ITEM 1. BUSINESS
The Commerce Group, Inc. (the "Company"), was incorporated in 1976. The Company is engaged in providing personal and commercial property and casualty insurance primarily in Massachusetts through its principal subsidiary, The Commerce Insurance Company ("Commerce"), which was incorporated in 1971 and began writing business in 1972. The Company's predominant insurance line is motor vehicle insurance, primarily covering Massachusetts personal automobiles. The Company also offers commercial automobile, homeowners, inland marine, fire, general liability and commercial multi-peril insurance. The Company also writes insurance in California and Oregon through Commerce West Insurance Company ("Commerce West"), primarily a personal automobile insurer located in Pleasanton, California. Additionally, the Company writes insurance through American Commerce Insurance Company ("American Commerce"), which it acquired on January 29, 1999. Located in Columbus, Ohio, American Commerce, is a wholly-owned subsidiary of ACIC Holding Co., Inc. with policies in 26 states and licenses in several others. In November of 1998, Commerce formed ACIC Holding Co., Inc., in a joint venture with AAA Southern New England ("AAA SNE") and invested $90,800,000 to fund the acquisition of the Automobile Club Insurance Company whose name was changed to American Commerce upon completion of the acquisition. Commerce invested $90,000,000 in the form of preferred stock and an additional $800,000 representing an 80% common stock ownership. AAA SNE invested $200,000 representing a 20% common stock ownership. The terms of the preferred stock call for Commerce to receive quarterly cash dividends at the rate of 10% per annum from ACIC Holding, Co., Inc. In the event cash dividends cannot be paid, additional preferred stock will be issued. Since 1995, Commerce has maintained an affinity group marketing relationship with AAA Insurance Agency, Inc., a subsidiary of AAA SNE. AAA Insurance Agency, Inc. has been a licensed insurance agent of Commerce since 1985. In addition to the property and casualty insurance business, the Company originates residential and commercial mortgages, within Massachusetts and on a limited basis in Connecticut and operates an insurance agency dealing in a full line of insurance products, including those of the Company.
The Company's business strategy is to focus its insurance activities primarily on the personal automobile market. The Company has over 1,042,000 polices in force, over 875,000 throughout the Commonwealth of Massachusetts and over 167,000 in the 27 states served by Commerce West and American Commerce. The Company, through Commerce and Citation Insurance Company ("Citation"), wholly-owned subsidiaries of Commerce Holdings, Inc. ("CHI"), which is a wholly-owned subsidiary of the Company, has been the largest writer of personal property and casualty insurance in Massachusetts in terms of market share of direct premiums written since 1990. At year end 2001, the Company's Massachusetts private passenger automobile market share was 23.3%, up from 22.3% in 2000. The Company is the second largest writer of Massachusetts homeowners insurance and the third largest writer of commercial automobile insurance in the Commonwealth. In addition, the Company's combined insurance companies were also ranked the 26th largest personal automobile insurance group in the country by A.M. Best, based on the most recently available direct premium written information.
The accompanying table lists direct premiums written for the years ended December 31, 2001 and 2000 for Massachusetts and other states business:
The Company attributes its success primarily to its strong relationships with professional independent agencies that provide quality business for the Company. Other factors that have been important to its success include an in-depth understanding of the Massachusetts regulatory and underwriting environments, an ability to operate efficiently with economies of scale, advanced information systems, an extensive underwriting database and, beginning in 1995, the ability to compete in an affinity group marketing environment.
Because the Company offers its product lines only through independent agencies, its relationships with those agencies are critical to its continued success. The Company believes that it is the preferred provider for most of its agencies and that, as a result of such position, it has gained access to policyholders with average or above-average underwriting profit characteristics in its personal and commercial automobile insurance lines. The Company carefully selects and retains agencies whose premium growth and loss ratio experience meet the Company's agency criteria, and devotes substantial resources to fostering and maintaining strong relationships with its existing agencies. The Company pays its agencies significant compensation in the form of profit sharing, which is based in part on the underwriting profits of the agency's business written with the Company. In addition, the Company occasionally sponsors incentive award trips to encourage agent profitability and growth. Refer to "Part I Item 1C - - Marketing" for the details. Based upon agency surveys conducted several times a year, the Company believes it is attentive to the needs and requirements of its agencies. The Company emphasizes its commitment to the Massachusetts insurance market, its responsiveness in servicing claims and its internal support for agency operations, including direct billing of insureds, direct claim reporting, on-line inquiry systems for its agents and by providing competitively priced automobile insurance programs and products.
Massachusetts Business
The Company's focus on automobile and homeowners insurance primarily in Massachusetts (over 86% of total direct premiums written) has also been a factor in its success. The terms, conditions and mandated rates of personal automobile insurance are subject to extensive regulation. Because the Company has primarily served the Massachusetts market, it has both an in- depth understanding of this market and the ability to respond effectively to shifts in the state's regulatory and underwriting environments. Currently, the Company is
required to accept virtually all automobile insurance business submitted to it by its agencies. The Company's ability to underwrite this business profitably, however, depends on its understanding of the risks in the business as well as its management of reinsurance through C.A.R.
The Company has actively pursued affinity group marketing programs since 1995. The primary purpose of affinity group marketing programs is to provide participating groups with a convenient means of purchasing private passenger automobile insurance through associations and employer groups. Emphasis is placed on writing larger affinity groups, although accounts with as few as 25 participants are considered. Affinity groups are eligible for rate discounts, which must be filed annually with the Division of Insurance. In general, the Company looks for affinity groups with mature/stable membership, favorable driving records and below average turnover ratios. Participants who leave the sponsoring group during the term of the policy are allowed to maintain the policy until expiration. At expiration, a regular Commerce policy may be issued through the agency at the insured's option.
Since the latter part of 1995, Commerce has been a leader in affinity group marketing through agreements with the four American Automobile Association Clubs of Massachusetts ("AAA clubs") offering discounts on private passenger automobile insurance to the clubs' members who reside in Massachusetts. A 6% discount was approved for policies effective January 1, 2002, which is the same as the discount for 2001. Membership in these clubs is estimated to represent approximately one-third of the Massachusetts motoring public, and has been the primary reason for a 62.6% increase in the number of personal automobile exposures written by Commerce since year-end 1995 (the AAA affinity group program incepted in October of 1995). In 2001, total direct premiums written attributable to the AAA group business were $545,496 or 47.3% of the Company's total direct premiums written (63.4% of the Company's total Massachusetts personal automobile premium), an increase of 1.8% over 2000. Total exposures attributable to the AAA clubs group business were 581,455 or 63.3% of total Massachusetts personal automobile exposures in 2001, as compared to 559,696 or 64.5% in 2000. Of the total Massachusetts automobile exposures written through the AAA affinity group program by the Company, approximately 13.0% were written through insurance agencies owned by the AAA clubs (8.7% of total Massachusetts automobile exposures). The remaining 87.0% of the AAA group program was written through the Company's network of independent agents (91.3% of total Massachusetts automobile exposures).
Massachusetts law allows two years to reach the required group penetration level of 35%. Commerce has continued to maintain AAA member participation in excess of 35% through December 31, 2001, when it was estimated at approximately 40%. The two-year penetration requirement was waived by the Massachusetts Legislature for 2000, 2001 and 2002. Waiving the penetration requirements allows insurance companies to continue offering group discounts without reaching the 35% level.
Commerce and the AAA clubs have agreed that Commerce shall be their exclusive under-writer of Massachusetts personal automobile group programs. A rolling three-year contract exists between Commerce and the AAA clubs which renews automatically and may be terminated upon a minimum of three years written notice to either party.
Through 2000, the Company has offered its Massachusetts customers safe driver deviations to drivers with SDIP classifications of either Steps 9 or 10 and to only Step 9 drivers in 2001. Safe driver deviations are rate discounts based on the customer's driving record and resulting SDIP classification and must be approved annually by the Commissioner. Steps 9 and 10 are the two best driver SDIP classifications in Massachusetts, representing drivers with no at fault accidents and not more than one minor moving vehicle violation in the last six years. In 2002, in response to the average personal automobile rate decisions over the last several years, the Company did not file for SDIP Step 9 or Step 10 deviations, for policies incepting in the 2002 calendar year. During 2001, 55.0% of the Company's exposures were eligible for Step 9 deviations, versus 55.1% and 14.0%, eligible for Step 9 and Step 10 deviations in 2000.
The Company's other than personal automobile products tend to be derived from its other two core product lines and therefore have had relatively predictable risk profiles. The Company offers a preferred risk homeowners product through Citation, which has an alternative pricing schedule for selected insureds meeting more restrictive underwriting guidelines. Citation also provides a separate rating tier for preferred commercial automobile business. Approximately 17% of the voluntary commercial automobile premium produced by its voluntary agents in 2001 was written by Citation. Citation also produced 49.0% of Massachusetts homeowner business based on direct premiums written. The Company expects that these secondary rating tiers will continue to assist the Company in retaining its better commercial automobile and homeowner accounts. The Company also expects to further increase the percentage of commercial automobile business that can be retained voluntarily by the Company in 2002 and beyond.
The Company's long-term commitment to providing consistent markets for Massachusetts independent agencies, coupled with the withdrawal by several national companies from the Massachusetts personal automobile market, which occurred during the years 1987 through 1991, has been a significant factor in enabling the Company to increase and maintain its market share by contracting with agencies, which meet its agency criteria. The Company believes that Massachusetts agencies are more likely to seek to develop and expand relationships with domestic insurers, which, like the Company, have a long-term commitment to and focus on the Massachusetts personal automobile market.
During the past few years, the Company has devoted substantial time and resources to the development of its current information systems, which enhanced both its underwriting and its agency support. Through the use of several customized software programs, the Company has the ability to analyze its internal historical underwriting data and use such information in making, in the Company's belief, more informed underwriting decisions. In particular, the Company believes that the amount and extent of detail data accumulated as a result of its share of the Massachusetts personal automobile market gives the Company a competitive advantage in determining which automobile risks to reinsure through C.A.R. The Company's information systems also enable it to provide extensive support to its agencies. This support includes a direct billing system, which covers over 98% of the Company's policyholders, an on-line inquiry system, which allows agencies to ascertain the status of pending claims and direct bill information and a system which allows Company agencies to quote premiums for the Company's three core product lines directly to policyholders. The Company has developed claims and direct bill inquiry, along with providing agents access to correspondence, manuals and reports via the Internet. This service is available to all agents. During 2001, approximately 504 agents had access to this service, which represents over 90% of all Massachusetts agents.
Other States Business
Direct premiums written in states other than Massachusetts by Commerce West and American Commerce, increased $22,554,000 or 18.7%. Roughly half of this growth resulted from an increase of $11,505,000 or 44.5% in personal automobile direct premiums written by Commerce West. The growth from Commerce West is primarily attributable to non-standard automobile business. Commerce West began writing in this segment of the market in late 1999. Commerce West also began writing commercial automobile in late 2000, resulting in writings of $1,514,000 in 2001. American Commerce direct premiums written increased $9,655,000 or 10.2%, primarily due to an increase in personal automobile premiums of $7,319,000 or 9.4%. American Commerce also experienced a 13.4% increase in homeowners premiums written. American Commerce, which writes business in 26 states, wrote greater than 90% of its business in eleven states.
Commerce West premiums and the eleven states with the highest percentages of premiums written by American Commerce are shown in the following table:
The decrease in other states for American Commerce is primarily attributable to business in several states being moved to other insurance companies affiliated with the ownership of the agencies representing that business. These and some future moves for business in other states were anticipated at the time the Company negotiated the acquisition of American Commerce.
Market Risk: Interest Rate Sensitivity and Equity Price Risk
The Company's investment strategy emphasizes investment yield while maintaining investment quality. The Company's investment objective continues to focus on maximizing after-tax investment income through investing in high quality diversified investments structured to maximize after-tax investment income while minimizing risk. The Company's funds are generally invested in securities with maturities intended to provide adequate funds to pay claims and meet other operating needs without the forced sale of investments. Periodically, sales have been made from the Company's fixed maturity portfolio to actively manage portfolio risks, including credit-related concerns, to optimize tax planning and to realize gains. This practice will continue in the future.
In conducting investing activities, the Company is subject to, and assumes, market risk. Market risk is the risk of an adverse financial impact from changes in interest rates and market prices. The level of risk assumed by the Company is a function of the Company's overall objectives, liquidity needs and market volatility.
The Company manages its market risk by focusing on higher quality equity and fixed income investments, by periodically monitoring the credit strength of companies in which investments are made, by limiting exposure in any one investment and by monitoring the quality of the investment portfolio by taking into account credit ratings assigned by recognized rating organizations. Of the Company's bonds, 97.9% are rated in either of the two highest qualities categories provided by the NAIC. Although the Company has significant holdings of various closed-end preferred stock mutual funds, these funds are comprised primarily of preferred stocks traded on national stock exchanges, thus limiting exposure to any one investment.
As part of its investing activities, the Company assumes positions in fixed maturity, equity, short-term and cash equivalents markets. The Company is, therefore, exposed to the impacts of interest rate changes in the market value of investments. At December 31, 2001, the Company's exposure to interest rate changes and equity price risk has been estimated using sensitivity analysis. The interest rate impact is defined as the effect of a hypothetical interest rate change of plus-or-minus 200 basis points on the market value of fixed maturities and preferred stocks. The equity price risk is defined as a hypothetical change of plus-or-minus 10% in the fair value of common stocks. Changes in interest rates would result in unrealized gains or losses in the market value of the fixed maturity and preferred stock portfolio due to differences between current market rates and the stated rates for these investments. Based on the results of the sensitivity analysis at December 31, 2001, the Company's estimated market exposure for a 200 basis point increase (decrease) in interest rates was calculated. A 200 basis point increase results in a $83,611,000 decrease in the market value of the fixed maturities and preferred stocks. A 200 basis point decrease results in a $47,436,000 increase in the market value of the same securities. The equity price risk impact at December 31, 2001, based upon a 10% increase in the fair value of common stocks and preferred stock mutual funds, would be an increase of $10,746,000 and $31,567,000, respectively. Based upon a 10% decrease, common stocks and preferred stock mutual funds would decrease $10,746,000 and $31,567,000, respectively. Long-term interest rates (30-year Treasury Bond) increased slightly to 5.47% at December 31, 2001 from 5.46% at December 31, 2000. The preceding sensitivity analysis does not represent a forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions such as the nature and timing of interest rate levels including the yield curve shape, prepayments on loans and securities, reinvestment and replacement of asset and liability cash flows and others. While assumptions are developed based upon current economic conditions, the Company cannot provide any assurance as to the predictive nature of these assumptions. Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to prepayment and refinancing levels likely deviating from those assumed and other internal and external variables. Furthermore, the sensitivity analysis does not reflect actions that management might take in responding to or anticipating changes in interest rates.
A. General
Insurance Lines
Commerce and Citation, the Company's Massachusetts property and casualty insurance subsidiaries, currently have a combined A.M. Best's rating of A+ (Superior). Commerce West, and American Commerce currently have A.M. Best's ratings of A (Excellent). According to Best's, an insurer with a Superior rating has achieved superior overall performance and has shown the strongest ability to meet their policyholder and other contractual obligations when compared to the norms of the property and casualty insurance industry. An insurer with an Excellent rating has demonstrated, in A.M. Best's opinion, excellent overall performance when compared to standards developed by A.M. Best.
The following table compares direct premiums written, net premiums written and earned premiums for the years ended December 31, 2001 and 2000:
*Calculation is not meaningful.
The Company's principal insurance line is personal automobile insurance. The Company offers automobile policyholders the following types of coverage: bodily injury liability coverage, including underinsured and uninsured motorist coverage, personal injury protection coverage, property damage liability coverage and physical damage coverage, including fire, theft and other hazards specified in the policy. In Massachusetts, policies are written for one-year terms. Personal automobile policies written by Commerce West and American Commerce outside of Massachusetts are primarily written for a policy term of six months. The Company's published liability limits for Massachusetts business written by Commerce is $500,000 per person for bodily injury, $1,000,000 per accident and $100,000 for property damage. Liability limits of $100,000 per person injured, $300,000 per accident and $100,000 for property damage are the limits most commonly purchased from the Company in Massachusetts. For California business written by Commerce West, liability limits of $15,000 per person injured and $30,000 per accident are most commonly purchased. For Oregon business written by Commerce West, liability limits of $25,000 per person insured and $50,000 per accident are most commonly purchased. For business written by American Commerce, liability limits of $100,000 per person injured and $300,000 per accident are most commonly purchased.
Massachusetts Automobile Business
In Massachusetts, private passenger automobile insurance is subject to extensive regulation. Owners of registered automobiles are generally required to maintain certain minimum automobile insurance coverages. With very limited exceptions, automobile insurers are required by law to issue a policy to any applicant seeking to obtain such coverages. Companies in Massachusetts are also assigned agents, known as Exclusive Representative Producers ("ERPs"), based primarily on market share, that have been unable to obtain a voluntary contract with an insurance carrier. Marketing and underwriting strategies for companies operating in Massachusetts are limited by maximum premium rates and minimum agency commission levels for personal automobile insurance, both of which are mandated by the Massachusetts Commissioner of Insurance ("Commissioner"). In Massachusetts, accident rates, bodily injury claims, and medical care costs continue to be among the highest in the nation. According to the Automobile Insurers Bureau of Massachusetts ("A.I.B."), Massachusetts "has higher than average medical costs and liability claims involving attorneys". According to the A.I.B., Massachusetts personal automobile premium per policy, based upon on the latest available premium information from 1999, was 5th highest in the nation.
During the three-year period from 1999 to 2001, average mandated Massachusetts personal automobile insurance premium rates decreased an average of 2.3% per year. The Commissioner approved no rate change in personal automobile premiums for 2002, as compared to an average rate decrease of 8.3% in 2001. Coinciding with the 2002 rate decision, the Commissioner also approved no change in the commission rate agents receive for selling private passenger automobile insurance from 12.3% in 2001.
State Mandated Average Commerce Average Rate Year Rate Change Change Per Exposure 2002 0.0% 5.0%(Estimated) 2001 (8.3%) (1.9%) 2000 0.7% 6.2% 1999 0.7% 9.1%
Although average mandated personal automobile premium rates were decreased by 8.3% in 2001, the Company's average rate decreased 1.9% per exposure. The 1.9% decrease for 2001 was primarily the result of the state mandated average rate decrease offset by decreases in the SDIP deviations for Step 9 and Step 10 drivers, the two best driver SDIP classifications in Massachusetts. The Company decrease was also due to the facts that the rate decision did not anticipate purchases of new automobiles in the year to which the rate decision applied and, secondly, the Company's mix of personal automobile business differs from that of the industry.
The 1999 average rate decision was partially driven by corrections for an industry error that had impacted prior year rate decisions. The industry error resulted from a miscalculation of industry expense allowances that had the effect of over-stating rates for 1991 through 1996. Mandated rates for 1997, 1998 and 1999 included an adjustment to recoup the effects of this error from the industry. The adjustment included in the rate decision to recoup the error was phased in during 1997, 1998 and 1999. The earned premium impact of this, coupled with the impact of a previous year imbalance in the SDIP, was approximately $14.0 million for 1999. The earnings per share after-tax impact resulting from lower earned premiums were estimated at $0.26 for 1999.
The Company also offers homeowners insurance in Massachusetts, including a very limited amount of policies in designated coastal areas. The Company's standard homeowners policy is an all risk, replacement cost insurance policy covering a dwelling and the content contained therein. The Company's published limits of liability for property damage to a dwelling are a minimum coverage of $60,000 and a maximum coverage of $750,000, although some policies over this amount are written on an exception basis. For personal liability, the minimum coverage is $100,000 and the maximum coverage is $1,000,000. The average dwelling coverage amount per policy is approximately $175,000, and generally, the average amount of contents coverage is 70% of the amount of coverage for the dwelling, with limitations on the amount of coverage per item placed on securities, cash, jewelry, furs, silverware, computer equipment and firearms. However, additional coverage for such items can be purchased on a scheduled personal property basis. The Company also offers $1,000,000, $2,000,000 and $3,000,000 personal liability umbrella coverage which is reinsured through American Reinsurance Corporation. Similar coverages are offered by American Commerce as part of its homeowner business.
The Company offers a preferred homeowners product through Citation, which has higher policy limits and a lower premium structure and is designed primarily for homes with above-average market values. The Company also applies more stringent underwriting criteria by, among other things, limiting the product to homes with modern electrical systems.
The Company also offers inland marine, fire, general liability and commercial multi-peril insurance in Massachusetts. Commerce West predominantly writes private passenger automobile insurance in California and Oregon through 617 independent insurance agencies and brokers. All business is underwritten at the Company's headquarters located in Pleasanton, California. Although primarily writing preferred business, Commerce West began writing non-standard business in late 1999. American Commerce predominantly writes private passenger automobile and homeowners insurance in 26 states exclusively through 36 AAA independent insurance agencies. Products are similar to those offered by Commerce and Citation. All business is underwritten at the Company's headquarters located in Columbus, Ohio. Both Companies target preferred insurance risks.
Mortgage Operations
Insurance companies are authorized to invest in mortgages. The Company formed Bay Finance Company, Inc. ("Bay Finance") to originate and service residential and commercial mortgages in Massachusetts and, on a limited basis, in Connecticut. During fiscal 2001, 2000 and 1999 the mortgage operations accounted for approximately $3,640,000, or 0.3%, $5,407,000, or 0.5% and $5,429,000, or 0.6% of the Company's consolidated total revenues, respectively.
Insurance Agency
Clark-Prout Insurance Agency, Inc. ("Clark-Prout") is a wholly-owned insurance agency that writes both for the Company and for other insurance companies. During fiscal 2001, 2000 and 1999, Clark-Prout's revenues amounted to $629,000, or 0.1%, $717,000, or 0.1% and $803,000, or 0.1% of the Company's consolidated total revenues, respectively.
Segment Information
The information in NOTE O in the Company's 2001 Annual Report is incorporated herein by reference.
B. Commonwealth Automobile Reinsurers
A significant aspect of the Company's automobile insurance business relates to its interaction with C.A.R. C.A.R. is a state-mandated reinsurance mechanism, which enables the Company and the Servicing Carriers to reinsure any under priced automobile risk. Servicing Carriers, which are responsible for over 99.0% of total direct premiums written for personal automobile insurance in Massachusetts, are required to offer automobile insurance coverage to all eligible applicants pursuant to "take-all-comers" regulations, but may reinsure under priced business with C.A.R. In addition, Servicing Carriers are obligated to accept involuntary agencies, known as ERPs, from C.A.R. and to provide an automobile insurance market in Massachusetts for those agencies.
C.A.R. maintains separate pools for liability and physical damage coverage in personal and commercial automobile risks. All companies writing automobile insurance in Massachusetts share in the underwriting results of C.A.R. business for their respective product line or lines, whether or not they are Servicing Carriers. Since its inception, C.A.R. has annually generated multi-million dollar underwriting losses in both the personal and commercial pools. Accordingly, each automobile insurer attempts to develop and implement underwriting strategies that will minimize its relative share of the C.A.R. deficit while maintaining acceptable loss ratios on risks not reinsured through C.A.R.
In general, the C.A.R. reinsurance mechanism operates as follows. Within established time frames, a Servicing Carrier must identify which policies it wishes to retain and which policies it wishes to cede to C.A.R. A Servicing Carrier pays to C.A.R. all of the premiums generated by the policies it has ceded and also reimburses C.A.R. the difference between standard rates and the reduced premium resulting from affinity group marketing discounts on policies ceded to C.A.R. C.A.R. reimburses Servicing Carriers for all losses incurred on account of ceded policies, although, as with reinsurance generally, reinsurance of a policy through C.A.R. does not legally discharge the Servicing Carrier from its liability to the policyholder for the full amount of the policy. In addition, Servicing Carriers also receive fees for servicing ceded policies based upon the expense structure established by C.A.R.
An insurer's proportionate share of the C.A.R. deficit is allocated on the basis of a formula called a participation ratio, which can vary significantly between the personal and commercial pools, and between different policy years. Under current regulations, an insurer's share of the C.A.R. deficit is based upon its market share for retained automobile risks for the particular pool, adjusted by a utilization formula, such that, in general, its participation ratio is disproportionately and adversely affected if its relative use of C.A.R. reinsurance exceeds that of the Massachusetts industry and favorably affected if its relative use of C.A.R. reinsurance is less than that of the Massachusetts industry. The current formula also contains a provision whereby certain high risk business, if reinsured through C.A.R., is excluded in determining an insurer's participation ratio. Finally, for the personal automobile C.A.R. pool, an insurer's participation ratio may be affected by credits received for not reinsuring through C.A.R. automobile risks in selected under priced classes and territories. An insurer's participation ratio will be favorably affected if its relative use of credits exceeds that of the Massachusetts industry.
Company Private Passenger Participation Ratio for C.A.R. versus Market Share
Company Participation Company Year Ratio in C.A.R. Market Share 2001* 16.8% 23.3% 2000 16.9% 22.3% 1999 16.5% 21.3% *Estimated
The Company's objective is to develop and implement underwriting strategies to obtain the optimum balance between its C.A.R. participation ratio and the loss ratios on automobile risks not reinsured through C.A.R. For each automobile risk and certain risk categories, the Company makes a judgment as to whether the projected impact on the Company's profitability from retaining the risk outweighs the incremental cost of reinsuring the risk through C.A.R. In determining the incremental cost of reinsuring a risk through C.A.R., the Company estimates its participation ratio for a given period by modeling the anticipated Massachusetts industry-wide C.A.R. trends. Once the Company estimates its participation ratio, it is then able to compare the incremental effect on the Company's share of the C.A.R. deficit of either reinsuring or retaining the particular automobile risks. Finally, the Company utilizes its internal underwriting database and internally-developed actuarial reporting and decision support systems to develop a projected underwriting loss ratio for each risk. It then compares the impact of the automobile risk on the Company's participation ratio in order to estimate whether, after taking all C.A.R. and other factors into account, the Company's profitability will be enhanced by reinsuring or retaining such risk. The Company believes that, because of its leading share of the Massachusetts automobile insurance market, it can utilize statistically credible data for a greater array of underwriting factors than its competitors, which in turn gives it a competitive advantage in deciding which automobile risks to reinsure through C.A.R.
The C.A.R. utilization-based participation ratio has been in place since 1993, and individual companies in the marketplace make minor yearly changes to find their optimum balance between voluntary and ceded writings. In 2001, the Company ceded approximately $60,277,000 or 7.0% of the Company's Massachusetts personal automobile direct premiums written, compared to $60,038,000, or 7.3% in 2000. The Company's strategy has been to voluntarily retain more of the types of personal automobile business that are factored as credits favorably impacting the utilization formula. These credits result from voluntarily writing business in under-priced territories and for under-priced risks. As a result of increased voluntary retention in excess of the industry, the credits impacting the utilization formula have favorably affected the Company's participation ratio. As indicated in the above table, this ratio is several percentage points below the Company's estimated 23.3% share of the Massachusetts personal automobile market.
Although commercial automobile insurance is a relatively smaller portion of the Company's total insurance writings, the related commercial automobile risk selection decisions remain an important element in determining profitability. In 2001, the Company ceded approximately $9,062,000 or 15.6% of its Massachusetts commercial automobile direct premiums written, as compared to $7,414,000 or 17.1% in 2000.
C.A.R. rule changes occur, as C.A.R. adjusts the operations of the personal and commercial reinsurance mechanisms to address the needs of the Massachusetts automobile insurance market. Any material change to the C.A.R. rules in the future will affect the Company. The Company is not currently aware of any likely future rule changes that could have a material impact on the Company, but there can be no assurance that such rule changes will not occur.
C. Marketing
The Company markets its insurance products through a network of licensed independent agencies, 539 throughout Massachusetts (of which 131 are ERPs), 617 in California and Oregon for Commerce West, and 36 for American Commerce. The non-ERP independent agencies may also represent other insurance companies, some of which may compete directly with the Company. The independent insurance agencies are under contract with the Company's subsidiaries and must conduct their business according to the provisions of their contract. Contracts for Massachusetts agencies may be terminated by the Company upon 180 days' notice to the agency or at will by the agency.
Massachusetts Business
The Company seeks to establish long-term relationships with agencies that can generate a sizable volume of business with profitable underwriting characteristics and for which the Company will be among the top two or three preferred writers of its core products. The Company also assesses whether the mix of a prospective agency's business will expand the Company's presence in one or more of its core product lines. In 2001, each agency representing the Company in Massachusetts produced an average of approximately $1,893,000 of Company direct premiums written or a 4.3% increase as compared to 2000. Also in Massachusetts during 2001, 201 agencies produced between $1.0 million and $2.0 million of direct premiums written, an additional 58 agencies produced between $2.0 million and $3.0 million, an additional 42 agencies produced between $3.0 million and $4.0 million and lastly, an additional 39 agencies produced over $4.0 million. The Company's three largest agencies produced approximately $67.5, $17.0 and $14.5 million of the Company's Massachusetts direct premiums written, respectively, or approximately 6.7%, 1.7% and 1.4% in 2001.
Once appointed, each agency's performance is carefully monitored. An Agency Evaluation Committee, comprised of representatives of the Company's Marketing, Underwriting and Premium Accounting departments, utilizes a host of pre-established criterion (loss ratio, premium volume, etc.) to continuously evaluate agencies. Generally, the Company will counsel an agency on how to improve its underwriting and profitability before any agency will be terminated.
Company agencies receive commissions on policies written for the Company and are eligible to receive contingent commissions through a profit sharing arrangement. The Commissioner annually establishes a minimum average direct commission for personal automobile insurance, which in 2001 was 12.3%. The Company's contingent commissions are tied to the underwriting profit on policies written by an agency. The Company generally pays up to 45% of the underwriting profit attributable to the agency's business. The arrangement for Massachusetts business utilizes a three year rolling plan, with one third of each of the current and the two prior years profit or loss calculations, summed to a single amount. This amount, if positive, is multiplied by the profit sharing rate and paid to the agent. To qualify for profit sharing, a three-year average loss ratio of 50% to 55% or better is generally required. C.A.R. credits for voluntary business written in urban areas or credits for writing youthful operators on a voluntary basis increase the loss ratio eligibility for profit sharing up to 55% from 50%. Books of business with no available credits must achieve a lower loss ratio. In 2001, total commission expensed by the Company to its agencies amounted to 15.5% of direct premiums written, of which direct commissions and contingent commissions constituted 14.1% and 1.4%, respectively, versus total commission expensed of 16.2%, of which 14.1% was direct and 2.1% was contingent in 2000. Direct commissions are higher than the personal automobile minimum commission rates primarily due to higher commission rates on SDIP Step 9 business coupled with higher commissions on other lines of business. In 2001, the Company's expense for contingent commissions was $14.0 million versus $19.5 million in 2000.
The Company also occasionally sponsors incentive award trips to encourage and reward agency profitability and growth. In 1998, the Company initiated the T2000 Sales Incentive Contest. One part of the measurement period concluded on December 31, 1999 and the other concluded on May 31, 2000 with agents earning incentive trips, which took place in April and September of 2000, respectively. The estimated total cost was approximately $1.3 million of which approximately $45,000 was expensed in 2000 and $571,000 in 1999.
The Company's information systems enable it to provide extensive support to its agencies. This support includes a direct billing system, which covers over 98% of the Company's Massachusetts policyholders, an on- line inquiry system which allows agents to ascertain quickly the status of pending claims or direct bill information and a system which allows Company agents to quote many premiums directly to policyholders. The Company also emphasizes its commitment to enhancing and expanding the role of its information systems. The Company has provided agencies with the ability to generate personal automobile policies from their own offices and continuously explores new options on an ongoing basis. The Company has also developed Internet connectivity for its independent agents.
The Company believes that, because of its compensation arrangements and by providing a consistent market with emphasis on service, an increasing number of the Company's agencies will rely on it as their principal supplier of insurance products. The Company believes that it is the preferred provider for most of its agencies. Although the Company believes, based on annual surveys of its agencies, that its relationships with its independent agencies are excellent, any disruption in these relationships could adversely affect the Company's business.
Since the latter part of 1995, Commerce has been a leader in affinity group marketing through agreements with the four American Automobile Association Clubs of Massachusetts ("AAA clubs") offering discounts on private passenger automobile insurance to the AAA clubs' members who reside in Massachusetts. A 6% discount was approved for policies effective January 1, 2002, which is the same as the discount for 2001. Membership in these AAA clubs is estimated to represent approximately one- third of the Massachusetts motoring public, and has been the primary reason for a 62.6% increase in the number of personal automobile exposures written by Commerce since year-end 1995 (the AAA affinity group program incepted in October of 1995). In 2001, total direct premiums written attributable to the AAA group business were $545,496 or 47.3% of the Company's total direct premiums written (63.4% of the Company's total Massachusetts personal automobile premium), an increase of 1.8% over 2000. Total exposures attributable to the AAA clubs' group business were 581,455 or 63.3% of total Massachusetts personal automobile exposures in 2001, as compared to 559,696 or 64.5% in 2000. Of the total Massachusetts personal automobile exposures written through the AAA affinity group program by the Company, approximately 13.0% were written through insurance agencies owned by the AAA clubs (8.7% of total Massachusetts automobile exposures). The remaining 87.0% of the AAA group program was written through the Company's network of independent agents (91.3% of total Massachusetts automobile exposures). For additional details, refer to the following table on discounts and deviations.
*For policies with effective dates as of January 1, 2002 or thereafter.
Agreements for the Transfer of Massachusetts Business from Other Companies in 2002
The Company entered into an agreement on September 28, 2001, with Berkshire Mutual Insurance Company ("Berkshire") for the transfer of Massachusetts personal automobile business written by Berkshire to The Commerce Insurance Company, effective January 1, 2002. Under terms of the agreement, Commerce agreed to offer agency contracts to independent agencies that represent Berkshire for personal automobile insurance in Massachusetts. This will allow agents of Berkshire the opportunity to offer Commerce automobile insurance policies to their customers whose policies renew in 2002. Commerce will assume all of Berkshire's obligations for future policy years beyond 2001 under the Massachusetts residual market system, (commonly known as C.A.R.), including assignment of Berkshire's involuntary agents. The Company received a cash payment of $7,000,000 from Berkshire in early January, 2002.
The Company announced the formation of a marketing alliance with Horace Mann Educators Corporation on October 18, 2001. Under the terms of an agency agreement between Commerce and Horace Mann Service Corporation ("HMSC"), a licensed brokerage agency in the State of Massachusetts, HMSC will provide its personal automobile customers with Commerce policies. New personal automobile policies sold by HMSC will be insured with Commerce, beginning no later than January 1, 2002 at the policyholder's option. All personal auto policies currently written by HMSC will convert to Commerce policies upon renewal in 2002.
Other States
Commerce West predominantly writes private passenger automobile insurance in California and Oregon through 617 independent insurance agencies and brokers. All business is underwritten at the Company's headquarters located in Pleasanton, California. Although primarily writing preferred business, Commerce West began writing non-standard business in late 1999. American Commerce predominantly writes private passenger automobile and homeowners insurance in 26 states exclusively through 36 AAA independent insurance agencies. All business is underwritten at the Company's headquarters located in Columbus, Ohio. Both Companies target preferred insurance risks.
D. Underwriting
The Company seeks to achieve an underwriting profit, as measured by a statutory combined ratio of less than 100%, in each of its three core product lines, personal automobile, commercial automobile and homeowners insurance, in both hard and soft markets. The strategy is designed to achieve consistent profitability with substantial growth in net premiums written during hard markets and more modest growth during soft markets. All of the Company's policies have been written on a "claims incurred basis," meaning that the Company covers claims based on occurrences that take place during the policy period.
Agencies are authorized to bind the Company on risks as limited by the Company's written underwriting rules and practices, which set forth eligibility rules for various policies and coverages, unacceptable risks, and maximum and minimum limits of liability. With respect to non-automobile policies, other than certain umbrella policies, the Company's agencies have the ability to bind the Company for a limited period, typically 60 days, during which time the Company reviews all risks to determine whether it will accept or reject the policy. During this review period, the Company is obligated to pay any claim, which would be covered under the policy. Violation of the Company's underwriting rules and practices is grounds for termination of the agency's contract with the Company.
Massachusetts Business
The Company and each of the approximately 38 other Servicing Carriers must write all automobile risks submitted to them. Massachusetts personal automobile insurance rates are fixed annually by the Commissioner. All companies writing personal automobile policies are required to use such mandated rates, unless they have received prior approval from the Commissioner to offer a lower rate. The actual premium paid by a particular policyholder, however, is adjusted, either up or down, based upon the SDIP record of the insured operator. Moving violations and accidents for which the insured was at fault within the most recent six year period are used to determine each operator's SDIP surcharge or credit. The competitive nature of the Massachusetts personal automobile insurance market, which began in 1995, continued through 2001.
Prices for Massachusetts commercial automobile insurance policies that are not reinsured through C.A.R. are set competitively subject to the Commissioner's authority to disapprove such prices. The rate for commercial automobile risks reinsured through C.A.R. is mandated by the Commissioner, except for private passenger type non-fleet business. The Company's rates for other product lines, including homeowners and commercial lines of general liability and property insurance, are based in part on loss cost data from the Insurance Services Office ("ISO"), which is an industry bureau providing policy forms and rate making data, and in part, on the Company's own experience and industry price levels.
The Company is not obligated by statute to accept every homeowners risk submitted to it. Accordingly, risks meeting the Company's underwriting guidelines are accepted, and all other risks are declined or not renewed. The Company has established an independent rate level for its homeowners product line, based on its own loss experience and recognizing the price levels available in the competitive marketplace. The Company uses ISO policy forms and has added special coverage features to meet its product needs. Rates and forms are filed with the Commissioner.
Under Massachusetts law, residential property owners are strictly liable for damages caused by lead poisoning in children under age six residing in the premises, unless the property owner has a Letter of Compliance or a Letter of Interim Control (i.e. has taken or is taking specific measures to prevent lead poisoning). The Company has reduced its exposure to lead poisoning by (i) excluding from coverage all intra-familial claims for bodily injury or medical expenses brought by minors living in an insured's household, (ii) revising its underwriting standards for new and renewal business to avoid insuring properties with lead poisoning hazards and (iii) excluding from homeowners and dwelling fire liability coverage all lead poisoning perils to children under the age of six on policies for properties built prior to 1978 that contain rental units and where strict liability for lead poisoning would otherwise apply. Effective on March 1, 1998 a similar exclusion was added to the Business Owners Program. With regard to the exclusion described in (iii), policyholders may buy a reinstatement of the excluded coverage through a policy endorsement for an additional premium, but very few such endorsements have been written. As a result of these remedial steps and its historical claims experience, the Company does not believe that its exposure to lead poisoning claims is material. The Company held reserves in the amount of $1,600,000 and $1,525,000 for lead paint related claims at December 31, 2001 and 2000, respectively.
The Company believes that its information systems give it a competitive advantage in making underwriting decisions, particularly in deciding which personal automobile risks should be reinsured through C.A.R. Utilizing data the Company accumulates as a result of its major market presence in the Massachusetts personal automobile line, the Company believes that its information systems allow it to make informed risk assessments and to respond effectively to shifts in the automobile insurance markets and regulatory environment.
Other States
In keeping with the Company's long-term growth objective to expand outside Massachusetts, the Company, in 1995, acquired Commerce West, a personal automobile insurer, located in Pleasanton, California. The Company formed a joint-venture (ACIC Holding Co., Inc.) in November 1998, and acquired in January 1999, American Commerce, located in Columbus, Ohio. Commerce West predominantly writes private passenger automobile insurance in California and Oregon through 617 independent insurance agencies and brokers. All business is underwritten at the Company's headquarters located in Pleasanton, California. Although primarily writing preferred business, Commerce West began writing non-standard business in late 1999. American Commerce predominantly writes private passenger automobile and homeowners insurance in 26 states exclusively through 36 AAA independent insurance agencies. All business is underwritten at the Company's headquarters located in Columbus, Ohio. Both Companies target preferred insurance risks.
E. Reinsurance
In addition to participating in C.A.R., the Company reinsures with other insurance companies on a claims incurred basis, a portion of its potential liability under the policies it has written, protecting itself against severe loss under individual policies, or catastrophic occurrences where a number of claims can produce an extraordinary aggregate loss. Reinsurance does not legally discharge the Company from its primary liability to the insured for the full amount of the policies, but it does make the reinsurer liable to the Company to the extent of the reinsured portion of any loss ultimately suffered. The Company seeks to utilize reinsurers, which it considers adequately capitalized and financially able to meet their respective obligations under reinsurance agreements with the Company. The Company utilizes a variety of reinsurance mechanisms to protect itself against loss as described below.
Property, Catastrophe and Quota Share Reinsurance
The Company maintains a 75% quota-share reinsurance program, covering all non-automobile property and liability business, except umbrella policies. The program is split between American Re-Insurance Company, Employers Reinsurance Corporation, Hartford Fire Insurance Company and Swiss Reinsurance America Corporation. The maximum per occurrence dollar recovery is equal to 250% of the net premiums ceded to the quota share arrangement in a contract year. The maximum aggregate per year dollar recovery under the quota share contract is equal to 350% of the net premium ceded to the quota share arrangement in a contract year. A sliding scale commission, based on loss ratio, is utilized under this program. This program provides the Company with sufficient protection for catastrophe coverage so as to enable the Company to forego pure catastrophe reinsurance coverage, which was previously tailored in conjunction with the former quota share arrangement.
The table below provides information depicting the approximate recovery under the quota share contract (described below) at various loss scenarios, if a single catastrophe were to strike (in thousands):
Net Loss Total Reinsurance Retained by Loss Recovery the Company
$ 50,000 $ 37,500 $12,500 100,000 75,000 25,000 150,000 112,500 37,500 200,000 150,000 50,000 250,000 187,500 62,500
Under the above scenario and based on the business subject to the quota-share reinsurance contract for 2001, the Company has no reinsurance recoveries for a single event catastrophe in excess of a total loss of approximately $262.0 million. The level of reinsurance protection increases (decreases) when the company cedes more (less) premium to the reinsurers. The Company's estimated total losses on its other than automobile business for 100 and 250-year hurricanes (including American Commerce) are approximately $176.0 million and $295.8 million, respectively. The Company estimates were derived through the services of Swiss Reinsurance America Corporation who utilized the RMS (Risk Management Solutions) IRAS risk assessment system. Most property and casualty insurance companies establish their catastrophe reinsurance programs up to the 100 year storm estimate.
Written premiums ceded in 2001, 2000 and 1999 under the above referenced program were $78.6 million, $69.4 million and $51.5 million, respectively. The 13.3% increase in written premiums ceded in 2001 versus 2000 in this program was primarily the result of a $7,592 or 11.6% increase in Massachusetts homeowner direct premiums written, coupled with a $2,212 or 13.4% increase in direct homeowner writings in states other than Massachusetts, as previously mentioned. Ceding commission income is calculated on a ceded earned premium basis.
Casualty Reinsurance
Casualty reinsurance is on an excess of loss basis for any one event or occurrence with a maximum recovery of $9.0 million over a net retention of $1.0 million. This coverage is placed with Swiss Reinsurance America Corporation (rated A++ by A.M. Best).
Personal and commercial liability umbrella policies are reinsured on a 95% quota share basis in regard to limits up to $1.0 million and 100% quota share basis for limits in excess of $1.0 million but not exceeding $5.0 million for policies with underlying automobile coverage of $250,000/$500,000 or more. The Company also has personal liability umbrella reinsurance coverage for policies with underlying automobile coverage of $100,000/$300,000, on a 65% quota share basis in regard to limits up to $1.0 million and 100% quota share basis for limits in excess of $1.0 million but not exceeding $3.0 million. These coverages are placed with American Re- Insurance Company (rated A++ by A.M. Best).
Earned premiums and losses and loss adjustment expenses are stated in the accompanying consolidated financial statements after deductions for ceded reinsurance. Those deductions for reinsurance other than C.A.R. are as follows (in thousands):
The Company, as primary insurer, would be required to pay losses in their entirety in the event that the reinsurers were unable to discharge their obligations under the reinsurance agreements.
The Company believes that the terms of its reinsurance contracts are consistent with industry practice in that they contain standard terms with respect to lines of business covered, limits, retentions, arbitration and occurrence. Based on its review of its reinsurers' financial statements and their reputations in the reinsurance marketplace, the Company believes that its reinsurers are financially sound. The Company had no amount of reinsurance receivables more than 90 days past due at December 31, 2001.
F. Settlement of Claims
Claims under insurance policies written by the Company are investigated and settled primarily by claims adjusters employed by the Company. In Massachusetts, the Company employs a staff of 814 people at its claims department, located in Webster, Massachusetts. In addition to these individuals, the Company utilizes the services of approximately 37 independent appraisal firms and 11 independent property adjusting companies who are strategically located throughout the states of Massachusetts and New Hampshire. The Company also has a special unit, which investigates suspected insurance fraud and abuse. If a claim or loss cannot be settled and results in litigation, the Company retains outside counsel to represent it. American Commerce employs a staff of 57 people that settle claims at four regional claims offices strategically located throughout the country. In addition to these individuals, American Commerce utilizes the services of approximately 331 independent appraisal firms and 166 independent property adjusting companies who are also strategically located throughout the country. Commerce West settles claims at their home office employing a staff of 31 in the claims department. In addition, Commerce West utilizes the services of approximately 14 independent appraisal firms strategically located in California and Oregon.
The Company believes that through its claims staff of experienced adjusters, appraisers, managers, and administrative staff, it has higher customer satisfaction than many of its competitors. All claims office staff members work closely with agents, insureds and claimants with a goal of settling claims fairly, rapidly and cost effectively.
Certain of the Company's Massachusetts agencies have settlement authority for claims for other than automobile property losses, which are less than $2,500. The settlement authority of agencies under automobile policies is limited to claims for towing.
The Massachusetts Unfair Claims Settlement Practices Act ("Chapter 176D"), and other similar provisions in states in which the Company does business, prohibits insurers from engaging in certain claim settlement practices. These include failing to acknowledge and act reasonably promptly upon communications with respect to claims arising under insurance policies, refusing to pay claims without conducting a reasonable investigation based upon all available information, failing to effectuate prompt, fair and equitable settlements of claims in which liability has become reasonably clear, and compelling insureds to institute litigation to recover amounts due under an insurance policy by offering substantially less than the amounts ultimately recovered in actions brought by such insureds. An insurer's
violation of any of these obligations expressly violates a number of state laws including the Massachusetts Consumer Protection Act ("Chapter 93A"). Any party, including claimants and insureds, whose rights are affected by an insurer's violation of Chapter 176D, is entitled to bring a claim against the insurer under Chapter 93A. Similar provisions exist in other states where the Company does business.
The damages available under Chapter 93A may not necessarily be related to the harm caused by the insurer's violation of Chapter 176D. Chapter 93A provides in effect that the party bringing the Chapter 93A claim will be entitled, at a minimum, to the amount of the judgment on all claims arising out of the same underlying occurrence, regardless of the limits of the policy issued by insurer. Moreover, Chapter 93A permits the court to double or triple the party's damages if the insurer's violation of Chapter 176D was willful or knowing. If the underlying policy risk was ceded to C.A.R., the Company may seek reimbursement from C.A.R. for the damages it will be obligated to pay if it is found liable under Chapter 93A or amounts paid in settlement of such claim. Such reimbursement is discretionary and C.A.R. may not reimburse an insurer if C.A.R. determines that the insurer was negligent in the handling of such claim and such negligence was the cause of Chapter 93A liability. Additionally, certain time notification restrictions apply to these judgments, which if not met, could preclude an insurer from seeking reimbursement from C.A.R. Accordingly, there can be no assurance that the Company will be reimbursed in any particular instance involving a Chapter 93A C.A.R. reinsured claim.
Since 1996, the Company has been expanding a twenty-four (24) hour claim reporting service in Massachusetts to third-party claimants and insureds of interested agencies. This service allows customers to report their first notice of a loss at anytime of the night or day; 365 days a year, including weekends and holidays. This reporting methodology allows the Company to improve customer satisfaction by making the initial claim handling much faster and ultimately reducing indemnity payments such as rental and storage. As of December 31, 2001, there were 390 Massachusetts agents who signed up for this claim reporting methodology. This compares to 377 agents as of December 31, 2000. This service is available to all agents and their use of the service fluctuates on an ongoing basis.
G. Loss and Loss Adjustment Expense Reserves
Unpaid Loss and LAE by their nature are inherently uncertain as to the ultimate outcome of the estimated amounts. The liability for unpaid losses and LAE represents Management's best estimate of the ultimate net cost of all losses and LAE incurred through the balance sheet date. The estimate for ultimate net cost of all losses incurred through the balance sheet date includes the adjusted case estimates for losses, incurred but not reported ("IBNR") losses, salvage and subrogation recoverable and a reserve for LAE. In arriving at its best estimate, management begins with the aggregate of individual case reserves and then makes adjustments to these amounts on a line of business basis. These adjustments to the aggregate case reserves by line of business are made based on analysis performed by Management as further described below. The entire liability for unpaid losses and LAE is also reviewed quarterly and annually by the Company's Actuarial Department. Liability estimates are continually analyzed and updated, and therefore, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimates are included in the results of operations in the period in which the estimates are revised.
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer's payment of that loss. To recognize liabilities for unpaid losses, insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and LAE. Quarterly, the Company reviews these reserves internally. Regulations of the Division of Insurance require the Company to annually obtain a certification from either a qualified actuary or an approved loss reserve specialist that its loss and LAE reserves are reasonable.
2. Unpaid Loss and Loss Adjustment Expenses ("LAE")
Unpaid Loss and LAE by their nature are inherently uncertain as to the ultimate outcome of the estimated amounts. The liability for unpaid losses and LAE represents Management's best estimate of the ultimate net cost of all losses and LAE incurred through the balance sheet date. The estimate for ultimate net cost of all losses incurred through the balance sheet date includes the adjusted case estimates for losses, incurred but not reported ("IBNR") losses, salvage and subrogation recoverable and a reserve for LAE. In arriving at its best estimate, management begins with the aggregate of individual case reserves and then makes adjustments to these amounts on a line of business basis. These adjustments to the aggregate case reserves by line of business are made based on analysis performed by Management as further described below. The entire liability for unpaid losses and LAE is also reviewed quarterly and annually by the Company's Actuarial Department. Liability estimates are continually analyzed and updated, and therefore, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimates are included in the results of operations in the period in which the estimates are revised.
The claim cycle begins when a claim is reported to the Company and claims personnel establish a "case reserve" for the estimated amount of the ultimate exposure to the Company. The amount of the reserve is primarily based upon an evaluation of the type of claim involved, the circumstances surrounding the claim and the policy provisions relating to the loss. This estimate reflects the informed judgment of such personnel based on general insurance reserving practices and on the experience and knowledge of the claims personnel adjusting the claim. During the loss adjustment period, these case basis estimates are revised as deemed necessary by the Company's claims department personnel based on subsequent developments and periodic reviews of the claim.
In accordance with industry practice, the Company also maintains reserves for estimated IBNR, salvage and subrogation recoverable and LAE. These reserves are determined on the basis of historical information and the experience of the Company. Adjustments to these reserves are made periodically to take into account changes in the volume of business written, claims frequency and severity, the mix of business, claims processing and other items that can be expected to affect the Company's liability for losses and LAE over time.
When reviewing the liability for unpaid losses and LAE, the Company analyzes historical data and estimates the impact of various factors such as: (i) payment trends; (ii) loss expense per exposure; (iii) the historical loss experience of the Company and industry; (iv) frequency and severity trends; and, (v) legislative enactments, judicial decisions, legal developments in the imposition of damages, changes and trends in general economic conditions, including the effects of inflation and recession. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors.
By using individual estimates of reported claims adjusted for managements best estimate by line of business and generally accepted actuarial reserving techniques, the Company estimates the ultimate net liability for losses and LAE. After taking into account all relevant factors, management believes that, based on existing information, the provision for losses and LAE at December 31, 2001 is adequate to cover the ultimate net cost of losses and claims incurred as of that date. The ultimate liability, however, may be greater or lower than established reserves. If the ultimate exposure is greater than (or less than) management's estimated liability for losses and LAE, based on any of the factors noted previously, the Company will incur additional expense (income) which may have a material impact.
For a reconciliation of beginning and ending reserves for losses and LAE, gross and net of reinsurance, see Note E to the Company's 2001 Consolidated Financial Statements, which is incorporated herein by reference from pages 52 through 54 of the Company's 2001 Annual Report.
Included in the loss reserve methodologies described above, are liabilities for unpaid claims and claim adjustment expenses for environmental related claims such as oil spills, mold and lead paint. Reserves have been established to cover these claims for known losses. Because of the Company's limited exposure to these types of claims, management believes they will not have a material impact on the consolidated financial position of the Company in the future. Loss reserves on environmental related claims amounted to $4,281,000 and $3,712,000 at December 31, 2001 and 2000, respectively.
The following table represents the development of reserves, net of reinsurance, for 1991 through 2001. The top line of the table shows the reserves at the balance sheet date for each of the indicated years. This represents the estimated amounts of losses and LAE for claims arising in all years that were unpaid at the balance sheet date, including losses that had been incurred but not yet reported to the Company. The upper portion of the table shows the cumulative amounts paid as of successive years expressed as a percentage with respect to that year's current reserve liability. The lower portion of the table shows the re-estimated amount as a percentage of the previously recorded reserves based on experience as of the end of each succeeding year, including cumulative payments made since the end of the respective year. The estimate changes as more information becomes known about the payments, frequency and severity of claims for individual years. Favorable loss development exists when the original reserve estimate is greater than the re-estimated reserves at December 31, 2001.
H. Operating Ratios
Loss and Underwriting Expense Ratios
Loss and underwriting expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. Losses and LAE are stated as a percentage of premiums earned because losses may occur over the life of a policy. Underwriting expenses on a statutory basis are stated as a percentage of net premiums written rather than earned premiums because most underwriting expenses are incurred when policies are written and are not spread over the policy period. Underwriting profit margins are reflected by the extent to which the combined loss and underwriting expense ratios, the combined ratio, is less than 100%. The combined ratio is considered the best simple index of current underwriting performance of an insurer. The Company's loss and LAE ratio, underwriting expense ratio and combined ratio, and the industry combined ratio, on a statutory basis, are shown in the following table. The Company's ratios include lines of insurance other than automobile as do the industry combined ratios for all writers. Data for the property and casualty industry generally may not be directly comparable to Company data. This is due to the fact that the Company conducts its business primarily in Massachusetts where approximately 87.6% of direct premiums are written.
(1) Source: A.M. Best's Review Preview (2002), as reported by A.M. Best for all property and casualty insurance companies and weighted to reflect the Company's product mix. The 2001 industry information is estimated by A.M. Best.
Premiums to Surplus Ratio
The following table shows, for the periods indicated, the Company's and the industry's statutory ratios of net premiums written to policyholders' surplus. While there is no statutory requirement applicable to the Company which establishes a permissible net premiums to surplus ratio, guidelines established by the National Association of Insurance Commissioners ("NAIC") provide that this ratio should be no greater than 300%.
I. Investments
Investment income is an important source of revenue for the Company and the return on its investment portfolio has a material effect on its net earnings. The Company's investment objective continues to focus on maximizing after-tax investment income through investing in high quality securities coupled with acquiring equity investments, which may forgo current investment yield in favor of potential higher yielding capital appreciation in the future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" incorporated herein by reference from pages 5 through 29 of the Company's 2001 Annual Report.
The Company's investment portfolio is carried at market value, except for the closed-end preferred stock mutual funds and other investments which are carried at equity value. At December 31, 2001, the carrying value of total investments was $1,498,201,000. Of that amount, 41.8% was invested in fixed maturities, 16.6% was invested in preferred stocks, 7.2% was invested in common stocks, 20.6% was invested in closed-end preferred stock mutual funds, 2.6% was invested in mortgage loans and 1.3% in other investments. Cash and cash equivalents accounted for the remaining 9.9%.
The focus of management's judgments and estimates relating to investments involves the potential impairment of investments for other than temporary declines in market values. Carrying value of investments in fixed maturities, which include taxable and non-taxable bonds, and investments in common and preferred stocks, are derived from market prices supplied by the Company's investment custodian. Unrealized investment gains and losses on common and preferred stocks and fixed maturities, to the extent that there is no other than temporary impairment of value, are credited or charged to a separate component of stockholders' equity, known as "net accumulated other comprehensive income (loss)", until realized, net of any tax effect. An impairment in an investment is deemed to be other than temporary when a security's market value has diminished to less than 75% of cost for two consecutive quarters. If the contractual terms of the security are being complied with, management performs a cash flow valuation to determine the potential impairment of the security. If the security is deemed impaired, the company adjusts the security's cost to market value through realized loss based on publicly available information or in the absence of such, to a value based on cash flow modeling. During 2001, the Company wrote down $2,665,000 in bonds and preferred stock investments with impairment as determined by management to be other than temporary. Given the makeup and quality of the Company's investments, management does not believe that a more stringent policy would have a material effect on the carrying value of its investments. When investment securities are sold, the realized gain or loss is determined based upon specific identification. Fair market value of fixed maturities and common and preferred stocks are based on quoted market prices. For other securities held as investments, fair market value equals quoted market price, if available. If a quoted market price is not available, fair market value is estimated using quoted market prices for similar securities. The Company has not invested more than 5% of fixed maturities in any one state or political subdivision.
The Company's bond portfolio at cost is comprised of Government National Mortgage Association ("GNMA") and Federal National Mortgage Association ("FNMA") mortgage backed bonds (15.9%), municipal bonds (62.5%), corporate bonds (21.6%) and U.S. Treasury bonds (0.0%). Of the Company's bonds, 97.9% are rated in the two highest quality categories provided by the NAIC.
During 2001, as required by the Emerging Issues Task Force ("EITF") D- 46, the Company amended its policy in regard to venture capital fund investments. EITF D-46 requires companies who own more than a 5% share of a limited partnership to account for these investments on an equity basis. The operating results of these venture capital fund investments have been reflected in realized gains and losses. Prior to this change, the operating results were not material and were therefore reflected in accumulated other comprehensive income and loss.
Beginning in the first quarter of 2001, the Company, in 2001 and prior years' results, classified its undistributed equity in the earnings and losses on investments in closed-end preferred stock mutual funds in net realized investment gains and losses. For the year ended 2000, the undistributed equity in the earnings and losses of these funds was reported in net investment income. The Company believes the current year presentation provides a more appropriate classification for analysis of ongoing operations of the Company. These investments are valued at original cost plus the cumulative undistributed equity in earnings and losses of the funds and adjusted over time by the premium or discount at the time of purchase to the applicable underlying net asset value of the funds.
The Company's investment policy, determined in accordance with guidelines established by the Company's Board of Directors, emphasizes after-tax investment yield while maintaining investment quality. The Board of Directors reviews and ratifies management's investment decisions on a quarterly basis. State insurance laws also impose restrictions on the nature and extent of investments by the Company.
The table below sets forth investments (at cost), net realized gains (losses), net accumulated other comprehensive income (loss) and the net investment income and yield thereon for the three years ended December 31, 2001.
At December 31, 2001, the Company's fixed income portfolio, which represented 41.8% of the Company's total invested assets, had a weighted average stated maturity of approximately 27.3 years versus 26.1 years at December 31, 2000. The calculation of average stated maturity utilizes the dollar weighted average of the actual maturity date for a security. In contrast, the Company's weighted average duration can be significantly less. At December 31, 2001 the Company's fixed income portfolio had a weighted average duration of 5.7 years versus 5.1 years at December 31, 2000. The "duration" of a security is the time-weighted present value of the security's expected cash flows and is used to measure a security's price sensitivity to changes in interest rates. The weighted average duration is short compared to the average stated maturity because of the relatively large percentage of GNMA and municipal housing bonds in the fixed maturity portfolio. The duration reflects industry prepayment assumptions. The municipal housing bonds are similar in nature to GNMAs in that they pay down principal during the life of the bond. For these types of bonds, investors are compensated primarily for reinvestment risk rather than credit quality risk. During periods of significant interest rate volatility, the underlying mortgages may prepay more quickly or more slowly than anticipated. If the repayment of principal occurs earlier than
anticipated during periods of declining interest rates, investment income may decline due to the reinvestment of these funds at the lower current market rates. In regards to municipal bonds, the Bloomberg Financial System, which was used to calculate the above duration data, utilizes optional call dates, sinking fund requirements and assumes a non-static prepayment pattern in deriving these averages.
J. Regulation
General
The Company's primary business is subject to extensive regulation. In Massachusetts, the Commissioner is appointed by the Governor of Massachusetts and has broad authority to fix and establish maximum policy rates and minimum agent commission levels on personal automobile insurance. In addition, the Commissioner grants and revokes licenses to write insurance, approves policy forms, sets reserve requirements, determines the form and content of statutory financial statements and establishes the type and character of portfolio investments. The Commissioner also approves company submissions regarding affinity group insurance programs and corresponding discounts along with SDIP deviations. Consequently, the policies and regulations set by the Commissioner are an important element of writing insurance in Massachusetts. In states outside of Massachusetts, premium rates generally must be filed with, and approved by the Commissioner of Insurance in that particular state. In general, minimum commissions to agents are not set by the other states commissioners.
The State Divisions of Insurance are responsible for conducting periodic examinations of insurance companies. Both Commerce and Citation were last examined for the five year period ended December 31, 1998. Commerce West was last examined in 2001 by the California Division of Insurance for the three year period ended December 31, 1999. American Commerce was examined in 1999 by the Ohio Division of Insurance for the three year period ending December 31, 1997. The concluded examinations produced no material findings. Massachusetts Division of Insurance regulations provide that insurance companies will be examined every five years or more frequently as deemed prudent by the Commissioner. California Division of Insurance regulations provide that insurance companies will be examined every three years. Ohio Division of Insurance regulations provide that insurance companies will be examined at least every five years.
Automobile Insurance Regulation Overview
Massachusetts has required compulsory automobile insurance coverage since 1925. States outside of Massachusetts generally have varying levels of minimum compulsory insurance. Under current law, all Massachusetts motorists are required to carry certain minimum coverages mandated by the State. The Commissioner fixes and establishes, among other things, the maximum rates insurers may charge for the compulsory personal automobile coverages. With very limited exceptions, each insurer writing automobile insurance in Massachusetts must accept all risks submitted to it for the compulsory coverage, but is permitted to reinsure these risks (including affinity group marketing insurance risks) through C.A.R.
Compulsory Coverage. Compulsory coverage includes no-fault coverage, limited bodily injury coverage, property damage coverage and coverage against uninsured or hit and run motorists. The Massachusetts no-fault statute provides for personal injury protection ("PIP") coverage, which entitles a party to be reimbursed directly by the party's own insurer for certain medical expenses, lost wages and other defined expenses arising from an automobile accident, up to a specific amount, even if another party caused the accident.
Rates and Commissions. All Massachusetts personal automobile insurance rates are fixed and established annually by the Commissioner. Affinity group marketing insurance programs and safe driver rate deviations must be annually approved by the Commissioner. For Massachusetts commercial automobile insurance, the rates for the voluntary market are competitive, with insurers filing rates for review by the Commissioner based on their own
experience. The rates for the Massachusetts commercial automobile risks reinsured through C.A.R. are fixed and established by the Commissioner except for non-fleet, private passenger-type automobiles. See Section A- General for additional information.
In fixing classifications of risks and establishing rates, the Commissioner must consider numerous factors including driver and automobile characteristics and the claim rate in the state's designated geographical territories. These factors are based upon data which are two or more years old. The insurer adjusts the premiums it charges to a policyholder based upon the SDIP record of the operator. Moving violations and at-fault accidents affect each driver's SDIP record. In addition, the Extra Risk Rating regulations permit insurers to deny or charge surcharged rates for physical damage coverage to both high risk vehicles and insureds with excessive prior loss or violation activity.
The Commissioner sets an average minimum direct agency commission rate for personal automobile insurance, which in 2001 was 12.3%. With respect to risks reinsured through C.A.R., the maximum amount of commissions that C.A.R. will reimburse is fixed at that prescribed rate.
Mandatory Underwriting. Massachusetts law specifies that all individuals holding a valid driver's license are entitled to purchase the mandatory automobile insurance coverages regardless of their driving experience or accident record. The Massachusetts Legislature has also placed certain restraints on insurers' discretion to refuse to renew automobile insurance policies. Policyholders are entitled to renew except in cases of fraud, material misrepresentation, revocation or suspension of an operator's license or nonpayment of premiums. With very limited exceptions, Servicing Carriers writing automobile insurance in Massachusetts must accept every automobile risk submitted to them.
Under the Massachusetts system of rate regulation, it is intended that some personal automobile insurance risks are under priced at the maximum rate permitted by the Commissioner, and therefore, absent state- intervention, insurers would not ordinarily choose to write those risks. The C.A.R. reinsurance program described below is intended to mitigate the burden imposed by the Massachusetts take-all-comers system by allowing insurers to transfer the exposure for under priced risks to an industry pool.
Commonwealth Automobile Reinsurers
General. C.A.R. is a Massachusetts state-mandated reinsurance mechanism, under which all premiums, expenses and losses on ceded business are shared by all insurers. It is similar to a joint underwriting association because a number of insurers (39, including the Company) act as Servicing Carriers for the risks it insures.
Agencies. In general, agencies licensed to issue automobile insurance policies are entitled to be assigned to at least one Servicing Carrier. There are two categories of agencies: those who have voluntary agreements with one or more Servicing Carriers and those who do not. The latter are assigned by C.A.R. to a single Servicing Carrier and are known as ERPs.
C.A.R. Operations. All companies writing automobile insurance in Massachusetts share in the underwriting results of the C.A.R. business for their respective product line or lines, whether or not they are Servicing Carriers. An insurer's share of the C.A.R. deficit is allocated on the basis of a formula called a participation ratio, which can vary significantly between the personal and commercial pools, and between different policy years. See "Business-Commonwealth Automobile Reinsurers" for a detailed discussion of the method of calculating the participation ratio.
An insurer may terminate its participation in C.A.R. as of the close of C.A.R.'s fiscal year by surrendering its license to write automobile policies in Massachusetts. Termination does not discharge or otherwise affect liability of an insurer incurred prior to termination. A withdrawing insurer is assessed a share of C.A.R.'s projected deficits for future years based on the insurer's prior years' participation in C.A.R. The assessment paid by the withdrawing insurer is redistributed to the remaining insurers based upon their participation ratios.
An insurer can transfer its obligations for its personal insurance policies to another insurer who formally agrees to assume these obligations. The transferring insurer is thereby relieved of future C.A.R. obligations which otherwise would have arisen as a consequence of the business transferred. See "Business-Commonwealth Automobile Reinsurers."
Insurance Holding Company Structure
As an insurance holding company, the Company is subject to regulation under the insurance holding company statutes of the states in which any of its subsidiary insurance companies are domiciled. Because the Company's subsidiaries are members of an insurance holding company system, they are required to register with their respective Divisions of Insurance and to submit reports describing the capital structure, general financial condition, ownership and management of each insurer and any person or entity controlling the insurer, the identity of every member of the insurance holding company system and the material outstanding transactions between the insurer and its affiliates.
Each member of the insurance holding company system must keep current the information required to be disclosed by reporting all material changes or additions within 15 days of the end of the month in which it learns of such change or addition.
Massachusetts law prohibits a party, which is not a domestic insurer from acquiring "control" of a domestic insurer or of a company controlling a domestic insurer without prior approval of the Commissioner. Control is presumed to exist if a party directly or indirectly holds, owns or controls more than ten percent of the voting stock of another party, but may be rebutted by a showing that control does not exist.
In the event of the insolvency, liquidation or other reorganization of any of the Company's insurance subsidiaries, the creditors and stockholders of the Company will have no right to proceed against the assets of those subsidiaries, or to cause the liquidation or bankruptcy of any company under federal or state bankruptcy laws. State laws govern such liquidation or rehabilitation proceedings and the Division of Insurance would act as receiver for the particular company. Creditors and policyholders of the insurance subsidiaries would be entitled to payment in full from such assets before the Company, as a stockholder, would be entitled to receive any distribution there from.
Payment of Dividends
Under Massachusetts' law, insurers may pay cash dividends only from earnings and statutory surplus, and the insurer's remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs.
Protection Against Insurer Insolvency-Massachusetts
All of the insurers writing the types of insurance covered by the Massachusetts Insurers Insolvency Fund ("M.I.I.F.") are M.I.I.F. members. M.I.I.F. is obligated to pay any unpaid claim, up to $300,000, against an insolvent insurer if the claim existed prior to the declaration of insolvency or arose within 60 days thereafter. M.I.I.F. assesses members the amounts it deems necessary to pay both its obligations and the expenses of handling covered claims. Subject to certain limitations, assessments are made in the proportion that each member's net written premiums for the preceding calendar year for all property and casualty lines of business bore to the corresponding net written premiums for all members for the same period. The statute that established M.I.I.F. also provides for the recoupment by insurers of amounts paid to M.I.I.F. Historically, the Commissioner has allowed insurers to recoup the amounts they paid M.I.I.F. through rate adjustments.
As provided in the statutes, insurance companies which write business in Massachusetts are assessed for losses attributable to the insolvency of other insurance companies by the Massachusetts Insurers Insolvency Fund. From M.I.I.F.'s inception, on August 2, 1972 through December 31, 2001, the M.I.I.F. has approved assessments totaling $188,071,000,
of which the Company's share was approximately $15,686,000. It is anticipated that there will be additional assessments from time to time relating to various insolvencies. By statute, no insurer may be assessed in any year an amount greater than two percent of that insurer's direct premiums written for the calendar year preceding the assessment. Although the timing and amounts of any such assessments are not known, based on existing knowledge, management is of the opinion that such assessments will not have a material effect on the consolidated financial position of the Company. According to statute, the assessed insurance companies have the right to recoup amounts paid to the M.I.I.F., over a reasonable length of time, through premium rates approved by the Commissioner. M.I.I.F. assessed the Company $3,111,000 during 2001 and $5,306,000 for the year ended December 31, 2000 after having no activity for the year ended December 31, 1999. The assessment for 2001 was the result of two insolvencies, The Trust Insurance Company and Reliance Insurance Company, which accounted for assessment amounts of $1,244,000 and $1,867,000, respectively. The assessment for 2000 was primarily the result of two insolvencies, The Trust Insurance Company and New England Fidelity Insurance Company, which accounted for assessment amounts of $4,939,000 and $1,205,000, respectively, offset by refunds for prior year assessments on numerous insurers' insolvencies.
Protection Against Insurer Insolvency-Other States
Commerce West, domiciled in California, is covered by the California Insurance Guarantee Association ("C.I.G.A."). American Commerce, domiciled in Ohio, is covered by the Ohio Guarantee Association ("O.G.A."). Both companies are also covered by similar Associations in the states where they do business. These Associations operate similarly to the M.I.I.F. described earlier. Payments made by American Commerce to the associations that they are covered under were $125,000 in 2001 and $36,000 in 2000. No payments were made to these Associations for insolvency assessments by Commerce West in 2001 and 2000.
Protection Against Insurer Insolvency-NAIC Guidelines
Insurance Regulatory Information System Ratios. The NAIC Insurance Regulatory Information System ("IRIS") was developed by a committee of state insurance regulators and is intended primarily to assist state insurance regulators in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies eleven industry ratios and specifies "usual values" for each ratio. Departure from the usual values on four or more of the ratios can lead to inquiries from individual state insurance commissioners as to certain aspects of an insurer's business. For the year ended December 31, 2001, the Company's consolidated property and casualty operations had no ratios outside the "usual values".
Risk-Based Capital ("RBC"). In order to enhance the regulation of insurer insolvency, the NAIC developed a formula and model law to provide for RBC requirements for property and casualty insurance companies. RBC requirements are designed to assess capital adequacy and to raise the level of protection, that statutory surplus provides for policyholder obligations. The RBC model for property and casualty insurance companies measures three major areas of risk facing property and casualty insurers: (i) underwriting, which encompasses the risk of adverse loss development and inadequate pricing; (ii) declines in asset values arising from credit risk; and, (iii) other business risks from investments. Insurers having less statutory surplus than required by the RBC calculation will be subject to varying degrees of regulatory action, depending on the level of capital inadequacy.
The RBC model formula proposes four levels of regulatory action. The extent of regulatory intervention and action increases as the percentage of surplus to RBC falls. The first level, the Company Action Level (as defined by the NAIC), requires an insurer to submit a plan of corrective actions to the regulator if surplus falls below 200% of the RBC amount. The Regulatory Action Level (as defined by the NAIC) requires an insurer to submit a plan containing corrective actions and permits the Commissioner to perform an examination or other analysis and issue a corrective order if surplus falls below 150% of the RBC amount. The Authorized Control Level (as defined by the NAIC) allows the regulator to rehabilitate or liquidate an insurer in addition to the aforementioned actions if surplus falls below 100% of the RBC amount. The fourth action level is the Mandatory Control Level
(as defined by the NAIC), which requires the regulator to rehabilitate or liquidate the insurer if surplus falls below 70% of the RBC amount.
The following table provides the key RBC information for the Company's insurance subsidiaries, Commerce, Citation, Commerce West, and American Commerce:
K. Competition
The property and casualty insurance industry is highly cyclical, characterized by periods of increasing premium rates and limited underwriting capacity, followed by periods of intensive price competition and abundant underwriting capacity. This industry also is highly competitive, with a large number of companies, many of which operate in more than one state, offering automobile, homeowners, commercial property and other lines of insurance. Some of the Company's competitors have larger volumes of business and greater financial resources and some sell insurance directly to policyholders rather than through independent agents.
Massachusetts
In 2002, in response to the average personal automobile rate decisions over the last several years, the Company did not file for SDIP Step 9 or Step 10 deviations, for policies incepting in the 2002 calendar year. During 2001, 55.0% of the Company's exposures were eligible for Step 9 deviations, versus 55.1% and 14.0%, eligible for Step 9 and Step 10 deviations in 2000.
Because the Company's insurance products are marketed exclusively through independent agencies, most of whom represent more than one company, the Company faces competition within each agency. The Company competes for business within independent agencies by offering a more attractively priced product to the consumer and by paying agents significant compensation in the form of commissions and profit sharing, which are based in part on the underwriting profits or losses of the agency business written with the Company. The Company also provides a consistent market, the prompt servicing of policyholder claims and agency support services. Although the Company believes, based upon regular surveys of its agencies, its relationships with its independent agencies are excellent, any disruption in these relationships could adversely affect the Company's business.
The Company believes the Massachusetts regulatory environment, which fixes maximum personal automobile insurance rates, apportions losses incurred by C.A.R. and establishes minimum agency commissions, has discouraged certain companies with more diverse geographic markets and interests from establishing a presence or expanding their market share in Massachusetts. Any material change in this situation could adversely affect the Company's business.
Other States
Both Commerce West and American Commerce file and receive approval for premium rates with the respective divisions of insurance in the states they do business. Commerce West competes for business by utilizing 617 independent insurance agencies and brokers that offer competitively priced products and provide quality service. Agents and brokers are offered compensation in the form of commissions and profit sharing, which are based in part on the underwriting profits and losses of the agency business written with Commerce West. American Commerce competes for business by utilizing 36 AAA owned and operated independent agencies that offer competitively priced products and provide quality service. The AAA owned independent agencies are offered compensation in the form of commission and profit sharing, based primarily on loss ratios, as well as stock options based on the volume of agency business written with American Commerce.
L. Other Matters
Human Resources
As of December 31, 2001, the Company and its subsidiaries employed 1,780 people. Commerce employed 1,574 people; Commerce West employed 77 people; American Commerce employed 169 people. The Company is not a party to any collective bargaining agreements and believes its relationship with employees to be very good.
The Company offers benefits, compensation and employee relations programs to assure a productive and positive working environment. The Company monitors job grades and salary scales of peer companies to assure that its compensation levels and benefits are competitive both within the property and casualty insurance industry and geographically in the areas its subsidiaries operate. The Company has been recognized for its progressive programs designed to meet the needs of a modern-day workforce. On-site child care has been offered to Massachusetts employees since 1986 making Commerce one of the first businesses in the region to offer this benefit. A newly constructed child care center can currently accommodate up to 200 children of our employees. In addition, alternative work schedules, casual dress, and free parking are also provided.
The Company offers an Employee Stock Ownership Plan ("E.S.O.P.") and 401(k) Plan for the benefit of substantially all employees, including those of the Company's subsidiaries as discussed in Note I of the Company's Annual Report. The E.S.O.P. is noncontributory on the part of Participants and contributions are made at the discretion of the Board of Directors. The Company is under no obligation to make contributions or maintain the E.S.O.P. for any length of time, and may completely discontinue or terminate the E.S.O.P. at any time without liability. Contributions by the Company and subsidiaries to the E.S.O.P. for the years ended December 31, 2001, 2000 and 1999 were $7,502,000, $5,702,000 and $5,744,000, respectively. The increase in the contribution in 2001 over 2000 was due primarily to the inclusion of American Commerce employees into the plan. The E.S.O.P. held 2,989,046 and 3,143,076 shares of the Company's common stock at December 31, 2001 and 2000, respectively. E.S.O.P. participants who are current employees of the Company or its subsidiaries and who are 100% vested in their E.S.O.P. accounts can annually elect to transfer out of the E.S.O.P. up to 100% of their allocated Company stock in the form of an eligible rollover distribution into another eligible retirement plan, such as a qualified individual retirement arrangement. Approximately 2,191,000 shares owned by Participants in the E.S.O.P. at December 31, 2001 are allocated to the E.S.O.P. accounts of these individuals. E.S.O.P. Participants who are former employees of the Company may generally elect to withdraw from the E.S.O.P. the total amount of shares allocated to their accounts at any time. Approximately 580,000 shares held by the E.S.O.P. at December 31, 2001 are allocated to the E.S.O.P. accounts of these individuals. The remaining approximately 219,000 shares held by the E.S.O.P. at December 31, 2001 are allocated to the E.S.O.P. accounts of Participants who have not yet reached 100% vesting in their account balances. Disposition of these unvested shares is restricted under the E.S.O.P. The Company pays for administration of the plan.
The 401(k) Plan, implemented in September 1998, enables eligible employees to contribute up to 15% of eligible compensation on a pre-tax basis up to the annual maximum limits under federal tax law. The Company incurs no expenses in the form of matching contributions but does pay for administration of the Plan. Effective June 1, 2000, the Directors of American Commerce voted to terminate the American Commerce noncontributory defined benefit pension plan (the "pension plan") and transition on January 1, 2001 to the E.S.O.P. The payment of the termination liability to participants from previously funded assets of the pension plan amounted to $4,558,000 in 2000. All participants of the pension plan were eligible to retire with full retirement benefits upon attainment of age 65 with 5 years of participation. Retirement benefits were payable for the life of the participant with guaranteed payments for 10 years. All retirees had taken lump-sum payments. American Commerce made contributions to a deposit administration contract, which provided the pension plan with assets sufficient to fund pension benefits to pension plan participants. The deposit administration contract was carried at contract value, which represented the cost of contributions plus interest and experience refunds. The pension plan was subject to and exceeded the minimum funding requirements of ERISA.
Effective January 1, 2001, the Directors of American Commerce voted to merge the 401(k) plan with the Company's 401(k) Plan. Previously, American Commerce maintained a separate 401(k) Plan for the benefit of substantially all of its employees. American Commerce matched 50% of all employee contributions up to 6% of pay. Both American Commerce and its employees shared in administration expenses of the plan. American Commerce contributed $181,000 and $165,000 to the plan in 2000 and 1999, respectively.
American Commerce maintains a noncontributory post-retirement benefit plan (the "post-retirement plan") for retirees that includes medical, dental and life insurance coverages. All participants of the post-retirement plan are eligible upon attainment of age 55 with 10 years of service or age 65 with 5 years of service. Dental coverage ceases at age 65 and life insurance coverage decreases based upon the age of the retiree until the attainment of age 70, at which time retirees are provided a nominal amount of coverage from age 70 and thereafter. Participant's spouses are also covered under the post-retirement plan. The cost of post-retirement medical, dental and life insurance benefits is accrued over the active service periods of employees to the date they attain full eligibility for such benefits. It is the policy of American Commerce to pay for post- retirement benefits as incurred. American Commerce did not contribute to the plan in 2001 due to the aforementioned merger.
Subsequent to December 31, 2001, the Directors of American Commerce voted to terminate that portion of the post-retirement plan applicable to future retirees of American Commerce. Termination will be effective May 1, 2002. Current retirees and employees who retire prior to May 1, 2002 will remain eligible for post-retirement benefits.
Additional Information
The information called for by this Item and not otherwise provided is contained in the following pages of the Company's Annual Report which disclosure is incorporated herein by reference: Pages 42 and 51 for Deferred Policy Acquisition Costs, pages 57 through 59 for 59 for Deferred Tax Assets and page 66 for Segment Information.
ITEM 2.
ITEM 2. PROPERTIES
The Company conducts its Massachusetts operations from approximately 300,000 square feet of space in several buildings, which it owns in Webster, Massachusetts, which is located approximately 50 miles southwest of Boston. The Company's principal administrative offices in Webster consist of recently rehabilitated and newly constructed buildings. Its data processing and operational departments are housed in modern office buildings on a separate nine acre site. The Company has a 20,000 square foot child care center located on a separate seven acre site in Webster, Massachusetts. The Company operated child care center can provide care for up to 200 children of employees. During 2001, Commerce purchased a 160,000 square foot building. Commerce expects to expend approximately $13 million renovating the building primarily in 2002. Commerce West currently leases approximately 12,000 square feet of office space in Pleasanton, California. Commerce West
anticipates it will relocate within the next three to four years. Land in Stockton, California was purchased on June 26, 2001 at an approximate cost of $1,125,000 as part of this relocation plan. American Commerce conducts its operations from approximately 40,000 square feet of space in a building located on a two acre site in Columbus, Ohio. American Commerce also leases property at three of its four district claims offices. The Company considers that its properties are in good condition, are well maintained, and are generally suitable to carry on the Company's business. For additional information concerning property, see NOTE D to the Company's 2001 Consolidated Financial Statements, which is incorporated herein by reference from page 52 of the Company's 2001 Annual Report.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
As is common with property and casualty insurance companies, the Company is a defendant in various legal actions arising from the normal course of its business, including claims based on Chapter 176D and Chapter 93A. These proceedings are considered to be ordinary to operations or without foundation in fact. Management is of the opinion that these actions will not have a material adverse effect on the consolidated financial position of the Company. In addition to the normal course of business legal actions noted above, the Company is named as defendant in a purported class action lawsuit alleging damages as a result of the alleged diminution of value to vehicles that are involved in accidents. The "diminution of value" theory asserts that the market value of any vehicle involved in an accident inevitably and irreparably declines as a result of such accident, even if all physical damage appears to be repaired completely. This case, entitled "Elena Given, individually and as a representative of all persons similarly situated v. The Commerce Insurance Company," filed in 2001, in the Bristol Superior Court in Massachusetts. The plaintiff has not sought certification of class action status. The Company is vigorously contesting this suit, but is currently unable to estimate the potential exposure. The Company and its outside legal counsel are of the opinion that the Company will prevail in this case. Another Superior Court judge in Massachusetts ruled, in a similar case brought by the same plaintiff counsel against another insurer, that claims for diminution of value are not covered by the Massachusetts automobile insurance policy. Other insurance companies face similar suits in cases outside of Massachusetts.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter of 2001.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The Company's executive officers are as follows:
Arthur J. Remillard, Jr. has been the President, Chief Executive Officer and Chairman of the Board of the Company since 1976. Mr. Remillard, Jr. has been Chief Executive Officer and Chairman of the Board of The Commerce Insurance Company ("Commerce") since 1972 and President of Commerce from 1972 to November, 2001. Mr. Remillard, Jr. is also Vice Chairman of the Governing Committee Review Panel, Chairman of the Budget Committee and a member of the Personnel Committee of the Commonwealth Automobile Reinsurers ("C.A.R."). Mr. Remillard, Jr. is also Chairman of the Governing Committee and a member of the Budget Committee, Executive Committee and Nominating Committee of the Automobile Insurers Bureau of Massachusetts ("A.I.B.").
Gerald Fels, a Certified Public Accountant, was appointed President and Chief Operating Officer of Commerce in November 2001, and Executive Vice President of the Company in November, 1989. From 1981 to November, 1989, Mr. Fels was Senior Vice President of the Company. Mr. Fels was the Treasurer of the Company from 1976 to 1995 and of Commerce from 1975 to 1995. Mr. Fels has also been Chief Financial Officer of the Company since 1976 and of Commerce since 1975. Mr. Fels is also Treasurer and a director of American Nuclear Insurers and an Advisory Committee Member of several investment funds managed by Conning Capital Partners.
Regan P. Remillard was appointed President of American Commerce Insurance Company in 2001, President of ACIC Holding Co., Inc. in 1998 and Vice Chairman of the Board and Chief Executive Officer of American Commerce Insurance Company in 1999. Mr. Remillard has been President of Commerce West Insurance Company since 1996. Mr. Remillard has been a Senior Vice President of the Company since 1995. From 1995 to February 2000, Mr. Remillard was General Counsel of the Company. From 1994 to 1995, Mr. Remillard was a practicing attorney at Hutchins, Wheeler & Dittmar, a Massachusetts law firm specializing in corporate law and litigation. From 1989 to 1993, Mr. Remillard was Government Affairs Monitor of the Company. Mr. Remillard is a member of the Massachusetts Bar.
Arthur J. Remillard, III was appointed Senior Vice President- Policyholder Benefits in 1988 and has been Assistant Clerk of the Company since 1982. From 1981 to 1988, Mr. Remillard, III had been Vice President- Mortgage Operations. In addition, Mr. Remillard, III has also served on the Board of Governors of the Insurance Fraud Bureau of the A.I.B. since 1991, the C.A.R. Claims Advisory Committee since 1990 and the A.I.B. Claims Committee since 1991.
David H. Cochrane has been the Senior Vice President-Underwriting of Commerce and Citation since 1988. For approximately four years prior to that, Mr. Cochrane was the Vice President of Financial Services of C.A.R. Mr. Cochrane has also served on the C.A.R. Market Review Committee since 1988.
Peter J. Dignan was appointed the Senior Vice President-Marketing and Premium Accounting of Commerce and Citation in 1997. From 1989 to 1997, Mr. Dignan was Vice President-Premium Accounting Commerce and Citation. From 1987 to 1989 Mr. Dignan was Assistant Vice President-Premiums Accounting of Commerce and Citation.
Joseph Staffieri has been Vice President of Human Resources of Commerce Since May of 2001. From May of 1997 through April of 2001, Mr. Staffieri was the Vice President of Human Resources for Ames Department Stores.
Joyce B. Virostek has been the Senior Vice President--Management Information Systems of Commerce and Citation since 1988. From 1981 to 1988, Ms. Virostek had been Vice President of Commerce and Citation in charge of data processing.
James A. Ermilio was appointed as Senior Vice President of the Company in May 2001. Mr. Ermilio was also appointed General Counsel of the Company in February 2000 and was a Vice President of the Company from November 1998 to May 2001. Mr. Ermilio is also Chief Legal Officer and Secretary of American Commerce Insurance Company and Secretary of ACIC Holding Co., Inc. Mr. Ermilio had been the Associate General Counsel of the Company since September 1998. Mr. Ermilio was Counsel for Glaxo Wellcome, Inc. (subsequently renamed Glaxo Smith Kline, Inc.) from 1993 to September 1998. Prior to 1993, Mr. Ermilio was an Associate with the law firm of Bingham Dana. Mr. Ermilio is a member of the Massachusetts and District of Columbia Bars.
Randall V. Becker, a Certified Public Accountant, has been Treasurer and Chief Accounting Officer of the Company since 1994. From 1990 to 1994, Mr. Becker was Assistant Treasurer and Comptroller of the Company. From 1986 to 1990, Mr. Becker was the Director of Internal Audit for the Company.
The only family relationship among the executive officers is that Arthur J. Remillard, III and Regan P. Remillard are the sons of Arthur J. Remillard, Jr.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Company's common stock trades on the NYSE under the symbol "CGI". The high, low and close prices for shares as quoted in The Boston Globe, of the Company's common stock for 2001 and 2000 were as follows:
As of March 1, 2002 there were 1,053 stockholders of record of the Company's Common Stock, not including stock held in "Street Name" or held in accounts for participants of the Company's E.S.O.P.
The Board of Directors of the Company voted to declare four quarterly dividends to stockholders of record totaling $1.19 per share and $1.15 per share in 2001 and 2000, respectively. On May 19, 2001, the Board voted to increase the quarterly stockholder dividend from $0.29 to $0.30 per share to stockholders of record as of June 4, 2000. Prior to that declaration, the Company had paid quarterly dividends of $0.29 per share dating back to May 15, 2000 when the Board voted to increase the dividend from $0.28 to $0.29 per share.
In May 1999, the Board of Directors of the Company authorized a stock buy-back program of up to 2,000,000 shares of common stock of the Company. At December 31, 2001, there are 273,700 shares of common stock authorized to be purchased under this program. In November 2001, the Board of Directors approved another stock buy-back program authorizing the purchase of up to an additional 2,000,000 shares. During the period from January 1, 2001 through December 31, 2001, the Company purchased 622,900 shares of its own common stock. During 2000, the Company purchased 606,200 shares of its own common stock under the May 1999 buy-back program. At December 31, 2001, the Company had authority to purchase a total of 2,273,700 additional shares of its common stock under the May 1999 and November 2001 buy-back programs. As of December 31, 2001, the Company holds a total of 4,869,548 shares of treasury stock.
A portion of the Company's cash flow consists of dividends received from CHI, which receives dividends from Commerce and Citation. The payment of any cash dividends to holders of common stock by the Company therefore depends on the receipt of dividend payments from CHI. To the extent Commerce and Citation are restricted from paying dividends to CHI, CHI will be limited in its ability to pay dividends to the Company. The payment of dividends by Commerce and Citation is subject to limitations imposed by Massachusetts law, as discussed under the caption "Payment of Dividends" in Item 1J of this report.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The five-year financial information under the caption "Selected Consolidated Financial Data" on page 69 of the Company's 2001 Annual Report is incorporated herein by reference.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information on pages 5 through 32 of the Company's 2001 Annual Report is incorporated herein by reference.
ITEM 7A.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
The information on pages 28 and 29 of the Company's 2001 Annual Report is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's Consolidated Financial Statements for the years ended December 31, 2001, 2000 and 1999 and the report of its independent auditors on pages 34 through 68 of the Company's 2001 Annual Report are incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH INDEPENDENT AUDITORS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information called for by this Item and not provided in Item 4A will be contained in the Company's Proxy Statement, which the Company intends to file within 120 days after the end of the Company's fiscal year ended December 31, 2001, and such information is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information called for by this Item will be contained in the Company's Proxy Statement, which the Company intends to file within 120 days after the end of the Company's fiscal year ended December 31, 2001 and such information is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information called for by this Item will be contained in the Company's Proxy Statement, which the Company intends to file within 120 days after the end of the Company's fiscal year ended December 31, 2001 and such information is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for by this Item will be contained in the Company's Proxy Statement, which the Company intends to file within 120 days after the end of the Company's fiscal year ended December 31, 2001 and such information is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
A. (1) The following financial statements have been incorporated herein by reference from the pages indicated below of the Company's 2001 Annual Report:
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: March 26, 2002
THE COMMERCE GROUP, INC.
By ARTHUR J. REMILLARD, JR. (Arthur J. Remillard, Jr.) (President, Chief Executive Officer, Chairman of the Board and Director)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the date indicated.
CONSENT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders of The Commerce Group, Inc.
We consent to the incorporation by reference in this Annual Report (Form 10-K) of The Commerce Group, Inc. of our report dated January 29, 2002, included in the 2001 Annual Report to Stockholders of The Commerce Group, Inc.
Our audits also included the financial statement schedules of The Commerce Group, Inc. listed in Item 14(a). These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also consent to the incorporation by reference in the Registration Statement (Form S-8 No. 333-62367) pertaining to The Commerce Group, Inc. 401(k) Plan of our report dated January 29, 2001, with respect to the consolidated financial statements incorporated herein by reference, and our report included in the preceding paragraph with respect to the financial statement schedules included in this Annual Report (Form 10-K) of The Commerce Group, Inc.
ERNST & YOUNG LLP
Boston, Massachusetts March 28, 2002
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
SCHEDULE II (continued)
CONDENSED FINANCIAL INFORMATION
THE COMMERCE GROUP, INC. (Parent Company Only)
NOTES TO CONDENSED FINANCIAL STATEMENTS (Thousands of Dollars)
The accompanying condensed financial statements should be read in conjunction with the Consolidated Financial Statements and the accompanying notes thereto in the Annual Report.
NOTE A--Dividends
The amounts of cash dividends paid to The Commerce Group, Inc. (Parent only) were as follows:
See Note M to the Consolidated Financial Statements in the Annual Report for a description of dividend restrictions applicable to the Company's subsidiaries.
NOTE B--Federal Income Tax Allocation
As a member of a consolidated group for tax purposes, the Company and its subsidiaries (said parties constituting an "Affiliated Group" as defined in and for purposes of the Internal Revenue Code) are jointly and severally liable for federal income taxes of the Affiliated Group and have entered into an agreement establishing an allocation of tax liability and for compensation of the respective members of the Affiliated Group for use of their tax losses and credits.
The method of allocation calls for current taxes to be allocated among all affiliated companies based on a written tax-sharing agreement. Under this agreement, allocation is made primarily on a separate return basis with current payment for losses and other tax items utilized in the consolidated return. However, to the extent that a payor member of the group has future net operating losses, which it cannot absorb in the year incurred, other members within the group will refund payments to the payor.
NOTE D--Reclassification of Prior Year Balances
Certain prior year balances have been reclassified to conform to the 2001 presentation.
Beginning in the first quarter of 2001, the Company, in the 2001 and prior years' results, classified its undistributed equity in the earnings and losses on investments in closed-end preferred stock mutual funds in net realized investment gains and losses. For the year ended 2000, the undistributed equity in the earnings and losses of these funds was reported in net investment income. The Company believes the current year presentation provides a more appropriate classification for analysis of the on-going operations of the Company. Prior period results previously reflected in investment income, have been reclassified to realized gains and losses to conform with current period presentation. For the years ended December 31, 2001, 2000, and 1999 the Company reflected realized gains (losses) of $4.6 million, $26.6 million and ($22.4) million, respectively, as a result of this change. These investments are valued at original cost plus the cumulative undistributed equity in earnings and losses of the funds and adjusted over time by the premium or discount at the time of purchase to the applicable underlying net asset value of the funds.
53A
53B
annual report
The CGI
The Commerce Group, Inc. 211 Main Street, Webster, Massachusetts 01570
THE COMMERCE GROUP, INC.
March 23, 2002
To Our Stockholders:
In 2001, your Company experienced satisfactory financial results for the 26th consecutive year. From the very first day the funding of The Commerce Insurance Company was accomplished (April 3, 1972) through December 31, 2001, we have achieved underwriting profit of $293.4 million on total premiums written of $10.0 billion. This underwriting profit represents 2.9% of total premiums written.
In October 2001, the 2002 personal automobile insurance rate decision was announced by the Massachusetts Insurance Commissioner. Despite the industry's request for a 7.8% increase, 2002 rates are to remain unchanged from 2001 rates. Although most companies, including yours, continued to modify safe driver deviations in response to the 2002 rate decision, the Massachusetts marketplace remains highly competitive. Throughout these ongoing competitive times, your Company's share of the Massachusetts personal automobile market has continued to grow, and at year-end, our market share was 23.3% up from 22.3% in 2000.
In 2001, direct premiums written in Massachusetts and earned premiums countrywide surpassed $1 billion for the first time in our history. Your Company will continue to pursue the goals of growing and expanding geographically beyond the borders of Massachusetts. In furtherance of this goal, direct premiums written outside of Massachusetts now represents 12.4% of our total business as compared to 11.3% in 2000.
Your Company has continued to grow and prosper. The Commerce Insurance Company continues to be the largest writer of Massachusetts private passenger automobile insurance, the second largest writer of Massachusetts homeowners insurance, as well as the third largest writer of Massachusetts commercial automobile insurance. The combined insurance companies were also ranked as the 26th largest personal automobile insurance group in the country by A.M. Best Co., based on the most recently available direct premium written information. Additionally, I am very pleased to report that your Company again received a group rating of A+ (Superior) from A.M. Best Co.
Net earnings, written premiums, earned premiums, investment income, total assets, total stockholders' equity and total stockholders' equity per share, as illustrated in the bar graph on the facing page, are all at new highs. For those of you who are interested in the details, I draw your attention to the pages in this report labeled "Management's Discussion and Analysis of Financial Condition and Results of Operations". Behind these numbers are an extremely dedicated group of people: Our policyholders (represented by over 1,042,000 policies in force); Agents (1,236); Employees (1,780); Officers (43); Commerce Group Directors (17); and, of course, our Stockholders (over 5,000, including our Employee Stock Ownership Plan Participants who now number 1,904).
Property-liability insurance remains a good business to be in and The Commerce Group, Inc. will continue its efforts to be one of the most profitable long-term players. Your Company's management continues to believe that owners' interests are its primary constituency.
Our sincere thanks to those who have helped in this building process especially our Agents, Employees, Officers and Board of Directors. This diverse force of committed, ethical and hard working people will continue to build on our past successes and look to the future with excitement and opportunity. Their individual ingenuity, enthusiasm, dedication and professionalism will continue to serve our stockholders well.
Your comments or questions regarding this report, or The Commerce Group, Inc. affairs in general, are solicited as always, at any time.
Arthur J. Remillard, Jr. President, Chief Executive Officer and Chairman of the Board
Caring in everything we do.
The bar graph on page 3 illustrates the Company's annual total stockholders' equity per share value and annual total stockholders' equity per share value including cumulative cash dividends paid per share through each December 31, year-end, over the most recent fifteen year period. The X-axis lists the years beginning with 1987 through 2001. The Y-axis lists the dollar values starting at $0.00 and increasing in one-dollar increments to $32.00. The graph depicts a total stockholders' equity per share value in 1987 of $1.40, 1988 of $1.95, 1989 of $2.53, 1990 of $3.36, 1991 of $4.80, 1992 of $7.42, 1993 of $10.09, 1994 of $10.88, 1995 of $14.96, 1996 of $16.28, 1997 of $18.11, 1998 of $19.72, 1999 of $19.44, 2000 of $23.16, and 2001 of $24.52. The graph also depicts the total stockholders' equity per share value adjusted to include cumulative dividends paid per share. The total of these amount to the per share value in 1987 of $1.40, 1988 of $1.95, 1989 of $2.53, 1990 of $3.36, 1991 of $4.80, 1992 of $7.42, 1993 of $10.09, 1994 of $11.03, 1995 of $15.34, 1996 of $17.47, 1997 of $20.33, 1998 of $23.01, 1999 of $23.84, 2000 of $28.71, and 2001 of $31.26.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Thousands of Dollars Except Per Share Data)
General
The property and casualty insurance industry continues to remain highly competitive and inherently volatile in nature. Property and casualty insurance company results have traditionally been impacted by the typical forces unique to the industry such as competition, frequency and severity of losses, the overall economy and the general regulatory environment in those states in which the insurer operates. Additional forces are impacting the industry in the form of deregulation, on-line commerce, price competition, empowered customers and technological advancement. The terrorists' attacks of September 11 have had a significant impact on the insurance industry. According to A.M. Best Co. ("A.M. Best"), "the unprecedented events of September 11 have forever changed the way the insurance industry defines risk. Both property and liability lines have been exposed to catastrophic risks that cannot be priced using traditional actuarial methods". A.M. Best goes on to state, "Against the backdrop of weak financial trends, this new risk environment has accelerated the hardening of the U.S. property/casualty market". Given this increased risk environment, A.M. Best "expects to see a renewed flight to quality that will benefit financially strong insurers". The financial losses due to this tragedy were significant to the insurance industry, however, due to the limited exposure that the Company has outside of Massachusetts, management believes the direct financial impact to the Company will not be material. Additionally, price competition remains quite heavy in many areas of the country, although it has improved in 2001 among independent agency companies in Massachusetts. Beyond Massachusetts, industry-underwriting results are expected to continue to deteriorate in the near future which further emphasizes the importance of competitive advantages gained by affinity marketing and efficient operations. With these issues on the forefront, The Commerce Group, Inc. ("Company") continues to position itself to respond to the prevailing forces and conditions in the market. The Company has utilized its strong agency relationships, a low-cost structure, affinity group alliances and a 1999 joint-venture acquisition all in an effort to keep the Company responsive in today's competitive environment.
The Company, incorporated in 1976, is a holding company for several property and casualty insurers, which, through these insurance subsidiaries, offers predominantly private passenger motor vehicle insurance along with a broad range of other property and casualty insurance products. These products are marketed to affinity groups, individuals, families and businesses through the Company's strong relationships with professional independent insurance agencies. The Company writes insurance primarily in the State of Massachusetts through The Commerce Insurance Company ("Commerce") and Citation Insurance Company ("Citation"), both wholly-owned subsidiaries of Commerce Holdings, Inc. ("CHI").
Additionally, the Company writes insurance in the States of California and Oregon through Commerce West Insurance Company ("Commerce West"), a wholly-owned subsidiary of Commerce, located in Pleasanton, California. The Company also writes insurance through American Commerce Insurance Company ("American Commerce"), which it acquired in January 1999. Located in Columbus, Ohio, American Commerce is a wholly-owned subsidiary of ACIC Holding Co., Inc., with policies in 26 states and licenses in several others.
In November 1998, Commerce formed ACIC Holding Co., Inc., in a joint venture with AAA Southern New England ("AAA SNE") and invested $90,800 to fund the January 29, 1999 acquisition of the Automobile Club Insurance Company whose name was changed to American Commerce upon completion of the acquisition. Commerce invested $90,000 in the form of preferred stock and an additional $800 representing an 80% common stock ownership. AAA SNE invested $200 representing a 20% common stock ownership. The terms of the preferred stock call for Commerce to receive quarterly cash dividends at the rate of 10% per annum from ACIC Holding Co., Inc. In the event cash dividends cannot be paid, additional preferred stock will be issued. Since the January 29, 1999 acquisition, ACIC Holding Co., Inc. and American Commerce's results have been consolidated into the Company's financial statements. Since 1995, Commerce has maintained an affinity group marketing relationship with AAA Insurance Agency, Inc., a subsidiary of AAA SNE. AAA Insurance Agency, Inc. has been a licensed insurance agent of Commerce since 1985.
The Company's business strategy remains focused on activities primarily related to personal automobile insurance. The Company has been the largest writer of personal property and casualty insurance in the State of Massachusetts in terms of market share of direct premiums written since 1990. The Company's share of the Massachusetts personal automobile market increased to 23.3% in 2001, as exhibited in the table below, exceeding our nearest competitor, which maintains a 10.8% market share.
As mentioned, the Company predominantly writes private passenger automobile insurance. The following tables indicate that direct premiums written for private passenger automobile, commercial automobile and homeowners represented 85.2%, 5.2% and 8.0%, respectively, of the Company's total direct premiums written in 2001, as compared to 86.9%, 4.0% and 7.7%, respectively, in 2000. Total direct premiums written increased $80,758 or 7.5% in 2001 over 2000. The 2001 increase was primarily attributable to a $32,742 or 4.0% increase in Massachusetts private passenger automobile direct premiums written. This was the result of a 5.8% increase in written exposures offset by a decrease of 1.9% in average premiums per exposure. Private passenger premiums written for all other states increased $18,824 or 18.2%, primarily attributable to an increase in American Commerce premiums of $7,319 or 9.4%, coupled with an increase of $11,505 or 44.5% additional premiums from Commerce West.
Massachusetts Automobile Business
In Massachusetts, private passenger automobile insurance is subject to extensive regulation. Owners of registered automobiles are generally required to maintain certain minimum automobile insurance coverages. With very limited exceptions, automobile insurers are required by law to issue a policy to any applicant seeking to obtain such coverages. Companies in Massachusetts are also assigned agents, known as Exclusive Representative Producers ("ERPs"), based primarily on market share, that have been unable to obtain a voluntary contract with an insurance carrier. Marketing and underwriting strategies for companies operating in Massachusetts are limited by maximum premium rates and minimum agency commission levels for personal automobile insurance, both of which are mandated by the
Massachusetts Commissioner of Insurance ("Commissioner"). In Massachusetts, accident rates, bodily injury claims, and medical care costs continue to be among the highest in the nation. According to the Automobile Insurers Bureau of Massachusetts ("A.I.B"), Massachusetts "has higher than average medical costs and liability claims involving attorneys". According to the A.I.B., Massachusetts personal automobile premium per policy, based on 1999 premium information, was 5th highest in the nation.
During the three-year period from 1999 to 2001, average mandated Massachusetts personal automobile insurance premium rates decreased an average of 2.3% per year. The Commissioner approved no rate change in personal automobile premiums for 2002, as compared to an average rate decrease of 8.3% in 2001. Coinciding with the 2002 rate decision, the Commissioner also approved no change in the commission rate agents receive for selling private passenger automobile insurance from 12.3% in 2001.
State Mandated Average Commerce Average Rate Year Rate Change Change Per Exposure 2002 0.0% 5.0%(Estimated) 2001 (8.3%) (1.9%) 2000 0.7% 6.2 1999 0.7% 9.1%
Although average mandated personal automobile premium rates decreased 8.3% in 2001, the Company's average rate decreased 1.9% per exposure. The 1.9% decrease for 2001 was primarily the result of the state mandated average rate decrease offset by decreases in the Safe Driver Insurance Plan ("SDIP") deviations for Step 9 and Step 10 drivers, the two best driver SDIP classifications in Massachusetts. The smaller Company decrease was also due to the facts that the rate decision did not anticipate purchases of new automobiles in the year to which the rate decision applied and, secondly, the Company's mix of personal automobile business differs from that of the industry.
The 1999 average rate decision was partially driven by corrections for an industry error that had impacted prior year rate decisions. The industry error resulted from a miscalculation of industry expense allowances that had the effect of over-stating rates for 1991 through 1996. Mandated rates for 1997, 1998 and 1999 included an adjustment to recoup the effects of this error from the industry. The adjustment included in the rate decision to recoup the error was phased in during 1997, 1998 and 1999. The earned premium impact of this, coupled with the impact of a previous year imbalance in the SDIP, was approximately $14.0 million for 1999. The earnings per share after-tax impact resulting from lower earned premiums were estimated at $0.26 for 1999.
The Company's performance in its personal and commercial automobile insurance lines is integrally tied to its participation in Commonwealth Automobile Reinsurers ("C.A.R."), a state-mandated reinsurance mechanism, which permits the Company and most other writers of automobile insurance in Massachusetts to reinsure any automobile risk that the insurer perceives to be under-priced at the premium level permitted by the Commissioner. All companies writing automobile insurance in Massachusetts share in the underwriting results of C.A.R. business for their respective product line or lines. Since its inception, C.A.R. has annually generated multi-million dollar underwriting losses in both its personal and commercial automobile pools. A company's proportionate share of the C.A.R. personal or commercial deficit (its participation ratio) is based upon its market share of the auto- mobile risks for the particular pool, adjusted by a utilization formula such that, in general, its participation ratio is disproportionately and adversely affected if its relative use of C.A.R. exceeds that of the industry, and favorably affected if its relative use of C.A.R. is less than that of the industry. Automobile insurers attempt to develop and implement underwriting strategies that will minimize their relative share of the C.A.R. deficit while maintaining acceptable loss ratios on risks not insured through C.A.R.
Significant changes in the utilization of the C.A.R. private passenger pooling mechanism are not expected for 2002. Various C.A.R. participation formula changes have been fully implemented since 1993 with only minor changes since then. The Company's ERP strategy has been to voluntarily retain more of the types of private passenger automobile business that are factored as credits favorably impacting the utilization formula. These credits primarily result from voluntarily writing business in under-priced territories and for under-priced risks. As a result of increased voluntary retention in excess of the industry, the credits impacting the utilization formula have favorably
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affected the Company's participation ratio. As indicated in the accompanying table, this ratio is several percentage points below the Company's estimated 23.3% share of the Massachusetts personal automobile market. The Company continues to expect the marketplace to make minor annual adjustments to find the optimum balance between voluntary and ceded writings.
Company Private Passenger Participation Ratio for C.A.R. versus Market Share
Company Participation Company Year Ratio in C.A.R. Market Share
2001* 16.8% 23.3% 2000 16.9% 22.3% 1999 16.5% 21.3%
*Estimated
The percentage of commercial automobile premiums ceded to C.A.R. by the industry was estimated by the Company to be 24% in 2001. The percentage of commercial automobile business ceded to C.A.R. by the Company was approximately 16.0%. C.A.R. depopulation over the last several years, coupled with C.A.R. rate increases for ceded commercial business, have led to a reduction in the size of the annual commercial automobile deficits. The Company intends to continue to respond to the incentives and disincentives provided by C.A.R. rules as deemed necessary and appropriate.
The Company provides a separate rating tier for preferred Massachusetts commercial automobile business through Citation. Approximately 17% of the Massachusetts commercial automobile premiums produced by voluntary agents in 2001 were written by Citation. The Company expects that this secondary rating tier will continue to assist the Company in retaining its better commercial automobile accounts, while also further increasing the percentage of commercial automobile business that can be retained voluntarily by the Company in 2002 and beyond.
The Company has actively pursued affinity group marketing programs since 1995. The primary purpose of affinity group marketing programs is to provide participating groups with a convenient means of purchasing private passenger automobile insurance through associations and employer groups. Emphasis is placed on writing larger affinity groups, although accounts with as few as 25 participants are considered. Affinity groups are eligible for rate discounts, which must be filed annually with the Division of Insurance. In general, the Company looks for affinity groups with mature/stable membership, favorable driving records and below average turnover ratios. Participants who leave the sponsoring group during the term of the policy are allowed to maintain the policy until expiration. At expiration, a regular Commerce policy may be issued through the agency at the insured's option.
Since the latter part of 1995, Commerce has been a leader in affinity group marketing through agreements with the four American Automobile Association Clubs of Massachusetts ("AAA clubs") offering discounts on private passenger automobile insurance to the clubs' members who reside in Massachusetts. A 6% discount was approved for policies effective January 1, 2002, which is the same as the discount for 2001. Membership in these clubs is estimated to represent approximately one-third of the Massachusetts motoring public, and has been the primary reason for a 62.6% increase in the number of personal automobile exposures written by Commerce since year-end 1995 (the AAA affinity group program incepted in October of 1995). In 2001, total direct premiums written attributable to the AAA group business were $545,496 or 47.3% of the Company's total direct premiums written (63.4% of the Company's total Massachusetts personal automobile premium), an increase of 1.8% over 2000. Total exposures attributable to the AAA clubs group business were 581,455 or 63.3% of total Massachusetts personal automobile exposures in 2001, as compared to 559,696 or 64.5% in 2000. Of the total Massachusetts automobile exposures written through the AAA affinity group program by the Company, approximately 13.0% were written through insurance agencies owned by the AAA clubs (8.7% of total Massachusetts automobile exposures). The remaining 87.0% of the AAA group program was written through the Company's network of independent agents (91.3% of total Massachusetts automobile exposures). For additional details, refer to the table found on page 12 entitled "AAA Affinity Group Discount and SDIP Deviations".
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Massachusetts law allows two years to reach the required group penetration level of 35%. Commerce has continued to maintain AAA member participation in excess of 35% through December 31, 2001, when it was estimated at approximately 40%. The two-year penetration requirement was waived by the Massachusetts Legislature for 2000, 2001 and 1999. Waiving the penetration requirements allows insurance companies to continue offering group discounts without reaching the 35% level.
Commerce and the AAA clubs have agreed that Commerce shall be their exclusive under-writer of Massachusetts personal automobile group programs. A rolling three-year contract exists between Commerce and the AAA clubs which renews automatically and may be terminated upon a minimum of three years written notice to either party.
Agreements for the Transfer of Massachusetts Business from Other Companies in
The Company entered into an agreement on September 28, 2001, with Berkshire Mutual Insurance Company ("Berkshire") for the transfer of Massachusetts personal automobile business written by Berkshire to The Commerce Insurance Company, effective January 1, 2002. Under terms of the agreement, Commerce Insurance agreed to offer agency contracts to independent agencies that represent Berkshire for personal automobile insurance in Massachusetts. This will allow agents of Berkshire the opportunity to offer Commerce automobile insurance policies to their customers whose policies renew in 2002. Commerce will assume all of Berkshire's obligations for future policy years beyond 2001 under the Massachusetts residual market system, (commonly known as C.A.R.), including assignment of Berkshire's involuntary agents. The Company received a cash payment of $7,000 from Berkshire in early January, 2002.
The Company announced the formation of a marketing alliance with Horace Mann Educators Corporation on October 18, 2001. Under the terms of an agency agreement between Commerce and Horace Mann Service Corporation ("HMSC"), a licensed brokerage agency in the State of Massachusetts, HMSC will provide its personal automobile customers with Commerce policies. New personal automobile policies sold by HMSC will be insured with Commerce, beginning no later than January 1, 2002. At the policyholders option, Massachusetts personal auto policies currently written by HMSC will convert to Commerce policies upon renewal in 2002.
Other States Business
Direct premiums written in states other than Massachusetts by Commerce West and American Commerce, increased $22,554 or 18.7%. Roughly half of this growth resulted from an increase of $11,505 or 44.5% in personal automobile direct premiums written by Commerce West. The growth from Commerce West is primarily attributable to non-standard automobile business. Commerce West began writing in this segment of the market in late 1999. Commerce West also began writing commercial automobile in late 2000, resulting in writings of $1,514 in 2001. American Commerce direct premiums written increased $9,655 or 10.2%, primarily due to an increase in personal automobile premiums of $7,319 or 9.4%. American Commerce also experienced a 13.4% increase in homeowners business. American Commerce, which writes business in 26 states, wrote greater than 90% of its business in eleven states.
The decrease in other states for American Commerce is primarily attributable to business in several states being moved to other insurance companies affiliated with the ownership of the agencies representing that business. These and some future moves for business in other states were anticipated at the time the Company negotiated the acquisition of American Commerce.
Insurance Ratios
Underwriting profit margins are reflected by the extent to which the combined ratio is less than 100%. This ratio is considered the best simple index of current underwriting performance of an insurer. During the five-year period ended December 31, 2001, the property and casualty insurance industry's combined ratio, as reported by A.M. Best and weighted to reflect the Company's product mix ("weighted industry average"), has ranged from a low of 100.1% in 1997 to a high of 109.7% in 2000 on a statutory accounting principles basis. During this same period of time, the Company's combined ratio has consistently remained below the weighted industry average, ranging from a low of 96.5% in 1997 to a high of 99.1% in 2001. On an average basis, the Company's combined ratio was 97.8% for the five-year period ended December 31, 2001 compared to a weighted industry average of 105.1%.
Investment Income and Net Realized Investment Gains and Losses
The Company's total revenues were supplemented in fiscal 2001, 2000 and 1999 by net investment income of $99,611, $96,830 and $89,789, respectively. Beginning in the first quarter of 2001, the Company, in the 2001 and prior years' results, classified its undistributed equity in the earnings and losses on investments in closed-end preferred stock mutual funds in net realized investment gains and losses. For the year ended 2000, the undistributed equity in the earnings and losses of these funds was reported in net investment income. The Company believes the current year presentation provides a more appropriate classification for analysis of the on-going operations of the Company. Prior period results previously reflected in investment income, have been reclassified to realized gains and losses to conform with current period presentation. For the years ended December 31, 2001, 2000, and 1999 the Company reflected realized gains (losses) of $4.6 million, $26.6 million and ($22.4) million, respectively, as a result of this change. These investments are valued at original cost plus the cumulative undistributed equity in earnings and losses of the funds and adjusted over time by the premium or discount at the time of purchase to the applicable underlying net asset value of the funds. Also in 2001, the Company began to account for venture capital fund investments on an equity basis. The equity in the operating results of these funds has been reflected in realized gains and losses. Prior to this change, the operating results were not material and were therefore reflected in accumulated other comprehensive income and loss. For 2001, the Company had a net realized loss of $10.6 million, of which the largest component, $9.1 million, was attributable to venture capital fund investments.
Regulatory Matters
General
Although the U.S. federal government does not directly regulate the insurance industry, federal initiatives often have an impact on the business. Congress and certain federal agencies continue to investigate the current condition of the insurance industry (encompassing both life and health and property and casualty insurance) in the United States in order to decide whether some form of federal role in the regulation of insurance companies would be appropriate. Congress conducts hearings relating, in general, to the solvency of insurers and has proposed federal legislation from time to time on this and other subjects.
In November 1999, the Gramm-Leach-Bliley Act was signed into law. The Act (1) repealed the Glass-Steagall Act of 1933, which had prohibited the merger of banks and securities firms, and (2) substantially modified the Bank Holding Company Act of 1956, which had the effect of separating banking and insurance underwriting business. The law contains pro-visions that govern competition, created safe-harbor protections for specific state laws and established consumer protections that govern bank-insurance sales.
At the state level, various forms of automobile insurance reform are continuously debated. New regulations and legislation are often proposed with the goal of reducing the need for premium increases. For further details, please refer to the general discussion on insurance regulation and premium rates beginning on page 5.
Personal Automobile Insurance
As previously mentioned, since 1995, the Company has been a leader in affinity group marketing in Massachusetts by providing discounts to members of the AAA clubs. Membership in these clubs is estimated to represent approximately one-third of the Massachusetts motoring public. The Company increased its Massachusetts private passenger automobile insurance exposures by 5.8%, ending the year with approximately 23.3% of the Massachusetts private passenger automobile market.
Through 2000, the Company offered its Massachusetts customers safe driver deviations to drivers with SDIP classifications of either Steps 9 or 10 and to only Step 9 drivers in 2001. Safe driver deviations are rate discounts based on the customer's driving record and resulting SDIP classification and must be approved annually by the Commissioner. Steps 9 and 10 are the two best driver SDIP classifications in Massachusetts, representing drivers with no at-fault accidents and not more than one minor moving vehicle violation in the last six years. The accompanying table depicts the AAA Affinity Group Discount, SDIP Deviations and their combined reduction from Massachusetts average mandated rates:
In 2002, in response to the average personal automobile rate decisions over the last several years, the Company did not file for SDIP Step 9 or Step 10 deviations, for policies incepting in the 2002 calendar year. During 2001, 55.0% of the Company's exposures were eligible for Step 9 deviations, versus 55.1% and 14.0%, eligible for Step 9 and Step 10 deviations in 2000.
Risk-Based Capital
In order to enhance the regulation of insurer insolvency, the National Association of Insurance Commissioners ("NAIC") developed a formula and model law to provide for Risk-Based Capital ("RBC") requirements for property and casualty insurance companies. RBC requirements are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholder obligations. The RBC model for property and casualty insurance companies measures three major areas of risk facing property and casualty insurers: (i) underwriting, which encompasses the risk of adverse loss development and inadequate pricing; (ii) declines in asset values arising from credit risk; and, (iii) other business risks from investments. Insurers having less statutory surplus than required by the RBC calculation will be subject to varying degrees of regulatory action, depending on the level of capital inadequacy.
The RBC model formula proposes four levels of regulatory action. The extent of regulatory intervention and action increases as the percentage of surplus to RBC falls. The first level, the Company Action Level (as defined by the NAIC), requires an insurer to submit a plan of corrective actions to the regulator if surplus falls below 200% of the RBC amount. The Regulatory Action Level (as defined by the NAIC) requires an insurer to submit a plan containing corrective actions and permits the Commissioner to perform an examination or other analysis and issue a corrective order if surplus falls below 150% of the RBC amount. The Authorized Control Level (as defined by the NAIC) allows the regulator to rehabilitate or liquidate an insurer in addition to the aforementioned actions if surplus falls below 100% of the RBC amount. The fourth action level is the Mandatory Control Level (as defined by the NAIC), which requires the regulator to rehabilitate or liquidate the insurer if surplus falls below 70% of the RBC amount.
The following table provides the key RBC information for the Company's insurance subsidiaries, Commerce, Citation, Commerce West, and American Commerce:
Year Ended December 31, 2001 Compared to Year Ended December 31, 2000
Premiums
The following table compares direct premiums written, net premiums written and earned premiums for the years ended December 31, 2001 and 2000:
*Calculation is not meaningful.
The $32,742 or 4.0% increase in Massachusetts personal automobile direct premiums written resulted primarily from increases of 5.8% and 7.1% in the number of Massachusetts personal automobile exposures for liability and physical damage coverage, respectively, offset in 2001 by decreases in rates for the coverage types noted below. The components of these changes from the previous year for 2001 and 2000 were as follows:
The above percentage changes were primarily the result of rate modifications in the individual coverage components in the 2001 state mandated rates, offset by changes in the Company's safe driver rate deviations. The combination of these factors resulted in a 1.9% decrease in the average personal automobile premium per exposure in 2001. Despite the 2001 state mandated average rate decrease of 8.3%, the smaller Company decrease in the average personal automobile premium per exposure was primarily due to the above noted changes coupled with the fact that the rate decision does not anticipate purchases of new auto-mobiles in the year to which the rate decision applies and the Company's mix of personal automobile business differs from that of the industry. In 2001, the Company offered its customers safe driver deviations of 2.0% to drivers with SDIP classifications of Step 9 and 0.0% for Step 10 (6.0% for Step 9 and 2.0% for Step 10 in 2000).
As shown in the table found on page 12, the AAA affinity group discount for 2001 was established at 6.0%, which was unchanged from 2000. In 2001, for drivers who qualified, the Company's AAA affinity group discount and safe driver deviations could be combined for up to a 7.9% reduction (11.6% in 2000) from state mandated rates.
Other states personal automobile direct premiums written increased $18,824 or 18.2%, however, an overall depressed rate environment resulted in diminished underwriting profits. The Company continues to evaluate a number of its other than Massachusetts state rating structures, has filed for increases in several states and will seek additional rate increases where appropriate. Personal automobile direct premiums written by American Commerce increased $7,319 or 9.4% to $85,124 as compared to $77,805 due primarily to book rollovers of business from existing agents, partially offset by decreases in states where the Company is not actively pursuing writings. Personal automobile direct premiums written from Commerce West increased $11,505 or 44.5% to $37,196 as compared to $25,691. Both companies target preferred insurance risks, however Commerce West's recent growth is attributable to the introduction of a non-standard auto product in late 2000. Both American Commerce and Commerce West write predominantly personal automobile insurance. American Commerce writes personal automobile insurance in 26 states while Commerce West writes personal automobile insurance in the states of California and Oregon. Personal automobile policies for both companies are written primarily for a policy term of six months. Homeowner and other policies in all states are written primarily for a policy term of one year.
Direct premiums written for Massachusetts commercial automobile insurance increased by $14,845 or 34.3%, due primarily to an increase of approximately 9.0% in the number of policies written, combined with a 23.5% increase in the average commercial automobile premium per policy. The increase in premium per policy was attributable to a hardening of the commercial automobile market, primarily in larger commercial accounts. The Company experienced an increase of approximately $3,700 from policies in excess of $50. In addition, rates for other voluntary commercial automobile policies have increased moderately, combined with an approximate 10% increase in rates for policies written through C.A.R. The increased business was attributable to the Company's initiative to expand writings.
Direct premiums written for Massachusetts homeowners insurance increased by $7,592 or 11.6% due primarily to a 6.4% increase in the number of Massachusetts policies written coupled with a 5.0% increase in the average Massachusetts premium per policy. The increase in business was primarily attributable to existing and newly appointed agents. Other states homeowners insurance written by American Commerce increased $2,212 or 13.4% to $18,710 due primarily to book rollovers of business from existing agents.
The $70,056 or 6.9% increase in net premiums written was primarily due to the growth in direct premiums written as described above offset by an increase in premiums ceded to C.A.R. coupled with an increase in premiums ceded to reinsurers other than C.A.R. Net premiums written for homeowners in all other states increased $6,234, with net premiums written of $4,576 in 2001, as compared to ($1,658) in 2000. The reason for negative written premium in 2000 was due to American Commerce joining the quota share reinsurance agreement effective January 1, 2000. An unearned premium transfer of $6,033 occurred effective January 1, 2000, which has a direct impact to net written premium.
The $89,169 or 9.3% increase in earned premiums during 2001, as compared to 2000, was primarily due to increases in written exposures for Massachusetts personal automobile liability and physical damage, coupled with an increase in earned premium per exposure. The increase in earned premium per exposure occurs (versus a decrease in written premium per exposure) because of the time lag in earning the premium once it is written. This resulted in a $61,580 or 8.6% increase for Massachusetts personal automobile earned premium.
Investment Income
Net investment income is affected primarily by the composition of the Company's investment portfolio and yield thereon. The following table summarizes the composition of the Company's investment portfolio, at cost, at December 31, 2001 and 2000 (the Company's investment portfolio, at market and equity is shown in the table on page 25):
The Company's investment strategy is to maximize after-tax investment income through investing in high quality securities coupled with acquiring equity investments, which may forgo current investment yield in favor of potential higher yielding capital appreciation in the future.
As depicted in the following table, 2001 net investment income increased $2,781 or 2.9%, compared to 2000, principally as a result of an increase in average invested assets (at cost), offset by a decrease in yield. The decrease in yield is primarily due to lower short-term yields on larger cash and cash equivalent balances, coupled with an environment of higher yielding fixed maturities being called. The Company continues to monitor interest rates on long-term securities and intends to maintain its high cash position until such time as the Company believes long-term rates have appropriately firmed. Net investment income as a percentage of total average investments was 6.6% in 2001 compared to 6.9% for 2000. Net investment income after tax as a percentage of total average investments was 5.3% and 5.7% for 2001 and 2000, respectively.
Premium Finance and Service Fees
Premium finance and service fees increased $2,592 or 17.0% during 2001, as a result of increased premiums as discussed earlier.
Amortization of Excess of Book Value of Subsidiary Interest over Cost
As a result of the acquisition of American Commerce (see "Management's Discussion and Analysis of Financial Condition and Results of Operations - General" and "Notes to Consolidated Financial Statements - NOTES A12 and A17"), the amount representing the excess of the fair value of the net assets acquired over the purchase price at January 29, 1999 was $16,947. This amount is being amortized into revenue on a straight-line basis over a five-year period. The amount amortized into revenue in 2001 was $3,389, compared to $3,390 in 2000.
Investment Gains and Losses
Net realized investment losses totaled $10,633 during 2001 as compared to gains of $29,550 in 2000. Of the net realized losses during 2001, $9,071 was a result of the Company's venture capital fund investments. These investments primarily provide seed capital for start- up companies with emerging high technology initiatives in the financial services industry. These investments are made in limited partnerships and the Company's exposure to loss is limited to its actual investment. In 2001, the Company began to account for these investments on an equity basis. The equity in the operating results of these funds has been reflected in realized gains and losses. Prior to this change, the operating results were not material and were therefore reflected in accumulated other comprehensive income and loss.
Also during 2001, the undistributed operating results of closed-end preferred stock mutual funds have been reflected in realized gains and losses. Year-end December 31, 2000 period results previously reflected in investment income, have been reclassified to realized gains and losses to conform with current period presentation. During 2001 and 2000, the Company reflected realized gains of $4,582 and $26,575, respectively, as a result of this change.
Gross realized gains and losses for the years ended December 31, 2001 and December 31, 2000 were as follows:
Loss and Loss Adjustment Expenses
Losses and loss adjustment expenses ("LAE") incurred increased $91,386 or 13.3% in 2001. Massachusetts operations experienced declining underwriting results primarily due to increased losses in the homeowners property business and in comprehensive personal automobile, due to more adverse weather conditions compared to last year. The ratio of net incurred losses, excluding LAE, to premiums earned ("pure loss ratio") on Massachusetts personal automobile was 65.4% in 2001 compared to 63.1% in 2000. The commercial automobile pure loss ratio increased to 61.8% in 2001 compared to 59.7% in 2000. This increase was primarily due to higher bodily injury losses and to higher physical damage losses coupled with worse experience in the business assumed from C.A.R. during this period. For Massachusetts homeowners (gross of reinsurance), the pure loss ratio was 47.6% in 2001 compared to 40.0% in 2000. This increase was the result of more claims for Massachusetts homeowner business due to less favorable weather conditions, as compared to last year, primarily during the first six months of 2001. Pure loss ratios of subsidiaries in other states increased to 67.5% in 2001 compared to 62.9% in 2000. The loss ratio (on a statutory basis) for Commerce West and American Commerce was 85.1% and 84.4%, respectively, in 2001, compared to 69.3% and 84.5% respectively, in 2000. The increase in the loss ratio for Commerce West was primarily attributable to a substantial increase in non-standard automobile writings with loss ratios that are significantly higher than their regular business.
Policy Acquisition Costs
Policy acquisition costs expensed increased by $17,613 or 7.2% in 2001. As a percentage of net premiums written, the Company's statutory underwriting expense ratio for 2001 was 24.4% compared to 25.1% in 2000. The decreased 2001 underwriting expense ratio resulted primarily from a lower provision for accrued contingent commissions, lower insolvency assessments and lower expenses due to the continued effects of certain cost reduction programs. The 2000 underwriting ratio includes a $4,900 charge versus $1,244 in 2001, representing the Company's allocation from the Massachusetts Insurers Insolvency Fund. The underwriting expense ratio (on a statutory basis) for Commerce West was 32.7% for 2001 as compared to 35.8% for 2000. The underwriting expense ratio (on a statutory basis) for American Commerce, was 32.6% for 2001 compared to 29.3% for 2000.
Income Taxes
The Company's effective tax rate was 20.1% and 22.5% for the years ended December 31, 2001 and 2000, respectively. In both years the effective rate was lower than the statutory rate of 35% primarily due to tax-exempt interest income and the corporate dividends received deduction.
Minority Interest in Net Loss of Subsidiary
As a result of the joint venture with AAA SNE and acquisition of American Commerce (see "Management's Discussion and Analysis of Financial Condition and Results of Operations - General" and "Notes to Consolidated Financial Statements - NOTES A13 and A17"), the Company's interest in ACIC Holding Co., Inc., through Commerce, a wholly-owned subsidiary of CHI, is represented by ownership of 80% of the outstanding shares of common stock at December 31, 2001. AAA SNE maintains a 20% common stock ownership. The minority interest of $863 included in the consolidated statement of earnings for 2001 represents 20% of the net loss for ACIC Holding Co., Inc., calculated after the $9,582 preferred stock dividend paid to Commerce, to the extent of the minority interest. This compares to $320 minority interest in net loss of subsidiary after $9,178 in preferred stock dividends paid to Commerce in 2000. During the third quarter of 2001, the net losses of ACIC Holding Co., Inc. exceeded the minority interest balance sheet component.
Net Earnings
Net earnings decreased $38,986 or 29.5% to $93,094 during 2001 as compared to $132,080 in 2000. Operating earnings, which exclude the after-tax impact of net realized investment gains and losses, decreased $10,751 or 9.8% to $98,880 ($2.94 per share basic and $2.93 per share diluted) during 2001 as compared to $109,631 ($3.21 per share basic and diluted) in 2000, as a result of the factors previously mentioned.
Year Ended December 31, 2000 Compared to Year Ended December 31, 1999
Premiums
The following table compares direct premiums, net premiums written and earned premiums for the years ended December 31, 2000 and 1999:
The $95,851 or 13.1% increase in Massachusetts personal automobile direct premiums written resulted primarily from increases of 6.4% and 8.5% in the number of Massachusetts personal automobile exposures for liability and physical damage coverage, respectively, coupled in 2000 with increases in rates for the coverage types noted below. The components of these changes from the previous year for 2000 and 1999 were as follows:
The above percentage changes were primarily the result of rate modifications in the individual coverage components in the 2000 state mandated average rate increase, combined with changes in the Company's safe driver rate deviations. The combination of these factors resulted in a 6.2% increase in the average personal automobile premium per exposure in 2000. Despite the 2000 state mandated average rate increase of only 0.7%, the Company's increase in the average personal automobile premium per exposure was primarily due to the above noted changes coupled with the fact that the rate decision does not anticipate purchases of new automobiles in the year to which the rate decision applies and the Company's mix of personal automobile business differs from that of the industry. In 2000, the Company offered its customers safe driver deviations of 6.0% to drivers with SDIP classifications of Step 9 and 2.0% for Step 10 (8.0% for Step 9 and 3.0% for Step 10 in 1999).
As shown in the table found on page 12, the AAA affinity group discount for 2000 was established at 6.0%, which was unchanged from 1999. In 2000, for drivers who qualified, the Company's AAA affinity group discount and safe driver deviations could be combined for up to a 11.6% reduction (13.5% in 1999) from state mandated rates.
Direct premiums written for commercial automobile insurance increased by $6,627 or 18.1%, due primarily to an increase of approximately 10.1% in the number of policies written, combined with a 6.9% increase in the average commercial automobile premium per policy. The increased business was attributable to the Company's intention to expand writings coupled with increased business due to the insolvency of Trust Insurance Company ("Trust"), a former Massachusetts insurance company that was placed in receivership in 2000. Direct premiums written for homeowners insurance increased by $7,801 or 10.5% due primarily to a 13.5% increase in the number of Massachusetts policies written offset by a 3.0% decrease in the average Massachusetts premium per policy, coupled with an additional month premium from American Commerce. The increased business was primarily attributable to the previously mentioned Trust insolvency.
The $96,918 or 10.6% increase in net premiums written was due to the growth in direct premiums written as described above, offset by a decrease of premiums assumed from C.A.R. The decrease in premiums assumed from C.A.R. was the result of fewer premiums ceded to C.A.R. by the servicing carriers in 2000 as compared to 1999. Premiums ceded to reinsurers other than C.A.R. increased $22,289 or 40.8% as compared to 1999 as a result of American Commerce joining the quota-share reinsurance program effective January 1, 2000 and increases in Massachusetts homeowners premiums.
The $82,653 or 9.5% increase in earned premiums during 2000 as compared to 1999 was primarily due to increases to the average rates per exposure for Massachusetts personal automobile liability and physical damage, and the increased business due to the insolvency of Trust mentioned previously. This resulted in an $85,316 or 12.5% increase for Massachusetts earned premiums. The remaining changes were attributable to a $3,004 or 3.5% decrease in earned premiums assumed from C.A.R. offset by $341, or 0.3% increase in earned premiums from all other states, primarily attributable to American Commerce whose year to date 2000 results reflect a full twelve months as compared to eleven months in 1999, offset by the effect of ceded earned premium to the quota share treaty.
Investment Income
Net investment income is affected primarily by the composition of the Company's investment portfolio and yield thereon. The following table summarizes the composition of the Company's investment portfolio, at cost, at December 31, 2000 and 1999:
The Company's investment strategy is to maximize after-tax investment income through high quality securities coupled with acquiring equity investments, which may forgo current investment yield in favor of potential higher yielding capital appreciation in the future.
As depicted in the accompanying table, net investment income before taxes increased $7,041 or 7.8%, compared to 1999, principally as a result of an increase in average invested assets (at cost). Net investment income as a percentage of total average investments was 6.9% in 2000 compared to 6.8% in 1999. Net investment income after tax as a percentage of total average investments was 5.6% in 2000 and 6.3% in 1999.
Premium Finance and Service Fees
Premium finance and service fees increased $453 or 3.1% during 2000.
Amortization of Excess of Book Value of Subsidiary Interest over Cost
As a result of the acquisition of American Commerce (see "Management's Discussion and Analysis of Financial Condition and Results of Operations - General" and "Notes to Consolidated Financial Statements - NOTES A12 and A17"), the amount representing the excess of the fair value of the net assets acquired over the purchase price at January 29, 1999 was $16,947. The amount is being amortized into revenues on a straight-line basis over a five-year period. The amount amortized into revenues in 2000 was $3,390, compared to $3,019 in 1999.
Investment Gains and Losses
During the fourth quarter of 2000, the Company changed its policy in regard to its investments in certain closed-end preferred stock mutual funds. On a forward going basis, the Company intends to take a proactive posture to affect the overall investment performance of these funds. The Company's ownership position of these various funds at December 31, 2000 range from 23% to 48% of outstanding shares. The level of ownership and new investment policy requires the company to account for these investments on an equity basis. The equity method requires that the investments are to be valued at original cost plus the cumulative equity in the earnings and losses of the funds and adjusted over time by the premium or discount at the time of purchase to the applicable underlying net asset value of the funds. Prior to the policy change, the Company reported the income on a cash basis, valued the investments at quoted market prices and recorded the change in quoted market prices through comprehensive income. The results of prior accounting periods impacted by this change have been restated.
During 2001, the undistributed operating results of closed-end preferred stock mutual funds have been reflected in realized gains and losses. Year-end December 31, 2000 period results previously reflected in investment income, have been reclassified to realized gains and losses to conform with current period presentation. During 2000 the Company reflected a realized gain of $26,575 versus a loss in 1999 of $22,401, as a result of this change.
Gross realized gains and losses for the years ended December 31, 2000 and December 31, 1999 were as follows:
The accumulated other comprehensive income on fixed maturities increased significantly as a result of the favorable performance in the bond market due to lower interest rates in 2000. Long-term interest rates (30-year Treasury Bond) decreased to 5.46% at December 31, 2000 from 6.48% at December 31, 1999.
Loss and Loss Adjustment Expenses
Losses and loss adjustment expenses ("LAE") incurred increased $61,067 or 9.8% in 2000. As a percentage of premiums earned, losses and LAE incurred for 2000 was 71.7% compared to 72.0% in 1999. The Company experienced higher assumed residual market losses during 2000, which were offset by improved voluntary loss ratios in Massachusetts. Additionally in 2000, the loss ratio was adversely impacted by approximately $8,000 of expense (0.8% of the loss ratio) attributable to the Trust insolvency. Also included in the 2000 increase in incurred expense is approximately $6,300 in higher corporate expenses which are allocated to losses and LAE for book value appreciation rights, director retirement compensation and state income taxes on non-insurance subsidiaries. The ratio of net incurred losses, excluding LAE, to premiums earned ("pure loss ratio") on personal automobile was 63.2% in 2000 compared to 65.1% in 1999. The decrease to the personal automobile pure loss ratio was primarily due to an increase in redundancies arising from prior accident years, and decreases in the cost of adjusting losses. The commercial automobile pure loss ratio decreased to 59.7% in 2000 compared to 60.3% in 1999. For homeowners, the pure loss ratio was 40.0% in 2000 compared to 35.9% in 1999. The increase was primarily due to fewer liability redundancies in 2000 compared to 1999. The loss ratio (on a statutory basis) for Commerce West was 69.3% for 2000 as compared to 71.2% in 1999. The loss ratio (on a statutory basis) for American Commerce was 84.5% for 2000 as compared to its eleven-month loss ratio of 75.8% in 1999.
Policy Acquisition Costs
Policy acquisition costs expensed increased by $9,597 or 4.1% in 2000. As a percentage of net premiums written, the Company's statutory underwriting expense ratio for 2000 was 25.1% compared to 26.5% in 1999. The decreased 2000 underwriting expense ratio resulted primarily from lower Massachusetts direct automobile commissions associated with a decrease in the state mandated minimum commissions, a lower provision for accrued contingent commissions, and lower expenses due to the continued effects of certain cost reduction programs, partially offset by the Trust insolvency assessment. The 2000 underwriting ratio includes a $4,900 charge (0.5% of the underwriting expense ratio) representing the Company's allocation from the Massachusetts Insurers Insolvency Fund for this insolvency. Also included in the 2000 increase in policy acquisition costs expensed is approximately $5,800 in higher corporate expenses which are allocated to policy acquisition costs for book value appreciation rights, director retirement compensation and state income taxes on non- insurance subsidiaries. The underwriting expense ratio (on a statutory basis) for Commerce West was 35.8% for 2000 as compared to 40.9% for 1999. The underwriting expense ratio (on a statutory basis) for American Commerce, was 29.3% for 2000 compared to its eleven-month expense ratio of 31.4% for 1999.
Income Taxes
The Company's effective tax rate was 22.5% and 16.0% for the years ended December 31, 2000 and 1999, respectively. In both years the effective rate was lower than the statutory rate of 35% primarily due to tax-exempt interest income and the corporate dividends received deduction. The higher effective tax rate for 2000 was the result of both the tax- exempt interest and the dividends received deduction comprising a lesser portion of earnings before taxes.
Minority Interest in Net Loss of Subsidiary
As a result of the joint venture with AAA SNE and acquisition of American Commerce (see "Management's Discussion and Analysis of Financial Condition and Results of Operations - General" and "Notes to Consolidated Financial Statements - NOTES A13 and A17"), the Company's interest in ACIC Holding Co., Inc., through Commerce, a wholly-owned subsidiary of CHI, is represented by ownership of 80% of the outstanding shares of common stock at December 31, 2000. AAA SNE maintains a 20% common stock ownership. The minority interest in net loss of subsidiary of $320 included in the consolidated statement of earnings for 2000 represents 20% of the net loss for ACIC Holding Co., Inc. calculated after the $9,178 preferred stock dividend paid to Commerce. This compares to $1,059 minority interest in net loss of subsidiary after $8,300 in preferred stock dividends paid to Commerce in 1999.
Net Earnings
Net earnings increased $43,404 or 48.9% to $132,080 during 2000 as compared to $88,676 in 1999. The net earnings for 2000 were increased by $20,514, or $0.60 per share and decreased $14,020 or $0.40 per share in 1999 as a result of the Company's change in its policy in regard to its investment in closed-end preferred stock mutual funds mentioned previously. Operating earnings, which exclude the after-tax impact of net realized investment gains, increased $12,220 or 12.5% to $109,631 ($3.21 per share basic and diluted) during 2000 as compared to $97,411 ($2.79 per share basic and diluted) in 1999, as a result of the factors previously mentioned.
Liquidity and Capital Resources
The focus of the discussion of liquidity and capital resources is on the Consolidated Balance Sheets on page 35 and the Consolidated Statements of Cash Flows on pages 38 and 39. Stockholders' equity increased by $30,393, or 3.9%, in 2001 as compared to 2000. The increase resulted from $93,094 in net earnings, and by net increases in other comprehensive income, net of income tax benefits, on fixed maturities and preferred and common stocks of $561, offset by dividends paid to stockholders of $39,951 and Treasury Stock purchased of $23,311. Total assets at December 31, 2001 increased $64,468, or 3.1% to $2,140,082 as compared to total assets of $2,075,614 at December 31, 2000. Invested assets, at market value and equity, increased $25,639 or 1.7%. Premiums receivable increased $15,641 or 6.8%. The increase in premiums receivable from December 31, 2000, was primarily attributable to increases in Massachusetts automobile business. Deferred policy acquisition costs increased $5,252 or 4.7%. Receivable from reinsurers increased $8,896 or 14.5%, primarily attributable to the increase in other than automobile business previously discussed. The deferred income tax asset increased $4,952, mainly as a result of accounting for certain investments on an equity basis. All other remaining assets increased $4,088 or 2.2%.
Preferred stocks increased $48,018, or 24.0% and common stocks decreased $8,369, or 7.2%, during 2001. Preferred stock mutual funds at equity, decreased $28,541 or 8.4% in 2001 compared to 2000. The majority of the increase in preferred stocks and the corresponding decrease in preferred stock mutual funds was primarily the result of a newly created trust fund. In 2001, the trustees of Putnam Dividend Income Fund ("PDI") liquidated the fund. The Company's pro-rata share of the portfolio securities and cash of PDI was transferred to a new fund created by the PDI trustees whose ownership was conveyed to the Company. At December 31, 2001 the fund was consolidated into the Company's financial statements, totaling $60,869. The majority of the fund represents investments valued at $59,019 and is included in preferred stocks and $1,332 in cash and cash equivalents. Other investments at equity, comprised of venture capital fund investments, decreased $8,059 or 30.1% during 2001 as a result of equity accounting changes mentioned previously. The Company's strategy continues to focus on maximizing after- tax investment income through investing in high quality securities coupled with acquiring equity investments, which may forgo current investment yield in favor of potential higher yielding capital appreciation in the future. The Company continues to monitor interest rates on long-term securities and intends to maintain its high cash position until such time as the Company believes the long-term rates have appropriately firmed.
The Company's liabilities increased $35,143 or 2.7% to $1,327,808 at December 31, 2001 as compared to $1,292,665 at December 31, 2000. Loss and loss adjustment expense reserves comprised 51.3% of the Company's liabilities at December 31, 2001 compared with 52.2% at December 31, 2000. Unearned premiums comprised 42.4% of the Company's liabilities at December 31, 2001 compared with 40.2% at December 31, 2000. All other liabilities comprised 6.3% of the Company's liabilities at December 31, 2001, compared with 7.6% at December 31, 2000. Loss and loss adjustment expense reserves increased $7,484 or 1.1%. Unearned premiums increased $43,571 or 8.4%, due primarily to increased business in 2001. Current income taxes decreased $13,988 or 80.4%. The net effect of all other liabilities decreased $4,659 or 5.5%.
The primary sources of the Company's liquidity are funds generated from insurance premiums, net investment income, premium finance and service fees and the maturing and sale of investments as reflected in the Consolidated Statements of Cash Flows on pages 38 and 39. The discussion of these items can be found under "Year Ended December 31, 2001 Compared to Year Ended December 31, 2000", herein.
The Company's operating activities provided cash of $106,172 in 2001, as compared to $147,906 in 2000, representing a decrease of $41,734 or 28.2% in 2000. The primary reason for this decrease is that the increase in premiums collected was outpaced by the increase in losses and LAE paid. Federal income tax payments increased $10,439 or 35.7% in 2001. Of the $39,703 in federal tax payments in 2001, $13,985 related to 2000, due to significant income in the fourth quarter of 2000. Net investment income received and premium and service fees received increased 8.9% and 17.0%, respectively.
For 2001 net cash flows from investing activities provided cash of $35,199, as compared to net cash flows used in investing activities of $45,226 in 2000. The majority of the $80,425 difference was a $54,142 decrease in purchases of fixed maturities, a $38,824 decrease in the purchase of preferred stock mutual funds, a $5,164 increase from proceeds from sale of equity securities, a $3,811 decrease in purchases of other assets, and a $4,974 increase in proceeds from maturity of fixed maturities. These were offset by a $12,787 increase in the purchase of equity securities coupled with a $6,790 increase in the purchase of property and equipment. Investing activities were funded by accumulated cash and cash provided by operating activities in 2001 and 2000. The decreased purchases of longer term investments coupled with the significant increase in cash and cash equivalents were primarily the result of the low interest rate environment in 2001.
During 2001, Commerce purchased a 160,000 square foot building. Costs for this building including the land and improvements to date at December 31, 2001, are $4,932. The Company anticipates expending an additional $13 million renovating this building, primarily in 2002.
Cash flows used in financing activities totaled $63,262 during 2001 compared to $54,694 during 2000. The 2001 cash flows used in financing activities consisted of $39,951 in dividends paid to stockholders and $23,311 used to purchase 622,900 shares of Treasury Stock. The 2000 cash flows used in financing activities consisted of $39,201 in dividends paid to stockholders and $15,493 used to purchase 606,200 shares of Treasury Stock.
The Company's funds are generally invested in securities with maturities intended to provide adequate funds to pay claims without the forced sale of investments. The carrying value (at market and equity) of total investments at December 31, 2001 was $1,498,201. At December 31, 2001, the Company held cash and cash equivalents of $148,630. These funds provide sufficient liquidity for the payment of claims and other short- term cash needs. The Company continues to monitor interest rates on long- term securities and intends to maintain its high cash position until such time as the Company believes long-term rates have appropriately firmed. The Company also relies upon dividends from its subsidiaries for its cash requirements. Every Massachusetts insurance company seeking to make any dividend or other distributions to its stockholders may, within certain limitations, pay such dividends and then file a report with the Commissioner. Dividends in excess of these limitations are called extraordinary dividends. An extraordinary dividend is any dividend or other property, whose fair value together with other dividends or distributions made within the preceding twelve months exceeds the greater of ten percent of the insurer's surplus as regards to policyholders as of the end of the preceding year, or the net income of a non-life insurance company for the preceding year. No pro-rata distribution of any class of the insurer's own securities is to be included. No Massachusetts insurance company shall pay an extraordinary dividend or other extraordinary distribution until thirty days after the Commissioner has received notice of the intended distribution and has not objected. No extraordinary dividends were paid in 2001, 2000 or 1999. Similar laws exist in California and Ohio. No extraordinary dividend was paid by American Commerce in 2001 or 2000 and no dividends were paid by Commerce West since its acquisition.
Periodically, sales have been made from the Company's fixed maturity investment portfolio to actively manage portfolio risks, including credit- related concerns, to optimize tax planning and to realize gains. This practice will continue in the future.
Industry and regulatory guidelines suggest that the ratio of a property and casualty insurer's annual net premiums written to statutory policyholders' surplus should not exceed 3.00 to 1.00. The Company's statutory premiums to surplus ratio was 1.51 to 1.00, 1.53 to 1.00, and 1.76 to 1.00 for the years ended December 31, 2001, 2000 and 1999, respectively.
In early 1999, Commerce, invested $90,800 in the joint venture (ACIC Holding Co., Inc.) to fund the American Commerce acquisition and to capitalize the joint venture that is owned together with AAA SNE. Of this $90,800, Commerce invested $90,000 in the form of preferred stock and an additional $800 representing its 80% common stock ownership. The terms of the preferred stock call for quarterly cash dividends at the rate of 10% per annum. In the event cash dividends cannot be paid, additional preferred stock will be issued. AAA SNE invested $200 representing its 20% common stock ownership. Commerce consolidates ACIC Holding Co., Inc. and its wholly-owned subsidiary, American Commerce, for financial reporting and tax purposes. Since 1995, Commerce has maintained an affinity group marketing relationship with AAA Insurance Agency, Inc., a subsidiary of AAA SNE. AAA Insurance Agency, Inc. has been an agent of Commerce since 1985.
In addition to the real estate commitment mentioned earlier, Commerce has commitments in two venture capital fund investments. These investments are made in limited partnerships and the Company's exposure to loss is limited to its actual investment.
In 2000, Commerce entered into a Limited Partnership Agreement with Conning Partners VI, L.P., a Delaware Limited Partnership. This partnership agreement required a commitment by the Company to invest up to $50,000 into the partnership. To date the Company has invested $15,091 into the partnership leaving a balance for funds still committed but not paid into the partnership of $34,909. The partnership was formed to operate as an investment fund principally for the purpose of making investments primarily in equity, equity-related and other securities issued in expansion financing, start-ups, buy-outs and recapitalization transactions relating to companies in the areas of insurance, financial services, e-commerce, healthcare, and related businesses, including, without limitation, service and technology enterprises supporting such businesses, in order to realize long-term capital returns, all as determined and managed by the General Partner for the benefit of the Partners.
Also in 2000, Commerce entered into a Limited Partnership Agreement with Distribution Partners Investment Capital, L.P. a Delaware Limited Partnership. This partnership agreement required a commitment by the Company to invest up to $3,500 into the partnership. To date the Company has invested $2,258 into the partnership leaving a balance of $1,242 for funds still committed. The partnership was formed to operate as an investment fund principally for the purpose of making investments primarily in equity and equity-related securities of companies operating in the area of insurance distribution and distribution related activities, all as determined and managed by the General Partner for the benefit of the Partners.
Market Risk: Interest Rate Sensitivity and Equity Price Risk
The Company's investment strategy emphasizes investment yield while maintaining investment quality. The Company's investment objective continues to focus on maximizing after-tax investment income through investing in high quality diversified investments structured to maximize after-tax investment income while minimizing risk. The Company's funds are generally invested in securities with maturities intended to provide adequate funds to pay claims and meet other operating needs without the forced sale of investments. Periodically, sales have been made from the Company's fixed maturity portfolio to actively manage portfolio risks, including credit-related concerns, to optimize tax planning and to realize gains. This practice will continue in the future.
In conducting investing activities, the Company is subject to, and assumes, market risk. Market risk is the risk of an adverse financial impact from changes in interest rates and market prices. The level of risk assumed by the Company is a function of the Company's overall objectives, liquidity needs and market volatility.
The Company manages its market risk by focusing on higher quality equity and fixed income investments, by periodically monitoring the credit strength of companies in which investments are made, by limiting exposure in any one investment and by monitoring the quality of the investment portfolio by taking into account credit ratings assigned by recognized rating organizations. Although the Company has significant holdings of various closed-end preferred stock mutual funds, these funds are comprised primarily of preferred stocks traded on national stock exchanges, thus limiting exposure to any one investment.
As part of its investing activities, the Company assumes positions in fixed maturity, equity, short-term and cash equivalents markets. The Company is, therefore, exposed to the impacts of interest rate changes in the market value of investments. At December 31, 2001, the Company's exposure to interest rate changes and equity price risk has been estimated using sensitivity analysis. The interest rate impact is defined as the effect of a hypothetical interest rate change of plus-or-minus 200 basis points on the market value of fixed maturities and preferred stocks. The equity price risk is defined as a hypothetical change of plus-or-minus 10% in the fair value of common stocks. Changes in interest rates would result in unrealized gains or losses in the market value of the fixed maturity and preferred stock portfolio due to differences between current market rates and the stated rates for these investments. Based on the results of the sensitivity analysis at December 31, 2001, the Company's estimated market exposure for a 200 basis point increase (decrease) in interest rates was calculated. A 200 basis point increase results in an $83,611 decrease in the market value of the fixed maturities and preferred stocks. A 200 basis point decrease results in a $47,436 increase in the market value of the same securities. The equity price risk impact at December 31, 2001, based upon a 10% increase in the fair value of common stocks and preferred stock mutual funds, would be an increase of $10,746 and $31,567, respectively. Based upon a 10% decrease, common stocks and preferred stock mutual funds would decrease $10,746 and $31,567, respectively. Long-term interest rates (30-year Treasury Bond) increased slightly to 5.47% at December 31, 2001 from 5.46% at December 31, 2000. The preceding sensitivity analysis does not represent a forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions such as the nature and timing of interest rate levels including the yield curve shape, prepayments on loans and securities, reinvestment and replacement of asset and liability cash flows and others. While assumptions are developed based upon current economic conditions, the Company cannot provide any assurance as to the predictive nature of these assumptions. Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to prepayment and refinancing levels likely deviating from those assumed and other internal and external variables. Furthermore, the sensitivity analysis does not reflect actions that management might take in responding to or anticipating changes in interest rates.
Recent Accounting Developments
The NAIC revised the Accounting Practices and Procedures Manual in a process referred to as Codification. The revised manual became effective January 1, 2001 for all insurance companies. The domiciliary states of the Company's insurance subsidiaries have adopted the provisions of the revised manual. The revised manual has changed certain prescribed statutory accounting practices and has resulted in changes to the accounting practices that the Company's insurance subsidiaries use to prepare their statutory-basis financial statements. The impact of these changes to the Company's insurance subsidiaries statutory-basis capital and surplus as of January 1, 2001 had a significant beneficial effect of approximately $38,737 primarily due to the inclusion of deferred taxes as an admitted asset. The codification changes had no impact on the Company's GAAP financial statements.
In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Certain Derivative Instruments and Hedging Activities", as amended in June 2000 by Statement of Financial Accounting Standards No. 138 ("SFAS 138"), "Accounting for Certain Derivative Instruments and Certain Hedging Activities", which requires companies to recognize all derivatives as either assets or liabilities in the balance sheet and measure such instruments at fair value. SFAS 138 also amended Statement of Financial Accounting Standards No. 137 ("SFAS 137"), "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133". The provisions of SFAS 133 require adoption for fiscal year beginning after June 15, 2000. The Company had no derivative or hedging activity in 2001, 2000, or 1999. The adoption of these FASBs had no material impact on the Company's consolidated financial statements.
In September 2000, the FASB issued Statement of Financial Accounting Standards No. 140 ("SFAS 140"), "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities", which replaced Statement of Financial Accounting Standards No. 125 ("SFAS 125"), "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". The Statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Those standards are based on consistent application of a "financial components" approach that focuses on control. Under that approach, after a transfer of financial assets, a company recognizes the financial and servicing assets it controls and the liabilities it has
incurred, does not recognize financial assets when control has been surrendered, and does not recognize liabilities when extinguished. The Statement provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. The Statement is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. Adoption of SFAS 140 did not have a material impact on the Company's consolidated financial statements.
In July 2001, the FASB issued Statements of Financial Accounting Standards No. 141, "Business Combinations", and No. 142, "Goodwill and Other Intangible Assets". SFAS No. 141, effective for business combinations initiated after June 30, 2001, requires that all business combinations be accounted for under a single method - the purchase method. Use of the pooling-of-interests method is no longer permitted. SFAS No. 141 also clarifies the criteria to recognize intangible assets separately from goodwill. SFAS No. 142 requires that goodwill and intangible assets deemed to have indefinite lives no longer be amortized to earnings, but instead be reviewed at least annually for impairment. Other intangible assets will continue to be amortized over their useful lives. SFAS No. 142 will be effective January 1, 2002.
The Company has evaluated the impact of adopting the provisions of SFAS No. 142 on earnings and financial position for the year ended December 31, 2002. Effective January 1, 2002, in accordance with SFAS No. 142, the Company will cease amortizing the balance sheet item "excess of book value of subsidiary interest over cost" which is $5.7 million at year end 2001. The 2001 impact of the amortization of this resulted in approximately $0.10 per share of annual operating earnings. Additionally, the Company will no longer amortize the negative goodwill resulting from the purchase of preferred stock mutual funds effective January 1, 2002. The amount of unamortized negative goodwill at year-end is $6.4 million. The 2001 impact of the amortization of this was $0.10 per share of earnings classified as capital gains. Both the excess of book value of subsidiary interest over cost and the negative goodwill on preferred stock mutual funds will be recognized as income in the first quarter of 2002 and classified as an extraordinary item. The estimated per share income impact of this change is $0.34 per share.
Critical Accounting Policies
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The following accounting policies, which are derived based on management's judgments and estimates, are considered critical to the preparation of the Company's financial statements.
1. Investments
The focus of management's judgments and estimates relating to investments involves the potential impairment of investments for other than temporary declines in market values. The carrying value of investments in fixed maturities, which include taxable and non-taxable bonds, and investments in common and preferred stocks, are derived from market prices supplied by the Company's investment custodian. Unrealized investment gains and losses on common and preferred stocks and fixed maturities, to the extent that there is no other than temporary impairment of value, are credited or charged to a separate component of stockholders' equity, known as "net accumulated other comprehensive income (loss)", until realized, net of any tax effect. An impairment in an investment is deemed to be other than temporary, when a security's market value has diminished to less than 75% of cost for two consecutive quarters. If the security is deemed impaired the Company adjusts the securities cost to market value through realized loss based on publicly available or, in the absence of such, to a value based on cash flow modeling. During 2001, the Company wrote down $2,665 in bonds and preferred stock investments with impairment as determined by management to be other than temporary. Given the makeup and quality of the Company's investments, management does not believe that a more stringent policy would have a material effect on the carrying value of its investments.
2. Unpaid Loss and Loss Adjustment Expenses ("LAE")
Unpaid Loss and LAE by their nature are inherently uncertain as to the ultimate outcome of the estimated amounts. The liability for unpaid losses and LAE represents Management's best estimate of the ultimate net cost of all losses and LAE incurred through the balance sheet date. The estimate for ultimate net cost of all losses incurred through the balance sheet date includes the adjusted case estimates for losses, incurred but not reported ("IBNR") losses, salvage and subrogation recoverable and a reserve for LAE. In arriving at its best estimate, management begins with the aggregate of individual case reserves and then makes adjustments to these amounts on a line of business basis. These adjustments to the aggregate case reserves by line of business are made based on analysis performed by Management as further described below. The entire liability for unpaid losses and LAE is also reviewed quarterly and annually by the Company's Actuarial Department. Liability estimates are continually analyzed and updated, and therefore, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimates are included in the results of operations in the period in which the estimates are revised.
The claim cycle begins when a claim is reported to the Company and claims personnel establish a "case reserve" for the estimated amount of the ultimate exposure to the Company. The amount of the reserve is primarily based upon an evaluation of the type of claim involved, the circumstances surrounding the claim and the policy provisions relating to the loss. This estimate reflects the informed judgment of such personnel based on general insurance reserving practices and on the experience and knowledge of the claims personnel adjusting the claim. During the loss adjustment period, these case basis estimates are revised as deemed necessary by the Company's claims department personnel based on subsequent developments and periodic reviews of the claim.
In accordance with industry practice, the Company also maintains reserves for estimated IBNR, salvage and subrogation recoverable and LAE. These reserves are determined on the basis of historical information and the experience of the Company. Adjustments to these reserves are made periodically to take into account changes in the volume of business written, claims frequency and severity, the mix of business, claims processing and other items that can be expected to affect the Company's liability for losses and LAE over time.
When reviewing the liability for unpaid losses and LAE, the Company analyzes historical data and estimates the impact of various factors such as: (i) payment trends; (ii) loss expense per exposure; (iii) the historical loss experience of the Company and industry; (iv) frequency and severity trends; and, (v) legislative enactments, judicial decisions, legal developments in the imposition of damages, changes and trends in general economic conditions, including the effects of inflation and recession. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors.
By using individual estimates of reported claims adjusted for managements best estimate by line of business and generally accepted actuarial reserving techniques, the Company estimates the ultimate net liability for losses and LAE. After taking into account all relevant factors, management believes that, based on existing information, the provision for losses and LAE at December 31, 2001 is adequate to cover the ultimate net cost of losses and claims incurred as of that date. The ultimate liability, however, may be greater or lower than established reserves. If the ultimate exposure is greater than (or less than) management's estimated liability for losses and LAE, based on any of the factors noted previously, the Company will incur additional expense (income) which may have a material impact.
Forward - Looking Statements
This annual report contains some statements that are not historical facts and are considered "forward-looking statements" as defined in the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve opinions, assumptions and predictions, and no assurance can be given that the future results will be achieved since events or results may differ materially as a result of risks facing the Company. These include, but are not limited to, those risks and uncertainties in our business, some of which are beyond the control of the Company, that are described in the Company's Forms 10-K and 10-Q, Schedules 13D and 13G, and other documents filed with the SEC, including the
possibility of adverse catastrophe experience and severe weather, adverse trends in claim severity or frequency, adverse state and federal regulation and legislation, adverse state judicial decisions, litigation risks, interest rate risk, rate making decisions for private passenger automobile policies in Massachusetts, potential rate filings outside of Massachusetts, adverse impacts related to consolidation activities, heightened competition, as well as the economic, market or regulatory conditions and risks associated with entry into new markets and diversification.
Effects of Inflation and Recession
The Company generally is unable to recover the costs of inflation in its personal automobile insurance line since the premiums it charges are subject to state regulation. Additionally, the premium rates charged by the Company for personal automobile insurance are adjusted by the Commissioner only at annual intervals. Such annual adjustments in premium rates may lag behind related cost increases. Economic recessions can have an impact upon the Company, primarily through the policyholder's election to decrease non-compulsory coverages afforded by the policy and increased driving, each of which tends to decrease claims.
To the extent inflation and economic recession influence yields on investments, the Company is also affected. As each of these environments affect current market rates of return, previously committed investments may rise or decline in value depending on the type and maturity of investment.
Inflation and recession must also be considered by the Company in the creation and review of loss and LAE reserves since portions of these reserves are expected to be paid over extended periods of time. The anticipated effect of economic conditions is implicitly considered when estimating liabilities for losses and LAE. The importance of continually adjusting reserves is even more pronounced in periods of changing economic circumstances.
COMMON STOCK PRICE AND DIVIDEND INFORMATION
The Company's common stock trades on the NYSE under the symbol "CGI". The high, low and close prices for shares, as quoted in The Boston Globe, of the Company's Common Stock for 2001 and 2000 were as follows:
As of March 1, 2002, there were 1,053 stockholders of record of the Company's Common Stock, not including stock held in "Street Name" or held in accounts for participants of the Company's Employee Stock Ownership Plan ("E.S.O.P.").
The Board of Directors of the Company voted to declare four quarterly dividends to stockholders of record totaling $1.19 per share and $1.15 per share in 2001 and 2000, respectively. On May 19, 2001, the Board voted to increase the quarterly stockholder dividend from $0.29 to $0.30 per share to stockholders of record as of June 4, 2000. Prior to that declaration, the Company had paid quarterly dividends of $0.29 per share dating back to May 15, 2000 when the Board voted to increase the dividend from $0.28 to $0.29 per share.
In May 1999, the Board of Directors of the Company authorized a stock buy-back program of up to 2,000,000 shares of common stock of the Company. At December 31, 2001, there are 273,700 shares of common stock authorized to be purchased under this program. In November 2001, the Board of Directors approved another stock buy-back program authorizing the purchase of up to an additional 2,000,000 shares. During the period from January 1, 2001 through December 31, 2001, the Company purchased 622,900 shares of its own common stock. During 2000, the Company purchased 606,200 shares of its own common stock under the May 1999 buy-back program. At December 31, 2001, the Company had authority to purchase a total of 2,273,700 additional shares of its common stock under the May 1999 and November 2001 buy-back programs. As of December 31, 2001, the Company holds a total of 4,869,548 shares of treasury stock.
REPORT OF MANAGEMENT
The management of the Company is responsible for the consolidated financial statements and all other information presented in this Annual Report. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States determined by management to be appropriate in the circumstances and include amounts based on management's informed estimates and judgments. Financial information presented elsewhere in this Annual Report is consistent with the financial statements. The appropriateness of data underlying such financial information is monitored through internal accounting controls, an internal audit department, independent auditors and the Board of Directors through its audit committee.
The Company maintains a system of internal accounting controls designed to provide reasonable assurance to management and the Board of Directors that assets are safeguarded and that transactions are executed in accordance with management's authorization and recorded properly. The system of internal accounting controls is supported by the selection and training of qualified personnel combined with the appropriate division of responsibilities.
Management recognizes its responsibility for fostering a strong ethical climate so that the Company's affairs are conducted according to the highest standards of personal and corporate conduct. The Board of Directors has adopted a formal Code of Conduct and Corporate Compliance Program governing employees and directors. Management encourages open communication within the Company and requires the confidential treatment of proprietary information and compliance with all domestic laws, including those relating to financial disclosure.
The 2001 consolidated financial statements were audited by the Company's independent auditors, Ernst & Young LLP, in accordance with auditing standards generally accepted in the United States. In addition, Ernst & Young LLP performs reviews of the unaudited quarterly financial statements, prior to the announcement of quarterly earnings. Management has made available to Ernst & Young LLP all of the Company's financial records and related data, including reports prepared by the Internal Audit Department as well as the minutes of stockholders' and directors' meetings. Furthermore, management believes that all representations made to Ernst & Young LLP were valid and appropriate.
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders of The Commerce Group, Inc.
We have audited the accompanying consolidated balance sheets of The Commerce Group, Inc. and Subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of earnings, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The Commerce Group, Inc. and Subsidiaries at December 31, 2001 and 2000, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States.
ERNST & YOUNG LLP
Boston, Massachusetts January 29, 2002
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY For the years ended December 31, (Thousands of Dollars)
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, (Thousands of Dollars)
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
THE COMMERCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE A - Summary of Significant Accounting Policies
1. Basis of Presentation
The consolidated financial statements of The Commerce Group, Inc. (the "Company") have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP").
The consolidated financial statements include The Commerce Group, Inc. and its wholly-owned subsidiaries, Bay Finance Company, Inc., Clark- Prout Insurance Agency, Inc. and Commerce Holdings, Inc. ("CHI"). The Commerce Insurance Company ("Commerce") and Citation Insurance Company ("Citation") are wholly-owned subsidiaries of CHI. Commerce West Insurance Company ("Commerce West") is a wholly-owned subsidiary of Commerce. American Commerce Insurance Company ("American Commerce") is a wholly-owned subsidiary of ACIC Holding Co., Inc. ACIC Holding Co., Inc. is owned jointly with AAA Southern New England ("AAA SNE") with Commerce maintaining an 80% common stock interest and AAA SNE maintaining a 20% common stock interest (see NOTE A17). All inter-company transactions and balances have been eliminated in consolidation. Certain prior year account balances have been reclassified to conform to the 2001 presentation. During the fourth quarter of 2000, the Company changed its policy in regard to its investments in certain closed-end preferred stock mutual funds. The level of ownership and new investment policy requires the Company to account for these investments on an equity basis. The results of prior accounting periods impacted by this change have been restated.
The insurance subsidiaries, Commerce, Citation, Commerce West and American Commerce, prepare statutory financial statements in accordance with accounting practices prescribed by the National Association of Insurance Commissioners ("NAIC"), the Commonwealth of Massachusetts, the State of California, and the State of Ohio.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
2. Investments
All investment transactions have credit exposure to the extent that a counter party may default on an obligation to the Company. Credit risk is a consequence of carrying investment positions. To manage credit risk, the Company focuses on higher quality fixed-income securities and preferred stocks, reviews the credit strength of all companies in which it invests, limits its exposure in any one investment category and monitors the portfolio quality, taking into account credit ratings assigned by recognized statistical rating organizations.
The focus of management's judgments and estimates relating to investments involves the potential impairment of investments for other than temporary declines in market values. Carrying values of investments in fixed maturities, which include taxable and non-taxable bonds, and investments in common and preferred stocks, are derived from market prices supplied by the Company's investment custodian. Unrealized investment gains and losses on common and preferred stocks and fixed maturities, to the extent that there is no other than temporary impairment of value, are credited or charged to a separate component of stockholders' equity, known as "net accumulated other comprehensive income (loss)", until realized, net of any tax effect. An impairment in an investment is deemed to be other than temporary when a security's market value has diminished to less than 75% of cost for two consecutive quarters. If the contractual terms of the security are being complied with, management performs a cash flow valuation to determine the potential impairment of the security. If the security is deemed impaired the Company adjusts the securities cost to market value through realized loss based on publicly available or, in the absence of such, to a value based on cash flow modeling. During 2001, the Company wrote down $2,665 in bonds and preferred stock investments with impairment as determined by management to be other than temporary. Given the makeup and quality of the Company's investments, management does not
THE COMMERCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE A - Summary of Significant Accounting Policies (continued)
believe that a more stringent policy would have a material effect on the carrying value of its investments. When investment securities are sold, the realized gain or loss is determined based upon specific identification. Fair market value of fixed maturities and common and preferred stocks are based on quoted market prices. For other securities held as investments, fair market value equals quoted market price, if available. If a quoted market price is not available, fair market value is estimated using quoted market prices for similar securities. The Company has not invested more than 5% of fixed maturities in any one state or political subdivision.
During 2001, as required by the Emerging Issues Task Force ("EITF") D-46, the Company began accounting for venture capital fund investments in which it owns more than a 5% interest on the equity method. The operating results of these venture capital fund investments have been reflected in realized gains and losses. Prior to this change, the operating results were not material and were therefore reflected in accumulated other comprehensive income and loss.
During the fourth quarter of 2000 the Company changed its policy in regard to investments in certain closed-end preferred stock mutual funds. From that point forward the Company intends to take a proactive posture to affect the overall investment performance of these funds. The Company's level of ownership and new investment policy required the Company to account for these investments from that point forward on the equity method. Under the equity method the Company recorded it's share of the changes in the mutual funds' undistributed net assets in net investment income. Prior to the fourth quarter of 2000 these investments were recorded at their fair market value with the changes in value reflected in accumulated other comprehensive income. With the adoption of the equity method in the fourth quarter of 2000 all prior periods were restated to reflect equity method accounting. Beginning in the first quarter of 2001 the Company began recording their equity in the changes in net assets of closed-end preferred stock mutual funds as a component of realized gains and losses. All prior periods have been reclassified to permit comparison with the current year presentation. The Company believes the current year presentation provides a more appropriate classification for analysis of ongoing operations of the Company. These investments are valued at original cost plus the cumulative undistributed equity in earnings and losses of the funds and adjusted over time by the premium or discount at the time of purchase to the applicable underlying net asset value of the funds.
The Company originates and holds mortgage loans on real estate on properties located in the Commonwealth of Massachusetts and the State of Connecticut. The Company controls credit risk through credit approvals, credit limits and monitoring procedures. The Company performs in-depth credit evaluations on all new mortgage customers. Bad debt expenses have not been material in recent years.
Mortgage loans on real estate and collateral notes receivable are stated at the amount of unpaid principal, less an allowance for possible loan losses. The adequacy of the allowance for possible loan losses is evaluated on a regular basis by management. Factors considered in evaluating the adequacy of the allowance include previous loss experience, current economic conditions and their effect on borrowers and the performance of individual loans in relation to contract terms. The provision for possible loan losses charged to operating expenses is based upon management's judgment of the amount necessary to maintain the allowance at a level adequate to absorb possible losses. Loan losses are charged against the allowance when management believes the collectibility of the principal is unlikely and recoveries are credited to the allowance when received.
Interest on mortgage loans is included in income as earned based upon rates applied to principal amounts outstanding. Accrual of interest on mortgage loans is discontinued either when reasonable doubt exists as to the full, timely collection of interest or principal, or when a loan becomes contractually past due more than ninety days. When a loan is placed on non-accrual status, all unpaid interest previously accrued is reversed against current period earnings.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE A - Summary of Significant Accounting Policies (continued)
3. Cash and Cash Equivalents
Cash and cash equivalents includes cash currently on hand to cover operating expenses. The Company invested $82,856 with Fidelity Investment Government Fund and $59,281 with Provident Institutional Fund. These are short-term money market investments in government backed securities. Money is invested on a daily basis. The Company held $17,210 and $13,775 in U.S. Government Repurchase Agreements at various financial institutions in 2001 and 2000, respectively. The amount of collateral, maintained by the seller, at the time of purchase and each subsequent business day, is required to have a market value that is equal to 102% of the resale price.
4. Deferred Policy Acquisition Costs
Policy acquisition costs are calculated by line of business as a percentage of unearned premiums by multiplying the sum of current commission rates plus current premium tax rates plus an estimate of the percentage of other underwriting expenses incurred at the policy issuance. These costs are deferred and amortized over the period in which the related premiums are earned, the amount being reduced by any potential premium deficiency. If any potential premium deficiency exists, it represents future estimated losses, loss adjustment expenses and amortization of deferred acquisition costs in excess of the related unearned premiums. There was no premium deficiency in 2001, 2000 and 1999. In determining whether a premium deficiency exists, the Company considers anticipated investment income.
5. Property and Equipment
Property and equipment are stated at cost and are depreciated on the straight line method over the estimated useful lives of the assets using the following rates: Percent Asset Classification Per Annum Buildings..................................... 2.5 Building improvements (prior to 1992)......... 2.5 Building improvements (1992 and subsequent)... 5.0 Equipment and office furniture................ 10.0 EDP equipment and copiers..................... 20.0 Automobiles................................... 33.3
Maintenance and repairs are charged to operations; betterments are capitalized. The cost of property sold or otherwise disposed of and the accumulated depreciation thereon is eliminated from the related property and accumulated depreciation accounts and any resulting gain or loss is credited or charged to income.
6. Non-Compete Agreement
The non-compete agreement of $2,479 represents the unamortized portion of the purchase price associated with the acquisition of American Commerce allocated to the arrangement whereby the American Automobile Association, Inc. ("AAA National") agreed not to compete with American Commerce prior to February 2009. The cost of $3,500 is being amortized on a straightline basis over the term of the arrangement. The amount of accumulated amortization at December 31, 2001 and 2000 was $1,021 and $671, respectively.
7. Unpaid Loss and Loss Adjustment Expenses
Loss and LAE reserves by their nature are inherently uncertain as to the ultimate outcome of the estimated amounts. The liability for unpaid losses and loss adjustment expenses ("LAE") represents the accumulation of individual case estimates for reported losses and estimates for incurred but not reported ("IBNR") losses and LAE net of, salvage and subrogation recoverable. The liability for losses and LAE is intended to cover the ultimate net cost of all losses and LAE incurred through the balance sheet date. Liability estimates are continually reviewed and updated, and therefore, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimates are included in the results of operations in the period in which the estimates are revised.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE A - Summary of Significant Accounting Policies (continued)
8. Premiums
Insurance premiums are recognized as income ratably over the terms of the policies. Unearned premiums are determined by prorating written premiums on a daily basis over the terms of the policies. A significant portion of the Company's Massachusetts premiums written is derived through the American Automobile Association Clubs of Massachusetts ("AAA clubs") affinity group marketing program. Of the Company's total direct premiums written, the portion attributable to the AAA affinity group marketing program in Massachusetts was $545,496 or 47.3% in 2001, $535,766 or 50.0% in 2000 and $495,962 or 52.3% in 1999. Of these amounts, 13.0% were written through insurance agencies owned by the AAA clubs and 87.0% were written through the Company's network of independent agents in 2001.
9. Income Taxes
The Company uses an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, the Company generally considers all expected future events other than changes in the tax law or rates, unless enacted. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. No valuation allowance was established in 2001, 2000 or 1999.
10. Deferred Income
Income consisting of expense reimbursements, which include servicing carrier fees from Commonwealth Automobile Reinsurers ("C.A.R."), a state- mandated reinsurance mechanism, on policies written for C.A.R., are deferred and amortized over the term of the related insurance policies (see "Notes to Consolidated Financial Statements - NOTE F").
11. Contingent Commissions
In addition to state mandated minimum and other commissions on policies written, the Company pays certain of its agencies compensation in the form of profit sharing. This is based, in part, on the underwriting profits of an individual agent's business written with the Company. The arrangement for Massachusetts business utilizes a three-year rolling plan, with one third of the agent's profit or loss for each of the current and the two prior years' calculations summed to a single amount. This amount, if positive, is multiplied by the profit sharing commission rate and paid to the agent. Outside of Massachusetts, Commerce West and American Commerce each have contingent commission plans tailored to their specific markets.
12. Excess of Book Value of Subsidiary Interest Over Cost
As a result of the acquisition of American Commerce, the amount representing the excess of the fair value of the net assets acquired over the purchase price at the January 29, 1999 acquisition date was $16,947. The amount is being amortized into revenue on the straight line basis over a five year period. The amount amortized into income in 2001, 2000 and 1999 was $3,389, $3,390 and $3,019, respectively. See "Notes to Consolidated Financial Statements - NOTE A17" for treatment of excess of book value of subsidiary interest over cost ("negative goodwill") subsequent to December 31, 2001.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE A - Summary of Significant Accounting Policies (continued)
13. Minority Interest in Net Loss of Subsidiary
As a result of the joint venture with AAA SNE and acquisition of American Commerce, the Company's interest in ACIC Holding Co., Inc., through Commerce, a wholly-owned subsidiary of CHI, is represented by ownership of 80% of the outstanding shares of common stock at December 31, 2001. AAA SNE maintains a 20% common stock ownership. The minority interest of $863 included in the consolidated statement of earnings for 2001 represents 20% of the net loss for ACIC Holding Co., Inc., calculated after the $9,582 preferred stock dividend paid to Commerce, to the extent of the minority interest. This compares to $320 minority interest in the net loss of ACIC Holding Co., Inc. after $9,178 in preferred stock dividends paid to Commerce in 2000. During the third quarter of 2001, the net losses of ACIC Holding Co., Inc. exceeded the minority interest balance sheet component.
14. Treasury Stock
In May 1999, the Board of Directors of the Company authorized a stock buy-back program of up to 2,000,000 shares of common stock of the Company. At December 31, 2001, there are 273,700 shares of common stock authorized to be purchased under this program. In November 2001, the Board of Directors approved another stock buy-back program authorizing the purchase of up to an additional 2,000,000 shares. During the period from January 1, 2001 through December 31, 2001, the Company purchased 622,900 shares of its own common stock. During 2000, the Company purchased 606,200 shares of its own common stock under the May 1999 buy-back program. At December 31, 2001, the Company had authority to purchase a total of 2,273,700 additional shares of its common stock under the May 1999 and November 2001 buy-back programs. As of December 31, 2001, the Company holds a total of 4,869,548 shares of treasury stock.
15. Net Earnings Per Common Share
Net earnings per basic common share is computed by dividing net earnings by the weighted average number of basic common shares outstanding. The weighted average number of basic common shares outstanding for the years ended December 31, 2001, 2000 and 1999 were 33,608,804, 34,121,047, and 34,940,074, respectively. Weighted average number of basic common shares outstanding is determined by taking the average of the following calculation for a specified period of time: The daily amount of (1) the total issued outstanding common shares minus (2) the total Treasury Stock purchased.
Earnings per diluted common share is based on the weighted average number of diluted common shares outstanding during each period. The weighted average number of diluted common shares outstanding for the years ended December 31, 2001, 2000 and 1999 were 33,794,938, 34,121,047 and 34,940,074, respectively. The Company's only potentially dilutive instruments are stock options outstanding and dilution from these is not significant.
16. New Accounting Pronouncements
The NAIC revised the Accounting Practices and Procedures Manual in a process referred to as Codification. The revised manual became effective January 1, 2001 for all insurance companies. The domiciliary states of the Company's insurance subsidiaries have adopted the provisions of the revised manual. The revised manual has changed certain prescribed statutory accounting practices and has resulted in changes to the accounting practices that the Company's insurance subsidiaries use to prepare their statutory-basis financial statements. The impact of these changes to the Company's insurance subsidiaries statutory-basis capital and surplus as of January 1, 2001 had a significant beneficial effect of approximately $38,737 primarily due to the inclusion of deferred taxes as an admitted asset. The codification changes had no impact on the Company's GAAP financial statements.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars Except for Per Share Data)
NOTE A - Summary of Significant Accounting Policies (continued)
In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Certain Derivative Instruments and Hedging Activities", as amended in June 2000 by Statement of Financial Accounting Standards No. 138 ("SFAS 138"), "Accounting for Certain Derivative Instruments and Certain Hedging Activities", which requires companies to recognize all derivatives as either assets or liabilities in the balance sheet and measure such instruments at fair value. SFAS 138 also amended Statement of Financial Accounting Standards No. 137 ("SFAS 137"), "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133". The provisions of SFAS 133 require adoption for fiscal years beginning after June 15, 2000. The Company had no derivative or hedging activity in 2001, 2000 or 1999. The adoption of these SFASs had no material impact on the Company's consolidated financial statements.
In September 2000, the FASB issued Statement of Financial Accounting Standards No. 140 ("SFAS 140"), "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities", which replaced Statement of Financial Accounting Standards No. 125 ("SFAS 125"), "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". The Statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Those standards are based on consistent application of a "financial components" approach that focuses on control. Under that approach, after a transfer of financial assets, a company recognizes the financial and servicing assets it controls and the liabilities it has incurred, does not recognize financial assets when control has been surrendered, and does not recognize liabilities when extinguished. The Statement provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. The Statement is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. Adoption of SFAS 140 did not have a material impact on the Company's consolidated financial statements.
In July 2001, the FASB issued Statements of Financial Accounting Standards No. 141, "Business Combinations", and No. 142, "Goodwill and Other Intangible Assets". SFAS No. 141, effective for business combinations initiated after June 30, 2001, requires that all business combinations be accounted for under a single method - the purchase method. Use of the pooling-of-interests method is no longer permitted. SFAS No. 141 also clarifies the criteria to recognize intangible assets separately from goodwill. SFAS No. 142 requires that goodwill and intangible assets deemed to have indefinite lives no longer be amortized to earnings, but instead be reviewed at least annually for impairment. Other intangible assets will continue to be amortized over their useful lives. SFAS No. 142 will be effective January 1, 2002.
The Company has evaluated the impact of adopting the provisions of SFAS No. 142 on earnings and financial position for the year ended December 31, 2002. Effective January 1, 2002, in accordance with SFAS No. 142, the Company will cease amortizing the balance sheet item "excess of book value of subsidiary interest over cost" which is $5.7 million at year end 2001. The 2001 impact of the amortization of this resulted in approximately $0.10 per share of annual operating earnings. Additionally, the Company will no longer amortize the negative goodwill resulting from the purchase of preferred stock mutual funds effective January 1, 2002. The amount of unamortized negative goodwill at year-end is $6.4 million. The 2001 impact of the amortization of this was $0.10 per share of earnings classified as capital gains. Both the excess of book value of subsidiary interest over cost and the negative goodwill on preferred stock mutual funds will be recognized as income in the first quarter of 2002 and classified as an extraordinary item. The estimated per share income impact for this change is $0.34 per share.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
17. Acquisition
In November 1998, Commerce formed ACIC Holding Co., Inc., in a joint venture with AAA SNE and invested $90,800 to fund the January 29, 1999 acquisition of the Automobile Club Insurance Company, whose name was changed to American Commerce upon completion of the acquisition. Commerce invested $90,000 in the form of preferred stock and an additional $800 representing an 80% common stock ownership. AAA SNE invested $200 representing a 20% common stock ownership. The terms of the preferred stock call for Commerce to receive quarterly cash dividends at the rate of 10% per annum from ACIC Holding, Co., Inc. In the event cash dividends cannot be paid, additional preferred stock will be issued. During 2001, 96 shares of Class B preferred stock were issued in lieu of the cash payment of dividends. The acquisition was accounted for as a purchase. Since the January 29, 1999 acquisition, American Commerce's results have been consolidated into the Company's financial statements. Since 1995, Commerce has maintained an exclusive affinity group marketing relationship with AAA Insurance Agency, Inc., a subsidiary of AAA SNE. AAA Insurance Agency, Inc. has been a licensed insurance agent of Commerce since 1985.
NOTE B - Investments and Investment Income
1. Fixed Maturities
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE B - Investments and Investment Income (continued)
Proceeds from sales of investments in fixed maturities, gross gains and gross losses realized on those sales were as follows:
THE COMMERCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE B - Investments and Investment Income (continued)
2. Closed-end Preferred Stock Mutual Funds
The following table reflects the shares held, percentage of ownership, carrying value at equity, book value, market value, and value of shares at net asset value, by fund at December 31, 2001 and 2000:
The difference between the carrying value at equity and the value of shares at net asset value is negative goodwill created at the time of the purchase of the shares. SFAS 141, which was implemented on July 1, 2001, specifically addresses the manner in which to account for negative goodwill. For purchases prior to July 1, 2001, that created negative goodwill, the Company continued to amortize the negative goodwill on these securities through the end of 2001. This negative goodwill was amortized into realized gains over various periods ranging from 1.25 years to 4 years based on the turnover ratios of the funds. In accordance with SFAS 141, for purchases subsequent to June 30, 2001, the difference between the cost and net asset value at the time of purchase was recognized as a realized gain, totaling $614 for 2001.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE B - Investments and Investment Income (continued)
3. Mortgage Loans on Real Estate and Collateral Notes Receivable
At December 31, 2001 and 2000, mortgage loans on real estate and collateral notes receivable consisted of the following:
Fair value of the Company's mortgage loans on real estate and collateral notes receivable is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit and for the same remaining maturities. The future cash flows associated with certain non-performing loans are estimated based on expected payments from borrowers either through work out arrangements or the disposition of collateral. The estimated fair value of mortgage loans on real estate and collateral notes receivable at December 31, 2001 and 2000, prior to the allowance for possible loan losses, was $41,391 and $54,141, respectively.
At December 31, 2001 and 2000 mortgage loans which were on non- accrual status amounted to $1,118 and $1,357, respectively. The reduction in interest income associated with non-accrual loans was $99, $118 and $129 for the years ended December 31, 2001, 2000 and 1999, respectively.
The Company originates and services residential and commercial mortgages in Massachusetts and Connecticut. The Company's exposure is generally 80% or less of the appraised value of any collateralized real property at the time of the loan origination. The ability and willingness of residential and commercial borrowers to honor their repayment commitments is generally dependent upon the level of overall economic activity and real estate values. The Company sold $20,042 of residential mortgages in 2000 without recourse to an unrelated third party.
A summary of the changes in the allowance for possible loan losses follows:
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE B - Investments and Investment Income (continued)
The following table describes mortgage principal balances by maturity, total mortgages over 90 days past due and total mortgages in foreclosure:
4. Net Investment Income
The components of net investment income were as follows:
5. Net Realized Investment Gains (Losses)
Net realized investment gains (losses) were as follows:
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE B - Investments and Investment Income (continued)
6. Other Comprehensive Income (Loss)
Net increases (decreases) in other comprehensive income (loss), less applicable income tax (expense) benefit, were as follows:
NOTE C - Deferred Policy Acquisition Costs
Policy acquisition costs incurred and amortized to income are as follows:
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE D - Property and Equipment
A summary of property and equipment at December 31, is as follows:
Depreciation expense was $4,280, $4,270 and $4,243 for the years ended December 31, 2001, 2000 and 1999, respectively. Depreciation expense is allocated evenly between losses and loss adjustment expenses and policy acquisition costs.
NOTE E - Unpaid Losses and Loss Adjustment Expenses
Liabilities for unpaid losses and loss adjustment expenses at December 31, consist of:
Unpaid Loss and LAE by their nature are inherently uncertain as to the ultimate outcome of the estimated amounts. The liability for unpaid losses and LAE represents Management's best estimate of the ultimate net cost of all losses and LAE incurred through the balance sheet date. The estimate for ultimate net cost of all losses incurred through the balance sheet date includes the adjusted case estimates for losses, incurred but not reported ("IBNR") losses, salvage and subrogation recoverable and a reserve for LAE. In arriving at its best estimate, management begins with the aggregate of individual case reserves and then makes adjustments to these amounts on a line of business basis. These adjustments to the aggregate case reserves by line of business are made based on analysis performed by Management as further described below. The entire liability for unpaid losses and LAE is also reviewed quarterly and annually by the Company's Actuarial Department. Liability estimates are continually analyzed and updated, and therefore, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimates are included in the results of operations in the period in which the estimates are revised.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE E - Unpaid losses and Loss Adjustment Expenses (continued)
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer's payment of that loss. To recognize liabilities for unpaid losses, insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and LAE. Quarterly, the Company reviews these reserves internally. Regulations of the Division of Insurance require the Company to annually obtain a certification from either a qualified actuary or an approved loss reserve specialist that its loss and LAE reserves are reasonable.
When a claim is reported to the Company, claims personnel establish a "case reserve" for the estimated amount of the ultimate exposure to the Company. The amount of the reserve is primarily based upon an evaluation of the type of claim involved, the circumstances surrounding the claim and the policy provisions relating to the loss. This estimate reflects the informed judgment of such personnel based on general insurance reserving practices and on the experience and knowledge of the claims personnel adjusting the claim. During the loss adjustment period, these estimates are revised as deemed necessary by the Company's claims department personnel based on subsequent developments and periodic reviews of the cases.
In accordance with industry practice, the Company also maintains reserves for estimated IBNR and LAE net of salvage and subrogation recoverable. These reserves are determined on the basis of historical information and the experience of the Company. Adjustments to these reserves are made periodically to take into account changes in the volume of business written, claims frequency and severity, the mix of business, claims processing and other items that can be expected to affect the Company's liability for losses and LAE over time.
When reviewing the liability for unpaid losses and LAE, the Company analyzes historical data and estimates the impact of various factors such as (i) payment trends; (ii) loss expense per exposure; (iii) the historical loss experience of the Company and industry; (iv) frequency and security trends; and, (v) legislative enactments, judicial decisions, legal developments in the imposition of damages, changes and trends in general economic conditions, including the effects of inflation and recession. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors.
By using both individual estimates of reported claims and generally accepted actuarial reserving techniques, the Company estimates the ultimate net liability for losses and LAE. After taking into account all relevant factors, management believes that, based on existing information, the provision for losses and LAE at December 31, 2001 is adequate to cover the ultimate net cost of losses and claims incurred as of that date. The ultimate liability, however, may be greater or lower than established reserves. If the ultimate exposure is greater than (or less than) management's estimated liability for losses and LAE, based on any of the factors noted previously, the Company will incur additional expense (income) which may have a material impact. The Company does not discount to present value that portion of its loss reserves expected to be paid in future periods.
Included in the loss reserve methodologies described above, are liabilities for unpaid claims and claim adjustment expenses for environmental related claims such as oil spills, mold and lead paint. Reserves have been established to cover these claims for known losses. Because of the Company's limited exposure to these types of claims, management believes they will not have a material impact on the consolidated financial position of the Company in the future. Loss reserves on environmental related claims amounted to $4,281 and $3,712 at December 31, 2001 and 2000, respectively.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE E - Unpaid losses and Loss Adjustment Expenses (continued)
The following table sets forth a reconciliation of beginning and ending reserves for losses and loss adjustment expense, net of reinsurance deductions from all reinsurers including C.A.R., as shown in the Company's consolidated financial statements for the periods indicated.
The decrease in provision for insured events of prior years represents redundancies for reserves established for prior year. This decrease in provision was principally the result of re-estimation of unpaid losses and loss adjustment expenses principally on the personal automobile, commercial automobile and homeowners lines of business.
The Company's loss and LAE reserves reflect its share of the aggregate C.A.R. loss and LAE reserves of the Company and the 38 other writers of automobile insurance in Massachusetts that participate in C.A.R. ("Servicing Carriers"). The Company is a defendant in various legal actions arising from the normal course of its business. These proceedings are considered to be ordinary to operations or without foundation in fact. Management is of the opinion that these actions will not have a materially adverse effect on the consolidated financial statements of the Company.
NOTE F - Reinsurance Activity
The Company has reinsurance contracts for casualty and catastrophe coverages. These reinsurance arrangements minimize the Company's losses arising from large risks and protect the Company against numerous losses from a single occurrence or event. The Company also has a quota share reinsurance contract on its other than automobile business.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
Property, Catastrophe and Quota Share Reinsurance
The Company maintains a 75% quota share reinsurance program, covering all non-automobile property and liability business, except umbrella policies. The program is split between American Re-Insurance Company, Employers Reinsurance Corporation, Hartford Fire Insurance Company and Swiss Reinsurance America Corporation. The maximum per occurrence dollar recovery is equal to 250% of the net premiums ceded to the quota share arrangement in a contract year. The maximum aggregate per year dollar recovery under the quota share contract is equal to 350% of the net premium ceded to the quota share arrangement in a contract year. A sliding scale commission, based on loss ratio, is utilized under this program. This program provides the Company with sufficient protection for catastrophe coverage so as to enable the Company to forego pure catastrophe reinsurance coverage, which was previously tailored in conjunction with the former quota share arrangement.
The table below provides information depicting the approximate recovery under the quota share contract (described below) at various loss scenarios, if a single catastrophe were to strike:
Under the above scenario and based on the business subject to the quota- share reinsurance contract for 2001, the Company has no reinsurance recoveries for a single event catastrophe in excess of a total loss of approximately $262.0 million. The level of reinsurance protection increases (decreases) when the company cedes more (less) premium to the reinsurers. The Company's estimated total losses on its other than automobile business for 100 and 250-year hurricanes (including American Commerce) are approximately $176.0 million and $295.8 million, respectively. The Company estimates were derived through the services of Swiss Reinsurance America Corporation who utilized the RMS (Risk Management Solutions) IRAS risk assessment system. Most property and casualty insurance companies establish their catastrophe reinsurance programs up to the 100 year storm estimate.
Written premiums ceded in 2001, 2000 and 1999 under the above referenced program were $78.6 million, $69.4 million and $51.5 million, respectively. The 13.3% increase in written premiums ceded in 2001 versus 2000 in this program was primarily the result of a $7,592 or 11.6% increase in Massachusetts homeowner direct written premium, coupled with a $2,212 or 13.4% increase in direct homeowner writings in states other than Massachusetts, as previously mentioned. Ceding commission income is calculated on a ceded earned premium basis.
Casualty Reinsurance
Casualty reinsurance is on an excess of loss basis for any one event or occurrence with a maximum recovery of $9.0 million over a net retention of $1.0 million. This coverage is placed with Swiss Reinsurance America Corporation (rated A++ by A.M. Best).
Personal and commercial liability umbrella policies are reinsured on a 95% quota share basis in regard to limits up to $1.0 million and 100% quota share basis for limits in excess of $1.0 million but not exceeding $5.0 million for policies with underlying automobile coverage of $250/$500 or more. The Company also has personal liability umbrella reinsurance coverage for policies with underlying automobile coverage of $100/$300, on a 65% quota share basis in regard to limits up to $1.0 million and 100% quota share basis for limits in excess of $1.0 million but not exceeding $3.0 million. These coverages are placed with American Re-Insurance Company (rated A++ by A.M. Best).
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE F - Reinsurance Activity (continued)
Earned premiums and losses and loss adjustment expenses are stated in the accompanying consolidated financial statements after deductions for ceded reinsurance. Those deductions for reinsurance other than C.A.R. are as follows:
The Company, as primary insurer, would be required to pay losses in their entirety in the event that the reinsurers were unable to discharge their obligations under the reinsurance agreements.
C.A.R.
C.A.R., a state-mandated reinsurance mechanism, enables the Company and the other Servicing Carriers to reinsure any automobile risk that the insurer perceives to be under priced at the premium level permitted by the Commissioner. Servicing Carriers, who are responsible for over 99.0% of total direct premiums written for personal automobile insurance in Massachusetts, are required to offer automobile insurance coverage to all eligible applicants pursuant to "take-all-comers" regulations, but may reinsure business with C.A.R.
Since its inception, C.A.R. has annually generated multi-million dollar underwriting losses in both the personal and commercial pools. The Company is required to share in the underwriting results of C.A.R. business for its respective product lines. Under current regulations, the Company's share of the C.A.R. personal or commercial deficit is based upon its market share for retained automobile risks for the particular pool, adjusted by a "utilization" concept, such that, in general, the Company is disproportionately and adversely affected if its relative use of C.A.R. reinsurance exceeds that of the industry, and favorably affected if its relative use of C.A.R. reinsurance is less than that of the industry. The Company's strategy has been to voluntarily retain more types of private passenger automobile business that are factored as credits, thereby favorably impacting the utilization formula. These credits result from voluntarily writing business in underpriced territories and for underpriced risks. As a result of increased voluntary retention, in excess of the industry, the credits impacting the utilization formula have favorably affected the Company's participation ratio compared to its market share. During 2001, 2000 and 1999, the Company's net participation in the C.A.R. personal automobile pool approximated 16.8%, 16.9% and 16.5%, respectively, as reported by C.A.R., compared to the Company's estimated market share in those years of 23.3%, 22.3% and 21.3%.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
Written premiums, earned premiums, losses and LAE incurred, underwriting expenses incurred and the liabilities for unearned premiums, unpaid losses and LAE ceded to and assumed from C.A.R. were as follows:
The Company pays to C.A.R. all of the premiums generated by the policies it has ceded and C.A.R. reimburses the Company for all losses incurred on account of ceded policies. In addition, the Company receives a fee for servicing ceded policies based on the expense structure established by C.A.R. For the years ended December 31, 2001, 2000 and 1999, these servicing fees amounted to $17,161, $16,783 and $17,235, respectively.
The Company presents assets and liabilities gross of reinsurance. The Residual Market Receivable represents the gross amount of reinsurance recoverable from C.A.R. including unpaid losses, unearned premiums, paid losses recoverable and unpaid ceded and assumed premiums.
The current C.A.R. utilization-based participation ratio has been in place for the personal automobile market since 1993. During 2001, 2000 and 1999 the Company's amount of personal automobile exposures it reinsured through C.A.R. approximated 4.9%, 4.9% and 5.6%, respectively, as compared to industry averages of 7.7%, 8.4% and 9.6%, respectively.
NOTE G - Income Taxes
The Company and its subsidiaries file a consolidated federal income tax return.
The federal income tax expense (benefit) consisted of the following:
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE G - Income Taxes (continued)
Deferred taxes arise from temporary differences in the basis of assets and liabilities for tax and financial statement purposes. The sources of these differences and the related tax effects of the activities that occurred consisted of the following:
Realization of a deferred tax asset is dependent on generating sufficient taxable income in future years. Although realization is not assured, management believes it is more likely than not that all of the deferred tax assets will be realized. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income or unrealized gains are reduced.
Deferred tax liabilities (assets) were comprised of the following at December 31, 2001 and 2000:
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE G - Income Taxes (continued)
Federal income tax on income is less than the amount computed by applying the statutory rate of 35% for the years ended 2001, 2000 and 1999 for the following reasons:
NOTE H - Related-Party Transactions
The Company has made loans to insurance agencies with which Commerce transacts business on a regular basis. At December 31, 2001, eleven loans with an aggregate outstanding principal balance of $3,476, were collateralized by the assets of the agencies, one of these loans with an outstanding balance of $313 was collateralized by real estate as the primary collateral and the assets of the agency as secondary collateral. There were no loans to insurance agencies collateralized solely by real estate. At December 31, 2000, ten loans with an aggregate outstanding balance of $3,556 were collateralized by the assets of the agencies and one of these loans with an outstanding balance of $328 was collateralized by real estate as the primary collateral and the assets of the agency as secondary collateral.
The immediate family of Raymond J. Lauring, a Director of the Company, owns more than a 10% equity interest in Lauring Construction Company. Mr. Lauring has no ownership interest in Lauring Construction Company. During 2001, Lauring Construction Company provided construction and construction management services in connection with a contract for the estimated $13 million renovation of a 160,000 square foot building purchased by the Company. Terms of the contract provide for a fixed fee of $650 for supervision and management of the project over the term of the contract. There were no payments made on the supervision or management services portion of the contract in 2001. Payments to Lauring Construction Company in 2001 for actual materials used and construction work performed on this project were $405 and payments for other work unrelated to the project were $31.
NOTE I - Employee Stock Ownership Plan and 401(k) Plan
The Company offers an Employee Stock Ownership Plan ("E.S.O.P.") and 401(k) Plan for the benefit of substantially all employees, including those of the Company's subsidiaries. The E.S.O.P. is noncontributory on the part of Participants and contributions are made at the discretion of the Board of Directors. The company is under no obligation to make contributions or maintain the E.S.O.P. for any length of time, and may completely discontinue or terminate the E.S.O.P. at any time without liability. Contributions by the Company and subsidiaries to the E.S.O.P. for the years ended December 31, 2001, 2000 and 1999 were $7,502, $5,702 and $5,744, respectively. The increase in the contribution in 2001 over 2000 was primarily due to the inclusion of American Commerce employees into the plan. The E.S.O.P. held 2,989,046 and 3,143,076 shares of the Company's common stock at December 31, 2001 and 2000, respectively. E.S.O.P. Participants who are current employees of the Company or its subsidiaries and who are 100% vested in their E.S.O.P. accounts can annually elect to transfer
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE I - Employee Stock Ownership Plan and 401(k) Plan (continued)
out of the E.S.O.P. up to 100% of their allocated Company stock in the form of an eligible rollover distribution into another eligible retirement plan, such as a qualified individual retirement arrangement. Approximately 2,191,000 shares owned by Participants in the E.S.O.P. at December 31, 2001 are allocated to the E.S.O.P. accounts of these individuals. E.S.O.P. Participants who are former employees of the Company may generally elect to withdraw from the E.S.O.P. the total amount of shares allocated to their accounts at any time. Approximately 580,000 shares held by the E.S.O.P. at December 31, 2001 are allocated to the E.S.O.P. accounts of these individuals. The remaining approximately 219,000 shares held by the E.S.O.P. at December 31, 2001 are allocated to the E.S.O.P. accounts of Participants who have not yet reached 100% vesting in their account balances. Disposition of these unvested shares is restricted under the E.S.O.P. The Company pays for administration of the E.S.O.P.
The 401(k) Plan, implemented in September 1998, enables eligible employees to contribute up to 15% of eligible compensation on a pre-tax basis up to the annual maximum limits under federal tax law. The Company incurs no expenses in the form of matching contributions but does pay for administration of the Plan.
NOTE J - American Commerce Pension and Post-Retirement Benefits
Effective June 1, 2000, the Directors of American Commerce voted to terminate the American Commerce noncontributory defined benefit pension plan (the "pension plan") and transition on January 1, 2001 to the E.S.O.P. The payment of the termination liability to participants from previously funded assets of the pension plan amounted to $4,558 in 2000. All participants of the pension plan were eligible to retire with full retirement benefits upon attainment of age 65 with 5 years of participation. Retirement benefits were payable for the life of the participant with guaranteed payments for 10 years. All retirees had taken lump-sum payments. American Commerce made contributions to a deposit administration contract, which provided the pension plan with assets sufficient to fund pension benefits to pension plan participants. The deposit administration contract was carried at contract value, which represented the cost of contributions plus interest and experience refunds. The pension plan was subject to and exceeded the minimum funding requirements of ERISA.
Effective January 1, 2001, the Directors of American Commerce voted to merge the 401(k) Plan with the Company's Plan. Previously, American Commerce maintained a separate 401(k) Plan for the benefit of substantially all of its employees. American Commerce matched 50% of all employee contributions up to 6% of pay. Both American Commerce and its employees shared in administration expenses of the plan. American Commerce did not contribute to the plan in 2001 due to the aforementioned merger. Commerce contributed $181 and $165 to the plan in 2000 and 1999, respectively.
American Commerce maintains a noncontributory post-retirement benefit plan (the "post-retirement plan") for retirees that includes medical, dental and life insurance coverages. All participants of the post-retirement plan are eligible upon attainment of age 55 with 10 years of service or age 65 with 5 years of service. Dental coverage ceases at age 65 and life insurance coverage decreases based upon the age of the retiree until the attainment of age 70, at which time retirees are provided a nominal amount of coverage from age 70 and thereafter. Participants' spouses are also covered under the post-retirement plan. The cost of post-retirement medical, dental and life insurance benefits is accrued over the active service periods of employees to the date they attain full eligibility for such benefits. It is the policy of American Commerce to pay for post-retirement benefits as incurred.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE J - American Commerce Pension and Post-Retirement Benefits (continued)
The following table shows, as of December 31, 2001 and 2000, the American Commerce post-retirement benefit plan funded status reconciled with amounts reported in the consolidated balance sheet and the assumptions used in determining the actuarial present value of the benefit obligation:
Net periodic cost of the American Commerce post-retirement benefit plan for the period ended December 31, 2001, 2000 and 1999 includes the following components:
The assumed health care cost trend rate for 2001 was 8.5% and 7.25% for medical and dental, respectively. These rates grade down until the final trend rates of 6.0% and 5.0% for medical and dental, respectively, are reached in 2010. A one percentage point increase in the assumed health and dental cost trend rates increases the sum of the service and interest costs components of the 2001, 2000 and 1999 periodic post-retirement benefit cost by 16.3%, 20.4% and 13.0% respectively, and the accumulated post-retirement benefit obligation as of December 31, 2001, 2000 and 1999 by 16.6%, 17.7% and 14.0%, respectively.
Subsequent to December 31, 2001, the Directors of American Commerce voted to terminate that portion of the post-retirement plan applicable to future retirees of American Commerce. Termination will be effective May 1, 2002. Current retirees and employees who retire prior to May 1, 2002 will remain eligible for post-retirement benefits.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE K - Directors' Retirement Compensation Plan
During 2000, the Company's Directors approved a Directors' Retirement Compensation Plan (the "Retirement Plan"). The Retirement Plan becomes effective for each Company Director upon terminating service on the Company's Board of Directors (the "Board") providing that such termination was not made under conditions adverse to the Company's interest. Effective with the annual meeting wherein the Director is not reappointed to the Board, and provided benefits are not paid until such time as the Director has attained the age of 65, the Company will pay an annual retirement benefit equal to 50% of the average annual total compensation of the Director for the immediately preceding three full years ("the three year average compensation"). The annual retirement benefit of 50% of the three year average compensation vests at the rate of 4.0% for each year of Board (or subsidiary) service up to a maximum of 100% vesting through termination of service. Payments continue for a maximum of ten years over the remaining life of the terminated Director, or his or her then spouse, if the Director pre-deceases the spouse. No payments are to be made after the death of the Director and spouse. Expenses related to the Retirement Plan in 2001 and 2000 amounted to $178 and $2,364, respectively. A total of $19 was paid under the Retirement Plan in 2001 and 2000.
NOTE L - Stockholders' Equity
Book Value Awards, Stock Appreciation Rights and Stock Options Program
The Management Incentive Plan approved by the Company's stockholders in May, 1994 provides for the award of incentive stock options, non-qualified stock options, book value awards, stock appreciation rights, restricted stock and performance stock units. Up to 2,500,000 shares of common stock (subject to increase for anti-dilution adjustments) may be issued under the Plan, including shares that may be issued pursuant to awards of restricted stock or upon the exercise of common stock equivalent awards such as stock options and stock appreciation rights payable in the form of common stock (not in the form of cash). At the discretion of the compensation committee all directors, officers and other senior management employees of the Company or any of its subsidiaries are eligible to participate in this Management Incentive Plan.
Book value awards issued relating to this Plan totaled 474,541, 496,685 and 447,185 in 2001, 2000 and 1999, respectively. Expenses relating to book value awards were $1,577, $3,081 and $438 in 2001, 2000 and 1999, respectively. Grants under the SAR plan ceased in 1999 and were replaced with the stock option program. No SARs were outstanding at December 31, 2001. Expenses (income) relating to stock appreciation rights were $0, $760 and ($3,159) in 2001, 2000 and 1999, respectively. The outstanding book value awards entitle the holders to cash payments based upon the extent to which, if at all, the per share book value exceeds certain thresholds set at the time the award was granted.
During 2001, 2000 and 1999, the Company granted stock options ("options") totaling 1,184,343, 644,520 and 700,179, respectively, including the issuance of options previously terminated. The outstanding options entitle the recipient to purchase the Company's common stock based upon the extent to which, if at all, the per share market value of the common stock exceeds certain thresholds set at the time the option was granted. Unexercised options terminate not later than eight years after the date of grant.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars Except for Per Share Data)
NOTE L - Stockholder's Equity (continued)
Aggregate liabilities for the combined programs were $2,614 and $2,972 at December 31, 2001 and 2000, respectively.
The following is a summary of the changes in options outstanding under the Plan:
No options were exercisable at December 31, 2001, 2000 and 1999.
The estimated weighted average fair value per share of the options was $5.26 in 2001, $4.16 in 2000 and $3.78 in 1999. Under the provisions of APB Opinion 25, no expense was recognized for these options in 2001, 2000 or 1999. No options were granted prior to 1999. Had the Company recognized such expense, the Company's net earnings and earnings per share would have approximated the pro forma amounts indicated below:
Additionally, the Company granted 250,000 and 1,872,380 options to certain agents of American Commerce (the "American Commerce Agents' Plan") in 2001 and 1999, respectively. The right of the recipient to exercise these options is contingent upon the average volume of other-than- Massachusetts private passenger automobile and homeowners direct written premiums placed and maintained with American Commerce for a five year period specified in the option agreement. If qualified, the recipient may purchase the Company's common stock at the exercise price for a period of five years beginning five years after the date of the grant ("the confirmation date"). Unexercised options terminate not later than ten years after the date of the grant ("the expiration date"). In conjunction with meeting specified premium growth levels over the term of the options, the Company provided "put rights" to the holders of the options granted in 1999. These put rights permit the option holders to require the Company to purchase the options at the difference between $40.00 less the exercise price, at any time from and after the confirmation date through and including the expiration date. Expenses related to these options, determined in accordance with the fair value accounting provisions of SFAS No. 123, "Accounting for Stock-Based Compensation", amounted to $2,862 in 2001, $1,307 in 2000 and $1,909 in 1999.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars Except for Per Share Data)
NOTE L - Stockholder's Equity (continued)
The following is a summary of the changes in options outstanding under the American Commerce Agents' Plan:
No options were exercisable at December 31, 2001, 2000 and 1999.
The fair value of each option granted under the American Commerce Agents' Plan was estimated on the date of grant using the Black-Scholes option-pricing model, with the following weighted average assumptions:
The estimated weighted average fair value per share of the options under the American Commerce Agents' Plan was $5.63, $4.48 and $5.28 at December 31, 2001, 2000 and 1999, respectively.
NOTE M - Net Capital Requirements
The insurance companies included in the consolidated financial statements are subject to the financial capacity guidelines established by their respective state Divisions of Insurance. Every Massachusetts insurance company seeking to make any dividend or other distributions to its stockholders may, within certain limitations, pay such dividends and then file a report with the Commissioner. Dividends in excess of these limitations are called extraordinary dividends. An extraordinary dividend is any dividend or other property, whose fair value together with other dividends or distributions made within the preceding twelve months exceeds the greater of ten percent of the insurer's surplus as regards policyholders as of the end of the preceding year, or the net income of a non-life insurance company for the preceding year. No pro-rata distribution of any class of the insurer's own securities is to be included. No Massachusetts insurance company shall pay an extraordinary dividend or other extraordinary distribution until thirty days after the Commissioner has received notice of the intended distribution and has not objected. No extraordinary dividends were paid in 2001, 2000 and 1999. California and Ohio have similar regulations. No extraordinary dividend was paid by American Commerce in 2001, 2000 and 1999 and no dividends were paid by Commerce West since its acquisition.
To the extent Commerce and Citation are restricted from paying dividends to CHI, CHI will be limited in its ability to pay dividends to the Company. On this basis, the Company's ability to pay dividends to its stockholders is limited. During 2001, Commerce and Citation paid $55,200 and $10,868 in dividends, respectively to CHI; CHI then paid $65,835 to the Company in March 2001. During 2000, Commerce and Citation paid $41,000 and $10,780 in dividends, respectively, to CHI; CHI then paid $51,660 to the Company in March 2000. Commerce West did not pay dividends on their common stock in 2001 and 2000. American Commerce paid ACIC Holding Co., Inc. a dividend of $9,281 in 2001, no dividend was paid in 2000. ACIC Holding Co., Inc. paid Commerce dividends of $9,582 and $9,178 in 2001 and 2000, respectively, on its outstanding preferred stock.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars Except for Per Share Data)
NOTE M - Net Capital Requirements (continued)
The Board of Directors of the Company voted to declare four quarterly dividends to stockholders of record totaling $1.19 per share and $1.15 per share in 2001 and 2000, respectively. On May 19, 2001, the Board voted to increase the quarterly stockholder dividend from $0.29 to $0.30 per share to stockholders of record as of June 4, 2001. Prior to that declaration, the Company paid quarterly dividends of $0.29 per share dating back to May 21, 2000 when the Board voted to increase the dividend from $0.28 to $0.29 per share.
NOTE N - Statutory Balances
Following is a GAAP to Statutory reconciliation for both earnings and policyholders surplus for the combined operations of Commerce, Citation, Commerce West and American Commerce:
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars)
NOTE O - Segment Information (continued)
The Company has four reportable segments: (1) property and casualty insurance - Massachusetts; (2) property and casualty insurance - other than Massachusetts; (3) real estate and commercial lending; and, (4) corporate and other. The Company's property and casualty insurance operations are written through Commerce, Citation, Commerce West, and American Commerce and are marketed to affinity groups, individuals, families and businesses through the Company's relationships with professional independent insurance agencies. The Company's real estate and commercial lending operations are a result of insurance companies having the authority to invest in mortgages. The Company's wholly-owned subsidiary, Bay Finance Company, Inc., originates and services residential and commercial mortgages in Massachusetts and Connecticut. The corporate and other segment represents the remainder of the Company's activities, including those of the parent company.
The Company evaluates performance and allocates resources based primarily on the property and casualty insurance segments, which represents 99.2% of the Company's total revenue for the past three years. The accounting policies of the reportable segments are the same as those described in NOTE A - Summary of Significant Accounting Policies.
Selected information by industry segment for 2001, 2000 and 1999 is summarized as follows:
NOTE P - Supplement to Consolidated Statements of Cash Flows
During the years ended December 31, 2001 and 2000, the Company did not acquire any property through foreclosure of mortgages.
THE COMMERCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars Except for Per Share Data)
NOTE Q - Insolvency Fund Assessments
As provided in the statutes, insurance companies which write business in Massachusetts are assessed for losses attributable to the insolvency of other insurance companies by the Massachusetts Insurers Insolvency Fund ("M.I.I.F."). From M.I.I.F.'s inception, on August 2, 1972 through December 31, 2001, the M.I.I.F. has approved assessments totaling $188,071, of which the Company's share was approximately $15,686. It is anticipated that there will be additional assessments from time to time relating to various insolvencies. By statute, no insurer may be assessed in any year an amount greater than two percent of that insurer's direct written premiums for the calendar year preceding the assessment. Although the timing and amounts of any such assessments are not known, based on existing knowledge, management is of the opinion that such assessments will not have a material effect on the consolidated financial position of the Company. According to statute, the assessed insurance companies have the right to recoup amounts paid to the M.I.I.F., over a reasonable length of time, through premium rates approved by the Commissioner. M.I.I.F. assessed the Company $3,111 during 2001 and $5,306 for the year ended December 31, 2000 after having no activity for the year ended December 31, 1999. The assessment for 2001 was the result of two insolvencies, The Trust Insurance Company and Reliance Insurance Company, which accounted for assessment amounts of $1,244 and $1,867, respectively. The assessment for 2000 was primarily the result of two insolvencies, The Trust Insurance Company and New England Fidelity Insurance Company, which accounted for assessment amounts of $4,939 and $1,205, respectively, offset by refunds for prior year assessments on numerous insurers' insolvencies.
NOTE R - Commitments
In 2000, Commerce entered into a Limited Partnership Agreement with Conning Partners VI, L.P., a Delaware Limited Partnership. This partnership agreement required a commitment by the Company to invest up to $50,000 into the partnership. To date the Company has invested $15,091 into the partnership leaving a balance for funds still committed but not paid into the partnership of $34,909. The partnership was formed to operate as an investment fund principally for the purpose of making investments primarily in equity, equity-related and other securities issued in expansion financing, start-ups, buy-outs and recapitalization transactions relating to companies in the areas of insurance, financial services, e-commerce, healthcare, and related businesses, including, without limitation, service and technology enterprises supporting such businesses, in order to realize long-term capital returns, all as determined and managed by the General Partner for the benefit of the Partners.
Also in 2000, Commerce entered into a Limited Partnership Agreement with Distribution Partners Investment Capital, L.P. a Delaware Limited Partnership. This partnership agreement required a commitment by the Company to invest up to $3,500 into the partnership. To date the Company has invested $2,258 into the partnership leaving a balance of $1,242 for funds still committed. The partnership was formed to operate as an investment fund principally for the purpose of making investments primarily in equity and equity-related securities of companies operating in the area of insurance distribution and distribution related activities, all as determined and managed by the General Partner for the benefit of the Partners.
NOTE S - Legal Proceedings
As is common with property and casualty insurance companies, the Company is a defendant in various legal actions arising from the normal course of its business, including claims based on Chapter 176D and Chapter 93A. These proceedings are considered to be ordinary to operations or without foundation in fact. Management is of the opinion that these actions will not have a material adverse effect on the consolidated financial position of the Company. In addition to the normal course of business legal actions noted above, the Company is named as defendant in a purported class action lawsuit alleging damages as a result of the alleged diminution of value to vehicles that are involved in accidents. The "diminution of value" theory asserts that the market value of any vehicle involved in an accident inevitably and irreparably declines as a result of such accident, even if all physical damage appears to be repaired completely. This case, entitled "Elena Given, individually and as a representative of all persons similarly situated v. The Commerce Insurance Company", filed in 2001, in the Bristol Superior Court in Massachusetts. The plaintiff has not sought certification of class
THE COMMERCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001, 2000 and 1999 (Thousands of Dollars Except for Per Share Data)
NOTE S - Legal Proceedings (continued)
action status. The Company is vigorously contesting this suit, but is currently unable to estimate the potential exposure. The Company and its outside legal counsel are of the opinion that the Company will prevail in this case. Another Superior Court judge in Massachusetts ruled, in a similar case brought by the same plaintiff counsel against another insurer, that claims for diminution of value are not covered by the Massachusetts automobile insurance policy. Other insurance companies face similar suits in cases outside of Massachusetts.
NOTE T - Quarterly Results of Operations (Unaudited)
An unaudited summary of the Company's 2001 and 2000 quarterly performance is as follows:
SELECTED CONSOLIDATED FINANCIAL DATA
The data below should be read in conjunction with the consolidated financial statements, related footnotes, and other financial information included herein. The financial statements for the five years ended December 31, 2001 have been audited by Ernst & Young LLP. All dollar amounts set forth in the following tables are in thousands, except per share data:
MANAGEMENT'S DISCUSSION OF THE SUPPLEMENTAL INFORMATION ON INSURANCE OPERATIONS (Thousands of Dollars)
The following tables depict the progress of the insurance operations of the Company over the past fifteen years. For these years of operation, net premiums written amounted to $8,358,235. During this period, the aggregate statutory financial ratios were 68.6% for losses and loss expenses and 26.1% for underwriting expenses resulting in an aggregate combined ratio of 94.7%. Total net investment income amounted to $876,134 or 10.5% of net premiums written. Net realized gains were $93,201. Stockholders' equity was $31,461 at the beginning of 1987 and $787,172, at the end of 2001, resulting in an average annual increase in excess of 23.9%, excluding dividends. This figure including dividends paid would have been 26.1%. The progress of the insurance operations during the most recent five year period, compared to the two previous five year periods, can best be illustrated by the following comparison:
The insurance operations of the Company include the operating results of Commerce and Citation, along with Commerce's subsidiary companies, Commerce West and American Commerce. Citation commenced business in 1981 as a wholly-owned subsidiary of Commerce. On December 31, 1989, the ownership of Citation was transferred to The Commerce Group, Inc. In September 1993, ownership of both Commerce and Citation was transferred from The Commerce Group, Inc. to CHI, a subsidiary of The Commerce Group, Inc. Results of Commerce West are included since its acquisition by Commerce on August 31, 1995. Results of American Commerce are included since its acquisition by Commerce on January 29, 1999. The combined balance sheets of these insurance subsidiaries appear on pages 71 and 72. The combined statements of earnings of insurance operations appear on pages 73 and 74. During 2001 certain amounts for years 1996 through 2000 were restated due to the change in accounting for closed-end preferred stock mutual funds to the equity method, reflected as realized gains or losses.
MANAGEMENT'S DISCUSSION OF THE SUPPLEMENTAL INFORMATION ON INSURANCE OPERATIONS (continued)
THE COMMERCE GROUP, INC. AND SUBSIDIARIES COMBINED BALANCE SHEETS OF INSURANCE SUBSIDIARIES December 31, (Thousands of Dollars)
MANAGEMENT'S DISCUSSION OF THE SUPPLEMENTAL INFORMATION ON INSURANCE OPERATIONS (continued)
THE COMMERCE GROUP, INC. AND SUBSIDIARIES COMBINED BALANCE SHEETS OF INSURANCE SUBSIDIARIES December 31, (Thousands of Dollars)
MANAGEMENT'S DISCUSSION OF THE SUPPLEMENTAL INFORMATION ON INSURANCE OPERATIONS (continued)
THE COMMERCE GROUP, INC. AND SUBSIDIARIES COMBINED STATEMENTS OF EARNINGS OF INSURANCE OPERATIONS Years Ended December 31, (Thousands of Dollars)
MANAGEMENT'S DISCUSSION OF THE SUPPLEMENTAL INFORMATION ON INSURANCE OPERATIONS (continued)
THE COMMERCE GROUP, INC. AND SUBSIDIARIES COMBINED STATEMENTS OF EARNINGS OF INSURANCE OPERATIONS Years Ended December 31, (Thousands of Dollars)
Stockholder Information
Annual Meeting
The Annual meeting of stockholders will be held at 9:00 a.m. on Friday, May 17, 2002 at the Company's Underwriting Building, 11 Gore Road (Route 16), Webster, MA.
Form 10-K
Stockholders interested in the detailed information contained in the Company's annual report on Form 10-K, as filed with the Securities and Exchange Commission, may obtain a copy without charge, by writing to the Assistant to the President at 211 Main Street, Webster, MA 01570.
Transfer Agent
The Commerce Group, Inc. c/o Equiserve Trust Company, N.A. P.O. Box 43010 Providence, RI 02940-3010 (781) 575-3100 or (800) 733-5001 http://www.equiserve.com
Executive Offices
211 Main Street Webster, MA 01570 (508) 943-9000
Company Websites
The Commerce Insurance Company http://www.commerceinsurance.com American Commerce Insurance Company http://www.acilink.com Bay Finance Company, Inc. http://www.bayfinance.com
Trading of Common Stock
The Company's Common Stock trades on the NYSE under the symbol "CGI".
Independent Auditors
Ernst & Young LLP 200 Clarendon Street Boston, MA 02116 (617) 266-2000 http://www.ey.com