10-K 1 ocgf10k.txt OHIO CASUALTY CORP FORM 10-K PERIOD 12/31/2001 ============================================================================== SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-K [x] Annual Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 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 --- --- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K [ X ]. The aggregate market value as of February 28, 2002 of the voting stock held by non-affiliates of the registrant was $1,004,983,423. On February 28, 2002 there were 60,186,435 shares outstanding. Page 1 of 75 INDEX TO EXHIBITS ON PAGES 74-75 ============================================================================== Documents Incorporated by Reference Portions of the Registrant's definitive Proxy Statement for its Annual Meeting of Shareholders to be held on April 17, 2002, are incorporated by reference into Part III of this Annual Report on Form 10-K. 2 PART I Item 1. Business (a) Business Overview Ohio Casualty Corporation ("the Corporation") was incorporated in Ohio in 1969. With its predecessors, the Corporation has been engaged in the property and casualty insurance business since 1919 through a group of six direct and indirect subsidiaries which are collectively known as the Ohio Casualty Group ("the Group"). The Group consists of: - The Ohio Casualty Insurance Company ("the Company"); - West American Insurance Company ("West American"); - Ohio Security Insurance Company ("Ohio Security"); - American Fire and Casualty Company ("American Fire"); - Avomark Insurance Company ("Avomark"); and - Ohio Casualty of New Jersey, Inc. ("OCNJ"). The Corporation is in the process of phasing out its premium finance business, which was conducted through Ocasco Budget, Inc. In 1995, the Company discontinued its life insurance operations, which had been conducted through The Ohio Life Insurance Company. On December 1, 1998, the Company acquired substantially all of the assets of the commercial lines business of the Great American Insurance Company ("GAI") and its affiliates. The major lines of business included in the acquisition were workers' compensation, commercial multi-peril, umbrella, general liability and commercial auto. Since late 1999, the property and casualty insurance industry has experienced a general improvement in pricing conditions, especially in the commercial lines business. While the industry tends to exhibit alternating cycles of rising prices, followed by declining prices and poor underwriting performance, the commercial lines business was in an unusually protracted period of declining or inadequate prices from the late 1980s until recently. The Group implemented renewal price increases in its Standard Commercial Lines business unit averaging 15.2% during 2001 and 9.9% during 2000. The commercial umbrella business in the Specialty Commercial Lines business unit average renewal price increases were 20.3% for 2001, compared with 8.9% for 2000. The Group continues to seek additional renewal price increases on its Standard Commercial Lines and commercial umbrella business in 2002. 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 GAI 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. 3 Item 1. Continued In June of 2001, a new Corporate Strategic Plan ("Plan") was announced. The Plan introduced an organization structured around three business units: Standard Commercial Lines, Specialty Commercial Lines, and Personal Lines and established measurable financial targets for each business unit and the Group. The Corporation also completed its senior management team in 2001 with the additions of experienced officers in the Chief Financial Officer, Chief Technology Officer and Chief Actuary positions. In the fourth quarter of 2001, OCNJ entered into an agreement to transfer its obligations to renew private passenger auto business in New Jersey. This transaction will allow the Group to stop writing business in the New Jersey private passenger auto market in early 2002. In recent years, the market in New Jersey private passenger auto insurance has become more unstable due to the inability to control either the volume of writings or the profitability. Under the terms of the transaction, OCNJ will pay $40.6 million to Proformance Insurance Company to transfer its renewal obligations. The $40.6 million amount was taken as a charge in the fourth quarter of 2001 and will be paid out over the course of twelve months beginning in early 2002. OCNJ will cease writing private passenger auto business in New Jersey in 2002, and OCNJ will be retained by the Company as a subsidiary. The Group will maintain all of its other lines of business in New Jersey. OCNJ may also have a contingent liability of up to $15.6 million to be paid to the transferee company to maintain a maximum premiums-to-surplus ratio of 2.5 to 1 on the transferred business during the next three years. At December 31, 2001, it is not possible to determine the likelihood or extent of the liability and, therefore, it has not been recognized in the financial statements. The transaction is expected to positively impact operating results beginning in 2002. (b) Financial Information About Industry Segments The revenues, operating profit and combined ratios of each industry segment for the three years ended December 31, 2001 are set forth in Item 14, Note 14, Segment Information, in the Notes to the Consolidated Financial Statements on page 58 of this Form 10-K. Business Unit Description Standard Commercial Lines The Group transacts business in over 40 states. The Group's Standard Commercial Lines business unit, which accounted for 46.9% of net premiums written in 2001, includes primarily: - commercial multi-peril insurance, which insures a business against several risks, usually including property, liability, crime and boiler and machinery explosion; - commercial automobile insurance, which insures policyholders against third party liability related to the ownership and operation of motor vehicles in the course of business and property damage to insured vehicles. These policies may provide uninsured motorist coverage, which provides coverage to insureds and their employees for bodily injury and property damage caused by an uninsured party; 4 Item 1. Continued - workers' compensation insurance, which provides coverage to employers for their obligations to provide workers' compensation benefits as required by applicable statutes, including medical payments, rehabilitation, lost wages, disability and death benefits. These policies also provide coverage to employees for their liability exposures under common law; and - general liability insurance, which insures policyholders against third party liability for bodily injury and property damage, including liability for products sold, and the defense of claims alleging such damages. Specialty Commercial Lines The Group's Specialty Commercial Lines business unit, which accounted for 9.2% of net premiums written in 2001 includes primarily: - commercial umbrella insurance, which insures policyholders against liability and defense costs which exceed coverage provided within the underlying policies, typically commercial automobile and general liability policies, and provides coverage for some items not covered by underlying policies; and - fidelity and surety, which insure against dishonest acts of bonded employees and against the non-performance of parties under contracts, respectively. Personal Lines The Group's Personal Lines business unit, which accounted for the remaining 43.9% of net premiums written in 2001, includes primarily personal automobile and homeowners' insurance sold to individuals. The following table shows the Group's total property and casualty net premiums written by business units and selected lines of business for the periods indicated. Net premiums written includes gross premiums less premiums ceded pursuant to reinsurance programs.
BUSINESS UNITS and SELECTED LINES OF BUSINESS Statutory Net Premiums Written -------------------------- ------------------------------ (in thousands) 2001 2000 1999 ---- ---- ---- Standard Commercial Lines $ 689,596 $ 721,681 $ 720,755 Workers' compensation 148,628 185,800 191,688 Auto - Commercial 186,726 178,727 175,482 General liability 79,034 80,663 82,489 CMP, fire & inland marine 275,207 276,491 271,096 Specialty Commercial Lines 136,085 107,255 102,499 Commercial umbrella 92,154 65,576 62,795 Fidelity & surety 38,739 37,600 37,684 Personal Lines 646,504 676,457 763,643 Auto - Agency 444,385 455,330 526,515 Auto - Direct 6,821 10,711 17,145 Homeowners 161,960 173,222 181,905 Total all lines $1,472,185 $1,505,393 $1,586,897
5 Item 1. Continued Property and casualty statutory net premiums written decreased $33.2 million in 2001 from 2000. The net premiums written decrease in 2001 and 2000 can be attributed primarily to a more selective underwriting philosophy that led to the elimination and cancellation of certain business. Renewal price increases had a positive impact during 2001. Actions taken in 2000 to cancel the Managing General Agents and the Group's most unprofitable agents and policies represented over $150 million in annual net premiums written. The Group terminated its relationships with all managing general agents in the first quarter of 2001. Managing general agents are granted wider latitude to make underwriting decisions than the Group's other agents. The Group concluded that this latitude was inconsistent with the emphasis on strengthening underwriting guidelines for the business. The managing general agent relationships were acquired as part of the GAI commercial lines business. (c) Narrative Description of Business Marketing and Distribution The Group is represented on a commission basis by approximately 3,200 independent insurance agencies with over 5,800 agents. In most cases, these agents also represent other unaffiliated companies which may compete with the Group. The six claim and eight underwriting and service offices operated by the Group assist these independent agents in producing and servicing the Group's business. Certain agencies that meet established profitability and production targets are eligible for "key agent" status. At December 31, 2001, these agencies represented 18.6% of the Group's total agency force and wrote 38.4% of its book of business. The policies placed by key agents have consistently produced a lower statutory loss ratio for the Group than policies placed by other agents. Historically, the Group has targeted small business customers for its Standard Commercial Lines business. The Group's typical commercial lines customer is a small business with a small number of employees and a need for a package of coverages which can be conveniently purchased. For the year 2001, this commercial lines customer group, categorized by commercial liability premium volume, included approximately 71% contractors/artisans, 10% building/premises, 12% mercantile and 7% manufacturing. The Company believes that this small business customer group offers the opportunity to develop strong customer and agent relationships, apply its underwriting experience to this specific type of customer and achieve superior underwriting results. 6 Item 1. Continued The Group markets personal automobile insurance primarily to standard and preferred risk drivers. Standard and preferred risk drivers are those who have met certain criteria, including a driving record which reflects a low historical incidence of at-fault accidents and moving violations of traffic laws. The Group does not target "non-standard" risk drivers who fall outside these criteria. Because the Group's personal automobile insurance line of business has been more profitable than its homeowners' insurance line of business, the Group emphasizes writing a single customer's auto insurance and homeowners' insurance and de-emphasizes the marketing of homeowners' insurance to those customers who have not purchased automobile insurance. The Group's business is geographically concentrated in the Midwest and Mid- Atlantic regions. The following table shows consolidated direct premiums written for the Group's ten largest states: Ten Largest States Direct Premiums Written From Continuing Operations (in thousands)
Percent Percent Percent 2001 of Total 2000 of Total 1999 of Total ---- -------- ---- -------- ---- -------- New Jersey* $264,866 17.1 New Jersey $221,965 15.6 New Jersey $230,652 17.4 Ohio 150,635 9.6 Ohio 153,057 10.8 Ohio 153,146 11.5 Kentucky 119,126 7.7 Kentucky 132,631 9.3 Kentucky 125,438 9.5 Pennsylvania 105,536 6.8 Pennsylvania 91,979 6.5 Pennsylvania 87,986 6.6 Illinois 78,954 5.1 Illinois 81,747 5.8 Illinois 77,035 5.8 North Carolina 70,910 4.6 Indiana 75,340 5.3 Indiana 74,073 5.6 Indiana 68,224 4.4 North Carolina 54,710 3.9 North Carolina 39,345 3.0 Maryland 58,516 3.8 Maryland 45,496 3.2 Maryland 38,851 2.9 Texas 49,181 3.2 Texas 45,386 3.2 Texas 37,894 2.9 New York 41,446 2.7 Michigan 39,347 2.8 Oklahoma 33,995 2.6 ---------- ---- -------- ---- -------- ---- $1,007,394 65.0 $941,658 66.4 $898,415 67.8 ========== ==== ======== ==== ======== ====
*New Jersey private passenger auto and personal umbrella business represented 46.4% of the total New Jersey direct premiums written in 2001. The New Jersey renewal transfer will allow the Group to stop writing business in the New Jersey private passenger auto and personal umbrella markets in early 2002. Excluding the Group's New Jersey private passenger auto and personal umbrella direct premiums written, New Jersey would have represented 14.1% of the total direct premiums written. 7 Item 1. Continued Investments The distribution of the Corporation's invested assets is determined by a number of factors, including: - insurance law requirements; - liquidity needs; - tax planning; - general market conditions; and - business mix and liability payout patterns. Periodically, the Group reallocates its investment portfolio subject to the parameters set by the investment committee. In 2001, the Group reallocated a portion of its equity portfolio to fixed income holdings. Significant appreciation in the equities sold, as part of the reallocation, contributed to before-tax realized gains of $182.9 million in 2001. During 1999, the Group reallocated a portion of its investment portfolio by selling approximately $200 million in equity securities, resulting in approximately $145 million of before-tax realized gains. The funds previously invested in equity securities were reallocated to investment grade fixed income securities. The Group also has reduced its tax exempt bond portfolio significantly since 1999. Tax exempt bonds decreased to 1.1% of the fixed income portfolio at December 31, 2001, versus 3.2% at December 31, 2000 and 19.4% at December 31, 1999. The Group applied the funds previously invested in tax exempt bonds to investment grade taxable bonds. Due to recent poor operating results, the Group reduced its holdings of tax exempt securities during the past three years in order to maximize after- tax income. Assets relating to property and casualty operations are invested to maximize after-tax returns with appropriate diversification of risk. The following table sets forth the carrying values and other data of the Corporation's invested assets as of the end of the years indicated: 8 Item 1. Continued Distribution of Invested Assets ($ in millions)
2001 Average % of % of % of Rating 2001 Total 2000 Total 1999 Total ------- ---- ----- ---- ----- ---- ----- U.S. government AAA $ 29.4 0.9 $ 55.6 1.7 $ 65.1 2.0 Tax exempt bonds and notes Investment grade AA+ 29.6 0.9 77.4 2.2 459.2 14.4 Below investment grade BB- 1.7 0.1 1.9 0.1 2.2 0.1 Corporate securities Investment grade A 1,516.6 45.7 1,143.1 34.3 877.7 27.6 Below investment grade BB- 87.0 2.6 111.8 3.4 188.4 5.9 Mortgage-backed securities Investment grade AA+ 1,102.2 33.2 1,110.2 33.4 761.1 23.9 Below investment grade BB 5.6 0.2 13.7 0.4 23.3 0.8 -------- ----- -------- ----- -------- ----- Total bonds A+ 2,772.1 83.6 2,513.7 75.5 2,377.0 74.7 Common stocks 488.6 14.7 754.8 22.7 698.0 22.0 Preferred stocks 0.4 - 0.1 - 0.1 - -------- ----- -------- ----- -------- ----- Total stocks 489.0 14.7 754.9 22.7 698.1 22.0 Short-term 54.8 1.7 59.7 1.8 104.4 3.3 -------- ----- -------- ----- -------- ----- Total investments $3,315.9 100.0 $3,328.3 100.0 $3,179.5 100.0 ======== ===== ======== ===== ======== ===== Total market value of investments $3,315.9 $3,328.3 $3,179.5 ======== ======== ======== Total amortized cost of investments $2,895.0 $2,698.8 $2,674.1 ======== ======== ========
At December 31, 2001, the Corporation's fixed income portfolio totaled $2,772.1 million, which consisted of 96.6% investment grade securities and 3.4% 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"). 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 adverse risks, including additional leveraging of, and changes in control of the issuer. In most instances, investors are unprotected with respect to these risks, the effects of which can be substantial. 9 Item 1. Continued The following table shows yield, based on cost, of the Corporation's fixed income portfolio as of the end of the years indicated:
2001 2000 1999 ---- ---- ---- Investment grade 7.3% 7.4% 7.5% Below investment grade 9.1% 10.1% 10.0% Total taxable 7.5% 7.6% 7.8% Tax exempt 6.5% 5.4% 5.5%
The Corporation has a diversified common stock portfolio. At December 31, 2001, the Corporation's common stock portfolio totaled $488.6 million and consisted of stocks of 46 separate entities, diversified across 34 different industries. The largest single position, however, was 11.8% of the portfolio. The portfolio strategy, with respect to common stocks, is to invest in companies whose stocks have below average valuations but above average growth prospects. The Corporation focuses on large companies with dominant or strong market positions, strong profitability and stability and strength in balance sheet structure. The turnover rate in the portfolio has been low for the past several years. These factors created a portfolio structure that has been overweighted in the financial services sector and underweighted in the technology sector for the ten years ending December 31, 2001. The Corporation is required by both accounting principles generally accepted in the United States ("GAAP") and statutory accounting principles to mark the value of its equity portfolio to market for reporting on its balance sheet. As a result, GAAP shareholders' equity and statutory surplus fluctuate with changes in the value of its equity portfolio. Liabilities for Unpaid Loss and Loss Adjustment Expenses Liabilities for loss and loss adjustment expenses are established for the estimated ultimate costs of settling claims for insured events, both reported claims and incurred but not reported claims, based on information known as of the evaluation date. As more information becomes available and claims are settled, the estimated liabilities are adjusted upward or downward with the effect of increasing or decreasing net income at the time of the adjustments. Such estimated liabilities include direct costs of the loss under terms of insurance policies, as well as legal fees and general expenses of administering the claims adjustment process. The effect of catastrophes on the Group's results cannot be accurately predicted and they may have a material adverse effect on the Group's results. In 2001, 2000 and 1999 the Group was impacted by 19, 24 and 27 catastrophes, respectively. The largest catastrophe in each of these years was $17.8 million, $7.1 million and $17.9 million in incurred losses. Additional catastrophes with over $1 million in incurred losses numbered 4 in 2001, 9 in 2000 and 7 in 1999. The additional catastrophes with over $1.0 million in incurred losses included $3.0 million of net of reinsurance losses related to the September 11, 2001 terrorist attacks in New York. For additional discussion of catastrophe losses, please refer to Item 14, Note 10, Loss and Loss Reserves, of the Notes to the Consolidated Financial Statements on pages 56 and 57 of this Form 10-K. 10 Item 1. Continued In the normal course of business, the Group is involved in disputes and litigation regarding the terms of insurance contracts and the amount of liability under such contracts arising from insured events. The liabilities for loss and loss adjustment expenses include estimates of the amounts for which the Group may be liable upon settlement or other conclusion of such litigation. Because of the inherent future uncertainties in estimating ultimate costs of settling claims, actual loss and loss adjustment expenses may deviate substantially from the amounts recorded in the Corporation's consolidated financial statements. Furthermore, the timing, frequency and extent of adjustments to the estimated liabilities cannot be accurately predicted since conditions and events which established historical loss and loss adjustment expense development and which serve as the basis for estimating ultimate claims cost may not occur in the future in exactly the same manner, if at all. The anticipated effect of inflation is implicitly considered when estimating the liability for losses and loss adjustment expenses based on historical loss development trends adjusted for anticipated changes in underwriting standards, policy provisions and general economic trends. The following tables present an analysis of losses and loss adjustment expenses and related liabilities for the periods indicated. The accounting policies used to estimate liabilities for losses and loss adjustment expenses are described in Item 14, Note 1H, Accounting Policies and Note 10, Losses and Loss Reserves, in the Notes to the Consolidated Financial Statements on pages 50, 56 and 57 of this Form 10-K. Reconciliation of Liabilities for Losses and Loss Adjustment Expense (in thousands)
2001 2000 1999 ---- ---- ---- Net liabilities, beginning of year $1,907,331 $1,823,329 $1,865,643 Provision for current accident year claims 1,145,545 1,237,319 1,176,072 Increase (decrease) in provisions for prior accident year claims 58,489 56,846 (418) ----------- ----------- ----------- 1,204,034 1,294,165 1,175,654 Payments for claims occurring during: Current accident year 520,232 596,114 600,942 Prior accident years 609,148 614,049 617,026 ----------- ----------- ----------- 1,129,380 1,210,163 1,217,968 Net liabilities, end of year 1,981,985 1,907,331 1,823,329 Reinsurance recoverable 168,737 96,188 85,126 ----------- ----------- ----------- Gross liabilities, end of year $2,150,722 $2,003,519 $1,908,455 =========== =========== ===========
11 Item 1. Continued Analysis of Development of Loss and Loss Adjustment Expense Liabilities (In thousands)
Year Ended December 31 1991 1992 1993 1994 1995 1996 ---------------------- ---- ---- ---- ---- ---- ---- Net liability as originally estimated: $1,566,738 $1,673,868 $1,693,551 $1,606,487 $1,557,065 $1,486,622 Life Operations Liability 599 663 656 961 3,934 3,722 P&C Operations Liabiity $1,566,139 $1,673,205 $1,692,895 $1,605,526 $1,553,131 $1,482,900 Net cumulative payments as of: One year later 526,973 561,133 533,634 510,219 486,168 483,574 Two years later 822,634 869,620 833,399 803,273 772,670 747,374 Three years later 1,007,189 1,060,433 1,017,893 997,027 944,294 950,138 Four years later 1,123,591 1,176,831 1,147,266 1,106,361 1,080,373 1,058,300 Five years later 1,201,317 1,264,900 1,218,916 1,203,717 1,151,001 1,121,263 Six years later 1,266,605 1,316,756 1,288,148 1,257,334 1,198,340 Seven years later 1,302,313 1,369,889 1,331,291 1,293,461 Eight years later 1,342,839 1,405,107 1,363,089 Nine years later 1,370,913 1,433,612 Ten years later 1,393,469 Gross cumulative payments as of: One year later 556,691 586,869 547,377 522,811 500,150 498,274 Two years later 867,483 904,911 859,142 827,232 798,078 781,853 Three years later 1,056,173 1,107,980 1,051,915 1,030,701 988,674 983,440 Four years later 1,182,598 1,231,386 1,190,466 1,158,798 1,123,163 1,098,738 Five years later 1,266,170 1,328,478 1,278,602 1,254,475 1,200,600 1,171,207 Six years later 1,339,559 1,394,890 1,347,025 1,314,586 1,257,360 Seven years later 1,387,821 1,446,560 1,396,505 1,359,925 Eight years later 1,428,103 1,487,891 1,437,481 Nine years later 1,461,989 1,524,506 Ten years later 1,492,373
Year Ended December 31 1997 1998 1999 2000 2001 ---------------------- ---- ---- ---- ---- ---- Net liability as originally estimated: $1,421,804 $1,865,643 $1,823,329 $1,907,331 $ 1,981,985 Life Operations Liability 100 98 - - - P&C Operations Liability 1,421,704 1,865,545 1,823,329 1,907,331 1,981,985 Net cumulative payments as of: One year later 449,802 640,209 614,049 609,148 Two years later 751,179 999,069 960,503 Three years later 919,272 1,223,348 Four years later 1,016,871 Five years later Six years later Seven years later Eight years later Nine years later Ten years later Gross cumulative payments as of: One year later 469,933 654,204 636,530 647,115 Two years later 775,371 1,022,220 1,007,084 Three years later 950,445 1,261,136 Four years later 1,057,505 Five years later Six years later Seven years later Eight years later Nine years later Ten years later
12 Item 1. Continued Analysis of Development of Loss and Loss Adjustment Expense Liabilities (continued)(In thousands)
Year Ended December 31 1991 1992 1993 1994 1995 1996 ---------------------- ---- ---- ---- ---- ---- ---- Net liability re-estimated as of: One year later 1,515,129 1,601,406 1,539,178 1,500,528 1,474,795 1,427,992 Two years later 1,500,890 1,555,452 1,510,943 1,501,530 1,441,081 1,403,059 Three years later 1,467,256 1,524,054 1,515,114 1,486,455 1,445,738 1,439,008 Four years later 1,449,789 1,559,492 1,525,493 1,507,331 1,478,787 1,456,890 Five years later 1,498,881 1,561,763 1,551,024 1,546,849 1,497,573 1,447,959 Six years later 1,499,009 1,588,063 1,587,885 1,566,276 1,491,985 Seven years later 1,526,136 1,627,385 1,609,600 1,560,871 Eight years later 1,558,571 1,649,372 1,606,164 Nine years later 1,577,553 1,649,387 Ten years later 1,577,036 Decrease (increase) in original estimates: $ (10,897) $ 23,818 $ 86,731 $ 44,655 $ 61,146 $ 34,941 Net liability as originally estimated: $1,566,139 $1,673,205 $1,692,895 $1,605,526 $1,553,131 $1,482,900 Reinsurance recoverable on unpaid losses and LAE 98,456 80,114 75,738 65,336 71,066 64,695 Gross liability as originally estimated: $1,665,194 $1,753,982 $1,769,289 $1,671,823 $1,631,184 $1,556,670 Life Operations Liability 599 663 656 961 6,987 9,075 P&C Operations Liability 1,664,595 1,753,319 1,768,633 1,670,862 1,624,197 1,547,595 One year later 1,609,793 1,693,958 1,611,032 1,574,177 1,546,001 1,496,100 Two years later 1,603,891 1,645,634 1,591,328 1,579,932 1,515,032 1,507,365 Three years later 1,567,801 1,623,559 1,601,354 1,565,580 1,561,675 1,537,356 Four years later 1,558,508 1,664,239 1,612,300 1,630,314 1,585,459 1,559,519 Five years later 1,612,537 1,666,556 1,680,806 1,657,037 1,608,296 1,558,160 Six years later 1,612,012 1,722,897 1,704,863 1,680,592 1,609,850 Seven years later 1,666,562 1,758,687 1,731,007 1,682,809 Eight years later 1,695,786 1,784,615 1,735,071 Nine years later 1,718,840 1,791,221 Ten years later 1,724,804 Decrease (increase) in original estimates: (60,209) (37,902) 33,562 (11,947) 14,347 (10,564)
Year Ended December 31 1997 1998 1999 2000 2001 ---------------------- ---- ---- ---- ---- ---- Net liability re-estimated as of: One year later 1,355,586 1,888,387 1,880,174 1,965,820 Two years later 1,386,401 1,885,236 1,907,575 Three years later 1,400,662 1,901,776 Four years later 1,391,970 Five years later Six years later Seven years later Eight years later Nine years later Ten years later Decrease (increase) in original estimates: $ 29,734 $ (36,232) $ (84,246) $ (58,489) Net liability as originally estimated: $1,421,704 $1,865,545 $1,823,329 $1,907,331 $1,981,985 Reinsurance recoverable on unpaid losses and LAE 59,952 80,215 85,126 96,188 168,737 Gross liability as originally estimated: $1,483,807 $1,956,939 $1,908,455 $2,003,519 $2,150,722 Life Operations Liability 2,150 11,180 - - - P&C Operations Liability 1,481,657 1,945,759 1,908,455 2,003,519 2,150,722 One year later 1,447,044 1,972,890 1,981,093 2,129,865 Two years later 1,477,874 1,975,657 2,041,717 Three years later 1,495,816 2,006,064 Four years later 1,495,563 Five years later Six years later Seven years later Eight years later Nine years later Ten years later Decrease (increase) in original estimates: (13,907) (60,305) (133,262) (126,346)
13 Item 1. Continued Reinsurance Reinsurance is a contract by which one insurer, called a reinsurer, agrees to cover, under certain defined circumstances, a portion of the losses incurred by a primary insurer in the event a claim is made under a policy issued by the primary insurer. The Group purchases reinsurance to protect against large or catastrophic losses. There are several programs that provide reinsurance coverage. The Group's property per risk program covers property losses in excess of $1.0 million for a single insured, for a single event. This property per risk program covers up to $29.0 million in losses in excess of the $1.0 million retention level for a single event. The Group's casualty per occurrence program covers liability losses. Workers' compensation, umbrella and other casualty reinsurance cover losses up to $99.0 million, $49.0 million and $23.0 million, respectively, in excess of the $1.0 million retention level for a single insured event. The property catastrophe reinsurance program protects the Group against an accumulation of losses arising from one defined catastrophic occurrence or series of events. This program provides $150.0 million of coverage in excess of the Group's $25.0 million retention level. In 2001, a portion of the catastrophe program was renewed with a multi-year placement as in previous years. This provides continuity and maintains rates and each reinsurer's overall share of the program. Over the last 20 years, two events triggered coverage under the catastrophe reinsurance program. Losses and loss adjustment expenses from the Oakland fires in 1991 totaled $35.6 million and losses and loss adjustment expenses from Hurricane Andrew in 1992 totaled $29.8 million. Both of these losses exceeded the prior retention amount of $13.0 million, resulting in significant recoveries from reinsurers. Reinsurance limits are purchased to cover exposure to catastrophic events having the probability of occurring every 150-250 years. GAI has agreed to maintain reinsurance on the commercial lines business that the Company acquired from GAI and its affiliates in 1998. GAI is obligated to reimburse the Company if Great American's reinsurers are unable to pay claims with respect to the acquired commercial lines business. Reinsurance contracts do not relieve the Group of their obligations to policyholders. The collectibility of reinsurance depends on the solvency of the reinsurers at the time any claims are presented. The Group monitors each reinsurer's financial health and claims settlement performance because reinsurance protection is an important component of the Corporation's financial plan. Each year, the Group reviews financial statements and calculates various ratios used to identify reinsurers who no longer meet appropriate standards of financial strength. Reinsurers who fail these tests are removed from the program at renewal. Additionally, a large base of reinsurers is utilized to mitigate concentration of risk. During the last three fiscal years, no reinsurer accounted for more than 15% of total ceded premiums. As a result of these controls, amounts of uncollectible reinsurance have not been significant. 14 Item 1. Continued All of the Company's insurance subsidiaries, except Ohio Casualty of New Jersey, Inc., have entered into an intercompany reinsurance pooling agreement. The purpose of this agreement is to: - pool or share proportionately the results of property and casualty insurance underwriting operations through reinsurance; - reduce administration and executive expense; and - broaden each participating insurance subsidiary's distribution of risk. Under the terms of the intercompany reinsurance pooling agreement, all of the participants' outstanding underwriting liabilities as of January 1, 1984 and all subsequent insurance transactions were pooled. The participating insurance subsidiaries share in losses based on the following percentages: Insurance Subsidiary Percentage of Losses -------------------- -------------------- The Company 46.75 West American 46.75 American Fire 5.00 Ohio Security 1.00 Avomark 0.50 Competition The Group competes on the basis of service, price and coverage. Competition in the property and casualty industry is highly competitive. According to A.M. Best, based on net insurance premiums written in 2000, the latest year for which industry nationwide comparison statistics are available: - more than $300 billion of net premiums were written by property and casualty insurance companies in the United States and no one company or company group had a market share greater than approximately 11.0%; and - the Group ranked as the thirty-seventh largest property and casualty insurance group in the United States. 15 Item 1. Continued Regulation State Regulation The Corporation's insurance subsidiaries are subject to regulation and supervision in the states in which they are domiciled and in which they are licensed to transact business. The Company, American Fire, Ohio Security and OCNJ are all domiciled in Ohio. West American and Avomark are domiciled in Indiana. Collectively, the Corporation's subsidiaries are licensed to transact business in all 50 states and the District of Columbia. Although the federal government does not directly regulate the insurance industry, federal initiatives can also impact the industry. The authority of state insurance departments extends to various matters, including: - the establishment of standards of solvency, which must be met and maintained by insurers; - the licensing of insurers and agents; - the imposition of restrictions on investments; - approval and regulation of premium rates for property and casualty insurance; - the payment of dividends and distributions; - the provisions which insurers must make for current losses and future liabilities; and - the deposit of securities for the benefit of policyholders and the approval of policy forms. State insurance departments also conduct periodic examinations of the financial and business affairs of insurance companies and require the filing of annual and other reports relating to the financial condition of insurance companies. Regulatory agencies require that premium rates not be excessive, inadequate or unfairly discriminatory. In general, the Corporation's insurance subsidiaries must file all rates for personal and commercial insurance with the insurance department of each state in which they operate. State laws also regulate insurance holding company systems. Each insurance holding company in a holding company system is required to register with the insurance supervisory agency of its state of domicile and furnish information concerning the operations of companies within the holding company system that may materially affect the operations, management or financial condition of the insurers. Pursuant to these laws, the respective departments may examine the parent and the insurance subsidiaries at any time and require prior approval or notice of various transactions including dividends or distributions to the parent from the subsidiary domiciled in that state. These state laws also require prior notice or regulatory agency approval of changes in control of an insurer or its holding company and of other material transfers of assets within the holding company structure. Under applicable provisions of Indiana and Ohio insurance statutes, the states in which the members of the Group are domiciled, a person would not be permitted to acquire direct or indirect control of the Corporation or any of its insurance subsidiaries, unless that person had obtained prior approval of the Indiana Insurance Commissioner and the Ohio Superintendent of Insurance. For the purposes of Indiana and Ohio insurance laws, any person acquiring more than 10% of the voting securities of a company is presumed to have acquired "control" of that company. 16 Item 1. Continued New Jersey New Jersey's private passenger auto net premiums written represented approximately 27% of the Group's total private passenger auto book of business in 2001. Given the unfavorable regulatory environment in New Jersey and the continued unprofitability of its private passenger auto business in the state, the Group announced in the fourth quarter of 2001 the transaction to allow the Group to stop writing business in early 2002 in the private passenger auto market in New Jersey. See discussion of this transaction and the New Jersey regulatory environment for private passenger automobile insurance in Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 25, 26, 32 and 33 of this Form 10-K. National Association of Insurance Commissioners The Corporation's insurance subsidiaries are subject to the general statutory accounting practices and reporting formats established by the NAIC. The NAIC also promulgates model insurance laws and regulations relating to the financial condition and operations of insurance companies, including the Insurance Regulating Information System. The Insurance Regulating Information System identifies twelve industry ratios and specifies "usual values" for each ratio for 2001. Departure from the usual values on four or more of the ratios can lead to inquiries from individual state insurance departments about aspects of the insurer's business. For the last five calendar years, none of Ohio Casualty's insurance subsidiaries, other than Avomark and Ohio Casualty of New Jersey, Inc. ("OCNJ"), had four or more ratios departing from the usual range. In 1998, Avomark had four ratios outside of the usual range due to the initial start-up of Avomark in 1997 and Avomark joining the intercompany reinsurance pooling agreement in 1998. In 2001, OCNJ had five ratios outside the usual range due to the $40.6 million transfer fee related to the New Jersey private passenger auto renewal obligation transfer. The Corporation expects the ratios outside the usual range to decrease as the $40.6 million transfer fee is paid and premiums written decrease as OCNJ discontinues the renewal of policies. NAIC model laws and rules are not usually applicable unless enacted into law or promulgated into regulation by the individual states. The adoption of NAIC model laws and regulations is a key aspect of the NAIC Financial Regulations Standards and Accreditation Program, which also sets forth minimum staffing and resource levels for all state insurance departments. Ohio and Indiana are accredited. The NAIC intends to create an eventual nationwide regulatory network of accredited states. The NAIC has developed a "Risk-Based Capital" model for property and casualty insurers. The model is used to establish standards, which relate insurance company statutory surplus to risks of operations and assist regulators in determining solvency requirements. The standards are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholders. The Risk-Based Capital model measures the following four major areas of risk to which property and casualty insurers are exposed: - asset risk; - credit risk; - underwriting risk; and - off-balance sheet risk. 17 Item 1. Continued The Risk-Based Capital model requires the calculation of a ratio of total adjusted capital to Authorized Control Level. Insurers with a ratio below 200% are subject to different levels of regulatory intervention and action. Based upon their 2001 statutory financial statements, each of Ohio Casualty's insurance subsidiaries had the following ratio of total adjusted capital to the Authorized Control Level: The Company 454.9% American Fire 887.1% Ohio Security 2,600.1% West American 668.6% Avomark 1,201.3% OCNJ 83.5% As of December 31, 2001, OCNJ was below the required ratio. The 2001 authorized control level of capital, as calculated by the Risk-Based Capital model, approximately doubled from previous years. The model assumes that OCNJ's unusually high underwriting expense ratio in 2001 continues in the future, therefore assuming an increase in underwriting risk. The unusually high underwriting expense ratio in 2001 related to the accrual of the $40.6 million transfer fee in the New Jersey private passenger auto transaction. In addition, the ratio was impacted by a temporary reduction in statutory surplus, which is the adjusted capital component of the Risk-Based Capital calculation. Statutory surplus, as of December 31, 2001, was negatively impacted by the temporary inability to recognize a deferred tax asset related to the New Jersey private passenger auto transfer fee due to statutory accounting limitations. The Corporation believes that as the OCNJ business transfers and as the transfer fee is paid in 2002 the ratio will improve, but the amount and timing of the improvement cannot be determined with certainty. The failure of OCNJ to meet the required ratio would give the regulators the right to take action against OCNJ, including requiring the Company to contribute capital into OCNJ. The Corporation does not anticipate that further regulatory action will be taken as long as the ratio shows continuing improvement. The Corporation has notified the state regulators for OCNJ of the temporary nature of the Risk-Based Capital ratio at a level that is below acceptable standards. The regulators will periodically review the financial results of OCNJ until the temporary items reverse and the ratio is at an acceptable level. In 1998, the NAIC adopted the Codification of Statutory Accounting Principles guidance, which replaced the former Accounting Practices and Procedures manual as the NAIC's primary guidance on statutory accounting. The new principles provide guidance for areas where statutory accounting had been silent and changed former statutory accounting in some areas. The Group implemented the Codification guidance effective January 1, 2001. The cumulative effect of adopting Codification reduced statutory policyholders' surplus by $21.7 million on January 1, 2001. Regulations on Dividends The Corporation is dependent on dividend payments from its insurance subsidiaries in order to meet operating expenses, debt obligations and to pay dividends. Insurance regulatory authorities impose various restrictions and prior approval requirements on the payment of dividends by insurance companies and holding companies. This regulation allows dividends to equal the greater of (1) 10% of policyholders' surplus or (2) 100% of the insurer's net income, each determined as of the preceding year end, without prior approval of the insurance department. 18 Item 1. Continued Dividend payments to the Corporation from the Company are limited to approximately $156.5 million during 2002 without restriction or prior approval of the Ohio insurance department based on 100% of the Company's net income for the year ending December 31, 2001. The ratio of net premiums written to statutory surplus is one of the measures used by insurance regulators to gauge the operating leverage of an insurance company and indicates the ability of Ohio Casualty's insurance subsidiaries to grow by writing additional business. The ratio of premiums written to statutory surplus for the Corporation's insurance subsidiaries was 1.9 to 1 at December 31, 2001. The ratio was 1.9 to 1 in 2000 and 1.8 to 1 in 1999. Employees At December 31, 2001, the Company had approximately 3,365 employees of which approximately 1,430 were located in the Fairfield and Hamilton, Ohio offices. Impact of 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 SFAS 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 does not expect that the adoption of the statement will have a material impact on the Corporation's financial position and results of operations. 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. In August 2001, the FASB issued SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of", and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations for a disposal of a segment of a business. SFAS 144 is effective for fiscal years beginning after December 15, 2001 (January 1, 2002 for the Corporation). The Corporation does not expect that the adoption of the statement will have a material impact on the Corporation's financial position and results of operations. 19 Item 2. Properties The Corporation owns and leases office space in various parts of the country. The principal office buildings consist of facilities owned in Fairfield and Hamilton, Ohio. Item 3. Legal Proceedings There are no material pending legal proceedings against the Corporation or its subsidiaries other than litigation arising in connection with settlement of insurance claims as described on page 11 of this Form 10-K. Item 4. Submission of Matters to a Vote of Shareholders There were no matters submitted during the fourth quarter of the Corporation's 2001 fiscal year to a vote of Shareholders through the solicitation of proxies or otherwise. 20 Item 4. Continued Executive Officers of the Registrant The following table provides information for executive officers of the Corporation who are not separately reported in the Corporation's Proxy Statement:
Position with Company and/or Principal Occupation or Employment Name Age During Last Five Years ---- --- ----------------------- John E. Bade, Jr. 47 Senior Vice President of the Corporation's insurance subsidiaries since February 2000. Mr. Bade served as Vice President of the Corporation's insurance subsidiaries from January 1997 through January 2000. Debra K. Crane 44 Senior Vice President and General Counsel of the Corporation since September 2000 and Senior Vice President of the Corporation's subsidiaries since April 2000. Ms. Crane served as Vice President of the Corporation's subsidiaries from May 1999 through March 2000 and as Assistant Treasurer of the Corporation's subsidiaries from February 1996 through April 1999. Ralph G. Goode 56 Senior Vice President of the Corporation's insurance subsidiaries since December 1998. Mr. Goode served as Vice President of the Corporation's insurance subsidiaries from October 1995 through November 1998. John S. Kellington 40 Chief Technology Officer of the Corporation's insurance subsidiaries since April 2001. Mr. Kellington served as Chief Architect and Principal, National Insurance Practice of IBM Global Services from 1996 to April 2001. Richard B. Kelly 47 Senior Vice President of the Corporation's insurance subsidiaries since February 2000. Mr. Kelly served as Vice President of the Corporation's insurance subsidiaries from November 1996 through January 2000. Donald F. McKee 55 Chief Financial Officer of the Corporation and its insurance subsidiaries since September 2001. Mr. McKee served as Chief Financial Officer and Senior Vice President, Titan Technology Partners from 2000 to 2001 and as Chief Investment Officer, The Capstone Group, LLC from 1997 to 2000. Mr. McKee also served as Senior Vice President, Information Systems and Chief Financial Officer, Integon Corporation from 1995 to 1997. Thomas E. Schadler 51 Chief Actuary of the Corporation's insurance subsidiaries since April 2001. Mr. Schadler served as Vice President and Chief Actuary of Grange Insurance Company from September 1997 to April 2001 and as Vice President and Chief Actuary of Shelby/Anthem/Vesta Companies from September 1988 to September 1997.
21 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters (a) The Corporation's common shares, par value $.125 per share, are traded on the Nasdaq Stock Market under the symbol OCAS. On February 28, 2002, the Corporation's common shares were held by 5,644 shareholders of record. (b) The following table shows the high and low sales prices for the Corporation's common shares for each quarterly period within the Corporation's last three most recent fiscal years:
High/Low Market Price Per Share (in dollars, adjusted for 1999 stock split) Quarter 1st 2nd 3rd 4th 2001 High 11.63 13.38 14.30 16.05 Low 8.38 8.47 10.93 12.43 2000 High 17.87 17.12 10.56 10.25 Low 11.06 10.94 6.34 6.50 1999 High 21.69 20.03 18.56 17.00 Low 19.03 17.81 15.06 15.06
(c) The following table shows the cash dividends paid by the Corporation to the holders of its common shares for the three most recent fiscal years of the Corporation. The Corporation's Board of Directors discontinued the Corporation's regular quarterly dividend in February, 2001.
Quarterly Cash Dividends Per Share Quarter 1st 2nd 3rd 4th 2001 $ - $ - $ - $ - 2000 $.23 $.12 $.12 $.12 1999 $.23 $.23 $.23 $.23
A description of statutory restrictions on the ability of the Corporation's insurance company subsidiaries to transfer funds to the Corporation in the form of cash dividends and distributions, which may limit the ability of the Corporation to pay dividends to its shareholders, may be found in Item 14, Note 17, Statutory Accounting Information, in the Notes to the Consolidated Financial Statements on pages 59 and 60 of this Form 10-K. 22 Item 6. Selected Financial Data Ohio Casualty Corporation & Subsidiaries TEN-YEAR SUMMARY OF OPERATIONS
(in millions, except per share data) 2001 2000 1999 1998 -------------------------------------------------------------------------------------------- Consolidated Operations Income (loss) after taxes Operating income (loss) $(36.4) $(77.7) $ 1.4 $ 73.6 Realized investment gains (losses) 135.0 (1.5) 104.5 9.4 -------------------------------------------------------------------------------------------- Income (loss) from continuing operations 98.6 (79.2) 105.9 83.0 Discontinued operations - - 4.3 1.9 Gain on sale of discontinued operations - - 6.2 - Cumulative effect of accounting changes - - (2.3) - -------------------------------------------------------------------------------------------- Net income (loss) 98.6 (79.2) 114.1 84.9 ============================================================================================ Income (loss) after taxes per average share outstanding - basic* Operating income (loss) (0.61) (1.29) 0.02 1.12 Realized investment gains (losses) 2.25 (0.03) 1.71 0.14 Discontinued operations - - 0.07 0.03 Gain on sale of discontinued operations - - 0.11 - Cumulative effect of accounting changes - - (0.04) - -------------------------------------------------------------------------------------------- Net income (loss) 1.64 (1.32) 1.87 1.29 ============================================================================================ Average shares outstanding - basic* 60.1 60.1 61.1 65.8 Income (loss) after taxes per average share outstanding - diluted* Operating income (loss) (0.61) (1.29) 0.02 1.12 Realized investment gains (losses) 2.25 (0.03) 1.71 0.14 Discontinued operations - - 0.07 0.03 Gain on sale of discontinued operations - - 0.11 - Cumulative effect of accounting changes - - (0.04) - -------------------------------------------------------------------------------------------- Net income (loss) 1.64 (1.32) 1.87 1.29 ============================================================================================ Average shares outstanding -diluted* 60.2 60.1 61.1 65.9 Total assets 4,524.6 4,489.4 4,476.4 4,802.3 Shareholders' equity 1,080.0 1,116.6 1,151.0 1,321.0 Book value per share* 17.97 18.59 19.16 21.12 Dividends paid per share* - 0.59 0.92 0.88 Percent increase/decrease over previous (100.0)% (35.9)% 4.5% 4.8% Property and Casualty Operations Net premiums written 1,472.2 1,505.4 1,586.9 1,299.6 Net premiums earned 1,506.2 1,533.0 1,554.1 1,267.8 GAAP underwriting loss before taxes (253.8) (312.8) (184.2) (74.1) Statutory loss ratio 66.5% 72.8% 66.9% 63.7% Statutory loss adjustment expense ratio 13.4% 11.6% 10.7% 9.1% Statutory underwriting expense ratio 35.4% 34.8% 35.2% 34.4% Statutory combined ratio 115.3% 119.2% 112.8% 107.2% Investment income before taxes 211.1 202.0 181.1 164.8 Per average share outstanding* 3.51 3.36 2.96 2.51 Property and casualty reserves Unearned premiums 666.7 696.4 725.2 668.4 Losses 1,746.8 1,627.6 1,545.0 1,569.5 Loss adjustment expense 403.9 376.0 363.5 376.3 Statutory policyholders' surplus 767.5 812.1 899.8 1,027.1 *Adjusted for 2 for 1 stock dividend effective July 22, 1999 (See Note 23)
23 Item 6. Selected Financial Data Ohio Casualty Corporation & Subsidiaries TEN-YEAR SUMMARY OF OPERATIONS
(in millions, except per share data) 1997 1996 1995 1994 -------------------------------------------------------------------------------------------- Consolidated Operations Income (loss) after taxes Operating income (loss) $ 97.4 $ 64.9 $ 91.4 $ 77.1 Realized investment gains (losses) 33.0 32.3 4.0 14.2 -------------------------------------------------------------------------------------------- Income (loss) from continuing operations 130.4 97.2 95.4 91.3 Discontinued operations 8.7 5.3 4.3 5.9 Gain on sale of discontinued operations - - - - Cumulative effect of accounting changes - - - (0.3) -------------------------------------------------------------------------------------------- Net income (loss) 139.1 102.5 99.7 96.9 ============================================================================================ Income (loss) after taxes per average share outstanding - basic* Operating income (loss) 1.42 0.93 1.28 1.07 Realized investment gains (losses) 0.48 0.46 0.05 0.20 Discontinued operations 0.13 0.07 0.06 0.08 Gain on sale of discontinued operations - - - - Cumulative effect of accounting changes - - - - -------------------------------------------------------------------------------------------- Net income (loss) 2.03 1.46 1.39 1.35 ============================================================================================ Average shares outstanding - basic* 68.5 70.4 71.5 72.0 Income (loss) after taxes per average share outstanding - diluted* Operating income (loss) 1.42 0.93 1.28 1.07 Realized investment gains (losses) 0.48 0.46 0.05 0.20 Discontinued operations 0.13 0.07 0.06 0.08 Gain on sale of discontinued operations - - - - Cumulative effect of accounting changes - - - - -------------------------------------------------------------------------------------------- Net income (loss) 2.03 1.46 1.39 1.35 ============================================================================================ Average shares outstanding -diluted* 68.5 70.5 71.5 72.0 Total assets 3,778.8 3,890.0 3,980.1 3,739.0 Shareholders' equity 1,314.8 1,175.1 1,111.0 850.8 Book value per share* 19.56 16.72 15.69 11.82 Dividends paid per share* 0.84 0.80 0.76 0.73 Percent increase/decrease over previous 5.0% 5.3% 4.1% 2.8% Property and Casualty Operations Net premiums written 1,207.6 1,209.0 1,250.6 1,286.4 Net premiums earned 1,204.3 1,223.4 1,264.6 1,297.7 GAAP underwriting loss before taxes (49.6) (112.2) (68.8) (92.9) Statutory loss ratio 62.7% 66.5% 61.2% 61.6% Statutory loss adjustment expense ratio 9.4% 9.7% 10.2% 10.0% Statutory underwriting expense ratio 33.2% 33.3% 32.6% 32.2% Statutory combined ratio 105.3% 109.5% 104.0% 103.8% Investment income before taxes 172.4 179.4 184.6 183.8 Per average share outstanding* 2.52 2.54 2.58 2.55 Property and casualty reserves Unearned premiums 494.9 491.4 505.8 517.8 Losses 1,174.5 1,215.8 1,268.1 1,303.6 Loss adjustment expense 307.2 331.8 356.1 367.3 Statutory policyholders' surplus 1,109.5 984.9 876.9 660.0
Ohio Casualty Corporation & Subsidiaries TEN-YEAR SUMMARY OF OPERATIONS
10-Year Compound (in millions, except per share data) 1993 1992 Annual Growth -------------------------------------------------------------------------------------- Consolidated Operations Income (loss) after taxes Operating income (loss) $ 51.5 $ 57.8 - Realized investment gains (losses) 28.7 35.1 30.3% Income (loss) from continuing operations 80.2 92.9 (1.3)% Discontinued operations 6.8 4.1 (100.0)% Gain on sale of discontinued operations - - - Cumulative effect of accounting changes - 1.5 - -------------------------------------------------------------------------------------- Net income (loss) 87.0 98.5 (1.2)% ====================================================================================== Income (loss) after taxes per average share outstanding - basic* Operating income (loss) 0.72 0.80 - Realized investment gains (losses) 0.40 0.49 32.0% Discontinued operations 0.09 0.06 (100.0)% Gain on sale of discontinued operations - - - Cumulative effect of accounting changes - 0.02 - -------------------------------------------------------------------------------------- Net income (loss) 1.21 1.37 0.9% ====================================================================================== Average shares outstanding - basic* 72.0 72.0 (1.7)% Income (loss) after taxes per average share outstanding - diluted* Operating income (loss) 0.72 0.80 - Realized investment gains (losses) 0.40 0.49 32.0% Discontinued operations 0.09 0.06 (100.0)% Gain on sale of discontinued operations - - - Cumulative effect of accounting changes - 0.02 - -------------------------------------------------------------------------------------- Net income (loss) 1.21 1.37 0.9% ====================================================================================== Average shares outstanding -diluted* 72.0 72.0 (1.7)% Total assets 3,816.8 3,760.7 2.5% Shareholders' equity 862.3 825.2 6.9% Book value per share* 11.97 11.72 5.2% Dividends paid per share* 0.71 0.67 (100.0)% Percent increase/decrease over previous 6.0% 8.1% - Property and Casualty Operations Net premiums written 1,306.0 1,508.5 (0.1)% Net premiums earned 1,379.4 1,517.6 0.2% GAAP underwriting loss before taxes (147.3) (130.8) 13.0% Statutory loss ratio 64.9% 63.7% Statutory loss adjustment expense ratio 11.8% 10.8% Statutory underwriting expense ratio 33.6% 33.5% Statutory combined ratio 110.3% 108.0% Investment income before taxes 190.4 194.6 1.0% Per average share outstanding* 2.64 2.70 2.8% Property and casualty reserves Unearned premiums 529.6 596.1 1.0% Losses 1,378.0 1,309.2 3.7% Loss adjustment expense 390.6 364.0 1.4% Statutory policyholders' surplus 713.6 674.2 1.8%
*Adjusted for 2 for 1 stock dividend effective July 22, 1999 (See Note 23) 24 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations OVERVIEW In June of 2001, a new Corporate Strategic Plan ("Plan") was announced. The Plan introduced an organization structured around three business units: Standard Commercial Lines, Specialty Commercial Lines, and Personal Lines and established measurable financial targets for each business unit and the Group. During 2001, certain operating results of the Corporation improved. The improvements were a result of renewal price increases, more favorable underwriting results and aggressive expense management. The year also included the tragic events of September 11, 2001, which had an impact on 2001. RESULTS OF OPERATIONS Net Income The Corporation reported after-tax net income of $98.6 million, or $1.64 per share for the year 2001, compared with a net loss of $79.2 million, or $1.32 per share in 2000, and net income of $114.1 million, or $1.87 per share in 1999. Operating Results For the year 2001, the Corporation reported a net operating loss(1) of $36.4 million, or $.61 per share. Excluding a one-time after-tax charge of $26.8 million, or $.45 per share, for the transfer of the renewal obligation of New Jersey private passenger auto business, the after-tax operating loss for the twelve months ending December 31, 2001, was $9.6 million, or $.16 per share, compared with an operating loss of $77.7 million, or $1.29 per share in 2000, and operating income of $1.4 million, or $.02 per share in 1999. Also contributing to the 2001 operating loss were the effects of additions to the Group's asbestos reserves and the impact of an early retirement plan. The 2000 operating loss included the adverse effects of write-offs to the agent relationships intangible asset relating to the 1998 acquisition of the Great American Insurance Company's ("GAI") commercial lines division, the impact of inadequate pricing and the negative effects of premium cessions on experience rated reinsurance contracts. Positively impacting 2000 results was the settlement of the California Proposition 103 liability. In the fourth quarter of 2001, a member of the Group, Ohio Casualty of New Jersey, Inc. ("OCNJ"), entered into an agreement to transfer its obligations to renew private passenger auto business in New Jersey. The transaction will allow the Group to stop writing business in the New Jersey private passenger auto market in early 2002. In recent years, the market in New Jersey private passenger auto has become more unstable due to the inability to control either the volume of writings or the profitability. Under the terms of the transaction, the Group member, OCNJ, will pay $40.6 million to a third party to transfer its renewal obligations. The $40.6 million amount was taken as a charge in the fourth quarter of 2001 and will be paid out over the course of twelve months beginning in early 2002. OCNJ may also have a contingent liability of up to $15.6 million to be paid to the transferee company to maintain a maximum premiums-to-surplus ratio of 2.5 to 1 25 (1) Operating income (loss) differs from net income by the exclusion of realized investment gains (losses). It is not intended as a substitute for net income prepared in accordance with accounting principles generally accepted in the United States. Item 7. Continued on the transferred business during the next three years. At December 31, 2001, it is not possible to determine the likelihood of the liability and, therefore, it has not been recognized in the financial statements. The transaction is expected to positively impact operating results beginning in 2002. The 2001 results were also impacted by additions to the Group's asbestos reserves and an early retirement charge. During 2001, loss and loss adjustment expense reserves were strengthened by $10.5 million after-tax for asbestos related claims development. Also in 2001, the Corporation adopted an early retirement plan. Of the approximately 330 employees eligible to retire under the program, 147 accepted. The early retirement plan resulted in a one-time after-tax charge of $4.0 million for the year. The events of September 11, 2001 had an impact on the results of operations for the year. The Group incurred before-tax losses of $3.0 million. This loss has not reached any reinsurance limits for the Group. The $3.0 million represents the Group's best estimate of total losses, which could ultimately exceed the amount estimated. Based upon year-end 2001 analysis of the financial strength of reinsurers, the Group believes any potential future increases in this estimate covered under its reinsurance programs would be collectible. In the first quarter of 2000, the Group made the decision to discontinue its relationship with all of its Managing General Agents. The business written by the Managing General Agents was acquired in the 1998 purchase of the GAI commercial lines division. The result of the decision was a before-tax write-off of $42.2 million to the agent relationships intangible asset, which was recorded on the balance sheet in connection with the GAI purchase. The asset was also written off in 2000 by $3.8 million as a result of additional agent cancellations for a total write-off of $46.0 million for the year. In 2001, the Corporation further wrote off the agent relationships asset by $11.0 million as a result of additional agency cancellations and for certain agents determined to be impaired. The impairment analysis is a critical accounting policy and was based on updated estimated future undiscounted cash flows that were insufficient to recover the carrying amount of the asset for the agent. The determination of impairment involves the use of management estimates and assumptions. Due to the inherent uncertainties and judgments involved in making these assumptions, changes in the valuation of the agent relationship asset could again occur in the future if the underlying estimates change materially. The 2000 operating loss was also impacted negatively by $23.2 million before tax for ceded premiums on certain experience rated reinsurance contracts covering losses exceeding $1.0 million. The 1999 operating income was impacted by $13.0 million before tax for similar premium cessions. The premium cessions reflect changes in estimated loss experience, and have resulted in the maximum premium cessions under these contracts for business written through year 2000. Investment Results Consolidated after-tax realized investment gains (losses) amounted to $135.0 million, or $2.25 per share in 2001, $(1.5) million, or $(.03) per share in 2000, and $104.5 million, or $1.71 per share in 1999. The 2001 realized gains included the effects of the Group's partial reallocation of its equity portfolio to fixed income holdings. Significant appreciation in the equities, as part of the reallocation, contributed to the realized gains in 2001. The 2001 realized gains included a non-recurring tax benefit of $16.1 million related to the sale of a minority interest in stock of OCNJ. Contributing to the 1999 realized investment gains were gains from a reallocation of the Group's investment portfolio during the second quarter. The Corporation completed the reallocation by selling approximately $200 million in equity securities, resulting in after-tax realized gains of approximately $94 million. 26 Item 7. Continued The Corporation's largest assets are its investments and, therefore, the related accounting policies are considered critical. See further discussion of important investment accounting policies in Note 1C. The Corporation reviews its investment portfolio quarterly to determine if any securities have sustained other than temporary decline in market value. Any loss on a security determined to be impaired is recognized as a realized loss in the current period. The after-tax realized gain (loss) was impacted by the write-down of securities for other than temporary declines in market value by $7.8 million in 2001, $10.9 million in 2000 and $5.3 million in 1999. Consolidated before-tax investment income increased 3.6% to $212.4 million in 2001, compared with $205.1 million in 2000 and $184.3 million in 1999. The increases in investment income can be attributed to the equity portfolio reallocations in 1999 and 2001. The reallocations in the investment portfolio reduced equity securities and increased investment grade securities. Also contributing to the increase in before-tax investment income was the reallocation of investments from tax exempt municipal bonds to taxable bonds. After-tax investment income totaled $141.3 million in 2001, compared with $140.3 million in 2000 and $138.0 million in 1999. Before-tax and after-tax investment income comparisons are impacted by investments in municipal bonds, which provide tax- advantaged investment income. Reinsurance Results The Group has renewed all of its reinsurance programs for 2002 with only moderate changes in the program structure and pricing. Although the terrorist events of September 11, 2001 had a significant impact on the reinsurance market, the Group's reinsurance contracts do include coverage for acts of terrorism. Instead of being unlimited as in the past, terrorism coverage in the 2002 contracts has been modified to exclude or limit coverage for certain upper layers of reinsurance. The Corporation believes that the terrorism coverage in its reinsurance programs is adequate to protect its financial health. The pricing of reinsurance in 2002 increased only moderately from prior years due to the tragic events of September 11, 2001 and from other changes in the reinsurance market. 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 certain software used in the Corporation's operations. The cost associated with this application is amortized on a straight-line basis over the estimated useful life of ten years from the date placed into service. Upon full implementation in 2003, the new application should impact results by approximately $4 to $5 million per year in amortization expense until 2012. Although management believes the asset represents its fair value, the useful life of the internally developed software was determined by using certain assumptions and estimates. Inherent changes in these assumptions could result in an immediate impairment to the asset and a corresponding charge to net income. Discontinued Operations During 1995, the Corporation's life operations were discontinued. In order to exit the life operations, the Company executed an agreement in 1995 to reinsure the existing blocks of business through a 100% coinsurance arrangement. 27 Item 7. Continued On December 31, 1999, the Company sold 100% of The Ohio Life Insurance Company stock, thereby transferring all remaining assets and liabilities to the buyer. The after-tax gain on this sale totaled $6.2 million, or $.11 per share. Net income from discontinued operations amounted to $4.3 million, or $.07 per share in 1999. Statutory Results Management uses statutory financial criteria to analyze the property and casualty results. Management analyzes statutory results through the use of insurance industry financial measures including statutory loss and loss adjustment expense ratios, statutory underwriting expense ratio, statutory combined ratio, net premiums written and net premiums earned. The statutory combined ratio is a commonly used gauge of underwriting performance measuring the percentages of premium dollars used to pay insurance losses and related expenses. A discussion of the differences between statutory accounting and accounting principles generally accepted in the United States is included in Note 17. All Lines Discussion Statutory net premiums written decreased $33.2 million in 2001 to $1.47 billion. Net premiums written totaled $1.51 billion in 2000 and $1.59 billion in 1999. The net premiums written decrease in 2001 and 2000 can be attributed primarily to a more selective underwriting philosophy that led to the elimination and cancellation of certain business. Actions taken in 2000 to cancel the Managing General Agents and the Group's most unprofitable agents and policies represented over $150 million in annual net premiums written. The Group's business is geographically concentrated in the Mid-West and Mid-Atlantic regions. The following table shows consolidated net premiums written for the Group's five largest states:
ALL LINES NET PREMIUMS WRITTEN DISTRIBUTED BY TOP STATES 2001 2000 1999 ---- ---- ---- New Jersey 17.4% 14.9% 15.8% Ohio 9.8% 9.7% 9.6% Kentucky 7.9% 8.5% 8.7% Pennsylvania 6.8% 6.2% 6.2% Illinois 5.1% 5.2% 5.1%
New Jersey is the Group's largest state with 17.4% of the total net premiums written during 2001. In recent years, New Jersey's legislative and regulatory environments have become less favorable to the Group. The state requires insurance companies to accept all risks that meet underwriting guidelines for private passenger automobile. In the fourth quarter of 2001, OCNJ entered into an agreement to transfer its New Jersey private passenger auto renewal obligations to Proformance Insurance Company. This transaction will allow the Group to stop writing business in the New Jersey private passenger auto and personal umbrella markets in early 2002. New Jersey private passenger auto and personal umbrella made up 46.9% of the Group's New Jersey net premiums written in 2001. Excluding the Group's New Jersey private passenger auto and personal umbrella net premiums written, New Jersey would have represented 10.1% of the total all lines net premiums written in 2001. The Group expects to continue writing all of its other lines of business in the state. 28 Item 7. Continued Excluding the $40.6 million, or 2.7 point impact of the New Jersey renewal obligation transfer fee, the statutory combined ratio improved 6.6 points to 112.6% in 2001, compared with 119.2% in 2000 and 112.8% in 1999. The improvement in the statutory combined ratio in 2001 over 2000 was due to improvement in the Standard Commercial Lines statutory loss ratio and all lines statutory underwriting expense ratio when excluding the $40.6 million New Jersey transfer fee. The 2001 Standard Commercial Lines statutory loss ratio improved to 64.5% from 78.6% in 2000. The 2000 statutory combined ratio was impacted adversely by increases in the loss and loss adjustment expense ratios. The 2000 loss ratio was impacted by adverse development in the workers' compensation and general liability lines of business for 1999 and prior accident years. The workers' compensation line of business added 6.8 points to the overall 2000 loss ratio. The 2001 all lines statutory accident year combined ratio excluding the New Jersey transfer fee was 108.8%, 3.8 points lower than the calendar year results. The loss and loss adjustment expense ("LAE") ratio component of the all lines statutory accident year combined ratio measures losses and claims expenses arising from insured events during the year. The loss and LAE ratio component of the all lines statutory calendar year combined ratio includes loss and LAE payments made during the current year and changes in the provision for future loss and LAE payments. The difference between the statutory accident year and calendar year combined ratios is concentrated in the workers' compensation, homeowners and general liability lines of business. At year-end 2000, the Group reallocated its carried bulk reserves in anticipation of Statement of Statutory Accounting Principles No. 55 under Statutory Accounting Codification, which requires that companies carry their best estimate of loss reserves for each line of business, while previous requirements focused on the overall reserves. The reallocation did not affect the all lines calendar year 2000 statutory combined ratio and did not have a material impact on most lines of business other than workers' compensation and general liability. The reallocation added 9.6 points to the workers' compensation statutory combined ratio and reduced the general liability statutory combined ratio by 4.7 points. Catastrophe losses in 2001 totaled $34.6 million, compared with $36.2 million in 2000 and $52.2 million in 1999. The Group was impacted by 19 separate catastrophes in 2001, compared with 24 catastrophes in 2000 and 27 in 1999. Catastrophe losses added 2.3 points to the statutory combined ratio in 2001, compared with 2.4 points in 2000 and 3.4 points in 1999. The 2001 catastrophes included the losses from the events of September 11, 2001. The Group incurred before-tax losses of $3.0 million related to the terrorist activities. The 1999 catastrophes included tornadoes in the greater Cincinnati and Oklahoma City areas as well as damage from Hurricane Floyd. The effects of catastrophes on the Corporation's results cannot be accurately predicted. As such, severe weather patterns, acts of war or terrorist activities could have a material adverse impact on the Corporation's results, reinsurance pricing and availability of reinsurance. Catastrophe losses, net of reinsurance, for each of the last three years were:
Catastrophe Losses (before-tax) Statutory Combined Dollar Impact Ratio Impact ------------- ------------ 2001 $34.6 million 2.3% 2000 $36.2 million 2.4% 1999 $52.2 million 3.4%
29 Item 7. Continued Statutory underwriting expenses, as a percentage of net premiums written, increased by .6 points in 2001 to 35.4%, compared with 34.8% in 2000 and 35.2% in 1999. The 2001 statutory underwriting expense ratio includes 2.7 points from the $40.6 million charge for the New Jersey transfer. Excluding the New Jersey transfer fee, the improvement in the 2001 statutory underwriting expense ratio was the result of actions to lower commissions, eliminate workers' compensation policyholder dividends and decrease the employee count. The actions to lower commissions to current market levels for selected product lines improved the 2001 underwriting expense ratio .5 points. The actions to eliminate workers' compensation policyholders dividends on new and renewal business and changes in reserves for dividends of issued policies improved the 2001 underwriting ratio .7 points. The reduction in employee count during 2001 improved the 2001 underwriting ratio by .6 points. The employee count was 3,365 as of December 31, 2001, compared with 3,470 at December 31, 2000 and 3,889 at December 31, 1999. The 2001 statutory underwriting expenses also included $.5 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. For year 2002, the Group will continue the rollout of the new application and expects the impact to statutory expenses to be approximately $2 million to $3 million in amortization. Upon full implementation in 2003, the new application amortization should impact the statutory expenses by approximately $8 to $10 million per year through 2007. The additional cost is expected to be offset in part by reduced labor costs related to policy processing. Segment Discussion In June of 2001, the Corporation introduced an organizational structure around three business units: Standard Commercial Lines, Specialty Commercial Lines, and Personal Lines. The Corporation also announced projected 2001 statutory combined ratios for the three business units. Standard Commercial Lines Standard Commercial Lines statutory combined ratio for the year 2001 decreased 13.8 points to 116.2% from 130.0% in 2000. The 1999 statutory combined ratio was 122.6%. The 2001 actual statutory combined ratio results were slightly better than the 2001 projected Standard Commercial Lines statutory combined ratio of 117.0%. Renewal price increases had a positive impact during the year. The 2001 average renewal price increase(2) was 15.2% for the Standard Commercial Lines direct premiums written, compared with a 9.9% average renewal price increase in 2000. The workers' compensation line of business in the Standard Commercial Lines segment impacted the year's results. Although overall results improved in 2001, continued deterioration in the workers' compensation line of business in 2001 led to disappointing results for the line. Workers' compensation statutory combined ratio decreased 27.0 points in 2001 to 138.6%, compared with 165.6% and 117.5% for 2000 and 1999, respectively. The statutory loss ratio was the main component driving the high statutory combined ratio. The 2001 statutory loss ratio was 30 (2) 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. Item 7. Continued 95.8%, compared with 118.8% and 71.9% in 2000 and 1999, respectively. Deterioration in prior year losses due to an increase in claims severity contributed to the poor 2001 results. The 2001 accident year loss ratio of 81.8% was 14.0 points lower than the calendar year loss ratio. The poor results in the workers' compensation line of business in 2000 added 6.8 points to the all lines statutory loss ratio, when including the year-end reserve reallocation mentioned in the All Lines Discussion section. In response to the deterioration of results, the Group took action in 2000 to begin non-renewing its most unprofitable workers' compensation policies. This business has a loss ratio approximately 10 points higher than the total workers' compensation line of business and is referred to as unsupported workers' compensation as it is the only product in the customer's account. As mentioned in the Operating Results section, the Group also took action to discontinue its relationship with Managing General Agents. These Managing General Agents accounted for $29.0 million in annual workers' compensation premium. These non-renewals and cancellations contributed to a 20.0%, or $37.2 million, decrease in 2001 workers' compensation net premiums written, and a 3.1%, or $5.9 million, decrease in 2000 workers' compensation net premiums written. The Group was able to achieve average renewal price increases for the workers' compensation business of 16.6% and 12.4% for 2001 and 2000, respectively. Net premiums written for 2001, 2000 and 1999 totaled $148.6 million, $185.8 million and $191.7 million, respectively. Commercial auto net premiums written increased $8.0 million, or 4.5% in 2001 to $186.7 million, compared with $178.7 million in 2000 and $175.5 million in 1999. The 2001 increase was driven by renewal price increases, averaging 15.5% on the commercial auto line of business. The 2001 commercial auto statutory combined ratio decreased to 107.6%, from 121.5% in 2000 and 117.1% in 1999. The improvement in 2001 was largely due to better underwriting and risk selection and the effect of renewal price increases. 2000 was hindered by increased severity combined with inadequate pricing. Commercial multi-peril ("CMP"), fire & inland marine net premiums written were $275.2 million in 2001, compared with $276.5 million in 2000 and $271.1 million in 1999. The statutory combined ratio decreased to 106.4% in 2001 from 111.1% in 2000 and 127.2% in 1999. The improvement in the line has been a result of implementing renewal price increases and more selective underwriting. General liability net premiums written decreased $1.6 million, or 2.0% in 2001 to $79.0 million, compared with $80.7 million in 2000 and $82.5 million in 1999. The 2001 and 2000 decreases reflected the Group's focus on fundamental underwriting strategies. The general liability statutory combined ratio decreased 6.1 points in 2001 to 120.8%, compared with 126.9% in 2000 and 130.8% in 1999. While improvement in underwriting is being shown, the higher than desired loss ratios are attributable to adverse development on prior accident years. The accident year statutory combined ratio for 2001 was 106.8%. The difference between the accident and calendar year results is primarily due to increases in asbestos reserves in 2001 for further development on existing claims outstanding. 31 Item 7. Continued Statutory Combined Ratios (by business unit, including selected major lines of business)
2001 2000 1999 ======================================================================== Standard Commercial Lines 116.2% 130.0% 122.6% Workers' Compensation 138.6% 165.6% 117.5% Auto Commercial 107.6% 121.5% 117.1% General Liability 120.8% 126.9% 130.8% CMP, Fire & Inland Marine 106.4% 111.1% 127.2% Specialty Commercial Lines 90.8% 79.8% 50.7% Commercial Umbrella 93.6% 81.9% 33.5% Fidelity & Surety 76.8% 70.7% 75.9% Personal Lines 119.2% 113.5% 112.2% Auto - Agency 118.2% 110.4% 106.3% Auto - Direct 155.2% 167.9% 208.4% Homeowners 120.5% 119.6% 124.1% ------------------------------------------------------------------------ Total All Lines 115.3% 119.2% 112.8% ========================================================================
Specialty Commercial Lines Specialty Commercial Lines statutory combined ratio for the year 2001 was 90.8%, compared with the 2001 projected statutory combined ratio of 88.9%. The statutory combined ratio was 79.8% and 50.7% for 2000 and 1999, respectively. The fidelity & surety line of business in the Specialty Commercial Lines contributed to the favorable results for the segment. Fidelity & surety net premiums written increased $1.1 million, or 3.0% in 2001 to $38.7 million, compared with $37.6 million in 2000 and $37.7 million in 1999. The statutory combined ratio was 76.8% in 2001, compared with 70.7% in 2000 and 75.9% in 1999. Commercial umbrella net premiums written increased $26.6 million, or 40.5% in 2001 to $92.2 million, compared with $65.6 million in 2000 and $62.8 million in 1999. The 2001 increase was primarily generated by renewal price increases implemented in 2001 and 2000. The average renewal price increase in 2001 was 20.3%, compared with 8.9% in 2000. The 2001 statutory combined ratio was 93.6%, compared with 81.9% in 2000 and 33.5% in 1999. Although the combined ratio increased, the results are still profitable for the Group. Personal Lines The Personal Lines statutory combined ratio for the year 2001 increased 5.7 points to 119.2% in 2001, compared with 113.5% in 2000 and 112.2% in 1999. Excluding the $40.6 million fee related to the New Jersey personal auto transaction, the 2001 statutory combined ratio was 112.9%, a decrease of .6 points from 2000. Excluding the New Jersey transfer fee, the actual 2001 statutory combined ratio was 1.4 points better than the projected 2001 statutory combined ratio of 113.7%. Private passenger auto - agency net premiums written decreased $10.9 million, or 2.4% to $444.4 million in 2001, compared with $455.3 million in 2000 and $526.5 million in 1999. Selective underwriting and agency cancellations contributed to the decline in premiums in 2001. New Jersey's private passenger auto net premiums written represented approximately 27% of the 32 Item 7. Continued Group's total private passenger auto book of business in 2001. 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 eliminates the Group's ability to control the volume and selection of writings in the state. The statutory combined ratio was 109.1%, excluding the fee related to the transfer of the New Jersey personal auto book in 2001, compared with 110.4% in 2000 and 106.3% in 1999. Poor underwriting results in New Jersey was the primary cause of the poor performance in 2001. The New Jersey results added 4.5 points to the 2001 private passenger auto-agency statutory loss ratio. New Jersey results were driven by regulatory restraints in the state which restrict the insurers' ability to raise rates. In addition, the New Jersey State Senate passed an auto insurance reform bill effective in 1999 that mandated a 15% rate reduction for personal auto policies. This reform bill was based on legal reform intended to provide a reduction in medical expense benefits, limitations on lawsuits and enhanced fraud protection. While the rate reduction was immediate, many of the reforms have not yet been implemented, resulting in inadequate rate levels for the Group. The state of New Jersey also requires additional assessments to be paid by insurers and requires insurance companies to write a portion of their business in high risk areas. New Jersey requires assessments to be paid for the New Jersey Unsatisfied Claim and Judgement Fund ("UCJF"). This assessment is based upon estimated future direct premiums written in that state. The Group paid assessments of $4.7 million in 2001, $3.3 million in 2000 and $3.4 million in 1999. 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 UEZ for every seven policies written outside UEZ. The Group is assigned premiums if it does not write the required quota. In 2001, the Group wrote $8.1 million in UEZ premiums, with $4.3 million in additional assigned premiums in 2001, compared with $6.5 million in UEZ premiums and $4.9 million in additional assigned premiums in 2000. In 1999, the Group wrote $5.7 million in UEZ premiums, with $6.7 million in additional assigned premiums in 1999. The loss ratios on UEZ premiums were 159.3%, 146.3% and 132.1% for 2001, 2000 and 1999, respectively. The loss ratios on the assigned business were 219.6%, 198.5% and 142.9% for 2001, 2000 and 1999, respectively. Given the unfavorable regulatory environment in New Jersey and the continued unprofitability of its private passenger auto business in the state, the Group announced in the fourth quarter of 2001 the transaction to allow the Group to stop writing business in early 2002 in the private passenger auto market in New Jersey. The transaction, described in the Operating Results section, is expected to positively impact private passenger auto results beginning in 2002. The Group is implementing price increases in other states, claims management procedures and insurance scoring to improve results. The Group began to rollout insurance scoring in selected states in 2001 and expects this to help improve results by matching prices more closely with anticipated loss experience. The Group began direct marketing of personal auto coverage in January 1998. In 2000, the Corporation first restructured its private passenger auto - direct operations with an Internet-only strategy, and later discontinued the private passenger auto - direct line of business in the fourth quarter. The line was discontinued in order to focus on the independent agency system as the distribution channel for the Group. As a result of the restructuring, net premiums written dropped from $10.7 million in 2000 to $6.8 million in 2001. The Group wrote $17.1 million of net premiums in 1999. Statutory combined ratios were 155.2%, 167.9% and 208.4% for 2001, 2000 and 1999, 33 Item 7. Continued respectively. The 2001 underwriting expense ratio included $2.0 million, or 29.3 points, in expenses for fees for the removal of certain obligations related to assigned private passenger auto policies in New York. Although the Group discontinued the private passenger auto - direct line, the Group remains committed to expanding its Internet capabilities that focus on full service options for our agents and convenience options for our policyholders. Homeowners net premiums written fell 6.5% in 2001 to $162.0 million from $173.2 million in 2000 and $181.9 million in 1999. The Group has placed emphasis on price increases, insurance scoring and agency management. The company introduced an Insurance-To-Value program in 2000 which addressed underinsured homeowner properties and emphasized adequate replacement cost values. The 2001 homeowners statutory combined ratio increased .9 points to 120.5%. This compares with a statutory combined ratio of 119.6% in 2000 and 124.1% in 1999. Combined ratios are heavily impacted by catastrophe losses which added 12.3 points to the combined ratio in 2001, 10.3 points in 2000 and 12.6 points in 1999. LIQUIDITY AND FINANCIAL STRENGTH Cash Flow Net cash generated from operations was $70.2 million in 2001, compared with cash generated of $99.6 million in 2000 and cash used of $137.7 million in 1999. The 2001 cash generated reflects the operating results and the reduction in paid losses and paid loss adjustment expenses. The change in 2000 is due in part to payment received in 2000 as part of the commutation of a reinsurance treaty in the fourth quarter of 1999 and a refund of prior year taxes paid. The 1999 cash used primarily resulted from lower operating results and taxes paid. Investing activities used net cash of $57.4 million in 2001, compared with net cash used of $103.5 million in 2000 and net cash generated of $108.1 million in 1999. Total cash used for financing activities was $10.6 million in 2001, compared with $56.0 million in 2000 and total cash used of $125.5 million in 1999. Cash used for financing decreased in 2001 was a result of the elimination of shareholder dividends. Cash used from financing decreased in 2000 from 1999 as a result of the reduction in shareholder dividends and the Corporation's decision not to repurchase any of its shares. Overall, total cash generated in 2001 was $2.2 million, compared with cash used of $59.9 million in 2000 and cash used of $155.0 million in 1999. The Corporation did not pay any shareholder dividends in 2001, compared with dividend payments of $35.4 million in 2000 and $56.0 million in 1999. The Corporation did not pay shareholder dividends in 2001 as a result of the Corporation's decision to further strengthen the Corporation's financial position. 34 Item 7. Continued Cash flow has also been impacted by our share repurchase program. Although the Corporation did not repurchase any shares of its common stock in 2001 or 2000, the Corporation did repurchase 2,478,000 shares for $46.1 million in 1999. Since the beginning of 1987, 31.7 million shares have been repurchased at an average cost of $14.10 per share. The Corporation is dependent on dividend payments from its insurance subsidiaries in order to meet operating expenses, debt obligations, and to pay dividends. Insurance regulatory authorities impose various restrictions and prior approval requirements on the payment of dividends by insurance companies and holding companies. As of December 31, 2001, approximately $156.5 million of statutory surplus was not subject to restriction or prior dividend approval requirements. The following table presents the Corporation's obligations (other than obligations relating to its ordinary insurance operations) to make future payments under contracts, such as debt and lease agreements:
($ in millions) Payments Due by Period ---------------------------------------------------------------------------- Less than 1-3 4-5 After 5 Contractual Obligations Total 1 year years years years ----------------------- ----- ------ ----- ----- ------- Notes payable $210.2 $205.6 $ 1.9 $1.3 $1.4 Operating leases 13.7 5.7 8.0 - - New Jersey transfer fee 40.6 30.5 10.1 - - ---------------------------------------------------------------------------- Total contractual cash obligations $264.5 $241.8 $10.0 $1.3 $1.4
Debt As of December 31, 2001, the Corporation had $210.2 million of outstanding notes payable. Of the $210.2 million, $5.2 million is a long-term low interest loan with the state of Ohio used in conjunction with the home office purchase. The remaining $205.0 million is a current note payable under a 1997 credit facility that provided a $300.0 million revolving line of credit to the Corporation. On March 19, 2001, the Corporation elected to reduce the aggregate amount available under the revolving 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 (as defined in the agreement) and a minimum statutory surplus of $750.0 million. Effective March 30, 2001, the covenant was amended to require a minimum statutory surplus of $675.0 million for the quarters ending March 31, 2001 and June 30, 2001, returning to minimum statutory surplus of $750.0 million for subsequent quarters. The Corporation continues to review its financial covenants in the credit agreement in light of its operating losses. As of December 31, 2001, the Corporation was in compliance with these covenants. However, further deterioration of operating results, reductions in the equity portfolio valuation, or other changes in statutory surplus may lead to covenant violations which could ultimately result in default. 35 Item 7. Continued The credit agreement expires in October 2002, with any outstanding loan balance due at that time. The Corporation is evaluating its capital requirements and is exploring ways to refinance its debt and increase its financial flexibility. The Corporation has taken steps to strengthen its financial position by aggressively managing expenses and first reducing quarterly dividends to shareholders and later eliminating the current quarterly dividend in the first quarter of 2001. The Corporation will be required to obtain additional external funding, either in the form of debt or equity, in order to repay the balance of its current notes payable, which comes due October 2002. While the Corporation believes that it should be able to obtain such external funding, the ability to raise such funding cannot be assured nor can the cost of such funding be determined at this time. Rating Agencies 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 its rating of the 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. Statutory Surplus Statutory surplus, a traditional insurance industry measure of strength and underwriting capacity, was $767.5 million at December 31, 2001, compared with $812.1 million at December 31, 2000 and $899.8 million at December 31, 1999. On January 1, 2001, statutory surplus was reduced by $21.7 million to $790.4 million for the cumulative effect of adopting new required statutory accounting principles. The 2001 surplus was further reduced by the $26.8 million after-tax charge associated with the New Jersey private passenger auto transfer and a decrease in the market value of the equity investment portfolio. Statutory surplus increased in 2001 due to the sale of a minority interest in the stock of a subsidiary, which caused a non- recurring tax benefit of $16.1 million. The decrease in the 2000 surplus was due primarily to poor underwriting results, dividend payments, and the statutory treatment of the final installment payment for the acquisition of the commercial lines division of GAI. The ratio of premiums written to statutory surplus is one of the measures used by insurance regulators to gauge the financial strength of an insurance company and indicates the ability of the Group to grow by writing additional business. At December 31, 2001, the Group's premiums written to surplus ratio is 1.9 to 1. The ratio was 1.9 to 1 and 1.8 to 1 in 2000 and 1999, respectively. 36 Item 7. Continued The National Association of Insurance Commissioners ("NAIC") has developed a "Risk-Based Capital" formula for property and casualty insurers and life insurers. The formula is intended to measure the adequacy of an insurer's capital given the asset structure and product mix of the company. As of December 31, 2001, all insurance companies in the Group, with the exception of OCNJ, exceed the necessary capital. The exception for OCNJ is due to a temporary difference in the recognition of deferred taxes related to the $40.6 million New Jersey transfer fee. In 1998, the NAIC adopted the Codification of Statutory Accounting Principles guidance, which replaced the former Accounting Practices and Procedures manual as the NAIC's primary guidance on statutory accounting. The new policies provide guidance for areas where statutory accounting had been silent and changed former statutory accounting in some areas. The Group implemented the Codification guidance effective January 1, 2001. The cumulative effect of changes in accounting principles adopted to conform to the Codification guidance were reported as an adjustment to statutory policyholders' surplus as of January 1, 2001. The cumulative effect of adopting Codification reduced statutory policyholders' surplus by $21.7 million on January 1, 2001. Reinsurance Reinsurance is a contract by which one insurer, called a reinsurer, agrees to cover, under certain defined circumstances, a portion of the losses incurred by a primary insurer in the event a claim is made under a policy issued by the primary insurer. The Group purchases reinsurance to protect against large or catastrophic losses. There are several programs that provide reinsurance coverage. The Group's property per risk program covers property losses in excess of $1.0 million for a single insured, for a single event. This property per risk program covers up to $29.0 million in losses in excess of the $1.0 million retention level for a single event. The Group's casualty per occurrence program covers liability losses. Workers' compensation, umbrella and other casualty reinsurance cover losses up to $99.0 million, $49.0 million and $23.0 million, respectively, in excess of the $1.0 million retention level for a single insured event. The property catastrophe reinsurance program protects the Group against an accumulation of losses arising from one defined catastrophic occurrence or series of events. This program provides $150.0 million of coverage in excess of the Group's $25.0 million retention level. In 2001, a portion of the catastrophe program was renewed with a multi-year placement as in previous years. This provides continuity and maintains rates and each reinsurer's overall share of the program. Over the last 20 years, two events triggered coverage under the catastrophe reinsurance program. Losses and loss adjustment expenses from the Oakland fires in 1991 totaled $35.6 million and losses and loss adjustment expenses from Hurricane Andrew in 1992 totaled $29.8 million. Both of these losses exceeded the prior retention amount of $13.0 million, resulting in significant recoveries from reinsurers. Reinsurance limits are purchased to cover exposure to catastrophic events having the probability of occurring every 150-250 years. 37 Item 7. Continued GAI has agreed to maintain reinsurance on the commercial lines business that the Company acquired from GAI and its affiliates in 1998. GAI is obligated to reimburse the Company if Great American's reinsurers are unable to pay claims with respect to the acquired commercial lines business. Reinsurance contracts do not relieve the Group of their obligations to policyholders. The collectibility of reinsurance depends on the solvency of the reinsurers at the time any claims are presented. The Group monitors each reinsurer's financial health and claims settlement performance because reinsurance protection is an important component of the Corporation's financial plan. Each year, the Group reviews financial statements and calculates various ratios used to identify reinsurers who no longer meet appropriate standards of financial strength. Reinsurers who fail these tests are removed from the program at renewal. Additionally, a large base of reinsurers is utilized to mitigate concentration of risk. During the last three fiscal years, no reinsurer accounted for more than 15% of total ceded premiums. As a result of these controls, amounts of uncollectible reinsurance have not been significant. Loss and Loss Adjustment Expenses The Group's largest liabilities are reserves for losses and loss adjustment expenses. The accounting policies related to the loss and loss adjustment expense reserves are considered critical. Loss and loss adjustment expense reserves are established for all incurred claims and are carried on an undiscounted basis before any credits for reinsurance recoverable. The establishment of loss and loss adjustment expense reserves involves the use of certain assumptions and estimates. Actual losses and loss adjustment expenses may change with further developments. These reserves amounted to $2.15 billion at December 31, 2001, $2.00 billion at December 31, 2000 and $1.91 billion at December 31, 1999. In recent years, asbestos and environmental liability claims have expanded greatly in the insurance industry. Historically, the Group has written small commercial accounts and has not sold policies with significant manufacturing liability coverages. Within the manufacturing category, we have concentrated on the light manufacturers, which further limits exposure to environmental claims. Consequently, the Group's asbestos and environmental liability exposure is substantially below the industry average. Estimated asbestos and environmental reserves are composed of case reserves, incurred but not reported reserves and reserves for loss adjustment expense. For 2001, 2000 and 1999, respectively, those reserves were $53.5 million, $40.4 million and $41.1 million. Asbestos reserves were $31.8 million, $13.5 million and $9.6 million and environmental reserves were $21.7 million, $26.9 million and $31.5 million for those respective years. These loss estimates are based on currently available information. However, given the expansion of coverage and liability by the courts and legislatures, there is substantial uncertainty as to the ultimate liability. The Group increased its asbestos reserves in 2001 for further development on existing claims outstanding. Construction defect claims filed under general liability insurance policies involve allegations of defective work on construction projects, such as condominiums, apartment complexes, housing developments, and office buildings. These claims usually involve multiple parties and carriers. 38 Item 7. Continued The loss estimates for these claims are based on currently available information. However, given the expansion of coverage and liability by the courts and legislatures, there is substantial uncertainty as to the ultimate liability. California Legal Proceedings Proposition 103 was passed in the state of California 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, the Administrative Law Judge issued a proposed ruling with a rollback liability of $24.4 million plus interest. The Group established a contingent liability for the Proposition 103 rollback of $24.4 million plus simple interest at 10% 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 Commissioner of Insurance of the state of California. Under the terms of the settlement, the members of the Group agreed to pay $17.5 million in refund premiums to eligible 1989 California policyholders. With this development, the total reserve was decreased to $17.5 million as of December 31, 2000. This decrease in the reserve resulted in an increase in operating income and net income in 2000, but had no effect on the statutory combined ratio reported. The Group began to make payments in the first quarter of 2001. The remaining liability was $7.8 million as of December 31, 2001. To date, the Group has paid approximately $5.7 million in legal costs related to the California withdrawal and Proposition 103. Investment Portfolio At year-end 2001, consolidated investments had a carrying value of $3.3 billion. The excess of market value over cost was $420.9 million, compared with $629.4 million at year-end 2000 and $505.4 million at year-end 1999. The decrease in 2001 was largely due to the recognition of realized gains in connection with the sale of appreciated equity securities in the 2001 equity portfolio reallocation. The 2000 increase was due to market growth in both the fixed income and equity portfolios, while a 1999 decrease in unrealized gains was largely attributable to the Group's reallocation of its investment portfolio mentioned in the Investment Results section. The Group's fixed income portfolio has an intermediate duration and a laddered maturity structure. The Group chooses always to remain fully invested and does not try to time markets. The Group also does not invest in off-balance sheet investments or arrangements. Tax exempt bonds decreased to 1.1% of the fixed income portfolio at year- end 2001 versus 3.2% and 19.4% for December 31, 2000 and 1999, respectively. The funds previously held in tax exempt bonds have been reallocated to investment grade taxable bonds. Due to poor underwriting results over the past few years, the Group has reduced its holdings to maximize after-tax income. As of December 31, 2001, the Group held $1,107.8 million in mortgage-backed securities, compared with $1,124.0 million and $784.3 million at December 31, 2000 and 1999, respectively. The increase from December 31, 1999 is attributable to a redistribution of investments previously held in tax exempt bonds and the 2001 and 1999 reallocations mentioned above. The majority of 39 Item 7. Continued mortgage-backed security holdings are less volatile planned amortization class, sequential structures and agency pass-through securities. Of this portfolio, $10.0 million, $13.1 million and $19.3 million were invested in more volatile bond classes (e.g. interest-only, super-floaters, inverses) in 2001, 2000 and 1999, respectively. At year-end 2001, consolidated equity investments had a market value of $489.0 million. Equity investments have decreased as a percentage of the consolidated portfolio from 22.0% in 1999 to 14.7% at year-end 2001. This decrease is attributable to the 2001 reallocation of the Group's investment portfolio. The Corporation adopted Statement of Financial Accounting Standards ("SFAS") 133 effective January 1, 2001. The adoption of SFAS 133 has had an immaterial impact on the financial results of the Corporation. The Corporation's largest assets are its investments and, therefore, the accounting policies are considered critical. The Corporation uses certain assumptions and estimates when valuing certain investments and related income. These assumptions include estimations of cash flows and interest rates. Although the Corporation believes the values of its investments represent fair value, due to the inherent uncertainties and judgments involved with accounting measurements, certain estimates could change and lead to changes in fair values. NEW ACCOUNTING STANDARDS See discussion in Note 22, New Accounting Standards, in the Notes to Consolidated Financial Statements on page 61 of this Form 10-K. FORWARD-LOOKING STATEMENTS From time to time, the Corporation 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 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 Corporation notes that a variety of factors could cause the Corporation's actual results and experience to differ materially from the anticipated results or other expectations expressed in the Corporation's forward-looking statements. The risks and uncertainties that may affect the operations, performance, development and results of the Corporation'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 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; ability to implement major software applications; and general economic and market conditions. 40 Item 7A. Quantitative and Qualitative Disclosures about Market Risk Market Risk Disclosures for Financial Instruments Market risk is the risk of loss resulting from adverse changes in interest rates. In addition to market risk, the Corporation is exposed to other risks such as credit, reinvestment and liquidity risk. Credit risk refers to the financial risk that an obligation will not be paid and a loss will result. Reinvestment risk is the risk that interest rates will fall causing interim cash flows to earn less than the original investment. Liquidity risk describes the ease with which an investment can be sold without substantially affecting the asset's price. The sensitivity analysis below summarizes only the exposure to market risk. The Corporation strives to produce competitive returns by investing in a diverse portfolio of high-quality companies. All investments are held as "available-for-sale," as defined by SFAS No. 115. Market Risk - The Corporation has exposure to losses resulting from potential volatility in interest rates. The Corporation attempts to mitigate its exposure to interest rate risk through active portfolio management, periodic reviews of asset and liability positions and through maintaining a laddered maturity structure with an intermediate duration. Estimates of cash flows and the impact of interest rate fluctuations relating to the Corporation's investment portfolio are modeled semi- annually and reviewed regularly. Equity Price Risk - Equity price risk can be separated into two elements. The first, systematic risk, is the portion of a portfolio or individual security's price movement attributed to stock market movement as a whole. The second element, nonsystematic risk, is the portion of price movement unique to the individual portfolio or security. This risk can be further divided between characteristics of the industry and of the individual issuer. The Corporation attempts to manage nonsystematic risk by monitoring a portfolio that is diversified across industries. The following tables illustrate the hypothetical effect of an increase in interest rates of 100 basis points (1%) and a 10% decrease in equity values at December 31, 2001, 2000 and 1999, respectively. The changes selected above reflect the Corporation's view of shifts in rates and values that are quite possible over a one-year period. These rates should not be considered a prediction of future events by the Corporation as interest rates may be much more volatile in the future. This analysis is not intended to provide a precise forecast of the effect of changes in interest rates and equity prices on the Corporation's income, cash flow or shareholders' equity. In addition, the analysis does not take into account any actions the Corporation may take to reduce its exposure in response to market fluctuations.
($ in thousands) Estimated Adjusted Market Value December 31, 2001 Fair Value as indicated above --------------------------------------------------------------------------- Interest Rate Risk: Fixed maturities $2,772 $2,633 Short-term investments 55 55 Equity Price Risk: Equity securities 489 440 ---------------------------------------------------------------------------- Totals $3,316 $3,128 ============================================================================
41 Item 7A. Continued
($ in thousands) Estimated Adjusted Market Value December 31, 2000 Fair Value as indicated above --------------------------------------------------------------------------- Interest Rate Risk: Fixed maturities $2,514 $2,419 Short-term investments 60 60 Equity Price Risk: Equity securities 755 679 ---------------------------------------------------------------------------- Totals $3,329 $3,158 ============================================================================
($ in thousands) Estimated Adjusted Market Value December 31, 1999 Fair Value as indicated above --------------------------------------------------------------------------- Interest Rate Risk: Fixed maturities $2,377 $2,272 Short-term investments 104 104 Equity Price Risk: Equity securities 698 698 ---------------------------------------------------------------------------- Totals $3,179 $3,004 ============================================================================
In addition to the above scheduled investments, the Corporation has a revolving line of credit. An increase in interest rates of one hundred basis points to the index against which the line of credit is priced would result in additional annual interest expense of $2.1 million. Certain assumptions are inherent in the above analysis. The Corporation assumes an instantaneous and parallel shift in interest rates and equity prices at December 31, 2001, 2000 and 1999, and that the composition of its investment portfolio remains relatively constant. Also, the Corporation assumes a change in interest rates is reflected uniformly across all financial instruments. The adjusted market values are estimated using discounted cash flow analysis and duration modeling. Item 8. Financial Statements and Supplementary Data See Item 14 for Index to Consolidated Financial Statements, including the Notes to Consolidated Financial Statements and the Report of Independent Auditors, and Schedules on page 44 of this Form 10-K. Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure None. 42 PART III Item 10. Directors and Executive Officers of the Registrant Incorporated by reference herein from those portions of the Corporation's Proxy Statement for the Annual Meeting of Shareholders of the Corporation for 2002 under the headings "Election of Directors," and "Other Directorships and Related Transactions" and "Section 16(a) Beneficial Ownership Reporting Compliance." Item 11. Executive Compensation Incorporated by reference herein from those portions of the Corporation's Proxy Statement for the Annual Meeting of Shareholders of the Corporation for 2002 under the headings "Executive Compensation," "Employment Agreement," "Change in Control Agreements," "Directors' Fees and Other Compensation," "Pension Plans," "Report of the Executive Compensation Committee," and "Comparison of Five-Year Cumulative Total Return." Item 12. Security Ownership of Certain Beneficial Owners and Management Incorporated by reference herein from those portions of the Corporation's Proxy Statement for the Annual Meeting of Shareholders of the Corporation for 2002 under the headings "Principal Shareholders," and "Shareholdings of Directors, Executive Officers and Nominees for Election as Director." Item 13. Certain Relationships and Related Transactions Incorporated by reference herein from those portions of the Corporation's Proxy Statement from the Annual Meeting of Shareholders of the Corporation for 2002 under the heading "Other Directorships and Related Transactions." 43 PART IV Item 14. Exhibits, Financial Statements Schedules, and Reports on Form 8-K (a) Financial statements and financial statement schedules required to be filed by Item 8 of this Form and Regulation S-X (1) The following statements are included herein: Page Number in this Report -------------- Consolidated Balance Sheet at December 31, 2001, 2000, 1999 45 Statement of Consolidated Income for the years ended December 31, 2001, 2000 and 1999 46 Statement of Consolidated Shareholders' Equity for the years ended December 31, 2001, 2000 and 1999 47 Statement of Consolidated Cash Flows for the years ended December 31, 2001, 2000 and 1999 48 Notes to Consolidated Financial Statements 49-62 Report of Independent Auditors 63 (2) The following financial statement schedules are included herein: Schedule I - Consolidated Summary of Investments Other Than Investments in Related Parties at December 31, 2001 66 Schedule II - Condensed Financial Information of Registrant for the years ended December 31, 2001, 2000 and 1999 67 Schedule III - Consolidated Supplementary Insurance Information for the years ended December 31, 2001, 2000 and 1999 68-70 Schedule IV - Consolidated Reinsurance for the years ended December 31, 2001, 2000 and 1999 71 Schedule V - Valuation and Qualifying Accounts for the years ended December 31, 2001, 2000 and 1999 72 Schedule VI - Consolidated Supplemental Information Concerning Property and Casualty Insurance Operations for the years ended December 31, 2001, 2000 and 1999 73 44 Item 14. Continued Ohio Casualty Corporation & Subsidiaries CONSOLIDATED BALANCE SHEET
December 31 (in thousands, except per share data) 2001 2000 1999 --------------------------------------------------------------------------------------------- Assets Investments: Fixed maturities: Available-for-sale, at fair value $2,772,104 $2,513,654 $2,376,973 (Cost: $2,729,998; $2,470,375; $2,408,201) Equity securities, at fair value 488,988 754,919 698,129 (Cost: $110,206; $168,779; $161,498) Short-term investments, at fair value 54,785 59,679 104,398 (Cost: $54,785; $59,679; $104,446) -------------------------------------------------------------------------------------------- Total investments 3,315,877 3,328,252 3,179,500 Cash 37,499 30,365 45,559 Premiums and other receivables, net of allowance for bad debts of $8,400, $10,700, and $9,338, respectively 341,986 357,108 366,202 Deferred policy acquisition costs 166,759 175,071 177,745 Property and equipment, net of accumulated depreciation of $133,213, $122,040, and $113,541, respectively 99,810 91,259 94,670 Reinsurance recoverable 237,688 148,633 139,021 Agent relationships, net of accumulated amortization of $36,310, $25,013, and $13,298, respectively 241,022 263,379 293,565 Interest and dividends due or accrued 43,319 38,227 38,022 Other assets 40,659 57,071 142,160 -------------------------------------------------------------------------------------------- Total assets $4,524,619 $4,489,365 $4,476,444 ============================================================================================ Liabilities Insurance reserves: Losses $1,746,828 $1,627,568 $1,544,967 Loss adjustment expenses 403,894 375,951 363,488 Unearned premiums 666,739 696,513 725,399 Notes payable 210,173 220,798 241,446 California Proposition 103 reserve 7,816 17,500 50,486 Deferred income taxes 3,124 65,613 62,843 Other liabilities 406,013 368,831 336,828 -------------------------------------------------------------------------------------------- Total liabilities (See Notes 1 and 9) 3,444,587 3,372,774 3,325,457 -------------------------------------------------------------------------------------------- Shareholders' Equity Common stock, $.125 par value Authorized: 150,000 shares; Issued: 94,418 shares 11,802 11,802 11,802 Preferred stock, No par value Authorized: 2,000 shares; Issued: 0 shares - - - Additional paid-in capital 4,152 4,180 4,286 Common stock purchase warrants 21,138 21,138 21,138 Accumulated other comprehensive income 274,359 409,904 329,354 Retained earnings 1,221,447 1,122,867 1,237,562 Treasury stock, at cost: (Shares: 34,312; 34,346; 34,335) (452,866) (453,300) (453,155) -------------------------------------------------------------------------------------------- Total shareholders' equity 1,080,032 1,116,591 1,150,987 -------------------------------------------------------------------------------------------- Total liabilities and shareholders' equity $4,524,619 $4,489,365 $4,476,444 ============================================================================================
See notes to consolidated financial statements 45 Item 14. Continued Ohio Casualty Corporation & Subsidiaries STATEMENT OF CONSOLIDATED INCOME
Year ended December 31 (in thousands, except per share data) 2001 2000 1999 ------------------------------------------------------------------------------------------ Premiums and finance charges earned $1,506,678 $1,533,998 $1,554,966 Investment income less expenses 212,385 205,062 184,287 Investment gains (losses) realized, net 182,940 (2,391) 160,827 ------------------------------------------------------------------------------------------ Total revenues 1,902,003 1,736,669 1,900,080 Losses and benefits for policyholders 1,001,590 1,116,271 1,008,668 Loss adjustment expenses 202,444 177,894 166,986 General operating expenses 111,833 136,898 151,088 Amortization of agent relationships 11,297 11,715 12,267 Write-off of agent relationships 10,966 45,971 - Early retirement charge 6,016 - - New Jersey renewal obligation transfer fee 40,600 - - Amortization of deferred policy acquisition costs 375,650 394,515 401,993 Depreciation expense 10,220 12,308 15,600 Amortization of software 4,999 3,785 4,146 California Proposition 103 reserve, including interest - (32,986) 2,443 ------------------------------------------------------------------------------------------ Total expenses 1,775,615 1,866,371 1,763,191 ------------------------------------------------------------------------------------------ Income (loss) from continuing operations before income taxes 126,388 (129,702) 136,889 Income tax (benefit) expense: Current 17,311 (9,850) 11,067 Deferred 10,497 (40,603) 19,886 ------------------------------------------------------------------------------------------ Total income tax (benefit)expense 27,808 (50,453) 30,953 ------------------------------------------------------------------------------------------ Income (loss) before discontinued operations and cumulative effect of accounting change 98,580 (79,249) 105,936 Income from discontinued operations, net of taxes of $- , $-, and $78, respectively (See Note 21) - - 4,270 Gain on sale of discontinued operations, net of taxes of $- , $-, and $235 (See Note 21) - - 6,190 Cumulative effect of accounting change, net of taxes - - (2,255) ------------------------------------------------------------------------------------------ Net income (loss) $ 98,580 $ (79,249) $ 114,141 ========================================================================================== Average shares outstanding - basic* 60,076 60,075 61,126 Average shares outstanding - diluted* 60,209 60,075 61,139 Earnings per share (basic and diluted):* Income (loss) from continuing operations, per share $1.64 $(1.32) $1.73 Income from discontinued operations, per share - - 0.07 Gain on sale of discontinued operations, per share - - 0.11 Effect of change in accounting principle (net of ta - - (0.04) ------------------------------------------------------------------------------------------ Net income (loss), per share $1.64 $(1.32) $ 1.87 ==========================================================================================
*Adjusted for 2 for 1 stock dividend effective July 22, 1999 See notes to consolidated financial statements 46 Item 14. Continued Ohio Casualty Corporation & Subsidiaries STATEMENT OF CONSOLIDATED SHAREHOLDERS' EQUITY
Common Accumulated Additional stock other Total (in thousands, except per Common paid-in purchase comprehensive Retained Treasury shareholders' share data) stock capital warrants income earnings stock equity ---------------------------------------------------------------------------------------------------------------------------- Balance, January 1, 1999 $ 5,901 $ 4,135 $21,138 $ 511,816 $1,185,349 $(407,358) $1,320,981 Net income 114,141 114,141 Net change in unrealized gain, net of deferred income tax of $(98,249) (182,462) (182,462) ----------- Comprehensive loss (68,321) Net issuance of treasury stock under stock option plan (24 shares) 151 290 441 Repurchase of treasury Stock (2,478 shares) (46,087) (46,087) Cash dividends paid ($.92 per share)* (56,027) (56,027) Stock dividend (47,209 shares) 5,901 (5,901) - --------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 1999 $11,802 $ 4,286 $21,138 $ 329,354 $1,237,562 $(453,155) $1,150,987 Net loss (79,249) (79,249) Net change in unrealized gain, net of deferred income tax of $43,374 80,550 80,550 ----------- Comprehensive income 1,301 Net forfeiture of treasury stock under stock award plan (11 shares) (106) (145) (251) Cash dividends paid ($.59 per share) (35,446) (35,446) --------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 2000 $11,802 $ 4,180 $21,138 $ 409,904 $1,122,867 $(453,300) $1,116,591 Net income 98,580 98,580 Net change in unrealized gain, net of deferred income tax of $(72,986) (135,545) (135,545) ----------- Comprehensive loss (36,965) Net issuance of treasury stock under stock award plan (34 shares) (28) 434 406 --------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 2001 $11,802 $ 4,152 $21,138 $ 274,359 $1,221,447 $(452,866) $1,080,032 ===========================================================================================================================
*Adjusted for 2 for 1 stock dividend effective July 22, 1999 (See Note 23) See notes to consolidated financial statements 47 Item 14. Continued Ohio Casualty Corporation & Subsidiaries STATEMENT OF CONSOLIDATED CASH FLOWS
Year ended December 31 (in thousands) 2001 2000 1999 ---------------------------------------------------------------------------------------- Cash flows from: Operations Net income (loss) $ 98,580 $ (79,249) $ 114,141 Adjustments to reconcile net income to cash from operations: Changes in: Insurance reserves 117,429 66,178 (17,153) Income taxes 31,951 (36,193) (5,510) Premiums and other receivables 15,122 9,094 (64,259) Deferred policy acquisition costs 8,312 2,674 (1,139) Reinsurance recoverable (89,055) (9,612) 15,101 Other assets 2,967 80,105 (16,930) Other liabilities 45,136 24,048 (38,806) California Proposition 103 reserves (9,684) (32,986) 2,443 Amortization and write-off of agent relationships 22,357 57,686 12,267 Depreciation and amortization 9,978 15,510 28,769 Investment (gains) losses (182,940) 2,391 (162,698) Gain on sale of discontinued operations (See Note 21) - - (6,190) Cumulative effect of an accounting change - - 2,255 ---------------------------------------------------------------------------------------- Net cash generated (used) from operating activity $ 70,153 $ 99,646 $ (137,709) ======================================================================================== Investing Purchase of securities: Fixed income securities - available-for-sale (1,571,538) (1,131,406) (1,572,645) Equity securities (55,446) (80,375) (26,696) Proceeds from sales: Fixed income securities - available-for-sale 1,215,596 990,390 1,287,982 Equity securities 298,659 54,817 302,355 Proceeds from maturities and calls: Fixed income securities - available-for-sale 77,542 57,930 133,269 Equity securities - 10,200 3,000 Property and equipment: Purchases (22,940) (9,511) (31,425) Sales 764 4,423 1,270 Cash proceeds from sale of discontinued operations (See Note 21) - - 11,011 ---------------------------------------------------------------------------------------- Net cash generated (used) from investing activities (57,363) (103,532) 108,121 ---------------------------------------------------------------------------------------- Financing Notes payable: Borrowings - - 16,500 Repayments (10,625) (20,648) (40,054) Proceeds from exercise of stock options 75 67 211 Purchase of treasury stock - - (46,087) Dividends paid to shareholders - (35,446) (56,027) ---------------------------------------------------------------------------------------- Net cash used from financing activities (10,550) (56,027) (125,457) ---------------------------------------------------------------------------------------- Net change in cash and cash equivalents 2,240 (59,913) (155,045) Cash and cash equivalents, beginning of year 90,044 149,957 305,002 ---------------------------------------------------------------------------------------- Cash and cash equivalents, end of year $ 92,284 $ 90,044 $ 149,957 ======================================================================================== Additional disclosures: Interest and related fees paid 14,271 15,953 13,790 Income taxes paid (refunded) (1,549) (14,248) 34,824
See notes to consolidated financial statements 48 Item 14. Continued NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (All dollar amounts in thousands, except share data, unless otherwise stated) NOTE 1 -- Accounting Policies A. Nature of Business Ohio Casualty Corporation is the holding company of The Ohio Casualty Insurance Company, which is one of six property-casualty companies that make up Ohio Casualty Group, whose primary products consist of insurance for personal auto, commercial property, homeowners, commercial auto, workers' compensation and other miscellaneous lines. The Group operates through the independent agency system in over 40 states. Of net premiums written in 2001, approximately 17.4% was generated in the state of New jersey, 9.8% in Ohio and 7.9% in Kentucky. B. Principles of Consolidation The consolidated financial statements have been prepared on the basis of accounting principles generally accepted in the United States and include the accounts of Ohio Casualty Corporation and its subsidiaries (The Ohio Casualty Insurance Company, West American Insurance Company, Ohio Security Insurance Company, American Fire and Casualty Company, Avomark Insurance Company, and Ohio Casualty of New Jersey, Inc.). Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant inter-company transactions have been eliminated. C. Investments Investment securities are classified upon acquisition into one of the following categories: (1) held to maturity securities (2) trading securities (3) available-for-sale securities Currently, all of the Corporation's investments are held as available-for-sale securities. Available-for-sale securities are those securities that would be available to be sold in the future in response to liquidity needs, changes in market interest rates and asset-liability management strategies, among others. Available-for-sale securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders' equity, net of deferred tax. Equity securities are carried at quoted market values and include nonredeemable preferred stocks and common stocks. Fair values of fixed maturities and equity securities are determined on the basis of dealer or market quotations or comparable securities on which quotations are available. The Corporation regularly evaluates all of its investments based on current economic conditions, credit loss experience and other specific developments. If there is a decline in a security's net realizable value that is other than temporary, it is treated as a realized loss and the cost basis of the security is reduced to its estimated fair value. Short-term investments include commercial paper and notes with original maturities of 90 days or less and are stated at fair value. Realized gains or losses on disposition of investments are determined on the basis of specific cost of investments. D. Premiums Property and casualty insurance premiums are earned principally on a monthly pro rata basis over the term of the policy; the premiums applicable to the unexpired terms of the policies are included in unearned premium reserve. Premiums receivable represents amounts due on insurance policies. The premiums receivable balance is presented net of allowances determined by management. E. Deferred Policy Acquisition Costs Acquisition costs incurred at policy issuance net of applicable ceding commissions are deferred and amortized over the term of the policy. Acquisition costs deferred consist of commissions, brokerage fees, salaries and benefits, and other underwriting expenses to include allocations for inspections, taxes, rent and other expenses which vary directly with the acquisition of insurance contracts. Periodically, an analysis of the deferred policy acquisition costs is performed in relation to the expected recognition of revenues including investment income to determine if any deficiency exists. No deficiencies have been indicated in the periods presented. F. Property and Equipment Property and equipment are carried at cost less accumulated depreciation. Depreciation is computed principally on the straight-line method over the estimated lives of the assets. The Corporation capitalizes costs incurred to internally develop certain software assets used in the Corporation's operations. The Corporation amortizes these costs on a straight-line basis over the estimated useful life of the asset when placed into service. Capitalized software costs are evaluated periodically as events or circumstances indicate a possible inability to recover their carrying amounts. Such evaluation is based on various analyses, including cash flow and profitability projections that incorporate, as applicable, the impact on existing company businesses. Unamortized software costs and accumulated amortization in the consolidated balance sheet were $41,410 and $1,035 at December 31, 2001, and $28,764 and $552 at December 31, 2000, respectively. G. Agent Relationships The Corporation recorded an asset (agent relationships) for the excess of cost over the fair value of net assets acquired. Agent relationships are amortized on a straight-line basis over a twenty-five year period. Agent relationships are evaluated periodically as events or circumstances, such as cancellation of agents, indicate a possible inability to recover their carrying amount. Such evaluation is based on various analyses, including cash flow and profitability projections that incorporate, as applicable, the impact on existing company businesses. The analyses necessarily involve significant management judgments to evaluate the capacity of an acquired business to perform within projections. If future 49 Item 14. Continued undiscounted cash flows are insufficient to recover the carrying amount of the asset, an impairment loss will be recognized (See Note 15). H. Loss Reserves The reserves for unpaid losses and loss adjustment expenses are based on estimates of ultimate claim costs, including claims incurred but not reported, salvage and subrogation and inflation without discounting. The methods of making such estimates are continually reviewed and updated, and any resulting adjustments are reflected in earnings currently. The amounts are necessarily based on estimates of future rates of inflation and other factors, and accordingly there can be no assurance that the ultimate liability will not vary from such estimates. I. Reinsurance In the normal course of business, the Group seeks to diversify risk and reduce the loss that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. To the extent that any reinsuring companies are unable to meet obligations under the agreements covering the reinsurance ceded, the Group would remain liable. Amounts recoverable from reinsurers are estimated in a manner consistent with the reinsured contract. J. Income Taxes The Corporation files consolidated federal income tax returns. The Corporation records deferred tax assets and liabilities based on temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect in the year in which the differences are expected to reverse. K. Stock Options The Corporation accounts for stock options issued to employees in accordance with Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees". Under APB 25, the Corporation recognizes expense based on the intrinsic value of options. L. Insurance Assessments The Group accrues a liability for insurance related assessments in accordance with Statement of Position 97-3 "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments". As of December 31, 2001, 2000, and 1999 the liability for these assessments was $6,582, $4,278, and $4,808, respectively. In 1999, the Corporation recorded the liability as a change in accounting method. M. Earnings Per Share Earnings per share of common stock is presented using basic and diluted earnings per share. Basic earnings per share is calculated using the weighted average number of common stock shares outstanding during the period. Diluted earnings per share include the effect of the assumed exercise of dilutive common stock options. N. Statement of Cash Flows Short-term investments are comprised of highly liquid investments that are readily convertible into known amounts of cash. Such investments have maturities of 90 days or less from the date of purchase. Short-term investments are deemed to be cash equivalents. O. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The insurance industry is subject to heavy regulation that differs by state. A dramatic change in regulation in a given state may have a material adverse impact on the Corporation. NOTE 2 -- Investments Investment income is summarized as follows:
2001 2000 1999 --------------------------------------------------------------- Investment income from: Fixed maturities $208,042 $199,474 $177,018 Equity securities 10,676 11,234 12,961 Short-term securities 3,188 5,352 5,942 --------------------------------------------------------------- Total investment income 221,906 216,060 195,921 Investment expenses 9,521 10,998 11,634 --------------------------------------------------------------- Net investment income $212,385 $205,062 $184,287 ===============================================================
The gross realized gains and gross realized losses from sales of available-for-sale securities were as follows:
Gross Gross Net Realized Realized Realized December 31 Gains (Losses) Gains/Losses --------------------------------------------------------------------- 2001 $202,758 $(19,818) $182,940 2000 18,728 (21,119) (2,391) 1999 169,301 (8,474) 160,827
The increase in realized gains in 2001 was due to the partial reallocation of the Corporation's equity portfolio to fixed income holdings. Significant appreciation in the equity holdings sold as part of the reallocation, contributed to the realized gains in 2001. The increase in realized gains in 1999 was due to a strategic asset reallocation involving the sale of approximately $200,000 in equity securities resulting in $145,000 of realized gains. Changes in unrealized gains (losses) on investment in securities are summarized as follows: 50 Item 14. Continued
2001 2000 1999 --------------------------------------------------------------------------- Unrealized gains (losses): Securities $(208,531) $123,924 $(280,711) Deferred tax 72,986 (43,374) 98,249 --------------------------------------------------------------------------- Net unrealized gains (losses) $(135,545) $ 80,550 $(182,462) ===========================================================================
The amortized cost and estimated market values of investments in debt and equity securities are as follows:
Gross Gross Estimated Amortized Unrealized Unrealized Fair 2001 Cost Gains Losses Value -------------------------------------------------------------------------------- Securities available- for-sale: U.S. Government $ 27,775 $ 1,611 $ (5) $ 29,381 States, municipalities and political subdivisions 30,057 1,271 - 31,328 Corporate securities 1,577,939 47,945 (22,325) 1,603,559 Mortgage-backed securities: U.S. Government Agency 56,307 243 (488) 56,062 Other 1,037,920 26,649 (12,795) 1,051,774 --------------------------------------------------------------------------------- Total fixed maturities 2,729,998 77,719 (35,613) 2,772,104 Equity securities 110,206 381,580 (2,798) 488,988 Short-term investments 54,785 - - 54,785 --------------------------------------------------------------------------------- Total securities, available-for-sale $2,894,989 $459,299 $(38,411) $3,315,877 =================================================================================
Gross Gross Estimated Amortized Unrealized Unrealized Fair 2000 Cost Gains Losses Value -------------------------------------------------------------------------------- Securities available- for-sale: U.S. Government $ 54,290 $ 1,530 $ (212) $ 55,608 States, municipalities and political subdivisions 78,049 1,322 (128) 79,243 Corporate securities 1,233,418 40,427 (18,994) 1,254,851 Mortgage-backed securities: U.S. Government Agency 25,764 199 (136) 25,827 Other 1,078,854 26,388 (7,117) 1,098,125 --------------------------------------------------------------------------------- Total fixed maturities 2,470,375 69,866 (26,587) 2,513,654 Equity securities 168,779 598,840 (12,700) 754,919 Short-term investments 59,679 - - 59,679 --------------------------------------------------------------------------------- Total securities, available-for-sale $2,698,833 $668,706 $(39,287) $3,328,252 =================================================================================
Gross Gross Estimated Amortized Unrealized Unrealized Fair 2001 Cost Gains Losses Value -------------------------------------------------------------------------------- Securities available- for-sale: U.S. Government $ 65,214 $ 1,001 $ (1,108) $ 65,107 States, municipalities and political subdivisions 456,959 9,724 (5,256) 461,427 Corporate securities 1,082,975 17,344 (34,196) 1,066,123 Mortgage-backed securities: U.S. Government Agency 47,865 30 (1,438) 46,457 Other 755,188 5,093 (22,422) 737,859 --------------------------------------------------------------------------------- Total fixed maturities 2,408,201 33,192 (64,420) 2,376,973 Equity securities 161,498 543,718 (7,087) 698,129 Short-term investments 104,446 29 (77) 104,398 --------------------------------------------------------------------------------- Total securities, available-for-sale $2,674,145 $576,939 $(71,584) $3,179,500 =================================================================================
The Group is required to hold investments on deposit with regulatory authorities in various states. As of December 31, 2001, 2000 and 1999, these investments had a fair value of $55,222, $50,863, and $43,801, respectively. The amortized cost and estimated fair value of debt securities at December 31, 2001, by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Estimated Amortized Fair Cost Value ----------------------------------------------------------------------------- Due in one year or less $ 11,144 $ 11,322 Due after one year through five years 297,429 306,584 Due after five years through ten years 861,646 880,050 Due after ten years 465,552 466,312 Mortgage-backed securities: U.S. Government Agency 56,307 56,062 Other 1,037,920 1,051,774 ----------------------------------------------------------------------------- Total fixed maturities $2,729,998 $2,772,104 =============================================================================
Certain securities were determined to have other than temporary declines in book value and were written down through realized investment losses. The before-tax realized gain (loss) was impacted by the write-down of securities for other than temporary declines in market value by $11,951, $16,720, and $8,195 in 2001, 2000 and 1999, respectively. Gross gains of $39,821, $14,179 and $13,677 and gross losses of $35,160, $35,858 and $37,126 were realized on the maturities and sales of debt securities in 2001, 2000 and 1999, respectively. 51 Item 14. Continued NOTE 3 -- Fair Value of Financial Instruments The following table presents the carrying amounts and fair values of the Corporation's financial instruments:
Carrying Fair 2001 Amount Value ----------------------------------------------------------------- Assets Cash and short-term investments $ 92,284 $ 92,284 Securities available- for-sale 3,261,092 3,261,092 Liabilities Notes payable $ 210,173 $ 210,173
Carrying Fair 2000 Amount Value ----------------------------------------------------------------- Assets Cash and short-term investments $ 90,044 $ 90,044 Securities available- for-sale 3,268,573 3,268,573 Liabilities Notes payable $ 220,798 $ 220,798
Carrying Fair 1999 Amount Value ----------------------------------------------------------------- Assets Cash and short-term investments $ 149,957 $ 149,957 Securities available- for-sale 3,075,102 3,075,102 Liabilities Notes payable $ 241,446 $ 241,446
The Corporation believes that the fair value of notes payable is approximately equal to its carrying value due to the market-based variable interest rates associated with the debt. NOTE 4 -- Deferred Policy Acquisition Costs Changes in deferred policy acquisition costs are summarized as follows:
2001 2000 1999 ----------------------------------------------------------------------------- Deferred, January 1 $175,071 $177,745 $176,606 ----------------------------------------------------------------------------- Additions: Commissions and brokerage 237,435 249,940 250,390 Salaries and employee benefits 57,559 61,067 70,823 Other 72,344 80,834 80,826 ----------------------------------------------------------------------------- Deferral of expense 367,338 391,841 402,039 ----------------------------------------------------------------------------- Amortization to expense Discontinued operations - - (1,093) Continuing operations 375,650 394,515 401,993 ----------------------------------------------------------------------------- Deferred, December 31 $166,759 $175,071 $177,745 =============================================================================
NOTE 5 -- Income Tax The effective income tax rate is less than the statutory corporate tax rate of 35% for 2001, 2000 and 1999 for the following reasons:
2001 2000 1999 ------------------------------------------------------------------------- Tax at statutory rate $ 44,236 $(45,396) $ 45,626 Tax exempt interest (875) (5,578) (12,543) Dividends received deduction (DRD) (2,677) (1,399) (3,483) Proration of DRD and tax exempt interest 275 1,012 2,124 Loss on disposition of subsidiary stock (16,100) - - Miscellaneous 2,949 908 (771) ------------------------------------------------------------------------ Actual tax expense (benefit) $ 27,808 $(50,453) $ 30,953 =========================================================================
The loss on disposition of subsidiary stock in 2001 was a non-recurring tax benefit related to the sale of a minority interest in stock of the Ohio Casualty of New Jersey, Inc. subsidiary. Tax years 1993 through 1995 and 1997 through 1999 are being examined by the Internal Revenue Service. Management believes there will not be a significant impact on the financial position or results of operations of the Corporation as a result of this audit. The components of the net deferred tax liability were as follows:
2001 2000 1999 ------------------------------------------------------------------------- Unearned premium proration $ 34,260 $ 36,640 $ 38,574 Accrued expenses 39,228 42,515 34,578 NOL and AMT carryforward 9,612 23,250 - Postretirement benefits 33,873 32,905 31,766 Discounted loss and loss expense reserves 85,579 80,647 69,955 ------------------------------------------------------------------------- Total deferred tax assets 202,552 215,957 174,873 ------------------------------------------------------------------------- Deferred policy acquisition costs (58,366) (61,275) (60,811) Unrealized gains on investments (147,310) (220,295) (176,905) ------------------------------------------------------------------------- Total deferred tax liabilities (205,676) (281,570) (237,716) ------------------------------------------------------------------------- Net deferred tax liability $ (3,124) $ (65,613) $ (62,843) =========================================================================
NOTE 6 -- Employee Benefits The Corporation has a non-contributory defined benefit retirement plan, a contributory health care, life and disability insurance plan and a savings plan covering substantially all employees. Benefit expenses are as follows:
2001 2000 1999 ------------------------------------------------------------------------- Employee benefit costs: Pension plan $(3,826) $(2,816) $ 1,858 Health care 15,569 16,718 16,180 Life and disability insurance 773 741 743 Savings plan 2,867 2,787 2,948 ------------------------------------------------------------------------- Total $15,383 $17,430 $21,729 =========================================================================
52 Item 14. Continued The pension benefit is determined as follows:
2001 2000 1999 ------------------------------------------------------------------------- Service cost earned during the year $ 6,334 $ 6,556 $ 8,545 Interest cost on projected benefit obligation 17,359 17,167 15,729 Expected return on plan assets (24,010) (23,348) (19,598) Amortization of unrecognized net asset (2,946) (2,946) (3,017) Amortization of accumulated gains (762) (444) - Amortization of unrecognized prior service cost 199 199 199 ------------------------------------------------------------------------- Net pension (benefit) cost $ (3,826) $ (2,816) $ 1,858 =========================================================================
Changes in the benefit obligation during the year:
2001 2000 1999 ------------------------------------------------------------------------- Benefit obligation at beginning of year $224,556 $229,094 $239,293 ------------------------------------------------------------------------- Service cost 6,334 6,556 8,545 Interest cost 17,359 17,167 15,729 Actuarial loss (gain) 6,352 (12,176) (24,141) Benefits paid (16,020) (16,085) (14,956) Curtailments 9,032 - 1,115 Special termination benefits - - 3,509 ------------------------------------------------------------------------- Benefit obligation at end of year $247,613 $224,556 $229,094 =========================================================================
Changes in pension plan assets during the year:
2001 2000 1999 ------------------------------------------------------------------------- Fair value of plan assets at beginning of year $273,469 $277,588 $252,224 ------------------------------------------------------------------------- Actual return on plan assets (1,319) 11,850 40,279 Benefits paid (15,031) (15,969) (14,915) ------------------------------------------------------------------------- Fair value of plan assets at end of year $257,119 $273,469 $277,588 =========================================================================
Pension plan funding at December 31:
2001 2000 1999 ------------------------------------------------------------------------- Funded status $ 9,506 $48,913 $48,495 Unrecognized net gain 3,284 37,558 37,323 Unrecognized net assets 1,735 5,892 8,837 Unrecognized prior service cost (1,672) (1,896) (2,093) ------------------------------------------------------------------------- Accrued pension asset $ 6,159 $ 7,359 $ 4,428 ========================================================================= Expected long-term return on plan assets 8.50% 9.00% 8.75% Discount rate on plan benefit obligations 7.50% 8.00% 7.75% Expected future rate of salary increases 5.25% 5.25% 5.25%
Pension benefits are based on service years and average compensation using the five highest consecutive years of earnings in the last decade of employment. The pension plan measurement date is October 1, 2001, 2000 and 1999. Plan assets at December 31, 2001 include $27,142 of the Corporation's common stock at market value compared to $18,066 and $27,057 at December 31, 2000 and 1999, respectively. Plan assets also include investments in mutual funds, common stock, corporate bonds, common/collective trusts, separate accounts, U.S. government securities, and other investements. The Corporation's postretirement benefit cost at December 31:
2001 2000 1999 ------------------------------------------------------------------------- Service cost $1,946 $2,333 $ 3,141 Interest cost 6,703 6,563 6,448 Amortization of unrecognized prior service costs 215 240 535 ------------------------------------------------------------------------- Net periodic postretirement benefit cost $8,864 $9,136 $10,124 =========================================================================
Changes in the postretirement benefit obligation during the year:
2001 2000 1999 ------------------------------------------------------------------------- Benefit obligation at beginning of year $86,973 $92,239 $98,347 ------------------------------------------------------------------------- Service cost 1,946 2,333 3,141 Interest cost 6,703 6,563 6,448 Plan participants' contributions (5,361) (5,719) (4,652) Increase due to actuarial loss (gain), change in discount rate, or other assumptions (5,101) (8,443) (11,045) ------------------------------------------------------------------------- Benefit obligation at end of year $85,160 $86,973 $92,239 =========================================================================
Accrued postretirement benefit liability at December 31:
2001 2000 1999 ------------------------------------------------------------------------- Accumulated postretirement benefit obligation $85,160 $86,973 $92,239 Unrecognized net gain 9,116 8,847 4,404 Unrecognized prior service cost (benefit) 2,505 (1,806) (5,882) ------------------------------------------------------------------------- Accrued postretirement benefit liability $96,781 $94,014 $90,761 =========================================================================
Postretirement benefit weighted average rate assumptions at October 1:
2001 2000 1999 ------------------------------------------------------------------------- Medical trend rate 8% 8% 8% Dental trend rate 5% 5% 5% Ultimate health care trend rate 5% 5% 5% Discount rate 7.50% 8.00% 7.75%
53 Item 14. Continued The above medical trend rates assumed for 2001, 2000 and 1999 were assumed to decrease .5% per year to the ultimate rate of 5% in 6 years. The postretirement plan measurement date is October 1 for 2001, 2000 and 1999. Increasing the assumed health care cost trend by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 2001 by approximately $11,071 and increase the postretirement benefit cost for 2001 by $1,418. Likewise, decreasing the assumed health care cost trend by one percentage point in each year would decrease the accumulated postretirement benefit obligation as of December 31, 2001 by approximately $9,368 and decrease the postretirement benefit cost for 2001 by $1,152. The Corporation's health care plan is a predominately managed care plan. Retired employees continue to be eligible to participate in the health care and life insurance plans. Employee contributions to the health care plan have been established as a flat dollar amount with periodic adjustments as determined by the Corporation. The health care plan is unfunded. Benefit costs are accrued based on actuarial projections of future payments. There are currently 3,049 active employees and 1,565 retired employees covered by these plans. Employees may contribute a percentage of their compensation to a savings plan. A portion of employee contributions is matched by the Corporation and invested in Corporation stock purchased on the open market by trustees of the plan. NOTE 7 - Stock Options and Warrants The Corporation is authorized under provisions of the 1993 and 1999 Stock Incentive Programs to grant options to purchase 2,587,000 and 1,500,000 shares, respectively, of the Corporation's common stock to key executive employees, directors and other full time employees at a price not less than the fair market value of the shares on dates the options are granted. The options granted under the 1993 program may be either "Incentive Stock Options" or "Nonqualified Stock Options" as defined by the Internal Revenue Code; the difference in the option plans affects treatment of the options for income tax purposes by the individual employee and the Corporation. The options granted under the 1999 program are "Nonqualified Stock Options". The options under both plans are non-transferable and exercisable at any time after the vesting requirements are met. Option expiration dates are ten years from the grant date. Options vest under the 1993 plan at either 50% per year for two consecutive years, or at 33% per year for three consecutive years. Options vest under the 1999 plan at 50% per year for two consecutive years from the date of the grant. The options also have accelerated vesting periods for participant retirement, death, or disability, subject to a holding period of 6 months for the 1993 program and 12 months for the 1999 program. As of December 31, 2001, there are 497,116 and 361,525 remaining options available to be granted for the 1993 and 1999 Stock Incentive Programs, respectively. In addition, the 1993 Stock Incentive Program provides for the grant of Stock Appreciation Rights. Stock Appreciation Rights provide the recipient with the right to receive payment in cash or stock equal to appreciation in value of the optioned stock from the date of grant in lieu of exercise of the stock options held. At December 31, 2001, there were no outstanding stock appreciation rights. In 2000 and 2001, the Corporation granted stock options to purchase 570,000 and 600,000 shares, respectively, of the Corporation's common stock to key executive employees and directors. The options were granted as either "Incentive Stock Options" or "Nonqualified Stock Options" in accordance with Market Place Rules available under NASDAQ Stock Market regulations. Option expiration dates are ten years from the grant date. The stock options granted vest at either 50% per year for two consecutive years, or at 33% per year for three consecutive years. Restricted stock awards are occasionally granted by the Corporation. The common shares covered by a restricted stock award may be sold or otherwise disposed of only after a minimum of three years from the grant date of the award. The difference between issue price and the fair market value on the date of issuance is recorded as compensation expense. The amount of compensation expense (benefit) recognized related to restricted stock awards was $(15) in 2001, $(319) in 2000 and $231 in 1999 before tax, respectively. The benefits in 2001 and 2000 related to employee forfeitures. Currently there are 3,800 shares of restricted stock outstanding. The Corporation also issues, at its discretion, dividend payment rights in connection with the grant of stock options. These rights entitle the holder to receive, for each dividend payment right, an amount in cash equal to the aggregate amount of dividends that the Corporation has paid on each common share from the date on which such right becomes effective through the payout date. One third of these rights becomes vested on each anniversary after the grant. Payment is made when the rights are fully vested by the rightholder. The Corporation recognizes compensation expense accordingly. The amount of compensation expense (benefit) related to dividend payment rights recognized in 2001 was $(26) with $(335) in 2000 and $52 in 1999 before tax. The benefit in 2000 related to employee forfeitures. As of December 31, 2001, 258,000 dividend payment rights were outstanding. The following table summarizes information about the stock-based compensation plan as of December 31, 2001, 2000 and 1999, and changes that occurred during the year: 54 Item 14. Continued
2001 2000 1999* --------------------------------------------------------------------------------- Weighted- Weighted- Weighted- Avg Avg Avg Shares Exercise Shares Exercise Shares Exercise (000) Price (000) Price (000) Price ------------------ ----------------- ----------------- Outstanding beginning of year 3,212 $13.91 1,324 $20.28 729 $20.26 Granted 1,352 10.96 2,679 12.05 723 20.31 Exercised (34) 12.27 - (16) 17.50 Forfeited (300) 15.56 (791) 18.25 (142) ------- ------- ------ Outstanding end of year 4,230 $12.87 3,212 $13.91 1,324 $20.28 ====== ======= ====== Options exercisable at year end 1,690 $14.64 590 $19.28 527 $19.38 Avg Remaining Contractual Life 8.37 yrs 8.73 yrs 7.97 yrs Weighted-Avg fair value of options granted during the year $5.73 $3.15 $4.70
*Adjusted for July 22, 1999 2 for 1 stock dividend (See Note 23). The following table summarizes the status of stock options outstanding and exercisable at December 31, 2001:
-------------------------------------------------------------- Stock Options Outstanding Stock Options Exercisable ---------------------------------- ------------------------- Weighted- Range of Avg Weighted- Weighted- Exercose Remaining Avg Avg Prices Per Shares Contractual Exercise Shares Exercise Share (000) Life (Yrs.) Price (000) Price --------------------------------------------------------------------------------- $8.60 - $8.60 18 9.31 $ 8.60 18 $ 8.60 $8.99 - $8.99 669 9.42 8.99 12 8.99 $9.07 - $9.75 441 8.98 9.70 139 9.72 $11.20 - $11.46 210 9.71 11.21 - - $12.38 - $12.38 1,693 8.16 12.38 881 12.38 $13.12 - $14.38 565 9.41 14.03 89 13.18 $14.88 - $20.34 440 6.11 19.19 357 18.92 $20.69 - $21.13 94 5.17 20.74 94 20.74 $23.47 - $23.47 82 6.13 23.47 82 23.47 $23.63 - $23.63 18 6.40 23.63 18 23.63 ------------------------------------------------------------------------------- $8.60 - $23.63 4,230 8.37 $12.87 1,690 $14.64 ===============================================================================
The Corporation continues to elect APB 25 for recognition of stock-based compensation expense. Under APB 25, expense is recognized based on the intrinsic value of the options. However, under the provision of FAS 123 the Corporation is required to estimate on the date of grant the fair value of each option using an option-pricing model. Accordingly, the Black-Scholes option pricing model is used with the following weighted-average assumptions: dividend yield of 1.8% for 2001, 4.5% for 2000 and 4.5% for 1999, expected volatility of 53.01% for 2001, 31.1% for 2000 and 28.5% for 1999, risk free interest rate of 5.10% for 2001, 5.87% for 2000 and 5.25% for 1999, and expected life of eight years. Had the Corporation adopted FAS 123, the amount of compensation expense that would have been recognized in 2001, 2000 and 1999 was $5,795, $4,367 and $1,831, respectively. The Corporation's net income and earnings per share would have been reduced to the pro forma amounts disclosed below:
2001 2000 1999 ------------------------------------------------------------------------- Net income (loss) As Reported: $98,580 $(79,249) $114,141 Pro Forma: $94,402 $(82,457) $112,491 Basic and diluted earnings per share As Reported: $1.64 $(1.32) $1.87 Pro Forma: $1.57 $(1.37) $1.84
In connection with the 1998 acquisition of substantially all of the Commercial Lines Division of Great American Insurance Companies (GAI), an insurance subsidiary of the American Financial Group, Inc. (AFG), the Corporation issued warrants to AFG to purchase 6 million shares of Ohio Casualty Corporation common stock. The warrants provide for the purchase of the Corporation's common stock at $22.505 per share and expire in December 2003. The warrants may be settled through physical or net share settlement and thus have been recorded as equity in the financial statements at their estimated fair value. Estimated fair value was determined based on a third party appraisal of the warrants. NOTE 8 -- Reinsurance In the normal course of business, the Group seeks to reduce the loss that may arise from catastrophes, including severe weather and terrorist activities, or other events that cause unfavorable underwriting results by reinsuring certain levels of risk with other insurers or reinsurers. In the event that such reinsuring companies might be unable at some future date to meet their obligations under the reinsurance agreements in force, the Group would continue to have primary liability to policyholders for losses incurred. The Group evaluates the financial condition of its reinsurers and monitors concentrations of credit risk to minimize its exposure to significant losses from reinsurer insolvencies. The following amounts are reflected in the financial statements as a result of reinsurance ceded:
2001 2000 1999 ------------------------------------------------------------------------- Ceded premiums written, presented net $ 93,984 $121,682 $96,610 Ceded premiums earned, presented net 89,664 122,923 72,297 Ceded losses incurred, presented net 107,544 38,751 19,346 Reserve for unearned premiums 39,681 35,361 36,603 Reserve for losses 151,111 83,897 75,882 Reserve for loss adjustment expenses 17,626 12,291 9,770 Reinsurance recoveries 34,186 25,935 22,875
NOTE 9 -- Other Contingencies and Commitments Annuities are purchased from other insurers to pay certain claim settlements. These payments are made directly to the claimants; should such insurers be unable to meet their obligations under the annuity contracts, the 55 Item 14. Continued Group would be liable to claimants for the remaining amount of annuities. The claim reserves are presented net of the related annuities on the Corporation's balance sheet. The total amount of unpaid annuities was $21,509, $22,505 and $23,267 at December 31, 2001, 2000 and 1999, respectively. The Corporation leases many of its operating and office facilities for various terms under long-term, non-cancelable operating lease agreements. The leases expire at various dates through 2006 and provide for renewal options ranging from one to five years. In the normal course of business, it is expected that these leases will be renewed or replaced by leases on other properties. The leases provide for increases in future minimum annual rental payments based on such measures as defined increases in the Consumer Price Index, increases in operating expenses, and pre-negotiated rates. Also, the agreements generally require the Corporation to pay executory costs (utilities, real estate taxes, insurance, and repairs). Lease expense and related items totaled $6,500, $5,900, and $4,100 during 2001, 2000 and 1999, respectively. The following is a schedule by year of future minimum rental payments required under the operating lease agreements:
Year Ending December 31 Amount --------------------------------------------------------- 2002 $ 5,724 2003 4,869 2004 2,993 2005 94 2006 15 --------------------------------------------------------- $13,695 =========================================================
Total minimum lease payments do not include contingent rentals that may be paid under certain leases because of use in excess of specified amounts. Contingent rental payments were not significant in 2001, 2000, or 1999. In the fourth quarter of 2001, Ohio Casualty of New Jersey, Inc. (OCNJ) entered into an agreement to transfer its obligations to renew private passenger auto business in New Jersey to Proformance Insurance Company (Proformance). The transaction will effectively exit the Group from the New Jersey private passenger auto market. The Group continues to write private passenger auto in other markets. Under the terms of the transaction, the Group member OCNJ, will pay Proformance $40,600 to assume its renewal obligations. The amount was taken as a charge in the fourth quarter of 2001 and will be paid out over the course of twelve months beginning in early 2002. OCNJ may also have a contingent liability of up to $15,600 to be paid to Proformance to maintain a premiums-to-surplus ratio of 2.5 to 1 on the transferred business during the next three years. At December 31, 2001, it is not possible to determine the likelihood of this liability and, therefore, has not been recognized in the financial statements. In the normal course of business, the Corporation and its subsidiaries are involved in lawsuits related to their operations. In each of the matters, the Corporation believes the ultimate resolution of such litigation will not result in any material adverse impact to operations or financial condition of the Corporation. NOTE 10 -- Losses and Loss Reserves The following table presents a reconciliation of liabilities for losses and loss adjustment expenses:
2001 2000 1999 ------------------------------------------------------------------------- Balance as of January 1, net of reinsurance recoverables of $96,188, $85,126 and$91,296 $1,907,331 $1,823,329 $1,865,643 Incurred related to: Current year 1,145,545 1,237,319 1,176,072 Prior years 58,489 56,846 (418) --------------------------------------------------------------------------- 1,204,034 1,294,165 1,175,654 Paid related to: Current year 520,232 596,114 600,942 Prior years 609,148 614,049 617,026 -------------------------------------------------------------------------- Total paid 1,129,380 1,210,163 1,217,968 -------------------------------------------------------------------------- Balance as of December 31, net of reinsurance recoverables of $168,737, $96,188 and $85,126 $1,981,985 $1,907,331 $1,823,329 ==========================================================================
The 2001 and 2000 incurred loss and loss adjustment expenses for prior years changed due to an increase in severity as losses developed. The 2001 change was concentrated in the workers' compensation and general liability lines of business. The 2000 change was concentrated in the workers' compensation line of business. The following table presents before-tax catastrophe losses incurred and the respective impact on the statutory loss ratio:
2001 2000 1999 ------------------------------------------------------------------------- Incurred losses $34,577 $36,181 $52,208 Statutory loss ratio effect 2.3% 2.4% 3.4%
In 2001, 2000 and 1999 there were 19, 24 and 27 catastrophes, respectively. The largest catastrophe in each year was $17,800, $7,095 and $17,900 in incurred losses. Additional catastrophes with over $1,000 in incurred losses numbered 4, 9 and 7 in 2001, 2000 and 1999. The additional catastrophes with over $1,000 in incurred losses included $3,000 of net of reinsurance losses related to the September 11, 2001 terrorist attacks in New York. 56 Item 14. Continued The effect of catastrophes on the Corporation's results cannot be accurately predicted. As such, severe weather patterns, acts of war or terrorist activities could have a material adverse impact on the Corporation's results. Inflation has historically affected operating costs, premium revenues and investment yields as business expenses have increased over time. The long-term effects of inflation are considered when estimating the ultimate liability for losses and loss adjustment expenses. The liability is based on historical loss development trends which are adjusted for anticipated changes in underwriting standards, policy provisions and general economic trends. It is not adjusted to reflect the effect of discounting. Reserves for asbestos-related illnesses and toxic waste cleanup claims cannot be estimated with traditional loss reserving techniques. In establishing liabilities for claims for asbestos-related illnesses and for toxic waste cleanup claims, management considers facts currently known and the current state of the law and coverage litigation. However, given the expansion of coverage and liability by the courts and the legislatures in the past and the possibilities of similar interpretations in the future, there is uncertainty regarding the extent of remediation. Accordingly, additional liability could develop. Estimated asbestos and environmental reserves are composed of case reserves, incurred but not reported reserves and reserves for loss adjustment expense. For 2001, 2000 and 1999, respectively, total case, incurred but not reported and loss adjustment expense reserves were $53,497, $40,368 and $41,098. Asbestos reserves were $31,792, $13,493 and $9,564 and environmental reserves were $21,705, $26,875 and $31,534 for those respective years. The increase in 2001 asbestos reserves related to additional claim development. NOTE 11 -- Earnings Per Share Basic and diluted earnings per share are summarized as follows:
2001 2000 1999 ------------------------------------------------------------------------- Income (loss) from continuing operations $98,580 $(79,249) $105,936 Average common shares outstanding - basic (000's) 60,076 60,075 61,126 Basic income (loss) from continuing operations per average share $1.64 $(1.32) $1.73 ========================================================================= Average common shares outstanding 60,076 60,075 61,126 Effect of dilutive securities 133 - 13 ------------------------------------------------------------------------- Average common shares outstanding - diluted 60,209 60,075 61,139 Diluted income (loss) from continuing operations per average share $1.64 $(1.32) $1.73 ========================================================================= Adjusted for July 22, 1999 2 for 1 stock dividend (See Note 23).
At December 31, 2001, 6,000,000 purchase warrants and 2,641,080 stock options were not included in earnings per share calculations for 2001 as they were antidilutive. NOTE 12 -- Quarterly Financial Information (Unaudited)
2001 First Second Third Fourth --------------------------------------------------------------------------- Premiums and finance charges earned $383,496 $376,574 $374,327 $372,281 Net investment income 51,280 52,120 53,068 55,917 Investment gains realized 12,613 42,419 71,033 56,875 Net income (loss) (4,095) 16,651 44,228 41,796 Basic net income (loss) per share (0.07) 0.28 0.74 0.70 Diluted net income (loss) per share (0.07) 0.28 0.73 0.69
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 sizeable investment gains realized during 2001.
2000 First Second Third Fourth --------------------------------------------------------------------------- Premiums and finance charges earned $387,188 $369,874 $394,015 $382,921 Net investment income 51,793 49,275 49,673 54,321 Investment gains (losses) realized (6,308) (2,387) 1,395 4,909 Net income (loss) (75,013) (8,198) 14,550 (10,588) Basic and diluted net income (loss) per share (1.25) (0.14) 0.24 (0.18)
The first quarter of 2000 was negatively impacted by approximately $33,000 due to write-offs to the agent relationships intangible asset. Positively impacting third quarter 2000 results by $22,100 was the settlement of the California Proposition 103 liability. NOTE 13 -- Comprehensive Income Changes in accumulated other comprehensive income related to changes in unrealized gains (losses) on securities were as follows:
2001 2000 1999 ------------------------------------------------------------------------- Unrealized holding gains (losses) arising during the period, net of taxes $ (678) $152,472 $ (56,994) Less: Reclassification adjustment for gains included in net income, net of taxes 134,867 71,922 125,468 ------------------------------------------------------------------------- Net unrealized gains (losses) on securities, net of taxes $(135,545) $ 80,550 $(182,462) =========================================================================
57 Item 14. Continued NOTE 14 -- Segment Information The Corporation has determined its reportable segments based upon its method of internal reporting, 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 is managed separately. 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.
Standard Commercial Lines 2001 2000 1999 ---------------------------------------------------------------------------- Net premiums written $689,596 $721,681 $720,755 % Increase (decrease) (4.4)% 0.1% 42.5% Net premiums earned 707,635 739,698 704,525 % Increase (decrease) (4.3)% 5.0% 40.9% Underwriting gain (loss) (before tax) (107,828) (215,193) (166,305) Loss ratio 64.5% 78.6% 69.9% Loss expense ratio 15.3% 13.2% 12.4% Underwriting expense ratio 36.4% 38.2% 40.3% Combined ratio 116.2% 130.0% 122.6%
Specialty Commercial Lines 2001 2000 1999 ---------------------------------------------------------------------------- Net premiums written $136,085 $107,255 $102,499 % Increase (decrease) 26.9% 4.6% 103.0% Net premiums earned 130,559 104,384 102,680 % Increase (decrease) 25.1% 1.7% 107.8% Underwriting gain (loss) (before tax) 9,880 19,841 50,777 Loss ratio 42.0% 30.0% 9.1% Loss expense ratio 10.4% 5.4% (1.9)% Underwriting expense ratio 38.4% 44.4% 43.5% Combined ratio 90.8% 79.8% 50.7%
Personal Lines 2001 2000 1999 ---------------------------------------------------------------------------- Net premiums written $646,504 $676,457 $763,643 % Increase (decrease) (4.4)% (11.4)% 2.7% Net premiums earned 667,985 688,939 747,103 % Increase (decrease) (3.0)% (7.8)% 4.0% Underwriting gain (loss) (before tax) (120,740) (89,268) (95,615) Loss ratio 73.4% 73.1% 72.0% Loss expense ratio 12.1% 10.8% 10.9% Underwriting expense ratio 33.7% 29.6% 29.3% Combined ratio 119.2% 113.5% 112.2%
Total Property & Casualty 2001 2000 1999 ---------------------------------------------------------------------------- Net premiums written $1,472,185 $1,505,393 $1,586,897 % Increase (decrease) (2.2)% (5.1)% 22.1% Net premiums earned 1,506,179 1,533,021 1,554,308 % Increase (decrease) (1.8)% (1.4)% 22.6% Underwriting loss(before tax) (218,688) (284,620) (211,143) Loss ratio 66.5% 72.8% 66.9% Loss expense ratio 13.4% 11.6% 10.7% Underwriting expense ratio 35.4% 34.8% 35.2% Combined ratio 115.3% 119.2% 112.8% Impact of catastrophe losses on combined ratio 2.3% 2.4% 3.4%
All other 2001 2000 1999 ---------------------------------------------------------------------------- Revenues $ 8,036 $ 4,146 $13,707 Expenses 14,159 14,366 20,814 ---------------------------------------------------------------------------- Net income $(6,123) $(10,220) $(7,107)
Reconciliation of Revenues 2001 2000 1999 ---------------------------------------------------------------------------- Net premiums earned for reportable segments $1,506,179 $1,533,021 $1,554,308 Investment income 211,017 201,812 181,078 Realized gain/loss 198,298 (5,904) 144,754 Miscellaneous income 382 444 (2,426) ---------------------------------------------------------------------------- Total property and casualty revenues (Statutory basis) 1,915,876 1,729,373 1,877,714 Property and casualty statutory to GAAP adjustment (21,909) 3,150 8,658 ---------------------------------------------------------------------------- Total revenues property and casualty (GAAP basis) 1,893,967 1,732,523 1,886,372 Other segment revenues 8,036 4,146 13,708 ---------------------------------------------------------------------------- Total revenues $1,902,003 $1,736,669 $1,900,080 ===========================================================================
Reconciliation of Underwriting loss (before tax) 2001 2000 1999 ---------------------------------------------------------------------------- Property and casualty under- writing loss (before tax) (Statutory basis) $(218,688) $(284,620) $(211,143) Statutory to GAAP adjustment (35,091) (28,175) 26,905 ---------------------------------------------------------------------------- Property and casualty under- writing loss (before tax) (GAAP basis) (253,779) (312,795) (184,238) Net investment income 212,385 205,062 184,287 Realized gain (loss) 182,940 (2,391) 160,827 Other income (15,158) (19,578) (23,987) ---------------------------------------------------------------------------- Income (loss) from continuing operations before income taxes $126,388 $(129,702) $136,889 ============================================================================
58 Item 14. Continued NOTE 15 -- Agent Relationships The agent relationship asset is an identifiable intangible asset acquired in connection with the 1998 Great American Insurance Company (GAI) commercial lines acquisition. The Corporation follows the practice of allocating purchase price to specifically identifiable intangible assets based on their estimated values as determined by appropriate valuation methods. In the GAI acquisition, allocation of the purchase price was made to agent relationships and deferred policy acquisition costs as the Corporation believes it did not acquire any other significant specifically identifiable intangible assets. Periodically, agent relationships are evaluated as events or circumstances indicate a possible inability to recover their carrying amount. 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 of the agent relationships asset by $42,170. In addition, the Corporation again wrote-off the agent relationships asset $3,801 in 2000 for further agent cancellations. In 2001, the Corporation further wrote off the agent relationships asset by $10,966 for additional agency cancellations and for 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. The remaining portion of the agent relationships asset will be amortized on a straight-line basis over the remaining amortization period of approximately 22 years. The purchase agreement with GAI called for an additional payment of up to $40,000 if annualized 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 Ohio Casualty Insurance Company paid an additional $27,400 for the final payment. Of the $27,400 payment, $27,100 was paid in 2000, while the remaining $300 was paid in 2001. The final payment was added to the agent relationships asset for the acquisition and will be amortized over the remaining life. NOTE 16 -- 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 $6,016, or $3,971 after-tax to 2001 results. NOTE 17 -- Statutory Accounting Information The following information has been prepared on the basis of statutory accounting principles which differ from generally accepted accounting principles. The principal differences relate to deferred acquisition costs, reinsurance, assets not admitted for statutory reporting, California Proposition 103 reserve, agent relationships and the treatment of deferred federal income taxes.
2001 2000 1999 ------------------------------------------------------------------------- Statutory net income (loss) $172,513 $(81,223) $109,172 Statutory policyholders' surplus 767,503 812,133 899,759
The Ohio Casualty Insurance Company (the Company), domiciled in Ohio, prepares its statutory financial statements in accordance with the accounting practices prescribed or permitted by the Ohio Insurance Department. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (NAIC), as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. The Company received written approval from the Ohio Insurance Department to have the California Proposition 103 liability reported as a direct charge to surplus and not included as a charge in the 1995 statutory statement of operations. Following this same treatment, during 2000 the principal reduction in the Proposition 103 liability was taken as an increase to statutory surplus and not included in the statutory statements of operations. For statutory purposes, agent relationships related to the GAI acquisition were taken as a direct charge to surplus. In 1998, the NAIC adopted the Codification of Statutory Accounting Principles guidance, which replaced the former Accounting Practices and Procedures manual as the NAIC's primary guidance on statutory accounting. The new principles provide guidance for areas where statutory accounting had been silent and changed former statutory accounting in some areas. The Group implemented the Codification guidance effective January 1, 2001. The cumulative effect of adopting Codification reduced statutory policyholders' surplus by $21,694 on January 1, 2001. The NAIC has developed a "Risk-Based Capital" formula for property and casualty insurers and life insurers. The formula is intended to measure the adequacy of an insurer's capital given the asset structure and product mix of the company. As of December 31, 2001, all insurance companies in the Group, with the exception of the Ohio Casualty of New Jersey, Inc. (OCNJ), exceed the necessary capital. The exception for OCNJ is due to a temporary difference in the recognition of deferred taxes related to the $40,600 New Jersey transfer fee. The Corporation is dependent on dividend payments from its insurance subsidiaries in order to meet operating expenses, debt obligations, and to pay dividends. 59 Item 14. Continued Insurance regulatory authorities impose various restrictions and prior approval requirements on the payment of dividends by insurance companies and holding companies. At December 31, 2001, approximately $156,480 of statutory surplus is not subject to restriction or prior dividend approval requirements. NOTE 18 -- Bank Note Payable During 1997, the Corporation signed a credit facility that makes available a $300,000 revolving line of credit. This line of credit was accessed in 1997 to refinance the outstanding term loan balance the Corporation had at that time. In 1998, the line of credit was used for capital infusion of $200,000 into the property and casualty subsidiaries due to the acquisition of the commercial lines division of GAI. The line of credit was again accessed during 1998 for the purchase of a building and to purchase shares. The remaining balance and any additional borrowings under the line of credit bear interest at a periodically adjustable rate (3.44% at December 31, 2001). The interest rate is determined on various bases including prime rates, certificate of deposit rates and the London Interbank Offered Rate. Interest incurred and related fees on borrowings amounted to $13,549, $16,075 and $14,385 in 2001, 2000 and 1999, respectively. The credit agreement contains financial covenants and provisions customary for such arrangements. Under the loan agreement the maximum permissible consolidated funded debt cannot exceed 30% of consolidated tangible net worth (as defined in the agreement) and statutory surplus cannot be less than $750,000. Effective March 30, 2001, the covenant was amended to require a minimum statutory surplus of $675,000 for the quarters ending March 31, 2001 and June 30, 2001, returning to minimum statutory surplus of $750,000 for subsequent quarters. The Corporation continues to review its financial covenants in the credit agreement in light of its operating losses. As of December 31, 2001, the Corporation was in compliance with these covenants. However, further deterioration of operating results, reductions in the equity portfolio valuation, or other changes in statutory surplus may lead to covenant violations, which could ultimately result in default. The credit agreement expires in October 2002, with any outstanding loan balance due at that time. The Corporation is evaluating its capital requirements and is exploring ways to restructure and/or reduce its debt and strengthen its financial position. The Corporation has taken steps to strengthen its financial position by aggressively managing expenses and first reducing quarterly dividends to shareholders and later eliminating the current quarterly dividend in the first quarter of 2001. The Corporation will be required to obtain additional external funding, either in the form of debt or equity funding, in order to repay the balance of its current notes payable which comes due October 2001. While the Corporation believes that it should be able to obtain such external funding, the availability of such funding cannot be assured nor can the cost of such funding be evaluated at this time. During 1999, the Corporation signed a $6,500 low interest loan with the state of Ohio used in conjunction with the home office purchase. The Corporation granted a mortgage on its home office property as security for the loan. As of December 31, 2001, the loan bears a fixed interest rate of 1%, increasing to 2% in December 2002, and increasing to the maximum rate of 3% in December 2004. The loan requires annual principal payments of approximately $630. The remaining balance at December 31, 2001 was $5,173. The loan expires in November 2009. NOTE 19 -- California Proposition 103 Proposition 103 was passed in the state of California 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, the Administrative Law Judge issued a proposed ruling with a rollback liability of $24,428 plus interest. The Group established a contingent liability for the Proposition 103 rollback of $24,428 plus simple interest at 10% from May 8, 1989. This brought the total reserve to $52,318 at September 30, 2000. On October 25, 2000, the Group announced a settlement agreement for California Proposition 103 that was approved by the Commissioner of Insurance of the state of California. Under the terms of the settlement, the members of the Group agreed to pay $17,500 in refund premiums to eligible 1989 California policyholders. With this development, the total reserve was decreased to $17,500 as of December 31, 2000. This decrease in the reserve resulted in an increase in operating income and net income for the third quarter 2000, and had no effect on the statutory combined ratio reported. The Corporation began to make payments in the first quarter of 2001. The remaining liability was $7,816 as of December 31, 2001. To date, the Group has paid approximately $5,713 in legal costs related to the withdrawal and Proposition 103. NOTE 20 -- Shareholder Rights Plan In December 1989, the Board of Directors adopted the Shareholders Rights Agreement (the Agreement). The Agreement is designed to deter coercive or unfair takeover tactics and to prevent a person(s) from gaining control of the Corporation without offering a fair price to all shareholders. Under the terms of the Agreement, each outstanding common share is associated with one half of one common share purchase right, expiring in 2009. Currently, each whole right, when exercisable, entitles the registered 60 Item 14. Continued holder to purchase one common share of the Corporation at a purchase price of $125 per share. The rights become exerciseable for a 60 day period commencing 11 business days after a public announcement that a person or group has acquired shares representing 20 percent or more of the outstanding shares of common stock, without the prior approval of the board of directors; or 11 business days following commencement of a tender or exchange of 20 percent or more of such outstanding shares of common stock. If after the rights become exercisable, the Corporation is involved in a merger, other business consolidation or 50 percent or more of the assets or earning power of the Corporation is sold, the rights will then entitle the rightholders, upon exercise of the rights, to receive shares of common stock of the acquiring company with a market value equal to twice the exercise price of each right. The Corporation can redeem the rights for $0.01 per right at any time prior to becoming exercisable. NOTE 21 -- Discontinued Operations (Life Insurance) Discontinued operations included the operations of Ohio Life, a subsidiary of The Ohio Casualty Insurance Company. On October 2, 1995, the Company transferred its life insurance and related businesses through a 100% coinsurance arrangement to Employers' Reassurance Corporation and entered into an administrative and marketing agreement with Great Southern Life Insurance Company (Great Southern). In connection with the reinsurance agreement, $144,469 in cash and $161,401 of securities were transferred to Employers' Reassurance to cover the liabilities of $348,479. Ohio Life received an adjusted ceding commission of $37,641 as payment. After deduction of deferred acquisition costs, the net ceding commission from the transaction was $17,284. During the fourth quarter of 1997, Great Southern legally replaced Ohio Life as the primary insurer for approximately 76% of the life insurance policies subject to the 1995 agreement. At December 31, 1998, Great Southern had assumed 95% of the life insurance policies subject to the 1995 agreement. As a result of this assumption, the Corporation recognized an additional amount of unamortized ceding commission of $1,093 before tax during 1999. During 1999, Great Southern replaced Employers' Reassurance on the 100% coinsurance treaty. On December 31, 1999, the Company completed the sale of the Ohio Life shell, thereby transferring all remaining assets and liabilities, as well as reinsurance treaty obligations, to the buyer. The after-tax gain on this sale totaled $6,190, or $.11 per share. For the year ended December 31, 1999, the discontinued life insurance operations had income before income taxes of $4,349 and net income of $4,270. NOTE 22 -- New 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 SFAS 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 does not expect that the adoption of the statement will have a material impact on the Corporation's financial position and results of operations. 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. In August 2001, the FASB issued SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of", and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations for a disposal of a segment of a business. SFAS 144 is effective for fiscal years beginning after December 15, 2001 (January 1, 2002 for the Corporation). The Corporation does not expect that the adoption of the statement will have a material impact on the Corporation's financial position and results of operations. 61 Item 14. Continued NOTE 23 -- Stock Dividend On May 27, 1999, the Board of Directors declared a 2 for 1 stock split effective in the form of a 100% stock dividend of the outstanding common shares of record on July 1, 1999. The dividend was payable on July 22, 1999. The number of common shares outstanding, earnings per share, and stock option information for prior years have been adjusted to reflect the stock dividend. 62 Item 14. Continued Report of Independent Auditors The Board of Directors and Shareholders Ohio Casualty Corporation We have audited the accompanying consolidated balance sheet of Ohio Casualty Corporation and subsidiaries as of December 31, 2001, and the related consolidated statements of income, shareholders' equity, and cash flows for the year then ended. Our audit also included the financial statement schedules listed in the Index at Item 14(a)(2) of this Form 10-K. These consolidated financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Ohio Casualty Corporation and subsidiaries at December 31, 2001, and the consolidated results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Ernst & Young LLP Ernst & Young LLP Cincinnati, Ohio February 15, 2002 To the Board of Directors and Shareholders of Ohio Casualty Corporation: In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) on page 44 present fairly, in all material respects, the financial position of Ohio Casualty Corporation and its subsidiaries at December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 14 (a)(2) on page 44, for the years ended December 31, 2000 and 1999, present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. /s/ PricewaterhouseCoopers LLP PricewaterhouseCoopers LLP Cincinnati, Ohio February 16, 2001 63 Item 14. Continued (b) Reports on Form 8-K or 8-K/A since October 1, 2001. On January 4, 2002, the Corporation filed Form 8-K announcing the transfer of private passenger automobile business renewal obligations from Ohio Casualty of New Jersey, Inc. to Proformance Insurance Company. (c) Exhibits. See Index to Exhibits on pages 74 and 75 of this Form 10-K. 64 Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. OHIO CASUALTY CORPORATION (Registrant) March 5, 2002 By: /s/ Dan R. Carmichael ----------------------- Dan R. Carmichael President Chief Executive Officer Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. March 5, 2002 /s/ Stanley N. Pontius ----------------------------------------- Stanley N. Pontius, Chairman of the Board March 5, 2002 /s/ Dan R. Carmichael ----------------------------------------- Dan R. Carmichael, President, Chief Executive Officer, and Director March 5, 2002 /s/ Terrence J. Baehr ----------------------------------------- Terrence J. Baehr, Director March 5, 2002 /s/ Arthur J. Bennert ----------------------------------------- Arthur J. Bennert, Director March 5, 2002 /s/ Jack E. Brown ----------------------------------------- Jack E. Brown, Director March 5, 2002 /s/ Catherine E. Dolan ----------------------------------------- Catherine E. Dolan, Director March 5, 2002 /s/ Wayne R, Embry ----------------------------------------- Wayne R. Embry, Director March 5, 2002 /s/ Vaden Fitton ----------------------------------------- Vaden Fitton, Director March 5, 2002 /s/ Stephen S. Marcum ----------------------------------------- Stephen S. Marcum, Director March 5, 2002 /s/ Edward T. Roeding ----------------------------------------- Edward T. Roeding, Director March 5, 2002 /s/ Howard L. Sloneker III ----------------------------------------- Howard L. Sloneker III, Sr. Vice President, Secretary and Director March 5, 2002 /s/ Donald F. McKee ----------------------------------------- Donald F. McKee, Chief Financial Officer 65 Schedule I Ohio Casualty Corporation and Subsidiaries Consolidated Summary of Investments Other than Investments in Related Parties (In thousands)
December 31, 2001 Amount shown in balance Type of investment Cost Value sheet ------------------ ---- ----- ---------- Fixed maturities Bonds: United States govt. and govt. agencies with auth. $ 27,775 $ 29,381 $ 29,381 States, municipalities and political subdivisions 30,057 31,328 31,328 Corporate securities 1,577,939 1,603,559 1,603,559 Mortgage-backed securities: U.S. government guaranteed 56,307 56,062 56,062 Other 1,037,920 1,051,774 1,051,774 ----------- ----------- ----------- Total fixed maturities 2,729,998 2,772,104 2,772,104 Equity securities: Common stocks: Banks, trust and insurance companies 30,808 164,766 164,766 Industrial, miscellaneous and all other 79,040 323,864 323,864 Preferred stocks: Non-redeemable 358 358 358 Convertible - - - ----------- ----------- ----------- Total equity securities 110,206 488,988 488,988 Short-term investments 54,785 54,785 54,785 ----------- ----------- ----------- Total investments $2,894,989 $3,315,877 $3,315,877 =========== =========== ===========
66 Schedule II Ohio Casualty Corporation Condensed Financial Information of Registrant (In thousands)
2001 2000 1999 ---- ---- ---- Condensed Balance Sheet: Investment in wholly-owned subsidiaries, at equity $1,242,718 $1,269,563 $1,304,268 Investment in bonds/stocks, at fair value 18,870 34,767 62,712 Cash and other assets 31,859 35,456 32,145 ----------- ----------- ----------- Total assets 1,293,447 1,339,786 1,399,125 Notes payable 210,173 220,798 241,446 Other liabilities 3,242 2,397 6,692 ----------- ----------- ----------- Total liabilities 213,415 223,195 248,138 ----------- ----------- ----------- Shareholders' equity $1,080,032 $1,116,591 $1,150,987 =========== =========== =========== Condensed Statement of Income: Dividends from subsidiaries $ 5,175 $ 59,571 $ 112,122 Equity in subsidiaries 103,050 (128,681) 8,955 Operating (expenses) (9,645) (10,139) (6,936) ----------- ----------- ----------- Net income (loss) $ 98,580 $ (79,249) $ 114,141 =========== =========== =========== Condensed Statement of Cash Flows: Cash flows from operations Net distributed income $ (4,470) $ 49,432 $ 105,186 Other 2,069 (16,255) (8,609) ----------- ----------- ----------- Net cash from operations (2,401) 33,177 96,577 Investing Purchase of bonds/stocks (6,037) (46,937) (11,987) Sales of bonds/stocks 19,392 69,525 42,148 ----------- ----------- ----------- Net cash from investing 13,355 22,588 30,161 Financing Notes payable: Borrowings - - 16,500 Repayments (10,625) (20,648) (40,054) Exercise of stock options 75 67 211 Purchase of treasury stock - - (46,087) Dividends paid to shareholders - (35,446) (56,027) ----------- ----------- ----------- Net cash from financing (10,550) (56,027) (125,457) Net change in cash 404 (262) 1,281 ----------- ----------- ----------- Cash, beginning of year 9,573 9,835 8,554 ----------- ----------- ----------- Cash, end of year $ 9,977 $ 9,573 $ 9,835 =========== =========== ===========
67 Schedule III Ohio Casualty Corporation and Subsidiaries Consolidated Supplementary Insurance Information (In thousands) December 31, 2001
Deferred Future policy policy benefits Net acquisition losses and Unearned Premium investment costs loss expenses premiums revenue income ----------- ------------- -------- ------- ---------- Segment ------- Property and casualty insurance: Underwriting Standard Commercial Lines $ 90,989 $1,467,331 $ 331,948 $ 707,635 Specialty Commercial Lines 21,095 188,340 88,782 130,559 Personal Lines 54,675 495,051 246,009 667,982 Miscellaneous income 392 Investment $211,114 ---------- ----------- ---------- ------------ --------- Total property and casualty insurance 166,759 2,150,722 666,739 1,506,568 211,114 Premium finance 110 126 Corporation 1,145 ---------- ----------- ---------- ------------ --------- Total $ 166,759 $2,150,722 $ 666,739 $1,506,678 $212,385 ========== =========== ========== =========== =========
Benefits, Amortization losses and of deferred General loss acquisition operating Premiums expenses costs expenses written ---------- ----------- --------- -------- Segment ------- Property and casualty insurance: Underwriting Standard Commercial Lin $564,468 $ 192,542 $ 86,926 $ 689,596 Specialty Commercial Li 68,450 37,662 13,797 136,085 Personal Lines 571,116 145,446 79,938 646,506 Miscellaneous income Investment ----------- ---------- ---------- ----------- Total property and casualty insurance 1,204,034 375,650 180,661 1,472,187 Premium finance 345 9 Corporation 14,925 ----------- ---------- ---------- ----------- Total $1,204,034 $ 375,650 $ 195,931 $1,472,196 =========== ========== ========== ===========
1. Net investment income has been allocated to principal business segments on the basis of separately identifiable assets. 2. The principal portion of general operating expenses has been directly attributed to business segment classifications incurring such expenses with the remainder allocated based on premium revenue. 68 Schedule III Ohio Casualty Corporation and Subsidiaries Consolidated Supplementary Insurance Information (In thousands) December 31, 2000
Deferred Future policy policy benefits Net acquisition losses and Unearned Premium investment costs loss expenses premiums revenue income ----------- ------------- -------- ------- ---------- Segment ------- Property and casualty insurance: Underwriting Standard Commercial Lines $ 97,985 $1,434,735 $ 351,506 $ 739,698 Specialty Commercial Lines 17,347 83,763 76,940 104,384 Personal Lines 59,739 485,021 267,967 688,865 Miscellaneous income 483 Investment $202,002 ---------- ----------- ---------- ------------ --------- Total property and casualty insurance 175,071 2,003,519 696,413 1,533,430 202,002 Premium finance 100 568 167 Corporation 2,893 ---------- ----------- ---------- ------------ --------- Total $ 175,071 $2,003,519 $ 696,513 $1,533,998 $205,062 ========== =========== ========== =========== =========
Benefits, Amortization losses and of deferred General loss acquisition operating Premiums expenses costs expenses written ---------- ----------- --------- -------- Segment ------- Property and casualty insurance: Underwriting Standard Commercial Lin $ 679,432 $ 191,133 $ 113,532 $ 721,681 Specialty Commercial Li 36,950 34,544 17,602 107,255 Personal Lines 577,783 168,838 26,415 676,416 Miscellaneous income Investment ----------- ---------- ---------- ----------- Total property and casualty insurance 1,294,165 394,515 157,549 1,505,352 Premium finance 857 480 Corporation 19,285 ----------- ---------- ---------- ----------- Total $1,294,165 $ 394,515 $ 177,691 $1,505,832 =========== ========== ========== ===========
1. Net investment income has been allocated to principal business segments on the basis of separately identifiable assets. 2. The principal portion of general operating expenses has been directly attributed to business segment classifications incurring such expenses with the remainder allocated based on premium revenue. 69 Schedule III Ohio Casualty Corporation and Subsidiaries Consolidated Supplementary Insurance Information (In thousands) December 31, 1999
Deferred Future policy policy benefits Net acquisition losses and Unearned Premium investment costs loss expenses premiums revenue income ----------- ------------- -------- ------- ---------- Segment ------- Property and casualty insurance: Underwriting Standard Commercial Lines $ 88,517 $1,329,039 $ 378,782 $ 704,525 Specialty Commercial Lines 17,598 71,107 66,670 102,680 Personal Lines 71,630 508,309 279,793 746,789 Miscellaneous income 69 Addition due to acquisition Investment $181,131 ---------- ----------- ---------- ------------ --------- Total property and casualty insurance 177,745 1,908,455 725,245 1,554,063 181,131 Life ins. (discontinued operations) 1,765 827 Premium finance 154 903 113 Corporation 3,043 ---------- ----------- ---------- ------------ --------- Total $ 177,745 $1,908,455 $ 725,399 $1,556,731 $185,114 ========== =========== ========== =========== =========
Benefits, Amortization losses and of deferred General loss acquisition operating Premiums expenses costs expenses written ---------- ----------- --------- -------- Segment ------- Property and casualty insurance: Underwriting Standard Commercial Lin $ 565,194 $ 171,455 $ 95,270 $ 720,755 Specialty Commercial Li 5,501 30,744 11,809 102,499 Personal Lines 604,959 168,392 53,574 763,412 Miscellaneous income Addition due to acquisition 31,402 Investment ----------- ---------- ---------- ----------- Total property and casualty insurance 1,175,654 401,993 160,653 1,586,666 Life ins. (discontinued operations) (731) 174 Premium finance 1,277 804 Corporation 23,614 ----------- ---------- ---------- ----------- Total $1,175,654 $ 401,262 $ 185,718 $1,587,470 =========== ========== ========== ===========
1. Net investment income has been allocated to principal business segments on the basis of separately identifiable assets. 2. The principal portion of general operating expenses has been directly attributed to business segment classifications incurring such expenses with the remainder allocated based on policy counts. 70 Schedule IV Ohio Casualty Corporation and Subsidiaries Consolidated Reinsurance (In thousands) December, 2001, 2000 and 1999
Percent of amount Ceded to Assumed assumed Gross other from other Net to net amount companies companies amount amount ------ --------- ---------- ------ ---------- Year Ended December 31, 2001 Premiums Property and casualty insurance $1,550,875 $ 93,827 $ 15,139 $1,472,187 1.0% Accident and health insurance 157 157 - - - ---------- -------- -------- ---------- Total premiums 1,551,032 93,984 15,139 1,472,187 1.0% Premium finance charges 9 ---------- Total premiums and finance charges written 1,472,196 Change in unearned premiums and finance charges 34,090 ---------- Total premiums and finance charges earned 1,506,286 Miscellaneous income 392 ---------- Total premiums & finance charges earned - continuing operations $1,506,678 ========== Year Ended December 31, 2000 Premiums Property and casualty insurance $1,418,835 $121,504 $208,021 $1,505,352 13.8% Accident and health insurance 178 178 - - - ---------- -------- -------- ---------- Total premiums 1,419,013 121,682 208,021 1,505,352 13.8% Premium finance charges 480 ---------- Total premiums and finance charges written 1,505,832 Change in unearned premiums and finance charges 27,682 ---------- Total premiums and finance charges earned 1,533,514 Miscellaneous income 484 ---------- Total premiums & finance charges earned - continuing operations $1,533,998 ========== Year Ended December 31, 1999 Life insurance in force $ 279 $ 279 $ - $ - - Premiums Property and casualty insurance $1,325,243 $ 96,412 $357,835 $1,586,666 22.6% Life insurance (Discontinued operations) 1,694 1,694 - - - Accident and health insurance 198 198 - - - ---------- -------- -------- ---------- Total premiums 1,327,135 98,304 357,835 1,586,666 22.6% Premium finance charges 804 ---------- Total premiums and finance charges written 1,587,470 Change in unearned premiums and finance charges (29,911) ---------- Total premiums and finance charges earned 1,557,559 Miscellaneous income (2,593) ---------- Total premiums & finance charges earned - continuing operations $1,554,966 ==========
71 Schedule V Ohio Casualty Corporation and Subsidiaries Valuation and Qualifying Accounts (In thousands)
Balance at Balance at beginning Charged to end of of period expenses period Year ended December 31, 2001 Reserve for bad debt $10,700 $(2,300) $ 8,400 Year ended December 31, 2000 Reserve for bad debt 9,338 1,362 10,700 Year ended December 31, 1999 Reserve for bad debt 8,739 599 9,338
72 Schedule VI Ohio Casualty Corporation and Subsidiaries Consolidated Supplemental Information Concerning Property and Casualty Insurance Operations (In thousands)
Reserves for Deferred unpaid claims policy and claim Discount Net Affiliation with acquisition adjustment of Unearned Earned investment registrant costs expenses reserves premiums premiums income ----------- ------------- -------- -------- -------- ---------- Property and casualty subsidiaries Year ended December 31, 2001 $ 166,759 $2,150,722 $ - $ 666,739 $1,506,568 $ 211,114 ========= ========== ====== ========= ========== ========= Year ended December 31, 2000 $ 175,071 $2,003,519 $ - $ 696,413 $1,533,430 $ 202,002 ========= ========== ====== ========= ========== ========= Year ended December 31, 1999 $ 177,745 $1,908,455 $ - $ 725,245 $1,554,063 $ 181,131 ========= ========== ====== ========= ========== =========
Claims and claim Amortization Paid adjustment expenses of deferred claims incurred related to policy and claim Affiliation with Current Prior acquisition adjustment Premiums registrant year years costs expenses written -------------------- ------------ ---------- -------- Property and casualty subsidiaries Year ended December 31, 2001 $1,145,545 $ 58,489 $ 375,650 $1,129,380 $1,472,187 ========== ======== ========= ========== ========== Year ended December 31, 2000 $1,237,319 $ 56,846 $ 394,515 $1,210,163 $1,505,352 ========== ======== ========= ========== ========== Year ended December 31, 1999 $1,176,072 $ (418) $ 401,993 $1,217,948 $1,586,666 ========== ======== ========= ========== ==========
73
Form 10-K Ohio Casualty Corporation Index to Exhibits Exhibit 4b First amendment to the Amended and Restated Rights Agreement dated as of February 19, 1998, signed November 8, 2001 Exhibit 10k Replacement carrier agreement between Ohio Casulaty of New Jersey, Inc. and Proformance Insurance Company and its parent, National Atlantic Holdings Corporation Exhibit 21 Subsidiaries of the Registrant Exhibit 23 Consent of Independent Auditors to incorporation of their opinion by reference in Registration Statements on Forms S-3 and Form S-8 Exhibit 23a Consent of Independent Accountants to incorporation of their opinion by reference in Registration Statements on Forms S-3 and Form S-8 Exhibit 28 Information from Reports Furnished to State Insurance Regulation Authorities Exhibits incorporated by reference: Exhibit 2 Asset Purchase Agreement between Ohio Casualty Corporation and Great American Insurance Company, filed as Exhibit 2 to the Registrant's SEC Form 10-Q on November 13, 1998 Exhibit 3 Articles of Incorporation, as amended, filed as Exhibits 4(a), 4(b), 4(c), 4(d), 4(e) and 4(f) to the Registrant's SEC Form S-8 (333-42942) on August 3, 2000 Exhibit 3a Code of Regulations, as amended, filed as Exhibits 4(g), 4(h) and 4(i) to the Registrant's SEC Form S-8 (333-42942) on August 3, 2000 Exhibit 4 Amended and Restated Rights Agreement between the Registrant and First Chicago Trust Company of New York as Rights Agent dated as of February 19, 1998, filed as Exhibit 4(g) to the Registrant's SEC Form 8-A/A amendment no. 3 on March 5, 1998 Exhibit 4a Certificate of Adjustment by the Registrant dated as of July 1, 1999, filed as Exhibit 9 to the Registrant's SEC Form 8-A/A amendment no. 4 on July 2, 1999 Exhibit 10a Ohio Casualty Corporation 1993 Stock Incentive Program, filed as Exhibit 10d to the Registrant's SEC Form 10-Q on May 31, 1993 Exhibit 10a1 Ohio Casualty Corporation amended 1993 Stock Incentive Program, filed as Exhibit 10.a1 to the Registrant's SEC Form 10-Q on May 14, 1997
74 Form 10-K Ohio Casualty Corporation Index to Exhibits, Continued
Exhibit 10b Coinsurance Life, Annuity and Disability Income Reinsurance Agreement between Employer's Reassurance Corporation and The Ohio Life Insurance Company dated as of October 2, 1995, filed as Exhibit 10b to the Registrant's SEC Form 10-K on March 26, 1996 Exhibit 10c Credit Agreement dated October 27, 1997 with Chase Manhattan Bank, N.A. as agent, filed as Exhibit 10c to the Registrant's SEC Form 10-Q on November 13, 1997 Exhibit 10c1 Amendment to Credit Agreement by and between Ohio Casualty, various lenders and The Chase Manhattan Bank (as administrative agent for the lenders), dated as of August 11, 1998, filed as Exhibit 99.2 to the Registrant's SEC Form S-3 (333-70761) on January 19, 1999 Exhibit 10c2 Amendment to Credit Agreement by and between Ohio Casualty, various lenders and The Chase Manhattan Bank (as administrative agent for the lenders), effective as of March 30, 2001, filed as Exhibit 99.1 to the Registrant's SEC Form 8-K on April 27, 2001 Exhibit 10d Employment Agreement with Dan R. Carmichael dated December 12, 2000, filed as Exhibit 10 to the Registrant's SEC Form 10-K on March 30, 2001 Exhibit 10e Employment Agreement with Donald F. McKee dated September 19, 2001, filed as Exhibit 10 to the Registrant's SEC Form 10-Q on November 14, 2001 Exhibit 10f Agreement with Howard L. Sloneker III, as Amended, dated July 24, 2000, filed as Exhibit 10.2 to the Registrant's SEC Form 10-Q on November 14, 2000 Exhibit 10g Information regarding Omitted Exhibits (Schedule to Exhibit 10.2) dated July 24, 2000, filed as Exhibit 10.3 to the Registrant's SEC Form 10-Q on November 14, 2000 Exhibit 10h Stock Option Agreement for Directors' year 2000 grant, filed as Exhibit 10.1 to the Registrant's SEC Form 10-Q on May 15, 2000 Exhibit 10i Stock Option Agreement for Chief Executive Officer year 2000 grant, filed as Exhibit 10.2 to the Registrant's SEC Form 10-Q on May 15, 2000 Exhibit 10j Ohio Casualty Corporation 1999 Warrant Registration, filed on Registrant's Form S-3 (333-90231) on November 3, 1999
75