ITEM 1. BUSINESS
GENERAL
20th Century Industries is an insurance holding company founded in 1958 and incorporated in California. The term "Company," unless the context requires otherwise, refers to 20th Century Industries and its wholly owned subsidiaries, 20th Century Insurance Company and 21st Century Casualty Company, both of which are incorporated in California as property and casualty insurance companies and licensed in California, Nevada, Oregon and Washington. The Common Stock of the Company is traded on the New York Stock Exchange under the trading symbol "TW."
The Company, through its subsidiaries, directly markets and underwrites private passenger automobile, homeowners and personal umbrella insurance. As a direct response writer, the Company has gained a reputation for excellent customer service and being among the most efficient and low cost providers of personal insurance in the markets it serves.
Historically, the Company's business has been concentrated in Southern California, principally the greater Los Angeles and Orange County areas. In the mid-1980's, however, the Company began expanding into the San Diego area, and in the early 1990's, the Northern California area. In August 1996, 20th Century Insurance Company of Arizona ("20th of Arizona") began writing private passenger automobile insurance in that state. 20th of Arizona is a joint venture between the Company, which owns a 49% interest, and American International Group, Inc. ("AIG"), which owns a 51% interest. AIG currently owns a majority interest in the Company. In December 1998, the Company further expanded its operations and began writing private passenger automobile policies independently in Nevada, Oregon and Washington.
The Company began providing homeowners insurance in 1982 and condominium insurance in 1989. A portion of policies issued or renewed prior to July 23, 1994 included optional earthquake coverage endorsements. In the wake of the Northridge Earthquake which occurred in the San Fernando Valley area of Southern California on January 17, 1994 , the Company's writings in these lines were reduced in the period 1994 to 1998. In compliance with an order by the California Department of Insurance in June 1994, the Company immediately began to non-renew
earthquake coverage endorsements and to cease writing new homeowners and condominium policies. The order also required the Company to begin non-renewing all homeowners and condominium policies effective July 23, 1996.
In late 1996, the Company obtained permission to renew its remaining homeowners policies effective February 15, 1997. As of that date, approximately 68,000 homeowners insurance policies remained in force. The condominium program was fully discontinued as of July 23, 1997. The Company is complying with California's requirement to offer earthquake coverage to its remaining homeowners customers through a separate residential earthquake insurance policy underwritten and issued by American Home Assurance Company, a subsidiary of AIG. The Company is not currently authorized by the California Insurance Commissioner to offer homeowners insurance to new or former customers. Although the Company has initiated discussions to obtain that authorization, it is unable to predict if or when the California Insurance Commissioner will grant the Company's request. The Company's reentry into the homeowners market is a strategy intended to complement its auto business and facilitate growth in that line.
LIMITS OF INSURANCE COVERAGE
The Company offers the following insurance coverages for private passenger automobiles: bodily injury liability; property damage; medical payments; uninsured and underinsured motorist; rental reimbursement; uninsured motorist property damage and collision deductible; towing; comprehensive and collision. Policies are written for a six-month term. Various limits of liability are underwritten with maximum limits of $500,000 per person and $500,000 per accident. The most frequent bodily injury liability limits purchased are $100,000 per person and $300,000 per accident.
The homeowners program utilizes an extended replacement cost policy, thereby limiting loss to 150% of the amount specified in the contract for Coverage A - Dwelling and Other Building Structures. Underwriting guidelines provide for a minimum dwelling amount of $65,000 and a maximum dwelling amount of $500,000. Personal liability coverage limits of $100,000, $200,000 and $300,000 are available.
The personal umbrella policy ("PUP") is written by 20th Century Insurance Company and provides liability coverage with a limit of $1,000,000 in excess of the underlying automobile and homeowners liability coverage. Minimum underlying automobile limits of $100,000 per person and $300,000 per accident are required while homeowners must have a minimum of $100,000 personal liability coverage. The underlying automobile coverage must be written by the Company.
MARKETING
The Company markets its policies directly to customers, without utilizing or engaging outside agents or brokers, using direct mail, print, radio, television and internet advertising. Quotes may be requested 24 hours a day, 7 days a week through a convenient toll-free 800 number. Prospective California policyholders may also obtain an instant rate quotation on the Company's internet site (http://www.20thCenturyInsurance.com). Traffic to the Company's internet site continues to increase, offering visitors an additional way to request a rate quotation, amend their policy, or obtain information about the Company.
Throughout 1998, the Company actively advertised in California's major metropolitan markets (Los Angeles and Orange Counties, the Inland Empire, the Bay Area, San Diego, Sacramento, Fresno and Bakersfield). Automobile quotations increased 22% over the prior year while the number of vehicles insured on new policies increased 24 % over the prior year.
The Company continues to increase penetration in the Sacramento and Bay Area markets, generating approximately 57% more new business from these two markets in 1998 than in 1997. Approximately 52% of all new business written in 1998 came from outside the Los Angeles/Orange County areas.
UNDERWRITING AND PRICING
The regulatory system in California requires the prior approval of insurance rates and forms. Within this regulatory framework, the Company establishes its automobile and homeowners premium rates based primarily on actuarial analyses of its own historical premium, loss and expense data. These data are compiled and analyzed to establish overall rate levels as well as classification differentials. The Company's rates are established at levels intended to generate underwriting profits and vary for individual policies based on a number of rating characteristics. The primary characteristics include, by statute in California, driving record, annual mileage and number of years the driver has been licensed. A number of other "optional" rating factors are also permitted in California.
The Company is required to offer insurance to any California prospect who meets the statutory definition of a "Good Driver." This definition includes all drivers who have been licensed more than three years and have had no more than one violation point count under criteria contained in the California Vehicle Code. These criteria include a variety of moving violations and certain at- fault accidents.
Effective January 1, 1999, the Company instituted a five-year guaranteed renewal feature for new and renewed business meeting certain conditions. This new feature is not a price guarantee.
The Company reviews many of its automobile policies prior to the time of renewal and as changes occur during the policy period. The customer may contact the Company to make changes, such as the addition or deletion of drivers or vehicles, changes in the classification of drivers or usage of vehicles, changes in garaging location and changes in coverages or limits. Some mid-term changes may result in premium adjustments and some may result in the policy being re-underwritten and eventually not renewed because of a substantial increase in risk.
With respect to the homeowners renewal program which started on February 15, 1997, underwriting procedures include a review of claims and identification of changes in circumstances that may warrant premium adjustments or cancellation of coverage in the case of a substantial increase in risk.
SERVICING OF BUSINESS
The Company continues to adapt its technological capabilities in keeping with its business strategies. Computerized systems provide the information resources, telecommunications and data processing capabilities which support the technical needs of the Company. In addition to providing ongoing support, the systems provide the strategic capabilities necessary to manage the Company's business. During 1997, the Company began the process of significantly upgrading its technology infrastructure and replacing aging information systems with newer, more flexible systems. This transition will take several more years to complete. In 1998, business operations supporting the states of Washington, Oregon and Nevada commenced using this new infrastructure. As of January 1, 1999, the Company's internal administrative processes, such as payroll and accounting, have been successfully converted to the new systems.
In November 1998, the Company completed the testing of its internal systems to ensure they are Year 2000 ("Y2K") compliant. During 1999, the Company expects to complete the Y2K compliance certification of its significant external suppliers and internal facilities and equipment that may contain imbedded technology with Y2K compliance issues. A contingency plan will be in place to ensure continued service to policyholders in the event of an unforeseen or uncontrollable failure (discussed in more detail in Management's Discussion and Analysis, Impact of Year 2000).
CLAIMS
Claims operations include the receipt and analysis of initial loss reports, assignment of legal counsel, when necessary, and management of the settlement process. Whenever possible, physical damage claims are handled through the use of Company drive-in claims facilities, vehicle inspection centers and Direct Repair Program ("DRP") providers. The claims management staff administers the claims settlement process and oversees the work of the legal and adjuster personnel involved in that process. Each claim is carefully analyzed to provide for fair loss payments, compliance with the Company's contractual obligations and management of loss adjustment expenses. Liability and property damage claims are handled by specialists in each area.
The Company utilizes its legal staff to handle most aspects of claims litigation, including trial, from offices in Brea, Ontario, Long Beach, San Diego and Woodland Hills. In-house attorneys handle approximately 70% of all lawsuits. Suits which may involve a conflict of interest are assigned to outside counsel.
Recognizing the need to provide its customers with convenient, local service, the Company has established eleven Division Service Offices in Los Angeles, Orange, San Diego and Ventura Counties and the San Francisco Bay Area. Each Division Service Office is a full service center, normally staffed with between seventy-five and one hundred employees who provide complete claims services from initial investigation to final settlement.
The Company makes extensive use of its DRP to expedite the repair process. The program involves agreements between the Company and over 130 independent repair facilities. The Company agrees to accept the estimate for damages prepared by the repair facility without requiring each vehicle to be inspected by staff adjusters. The facilities selected undergo a screening process before being accepted, and the Company maintains an aggressive reinspection program to assure quality results; the Company's reinspection team visits all repair facilities each month and reinspects approximately 40% of all repairable vehicles in this program. The customer benefits by getting the repair process started faster, and the repairs are guaranteed for as long as the customer owns the vehicle. The Company benefits by not incurring the overhead expense of a larger staff of appraisers and by negotiating repair rates it believes are beneficial. Currently, over 30% of all damage repairs are handled using the DRP method.
The Company has three vehicle inspection centers located in Los Angeles and Orange Counties. Each vehicle inspection center is staffed with between fifteen and twenty employees who handle total losses, total thefts and vehicles which are not driveable.
The Claims Services Division employs approximately 100 people who are responsible for subrogation, medical payment claims and workers' compensation claims arising under the homeowners policies.
The Company also maintains a Special Investigations Unit with approximately 40 personnel who investigate suspected fraudulent claims. The Company believes its efforts in this area have been responsible for saving several million dollars annually.
The Homeowners Division processes all homeowners property claims on a regional basis and is made up of two units of approximately twelve employees each. The units are located in Brea and Woodland Hills.
LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
The Company establishes reserves, or liabilities, at each accounting date for losses and loss adjustment expenses arising from claims, both reported and unreported, which have been incurred but which remain to be paid. Such reserves are estimates, as of a particular date, of the amount the Company will ultimately pay, net of any recoverable salvage and subrogation, for claims incurred as of the accounting date.
"Case basis" reserves are established for bodily injury liability and uninsured motorist claims which are either expected to exceed $15,000 or are older than two years. Such case reserves are based on the specific circumstances of the claim.
Case reserves for other bodily injury and uninsured motorists claims and for all other coverages are established at an average case reserve value. These average values are based on a review of prior claims payments for each coverage.
The Company supplements the case basis reserve estimates with bulk loss reserves estimated using actuarial methodologies. These reserves are designed to provide for claims incurred but not reported ("IBNR") to or recorded by the Company as of the accounting date, changes over time in case reserve estimates, and loss adjustment expenses which include estimates of the legal and other costs of settling claims. The actuarial estimates utilize the Company's own historical loss experience and are reviewed each quarter. The effects of inflation are implicitly considered in the
actuarial estimates, and the Company does not discount its reserves to present value for financial reporting purposes.
Reserve estimates are necessarily subject to the impact of future changes in economic and social conditions. Management believes that, given the inherent variability in any such estimates, the aggregate reserves are within a reasonable and acceptable range of adequacy. The methods of making such estimates and for establishing the resulting reserves are reviewed and updated quarterly and any adjustments resulting therefrom are reflected in earnings currently.
A rollforward of loss and loss adjustment expense reserves, including the effects of reserve changes, loss payments, and reinsurance for each of the three years in the period ended December 31, 1998, is presented in Note 8 of the Notes to Consolidated Financial Statements.
The following table presents the development of loss and loss adjustment expense reserves, net of reinsurance, for the years 1988 through 1998. The top line of the table shows the reserves at the balance sheet date, net of reinsurance recoverables, for each of the years indicated. The upper portion of the table indicates the cumulative amounts paid as of subsequent year-ends with respect to that reserve liability. The lower portion of the table indicates the re-estimated amount 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 estimates change as more information becomes known about the frequency and severity of claims for individual years. A redundancy (deficiency) exists when the original reserve estimate is greater (less) than the re-estimated reserves. The deficiencies shown in the 1994, 1995 and 1997 columns, and the smaller redundancy shown in the 1996 column, result from the additional earthquake losses and loss adjustment expenses recorded subsequent to 1994. The impact on the redundancy or deficiency shown is $164.75 million for 1994, $104.75 million for 1995, $64.75 million for 1996 and $40 million for 1997.
Each amount in the preceding table includes the effects of all changes in amounts for prior periods. The table does not present accident year or policy year development data. Conditions and trends that have affected the development of liabilities in the past may not necessarily occur in the future. Therefore, it would not be appropriate to extrapolate future deficiencies or redundancies based on the table.
In the consolidated balance sheet, the reserves for losses and loss adjustment expenses are shown "gross," that is, before reduction for reinsurance. The table which follows presents the development of gross losses and loss adjustment expense reserves for calendar years 1996 through 1998. As in the ten-year table presented net of reinsurance, each amount in the following table includes the effects of all changes in amounts for prior periods. The table does not present accident year or policy year development data and it would not be appropriate to extrapolate future development based on this table.
The redundancies indicated above result from the additional earthquake losses and loss adjustment expenses recorded subsequent to 1994.
OPERATING RATIOS
Combined Ratios
Underwriting profit margins are measured by the extent to which the combined ratios (loss and loss adjustment expense ("LAE") ratio and underwriting expense ratio) are less than 100% of premium
revenues. Combined ratios are used to measure the underwriting success of property and casualty insurance companies. Losses and loss adjustment expenses are stated as a percentage of premiums earned because losses may occur over the life of a particular insurance policy. An important indicator of operating efficiency, the underwriting expense ratio is based on premiums written for statutory accounting practices ("SAP") and earned premiums for reporting under generally accepted accounting principles ("GAAP"). The loss and LAE ratios, underwriting expense ratios (excluding interest and fees), and combined ratios for the Company's subsidiaries, on a SAP and GAAP basis, are shown in the following tables.
The effects of the Northridge Earthquake and other non-recurring charges (accelerated amortization of restricted stock grants in 1998 and Y2K costs in both 1998 and 1997) contributed 6.1 and 3.3 percentage points on both a GAAP and SAP basis to the 1998 and 1997 combined ratios, respectively. In 1996, 1995 and 1994, the Northridge Earthquake contributed 4.7, 2.9 and 85.1 percentage points, respectively, on both a GAAP and SAP basis to the combined ratios. In 1997, most of the improvement in the combined ratio is due to favorable loss trends in the automobile line. In 1998, the loss and LAE ratio for the automobile line increased 0.9% and the underwriting expense ratio increased 1.2%. The Company's underwriting results
and loss ratios by line of business are discussed in more detail in Management's Discussion and Analysis, Underwriting Results, and in Note 17 of the Notes to Consolidated Financial Statements.
Premiums to Surplus Ratio
The following table shows, for the periods indicated, the Company's statutory ratios of net premiums written to policyholders' surplus. Because each property and casualty insurance company has different capital needs, an "appropriate" ratio of net premiums written to policyholders' surplus for one company may not be the same as for another company. While there is no statutory requirement applicable to the Company, guidelines established by the National Association of Insurance Commissioners provide that such ratio generally should be no greater than 3 to 1 on a statutory basis.
The 1994 and 1995 ratios were high because of surplus strain caused by the Northridge Earthquake. Capital infusions in 1994 and a return to profitable operations in 1995 resulted in improved surplus levels that reduced the ratio below 3 to 1 in 1995 and below 2 to 1 in 1996, 1997 and 1998.
INVESTMENTS AND INVESTMENT RESULTS
The Company's investment guidelines emphasize buying high-quality, fixed income investments. The Investment Committee of the Company's Board of Directors regularly reviews these guidelines and the performance of the portfolio. Because of the net operating loss ("NOL") carryforwards available for tax purposes, the Company's investment strategy emphasized taxable securities to maximize overall cash flow following the Northridge Earthquake in 1994 until the fourth quarter of 1998, by which time the NOL had
been substantially reduced. While the Company does not invest with a view to achieving realized gains, securities are bought and sold in order to meet the main objectives of the investment portfolio. These objectives are to maximize after-tax investment income and total investment returns while minimizing credit and liquidity risk. The Company currently has designated all of its portfolio as "available-for-sale."
The following table summarizes investment results for the five most recent years:
Investment income and average invested assets increased in 1998 compared to 1997 due to cash flow from operations and $145.6 million received from AIG in the third quarter of 1998 for the exercise of warrants to purchase common stock of the Company (see Note 12 of the Notes to Consolidated Financial Statements). The decline in the investment portfolio from 1994 through 1997 resulted largely from the sale
of investments to generate cash to cover the severe losses and other ongoing expenses resulting from the Northridge Earthquake. The declining after-tax return on investments in the previous table is a result of the shift to taxable securities since 1994; the sale, maturity or early redemption of older securities with high yields; and re-investment in securities with significantly lower yields due to general market conditions. In addition, in 1998, a greater portion of the portfolio was invested in commercial paper for liquidity purposes which yielded a lower return than the portion invested in bonds.
The following table sets forth the composition of the Company's investments and cash and cash equivalents at the dates indicated.
COMPETITION
The property and casualty insurance market is highly competitive and is comprised of a large number of well-capitalized companies, many of which operate in a number of states and offer a wide variety of products. Several of these competitors are larger and have greater financial resources than the Company. Based on earned premium, the Company is the seventh largest writer of private passenger automobile insurance in California.
The Company's main competition comes from other major writers which concentrate on the good driver market. The Company generally has sought to avoid, to the extent regulations permit, the "non-standard," "high-risk" and similar niche market segments.
The Company's marketing and underwriting strategy is to appeal to careful and responsible drivers who deal directly with the Company in order to save significant amounts of money on their insurance premiums. By selling its products directly to the insured, the Company has eliminated agent and broker commissions. The Company relies heavily on its centralized operations and its efficient computerized systems to service its policyholders and claimants.
Consequently, the Company consistently operates with one of the lowest underwriting expense ratios in the industry and is able to maintain its rates among the lowest in the markets it serves while still providing quality service to its customers. As a result, the Company has been able to achieve profitable growth and to maintain policy renewal rates which it believes are significantly above industry averages.
REINSURANCE
A reinsurance transaction occurs when an insurer transfers or cedes a portion of its exposure from direct business written to a reinsurer which assumes that exposure for a premium. The reinsurance cession does not legally discharge the insurer from its liability for a covered loss, but provides for reimbursement from the reinsurer to the insurer for the ceded portion. The Company periodically monitors the continuing appropriateness of all its reinsurance arrangements to determine that its reinsurers maintain high A. M. Best ratings and other indicators of ability to meet their obligations as well as competitive pricing for the risk involved.
The Company's insurance subsidiaries have entered into a five-year quota share reinsurance agreement with an AIG affiliate covering all ongoing lines of business. Under this contract, which attaches to the Company's retained risks net of all other reinsurance, 10% of each subsidiary's premiums earned and losses and loss adjustment expenses incurred in connection with policies incepted during the period January 1, 1995 through December 31, 1999 is ceded. At the end of the five-year period, the AIG affiliate has the option of renewing the agreement annually for four years at declining coverage percentages. A ceding commission of 10.8% was earned by the insurance subsidiaries for 1995 and, thereafter, a commission is paid at a rate equal to the prior year's gross SAP underwriting expense ratio. The ceding commission rate was 9.13%, 9.36% and 9.40% for 1996, 1997 and 1998, respectively.
Since mid-1996, when the homeowners line began to shrink considerably for reasons discussed earlier, the Company has found it more economical to maintain 100% quota share reinsurance arrangements for its homeowners line rather than purchasing alternative reinsurance coverage for its remaining exposure to catastrophes such as fire following earthquake. These reinsurance arrangements are discussed in more detail in Note 10 of the Notes to Consolidated Financial Statements.
The Company has a quota share reinsurance treaty for the PUP whereby 60% of premiums and losses are ceded to the reinsurer. After the effect of the 10% quota share treaty with AIG, the Company effectively retains 36% of the risk for this line.
REGULATION
An insurance company is subject to regulation and supervision by the insurance departments of the states in which it does business. These insurance departments have broad regulatory, supervisory and administrative powers, such as:
- - - Licensing of insurance companies and agents - - - Prior approval of rates, rules and forms - - - Standards of solvency - - - Nature of, and limitations on, insurance company investments - - - Periodic examinations of the affairs of insurers
- - - Annual and other periodic reports of the financial condition and results of operations of insurers - - - Establishment of accounting rules - - - Issuance of securities by insurers - - - Payment of dividends
State regulations are designed principally for the benefit of policyholders. Currently, the California Department of Insurance ("CDOI") has primary regulatory jurisdiction over the Company. In general, the current regulatory requirements in the other states in which the Company is a licensed insurer are no more stringent than in California.
In June 1994, the CDOI ordered the Company to immediately begin non-renewing earthquake coverage endorsements and to cease writing new homeowners and condominium policies and, effective July 23, 1996, to begin non-renewing all its remaining homeowners and condominium policies. On December 23, 1996, the order was amended, permitting the Company to resume renewing its remaining homeowners policies effective February 15, 1997, with the statutorily required offer of earthquake coverage to be made by an affiliate of AIG. The Company continues to seek approval to resume writing new homeowners policies, but there is no assurance the CDOI will grant the Company's request. Inability to write new homeowners policies hinders the Company's efforts to sell automobile insurance to certain consumers who prefer the convenience of having both coverages provided by the same insurer.
The operations of the Company are governed by the laws of the State of California and by the laws of the other states in which it is a licensed insurer. Changes in those laws can affect the revenues and expenses of the Company. In 1998, no new laws were enacted by any such state that are expected to have a material impact on the auto insurance industry.
Ballot Proposition 213 was approved by an overwhelming majority of California voters on November 5, 1996. This proposition bars certain drivers and most uninsured drivers from recovering non-economic damages for injuries they suffer in vehicle accidents. Two lawsuits challenged the constitutionality of the proposition, but the appellate courts in 1997 upheld the proposition's constitutionality. The California Supreme Court in March 1998 denied the petition for review with the plaintiffs thereafter petitioning the
U.S. Supreme Court for writ of certiorari. The petition is still pending as of late March 1999. This proposition has had a beneficial effect on underwriting profit in 1997 and 1998.
The Company anticipates that legislation allowing third parties to bring an independent cause of action for a breach of Unfair Claims Practices regulations and statutes may be introduced in the current legislative session in California. If such legislation were to be enacted, claims costs would increase, which may or may not adversely affect the Company's operating results depending on the Company's ability to pass the increased costs on to its customers through higher rates.
Additionally, the Company anticipates that the California Insurance Commissioner will propose changes to the rating regulations during 1999. There can be no assurance that adoption of such changes would not be detrimental to the Company's future operating results.
The Company is a member of industry organizations which may advocate legislative and initiative proposals and which provide financial support to officeholders and candidates for California statewide public offices. The Company also makes financial contributions to those officeholders and candidates who, in the opinion of management, have a favorable understanding of the needs of the property and casualty insurance industry. In 1998, these contributions were nominal. The Company believes that such contributions are important to the future of the property and casualty insurance industry in California and intends to continue to make such contributions as it determines to be appropriate and in compliance with applicable law.
HOLDING COMPANY ACT
The Company's subsidiaries are also subject to regulation by the CDOI pursuant to the provisions of the California Insurance Holding Company System Regulatory Act (the "Holding Company Act"). Certain transactions defined to be of an "extraordinary" nature may not be effected without the prior approval of the CDOI. Such transactions include, but are not limited to, sales, purchases, exchanges, loans and extensions of credit, and investments made within the immediately preceding 12 months involving in the net aggregate, more than the lesser of (i) 3% of the Company's admitted assets or (ii) 25% of the policyholder's surplus as of the preceding December 31. An extraordinary transaction also includes a dividend which, together with other dividends or distributions made within the preceding twelve months, exceeds the greater of (i) 10% of the insurance company's policyholders' surplus as of the preceding December 31 or (ii) the insurance
company's net income for the preceding calendar year. The California code further provides that property and casualty insurers may pay dividends only from earned surplus. The Holding Company Act generally restricts the ability of any one person to acquire more than 10% of the Company's voting securities without prior regulatory approval.
NON-VOLUNTARY BUSINESS
Automobile liability insurers in California are required to participate in the California Automobile Assigned Risk Plan ("CAARP"). Drivers whose driving records or other relevant characteristics make them difficult to insure in the voluntary market may be eligible to apply to CAARP for placement as "assigned risks." The number of assignments for each insurer is based on the total applications received by the plan and the insurer's market share. With the passage of AB 650 on January 1, 1997, which requires proof of financial responsibility for vehicle registration renewals, the number of drivers applying to CAARP increased, and the Company's share of CAARP assignments grew commensurately from 6,847 vehicles insured at the end of 1996 to 12,133 vehicles at the end of 1997. As of December 31, 1998, assigned risk vehicles insured decreased to 4,485. This is a result of assigned risk participants finding affordable coverage in the voluntary market as well as drivers who dropped out of the program after initially responding to the new legislation. The CAARP assignments have historically produced underwriting losses. As of December 31, 1998, this business represented less than 0.6% of the Company's total gross premiums written.
Insurers offering homeowners insurance in California are required to participate in the California Fair Plan ("Fair Plan"). Fair Plan is a state administered pool of difficult to insure homeowners. Each participating insurer is allocated a percentage of the total premiums written and losses incurred by the pool according to its share of total homeowners direct premiums written in the state. The Company's Fair Plan underwriting results for 1998 were immaterial.
EMPLOYEES
The Company had 2,284 full and part-time employees at December 31, 1998. The Company provides medical, pension and 401(k) savings plan benefits to eligible employees according to the provisions of each plan. The Company believes that its relationship with its employees is excellent, and employee turnover is generally very low.
ITEM 2.
ITEM 2. PROPERTIES
The Company leases its Home Office building in Woodland Hills, California, which contains approximately 230,000 square feet of leasable office space. The lease was amended in April 1998 to extend its term until November 2014. The lease may be renewed for two consecutive five-year periods.
In April 1998, the Company signed an agreement to become the primary tenant of the new 20th Century Plaza project to be completed in late 1999. As part of its goal to maintain centralized operations, five of the Company's outlying offices will be incorporated into the 20th Century Plaza. The project includes the construction of a second office building and a parking structure.
The Company also leases office space in 23 other locations throughout California. The Company anticipates no difficulty in extending these leases or obtaining comparable office facilities in suitable locations.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In the normal course of business, the Company is named as a defendant in lawsuits related to claim issues. Some of the actions request exemplary or punitive damages. These actions are vigorously defended unless a reasonable settlement appears appropriate.
Currently included in this class of litigation are certain actions that arose out of the Northridge Earthquake. It is believed that a majority of these actions were filed to resolve claims involving disputed damages or to contest the applicability of the statute of limitations. While any litigation has an element of uncertainty, the Company does not believe that the ultimate outcome of any pending action will have a material effect on its consolidated financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II -------
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
(A) PRICE RANGE OF COMMON STOCK
The stock is currently traded on the New York Stock Exchange under the trading symbol "TW." The following table sets forth the high and low bid prices for the common stock for the indicated periods.
(B) HOLDERS OF COMMON STOCK
The approximate number of record holders of common stock on December 31, 1998, was 925.
(C) DIVIDENDS
The Company paid cash dividends on its common stock each year since 1973 through the second quarter of 1994. Dividends were resumed in the fourth quarter of 1996. Dividends of $0.05 per share were paid in the first three quarters of 1997 and then doubled to $0.10 per share for the fourth quarter of 1997 and the first quarter of 1998. Dividends increased to $0.16 per share for each of the last three quarters of 1998.
The parent company is dependent upon dividends from its subsidiaries to service debt and pay dividends to its stockholders. Based on 1998 operating results and earned surplus as of December 31, 1998, the Company believes it will not require regulatory approval in 1999 for any extraordinary dividends.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data presented below as of the end of and for each of the years in the five-year period ended December 31, 1998, are derived from the consolidated financial statements of 20th Century Industries and its subsidiaries. The consolidated financial statements as of December 31, 1998 and 1997 and for each of the years in the three-year period ended December 31, 1998, are included elsewhere in this Form 10-K. The earnings per share amounts prior to 1997 have been restated as required to comply with Statement of Financial Accounting Standards No. 128, Earnings Per Share. For further discussion of earnings per share, see Note 3 of the Notes to Consolidated Financial Statements.
All dollar amounts set forth in the following tables are in thousands, except per share data.
In 1998 and 1997, the Company's financial statements include the effects of non-recurring charges of $7.7 million and $1.5 million, respectively. Such charges represent accelerated amortization of restricted stock grants in 1998 and Year 2000 costs in both 1998 and 1997. Additionally, increases in earthquake reserves in 1998 of $40 million, in 1997 of $24.75 million, in 1996 of $40 million and in 1995 of $60 million offset partially by a $32 million reduction in the Proposition 103 liability per an order from the CDOI are also included in the financial statements. In 1994, earthquake-related losses and expenses were $844.1 million. On an after-tax basis, these additional charges reduced (increased) basic earnings (loss) per share by $0.46, $0.33, $0.51, $0.35 and ($10.67) for 1998, 1997, 1996, 1995 and 1994, respectively.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FINANCIAL CONDITION
The Company's financial condition continued to improve in 1998 as shown in the following table:
(1) For 1996, excludes $29.2 million, net of commissions, in homeowners unearned premiums ceded to reinsurers in July 1996. (2) Equity adjusted to exclude unrealized investment gains.
With its strong financial position restored, the Company has positioned itself for renewed and profitable growth. Additionally, the Company's direct exposure to future earthquake events was substantially eliminated in 1995. The Company maintains full insurance protection against its only significant remaining catastrophe exposure in the homeowners line, primarily relating to potential wild fires and fire following an earthquake event.
RESULTS OF OPERATIONS
Units in Force Units in force for the Company's insurance programs as of December 31 were as follows (excluding 15,541, 10,853 and 3,006 in 1998, 1997 and 1996, respectively, of vehicles insured by 20th Century Insurance Company of Arizona):
Information about recent developments relating to units in force within each major coverage line follows.
PRIVATE PASSENGER AUTOMOBILE. Strong unit growth in the auto business remains the Company's priority. Vehicles in force grew by 53,153 in 1998, compared to an increase of 65,267 in 1997. The Company continues to increase its vehicles in force despite intense competition in the automobile insurance market. In view of the favorable trends in loss costs and frequency in 1997 and 1998, the Company lowered overall rate levels approximately 3.4% and 3.2% in 1998 and 1997, respectively, and by an additional 6.8% in February 1999. Through its aggressive marketing efforts and the introduction of rating plans that offer lower rates to its more profitable, preferred customers and higher rates for drivers deemed to be greater risks, the Company has been able to enhance its profitable customer mix. The Company's average customer retention rate was approximately 96% for both 1998 and 1997.
HOMEOWNERS. The Company's position in the homeowners market has always been intended to complement its auto business and facilitate growth in that line. Units in force for the Company's homeowners program declined by 9% from December 31, 1997 to December 31, 1998, mainly due to attrition resulting from the prohibition by the California Department of Insurance against the Company's writing any new homeowners policies. Although the Company continues to seek approval to resume writing new business, it is unable to predict if or when the California Insurance Commissioner will grant the Company's request which, in turn, has a negative impact on customer retention.
PUP. The penetration of this coverage has averaged about 1% of the vehicles in force during each of the three years ended December 31, 1998.
Underwriting Results
Premium revenue and underwriting results for the Company's insurance programs follow, presented in conformity with generally accepted accounting principles ("GAAP"). To facilitate comparability, the effects of the earthquake, non-recurring costs and the Proposition 103 settlement have been isolated from the core business in the tables below.
Automobile - Excluding Non-recurring Costs
Automobile insurance is the primary line of business written by the Company and has been consistently profitable. The majority of the Company's insured autos are located in southern California. However, the Company continues to expand its coverage throughout the state by aggressively marketing its business in northern California and San Diego County, which accounted for approximately 43% of all new business written in 1998.
The auto line experienced a $120.4 million underwriting profit in 1998 compared to $135.6 million and $81 million in 1997 and 1996, respectively, as adjusted for the effects of nonrecurring costs. These results were achieved despite increased competition and the effects of premium rate reductions of 3.2% and 3.4% effective October 31, 1997, and January 1, 1998, respectively. Favorable loss trends contributed to the solid underwriting results in all three years. However, underwriting results for 1998 fell below the 1997 level primarily due to an increase in claims frequency that emerged principally in the fourth quarter and the rate decreases mentioned previously.
The 1998 decrease in gross premiums written reflects the 5.0% increase in insured units coupled with the effect of the premium rate reductions mentioned above. The 1997 decrease in gross premiums written
reflects the 6.5% increase in insured units offset by the effect of the 3.2% premium rate reduction implemented in 1997 and the impact of 1996 rate reductions which were fully felt in 1997.
Including a first quarter 1999 rate reduction of 6.8%, the Company has reduced average California auto premiums by more than 25% since 1996. Although the reduction in premium revenues produced lower top-line and investment income growth, underwriting margins continue to be favorable.
While a growth in business generally indicates the need for an increase in incurred but not reported ("IBNR") reserves, favorable development in older case reserves and the lower frequency and severity of new claims have resulted in the Company making a smaller provision for IBNR reserves than in the past, favorably impacting underwriting results.
Homeowners - Excluding Earthquake
Underwriting results for this program are subject to variability caused by weather-related claims and by infrequent disasters. In 1998, 1997 and 1996, no significant losses were incurred.
Since July 1, 1996, the Company has maintained reinsurance programs to provide coverage for its remaining homeowners policies as discussed in Note 10 of the Notes to Consolidated Financial Statements. The Company had previously maintained separate catastrophe coverage which expired in June 1996. Written premiums ceded in 1998 totaled $24.5 million compared to $24.4 million in 1997 and $10.7 million in 1996 (excluding the $33.3 million portfolio transfer of unearned premium liabilities under the 100% quota share reinsurance agreement).
Personal Umbrella Policy
The personal umbrella program has remained stable over the three-year period ended December 31, 1998, producing approximately $2 million in gross written premiums each year. Underwriting profits for this business can vary significantly with the number of claims which occur infrequently.
Earthquake
Although the Company did not write new or renewal earthquake premiums in 1995 through 1998, the Company assumes a small amount of earthquake premium from the California Fair Plan, a state-administered pool of difficult to insure risks in which insurers are required to participate in proportion to their share of direct written homeowners coverage in the state. As indicated previously, the Company recorded additional provisions for the 1994 Northridge Earthquake in 1998, 1997 and 1996 of $40 million, $24.75 million and $40 million, respectively. The Company remains exposed to possible further upward development in the estimated cost to resolve certain Northridge Earthquake claims. Although management believes current reserves are adequate, the outcome of future events could require changes in previous estimates.
Policy Acquisition and General Operating Expenses
The Company's policy acquisition and general operating expense ratio continues to be among the most competitive in the industry. As a direct writer, the Company does not incur agent commissions and, thus, enjoys an expense advantage over most of its competitors. The ratio of underwriting expenses (excluding interest and fees) to earned premiums was 10.2% in 1998, 9.4% in 1997 and 9.3% in 1996. Excluding non-recurring charges (accelerated amortization of restricted stock grants of $2.0 million in 1998 and "Year 2000" ("Y2K") costs of $5.7 million and $1.5 million in 1998 and 1997, respectively), the expense ratios remained relatively flat at 9.2% in 1998 and 1997 and 9.3% in 1996 despite a decline in premiums earned and an increase in marketing expenses.
Impact of Year 2000
The Y2K problem arose because some computer programs and hardware utilize two digits rather than four to define the applicable year. As a result, these systems, programs and hardware ("Information Technology systems" or "IT systems") may not calculate dates beyond 1999, which may cause errors or system failures. In addition, today's business environment contains many non-IT systems, ranging from elevators to automobiles, which utilize microprocessors, and these devices are also potentially susceptible to the same or similar types of date problems.
The following discussion summarizes the Company's state of readiness, costs to address its Y2K issues, the risks inherent in these issues, and the Company's contingency plans.
State of Readiness The Company has taken what it believes is a comprehensive approach to remediating its Y2K issues, as summarized in the following table:
The Company plans to complete its compliance testing of all critical components in the summer of 1999.
Y2K Remediation Costs The total Year 2000 project cost is estimated to be approximately $8.9 million, which is being expensed as incurred. Approximately one third of that amount represents the direct cost of personnel in the Company's Information Services department who have been dedicated to this project, with most of the remainder representing external consultants. Costs incurred during 1998 were approximately $5.7 million, compared to $1.5 million for 1997.
Risks Without regard to the Company's remediation efforts, given the highly computerized nature of the Company's operations, the Y2K problem would pose a serious risk to the Company's ability to efficiently and effectively service its customers, or to conduct its affairs in a profitable manner. Because of the nature of its operations and the availability of alternate suppliers and service providers, the potential Y2K issues
for the Company in the non-IT area generally are less than for manufacturers or distributors of non-financial products. Apart from written assurances the Company has or expects to receive, the Company can offer no assurances that the impact of the Y2K problem on certain services, such as those provided by third-party electric utilities, will be insignificant or within the Company's ability to correct in a fashion timely enough to avoid any potentially significant adverse impact. Although no remediation plan is capable of foreseeing every possible contingency that could have a potentially significant adverse effect, management is confident that the steps taken to address the Company's Y2K issues will prevent or promptly detect and correct any serious instances of noncompliance that are reasonably within the Company's ability to control.
Contingency Plans For all critical systems within the Company's control, revised contingency plans that take account of the Y2K issue are scheduled to be tested and in place by June 1999. These contingency plans generally cover steps the Company would take, such as use of back-up computer facilities, in the event of a business interruption from a variety of causes, including the remote possibility of an interruption caused by one or more Y2K problems. The Company's contingency planning team is staffed by representatives from all key business departments. Contingency planning currently under development includes the following considerations: - - - Defining a rapid response team including identification of resources and responsibilities at a departmental level; - - - Identifying manual procedures to be implemented until the automated process is recovered, if necessary; - - - For critical suppliers or service providers not expected to be compliant, selecting feasible alternate suppliers; - - - When alternate suppliers are infeasible, addressing any means the Company can take to assist key suppliers in a timely manner; - - - Determining key mission critical contingency plans and testing when feasible before the Year 2000.
Investment Income
Net pre-tax investment income was $75.1 million in 1998 compared to $73.5 million in 1997 and $73.2 million in 1996. Average invested assets increased 5.4% in 1998 compared to decreases of 2.0% and 6.9% in 1997 and 1996, respectively. The increase in 1998 is primarily due to additional cash received from the exercise of AIG's common stock warrants in the third quarter of 1998 as discussed in Note 12 of the Notes to Consolidated Financial Statements. The decline in invested assets for 1997 and 1996 resulted from the decline in net earned premiums and the sale of investments to meet the payment requirements of both developing earthquake losses and reinsurance premiums. The average annual pre-tax yield on invested assets was 6.6% in 1998, 6.7% in 1997 and 6.6% in 1996.
Realized capital gains on the sales of investments increased to $22.6 million for 1998 compared to $4.1 million and $7.3 million for 1997 and 1996, respectively. The 1998 increase in realized gains is primarily due to the Company's decision to begin switching its investment portfolio from taxable to nontaxable securities during 1998 in anticipation of fully utilizing its remaining net operating loss deduction in 1999. At December 31, 1998, $141.4 million of the Company's total investments at fair value was invested in tax-exempt bonds with the balance representing 86.8% of the portfolio invested in taxable securities compared to 97.7% at December 31, 1997.
As of December 31, 1998, the Company had a pre-tax unrealized gain on fixed maturity investments of $34.9 million compared to $29.7 million in 1997 and $3.7 million in 1996. Interest rates fell in 1998 and 1997 which increased the fair value of the bond portfolio for those years.
Liquidity and Capital Resources
Loss and loss adjustment expense payments are the most significant cash flow requirements of the Company. The Company continually monitors loss payments to provide projections of future cash requirements. Additional cash requirements include servicing the bank debt and paying dividends as approved from time to time by the Company's Board of Directors. With the anticipated growth of its core auto business and continued settlement of remaining earthquake losses, the Company expects that future cash flows from operations will continue to be sufficient to fund future expenditures.
The Company has historically written its core business at an underwriting profit and thus each premium dollar generates a positive cash flow. A significant part of the decline in 1996 and subsequent increase in cash flow from operations in 1997 and 1998 is due to the fall and rise, respectively, in the size of the net book of business during these periods. In 1996, approximately $29.2 million of the $32.5 million net decrease in cash and cash equivalents was related to the portfolio transfer of unearned premiums on homeowners business.
Funds required by 20th Century Industries to pay dividends and meet its debt obligations are provided by the insurance subsidiaries. Information regarding the Company's debt service obligation is included in Note 9 of the Notes to Consolidated Financial Statements. The ability of the insurance subsidiaries to pay dividends to the parent company is regulated by state law. Based on the operating results in 1996 and the favorable ratio of premiums to surplus, the Company was able to resume normal dividends from the insurance subsidiaries in 1996 to service the parent's debt and dividend requirements. Based upon 1998 operating results and earned surplus as of December 31, 1998, the Company believes it will not require regulatory approval in 1999 for any extraordinary dividends.
The Company's remaining net operating loss carryforward is expected to be fully utilized during 1999 (see Note 5 of the Notes to Consolidated Financial Statements). As a result, income tax payments will increase in 1999 and future years compared to the years 1994 through 1998. To the extent practicable, the Company's investment portfolio is being switched from taxable to nontaxable securities in order to minimize future tax payments.
In 1997, the Company embarked on a major project to upgrade its technological infrastructure and to conform certain of its procedures to "industry best practices." Although the ultimate cost of this project is not yet determinable, management believes cash flow from operations as well as expected improvements in operational efficiencies will be more than adequate to fund the project's implementation which is expected to be completed over the next several years.
Risk-Based Capital
The National Association of Insurance Commissioners requires property and casualty insurance companies to calculate and report information under a Risk-Based Capital ("RBC") formula in their Annual Statements. The RBC requirements are intended to assist regulators in identifying inadequately capitalized companies. The RBC calculation is based on the type and mix of risks inherent in the Company's business and includes components for underwriting, asset, interest rate and other risks. To the extent that a subsidiary's surplus fell below prescribed levels, it would be the parent company's intention to infuse necessary capital to support that entity. The Company's insurance subsidiaries exceeded their RBC statutory surplus standards by a considerable margin as of December 31, 1998.
Home Office Lease
The Company leases its Home Office building in Woodland Hills, California, which contains approximately 230,000 square feet of leasable office space. The current lease expires in 2014 and may be renewed for two consecutive five-year periods.
In addition, the Company will expand its headquarters to nearly double the size of its current facility in late 1999, the anticipated completion date of construction of the new 20th Century Plaza. The company has signed a 15-year lease expiring in November 2014, which may be renewed for two consecutive five-year periods.
Forward-Looking Statements
The Company's management has made in this report, and from time to time may make in its public filings and press releases as well as in oral presentations and discussions, forward-looking statements concerning the Company's operations, economic performance and financial condition. Forward-looking statements include, among other things, discussions concerning the Company's potential expectations, beliefs, estimates, forecasts, projections and assumptions. Forward-looking statements are subject to risks and uncertainties. Actual results could differ materially from those anticipated by forward-looking statements due to a number of important factors including, but not limited to, those discussed elsewhere in this report and in the Company's other public filings, press releases, oral presentations and discussions and
the following: (a) the intensity of competition from other companies in the insurance industry; (b) the Company's experience with respect to persistency and claims experience; (c) the Company's ability to distribute and administer competitive services in a timely, cost-effective manner; (d) the Company's visibility in the market place and its financial and claims-paying ratings; (e) the effect of changes in laws and regulations affecting the Company's business, including changes in tax laws affecting insurance products; (f) market risks related to interest rates; (g) the Company's ability to develop information technology and management information systems to support strategic goals while continuing to control costs and expenses; (h) the costs of defending litigation and the risk of unanticipated material adverse outcomes in such litigation; (i) changes in accounting and reporting practices; and (j) the Company's access to adequate financing to support its future business. The Company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. For additional information, refer to the Company's filings with the Securities and Exchange Commission.
ITEM 7a.
ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and interest rates. In addition to market risk, the Company is exposed to other risks, including the credit risk related to its financial instruments and the underlying insurance risk related to its core business. The first column in the following table shows the financial statement carrying values of the Company's financial instruments. The Company's investment portfolio is carried at fair value; the fair value of the Company's variable-rate bank loan payable is presumed to equal its carrying value. The second column shows the effect on current carrying values and estimated fair values assuming a 100 basis point increase in market interest rates and a 10% decline in equity prices. The following sensitivity analysis summarizes only the exposure to market risk as of December 31, 1998.
Because the Company historically has generated an underwriting profit, its cash flow from operations and short term cash position generally is more than sufficient to meet its obligations for claim payments, which by the nature of the personal automobile insurance business tend to have an average duration of less than a year. As a result, the Company generally has the ability to hold its investments to maturity, and it has been unnecessary for the Company to employ elaborate market risk management techniques involving complicated asset and liability duration matching or hedging strategies. For all its financial assets and liabilities, the Company seeks to maintain reasonable average durations, consistent with the maximization of income without sacrificing investment quality and providing for liquidity and diversifications. Financial instruments are not used for trading purposes.
The sensitivity analysis provides only a limited, point-in-time view of the market risk sensitivity of the Company's financial instruments. The actual impact of market interest rate and price changes on the financial instruments may differ significantly from those shown in the analysis. This analysis is further limited as it does not consider any actions the Company could take in response to actual and/or anticipated changes in interest rates and equity prices.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT AUDITORS
Stockholders and Board of Directors 20th Century Industries
We have audited the accompanying consolidated balance sheets of 20th Century Industries and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of 20th Century Industries and subsidiaries at December 31, 1998 and 1997, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
ERNST & YOUNG LLP
Los Angeles, California January 22, 1999
See accompanying notes to financial statements.
See accompanying notes to financial statements.
See accompanying notes to financial statements.
See accompanying notes to financial statements.
See accompanying notes to financial statements.
20TH CENTURY INDUSTRIES AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998
NOTE 1. DESCRIPTION OF BUSINESS
20th Century Industries, through its wholly owned subsidiaries, 20th Century Insurance Company and 21st Century Casualty Company (collectively, the "Company"), is engaged in the sale of private passenger automobile insurance policies in California, Nevada, Oregon and Washington and homeowners and personal umbrella insurance policies in California. At this time, almost all of the Company's business is concentrated in California. The Company also provides private passenger automobile insurance in Arizona through a joint venture with American International Group, Inc. ("AIG"), which owned a majority of the Company's outstanding common stock at December 31, 1998. An order from the California Department of Insurance ("CDOI") has prohibited the Company from writing any new homeowners policies since June 1994, and beginning in July 1996, the Company was required to begin non-renewing these policies. Effective February 15, 1997, the CDOI allowed the Company to resume renewing its remaining homeowners policies.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Consolidation and Presentation
The accompanying consolidated financial statements include the accounts and operations of 20th Century Industries and its wholly owned subsidiaries. All material intercompany accounts and transactions have been eliminated. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP") which differ from statutory accounting practices ("SAP") prescribed or permitted by insurance regulatory authorities. The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from these estimates.
Investments
The Company classifies its investment portfolio as available-for-sale and carries it at fair value with unrealized gains and losses, net of any tax effect, reported as accumulated other comprehensive income in a separate component of stockholders' equity.
Fair values for fixed maturity and equity securities are based on quoted market prices. The cost of investment securities sold is determined by the specific identification method.
The Company's 49% interest in 20th Century Insurance Company of Arizona, which is a joint venture between the Company and AIG and which began operations in August 1996, has a carrying value of $3,656,000 at December 31, 1998, and is included in other assets in the consolidated balance sheet. The Company's equity in the 1998, 1997 and 1996 net loss of this venture amounted to $373,000, $656,000 and $186,000, respectively, and is included in investment income in the consolidated statements of income.
Cash and Cash Equivalents
Cash and cash equivalents include cash and short-term investments in demand deposits having a maturity of three months or less at the date of purchase.
Recognition of Revenues
Insurance premiums are recognized as revenue pro rata over the terms of the policies. The unearned portion is included in the balance sheet as a liability for unearned premiums.
Losses and Loss Adjustment Expenses
The estimated liabilities for losses and loss adjustment expenses include the accumulation of estimates of losses for claims reported prior to the balance sheet dates, estimates (based upon actuarial analysis of historical data) of losses for claims incurred but not reported and estimates of expenses for investigating and adjusting all incurred and unadjusted claims. Amounts reported are estimates of the ultimate costs of settlement, net of estimated salvage and subrogation, which are necessarily subject to the impact of future changes in economic and social conditions. Management believes that, given the inherent variability in any such estimates, the aggregate reserves are within a
reasonable and acceptable range of adequacy. The methods of making such estimates and for establishing the resulting reserves are reviewed and updated quarterly and any adjustments resulting therefrom are reflected in current earnings.
Reinsurance
In the normal course of business, the Company seeks to reduce the loss that may arise from catastrophes and to reduce its overall risk levels by reinsuring certain areas of exposure with other insurance enterprises or reinsurers. Reinsurance premiums and reserves on reinsured business are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Amounts applicable to ceded unearned premiums and ceded claim liabilities are reported as assets in the accompanying balance sheets. The Company believes that the fair value of its reinsurance recoverables approximates their carrying amounts.
Policy Acquisition Costs
Policy acquisition costs, principally direct and indirect costs related to production of business, are deferred and amortized to expense as the related premiums are earned.
Income Taxes
Deferred income tax assets and liabilities are determined based on the differences between the financial reporting and the tax bases of assets and liabilities and are measured using the enacted tax rates and laws.
New Accounting Standards
Statement of Financial Accounting Standards ("SFAS") No. 130, Reporting Comprehensive Income, became effective in the first quarter of 1998. SFAS No. 130 established rules for the reporting and display of comprehensive income and its components; however, the adoption of this Statement had no impact on the Company's net income or stockholders' equity. Essentially, under SFAS No. 130, the new label "accumulated other comprehensive income" has replaced that of the former "unrealized investment gains, net" in the stockholders' equity section of the consolidated balance sheet. Also, the consolidated statement of stockholders' equity has been reformatted to conform to the requirements of SFAS No. 130.
In 1997, the Financial Accounting Standards Board also issued SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, which became effective on December 31, 1998. This Statement did not require disclosure of any significant information beyond that previously provided in the Company's annual financial statements.
NOTE 3. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings per share:
NOTE 4. INVESTMENTS
A summary of net investment income is as follows:
A summary of realized investment gains and losses before income taxes is as follows:
The amortized cost, gross unrealized gains and losses, and fair values of investments as of December 31, 1998 and 1997 are as follows:
The amortized cost and fair value of the Company's fixed maturity investments at December 31, 1998 are summarized, by contractual maturity, as follows:
Expected maturities of the Company's investments may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
Details follow concerning the change in the after-tax net unrealized gain on investments for 1998, 1997, and 1996, which is included in the accumulated other comprehensive income in the consolidated balance sheets:
NOTE 5. FEDERAL INCOME TAXES
Federal income tax expense consists of:
The Company's net deferred income tax asset is comprised of:
Ordinarily, the Company's principal deferred tax assets arise from the discounting of loss reserves for tax purposes, which delays a portion of the loss deduction, and from the acceleration of 20% of the unearned premium reserve into taxable income before it is earned. During 1998, the
Company utilized net operating loss carryforwards of $115,000,000 to reduce taxable income. As of December 31, 1998, the Company has a net operating loss carryforward of approximately $156,000,000 for regular tax purposes expiring in the year 2009 and an alternative minimum tax credit carryforward of $16,929,000. Alternative minimum tax credits may be carried forward indefinitely to offset future regular tax liabilities. The Company expects the net operating loss carryforward to be fully utilized during 1999.
The Company is required to establish a "valuation allowance" for any portion of the deferred tax asset that management believes will not be realized. The Company believes that because of its historically strong earnings performance, and tax planning strategies available, it is more likely than not that the Company will realize the benefit of the deferred tax asset, and therefore, no valuation allowance has been established.
A reconciliation of income tax computed at the federal statutory tax rate, which was 35% for 1996 through 1998, to total income tax expense follows:
Payments for income taxes were $13,661,000, $3,150,000 and $2,367,500 for the years ended December 31, 1998, 1997 and 1996, respectively.
NOTE 6. POLICY ACQUISITION COSTS
Following is a summary of policy acquisition costs deferred for amortization against future income and the related amortization charged to income from operations:
NOTE 7. EMPLOYEE BENEFITS
Pension Plan and Supplemental Executive Retirement Plan
The Company sponsors a non-contributory defined benefit pension plan which covers essentially all employees who have completed at least one year of service. The benefits are based on employees' compensation during all years of service. The Company's funding policy is to make annual contributions as required by applicable regulations. The pension plan's assets consist of high-grade fixed income securities and cash equivalents.
The Company also sponsors an unfunded supplemental executive retirement plan which covers certain key employees designated by the Board of Directors. The supplemental plan benefits are based on years of service and compensation during the last three years of employment, and are reduced by the benefit payable from the pension plan.
The net periodic pension cost for these plans was $4,117,000, $4,012,000 and $3,925,000 in 1998, 1997 and 1996, respectively. Accrued pension costs included in the consolidated balance sheets at December 31, 1998 and 1997 are $3,083,000 and $2,521,000, respectively.
Savings and Security Plan
The Company sponsors a contributory savings and security plan for eligible employees. The Company provides matching contributions equal to 75% of the lesser of 6% of an employee's compensation or the amount contributed by the employee. Contributions charged against operations were $2,728,000, $2,697,000 and $2,556,000 in 1998, 1997 and 1996, respectively.
NOTE 8. LIABILITY FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
The following table provides a reconciliation of the beginning and ending liability for unpaid losses and loss adjustment expenses ("LAE"):
The 1998 increase in provision for insured events of prior years includes $40 million related to the Northridge Earthquake. The 1997 and 1996 decreases in provisions for insured events of prior years is offset by increases in earthquake losses of $24.75 million and $40 million, respectively.
NOTE 9. BANK LOAN PAYABLE
The Company has entered into a revolving credit facility ("the Facility") that provides an aggregate commitment of $112.5 million at December 31, 1998. The commitment decreases by $11.25 million on the first day of each quarter until April 1, 2001. Principal repayments are required when total outstanding advances exceed the aggregate commitment. The Company may prepay principal amounts of the advances, as well as voluntarily cause the aggregate commitment to be reduced at any time during the term of the Facility.
As of December 31, 1998, the Company's outstanding advances against the Facility totaled $112.5 million, which approximates its fair value. Interest is charged at a variable rate based, at the option of the Company, on either (1) the contractually defined Alternate Base Rate ("ABR") plus a margin of 0.25% or (2) the Eurodollar Rate plus a margin of .75%. Margins are adjusted in relation to certain financial and operational levels of the Company. The ABR is defined as a daily rate which is the higher of (a) the prime rate for such day or (b) the Federal Funds Effective Rate for such day plus .5% per annum. Interest is payable at the end of each interest period. The stock of the Company's insurance subsidiaries is pledged as collateral under the Facility. At December 31, 1998, the annual interest rate for the specified interest period was approximately 6.3%. Interest paid was $8,660,000 in 1998, $12,758,000 in 1997 and $9,813,000 in 1996.
NOTE 10. REINSURANCE
Reinsurance contracts do not relieve the Company from its obligations to policyholders. The Company periodically reviews the financial condition of its reinsurers to minimize its exposure to losses from reinsurer insolvencies. It is the Company's policy to hold collateral under related reinsurance agreements in the form of letters of credit for unpaid losses for all reinsurers not licensed to do business in the Company's state of domicile.
The effect of reinsurance on premiums written and earned is as follows (amounts in thousands):
Losses and loss adjustment expenses have been reduced by reinsurance ceded as follows (amounts in thousands):
In connection with an investment agreement executed in 1994 with AIG, each of the Company's insurance subsidiaries entered into a five-year quota share reinsurance agreement with an AIG affiliate to provide coverage for all ongoing lines of business. Under this contract, which attaches to the Company's retained risks net of all other reinsurance, the subsidiaries cede 10% of their premiums earned and losses incurred in connection with policies incepted during the period
January 1, 1995 through December 31, 1999. The majority of the Company's reinsurance receivables are due from the AIG affiliate. At the end of the five-year period, the AIG affiliate may elect to renew the agreement annually at declining coverage percentages. Ceding commissions of 9.40%, 9.36% and 9.13% were earned by the insurance subsidiaries for 1998, 1997 and 1996, respectively. The ceding commission is adjusted annually to equal the prior year's gross SAP underwriting expense ratio.
In 1996, the Company's insurance subsidiaries entered into a 100% quota share reinsurance agreement with F&G Re and Risk Capital Re covering the homeowners line of business. This agreement covers, for a one-year policy term, all business in force as of July 1, 1996 plus renewal business attaching between July 1, 1996 and July 23, 1996, effectively terminating with the expiration of the underlying, one-year policies. Under this contract, 100% of each subsidiary's homeowners unearned premium reserves as of June 30, 1996 were ceded 50/50 to F&G Re and Risk Capital Re, a total of $33.3 million. Additionally, 100% of written premiums and incurred losses and allocated loss adjustment expenses subsequent to June 30, 1996, on covered policies, are ceded under this contract. The Company's insurance subsidiaries earn a commission on ceded premiums based on a sliding scale dependent on the incurred loss ratio. In 1998, 1997 and 1996, the Company earned commissions at a rate of 12.5% on this treaty. Homeowners policies renewed February 15, 1997 and subsequent are covered in full by quota share reinsurance agreements with three reinsurers, as follows: National Union Fire Insurance Co. of Pittsburgh, PA (50%), a subsidiary of AIG, F&G Re (25%) and Risk Capital Re (25%). The Company's insurance subsidiaries earn a commission on ceded premiums based on a sliding scale dependent on the incurred loss ratio. The Company earned commissions at a rate of 14% on this treaty for 1998 and 1997.
The Company has a quota share treaty for its Personal Umbrella Policy line of business whereby it cedes 60% of premiums and losses. After the effect of the 10% quota share treaty with AIG discussed earlier, the Company effectively retains 36% of the risk for this line of business.
NOTE 11. LEASE COMMITMENTS
The Company leases office space in a building in Woodland Hills, California. The lease was amended in April 1998 to extend its term until November 2014. The lease may be renewed for two consecutive five-year periods. The Company also leases office space in several other locations throughout California, primarily for claims servicing.
In April 1998, the Company signed an agreement to become the primary tenant of a new office tower adjacent to its headquarters to be completed in late 1999. The new building will nearly double the size of its current facility to total almost 500,000 square feet. This lease expires in November 2014 and may be renewed for two consecutive five-year periods.
Minimum rental commitments under the Company's lease obligations are as follows:
Rental expense charged to operations for the years ended December 31, 1998, 1997 and 1996 was $12,879,000, $11,969,000 and $11,243,000, respectively.
NOTE 12. STOCKHOLDERS' EQUITY
During the third quarter of 1998, AIG exercised 16 million warrants to purchase shares of common stock at a price of $9.10 per share, which increased the Company's stockholders' equity by $145.6 million. AIG also tendered 224,950 shares of Series A preferred stock for conversion to 19,854,368 shares of common stock. As a result of these transactions, as well as additional common stock purchases, AIG now owns a majority interest in the Company.
The Company's insurance subsidiaries are subject to restriction as to the amount of dividends which may be paid to the parent company within any one year without the approval of the California Department of Insurance ("CDOI"). The California Insurance Code provides that amounts may be paid as dividends from earned surplus on an annual, noncumulative basis, without prior approval by the CDOI, up to the greater of (1) net income for the preceding year, or (2) 10% of statutory surplus as regards policyholders as of the preceding December 31. Earned surplus available for dividends as of December 31, 1998 was approximately $228.7 million.
Surplus of the insurance subsidiaries on a statutory basis at December 31, 1998 and 1997 was $600,654,000 and $548,043,000, respectively. Statutory net income for the insurance subsidiaries was $154,916,000, $178,727,000 and $121,780,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
NOTE 13. STOCK-BASED COMPENSATION
The Company has two separate stock compensation plans: the 1995 Stock Option Plan, which provides for grants of stock options to key employees and non-employee directors of the Company, and the Restricted Shares Plan, which provides for stock grants to key employees.
The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25") and related Interpretations in accounting for its stock-based compensation. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. Also, under APB 25, the fair value of stock grants made under the Restricted Shares Plan is amortized to expense over the vesting period of the grants. This accounting treatment results in compensation expense being recorded in a manner consistent with that required under SFAS No. 123, Accounting for Stock-Based Compensation, and, therefore, pro forma net income and earnings per share amounts would be unchanged from those reported in the financial statements. SFAS No. 123 requires disclosure of the pro forma net income and earnings per share as if the Company had accounted for its employee stock compensation under the fair value method of that Statement.
1995 Stock Option Plan
The aggregate number of common shares issued and issuable under the Plan currently is limited to 4,000,000. At December 31, 1998, 2,219,250 common shares remain available for future grants. All options granted have ten year terms. As a consequence of AIG's acquiring a controlling interest in the Company, vesting was accelerated for all options granted as of July 27, 1998. Options granted after July 27, 1998, vest over various future periods.
Exercise prices for options outstanding at December 31, 1998 ranged from $12.50 to $29.25. The weighted-average remaining contractual life of those options is 8.3 years.
A summary of the Company's stock option activity and related information follows:
The Company's pro forma information using the Black-Scholes valuation model follows:
For pro forma disclosure purposes, the fair value of stock options was estimated at each date of grant using a Black-Scholes option pricing model using the following assumptions: Risk-free interest rates of 5.02% to 5.65% for 1998, 6.23% to 6.67% for 1997 and 6.51% to 6.54% for 1996; dividend yields ranging from 1.98% to 2.33% in 1998, 1.14% to 1.44% in 1997 and 1.0% to 1.3% in 1996; volatility factors of the expected market price of the Company's common stock of .23, .27 and .39 for 1998, 1997 and 1996, respectively; and a weighted-average expected life of the options of 8 years in 1998, 8 years in 1997 and 10 years in 1996.
In management's opinion, existing stock option valuation models do not provide an entirely reliable measure of the fair value of non-transferable employee stock options with vesting restrictions.
Restricted Shares Plan
The Restricted Shares Plan currently provides for grants of up to 921,920 shares of common stock to be made available to key employees as determined by the Key Employee Incentive Committee of the Board of Directors. The common shares granted are restricted. Restrictions are removed on 20% of the shares of each employee on January 1 of each of the five years following the year of grant. Upon issuance of grants of common shares under the plan, unearned compensation equivalent to the market value on the date of grant is charged to common stock and subsequently amortized in equal monthly installments over the five-year vesting period of the grant. As a consequence of AIG's acquiring a controlling interest in the Company, the previously unamortized balance of $2,280,000 was recognized as a charge to income as of July 27, 1998. Total amortization
expense relating to the Restricted Shares Plan was $2,698,000, $534,900 and $365,500 in 1998, 1997 and 1996, respectively.
A summary of grants under the plan from 1996 through 1998 follows:
NOTE 14. LITIGATION
In the normal course of business, the Company is named as a defendant in lawsuits related to claim issues. Some of the actions request exemplary or punitive damages. These actions are vigorously defended unless a reasonable settlement appears appropriate.
Currently included in this class of litigation are certain actions that arose out of the Northridge Earthquake. It is believed that a majority of these actions were filed to resolve claims involving disputed damages or to contest the applicability of the statute of limitations. While any litigation has an element of uncertainty, the Company does not believe that the ultimate outcome of any pending action will have a material effect on its consolidated financial condition or results of operations.
NOTE 15. NORTHRIDGE EARTHQUAKE
The Northridge Earthquake, which occurred on January 17, 1994, significantly affected the operating results and the financial position of the Company. Provisions charged to income for this event amounted to $40 million, $24.75 million and $40 million in 1998, 1997 and 1996, respectively.
NOTE 16. UNAUDITED QUARTERLY RESULTS OF OPERATIONS
The summarized unaudited quarterly results of operations were as follows:
The quarterly earnings per share amounts do not necessarily add to annual amounts due to the changing dilutive effect of common stock equivalents as the price of the common stock fluctuates.
Additional Northridge Earthquake reserves of $40 million were recorded in the fourth quarter of 1998. The second and fourth quarters of 1997 were also impacted by additional reserves of $6.75 million and $18 million, respectively, related to the 1994 Northridge Earthquake.
NOTE 17. RESULTS OF OPERATIONS BY LINE OF BUSINESS
The following table presents premium revenue and underwriting profit (loss) for the Company's insurance lines on a GAAP basis for the years ended December 31.
AUTO. The $21.4 million decrease in underwriting profit in 1998 compared to 1997 resulted from increased competition, an increase in claims frequency that emerged principally in the 1998 fourth quarter, and premium rate reductions of 3.2% and 3.4% effective October 31, 1997, and January 1, 1998, respectively. In addition, non-recurring costs for accelerated amortization of restricted stock grants of $2.0 million were recorded in 1998 as well as Year 2000 costs of $5.7 million and $1.5 million in 1998 and 1997, respectively. The $53.1 million increase in underwriting profit in 1997 compared to 1996 was largely the result of growth in the number of vehicles in force, relatively dry weather, and a continued strong decline in claim frequencies and severities.
HOMEOWNERS. The 1998, 1997 and 1996 underwriting losses in these lines included respective provisions for additional earthquake reserves of $40 million, $24.75 million and $40 million, respectively. Also affecting the three years was an overall decline in premium volume resulting from the CDOI's prohibition against the Company's writing of any new business in this line since June 1994.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There have been no disagreements with the Company's independent auditors on any matters of accounting principles or practices, financial statement disclosure or auditing scope or procedure, or any reportable events.
PART III --------
ITEM 10.
ITEM 10. DIRECTORS AND OFFICERS OF THE REGISTRANT
Information in response to Item 10 is incorporated by reference from the Company's definitive proxy statement used in connection with the Company's 1999 Annual Meeting of Shareholders pursuant to Instruction G(3) of Form 10-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information in response to Item 11 is incorporated by reference from the Company's definitive proxy statement used in connection with the Company's 1999 Annual Meeting of Shareholders pursuant to Instruction G(3) of Form 10-K.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information in response to Item 12 is incorporated by reference from the Company's definitive proxy statement used in connection with the Company's 1999 Annual Meeting of Shareholders pursuant to Instruction G(3) of Form 10-K.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information in response to Item 13 is incorporated by reference from the Company's definitive proxy statement used in connection with the Company's 1999 Annual Meeting of Shareholders pursuant to Instruction G(3) of Form 10-K. All related party transactions which require disclosure are included in the Management's Discussion and Analysis or the Notes to Consolidated Financial Statements.
(3) EXHIBITS REQUIRED
The following exhibits required by Item 601 of Regulation S-K and by paragraph (c) of Item 14