-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, GsdgZbeNo/4gvxp0JBXStOhbxv9PqWeargAVf/SZVpTI1kGYHkPTDwiZZPeiqUtc 7waQmYCngLmi1aWG0XPaUA== 0001015402-02-003440.txt : 20021025 0001015402-02-003440.hdr.sgml : 20021025 20021024202747 ACCESSION NUMBER: 0001015402-02-003440 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20020930 FILED AS OF DATE: 20021025 FILER: COMPANY DATA: COMPANY CONFORMED NAME: 21ST CENTURY INSURANCE GROUP CENTRAL INDEX KEY: 0000100331 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 951935264 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-10828 FILM NUMBER: 02797915 BUSINESS ADDRESS: STREET 1: 6301 OWENSMOUTH AVE STE 700 CITY: WOODLAND HILLS STATE: CA ZIP: 91367 BUSINESS PHONE: 8187043700 FORMER COMPANY: FORMER CONFORMED NAME: 20TH CENTURY INDUSTRIES DATE OF NAME CHANGE: 19950420 10-Q 1 doc1.txt SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934 For Quarter Ended September 30, 2002 Commission File Number 0-6964 21ST CENTURY INSURANCE GROUP - -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) CALIFORNIA 95-1935264 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification number) 6301 OWENSMOUTH AVENUE WOODLAND HILLS, CALIFORNIA 91367 (Address of principal executive offices) (Zip Code) (818) 704-3700 (Registrant's telephone number, including area code) Web site: www.21st.com None - -------------------------------------------------------------------------------- Former name, former address and former fiscal year, if changed since last report. Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Common Stock, Without Par Value Outstanding at October 17, 2002 (Title of Class) 85,431,505 shares 1
PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS 21ST CENTURY INSURANCE GROUP CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, December 31, 2002 2001 AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA (UNAUDITED) - ----------------------------------------------------------------------------------------------- ASSETS Fixed maturity investments available-for-sale, at fair value (amortized cost: $869,265 and $857,209) $ 917,865 $ 855,724 Cash and cash equivalents 58,391 28,909 - ----------------------------------------------------------------------------------------------- Total investments and cash 976,256 884,633 Accrued investment income 13,087 11,733 Premiums receivable 89,371 75,559 Reinsurance receivables and recoverables 35,935 40,138 Prepaid reinsurance premiums 2,848 15,444 Deferred income taxes 94,455 96,216 Deferred policy acquisition costs 35,657 24,662 Property and equipment, at cost less accumulated depreciation of $80,915 and $66,462 139,984 178,672 Other assets 13,675 24,959 - ----------------------------------------------------------------------------------------------- Total assets $ 1,401,268 $ 1,352,016 - ----------------------------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY Unpaid losses and loss adjustment expenses $ 394,510 $ 349,290 Unearned premiums 254,315 236,473 Claims checks payable 37,714 36,105 Reinsurance payable 789 12,993 Other liabilities 60,943 57,849 - ----------------------------------------------------------------------------------------------- Total liabilities 748,271 692,710 - ----------------------------------------------------------------------------------------------- Stockholders' equity: Common stock, without par value; authorized 110,000,000 shares, outstanding 85,439,641 in 2002 and 85,361,848 in 2001 418,845 416,991 Retained earnings 208,119 248,635 Accumulated other comprehensive income (loss) 26,033 (6,320) - ----------------------------------------------------------------------------------------------- Total stockholders' equity 652,997 659,306 - ----------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $ 1,401,268 $ 1,352,016 - -----------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements. 2
21ST CENTURY INSURANCE GROUP CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) AMOUNTS IN THOUSANDS, EXCEPT PER SHARE Three Months Ended September 30, Nine Months Ended September 30, DATA 2002 2001 2002 2001 - ---------------------------------------------------------------------------------------------------------------------- REVENUES Net premiums earned: Personal auto lines $ 234,666 $ 210,340 $ 669,968 $ 629,306 Homeowner and earthquake lines in runoff - 6,291 - 19,302 Net investment income 11,729 10,958 34,378 34,036 Realized investment gains 3,045 962 7,343 2,512 - ---------------------------------------------------------------------------------------------------------------------- Total revenues 249,440 228,551 711,689 685,156 - ---------------------------------------------------------------------------------------------------------------------- LOSSES AND EXPENSES Net losses and loss adjustment expenses: Personal auto lines 193,081 181,041 559,805 545,150 Homeowner and earthquake lines in runoff 46,863 14,179 58,677 37,177 Policy acquisition costs 31,517 25,574 87,836 76,786 Write-off of software 37,177 - 37,177 - Other operating expenses 7,395 6,305 14,363 16,774 - ---------------------------------------------------------------------------------------------------------------------- Total losses and expenses 316,033 227,099 757,858 675,887 - ---------------------------------------------------------------------------------------------------------------------- (Loss) income before federal income taxes (66,593) 1,452 (46,169) 9,269 Federal income tax benefit 21,358 1,227 19,116 4,129 - ---------------------------------------------------------------------------------------------------------------------- Net (loss) income $ (45,235) $ 2,679 $ (27,053) $ 13,398 - ---------------------------------------------------------------------------------------------------------------------- (LOSS) EARNINGS PER COMMON SHARE Basic $ (0.53) $ 0.03 $ (0.32) $ 0.16 - ---------------------------------------------------------------------------------------------------------------------- Diluted $ (0.53) $ 0.03 $ (0.32) $ 0.16 - ---------------------------------------------------------------------------------------------------------------------- WEIGHTED-AVERAGE SHARES OUTSTANDING Basic 85,439,641 85,353,450 85,408,266 85,337,162 - ---------------------------------------------------------------------------------------------------------------------- Diluted 85,439,641 85,503,127 85,408,266 85,387,616 - ----------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements 3
21ST CENTURY INSURANCE GROUP CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited) Accumulated Other Common Retained Comprehensive AMOUNTS IN THOUSANDS Stock Earnings Income (Loss) Total - --------------------------------------------------------------------------------------- Balance - January 1, 2002 $416,991 $248,635 $ (6,320) $659,306 Comprehensive income (27,053)(1) 32,353(2) 5,300 Cash dividends paid on common stock (13,665) (13,665) Other 1,854 202 2,056 - --------------------------------------------------------------------------------------- Balance - September 30, 2002 $418,845 $208,119 $ 26,033 $652,997 - ---------------------------------------------------------------------------------------
(1) Net loss. (2) Net change in accumulated other comprehensive income for the nine months ended September 30, 2002, is comprised of unrealized gains on available-for-sale investments of $37,396 (net of income tax expense of $20,137), the reclassification adjustment for gains included in net income of $4,841 (net of income tax expense of $2,607), and net changes in minimum pension liability in excess of unamortized prior service costs of $202. See accompanying notes to consolidated financial statements. 4
21ST CENTURY INSURANCE GROUP CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) AMOUNTS IN THOUSANDS Year-to-Date September 30, 2002 2001 - ------------------------------------------------------------------------------ OPERATING ACTIVITIES Net (loss) income $ (27,053) $ 13,398 Adjustments to reconcile net (loss) income to net cash provided by operating activities: Provision for depreciation and amortization 15,113 16,441 Write-off of software 37,177 - Amortization of restricted stock grants 369 500 (Expense) benefit for deferred income taxes (15,660) 1,265 Realized gains on sale of investments (7,343) (2,512) Federal income tax benefit 4,670 10,129 Reinsurance balances 4,596 9,081 Unpaid losses and loss adjustment expenses 45,220 (6,839) Unearned premiums 17,842 3,700 Claims checks payable 1,609 1,038 Other assets (19,381) (1,322) Other liabilities 3,457 14,424 - ------------------------------------------------------------------------------ Net cash provided by operating activities 60,616 59,303 - ------------------------------------------------------------------------------ INVESTING ACTIVITIES Fixed maturities available-for-sale Purchases (466,287) (315,301) Calls or maturities 18,617 2,158 Sales 441,928 381,687 Net purchases of property and equipment (13,212) (53,497) - ------------------------------------------------------------------------------ Net cash (used in) provided by investing activities (18,954) 15,047 - ------------------------------------------------------------------------------ FINANCING ACTIVITIES Dividends declared and paid (13,665) (20,481) Proceeds from the exercise of stock options 1,485 921 - ------------------------------------------------------------------------------ Net cash used in financing activities (12,180) (19,560) - ------------------------------------------------------------------------------ Net increase in cash 29,482 54,790 Cash and cash equivalents, beginning of period 28,909 7,240 - ------------------------------------------------------------------------------ Cash and cash equivalents, end of period $ 58,391 $ 62,030 - ------------------------------------------------------------------------------ SUPPLEMENTAL INFORMATION - ------------------------------------------------------------------------------ Income taxes refunded $ 12,920 $ 11,285 - ------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements. 5 21ST CENTURY INSURANCE GROUP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2002 (Unaudited) NOTE 1. BASIS OF PRESENTATION - ------------------------------- The accompanying unaudited consolidated financial statements of 21st Century Insurance Group and subsidiaries (the "Company") have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal, recurring accruals) considered necessary for a fair presentation have been included. All material intercompany accounts and transactions have been eliminated. Operating results for the nine-month period ended September 30, 2002, are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. For further information, refer to the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2001. Certain amounts in the 2001 financial statements have been reclassified to conform to the 2002 presentation. Effective January 1, 2002, the Company acquired American International Group, Inc.'s ("AIG") 51% interest in 21st Century Insurance Company of Arizona ("21st of Arizona") for $4.4 million, which approximated its GAAP book value. The Company previously held a 49% interest in 21st of Arizona, which writes personal auto insurance exclusively in Arizona. Beginning in 2002, 21st of Arizona is reported on a consolidated basis. Prior to January 1, 2002, the Company's interest in and advances to 21st of Arizona were included in other assets in the consolidated balance sheet, and the Company's 49% equity in 21st of Arizona's net loss, which was immaterial in the third quarter and first nine months of 2001, was included in net investment income in the Company's consolidated statement of income. NOTE 2. HOMEOWNER AND EARTHQUAKE LINES IN RUNOFF - ------------------------------------------------- California Senate Bill 1899 ("SB 1899"), effective from January 1, 2001, to December 31, 2001, allowed the re-opening of previously closed earthquake claims arising out of the 1994 Northridge Earthquake. The Company's constitutional challenge to SB 1899 came to an unsuccessful end on April 29, 2002, when the United States Supreme Court refused to hear the Company's case. In the fourth quarter of 2001, the Company recorded a $50.0 million pre-tax charge for loss and inspection costs but, at that time, it was impracticable to reasonably estimate the legal defense costs associated with previously closed earthquake claims. Based on current information now available to the Company, the Company recorded an additional $46.9 million pre-tax charge for such legal defense costs in the third quarter of 2002 ($58.8 million for the nine months ended September 30, 2002). The Company cautions that the recorded estimates for this event are subject to a greater than normal degree of uncertainty for a variety of reasons. For example, the claimants allege facts about earthquake damages that ostensibly occurred on January 17, 1994, but many of the claimants are represented by legal counsel who are acting to prevent access of Company personnel to inspect the allegedly damaged property. Thus, in many cases, the best information currently available to the Company is several years old. As new information becomes available in the near term, the Company's estimate of its ultimate 6 21ST CENTURY INSURANCE GROUP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2002 (CONTINUED) (Unaudited) exposure may change by an amount that could be material. In addition, actual expenses for legal defense costs are susceptible to a wide range of outcomes depending on a variety of factors including plaintiff strategies, future judicial decisions, the percentage of cases which settle, and the period of time cases remain outstanding before settlement. On October 10, 2002, a Los Angeles Superior Court granted the Company's motion for summary judgment in the matter of 21st Century Insurance Company vs. People of the State of California ex rel. Bill Lockyer, Attorney General et al. The court determined that the Company's April 21, 1999, settlement with the California Department of Insurance with respect to regulatory actions arising out of the 1994 Northridge Earthquake was fully valid and enforceable. The Court denied the Attorney General's motion seeking to have the settlement declared void and unenforceable, a result that may have allowed the California Department of Insurance to reinstitute regulatory proceedings with respect to the Company's handling of claims arising out of the 1994 Northridge Earthquake. The State of California may appeal the ruling. The Company has executed various transactions to exit from its homeowner line. Under a January 1, 2002, agreement with Balboa Insurance Company ("Balboa"), a subsidiary of Countrywide Credit Industries, Inc. ("Countrywide"), 100% of homeowner unearned premium reserves and future related losses are reinsured by Balboa. Obligations relating to the 1994 Northridge Earthquake are not covered by the agreements with Balboa. The Company began non-renewing homeowner policies expiring on February 21, 2002, and thereafter. Substantially all of these customers are being offered homeowner coverage through an affiliate of Countrywide. Loss and loss adjustment expenses for the homeowner and earthquake lines in runoff were $46.9 million and $58.8 million for the quarter and nine months ended September 30, 2002, respectively, compared to $14.2 million and $37.2 million for the same periods in 2001. NOTE 3. WRITE-OFF OF SOFTWARE - ------------------------------ Since 1997, the Company has engaged an external software development company, Computer Sciences Corporation ("CSC"), to build an advanced personal lines processing system. The system has four main components: Policy, Claims, Billing, and Customer Service. The system is still in development and currently supports less than 2% of the Company's business. To date, the Company has spent nearly $100 million on this project, most of which was paid directly to CSC. In the third quarter of 2002, it became evident through a series of tests and reviews conducted by the Company that material components of this new system do not perform at levels necessary to support the entire operations of the Company. Consequently, the Company recorded a one-time pre-tax charge to write-off $37.2 million of previously capitalized software costs. The Company is pursuing solutions with CSC as well as exploring other alternatives. NOTE 4. REINSURANCE - -------------------- In the third quarter of 2002, the Company entered into a catastrophe reinsurance agreement on its auto lines with AIG, Folksamerica Reinsurance Company and Transatlantic Reinsurance Company, which reinsures any covered events up to $30.0 million in excess of $15.0 million. Effective September 1, 2002, the Company entered into an agreement to cancel future cessions under its quota share reinsurance treaty with AIG resulting in a one time pre-tax charge of $0.9 million. The treaty would have ceded 4% of premiums to AIG in the remainder of 2002 and 2% in 2003. 7 21ST CENTURY INSURANCE GROUP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2002 (CONTINUED) (Unaudited) NOTE 5. CONTINGENCIES - ---------------------- Litigation. In the normal course of business, the Company is named as a defendant in lawsuits related to claim and other insurance policy issues. Some of the actions request extra-contractual and/or punitive damages. These actions are vigorously defended unless a reasonable settlement appears appropriate. In the opinion of management, except for the matters discussed above in Note 2, the ultimate outcome of such litigation is not expected to be material to the Company's financial condition, results of operations or cash flows. California Income Taxes. In a recent court ruling, a statute that allowed a tax deduction for the dividends received from wholly owned insurance subsidiaries was held unconstitutional on the grounds that it discriminated against out-of-state insurance holding companies. Subsequent to the court ruling, the staff of the California Franchise Tax Board (FTB) has decided to take the position that the discriminatory sections of the statute are not severable and the entire statute is invalid. As a result, the FTB is disallowing dividend-received deductions for all insurance holding companies, regardless of domicile, for open tax years ending on or after December 1, 1997. Although the FTB has not made a formal assessment for tax years 1997 through 2000, the Company anticipates a retroactive disallowance that would result in additional tax assessments. The amount of any such possible assessments and the ultimate amounts, if any, that the Company may be required to pay, are impossible to predict because so many ostensibly long-settled aspects of California tax law have been thrown into disarray and uncertainty by the action of the courts that, in the absence of legislative relief, years of future litigation may be required to determine the ultimate outcome. The range of possible loss, net of federal tax benefit, ranges from close to zero to approximately $20.8 million depending on which position future courts may decide to uphold or on whether the California legislature may decide to enact corrective legislation. The Company has recorded an amount within that range representing management's current best estimate of the probable outcome. 8 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION Investment grade bonds comprised 100% of the fair value of the fixed-maturity portfolio at September 30, 2002. The Company has no investments in equity securities as of September 30, 2002. Of the Company's total investments at September 30, 2002, approximately 58.5% were invested in tax-exempt, fixed-income securities, compared to 80.2% at December 31, 2001. The Company has begun shifting its investment focus to investment-grade taxable bonds to accelerate the realization of the tax benefit of its net operating loss deduction (see Deferred Income Taxes below under Critical Accounting Policies). As of September 30, 2002, the pre-tax net unrealized gain on investments was $48.6 million (gross unrealized gains were $52.8 million; gross unrealized losses were $4.2 million) compared to an after-tax net unrealized loss of $1.0 million at December 31, 2001. This change is primarily due to declining market interest rates. The Company's policy is to investigate on a quarterly basis any investment for possible "other than temporary" impairment in the event the fair value of the security falls below its amortized cost, based on all relevant facts and circumstances (see Investments below under Critical Accounting Policies). Premiums receivable were $89.4 million at September 30, 2002, compared to $75.6 million at December 31, 2001, with the increase mainly being attributable to growth in the Company's customer base and higher premium rates. Company policy is to write-off receivable balances when they become past due 180 days, and the Company historically has not considered an allowance for doubtful accounts to be necessary. Prepaid reinsurance premiums and reinsurance payables were $2.8 million and $0.8 million at September 30, 2002, compared to $15.4 million and $13.0 million at December 31, 2001, respectively. The decline in balances is primarily due to the cancellation of the quota share treaty with AIG (see Note 4 to the consolidated financial statements). Higher advertising and other costs through September 30, 2002, associated with increased customer volume contributed to an increase in deferred policy acquisitions costs (DPAC) of $11.0 million compared to the balance at December 31, 2001. Of the $11 million increase in DPAC, $1.5 million is attributable to the decrease in unearned ceding commissions resulting from termination of the AIG quota share reinsurance program (see Note 4 to the consolidated financial statements). The Company's DPAC is estimated to be fully recoverable (see Deferred Policy Acquisition Costs below under Critical Accounting Policies). Property and equipment decreased $38.7 million primarily due to the write-off of certain software in the third quarter of 2002 (see Note 3 to the consolidated financial statements). The results of management's third-quarter 2002 recoverability test indicated that the remaining carrying value of the Company's software under development is likely to be recoverable from future operations (see Property and Equipment below under Critical Accounting Policies). Unpaid losses and loss adjustment expenses ("LAE") increased $41.7 million in the third quarter of 2002 primarily due to the increase in reserves for SB 1899 Northridge Earthquake legal defense costs (see Note 2 to the consolidated financial statements) and increases in auto reserves. For the nine months ended September 30, 2002, loss and LAE reserves increased $45.2 million. As indicated in the following table, the Company's auto reserves, gross of reinsurance, have increased $26.3 million in the nine months ended September 30, 2002: 9 21ST CENTURY INSURANCE GROUP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2002 (CONTINUED) (Unaudited)
September 30, 2002 December 31, 2001 ------------------- ------------------- AMOUNTS IN THOUSANDS GROSS NET Gross Net - ------------------------------------------------------------------ Unpaid Losses and LAE Personal auto lines $328,300 $311,313 $301,985 $280,781 Homeowner and earthquake 66,210 61,189 47,305 44,997 - ------------------------------------------------------------------ Total $394,510 $372,502 $349,290 $325,778 - ------------------------------------------------------------------
The increase in the gross auto reserves for the nine months ended September 30, 2002, comprises $5.0 million due to the consolidation of 21st of Arizona, growth in reserves attributable to the higher number of insured automobiles of approximately $10.1 million, and approximately $11.2 million relating to the effects of higher average loss costs. The following table summarizes the provision for losses and LAE for the periods indicated:
Three Months Ended September 30, Nine Months Ended September 30, ------------------------------------ ----------------------------------- AMOUNTS IN THOUSANDS 2002 2001 2002 2001 - ----------------------------------------------------------------------------------------------------------------- Net Losses and LAE incurred related to insured events of: Current year $ 192,685 $ 182,288 $ 542,682 $ 526,665 Prior years 47,259 12,932 75,800 55,662 - ----------------------------------------------------------------------------------------------------------------- Total $ 239,944 $ 195,220 $ 618,482 $ 582,327 - -----------------------------------------------------------------------------------------------------------------
The amounts above relating to insured events of prior years represent changes in previously recorded estimates that have been charged to expense in the current period. In the third quarter of 2002, $46.9 million of the changes in estimate related to the Northridge Earthquake (see Note 2 to the consolidated financial statements) $1.7 million related to the auto lines and $(1.3) million to homeowner, compared to $9.3 million, $3.4 million and -0-, respectively, in the third quarter of 2001. For the first nine months of 2002, the change in estimate comprised Northridge Earthquake provisions of $52.6 million, auto lines provisions of $21.6 million and homeowners provisions of $1.6 million. The comparable figures for the first nine months of 2001 were $20.1 million, $34.1 million and $1.5 million, respectively. The changes in estimates relating to the auto lines in 2002 were attributable to increased severity partially offset by lower frequency, particularly in the first half of the year, while the 2001 changes in estimates relating to the auto lines were attributable to the Company's under-estimate of loss severity trends. Stockholders' equity and book value per share decreased to $653.0 million and $7.64 at September 30, 2002, compared to $659.3 million and $7.72 at December 31, 2001. The decrease for the nine months ended September 30, 2002, was primarily due to a net loss of $27.1 million and dividends to stockholders of $13.7 million, offset in part by the increase in unrealized investment gains of $32.4 million and other changes in comprehensive income of $2.1 million. LIQUIDITY AND CAPITAL RESOURCES Holding Company. The parent company's main sources of liquidity historically have been dividends received from its insurance subsidiaries and proceeds from issuance of debt or equity securities. The parent company currently has no indebtedness for borrowed money outstanding. The parent's only equity security currently outstanding is its common stock, which has no mandatory dividend obligations. 10 Cash and investments at the holding company were $13.8 million at September 30, 2002, compared to $52.8 million at December 31, 2001. The decline in the parent's cash and investments is primarily due to the payment of dividends and the repayments of intercompany balances. On September 25, 2002, the Company's Board of Directors declared a $6.9 million dividend to stockholders of record on October 7, 2002. The dividend will be paid on October 25, 2002. If necessary, the Company believes it can access the capital markets should the need arise for additional capital to support its growth and other corporate objectives. The Company's S&P claims-paying rating currently is A+, and its AM Best rating is A+. The insurance subsidiaries do not currently have, and likely will not have until 2004, the ability to pay dividends to the parent company without prior written approval from insurance regulatory authorities. In addition, recent court rulings may subject certain dividends from the insurance subsidiaries to California State income tax (see Note 5 to the consolidated financial statements). The Company believes the parent's cash resources at September 30, 2002 are adequate to meet its estimated cash needs for dividends to shareholders, growth or other general corporate purposes without receiving additional dividends from its insurance subsidiaries at least through the end of 2002. However, there is no assurance that insurance regulatory authorities will approve future dividends from the insurance subsidiaries or that the tax issue will be favorably resolved in the near term, in which case the Company faces the prospect of raising additional capital, cutting or ceasing dividends to shareholders, or both. Insurance Subsidiaries. The Company believes it has taken the proper actions to restore underwriting profitability in its core auto insurance operations and has thereby enhanced its liquidity. The Company received approval for a 5.7% auto premium rate increase in California effective May 6, 2002, and also has a further 6.7% auto premium rate increase pending in California. Average loss costs in 2002 have increased at an annualized overall rate of approximately 4.5% over 2001, although this rate would be somewhat higher but for the favorable impact on claim frequency of drought conditions that have largely prevailed in southern California over the past 12 months. There can be no assurance that insurance regulators will grant future rate increases that may be necessary to offset possible future increases in claims cost trends. Also, the Company remains exposed to possible upward development in previously recorded reserves for SB 1899 claims as previously discussed. As a result of such uncertainties, underwriting losses could recur in the future. Further, the Company could be required to liquidate investments to pay claims, possibly during unfavorable market conditions, which could lead to the realization of losses on sales of investments. Adverse outcomes to any of the foregoing uncertainties would create some degree of downward pressure on the insurance subsidiaries' statutory surplus, which in turn could negatively impact the Company's liquidity. As of September 30, 2002, the Company's insurance subsidiaries had a combined statutory surplus of $351.4 million compared to $393.1 million at December 31, 2001. The decrease in surplus is primarily due to a statutory net loss of $49.6 million and a $26.4 million decrease in the statutory deferred tax asset, partially offset by a $36.2 million decrease in non-admitted assets during the nine months ended September 30, 2002. The decrease in nonadmitted assets is primarily related to the write-off of software. The statutory net loss for the third quarter of 2002 was $68.6 million. For the quarter and nine months ended September 30, 2001, statutory net income was $1.6 million and $8.9 million, respectively. The Company's ratio of net premiums written to surplus was 2.6 for the twelve month period ended September 30, 2002, compared to 2.2 for the year ended December 31, 2001. On October 23, 2002, California Department of Insurance ("DOI") finalized its examination report on the 1999 statutory financial statements for the Company's California-domiciled insurance subsidiaries. The report did not require the insurance subsidiaries to restate those financial statements. 11 RESULTS OF OPERATIONS Overall Results. The Company reported a net loss of $45.2 million, or $0.53 loss per share, on direct premiums written of $257.9 million for the quarter ended September 30, 2002, compared to net income of $2.7 million, or $0.03 earnings per share, on direct premiums written of $229.0 million for the same 2001 quarter. The results for the latest quarter included pre-tax charges of $46.9 million for estimated legal defense costs to resolve Northridge Earthquake claims and $37.2 million to write-off the costs of a software development effort (see Notes 2 and 3 to the consolidated financial statements). For the nine months ended September 30, 2002, the net loss was $27.1 million, or $0.32 loss per share, on direct premiums written of $729.4 million. Net income for the nine months ended September 30, 2001, was $13.4 million, or $0.16 earnings per share, on direct premiums written of $701.8 million. Personal Auto Lines Operating Income, as presented in the following tables, is a key measure used by management in monitoring the operating results of the Company's core business. Personal auto lines operating income includes (a) the underwriting revenues and expenses attributable to the (i) personal auto lines, (ii) personal umbrella lines, and (iii) motorcycle lines, plus (b) investment income excluding realized capital gains or losses on the investment portfolio; it also excludes (c) the results of the homeowners and earthquake lines, which are in runoff, and (d) the write-off of software discussed above. The following table reconciles the Company's net income to its personal auto lines operating income:
Three Months Ended Year-to-Date September 30, September 30, AMOUNTS IN THOUSANDS 2002 2001 2002 2001 - --------------------------------------------------------------------------------------------- Net (loss) income $(45,235) $ 2,679 $(27,053) $13,398 Underwriting loss on homeowner and earthquake lines 46,863 8,546 58,768 21,316 Realized capital gains (3,045) (962) (7,343) (2,512) Write-off of software 37,177 - 37,177 - Federal income tax benefit on above (24,574) (1,766) (26,710) (5,225) - --------------------------------------------------------------------------------------------- Personal auto lines operating income, net of tax $ 11,186 $ 8,497 $ 34,839 $26,977 - ---------------------------------------------------------------------------------------------
The following table presents the components of the Company's personal auto lines operating income:
Three Months Ended Year-to-Date September 30, September 30, AMOUNTS IN THOUSANDS 2002 2001 2002 2001 - ---------------------------------------------------------------------------------------------------- Direct premiums written $257,978 $224,379 $726,932 $674,583 - ---------------------------------------------------------------------------------------------------- Net premiums written $260,034 $210,279 $709,185 $632,455 - ---------------------------------------------------------------------------------------------------- Net premiums earned $234,666 $210,340 $669,968 $629,306 Loss and loss adjustment expenses incurred 193,081 181,041 559,805 545,150 Underwriting expenses incurred 38,912 31,221 102,108 90,119 - ---------------------------------------------------------------------------------------------------- Pretax underwriting profit (loss) on personal auto lines 2,673 (1,922) 8,055 (5,963) Investment income 11,729 10,958 34,378 34,036 Federal income tax expense on above (3,216) (539) (7,594) (1,096) - ---------------------------------------------------------------------------------------------------- Personal auto lines operating income, net of tax $ 11,186 $ 8,497 $ 34,839 $ 26,977 - ----------------------------------------------------------------------------------------------------
12 The following table presents the components of the GAAP combined ratio for the personal auto lines:
Three Months Ended Year-to-Date September 30, September 30, 2002 2001 2002 2001 - ------------------------------------------------------------------------------------ Personal auto lines Loss and loss adjustment expense ratio 82.3% 86.1% 83.6% 86.7% Underwriting expense ratio 16.6% 14.8% 15.2% 14.3% - ------------------------------------------------------------------------------------ GAAP combined ratio 98.9% 100.9% 98.8% 101.0% - ------------------------------------------------------------------------------------
Comments relating to the underwriting results of the personal auto lines and the results of the Company's investment activities are presented below. Underwriting Results - Personal Auto Lines. Automobile insurance is the primary line of business written by the Company. Vehicles insured outside of California accounted for less than 3% of the Company's direct written premium in the first nine months of 2002 and 2001. The Company currently is licensed to write automobile insurance in 24 states compared to 21 states at the end of 2001. The Company currently is evaluating opportunities relating to expansion into new states but has not yet adopted definitive plans. Because of the lead times involved, expansion into new states is not expected to materially affect the Company's financial results in 2002 or 2003. Company management remains focused on achieving sustainable 15% growth and a combined ratio of 96. Since 1980, the Company has simultaneously met those benchmarks only twice (1980 and 1981). Direct premiums written for the auto lines in the third quarter of 2002 increased $33.6 million (15.0%) to $258.0 million from $224.4 million in the same period last year. For the first nine months of 2002 direct premiums written for the auto lines increased $52.3 million (7.8%) to $726.9 million from $674.6 million in the first nine months of 2001. The increases in 2002 included rate increases ($10.0 million for the quarter; $27.5 million year to date) and the effects of the consolidation of 21st of Arizona ($2.5 million for the quarter; $7.6 million year to date). Also, the higher number of insured vehicles in the third quarter of 2002 caused premiums to be $21.1 million higher than in the third quarter of 2001 and $17.3 million higher in the first nine months of 2002 than in the comparable period of 2001. The third quarter of 2002 increase is greater than the 2002 year-to-date increase, because the number of insured vehicles in the first half of 2002 was smaller than in the first half of 2001. California auto retention was 93% in both the third quarter and first nine months of 2002 compared to 92% in both of the comparable periods of last year; the improvement in 2002 reflects the fact that the Company's major competitors have taken significant rate increases in 2002 and, therefore, our customers are less likely to find more favorable rates elsewhere. Net premiums earned increased $24.3 million (11.6%) and $40.7 million (6.5%) for the quarter and nine months ended September 30, 2002, respectively, compared to the same periods a year ago. These increases are mainly due to rate increases, the consolidation of 21st of Arizona and the scheduled decrease in the cession rate under a quota share reinsurance treaty from 6% in 2001 to 4% in 2002. Additionally, this quota share treaty was cancelled as of September 1, 2002 (see Note 4 to the consolidated financial statements). On April 10, 2002, the Company received approval from the California DOI to implement, effective May 6, 2002, a 5.7% rate increase on its California personal auto lines. The Company has a further 6.7% rate increase pending with the California DOI. In May 2002, the Company began offering motorcycle insurance in the state of California, which is marketed to existing auto customers. In August 2002, the Company also began offering a limited-feature 13 California auto policy, which provides fewer features than the Company's standard policy but which generally is comparable to the product offered by many of the Company's competitors. It is anticipated that the limited-feature policy will improve retention by providing a lower cost product to customers who need fewer features. Through September 30, 2002, the impact of these two new products on the results of operations has been immaterial. Compared to the same periods in 2001, net incurred losses and loss adjustment expenses increased $12.0 million (6.6%) and $14.7 million (2.7%) during the quarter and nine months ended September 30, 2002, respectively. The ratio of loss and loss adjustment expenses to net premiums earned was 82.3% for the three months ended September 30, 2002, and 86.1% for the same period last year. For the nine-month periods ended September 30, 2002 and 2001, the loss and loss adjustment expense ratios were 83.6% and 86.7%, respectively. The improvement in the loss and loss adjustment expense ratio resulted from the earn-in of earlier premium rate increases and a reduction in frequency due to drought conditions in California. The ratio of net underwriting expenses to net premiums earned was 16.6% and 14.8%, for the three months ended September 30, 2002 and 2001, respectively. For the nine-month periods ending September 30, 2002 and 2001, the underwriting expense ratios were 15.2% and 14.3%, respectively. The increase was primarily due to growth in advertising expenditures and costs associated with approximately doubling the capacity of the Company's new business call center, which has been handling a record volume of new business throughout 2002. Several productivity enhancement initiatives are underway aimed at reducing per unit process costs, and lowering fixed costs in corporate support areas, which management believes will begin favorably impacting the Company's expense ratio during the next year. The combined ratio was 98.9% and 98.8% in the quarter and nine months ended September 30, 2002, respectively, compared to 100.9% and 101.0% for the same periods of 2001. The third quarter of 2002 marks the first time since 1988 that the Company has achieved both an underwriting profit and growth of 15% in direct premiums written in its auto lines. In the third quarter the Company entered into a catastrophe reinsurance agreement with AIG, Folksamerica Reinsurance Company and Transatlantic Reinsurance Company on its auto lines which reinsures any covered events up to $30.0 million in excess of $15.0 million. The premium for this reinsurance coverage is approximately $0.1 million per month. Investment Results. The average annual pre-tax yield on invested assets for the three and nine-month periods ended September 30, 2002, as well as the comparable periods in 2001 was 5.1%. On an after-tax basis, the yields were 4.3% and 4.4% for the quarter and nine months ended September 30, 2002, respectively, compared to 4.5% for both of the same periods in 2001. The average fair value of invested assets for the quarters ended September 30, 2002, and September 30, 2001, were $918.4 million and $900.1 million. This 2% increase in average investments between the periods is due to the investment of cash flows generated by operations and increased market value of bonds due to declining interest rates. For the nine months ended September 30, 2002 and 2001, the average invested assets were $903.0 million and $909.0 respectively. Of the Company's total investments at September 30, 2002, 58.5% were invested in tax-exempt, fixed-income securities, compared to 80.2% at December 31, 2001. The Company has begun shifting its investment focus to investment-grade taxable bonds to accelerate the realization of the tax benefit of its net operating loss deduction and to increase pre-tax yields. Although, the movement to taxable investments increases the Company's exposure to credit risk, that is mitigated to some extent by the Company acquiring only investment-grade corporate bonds. 14 The Company's policy is to investigate on a quarterly basis any investment for possible "other than temporary impairment" in the event the fair value of the security falls below its amortized cost, based on all relevant facts and circumstances. Declines in value below cost for fixed maturity investments with unrealized losses due to market conditions or industry related events, and for which the Company has the intent to hold the investment for a period of time believed to be sufficient to allow a market recovery or to maturity, are considered to be temporary. At September 30, 2002, 49% of the $4.2 million aggregate gross unrealized loss is attributable to three corporate bonds whose amortized cost has exceeded their market value for more than twelve months. Management considers none of these bonds to be at risk of default. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company believes its critical accounting policies are those which require management to make significant assumptions or estimates, and to ascertain the appropriateness and timing of any changes in those assumptions or estimates, that can have a material effect on the Company's financial condition, results of operation or cash flows. Specifically, the following areas require management to make such assumptions and estimates each time the Company prepares its financial statements: losses and loss adjustment expenses, particularly the liability for unpaid losses and loss adjustment expenses included in the liability section of the Company's balance sheet; the recoverability of certain property and equipment, deferred income taxes, and deferred policy acquisition costs included in the asset section of the Company's balance sheet; and the review of the Company's investments for possible "other than temporary" declines in fair value. Management has discussed the Company's critical accounting policies and estimates, together with any changes therein, with the Audit Committee of the Company's Board of Directors. The Company's Disclosure Committee and Audit Committee have reviewed the Company's disclosures in this document. Losses and Loss Adjustment Expenses. The estimated liabilities for losses and loss adjustment expenses ("LAE") 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 the development of case reserves to ultimate values, and estimates of expenses for investigating, adjusting and settling all incurred claims. Amounts reported are estimates of the ultimate costs of settlement, net of estimated salvage and subrogation. The estimated liabilities are necessarily subject to the outcome of future events, such as changes in medical and repair costs as well as economic and social conditions that impact the settlement of claims. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims. For the Company's current mix of auto exposures, which include both property and liability exposures, an average of approximately 63% of the ultimate losses are settled within twelve months of the date of loss. Given the inherent variability in the estimates, management believes the aggregate reserves are within a reasonable and acceptable range of adequacy, although the Company continues to caution that the reserve estimates relating to SB 1899 are subject to a greater than normal degree of variability and possible future material adjustment as new facts become known (see Note 2 to the consolidated financial statements). The methods of making such estimates and establishing the resulting reserves are reviewed and updated quarterly and any resulting adjustments resulting are reflected in current operations. Changes in the estimates for these liabilities flow directly to the income statement on a dollar-for-dollar basis. For example, an upward revision of $1 million in the estimated liability for unpaid losses and loss adjustment expenses would decrease underwriting profit, and pre-tax income, by the same $1 million amount. Conversely, a downward revision of $1 million would increase pre-tax income by the same $1 million amount. 15 Property and Equipment. Accounting standards require long-term assets to be tested for possible impairment under certain conditions. At September 30, 2002, management believes the Company's remaining capitalized costs for Policy and Claims software is the only long-term asset that meets the conditions for impairment testing. Under the applicable accounting standards, the first step is to determine whether the carrying value and cost to complete the asset is recoverable from future operations, based on estimates of future undiscounted cash flows; if not, then an impairment write down would be required to be recognized based on the fair value of the asset. At September 30, 2002, management has estimated that the $62.5 million carrying value and $25 million estimated cost to complete such software, or $87.5 million in total, is recoverable from cost savings from future operations. This conclusion is based primarily on the assumptions that the software can be successfully implemented and can reduce the Company's employee count by at least 125 people (about 5% of its workforce) for the 10 to 15 years after implementation (i.e., the current estimate of the probable productive life of the software). Once the project has successfully reached the stage where it is substantially complete and ready for its intended use, the Company anticipates there will be annual depreciation charges varying from approximately $5.8 million to $8.8 million. However, although management believes it is reasonable to assume these future cost savings, it must be noted that any such estimates are subject to considerable uncertainty and there can be no assurance that such cost savings will be achieved. Deferred Income Taxes. The Company recognizes deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities and expected benefits of utilizing net operating loss and credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The impact on deferred taxes of changes in tax rates and laws, if any, are applied to the years during which temporary differences are expected to be settled and reflected in the financial statements in the period enacted. The Company is required to establish a "valuation allowance" for any portion of the deferred tax asset that management believes will not be realized. At this time, the Company reasonably expects that the deferred tax asset will be recovered and, therefore, has not established a valuation allowance. Realization of deferred tax assets is dependent on the generation of taxable income in future periods. Favorable loss ratios are a key driver of taxable income. Uncertainties affecting loss ratios include but are not limited to the number of vehicles insured by the Company, premium rates and changes in the regulatory environment. Deferred Policy Acquisition Costs. Deferred policy acquisition costs ("DPAC") include premium taxes and other variable costs incurred in connection with writing business. These costs are deferred and amortized over the period in which the related premiums are earned. Management assesses the recoverability of deferred policy acquisition costs on a quarterly basis. The assessment calculates the relationship of actuarially estimated costs incurred to premiums from contracts issued or renewed for the period. The Company does not consider anticipated investment income in determining the recoverability of these costs. Based on current indications, no reduction in DPAC is required unless the loss and loss adjustment expense ratio should exceed 85.7%. The loss and LAE ratio used in the recoverability estimate is based primarily on the assumption that the future loss and LAE ratio will approximate that of the recent past. While management believes that is a reasonable assumption, actual results could differ materially from such estimates. 16 Investments. The Company classifies its investment portfolio as available-for-sale and carries it at fair value. Unrealized investment gains and losses, net of any tax effect, are included as an element of accumulated other comprehensive income (loss), which is classified as a separate component of stockholders' equity. Fair values for fixed maturity securities are based on quoted market prices. The cost of investment securities sold is determined by the specific identification method. The Company's policy is to investigate any investment for possible "other than temporary impairment" in the event the fair value of the security falls below its amortized cost, based on all relevant facts and circumstances. Declines in value below cost for fixed maturity investments with unrealized losses due to market conditions or industry related events, and for which the Company has the intent to hold the investment for a period of time believed to be sufficient to allow a market recovery or to maturity, are considered to be temporary. Where declines in values of securities below cost or amortized cost are considered to be other than temporary, a charge is reflected in income for the difference between cost or amortized cost and estimated net realizable value. No such charges were recorded in the first nine months of 2002 or 2001. At September 30, 2002, 49% of the $4.2 million aggregate gross unrealized loss is attributable to three corporate bonds whose amortized cost has exceeded their market value for more than twelve months. Management considers none of these bonds to be at risk of default. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the risk of loss from adverse changes in market prices and interest rates. In addition to market risk, 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. As of September 30, 2002, there have been no material changes in the Company's investment strategies, types of financial instruments held or the risks associated with such instruments which would materially alter the market risk disclosures made in the Company's Annual Statement on Form 10-K for the year ended December 31, 2001, except that the Company has begun shifting its investment focus to investment-grade taxable bonds to accelerate the realization of the tax benefit of its net operating loss deduction. The second column of the following table shows the financial statement carrying value of the Company's financial instruments. The Company's investment portfolio is carried at fair value. The third column shows the effect on the current carrying value and estimated fair value assuming a 100 basis point increase in market interest rates. The following sensitivity analysis summarizes only the exposure to market interest rate risk as of September 30, 2002.
Estimated Fair Value at Adjusted Market Carrying Rates/Prices (Amounts in millions) Value Indicated Below * - -------------------------------------------------------------------------------- Fixed maturity investments available-for-sale $ 917.9 $ 852.5
* Adjusted interest rates assume a 100 basis point increase in market rates at September 30, 2002. 17 ITEM 4. DISCLOSURE CONTROLS AND PROCEDURES The Company's certifying officers have established and maintained disclosure controls and procedures to ensure that material information is made known to them for purposes of complying with applicable laws and regulations. As part of these procedures, the Company has established a Disclosure Committee comprised of the senior officers responsible for the Company's operations, including the Chief Executive Officer and Chief Financial Officer. The Disclosure Committee met during September and October 2002 in connection with the preparation of this report on Form 10-Q, specifically regarding the design and effectiveness of the internal controls over financial reporting and disclosure. The Disclosure Committee's evaluation for the quarter ended September 30, 2002, was completed on or about September 24, 2002. Based on the Disclosure Committee's evaluation, the Company's Chief Executive Officer and Chief Financial Officer reached the following conclusions: - - There were no significant deficiencies in the design or operation of internal controls which could affect the Company's ability to record, process, summarize and report financial data in accordance with applicable laws and regulations; - - No material weaknesses in internal controls were noted that should be disclosed to the Company's independent auditors, Audit Committee or Board of Directors; - - No fraud, whether or not material, that involves management or employees who have a significant role in the Company's internal controls, was identified. Subsequent to the date of the evaluation, the Disclosure Committee and certifying officers have not become aware of any significant changes in internal controls or in other factors that could significantly affect internal controls, including any corrective actions with regard to significant deficiencies or material weaknesses. FORWARD-LOOKING STATEMENTS The Company's management has made in this report, and from time to time may make in its public filings, press releases, and 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 communications, as well as the following: (a) the intensity of competition from other companies in the insurance industry; (b) the Company's experience with respect to persistency, underwriting and claims experience including revived claims under SB 1899; (c) the Company's ability to distribute and administer competitive services in a timely, cost-effective manner; (d) the Company's visibility in the marketplace and its financial and claims-paying ratings; (e) regulatory approval for rate increases and product changes; (f) the effect of changes in laws and regulations affecting the Company's business, including changes in tax laws affecting insurance products; (g) market risks related to interest rates; (h) the Company's ability to develop and deploy information technology and management information systems to support strategic goals while continuing to control costs and expenses; (i) the costs of defending litigation or regulating proceedings and the risk of unanticipated material adverse outcomes in such litigation or proceedings; (j) changes in accounting and reporting practices; and (k) 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. 18 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In the normal course of business, the Company is named as a defendant in lawsuits related to claim and insurance policy issues. Some of the actions request extra-contractual and/or punitive damages. The actions are vigorously defended unless a reasonable settlement appears appropriate. On October 10, 2002, a Los Angeles Superior Court granted the Company's motion for summary judgment in the matter of 21st Century Insurance Company vs. People of the State of California ex rel. Bill Lockyer, Attorney General et al. The court determined that the Company's April 21, 1999 settlement with the California Department of Insurance with respect to regulatory actions arising out of the 1994 Northridge Earthquake was fully valid and enforceable. The Court denied the Attorney General's motion seeking to have the settlement declared void and unenforceable, a result that may have allowed the California Department of Insurance to reinstitute regulatory proceedings with respect to the Company's handling of claims arising out of the 1994 Northridge Earthquake. The State of California may appeal the ruling. Except as disclosed in the Notes to the Consolidated Financial Statements, the Company does not believe the outcome of any pending legal proceedings will have a material adverse effect on its financial position, results of operations or cash flows. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 10(o) Agreement with AIG pursuant to which the quota share reinsurance treaty with AIG was terminated 10(p) Catastrophe reinsurance agreement re auto lines 99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to the Sarbanes Oxley Act of 2002 (b) Reports on Form 8-K None. 19 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. 21ST CENTURY INSURANCE GROUP ------------------------------------------- (Registrant) Date: October 24, 2002 /s/ Bruce W. Marlow --------------------- ------------------------------------------- BRUCE W. MARLOW President and Chief Executive Officer Date: October 24, 2002 /s/ Douglas K. Howell --------------------- ------------------------------------------- DOUGLAS K. HOWELL Senior Vice President, Chief Financial Officer and Treasurer 20 CERTIFICATION OF PRESIDENT AND CHIEF EXECUTIVE OFFICER - ------------------------------------------------------ I, Bruce W. Marlow, certify that: 1. I have reviewed this quarterly report on Form 10-Q of 21st Century Insurance Group: 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: October 24, 2002 /s/ Bruce W. Marlow ------------------ ------------------------------------- Bruce W. Marlow President and Chief Executive Officer 21 CERTIFICATION OF CHIEF FINANCIAL OFFICER - ---------------------------------------- I, Douglas K. Howell, certify that: 1. I have reviewed this quarterly report on Form 10-Q of 21st Century Insurance Group: 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: October 24, 2002 /s/ Douglas K. Howell ------------------ -------------------------------------- Douglas K. Howell Senior Vice President, Chief Financial Officer and Treasurer 22 EXHIBIT INDEX Exhibit No. Description 10(o) Agreement with AIG pursuant to which the quota share reinsurance treaty with AIG was terminated 10(p) Catastrophe reinsurance agreement re auto lines 99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to the Sarbanes-Oxley Act of 2002 23 EX-10.(O) 3 doc2.txt Exhibit 10(o) AGREEMENT TO TERMINATE QUOTA SHARE REINSURANCE AGREEMENT Effective as of January 1, 1995 (hereinafter referred to as the "Agreement") between 21ST CENTURY INSURANCE COMPANY (formerly 20th Century Insurance Company) and 21ST CENTURY CASUALTY COMPANY (hereinafter referred to as the "Cedants") and AMERICAN INTERNATIONAL INSURANCE COMPANY (hereinafter referred to as the "Reinsurer") Pursuant to ARTICLE XIII of the Agreement, the parties hereto agree to terminate such Agreement, effective 12:00 P.M. (Midnight) August 31, 2002 (the Termination Date). As stated in ARTICLE XIII of the Agreement, "In the event of termination, the Reinsurer shall refund to the Cedants the applicable unearned premium minus the ceding commission and shall continue to remain liable for all losses occurring prior to the date of termination. However, if this Contract shall terminate while a loss occurrence covered hereunder is in progress, it is agreed that, subject to the other conditions of this contract, the Reinsurer is responsible for its proportion of the entire loss. In consideration for the early termination of this Agreement, the parties hereto further agree that Reinsurer shall be entitled to be paid a fee by 21st Century Insurance Company of nine hundred thousand dollars ($900,000), payable in cash within 15 days of the Termination Date hereof. IN WITNESS THEREOF, the parties hereto have caused this Agreement to be executed by their duly authorized representatives. 21st CENTURY INSURANCE COMPANY 21ST CENTURY CASUALTY COMPANY By: ------------------------------ Title: ------------------------------ Date: ------------------------------ AMERICAN INTERNATIONAL INSURANCE COMPANY By: ------------------------------ Title: ------------------------------ Date: ------------------------------ 24 EX-10.(P) 4 doc3.txt Exhibit 10(p) AUTO PHYSICAL DAMAGE CATASTROPHE EXCESS OF LOSS REINSURANCE AGREEMENT FINAL PLACEMENT SLIP -------------------- COMPANY: 21st Century Insurance Company a California corporation 21st Century Casualty Company a California corporation 21st Century Insurance Company of Arizona an Arizona corporation and any and all insurance companies 50% or more owned by, or which hereafter come under the same ownership or management of, 21st Century Insurance Group. TERM: Losses occurring during the 16-month term extending from 12:01 a.m. Pacific Time on September 1, 2002, to 12:01 a.m. Pacific Time on January 1, 2004. Should this Agreement expire while a loss occurrence covered hereunder is in progress, the Reinsurers will be responsible for their portion of the entire loss or damage caused by such loss occurrence, subject to the other conditions of this Agreement, and provided that no part of said loss occurrence is claimed against any renewal or replacement of this Agreement. BUSINESS COVERED: All business classified by the Company as Auto Physical Damage (Comprehensive only) and any business the Company is required to write by reason of its participation in any Fair Plan. TERRITORY: Arizona, California, Nevada, Oregon, Washington and all extra territorial limits as provided for in the Company's policies. EXCLUSIONS: As per attached. RETENTION AND LIMIT: $30,000,000 Ultimate Net Loss each loss occurrence excess of $15,000,000 Ultimate Net Loss each loss occurrence. WARRANTY: The Company will retain a minimum of 2.50% of the limit hereon net and unreinsured. REINSTATEMENT: One full reinstatement with additional premium, 100% as to time, pro rata as to amount. Paid at the same time the Reinsurers pay the loss. 25 PREMIUM: Deposit premium of $1,800,000 payable in equal installments of $360,000 in advance at September 1, 2002, January 1, 2003, April 1, 2003, July 1, 2003, and October l, 2003. To be adjusted at Agreement expiration at a rate of 1.43% against Gross Net Earned Premium, subject to a minimum premium of $1,620,000. Adjustment against minimum and deposit as soon as practicable following the expiration of the Agreement. "Gross Net Earned Premium" as used herein will mean the Company's gross premium earned less earned premium paid for reinsurances, recoveries under which would inure to the benefit of the Reinsurer. LOSS EXPENSE: Included within Ultimate Net Loss. OTHER REINSURANCE: The Company is permitted to purchase facultative and other treaty reinsurance (including other Catastrophe Reinsurance), and the premium for any such reinsurance that inures to the benefit of this Agreement will not be included within the subject premium hereunder. GENERAL CONDITIONS: Reinsurers will be subject to the same terms, conditions, interpretations, waivers, modifications, and alterations as the respective policies of the Company to which this Agreement applies. Reserve Deposit Clause (Non-Admitted Reinsurers) - as attached Net Retained Lines Clause - as attached Loss Occurrence Clause - as attached Ultimate Net Loss Clause - as attached ECO 80%; XPL 80% (Subject to 25% of UNL.) Notice of Loss and Loss Settlements Clause- as attached Insolvency Clause Entire Agreement, Interpretation Clause - as attached Service of Suit Clause (U.S.A.) - N.M.A. 1998 Agency Clause Special Termination or Settlement Clause - as attached Confidentiality Clause - as attached Taxes Clause Currency Clause Access to Records Clause - as attached Delays, Errors or Omissions Clause Arbitration Clause Federal Excise Tax Clause Extended Expiration Clause Aon Re Inc. Intermediary clause ALLOCATION OF SHARES: The Company shall have the right to review all authorizations and the full authority to allocate final shares. Such decisions will be at the sole discretion of the Company and may result in other than a "proportional sign-down" of authorizations. As respects sign-downs within the London marketplace, the final allocation of shares to individual companies or syndicates may not be proportionate to the original authorizations. 26 INFORMATION: Estimated Subject Gross Net Earned Premium Income: $125,800,000. Information package provided. In accordance with your instructions, we have placed reinsurance with the Reinsurers listed hereon, subject to the terms and conditions hereinabove stated. We ask that you promptly advise us if the terms, conditions, or Reinsurers vary in any respect from your instructions. Aon Re Inc. will not be responsible for the financial or other obligations of any Reinsurers. Should you desire financial information regarding the Reinsurers listed hereon, please contact us and we will furnish it. The Reinsurer's obligations under this Agreement are several and not joint and are limited solely to the extent of their individual participations. The Reinsurers are not responsible for the participation of any co-subscribing Reinsurer who for any reason does not satisfy all or part of its obligations. REINSURED WITH: - --------------- COMPANY NAME NAIC# FEIN# LAYER 1 - ------------ ------ ---------- --------- Domestic Companies Folksamerica Reinsurance Company 38776 13-2997499 6.66666% Transatlantic Reinsurance Company 19453 13-5616275 16.66667% Total Domestic Companies 23.33333% Non-Domestic Companies Endurance Specialty Insurance Ltd. AA-3194130 16.66667% TOTAL ALL PARTICIPANTS 40.00000% Assuming that you find everything in order, please indicate your acceptance and approval by signing and returning this Final Placement Slip to Aon Re Inc. ACCEPTED & APPROVED: /s/ Douglas K. Howell ------------------------------------------------------------------- REFERENCE NUMBER: 09021203 CATCOMP DATED: 9-26-02 ------------------------ ------------------------ (FOR PROCESSING PURPOSES IT IS IMPORTANT THAT YOU PROVIDE YOUR COMPANY'S REFERENCE NUMBER FOR THIS PROGRAM.) 27 EXCLUSIONS ---------- This Agreement does not apply to and specifically excludes the following: A. Liability assumed by the Company under any form of treaty reinsurance; however, group intra-company reinsurance (if applicable), local agency reinsurance accepted in the normal course of business and/or policies written by another carrier at the Company's request and reinsured 100% by the Company will not be excluded hereunder. B. Financial Guarantee and Insolvency coverages and/or similar coverage, however styled. C. Loss or damage occasioned by war, invasion, hostilities, acts of foreign enemies, civil war, rebellion, insurrection, military or usurped power, martial law, or confiscation by order of any government or public authority; however, the foregoing will not apply to reinsured policies containing a standard war exclusion clause. D. Loss or liability excluded by the Pools, Associations and Syndicates Exclusion Clause. E. Loss or liability excluded by the Insolvency Funds Exclusion Clause. F. Loss or liability excluded by the Nuclear Incident Exclusion Clauses -- Physical Damage- Reinsurance, U.S.A. and Canada and Nuclear Energy Risks Exclusion Clause (Reinsurance) (1994) (Worldwide - Excluding U.S.A. & Canada) attached to this Agreement. G. Any of the following: 1. Bodily Injury 2. Property Damage Liability 3. Medical Payments 4. UIM. 5. Collision H. Commercial Auto. I. Notwithstanding any provision to the contrary within this reinsurance agreement or any endorsement thereto, it is agreed that this reinsurance agreement excludes loss, damage, cost, or expense directly or indirectly caused by, contributed to by, resulting from, or arising out of or in connection with any act of terrorism, as defined herein, regardless of any other cause or event contributing concurrently or in any other sequence to the loss. An act of terrorism includes any act, or preparation in respect of action, or threat of action designed to influence the government de jure or de facto of any nation or any political division thereof, or in pursuit of political, religious, ideological, or similar purposes to intimidate the public or a section of the public of any nation by any person or group(s) of persons whether acting alone or on behalf of or in connection with any organization(s) or government(s) de jure or de facto, and which: (i) involves violence against one or more persons; or (ii) involves damage to property; or (iii) endangers life other than that of the person committing the action; or (iv) creates a risk to health or safety of the public or a section of the public; or (v) is designed to interfere with or to disrupt an electronic system. This reinsurance agreement also excludes loss, damage, cost, or expense directly or indirectly caused by, contributed to by, resulting from, or arising out of or in connection with any action in controlling, preventing, suppressing, retaliating against, or responding to any act of terrorism. 28 Notwithstanding the above and subject otherwise to the terms, conditions, and limitations of this reinsurance agreement, in respect only of personal lines this reinsurance agreement will pay actual loss or damage (but not related cost or expense) caused by any act of terrorism provided such act is not directly or indirectly caused by, contributed to by, resulting from, or arising out of or in connection with biological, chemical, or nuclear pollution or contamination. This exclusion shall not apply, however, to any act that has been determined not to be terrorism by the government of the United States or other applicable governmental authority. J. This Agreement excludes any loss, damage, costs or expenses related thereto, which are occasioned by or in consequence of, directly or indirectly, or result from the dispersal, release, escape, growth, infestation, contamination, or exposure to the following: 1. Mold, defined as any form of multicellular fungi that live on plant or animal matter and in indoor environments, toxic mold and mold spores. Indoor environments will include the affected dwelling unit or affected commercial or industrial building; 2. Fungus, mildew and bacteria; and 3. Bioaerosols, defined as toxic airborne particles related to mold. The Company may submit in writing to the Reinsurers, for special acceptance hereunder, business not covered by this Agreement. If said business is accepted in writing by the Reinsurers, it will be subject to the terms of this Agreement, except as such terms are modified by such acceptance. Any special acceptance business covered under the reinsurance agreement being replaced by this Agreement will be automatically covered hereunder. Further, should Reinsurers become a party to this Agreement subsequent to the acceptance of any business not normally covered hereunder, they will automatically accept same as being part of this Agreement. Should any judicial entity having jurisdiction invalidate any exclusion in the Company's policy that is also the subject of one or more of the exclusions herein, then subject to the limits of this Agreement, a loss for which the Company is liable because of such invalidation will not be excluded hereunder. RESERVE DEPOSIT (NON-ADMITTED REINSURERS) ----------------------------------------- A. With respect to any jurisdiction in which a ceding company is domiciled but the Reinsurer is not admitted, the Reinsurer shall fund an amount herein called the "Deposit." The Deposit shall be (i) 110% of the outstanding loss and LAE reserves, excluding IBNR; or (ii) such other amount as may be provided by law or any applicable insurance regulatory agencies excluding IBNR, whichever is greatest. B. The Deposit shall be adjusted quarterly. C. The Company may, at any time after default by the Reinsurer of payments owing to the Company, require, by notice in writing to the Reinsurer, the payment of the sum due. In the event the Reinsurer shall not pay such sum within seven days after receipt of said notice, the Company shall be entitled to appropriate so much of the deposit as may be required to eliminate the default. Until the deposit shall have been utilized in the manner aforesaid, interest thereon shall be credited to the Reinsurer quarterly at the rate of four percent per annum. 29 D. The Company may at its discretion, instead of taking any part of the deposit, require payment of any sum in default, and it shall be no defense to any such claim that the Company might have had recourse to the deposit. E. The deposit may be in the form of cash, a Letter of Credit, or other security, provided such Letter of Credit or other security satisfies the requirements of the law and the applicable Insurance Regulatory Agency. However, a Letter of Credit is not an acceptable substitute in Canada. F. Notwithstanding any other provisions of this Agreement, the Letter of Credit or other security may be drawn upon by the Company at any time to fund the deposit or for any amounts due from the Reinsurer under this Agreement. NET RETAINED LINES ------------------ A. This Agreement applies only to that portion of any insurance or reinsurance which the Company retains net for its own account and in calculating the amount of any loss hereunder and also in computing the amount of any loss hereunder and also in computing the amount or amounts in excess of which this Agreement attaches, only loss or losses in respect of that portion of any insurance or reinsurance which the Company retains net for its own account shall be included. B. The amount of the Reinsurer's liability hereunder in respect of any loss or losses shall not be increased by reason of the inability of the Company to collect from any other Reinsurers, whether specific or general, any amounts which may become due from them whether such inability arises from the insolvency of such other Reinsurers or otherwise. C. Reinsurance or pooling agreements effected or entered into by the Company with any of its affiliated companies under common management or common ownership which reduce the individual retained line of the Company shall be disregarded for the purposes of this Agreement. DEFINITION OF LOSS OCCURRENCE ----------------------------- The term "Loss Occurrence" shall mean the sum of all individual losses directly occasioned by any one disaster, accident or loss or series of disasters, accidents or losses arising out of one event which occurs within the area of one state of the United States or province of Canada and states or provinces contiguous thereto and to one another. However, the duration and extent of any one "Loss Occurrence" shall be limited to all individual losses sustained by the Company occurring during any period of 168 consecutive hours arising out of and directly occasioned by the same event except that the term "Loss Occurrence" shall be further defined as follows: (i) As regards windstorm, hail, tornado, hurricane, cyclone, including ensuing collapse and water damage, all individual losses sustained by the Company occurring during any period of 72 consecutive hours arising out of and directly occasioned by the same event. However, the event need not to be limited to one state or province or states or provinces contiguous thereto. (ii) As regards riot, riot attending a strike, civil commotion, vandalism and malicious mischief, all individual losses sustained by the Company occurring during any period of 72 consecutive hours within the area of one municipality or county and the municipalities or counties contiguous thereto arising out of and directly occasioned by the same event. The maximum duration of 72 consecutive hours may be extended in respect of individual losses which occur beyond such 72 consecutive hours during the continued occupation of an Assured's premises by strikers, provided such occupation commenced during the aforesaid period. 30 (iii) As regards earthquake (the epicentre of which need not necessarily be within the territorial confines referred to in the opening paragraph of this Article) and fire following directly occasioned by the earthquake, only those individual fire losses which commence during the period of 168 consecutive hours may be included in the Company's "Loss Occurrence". (iv) As regards "Freeze", only individual losses directly occasioned by collapse, breakage of glass and water damage (caused by bursting of frozen pipes and tanks) may be included in the Company's "Loss Occurrence". Except for those "Loss Occurrences" referred to in (i) and (ii) the Company may choose the date and time when any such period of consecutive hours commences provided that it is not earlier than the date and time of the occurrence of the first recorded individual loss sustained by the Company arising out of that disaster, accident or loss and provided that only one such period of 168 consecutive hours shall apply with respect to one event. However, as respects those "Loss Occurrences" referred to in (i) and (ii), if the disaster, accident or loss occasioned by the event is of greater duration than 72 consecutive hours, then the Company may divide that disaster, accident or loss into two or more "Loss Occurrences" provided no two periods overlap and no individual loss is included in more than one such period and provided that no period commences earlier than the date and time of the occurrence of the first recorded individual loss sustained by the Company arising out of that disaster, accident or loss. No individual losses occasioned by an event that would be covered by 72 hours clauses may be included in any "Loss Occurrence" claimed under the 168 hours provision. (v) Losses directly or indirectly occasioned by: (i) loss of, alteration of, or damage to or (ii) a reduction in the functionality, availability or operation of a computer system, hardware, programme, software, data, information repository, microchip, integrated circuit or similar device in computer equipment or non-computer equipment, whether the property of the policyholder of the Company or not, do not in and of themselves constitute an event unless arising out of one or more of the following perils: fire, lightning, explosion, aircraft or vehicle impact, falling objects, windstorm, hail, tornado, cyclone, hurricane, earthquake, volcano, tsunami, flood, freeze or weight of snow. ULTIMATE NET LOSS ----------------- A. The term "Ultimate Net Loss" shall mean the actual loss or losses sustained by the Company, such loss to include all expenses (regardless of how such expenses are classified for statutory reporting purposes) incurred by the Company in connection with the settlement of losses or resistance to or negotiations concerning a loss, including those losses which are the result of actions and/or disputes between the insured and the Company and legal expenses incurred in connection with coverage questions and legal actions connected thereto, excluding, however, any part of the office expenses of the Company and salaries of employees other than salary charges for staff adjusters, fieldpersons or other employees while actually engaged in the settlement of losses (including but not limited to charges and/or expenses incurred through the use of AIG Claim Services and AIG Technical Services. B. Salvages and recoveries, whether recovered or received prior or subsequent to loss settlement under this Contract, including amounts recoverable under all Reinsurances, whether collected or not, shall be applied as if recovered or received prior to the aforesaid settlement and shall be first deducted from the actual loss sustained to arrive at the amount of ultimate net loss. Nothing, however, in this Article shall be construed to mean losses are not recoverable hereunder until the ultimate net loss to the Company has been ascertained. 31 C. Any reinsurance effected by the Company where the ultimate purpose is to procure a catastrophe bond or other financial instrument, shall inure solely to the benefit of the Company and is to be disregarded in determining the ultimate net loss. D. The Company is granted permission to carry underlying excess of loss catastrophe reinsurance, recoveries under which shall inure to the sole benefit of the Company and shall be entirely disregarded for the purpose of determining the Company's ultimate net loss under this Contract, unless otherwise stipulated by the Company. NOTICE OF LOSS AND LOSS SETTLEMENTS ----------------------------------- A. In the event of a loss which either results in or appears to be of serious enough nature to result in the involvement of this Agreement, the Company shall give notice as soon as reasonably practicable to the Reinsurer and the Company shall keep the Reinsurer advised of all subsequent developments in connection therewith. B. The Reinsurer agrees to abide by the loss settlements of the Company, such settlements to be considered as satisfactory proofs of loss, and amounts falling to the share of the Reinsurer shall be immediately payable to the Company by them upon reasonable evidence of the amount paid or to be paid by the Company being presented to the Reinsurer by the Company. EXTRA CONTRACTUAL OBLIGATIONS AND --------------------------------- EXCESS LIMITS LIABILITY DEFINITION ---------------------------------- This Agreement will extend to cover 80% of any claims-related extra contractual obligations and/or excess limits liability arising because of, but not limited to, the following: A. Failure of the Company to agree to pay a claim within the policy limits or to provide a defense against such claims. B. Actual or alleged bad faith, fraud, or negligence in investigating or handling a claim or in rejecting an offer of settlement. C. Negligence or breach of duty in the preparation of the defense of the conduct of a trial or the preparation or prosecution of any appeal and/or subrogation and/or any subsequent action resulting therefrom. "Extra contractual obligations" as used in this Agreement will mean those liabilities not covered under any other provision of this Agreement for which the Company is liable to its insured or a third-party claimant, or that the company paid as its share of a claims related extra contractual obligation awarded against one or more of its co-insurers. "Excess limits liability" as used in this Agreement will mean any amount for which the Company would have been contractually liable to pay had it not been for the limits of the reinsured policy. There will be no recovery hereunder where the extra contractual obligation or excess limits liability has been incurred due to fraud committed by a member of the board of directors or a corporate officer of the Company, acting individually, collectively, or in collusion with a member of the board of directors, a corporate officer, or a partner of any other corporation, partnership, or organization involved in the defense or settlement of a claim on behalf of the Company. The date on which any extra contractual obligation and/or excess limits liability is incurred by the Company will be deemed, in all circumstances, to be 32 the date of the original loss. Nothing in this Article will be construed to create a separate or distinct loss apart from the original covered loss that gave rise to the extra contractual obligations and/or excess limits liability discussed in the preceding paragraphs. The Reinsurers liability as respects extra contractual obligations and/or excess limits liability under this Agreement will be in addition to the indemnification coverage set forth in the Retention and Limit Article, but the Reinsurers additional liability as respects extra contractual obligations and/or excess limits liability will not exceed an amount equal to 25% of the Company's ultimate net loss, each loss occurrence. ENTIRE AGREEMENT, INTERPRETATION -------------------------------- A. With respect to the business being reinsured hereunder, (i) this Agreement constitutes the entire agreement between the parties, and (ii) there are no understandings or agreements between the parties other than those expressed in this Agreement. Any change to or modification of this Agreement will be made by written amendment to this Agreement and signed by the parties hereto. B. This Agreement is between sophisticated parties, each of which has reviewed the Agreement and is fully knowledgeable about its terms and conditions. The parties therefore agree that this Agreement shall be construed without regard to the authorship of the language and without any presumption or rule of construction in favor of either of them. SPECIAL TERMINATION OR SETTLEMENT --------------------------------- Section I: Termination - ------------------------ A. Either party may terminate this Agreement upon 45 days notice in the event that: 1. The other party should at any time become insolvent, or suffer any impairment of capital, or file a petition in bankruptcy, or go into liquidation or rehabilitation, or have a receiver appointed, or be acquired or controlled by any other insurance company or organization, or 2. There is a severance or obstruction of free and unfettered communication and/or normal commercial and/or financial intercourse between the United States of America and the country in which the Reinsurer is incorporated or has its principal office as a result of war, currency regulations, or any circumstances arising out of political, financial or economic emergency. B. The Company may terminate this Agreement forthwith in the event that: 1. The Reinsurer ceases writing reinsurance and elects to run-off its existing business; 2. As respects domestic reinsurers: Upon application of the NAIC Insurance Regulatory Information System (IRIS) tests to the Reinsurer's quarterly and annual statements (which the Reinsurer hereby agrees to furnish to the Company upon request) it is found that four (4) or more of the Reinsurer's IRIS financial ratio values are outside the usual range established in the IRIS System. 3. As respects alien reinsurers: Upon review of the Insurance Solvency International (ISI) Performance Tests as published with respect to the Reinsurer (or upon application of such Performance Tests to the Reinsurer's annual financial statements which the Reinsurer hereby agrees to furnish to the Company upon request) it is found that four (4) or more of the Reinsurer's ratios are outside of the normal range (as defined by the ISI standard). 33 Termination under A. or B. shall be effected by written notice of cancellation. The Company will specify the mode of payment, i.e., a run-off basis or a clean cut basis with portfolio transfer, if applicable. In the event the Company elects a run-off basis, the Reinsurer will fund all of the outstanding ceded liabilities through a Trust Account or by providing a Letter of Credit that meets the requirements of the New York State Insurance Department. Section II: Settlement - ---------------------- After termination of this Agreement under this or any article, including the natural expiry of the Agreement, if the Reinsurer has any residual liability to the Company, the Reinsurer will, at the request of the Company, furnish to the Company statements as specified in Section B. above, and if four or more values are outside of the usual range established in the IRIS or ISI System (as applicable in accordance with Section B above) the Company shall have the option of an immediate settlement of all present and future obligations under this Agreement in accordance with Section III, or requiring the Reinsurer to fund all of the outstanding ceded liabilities through a Trust Account or by providing a Letter of Credit that meets the requirements of the New York State Insurance Department. In the event the Company elects the funding option, it shall then notify the Reinsurer in writing and the Reinsurer shall provide such funding within 15 days of such notification; however, it is agreed that the Company retains the right to require settlement in accordance with Section III at any subsequent date. Section III: Payment - -------------------- A. Amounts due the Company or the Reinsurer under this Article shall include all present and future obligations and shall include unearned premiums, outstanding losses, (including IBNR) and all other balances. B. In the event of a clean-cut termination with portfolio transfer or an immediate settlement of all present and future obligations the Company will, upon receipt of payment, provide to the Reinsurers a full and final release of Reinsurer's liability under the Agreement. C. When requested by either party an appraisal of outstanding losses and IBNR shall be made to a disinterested actuary. D. Settlement shall take into account adjustment for Net Present Value. This Article shall survive the termination of this Agreement. CONFIDENTIALITY --------------- All terms and conditions of this Agreement and any materials provided in the course of inspection shall be kept confidential by the Reinsurer as against third parties, unless the disclosure is required pursuant to process of law or unless the disclosure is to Reinsurer's retrocessionaires, financial auditors or governing regulatory bodies. Disclosing or using this information for any purpose beyond the scope of this Agreement, or beyond the exceptions set forth above, is expressly forbidden without the prior consent of the Company. 34 ACCESS TO RECORDS ----------------- The Reinsurer, or its duly authorized representative, shall have free access at all reasonable times during and after the currency of this agreement, to books and records maintained by any of the division, department and branch offices of the Company which are involved in the subject matter of this Agreement and which pertain to the reinsurance provided hereunder and all claims made in connection therewith. Notwithstanding the provisions of the preceding sentence, if undisputed balances due from the Reinsurer under this Agreement have not been paid for the two most recent reported calendar quarters, the Reinsurer shall not have access to any of the Company's records relating to this Agreement without the specific consent of the Company. 35 EX-99.1 5 doc4.txt Exhibit 99.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 Each of the undersigned hereby certifies, in his capacity as an officer of 21st Century Insurance Group (the "Company"), for purposes of 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of his knowledge: - the Quarterly Report of the Company on Form 10-Q for the period ended September 30, 2002 fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934; and - the information contained in such report fairly presents, in all material respects, the financial condition and results of operation of the Company. Dated: October 24, 2002 /s/ Bruce W. Marlow - --------------------------------------- Bruce W. Marlow President and Chief Executive Officer /s/ Douglas K. Howell - ---------------------------------------- Douglas K. Howell Senior Vice President, Chief Financial Officer and Treasurer 36 -----END PRIVACY-ENHANCED MESSAGE-----