three
Months Ended
September
30,
|
Nine
Months Ended
September
30,
|
|
|
2006
|
2005
|
2006
|
2005
|
Segment
profit
|
|
$
|
27,257
|
|
$
|
16,359
|
|
$
|
72,680
|
|
$
|
46,052
|
|
Net
investment income
|
|
|
16,897
|
|
|
17,042
|
|
|
51,827
|
|
|
51,085
|
|
Other
income
|
|
|
58
|
|
|
(3
|
)
|
|
68
|
|
|
364
|
|
Net
realized investment gains (losses)
|
|
|
159
|
|
|
(939
|
)
|
|
(878
|
)
|
|
(2,666
|
)
|
Other
expense
|
|
|
—
|
|
|
—
|
|
|
(924
|
)
|
|
—
|
|
Interest
and fees expense
|
|
|
(1,820
|
)
|
|
(1,988
|
)
|
|
(5,572
|
)
|
|
(6,076
|
)
|
Income
before provision for income taxes
|
|
$
|
42,551
|
|
$
|
30,471
|
|
$
|
117,201
|
|
$
|
88,759
|
|
3 |
2005
revenue for the homeowner and earthquake lines in runoff segment
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)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
September
30, 2006
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 September 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.
In
addition to the above, the Company held $8.5 million and $6.2 million in other
Impact related fixed-income investments as of September 30, 2006 and December
31, 2005, respectively. The Company also held $0.3 million in other Impact
related private equity investments reclassified as other long-term investments
as of September 30, 2006. Total Impact related investment income was $0.2
million and $0.7 million for the three and nine months ended September 30,
2006,
respectively, and $0.1 million and $0.5 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
investment program, which is 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 is longer
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 during
the third quarter in 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, New Jersey, 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 over
the phone with our licensed insurance professionals at 1-800-211-SAVE. Service
is offered in English and Spanish, both over 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 and has
previously announced plans to operate in additional states during the fourth
quarter of 2006. The entry into New Jersey in October 2006 is the latest step
of
this strategy. 21st entered the Midwest in 2004, Texas in 2005, and three
Eastern states - Florida, Georgia and Pennsylvania - during the second quarter
of 2006. During the first 10 months of 2006, the Company has increased the
percentage of the U.S. personal auto market in which it operates from 34 percent
to 53 percent. Growth in direct premiums written in non-California markets
in
the third quarter of 2006 was 79.6% and we wrote 12.3% of the third quarter’s
direct premium outside of California, versus 6.6% for the same period in 2005.
Implementation of our growth strategy could be affected by a number of factors
beyond our control, such as increased competition, judicial, regulatory, or
legislative developments, general economic conditions or increased operating
costs, and we cannot assure you that we will be able to maintain previously
announced timetables. 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 third quarters ended September 30, 2006 and
2005:
|
·
|
Total
direct premiums written decreased 3.4% to $337.2 million
in 2006, from $349.1 million for same period in
2005.
|
|
·
|
California
direct premiums written decreased 9.3% to $295.8 million in 2006,
compared
to $326.0 million for the same period in 2005.
|
|
·
|
Non-California
direct premiums written increased 79.6% to $41.4 million in 2006,
compared
to $23.1 million for the same period in 2005.
|
|
·
|
2006
consolidated combined ratio was 91.7%, versus 95.2% for the third
quarter
of 2005. 2006 was favorably impacted by 4.4 points of prior accident
year
loss and loss adjustment expenses (“LAE”) reserve development in 2006,
while 2005 was favorably impacted by 0.3 points of prior accident
year
development.
|
Financial
highlights for the nine months ended September 30, 2006 and 2005:
|
·
|
Total
direct premiums written decreased 3.6% to $992.6 million
in 2006, from $1,029.9 million for the same period in
2005.
|
|
·
|
California
direct premiums written decreased 7.5% to $895.0 million in 2006,
compared
to $967.8 million for the same period in
2005.
|
|
·
|
Non-California
direct premiums written increased 57.2% to $97.6 million in 2006,
compared
to $62.1 million for the same period in
2005.
|
|
·
|
2006
consolidated combined ratio was 92.6%, versus 95.5% for the same
period in
2005. 2006 was favorably impacted by 4.0 points of prior accident
year
loss and LAE reserve development in 2006, while 2005 was favorably
impacted by 2.0 points of prior accident year
development.
|
For
the
three months and nine months ended September 30, 2006, 21st’s insurance
subsidiaries achieved underwriting profitability, but total direct premiums
written declined. In recent quarters, the California market, which represented
87.7% of our total direct premiums written during the third 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 filing
in the third quarter of 2006, competitive rate levels may change and consumer
shopping behavior may increase in the future. As of this date, the Company
has
filed for an overall rate decrease in California of approximately 5% of premium.
Most of the Company’s main competitors have also filed for overall rate
decreases of varying amounts, while others have not substantially changed
overall rate levels while attempting to comply with the new regulations. 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. All rate changes and class plan filings must be approved
by the California Department of Insurance. 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 and casualty insurance written in California. In October
2006, these proposed regulations were further amended. If approved without
additional 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 34.6% to $28.4 million
for the three months ended September 30, 2006, or $0.33 per
basic
share, compared to $21.1 million, or $0.25 per basic share, for the same period
in 2005. The third quarter 2006 results include prior year favorable reserve
development totaling $14.4 million, versus $1.2 million in the third quarter
of
2005. Net income increased 27.9% to $78.0 million,
or $0.91 per
basic
share, for the nine months ended September 30, 2006, compared to $61.0 million,
or $0.71 per basic share, for the same nine-month period in 2005. The nine
months ended September 30, 2006 include favorable prior year reserve development
totaling $39.5 million, versus $20.8 million for the same period in
2005.
The
underwriting expense to net premiums earned ratio increased to 23.7% for the
three months ended September 30, 2006 from 20.2% for the same period in 2005.
For the nine months ended September 30, 2006, the underwriting expense to net
premiums earned ratio increased to 22.9% from 21.0% 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 deferred policy acquisition costs.
Underwriting expenses during the nine months ended September 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 Cost
for
further discussion. Stock-based compensation classified as underwriting expense
for the three and nine months ended September 30, 2006, was $1.4
million
and $4.6
million,
respectively.
Non-GAAP
Measures
Information
concerning premiums written, underwriting profit 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. We use premiums written as a measure of the underlying growth of our
insurance business from period to 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.
Underwriting
profit (loss) consists of net premiums earned less losses from claims, loss
adjustment expenses and underwriting expenses. 21st believes that underwriting
profit (loss) provides investors with financial information that is not only
meaningful, but critically important to understanding the results of property
and casualty insurance operations. The results of operations of a property
and
casualty insurance company includes three components: underwriting profit
(loss), net investment income and realized capital gains (losses). Without
disclosure of underwriting profit (loss), it is difficult to determine how
successful an insurance company is in its core business activity of assessing
and underwriting risk, as including investment income and realized capital
gains
(losses) in the results of operations without disclosing underwriting profit
(loss) can mask underwriting losses.
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 Pronouncements
|
|
·
|
Forward-Looking
Statements
|
RESULTS
OF OPERATIONS
Consolidated
Results
The
following table summarizes our condensed consolidated results of operations
and
reconciles personal auto lines underwriting profit to net income:
|
|
Three
Months Ended
September
30,
|
|
Nine
Months Ended
September
30,
|
AMOUNTS
IN THOUSANDS,
EXCEPT
SHARE DATA
|
|
2006
|
2005
|
|
Increase/
(Decrease)
|
|
2006
|
2005
|
|
Increase/
(Decrease)
|
Personal
auto lines underwriting profit
|
|
$
|
27,447
|
|
$
|
16,972
|
|
|
|
61.7
|
% |
|
$
|
73,213
|
|
$
|
47,035
|
|
|
|
55.7
|
%
|
Homeowner
and earthquake lines in runoff underwriting loss
|
|
|
(190
|
)
|
|
(613
|
)
|
|
|
(69.0
|
) |
|
|
(533
|
)
|
|
(983
|
)
|
|
|
(45.8
|
)
|
Net
investment income
|
|
|
16,897
|
|
|
17,042
|
|
|
|
(0.9
|
) |
|
|
51,827
|
|
|
51,085
|
|
|
|
1.5
|
|
Other
income (loss)
|
|
|
58
|
|
|
(3
|
)
|
|
|
N/M
|
1 |
|
|
68
|
|
|
364
|
|
|
|
N/M
|
1 |
Net
realized investment gain (losses)
|
|
|
159
|
|
|
(939
|
)
|
|
|
N/M
|
1 |
|
|
(878
|
)
|
|
(2,666
|
)
|
|
|
(67.1
|
)
|
Other
expense
|
|
|
—
|
|
|
—
|
|
|
|
—
|
|
|
|
(924
|
)
|
|
—
|
|
|
|
—
|
|
Interest
and fees expense
|
|
|
(1,820
|
)
|
|
(1,988
|
)
|
|
|
(8.5
|
) |
|
|
(5,572
|
)
|
|
(6,076
|
)
|
|
|
(8.3
|
)
|
Provision
for income taxes
|
|
|
(14,144
|
)
|
|
(9,369
|
)
|
|
|
51.0
|
|
|
|
(39,155
|
)
|
|
(27,725
|
)
|
|
|
41.2
|
|
Net
income
|
|
$
|
28,407
|
|
$
|
21,102
|
|
|
|
34.6
|
|
|
$
|
78,046
|
|
$
|
61,034
|
|
|
|
27.9
|
|
Basic
earnings per share
|
|
|
0.33
|
|
|
0.25
|
|
|
|
32.0
|
|
|
|
0.91
|
|
|
0.71
|
|
|
|
28.2
|
|
Diluted
earnings per share
|
|
|
0.33
|
|
|
0.24
|
|
|
|
37.5
|
|
|
|
0.90
|
|
|
0.71
|
|
|
|
26.8
|
|
1 |
Ratio
is not meaningful.
|
Underwriting
results above include the effect of prior years’ reserve redundancy recorded in
the current year. The following table summarizes losses and LAE incurred, net
of
applicable reinsurance, for the periods indicated:
|
|
Three
Months Ended
September
30,
|
Nine
Months Ended
September
30,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
2006
|
2005
|
Net
losses and LAE incurred related to insured events in:
|
|
|
|
|
|
|
|
|
|
Current
accident year personal auto lines
|
|
$
|
236,942
|
|
$
|
259,301
|
|
$
|
721,668
|
|
$
|
778,203
|
|
Prior
accident years:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Personal
auto lines
|
|
|
(14,582
|
)
|
|
(1,811
|
)
|
|
(40,061
|
)
|
|
(21,774
|
)
|
Homeowner
and earthquake lines in runoff
|
|
|
190
|
|
|
615
|
|
|
533
|
|
|
991
|
|
Total
prior years’ redundancy recorded in current year
|
|
|
(14,392
|
)
|
|
(1,196
|
)
|
|
(39,528
|
)
|
|
(20,783
|
)
|
Total
net losses and LAE incurred
|
|
$
|
222,550
|
|
$
|
258,105
|
|
$
|
682,140
|
|
$
|
757,420
|
|
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.
Consequently, 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 September 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
Auto Lines Underwriting Results
Personal
automobile insurance is our primary line of business. Non-California vehicles
accounted for 12.3% of our direct premiums written for the three months ended
September 30, 2006, compared to 6.6% for the same period in 2005. For the nine
months ended September 30, 2006, non-California vehicles accounted for 9.8%
of
our direct premiums written, compared to 6.0% for the same period in 2005.
This
increase is due to our ongoing national expansion program, which includes
marketing in non-California states. Prior to September 30, 2006, 21st sold
policies in 12 states. The Company entered New Jersey in October 2006 and plans
to expand into additional states during the fourth quarter of 2006 as part
of
its national expansion strategy. The following table presents the components
of
our personal auto lines underwriting profit and the components of the combined
ratio:
|
|
Three
Months Ended
September
30,
|
|
Nine
Months Ended
September
30,
|
AMOUNTS
IN
THOUSANDS
|
|
2006
|
2005
|
|
Increase/
(Decrease)
|
|
2006
|
2005
|
|
Increase/
(Decrease)
|
Direct
premiums written
|
|
$
|
337,217
|
|
$
|
349,119
|
|
|
|
(3.4
|
)%
|
|
$
|
992,623
|
|
$
|
1,029,905
|
|
|
|
(3.6
|
)%
|
Net
premiums written
|
|
$
|
335,809
|
|
$
|
347,827
|
|
|
|
(3.5
|
)
|
|
$
|
988,509
|
|
$
|
1,026,247
|
|
|
|
(3.7
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
327,325
|
|
$
|
344,099
|
|
|
|
(4.9
|
)
|
|
$
|
978,661
|
|
$
|
1,017,302
|
|
|
|
(3.8
|
)
|
Net
losses and LAE
|
|
|
(222,360
|
)
|
|
(257,489
|
)
|
|
|
(13.6
|
)
|
|
|
(681,607
|
)
|
|
(756,428
|
)
|
|
|
(9.9
|
)
|
Underwriting
expenses
|
|
|
(77,518
|
)
|
|
(69,638
|
)
|
|
|
11.3
|
|
|
|
(223,841
|
)
|
|
(213,839
|
)
|
|
|
4.7
|
|
Underwriting
profit
|
|
$
|
27,447
|
|
$
|
16,972
|
|
|
|
61.7
|
|
|
$
|
73,213
|
|
$
|
47,035
|
|
|
|
55.7
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ratios:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
and LAE ratio
|
|
|
67.9
|
%
|
|
74.8
|
%
|
|
|
(6.9
|
)
|
|
|
69.6
|
%
|
|
74.4
|
%
|
|
|
(4.8
|
)
|
Underwriting
expense ratio
|
|
|
23.7
|
|
|
20.3
|
|
|
|
3.4
|
|
|
|
22.9
|
|
|
21.0
|
|
|
|
1.9
|
|
Combined
ratio
|
|
|
91.6
|
%
|
|
95.1
|
%
|
|
|
(3.5
|
)
|
|
|
92.5
|
%
|
|
95.4
|
%
|
|
|
(2.9
|
)
|
The
following table reconciles our personal auto lines direct premiums written
to
net premiums earned:
|
|
Three
Months Ended
September
30,
|
|
Nine
Months Ended
September
30,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
|
2006
|
2005
|
Direct
premiums written
|
|
$
|
337,217
|
|
$
|
349,119
|
|
|
$
|
992,623
|
|
$
|
1,029,905
|
|
Ceded
premiums written
|
|
|
(1,408
|
)
|
|
(1,292
|
)
|
|
|
(4,114
|
)
|
|
(3,658
|
)
|
Net
premiums written
|
|
|
335,809
|
|
|
347,827
|
|
|
|
988,509
|
|
|
1,026,247
|
|
Net
change in unearned premiums
|
|
|
(8,484
|
)
|
|
(3,728
|
)
|
|
|
(9,848
|
)
|
|
(8,945
|
)
|
Net
premiums earned
|
|
$
|
327,325
|
|
$
|
344,099
|
|
|
$
|
978,661
|
|
$
|
1,017,302
|
|
Direct
premiums written decreased in the three months and nine months ended September
30, 2006, as compared to the same period in 2005, primarily due to continued
competitiveness in the California market. As discussed in the Highlights,
the
California Department of Insurance issued changes to regulations relating to
automobile insurance rating factors, particularly concerning territorial rating
in July 2006. 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, subsequently amended in October of 2006,
which if approved without further modification, could have a materially adverse
impact on the Company’s California results. See further discussion of both
regulations 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.
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 nine months ended
September 30, 2006 of 6.9 points and 4.8 points, respectively, are primarily
due
to the effect of favorable development related to prior accident years and
lower
accident frequency. The loss and LAE ratios for the three months ended September
30, 2006, included 4.5 points ($14.6 million) of favorable development compared
to 0.5 points ($1.8 million) in the same period of 2005. For the nine months
ended September 30, 2006 loss and LAE ratio included 4.1 points ($40.1 million)
of favorable reserve development compared to 2.1 points ($21.8 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 of the 2006 periods
was
primarily attributable to the decline in frequency.
The
underwriting expense to net premiums earned ratios increased in the three months
and nine months ended September 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 nine months ended September 30, 2006 was
impacted by severance costs and corporate litigation
incurred during the three months ended March 31, 2006.
Homeowner
and Earthquake Lines in Runoff
We
have
not written any earthquake policies since 1994 and exited the voluntary
homeowner insurance business in 2002. Underwriting results of the homeowner
and
earthquake lines, which are in runoff, include losses and LAE incurred of $0.2
million for the three months ended September 30, 2006, compared to $0.6 million
for the same period in 2005. For the nine months ended September 30, 2006 and
2005, losses and LAE for those same lines were $0.5 million and $1.0 million,
respectively, of which the earthquake lines accounted for $0.1 million in loss
and LAE during the three months and nine months ended September 30,
2006.
Net
Investment Income
We
utilize a conservative investment philosophy. No derivatives are held in our
investment portfolio and there were no equity securities at September 30, 2006.
The Company had previously held publicly traded equities, but exited the asset
class in the first quarter of 2006. Substantially the entire fixed maturity
portfolio is investment grade, having a weighted average Standard & Poor’s
credit quality of “AA”. The components of net investment income were as
follows:
|
|
Three
Months Ended
September
30,
|
|
Nine
Months Ended
September
30,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
|
2006
|
2005
|
Fixed
maturity securities available-for-sale
|
|
$
|
16,597
|
|
$
|
15,471
|
|
|
$
|
50,095
|
|
$
|
46,145
|
|
Equity
securities available-for-sale
|
|
|
—
|
|
|
1,188
|
|
|
|
811
|
|
|
4,164
|
|
Cash
and cash equivalents
|
|
|
300
|
|
|
383
|
|
|
|
921
|
|
|
776
|
|
Net
investment income
|
|
$
|
16,897
|
|
$
|
17,042
|
|
|
$
|
51,827
|
|
$
|
51,085
|
|
The
fixed
maturity portfolio comprised 99% and 95% of the total investment portfolio
at
September 30, 2006 and December 31, 2005, respectively. The average annual
yields on fixed income assets were as follows:
|
|
Three
Months Ended
September
30,
|
|
Nine
Months Ended
September
30,
|
|
|
2006
|
2005
|
|
2006
|
2005
|
Pre-tax
- fixed maturity securities
|
|
|
4.5
|
%
|
|
4.6
|
%
|
|
|
4.6
|
%
|
|
4.6
|
%
|
After-tax
- fixed maturity securities
|
|
|
3.3
|
%
|
|
3.3
|
%
|
|
|
3.3
|
%
|
|
3.3
|
%
|
The
yield
declined slightly due to the reinvestment of funds from sales of equity
securities and maturities of fixed-income securities into lower yielding fixed
maturity securities during the first and second quarters of 2006.
At
September 30, 2006, $408.4 million, or 27.8%, of our total fixed maturity
investments at fair value were invested in tax-exempt bonds with the remainder,
representing 72.2% of the portfolio, invested in taxable securities, compared
to
23.1% and 76.9%, respectively, at December 31, 2005 and 22.5% and 77.5%,
respectively, at September 30, 2005. As of September 30, 2006, no investments
were rated below investment grade.
The
net realized gains (losses) on investments were as follows:
|
|
Three
Months Ended
September
30,
|
Nine
Months Ended
September
30,
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
2006
|
2005
|
Gross
realized gains 2
|
|
$
|
172
|
|
$
|
1,292
|
|
$
|
1,722
|
|
$
|
4,587
|
|
Gross
realized losses 3
|
|
|
(13
|
)
|
|
(2,231
|
)
|
|
(2,600
|
)
|
|
(7,253
|
)
|
Net
realized gains (losses) on investments
|
|
$
|
159
|
|
$
|
(939
|
)
|
$
|
(878
|
)
|
$
|
(2,666
|
)
|
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 nine months ended September 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 Internal
Revenue Service. 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 was sublet during the third
quarter.
FINANCIAL
CONDITION
Investments
and cash were $1.5 billion at September 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 September 30, 2006. Applicable
funds realized from the sale of equity securities were primarily reinvested
in
fixed maturity investments. However, we 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 funded $9.1 million of the commitment in the third quarter of 2006.
The
Company also has unrated, community investments representing 1.0% 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 third quarter of 2006
contributed to an increase in deferred policy acquisition costs (“DPAC”) of
$7.7 million
to $67.6 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).
The
following table summarizes unpaid losses and LAE, gross and net of applicable
reinsurance, with respect to our lines of business:
|
|
September
30, 2006
|
|
December
31, 2005
|
AMOUNTS
IN THOUSANDS
|
|
Gross
|
Net
|
|
Gross
|
Net
|
Unpaid
losses and LAE
|
|
|
|
|
|
|
|
|
|
|
Personal
auto lines
|
|
$
|
482,871
|
|
$
|
478,039
|
|
|
$
|
521,528
|
|
$
|
516,849
|
|
Homeowner
and earthquake lines in runoff
|
|
|
1,387
|
|
|
688
|
|
|
|
2,307
|
|
|
1,368
|
|
Total
|
|
$
|
484,258
|
|
$
|
478,727
|
|
|
$
|
523,835
|
|
$
|
518,217
|
|
2 |
Gross
realized gains during the three months ended September 30, 2005
include
$1.2 million from the sale of equity securities. Gross realized
gains
during the nine months ended September 30, 2006 and 2005 include
$1.2
million and $4.4 million from the sale of equity securities,
respectively.
|
3 |
Gross
realized losses during the three months ended September 30, 2005
include
$2.2 million from the sale of equity securities. Gross realized
losses
during the nine months ended September 30, 2006 and 2005 include
$2.6
million and $ 5.9 million from the sale of equity securities,
respectively.
|
At
September 30, 2006, gross unpaid losses and LAE decreased $39.6 million,
primarily due to a reserve decrease of $38.7 million in the personal auto lines
as a result of $40.1 million of favorable loss development related to prior
accident years recorded during the nine months ended September 30, 2006 and
a
decline in the number of insured vehicles. The gross unpaid losses and LAE
in
the homeowner and earthquake lines decreased $0.9 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
$118.9 million consists of $19.0 million of capital lease obligations and $99.9
million of Senior Notes, net of discount. The decrease in debt of $9.0 million
during the nine months ended September 30, 2006 is primarily attributable to
principal payments on the capital leases.
Stockholders’
equity and book value per share increased to $897.6 million and $10.39,
respectively, at September 30, 2006, compared to $830.0 million and $9.66 at
December 31, 2005, respectively. The increase in stockholders’ equity for the
nine months ended September 30, 2006 was primarily due to net income of $78.0
million, stock-based compensation cost of $8.9 million, and $4.3 million from
the exercise of stock options. This was partially offset by dividends to
stockholders of $20.7 million and an increase in accumulated other comprehensive
loss of $2.9 million, which resulted from a $4.5 million increase in net
unrealized losses on the investment portfolio due to rising market interest
rates.
LIQUIDITY
AND CAPITAL RESOURCES
Holding
Company
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 September 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 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 September 30,
2006,
was $86.0 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 $86.0 million principal on the term loan line to the
insurance subsidiary (scheduled payments include $18.0 million, $40.0
million, and $28.0 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 $24.1 million
at September 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 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, subsequently amended in October of 2006, which if approved without
further modification, could have a materially adverse impact on the Company’s
California results. See further discussion of both regulations 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.
At
September 30, 2006, our insurance subsidiaries had a combined statutory surplus
of $781.6 million compared to $704.7 million at December 31, 2005. The increase
in statutory surplus was primarily due to statutory net income of $96.1 million
and an increase in net unrealized investment gains of $1.2 million, partially
offset by a $13.2 million decrease in the deferred income tax asset and an
increase in nonadmitted assets of $7.8 million. The net premiums written to
statutory surplus ratio, which is required to be below 3.0 by the insurance
regulators, was 1.6 at September 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 at September 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
|
|
September
30,
2006
|
December
31,
2005
|
Stockholders’
equity - GAAP
|
|
$
|
897,623
|
|
$
|
829,972
|
|
Condensed
adjustments to reconcile GAAP shareholders’ equity to statutory
surplus:
|
|
|
|
|
|
|
|
Net
book value of fixed assets under capital leases
|
|
|
(21,200
|
)
|
|
(24,185
|
)
|
Deferred
gain under capital lease transactions
|
|
|
(288
|
)
|
|
(914
|
)
|
Capital
lease obligation
|
|
|
18,946
|
|
|
28,074
|
|
Nonadmitted
net deferred tax assets
|
|
|
(16,018
|
)
|
|
(34,936
|
)
|
Net
deferred tax assets related to items nonadmitted under SAP
|
|
|
32,641
|
|
|
38,544
|
|
Intercompany
receivables
|
|
|
(85,683
|
)
|
|
(57,683
|
)
|
Fixed
assets
|
|
|
(22,801
|
)
|
|
(22,492
|
)
|
Equity
in non-insurance entities
|
|
|
54,827
|
|
|
26,798
|
|
Net
unrealized losses on investments
|
|
|
16,956
|
|
|
10,788
|
|
Deferred
policy acquisition costs
|
|
|
(67,592
|
)
|
|
(59,939
|
)
|
Prepaid
pension costs and intangible pension asset
|
|
|
(17,249
|
)
|
|
(21,309
|
)
|
Other
prepaid expenses
|
|
|
(13,680
|
)
|
|
(11,049
|
)
|
Other,
net
|
|
|
5,151
|
|
|
3,002
|
|
Statutory
surplus
|
|
$
|
781,633
|
|
$
|
704,671
|
|
Operating
Cash Flows
Our
operating cash flows were as follows:
|
|
Nine
Months Ended
September
30,
|
|
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
Decrease
|
Net
cash provided by operating activities
|
|
$
|
84,250
|
|
$
|
122,369
|
|
$
|
38,119
|
|
Net
cash
provided by operating activities decreased primarily due to a decline in direct
premiums collected resulting from the decline in premiums written and an
increase in taxes paid as a result of the utilization of the carryforward of
net
operating losses during 2006. 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
decreased slightly due to the increase in other liabilities of $17.0 million,
primarily as a result of expenditures incurred in connection with our 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:
|
|
Nine
Months Ended
September
30,
|
|
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
Increase
|
Net
cash used in investing activities
|
|
$
|
113,765
|
|
$
|
78,764
|
|
$
|
35,001
|
|
Net
cash
used in investing activities increased due to a $44.2 million increase in net
acquisitions (purchases, net of maturities, calls and sales) of investments
primarily as a result of the redeployment of cash equivalents, partially offset
by a $9.2 million decrease in purchases of property and equipment.
Financing
Activities
Our
cash
flows from financing activities were as follows:
|
|
Nine
Months Ended
September
30,
|
|
|
AMOUNTS
IN THOUSANDS
|
|
2006
|
2005
|
Increase
|
Net
cash used in financing activities
|
|
$
|
19,656
|
|
$
|
13,038
|
|
$
|
6,618
|
|
Net
cash
used in financing activities increased due to the doubling of the quarterly
dividend since the prior year from $0.04 per share to $0.08 per share, partially
offset by a $1.1 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, corporate insurance coverage,
and investment management and investment accounting.
Reinsurance
Agreements
The
Company has a catastrophe reinsurance agreement for the comprehensive portion
of
its auto physical damage lines that 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 $0.8 million for the three and nine months ended September 30,
2006,
respectively, and $0.2 million and $0.7 million for the three and nine months
ended September 30, 2005, respectively. Total reinsurance recoverables, net
of
payables, from AIG subsidiaries were $0.4 million and $0.6 million at September
30, 2006 and December 31, 2005, respectively.
Corporate
Insurance Coverage
We
have
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 $0.7 million
and
$2.8 million for the three and nine months ended September 30, 2006,
respectively, and $1.1 million and $3.3 million for the three and nine months
ended September 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. 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 $0.7 million for the three and
nine
months ended September 30, respectively, for both 2006 and 2005.
In
June
2006, the Company executed a $35 million funding commitment for a private equity
investment program, which is managed by AIGGIC. In the event that we do 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 us 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 us (with the right of offset); terminate
our 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
is
longer than 10 years. Multiple investments are expected to be purchased and
liquidated over the investment term. We funded $9.1 million of the commitment
during the third quarter in 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
nine-month period ended September 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
MD&A. 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 consolidated 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 September 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 September 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 over the long term.
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 14%
lower bodily injury claim frequency over the past three years 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 1.0%, or $4.8 million, at September 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 we may not
realize a full recovery on its investment securities, irrespective
of the
occurrence of one of the foregoing
events.
|
For
investments with unrealized losses due to market conditions or industry-related
events, where we have 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 nine months ended September 30, 2006 or for the same periods in
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 loss.
Substantially
the entire fixed maturity securities portfolio is investment grade. The
following is a summary of the Standard & Poor’s credit rating for the fixed
maturity securities portfolio (the weighted average is “AA”):
|
|
September
30, 2006
|
December
31, 2005
|
AMOUNTS
IN THOUSANDS
|
|
#
issues
|
Fair
Value
|
#
issues
|
Fair
Value
|
AAA
|
|
|
324
|
|
$
|
737,497
|
|
|
286
|
|
$
|
604,812
|
|
AA
|
|
|
112
|
|
|
183,576
|
|
|
116
|
|
|
169,708
|
|
A
|
|
|
115
|
|
|
429,433
|
|
|
118
|
|
|
486,338
|
|
BBB
|
|
|
44
|
|
|
114,702
|
|
|
44
|
|
|
88,918
|
|
BB
|
|
|
—
|
|
|
—
|
|
|
3
|
|
|
2,495
|
|
Unrated
|
|
|
6
|
|
|
5,177
|
|
|
2
|
|
|
2,436
|
|
Total
fixed maturity securities
|
|
|
601
|
|
$
|
1,470,385
|
|
|
569
|
|
$
|
1,354,707
|
|
The
following is a summary by issuer of non-investment grade investments and unrated
investments held (at fair value):
AMOUNTS
IN THOUSANDS
|
|
September
30,
2006
|
December
31,
2005
|
Non-investment
grade investments:
|
|
|
|
|
|
AmerUs
Group Co.4
|
|
$
|
—
|
|
$
|
864
|
|
Ford
Motor Credit Company 5
|
|
|
—
|
|
|
2,495
|
|
Total
non-investment grade investments
|
|
|
—
|
|
|
3,359
|
|
Unrated
fixed maturity securities:
|
|
|
|
|
|
|
|
Impact
Community Capital, LLC 6
|
|
|
1,999
|
|
|
2,023
|
|
Impact
Healthcare, LLC 6
|
|
|
413
|
|
|
413
|
|
Impact
Childcare, LLC 6
|
|
|
330
|
|
|
—
|
|
Impact
Commercial Opportunities, LLC 6
|
|
|
1,858
|
|
|
—
|
|
Impact
Childcare 2, LLC 6
|
|
|
480
|
|
|
—
|
|
Impact
Healthcare 2, LLC 6
|
|
|
97
|
|
|
—
|
|
Total
unrated fixed maturity securities
|
|
|
5,177
|
|
|
2,436
|
|
Unrated
other long-term investments
|
|
|
|
|
|
|
|
Impact
Workforce, LLC 6
|
|
|
320
|
|
|
—
|
|
AIG
PEP7
|
|
|
9,123
|
|
|
—
|
|
Total
unrated other long-term investments
|
|
|
9,443
|
|
|
—
|
|
Total
non-investment grade and unrated investments
|
|
$
|
14,620
|
|
$
|
5,795
|
|
|
|
|
|
|
|
|
|
Percentage
of total investments, at fair value
|
|
|
1.0
|
%
|
|
0.4
|
%
|
4 |
The
AmerUs Group Co. was a preferred stock holding that had an unrealized
gain
as of December 31, 2005.
|
5 |
The
Ford Motor Credit Company security matured in the first quarter
of 2006
and the Company received all amounts due, thereby incurring no
loss.
|
6 |
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.
|
7 |
AIG
PEP is a private equity investment program managed by AIGGIC.
See further discussion in Note 9 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 September 30, 2006 and December 31,
2005:
|
|
September
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
|
|
|
1
|
|
$
|
9,771
|
|
$
|
228
|
|
|
16
|
|
$
|
141,034
|
|
$
|
3,074
|
|
6-12
months
|
|
|
29
|
|
|
232,850
|
|
|
7,297
|
|
|
16
|
|
|
129,044
|
|
|
4,072
|
|
More
than 1 year
|
|
|
61
|
|
|
475,781
|
|
|
19,530
|
|
|
56
|
|
|
433,368
|
|
|
16,896
|
|
Less
than $0.1 million
|
|
|
127
|
|
|
264,782
|
|
|
4,758
|
|
|
113
|
|
|
204,724
|
|
|
4,347
|
|
Total
fixed maturity securities with unrealized losses
|
|
|
218
|
|
|
983,184
|
|
|
31,813
|
|
|
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 losses8
|
|
|
218
|
|
$
|
983,184
|
|
$
|
31,813
|
|
|
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, then our liquidity,
financial position and financial results could be materially 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
of fixed maturity securities in an unrealized loss position by year of maturity
follows:
|
|
September
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
|
|
$
|
3,037
|
|
$
|
3,005
|
|
$
|
32
|
|
$
|
5,562
|
|
$
|
5,512
|
|
$
|
50
|
|
Due
after one year through five years
|
|
|
466,042
|
|
|
451,858
|
|
|
14,184
|
|
|
205,363
|
|
|
200,075
|
|
|
5,288
|
|
Due
after five years through ten years
|
|
|
212,214
|
|
|
205,040
|
|
|
7,174
|
|
|
415,417
|
|
|
401,533
|
|
|
13,884
|
|
Due
after ten years
|
|
|
333,704
|
|
|
323,281
|
|
|
10,423
|
|
|
310,216
|
|
|
301,050
|
|
|
9,167
|
|
Total
fixed maturity securities with unrealized losses
|
|
$
|
1,014,997
|
|
$
|
983,184
|
|
$
|
31,813
|
|
$
|
936,558
|
|
$
|
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 requires
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 20
years for losses incurred after 1998.
At
September 30, 2006, our DTAs were $111.2 million and our DTLs were $68.6
million, for a net DTA of $42.6 million. At
December 31, 2005, our DTAs were $128.5 million and our DTLs were $72.3 million,
for a net DTA of $56.2 million. The net DTAs are classified as an asset,
“Deferred income taxes”, in the condensed consolidated balance
sheets.
8 |
Unrealized
losses represent approximately 3.2% of the total fair value of
investments
with unrealized losses at both September 30, 2006 and December
31,
2005.
|
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 $9.3
million, representing an unrealized tax benefit of $3.3 million at September
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 nine months ended September
30, 2006.
Portions
of our NOL carryforward are scheduled to expire beginning in 2017, as shown
in
the table below (amounts in thousands):
Year
of Expiration
|
|
SRLY 9
NOL
of 21st of
the
Southwest
|
2017
|
|
$
|
1,456
|
|
2018
|
|
|
1,068
|
|
2019
|
|
|
1,466
|
|
2020
|
|
|
3,172
|
|
2021
|
|
|
2,180
|
|
2022
|
|
|
—
|
|
Total
|
|
$
|
9,342
|
|
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 sufficient future taxable income to
reasonably conclude that 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 September 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 our refund
claims. In December 2005, the Company filed an appeal with the SBE. The Company
is in the process of settlement of its refund claim, but because any settlement
is subject to various governmental approvals, at this time the Company is unable
to assess the likelihood that any refunds ultimately will be received from
the
State of California.
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 six-month policy period in which the related
premiums are earned.
Management
assesses the recoverability of DPAC 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
at
September 30, 2006.
9 |
”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.
|
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 it
is
a reasonable assumption, actual results could differ materially from such
estimates.
Property
and Equipment
At
September 30, 2006, property and equipment included $129.1 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 third quarter of 2006 that would require a reassessment
of
any asset group for impairment.
Stock-Based
Compensation Cost
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 (“FAS
123”). 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
the
closing market price on the grant date. 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,
we 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. We use 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 $2.1 million and $8.1 million in the three
and
nine months ended September 30, 2006, respectively, which previously would
have
been only presented in a pro forma footnote disclosure. We expect this cost
to
approximate $10.0 million for fiscal year 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 us
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 consolidated 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 nine months ended September 30,
2006
would have been $0.35 and $0.97, respectively, if the Company had not adopted
FAS 123R, compared to reported basic earnings per share of $0.33 and $0.91,
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, we 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,
we
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 PRONOUNCEMENTS
In
September 2006, Financial
Accounting Standards Board (“FASB”)
issued
FAS 158,
Employers’
Accounting for Defined Benefit Pension and Other Postretirement Plans - an
Amendment of FASB Statements No. 87, 88, 106 and 132(R)
("FAS
158"). FAS 158 requires an employer that is a business entity and sponsors
one
or more single employer benefit plans to (1) recognize the funded
status of the benefit in its statement of financial position, (2) recognize
as a
component of other comprehensive income, net of tax, the gains or
losses
and prior service costs or credits that arise during the period, but are not
recognized as components of net periodic benefit cost, (3) measure defined
benefit plan assets and obligations as of the date of the employer's fiscal
year
end statement of financial position and (4) disclose in the notes to
financial statements additional information about certain effects on net
periodic benefit cost for the next fiscal year that arise from
delayed recognition
of the gains or losses, prior service costs on credits, and transition asset
or
obligations. Under
FAS
158, the Company will be required to recognize the funded status of its defined
benefit plans and to provide the required disclosures as of December 31,
2006.
However,
had we been required to adopt the provisions of FAS 158 as of September 30,
2006, the estimated cumulative impact on the Company’s condensed consolidated
financial statements as a result of the adoption of this standard would have
resulted in an approximate $17 million net after-tax reduction in equity with
a
corresponding reduction of $7.8 million in total assets, and an increase of
$9.3
million in total liabilities. Because our net pension liabilities
are dependent
upon future events and circumstances, the impact at the time of adoption of
FAS
158 may differ from these amounts. Adoption of FAS 158 will not
have
any effect on the Company's compliance with its financial
covenants.
In
September 2006, the FASB issued FAS 157, Fair
Value Measurements (“FAS
157”). FAS 157 clarifies the principle that fair value should be based on the
assumptions market participants would use when pricing an asset or liability
and
establishes a fair value hierarchy that prioritizes the information used to
develop those assumptions. Under the standard, fair value measurements would
be
separately disclosed by level within the fair value hierarchy. FAS 157 is
effective for financial statements issued for fiscal years beginning after
November 15, 2007 and interim periods within those fiscal years, with early
adoption permitted. We have not yet determined the effect, if any, that the
implementation of FAS 157 will have on our results of operations or financial
condition.
In
September 2006, the Securities and Exchange Commission (“SEC”) issued Staff
Accounting Bulletin No. 108, Considering
the Effects of Prior Year Misstatements when Quantifying Misstatements in
Current Year Financial Statements
(“SAB
108”). SAB 108 provides interpretive guidance on how the effects of the
carryover or reversal of prior year misstatements should be considered in
quantifying a current year misstatement. The SEC staff believes that registrants
should quantify errors using both a balance sheet and an income statement
approach and evaluate whether either approach results in quantifying a
misstatement that, when all relevant quantitative and qualitative factors are
considered, is material. SAB 108 is effective for the Company’s fiscal year
ending December 31, 2006. We do not expect SAB 108 to have a material impact
on
our consolidated financial statements.
In
June
2006, the FASB issued Financial Interpretation No. 48, Accounting
for Uncertainty in Income Taxes - an Interpretation of FAS No. 109
(“FIN
48”). This interpretation clarifies the accounting for uncertainty in income
taxes recognized in an enterprise’s financial statements in accordance with FAS
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. We are currently assessing the effect of implementing FIN
48.
Statement
of Position 05-1,
Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection
with Modifications or Exchanges of Insurance Contracts (“SOP
05-1”),
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 No. 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. We are currently assessing
the effect of implementing this guidance.
FORWARD-LOOKING
STATEMENTS
This
report contains statements that constitute forward-looking information. Readers
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 MD&A 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
flows from operations and short-term cash positions 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 securities, 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 securities 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 security 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 4.0 years at September 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 securities,
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 security 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
September
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 securities available-for-sale, at fair value
|
|
$
|
1,470.4
|
|
$
|
1,411.1
|
|
|
(4.0
|
%)
|
Debt,
at amortized cost
|
|
|
118.9
|
|
|
125.3
|
|
|
5.5
|
%
|
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 securities 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
securities portfolio.
|
|
Effective
Duration Ranges (in years)
|
September
30, 2006
|
|
Below
1
|
1
to 3
|
3
to 5
|
5
to 7
|
7
to 10
|
10
to 20
|
Fair
value percentage of fixed maturity security portfolio
|
|
|
1.2
|
%
|
|
16.2
|
%
|
|
43.6
|
%
|
|
33.9
|
%
|
|
4.1
|
%
|
|
1.0
|
%
|
ITEM
4. CONTROLS AND PROCEDURES
Evaluation
of Disclosure Controls and Procedures
The
Company has established disclosure controls and procedures designed 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.
As
required by Rule 13a-15(b) of the Securities Exchange Act of 1934 (the “Exchange
Act”), our management, including our Principal Executive Officer and Principal
Financial Officer, has evaluated the effectiveness of our disclosure controls
and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based
on
that evaluation the Principal Executive Officer and Principal Financial Officer
have concluded that such disclosure controls and procedures are effective as
of
the end of the period covered by this report in providing reasonable level
of
assurance that information we are required to disclose in reports that we file
or submit under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in Securities and Exchange Commission rules
and forms, and a reasonable level of assurance that information required to
be
disclosed by us in such reports is accumulated and communicated to our
management, including our Principal Executive Officer and Principal Financial
Officer, as appropriate to allow timely decisions regarding required
disclosure.
Changes
in Internal Control Over Financial Reporting
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
September 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 its insurance operations and business practices. Information
regarding reportable legal proceedings is contained in Part
I, Item 3. Legal Proceedings
in our
Annual Report on Form 10-K, as updated in our subsequent Quarterly Reports
on
Form 10-Q for the quarters ended March 31, 2006 and June 30, 2006, respectively.
A current description of the reportable 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,
and is
incorporated herein by reference. The description identifies legal proceedings,
if any, that become reportable during the quarter ended September 30, 2006,
and
amends and restates descriptions of previously reported legal proceedings in
which there have been material developments during such quarter or which are
otherwise updated due to other developments.
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:
We
write a substantial portion of our business in California, and therefore recent
changes in California insurance regulations could have a material impact on
the
Company.
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 primarily enjoin the implementation of the Auto Rating Factor Regulations
and
have them declared in violation of California law has been unsuccessful. As
a
result, the Company has submitted class plan and rate filings to the CDI for
its
review. The Company’s rate filing proposes an overall rate decrease of 5% of
premium. 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, competitive
rate
levels may change and consumer shopping behavior may increase in the future.
As
of this date, most of the Company’s main competitors have also filed for overall
rate decreases of varying amounts, while others have not substantially changed
overall rate levels while attempting to comply with the new regulations. 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. In October 2006, the CDI issued
additional amendments to the Rate Approval Regulations. Multiple changes from
the current regulations include capping the maximum permitted after-tax rate
of
return on derived capital at a floating rate equal to a “risk free” rate of
return plus 6% for all affected lines of insurance. The proposed amended Rate
Approval Regulations provide for several “variances” from the rates specified by
the formula. The Company is reviewing the current version of 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
6. EXHIBITS
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.
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21ST
CENTURY INSURANCE GROUP
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(Registrant)
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Date:
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November
2, 2006
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/s/
Bruce W. Marlow
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BRUCE
W. MARLOW
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President
and Chief Executive Officer
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(Principal
Executive Officer)
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Date:
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November
2, 2006
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/s/
Steven P. Erwin
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STEVEN
P. ERWIN
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Senior
Vice President and Chief Financial Officer
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(Principal
Financial Officer)
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Exhibit
No.
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Description
of Exhibit
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Location
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10.1
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Employment
Letter between Steven P. Erwin and the Company, dated May 5,
2006
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Current
Report on Form 8-K (filed with SEC on May 11, 2006; Exhibit 10.1
therein).
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Certification
of principal executive officer pursuant to Rule 13a-14(a) under the
Securities Exchange Act of 1934
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Filed
herewith
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Certification
of principal financial officer pursuant to Rule 13a-14(a) under the
Securities Exchange Act of 1934
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Filed
herewith
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Certification
Pursuant to 18 U.S.C. Section 1350
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Filed
herewith
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