10-Q 1 ocg10q3.txt OHIO CASUALTY CORP FORM 10-Q SEPT. 30, 2001 =============================================================================== SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-Q [x] Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934 For the quarter ended September 30, 2001. ------------------ [ ] Transition Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934 For the transition period from to ------------- ------------ Commission File Number 0-5544 OHIO CASUALTY CORPORATION (Exact name of registrant as specified in its charter) OHIO (State or other jurisdiction of incorporation or organization) 31-0783294 (I.R.S. Employer Identification No.) 9450 Seward Road, Fairfield, Ohio (Address of principal executive offices) 45014 (Zip Code) (513) 603-2400 (Registrant's telephone number) Securities registered pursuant to Section 12(g) of the Act: Common Shares, Par Value $.125 Each (Title of Class) Common Share Purchase Rights (Title of Class) 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 The aggregate market value as of November 1, 2001 of the voting stock held by non-affiliates of the registrant was $783,614,700. On November 1, 2001 there were 60,080,185 shares outstanding. Page 1 of 18 =============================================================================== PART I ITEM 1. FINANCIAL STATEMENTS
Ohio Casualty Corporation & Subsidiaries CONSOLIDATED BALANCE SHEET September 30, December 31, (In thousands, except per share data) (Unaudited) 2001 2000 ----------------------------------------------------------------------------------- Assets Investments: Fixed maturities: Available for sale, at fair value (cost: $2,635,216 and $2,470,375) $2,718,990 $2,513,654 Equity securities, at fair value (cost: $116,349 and $168,779) 521,613 754,919 Short-term investments, at fair value (cost: $121,877 and $59,679) 121,877 59,679 ----------------------------------------------------------------------------------- Total investments 3,362,480 3,328,252 Cash 19,002 30,365 Premiums and other receivables, net of allowance for bad debts of $9,000 and $10,700, respectively 365,404 357,108 Deferred policy acquisition costs 169,190 175,071 Property and equipment, net of accumulated depreciation of $129,498 and $122,040, respectively 95,285 91,259 Reinsurance recoverable 217,300 148,633 Agent relationships, net of accumulated amortization of $33,532 and $25,013, respectively 246,224 263,379 Other assets 96,382 95,298 ----------------------------------------------------------------------------------- Total assets $4,571,267 $4,489,365 =================================================================================== Liabilities Insurance reserves: Unearned premiums $ 697,534 $ 696,513 Losses 1,751,526 1,627,568 Loss adjustment expenses 385,251 375,951 Notes payable 210,330 220,798 California Proposition 103 reserve 7,851 17,500 Deferred income taxes 37,762 65,613 Other liabilities 398,824 368,831 ----------------------------------------------------------------------------------- Total liabilities 3,489,078 3,372,774 Shareholders' Equity Common stock, $.125 par value Authorized: 150,000 shares; issued shares: 94,418 11,802 11,802 Preferred stock, No par value Authorized: 2,000 shares; issued shares: 0 0 0 Additional paid-in capital 4,179 4,180 Common stock purchase warrants 21,138 21,138 Accumulated other comprehensive income: Unrealized gain on investments, net of applicable income taxes 318,658 409,904 Retained earnings 1,179,651 1,122,867 Treasury stock, at cost: (Shares: 34,341; 34,346) (453,239) (453,300) ----------------------------------------------------------------------------------- Total shareholders' equity 1,082,189 1,116,591 ----------------------------------------------------------------------------------- Total liabilities and shareholders' equity $4,571,267 $4,489,365 ===================================================================================
Accompanying notes are an integral part of these financial statements. For complete disclosures see Notes to Consolidated Financial Statements on pages 29-40 of the Corporation's 2000 Annual Report to Shareholders. 2 Ohio Casualty Corporation & Subsidiaries STATEMENT OF CONSOLIDATED INCOME AND COMPREHENSIVE INCOME
Three Months Ended September 30, (in thousands, except per share data) (Unaudited) 2001 2000 ------------------------------------------------------------------------------------ Premiums and finance charges earned $374,327 $394,015 Investment income less expenses 53,068 49,673 Investment gains realized, net 71,033 1,395 ------------------------------------------------------------------------------------ Total revenues 498,428 445,083 Losses and benefits for policyholders 252,249 276,099 Loss adjustment expenses 51,181 45,042 General operating expenses 27,190 35,286 Amortization of agent relationships 2,792 2,915 Write-off of agent relationships 1,267 1,083 Amortization of deferred policy acquisition costs 93,076 98,941 California Proposition 103 reserve, including interest 0 (34,208) ------------------------------------------------------------------------------------ Total expenses 427,755 425,158 ------------------------------------------------------------------------------------ Income from continuing operations before income taxes 70,673 19,925 Income tax (benefit) expense: Current 6,194 (948) Deferred 20,251 6,323 ------------------------------------------------------------------------------------ Total income tax expense 26,445 5,375 ------------------------------------------------------------------------------------ Net income $ 44,228 $ 14,550 ==================================================================================== Other comprehensive income (loss), net of taxes: Net increase/(decrease) in unrealized gains, net increase/(decrease) in tax expense of $(25,984) and $31,499, respectively (48,254) 58,499 ------------------------------------------------------------------------------------ Comprehensive income (loss) $ (4,026) $ 73,049 ==================================================================================== Average shares outstanding - basic* 60,076 60,074 ==================================================================================== Earnings per share - basic:* Net income, per share $ 0.74 $ 0.24 Average shares outstanding - diluted* 60,400 60,074 ==================================================================================== Earnings per share - diluted:* Net income, per share $ 0.73 $ 0.24 Cash dividends, per share $ 0.00 $ 0.12 ====================================================================================
Accompanying notes are an integral part of these financial statements. For complete disclosures see Notes to Consolidated Financial Statements on pages 29-40 of the Corporation's 2000 Annual Report to Shareholders. 3 Ohio Casualty Corporation & Subsidiaries STATEMENT OF CONSOLIDATED INCOME AND COMPREHENSIVE INCOME
Nine Months Ended September 30, (in thousands, except per share data) (Unaudited) 2001 2000 ----------------------------------------------------------------------------------- Premiums and finance charges earned $1,134,397 $1,151,077 Investment income less expenses 156,468 150,741 Investment gains (losses) realized, net 126,065 (7,300) ----------------------------------------------------------------------------------- Total revenues 1,416,930 1,294,518 Losses and benefits for policyholders 783,775 847,355 Loss adjustment expenses 141,632 132,771 General operating expenses 92,263 115,734 Amortization of agent relationships 8,520 8,801 Write-off of agent relationships 8,541 43,252 Early retirement charge 9,600 0 Amortization of deferred policy acquisition costs 283,636 296,390 Restructuring charge 0 22 California Proposition 103 reserve, including interest 0 (32,986) ----------------------------------------------------------------------------------- Total expenses 1,327,967 1,411,339 ----------------------------------------------------------------------------------- Income (loss) from continuing operations before income taxes 88,963 (116,821) Income tax (benefit) expense: Current 10,897 (26,032) Deferred 21,282 (22,128) ----------------------------------------------------------------------------------- Total income tax (benefit) expense 32,179 (48,160) ----------------------------------------------------------------------------------- Net income (loss) $ 56,784 $ (68,661) =================================================================================== Other comprehensive income (loss), net of taxes: Net increase/(decrease) in unrealized gains, net increase/(decrease) in tax expense of $(49,133) and $15,767, respectively (91,246) 29,281 ----------------------------------------------------------------------------------- Comprehensive loss $ (34,462) $ (39,380) =================================================================================== Average shares outstanding - basic* 60,074 60,076 =================================================================================== Earnings per share - basic:* Net income (loss), per share $ 0.95 $ (1.14) Average shares outstanding - diluted* 60,146 60,076 =================================================================================== Earnings per share - diluted:* Net income (loss), per share $ 0.94 $ (1.14) Cash dividends, per share $ 0.00 $ 0.47 ===================================================================================
Accompanying notes are an integral part of these financial statements. For complete disclosures see Notes to Consolidated Financial Statements on pages 29-40 of the Corporation's 2000 Annual Report to Shareholders. 4 Ohio Casualty Corporation and Subsidiaries STATEMENT OF CONSOLIDATED SHAREHOLDERS' EQUITY
Accumulated Additional Common other Total (in thousands, except per Common paid-in stock purchase comprehensive Retained Treasury shareholders' share data) (Unaudited) Stock capital warrants income earnings stock equity ---------------------------------------------------------------------------------------------------------------------------- Balance January 1, 2000 $11,802 $4,286 $21,138 $329,354 $1,237,562 $(453,155) $1,150,987 Net change in unrealized gain 45,048 45,048 Deferred income tax on net change in unrealized gain (15,767) (15,767) Net forfeiture of stock under stock award plan (10 shares) (94) (126) (220) Net loss (68,661) (68,661) Cash dividends paid ($.47 per share) (28,237) (28,237) --------------------------------------------------------------------------------------------------------------------------- Balance, September 30, 2000 $11,802 $4,192 $21,138 $358,635 $1,140,664 $(453,281) $1,083,150 =========================================================================================================================== Balance January 1, 2001 $11,802 $4,180 $21,138 $409,904 $1,122,867 $(453,300) $1,116,591 Net change in unrealized gain (140,379) (140,379) Deferred income tax on net change in unrealized gain 49,133 49,133 Net issuance of stock under stock award plan (5 shares) (1) 61 60 Net income 56,784 56,784 --------------------------------------------------------------------------------------------------------------------------- Balance, September 30, 2001 $11,802 $4,179 $21,138 $318,658 $1,179,651 $(453,239) $1,082,189 ===========================================================================================================================
Accompanying notes are an integral part of these financial statements. For complete disclosures see Notes to Consolidated Financial Statements on pages 29-40 of the Corporation's 2000 Annual Report to Shareholders. 5 Ohio Casualty Corporation and Subsidiaries STATEMENT OF CONSOLIDATED CASH FLOWS
Nine Months Ended September 30, (in thousands) (Unaudited) 2001 2000 ----------------------------------------------------------------------------------------- Cash flows from: Operations Net income (loss) $ 56,784 $ (68,661) Adjustments to reconcile net income to cash from operations: Changes in: Insurance reserves 134,279 79,431 Income taxes 57,235 (36,455) Premiums and other receivables (8,296) (10,335) Deferred policy acquisition costs 5,881 (3,212) Reinsurance recoverable (68,667) (18,231) Other assets 5,440 81,488 Other liabilities 660 22,666 California Proposition 103 reserves (9,649) (32,986) Amortization and write-down of agent relationships 17,061 52,053 Depreciation and amortization 6,095 12,200 Investment (gains) losses (126,065) 7,300 ----------------------------------------------------------------------------------------- Net cash generated by operating activities 70,758 85,258 ----------------------------------------------------------------------------------------- Investments Purchase of investments: Fixed income securities - available for sale (1,129,122) (878,846) Equity securities (6,787) (54,188) Proceeds from sales: Fixed income securities - available for sale 897,689 771,715 Equity securities 177,520 44,028 Proceeds from maturities and calls: Fixed income securities - available for sale 66,011 53,658 Equity securities 0 10,200 Property and equipment: Purchases (15,506) (7,560) Sales 674 1,809 ----------------------------------------------------------------------------------------- Net cash used from investing activities (9,521) (59,184) ----------------------------------------------------------------------------------------- Financing Notes payable: Repayments (10,468) (20,488) Proceeds from exercise of stock options 66 67 Dividends paid to shareholders 0 (28,237) ----------------------------------------------------------------------------------------- Net cash used in financing activities (10,402) (48,658) ----------------------------------------------------------------------------------------- Net change in cash and cash equivalents 50,835 (22,584) Cash and cash equivalents, beginning of period 90,044 149,957 ----------------------------------------------------------------------------------------- Cash and cash equivalents, end of period $ 140,879 $ 127,373 =========================================================================================
Accompanying notes are an integral part of these financial statements. For complete disclosures see Notes to Consolidated Financial Statements on pages 45-85 of the Corporation's 2000 Form 10-K, Item 14. 6 Ohio Casualty Corporation & Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Ohio Casualty Corporation (the Corporation) is the holding company of The Ohio Casualty Insurance Company (the Company), which is one of six property- casualty companies that make up the Ohio Casualty Group (the Group). NOTE I - INTERIM ADJUSTMENTS It is believed that all material adjustments necessary to present a fair statement of the results of the interim period covered are reflected in this report. The operating results for the interim periods are not necessarily indicative of the results to be expected for the full year. These statements should be read in conjunction with the financial statements and notes thereto in the Corporation's 2000 Annual Report to Shareholders. NOTE II - RECENTLY ISSUED ACCOUNTING STANDARDS In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) 133 "Accounting for Derivative Instruments and Hedging Activities." This statement standardizes the accounting for derivative instruments by requiring those items to be recognized as assets or liabilities with changes in fair value reported in earnings or other comprehensive income in the current period. In June 1999, the FASB issued SFAS 137 which deferred the effective date of adoption of SFAS 133 for fiscal quarters of fiscal years beginning after June 15, 2000 (January 1, 2001 for the Corporation). The adoption of FAS 133 has had an immaterial impact on the financial results of the Corporation. In June 2001, the FASB issued SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill will no longer be amortized but will be subject to annual impairment tests in accordance with the standards. Other intangible assets will continue to be amortized over their useful lives. The Corporation will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of 2002. The Corporation's only current intangible asset, agent relationships, is reported on the balance sheet in accordance with the standards and is being amortized over its useful life. The agent relationships intangible asset is also evaluated periodically for possible impairment. NOTE III - EARNINGS PER SHARE Basic and diluted earnings per share are summarized as follows (in thousands, except per share data):
Three months ended Nine months ended September 30 September 30 2001 2000 2001 2000 ---- ---- ---- ---- Income (loss) from continuing operations $44,228 $14,550 $56,784 $(68,661) Weighted average common shares outstanding - basic 60,076 60,074 60,074 60,076 Basic income (loss) from continuing operations - per average share $ 0.74 $ 0.24 $ 0.95 $ (1.14) ============================================================================= Weighted average common shares outstanding 60,076 60,074 60,074 60,076 Effect of dilutive securities 324 0 72 0 ----------------------------------------------------------------------------- Weighted average common shares outstanding - diluted 60,400 60,074 60,146 60,076 Diluted income (loss) from continuing operations - per average share $ 0.73 $ 0.24 $ 0.94 $ (1.14) =============================================================================
7 NOTE IV -- SEGMENT INFORMATION The Corporation has determined its reportable segments based upon its method of internal reporting in the quarter, which was organized by product line. The Corporation adopted a new Corporate Strategic Plan in the second quarter of 2001 that realigned its method of internal reporting during the quarter to three reportable segments. In accordance with SFAS 131, the Corporation has elected to restate prior period segment information in order to present comparable segment information. The new property and casualty segments are standard commercial lines, specialty commercial lines, and personal lines. Standard commercial lines includes workers' compensation, general liability, CMP, fire, inland marine, and commercial auto. Specialty commercial lines includes umbrella, fidelity and surety. Personal lines includes private passenger auto, homeowners, fire, inland marine, and umbrella. These segments generate revenues by selling a wide variety of personal, commercial and surety insurance products. The Corporation also has an all other segment which derives its revenues from investment income and premium financing. Each segment of the Corporation was managed separately during the quarter. The property and casualty segments are managed by assessing the performance and profitability of the segments through analysis of industry financial measurements including statutory loss and loss adjustment expense ratios, statutory combined ratio, premiums written, premiums earned and statutory underwriting gain/loss. The following tables present this information by segment as it is reported internally to management. Asset information by reportable segment is not reported, since the Corporation does not produce such information internally. 8 New Reportable Segments (Effective Second Quarter of 2001) Nine Months Ended September 30 (in thousands)
Standard Commercial Lines 2001 2000 -------------------------------------------------------------------- Net premiums written $528,850 $563,690 % Increase (decrease) (6.2)% 8.1% Net premiums earned 533,956 554,983 % Increase (decrease) (3.8)% 8.8% Underwriting gain (loss) (before tax) (103,480) (150,511) Loss ratio 68.9% 75.6% Loss expense ratio 14.8% 13.2% Underwriting expense ratio 36.0% 37.7% Combined ratio 119.7% 126.5%
Specialty Commercial Lines 2001 2000 -------------------------------------------------------------------- Net premiums written $105,461 $79,849 % Increase (decrease) 32.1% 4.9% Net premiums earned 99,166 75,617 % Increase (decrease) 31.1% 8.4% Underwriting gain (loss)(before tax) 16,638 8,337 Loss ratio 40.3% 37.2% Loss expense ratio 6.3% 4.7% Underwriting expense ratio 34.4% 44.6% Combined ratio 81.0% 86.5%
Personal Lines 2001 2000 -------------------------------------------------------------------- Net premiums written $494,247 $516,831 % Increase (decrease) (4.4)% (12.9)% Net premiums earned 500,774 519,731 % Increase (decrease) (3.6)% (7.4)% Underwriting gain (loss)(before tax) (65,143) (89,709) Loss ratio 75.1% 76.8% Loss expense ratio 11.2% 10.8% Underwriting expense ratio 27.1% 29.8% Combined ratio 113.4% 117.4%
Total Property & Casualty 2001 2000 -------------------------------------------------------------------- Net premiums written $1,128,558 $1,160,370 % Increase (decrease) (2.7)% (2.6)% Net premiums earned 1,133,896 1,150,331 % Increase (decrease) (1.4)% 0.8% Underwriting gain (loss)(before tax) (151,985) (231,883) Loss ratio 69.1% 73.7% Loss expense ratio 12.5% 11.5% Underwriting expense ratio 31.9% 34.7% Combined ratio 113.5% 119.9% Impact of catastrophe losses on combined ratio 2.9% 2.9%
All other 2001 2000 -------------------------------------------------------------------- Revenues $ 6,197 $ 3,297 Expenses 10,107 13,371 ------------------------------------------------------------------- Net income (loss) $(3,910) $(10,074)
Reconciliation of Revenues 2001 2000 -------------------------------------------------------------------- Net premiums earned for reportable segments $1,133,896 $1,150,331 Investment income 155,336 148,106 Realized gains (losses) 119,961 7,379 Miscellaneous income 392 357 -------------------------------------------------------------------- Total property and casualty revenues (Statutory basis) 1,409,585 1,306,173 Property and casualty statutory to GAAP adjustment 1,148 (14,952) ------------------------------------------------------------------- Total revenues property and casualty (GAAP basis) 1,410,733 1,291,221 Other segment revenues 6,197 3,297 ------------------------------------------------------------------- Total revenues $1,416,930 $1,294,518 ===================================================================
Reconciliation of Underwriting gain (loss) (before tax) 2001 2000 -------------------------------------------------------------------- Property and casualty under- writing gain (loss) (before tax) (Statutory basis) $(151,985) $(231,883) Statutory to GAAP adjustment (29,172) (13,231) -------------------------------------------------------------------- Property and casualty under- writing gain (loss) (before tax) (GAAP basis) (181,157) (245,114) Net investment income 156,468 150,741 Realized gains (losses) 126,065 (7,300) Other income (losses) (12,413) (15,148) -------------------------------------------------------------------- Income (loss) from continuing operations before income taxes $ 88,963 $(116,821) ====================================================================
9 New Reportable Segments (Effective Second Quarter of 2001) Three months ended September 30 (in thousands)
Standard Commercial Lines 2001 2000 -------------------------------------------------------------------- Net premiums written $164,709 $179,902 % Increase (decrease) (8.4)% 7.8% Net premiums earned 174,518 193,761 % Increase (decrease) (9.9)% 13.7% Underwriting gain (loss) (before tax) (27,562) (43,061) Loss ratio 66.3% 74.0% Loss expense ratio 15.3% 13.7% Underwriting expense ratio 36.2% 37.2% Combined ratio 117.8% 124.9%
Specialty Commercial Lines 2001 2000 -------------------------------------------------------------------- Net premiums written $38,492 $26,979 % Increase (decrease) 42.7% (16.1)% Net premiums earned 34,971 26,529 % Increase (decrease) 31.8% (0.3)% Underwriting gain (loss) (before tax) 1,393 3,482 Loss ratio 51.6% 37.7% Loss expense ratio 8.3% 5.9% Underwriting expense ratio 32.8% 42.6% Combined ratio 92.7% 86.2%
Personal Lines 2001 2000 -------------------------------------------------------------------- Net premiums written $164,625 $176,635 % Increase (decrease) (6.8)% (7.5)% Net premiums earned 164,789 173,579 % Increase (decrease) (5.1)% (6.6)% Underwriting gain (loss) (before tax) (18,456) (16,668) Loss ratio 71.8% 70.7% Loss expense ratio 13.1% 9.8% Underwriting expense ratio 26.3% 28.6% Combined ratio 111.2% 109.1%
Total Property & Casualty 2001 2000 -------------------------------------------------------------------- Net premiums written $367,826 $383,516 % Increase (decrease) (4.1)% (1.7)% Net premiums earned 374,278 393,869 % Increase (decrease) (5.0)% 2.9% Underwriting gain (loss) (before tax) (44,625) (56,247) Loss ratio 67.4% 70.1% Loss expense ratio 13.7% 11.4% Underwriting expense ratio 31.4% 33.6% Combined ratio 112.5% 115.1% Impact of catastrophe losses on combined ratio 3.2% 1.0%
All other 2001 2000 -------------------------------------------------------------------- Revenues $2,786 $ 874 Expenses 3,096 5,215 -------------------------------------------------------------------- Net income (loss) $ (310) $(4,341) ====================================================================
Reconciliation of Revenues 2001 2000 ------------------------------------------------------------------- Net premiums earned for reportable segments $374,278 $393,869 Investment income 52,765 49,084 Realized gains (losses) 69,293 7,848 Miscellaneous income 40 16 ------------------------------------------------------------------- Total property and casualty revenues (Statutory basis) 496,376 450,817 Property and casualty statutory to GAAP adjustment (734) (6,608) ------------------------------------------------------------------- Total revenues property and casualty (GAAP basis) 495,642 444,209 Other segment revenues 2,786 874 ------------------------------------------------------------------- Total revenues $498,428 $445,083 ===================================================================
Reconciliation of Underwriting gain (loss) (before tax) 2001 2000 -------------------------------------------------------------------- Property and casualty under- writing gain (loss) (before tax) (Statutory basis) $(44,625) $(56,247) Statutory to GAAP adjustment (5,320) 29,207 ------------------------------------------------------------------- Property and casualty under- writing gain (loss) (before tax) (GAAP basis) (49,945) (27,040) Net investment income 53,068 49,673 Realized gains (losses) 71,033 1,395 Other income (3,483) (4,103) ------------------------------------------------------------------- Income (loss) from continuing operations before income taxes $ 70,673 $ 19,925 ===================================================================
NOTE V - AGENT RELATIONSHIPS The agent relationship asset is the identifiable intangible asset acquired in connection with the Great American Insurance Company commercial lines acquisition. Agent relationships are evaluated periodically as events or circumstances indicate a possible inability to recover their carrying amount. The third quarter of 2001 included a $1.3 million before-tax write-off to the agent relationships asset. Year-to-date 2001 included an $8.5 million before-tax write-off to the agent relationships asset. Included in the write-offs were agents cancelled and certain agents determined to be impaired based on updated estimated future undiscounted cash flows that were insufficient to recover the carrying amount of the asset for the agent. During the first quarter of 2000, the Group made the strategic decision to discontinue its relationship with Managing General Agents. The result was a write-off to the agent relationships asset of $42.2 million. The Group believes the termination of Managing General Agents will give it better control of its underwriting and pricing practices. The remaining portion of the agent relationships asset will be amortized on a straight-line basis over the remaining amortization period. 10 The purchase agreement with the Great American Insurance Company called for an additional payment of up to $40.0 million if annualized revenue production of the transferred agents for the 18 month period ending June 1, 2000 equaled or exceeded production for the twelve months prior to the acquisition. The Company paid an additional $27.4 million for the final payment. Of the $27.4 million payment, $27.1 million was paid in 2000, while the remaining $.3 million was paid in 2001. This amount was added to the agent relationships asset for the acquisition and will be amortized over the remaining life. Additional information related to agent relationships is included in Note 1G, Agent Relationships on page 29 of the Corporation's 2000 Annual Report to Shareholders. NOTE VI - RESTRUCTURING CHARGE During December 1998, the Group adopted a plan to restructure its branch operations. To continue in the Corporation's efforts to reduce expenses, personal lines business centers were reduced from five to three locations. Underwriting branch locations were reduced from seventeen to eight locations and claims branches were reduced from thirty-eight to six locations in 1999. As part of this plan, the Corporation established a $10.0 million liability for future expenses related to its branch office consolidation plan, resulting in a one-time charge of $10.0 million being reflected in the 1998 income statement. These expenses consisted solely of future contractual lease payments related to abandoned facilities. The activities under the plan were completed in 1999, but due to leases still in effect, the balance in the restructuring reserve will continue to remain as leases expire. The Corporation reduced $2.2 million of liability in 2000 due to payments under leases. In the first nine months of 2001, the Corporation further reduced $.7 million of the liability due to payments under leases. The balance in the restructuring reserve was $1.8 million at September 30, 2001. NOTE VII - EARLY RETIREMENT CHARGE During the second quarter of 2001, the Corporation adopted an early retirement plan. The early retirement plan was available to approximately 330 employees. Of the employees eligible to retire under the program, 147 accepted. The early retirement plan resulted in a one-time before-tax charge of $9.6 million, or $.16 per share, to second quarter 2001 results. The after-tax impact of this one-time charge to earnings was $6.2 million, or $.10 per share to second quarter 2001 results. NOTE VIII - INTERNALLY DEVELOPED SOFTWARE In 2001, the Corporation introduced into limited production a new internally developed application for issuing and maintaining insurance policies. The Corporation capitalizes costs incurred to develop software used in the Corporation's operations. The cost associated with this application is then amortized on a straight-line basis over the estimated useful life of 10 years from the date placed into service. Upon full implementation, the new application should impact results by approximately $4 to $5 million per year. Unamortized software costs and accumulated amortization in the consolidated balance sheet were $33.1 million and $0.1 million at September 30, 2001, and $25.3 million and $0.0 million at December 31, 2000, respectively. 11 ITEM 2. Management's Discussion and Analysis of Financial ------- Condition and Results of Operations ------------------------------------------------------ Ohio Casualty Corporation (the Corporation) is the holding company of The Ohio Casualty Insurance Company (the Company), which is one of six property- casualty companies that make up the Ohio Casualty Group (the Group). RESULTS OF OPERATIONS Property and casualty before-tax underwriting losses, excluding California Proposition 103 and restructuring charges, for the nine months ended September 30, 2001 were $181.2 million, $3.01 per share, compared with $278.1 million, $4.63 per share for the same period in 2000. The 2001 loss included a one-time early retirement charge of $9.6 million and an $8.5 million write- off of the agent relationships intangible asset. The 2000 loss included a $43.3 million write-off of the agent relationships intangible asset and $17.0 million in additional ceded premiums on experience rated reinsurance contracts. The results for both periods were impacted by poor results in the workers' compensation line of business. For the third quarter of 2001, property and casualty before-tax underwriting losses, excluding California Proposition 103 were $49.9 million, or $.83 per share, compared with $61.2 million, or $1.02 per share, for the third quarter of 2000. The table below summarizes the increase (decrease) in property and casualty premium results compared with same period prior year results:
2001 increase (decrease) from 2000 ($ in millions) Gross Premiums Written Net Premiums Written Third Year Third Year Quarter To Date Quarter To Date ------- ------- ------- ------- Business Units -------------- Standard Commercial Lines $(15.1) $(54.1) $(15.2) $(34.8) Specialty Commercial Lines 10.2 29.6 11.5 25.6 Personal Lines (13.6) (31.9) (12.0) (22.6) All Lines (18.5) (56.4) (15.7) (31.8)
Agency cancellations and tighter underwriting guidelines combined with strong competition in the personal lines market contributed to the decrease in personal lines premiums for the current year. The year-to-date 2000 personal lines net premiums written results included $5.8 million in additional ceded premiums on experience rated reinsurance contracts. Despite the positive impact of renewal price increases in the standard commercial lines, 2001 premiums written decreased due to the cancellation and elimination of consistently unprofitable business. This decrease in premiums was primarily in the workers' compensation line of business. The year-to-date 2000 standard commercial lines net premiums written results included $11.2 million in additional ceded premiums on experience rated reinsurance contracts. Renewal price increases in the umbrella line of business in the specialty commercial lines contributed to the increase in premiums for the current year. When used in this report, renewal price increase means the average increase in premium for policies renewed by the Group. The average increase in premiums for each renewed policy is calculated by comparing the total expiring premium for the policy with the total renewal premium for the same policy. Renewal price increases include, among other things, the effects of rate increases and changes in the underlying insured exposures of the policy. Only policies issued by the Group in the previous policy term with the same policy identification codes are included. Therefore, renewal price increases do not include changes in premiums for newly issued policies and business assumed through reinsurance agreements, including Great American business not yet issued in the Group's systems. Renewal price increases also do not reflect the cost of any reinsurance purchased on the policies issued. During the first nine months of 2001, 17.4% of the Group's total net premiums written were for policyholders in New Jersey, compared with 15.0% of the Group's total net premiums written for the same period in 2000. For the third quarter 2001, 17.5% of the Group's total net premiums written were for policyholders in New Jersey, compared with 14.5% of the Group's total net premiums written in the same quarter in 2000. New 12 Jersey has historically been a profitable state for the Group. In recent years, however, New Jersey's legislative and regulatory environments have become less favorable. Legislative rules and regulations have adversely impacted the Group's results. Year-to-date consolidated before-tax realized investment gain was $126.1 million, or $2.10 per share, compared with a before-tax realized investment loss of $7.3 million, or $.12 per share, for year-to-date 2000. For the third quarter, consolidated before-tax realized investment gain was $71.0 million, or $1.18 per share, compared with a before-tax realized investment gain of $1.4 million, or $.02 per share, for the same period of 2000. As part of the Corporate Strategic Plan announced in the second quarter of 2001, the Corporation began to reallocate a portion of its equity portfolio holdings to fixed income holdings. Significant appreciation in the equity holdings sold as part of the reallocation contributed to the realized investment gains during 2001. This reallocation should reduce the effect on statutory surplus of future stock market volatility. Year-to-date consolidated before-tax investment income was $156.5 million, or $2.60 per share, increasing from $150.7 million, or $2.51 per share, for the same period last year. The investment income effective tax rate year-to-date 2001 was 33.3%, compared with 31.3% for year-to-date 2000. Third quarter consolidated before-tax investment income was $53.1 million, or $.88 per share, increasing from $49.7 million, or $.83 per share, for the same period last year. The investment income effective tax rate for the third quarter of 2001 was 33.6% compared with 31.8% for the comparable period in 2000. The increase in effective tax rate reflects a reallocation of investments from tax exempt municipal bonds to taxable bonds. STATUTORY RESULTS Management uses statutory results to analyze the property and casualty operating results. Management analyzes statutory results through the use of industry financial measurements including statutory loss and loss adjustment expense ratios, statutory underwriting expense ratio, statutory combined ratio, premiums written, and premiums earned. The statutory combined ratio is a commonly used gauge of statutory underwriting performance measuring the percentage of premium dollars used to pay customer losses and expenses. All Lines Discussion The statutory combined ratio for the first nine months of 2001 was 113.5%, decreasing from 119.9% in the same period of 2000. For the third quarter, the statutory combined ratio was 112.5%, compared with 115.1% in the same quarter of 2000. The decline in the statutory combined ratio is attributable to improvement in the standard commercial lines statutory loss ratio and all lines statutory underwriting expense ratio. Both periods were negatively impacted by high losses in the workers' compensation line of business. The year-to-date September 30, 2001 all lines accident year loss ratio of 67.7% was better than the calendar year-to-date statutory loss ratio of 69.1%. The year-to-date September 30, 2000 all lines accident year loss ratio of 68.9% was better than the calendar year-to-date statutory loss ratio of 73.7%. The year-to-date 2001 catastrophe losses were $32.7 million before tax and accounted for 2.9 points on the statutory combined ratio. This compares with $32.9 million and a 2.9 point catastrophe impact for the same period in 2000. The effect of future catastrophes on the Corporation's results cannot be accurately predicted. Severe weather patterns and other catastrophic results can have a material adverse impact on the Corporation's results. During the third quarter of 2001, there were 4 additional catastrophes with the largest catastrophe generating $7.0 million in losses as compared with 3 additional catastrophes in the third quarter of 2000 with the largest catastrophe generating $.3 million in losses. The third quarter 2001 losses included before-tax net of reinsurance losses of $7.0 million related to the September 11 terrorist attacks. For additional disclosure of catastrophe losses, refer to Note 9, Losses and Loss Reserves in the Notes to the Consolidated Financial Statements on pages 35 and 36 of the Corporation's 2000 Annual Report to Shareholders. 13 The year-to-date statutory underwriting expense ratio through September 30, 2001, was 31.9% compared with 34.7% in the same period of 2000. The third quarter 2001 statutory underwriting expense ratio improved to 31.4% from 33.6% in the same quarter of 2000. Actions to lower commissions and eliminate workers' compensation policyholder dividends on new and renewal policies led to the third quarter 2001 decrease. The third quarter 2001 results included $.3 million of software amortization related to the limited rollout of a new internally developed software application. On a statutory accounting basis, the new application is being amortized over a five-year period in accordance with statutory accounting principles. Upon full implementation, the new application should impact the statutory underwriting expenses by approximately $8 to $10 million per year. Segment Discussion Personal Lines The personal lines statutory combined ratio for the first nine months of 2001 decreased 4.0 points to 113.4% from 117.4% during the same period last year. For the third quarter of 2001, the personal lines statutory combined ratio increased 2.1 points to 111.2% from 109.1% in the same period of 2000. Private passenger auto-agency, the Group's largest line, recorded a 2001 nine- month statutory combined ratio of 108.7%, decreasing from 113.2% in 2000. For the third quarter of 2001, private passenger auto-agency statutory combined ratio was 110.6%, compared with 104.8% in the same quarter of 2000. Although the year-to-date results improved in 2001 from 2000, poor underwriting results in New Jersey business continue to impact this line's performance, adding 3.8 points to the statutory loss ratio in the first nine months of 2001, compared with adding 1.0 point in the first nine months of 2000. The New Jersey results added 3.3 points to the statutory loss ratio in the third quarter 2001, compared with 1.4 points in the same quarter of 2000. The poor New Jersey private passenger automobile results are driven by regulatory restraints in the state which restrict insurers' ability to raise rates. In addition, the New Jersey State Senate passed an auto insurance reform bill effective in early 1999 that mandated a 15% rate reduction for personal auto policies based on legal reform intended to provide a reduction in medical expense benefits, limitations on lawsuits and enhanced fraud prevention. While the rate reduction was immediate, many of the reforms have not yet been implemented, resulting in inadequate rate levels for the Group. Since 1999, New Jersey has also required insurance companies to write a portion of their personal auto premiums in Urban Enterprise Zones (UEZ). These zones are generally higher risk urban areas. The Group is required to write one policy in an UEZ for every seven policies written outside an UEZ. The Group is assigned policies if it does not write the required quota. As of September 30, 2001, the Group has written $6.5 million year to date in UEZ premiums, with $3.5 million in additional assigned premiums, compared with $4.7 million in UEZ premiums and $3.9 million in additional assigned premiums through the first nine months of 2000. For the three months ending September 30, 2001, the Group has written $1.8 million in UEZ premiums and $.1 million in additional assigned premiums, compared with $1.5 million in UEZ premiums and $0.0 million in additional assigned premiums in the same period 2000. The 2001 year-to-date loss ratio on the UEZ premiums was 165.3% and the loss ratio on the assigned business was 234.0%, compared with a loss ratio of 148.5% on UEZ premiums and 193.4% on assigned business for the same period last year. The third quarter 2001 loss ratio on UEZ premiums was 141.9% and the loss ratio on the assigned business was 206.7%, compared with a loss ratio of 131.5% on UEZ premiums and 180.6% on assigned business for the same quarter of last year. New Jersey's private passenger auto net premiums written represented approximately 26.6% of the Group's total private passenger auto-agency book of business in the first nine months of 2001, compared with approximately 21.7% in the first nine months of 2000. For the third quarter 2001, New Jersey's private passenger auto net premiums written represented approximately 27.2% of the Group's total private passenger auto-agency book of business, compared with approximately 19.1% in the third quarter of 2000. New Jersey regulation mandates private passenger automobile insurers in the state to provide insurance to all eligible consumers with limited exceptions. This "take-all- comers" regulation effectively eliminates the Group's ability to control the volume of writings in the state. 14 Given the unfavorable regulatory environment in New Jersey and the continued unprofitability of its private passenger auto business in the state, the Group is evaluating its options for the New Jersey private passenger automobile book of business. Standard Commercial Lines The standard commercial lines statutory combined ratio for the first nine months of 2001 decreased 6.8 points to 119.7% from 126.5% during the same period of 2000. For the third quarter of 2001, the standard commercial lines statutory combined ratio decreased 7.1 points to 117.8% from 124.9% in the same quarter of 2000. The 2001 statutory combined ratio improvement was driven by actions taken to improve loss results. Standard commercial lines reported a statutory loss and loss adjustment expense ratio of 83.7% for the first nine months of 2001, compared with 88.8% in the same period of 2000. Average renewal price increases for standard commercial lines direct premiums written were 14.9% for the first nine months of 2001, compared with an average renewal price increase of 7.7% for the first nine months of 2000. Commercial auto reported a year-to-date statutory combined ratio of 110.2%, a decrease of 10.5 points over the same period of 2000 statutory combined ratio of 120.7%. For the third quarter 2001, commercial auto statutory combined ratio was 111.0%, compared with 114.6% in the same period of 2000. For this line, as well as other commercial lines, the impact of price increases are being realized in earned premiums. The commercial auto average renewal price increase for the nine months ending September 30, 2001 was 14.8% compared with 7.1% for the same period in 2000. Workers' compensation statutory combined ratio for the first nine months of 2001 decreased 8.6 points to 140.1% from 148.7% during the same period last year. The results for the line of business have improved each quarter of 2001. Third quarter 2001 workers' compensation statutory combined ratio improved to 112.7% from 162.8% in the same period of 2000. The improvement is a result of actions taken to eliminate and cancel the most unprofitable workers' compensation business. The results have also been positively impacted by renewal price increases, the decision to eliminate dividends on new and renewal policies and the implementation of more restrictive underwriting guidelines. The statutory combined ratio for CMP, fire and inland marine for the first nine months of 2001 increased .1 points to 109.4% from 109.3% in the same period last year. For the third quarter of 2001, the CMP, fire and inland marine statutory combined ratio was 114.3%, compared with 101.9% in the same quarter last year. The CMP, fire and inland marine line of business year-to-date 2001 statutory loss ratio was impacted by 1.7 points for property losses related to the September 11 terrorists attacks, while the third quarter 2001 statutory loss ratio was impacted by 5.1 points due to this event. Specialty Commercial Lines Specialty commercial lines reported a nine-month statutory combined ratio of 81.0% in 2001, compared with 86.5% in 2000. For the third quarter of 2001, the specialty commercial lines statutory combined ratio was 92.7% compared with 86.2% in the same period of 2000. The umbrella line of business statutory combined ratio for the first nine months of 2001 decreased to 81.9% from 93.0% in 2000. For the third quarter of 2001, the umbrella statutory combined ratio was 92.3%, compared with 97.5% in the same period of 2000. The decrease is largely due to the impact of price increases being realized in earned premiums. Average renewal price increases for the umbrella business in the specialty commercial lines business unit were 19.7% for the first nine months of 2001, compared with an average renewal price increase of 7.7% for the first nine months of 2000. INVESTMENTS At September 30, 2001, the Corporation's fixed income portfolio totaled $2.7 billion, which consisted of 96.2% investment grade and 3.8% below investment grade securities. The Corporation classifies securities as below investment grade based upon ratings provided by Standard & Poor's Ratings Group, Moody's Investors Service or other rating agencies, including the National Association of Insurance Commissioners (NAIC). Below investment grade securities are summarized as follows: 15
September 30, December 31, (in millions) 2001 2000 ------------------------------------------------------------------------------ Below investment grade securities: Carrying value $103.0 $127.4 Amortized cost 116.7 133.6
Investments in below investment grade securities have greater risks than investments in investment grade securities. The risk of default by borrowers that issue below investment grade securities is significantly greater because these borrowers are often highly leveraged and more sensitive to adverse economic conditions, including a recession or a sharp increase in interest rates. Additionally, investments in below investment grade securities are generally unsecured and subordinate to other debt. Investment grade securities are also subject to significant risks, including additional leveraging or changes in control of the issuer. In most instances, investors are unprotected with respect to these risks, the effects of which can be substantial. The Corporation marks the value of its equity portfolio to fair market value on its balance sheet. As a result, shareholders' equity and statutory surplus fluctuate with changes in the value of the equity portfolio. As of September 30, 2001, the equity portfolio consisted of stock of 46 separate entities in 34 different industries. As of that date, 43.8% of the Corporation's equity portfolio was invested in five companies and the largest single position was 13.2% of the equity portfolio. For further discussion of the Corporation's investments, see Item 1 pages 6 through 9 of the Corporation's Form 10-K for the year ended December 31, 2000. LIQUIDITY AND FINANCIAL STRENGTH Net cash generated by operations was $70.8 million for the first nine months of the year compared with cash generated of $85.3 million for the same period in 2000. Net cash used by investing activities was $9.5 million for the first nine months of the year, compared with net cash used of $59.2 million for the first nine months of 2000. The change in cash used is a result of management's decision to reallocate a portion of its equity portfolio into fixed income securities. Current operational liquidity needs of the Group are expected to be met by scheduled bond maturities, dividend payments, interest payments, and cash balances. The Corporation had no shareholder dividend payments in the first nine months of 2001 compared with payments of $28.2 million for the same period in 2000. On February 8, 2001, the Corporation eliminated its quarterly dividend in order to further strengthen the Corporation's financial position. Ohio Casualty Corporation did not repurchase any of its shares during the first nine months of the year. The Corporation has remaining authorization to repurchase 1,649,824 additional shares. As of September 30, 2001, the Corporation had $210.3 million of outstanding notes payable. Of the $210.3 million, $5.3 million related to a low interest loan outstanding with the state of Ohio used in conjunction with the purchase of a new home office located in Fairfield, Ohio. The remaining $205.0 million is related to a 1997 credit facility that provided a $300.0 million revolving line of credit available to the Corporation. On March 19, 2001, the Corporation elected to reduce the aggregate amount available under the line of credit from $300.0 million to $250.0 million. The credit facility agreement contains financial covenants and provisions customary for such arrangements. The most restrictive covenants include a maximum permissible consolidated funded debt that cannot exceed 30% of consolidated tangible net worth and a minimum statutory surplus required to be at least $750.0 million. As of September 30, 2001, the Corporation is in compliance with these covenants. However, further deterioration of operating results, reductions in the equity portfolio valuation or other changes in surplus, including the effects of adopting new statutory accounting principles (such as the Codification of Statutory Accounting Principles guidance adopted by the NAIC in 1998), could lead to violations and ultimately result in default. The Corporation continues to review its financial covenants in the credit agreement in light of its operating losses. The 1997 credit facility expires in October 2002, with any outstanding loan balance due at that time. The Corporation may be required to obtain additional external funding, either in the form of debt or equity funding, to support its insurance operations in the future. While the Corporation believes that it should be able to obtain such 16 external funding, if needed, the availability of such funding cannot be assured nor can the cost of such funding be evaluated at this time. Additional information related to bank notes payable is included in Note 17 Bank Note Payable on page 39 of the Corporation's 2000 Annual Report to Shareholders. Regularly the Group's financial strength is reviewed by independent rating agencies. These agencies may upgrade, downgrade, or affirm their previous ratings of the Group. On July 25, 2001, A.M. Best announced that their rating of our group of companies is now "A-" (Excellent) from "A" previously. The rating action reflects the sharp deterioration in the Group's earnings and the significant reduction in policyholders' surplus over recent years. A.M. Best stated the "Excellent" rating was due to solid capitalization and strategic initiatives put in place by management to improve earnings. A.M. Best has placed a silent outlook on the Group's rating. On May 7, 2001, Standard & Poor's (S&P) Rating Services downgraded the Group's financial strength rating. The Group's S&P rating moved from "BBB+" to "BBB". S&P cited operating performance, declining capitalization, and limited financial flexibility as reasons for the rating change. S&P recognized the Group's improved strategic focus and re-underwriting actions as positive attributes. S&P has placed a negative outlook on the Group's rating. On May 2, 2001, Moody's Investors Services affirmed the Group's "A2" rating based on new executive leadership, ongoing expense reduction and re- underwriting initiatives, reduction or elimination of its shareholder dividends, and strength of its independent agency relationships. Moody's has revised the outlook for the Group's rating from negative to stable. LEGAL PROCEEDINGS California voters passed Proposition 103 in 1988 in an attempt to legislate premium rates for that state. The proposition required premium rate rollbacks for 1989 California policyholders while allowing for a "fair" return for insurance companies. In 1998, an Administrative Law Judge issued a proposed ruling with a rollback liability for the Group of $24.4 million plus simple interest at 10% per annum from May 8, 1989. This brought the total reserve to $52.3 million at September 30, 2000. On October 25, 2000, the Group announced a settlement agreement for California Proposition 103 that was approved by the California Insurance Commissioner. Under the terms of the settlement, the members of the Group will pay $17.5 million in refunded premiums to eligible 1989 California policyholders. With this development, the total reserve was decreased to $17.5 million as of December 31, 2000. The Corporation began to make payments in the first quarter of 2001. The remaining liability was $7.9 million as of September 30, 2001. FORWARD LOOKING STATEMENTS From time to time, the Company may publish forward looking statements relating to such matters as anticipated financial performance, business prospects and plans, regulatory developments and similar matters. The statements contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations that are not historical information, are forward looking statements. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. In order to comply with the terms of the safe harbor, the Company notes that a variety of factors could cause the Company's actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. The risks and uncertainties that may affect the operations, performance, development and results of the Company's business include the following: changes in property and casualty reserves; catastrophe losses; premium and investment growth; product pricing environment; availability of credit; changes in government regulation; performance of financial markets; fluctuations in interest rates; availability and pricing of reinsurance; litigation and administrative proceedings; acts of war and terrorist activities; rating agency actions; ability of Ohio Casualty to integrate and to retain the business acquired from the Great American Insurance Company; ability to achieve targeted expense savings; ability to refinance indebtedness; ability to achieve premium targets and profitability goals; and general economic and market conditions. 17 ITEM 3. Quantitative And Qualitative Disclosures About Market Risk There have been no material changes in the information about market risk set forth in the Corporation's Annual Report on Form 10-K. PART II ITEM 1. Legal Proceedings - Refer to Legal Proceedings as described on Page 17 of this Form 10-Q regarding California Proposition 103. ITEM 2. Changes in Securities - None ITEM 3. Defaults Upon Senior Securities - None ITEM 4. Submission of Matters to a Vote of Security Holders - None ITEM 5. Other Information - None ITEM 6. Exhibits and reports on Form 8-K - (a) Exhibits: 10 Employment Agreement with Donald F. McKee dated September 19, 2001 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. OHIO CASUALTY CORPORATION ------------------------- (Registrant) November 13, 2001 /s/ Donald F. McKee --------------------------- Donald F. McKee, CFO (on behalf of Registrant and as Principal Accounting Officer) 18