ITEM 1. BUSINESS
In this discussion, all dollar amounts are presented in thousands, except share and per share data.
A. General
We are a leading provider of private passenger automobile insurance in Massachusetts. In addition to private passenger automobile insurance (which represented 81.0% of our direct written premiums in 2004), we offer a portfolio of property and casualty insurance products, including commercial automobile, homeowners, dwelling fire, umbrella and business owner policies. Operating exclusively in Massachusetts through our insurance subsidiaries, Safety Insurance Company ("Safety Insurance") and Safety Indemnity Insurance Company (together referred to as the "Insurance Subsidiaries"), we have established strong relationships with 556 independent insurance agents in 659 locations throughout Massachusetts. We have used these relationships and our extensive knowledge of the Massachusetts market to become the second largest private passenger automobile carrier, capturing an approximate 11.0% share of the Massachusetts private passenger automobile insurance market, and the fourth largest commercial automobile carrier, with a 8.4% share of the Massachusetts commercial automobile insurance market, in 2004 according to statistics compiled by Commonwealth Automobile Reinsurers ("CAR"). In addition, we were also ranked the 52nd largest automobile writer in the country according to A.M. Best, based on 2003 direct written premiums. We were incorporated under the laws of Delaware in 2001, but through our predecessors, we have underwritten insurance in Massachusetts since 1979.
Our share of the Massachusetts private passenger automobile insurance market has grown from 9.8% in 2000 to 11.0% in 2004. As a result of this increased market share and the expansion of our product offerings, our direct written premiums have increased by 47.0% between 2000 and 2004, from $427,457 to $628,295. We have also maintained profitability in part by managing our cost structure through, for example, the use of technology.
Website Access to Information
The Internet address for our website is www.SafetyInsurance.com. All of our press releases and SEC report are available for viewing or download at our website. These documents are made available on our website as soon as reasonably practicable after each press release and SEC report is filed with, or furnished to, the SEC. Copies of any current public information about our company are available without charge upon written, telephone, faxed or e-mailed request to the Office of Investor Relations, Safety Insurance Group, Inc., 20 Custom House Street, Boston, MA 02110, Tel: 877-951-2522, Fax: 617-603-4837, or e-mail: InvestorRelations@SafetyInsurance.com. The materials on our website are not part of this report on Form 10-K or incorporated by reference into this report and the URL above is intended to be an inactive textual reference only.
Our Competitive Strengths
We Have Strong Relationships with Independent Agents. In 2003, independent agents accounted for approximately 79.1% of the Massachusetts automobile insurance market measured by direct written premiums as compared to only about 40.6% nationwide, according to A.M. Best. For that reason, our strategy is centered around, and we sell exclusively through, a network of 556 independent agents (of which 119 are Exclusive Representative Producers ("ERPs")) in 659 locations throughout
Massachusetts. In order to support our independent agents and enhance our relationships with them, we:
•Provide our agents with a portfolio of property and casualty insurance products at competitive prices to help our agents address effectively the insurance needs of their clients;
•Provide our agents with a variety of technological resources which enable us to deliver superior service and support to them; and
•Offer our agents competitive commission schedules and profit sharing programs.
Through these measures, we strive to become the preferred provider of the independent agents in our agency network and capture a growing share of the total insurance business written by these agents in Massachusetts. We must compete with other insurance carriers for the business of independent agents.
We Have an Uninterrupted Record of Profitable Operations. In every year since our inception in 1979, we have been profitable and increased our direct written premiums from the prior year. We have achieved profitable growth by, among other things:
•Increasing by 16.9% the number of private passenger automobile exposures we underwrite from 392,889 in 2000 to 459,133 in 2004 and the average premium we receive per automobile exposure from $915 to $1,092;
•Maintaining a statutory combined ratio (refer to page 36 for a definition of statutory combined ratio) that is consistently below industry averages;
•Taking advantage of the institutional knowledge our management has amassed during our long operating history in the unique Massachusetts market;
•Introducing new lines of insurance products, such as homeowners, which unlike private passenger automobile do not have state-established maximum premium rates;
•Investing in technology to simplify internal processes and enhance our relationships with our agents; and
•Maintaining a high-quality investment portfolio.
We Are a Technological Leader. We have dedicated significant human and financial resources to the development of advanced information systems. Our technology efforts have benefited us in two distinct ways. First, we continue to develop technology that empowers our independent agent customers to make it easier for them to transact business with their clients and with Safety. In our largest business line, private passenger automobile insurance, our agents now submit approximately 98% of all applications for new policies or endorsements for existing policies to us electronically through our proprietary information portal, the Agents Virtual Community. Second, our investment in technology has allowed us to re-engineer internal back office processes to provide more efficient service at lower cost. Our adjusted statutory expense ratios have been below the average industry statutory expense ratio in each of the past five years. Our systems have also improved our overall productivity, as evidenced by our direct written premiums per employee increasing to $1,164 in 2004 from $835 in 2000.
We Have an Experienced, Committed and Knowledgeable Management Team. Our senior management team owns approximately 11% of the common stock of Safety on a fully diluted basis. Our senior management team, led by our President, Chief Executive Officer and Chairman of the Board, David F. Brussard, has an average of over 29 years of industry experience per executive, as well as an average of over 23 years of experience with Safety. The team has demonstrated an ability to operate successfully within the regulated Massachusetts private passenger automobile insurance market.
Our Strategy
To achieve our goal of increasing shareholder value, our strategy is to maintain and develop strong independent agent relationships by providing our agents with a full package of insurance products and information technology services. We believe this strategy will allow us to:
•Further penetrate the Massachusetts private passenger automobile insurance market;
•Continue to selectively cross-sell homeowners, dwelling fire, personal umbrella and business owner policies in order to capture a larger share of the total Massachusetts property and casualty insurance business written by each of our independent agents; and
•Continue to expand our technology to enable independent agents to more easily serve their customers and conduct business with us, thereby strengthening their relationships with us.
B. The Massachusetts Property and Casualty Insurance Market
Introduction. We are licensed by the Commonwealth of Massachusetts Commissioner of Insurance ("the Commissioner") to transact property and casualty insurance in Massachusetts. All of our business is extensively regulated by the Commissioner.
The Massachusetts Market for Private Passenger Automobile Insurance. Private passenger automobile insurance is heavily regulated in Massachusetts. In many respects, the private passenger automobile insurance market in Massachusetts is unique, in comparison to other states. This is due to a number of factors, including unusual regulatory conditions, the market dominance of domestic companies, the relative absence of large national companies, and the heavy reliance on independent insurance agents as the market's principal distribution channel. For many insurance companies, these factors present substantial challenges, but we believe they provide us a competitive advantage, because, as our financial history shows, we have a thorough understanding of this market.
The principal factors that generally distinguish the Massachusetts private passenger automobile insurance market from that market in other states are as follows:
•Compulsory Insurance. Massachusetts motorists must obtain automobile insurance prior to registering a vehicle with the Registry of Motor Vehicles. Insurers are required to notify the Registry of Motor Vehicles when coverage is cancelled and the Registry of Motor Vehicles is authorized to seize the license plates of uninsured motor vehicles.
•"Take All Comers." With very few exceptions, CAR, which is the residual market program for automobile insurance in Massachusetts, may not refuse to cover an applicant. Servicing carriers of CAR, such as us, may not refuse to issue a policy to an applicant based on the applicant's driving record or other underwriting criteria commonly used by insurers in other states to decide whether to insure a motorist.
•Standard Policy Form. The policy form that is used by all automobile insurers is developed by the Commissioner and must be used by all companies. The policy consists of several mandatory coverages: no fault coverage (i.e., "personal injury protection"); minimum limits of bodily injury and property damage liability coverage; and coverage for accidents caused by uninsured or hit-and-run motorists. In addition to these standard mandatory coverages, several additional optional coverages (such as higher bodily injury and property damage liability coverages, and collision and comprehensive coverages) must be offered. No carrier may offer any other type of coverage or deductible or use any form of policy endorsement without the prior approval of the Commissioner, which can be granted only after a formal hearing.
•Premium Rates are "fixed and established" by the Commissioner. In Massachusetts, automobile insurance companies are obligated to use premium rates that are determined on an annual basis
by the Commissioner. As a matter of law, the Commissioner's rate must be adequate, which the Massachusetts courts have ruled requires that the rate be sufficient to allow insurers the opportunity to earn a reasonable rate of return. The rate setting process involves a lengthy and complex administrative proceeding in which the Commissioner considers historic information related to claim costs as well as outside factors affecting insurance costs. Different data is presented for the Commissioner's consideration by the Automobile Insurers Bureau (on behalf of the insurance industry), the State Rating Bureau, and the Massachusetts Attorney General. At the close of this proceeding, the Commissioner sets a premium rate for each of several classes of drivers, many different types of vehicles, and twenty-seven different geographic territories within Massachusetts. The Commissioner usually sets the rate during the last quarter of the year. The Commissioner mandated an average rate increase in private passenger automobile premiums of 2.5% for 2004, 2.7% for 2003, no rate change for 2002, and an average 8.3% decrease in 2001. The Commissioner announced on December 15, 2004, a 1.7% statewide average rate decrease for 2005. In addition, the Commissioner annually establishes the minimum commission rate that insurers must pay their auto insurance agents. The Commissioner approved a commission rate, as a percentage of premiums of 10.5% in 2004, 11.0% in 2003, 11.7% in 2002, and 12.3% in 2001. The Commissioner approved a increase in the commission rate to 10.9% for 2005.
•Safe Driver Insurance Plan. In other states, insurance companies are free to design their own systems for rewarding drivers with superior driving records by providing lower prices to such drivers and charging higher prices for drivers who have caused claims or who have poor driving records. In Massachusetts, all companies must use the system the Commissioner has developed. Known as the Safe Driver Insurance Plan, the system consists of a series of steps, ranging from Step 9 to Step 35, with each step above or below Step 15 granting premium credits to motorists in lower steps (Steps 9 to 14) or imposing surcharges on motorists in higher steps (Steps 16 to 35). Each driver is assigned a step classification by the state. The Safe Driver Insurance Plan system is revenue neutral, which means that the aggregate cost of the discounts must be funded by the aggregate income of the surcharges. The effect of this system is that bad drivers actually pay less than the actuarially appropriate premium and are subsidized by better drivers, who pay more than the actuarially appropriate premium.
•Price competition is limited. An insurer may charge less than the Commissioner's fixed and established premium rates by offering discounts to all members of a particular class of motorists, but only if the discount is approved by the Commissioner after a public hearing. During the years 1996 to 2001, most insurance companies offered rate discounts for drivers with the best driving records. We offered competitively priced discounts during the 1996 to 2001 time period, but like most of our competitors, we have discontinued using these discounts since 2001. Only three companies offered such discounts in 2004, further reduced to two companies in 2005.
•Affinity Group Marketing. In addition to the use of class discounts, insurers can charge lower rates than the Commissioner's fixed rate by providing discounts to all members of an affinity group. An affinity group consists of all of the employees of a particular employer or the members of a trade union, association or other organization. These discounts must be filed with the Commissioner and are subject to the Commissioner's approval. We currently offer discounts to 194 groups representing approximately 9.8% of the private passenger automobile policies we issue, with discounts ranging from 1% to 5%.
•Exclusive Representative Producers. As noted above, the Commissioner sets a different rate for each of twenty-seven territories in Massachusetts. The methodology the Commissioner uses to adjust the rates among each territory results in the reduction of rates in high cost urban communities from the actuarially appropriate rate while increasing rates in suburban and rural parts of Massachusetts. As a result, in the aggregate, rates in urban communities are considered inadequate by most insurers. In order to ensure that motorists living in such communities have
access to automobile insurance, licensed insurance producers located in such areas who have not been appointed as a voluntary agent of a company may apply to CAR, to be appointed as an involuntary agent, or ERP, of an insurer selected by CAR. Under CAR's current rules, ERPs are assigned to all insurers writing private passenger automobile insurance in Massachusetts. ERP assignments are intended to be based upon an insurer's market share.
•Commonwealth Automobile Reinsurers. In order to protect insurers from the assignment of ERPs and certain other insurance regulatory conditions, the Massachusetts Legislature created CAR, which runs a reinsurance pool. CAR is governed by a committee that is appointed by the Commissioner, but its rules and decisions are subject to the review and approval of the Commissioner. Under CAR's current rules, companies may cede to the reinsurance pool policies that they determine are not likely to be profitable. As a result, CAR operates at an underwriting deficit. This deficit is allocated among every automobile insurance company based on a complex formula that takes into consideration a company's voluntary market share, the amount of business it cedes to CAR and credits the company earns under a system CAR has designed to encourage carriers to voluntarily write business in selected under-priced classes and territories. We have developed underwriting and actuarial analysis systems to evaluate the profitability of ceding a risk to CAR or writing it voluntarily.
•Proposed Reform of CAR. On December 31, 2004, the Commissioner approved new rules for CAR, which became effective on January 1, 2005 (the "Approved Rules"). Pursuant to the Approved Rules, CAR's current system of assigning ERPs to each insurer and providing reinsurance to insurers is to be replaced by the Massachusetts Assigned Insurance Plan (the "MAIP"). The MAIP is a type of assigned risk plan similar to that used to manage the automobile insurance residual market in most other states. Under the Approved Rules, the MAIP will be fully effective on January 1, 2008. The Approved Rules contain certain transition rules which apply to CAR during 2005, 2006 and 2007, during which time the MAIP would be phased in. A lawsuit has been filed in Suffolk Superior Court by Commerce Insurance Company against the Commissioner that seeks an order permanently enjoining implementation and/or enforcement of the Approved Rules. Certain ERPs, Arbella Mutual Insurance Company and the Center for Insurance Research have intervened as plaintiffs and CAR has intervened as a defendant in this lawsuit. On February 1, 2005 the Court issued an order approving a motion by the ERP plaintiffs that stayed the Approved Rules pending a final decision in this lawsuit. At the present time, we are unable to predict the outcome of this litigation. The Approved Rules and other recent related developments are discussed further in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, Executive Summary and Overview.
•Dominance of Domestic Companies. Many large national private passenger automobile insurance writers, such as State Farm, Allstate, Nationwide, and Farmers, write very little or no private passenger automobile insurance business in Massachusetts. We actively participate in major industry policy-making organizations in Massachusetts, such as the Automobile Insurers Bureau and CAR, where our employees serve on a number of committees.
•Prominence of Independent Insurance Agents. Finally, and perhaps most importantly to our Company's success, approximately 79.1% of the direct written premiums in the Massachusetts automobile insurance market was placed by independent agents in 2003, according to A.M. Best. Nationally, independent agents wrote only about 40.6% of the private passenger automobile insurance market in 2003, according to A.M. Best. Accordingly, to be successful, a company must have a strategy designed to encourage the best agents to place their best business with that company. At Safety, we have designed a system of agent commissions, profit sharing, bonuses and other strategies, such as our information technology capabilities, that we believe favorably
distinguishes our company from our competitors. We aggressively market our company to independent agents in attempting to get the best agents and the best business.
C. Products
Historically, we have focused on underwriting private passenger automobile insurance. Since 1997, we have expanded the breadth of our product line in order for agents to address a greater portion of their clients' insurance needs by selling multiple Safety products. The table below shows our premiums in each of these product lines for the periods indicated and the portions of our total premiums each product line represented.
Our product lines are as follows:
Private Passenger Automobile (81.0% of 2004 direct written premiums). Private passenger automobile insurance is our primary product, and we support all Massachusetts policy forms and limits of coverage. Private passenger automobile policies provide coverage for bodily injury and property damage to others, no-fault personal injury coverage for the insured/insured's car occupants, and physical damage coverage for an insured's own vehicle for collision or other perils. We have priced our private passenger coverage competitively by offering group discounts since 1995 and Safe Driver Insurance Plan rate deviations from 1996 to 2001. Since 2001, we have not filed for any Safe Driver Insurance Plan deviation. We currently offer approximately 194 affinity group discount programs ranging from 1% to 5% discounts.
Commercial Automobile (10.4% of 2004 direct written premiums). Our commercial automobile program supports all Massachusetts policy forms and limits of coverage including endorsements that broaden coverage over and above that offered on the standard Massachusetts policy forms. Commercial automobile policies provide coverage for bodily injury and property damage to others, no-fault personal injury coverage, and physical damage coverage for an insured's own vehicle for collision or other perils resulting from the ownership or use of commercial vehicles in a business. We offer insurance for commercial vehicles used for business purposes such as private passenger-type vehicles, trucks, tractors and trailers, and insure individual vehicles as well as commercial fleets. Commercial automobile policies are written at a standard rate with qualifying risks eligible for preferred lower rates. We received approval for a rate increase of 2.1% effective December 16, 2004.
Homeowners (7.2% of 2004 direct written premiums). We offer a broad selection of coverage forms for qualified policyholders. Homeowners policies provide coverage for losses to a dwelling and its contents from numerous perils, and coverage for liability to others arising from ownership or occupancy. We write policies on homes, condominiums, and apartments. We offer loss-free credits of up to 16% for eight years of loss free experience, along with a discount of 10% when a home is written together with an automobile. All forms of homeowners coverage are written at a standard rate with
qualifying risks eligible for preferred lower rates. We received approval for a rate increase of 9.0% effective March 1, 2004.
Business Owners Policies (Less than 1.0% of 2004 direct written premiums). We serve eligible small and medium sized commercial accounts with a program that covers apartments and residential condominiums; mercantile establishments, including limited cooking restaurants; offices, including office condominiums; processing and services businesses; special trade contractors; and wholesaling businesses. Business owner policies provide liability and property coverage for many perils, including business interruption from a covered loss. Equipment breakdown coverage is automatically included, and a wide range of additional coverage is available to qualified customers. We write policies for business owners at standard rates with qualifying risks eligible for preferred lower rates.
Commercial Package Policies (Included in our Business Owners Policies direct written premiums). For larger commercial accounts, or those clients that require more specialized or tailored coverages, we offer a commercial package policy program that covers a more extensive range of business enterprises. Commercial package policies provide any combination of property, general liability, crime and inland marine insurance. Property automatically includes equipment breakdown coverage, and a wide range of additional coverage is available to qualified customers. We write commercial package policies at standard rates with qualifying risks eligible for preferred lower rates.
Personal Umbrella (Less than 1.0% of 2004 direct written premiums). We offer personal excess liability coverage over and above the limits of individual automobile, watercraft, and homeowner's insurance policies to clients. We offer a discount of 10% when an umbrella policy is written together with an automobile insurance policy. We write policies at standard rates with limits of $1.0 million to $5.0 million.
Dwelling Fire (Less than 1.0% of 2004 direct written premiums). We underwrite dwelling fire insurance, which is a limited form of a homeowner's policy for non-owner occupied residences. We offer superior construction and protective device credits, with a discount of 5% when a dwelling fire policy is issued along with an automobile policy. We write all forms of dwelling fire coverage at standard rates with qualifying risks eligible for preferred lower rates.
Commercial Umbrella (Less than 1.0% of 2004 direct written premiums). We offer an excess liability product to clients for whom we underwrite both commercial automobile and business owner policies. The program is directed at commercial automobile risks with private passenger-type automobiles or light and medium trucks. We write commercial umbrella policies at standard rates with limits ranging from $1.0 million to $5.0 million.
Inland Marine (Included in our Homeowners direct written premiums). We offer inland marine coverage as an endorsement for all homeowners and business owner policies, and as part of our commercial package policy. Inland marine provides additional coverage for jewelry, fine arts and other items that a homeowners or business owner policy would limit or not cover. Scheduled items valued at more than $5,000 must meet our underwriting guidelines and be appraised.
Watercraft (Included in our Homeowners direct written premiums). We offer watercraft coverage for small and medium sized pleasure craft with maximum lengths of 32 feet, values less than $75,000, and maximum speeds of 39 knots. We write this coverage as an endorsement to our homeowner's policies.
In the wake of the September 11, 2001 tragedies, the insurance industry is also impacted by terrorism, and we have filed and received approval for a number of terrorism endorsements from the Commissioner, which limit our liability and property exposure according to the Terrorism Risk Insurance Act of 2002. See "J. Reinsurance", discussed below.
D. Distribution
We distribute our products exclusively through independent agents, unlike some of our competitors, which use multiple distribution channels. We believe this gives us a competitive advantage with the agents. We have two types of independent agents: those with which we have voluntarily entered into an agreement, which we refer to as voluntary agents, and those that CAR has assigned to us as ERPs. With the exception of our ERPs, we do not accept business from insurance brokers. Our voluntary agents have authority pursuant to our voluntary agency agreement to bind our Insurance Subsidiaries for any coverage that is within the scope of their authority. We reserve the ability under Massachusetts law to cancel any coverage, other than private passenger automobile insurance, within the first 30 days after it is bound. In total, our 556 independent agents have 659 offices (some agencies have more than one office) and approximately 3,000 customer service representatives.
Voluntary Agents. In 2004, we obtained approximately 73.6% of our direct written premiums for automobile insurance and 100% of our direct written premiums for all of our other lines of business through our voluntary agents. As of February 28, 2005, we had agreements with 437 voluntary agents. Our voluntary agents are located in all regions of Massachusetts.
We look for agents with profitable portfolios of business. To become a voluntary agent for our Company, we generally require that an agency: (i) have been in business for at least five years; (ii) have exhibited a three year average ratio of losses, excluding loss adjustment expenses, to net earned premiums ("pure loss ratio") of 64.0% or less on the portion of the agent's portfolio that we would underwrite; (iii) currently write policies for a minimum of two automobile carriers; (iv) make a commitment for us to underwrite at least 500 policies from the agency during the first twelve months after entering an agreement with us; and (v) offer multiple product lines. Every year, we review the performance of our agents during the prior year. If an agent fails to meet our profitability standards, we try to work with the agent to improve the profitability of the business it places with us. We generally terminate contracts each year with a few agencies, which, despite our efforts, have been consistently unable to meet our standards. Although independent agents usually represent several unrelated insurers, our goal is to be one of the top two insurance companies represented in each of our agencies, as measured by premiums. No individual agency generated more than 3% of our direct written premiums in 2004.
Exclusive Representative Producers. In 2004, our ERPs generated approximately 26.4% of our direct written premiums for automobile insurance. As of December 31, 2004, we had 80 private passenger automobile ERPs. CAR defines ERPs as licensed dwelling fire or casualty insurance agents or brokers who have a place of business in Massachusetts, but have no existing voluntary independent agency relationship with an automobile insurer conducting business in Massachusetts. An ERP's policy portfolio typically includes a significant percentage of what are considered to be under-priced automobile policies.
Massachusetts law guarantees that CAR provide motor vehicle insurance coverage to all qualified applicants. To facilitate this system, under CAR's current rules, any qualified licensed insurance producer that is unable to obtain a voluntary automobile relationship with an insurer becomes an ERP and is assigned to an insurer, which is then required to write that agent's policies. The number of mandated ERP policies assigned to a Massachusetts insurance carrier is intended to be proportionate to its voluntary market share. However, because no insurer can control the relative volumes of voluntary and ERP business with certainty, carriers are usually either relatively oversubscribed or undersubscribed with ERP policies. Periodically, CAR assigns or re-assigns an ERP to the most undersubscribed insurer.
We continuously monitor our ERP subscription level to attempt to reduce our exposure to becoming oversubscribed with ERP business. By properly managing our ERP subscription levels, we reduce the probability that we will be forced to write excessive levels of ERP business, which is usually
unprofitable. According to the February 25, 2005 CAR Private Passenger Subscription Report, as of December 31, 2004, our ERP policies totaled 119,881, or approximately 97.8% of our market share percentage of ERP policies, making us the third most undersubscribed carrier as of that date. Nevertheless, we have a higher percentage than our market share of High Loss Ratio ERPs (ERPs with loss ratios of 125% or greater).
From time to time, as our market share grows, we are required to add a new ERP. When we need to add an ERP, we can either negotiate an agreement to obtain one we select from an oversubscribed carrier or have CAR assign one to us.
E. Marketing
We view the independent agent as our customer and business partner. As a result, our marketing efforts focus on developing interdependent relationships with leading Massachusetts agents that write profitable business and positioning ourselves as the preferred insurance carrier of those agents, thereby receiving a larger portion of each agent's aggregate business. We do not market ourselves to potential policyholders.
Our principal marketing strategies are:
•To offer a range of products, which we believe enables our agents to meet the insurance needs of their clients, and overcomes agents' resistance to placing their clients' automobile insurance and other coverages with different insurers;
•To price our products competitively, including offering discounts when and where appropriate for safer drivers and for affinity groups, and also offering account discounts for policyholders that have both an automobile and homeowners policy with us;
•To offer agents competitive commissions, with incentives for placing their more profitable business with us; and
•To provide a level of support and service that enhances the agent's ability to do business with its clients and with us.
Commission Schedule and Profit Sharing Plan. We have several programs designed to attract profitable new private passenger automobile business from agents by paying them more than the minimum commission the law requires (which is 10.5% of premiums for 2004, and 10.9% in 2005). We recognize our top performing agents by making them members of our President's Club or Executive Club. In 2004 and 2005, President's Club members receive a commission equal to 14.5% of premiums for each new policy with a driver in Safe Driver Insurance Plan step 9 or 10, while Executive Club members receive a commission equal to 12.5% of premiums for such policies. In 2004, 68.2% of our drivers were in Safe Driver Insurance Plan steps 9 or 10, as compared to 68.6% for the Massachusetts private passenger automobile industry as a whole, based on the number of drivers per month in each step according to CAR.
Further, we have a competitive agency incentive commission program under which we pay agents up to 7% of premiums based on the loss ratio on their business.
We have received no inquiries from the Commissioner, the Massachusetts Attorney General, or any other government agency relative to how we conduct our contingent commissions and profit sharing programs.
Service and Support. We believe that the level and quality of service and support we provide helps differentiate us from other insurers. We have made a significant investment in information technology designed to facilitate our agents' business. This investment includes providing each of our agents with high-speed access to the Internet through a network, which we own. In addition, our Agents Virtual
Community website helps agents manage their work efficiently. We provide a substantial amount of information online that agents need to serve their customers, such as information about the status of new policies, bill payments and claims. Providing this type of content reduces the number of customer calls we receive and empowers the agent's customer service representatives by enabling them to respond to customers' inquiries while the customer is on the telephone. Finally, we believe that the knowledge and experience of our employees enhance the quality of support we provide.
F. Underwriting
Our underwriting department is responsible for a number of key decisions affecting the profitability of our business, including:
•Pricing of discounts offered on our private passenger automobile product;
•Pricing of our commercial automobile, homeowners, dwelling fire, personal umbrella, business owners policies, commercial umbrella and commercial package products;
•Determining which policies to cede to CAR's reinsurance pool and which to retain; and
•Evaluating whether to accept transfers of a portion of an existing or potential new agent's portfolio from another insurer.
We are organized into a personal lines underwriting unit, which includes private passenger automobile, homeowners, dwelling fire, personal umbrella and inland marine coverages, as well as a separate unit for commercial lines, including commercial auto, business owners policies, commercial umbrella and commercial package policies.
Pricing. Our pricing strategy for private passenger automobile insurance primarily depends on the maximum permitted premium rates and minimum permitted commission levels mandated by the Commissioner. For several years prior to 2002, we offered discounts off the state-mandated rates to drivers in the lower Safe Driver Insurance Plan steps, as did a number of other insurers. However, starting in 1998, we began to reduce the discounts we offered, in light of the reductions or minimal increases in average rates the Commissioner has mandated in each year since 1998. We currently do not offer any Safe Driver Insurance Plan step-based discounts. As a result primarily of reducing discounts and of our insureds purchasing new cars (for which we are permitted to charge higher premiums), our average premium received per policy increased 5.2% in 2002, 6.9% in 2003 and 6.1% in 2004.
In addition to Safe Driver Insurance Plan discounts, we also offer group discounts to members of 194 affinity groups, including the Boston College Alumni Association, the Massachusetts Bar Association and the Massachusetts Medical Society. In general, we target affinity groups with a mature and stable membership base along with favorable driving records, offering between a 3% and 5% discount (with 4% being the average discount offered). Approximately 9.8% of the private passenger policies we issue receive an affinity group discount.
CAR and the Commissioner set the premium rates for commercial automobile policies reinsured through CAR. Subject to Commissioner review, we set rates for commercial automobile policies that are not reinsured through CAR, and for all other insurance lines we offer, including homeowners, dwelling fire, personal umbrella, commercial umbrella, commercial package policies and business owner policies. We base our rates on industry loss cost data, our own loss experience, catastrophe modeling and prices charged by our competitors in the Massachusetts market. We received approval for a rate increase of 2.1% for our commercial automobile line effective December 16, 2004, and also received approval for a rate increase of 9.0% for our homeowners line effective March 1, 2004.
Cede/Retain Decisions. Under CAR's current rules, we must decide, within 23 days after the effective date of a new policy or before renewing an existing policy, whether to cede it to CAR's
reinsurance pool. Each Massachusetts automobile insurer must bear a portion of the losses of the reinsurance pool. Under CAR's current rules, we are able to reduce our total allocated share of the losses of the reinsurance pool by ceding less business to the pool than our proportionate share. As a result, in determining whether to cede an underpriced policy to CAR's private passenger automobile reinsurance pool, we attempt to evaluate whether we are likely to incur greater total losses by ceding it to the pool or by retaining it. According to the March 1, 2005 CAR Cession Volume Analysis-Private Passenger Report, as of December 31, 2004, we have ceded 8.8% of our private passenger automobile business to the pool in 2004, compared to an average of 6.7% for the industry. Our goal is to cede only those policies that incur less total losses resulting from a cession to CAR, than the total losses incurred by retaining the policy.
CAR also runs a reinsurance pool for commercial automobile policies. We analyze whether to cede or retain our business in that line in a similar fashion. According to the March 1, 2005 CAR Cession Volume Analysis-All Other Than Private Passenger Report, as of December 31, 2004, we have ceded 16.8% of our commercial automobile business to the pool in 2004, compared to an average of 26.9% for the industry.
Bulk Policy Transfers and New Voluntary Agents. From time to time, we receive proposals from existing voluntary agents to transfer a portfolio of the agent's business from another insurer to us. Our underwriters model the profitability of these portfolios before we accept these transfers. Among other things, we usually require that the portfolio have a pure loss ratio of 64% or less on the portion of the agent's portfolio that we would underwrite. In addition, we require any new voluntary agent to commit to transfer a portfolio to us consisting of at least 500 policies.
Policy Processing and Rate Pursuit. Our underwriting department assists in processing policy applications, endorsements, renewals and cancellations. In the past three years, we have introduced new proprietary software that enables agents to connect to our network and enter policy and endorsement applications for private passenger automobile insurance from their office computers. In our private passenger automobile insurance line, our agents now submit approximately 98% of all applications for new policies or endorsements for existing policies through our proprietary information portal, the Agents Virtual Community.
Our rate pursuit team aggressively monitors all insurance transactions to make sure we receive the correct premium for the risk insured. We accomplish this by verifying Massachusetts pricing criteria, such as proper classification of drivers, the make, model and age of insured vehicles and the availability of discounts. We verify that operators are properly listed and classified, assignment of operators to vehicles, vehicle garaging, vehicle preinspection requirements and in some cases the validity of discounts. In our homeowners and dwelling fire lines, our team has completed a project to update the replacement costs for each dwelling. We use third-party software to assist in these appraisal efforts.
G. Technology
The focuses of our information technology effort are:
•to constantly reengineer internal processes to allow more efficient operations, resulting in lower operating costs;
•to make it easier for independent agents to transact business with us; and
•to enable agents to efficiently provide their clients with a high level of service.
We believe that our technology initiatives have increased revenue and decreased cost. For example, these initiatives have allowed us to reduce the number of call-center transactions which we perform, and to transfer many manual processing functions from our internal operations to our independent agents. We also believe that these initiatives have contributed to our overall increases in productivity. In
1990, we had 399 employees and $154,997 in direct written premiums. As of December 31, 2004, we had 540 employees and $628,295 in direct written premiums, which represents an increase from $388 direct written premiums per employee in 1990 to $1,164 direct written premiums per employee in 2004.
Internal Applications (Intranet). Our employees access our proprietary applications through our corporate intranet. Our intranet applications streamline internal processes and improve overall operational efficiencies in areas including:
Claims. Our claims workload management application allows our claims and subrogation adjusters to better manage injury claims. Subrogation refers to the process by which we are reimbursed by other insurers for claims costs we incur due to the fault of their insureds. The use of this application has reduced the time it takes for us to respond to and settle casualty claims, which we believe helps reduce the total amount of our claims expense.
The automated adjuster assignment system categorizes our new claims by severity and assigns them to the appropriate adjuster responsible for investigation. Once assigned, the integrated workload management tools facilitate the work of promptly assigning appraisers, investigating liability, issuing checks and receiving subrogation receipts.
Billing. Proprietary billing systems, integrated with the systems of our print and lock-box vendors, expedite the processing and collection of premium receipts and finance charges from agents and policyholders. We believe the sophistication of our direct bill system helps us to limit our bad debt expense. In both 2003 and 2004, our bad debt expense as a percentage of direct written premiums was 0.1%.
External Applications. Agency employees can securely access business critical applications through our corporate extranet, which we call Agents Virtual Community. Agents Virtual Community includes Web-enabled applications, advanced security and an Internet-enabled communications network, which we believe constitutes many of our agents' only high-speed Internet connection. We believe that Agents Virtual Community is unique to the Massachusetts private passenger automobile insurance industry because using Agents Virtual Community allows an agent to access a variety of vendors and other carriers over the Internet through a single portal. We currently have a patent application pending on Agents Virtual Community. The patent application pertains to the method and system by which Agents Virtual Community delivers customer services to independent insurance agents. The capability for agency personnel to schedule online appointments with third-party vendors (such as glass repair retailers and rental car agencies) for their clients is also available. We designed Agents Virtual Community to be scalable so that these types of vendors and potentially, other insurers, can link to the network and create a "once and done" environment for the independent agent.
Listed below are examples of the business critical applications agents may access through Agents Virtual Community.
New Business and Endorsement Processing. Agents can perform new business and endorsement processing with our point of sale application. Agents can upload policy data to our system directly from their agency system or rate quote software in Agents Virtual Community's secure Web environment without having to re-enter policy information.
Inquiry Access. Inquiry Access is a customer service application designed to provide agency customer service representatives with real-time access to our database of insured information. This application allows agents to view the status of claims, billing and policy detail.
Policyholder Inquiry. Policyholder Inquiry provides 24 hours a day, 7 days a week self-service account information to our policyholders through our website or through their independent agents' websites. This application provides policyholders with round-the-clock access to billing and claims information.
Other Tools and Services. Agents Virtual Community gives agents access to electronic versions of underwriting manuals, which include updated guidelines for acceptable risks, commission levels and product pricing. Further, we have our agents using third-party software (the XNET Cost Estimator from Marshall Swift/Boeck) that we make available through Agents Virtual Community to help assess home replacement costs. This initiative helps ensure that we receive the correct premium with respect to homeowners policies and provide the correct level of coverage against home loss. Finally, we provide agents a daily report of all their insurance transactions processed through Agents Virtual Community. This report allows our agents to monitor their performance and review profitability goals.
H. Claims
Because of the unique differences between the management of casualty claims and property claims, we use separate departments for each of these types of claims.
Casualty Claims
We have a proven record of settling casualty claims below the industry average in Massachusetts. According to the Automobile Insurers Bureau, our average casualty claim settlement during the period from January 1994 through September 30, 2004 was $5,410, approximately 4.6% lower than the Massachusetts industry average of $5,673.
We have adopted stringent claims settlement procedures, which include guidelines that establish maximum settlement offers for soft tissue injuries, which constituted approximately 75% of our bodily injury claims. If we are unable to settle these claims within our guidelines, we generally take the claim to litigation. We believe that these procedures result in providing our adjusters with a uniform approach to negotiation.
We believe an important component of handling claims efficiently is prompt investigation and settlement. We find that faster claims settlements often result in less expensive claims settlements. Our E-Claim reporting system is an online product that reduces the time it takes for agents to notify our adjusters about claims, thereby enabling us to contact third-party claimants and other witnesses quickly. After business hours we outsource claims adjustment support to an independent firm whose employees contact third-party claimants and other witnesses. We believe that early notification results in our adjusters conducting prompt investigations of claims and compiling more accurate information about those claims. Our claims workload management software also assists our adjusters in handling claims quickly.
We believe the structure of our casualty claims unit allows us to respond quickly to claimants anywhere in the Commonwealth. Comprising 115 people, the department is organized into distinct claim units that contain loss costs for soft tissue injuries. Field adjusters are located geographically for prompt response to claims, with our litigation unit focused on managing loss costs and litigation expenses for serious injury claims.
Additionally, we utilize a special unit to investigate fraud in connection with casualty claims. This special unit has one manager and eight employees. In cases where adjusters suspect fraud in connection with a claim, we deploy this special unit to conduct investigations. We deny payment to claimants in cases in which we have succeeded in accumulating sufficient evidence of fraud.
Property Claims
Our property claims unit handles property claims arising in our private passenger and commercial automobile, homeowners and other insurance lines. Process automation has streamlined our property claims function. Many of our property claims are now handled by the agents through Agents Virtual Community using our Power Desk software application. As agents receive calls from claimants, Power Desk permits the agent to immediately send information related to the claim directly to us and to an independent appraiser selected by the agent to value the claim. Once we receive this information, an automated system redirects the claim to the appropriate internal adjuster responsible for investigating the claim to determine liability. Upon determination of liability, the system automatically begins the process of seeking a subrogation recovery from another insurer, if liable. We believe this process results in a shorter time period from when the claimant first contacts the agent to when the claimant receives a claim payment, while enabling our agents to build credibility with their clients by responding to claims in a timely and efficient manner. We benefit from decreased labor expenses from the need for fewer employees to handle the reduced property claims call volume.
Another important factor in keeping our overall property claims costs low is collecting subrogation recoveries. Subrogation refers to the process by which we are reimbursed by other insurers for claims costs we incur due to the fault of their insureds. We track the amounts we pay out in claims costs and identify cases in which we believe we can reclaim some or all of those costs through the use of our automated workload management tools.
I. Reserves
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer's payment of that loss. To recognize liabilities for unpaid losses, insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and the expenses associated with investigating and paying the losses, or loss adjustment expenses. Every quarter, we review our reserves internally. Regulations promulgated by the Commissioner require us to annually obtain a certification from either a qualified actuary or an approved loss reserve specialist that our loss and loss adjustment expenses reserves are reasonable.
When a claim is reported, claims personnel establish a "case reserve" for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon an evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the loss. The estimate reflects informed judgment of such personnel based on general insurance reserving practices and on the experience and knowledge of the claims person. During the loss adjustment period, these estimates are revised as deemed necessary by our claims department based on subsequent developments and periodic reviews of the cases.
In accordance with industry practice, we also maintain reserves for estimated losses incurred but not yet reported. Incurred but not yet reported reserves are determined in accordance with commonly accepted actuarial reserving techniques on the basis of our historical information and experience. We make adjustments to incurred but not yet reported reserves quarterly to take into account changes in the volume of business written, claims frequency and severity, our mix of business, claims processing and other items that can be expected to affect our liability for losses and loss adjustment expenses over time.
When reviewing reserves, we analyze historical data and estimate the impact of various loss development factors, such as our historical loss experience and that of the industry, legislative enactments, judicial decisions, legal developments in imposition of damages, and changes and trends in general economic conditions, including the effects of inflation. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors. After taking into account all relevant factors,
management believes that our provision for unpaid losses and loss adjustment expenses at December 31, 2004 is adequate to cover the ultimate net cost of losses and claims incurred as of that date.
Management calculates its loss and LAE reserves estimates, independently from the Company's actuaries. The Company's actuarial estimate for loss and LAE reserves, net of the effect of ceded reinsurance, ranges from a low of $329,403 to a high of $384,536 as of December 31, 2004. The Company's loss and LAE reserves, based on management's best estimate, were set at $366,730 as of December 31, 2004. The ultimate liability may be greater or less than reserves carried at the balance sheet date. Establishment of appropriate reserves is an inherently uncertain process, and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience. To the extent that reserves are inadequate and are strengthened, the amount of such increase is treated as a charge to earnings in the period that the deficiency is recognized. To the extent that reserves are redundant and are released, the amount of the release is a credit to earnings in the period the redundancy is recognized. We do not discount any of our reserves.
The following table presents development information on changes in the reserves for losses and loss adjustment expenses ("LAE") of our Insurance Subsidiaries for the three years ended December 31, 2004.
The increase or decrease in prior year incurred losses and LAE represents deficiences or redundancies for reserves established in prior years. The $6,778 of favorable development recorded during 2004, which resulted primarily from a reduction in our share of CAR's results for the 2003 policy year, indicates that management's estimation of year-end 2003 and prior loss and LAE reserves varied by 2.2% of the net reserves established at December 31, 2003.
The following table represents the development of reserves, net of reinsurance, for calendar years 1994 through 2004. The top line of the table shows the reserves at the balance sheet date for each of the indicated years. This represents the estimated amounts of losses and loss adjustment expenses for claims arising in all years that were unpaid at the balance sheet date, including losses that had been incurred but not yet reported to us. The upper portion of the table shows the cumulative amounts paid as of the end of each successive year with respect to those claims. The lower portion of the table shows the re-estimated amount of the previously recorded reserves based on experience as of the end of each
succeeding year, including cumulative payments made since the end of the respective year. The estimate changes as more information becomes known about the payments, frequency and severity of claims for individual years. Favorable loss development, shown as a cumulative redundancy in the table, exists when the original reserve estimate is greater than the re-estimated reserves at December 31, 2004.
Information with respect to the cumulative development of gross reserves (that is, without deduction for reinsurance ceded) also appears at the bottom portion of the table.
In evaluating the information in the table, it should be noted that each amount entered incorporates the effects of all changes in amounts entered for prior periods. Thus, if the 1998 estimate for a previously incurred loss was $150,000 and the loss was reserved at $100,000 in 1994, the $50,000 deficiency (later estimate minus original estimate) would be included in the cumulative redundancy (deficiency) in each of the years 1995-1998 shown in the table. It should further be noted that the table does not present accident or policy year development data. In addition, conditions and trends that have affected the development of liability in the past may not necessarily recur in the future. Accordingly, it is not appropriate to extrapolate future redundancies or deficiencies from the table.
As the table shows, our net reserves grew at a faster rate than our gross reserves over the ten-year period. As we have grown, we have been able to retain a greater percentage of our direct business. Additionally, we used to conduct substantial business as a servicing carrier for other insurers, in which we would service the residual market automobile insurance business assigned to other carriers for a fee. All business generated through this program was ceded to the other carriers. As we reduced the amount of our servicing carrier business, our proportion of reinsurance ceded diminished.
The table also shows that we have substantially benefited in prior years from releasing redundant reserves. Massachusetts private passenger automobile insurance pricing was very favorable in the early to mid-1990s and the reserves we established for business written during that period developed favorably, allowing us to release substantial reserves in following years. As maximum permitted rates declined in the latter part of the 1990s through 2001, and the redundancies resulting from favorable development of earlier years were released, our redundancies in subsequent years began to diminish. In the year ended December 31, 2002 we released $2,262 in reserves relating to prior years, compared to increasing loss reserves $181 in 2003. In the year ended December 31, 2004 we released $6,778 in reserves related to prior years.
As a result of our focus on core business lines since our founding in 1979, we believe we have no exposure to asbestos or environmental pollution liabilities.
J. Reinsurance
We reinsure with other insurance companies a portion of our potential liability under the policies we have underwritten, thereby protecting us against an unexpectedly large loss or a catastrophic occurrence that could produce large losses. Reinsurance involves an insurance company transferring (ceding) a portion of its exposure on insurance underwritten by it to another insurer (reinsurer). The reinsurer assumes a portion of the exposure in return for a share of the premium. Reinsurance does not legally discharge an insurance company from its primary liability for the full amount of the policies, but it does make the reinsurer liable to the company for the reinsured portion of any loss realized.
We are very selective in choosing our reinsurers, seeking only those companies that we consider to be financially stable and adequately capitalized. In an effort to minimize exposure to the insolvency of a reinsurer, we continuously evaluate and review the financial condition of our reinsurers. All of our reinsurers have an A.M. Best rating of "A" or better and Swiss Re, our primary reinsurer, maintains an A.M. Best rating of "A+" (Superior).
We maintain reinsurance coverage to help lessen the effect of losses from catastrophic events, maintaining coverage in 2004 that protects us in the event of a "315-year storm" (that is, a storm of a severity expected to occur once in a 315 year period). We use various software products to measure our exposure to catastrophe losses to model the probable maximum loss to us for catastrophe losses such as hurricanes. In 2004 we purchased six layers of excess catastrophe reinsurance contracts providing coverage for property losses in excess of $5,000 up to a maximum of $210,000. Our reinsurers co-participation ratio was 70.0% of $5,000 for the 1st layer, 80.0% of $5,000 for the 2nd layer, 90.0% of $15,000 for the 3rd layer, 90.0% of $30,000 for the 4th layer, 95.0% of $100,000 for the 5th layer, and 85.0% of $50,000 for the 6th layer.
Beginning in 2005 we have changed our reinsurance coverage to protect us in the event of a "426-year storm" (that is, a storm of a severity expected to occur once in a 426-year period). We have purchased four layers of excess catastrophe reinsurance contracts providing coverage for property losses in excess of $10,000 up to a maximum of $250,000. Our reinsurers co-participation is 25.0% of $5,000 for the 1st layer, 90.0% of $15,000 for the 2nd layer, 90.0% of $30,000 for the 3rd layer, and 90.0% of $190,000 for the 4th layer.
We also have a casualty excess of loss reinsurance contract for large casualty losses occurring in our automobile, homeowners, dwelling fire, business owners policies, commercial package policies, personal umbrella and commercial umbrella lines of business in excess of $1,000 up to a maximum of $5,000, with an annual aggregate deductible of $500. In addition, we have a quota share reinsurance agreement under which we cede 90.0% of the premiums and losses under our personal and commercial umbrella policies. We also have a reinsurance agreement with Hartford Steam Boiler Inspection and Insurance Company, which is a quota share agreement under which we cede 100% of the premiums and losses for the equipment breakdown coverage under our business owner policies and commercial package policies. We have property excess of loss reinsurance coverage for large property losses, with coverage in excess of $1,000 up to a maximum of $10,000, for our homeowners, business owner, and commercial package policies.
In the wake of the September 11, 2001 tragedies, reinsurers have begun to exclude coverage for claims in connection with any act of terrorism. Our reinsurance programs for 2003, 2004 and 2005 excludes coverage for acts of terrorism, except for fire or collapse losses as a result of terrorism, under homeowners, dwelling fire, private passenger automobile and commercial automobile policies. For business owner policies and commercial package policies, terrorism is excluded if the total insured value is greater than $20,000.
The Terrorism Risk Insurance Act of 2002 (TRIA) was signed into law on November 26, 2002. The intent of this legislation is to provide federal assistance to the insurance industry for the needs of
commercial insurance policyholders with the potential exposure for losses due to acts of terrorism. The TRIA provides reinsurance for certified acts of terrorism. Effective February 24, 2003 we issued policy endorsements for all commercial policyholders to comply with TRIA after obtaining Commissioner approval.
As of December 31, 2004, we had no material amounts recoverable from any reinsurer, excluding the residual markets described below. On March 10, 2005, our Board of Directors adopted a resolution that prohibits Safety from purchasing finite reinsurance without approval by the Board. To date, the Company has never purchased a finite reinsurance contract.
In addition to the above mentioned reinsurance programs, we are a participant in CAR, the Massachusetts mandated residual market under which premiums, expenses, losses and loss adjustment expenses on ceded business are shared by all insurers writing automobile insurance in Massachusetts. We also participate in the Massachusetts Property Insurance Underwriting Association in which premiums, expenses, losses and loss adjustment expenses on homeowners business that cannot be placed in the voluntary market are shared by insurers writing homeowners insurance in Massachusetts.
K. Competition
The property and casualty insurance business is highly competitive and many of our competitors have substantially greater financial and other resources than us. We compete with both large national writers and smaller regional companies. Our competitors include companies, which, like us, serve the independent agency market, as well as companies which sell insurance directly to customers. Direct writers may have certain competitive advantages over agency writers, including increased name recognition, loyalty of the customer base to the insurer rather than to an independent agency and, potentially, lower cost structures. A material reduction in the amount of business independent agents sell would adversely affect us. In the past, competition in the Massachusetts private passenger automobile market has included offering significant discounts from the maximum permitted rates, and there can be no assurance that these conditions will not recur. Further, we and others compete on the basis of the commissions and other cash and non-cash incentives provided to agents. Although a number of national insurers that are much larger than we are do not currently compete in a material way in the Massachusetts private passenger automobile market, if one or more of these companies decided to aggressively enter the market it could have a material adverse effect on us. These companies include some that would be able to sustain significant losses in order to acquire market share, as well as others which use distribution methods that compete with the independent agent channel. There can be no assurance that we will be able to compete effectively against these companies in the future.
In Massachusetts, as of December 31, 2004, 19 insurers actively wrote private passenger automobile insurance, according to CAR. Of these 19 insurers, 4 are national companies which use independent agents to sell their products, 8 are regional or Massachusetts-only companies which use independent agents to sell their products (including us) and 7 are national, regional or Massachusetts-only companies which sell their products directly to policyholders. Our principal competitors within the Massachusetts private passenger automobile insurance industry are both regional companies, Commerce Group, Inc. and Arbella Insurance Group, which held 29.1% and 9.2% market shares based on automobile exposures, respectively, in 2004 according to CAR.
L. Employees
At March 9, 2005, we employed 536 employees. Our employees are not covered by any collective bargaining agreement. Management considers our relationship with our employees to be good.
M. Investments
Investment income is an important source of revenue for us and the return on our investment portfolio has a material effect on our net earnings. Our investment objective is to focus on maximizing total returns while investing conservatively. We maintain a high quality investment portfolio consistent with our established investment policy. As of December 31, 2004, there were no securities below investment grade (as defined by Moody's, S&P, and the Securities Valuation Office of the NAIC (see further details below)) in our fixed income securities portfolio. According to our investment guidelines, no more than 1% of our portfolio may be invested in the securities of any one issuer (excluding U.S. government-backed securities), and no more than 0.5% of our portfolio may be invested in securities rated "BBB," or the lowest investment grade assigned by Moody's. We continually monitor the mix of taxable and tax-exempt securities, in an attempt to maximize our total after-tax return. Since 1986, our investment manager has been Deutsche Asset Management, formerly known as Scudder Investments.
The following table reflects the composition of our investment portfolio at December 31, 2004, 2003 and 2002:
(1)Obligations of U.S. Government agencies include collateralized mortgage obligations issued, guaranteed and/or insured by the following issuers: Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), and Federal National Mortgage Association (FNMA). The total of these fixed maturity securities was $120,636 at fair value and $120,729 at amortized cost as of December 31, 2004. As such, the asset-backed securities presented exclude such issuers already presented under U.S. Treasury securities and obligations of U.S. Government Agencies. While we have held common equity securities in our investment portfolio in the past, as of December 31, 2004, we held no such securities in our investment portfolio, except for interests in mutual funds to fund the executive deferred compensation plan. We made the decision to divest common equity securities in order to maximize the current investment income earned by our portfolio and to reduce our overall investment risk. We continuously evaluate market conditions and we expect in the future to purchase common equity securities.
The principal risks inherent in holding mortgage-backed securities and other pass-through securities are prepayment and extension risks, which affect the timing of when cash flows will be received. When interest rates decline, mortgages underlying mortgage-backed securities tend to be prepaid more rapidly than anticipated, causing early repayments. When interest rates rise, the underlying mortgages tend to be prepaid at a slower rate than anticipated, causing the principal repayments to be extended. Although early prepayments may result in acceleration of income from recognition of any unamortized discount, the proceeds typically are reinvested at a lower current yield, resulting in a net reduction of future investment income.
The following table reflects our investment results for each year in the three-year period ended December 31, 2004:
(1)After investment expenses, excluding realized investment gains (losses). (2)Net investment income for the period divided by average invested securities and cash for the same period.
Net effective yield declined as a result of management's investment strategy to shorten the duration of our portfolio, shift to higher rated securities, and increase our tax-exempt holdings.
As of December 31, 2004, our portfolio of fixed maturity investments was comprised entirely of investment grade corporate fixed maturity securities, U.S. government and agency securities and asset-backed securities (i.e., all our securities received a rating assigned by Moody's Investors Service, Inc. of Baa or higher, except the few securities not rated by Moody's which received S&P ratings of AA/A or higher, as well as a rating assigned by the Securities Valuation Office of the National Association of Insurance Commissioners of 1 or 2).
The composition of our fixed income security portfolio by Moody's rating was as follows:
Ratings are assigned by Moody's, or the equivalent, as discussed above. Such ratings are generally assigned upon the issuance of the securities and are subject to revision on the basis of ongoing evaluations. Ratings in the table are as of the date indicated.
Moody's rating system utilizes nine symbols to indicate the relative investment quality of a rated bond. Aaa rated bonds are judged to be of the best quality and are considered to carry the smallest degree of investment risk. Aa rated bonds are also judged to be of high quality by all standards. Together with Aaa bonds, these bonds comprise what are generally known as high grade bonds. Bonds rated A possess many favorable investment attributes and are considered to be upper medium grade obligations. Baa rated bonds are considered as medium grade obligations; they are neither highly protected nor poorly secured. Bonds rated Ba or lower (those rated B, Caa, Ca and C) are considered to be too speculative to be of investment quality.
The Securities Valuation Office of the National Association of Insurance Commissioners evaluates all public and private bonds purchased as investments by insurance companies. The Securities Valuation Office assigns one of six investment categories to each security it reviews. Category 1 is the highest quality rating and Category 6 is the lowest. Categories 1 and 2 are the equivalent of investment grade debt as defined by rating agencies such as Standard & Poor's Ratings Services and Moody's, while Categories 3-6 are the equivalent of below investment grade securities. Securities Valuation Office ratings are reviewed at least annually. At December 31, 2004, approximately 74.4% of our fixed
maturity investments were rated Category 1, and 25.6% of our fixed maturity investments were rated Category 2, the two highest ratings assigned by the Securities Valuation Office. At December 31, 2004, we had no fixed maturity investments rated Category 3 or lower by the Securities Valuation Office.
The following table indicates the composition of our fixed income security portfolio (at carrying value) by time to maturity as of December 31, 2004:
(1)Actual maturities of asset-backed securities differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including: the relative sensitivity of the underlying mortgages or other collateral to changes in interest rates; a variety of economic, geographic and other factors; and the repayment priority of the securities in the overall securitization structures. N. Ratings
A.M. Best, which rates insurance companies based on factors of concern to policyholders, currently assigns Safety Insurance an "A (Excellent)" rating. Our "A" rating was reaffirmed by A.M. Best on November 22, 2004. Such rating is the third highest rating of 13 ratings that A.M. Best assigns to solvent insurance companies, which currently range from "A++ (Superior)" to "D (Very Vulnerable)." Publications of A.M. Best indicate that the "A" rating is assigned to those companies that in A.M. Best's opinion have a strong ability to meet their obligations to policyholders over a long period of time. In evaluating a company's financial and operating performance, A.M. Best reviews the company's profitability, leverage and liquidity, as well as its book of business, the adequacy and soundness of its reinsurance, the quality and estimated market value of its assets, the adequacy of its loss reserves, the adequacy of its surplus, its capital structure, the experience and competence of its management and its market presence. A.M. Best's ratings reflect its opinion of an insurance company's financial strength, operating performance and ability to meet its obligations to policyholders and are not evaluations directed to purchasers of an insurance company's securities.
In reaffirming Safety Insurance's rating, A.M. Best recognized its excellent capitalization, sustained operating profitability, and favorable market position as an automobile insurer in Massachusetts. A.M. Best also noted amongst our positive attributes: favorable operating earnings in recent years; our disciplined underwriting approach; and expertise in the highly regulated Massachusetts automobile insurance industry. A.M. Best cited other factors that partially offset these positive attributes, including our geographic concentration, unfavorable reserve development, elevated underwriting leverage and limited product scope. We are subject to the competitive and highly regulated Massachusetts private passenger automobile market, which is characterized by mandated rates set by the Commissioner.
O. Supervision and Regulation
Introduction. Our principal operations are conducted through the Insurance Subsidiaries which are subject to comprehensive regulation by the Division of Insurance, of which the Commissioner is the senior official. The Commissioner is appointed by the Governor. We are subject to the authority of the Commissioner in many areas of our business under Massachusetts law, including:
•our licenses to transact insurance;
•the premium rates and policy forms we may use;
•our financial condition including the adequacy of our reserves and provisions for unearned premium;
•the solvency standards that we must maintain;
•the type and size of investments we may make;
•the prescribed or permitted statutory accounting practices we must use; and
•the nature of the transactions we may engage in with our affiliates.
In addition, the Commissioner periodically conducts a financial examination of all licensees domiciled in Massachusetts. We were most recently examined for the five-year period ending December 31, 2003. The Division had no material findings as a result of this examination.
Insurance Holding Company Regulation. Our principal operating subsidiaries are insurance companies, and therefore we are subject to certain laws in Massachusetts regulating insurance holding company systems. These laws require that we file a registration statement with the Commissioner that discloses the identity, financial condition, capital structure and ownership of each entity within our corporate structure and any transactions among the members of our holding company system. In some instances, we must provide prior notice to the Commissioner for material transactions between our insurance company subsidiaries and other affiliates in our holding company system. These holding company statutes also require, among other things, prior approval of the payment of extraordinary dividends or distributions and any acquisition of a domestic insurer.
Insurance Regulation Concerning Dividends. We rely on dividends from the Insurance Subsidiaries for our cash requirements. The insurance holding company law of Massachusetts requires notice to the Commissioner of any dividend to the stockholders of an insurance company. The Insurance Subsidiaries may not make an "extraordinary dividend" until thirty days after the Commissioner has received notice of the intended dividend and has not objected in such time. As historically administered by the Commissioner, this provision requires the prior approval by the Commissioner of an extraordinary dividend. An extraordinary dividend is defined as any dividend or distribution that, together with other distributions made within the preceding twelve months exceeds the greater of 10% of the insurer's surplus as of the preceding December 31, or the insurer's net income for the twelve-month period ending the preceding December 31, in each case determined in accordance with statutory accounting practices. Under Massachusetts law, an insurer may pay cash dividends only from its unassigned funds, also known as its earned surplus, and the insurer's remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. At year-end 2004, the statutory surplus of Safety Insurance was $278,161 and its net income for 2004 was $42,251. A maximum of $42,251 will be available by the end of 2005 for such dividends without prior approval of the Division.
Acquisition of Control of a Massachusetts Domiciled Insurance Company. Massachusetts law requires advance approval by the Commissioner of any change in control of an insurance company that is domiciled in Massachusetts. That law presumes that control exists where any person, directly or indirectly, owns, controls, holds the power to vote or holds proxies representing 10% or more of our
outstanding voting stock. Even persons who do not acquire beneficial ownership of more than 10% of the outstanding shares of our common stock may be deemed to have acquired control if the Commissioner determines that control exists in fact. Any purchaser of shares of common stock representing 10% or more of the voting power of our capital stock will be presumed to have acquired control of the Insurance Subsidiaries unless, following application by that purchaser the Commissioner determines that the acquisition does not constitute a change of control or is otherwise not subject to regulatory review. These requirements may deter, delay or prevent transactions affecting the control of or the ownership of our common stock, including transactions that could be advantageous to our stockholders.
Protection Against Insurer Insolvency. Massachusetts law requires that insurers licensed to do business in Massachusetts participate in the Massachusetts Insurers Insolvency Fund. The Massachusetts Insurers Insolvency Fund must pay any claim up to $300 of a policyholder of an insolvent insurer if the claim existed prior to the declaration of insolvency or arose within sixty days after the declaration of insolvency. Members of the Massachusetts Insurers Insolvency Fund are assessed the amount the Massachusetts Insurers Insolvency Fund deems necessary to pay its obligations and expenses in connection with handling covered claims. Subject to certain exceptions, assessments are made in the proportion that each member's net written premiums for the prior calendar year for all property and casualty lines bore to the corresponding net written premiums for Massachusetts Insurers Insolvency Fund members for the same period. As a matter of Massachusetts law, insurance rates and premiums include amounts to recoup any amounts paid by insurers for the costs of the Massachusetts Insurers Insolvency Fund. With respect to private passenger automobile insurance rates and premiums, the Commissioner has historically made an adjustment in his or her annual rate decision reflecting any Massachusetts Insurers Insolvency Fund-related costs reported by the industry in its rate filing. By statute, no insurer in Massachusetts may be assessed in any year an amount greater than two percent of that insurer's direct written premium for the calendar year prior to the assessment. We account for allocations from the Massachusetts Insurers Insolvency Fund as underwriting expenses. Underwriting expenses in 2004, 2003 and 2002 included $2,538, $3,423 and $2,103 of charges representing our allocation from the Massachusetts Insurers Insolvency Fund for the insolvencies of other insurers. CAR also assesses its members as a result of insurer insolvencies. Because CAR is not able to recover an insolvent company's share of the net CAR losses from the Massachusetts Insurers Insolvency Fund, CAR must increase each of its member's share of the deficit in order to compensate for the insolvent carrier's inability to pay its deficit assessment. It is anticipated that there will be additional assessments from time to time relating to various insolvencies.
The Insurance Regulatory Information System. The Insurance Regulatory Information System was developed to help state regulators identify companies that may require special financial attention. The Insurance Regulatory Information System consists of a statistical phase and an analytical phase whereby financial examiners review annual statements and financial ratios. The statistical phase consists of 12 key financial ratios based on year-end data that are generated from the National Association of Insurance Commissioners' database annually; each ratio has an established "usual range" of results. These ratios assist state insurance departments in executing their statutory mandate to oversee the financial condition of insurance companies.
A ratio result falling outside the usual range of Insurance Regulatory Information System ratios is not considered a failing result; rather, unusual values are viewed as part of the regulatory early monitoring system. Furthermore, in some years, it may not be unusual for financially sound companies to have several ratios with results outside the usual ranges. Generally, an insurance company will become subject to regulatory scrutiny if it falls outside the usual ranges of four or more of the ratios. With the exception of investment yield in 2004 and 2003, all our ratios for both the Insurance Subsidiaries were within the normal range for 2004, 2003 and 2002.
Risk Based Capital Requirements. The National Association of Insurance Commissioners has adopted a formula and model law to implement risk based capital requirements for most property and casualty insurance companies, which are designed to determine minimum capital requirements and to raise the level of protection that statutory surplus provides for policyholder obligations. The risk based capital formula for property and casualty insurance companies measures three major areas of risk facing property and casualty insurers:
•underwriting, which encompasses the risk of adverse loss developments and inadequate pricing;
•declines in asset values arising from market and/or credit risk; and
•off-balance sheet risk arising from adverse experience from non-controlled assets, guarantees for affiliates or other contingent liabilities and reserve and premium growth.
Under Massachusetts law, insurers having less total adjusted capital than that required by the risk based capital calculation will be subject to varying degrees of regulatory action, depending on the level of capital inadequacy.
The risk based capital law provides for four levels of regulatory action. The extent of regulatory intervention and action increases as the level of total adjusted capital to risk based capital falls. The first level, the company action level, as defined by the National Association of Insurance Commissioners, requires an insurer to submit a plan of corrective actions to the Commissioner if total adjusted capital falls below 200% of the risk based capital amount. The regulatory action level, as defined by the National Association of Insurance Commissioners requires an insurer to submit a plan containing corrective actions and requires the Commissioner to perform an examination or other analysis and issue a corrective order if total adjusted capital falls below 150% of the risk based capital amount. The authorized control level, as defined by the National Association of Insurance Commissioners, authorizes the Commissioner to take whatever regulatory actions he or she considers necessary to protect the best interest of the policyholders and creditors of the insurer which may include the actions necessary to cause the insurer to be placed under regulatory control, i.e., rehabilitation or liquidation, if total adjusted capital falls below 100% of the risk based capital amount. The fourth action level is the mandatory control level, as defined by the National Association of Insurance Commissioners, which requires the Commissioner to place the insurer under regulatory control if total adjusted capital falls below 70% of the risk based capital amount.
The formulas have not been designed to differentiate among adequately capitalized companies that operate with higher levels of capital. Therefore, it is inappropriate and ineffective to use the formulas to rate or to rank these companies. At December 31, 2004, our Insurance Subsidiaries had total adjusted capital in excess of amounts requiring company or regulatory action at any prescribed risk based capital action level.
Regulation of Private Passenger Automobile Insurance in Massachusetts. Our principal line of business is Massachusetts private passenger automobile insurance. As described in more detail above under "B. The Massachusetts Property and Casualty Insurance Market", regulation of private passenger automobile insurance in Massachusetts differs significantly from how this line of insurance is regulated in other states. These differences include the requirements that the premium rate we and all insurers must charge is fixed and established by the Commissioner, that our ability and that of our competitors to deviate from the rate set by the Commissioner is restricted, and that some of our insurance producers are assigned to us as a matter of law. See "B. The Massachusetts Property and Casualty Insurance Market", as discussed above.
ITEM 2.
ITEM 2. PROPERTIES
We conduct almost all of our operations in approximately 89,099 square feet of leased space at 20 Custom House Street in downtown Boston, Massachusetts. Our lease expires in December 2008.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Our Insurance Subsidiaries are parties to a number of lawsuits arising in the ordinary course of their insurance business. We believe that the ultimate resolution of these lawsuits will not, individually or in the aggregate, have a material adverse effect on our financial condition. Other than these lawsuits, we are not involved in any legal proceedings.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of the Company's shareholders during the fourth quarter of 2004.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The table below sets forth certain information concerning our directors and executive officers as of the date of this annual report.
David F. Brussard was appointed Chairman of the Board in March 2004 and President and Chief Executive Officer ("CEO") in June 2001. Mr. Brussard has served as a Director of the Company since October 2001. Since January 1999, Mr. Brussard has been the CEO and President of the Insurance Subsidiaries. Previously, Mr. Brussard served as Executive Vice President of the Insurance Subsidiaries from 1985 to 1999 and as Chief Financial Officer and Treasurer of the Insurance Subsidiaries from 1979 to 1999. Mr. Brussard has been employed by one or more of our subsidiaries for over 29 years. Mr. Brussard is also a member of the governing committee, budget committee, executive committee and nominating committee of the Automobile Insurers Bureau and is Vice Chairman of the Governing Committee, Chairman of the Governing Committee Review Panel, and a member of the Actuarial Committee of CAR. Mr. Brussard is also on the Board of Trustees of the Insurance Library Association of Boston.
William J. Begley, Jr. was appointed Chief Financial Officer, Vice President and Secretary of the Company on March 4, 2002. Since January 1999, Mr. Begley has been the Chief Financial Officer and Treasurer of the Insurance Subsidiaries. Previously, Mr. Begley served as Assistant Controller of the Insurance Subsidiaries from 1985 to 1987, as Controller from 1987 to 1990 and as Assistant Vice President/Controller from 1990 to 1999. Mr. Begley has been employed by the Insurance Subsidiaries for over 19 years. Mr. Begley also serves on the audit committee of CAR.
Daniel F. Crimmins was appointed Vice President of Marketing of the Company on March 4, 2002. Mr. Crimmins has served as Vice President of Marketing of the Insurance Subsidiaries since 1985 and has been employed by the Insurance Subsidiaries for over 20 years. Mr. Crimmins has over 44 years of experience in the insurance industry. Mr. Crimmins is a member of the market review committee of CAR.
Robert J. Kerton was appointed Vice President of Casualty Claims of the Company on March 4, 2002. Mr. Kerton has served as Vice President of Casualty Claims of the Insurance Subsidiaries since 1986 and has been employed by the Insurance Subsidiaries for over 18 years. Mr. Kerton previously served 18 years with Allstate Insurance Company in various Massachusetts claim management assignments. Mr. Kerton serves as Chairman of the Automobile Insurers Bureau claims committee, vice chairman of the CAR claims committee and on the governing board of the Massachusetts Insurance Fraud Bureau.
David E. Krupa was appointed Vice President of Property Claims of the Company on March 4, 2002. Mr. Krupa has served as Vice President of Property Claims of the Insurance Subsidiaries since July 1990 and has been employed by the Insurance Subsidiaries for over 22 years. Mr. Krupa was first employed by the Company in 1982 and held a series of management positions in the Claims Department before being appointed Vice President in 1990. In addition, Mr. Krupa has been a member of several claims committees both at the Automobile Insurers Bureau and CAR.
Daniel D. Loranger was appointed Vice President of Management Information Systems of the Company on March 4, 2002. Mr. Loranger has served as Vice President of Management Information Systems and Chief Information Officer of the Insurance Subsidiaries since 1980 and has been employed by the Insurance Subsidiaries for over 24 years. Mr. Loranger began his data processing career with Raytheon Manufacturing in 1960. BEYOND COMPUTING MAGAZINE awarded Mr. Loranger the first place 2000 Partnership Award for the strategic alliance of technology with the Company's business objectives and for development of internal software for the Company.
Edward N. Patrick, Jr. was appointed Vice President of Underwriting of the Company on March 4, 2002. Mr. Patrick has served as Vice President of Underwriting of the Insurance Subsidiaries since 1979 and as Secretary since 1999. He has been employed by one or more of our subsidiaries for over 31 years. Mr. Patrick has served on several committees of CAR, including the market review, servicing carrier, statistical, automation and reinsurance operations committees. Mr. Patrick has also served on the CAR operations committee since 1984 and has served as its chairman since 1998.
A. Richard Caputo, Jr. has served as a director of the Company since June 2001. Mr. Caputo is a Senior Principal and was a Managing Director of The Jordan Company L.P. and its predecessors, a private investment firm, since 1990. Mr. Caputo is also a director of TAL International, Inc., Universal Technical Institute, Inc. and various privately held companies.
Frederic H. Lindeberg has served as a director of the Company since August 2004. Mr. Lindeberg has had a consulting practice providing taxation, management and investment counsel since 1991, focusing on finance, real estate, manufacturing and retail industries. Mr. Lindeberg retired in 1991 as Partner-In-Charge of various KPMG tax offices, after 24 years of service where he provided both accounting and tax counsel to various clients. Mr. Lindeberg was formerly an adjunct professor at Penn State Graduate School of Business. Mr. Lindeberg is currently a trustee of Provident Senior Living Trust.
Peter J. Manning has served as a director of the Company since September 2003. Mr. Manning retired in 2003 as Vice Chairman of FleetBoston Financial, after thirty-one years with FleetBoston Financial Corporation (formerly BankBoston) where he also held the positions of Comptroller and Executive Vice President and Chief Financial Officer. Mr. Manning started his career with Coopers &
Lybrand in 1962 prior to his 1972 employment with BankBoston. He currently is a director of Thermo Electron, Papa Gino's, and various non-profit companies and is Chairman of the Board of the Tournament Players Club of Boston.
David K. McKown has served as director of the Company since November 2002. Mr. McKown has been a Senior Advisor to Eaton Vance Management since 2000, focusing on business origination in real estate and asset-based loans. Mr. McKown retired in March 2000 having served as a Group Executive with BankBoston since 1993, where he focused on acquisitions and high-yield bank debt financings. Mr. McKown has been in the banking industry for 41 years, worked for BankBoston for over 32 years and had previously been the head of BankBoston's real estate department, corporate finance department, and a managing director of BankBoston's private equity unit. Mr. McKown is currently a trustee of Equity Office Properties Trust, and a director of Newcastle Investment Corp. and various privately held companies.
PART II.
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
As of March 15, 2005, there were 73 holders of record of the Company's common stock, par value $0.01 per share, not including stock held in "Street Name".
The Company's common stock (symbol: SAFT) is listed on the NASDAQ National Market. The following table shows the quarterly range of the daily high and low sales prices per share during the past nine quarters in 2004, 2003 and 2002 that we have been public:
The closing price of the Company's common stock on March 15, 2005 was $36.74 per share.
During 2004 the Company declared and paid four quarterly cash dividends to stockholders, which totaled $6,767. The Company's Board of Directors declared a quarterly cash dividend on February 17, 2005 of $0.12 per share to stockholders of record on March 1, 2005, payable on March 15, 2005. The Company plans to continue to declare and pay quarterly cash dividends in 2005, depending on the Company's financial position and the regularity of its cash flows. See 2004 and 2003 dividend information on page 48.
The Company relies on dividends from its Insurance Subsidiaries for a portion of its cash requirements. The payment by the Company of any cash dividends to the holders of common stock therefore depends on the receipt of dividend payments from its Insurance Subsidiaries. The payment of dividends by the Insurance Subsidiaries is subject to limitations imposed by Massachusetts law, as discussed in Item 1.O., Business, Supervision and Regulation, "Insurance Regulation Concerning Dividends", and also in Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, Liquidity and Capital Resources.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth our selected historical consolidated financial data as of and for each of the five years ended December 31, 2004. Prior to October 16, 2001, Thomas Black Corporation was the ultimate parent company of Safety Insurance. In the Acquisition, on October 16, 2001, Safety Insurance Group, Inc. became the parent company of Thomas Black Corporation.
The selected historical consolidated financial data for the years ended December 31, 2004, 2003 and 2002 and as of December 31, 2004 and 2003 have been derived from the financial statements of Safety Insurance Group, Inc. included in this annual report which have been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm. The selected historical consolidated financial data as of December 31, 2002 and 2001 and for the successor period October 16, 2001 to December 31, 2001 and for the predecessor period January 1, 2001 to October 15, 2001 have been derived from Safety Insurance Group, Inc.'s consolidated financial statements not included in this
annual report, which have been audited by PricewaterhouseCoopers LLP. The selected historical consolidated financial data for the year ended December 31, 2000 and as of December 31, 2000 have been derived from Thomas Black Corporation's consolidated financial statements not included in this annual report, which have been audited by PricewaterhouseCoopers LLP. As a result of the Acquisition, financial data for periods prior to the Acquisition may not be comparable with financial data for periods following the Acquisition.
We have prepared the selected historical consolidated financial data, other than statutory data, in conformity with U. S. generally accepted accounting principles ("GAAP"). We have derived the statutory data from the annual statements of our Insurance Subsidiaries filed with insurance regulatory authorities, which were prepared in accordance with statutory accounting practices, which vary in certain respects from GAAP.
The selected financial data presented below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and the accompanying notes included in this Form 10-K in order to more fully understand the historical consolidated financial data.
(1)In this financial presentation, the financial data for 2001 has been split into a predecessor period from January 1, 2001 to October 15, 2001 and a successor period from October 16, 2001 to December 31, 2001.
(2)Our transaction expenses reflect the costs we incurred in connection with our October 16, 2001 acquisition of TBC. Please refer to our 2003 Annual Report on Form 10-K, "Management's Discussion and Analysis of Financial Condition and Results of Operations-The Acquisition" for further information.
(3)The loss ratio is the ratio of losses and loss adjustment expenses to net earned premiums. The expense ratio, when calculated on a statutory accounting basis, is the ratio of underwriting expenses to net written premiums, and when calculated on a GAAP basis is the ratio of underwriting expense to net earned premiums. The combined ratio is the sum of the loss ratio and the expense ratio. Please refer to page 36 for a discussion on the comparison of the above statutory insurance ratios to our GAAP ratios.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our accompanying consolidated financial statements and notes thereto, which appear elsewhere in this document. In this discussion, all dollar amounts are presented in thousands, except share and per share data.
The following discussion contains forward-looking statements. We intend statements which are not historical in nature to be, and are hereby identified as "forward-looking statements" to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. In addition, the Company's senior management may make forward-looking statements orally to analysts, investors, the media and others. This safe harbor requires that we specify important factors that could cause actual results to differ materially from those contained in forward-looking statements made by or on behalf of us. We cannot promise that our expectations in such forward-looking statements will turn out to be correct. Our actual results could be materially different from and worse than our expectations. See "Forward-Looking Statements" on page 49 for specific important factors that could cause actual results to differ materially from those contained in forward-looking statements.
Executive Summary and Overview
In this discussion, "Safety" refers to Safety Insurance Group, Inc. and "our Company," "we," "us" and "our" refer to Safety Insurance Group, Inc. and its consolidated subsidiaries. Our subsidiaries consist of Safety Insurance Company ("Safety Insurance"), Safety Indemnity Insurance Company, Thomas Black Insurance Agency, Inc. ("TBIA") and RBS, Inc., TBIA's holding company.
We are a leading provider of private passenger automobile insurance in Massachusetts. In addition to private passenger automobile insurance (which represented 81.0% of our direct written premiums in 2004), we offer a portfolio of other insurance products, including commercial automobile (10.4% of 2004 direct written premiums), homeowners (7.2% of 2004 direct written premiums), dwelling fire, umbrella and business owner policies. Operating exclusively in Massachusetts through our insurance company subsidiaries, Safety Insurance and Safety Indemnity Insurance Company (together referred to as the "Insurance Subsidiaries"), we have established strong relationships with 556 independent insurance agents in 659 locations throughout Massachusetts. We have used these relationships and our extensive knowledge of the Massachusetts market to become the second largest private passenger automobile insurance carrier in Massachusetts, capturing an approximate 11.0% share of the Massachusetts private passenger automobile market in 2004, according to the CAR Cession Volume Analysis Report of March 1, 2005, based on automobile exposures. These statistics total, for each vehicle insured, the number of months during the year insurance for that vehicle is in effect, to arrive at an aggregate number of car-months for each insurer; this aggregate number, divided by 12, equals the insurer's number of car-years, a measure we refer to in this Form 10-K as automobile exposures.
Massachusetts Automobile Insurance Market
We are subject to the extensive regulation of the private passenger automobile insurance industry in Massachusetts, which represented 81.0% of our direct written premiums in 2004. Owners of registered automobiles in Massachusetts are required to maintain minimum automobile insurance coverages. We are required to participate in a state-mandated reinsurance program run by Commonwealth Automobile Reinsurers ("CAR") to which we cede certain unprofitable risks and from which we are allocated a portion of the overall losses. CAR is, with few exceptions, required by law to issue a policy to any applicant who seeks it. As a servicing carrier of CAR, this requirement applies to us. This program operates at an underwriting deficit. This deficit is allocated among every Massachusetts automobile insurance company, including us, based on a complex formula that takes into consideration a company's voluntary market share, the rate at which it cedes business to CAR, and the
company's utilization of a credit system CAR has designed to encourage carriers to reduce their use of CAR. In addition, based on our market share, we are assigned certain licensed producers by CAR that have been unable to obtain a voluntary contract with another insurer. We call these agents Exclusive Representative Producers, or ERPs.
On April 29, 2004, the Governor of Massachusetts (the "Governor") announced the formation of a bipartisan task force charged with reviewing potential changes to the Massachusetts personal automobile insurance system that, according to the Governor's announcement, "will open the door to more competition, move to a rate-setting system that is more in line with the rest of the country, examine the costs and benefits of our current "no fault' claims process, crack down on fraud and eliminate the subsidy that good drivers pay for bad drivers." The Governor also announced "that the Division of Insurance has taken the first steps toward reform by pushing for changes in the distribution of losses generated by high-risk drivers." As a result, in a letter to CAR dated April 29, 2004 (attached as Exhibit 99.1 to our March 31, 2004 Form 10-Q filed with the SEC on May 10, 2004) the Massachusetts Insurance Commissioner (the "Commissioner") directed CAR to materially change the operation of the residual market in Massachusetts, including the formula by which CAR's deficit is allocated and the manner in which policies produced by ERPs are assigned to insurers.
On December 31, 2004, the Commissioner approved new rules for CAR, which became effective on January 1, 2005 (the "Approved Rules"). The Approved Rules replace CAR with an assigned insurance plan, the "Massachusetts Assigned Insurance Plan" (the "MAIP"), similar to those employed in 42 other states. The Approved Rules consist of two parts. One part applies to the operation of the MAIP, which will be phased in during 2006 and 2007 and which will fully replace CAR beginning January 1, 2008. The MAIP will provide for random and equitable distribution to companies of risks unable to obtain insurance in the voluntary market. The second part of the Approved Rules consists of a series of transition rules that are scheduled to take effect in 2005, 2006 and 2007. The Approved Rules include the following provisions:
•The ERP financial burden will be distributed amongst all companies in a manner that ensures that each company's share of the ERP burden is proportional to its voluntary agent market share.
•Starting in 2005:
•Companies with more than 2% of the market are required to be servicing carriers for CAR.
•On February 1, 2005 CAR will redistribute ERPs amongst the 12 largest companies such that:
•Each company will have an equitable share or number of ERP policies, and
•Each company's ERP policies will produce similar loss ratios to ensure equitable financial results of the ERP burden.
•Starting in 2006:
•A transition to the MAIP will commence.
•Producers will have real time access to the MAIP for assigning a risk to a company and issuing a policy.
•Risks that are accident and violation free during the prior three years (so called "Clean in 3") are not eligible for placement in MAIP.
•Beginning January 1, 2006, new business will be eligible for the MAIP.
•Starting in 2007:
•Beginning January 1, 2007, renewal business will be eligible for the MAIP.
•Starting in 2008:
•Beginning January 1, 2008, the MAIP replaces CAR as the method of distributing residual market risks and apportioning the residual market burden to companies in Massachusetts.
On January 14, 2005, we filed, on Form 8-K, an estimate of the financial impact the Approved Rules may have on us and we stated that a lawsuit had been filed in Suffolk Superior Court by Commerce Insurance Company against the Commissioner that seeks an order permanently enjoining implementation and/or enforcement of the Approved Rules. Certain ERPs, Arbella Mutual Insurance Company and the Center for Insurance Research have intervened as plaintiffs and CAR has intervened as a defendant in this lawsuit. On February 1, 2005 the Court issued an order approving a motion by the ERP plaintiffs that stayed the Approved Rules pending a final decision in this lawsuit. The Massachusetts Supreme Judicial Court has denied a request by the Commissioner to consider this lawsuit on an expedited basis.
CAR annually approves the rules that set the value of credits and the cost to cede business. On March 9, 2005, CAR approved rules for the operation of the residual market for 2005 (the "2005 Rules"), and has subsequently sought clarification from the Suffolk Superior Court that the stay of the Approved Rules does not otherwise affect CAR's ability to implement the 2005 Rules. The 2005 Rules revise the value of credits based on the actual rate subsidies contained in the Commissioner's rate decision, and reduce the cost for ceding high loss ratio ERP business to CAR. The 2005 Rules would reduce the penalty in the current rules for ceding high loss ratio ERP business to CAR, and would therefore result in a reduction of the expense we incur because of our disproportionate share of high loss ratio ERP business. At the present time, we are unable to predict the outcome of the litigation surrounding the Approved Rules or the clarification sought by CAR regarding the 2005 Rules.
Each year, the Commissioner sets maximum premium rates that may be charged and minimum commissions that must be paid to agents for private passenger automobile insurance. The Commissioner announced on December 15, 2004 a 1.7% statewide average private passenger automobile insurance rate decrease for 2005, as compared to a 2.5% increase for 2004 and a 2.7% increase for 2003. Coinciding with the 2005 rate decision, the Commissioner also approved a 10.9% commission rate agents receive for selling private passenger automobile insurance, as a percentage of premiums, as compared to a commission rate of 10.5% in 2004, and 11.0% in 2003.
While state-mandated average maximum private passenger automobile insurance rates increased 2.5% for 2004, our average premium per automobile exposure in the year ended December 31, 2004 increased from the year ended December 31, 2003 by approximately 6.1%. This increase was primarily the result of purchases of new automobiles by our insureds. We believe that the continued benefits of our rate pursuit initiative, which validates insured rating classifications and discount eligibility, contributed to the increase in our average premiums received per automobile exposure. The table below shows average Massachusetts-mandated private passenger automobile premium rate changes and changes in our average premium per automobile exposure from 1995-2004.
Massachusetts Private Passenger Rate Decisions
(1)Source: Commissioner rate decisions for 1995 - 2004. (2)Source: Safety Insurance. Statutory Accounting Principles
Our results are reported in accordance with GAAP, which differ from amounts reported in accordance with statutory accounting principles ("SAP") as prescribed by insurance regulatory authorities. Specifically, under GAAP:
•Policy acquisition costs such as commissions, premium taxes and other variable costs incurred in connection with writing new and renewal business are capitalized and amortized on a pro rata basis over the period in which the related premiums are earned, rather than expensed as incurred, as required by SAP.
•Certain assets are included in the consolidated balance sheets whereas, under SAP, such assets are designated as "nonadmitted assets," and charged directly against statutory surplus. These assets consist primarily of premium receivables that are outstanding over 90 days, federal deferred tax assets in excess of statutory limitations, furniture, equipment, leasehold improvements and prepaid expenses.
•Amounts related to ceded reinsurance are shown gross as prepaid reinsurance premiums and reinsurance recoverables, rather than netted against unearned premium reserves and loss and loss adjustment expense reserves, respectively, as required by SAP.
•Fixed maturities securities, which are classified as available-for-sale, are reported at current market values, rather than at amortized cost, or the lower of amortized cost or market, depending on the specific type of security, as required by SAP.
•Equity securities are reported at quoted market values, which may differ from the National Association of Insurance Commissioners market values as required by SAP.
•The differing treatment of income and expense items results in a corresponding difference in federal income tax expense. Changes in deferred income taxes are reflected as an item of income tax benefit or expense, rather than recorded directly to surplus as regards policyholders, as required by SAP. Admittance testing may result in a charge to unassigned surplus for non-admitted portions of deferred tax assets. Under GAAP reporting, a valuation allowance may be recorded against the deferred tax asset and reflected as an expense.
Insurance Ratios
The property and casualty insurance industry uses the combined ratio as a measure of underwriting profitability. The combined ratio is the sum of the loss ratio (losses and loss adjustment expenses incurred as a percent of net earned premiums) plus the expense ratio (underwriting expenses as a percent of net written premiums, if calculated on a SAP basis, or net earned premiums, if calculated on a GAAP basis). The combined ratio reflects only underwriting results, and does not include income from investments or finance and other service income. Underwriting profitability is subject to significant fluctuations due to competition, catastrophic events, weather, economic and social conditions and other factors.
Our statutory insurance ratios are outlined in the following table:
Under GAAP, the loss ratio is computed in the same manner as under SAP, but the expense ratio is determined by matching underwriting expenses to the period over which net premiums were earned, rather than to the period that net premiums were written. Our GAAP insurance ratios are outlined in the following table:
Stock-Based Compensation
On June 25, 2002, the Board adopted the 2002 Management Omnibus Incentive Plan (the "Incentive Plan"). The Incentive Plan provides for a variety of awards, including nonqualified stock options ("NQSOs"), stock appreciation rights and restricted stock ("RS") awards. The maximum number of shares of common stock with respect to which awards may be granted under the Incentive Plan is 1,250,000. On December 31, 2004, there were 298,529 shares available for future grant. The Board and the Compensation Committee intend to issue more awards under the Incentive Plan in the future. Grants outstanding under the Incentive Plan as of December 31, 2004 were comprised of 70,271
restricted shares and 711,410 nonqualified stock options. Grants made under the Incentive Plan are as follows:
(1)The exercise price of the options grant effective on November 27, 2002 is equal to the IPO price of our stock on that same day. The exercise price of the remaining option grants is equal to the closing price of our common stock on the grant effective date.
(2)The fair value of the restricted stock grant is equal to the closing price of our common stock on the grant effective date.
Reinsurance
We reinsure with other insurance companies a portion of our potential liability under the policies we have underwritten, thereby protecting us against an unexpectedly large loss or a catastrophic occurrence that could produce large losses, primarily in our homeowners line of business. As of January 1, 2005 our catastrophe reinsurance provides gross per occurrence reinsurance coverage up to $250,000. This catastrophe reinsurance protects us in the event of a "426-year storm" (that is, a storm of a severity expected to occur once in a 426-year period). Swiss Re, our primary reinsurer, maintains an A.M. Best rating of "A+" (Superior). All of our other reinsurers have an A.M. Best rating of "A" (Excellent) or better. We are a participant in CAR, a state-established body that runs the residual market reinsurance programs for both private passenger and commercial automobile insurance in Massachusetts under which premiums, expenses, losses and loss adjustment expenses on ceded business are shared by all insurers writing automobile insurance in Massachusetts. We also participate in the Massachusetts Property Insurance Underwriting Association in which premiums, expenses, losses and loss adjustment expenses on homeowners business that cannot be placed in the voluntary market are shared by all insurers writing homeowners insurance in Massachusetts. As of December 31, 2004, we had no material amounts recoverable from any reinsurer, excluding the residual markets described above.
Effects of Inflation
We do not believe that inflation has had a material effect on our consolidated results of operations, except insofar as inflation may affect interest rates.
Critical Accounting Policies
Loss and Loss Adjustment Expense Reserves.
Significant periods of time can elapse between the occurrence of an insured loss, the reporting to us of that loss and our final payment of that loss. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities. Our reserves represent estimates of amounts needed to pay reported and unreported losses and the expenses of investigating and paying those losses, or loss
adjustment expenses. Every quarter, we review our previously established reserves and adjust them, if necessary.
When a claim is reported, claims personnel establish a "case reserve" for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon an evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the loss. The estimate reflects the informed judgment of such personnel based on general insurance reserving practices and on the experience and knowledge of the claims person. During the loss adjustment period, these estimates are revised as deemed necessary by our claims department based on subsequent developments and periodic reviews of the cases.
In accordance with industry practice, we also maintain reserves for estimated losses incurred but not yet reported. Incurred but not yet reported reserves are determined in accordance with commonly accepted actuarial reserving techniques on the basis of our historical information and experience. We review and make adjustments to incurred but not yet reported reserves quarterly.
When reviewing reserves, we analyze historical data and estimate the impact of various loss development factors, such as our historical loss experience and that of the industry, trends in claims frequency and severity, our mix of business, our claims processing procedures, legislative enactments, judicial decisions, legal developments in imposition of damages, and changes and trends in general economic conditions, including the effects of inflation. A change in any of these factors from the assumption implicit in our estimate can cause our actual loss experience to be better or worse than our reserves, and the difference can be material. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors. Establishment of appropriate reserves is an inherently uncertain process, and currently established reserves may not prove adequate in light of subsequent actual experience. To the extent that reserves are inadequate and are strengthened, the amount of such an increase is treated as a charge to earnings in the period that the deficiency is recognized. To the extent that reserves are redundant and are released, the amount of the release is a credit to earnings in the period the redundancy is recognized. We do not discount reserves.
The changes we have recorded in our reserves in the past three years illustrate the uncertainty of estimating reserves. Primarily due to an improvement in CAR results, our prior year reserves decreased by $6,778 for the year ended December 31, 2004 as compared to the increase of $181 for 2003 and the decrease of $2,262 for 2002. The $6,778 decrease in our prior year reserves resulted from re-estimations of prior year accident year ultimate loss and LAE liabilities and is composed of a reduction of $2,523 in our homeowners reserves, a reduction of $6,854 in CAR assumed reserves, a reduction of $329 in FAIR Plan assumed reserves and an increase of $2,928 in our automobile reserves. It is not appropriate to extrapolate future favorable or unfavorable development of reserves from this past experience.
For further information, see "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations: Losses and Loss Adjustment Expenses."
Other-Than-Temporary Impairments.
We use a systematic methodology to evaluate declines in market values below cost or amortized cost of our investments. This methodology ensures that we evaluate available evidence concerning any declines in a disciplined manner.
In our determination of whether a decline in market value below amortized cost is an other-than-temporary impairment, we consider and evaluate several factors and circumstances including the issuer's overall financial condition, the issuer's credit and financial strength ratings, a weakening of the general market conditions in the industry or geographic region in which the issuer operates, a prolonged period (typically six months or longer) in which the fair value of an issuer's securities remains below our amortized cost, our ability and intent to hold these investments for a period of time sufficient to allow for recovery of our costs, and any other factors that may raise doubt about the issuer's ability to continue as a going concern.
We record other-than-temporary impairments as realized losses, which serve to reduce net income and earnings per share. We record temporary losses as unrealized losses, which do not impact net income and earnings per share but reduce other comprehensive net income. The risks inherent in our assessment of other-than-temporary impairments include the risk that market factors may differ from our expectations, or that the credit assessment could change in the near term, resulting in a charge to earnings.
For further information, see "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations: Net Realized Investment Losses."
Results of Operations
The following table shows certain of our selected financial results:
YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED DECEMBER 31, 2003
Direct Written Premiums. Direct written premiums for the year ended December 31, 2004 increased by $56,750, or 9.9%, to $628,295 from $571,545 for 2003. The 2004 increase occurred primarily in our personal automobile line, which experienced a 6.1% increase in average written premium and a 3.5% increase in written exposures. In addition, our commercial automobile line's average written premium increased by 6.0%, while we had a 5.6% increase in written exposures. Our homeowners line average written premium increased by 8.3%, which was partly offset by a 1.7% decrease in written exposures.
Net Written Premiums. Net written premiums for the year ended December 31, 2004 increased by $51,953, or 9.2%, to $618,923 from $566,970 for 2003. This was primarily due to the increase in direct written premiums.
Net Earned Premiums. Net earned premiums for the year ended December 31, 2004 increased by $52,044, or 9.6%, to $592,292 from $540,248 for 2003. This was primarily due to the factors that increased direct written premiums, including increased premium rates on personal automobile, commercial automobile and homeowners product lines.
Net Investment Income. Investment income for the year ended December 31, 2004 was $27,259 compared to $26,086 for 2003. Average cash and investment securities (at amortized cost) increased by $95,645, or 15.0%, to $734,576 for the year ended December 31, 2004 from $638,931 for 2003 due to a $53,491 increase in average cash and a $42,154 increase in average securities. Net effective yield on the investment portfolio decreased to 3.7% during the year ended December 31, 2004 from 4.1% during 2003 due to management's investment strategy to shorten the portfolio duration, shift to higher rated securities, and increase tax-exempt holdings. Our duration decreased to 3.4 years at December 31, 2004 from 4.2 years at December 31, 2003.
Net Realized Gains on Investments. Net realized gains on investments decreased to $1,274 for the year ended December 31, 2004 from $10,051 for 2003.
The gross unrealized appreciation (depreciation) of investments in fixed maturity securities, including redeemable preferred stocks that have characteristics of fixed maturities, and equity securities, was as follows:
(1)Obligations of U.S. Government agencies include collateralized mortgage obligations issued, guaranteed and/or insured by the following issuers: Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC) and Federal National Mortgage Association (FNMA). The total of these fixed maturity securities was $120,636 at fair value and $120,729 at amortized cost as of December 31, 2004. As such, the asset-backed securities presented exclude such issuers already presented under U.S. Treasury securities and obligations of U.S. Government Agencies. As of December 31, 2004, our portfolio of fixed maturity investments was comprised entirely of investment grade corporate fixed maturity securities, U.S. government and agency securities and asset-backed securities (i.e., all our securities received a rating assigned by Moody's Investors Service, Inc. of Baa or higher, except the few securities not rated by Moody's which received S&P ratings of AA/A or higher, as well as a rating assigned by the Securities Valuation Office of the National Association of Insurance Commissioners of 1 or 2).
The composition of our fixed income security portfolio by Moody's rating was as follows:
Ratings are assigned by Moody's, or the equivalent, as discussed above. Such ratings are generally assigned upon the issuance of the securities and are subject to revision on the basis of ongoing evaluations. Ratings in the table are as of the date indicated.
In our determination of other-than-temporary impairments, we consider several factors and circumstances including the issuer's overall financial condition, the issuer's credit and financial strength ratings, a weakening of the general market conditions in the industry or geographic region in which the issuer operates, a prolonged period (typically six months or longer) in which the fair value of an issuer's securities remains below our amortized cost, our ability and intent to hold these investments for a period of time sufficient to allow for recovery of our costs, and any other factors that may raise doubt about the issuer's ability to continue as a going concern.
Other-than-temporary impairments are recorded as realized losses, which serve to reduce net income and earnings per share. Temporary losses are recorded as unrealized losses, which do not impact net income and earnings per share but reduce other comprehensive net income. The risks inherent in the assessment of other-than-temporary impairments include the risk that market factors may differ from our expectations; we may decide to subsequently sell a security for unforeseen business needs; or the credit assessment could change in the near term, resulting in a charge to earnings.
The following table illustrates the gross unrealized losses included in the Company's investment portfolio and the fair value of those securities, aggregated by investment category. The table also illustrates the length of time that they have been in a continuous unrealized loss position as of December 31, 2004.
The unrealized losses recorded on the fixed maturity investment portfolio at December 31, 2004 resulted from fluctuations in market interest rates as opposed to fundamental changes in the credit quality of the issuers of such securities. Therefore, these decreases in values are viewed as being temporary as we have the intent and ability to retain such investments for a period of time sufficient to allow for recovery in market value.
Of the $2,967 gross unrealized losses as of December 31, 2004, $2,269 relates to fixed maturity obligations of states and political subdivisions and U.S. government agencies. The remaining $698 of gross unrealized losses relates primarily to holdings of investment grade asset-backed, corporate and other fixed maturity securities.
During the year ended December 31, 2004, there was no significant deterioration in the credit quality of any of the Company's holdings and no other-than-temporary impairment charges were recorded related to the Company's portfolio of investment securities. However, during the year ended December 31, 2003, there was a significant deterioration in the credit quality of one of the Company's holdings, Continental Airlines. Accordingly, during the first quarter of 2003, the Company recorded an other-than-temporary impairment of $837 for this security. During May 2003, this security was sold at a realized gain of $426.
Finance and Other Service Income. Finance and other service income includes revenues from premium installment charges, which we recognize when earned, and other miscellaneous income and fees. Finance and other service income for the year ended December 31, 2004 remained constant at $15,615 compared to $15,409 for the 2003 period. This resulted from increases in premium installment billing fees due to growth in the number of policies and the fee charged per policy, offset by decreases in miscellaneous income from CAR.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred for the year ended December 31, 2004 increased $4,092, or 1.0%, to $425,061 from $420,969 for the comparable 2003 period. Our GAAP loss ratio for the year ended December 31, 2004 decreased to 71.8% compared to 77.9% for the comparable 2003 period. Our GAAP loss ratio excluding loss adjustment expenses for the year ended December 31, 2004 decreased to 64.6% from 70.2% for the comparable 2003 period. The 2004 decrease in our GAAP loss ratios is primarily due to an increase in average written premium, a decrease in claim frequency in our personal automobile, commercial automobile and homeowners lines of business and favorable loss development primarily due to an improvement in prior year CAR results.
Underwriting, Operating and Related Expenses. Underwriting, operating and related expense for the year ended December 31, 2004 increased by $14,439, or 11.1%, to $145,075 from $130,636 for the comparable 2003 period. Our GAAP expense ratios for the year ended December 31, 2004 increased to 24.5% compared to 24.2% for the comparable 2003 periods.
Interest Expenses. Interest expense for the year ended December 31, 2004 was $672 compared to $646 for the comparable 2003 period.
Income Tax Expense. Our effective tax rates were 31.5% and 28.0% for the year ended December 31, 2004 and 2003, respectively. These effective rates were lower than the statutory rate of 35% primarily due to adjustments for tax-exempt investment income. The increase in the effective tax rate during 2004 was due to a reduced level of annual estimated tax-exempt interest relative to annual estimated income before taxes in the current period. Additionally, our effective tax rate for the year ended December 31, 2004 was adversely impacted by an adjustment of $544 related to an increase in a previously established valuation allowance against state deferred tax assets from 80% to a full 100% of the asset.
Net Income. Net income for the year ended December 31, 2004 increased by $16,508, or 58.0%, to $44,990 from $28,482 for the comparable 2003 period. These increases in net income during 2004 are a result of decreases in the loss ratios, which are due to an increase in average written premium and a decrease in claim frequency in our personal automobile, commercial automobile and homeowners lines of business.
YEAR ENDED DECEMBER 31, 2003 COMPARED TO YEAR ENDED DECEMBER 31, 2002
Direct Written Premiums. Direct written premiums for the year ended December 31, 2003 increased by $54,989, or 10.6%, to $571,545 from $516,556 for the comparable 2002 period. The 2003 increase occurred primarily in our private passenger automobile line which experienced a 6.9% increase in average written premium and a 2.8% increase in written exposures. In addition, we increased our commercial automobile line average rates by 7.1% effective December 16, 2002 and had a 6.9% increase in written exposures, while we increased our homeowners line average rates by 9.3% effective February 19, 2003, which was partly offset by a 2.4% decrease in written exposures.
Net Written Premiums. Net written premiums for the year ended December 31, 2003 increased by $49,356, or 9.5%, to $566,970 from $517,614 for the comparable 2002 period. This was primarily due to an increase in direct written premiums, partly offset by an increase in premiums ceded to CAR.
Net Earned Premiums. Net earned premiums for the year ended December 31, 2003 increased by $50,992, or 10.4%, to $540,248 from $489,256 for the comparable 2002 period. This was primarily due to increased rates on private passenger automobile, commercial automobile and homeowners product lines.
Net Investment Income. Investment income for the year ended December 31, 2003 decreased to $26,086 from $26,142 for the comparable 2002 period. Average cash and investment securities (at amortized cost) increased by $79,008 or 14.1% to $638,931 for the year ended December 31, 2003 from $559,923 for the comparable 2002 period. Offsetting the effect of this increase was a decrease in net effective yield on our investment portfolio to 4.1% from 4.7% during the same period in 2003 due to declining interest rates, as well as a change in management's investment strategy to shorten the portfolio duration, shift to higher rated securities, and increase tax-exempt holdings. Our duration decreased to 4.2 years at December 31, 2003 from 5.0 years at December 31, 2002. In addition, during the third quarter of 2003, a retrospective adjustment was made which decreased investment income by $595 due to a periodic revaluation of our asset-backed securities using revised prepayment assumptions and resulting assumed cash flows associated with the loans underlying these securities.
Net Realized Gains (Losses) on Investments. Net realized gains (losses) on investments for the year ended December 31, 2003 increased to $10,051 gain from $(277) loss for the comparable 2002 period. This increase was primarily due to the sale of certain securities related to our current investment strategy to shorten portfolio duration as protection against future increases in interest rates.
The gross unrealized appreciation (depreciation) of investments in fixed maturities securities was as follows:
(1)Obligations of U.S. Government agencies include collateralized mortgage obligations issued, guaranteed and/or insured by the following issuers: Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), and Federal National Mortgage
Association (FNMA). The total of these fixed maturity securities was $121,833 at fair value and $120,928 at amortized cost as of December 31, 2003. As such, the asset-backed securities presented exclude such issuers already presented under U.S. Treasury securities and obligations of U.S. Government Agencies.
As of December 31, 2003, our portfolio of fixed maturity investments was comprised entirely of investment grade corporate fixed maturities securities, U.S. government and agency securities and asset-backed securities (i.e., all our securities received a rating assigned by Moody's Investors Services, Inc. of Baa or higher, except the few securities not rated by Moody's which received S&P ratings of Aaa/Aa or higher, as well as a rating assigned by the Securities Valuation Office of the National Association of Insurance Commissioners of 1 or 2).
The composition of our fixed income security portfolio by Moody's rating(1) was as follows:
(1)Ratings are assigned by Moody's or the equivalent, as discussed above. Such ratings are generally assigned upon the issuance of the securities and are subject to revision on the basis of ongoing evaluations. Ratings in the table are as of the date indicated. In our determination of other-than-temporary impairments, we consider several factors and circumstances including the issuer's overall financial condition, the issuer's credit and financial strength ratings, a weakening of the general market conditions in the industry or geographic region in which the issuer operates, a prolonged period (typically six months or longer) in which the fair value of an issuer's securities remains below our amortized cost and any other factors that may raise doubt about the issuer's ability to continue as a going concern.
Other-than-temporary impairments are recorded as a realized loss, which serves to reduce net income and earnings per share. Temporary losses are recorded as unrealized losses, which do not impact net income and earnings per share but reduce other comprehensive net income. The risks inherent in the assessment of other-than-temporary impairments include the risk that market factors may differ from our expectations; we may decide to subsequently sell a security for unforeseen business needs; or the credit assessment could change in the near term, resulting in a charge to earnings.
The following table illustrates the gross unrealized losses included in the Company's investment portfolio and the fair value of those securities, aggregated by investment category. The table also
illustrates the length of time that they have been in a continuous unrealized loss position as of December 31, 2003.
The unrealized losses recorded on the fixed maturity investment portfolio at December 31, 2003 resulted primarily from fluctuations in market interest rates as opposed to fundamental changes in the credit quality of the issuers of such securities. Therefore, these decreases in values are viewed as being temporary as we have the intent and ability to retain such investments for a period of time sufficient to allow for recovery in market value.
Of the $1,993 gross unrealized losses as of December 31, 2003, $1,593 relates to fixed maturity obligations of states and political subdivisions and U.S. government agencies. The remaining $400 of gross unrealized losses relates to holdings of investment grade asset-backed, corporate and other fixed maturities securities. Gross unrealized losses increased to $1,993 at December 31, 2003 from $926 at December 31, 2002.
During the last half of 2003 and 2002, there were no significant deteriorations in the credit quality of any of our holdings and no other-than-temporary impairment charges were recorded related to our portfolio of investment securities. However, during the first quarter of 2003 there was a significant deterioration in the credit quality of one of our holdings, Continental Airlines. Accordingly, during the first quarter of 2003 we recorded an other-than-temporary impairment of $837 for this security. During May 2003, this security was sold at a realized gain of $426. In comparison, during the second quarter of 2002 there was a significant deterioration in the credit quality of two of our holdings in the telecommunications sector. We recognized a realized loss of $2,020 for one of these securities, which was sold in June 2002. In addition, we recorded an other-than-temporary impairment charge of $1,043 for the other telecommunications security. During September 2002, this security was sold at a realized loss of $79.
Finance and Other Services Income. Finance and other services income includes revenues from premium installment charges, which we recognize when earned, and other miscellaneous income and fees. Finance and other services income for the year ended December 31, 2003 increased by $1,241, or 8.8%, to $15,409 from $14,168 for the comparable 2002 period. This increase was due to a $1,172 increase in premium installment billing fees due to growth in the number of policies and the fee charged per policy, coupled with a $69 increase in miscellaneous income from CAR.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses incurred for the year ended December 31, 2003 increased $45,791, or 12.2%, to $420,969 from $375,178 for the comparable 2002 period. Our GAAP loss ratio for the year ended December 31, 2003 increased to 77.9% compared to 76.7% for the comparable 2002 period. Our GAAP loss ratio excluding loss adjustment expenses for the year ended December 31, 2003 increased to 70.2% compared to 68.3% for the comparable 2002 period. The 2003 increase in our GAAP loss ratio excluding loss adjustment expenses is primarily due
to increased claim frequency and severity from unusually harsh winter conditions in Massachusetts during the first quarter of 2003 on our homeowners line of business.
Underwriting, Operating and Related Expenses. Underwriting, operating and related expense for the year ended December 31, 2003 increased by $1,770, or 1.4%, to $130,636 from $128,866 for the comparable 2002 period.
Massachusetts law requires that we participate in the Massachusetts Insurers Insolvency Fund, which pays claims up to $300 of a policyholder of an insolvent insurer if the claim existed prior to the declaration of insolvency or arose within sixty days after the declaration of insolvency. We account for allocations from the Massachusetts Insurers Insolvency Fund as underwriting expenses. Underwriting expenses in 2003 and 2002 included $3,423 and $2,103 of charges representing our allocation from the Massachusetts Insurers Insolvency Fund. Although the timing and amounts of any future assessments are not known, based upon existing knowledge, management's opinion is that such future assessments will not have a material effect on the consolidated financial position of the Company.
Our GAAP expense ratio (a percentage of net premiums earned) for the year ended December 31, 2003 improved to 24.2% compared to 26.3% for the comparable 2002 period. This improvement was a result of an increase in earned premiums coupled with ongoing cost control programs, employee productivity improvements through the use of technology, and reduced expenses assumed from CAR.
Other Expenses. Other expenses for the year ended December 31, 2003 decreased to $0 from $6,250 for the comparable 2002 period. Other expenses in 2002 was comprised of $4,000 of TJC management termination fee expense related to services that ceased at the IPO, and $2,250 of unamortized deferred debt issuance costs related to the Acquisition debt which were expensed upon the repayment of this debt, concurrent with the IPO.
Interest Expense. Interest expense for the year ended December 31, 2003 decreased by $6,608 to $646 from $7,254 for the comparable 2002 period. Interest expense for the 2002 period was related to old debt facilities that were extinguished concurrent with Safety's IPO on November 27, 2002. Primarily as a result of the IPO, Safety significantly reduced debt outstanding to $19,956 at December 31, 2003 from $96,500 prior to the November 27, 2002 IPO.
Income Taxes. Our effective tax rate on net income before preferred stock dividends was 28.0% and 10.9% for the years ended December 31, 2003 and 2002, respectively. For the years ended December 31, 2003 and 2002, the effective rate was lower than the statutory rate of 35% primarily due to adjustments for tax-exempt investment income.
Net Income Before Preferred Stock Dividends. Net income for the year ended December 31, 2003 increased to $28,482 from net income before preferred stock dividends of $10,461 for the comparable 2002 period.
Liquidity and Capital Resources
As a holding company, Safety's assets consist primarily of the stock of our direct and indirect subsidiaries. Our principal source of funds to meet our obligations and pay dividends to shareholders, therefore, is dividends and other permitted payments from our subsidiaries, principally Safety Insurance. Safety is the borrower under our credit facilities.
Safety Insurance's sources of funds primarily include premiums received, investment income and proceeds from sales and redemptions of investments. Safety Insurance's principal uses of cash are the payment of claims, operating expenses and taxes, the purchase of investments and payment of dividends to Safety.
Net cash provided by operating activities was $126,176 and $85,185 during the year ended December 31, 2004 and 2003, respectively. Our operations typically generate substantial positive cash flows from operations as most premiums are received in advance of the time when claim and benefit payments are required. These positive operating cash flows are expected to continue to meet our liquidity requirements.
Net cash provided by investing activities was $7,820 during the year ended December 31, 2004, which resulted primarily from sales and maturities of fixed maturities in excess of purchases of fixed maturities. Net cash used for investing activities was $89,205 during the year ended December 31, 2003, which resulted primarily from purchases of fixed maturities in excess of sales of fixed maturities.
Net cash used for financing activities was $4,607 and $4,473 during the year ended December 31, 2004 and 2003, respectively, which resulted from dividends paid to shareholders less payments of management notes and proceeds from stock option exercises.
Credit Facility
Concurrent with the closing of our IPO and repayment of the old credit facility, Safety obtained a new $30,000 revolving credit facility. Bank of America is the lender under this credit facility. Safety borrowed the entire $30,000 under this credit facility at the closing of the IPO and paid down the balance to $19,956 on December 5, 2002 with the approximately $10,000 net proceeds from the exercise of the underwriter's over-allotment option for 900,000 shares of our common stock. Loans under the credit facility bear interest at our option at either (i) the LIBOR rate plus 1.50% per annum or (ii) the higher of Bank of America's prime rate or 0.50% above the federal funds rate plus 1.50% per annum. The credit facility is due and payable at maturity on November 27, 2005, which is three years from the closing of the IPO. Interest only is payable prior to maturity. The obligations of Safety under the credit facility are secured by pledges of the assets of Safety and the capital stock of Safety's operating subsidiaries. The credit facility is guaranteed by the non-insurance company subsidiaries of Safety. The credit facility contains covenants including requirements to maintain minimum risk based capital ratios and statutory surplus of Safety Insurance as well as limitations or restrictions on indebtedness, liens, dividends, and other matters. As of December 31, 2004, we were in compliance with all such covenants.
Regulatory Matters
Our insurance subsidiaries are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid to their parent without prior approval of the Commissioner. The Massachusetts statute limits the dividends an insurer may pay in any twelve-month period, without the prior permission of the Commissioner, to the greater of (i) 10% of the insurer's surplus as of the preceding December 31 or (ii) the insurer's net income for the twelve-month period ending the preceding December 31, in each case determined in accordance with statutory accounting practices. Our insurance company subsidiaries may not declare an "extraordinary dividend" (defined as any dividend or distribution that, together with other distributions made within the preceding twelve months, exceeds the limits established by Massachusetts' statute) until thirty days after the Commissioner has received notice of the intended dividend and has not objected. As historically administered by the Commissioner, this provision requires the Commissioner's prior approval of an extraordinary dividend. Under Massachusett's law, an insurer may pay cash dividends only from its unassigned funds, also known as earned surplus, and the insurer's remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. At year-end 2004, the statutory surplus of Safety Insurance was $278,161, and its net income for 2004 was $42,251. As a result, a maximum of $42,251 is available in 2005 for such dividends without prior approval of the Division. During the year ended December 31, 2004, Safety Insurance recorded dividends to Safety of $25,966.
The maximum dividend permitted by law is not indicative of an insurer's actual ability to pay dividends, which may be constrained by business and regulatory considerations, such as the impact of dividends on surplus, which could affect an insurer's ratings or competitive position, the amount of premiums that can be written and the ability to pay future dividends.
On both February 17, 2005 and November 18, 2004, our Board approved a quarterly cash dividend on our common stock of $0.12 per share, or $1,861 and $1,860, based on 15,504,852 and 15,500,052 common shares outstanding, respectively, paid on March 15, 2005 and December 15, 2004, respectively. On August 12, 2004, the Board of Directors approved an increase to its quarterly cash dividend to $0.12 per share or $1,847, based on 15,391,844 common shares outstanding, which was paid on September 15, 2004. On May 20, 2004, Safety's Board approved a quarterly cash dividend of $0.10 per share, or $1,534, based on 15,338,589 common shares outstanding, which was paid on June 15, 2004. On February 24, 2004 and November 21, 2003, our Board approved a quarterly cash dividend of $0.10 per share, or $1,526, based on 15,259,991 common shares outstanding, which was paid on March 15, 2004 and December 15, 2003, respectively. We plan to continue to declare and pay quarterly cash dividends in 2005, depending on our financial position and the regularity of our cash flows.
Management believes that the current level of cash flow from operations provides us with sufficient liquidity to meet our operating needs over the next 12 months. We expect to be able to continue to meet our operating needs after the next 12 months from internally generated funds. Since our ability to meet our obligations in the long term (beyond such twelve-month period) is dependent upon such factors as market changes, insurance regulatory changes and economic conditions, no assurance can be given that the available net cash flow will be sufficient to meet our operating needs. We expect that we would need to borrow or issue capital stock if we needed additional funds, for example, to pay for an acquisition or a significant expansion of our operations. There can be no assurance that sufficient funds for any of the foregoing purposes would be available to us at such time.
Off-Balance Sheet Arrangements
We have no material obligations under a guarantee contract meeting the characteristics identified in paragraph 3 of Financial Accounting Standards Board ("FASB") Interpretation No. ("FIN") 45, "Guarantor's Accounting and Disclosure Requirements, Including Indirect Guarantees of Indebtedness of Others". We have no material retained or contingent interests in assets transferred to an unconsolidated entity. We have no material obligations, including contingent obligations, under contracts that would be accounted for as derivative instruments. We have no obligation, including contingent obligations, arising out of a variable interest in an unconsolidated entity held by, and material to, us, where such entity provides financing, liquidity, market risk or credit risk support to, or engages in leasing, hedging or research and development services with us. We have no direct investments in real estate and no holdings of mortgages secured by commercial real estate. Accordingly, we have no material off-balance sheet arrangements.
Contractual Obligations
We have obligations to make future payments under contracts and credit-related financial instruments and commitments. At December 31, 2004, certain long-term aggregate contractual obligations and credit-related commitments are summarized as follows:
(1)We cannot reasonably estimate the future payments due by year as our loss and LAE reserves do not have contractual maturity dates and the timing of future payments and final settlement of claims is subject to significant uncertainty. There were no material changes in any of our contractual obligations outside the ordinary course of our business during the year ended December 31, 2004. Our loss and loss adjustment expense reserves, debt and capital lease obligations are currently reflected in our December 31, 2004 and 2003 balance sheets under GAAP.
Forward-Looking Statements
Forward-looking statements might include one or more of the following, among others:
•Projections of revenues, income, earnings per share, capital expenditures, dividends, capital structure or other financial items;
•Descriptions of plans or objectives of management for future operations, products or services;
•Forecasts of future economic performance, liquidity, need for funding and income; and
•Descriptions of assumptions underlying or relating to any of the foregoing.
Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words such as "believe," "expect," "anticipate," "intend," "plan," "estimate," "aim," "projects," or words of similar meaning and expressions that indicate future events and trends, or future or conditional verbs such as "will," "would," "should," "could," or "may". All statements that address expectations or projections about the future, including statements about the Company's strategy for growth, product development, market position, expenditures and financial results, are forward-looking statements.
Forward-looking statements are not guarantees of future performance. By their nature, forward-looking statements are subject to risks and uncertainties. There are a number of factors, many of which are beyond our control, that could cause actual future conditions, events, results or trends to differ significantly and/or materially from historical results or those projected in the forward-looking statements. These factors include but are not limited to the competitive nature of our industry and the possible adverse effects of such competition. Although a number of national insurers that are much larger than we are do not currently compete in a material way in the Massachusetts private passenger automobile market, if one or more of these companies decided to aggressively enter the market it could have a material adverse effect on us. Other significant factors include conditions for business operations and restrictive regulations in Massachusetts, the possibility of losses due to claims resulting
from severe weather, the possibility that the Approved Rules are successfully appealed by Commerce or one or more of our other competitors, the possibility that the Commissioner may approve future Rule changes that change the operation of the residual market, our possible need for and availability of additional financing, and our dependence on strategic relationships, among others, and other risks and factors identified from time to time in our reports filed with the SEC, such as those set forth under the caption "Risk Factors" in our prospectus in the registration statement on Form S-1 filed with the SEC on November 22, 2002.
Some other factors, such as market, operational, liquidity, interest rate, equity and other risks, are described elsewhere in this Annual Report on Form 10-K. Factors relating to the regulation and supervision of our Company are also described or incorporated in this report. There are other factors besides those described or incorporated in this report that could cause actual conditions, events or results to differ from those in the forward-looking statements.
Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We do not undertake any obligation to update publicly or revise any forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risk. Market risk is the risk that we will incur losses due to adverse changes in market rates and prices. We have exposure to market risk through our investment activities and our financing activities. Our primary market risk exposure is to changes in interest rates. We use both fixed and variable rate debt as sources of financing. We have not entered, and do not plan to enter, into any derivative financial instruments for trading or speculative purposes.
Interest Rate Risk. Interest rate risk is the risk that we will incur economic losses due to adverse changes in interest rates. Our exposure to interest rate changes primarily results from our significant holdings of fixed rate investments and from our financing activities. Our fixed maturity investments include U.S. and foreign government bonds, securities issued by government agencies, obligations of state and local governments and governmental authorities, corporate bonds and asset-backed securities, most of which are exposed to changes in prevailing interest rates.
We manage our exposure to risks associated with interest rate fluctuations through active review of our investment portfolio by our management and Board and consultation with third-party financial advisors. As a general matter, we do not attempt to match the durations of our assets with the durations of our liabilities, and the majority of our liabilities are "short tail." Our goal is to maximize the total after-tax return on all of our investments. An important strategy that we employ to achieve this goal is to try to hold enough in cash and short-term investments in order to avoid liquidating longer-term investments to pay claims.
Based upon the results of interest rate sensitivity analysis, the following tables show the interest rate risk of our investments in fixed maturities, including preferred stocks with characteristics of fixed
maturities, measured in terms of fair value (which is equal to the carrying value for all our fixed maturity securities).
An important market risk for all of our outstanding long-term debt is interest rate risk. We continue to monitor the interest rate environment and to evaluate refinancing opportunities as maturity dates approach. With respect to floating rate debt, we are also exposed to the effects of changes in prevailing interest rates. At December 31, 2004 we had $19,956 of debt outstanding under our credit facility at a variable rate of 4.3%. A 2.0% change in the prevailing interest rate on our variable rate debt would result in interest expense fluctuating approximately $400 for 2004, assuming that all of such debt is outstanding for the entire year.
Equity Risk. Equity risk is the risk that we will incur economic losses due to adverse changes in equity prices. In the past, our exposure to changes in equity prices primarily resulted from our holdings of common stocks, mutual funds and other equities. While we have in the past held common equity securities in our investment portfolio, presently we hold none, except for interests in mutual funds to fund the executive deferred compensation plan. We continuously evaluate market conditions and we expect in the future to purchase equity securities. We principally managed equity price risk through industry and issuer diversification and asset allocation techniques.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
SAFETY INSURANCE GROUP, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of Safety Insurance Group, Inc.:
We have completed an integrated audit of Safety Insurance Group, Inc.'s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements and financial statement schedules
In our opinion, the consolidated financial statements listed in the accompanying index, present fairly, in all material respects, the financial position of Safety Insurance Group, Inc. at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 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 15(a)(2) 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 the standards of the Public Company Accounting Oversight Board (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 of financial statements 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.
Internal control over financial reporting
Also, in our opinion, management's assessment, included in Management's Report on Internal Control over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the COSO. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management's assessment and on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
Boston, Massachusetts
March 15, 2005
Safety Insurance Group, Inc. and Subsidiaries
Consolidated Balance Sheets
(Dollars in thousands, except share data)
The accompanying notes are an integral part of these financial statements.
Safety Insurance Group, Inc. and Subsidiaries
Consolidated Statements of Operations
(Dollars in thousands, except per share and share data)
The accompanying notes are an integral part of these financial statements.
Safety Insurance Group, Inc. and Subsidiaries
Consolidated Statements of Changes in Shareholders' Equity
(Dollars in thousands)
The accompanying notes are an integral part of these financial statements.
Safety Insurance Group, Inc. and Subsidiaries
Consolidated Statements of Comprehensive Income
(Dollars in thousands)
The accompanying notes are an integral part of these financial statements.
Safety Insurance Group, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Dollars in thousands)
The accompanying notes are an integral part of these financial statements.
Safety Insurance Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands except per share and share data)
1. Basis of Presentation
The consolidated financial statements have been prepared on the basis of accounting principles generally accepted in the United States of America ("GAAP"). The consolidated financial statements include Safety Insurance Group, Inc. and its subsidiaries (together referred to as the "Company"). The subsidiaries consist of Safety Insurance Company, Safety Indemnity Insurance Company, Thomas Black Insurance Agency, Inc. ("TBIA"), and RBS, Inc., TBIA's holding company. All intercompany transactions have been eliminated.
The Company is a leading provider of personal lines property and casualty insurance focused exclusively on the Massachusetts market. Its principal product line is private passenger automobile insurance, which accounted for 81.0% of its direct written premiums in 2004. The Company operates through its insurance company subsidiaries, Safety Insurance Company and Safety Indemnity Insurance Company (together referred to as the "Insurance Subsidiaries").
2. Acquisition and IPO
Acquisition
The Company was incorporated on June 25, 2001, in the State of Delaware. On October 16, 2001, the Company acquired (the "Acquisition") all of the issued and outstanding common stock of Thomas Black Corporation ("TBC") and its property and casualty subsidiaries. In connection with financing the Acquisition, the Company incurred debt of $99,500 and issued 22,400 shares of Series A senior mandatorily redeemable preferred stock at $1,000 per share.
Prior to the November 27, 2002 initial public offering ("IPO"), approximately 72% of the outstanding common stock of the Company was owned by certain investors assembled by The Jordan Company, LLC, an investment firm that sponsored the Acquisition. The remaining 28% was owned by executive management. (See Note 12 regarding promissory notes received from management.) JZ Equity Partners plc, a London-based publicly traded investment trust, owned approximately 50% of the outstanding mandatorily redeemable preferred stock of the Company; the other 50% was owned by third parties. The preferred stock was cumulative, non-voting with a 6% dividend rate and was mandatorily redeemable on October 16, 2012 or upon a change in control. See Note 9.
The holders of the preferred stock agreed to amend the terms of the preferred stock to cause it to automatically convert into common stock upon the closing of the IPO at the IPO price (the "Preferred Share Exchange"). Based upon the $12.00 per share IPO price, 1,866,665 additional common shares were issued in connection with the exchange upon the close of the IPO.
IPO
The Company sold 6,333,334 common shares in its IPO, 350,000 common shares in a direct sale and 900,000 common shares from the exercise of the underwriters' over-allotment option all at $12.00 per share. Net proceeds received were $81,819 from these stock issuances after deducting underwriting discounts and other offering expenses. The Company also received $30,000 from borrowings under its new credit facility. These net proceeds and borrowings were used to repay principal and interest on the outstanding debt as well as dividends on the outstanding mandatorily redeemable preferred stock. In addition, $22,400 of common stock and additional paid in capital was recognized from the issuance of
1,866,665 common shares upon conversion of all outstanding preferred stock (the "Preferred Share Exchange"), concurrent with the IPO.
3. Summary of Significant Accounting Policies
Investments
Investments in fixed maturities available for sale, which include taxable and non-taxable bonds and redeemable preferred stocks, are reported at fair value. Investments in equity securities available for sale, which include interests in mutual funds, are reported at fair value. Fair values are derived from external market quotations. Unrealized gains or losses on fixed maturity and equity securities, reported at fair value, are excluded from earnings and reported in a separate component of shareholders' equity, known as "Accumulated other comprehensive income (loss), net of federal income taxes", until realized. Realized gains or losses on the sale or maturity of investments are determined on the basis of the specific cost identification method. Fixed maturities and equity securities that experience declines in value that are other-than-temporary are written down to fair value with a corresponding charge to net realized losses on investments.
Investment income is recognized on an accrual basis of accounting. Bonds not backed by other loans are amortized using the interest method. Loan-backed bonds and structured securities are amortized using the interest method and significant changes in estimated cash flows from the original purchase assumptions are accounted for using the retrospective method.
Cash Equivalents
Cash equivalents, consist of money market accounts and United States ("U.S.") Treasury bills with original maturities of three months or less, are stated at cost, which approximates fair value.
Accounts Receivable
Amounts included in accounts receivable represent premiums as well as finance charges, which are billed on a monthly installment basis. A majority of the Company's premiums are billed on a monthly installment basis. Accounts receivable are stated net of allowances for doubtful accounts. At December 31, 2004 and 2003, these allowances were $183 and $484, respectively. Uncollected premium balances over 90 days past due are written off.
Deferred Policy Acquisition Costs
Amounts that vary with and are primarily related to acquiring new and renewal business, principally commissions and premium taxes, are deferred and amortized ratably over the effective period of the policies. All other acquisition expenses are charged to expenses as incurred. Deferred policy acquisition costs are reviewed to determine if they are recoverable from future income, and if not, are charged to expense. Future investment income attributable to related premiums is taken into account in measuring the recoverability of the carrying value of this asset. All other acquisition expenses are charged to expense as incurred. Amortization of acquisition costs in the amount of $88,425, $82,203 and $69,644 were charged to underwriting expenses for the years ended December 31, 2004, 2003 and 2002, respectively.
Equity and Deposits in Pools
Equity and deposits in pools represents the net receivable cash amounts due from the residual market mechanisms, Commonwealth Automobile Reinsurers ("CAR"), for automobile and Massachusetts Property Insurance Underwriting Association ("FAIR Plan"), for homeowner insurance in Massachusetts. See Note 10 for a discussion of the Company's accounting for amounts assumed from residual markets.
Deferred Debt Issuance Costs
Deferred debt issuance costs represent those costs incurred by the Company in connection with securing debt financing. These costs include closing and arranger's fees and are amortized over the life of the related loans. Included in other expenses for the years ended December 31, 2004, 2003 and 2002 is $0, $0 and $2,250, respectively, of unamortized deferred debt acquisition costs related to the Acquisition debt which were expensed upon the repayment of this debt, concurrent with the IPO.
Equipment and Leasehold Improvements
Purchases of equipment and leasehold improvements are carried at cost less accumulated depreciation. Maintenance and repairs are charged to expense as incurred; improvements are capitalized.
Methods of depreciation and useful lives by asset category are as follows:
Losses and Loss Adjustment Expenses
Liabilities for losses and loss adjustment expenses ("LAE") include case basis estimates for open claims reported prior to year-end and estimates of unreported claims and claim adjustment expenses. The estimates are continually reviewed and modified to reflect current conditions, and any resulting adjustments are reflected in current operating results. Adjustments for anticipated salvage and subrogation are recorded on incurred and reported and incurred but not reported losses.
Premiums and Unearned Premiums
Premiums are earned over the terms of the respective policies, which are generally one year. Unearned premiums represent the portion of premiums written applicable to the unexpired terms of the policies.
Ceded premiums are charged to income over the terms of the respective policies and the applicable term of the reinsurance contracts with third party reinsurers. Prepaid reinsurance premiums represent the unexpired portion of premiums ceded to CAR and other reinsurers.
Advance premiums are recorded as a liability and not recognized as income until earned. Such amounts are included in accounts payable and accrued liabilities and totaled $21,207 and $21,551 at December 31, 2004 and 2003, respectively.
Promissory Notes Received From Management
In connection with the Acquisition, the Company obtained promissory notes from the executive management team to finance management's purchase of the Company's common stock, including the restricted stock purchased by management.
In accordance with the provisions of the Financial Accounting Standards Board's Emerging Issues Task Force ("EITF") No. 85-1, "Classifying Notes Received for Capital Stock," all outstanding principal and accrued interest related to these notes are recorded as contra-equity in the consolidated financial statements.
See Note 12 for terms of promissory notes received from management.
Finance and Other Service Income
Finance and other service income includes revenues from premium installment charges, which are recognized when earned.
Income Taxes
The Company and its subsidiaries file a consolidated U.S. federal income tax return. The method of allocation among members of the consolidated group is subject to a written agreement approved by the Board. The consolidated tax liability is allocated on the basis of the members' proportionate contribution to consolidated taxable income.
Deferred income taxes are generally recognized when assets and liabilities have different values for financial statement and tax reporting purposes, and for other temporary taxable and deductible differences as defined by Statement of Financial Accounting Standards ("FAS") No. 109, "Accounting for Income Taxes". A valuation allowance is established where management has assessed that it is more likely than not that the Company will not be able to utilize the full deferred tax asset.
Earnings per Weighted Average Common Share
Basic earnings per weighted average common share ("EPS") are calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted EPS are calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding and the net effect of potentially dilutive common shares. At December 31, 2004, 2003 and 2002, the Company's potentially dilutive instruments were common shares under options of 711,410, 771,000 and 379,000, respectively, and common shares under restriction of 70,271, 0 and 0, respectively. In accordance with the provisions
of FAS 128, EPS for the year ended December 31, 2002 is determined based upon $10,461 of net income less $1,219 of after-tax dividends on the mandatorily redeemable preferred stock.
Stock-Based Compensation
As described in Note 6, certain members of management were granted stock appreciation rights ("SARs") on October 16, 2001. Prior to the IPO, the SARs were to vest 20% per annum commencing on December 31, 2002. As of the close of the IPO, the SARs became fully vested and were automatically exercised. The SARs were accounted for in accordance with the provisions of FASB Interpretation ("FIN") No. 28 "Accounting for Stock Appreciation Rights and Other Variable Stock Options or Awards Plans". Under FIN 28, compensation expense is accrued over the period or periods in which the employee performs the related services and is recognized to the extent that the fair market of the Company's stock exceeds the exercise price of the SARs. Changes in the fair market value of the stock in an accounting period, to the extent it still exceeds the exercise price, are recorded as compensation expense.
On June 25, 2002, the Board adopted the 2002 Management Omnibus Incentive Plan ("the Incentive Plan"). The Incentive Plan provides for a variety of awards, including nonqualified stock options, SARs and restricted stock awards. The Company has granted certain stock option awards under this Incentive Plan and follows the accounting for these options under the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees", as allowed by FAS 123, "Accounting for Stock-Based Compensation" and as amended by FAS 148, "Accounting for Stock-Based Compensation-Transition and Disclosure".
No stock-based employee compensation cost is reflected in net income, as all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant.
The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FAS 123, "Accounting for Stock-Based Compensation", to these stock options.
The fair value of stock options used to compute pro forma net income and earnings per share disclosures for the years ended December 31, 2004, 2003 and 2002 is the estimated fair value at grant date using the Black-Scholes option-pricing model with the following assumptions:
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Financial Instruments
In the normal course of business, the Company enters into transactions involving various types of financial instruments, including investments in fixed maturities and equity securities. Investment transactions have credit exposure to the extent that a counter party may default on an obligation to the Company. Credit risk is a consequence of carrying, trading and investing in securities. To manage credit risk, the Company focuses on higher quality fixed income securities, reviews the credit strength of all companies in which it invests, limits its exposure in any one investment and monitors the portfolio quality, taking into account credit ratings assigned by recognized statistical rating organizations.
Statutory Accounting Practices
The Company's insurance subsidiaries, domiciled in the Commonwealth of Massachusetts, prepare statutory financial statements in accordance with the accounting practices prescribed or permitted by the Commonwealth of Massachusetts Division of Insurance ("the Division"). Prescribed statutory accounting practices are those practices that are incorporated directly or by reference in state laws, regulations, and general administrative rules applicable to all insurance enterprises domiciled in a particular state. Permitted statutory accounting practices include practices not prescribed by the Division, but allowed by the Division. See Note 14.
New Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board ("FASB") issued FAS 123 (revised 2004), Share-Based Payment ("FAS 123(R)"). This statement requires companies to measure and recognize the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value. FAS 123(R) replaces FAS 123, Accounting for Stock-Based Compensation ("FAS 123"), and supersedes APB 25, Accounting for Stock Issued to Employees. The provisions of this statement are effective for interim and annual periods beginning after June 15, 2005. The Company is evaluating the effects of FAS 123(R) and expects to begin expensing stock options in the third quarter of 2005.
Reclassifications
Prior period amounts have been reclassified to conform to the current year presentation.
Segments
The Company comprises one business segment: property and casualty insurance operations. Management organizes the business around private passenger automobile insurance in Massachusetts sold exclusively through independent agents and offers other personal and commercial insurance as complementary products. In accordance with FAS 131, Disclosures About Segments of an Enterprise and Related Information, the financial information of the segment is presented consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance.
4. Investments
The gross unrealized appreciation (depreciation) of investments in fixed maturities securities, including redeemable preferred stocks that have characteristics of fixed maturities, and equity securities, including interests in mutual funds, was as follows:
(1)Obligations of U.S. Government agencies includes collateralized mortgage obligations issued, guaranteed and/or insured by the following issuers: Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC) and Federal National Mortgage Association (FNMA). The total of these fixed maturity securities was $120,636 and $121,833 at estimated fair value and $120,729 and $120,928 at amortized cost as of December 31, 2004 and 2003, respectively. As such, the asset-backed securities presented exclude such issuers already presented under U.S. Treasury securities and obligations of U.S. Government Agencies.
The amortized cost and the estimated fair value of fixed maturity securities, by maturity, at December 31, 2004 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.
Gross gains of $1,535, $11,141 and $4,022 and gross losses of $263, $253 and $3,256 were realized on sales of fixed maturities for years ended December 31, 2004, 2003 and 2002, respectively. Gross gains of $2 were realized on the sales of equity securities for the year need December 31, 2004. Proceeds from fixed maturities maturing were $7,520, $0, and $71,750 for the years ended December 31, 2004, 2003 and 2002.
The following tables illustrate the gross unrealized losses included in the Company's investment portfolio and the fair value of those securities aggregated by investment category. The tables also illustrates the length of time that they have been in a continuous unrealized loss position.
The Company's investment portfolio included 80 securities in an unrealized loss position at December 31, 2004. The Company's methodology of assessing other-than-temporary impairment is based upon analysis of each security as of the balance sheet date and considers various factors including the length of time and the extent to which fair value has been less than the cost, the financial condition and the near term prospects of the issuer, whether the debtor is current on its contractually obligated interest and principal payments, and the Company's intent to hold the investment for a period of time sufficient to allow for recovery of its costs.
During the year ended December 31, 2004, there was no significant deterioration in the credit quality of any of the Company's holdings and no other-than-temporary impairment charges were recorded related to the Company's portfolio of investment securities. However, during the year ended December 31, 2003, there was a significant deterioration in the credit quality of one of the Company's holdings, Continental Airlines. Accordingly, the Company recorded an other-than-temporary impairment of $837 for this security. During May 2003, this security was sold at a realized gain of $426. During the year ended December 31, 2002, there was a significant deterioration in the credit quality of two of the Company's holdings in the telecommunications sector. The Company recognized a realized loss of $2,020 for one of these securities, which was sold in June 2002. In addition, the Company recorded an other-than-temporary impairment charge of $1,043 for the other telecommunications security. During September 2002, this security was sold at a realized loss of $79.
Net Investment Income
The components of net investment income were as follows:
Safety Insurance Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands except per share and share data)
5. Equipment and Leasehold Improvements
At December 31, 2004 and 2003, the Company held equipment and leasehold improvements with a carrying value of $973 and $1,309, which is net of accumulated depreciation of $1,182 and $415, respectively. Depreciation and amortization expense for the years ended December 31, 2004, 2003 and 2002 was $767, $331 and $84, respectively.
6. Employee Benefit Plans
SARs Agreements
The Company entered into SARs agreements with executive management on October 16, 2001. Under the terms of the agreements, the Company granted 103,488 SARs on October 16, 2001 for past and future services. The agreements designated the number of "covered shares" for each executive and other employees and established the exercise price of $6.88 per share. Prior to the IPO, the SARs were to vest 20% at the end of each year commencing on December 31, 2002. As of the close of the IPO, the SARs became fully vested and were automatically exercised. Soon thereafter, the participants each received a cash payment equal to the excess of the $12.00 IPO price per common share over the exercise price of $6.88 per share. Compensation expense related to the SARs of $0, $0 and $529 was recognized as a charge to earnings for the years ended December 31, 2004, 2003 and 2002, respectively.
Management Subscription Agreements
On October 16, 2001, the Company entered into a management subscription agreement with certain employees. The management subscription agreement contained certain Company call and employee put options that allowed the employee to put the stock owned by the employee at the time of exercise at a price based upon a formula calculation to the Company under certain circumstances outside of the Company's control and within the employee's control (e.g., employee retirement or resignation). The management subscription agreement was being accounted for as a variable plan in accordance with EITF 00-23, "Issues Related to the Accounting for Stock Compensation under APB Opinion No. 25 and FASB Interpretation No. 44", whereby employee compensation expenses were being recorded over the period of service of the employee in accordance with FIN 28. Compensation expense related to the management subscription agreement totaled $0, $0 and $4,476 for the years ended December 31, 2004, 2003 and 2002, respectively.
The management subscription agreements, including the Company call and employee put options, terminated upon the IPO, at which point variable plan accounting ceased and the liability accrued at the IPO date was re-classified to paid-in capital.
Restricted Stock Plan
On October 16, 2001, the Company implemented a Restricted Stock Plan and entered into Executive Restricted Stock Award Agreements under this plan with two employees of the Company. Under these agreements, 290,500 restricted shares of common stock, the maximum number that could be granted or sold under the plan, were sold at a cost of $0.43 per share, which approximated the fair value of the shares at the date of the sale. The Restricted Stock Plan permits the Board to grant restricted shares of common stock to select employees of the Company or any of its affiliates. The Board has the right to amend or terminate the Restricted Stock Plan at any time, subject to certain
limitations, but no amendment or termination may alter the rights of a participant under any awards previously granted. The restricted shares were subject to the put and call provisions of the Management Subscription Agreement, which under certain circumstances may have required the Company to purchase the restricted shares at a price based upon a formula calculation. These put and call provisions were accounted for in accordance with EITF 00-23 whereby the employee compensation expense was recorded over the period of service of the employee in accordance with FIN 28. Compensation expense related to these agreements was $0, $0 and $470 for the years ended December 31, 2004, 2003 and 2002, respectively.
These restricted shares vested in full and the related put and call provisions terminated upon the IPO.
The Safety Insurance 401(k) Retirement Plan
Effective January 1, 2002, the Company re-established the Safety Insurance Company 401(k) qualified defined contribution retirement plan (the "Retirement Plan"). The Retirement Plan is available to all eligible employees of the Company. An employee must be 21 years of age to be eligible to participate in the Retirement Plan, and is allowed to contribute on a pre-tax basis up to the maximum allowed under federal law. The Retirement Plan is administered by the Company and is subject to the provisions of the Employee Retirement Income Security Act of 1974 ("ERISA"). At the close of each Retirement Plan year, the Company makes a matching contribution equal to 75% of the amount each participant contributed during the plan year from their total pay, up to a maximum amount of 8% of the patrticipant's base salary, to those participants who have contributed to the Retirement Plan, worked 1,000 hours and were employed on the last day of the Retirement Plan year. Compensation expense related to the Retirement Plan was $1,113, $969 and $567 for the years ended December 31, 2004, 2003 and 2002, respectively.
Management Omnibus Incentive Plan
The Incentive Plan provides for a variety of awards, including nonqualified stock options ("NQSOs"), stock appreciation rights and restricted stock ("RS") awards. The maximum number of shares of common stock with respect to which awards may be granted under the Incentive Plan is 1,250,000. On December 31, 2004, there were 298,529 shares available for future grant. The Board and the Compensation Committee intend to issue more awards under the Incentive Plan in the future. Grants made under the Incentive Plan are as follows:
(1)The exercise price of the options grant effective on November 27, 2002 is equal to the IPO price of the Company's stock on that same day. The exercise price of the remaining option grants is equal to the closing price of the Company's common stock on the grant effective date.
(2)The fair value of the restricted stock grant is equal to the closing price of the Company's common stock on the grant effective date.
Grants outstanding under the Incentive Plan as of December 31, 2004 were comprised of 70,271 restricted shares and 711,410 nonqualified stock options. There were no forfeitures of restricted stock during 2004. The following table summarizes option activity during 2004 and 2003:
7. Commitments and Contingencies
Lease Commitments
The Company has various noncancelable long-term operating leases. The approximate minimum annual rental payments due under these lease agreements as of December 31, 2004 are as follows:
Certain lease agreements contain renewal options and, in addition to the minimum annual rentals, generally provide for payment of a share of the real estate taxes and operating expenses in excess of a base amount. Rental expense was $2,826, $2,718, $2,737 for the years ended December 31, 2004, 2003 and 2002, respectively. All leases expire prior to 2009. The Company expects that in the normal course of business, leases that expire will be renewed.
Employee Tax Indemnification
In connection with the Acquisition, the Company entered into an agreement with members of its management team to indemnity them for any tax loss they may incur in connection with the purchase of its common stock at the time the Company acquired TBC, due to a determination by the Internal Revenue Service that the value of such stock was higher than the purchase price agreed upon by the Company and its management team.
Contingencies
Various claims, generally incidental to the conduct of normal business, are pending or alleged against the Company from time to time. In the opinion of management, based in part on the advice of legal counsel, the ultimate resolution of such claims will not have a material adverse effect on the Company's consolidated financial statements. However, liabilities related to those proceedings could be established in the near term if estimates of the ultimate resolutions of those proceedings are revised.
Massachusetts law requires that insurers licensed to do business in Massachusetts participate in the Massachusetts Insurers Insolvency Fund ("Insolvency Fund"). Members of the Insolvency Fund are assessed a proportionate share of the obligations and expenses of the Insolvency Fund in connection with an insolvent insurer. It is anticipated that there will be additional assessments from time to time relating to various insolvencies. Although the timing and amounts of any future assessments are not known, based upon existing knowledge, management's opinion is that such future assessments will not have a material effect upon the financial position of the Company. In 2004, 2003 and 2002, the Company received notice of assessments from the Insolvency Fund amounting to $2,538, $3,423 and $2,103, which it expensed for the years ended December 31, 2004, 2003 and 2002, respectively.
8. Debt
New Secured Revolving Credit Facility
Concurrent with the IPO and repayment of the old credit facility, Safety obtained a new $30,000 revolving credit facility. Bank of America is the lender under this credit facility. Safety borrowed the entire $30,000 under this credit facility at the closing of the IPO and paid down the balance to $19,956 on December 5, 2002 with the approximately $10,000 net proceeds from the exercise of the underwriter's over-allotment option for 900,000 shares of the Company's common stock. Loans under the credit facility bear interest at the Company's option at either (i) the LIBOR rate plus 1.50% per annum or (ii) the higher of Bank of America's prime rate or 0.50% above the federal funds rate plus 1.50% per annum. The credit facility is due and payable at maturity on November 27, 2005, which is three years from the closing of the IPO. Interest only is payable prior to maturity. The obligations of Safety under the credit facility are secured by pledges of the assets of Safety and the capital stock of Safety's operating subsidiaries. The credit facility is guaranteed by the non-insurance company subsidiaries of Safety. The credit facility contains covenants including requirements to maintain minimum risk based capital ratios and statutory surplus of Safety Insurance as well as limitations or restrictions on indebtedness, liens, dividends, and other matters. As of December 31, 2004, the Company was in compliance with all such covenants.
At December 31, 2004 and 2003, the Company had utilized advances of $19,956. The interest rate was 4.26% at December 31, 2004 and an average of 3.27% during 2004. The interest rate was 2.81% at December 31, 2003 and an average of 3.22% during 2003.
Secured Revolving Credit Facility and Term Loan
As part of the funding for the Acquisition, the Company entered into a $20,000 revolving credit facility and a $55,000 senior secured term loan with a bank in October 2001. The obligations of the Company on these loans were collateralized by (i) a 100% pledge of the stock of Safety Insurance Company, RBS, Inc. and TBIA, and (ii) a perfected first priority security interest, subject to permitted liens, in all of the assets, whenever acquired, of TBC, RBS, Inc. and TBIA. Both loans bore interest at LIBOR plus 3.75%. The Company utilized the net proceeds from the IPO and the new secured revolving credit facility to repay $66,550 of indebtedness (including accrued interest) in 2002, thereby paying off this prior credit facility.
Subordinated Notes
The Company also issued $30,000 of senior subordinated notes to obtain funds for the Acquisition. Interest was payable semi-annually on each April 30 and October 31. The senior subordinated notes
were to mature December 31, 2011 and could be redeemed at the option of the Company prior to maturity with no redemption premium or penalty. The senior subordinated notes bore an interest rate of 13%. The Company utilized the net proceeds from the IPO and the new secured revolving credit facility to repay $30,293 of indebtedness (including accrued interest) in 2002, thereby paying off these notes.
The Company incurred interest expense of $672, $646 and $7,254 for the years ended December 31, 2004, 2003 and 2002, respectively, related to all current outstanding obligations during these periods.
Capital Lease Obligation
During 2003, the Company entered in to a three-year term lease agreement to finance the acquisition of new equipment. Minimum payments due under this capital lease obligation as of December 31, 2004 are as follows:
9. Mandatorily Redeemable Preferred Stock
In connection with the Acquisition (see Note 2), the Company issued 22,400 shares of the 100,000 authorized shares of 6% Series A senior mandatorily redeemable preferred stock at $1,000 per share. The stock had a liquidation preference and entitled its holders to receive dividends of $60 per share per annum. To the extent that the dividends were not paid, they accrued in arrears.
The preferred stock was redeemable at any time at the option of the Company at the stock's liquidation preference plus any accrued dividends. The stock was mandatorily redeemable (at the issue price) at the earlier of October 16, 2012 or upon a change in control of the Company.
The holders of the preferred stock agreed to amend the terms of the preferred stock to cause it to automatically convert into common stock upon the closing of the IPO at the IPO price. Based upon the $12.00 per share IPO price, 1,866,665 additional common shares were issued in connection with this Preferred Share Exchange upon the close of the IPO. A total of $1,499 of dividends was accrued through the closing of the IPO and paid to the holders of the preferred stock concurrent with the Preferred Share Exchange.
10. Reinsurance
The Company cedes insurance to CAR and to other reinsurers. The Company has a property catastrophe excess of loss agreement and a casualty excess of loss agreement that qualify as reinsurance treaties and are designed to protect against large or unusual loss and LAE activity. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers and monitors economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies.
The Company is subject to concentration of credit risk with respect to reinsurance ceded to CAR. At December 31, 2004 and 2003, respectively, reinsurance receivables on paid and unpaid loss and LAE with a carrying value of $90,126 and $106,808 and prepaid reinsurance premiums of $38,229 and $28,859 were associated with CAR. The Company's participation in CAR resulted in assumed net losses of $39,038, $48,367 and $38,589 for the years ended December 31, 2004, 2003 and 2002, respectively.
CAR is, with few exceptions, required by law to issue a policy to any applicant who seeks it. As a servicing carrier of CAR, this request applies to the Company. The Company has entered into service contracts with other insurance carriers under which the Company services the residual market business assigned to the carriers by CAR (the "buyout program"). Business generated through the buyout program is 100% ceded to the applicable carrier and serviced for a fee. Servicing carrier fees amounted to $628, $548 and $499 for the years ended December 31, 2004, 2003 and 2002, respectively.
The effect of reinsurance on net written and earned premiums and losses and LAE is as follows:
Safety Insurance Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands except per share and share data)
11. Loss and Loss Adjustment Expense Reserves
The following table sets forth a reconciliation of beginning and ending reserves for losses and LAE, as shown, in the Company's consolidated financial statements for the years indicated:
At the end of each period, the reserves were re-estimated for all prior accident years. Primarily due to an improvement in CAR results, prior year reserves decreased by $6,778 for the year ended December 31, 2004. This decrease in prior year reserves resulted from re-estimations of prior accident years ultimate loss and LAE liabilities which resulted in a reduction of $2,523 in homeowner reserves, a reduction of $6,854 in CAR assumed reserves, a reduction of $329 in FAIR Plan assumed reserves, and an increase of $2,928 in the Company's automobile reserves. Prior year reserves increased by $181 for the year ended December 31, 2003 and decreased by $2,262 for the year ended December 31, 2002. Conditions and trends that have affected development of the loss and LAE reserves in the past may not necessarily occur in the future.
Due to the nature of the risks that the Company underwrites and has historically underwritten, management does not believe that it has an exposure to asbestos or environmental pollution liabilities.
12. Related Party Transactions
Upon closing of the IPO, the Company paid TJC Management Corporation, an affiliate of the Jordan Company ("TJC"), a $4,000 termination fee related to the annual fee that ceased at the IPO, as agreed with TJC under the amended management agreement. This has been included in other expenses in the statement of operations for the year ended December 31, 2002.
The agreement, which was amended concurrent with the IPO, provides for:
•an investment banking and sponsorship fee payable up to 2% of the aggregate consideration (i) paid by the Company for any Acquisition by the Company of all or substantially all of the outstanding capital stock, warrants or options or substantially all of the business or assets of another individual or business entity, or (ii) paid to the Company in connection with any sale by the Company of all or substantially all of its stock, warrants, options, business or assets or the stock, warrants, options, business or assets of any of its subsidiaries;
•a financial consulting fee of up to 1% of the amount obtained or made available to the Company pursuant to any debt, equity or other financing by the Company with the assistance of TJC; and
•payment by the Company of an amount equal to TJC's out-of-pocket expenses, including an allocable amount of TJC's overhead expenses attributable to services provided to the Company.
In connection with the Acquisition, each member of the executive management team issued a recourse promissory note to, and entered into a pledge agreement with the Company. Pursuant to the notes, the Company loaned management an aggregate of $695 in order to purchase common stock in connection with the Acquisition and the Restricted Stock Plan. Pursuant to pledge agreements, the management team pledged the common stock back to the Company as security for the loans made under the promissory notes. The notes bore interest at a rate of 5% annually and were due and payable on the earlier of December 31, 2011 or 90 days after any management team member ceases to be an employee of the Company. Each member may prepay his note at any time without penalty. At December 31, 2003, the loans were carried in the financial statements at $34, which represents the outstanding principal and accrued interest on the notes. During 2004 the Company received $34 representing prepayments of all outstanding loan principal and accrued interest through the dates of final payments. Such loans had been recorded as contra-equity in accordance with the accounting policy described in Note 3.
13. Income Taxes
Provision for income taxes have been calculated in accordance with the provision of Statement No. 109. A summary of the income tax expense in the Consolidated Statements of Income is shown below:
The income tax expense attributable to the consolidated results of operations is different from the amounts determined by multiplying income before federal income taxes by the statutory federal income tax rate. The sources of the difference and the tax effects of each were as follows:
The deferred income tax asset (liability) represents the tax effects of temporary differences attributable to the Company's consolidated federal tax return group. Its components were as follows:
Gross deferred income tax assets prior to valuation allowances totaled $37,470 and $34,480 at December 31, 2004 and 2003, respectively. Gross deferred income tax liabilities totaled $20,581 and $22,237 at December 31, 2004 and 2003, respectively.
The Company believes, based upon consideration of objective and verifiable evidence, including its recent earnings history and its future expectations, that the Company's taxable income in future years will be sufficient to realize all federal deferred tax assets. A valuation allowance of $4,210 and $3,551 was established against state deferred tax assets at December 31, 2004 and 2003, respectively. This valuation allowance is based upon management's assessment that it is more likely than not that the Company will not be able to utilize these state deferred tax assets.
The Company's federal income tax returns for the tax periods ended December 31, 2002 and 2001 are currently under examination by the Internal Revenue Service. In the Company's opinion, adequate tax liabilities have been established for all years. However, the amount of these tax liabilities could be revised in the near term if estimates of the Company's ultimate liability are revised. Tax years prior to 2000 are closed.
14. Statutory Net Income and Surplus
Statutory Accounting Practices
The Company's Insurance Subsidiaries, domiciled in the Commonwealth of Massachusetts, prepare statutory financial statements in accordance with the accounting practices prescribed or permitted by the Division. Statutory net income of the Company's insurance subsidiaries was $44,575, $28,480 and $21,496 for the years ended December 31, 2004, 2003 and 2002, respectively. Statutory capital and surplus of the Company's insurance subsidiaries was $278,160 and $258,551 at December 31, 2004 and 2003, respectively.
Dividends
The Company's insurance subsidiaries are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid to their parent without prior approval of the Commonwealth of Massachusetts Commissioner of Insurance (the "Commissioner"). Massachusetts' statute limits the dividends an insurer may pay in any twelve month period, without the prior permission of the Commissioner, to the greater of (i) 10% of the insurer's surplus as of the preceding December 31 or (ii) the insurer's net income for the twelve-month period ending the preceding December 31, in each case determined in accordance with statutory accounting practices. The Company's insurance company subsidiaries may not declare an "extraordinary dividend" (defined as any dividend or distribution that, together with other distributions made within the preceding twelve months, exceeds the limits established by Massachusetts' statute) until thirty days after the Commissioner has received notice of the intended dividend and has not objected. As historically administered by the Commissioner, this provision requires the Commissioner's prior approval of an extraordinary dividend. Under Massachusetts law an insurer may pay cash dividends only from its unassigned funds, also known as earned surplus, and the insurer's remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. At year-end 2004, the statutory surplus of Safety Insurance was $278,161, and its net income for 2004 was $42,251. As a result, a maximum of $42,251 is available in 2005 for such dividends without prior approval of the Commissioner.
15. Fair Value of Financial Instruments
The Company uses various financial instruments in the normal course of its business. Certain insurance contracts are excluded by Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," and, therefore, are not included in the amounts discussed.
At December 31, 2004 and 2003, investments in fixed maturities had a fair value, which equaled carrying value, of $664,596 and $673,636, respectively. There were no investments in fixed maturities for which a quoted market price or dealer price was not available at December 31, 2004 or, 2003, respectively.
The carrying values of cash and cash equivalents and investment income accrued approximates fair value.
At December 31, 2004 and 2003, the carrying value of $19,956 of the secured revolving credit facility approximated its fair value as described in Note 8. This amount is due and payable at the maturity date of November 27, 2005.
16. Quarterly Results of Operations
An unaudited summary of the Company's 2004 and 2003 quarterly performance, and audited annual performance, is as follows:
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report. Based on that evaluation, our CEO and CFO have concluded that our disclosure controls and procedures are adequate and effective and ensure that all information required to be disclosed is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and that information required to be disclosed in such reports is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures.
Management's Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control-Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2004.
Our management's assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein.
Changes in Internal Control over Financial Reporting
There have been no significant changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
The following disclosures relate to actions taken by the Board of Directors of the Company (the "Board"), the Compensation Committee of the Board and the Board of Directors of Safety Insurance Company and would otherwise have been filed during the first fiscal quarter of 2005 on a Form 8-K under the heading "Item 1.01. Entry into a Material Definitive Agreement."
•Upon recommendation from the Compensation Committee, on March 11, 2005, the Board approved the 2004 annual executive cash bonus pool in the total amount of $2.0 million. The total $2.0 million pool will be allocated as follows: David Brussard, $770,000; William J. Begley, Jr., $227,000; Daniel F. Crimmins, $223,000; Robert J. Kerton, $105,000; David E. Krupa, $111,000; Daniel D. Loranger, $300,000; and Edward N. Patrick, Jr., $264,000.
•On March 14, 2005, the Compensation Committee approved executive long-term incentive awards to certain members of senior management pursuant to our 2002 Management Omnibus Incentive Plan. The long-term incentive awards were granted in a total amount of $2.0 million in the form of restricted stock, to be effective on and given a fair value of the closing price of our common stock on March 16, 2005. The restricted stock vests in three annual installments of 30% on March 16, 2006, 30% on March 16, 2007, and 40% on March 16, 2008. The $2.0 million aggregate amount will be allocated as follows: David Brussard, $800,000 worth of restricted stock; William J. Begley, Jr., $220,000 worth restricted stock; Daniel F. Crimmins, $220,000 worth of restricted stock; Robert J. Kerton, $80,000 worth of restricted stock; David E. Krupa $80,000 worth of restricted stock; Daniel D. Loranger, $300,000 worth of restricted stock; and Edward N. Patrick, Jr., $300,000 worth of restricted stock. The form of restricted stock agreement that will be entered into is attached hereto as Exhibit 10.54.
•On March 14, 2005, the Compensation Committee approved a grant of 1,000 shares of restricted stock to each of our non-employee directors (A. Richard Caputo, Jr., Frederic H. Lindeberg, Peter J. Manning, and David K. McKown) pursuant to our 2002 Management Omnibus Incentive Plan, to be effective on March 16, 2005. The shares cannot be sold, assigned, pledged or otherwise transferred, encumbered or disposed of until the recipient is no longer a member of our Board. The form of restricted stock agreement that will be entered into is attached hereto as Exhibit 10.55.
•On March 15, 2005, the Board of Directors of Safety Insurance Company approved an amendment to the Executive Incentive Compensation Plan-Adoption Agreement. The Executive Incentive Compensation Plan provides a deferred compensation benefit with a supplemental matching provision that mirrors the Company's current 401(k) retirement plan. The Company makes a matching contribution equal to 75% of the participant's elective deferrals under the plan up to 8% of the participant's compensation for the Plan Year. The adoption agreement was amended to provide that the participant's compensation for this purpose means the participant's base salary and annual bonus received (or deferred) in the plan year. The adoption agreement was also amended to permit deferral elections in 2005 pursuant to transition relief provided in connection with Section 409A of the Internal Revenue Code. The Safety Insurance Company Executive Incentive Compensation Plan, the related Adoption Agreement and the Rabbi Trust Agreement are attached hereto as Exhibits 10.51, 10.52 and 10.53, respectively.
In addition, on August 30, 2004, the Company granted Frederic H. Lindeberg 10,000 non-qualified stock options pursuant to our 2002 Management Omnibus Incentive Plan, in connection with Mr. Lindeberg's appointment to our Board. The options vest in five equal 20% annual installments beginning August 30, 2005. The option agreement entered into with Mr. Lindeberg is substantially in the form attached hereto as Exhibit 10.56.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information called for by Item 401 of Regulation S-K, regarding directors, executive officers, promoters and control persons, and not provided in Part I. Item 4A, "Executive Officers of the Registrant", will be contained in the Company's Proxy Statement for its Annual Meeting of Shareholders, to be held on May 20, 2005 in Boston, MA, which the Company intends to file with the U.S. Securities and Exchange Commission within 120 days after December 31, 2004 (the Company's fiscal year end), and such information is incorporated herein by reference.
The information called for by Item 405 of Regulation S-K regarding compliance with Section 16(a) of the Exchange Act and disclosures regarding delinquent filers will be contained in the Company's Proxy Statement for its Annual Meeting of Shareholders, to be held on May 20, 2005 in Boston, MA,
which the Company intends to file with the U.S. Securities and Exchange Commission within 120 days after December 31, 2004 (the Company's fiscal year end), and such information is incorporated herein by reference.
The information called for by Item 406 of Regulation S-K regarding the Company's code of ethics can be found on the Company's public website located on the internet at www.SafetyInsurance.com under "About Safety" and "Investor Information".
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information called for by this Item will be contained in the Company's Proxy Statement for its Annual Meeting of Shareholders, to be held on May 20, 2005 in Boston, MA, which the Company intends to file with the U.S. Securities and Exchange Commission within 120 days after December 31, 2004 (the Company's fiscal year end), and such information is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information called for by this Item will be contained in the Company's Proxy Statement for its Annual Meeting of Shareholders, to be held on May 20, 2005 in Boston, MA, which the Company intends to file with the U.S. Securities and Exchange Commission within 120 days after December 31, 2004 (the Company's fiscal year end), and such information is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for by this Item will be contained in the Company's Proxy Statement for its Annual Meeting of Shareholders, to be held on May 20, 2005 in Boston, MA, which the Company intends to file with the U.S. Securities and Exchange Commission within 120 days after December 31, 2004 (the Company's fiscal year end), and such information is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information called for by this Item will be contained in the Company's Proxy Statement for its Annual Meeting of Shareholders, to be held on May 20, 2005 in Boston, MA, which the Company intends to file with the U.S. Securities and Exchange Commission within 120 days after December 31, 2004 (the Company's fiscal year end), and such information is incorporated herein by reference.
PART IV.
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
(a)The following documents are filed as a part of this report:
1.Financial Statements: The Consolidated Financial Statements for the year ended December 31, 2004 are contained herein as listed in the Index to Consolidated Financial Statements on page 52.
2.Financial Statement Schedules: The Financial Statement Schedules are contained herein as listed in the Index to Financial Statement Schedules on page 85.
3.Exhibits: The exhibits are contained herein as listed in the Index to Exhibits on page 94.
SAFETY INSURANCE GROUP, INC.
INDEX TO FINANCIAL STATEMENT SCHEDULES
Safety Insurance Group, Inc
Summary of Investments-Other than Investments in Related Parties
Schedule I
At December 31, 2004
(Dollars in thousands)
Safety Insurance Group, Inc.
Condensed Financial Information of the Registrant
Condensed Balance Sheet
Schedule II
(Dollars in thousands)
Safety Insurance Group, Inc.
Condensed Financial Information of the Registrant
Condensed Statement of Income and Comprehensive Income
Schedule II
(Dollars in thousands)
Safety Insurance Group, Inc.
Condensed Financial Information of the Registrant
Condensed Statement of Cash Flows
Schedule II
(Dollars in thousands)
Safety Insurance Group, Inc.
Supplementary Insurance Information
Schedule III
(Dollars in thousands)
Safety Insurance Group, Inc.
Reinsurance
Schedule IV
(Dollars in thousands)
Safety Insurance Group, Inc.
Valuation and Qualifying Accounts
Schedule V
(Dollars in thousands)
Safety Insurance Group, Inc.
Supplemental Information Concerning Property-Casualty Insurance
Operations
Schedule VI
(Dollars in thousands)
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SAFETY INSURANCE GROUP, INC.
(Registrant)
Date: March 16, 2005
By:
/s/ DAVID F. BRUSSARD David F. Brussard
President, Chief Executive Officer and Chairman of the Board
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints David F. Brussard and William J. Begley, Jr., and each of them individually, his true and lawful attorney-in-fact and agent with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto each such attorney-in-fact and agent, or his substitutes, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, to all intents and purposes and as fully as he might or could do in person, hereby ratifying and confirming all that each such attorney-in-fact and agent, or his substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed by the following persons in the capacities and on the date indicated:
Signature
Title
Date
/s/ DAVID F. BRUSSARD David F. Brussard
President, Chief Executive Officer and Chairman of the Board (Principal Executive Officer)
March 16, 2005
/s/ WILLIAM J. BEGLEY, JR. William J. Begley, Jr.
Chief Financial Officer, Vice President and Secretary (Principal Financial and Accounting Officer)
March 16, 2005
/s/ A. RICHARD CAPUTO, JR. A. Richard Caputo, Jr.
Director
March 16, 2005
/s/ FREDERIC H. LINDEBERG Frederic H. Lindeberg
Director
March 16, 2005
/s/ PETER J. MANNING Peter J. Manning
Director
March 16, 2005
/s/ DAVID K. MCKOWN David K. McKown
Director
March 16, 2005
SAFETY INSURANCE GROUP, INC.
INDEX TO EXHIBITS
Exhibit
Number
Description
2.1
Merger Agreement dated May 31, 2001 by and among Safety Holdings, Inc., Safety Acquisition, Inc., Thomas Black Corporation and the stockholders of Thomas Black Coporation**
2.2
First Amendment to the Merger Agreement, dated July 17, 2001 by and among Safety Holdings, Inc., Safety Merger Co., Inc. and Thomas Black Corporation**
3.1
Form of Amended and Restated Certificate of Incorporation of Safety Insurance Group, Inc.**
3.2
Form of Amended and Restated Bylaws of Safety Insurance Group, Inc.**
Form of Stock Certificate for the Common Stock**
10.1
Lease Agreement between Thomas Black Corporation and Aman, Inc. for the lease of office space located on the 1st through 5th, 11th and 12th floors of 20 Custom House Street, Boston, Massachusetts, dated June 11, 1987, and as amended on October 11, 1988, September 14, 1989, September 19, 1990, February 23, 1994 and December 20, 1996.**
10.2
Stockholders Agreement of Safety Holdings, Inc., dated October 16, 2001.(1)**
10.3
Purchase Agreement between Safety Holdings, Inc. and JZ Equity Partners plc, dated as of October 15, 2001.**
10.4
Subscription Agreement by and among Safety Holdings, Inc. and the Management Team, dated as of October 16, 2001.(1)**
10.5
Subscription Agreement by and among Safety Holdings, Inc. and John W. Jordan II Revocable Trust, Leucadia Investors, Inc., David W. Zalaznick, Jonathan F. Boucher, Adam E. Max, A. Richard Caputo, Jr., Paul Rodzevik, Brian Higgins, Douglas J. Zych and Robert D. Mann, dated as of October 16, 2001.**
10.6
Promissory Note between Safety Holdings, Inc. and David F. Brussard, dated October 16, 2001.(1)**
10.7
Promissory Note between Safety Holdings, Inc. and David F. Brussard, dated October 16, 2001.(1)**
10.8
Promissory Note between Safety Holdings, Inc. and Daniel F. Crimmins, dated October 16, 2001.(1)**
10.9
Promissory Note between Safety Holdings, Inc. Robert J. Kerton, dated October 16, 2001.(1)**
10.10
Promissory Note between Safety Holdings, Inc. and Daniel D. Loranger, dated October 16, 2001.(1)**
10.11
Promissory Note between Safety Holdings, Inc. and Daniel D. Loranger, dated October 16, 2001.(1)**
10.12
Promissory Note between Safety Holdings, Inc. and Edward N. Patrick, Jr., dated October 16, 2001.(1)**
10.13
Pledge Agreement between Safety Holdings, Inc. and David F. Brussard, dated October 16, 2001.(1)**
10.14
Pledge Agreement between Safety Holdings, Inc. and David F. Brussard, dated October 16, 2001.(1)**
10.15
Pledge Agreement between Safety Holdings, Inc. and Daniel F. Crimmins, dated October 16, 2001.(1)**
10.16
Pledge Agreement between Safety Holdings, Inc. and Robert J. Kerton, dated October 16, 2001.(1)**
10.17
Pledge Agreement between Safety Holdings, Inc. and Daniel D. Loranger, dated October 16, 2001.(1)**
10.18
Pledge Agreement between Safety Holdings, Inc. and Daniel D. Loranger, dated October 16, 2001.(1)**
10.19
Pledge Agreement between Safety Holdings, Inc. and Edward N. Patrick, Jr., dated October 16, 2001.(1)**
10.20
Tax Indemnity Agreement by and among Safety Holdings, Inc. and the Management Team, dated October 16, 2001.**
10.21
Management Consulting Agreement by and among TJC Management Corporation and Safety Holdings, Inc., dated October 16, 2001.**
10.22
Form of First Amendment to the Management Consulting Agreement by and among TJC Management Corporation and Safety Group.**
10.23
2001 Restricted Stock Plan(1)**
10.24
Executive Incentive Compensation Plan(1)**
10.25
2002 Management Omnibus Incentive Plan(1)**
10.26
Employment Agreement by and between Safety Insurance Group, Inc. and David F. Brussard, dated November 8, 2004.(1)*
10.27
Employment Agreement by and between Safety Insurance Group, Inc. and Edward N. Patrick, Jr., dated November 8, 2004.(1)*
10.28
Employment Agreement by and between Safety Insurance Group, Inc. and Daniel F. Crimmins, dated November 8, 2004.(1)*
10.29
Employment Agreement by and between Safety Insurance Group, Inc. and Daniel D. Loranger, dated November 8, 2004.(1)*
10.30
Employment Agreement by and between Safety Insurance Group, Inc. and Robert J. Kerton, dated November 8, 2004.(1)*
10.31
Stock Appreciation Rights Agreement by and between Safety Holdings, Inc. and David F. Brussard.(1)**
10.32
Stock Appreciation Rights Agreement by and between Safety Holdings, Inc. and Daniel F. Crimmins.(1)**
10.33
Stock Appreciation Rights Agreement by and between Safety Holdings, Inc. and Daniel D. Loranger.(1)**
10.34
Stock Appreciation Rights Agreement by and between Safety Holdings, Inc. and Robert J. Kerton.(1)**
10.35
Stock Appreciation Rights Agreement by and between Safety Holdings, Inc. and Edward N. Patrick, Jr.(1)**
10.36
Senior Subordinated Note issued to Fairholme Partners, L.P. **
10.37
Senior Subordinated Note issued to TCW/Crescent Mezzanine Trust III.**
10.38
Senior Subordinated Note issued to TCW/Crescent Mezzanine Partners III, L.P.**
10.39
Senior Subordinated Note issued to TCW/Crescent Mezzanine Partners III Netherlands, L.P.**
10.40
Senior Subordinated Note issued to J/Z CBO (Delaware), LLC.**
10.41
Senior Subordinated Note issued to JZ Equity Partners plc.**
10.42
Reinsurance Agreement between Safety Insurance Company, Safety Indemnity Insurance Company and the Hartford Steam Boiler Inspection and Insurance Company, effective February 1, 2000.**
10.43
Reinsurance Terms Sheet between Safety Insurance Company and Swiss Re America Corporation, effective January 1, 2002.**
10.44
Excess Catastrophe Reinsurance Program Terms Sheet between Safety Insurance Company, Safety Indemnity Insurance Company and Benfield Blanch, effective January 1, 2002.**
10.45
Property Risk Excess of Loss Reinsurance Program Terms Sheet between Safety Insurance Company, Safety Indemnity Insurance Company and Benfield Blanch, effective January 1, 2002.**
10.46
Safety Insurance Group, Inc. Stock Purchase Agreement by and between Safety Insurance Group, Inc. and Fairholme Partners, L.P.**
10.47
Form of Second Omnibus Agreement by and among Safety Insurance Group, Inc. and David F. Brussard, Edward N. Patrick, Jr., William J. Begley, Jr., Daniel F. Crimmins, Daniel D. Loranger, Robert J. Kerton, David E. Krupa, Leucadia Investors, Inc., John W. Jordan II Rev. Trust, David W. Zalaznick, Jonathan F. Boucher, A. Richard Caputo, Jr., Adam E. Max, Douglas J. Zych, Brian Higgins, Paul Rodzevik, JZ Equity Partners plc, J/Z CBO (Delaware), LLC, TCW/Crescent Mezzanine Trust III, TCW/Crescent Mezzanine Partners III, L.P., TCW/Crescent Mezzanine Partners III (Netherlands), L.P., Fairholme Partners, L.P. and Robert D. & Ann Marie Mann, Trustees, Mann Trust, 4/16/00.(1)**
10.48
Promissory Note between Safety Holdings, Inc. and William J. Begley, Jr., dated October 16, 2001.(1)(2)
10.49
Pledge Agreement between Safety Holdings, Inc. and William J. Begley, Jr., dated October 16, 2001.(1)(2)
10.50
Employment Agreement by and between Safety Insurance Group, Inc. and William J. Begley, Jr., dated November 8, 2004.(1)*
10.51
Safety Insurance Company Executive Incentive Compensation Plan-Basic Document(1)(2)
10.52
Safety Insurance Company Executive Incentive Compensation Plan-Adoption Agreement(1)(2)
10.53
Safety Insurance Company Executive Incentive Compensation Plan-Rabbi Trust Agreement(1)(2)
10.54
Form of Restricted Stock Notice and Agreement (with vesting) under the 2002 Management Omnibus Incentive Plan(1)(2)
10.55
Form of Restricted Stock Notice and Agreement (without vesting) under the 2002 Management Omnibus Incentive Plan(1)(2)
10.56
Form of Nonqualified Stock Option Notice and Agreement under the 2002 Management Omnibus Incentive Plan(1)(2)
10.57
Form of Incentive Stock Option Notice and Agreement under the 2002 Management Omnibus Incentive Plan(1)(2)
10.58
Form of Stock Appreciation Right Notice and Agreement under the 2002 Management Omnibus Incentive Plan(1)(2)
10.59
Employment Agreement by and between Safety Insurance Group, Inc. and David E. Krupa, dated November 8, 2004.(1)*
Subsidiaries of Safety Insurance Group, Inc.**
Consent of PricewaterhouseCoopers LLP.(2)
Power of Attorney**
31.1
CEO Certification Pursuant to Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.(2)
31.2
CFO Certification Pursuant to Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.(2)
32.1
CEO Certification Pursuant to U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(2)
32.2
CFO Certification Pursuant to U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(2)
*Incorporated herein by reference to the Registrant's September 30, 2004 Quarterly Report on Form 10-Q (File No. 000-50070) filed November 9, 2004.
**Incorporated herein by reference to the Registant's Registration Statement on Form S-1 (File No. 333-87056) filed April 26, 2002, as amended.
(1)Denotes management contract or compensation plan or arrangement.
(2)Included herein.
SAFETY INSURANCE GROUP, INC. Table of Contents
PART I.
ITEM 1. BUSINESS
ITEM 2. PROPERTIES
ITEM 3. LEGAL PROCEEDINGS
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
PART II.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
ITEM 6. SELECTED FINANCIAL DATA
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
SAFETY INSURANCE GROUP, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
Safety Insurance Group, Inc. and Subsidiaries Consolidated Balance Sheets (Dollars in thousands, except share data)
Safety Insurance Group, Inc. and Subsidiaries Consolidated Statements of Operations (Dollars in thousands, except per share and share data)
Safety Insurance Group, Inc. and Subsidiaries Consolidated Statements of Changes in Shareholders' Equity (Dollars in thousands)
Safety Insurance Group, Inc. and Subsidiaries Consolidated Statements of Comprehensive Income (Dollars in thousands)
Safety Insurance Group, Inc. and Subsidiaries Consolidated Statements of Cash Flows (Dollars in thousands)
Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)
Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)
Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
ITEM 9A. CONTROLS AND PROCEDURES
ITEM 9B. OTHER INFORMATION
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
ITEM 11. EXECUTIVE COMPENSATION
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
PART IV.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
SAFETY INSURANCE GROUP, INC. INDEX TO FINANCIAL STATEMENT SCHEDULES
Safety Insurance Group, Inc Summary of Investments-Other than Investments in Related Parties Schedule I At December 31, 2004 (Dollars in thousands)
Safety Insurance Group, Inc. Condensed Financial Information of the Registrant Condensed Balance Sheet Schedule II (Dollars in thousands)
Safety Insurance Group, Inc. Condensed Financial Information of the Registrant Condensed Statement of Income and Comprehensive Income Schedule II (Dollars in thousands)
Safety Insurance Group, Inc. Condensed Financial Information of the Registrant Condensed Statement of Cash Flows Schedule II (Dollars in thousands)
Safety Insurance Group, Inc. Reinsurance Schedule IV (Dollars in thousands)
Safety Insurance Group, Inc. Valuation and Qualifying Accounts Schedule V (Dollars in thousands)
Safety Insurance Group, Inc. Supplemental Information Concerning Property-Casualty Insurance Operations Schedule VI (Dollars in thousands)
SIGNATURES
POWER OF ATTORNEY
SAFETY INSURANCE GROUP, INC. INDEX TO EXHIBITS