form10q.htm
UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM
10-Q
x QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES
EXCHANGE ACT OF 1934
For
the
quarterly period ended June 30, 2007
o 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 o
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 o
|
Accelerated
filer x
|
Non-accelerated
filer o
|
Indicate
by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes o
No x
The
number of shares outstanding of the issuer’s common stock as of July 18, 2007
was 88,126,045.
Description
|
Page
Number
|
PART
I – FINANCIAL INFORMATION
|
|
Item
1.
|
|
2
|
Item
2.
|
|
15
|
Item
3.
|
|
31
|
Item
4.
|
|
32
|
PART
II – OTHER INFORMATION
|
|
Item
1.
|
|
33
|
Item
1A.
|
|
33
|
Item
6.
|
|
34
|
|
35
|
EXHIBIT
INDEX
|
36
|
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
|
|
32.1
|
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
|
|
June
30,
|
|
December
31,
|
AMOUNTS
IN THOUSANDS, EXCEPT SHARE DATA
|
|
2007
|
|
2006
|
Assets
|
|
|
|
|
|
|
Investments
available-for-sale
|
|
|
|
|
|
|
Fixed
maturity securities, at fair value (amortized cost: $1,427,975
and
$1,453,468)
|
|
$
|
1,398,237
|
|
|
$
|
1,435,016
|
|
Other
long-term investments, equity method
|
|
|
18,440
|
|
|
|
14,705
|
|
Total
investments
|
|
|
1,416,677
|
|
|
|
1,449,721
|
|
Cash
and cash equivalents
|
|
|
89,578
|
|
|
|
51,999
|
|
Accrued
investment income
|
|
|
16,965
|
|
|
|
17,215
|
|
Premiums
receivable
|
|
|
112,993
|
|
|
|
110,115
|
|
Reinsurance
receivables and recoverables
|
|
|
6,411
|
|
|
|
6,338
|
|
Prepaid
reinsurance premiums
|
|
|
2,051
|
|
|
|
2,095
|
|
Deferred
income taxes
|
|
|
45,970
|
|
|
|
48,437
|
|
Deferred
policy acquisition costs
|
|
|
63,621
|
|
|
|
63,581
|
|
Leased
property under capital leases, net of deferred gain of $871 and
$1,092 and
net of accumulated amortization of $43,801 and $42,149
|
|
|
17,048
|
|
|
|
19,281
|
|
Property
and equipment, at cost less accumulated depreciation of $111,819
and
$104,279
|
|
|
153,608
|
|
|
|
154,966
|
|
Other
assets
|
|
|
33,070
|
|
|
|
27,949
|
|
Total
assets
|
|
$
|
1,957,992
|
|
|
$
|
1,951,697
|
|
Liabilities
and stockholders’ equity
|
|
|
|
|
|
|
|
|
Unpaid
losses and loss adjustment expenses
|
|
$
|
451,254
|
|
|
$
|
482,269
|
|
Unearned
premiums
|
|
|
328,793
|
|
|
|
321,927
|
|
Debt
|
|
|
109,197
|
|
|
|
115,895
|
|
Claims
checks payable
|
|
|
41,155
|
|
|
|
42,931
|
|
Reinsurance
payable
|
|
|
636
|
|
|
|
680
|
|
Other
liabilities
|
|
|
94,575
|
|
|
|
89,446
|
|
Total
liabilities
|
|
|
1,025,610
|
|
|
|
1,053,148
|
|
|
|
|
|
|
|
|
|
|
Commitments
and contingencies
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stockholders’
equity:
|
|
|
|
|
|
|
|
|
Common
stock, par value $0.001 per share; 110,000,000 shares authorized;
shares
issued 88,102,464 and 86,489,082
|
|
|
88
|
|
|
|
86
|
|
Additional
paid-in capital
|
|
|
472,404
|
|
|
|
441,969
|
|
Treasury
stock; at cost shares: 33,841 and 17,328
|
|
|
(530 |
) |
|
|
(259 |
) |
Retained
earnings
|
|
|
495,168
|
|
|
|
484,539
|
|
Accumulated
other comprehensive loss
|
|
|
(34,748 |
) |
|
|
(27,786 |
) |
Total
stockholders’ equity
|
|
|
932,382
|
|
|
|
898,549
|
|
Total
liabilities and stockholders’ equity
|
|
$
|
1,957,992
|
|
|
$
|
1,951,697
|
|
See
accompanying Notes to Condensed Consolidated Financial
Statements.
21ST
CENTURY INSURANCE GROUP
CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS
Unaudited
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS, EXCEPT SHARE DATA
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
Revenues
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
334,424
|
|
|
$
|
325,512
|
|
|
$
|
663,706
|
|
|
$
|
651,336
|
|
Net
investment income
|
|
|
17,582
|
|
|
|
17,174
|
|
|
|
34,507
|
|
|
|
34,929
|
|
Other
income
|
|
|
—
|
|
|
|
10
|
|
|
|
—
|
|
|
|
10
|
|
Net
realized investment gains (losses)
|
|
|
64
|
|
|
|
30
|
|
|
|
351
|
|
|
|
(1,037 |
) |
Total
revenues
|
|
|
352,070
|
|
|
|
342,726
|
|
|
|
698,564
|
|
|
|
685,238
|
|
Losses
and expenses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
losses and loss adjustment expenses
|
|
|
235,221
|
|
|
|
223,094
|
|
|
|
468,678
|
|
|
|
459,590
|
|
Policy
acquisition costs
|
|
|
70,466
|
|
|
|
64,887
|
|
|
|
139,118
|
|
|
|
124,219
|
|
Other
underwriting expenses
|
|
|
9,795
|
|
|
|
9,504
|
|
|
|
21,520
|
|
|
|
22,104
|
|
Other
expense
|
|
|
2,436
|
|
|
|
923
|
|
|
|
6,613
|
|
|
|
923
|
|
Interest
and fees expense
|
|
|
1,677
|
|
|
|
1,854
|
|
|
|
3,403
|
|
|
|
3,752
|
|
Total
losses and expenses
|
|
|
319,595
|
|
|
|
300,262
|
|
|
|
639,332
|
|
|
|
610,588
|
|
Income
before provision for income taxes
|
|
|
32,475
|
|
|
|
42,464
|
|
|
|
59,232
|
|
|
|
74,650
|
|
Provision
for income taxes
|
|
|
9,637
|
|
|
|
14,143
|
|
|
|
18,048
|
|
|
|
25,011
|
|
Net
income
|
|
$
|
22,838
|
|
|
$
|
28,321
|
|
|
$
|
41,184
|
|
|
$
|
49,639
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Earnings
per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
0.26
|
|
|
$
|
0.33
|
|
|
$
|
0.47
|
|
|
$
|
0.58
|
|
Diluted
|
|
$
|
0.25
|
|
|
$
|
0.33
|
|
|
$
|
0.46
|
|
|
$
|
0.57
|
|
Cash
dividends declared per share
|
|
$
|
0.16
|
|
|
$
|
0.08
|
|
|
$
|
0.32
|
|
|
$
|
0.16
|
|
Weighted-average
shares outstanding:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
87,782,310
|
|
|
|
85,968,155
|
|
|
|
87,447,464
|
|
|
|
85,918,791
|
|
Additional
common shares assumed issued under treasury stock method
|
|
|
1,888,961
|
|
|
|
263,948
|
|
|
|
1,475,742
|
|
|
|
455,054
|
|
Diluted
|
|
|
89,671,271
|
|
|
|
86,232,103
|
|
|
|
88,923,206
|
|
|
|
86,373,845
|
|
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
|
|
|
|
|
|
|
|
|
|
|
Accumulated
|
|
|
|
AMOUNTS
IN THOUSANDS,
EXCEPT
SHARE DATA
|
|
Issued
Shares
|
|
Amount
|
|
Additional
Paid-in
Capital
|
|
Treasury
Stock
|
|
Retained
Earnings
|
|
Other
Comprehensive
Loss
|
|
Total
|
Balance
– January 1, 2007
|
|
|
86,489,082
|
|
|
$
|
86
|
|
|
$
|
441,969
|
|
|
$
|
(259 |
) |
|
$
|
484,539
|
|
|
$
|
(27,786 |
) |
|
$
|
898,549
|
|
Cumulative
effect of adopting FIN 48
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(2,422 |
) |
|
|
|
|
|
|
(2,422 |
) |
Adjusted
balance – January 1, 2007
|
|
|
86,489,082
|
|
|
$
|
86
|
|
|
$
|
441,969
|
|
|
$
|
(259 |
) |
|
$
|
482,117
|
|
|
$
|
(27,786 |
) |
|
$
|
896,127
|
|
Comprehensive
income (loss)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
41,184 |
(1) |
|
|
(6,962 |
)(2) |
|
|
34,222
|
|
Cash
dividends declared on common stock
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(28,133 |
) |
|
|
|
|
|
|
(28,133 |
) |
Exercise
of stock options
|
|
|
1,494,232
|
|
|
|
2
|
|
|
|
24,063
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
24,065
|
|
Issuance
of restricted stock
|
|
|
119,150
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
—
|
|
Forfeiture
of 16,513 shares
of restricted
stock
|
|
|
|
|
|
|
|
|
|
|
271
|
|
|
|
(271 |
) |
|
|
|
|
|
|
|
|
|
|
—
|
|
Stock-based
compensation cost
|
|
|
|
|
|
|
|
|
|
|
3,625
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
3,625
|
|
Excess
tax benefit of stock-based compensation
|
|
|
|
|
|
|
|
|
|
|
2,476
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2,476
|
|
Balance
– June 30, 2007
|
|
|
88,102,464
|
|
|
$
|
88
|
|
|
$
|
472,404
|
|
|
$
|
(530 |
) |
|
$
|
495,168
|
|
|
$
|
(34,748 |
) |
|
$
|
932,382
|
|
(1)
|
Net
income for the six months ended June 30,
2007.
|
|
|
|
Six
Months Ended
|
|
(2)
|
Net
change in accumulated other comprehensive loss follows:
|
|
June
30, 2007
|
|
|
Unrealized
holding losses arising during the period, net of tax benefit of
$3,957
|
|
$ |
(7,350 |
) |
|
Reclassification
adjustment for investment losses included in net income, net of tax
expense of $8
|
|
|
14
|
|
|
Amortization
of prior service cost and net actuarial loss on defined benefit plans,
net
of deferred tax expense of $201
|
|
|
374
|
|
|
Total
net other comprehensive loss
|
|
$ |
(6,962 |
) |
See
accompanying Notes to Condensed Consolidated Financial
Statements.
21ST
CENTURY INSURANCE GROUP
CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited
AMOUNTS
IN THOUSANDS, EXCEPT SHARE DATA
|
|
|
|
Six
Months Ended June 30,
|
|
2007
|
|
2006
|
Operating
activities
|
|
|
|
|
|
|
Net
income
|
|
$
|
41,184
|
|
|
$
|
49,639
|
|
Adjustments
to reconcile net income to net cash provided by operating
activities:
|
|
|
|
|
|
|
|
|
Depreciation
and amortization
|
|
|
12,742
|
|
|
|
13,304
|
|
Net
amortization of investment premiums and discounts
|
|
|
5,269
|
|
|
|
4,496
|
|
Stock-based
compensation cost
|
|
|
3,625
|
|
|
|
6,478
|
|
Provision
for deferred income taxes
|
|
|
4,816
|
|
|
|
9,431
|
|
Provision
for premiums receivable losses
|
|
|
1,086
|
|
|
|
1,151
|
|
Net
realized investment (gains) losses
|
|
|
(351 |
) |
|
|
1,037
|
|
Equity
loss of other long-term investment
|
|
|
187
|
|
|
|
—
|
|
Changes
in assets and liabilities
|
|
|
|
|
|
|
|
|
Premiums
receivable
|
|
|
(3,964 |
) |
|
|
862
|
|
Deferred
policy acquisition costs
|
|
|
(40 |
) |
|
|
(8,309 |
) |
Reinsurance
receivables and recoverables
|
|
|
(73 |
) |
|
|
(3 |
) |
Federal
income taxes
|
|
|
2,285
|
|
|
|
2,786
|
|
Other
assets
|
|
|
(3,216 |
) |
|
|
(1,866 |
) |
Unpaid
losses and loss adjustment expenses
|
|
|
(31,015 |
) |
|
|
(28,743 |
) |
Unearned
premiums
|
|
|
6,866
|
|
|
|
1,490
|
|
Claims
checks payable
|
|
|
(1,776 |
) |
|
|
(4,318 |
) |
Other
liabilities
|
|
|
2,216
|
|
|
|
16,983
|
|
Net
cash provided by operating activities
|
|
|
39,841
|
|
|
|
64,418
|
|
Investing
activities
|
|
|
|
|
|
|
|
|
Purchases
of:
|
|
|
|
|
|
|
|
|
Fixed
maturity securities available-for-sale
|
|
|
(22,848 |
) |
|
|
(180,179 |
) |
Equity
securities available-for-sale
|
|
|
—
|
|
|
|
(35,627 |
) |
Other
long-term investments, equity method
|
|
|
(4,045 |
) |
|
|
—
|
|
Property
and equipment
|
|
|
(8,570 |
) |
|
|
(13,346 |
) |
Maturities
and calls of fixed maturity securities available-for-sale
|
|
|
27,908
|
|
|
|
12,618
|
|
Sales
of:
|
|
|
|
|
|
|
|
|
Fixed
maturity securities available-for-sale
|
|
|
15,142
|
|
|
|
55,346
|
|
Equity
securities available-for-sale
|
|
|
—
|
|
|
|
84,836
|
|
Other
long-term investments, equity method
|
|
|
123
|
|
|
|
—
|
|
Net
cash provided by (used in) investing activities
|
|
|
7,710
|
|
|
|
(76,352 |
) |
Financing
activities
|
|
|
|
|
|
|
|
|
Repayment
of debt
|
|
|
(7,359 |
) |
|
|
(6,740 |
) |
Dividends
paid (per share: $0.32 and $0.16)
|
|
|
(28,133 |
) |
|
|
(13,763 |
) |
Proceeds
from the exercise of stock options
|
|
|
24,065
|
|
|
|
3,844
|
|
Excess
tax benefit from stock-based compensation
|
|
|
1,455
|
|
|
|
113
|
|
Net
cash used in financing activities
|
|
|
(9,972 |
) |
|
|
(16,546 |
) |
|
|
|
|
|
|
|
|
|
Net
increase (decrease) in cash and cash equivalents
|
|
|
37,579
|
|
|
|
(28,480 |
) |
|
|
|
|
|
|
|
|
|
Cash
and cash equivalents, beginning of period
|
|
|
51,999
|
|
|
|
68,668
|
|
Cash
and cash equivalents, end of period
|
|
$
|
89,578
|
|
|
$
|
40,188
|
|
|
|
|
|
|
|
|
|
|
Supplemental
information:
|
|
|
|
|
|
|
|
|
Income
taxes paid
|
|
$
|
11,555
|
|
|
$
|
12,863
|
|
Interest
paid
|
|
|
3,321
|
|
|
|
3,682
|
|
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
June
30, 2007
NOTE
1. FINANCIAL STATEMENT
PRESENTATION
General
21st
Century Insurance Group and
subsidiaries (the “Company” or “21st Century”) 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, 2006.
These
unaudited condensed consolidated
financial statements include all adjustments (including normal, recurring
accruals) that are considered necessary for the fair presentation of our
financial position and results of operations in accordance with
GAAP. Intercompany accounts and transactions have been eliminated in
consolidation. Operating results for the six-month period ended June 30, 2007
are not necessarily indicative of results that may be expected for the remaining
interim period or the year as a whole.
Other
Expense
In
the
first quarter of 2007, the Company reduced its workforce by approximately three
percent in connection with efforts to streamline operations. The
Company incurred $3.4 million in severance and other benefits costs during
the
first quarter of 2007 and recognized an additional $0.2 million during the
second quarter for differences between the original estimate and subsequent
payments. The undistributed severance and other benefits payments for
this workforce reduction were $0.4 million at March 31 and June 30, 2007, due
to
payments of $0.2 million in the second quarter that were offset by the second
quarter increase discussed above. The remaining payments are expected to be
distributed by the end of 2007.
The
Company also incurred $2.3 million and $3.0 million for the three and six months
ended June 30, 2007, respectively, for costs associated with the Special
Committee of the Board of Directors and its advisors’ evaluation and negotiation
of the merger proposal by the majority shareholder, as discussed in Note 2
of
the Notes to Condensed Consolidated Financial Statements.
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
June
30,
|
|
Six
Months Ended
June
30,
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
Common
stock equivalents excluded from calculation of diluted EPS
|
|
|
845,008
|
|
|
|
6,157,293
|
|
|
|
2,141,139
|
|
|
|
5,359,356
|
|
Recent
Accounting Pronouncements
In
February 2007, the Financial Accounting Standards Board (“FASB”) issued
Financial Accounting Standard No. (“FAS”) 159, The Fair Value Option for
Financial Assets and Financial Liabilities – including an amendment of FASB
Statement No. 115, (“FAS 159”), which permits an entity to choose to
measure many financial instruments and certain other items at fair value that
are not currently required to be measured at fair value. The objective is to
provide entities with an opportunity to mitigate volatility in reported earnings
caused by measuring related assets and liabilities differently without having
to
apply complex hedge accounting provisions. Entities that choose to measure
eligible items at fair value will report unrealized gains and losses in earnings
at each subsequent reporting date. The fair value option may be elected at
specified election dates on an instrument-by-instrument basis, with few
exceptions. The Statement also establishes presentation and disclosure
requirements designed to facilitate comparisons between entities that choose
different measurement attributes for similar types of assets and liabilities.
FAS 159 is effective at the beginning of the first fiscal year beginning after
November 15, 2007. The Company is currently evaluating the impact of adopting
FAS 159.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
June
30, 2007
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 its results of operations or
financial condition.
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. The effect of this adoption on January 1, 2007, resulted
in a $2.4 million decrease to opening retained earnings. Adoption of
FIN 48 had no impact on net income in the six months ended June 30,
2007.
As
permitted by FIN 48, the Company also adopted a policy of including interest
and
penalties related to income taxes with the provision for income taxes in the
consolidated statements of operations. As required by FIN 48, this
change was done prospectively. Previously, penalties and interest
were classified as Other Income or Other
Expense. The Company had no accrued penalties and no material
interest receivable or interest payable at the date of adoption or at June
30,
2007.
At
January 1, 2007, the Company had unrecognized tax benefits for all jurisdictions
of approximately $9.1 million, which would favorably impact the effective tax
rate if recognized. For the three and six months ended June 30, 2007,
the total amount of unrecognized tax benefits declined by approximately $1.8
million and $3.5 million, respectively, representing the proportionate amount
deemed utilized for tax purposes in the first quarter and second quarter of
the
year, respectively, and the Company established an estimated liability for
uncertain tax position of the same amount. Absent changes in
profitability or other facts and circumstances, the Company currently
anticipates that the unrecognized tax benefits will decline to zero by the
end
of 2007 as the benefits are used for tax purposes, in which case the estimated
liability for uncertain tax position would total approximately $9.1
million.
Tax
years
2003 to 2006 and 2002 to 2006 are subject to examination by Federal and
California jurisdictions, respectively.
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”) was adopted January 1, 2007. SOP
05-1 provides guidance on accounting for deferred policy
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’s prospective application of SOP 05-1
since January 1, 2007 resulted in a $3.8 million reduction in deferred policy
acquisition costs as of June 30, 2007, and a corresponding increase in policy
acquisition costs during the six months ended June 30, 2007.
Reclassifications
Certain
prior year amounts have been reclassified to conform to the current year
presentation.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
June
30, 2007
NOTE
2. AGREEMENT AND PLAN OF MERGER
On May
15, 2007, 21st Century Insurance Group and American International Group,
Inc. (”AIG”) entered into a merger agreement (the “Merger Agreement”)
providing for the acquisition by AIG of all of the outstanding shares of common
stock of 21st Century not currently owned by AIG for $22.00 per share in
cash. The Company’s Board of Directors unanimously approved the
Merger Agreement following the recommendation and approval of a Special
Committee comprised of directors of 21st Century who are independent of
AIG. AIG currently owns approximately 60.8% of the outstanding shares of
21st Century. The transaction represents a 32.6% premium over 21st
Century’s closing price on January 24, 2007, the day of AIG’s unsolicited merger
proposal, and an 11.4% premium over AIG's original proposal price of $19.75
per
share. Upon completion of the transaction, 21st Century will become a
wholly owned subsidiary of AIG.
The
Merger is expected to be completed in the third quarter of calendar year 2007,
subject to customary conditions and approvals. The exact timing is
dependent on the review and clearance of necessary filings with the Securities
and Exchange Commission. The transaction is subject to the affirmative
vote of the holders of a majority of the outstanding shares of 21st
Century. However, AIG has agreed to vote all of its 21st Century shares in
favor of the Merger, thereby assuring that approval will be obtained at the
21st
Century stockholders’ meeting relating to the Merger.
Provisions
in certain agreements, including the supplemental executive retirement plan
and
stock-based compensation plans, will be accelerated as a result of
provisions in the Merger Agreement, resulting in the accelerated recognition
of
expense on the date of the Merger that could materially impact the Company’s
future results of operations. The Company’s stock option and
retirement valuation assumptions have not been altered for provisions in
the Merger Agreement.
The
following items will occur upon the Merger:
|
·
|
Expected
payment of equity awards of approximately $47.2 million, which will
reduce
stockholders’ equity on the date of
payment;
|
|
·
|
Accelerated
recognition of stock-based compensation of $2.7 million, which will
increase other expense and additional paid-in
capital;
|
|
·
|
Payment
of retention bonuses to certain employees of $2.1 million, including
$0.9
million of retention bonus that will be accelerated by the Merger
Agreement and borne by AIG; and
|
|
·
|
Payment
of supplemental employee retirement plan benefits of $14.5 million,
including $2.2 million that will be accelerated by the Merger Agreement
and borne by AIG.
|
NOTE
3. 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. In addition, the Company denies liability
and
has not established a reserve for the matters discussed below. A range of
potential losses in the event of a negative outcome is discussed where
known.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
June
30, 2007
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. In January of 2007, a settlement for an immaterial amount
was reached with the Axen plaintiff, which the Company has now
finalized.
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 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 could not 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 $2.9 million. This matter is now subject to
three separate appeals by the parties. The Company’s Motion to Consolidate the
three appeals was recently denied by the Court of Appeal.
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. On January 11, 2007, Plaintiff’s motion to
certify a “med-pay” class was granted. The Company filed a writ of
mandate with the Court of Appeal, challenging the trial court’s certification,
which was subsequently denied. The matter is now in the discovery
phase.
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 “make-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. The court, in a
published opinion entitled Delanzo v. Allstate, held that in
California, the make-whole rule does not require insurance companies to deduct
an insured’s attorney fees and costs before recovering medical payments made to
an insured. The trial court in the Qunitana case was
ordered to enter judgment consistent with the Delanzo
decision.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
June
30, 2007
Ronald
A. Katz Technology Licensing, L.P. v. 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.
Edward
Bronstein v. 21st Century Insurance Group, et al and companion cases,
Francis A. Sliwinski v. 21st Century Insurance Group, et
al and
Paul Roberts v. 21st Century Insurance, all allege the
Company, its directors and AIG have, or will, breach fiduciary duties as a
result of AIG’s January 24, 2007 merger proposal to acquire the remaining shares
of Company common stock which AIG does not yet own. Both actions were filed
in
the Los Angeles Superior Court in January 2007 and seek class action
certification and equitable relief. The Company formed a Special Committee
of
the Company’s Board of Directors, independent of AIG, to evaluate the terms of
any merger proposal. The Company believes these actions are without
merit.
NOTE
4. ACCUMULATED OTHER COMPREHENSIVE
LOSS
Accumulated
other comprehensive loss is a component of stockholders’ equity and includes all
net changes in the unrealized appreciation and depreciation in value of
available-for-sale investments and changes in unamortized prior service cost
and
actuarial loss of defined benefit pension plans.
A
summary
of accumulated other comprehensive loss follows:
|
|
June
30,
2007
|
|
December
31,
2006
|
Net
unrealized losses on
available-for-sale investments, net of deferred income tax benefit
of $10,408 and
$6,458
|
|
$
|
(19,330 |
) |
|
$
|
(11,994 |
) |
Unamortized
prior service cost and net actuarial loss of defined benefit pension
plans, net of deferred income tax benefit of $8,302 and
$8,503
|
|
|
(15,418 |
) |
|
|
(15,792 |
) |
Total
accumulated other comprehensive loss
|
|
$
|
(34,748 |
) |
|
$
|
(27,786 |
) |
NOTE
5. 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. For certain key employees designated by the Board of
Directors, the Company sponsors a non-qualified supplemental executive
retirement plan (“SERP”). The SERP 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. The SERP has “change in control” provisions
that could immediately vest benefits for certain
individuals. However, the retirement assumptions used to determine
the SERP benefit obligations have not been altered by these “change in control”
provisions in response to the offer by AIG to purchase the remaining Company
common stock.
Components
of Net Periodic Benefit Cost
The
following table presents the
components of net periodic benefit costs for all plans:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
Service
cost
|
|
$
|
1,771
|
|
|
$
|
1,693
|
|
|
$
|
3,542
|
|
|
$
|
3,565
|
|
Interest
cost
|
|
|
2,105
|
|
|
|
1,898
|
|
|
|
4,210
|
|
|
|
3,869
|
|
Expected
return on plan assets
|
|
|
(2,360 |
) |
|
|
(2,112 |
) |
|
|
(4,721 |
) |
|
|
(4,220 |
) |
Amortization
of prior service cost
|
|
|
36
|
|
|
|
39
|
|
|
|
72
|
|
|
|
73
|
|
Amortization
of net loss
|
|
|
251
|
|
|
|
628
|
|
|
|
503
|
|
|
|
1,306
|
|
Total
|
|
$
|
1,803
|
|
|
$
|
2,146
|
|
|
$
|
3,606
|
|
|
$
|
4,593
|
|
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
June
30, 2007
Pension
Plan Contributions
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. 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. The Company did not make any
contributions to its qualified defined benefit pension plan in 2006. Based
on
current assumptions, the Company does not expect to be required to contribute
to
its qualified defined benefit pension plan in 2007.
As
the
Internal Revenue Code does not allow current deductions for advance funding
of a
non-qualified plan, the Company’s funding policy with respect to this plan is to
make contributions as benefits become payable to participants. Contributions
to
our non-qualified defined benefit pension plan generally are limited to amounts
needed to make benefit payments to retirees, which are expected to total
approximately $0.9 million in 2007. Contributions to our non-qualified defined
benefit pension plan totaled $0.3 million and $0.5 million for the three and
six
months ended June 30, 2007, respectively, and $0.2 million and $0.5 million
for
the three and six months ended June 30, 2006, respectively.
NOTE
6. STOCK–BASED AWARDS
Stock
Option Plans
No
stock
options were granted during the six months ended June 30, 2007. Results for
the
six months ended June 30, 2006 include $0.7 million of accelerated costs
incurred 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. Unrecognized compensation
cost for unvested stock option awards was $5.5 million and $8.7 million at
June
30, 2007 and December 31, 2006, respectively. The unrecognized cost as of June
30, 2007, is scheduled to be recognized over a weighted-average period of 1.4
years.
Stock-based
compensation recognized for our stock option awards is as follows:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS, EXCEPT PER SHARE DATA
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
Net
losses and loss adjustment expenses
|
|
$
|
184
|
|
|
$
|
759
|
|
|
$
|
412
|
|
|
$
|
1,893
|
|
Policy
acquisition costs
|
|
|
561
|
|
|
|
448
|
|
|
|
710
|
|
|
|
935
|
|
Other
underwriting expenses
|
|
|
638
|
|
|
|
434
|
|
|
|
1,567
|
|
|
|
2,269
|
|
Income
before provision for income taxes
|
|
|
(1,383 |
) |
|
|
(1,641 |
) |
|
|
(2,689 |
) |
|
|
(5,097 |
) |
Provision
for income taxes
|
|
|
311
|
|
|
|
288
|
|
|
|
666
|
|
|
|
1,045
|
|
Net
income
|
|
$
|
(1,072 |
) |
|
$
|
(1,353 |
) |
|
$
|
(2,023 |
) |
|
$
|
(4,052 |
) |
Basic
and diluted earnings per share
|
|
$
|
(0.01 |
) |
|
$
|
(0.02 |
) |
|
$
|
(0.02 |
) |
|
$
|
(0.05 |
) |
Outstanding
Options
The
following table summarizes information about stock options outstanding at June
30, 2007:
AMOUNTS
IN THOUSANDS, EXCEPT FOR PRICE DATA
|
|
Number
of
Options
|
|
Aggregate
Intrinsic
Value
|
|
Weighted-
Average
Exercise
Price
|
Outstanding
|
|
|
8,320
|
|
|
$
|
45,699
|
|
|
$
|
16.37
|
|
Exercisable
|
|
|
6,739
|
|
|
|
36,220
|
|
|
|
16.48
|
|
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 at June 30, 2007.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
June
30, 2007
Current
Activity
A
summary
of the Company’s stock option activity and related information
follows:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2007
|
|
2006
|
|
2007
|
|
|
2006
|
|
Fair
value of stock options granted
|
|
$
|
—
|
|
|
$
|
900
|
|
|
$
|
—
|
|
|
$
|
9,994
|
|
Intrinsic
value of options exercised
|
|
|
941
|
|
|
|
266
|
|
|
|
7,510
|
|
|
|
483
|
|
Grant
date fair value of options vested
|
|
|
967
|
|
|
|
884
|
|
|
|
7,614
|
|
|
|
7,399
|
|
Proceeds
from exercise of stock options
|
|
|
2,911
|
|
|
|
3,126
|
|
|
|
23,992
|
|
|
|
3,844
|
|
Tax
benefit realized as a result of stock option exercises
|
|
|
334
|
|
|
|
53
|
|
|
|
2,633
|
|
|
|
97
|
|
Restricted
Shares Plan
Total
compensation expense relating to the Restricted Shares Plan was $0.4 million
and
$0.7 million for the three and six months ended June 30, 2007, respectively,
and
$0.4 million and $0.5 million for the three and six months ended June 30, 2006,
respectively. The Company granted 119,150 and 108,550 restricted shares with
a
total fair value of $2.6 million and $1.8 million during the six months ended
June 30, 2007 and 2006, respectively. Unrecognized compensation cost for
restricted stock grants totaled $3.3 million and $1.7 million at June 30, 2007
and December 31, 2006, respectively. The unrecognized cost as of June 30, 2007,
is scheduled to be recognized over a weighted-average period of 2.3
years.
Accelerated
Vesting Provisions
The
Merger Agreement discussed in Note 2 of the Notes to Condensed Consolidated
Financial Statements provides for the immediate vesting of certain stock
option awards and restricted share awards on the effective date of the Merger.
The assumptions used to recognize expense over the service period have not
been
altered by the acceleration provisions contained in the Merger
Agreement.
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.
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, 2006. 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
June
30, 2007
The
following table presents net premiums earned, depreciation and amortization
expense, and segment profit (loss) for the Company’s segments.
|
|
|
|
|
Homeowner
and
|
|
|
|
|
|
Personal
|
|
Earthquake
|
|
|
|
|
|
Auto
Lines
|
|
Lines
in Runoff
|
|
Total
|
Three
Months Ended June 30, 2007
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
334,424
|
|
|
$
|
—
|
|
|
$
|
334,424
|
|
Depreciation
and amortization expense
|
|
|
6,524
|
|
|
|
—
|
|
|
|
6,524
|
|
Segment
profit (loss)
|
|
|
19,108
|
|
|
|
(166 |
) |
|
|
18,942
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three
Months Ended June 30, 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
325,512
|
|
|
$
|
—
|
|
|
$
|
325,512
|
|
Depreciation
and amortization expense
|
|
|
6,642
|
|
|
|
1
|
|
|
|
6,643
|
|
Segment
profit (loss)
|
|
|
28,293
|
|
|
|
(266 |
) |
|
|
28,027
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six
Months Ended June 30, 2007
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
663,706
|
|
|
$
|
—
|
|
|
$
|
663,706
|
|
Depreciation
and amortization expense
|
|
|
12,741
|
|
|
|
1
|
|
|
|
12,742
|
|
Segment
profit (loss)
|
|
|
34,618
|
|
|
|
(228 |
) |
|
|
34,390
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six
Months Ended June 30, 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
premiums earned
|
|
$
|
651,336
|
|
|
$
|
—
|
|
|
$
|
651,336
|
|
Depreciation
and amortization expense
|
|
|
13,301
|
|
|
|
3
|
|
|
|
13,304
|
|
Segment
profit (loss)
|
|
|
45,765
|
|
|
|
(342 |
) |
|
|
45,423
|
|
The
following table reconciles segment profit to consolidated income before
provision for income taxes:
|
|
Three
Months Ended
|
|
Six
Months Ended
|
|
|
June
30,
|
|
June
30,
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
Segment
profit
|
|
$
|
18,942
|
|
|
$
|
28,027
|
|
|
$
|
34,390
|
|
|
$
|
45,423
|
|
Net
investment income
|
|
|
17,582
|
|
|
|
17,174
|
|
|
|
34,507
|
|
|
|
34,929
|
|
Other
income
|
|
|
—
|
|
|
|
10
|
|
|
|
—
|
|
|
|
10
|
|
Net
realized investment gains (losses)
|
|
|
64
|
|
|
|
30
|
|
|
|
351
|
|
|
|
(1,037 |
) |
Other
expense
|
|
|
(2,436 |
) |
|
|
(923 |
) |
|
|
(6,613 |
) |
|
|
(923 |
) |
Interest
and fees expense
|
|
|
(1,677 |
) |
|
|
(1,854 |
) |
|
|
(3,403 |
) |
|
|
(3,752 |
) |
Consolidated
income before provision for income taxes
|
|
$
|
32,475
|
|
|
$
|
42,464
|
|
|
$
|
59,232
|
|
|
$
|
74,650
|
|
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.
21ST
CENTURY INSURANCE GROUP
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Unaudited
TABULAR
DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
June
30, 2007
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%
($52.8 million) of $475.0 million of the entity’s funding activities. These
commitments consist of a $10.6 million minimum investment and a $42.2 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 $8.3 million and $8.6 million at June
30, 2007 and December 31, 2006, 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
a
non-controlling interest with voting rights, beneficiary rights, obligations,
and ownership in proportion to each of its Impact related
investments.
In
addition to the above, the Company held $8.2 million in other Impact related
fixed-income investments at June 30, 2007 and December 31, 2006. The Company
also held $0.3 million in other Impact related private equity investments
classified as other long-term investments at June 30, 2007 and December 31,
2006. Total Impact related investment income was $0.2 million and $0.5 million
for the three and six months ended June 30, 2007, respectively, and $0.2 million
and $0.5 million for the same periods in 2006, respectively.
ITEM
2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Management’s
Discussion and Analysis of Financial Condition and Results of Operations
(“MD&A”) is intended to help the reader understand the Company, our
operations and our present business environment. MD&A should be
read in conjunction with the accompanying condensed consolidated financial
statements. MD&A includes the following sections:
|
·
|
Liquidity
and Capital
Resources
|
|
·
|
Contractual
Obligations and
Commitments
|
|
·
|
Critical
Accounting
Estimates
|
|
·
|
Recent
Accounting
Pronouncements
|
|
·
|
Forward-Looking
Statements
|
OVERVIEW
General
21st
Century Insurance Group is an insurance holding company registered on the New
York Stock Exchange. For convenience, the terms “Company”, “21st”, “21st Century”,
“we”, “us”
or “our”
are used
to refer collectively to the parent company and its
subsidiaries.
Founded
in 1958, we are a direct-to-consumer provider of personal auto
insurance. With $1.4 billion of revenue in 2006, we insure over 1.6
million vehicles in Arizona, California, Florida, Georgia, Illinois, Indiana,
Nevada, New Jersey, Ohio, Oregon, Pennsylvania, Texas, Washington, Colorado,
Minnesota, Missouri, New York, and Wisconsin. 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 (our primary
insurance subsidiary), 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.
Our
long-term financial goals include achieving a 96% or lower combined ratio,
15%
annual growth in direct premiums written, 15% return on stockholders’ equity,
and strong financial ratings.
Agreement
and Plan of Merger
On May
15, 2007, 21st Century Insurance Group and American International Group,
Inc. (“AIG”) entered into a merger agreement (the “Merger Agreement”)
providing for the acquisition by AIG of all of the outstanding shares of common
stock of 21st Century not currently owned by AIG for $22.00 per share in
cash. The Company’s Board of Directors unanimously approved the
Merger Agreement following the recommendation and approval of a Special
Committee comprised of directors of 21st Century who are independent of
AIG. AIG currently owns approximately 60.8% of the outstanding shares of
21st Century. The transaction represents a 32.6% premium over 21st
Century’s closing price on January 24, 2007, the day of AIG’s unsolicited merger
proposal, and an 11.4% premium over AIG’s original proposal price of $19.75 per
share. Upon completion of the transaction, 21st Century will become a
wholly owned subsidiary of AIG.
The
Merger is expected to be completed in the third quarter of calendar year 2007,
subject to customary conditions and approvals. The exact timing is
dependent on the review and clearance of necessary filings with the Securities
and Exchange Commission. The transaction is subject to the affirmative
vote of the holders of a majority of the outstanding shares of 21st
Century. However, AIG has agreed to vote all of its 21st Century shares in
favor of the Merger, thereby assuring that approval will be obtained at the
21st
Century stockholders’ meeting relating to the Merger.
In
connection with the Merger, AIG estimates the total amount of funds required
to
purchase all of the outstanding common stock of the Company not currently owned
by AIG and its subsidiaries and to pay estimated fees and expenses will be
approximately $825.0 million.
Acceleration
provisions in certain agreements, including the supplemental executive
retirement plan and stock-based compensation plans, will be triggered
as a result of provisions in the Merger Agreement, resulting in the accelerated
recognition of expense on the date of the Merger that could materially impact
the Company’s future results of operations. The Company's retirement
and stock option valuation assumptions have not been altered for provisions
in the Merger Agreement. See further discussion in Note 2
of the Notes to Condensed Consolidated Financial
Statements.
National
Expansion
The
Company is implementing a multi-year strategy for national expansion to realize
benefits from 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. In execution of this strategy,
21st expanded its operations into the Midwest (2004); Texas (2005); Florida,
Georgia and Pennsylvania (second quarter of 2006); New Jersey (October 2006);
Colorado, Minnesota, Missouri, and Wisconsin (fourth quarter 2006); and New
York
(April 2007). The Company increased the share of total U.S. personal auto market
in which it operates from approximately 18% in 2003 to 66% in 2007. Growth
in
direct premiums written in non-California markets in the three months and six
months ended June 30, 2007 was 143.4% and 153.9%, respectively, as compared
to
51.8% and 189.1% in the same period in 2006, respectively, and we wrote
approximately 22% of the first half of 2007’s direct premiums outside of
California, versus 9% for the same period of 2006. Continued implementation
of
our geographic expansion strategy could be affected by a number of factors
beyond our control, such as increased competition, judicial, regulatory,
legislative developments, general economic conditions, increased operating
costs, or change in control of the Company.
Highlights
The
following table summarizes our
underwriting profit, which is reconciled to net income in Results of
Operations:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2007
|
|
2006
|
|
%
Change
’07
vs.‘06
|
|
2007
|
|
2006
|
|
%
Change
’07
vs.‘06
|
Direct
premiums written
|
|
$
|
323,122
|
|
|
$
|
316,838
|
|
|
|
2.0 |
% |
|
$
|
673,652
|
|
|
$
|
655,406
|
|
|
|
2.8 |
% |
Net
premiums written
|
|
|
321,594
|
|
|
|
315,477
|
|
|
|
1.9
|
|
|
|
670,616
|
|
|
|
652,699
|
|
|
|
2.7
|
|
Net
premiums earned
|
|
$
|
334,424
|
|
|
$
|
325,512
|
|
|
|
2.7
|
|
|
$
|
663,706
|
|
|
$
|
651,336
|
|
|
|
1.9
|
|
Net
losses and loss adjustment expenses (“LAE”)
|
|
|
(235,221 |
) |
|
|
(223,094 |
) |
|
|
5.4
|
|
|
|
(468,678 |
) |
|
|
(459,590 |
) |
|
|
2.0
|
|
Underwriting
expenses
|
|
|
(80,261 |
) |
|
|
(74,391 |
) |
|
|
7.9
|
|
|
|
(160,638 |
) |
|
|
(146,323 |
) |
|
|
9.8
|
|
Underwriting
profit
|
|
$
|
18,942
|
|
|
$
|
28,027
|
|
|
|
(32.4 |
) |
|
$
|
34,390
|
|
|
$
|
45,423
|
|
|
|
(24.3 |
) |
Financial
highlights for the three months ended June 30, 2007 and 2006:
|
·
|
California
direct premiums written decreased 12.5% to $251.4 million for the
quarter
ended June 30, 2007, compared to $287.4 million for the same period
in
2006.
|
|
·
|
Non-California
direct premiums written increased 143.4% to $71.7 million for the
quarter
ended June 30, 2007, compared to $29.4 million for the same period
in
2006.
|
|
·
|
Consolidated
combined ratio was 94.3% for the quarter ended June 30, 2007, versus
91.4%
for the same period in 2006. The consolidated combined ratios
for the three months ended June 30, 2007 and 2006 were both favorably
impacted by 5.6 points of prior accident year loss and LAE reserve
development.
|
Financial
highlights for the six months ended June 30, 2007 and 2006:
|
·
|
California
direct premiums written decreased 11.4% to $531.0 million for the
six
months ended June 30, 2007, compared to $599.2 million for the same
period
in 2006.
|
|
·
|
Non-California
direct premiums written increased 153.9% to $142.7 million for the
six
months ended June 30, 2007, compared to $56.2 million for the same
period
in 2006.
|
|
·
|
Consolidated
combined ratio was 94.8% for the six months ended June 30, 2007,
versus
93.0% for the same period in 2006. 2007 was favorably impacted
by 5.5 points of prior accident year loss and LAE reserve development,
while 2006 was favorably impacted by 3.9 points of prior accident
year
development.
|
For
the
three months and six months ended June 30, 2007, 21st’s insurance subsidiaries
achieved underwriting profitability and realized growth in total direct premiums
written in spite of developments in the California market. In recent quarters,
the California market, which represented approximately 78% of our total direct
premiums written during the first half of 2007, compared to 91% for the first
half of 2006, 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, but this was offset by growth
realized in non-California markets as a result of our national expansion
efforts.
The
underwriting expense (policy acquisition costs and other underwriting expenses)
to net premiums earned ratio increased to 24.0% for the three months ended
June
30, 2007 from 22.9% for the same period in 2006. For the six months
ended June 30, 2007, the underwriting expense to net premiums earned ratio
increased to 24.2% from 22.4% for the same period in 2006. These
increases are primarily the result of expenses associated with the Company’s
national expansion efforts.
Net
income decreased 19.4% to $22.8 million, or $0.26 per
basic share, for the
three months ended June 30, 2007, compared to $28.3 million, or $0.33 per basic
share, for the same period in 2006. This was primarily due to higher
underwriting expenses discussed above. Also, net income during the
second quarter 2007 was impacted by $2.4 million ($1.7 million after-tax, or
$0.02 per basic share) of costs associated with the Special Committee of the
Board of Directors and its advisors’ evaluation and negotiation of the merger
proposal from AIG. Net income decreased 17.0% to $41.2 million, or $0.47 per
basic share, for the
six months ended June 30, 2007, compared to $49.6 million, or $0.58 per basic
share, for the same six-month period in 2006. This was primarily due to lower
underwriting profit realized as a result of the California rate decrease
discussed below, and higher underwriting expenses discussed above. Additionally,
2007 results were impacted by $6.6 million ($4.4 million after-tax, or $0.05
per
basic share) of non-operational items comprised of $3.6 million of severance
costs associated with the Company’s efforts to streamline operations and $3.0
million of costs associated with the Special Committee of the Board of Directors
and its advisors’ evaluation and negotiation of the merger proposal from
AIG.
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 required 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 have changed
and consumer shopping behavior may increase in the future. The
Company has filed for a personal automobile overall rate decrease in California
of approximately 5%. The CDI approved the Company’s class plan and rate filings
and the new rates took effect January 3, 2007. Most of the Company’s main
competitors have also received approval of overall rate decreases of varying
amounts, while some 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 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 (the “Rate
Approval Regulations”) affecting personal auto, homeowners and most lines of
commercial property and casualty insurance written in California. The
regulations became effective on April 3, 2007. These regulations could have
a
materially adverse impact on the Company’s California results.
Non-GAAP
Measures
Information
concerning premiums written, underwriting profit, combined ratio and statutory
surplus have been presented to enhance readers’ understanding of the Company’s
operations. These widely used financial measures in the insurance
industry do not have formal definitions currently under 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 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 include 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 at 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 in the following locations: premiums written and underwriting
profit are located in Results of Operations and statutory surplus is
located in Liquidity and Capital Resources. 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.
RESULTS
OF OPERATIONS
Consolidated
Results
The
following table summarizes our segment results of operations and reconciles
underwriting profit to consolidated net income:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS,
EXCEPT
SHARE DATA
|
|
2007
|
|
2006
|
|
%
Change
’07
vs.‘06
|
|
2007
|
|
2006
|
|
%
Change
’07
vs.‘06
|
Personal
auto lines underwriting profit
|
|
$
|
19,108
|
|
|
$
|
28,293
|
|
|
|
(32.5 |
)% |
|
$
|
34,618
|
|
|
$
|
45,765
|
|
|
|
(24.4 |
)% |
Homeowner
and earthquake lines in runoff,
underwriting loss
|
|
|
(166 |
) |
|
|
(266 |
) |
|
|
(37.6 |
) |
|
|
(228 |
) |
|
|
(342 |
) |
|
|
(33.3 |
) |
Net
investment income
|
|
|
17,582
|
|
|
|
17,174
|
|
|
|
2.4
|
|
|
|
34,507
|
|
|
|
34,929
|
|
|
|
(1.2 |
) |
Other
income
|
|
|
—
|
|
|
|
10
|
|
|
N/M1
|
|
|
|
—
|
|
|
|
10
|
|
|
N/M1
|
|
Net
realized investment gains (losses)
|
|
|
64
|
|
|
|
30
|
|
|
|
113.3
|
|
|
|
351
|
|
|
|
(1,037 |
) |
|
|
133.8
|
|
Other
expense
|
|
|
(2,436 |
) |
|
|
(923 |
) |
|
|
163.9
|
|
|
|
(6,613 |
) |
|
|
(923 |
) |
|
|
616.5
|
|
Interest
and fees expense
|
|
|
(1,677 |
) |
|
|
(1,854 |
) |
|
|
(9.5 |
) |
|
|
(3,403 |
) |
|
|
(3,752 |
) |
|
|
(9.3 |
) |
Provision
for income taxes
|
|
|
(9,637 |
) |
|
|
(14,143 |
) |
|
|
(31.9 |
) |
|
|
(18,048 |
) |
|
|
(25,011 |
) |
|
|
(28.0 |
) |
Net
income
|
|
$
|
22,838
|
|
|
$
|
28,321
|
|
|
|
(19.4 |
) |
|
$
|
41,184
|
|
|
$
|
49,639
|
|
|
|
(17.0 |
) |
Basic
earnings per share
|
|
$
|
0.26
|
|
|
$
|
0.33
|
|
|
|
(21.2 |
) |
|
$
|
0.47
|
|
|
$
|
0.58
|
|
|
|
(19.0 |
) |
Diluted
earnings per share
|
|
$
|
0.25
|
|
|
$
|
0.33
|
|
|
|
(24.2 |
) |
|
$
|
0.46
|
|
|
$
|
0.57
|
|
|
|
(19.3 |
) |
Underwriting
results above include the effect of prior accident years’ reserve development
recorded in the current year. The following table summarizes losses and LAE
incurred, net of applicable reinsurance, for the periods indicated:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
Net
losses and LAE incurred related to insured events in:
|
|
|
|
|
|
|
|
|
|
|
|
|
Current
accident year personal auto lines
|
|
$
|
253,905
|
|
|
$
|
241,215
|
|
|
$
|
505,245
|
|
|
$
|
484,726
|
|
Prior
accident years:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Personal
auto lines
|
|
|
(18,850 |
) |
|
|
(18,387 |
) |
|
|
(36,795 |
) |
|
|
(25,479 |
) |
Homeowner
and earthquake lines in runoff
|
|
|
166
|
|
|
|
266
|
|
|
|
228
|
|
|
|
343
|
|
Total
prior years’ development recorded in current year
|
|
|
(18,684 |
) |
|
|
(18,121 |
) |
|
|
(36,567 |
) |
|
|
(25,136 |
) |
Total
net losses and LAE incurred
|
|
$
|
235,221
|
|
|
$
|
223,094
|
|
|
$
|
468,678
|
|
|
$
|
459,590
|
|
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 at June 30, 2007 and 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
states accounted for 22.2% of our direct premiums written for the three months
ended June 30, 2007, compared to 9.3% for the same period in
2006. For the six months ended June 30, 2007, non-California states
accounted for 21.2% of our direct premiums written, compared to 8.6% for the
same period in 2006. This increase is due to our ongoing national
expansion program. The Company currently plans to expand into additional states
to further its national expansion strategy.
1
Ratio
is not
meaningful.
The
following table presents the components of our personal auto lines underwriting
profit and the components of the combined ratio:
|
|
Three
Months Ended
|
|
Six
Months Ended
|
|
|
June
30,
|
|
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2007
|
|
2006
|
|
Change
’07
vs.‘06
|
|
%
Change
’07
vs.‘06
|
|
2007
|
|
2006
|
|
Change
’07
vs.‘06
|
|
%
Change
’07
vs.‘06
|
Direct
premiums written
|
|
$
|
323,122
|
|
|
$
|
316,837
|
|
|
$
|
6,285
|
|
|
|
2.0 |
% |
|
$
|
673,652
|
|
|
$
|
655,406
|
|
|
$
|
18,246
|
|
|
|
2.8 |
% |
Net
premiums written
|
|
$
|
321,594
|
|
|
$
|
315,476
|
|
|
$
|
6,118
|
|
|
|
1.9
|
|
|
$
|
670,616
|
|
|
$
|
652,700
|
|
|
$
|
17,916
|
|
|
|
2.7
|
|
Net
premiums earned
|
|
$
|
334,424
|
|
|
$
|
325,512
|
|
|
$
|
8,912
|
|
|
|
2.7
|
|
|
$
|
663,706
|
|
|
$
|
651,336
|
|
|
$
|
12,370
|
|
|
|
1.9
|
|
Net
losses and LAE
|
|
|
(235,055 |
) |
|
|
(222,828 |
) |
|
|
12,227
|
|
|
|
5.5
|
|
|
|
(468,450 |
) |
|
|
(459,248 |
) |
|
|
9,202
|
|
|
|
2.0
|
|
Underwriting
expenses
|
|
|
(80,261 |
) |
|
|
(74,391 |
) |
|
|
5,870
|
|
|
|
7.9
|
|
|
|
(160,638 |
) |
|
|
(146,323 |
) |
|
|
14,315
|
|
|
|
9.8
|
|
Underwriting
profit
|
|
$
|
19,108
|
|
|
$
|
28,293
|
|
|
$
|
(9,185 |
) |
|
|
(32.5 |
) |
|
$
|
34,618
|
|
|
$
|
45,765
|
|
|
$
|
(11,147 |
) |
|
|
(24.4 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ratios:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
and LAE ratio
|
|
|
70.3 |
% |
|
|
68.5 |
% |
|
|
1.8
|
|
|
|
|
|
|
|
70.6 |
% |
|
|
70.5 |
% |
|
|
0.1
|
|
|
|
|
|
Underwriting
expense ratio
|
|
|
24.0
|
|
|
|
22.9
|
|
|
|
1.2
|
|
|
|
|
|
|
|
24.2
|
|
|
|
22.5
|
|
|
|
1.7
|
|
|
|
|
|
Combined
ratio
|
|
|
94.3 |
% |
|
|
91.4 |
% |
|
|
3.0
|
|
|
|
|
|
|
|
94.8 |
% |
|
|
93.0 |
% |
|
|
1.8
|
|
|
|
|
|
The
following table reconciles our personal auto lines direct premiums written
to
net premiums earned:
|
|
Three
Months Ended
|
|
Six
Months Ended
|
|
|
June
30,
|
|
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
Direct
premiums written
|
|
$
|
323,122
|
|
|
$
|
316,837
|
|
|
$
|
673,652
|
|
|
$
|
655,406
|
|
Ceded
premiums written
|
|
|
(1,528 |
) |
|
|
(1,361 |
) |
|
|
(3,036 |
) |
|
|
(2,706 |
) |
Net
premiums written
|
|
|
321,594
|
|
|
|
315,476
|
|
|
|
670,616
|
|
|
|
652,700
|
|
Net
change in unearned premiums
|
|
|
12,830
|
|
|
|
10,036
|
|
|
|
(6,910 |
) |
|
|
(1,364 |
) |
Net
premiums earned
|
|
$
|
334,424
|
|
|
$
|
325,512
|
|
|
$
|
663,706
|
|
|
$
|
651,336
|
|
California
direct premiums written decreased in the three months and six months ended
June
30, 2007, as compared to the same periods in 2006, primarily due to a 5% rate
decrease and continued competitiveness in the California market. As discussed
in
the Highlights, the CDI 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 impact
of these changes, which could have either a favorable or adverse impact on
the
Company. Also in July 2006, the CDI proposed new amended rate
approval regulations affecting personal auto, homeowners and most lines of
commercial property and casualty insurance written in California, subsequently
amended in October of 2006 and approved in January of 2007 with an effective
date of April 3, 2007. These regulations could have a materially adverse impact
on the Company’s California results.
As
the
Company proceeds with its national expansion strategy, 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
increase in the loss and LAE ratio for the three months ended June 30, 2007
over
the same period in 2006 of 1.8 points is primarily due to the California rate
decrease discussed above. The loss and LAE ratios for the three months ended
June 30, 2007 and 2006 were both favorably impacted by 5.6 points of prior
accident year loss and LAE reserve development. The loss and LAE ratios included
$18.9 million and $18.4 million of favorable reserve development for the three
months ended June 30, 2007 and 2006, respectively. The loss and LAE ratio for
the six months ended June 30, 2007 is consistent with the same period in
2006. For the six months ended June 30, 2007 loss and LAE ratio
included 5.5 points ($36.8 million) of favorable reserve development compared
to
3.9 points ($25.5 million) in the same period of 2006. In general,
changes in estimates are recorded in the period in which new information becomes
available indicating that a change is warranted.
The
underwriting expense to net premiums earned ratios increased in the three months
and six months ended June 30, 2007, as compared to the same period in the prior
year. This increase is primarily the result of expenses associated
with the Company’s national expansion efforts.
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 and six months ended June 30, 2007 and $0.3 million for
the three and six months ended June 30, 2006. California Senate Bill 1899
(“SB 1899”), effective from January 1, 2001 to December 31, 2001, allowed the
re-opening of previously closed earthquake claims arising out of the 1994
Northridge earthquake. The last remaining earthquake claim brought
against the Company as a result of SB 1899 was resolved in the first quarter
of
2007.
Net
Investment Income
We
utilize a conservative investment philosophy. Substantially the entire fixed
maturity securities portfolio is investment grade, having a weighted-average
Standard & Poor’s credit quality of “AA”. No derivatives are held
in our investment portfolio and there were no publicly traded equity securities
at June 30, 2007. The Company previously held publicly traded
equities, but sold them in the first quarter of 2006, lowering the risk and
yield of the overall investment portfolio. The components of net investment
income were as follows:
|
|
Three
Months Ended
|
|
Six
Months Ended
|
|
|
June
30,
|
|
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
Interest
on fixed maturity securities, at fair value
|
|
$
|
16,889
|
|
|
$
|
17,087
|
|
|
$
|
33,715
|
|
|
$
|
33,954
|
|
Interest
on cash and cash equivalents
|
|
|
942
|
|
|
|
287
|
|
|
|
1,469
|
|
|
|
621
|
|
Loss
from other long-term investments, equity method
|
|
|
—
|
|
|
|
—
|
|
|
|
(187 |
) |
|
|
—
|
|
Dividends
on equity securities
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
811
|
|
Total
investment income
|
|
|
17,831
|
|
|
|
17,374
|
|
|
|
34,997
|
|
|
|
35,386
|
|
Investment
expense
|
|
|
(249 |
) |
|
|
(200 |
) |
|
|
(490 |
) |
|
|
(457 |
) |
Net
investment income
|
|
$
|
17,582
|
|
|
$
|
17,174
|
|
|
$
|
34,507
|
|
|
$
|
34,929
|
|
The
fixed
maturity securities portfolio comprised 99% of the total investment portfolio
at
June 30, 2007 and December 31, 2006.The average annual yields on fixed maturity
securities were as
follows:
|
|
Three
Months Ended
|
|
Six
Months Ended
|
|
|
June
30,
|
|
June
30,
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
Pre-tax
– fixed maturity securities
|
|
|
4.6 |
% |
|
|
4.6 |
% |
|
|
4.6 |
% |
|
|
4.7 |
% |
After-tax
– fixed maturity securities
|
|
|
3.3 |
% |
|
|
3.3 |
% |
|
|
3.3 |
% |
|
|
3.4 |
% |
At
June 30, 2007, $368.6 million, or
26.4%, of our total fixed maturity securities at fair value were invested in
tax-exempt bonds, compared to 26.4% at December 31, 2006, with the remainder
invested in taxable securities. At June 30, 2007, no investments were rated
below investment grade.
The
net
realized gains (losses) on investments were as follows:
|
|
Three
Months Ended
June
30,
|
|
Six
Months Ended
June
30,
|
AMOUNTS
IN THOUSANDS
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
Gross
realized gains
|
|
$
|
239
|
|
|
$
|
97
|
|
|
$
|
621
|
|
|
$
|
1,549
|
|
Gross
realized losses
|
|
|
(175 |
) |
|
|
(67 |
) |
|
|
(270 |
) |
|
|
(2,586 |
) |
Net
realized gains (losses) on investments
|
|
$
|
64
|
|
|
$
|
30
|
|
|
$
|
351
|
|
|
$
|
(1,037 |
) |
During
the first quarter of 2006, the Company sold its investments in publicly held
equity securities, contributing to the recognition of a $1.4 million loss on
equity securities in the period. Our policy is to investigate, on a quarterly
basis, all investments for possible “other-than-temporary” impairment when the
fair value of a security falls below its amortized cost, based on all relevant
facts and circumstances. No such impairments were recorded in the
three and six months ended June 30, 2007 or for the same periods in 2006. See
discussion under Critical Accounting Estimates – Investments for
further information.
Other
Expense
In
the
first quarter of 2007, the Company reduced its workforce by an approximate
three
percent in connection with efforts to streamline operations. The
Company incurred $3.4 million in severance and other benefits costs during
the
first quarter of 2007 and subsequently adjusted this estimate by $0.2 million
during the second quarter for the differences between the original estimate
and
subsequent payments. At March 31 and June 30, 2007, the undistributed
severance and other benefits payments in connection with this workforce
reduction was $0.4 million due to the payments of $0.2 million in the second
quarter that were offset by the revision of the estimate. The remaining payments
are expected to be distributed by the end of 2007. Annual savings from this
reduction in workforce are estimated to be primarily offset by merit increases
and costs associated with national expansion efforts.
The
Company also incurred $2.3 million and $3.0 million for the three and six months
ended June 30, 2007, respectively, in connection with the Merger Agreement,
as
discussed in Note 2 of the Notes to Condensed Consolidated Financial
Statements.
FINANCIAL
CONDITION
Investments
and cash were $1.5 billion
at June 30, 2007 and December 31, 2006. The Company sold its
investments in publicly held equity securities during the first quarter of
2006,
with the proceeds primarily reinvested in fixed maturity securities and did
not
hold any publicly held equity securities at June 30, 2007. However,
we executed a $35 million funding commitment for a private equity investment
program during the second quarter of 2006. The Company’s funded commitment was
$18.1 million and $14.4 million at June 30, 2007 and December 31, 2006,
respectively.
The
Company also has unrated, community
investments representing 1.7% 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.
Deferred
policy acquisition costs
totaled $63.6 million at June 30, 2007 and December 31, 2006. This balance
remained consistent between periods as increased advertising, sales and customer
service costs due to the Company’s national expansion efforts during 2007 were
offset by amortization, as spending was concentrated in the first quarter,
and a
$3.8 million decrease in deferred policy acquisition costs (“DPAC”) resulting
from the adoption of Statement of Position 05-1 (see Recent Accounting
Pronouncements). 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:
|
|
June
30, 2007
|
|
December
31, 2006
|
AMOUNTS
IN THOUSANDS
|
|
Gross
|
|
Net
|
|
Gross
|
|
Net
|
Unpaid
losses and LAE
|
|
|
|
|
|
|
|
|
|
|
|
|
Personal
auto lines
|
|
$
|
449,893
|
|
|
$
|
444,433
|
|
|
$
|
480,731
|
|
|
$
|
475,261
|
|
Homeowner
and earthquake lines in runoff
|
|
|
1,361
|
|
|
|
680
|
|
|
|
1,538
|
|
|
|
808
|
|
Total
|
|
$
|
451,254
|
|
|
$
|
445,113
|
|
|
$
|
482,269
|
|
|
$
|
476,069
|
|
At
June 30, 2007, gross unpaid losses
and LAE decreased $31.0 million, primarily due to a reserve decrease of $30.8
million in the personal auto lines as a result of $36.8 million of favorable
prior year loss development recorded during the six months ended June 30, 2007.
The gross unpaid losses and LAE in the homeowner and earthquake lines decreased
$0.2 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
$109.2 million at June 30, 2007, compared to $115.9 million at December 31,
2006, consists of $9.3 million of capital lease obligations and $99.9 million
of
Senior Notes, net of discount. The decrease in debt of $6.7 million during
the
six months ended June 30, 2007 is primarily attributable to principal payments
on the capital leases.
Stockholders’
equity
and book value per
share increased to $932.4 million and $10.59, respectively, at June 30, 2007,
compared to $898.5 million and $10.39 at December 31, 2006,
respectively. The increase in stockholders’ equity for the six months
ended June 30, 2007 was primarily due to net income of $41.2 million, $26.5
million from the exercise of stock options, and stock-based compensation cost
of
$3.6 million. This
was partially offset by dividends
to stockholders of $28.1 million, other comprehensive loss of $7.0 million
and
an adjustment of $2.4 million for the adoption of Financial Interpretation
No.
48, Accounting for
Uncertainty in Income Taxes – an Interpretation of FAS No. 109.
LIQUIDITY
AND CAPITAL RESOURCES
Holding
Company
Our
holding company’s main sources of liquidity historically have been dividends
received from our insurance subsidiaries, borrowing from our primary insurance
subsidiary, 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 AIG exercised its warrants to purchase 16 million
shares of common stock for
cash of $145.6 million. Our insurance subsidiaries did not pay any dividends
to
our holding company from 2001 to 2004 due to the previous uncertainty
surrounding the taxability of dividends received by holding companies from
their
insurance subsidiaries in California, which was resolved in 2004. Our primary insurance
subsidiary, 21st Century Insurance Company, declared and paid a $110.0 million
dividend in December 2006.
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 $0.9 million, started in January 2004 and
has
been subject to upward adjustments based on the cost incurred by the holding
company to enhance the software.
Our
holding company’s significant cash obligations over the next several years
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;
|
|
·
|
Related
interest on the Senior Notes above;
|
|
·
|
The
repayment of the $60 million term loan due to subsidiary;
and
|
|
·
|
Any
dividends to stockholders that our board of directors may
declare.
|
The
declaration and payment of dividends is subject to the discretion of our board
of directors and will depend on our financial condition, results of operations,
cash requirements, future prospects, and regulatory and contractual restrictions
on the payment of dividends by our subsidiaries, and other factors deemed
relevant by our board of directors. There is no requirement that we must, and
we
cannot assure you that we will, declare and pay any dividends in the future.
Our
board of directors may determine to retain such capital for general corporate
or
other purposes. The Merger Agreement among the Company and AIG limits the amount
of dividends that the Company may declare to regular quarterly dividends on
shares of no more than $0.16 per share (the record dates for which shall be
the
close of business, September 24, 2007, December 21, 2007 and March 5, 2008,
respectively) which are payable after the last day of any quarter. If the Merger
closes between record dates, the Merger Agreement allows for a special dividend
equivalent up to $0.16 per share (adjusted on a pro rata basis for the passage
of time since the last record date).
We
expect
to be able to meet these obligations from sources of cash currently available
(i.e., cash and investments at the holding company, which totaled $94.0 million
at June 30, 2007, dividends received from our insurance subsidiaries, payments
received from the intercompany lease, and borrowing from our insurance
subsidiary), or additional funds that may be obtainable from the capital
markets. The effective California state income tax rate applicable to dividends
received from our insurance subsidiaries is approximately 1.8%, or 1.2% net
of
federal benefit. In December 2007, our primary insurance subsidiary could pay
$124.0 million as dividends to the holding company without prior written
approval from insurance regulatory authorities.
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 changes, there
can
be no assurance that insurance regulators will grant future rate changes 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 affecting personal auto, homeowners and most lines of
commercial property and casualty insurance written in California, subsequently
amended in October of 2006, which could have a materially adverse impact on
the
Company’s California results. The regulations became effective on
April 3, 2007.
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
June
30, 2007, our insurance subsidiaries had a combined statutory surplus of $753.1
million compared to $771.0 million at December 31, 2006. The decrease in
statutory surplus was primarily due to an increase in nonadmitted assets of
$49.7 million, dividends to the holding company of $14.0 million and an increase
in deferred taxes of $7.0 million, partially offset by statutory net income
of
$52.2 million. The net premiums written to statutory surplus ratio, which is
required to be below 3.0 by the insurance regulators, was 1.7 at June 30, 2007
and December 31, 2006.
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 June 30, 2007, all of our insurance subsidiaries
met
their respective regulatory requirements.
The
following is a reconciliation of our stockholders’ equity to statutory
surplus:
AMOUNTS
IN THOUSANDS
|
|
June
30,
2007
|
|
December
31,
2006
|
Stockholders’
equity – GAAP
|
|
$
|
932,382
|
|
|
$
|
898,549
|
|
Condensed
adjustments to reconcile GAAP stockholders’ equity to statutory
surplus:
|
|
|
|
|
|
|
|
|
Net
book value of fixed assets under capital leases
|
|
|
(17,919 |
) |
|
|
(20,373 |
) |
Deferred
loss (gain) under capital lease transactions
|
|
|
339
|
|
|
|
(79 |
) |
Capital
lease obligation
|
|
|
9,280
|
|
|
|
15,985
|
|
Nonadmitted
net deferred tax assets
|
|
|
(16,724 |
) |
|
|
(17,419 |
) |
Difference
in net deferred tax assets reported under Statutory Accounting
Principles
|
|
|
21,557
|
|
|
|
24,200
|
|
Intercompany
receivables
|
|
|
(64,345 |
) |
|
|
(11,488 |
) |
Fixed
assets
|
|
|
(21,698 |
) |
|
|
(22,955 |
) |
Equity
in non-insurance entities
|
|
|
(54,053 |
) |
|
|
(47,006 |
) |
Net
unrealized losses on investments
|
|
|
28,989
|
|
|
|
17,881
|
|
Deferred
policy acquisition costs
|
|
|
(63,621 |
) |
|
|
(63,581 |
) |
Pension
related liabilities
|
|
|
18,481
|
|
|
|
15,648
|
|
Other
prepaid expenses
|
|
|
(18,214 |
) |
|
|
(14,195 |
) |
FIN
48 liability
|
|
|
3,500
|
|
|
|
—
|
|
Other,
net
|
|
|
(4,822 |
) |
|
|
(4,158 |
) |
Statutory
surplus
|
|
$
|
753,132
|
|
|
$
|
771,009
|
|
Cash
Flows
Our
net
increase (decrease) in cash and cash equivalents were as follows:
AMOUNTS
IN THOUSANDS
Six
Months Ended June 30,
|
|
2007
|
|
2006
|
|
‘07
vs.‘06
Increase/
(Decrease)
|
Net
cash and cash equivalents provided by operating activities
|
|
$
|
39,841
|
|
|
$
|
64,418
|
|
|
$
|
(24,577
|
)
|
Net
cash and cash equivalents provided by (used in) investing
activities
|
|
|
7,710
|
|
|
|
(76,352
|
)
|
|
|
84,062
|
|
Net
cash and cash equivalents used in financing activities
|
|
|
(9,972
|
)
|
|
|
(16,546
|
)
|
|
|
6,574
|
|
Net
increase (decrease) in cash and cash equivalents
|
|
$
|
37,579
|
|
|
$
|
(28,480
|
)
|
|
$
|
66,059
|
|
Operating
Activities
Net
cash
provided by operating activities decreased primarily due to an increase in
underwriting costs as a result of the Company’s national expansion strategy; an
increase in payments for losses and LAE attributable to growth realized in
the
current quarter; expenditures related to the merger proposal from the majority
owner, AIG, to acquire the remaining shares of the Company common stock it
does
not own; and severance costs in connection with the Company’s efforts to
streamline operations. This was partially offset by an increase in direct
premiums collected resulting from the increase in direct premiums written
realized as a result of the Company’s national expansion efforts.
Investing
Activities
Our
cash
flow from investing activities is primarily impacted by the sales, maturities
and purchases of our available-for-sale investment securities. Our
investment objective is to maintain a low level of risk and to preserve
principal by investing in high quality, investment grade securities while
maintaining liquidity in each portfolio sufficient to meet our cash flow
requirements.
Our
cash
flows from investing activities changed from a net outflow in 2006 to a net
inflow in 2007. This change is primarily a result of a decrease in investment
purchases due to decline in operating cash flows. Additionally, the redeployment
of cash from operating cash flows to the investment portfolio declined as
available funds in the current year were instead invested in more liquid cash
equivalents that have similar returns as a result of the relatively flat yield
curve.
Financing
Activities
Net
cash
used in financing activities decreased due to the favorable impact of a $20.2
million increase in cash receipts for stock option exercises, partially offset
by the doubling of the quarterly dividend since the prior year from $0.08 per
share to $0.16 per share, resulting in a $14.4 million increase in dividends
paid.
CONTRACTUAL
OBLIGATIONS AND COMMITMENTS
See
our
discussion about variable interest entities and commitments in Note 8 of the
Notes to Condensed Consolidated Financial Statements. There were no
material changes outside the ordinary course of our business in our contractual
obligations during the six-month period ended June 30, 2007.
CRITICAL
ACCOUNTING ESTIMATES
The
preparation of financial statements
in accordance with GAAP requires management to make estimates and assumptions
that affect reported amounts and related disclosures. Our significant
accounting policies are essential to understanding Management’s Discussion and
Analysis of Financial Condition and Results of Operations. Management considers
an accounting estimate to be critical if:
|
·
|
It
requires assumptions to be made that were uncertain at the time the
estimate was made; and
|
|
·
|
Change
in the estimate or different estimates that may have been selected
could
have a material impact on the Company’s consolidated results of operations
or financial condition.
|
The
following is a summary of the more
critical accounting estimates. In each area, we have discussed the assumptions
most important in the estimation process. We have used the best information
available to estimate the related items involved. Actual performance that
differs from our estimates and future changes in the key assumptions could
change future valuations and materially impact our financial condition and
results of operations.
Management
has discussed the
development and selection of our critical accounting estimates with the Audit
Committee of our Board of Directors.
Unpaid
Losses and Loss Adjustment Expenses
The
estimated liabilities for unpaid
losses and LAE include estimates of the ultimate resolution for known claims
reported on or prior to the balance sheet dates, estimates of losses for claims
incurred but not reported, and estimates of expenses for investigating,
adjusting and settling all incurred claims. Amounts reported are estimates
of
the ultimate costs of settlement, net of estimated salvage and subrogation.
The
estimated liabilities are necessarily subject to the outcome of future events,
such as changes in medical and repair costs, as well as economic and social
conditions that impact the settlement of claims. In addition, time can be a
critical part of reserving determinations since the variability of the ultimate
settlement amount is likely to increase as the time between the occurrence
and
settlement of the claim increased.
The
methods used to determine such estimates and to establish the resulting reserves
are continually monitored, 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 at June 30, 2007. While we perform quarterly
reviews of the adequacy of established unpaid losses and LAE, 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
at
June 30, 2007. 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.
Because
these are unknown future events, there is uncertainty in the Company’s estimates
of ultimate losses and LAE. This uncertainty comes from various
factors, both positive and negative, that may include changes in claims
reporting and settlement patterns, changes in regulatory and legal environment,
and inflation rates. The Company does not make a specific provision
for these uncertainties; however, they are considered in establishing the
reserves by analyzing historical patterns and trends.
The
process of estimating 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 several commonly accepted actuarial methods
utilizing paid and incurred loss histories, claim frequency and severity, and
expected loss ratios.
The
incurred loss development method analyzes historical case incurred loss (paid
loss plus case reserves) development to estimate ultimate losses. The
Company applies loss development factors against case incurred losses by
accident period to calculate ultimate losses. The paid loss
development method is similar to the incurred loss development method except
only paid losses are used.
The
claim
count development method analyzes historical claim count development to estimate
ultimate claim counts. The Company applies these development factors
against claim counts by accident period to calculate ultimate claim
counts. Severity is the amount of loss per claim. The
average severity method analyzes historical severity development to calculate
an
ultimate average cost per claim. From this, the ultimate severity can
be estimated. The claim count development method coupled with the
average severity method also provides useful information regarding frequency
and
inflationary trends that the Company believes is useful in setting
reserves. In states with little operating history the Company’s
experience is supplemented with industry statistics.
The
Company uses similar methods for LAE. The Company estimates the loss
IBNR reserves as the difference between its projection of ultimate losses and
the sum of the payments and case reserves for losses.
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 months would require more judgment. We do
not believe disclosure of specific indicated point estimates as calculated
by
the various methods 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.
Volatility
of Reserve Estimates and Sensitivity Analysis
The
Company uses numerous assumptions
in determining its best estimates of reserves for losses and LAE for each
coverage of the personal auto business. If actual experience differs
from key assumptions used in establishing reserves, there is potential for
significant variation in the development of loss and LAE
reserves. Set forth below is a sensitivity analysis that estimates
the effect on the loss and LAE reserve position of using alternative loss cost
trend or loss development factor assumptions rather than those actually used
in
determining the best estimates in the second quarter 2007 loss and LAE reserve
analyses. The analysis addresses the personal auto business in
California for which a material deviation to the Company’s overall reserve
position is believed reasonably possible, and uses what the Company believes
is
a reasonably likely range of potential deviation. There can be no
assurance, however, that actual reserve development will be consistent with
either the original or the adjusted loss cost trend or loss development
assumptions, or that other assumptions made in the reserving process will not
materially affect reserve development for a particular coverage.
After
evaluating the historical loss
cost trends from prior years since 1994, in Management’s judgment, it is
reasonably likely that actual loss cost trends applicable to the second quarter
2007 loss and LAE reserve analysis will range from negative 13% to positive
6%,
or approximately 10% lower and 9% higher than the assumptions utilized in the
second quarter 2007 reserve analysis. These changes in the assumed
loss cost trend would cause approximately a $67 million decrease or a $56
million increase in the loss and LAE reserves. It should be
emphasized that these deviations are not considered the highest possible
deviations that might be expected, but rather what is considered by the Company
to reflect a reasonably likely range of potential deviation as of June 30,
2007. The Company’s sensitivity analysis that estimated the effect on
the loss and LAE reserve position of using alternative loss cost trend
assumptions as of December 31, 2006 rather than those actually used in
determining the best estimate in the year-end loss and LAE reserve analyses
for
2006 indicated an approximate $84 million decrease or a $47 million increase
in
the loss and LAE reserves.
The
assumed loss development factors are also a key assumption. After
evaluating the historical loss development factors from prior accident years
since 1999, in Management’s judgment, it is reasonably likely that actual loss
development factors will range from approximately 1.2 percent lower than those
actually utilized in the second quarter 2007 loss and LAE reserve analysis
to
approximately 1.1 percent higher than those actually utilized. If the
loss development factor assumptions were reduced by 1.2 percent and increased
by
1.1 percent, the loss and LAE reserves would decrease by approximately $64
million under the lower assumptions or increase by approximately $62 million
under the higher assumptions. The Company’s sensitivity analysis that
estimated the effect on the loss and LAE reserve position of using alternative
loss development factors as of December 31, 2006 rather than those actually
used
in determining the best estimate in the year-end loss and LAE reserve analyses
for 2006 indicated an approximate $86 million decrease or a $42 million increase
in the loss and LAE reserves. Generally, historical loss development factors
are
used to project future loss development. However, there can be no
assurance that future loss development patterns will be the same as in the
past,
or that they will not deviate by more than the amounts illustrated
above. Thus, there is the potential for the reserves with respect to
a number of accident years to be significantly affected by changes in the loss
cost trends or loss development factors that were initially relied upon in
setting the reserves. These changes in loss cost trends or loss
development factors could be attributable to changes in inflation or in the
judicial environment, or in other social or economic conditions affecting
claims. Thus, there is the potential for variations greater than the
amounts cited above, either negatively or positively.
The
primary responsibility of an
insurance company is paying the claims of its policyholders in a fair and timely
manner. Having adequate loss reserves, with special consideration for
the upside potential of claims not yet paid is central to this responsibility.
The Company experienced significant losses from the 1994 Northridge earthquake
and the subsequent reopening of claims resulting from California Senate Bill
1899 (“SB 1899”). The costs related to both the original event and SB
1899 illustrate the uncertainty that can result from estimating loss
reserves. The number and severity of claims far exceeded initial
estimates of losses. The two Northridge events point to the
importance of the adequacy of loss reserves and the inherent estimating
uncertainties of the loss reserving process.
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 the debtor defaulting or seeking bankruptcy
or
insolvency protection or voluntary reorganization;
and
|
|
·
|
The
probability of
non-realization of a full recovery on our investment, irrespective
of the
occurrence of one of the foregoing
events.
|
For
investments with unrealized losses due to market conditions or industry-related
events, where 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 or amortized cost are not assumed to be
other-than-temporary. Where declines in fair 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. The Company’s intent is to hold all
of its fixed securities with unrealized losses for a period of time sufficient
to allow a market recovery or to maturity as long as these securities continue
to be consistent with our investment strategy. If our strategy were
to change and these securities were impaired, we would recognize a write down
in
accordance with our stated policy. Additionally, it is possible that future
information will become available about our current investments that would
require accounting for them as realized losses due to other-than-temporary
declines in value. No
such charges were recorded in the three or six months ended June 30, 2007 or
for
the same periods in 2006. 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 at the end of the periods presented because
any unrealized losses would have been 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”):
|
|
June
30, 2007
|
|
December
31, 2006
|
AMOUNTS
IN THOUSANDS,
EXCEPT
NUMBER OF ISSUES
|
|
#
issues
|
|
Fair
Value
|
|
#
issues
|
|
Fair
Value
|
AAA
|
|
|
315
|
|
|
$
|
708,024
|
|
|
|
322
|
|
|
$
|
728,033
|
|
AA
|
|
|
114
|
|
|
|
200,808
|
|
|
|
106
|
|
|
|
165,216
|
|
A
|
|
|
101
|
|
|
|
372,793
|
|
|
|
109
|
|
|
|
423,429
|
|
BBB
|
|
|
39
|
|
|
|
111,378
|
|
|
|
42
|
|
|
|
113,162
|
|
Unrated
|
|
|
7
|
|
|
|
5,234
|
|
|
|
4
|
|
|
|
5,176
|
|
Total
fixed maturity securities
|
|
|
576
|
|
|
$
|
1,398,237
|
|
|
|
583
|
|
|
$
|
1,435,016
|
|
The
following is a summary by issuer of unrated securities held:
|
|
June
30,
|
|
December
31,
|
AMOUNTS
IN THOUSANDS
|
|
2007
|
|
2006
|
Unrated
fixed maturity securities (fair value):
|
|
|
|
|
|
|
Impact
Community Capital, LLC 2
|
|
$
|
1,999
|
|
|
$
|
1,999
|
|
Impact
Healthcare, LLC 2
|
|
|
568
|
|
|
|
510
|
|
Impact
Childcare, LLC 2
|
|
|
810
|
|
|
|
810
|
|
Impact
Commercial Opportunities, LLC 2
|
|
|
1,857
|
|
|
|
1,857
|
|
Total
unrated fixed maturity securities
|
|
|
5,234
|
|
|
|
5,176
|
|
Unrated
other long-term investments (equity method):
|
|
|
|
|
|
|
|
|
Impact
Workforce, LLC 2
|
|
|
320
|
|
|
|
320
|
|
AIG
PEP 3
|
|
|
18,120
|
|
|
|
14,385
|
|
Total
unrated other long-term investments
|
|
|
18,440
|
|
|
|
14,705
|
|
Total
unrated investments
|
|
$
|
23,674
|
|
|
$
|
19,881
|
|
Percentage
of total investments, at fair value
|
|
|
1.7 |
% |
|
|
1.4 |
% |
At
June
30, 2007 and December 31, 2006, unrated securities had no unrealized gains
and
losses.
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:
|
|
June
30, 2007
|
|
December
31, 2006
|
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
|
|
|
$
|
10,339
|
|
|
$
|
117
|
|
|
|
2
|
|
|
$
|
12,075
|
|
|
$
|
216
|
|
6-12
months
|
|
|
11
|
|
|
|
57,298
|
|
|
|
2,189
|
|
|
|
1
|
|
|
|
9,625
|
|
|
|
375
|
|
More
than 1 year
|
|
|
88
|
|
|
|
680,015
|
|
|
|
30,535
|
|
|
|
88
|
|
|
|
698,674
|
|
|
|
25,919
|
|
Less
than $0.1 million
|
|
|
147
|
|
|
|
304,484
|
|
|
|
5,007
|
|
|
|
142
|
|
|
|
304,838
|
|
|
|
4,764
|
|
Total
investments with unrealized losses 4
|
|
|
247
|
|
|
$
|
1,052,136
|
|
|
$
|
37,848
|
|
|
|
233
|
|
|
$
|
1,025,212
|
|
|
$
|
31,274
|
|
2
|
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 Condensed Consolidated
Financial Statements.
|
3
|
AIG
PEP is a private equity
investment program managed by AIG
Investments.
|
4
|
Unrealized
losses
represent approximately
2.7% and 2.2% of the total fair value of investments at June 30,
2007 and
December 31, 2006,
respectively.
|
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
by contractual maturity of fixed maturity securities in an unrealized loss
position by year of maturity follows:
|
|
June
30, 2007
|
|
December
31, 2006
|
AMOUNTS
IN THOUSANDS
|
|
Amortized
Cost
|
|
Fair
Value
|
|
Unrealized
Loss
|
|
Amortized
Cost
|
|
Fair
Value
|
|
Unrealized
Loss
|
Fixed
maturity securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Due
in one year or less
|
|
$
|
28,079
|
|
|
$
|
27,764
|
|
|
$
|
315
|
|
|
$
|
3,040
|
|
|
$
|
2,983
|
|
|
$
|
57
|
|
Due
after one year through five years
|
|
|
622,935
|
|
|
|
601,544
|
|
|
|
21,391
|
|
|
|
602,148
|
|
|
|
584,279
|
|
|
|
17,869
|
|
Due
after five years through ten years
|
|
|
111,190
|
|
|
|
107,746
|
|
|
|
3,444
|
|
|
|
96,077
|
|
|
|
93,043
|
|
|
|
3,034
|
|
Due
after ten years
|
|
|
327,780
|
|
|
|
315,082
|
|
|
|
12,698
|
|
|
|
355,221
|
|
|
|
344,907
|
|
|
|
10,314
|
|
Total
fixed maturity securities with unrealized losses
|
|
$
|
1,089,984
|
|
|
$
|
1,052,136
|
|
|
$
|
37,848
|
|
|
$
|
1,056,486
|
|
|
$
|
1,025,212
|
|
|
$
|
31,274
|
|
Income
Taxes
Determining
the consolidated provision
for income tax expense, deferred tax assets and liabilities and any related
valuation allowance requires the use of estimates and assumptions about the
outcome of future events, as well as assessments of the likelihood that the
tax
positions taken by the Company ultimately will be sustained.
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 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 may be
carried forward 20 years for losses incurred after 1998.
At
June 30, 2007, our DTAs were $114.0
million and our DTLs were $68.0 million, for a net DTA of $46.0 million. At December 31, 2006,
our
DTAs were $117.9 million and our DTLs were $69.5 million, for a net DTA of
$48.4
million. The net DTAs are classified as an asset, “Deferred income taxes,” in
the condensed consolidated balance sheets.
We
are required to reduce DTAs (but not
DTLs) by a valuation allowance to the extent that, based on the weight of
available evidence, it is “more likely than not” (i.e., a likelihood of more
than 50%) that any DTAs will not be realized. Recognition of a valuation
allowance would decrease reported earnings on a dollar-for-dollar basis in
the
year in which any such recognition were to occur. The determination of whether
a
valuation allowance is appropriate requires the exercise of management judgment.
In making this judgment, management is required to weigh the positive and
negative evidence as to the likelihood that the DTAs will be
realized.
The
Company’s net deferred tax assets include a net operating loss (“NOL”)
carryforward for regular federal corporate tax purposes of $9.2 million,
representing an unrealized tax benefit of $3.2 million at June 30, 2007,
compared to $3.3 million at December 31, 2006. As a result of taxable income
since 2002, our NOL has been fully utilized through June 30, 2007 except for
the
amount relating to 21st of the Southwest that is subject to the Internal Revenue
Service separate return limitation year provisions. The remaining NOL expires
as
follows: $1.2 million in 2017; $1.1 million in 2018; $1.5 million in 2019;
$3.2
million in 2020, and $2.2 million in 2021.
Our
ability to fully utilize the NOL of
21st of the Southwest and our other DTAs depends primarily on future taxable
income from operations and tax planning strategies. Because of the Company’s
profitable operating history and the availability of tax planning
strategies, management believes it is reasonable to conclude that it is at
least more likely than not that we will be able to realize the benefits of
all
of our DTAs. Accordingly, no valuation allowance has been recognized at June
30,
2007. 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. Implementation of tax planning strategies to effect
realization of our remaining NOL may require regulatory approvals, which
although reasonably expected cannot be assured by management. Future operating
losses could possibly jeopardize our ability to realize our other DTAs. Future
unfavorable regulatory actions or operating losses would lead management to
reach a different conclusion about the likelihood of realizing the DTAs and,
if
so, to recognize a valuation allowance at that time for some or all of the
DTAs.
Effective
January 1, 2007, as explained
more fully in Note 1 of the Notes to Condensed Consolidated Financial
Statements, the Company adopted Financial Interpretation No. 48,
Accounting for Uncertainty in Income Taxes – an Interpretation of FAS No.
109 (“FIN 48”), which had the effect of decreasing opening retained
earnings and stockholders’ equity by $2.4 million. Adoption of FIN 48 had no
impact on net income in the six months ended June 30, 2007.
At
January 1, 2007, the Company had no liabilities for uncertain tax liabilities
for uncertain tax positions and the total amount of unrecognized tax benefits
for all jurisdictions was approximately $9.1 million, which would favorably
affect the effective tax rate if recognized. For the three and six
months ended June 30, 2007, the total amount of unrecognized tax benefits
declined by approximately $1.8 million and $3.5 million, respectively,
representing the proportionate amount deemed utilized for tax purposes in the
first and second quarters of the year, respectively, and the Company established
an estimated liability for uncertain tax position of the same
amount. Absent changes in profitability or other facts and
circumstances, the Company currently anticipates that the unrecognized tax
benefits will decline to zero by the end of 2007 as the benefits are used for
tax purposes, in which case the estimated liability for uncertain tax position
would total approximately $9.1 million.
The
Company had no accrued penalties
and no material interest receivable or interest payable at the date of adoption
or at June 30, 2007.
In
the first quarter of 2005, the
Company filed amended California tax returns and paid the State of California
$6.8 million to cover all issues outstanding with the Franchise Tax
Board (“FTB”), including certain matters paid under protest as to
which the Company reserved all its rights to file for refunds and appeal to
the
California State Board of Equalization (“SBE”) any adverse rulings by the
California FTB. In September 2005, the FTB completed its audit and denied our
refund claims. In December 2005, the Company filed an appeal with the SBE.
In
the fourth quarter of 2006, the Company executed a settlement agreement with
the
FTB. This settlement agreement received regulatory approval in February 2007.
Accordingly, the tax refund and accrued interest totaling approximately $2.9
million ($1.9 million net of federal tax effect) was recorded as a reduction
of
state income tax expense effective December 31, 2006. This amount was received
in July 2007.
Deferred
Policy Acquisition Costs
Deferred
policy acquisition costs
(“DPAC”) include premium taxes, advertising after it takes place, and other
variable costs incurred with writing business. While our customers typically
renew their policies numerous times and on average stay with us for over five
years, 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
actuarially 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 June
30, 2007.
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
June 30, 2007, net property and
equipment included $130.8 million in software, net of related accumulated
depreciation. This amount represented 85.2% of total net property and equipment,
with the remaining balance consisting of furniture and equipment, leasehold
and
building improvements, building, and land.
Management
evaluates the recoverability
of long-lived assets upon indication of possible impairment when events or
changes in circumstances indicate that the carrying amount may not be
recoverable by measuring the carrying amount of the assets against the related
estimated undiscounted cash flows. For purposes of recognition and measurement
of an impairment loss, long-lived 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. When an
evaluation indicates that the future undiscounted cash flows are not sufficient
to recover the carrying value of the assets, the assets are adjusted to their
estimated fair value. The determination of what constitutes an indication of
possible impairment, the estimation of future cash flows, and the determination
of estimated fair value are all significant judgments. There have been no events
or circumstances in the second quarter of 2007 that would require a reassessment
of any asset group for impairment.
RECENT
ACCOUNTING PRONOUNCEMENTS
In
February 2007, the Financial Accounting Standards Board (“FASB”) issued
Financial Accounting Standard No. (“FAS”) 159, The Fair Value Option for
Financial Assets and Financial Liabilities – including an amendment of FASB
Statement No. 115, (“FAS 159”), which permits an entity to choose to
measure many financial instruments and certain other items at fair value that
are not currently required to be measured at fair value. The objective is to
provide entities with an opportunity to mitigate volatility in reported earnings
caused by measuring related assets and liabilities differently without having
to
apply complex hedge accounting provisions. Entities that choose to measure
eligible items at fair value will report unrealized gains and losses in earnings
at each subsequent reporting date. The fair value option may be elected at
specified election dates on an instrument-by-instrument basis, with few
exceptions. The Statement also establishes presentation and disclosure
requirements designed to facilitate comparisons between entities that choose
different measurement attributes for similar types of assets and liabilities.
FAS 159 is effective at the beginning of the first fiscal year beginning after
November 15, 2007. The Company is currently evaluating the impact of adopting
FAS 159.
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 its results of operations
or financial condition.
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. The effect of this adoption on January 1, 2007, resulted
in a $2.4 million decrease to opening retained earnings. Adoption of
FIN 48 had no impact on net income in the six months ended June 30,
2007.
As
permitted by FIN 48, the Company also adopted a policy of including interest
and
penalties related to income taxes with the provision for income taxes in the
consolidated statements of operations. As required by FIN 48, this
change was done prospectively. Previously, penalties and interest
were classified as Other Income or Other Expense.
At
January 1, 2007, the Company had unrecognized tax benefits for all jurisdictions
of approximately $9.1 million, which would favorably impact the effective tax
rate if recognized. The Company does not anticipate any material
changes in unrecognized tax benefits within 12 months of the date of
adoption.
The
Company had no accrued penalties and no material interest receivable or interest
payable at the date of adoption or at June 30, 2007.
Tax
years
2003 to 2006 and 2002 to 2006 are subject to examination by Federal and
California jurisdictions, respectively.
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”) was adopted January 1, 2007. SOP
05-1 provides guidance on accounting for deferred policy
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’s prospective application of SOP 05-1
since January 1, 2007 resulted in a $3.8 million reduction in deferred policy
acquisition costs as of June 30, 2007, and a corresponding increase in policy
acquisition costs during the six months ended June 30, 2007.
FORWARD-LOOKING
STATEMENTS
The
Private Securities Litigation Reform Act of 1995 provides a safe harbor for
forward-looking statements made by or on behalf of the Company. 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. Forward-looking statements include,
but are not limited to, discussions concerning our potential expectations,
beliefs, estimates, forecasts, projections, and assumptions.
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. These
statements are made on the basis of management’s views and assumptions at the
time the statements are made. There can be no assurance, however, that our
expectations will necessarily come to pass.
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 automobile 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 primary insurance subsidiary in 2002 and 2003. The
following disclosure reflects estimated changes in value that result from
selected hypothetical changes in market rates and prices. Actual results may
differ.
Our
cash
flows from operations and short-term cash position generally have been more
than
sufficient to meet our projected obligations for claim payments, which by the
nature of the personal automobile insurance business, tend to have an average
duration of less than one year. As a result, it has been unnecessary
for the Company to employ elaborate market risk management techniques involving
complicated asset and liability duration matching or hedging
strategies.
Fixed
Maturity Financial Instruments
For
all
of our fixed maturity securities, which comprise the majority of the Company’s
investment portfolio, we seek to provide for liquidity and diversification
while
maximizing income without sacrificing investment quality. The value
of the fixed maturity securities portfolio is subject to interest rate risk
where the value of the fixed maturity securities portfolio decreases as market
interest rates increase, and conversely, when market interest rates decrease,
the value of the fixed maturity securities portfolio increases. Duration is
a
common measure of the sensitivity of a fixed maturity security’s value to
changes in interest rates. More specifically, it is the approximate
percentage change in the value of a bond or bond portfolio due to a 100 basis
point change 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 past investment philosophy typically
resulted in a portfolio with an effective duration of over 6. Due to
the changing interest rate environment in 2004, Management, in consultation
with
the Investment Committee, targeted 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 total fixed maturity security portfolio
declined from approximately 5.4 at December 31, 2004 to 3.5 at June 30,
2007.
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
June
30, 2007
|
|
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
|
|
$
|
1,398.2
|
|
|
$
|
1,350.9
|
|
|
|
(3.4 |
%) |
Debt,
at amortized cost
|
|
|
109.2
|
|
|
|
114.8
|
|
|
|
5.2 |
% |
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.
The
difference between long-term Treasury yields and short-term Treasury yields
are
usually referred 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.
|
|
|
|
|
Duration
Ranges
|
|
|
|
June
30, 2007
|
|
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
|
|
|
5.0
|
%
|
|
|
24.9
|
%
|
|
|
57.6
|
%
|
|
|
8.6
|
%
|
|
|
3.2
|
%
|
|
|
0.7
|
%
|
Equity
Investments
In
an
effort to enhance yield and provide some non-correlated diversification to
our
fixed income portfolio, the Company has invested in non-publicly held equity
securities. In the first quarter of 2006, the Company sold its
publicly traded equity security portfolio and subsequently invested in a private
equity portfolio. The value of these privately held equity
assets are less sensitive to interest rate risk and more subject to credit
and
liquidity risks. However, interest rate risk still exists, just to a
lesser extent. A rise in interest rates may increase the rate on
floating rate debt and, therefore, use an increasing proportion of a company's
cash flow, or may raise market rates to a level that limits the underlying
company's access to the capital markets. In a fixed income portfolio,
credit risk refers to the risk that an issuer of a fixed income security may
default on principal or interest payments. When evaluating private
equity assets, the same financial and operating factors that can reduce cash
flow and increase the likelihood of default can also have a real or perceived
negative effect on the value of the equity asset. Liquidity risk also
may decrease private equity values if the assets have to be sold during a time
of slack demand for the asset or if the multiples for recent comparable
transactions have fallen.
The
Company committed $35 million to an AIG Investments managed fund of private
equity investments and funded $14.4 million of the $35 million commitment in
2006. The funded commitment at June 30, 2007 was $18.1 million. The value of
these private equity investments are calculated on a quarterly basis, as AIG
Investments consolidates the performance of each fund partner and each
particular investment. The primary risk in this portfolio is
event-driven risk. This is managed via diversification across fund
managers and styles, as well as by AIG Investments’ long history of experience
in the asset class. The Company also has a small portion, $0.3
million, of its community-related investment portfolio invested in a single
private equity transaction.
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, which includes 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 a 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
June 30, 2007 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. A description of the reportable legal
proceedings to which the Company and its subsidiaries are a party is contained
in Note 3 of the Notes to Condensed Consolidated Financial Statements,
and is incorporated herein by reference. The description identifies legal
proceedings, if any, that became reportable during the quarter ended June 30,
2007, 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. The following claim
was dismissed in March 2007:
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. On October 13, 2006, Plaintiff’s counsel offered to dismiss this
case, with prejudice, in exchange for the Company waiving its costs. The Company
accepted the offer from the Plaintiff’s counsel to dismiss the matter in March
2007 and no settlement was paid by the Company to the Plaintiffs or Plaintiffs’
counsel.
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, 2006, except for the
following risks related to the pending AIG merger:
Business Uncertainties
Uncertainty
about the effect of the
Agreement and Plan of Merger, dated as of May 15, 2007, among the Company,
AIG,
and AIG TW Corp. (“Merger Sub”), as amended pursuant to Amendment No. 1 to
Agreement and Plan of Merger, dated as of June 8, 2007, among the Company,
AIG
and Merger Sub (the “Merger Agreement”), providing for the merger of Merger Sub
with and into the Company (the “Merger”), on employees, suppliers, partners and
customers may have an adverse effect on us. These uncertainties may
impair our ability to attract, retain and motivate key personnel until the
Merger is consummated, and could cause suppliers, customers and others that
deal
with us to defer purchases or other decisions concerning us, or seek to change
existing business relationships with us.
Failure
to complete the proposed Merger could negatively impact stock price and
financial results.
Although
our Board of Directors and the
Special Committee of the Board of Directors has recommended that our
stockholders approve and adopt the Merger Agreement, there is no assurance
that
all of the conditions to the completion of the Merger will be satisfied or
waived. If the Merger is not completed, we will be subject to several
risks, including the following:
|
·
|
Under
certain circumstances, if the Merger is not completed, we may be
required
to pay AIG a termination fee of
$24,300,000;
|
|
·
|
The
current market price of our common stock may reflect a market assumption
that the Merger will occur, and a failure to complete the Merger
could
result in a negative perception by the stock market of us generally
and a
decline in the market price of our common
stock;
|
|
·
|
Certain
costs relating to the Merger, such as legal, accounting and financial
advisory fees, are payable by us whether or not the Merger is completed;
and
|
|
·
|
We
would continue to face the risks that we currently face as an independent
company.
|
The
Merger Agreement restricts our ability to take certain actions pending the
closing of the Merger.
In
the
Merger Agreement, we have agreed that, except as agreed to by AIG and subject
to
certain exceptions, we will not take certain actions pending the closing of
the
Merger. Our inability to take certain actions that our management may
deem desirable pending the Merger could have a negative impact on our business
or the future prospects for our company. For more information
regarding the Merger, including the limitations on our ability to operate
pending the Merger, please see the preliminary proxy statement we filed with
the
SEC on June 11, 2007.
See
accompanying exhibit index.
Pursuant
to the requirements of the Securities and Exchange Act of 1934, the registrant
has duly caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.
|
|
21ST
CENTURY INSURANCE GROUP
|
|
|
(Registrant)
|
|
|
|
|
|
|
Date:
|
July
31, 2007
|
|
|
/s/
Bruce W. Marlow
|
|
|
BRUCE
W. MARLOW
|
|
|
President
and Chief Executive Officer
|
|
|
(Principal
Executive Officer)
|
|
|
|
|
|
|
Date:
|
July
31, 2007
|
|
|
/s/
Steven P. Erwin
|
|
|
STEVEN
P. ERWIN
|
|
|
Senior
Vice President and Chief Financial Officer
|
|
|
(Principal
Financial Officer)
|
EXHIBIT
INDEX
Exhibit
No.
|
Description
of Exhibit
|
Location
|
2.1
|
Agreement
and Plan of Merger among Registrant, American International Group,
Inc. and AIG TW Corp, dated as of May 15, 2007.
|
Current
Report on Form 8-K (filed with SEC on May 16, 2007; Exhibit 2.1
therein).
|
10.1
|
Employment
Agreement between Bruce W. Marlow, President and CEO, Registrant,
and
American International Group, Inc., dated May 14, 2007.
|
Current
Report on Form 8-K (filed with SEC on May 18, 2007; Exhibit 10.1
therein).
|
10.2
|
Retention
and Severance Agreement between Michael J. Cassanego and
Registrant.
|
Current
Report on Form 8-K (filed with SEC on May 18, 2007; Exhibit 10.1
therein).
|
10.3
|
Retention
and Severance Agreement between Dean E. Stark and
Registrant.
|
Current
Report on Form 8-K (filed with SEC on May 18, 2007; Exhibit 10.2
therein).
|
10.4
|
Retention
and Severance Agreement between Michael T. Ray and
Registrant.
|
Current
Report on Form 8-K (filed with SEC on May 18, 2007; Exhibit 10.3
therein).
|
10.5
|
Retention
and Severance Agreement between Jesús C. Zaragoza and
Registrant.
|
Current
Report on Form 8-K (filed with SEC on May 18, 2007; Exhibit 10.4
therein).
|
|
Certification
of principal executive officer pursuant to Rule 13a-14(a) under the
Securities Exchange Act of 1934
|
Filed
herewith.
|
|
Certification
of principal financial officer pursuant to Rule 13a-14(a) under the
Securities Exchange Act of 1934
|
Filed
herewith.
|
|
Certification
Pursuant to 18 U.S.C. Section 1350
|
Filed
herewith.
|