FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For Quarterly Period Ended March 31, 2004
OR
For the Transition Period from to
Commission file number 0-18298
Unitrin, Inc.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
(312) 661-4600
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
68,291,332 shares of common stock, $0.10 par value, were outstanding as of April 20, 2004.
UNITRIN, INC.
INDEX
PART I.
Item 1.
Item 2.
Item 3.
Item 4.
PART II.
Item 6.
Signatures
UNITRIN, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Dollars in millions, except per share amounts)
(Unaudited)
Revenues:
Earned Premiums
Consumer Finance Revenues
Net Investment Income
Other Income
Net Realized Investment Gains
Total Revenues
Expenses:
Insurance Claims and Policyholders’ Benefits
Insurance Expenses
Consumer Finance Expenses
Interest and Other Expenses
Total Expenses
Income before Income Taxes and Equity in Net Income (Loss) of Investee
Income Tax Expense
Income before Equity in Net Income (Loss) of Investee
Equity in Net Income (Loss) of Investee
Net Income
Net Income Per Share
Net Income Per Share Assuming Dilution
The Notes to the Condensed Consolidated Financial Statements are an integral part of these financial statements.
1
CONDENSED CONSOLIDATED BALANCE SHEETS
Assets:
Investments:
Fixed Maturities at Fair Value (Amortized Cost: 2004 - $3,634.2; 2003 - $3,531.6)
Northrop Grumman Corporation Preferred Stock at Fair Value (Cost: 2004 - $177.5; 2003 - $177.5)
Northrop Grumman Corporation Common Stock at Fair Value (Cost: 2004 - $518.4; 2003 - $572.2)
Other Equity Securities at Fair Value (Cost: 2004 - $341.4; 2003 - $342.7)
Investee (UNOVA, Inc.) at Cost Plus Cumulative Undistributed Earnings (Fair Value: 2004 - $273.5; 2003 - $290.5)
Short-term Investments at Cost which Approximates Fair Value
Other
Total Investments
Cash
Consumer Finance Receivables at Cost (Fair Value: 2004 - $917.4; 2003 - $906.7)
Other Receivables
Deferred Policy Acquisition Costs
Goodwill
Other Assets
Total Assets
Liabilities and Shareholders’ Equity:
Insurance Reserves:
Life and Health
Property and Casualty
Total Insurance Reserves
Investment Certificates and Savings Accounts at Cost (Fair Value: 2004 - $919.4; 2003 - $918.9)
Unearned Premiums
Accrued and Deferred Income Taxes
Senior Notes Payable at Amortized Cost (Fair Value: 2004 - $532.5; 2003 - $519.4)
Accrued Expenses and Other Liabilities
Total Liabilities
Shareholders’ Equity:
Common Stock, $0.10 par value, 100 million Shares Authorized; 68,205,150 Shares Issued and Outstanding at March 31, 2004 and 67,778,023 Shares Issued and Outstanding at December 31, 2003
Paid-in Capital
Retained Earnings
Accumulated Other Comprehensive Income
Total Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
2
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in millions)
Operating Activities:
Adjustments to Reconcile Net Income to Net Cash Provided (Used) by Operating Activities:
Increase in Deferred Policy Acquisition Costs
Equity in Net (Income) Loss of Investee before Taxes
Amortization of Investments
Decrease in Other Receivables
Increase in Insurance Reserves and Unearned Premiums
Increase (Decrease) in Accrued and Deferred Income Taxes
Increase in Accrued Expenses and Other Liabilities
Provision for Loan Losses
Other, Net
Net Cash Provided by Operating Activities
Investing Activities:
Sales and Maturities of Fixed Maturities
Purchases of Fixed Maturities
Sales of Northrop Common Stock
Sales of Other Equity Securities
Purchases of Equity Securities
Change in Short-term Investments
Acquisition and Improvements of Investment Real Estate
Sale of Investment Real Estate
Change in Other Investments
Change in Consumer Finance Receivables
Net Cash Used by Investing Activities
Financing Activities:
Change in Investment Certificates and Savings Accounts
Change in Universal Life and Annuity Contracts
Change in Liability for Funds Held for Securities on Loan
Notes Payable Proceeds
Notes Payable Payments
Cash Dividends Paid
Common Stock Repurchases
Cash Exercise of Stock Options
Net Cash Provided by Financing Activities
Increase in Cash
Cash, Beginning of Year
Cash, End of Period
3
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - Basis of Presentation
The unaudited Condensed Consolidated Financial Statements included herein have been prepared by Unitrin, Inc. (“Unitrin” or the “Company”) pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”) but do not include all information and footnotes required by accounting principles generally accepted in the United States of America. In the opinion of the Company’s management, the unaudited Condensed Consolidated Financial Statements include all adjustments necessary for a fair presentation. The preparation of interim financial statements relies heavily on estimates. This factor and certain other factors, such as the seasonal nature of some portions of the insurance business, as well as market conditions, call for caution in drawing specific conclusions from interim results. The accompanying unaudited Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and related notes included in the Company’s Annual Report on Form 10-K, filed with the SEC for the year ended December 31, 2003.
Stock-Based Compensation
Effective January 1, 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” and as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” prospectively to all awards granted, modified or settled on or after January 1, 2003.
The effects on Net Income, Net Income Per Share and Net Income Per Share Assuming Dilution if the fair value based method had been applied to all awards since the effective date of SFAS No. 123 for the periods presented below were:
(Dollars in Millions, Except Per Share Amounts)
Net Income, As Reported
Add: Stock-Based Compensation Expense Included in Reported Net Income, Net of Related Tax Effects
Deduct: Total Stock-Based Employee Compensation Expense Determined under Fair Value Based Method for All Awards, Net of Related Tax Effects
Pro Forma Net Income
Net Income Per Share:
As Reported
Pro Forma
Net Income Per Share Assuming Dilution:
4
Note 2 - Acquisition of Businesses
In June 2002, the Company acquired the personal lines property and casualty insurance business of the Kemper Insurance Companies (“KIC”). KIC retained all liabilities for policies issued by Kemper Auto and Home (“KAH”) prior to the closing, while Trinity Universal Insurance Company (“Trinity”), a subsidiary of Unitrin, is entitled to premiums written for substantially all policies issued or renewed by the Kemper Auto and Home segment after the closing and is liable for losses and expenses incurred thereon. At the acquisition date, Unitrin’s property and casualty insurance subsidiaries were not licensed in all the states where the KAH business is written nor were certain computer and data processing modifications completed to allow for the migration of the KAH business to the Company’s property and casualty insurance subsidiaries. Accordingly, to facilitate the transition of such business to Unitrin’s property and casualty insurance subsidiaries, KIC and Trinity entered into a quota share reinsurance agreement whereby Trinity reinsured, on a 100% indemnity basis, substantially all of the KAH business written or renewed by KIC after the acquisition date. KIC’s financial condition deteriorated rapidly after the acquisition, and accordingly, Unitrin accelerated its plans to transition the business directly to its property and casualty insurance subsidiaries. As of March 31, 2004, Unitrin’s property and casualty insurance subsidiaries have obtained all necessary licenses, have completed all computer and data processing modifications and approximately 75% of the in-force KIC personal lines policies had been renewed directly by Unitrin’s property and casualty insurance subsidiaries and renewal notices for an additional 10% had been sent to policyholders. Unitrin expects that approximately 92% of the in-force KIC personal lines policies at the end of the second quarter of 2004 will have been renewed directly by Unitrin’s property and casualty insurance subsidiaries and renewal notices will have been sent to an additional 5% of policyholders.
Note 3 - Investment in Investee
Equity in Net Income (Loss) of Investee was a loss of $0.1 million and income of $0.4 million for the three months ended March 31, 2004 and 2003, respectively. Unitrin accounts for its investment in its investee, UNOVA, Inc. (“UNOVA”), under the equity method of accounting using the most recent and sufficiently timely publicly-available financial reports and other publicly-available information, which generally results in a three month delay in the inclusion of UNOVA’s results in Unitrin’s consolidated financial statements. Prior to the periods presented in the Condensed Consolidated Financial Statements, Unitrin determined that a decline in the fair value of its investment in UNOVA was other than temporary under applicable accounting standards. Accordingly, Unitrin reduced the carrying value of its investment in UNOVA to its then current estimated realizable value and allocated the reduction to Unitrin’s proportionate share of UNOVA’s non-current assets. Accordingly, Unitrin’s reported equity in the net income of UNOVA differs from Unitrin’s proportionate share of UNOVA’s reported results to the extent that such results include depreciation, amortization or other charges related to such non-current assets. The fair value of Unitrin’s investment in UNOVA subsequently recovered such that the fair value exceeded the carrying value of Unitrin’s investment in UNOVA by $207.6 million and $225.8 million at March 31, 2004 and December 31, 2003, respectively. In accordance with applicable accounting standards, such excess is not included in the Condensed Consolidated Financial Statements.
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Note 4 - Other Receivables
Under the agreement governing the 1999 acquisition of Valley Group, Inc. (“VGI”), the Company is entitled to recover 90% of unfavorable development on VGI’s pre-acquisition loss and loss adjustment expense reserves from the seller, White Mountains Insurance Group, Ltd. (“White Mountains”) (formerly Fund American Enterprise Holdings, Inc.). Recovery is subject to a maximum limit of $50 million. Such reserves have experienced unfavorable development, 90% of the amount of which exceeded the maximum recovery under the agreement. Accordingly, the recoverable at March 31, 2004 is recorded at the maximum limit. The Company delivered a final reserve report to White Mountains on March 7, 2003. On April 4, 2003, White Mountains responded to the Company and indicated, among other things, that it believes that “the final reserve report does not constitute an appropriate calculation of the [unfavorable development] and we will not pay Unitrin the amount indicated.” An exchange of information between the parties ensued. The Company believes it has accurately calculated the reserve amount in question and is pursuing resolution of the matter in accordance with the dispute resolution process provided in the agreement.
On December 31, 2002, Unitrin completed the acquisition of two insurance companies, General Security Insurance Company and General Security Property and Casualty Company (the “SCOR Companies”), from SCOR Reinsurance Company (“SCOR”). Other Receivables at March 31, 2004 and December 31, 2003 included reinsurance recoverables of $218.4 million and $234.4 million, respectively, from General Security National Insurance Company (“GSNIC”), a subsidiary of SCOR. Under the agreement governing the acquisition of the SCOR Companies, SCOR and/or GSNIC are responsible for all liabilities of the SCOR Companies incurred prior to the acquisition. Accordingly, in connection with the sale, GSNIC entered into a reinsurance agreement with the SCOR Companies whereby GSNIC reinsured all of the business written by the seller using the SCOR Companies. To the extent the SCOR Companies are not fully relieved of their legal obligations to policyholders under the reinsurance agreement, Unitrin reports an obligation to policyholders as a liability of the SCOR Companies, with an offsetting and corresponding reinsurance recoverable from GSNIC. The ceding of the SCOR Companies’ insurance liabilities does not discharge the primary liability of the SCOR Companies; therefore, the SCOR Companies remain contingently liable should GSNIC not be financially able to meet the obligations. Pursuant to the reinsurance agreement, should GSNIC become unauthorized in any jurisdiction where authorization or licensure by governmental authorities is required in order for the SCOR Companies to take full credit on their statutory financial statements for reinsurance ceded to GSNIC, or should GSNIC be notified that it is required to file a risk-based capital (“RBC”) plan as a result of its RBC falling below required levels, certain remedies are available. In either case, the reinsurance agreement requires GSNIC to collateralize its outstanding reinsured obligation. On April 1, 2004, A.M. Best Co., Inc., the principal insurance company rating agency, reaffirmed the “B++” rating of GSNIC, assigned the rating an outlook of “stable” and removed the “under review” status of the rating. The Company believes that its reinsurance recoverable from GSNIC continues to be fully collectable at March 31, 2004.
Note 5 - Income Taxes
During the first quarter of 2003, Fireside Securities Corporation (“Fireside”) a subsidiary of Unitrin, was officially notified that its California franchise tax returns for 1998, 1999 and 2000 would be examined by the California Franchise Tax Board (the “FTB”). During the first quarter of 2004, the FTB and Fireside reached agreement on adjustments to these tax returns. The impact of these adjustments was not material to the Company’s consolidated financial statements.
6
Note 6 - Notes Payable
Total Debt Outstanding at March 31, 2004 and December 31, 2003 was:
(Dollars in Millions)
Senior Notes at Amortized Cost:
5.75% Senior Notes due July 1, 2007
4.875% Senior Notes due November 1, 2010
Total Debt Outstanding
The Company had no outstanding advances under its unsecured revolving credit agreement at March 31, 2004 and December 31, 2003.
Interest Paid, including facility fees, for the three months ended March 31, 2004 and 2003 was:
Notes Payable under Revolving Credit Agreement
Total Interest Paid
Interest Expense, including facility fees, for the three months ended March 31, 2004 and 2003 was:
Total Interest Expense
Note 7 - Securities Lending
Some of the Company’s subsidiaries are parties to securities lending agreements whereby unrelated parties, primarily large brokerage firms, borrow securities from the subsidiaries’ accounts. Borrowers of these securities must deposit cash collateral with the subsidiaries equal to 102% of the fair value of the securities loaned. The subsidiaries continue to receive the interest on loaned securities as beneficial owners, and accordingly, the loaned securities are included in Fixed Maturities. The amount of collateral received is invested in short-term securities and is included in these financial statements as Short-term Investments with a corresponding Liability for Funds Held for Securities on Loan included in Accrued Expenses and Other Liabilities. The fair value of collateral held was $132.3 million at March 31, 2004. No securities were on loan at December 31, 2003.
7
Note 8 - Net Income Per Share
Net Income Per Share and Net Income Per Share Assuming Dilution for the three months ended March 31, 2004 and 2003 were as follows:
(Dollars and Shares in Millions, Except Per Share Amounts)
Dilutive Effect on Net Income from Investee’s Equivalent Shares
Net Income Assuming Dilution
Weighted Average Common Shares Outstanding
Dilutive Effect of Unitrin Stock Option Plans
Weighted Average Common Shares and Equivalent Shares Outstanding Assuming Dilution
Options outstanding at March 31, 2004 and 2003 to purchase 0.9 million shares and 6.1 million shares, respectively, of Unitrin common stock were excluded from the computation of Net Income Per Share Assuming Dilution for the three months ended March 31, 2004 and 2003, respectively, because the exercise price exceeded the average market price.
Note 9 - Other Comprehensive Income (Loss)
Other Comprehensive Income (Loss) for the three months ended March 31, 2004 and 2003 was:
Increase (Decrease) in Unrealized Gains, Net of Reclassification Adjustment for Gains Included in Net Income
Effect of Income Taxes
Other Comprehensive Income (Loss)
The Company’s Investment in Investee is accounted for under the equity method of accounting and, accordingly, changes in its fair value are excluded from the determination of Total Comprehensive Income and Other Comprehensive Income (Loss). Total Comprehensive Income for the three months ended March 31, 2004 was $101.6 million. Total Comprehensive Loss for the three months ended March 31, 2003 was $57.5 million.
8
Note 10 - Income from Investments
Net Investment Income for the three months ended March 31, 2004 and 2003 was:
Investment Income:
Interest and Dividends on Fixed Maturities
Dividends on Northrop Preferred Stock
Dividends on Northrop Common Stock
Dividends on Other Equity Securities
Short-term
Real Estate
Total Investment Income
Investment Expenses:
Total Investment Expenses
Dividends on Northrop Preferred Stock increased for the three months ended March 31, 2004, compared to the same period in 2003, due to the timing of the ex-dividend date.
The components of Net Realized Investment Gains for the three months ended March 31, 2004 and 2003 were:
Fixed Maturities:
Gains on Dispositions
Losses on Dispositions
Losses from Write-downs
Northrop Common Stock:
Other Equity Securities:
Other Investments:
9
Note 10 - Income from Investments (continued)
Net Realized Investment Gains was $18.5 million for the three months ended March 31, 2004, compared to $5.9 million for the same period in 2003. Net Realized Investment Gains for the three months ended March 31, 2004 includes pre-tax gains of $8.3 million from sales of a portion of the Company’s investment in Northrop Grumman Corporation (“Northrop”) common stock, pre-tax gains of $4.1 million from sales of a portion of the Company’s investment in Baker Hughes, Inc. (“Baker Hughes”) common stock and pre-tax gains of $3.2 million resulting from sales of a portion of the Company’s investment in Hartford Financial Services Group, Inc. (“Hartford”) common stock. The fair value of the Company’s remaining investments in Northrop common stock, Baker Hughes common stock and Hartford common stock was $591.3 million, $84.1 million and $19.7 million, respectively, at March 31, 2004. The Company cannot anticipate when or if similar investment gains may occur in the future.
Net Realized Investment Gains for the three months ended March 31, 2003 includes pre-tax gains of $11.9 million from sales of a portion of the Company’s investment in ITT Industries, Inc. common stock and pre-tax gains of $4.4 million resulting from sales of a portion of the Company’s investment in Baker Hughes common stock. The Company cannot anticipate when or if similar investment gains may occur in the future.
The Company regularly reviews its investment portfolio for factors that may indicate that a decline in fair value of an investment is other than temporary. Some factors considered in evaluating whether or not a decline in fair value is other than temporary include: 1) the Company’s ability and intent to retain the investment for a period of time sufficient to allow for a recovery in value; 2) the duration and extent to which the fair value has been less than cost; and 3) the financial condition and prospects of the issuer. Net Realized Investment Gains for the three months ended March 31, 2004 and 2003 includes pre-tax losses of $0.7 million and $13.1 million, respectively, resulting from other than temporary declines in the fair value of investments. The Company cannot anticipate when or if similar other than temporary declines in the fair value of investments may occur in the future.
Note 11 – Pension Benefits and Postretirement Benefits Other Than Pensions
The components of Pension Expense for the three months ended March 31, 2004 and 2003 were:
Service Cost Benefits Earned
Interest Cost on Projected Benefit Obligations
Expected Return on Plan Assets
Net Amortization and Deferral
Total Pension Expense
The components of Postretirement Benefits Other than Pensions Expense for the three months ended March 31, 2004 and 2003 were:
Total Postretirement Benefits Other than Pensions Expense
10
Note 12 - Business Segments
The Company is engaged, through its subsidiaries, in the property and casualty insurance, life and health insurance and consumer finance businesses. The Company conducts its operations through six operating segments: Multi Lines Insurance, Specialty Lines Insurance, Kemper Auto and Home, Unitrin Direct, Life and Health Insurance and Consumer Finance.
Insurance provided by the Multi Lines Insurance segment consists of preferred and standard risk automobile, homeowners, fire, commercial liability and workers compensation and other related lines. Multi Lines Insurance products are marketed to individuals and businesses with favorable risk characteristics and loss histories and are sold by independent agents.
The Specialty Lines Insurance segment primarily consists of automobile and motorcycle insurance sold to individuals and businesses in the non-standard and specialty market through independent agents. The non-standard automobile insurance market consists of individuals and companies that have difficulty obtaining standard or preferred risk insurance, usually because of their driving records.
Kemper Auto and Home provides preferred and standard risk personal automobile and homeowners insurance through independent agents.
Unitrin Direct markets personal automobile insurance through direct mail and the Internet through web insurance portals, click-thrus and its own website. Unitrin Direct, as a direct marketer, typically incurs higher up-front acquisition costs associated with marketing products and acquiring new policies but is expected to experience lower renewal costs than traditional insurance providers.
The Life and Health Insurance segment includes individual life, accident, health and hospitalization insurance. The Company’s Life and Health Insurance employee-agents also market property insurance products under common management.
The Consumer Finance segment makes consumer loans primarily for the purchase of pre-owned automobiles and offers savings products in the form of investment certificates and savings accounts.
It is the Company’s management practice to allocate certain corporate expenses to its operating units. The Company considers the management of certain investments, including Northrop common and preferred stock, Baker Hughes common stock and UNOVA common stock, to be a corporate responsibility. Accordingly, the Company does not allocate dividend income from these investments to its operating segments. The Company does not allocate Net Realized Investment Gains to its operating segments. In the first quarter of 2004, the Company began allocating income taxes to its operating segments. Income taxes for prior periods have been allocated to conform to the current presentation.
11
Note 12 - Business Segments (continued)
Segment Revenues for the three months ended March 31, 2004 and 2003 were:
Multi Lines Insurance:
Total Multi Lines Insurance
Specialty Lines Insurance:
Total Specialty Lines Insurance
Kemper Auto and Home:
Total Kemper Auto and Home
Unitrin Direct:
Total Unitrin Direct
Life and Health Insurance:
Total Life and Health Insurance
Consumer Finance
Total Segment Revenues
Unallocated Dividend Income
12
Segment Operating Profit for the three months ended March 31, 2004 and 2003 was:
Segment Operating Profit (Loss):
Multi Lines Insurance
Specialty Lines Insurance
Kemper Auto and Home
Unitrin Direct
Life and Health Insurance
Total Segment Operating Profit
Other Expense, Net
Income Before Income Taxes and Equity in Net Income (Loss) of Investee
Segment Net Income for the three months ended March 31, 2004 and 2003 was:
Segment Net Income (Loss):
Total Segment Net Income
Net Income From:
Income Before Equity in Net Income (Loss) of Investee
13
Note 13 - Related Party Transactions
One of Unitrin’s directors, Mr. Fayez Sarofim, is the Chairman of the Board, President and the majority shareholder of Fayez Sarofim & Co. (“FS&C”), a registered investment advisory firm. Certain of the Company’s insurance company subsidiaries and FS&C are parties to agreements under which FS&C provides investment management services. In addition, FS&C provides investment management services with respect to certain funds of the Company’s pension plan. The agreements governing these arrangements are terminable by either party at any time upon 30 days advance written notice.
Under these investment advisory arrangements, FS&C is entitled to a fee calculated and payable quarterly based upon the fair market value of the assets under management. At March 31, 2004, the Company’s subsidiaries and the Company’s pension plan had approximately $162.0 million and $71.2 million, respectively, in investments managed by FS&C. During the first three months of 2004, the Company’s subsidiaries and the Company’s pension plan paid $0.1 million in the aggregate to FS&C. During the first three months of 2003, the Company’s subsidiaries and the Company’s pension plan paid $0.1 million in the aggregate to FS&C.
With respect to the Company’s 401(k) Savings Plan, one of the alternative investment choices afforded to participating employees is the Dreyfus Appreciation Fund, an open-end, diversified managed investment fund. FS&C provides investment management services to the Dreyfus Appreciation Fund as a sub-investment advisor. According to published reports filed by FS&C with the SEC, the Dreyfus Appreciation Fund pays monthly fees to FS&C according to a graduated schedule computed at an annual rate based on the value of the Dreyfus Appreciation Fund’s average daily net assets. The Company does not compensate FS&C for services provided to the Dreyfus Appreciation Fund. As of March 31, 2004, employees participating in the Company’s 401(k) Savings Plan had allocated approximately $24.9 million for investment in the Dreyfus Appreciation Fund, representing approximately 12% of the total amount invested in the Company’s 401(k) Savings Plan.
The Company believes that the transactions described above have been entered into on terms no less favorable than could have been negotiated with non-affiliated third parties.
As described in Note 15, the Company also has certain relationships with mutual insurance holding companies and mutual insurance companies. Such companies are owned by the policyholders of such companies or their insurance subsidiaries.
Note 14 - Legal Proceedings
The Company and its subsidiaries are defendants in various legal actions incidental to their businesses. Many of these actions are pending in jurisdictions that permit damages, including punitive damages, that are disproportionate to the actual economic damages alleged to have been incurred. The plaintiffs in certain of these suits seek class action status that, if granted, could expose the Company and its subsidiaries to potentially significant liability by virtue of the size of the purported classes. The State of Mississippi, where the Company and some of its subsidiaries are defendants in a number of lawsuits, has received national attention for a large number of multi-million dollar jury verdicts and settlements against corporations in a variety of industries. Although Mississippi law does not permit class actions, case law there allows for virtually unlimited joinder of plaintiffs in a single action, thereby simulating a class action lawsuit, and the Company and some of its subsidiaries are defendants in such quasi-class action lawsuits. The Company and its subsidiaries believe that there are meritorious defenses to the cases referenced in this paragraph and are defending them vigorously. Although the Company believes that resolution of these cases will not have a material adverse effect on the Company’s financial position, the frequency of large damage awards, including punitive damage awards having little or no relationship to the actual economic damages allegedly incurred, means that there can be no assurance that one or more of these cases will not produce a damage award which could have a material adverse effect on the Company’s financial results for any given period.
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Note 15 – Relationships with Mutual Holding Companies and Mutual Insurance Companies
Trinity and Milwaukee Insurance Company (“MIC”) are parties to a quota share reinsurance agreement whereby Trinity assumes 95% of the business written or assumed by MIC. MIC is owned by Mutual Insurers Holding Company (“MIHC”), which in turn is owned by MIC’s policyholders. Effective July 1, 2001, MIC and First Nonprofit Insurance Company (through its predecessor, First Nonprofit Mutual Insurance Company) (“FNP”) are parties to a quota share reinsurance agreement whereby MIC assumes 80% of the business written or assumed by FNP. Pursuant to an amendment to the MIC/FNP reinsurance agreement, which became effective January 15, 2003, FNP agrees to arrange for its parent company, First Nonprofit Mutual Holding Company (“FNMHC”), to nominate a simple majority to the FNMHC Board of Directors selected by MIC. On January 15, 2003, FNMHC elected five employees of the Company, as selected by MIC, to the FNMHC Board of Directors pursuant to the terms of the amendment. FNP is owned by FNMHC, which in turn is owned by FNP’s policyholders. Five employees of the Company also serve as directors of MIHC’s nine member Board of Directors. Two employees of the Company also serve as directors of MIC, but together do not constitute a majority of MIC’s Board of Directors. The quota share agreements above can be terminated at anytime by each of the parties to the respective agreements, subject to the notice requirements in such agreements.
Trinity and Capitol County Mutual Fire Insurance Company (“Capitol”) are parties to a quota share reinsurance agreement whereby Trinity assumes 95% of the business written by Capitol. Capitol is a mutual insurance company and, accordingly, is owned by its policyholders. The Reliable Life Insurance Company (“Reliable”), a wholly-owned subsidiary of Unitrin, provides certain administrative services to Capitol and its subsidiary, Old Reliable Casualty Company (“ORCC”). In addition, agents employed by Reliable are also appointed by Capitol and ORCC to sell property insurance products. Union National Life Insurance Company, a wholly-owned subsidiary of Unitrin, also provides claims administration services to Capitol and ORCC.
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Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition
Summary of Results
Net Income was $48.0 million ($0.71 per common share) for the three months ended March 31, 2004, compared to $13.4 million ($0.20 per common share) for the same period in 2003. Net Income increased for the three months ended March 31, 2004, due primarily to higher segment operating profit and higher net realized investment gains as discussed throughout this Management’s Discussion and Analysis of Results of Operations and Financial Condition.
Earned Premiums for the three months ended March 31, 2004 increased by $33.1 million, compared to the same period in 2003, due primarily to a $46.8 million increase in earned premiums in the Kemper Auto and Home segment and a $8.6 million increase in earned premiums in the Unitrin Direct segment, partially offset by a $23.0 million decrease in earned premiums in the Multi Lines Insurance segment.
Consumer Finance Revenues increased by $3.0 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to a higher level of loans outstanding.
Net Investment Income increased by $8.5 million for the three months ended March 31, 2004, compared to the same period in 2003, due to higher levels of investments and the timing of dividends on Northrop Grumman Corporation (“Northrop”) preferred stock, partially offset by lower yields on investments. Other Income decreased by $7.5 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to lower administration fees earned to administer run-off business excluded from the acquisition of the personal lines business of the Kemper Insurance Companies (“KIC”).
Net Realized Investment Gains was a pre-tax gain of $18.5 million for the three months ended March 31, 2004, compared to a pre-tax gain of $5.9 million for the same period in 2003. Net Realized Investment Gains for the three months ended March 31, 2004 primarily consisted of pre-tax gains of $8.3 million from sales of Northrop common stock and pre-tax gains of $10.0 million from sales of Other Equity Securities. Net Realized Investment Gains for the three months ended March 31, 2003 primarily consisted of pre-tax gains of $17.9 million from sales of Other Equity Securities, partially offset by pre-tax losses of $13.1 million to write down certain securities. The Company cannot anticipate when or if similar investment gains and losses may occur in the future.
Critical Accounting Policies
The Company’s subsidiaries conduct their businesses in three industries: property and casualty insurance, life and health insurance and consumer finance. Accordingly, the Company is subject to several industry-specific accounting principles under accounting principles generally accepted in the United States of America (“GAAP”). The preparation of financial statements in accordance with GAAP requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The process of estimation is inherently uncertain. Accordingly, actual results could ultimately differ materially from the estimated amounts reported in the Company’s financial statements. Different assumptions are likely to result in different estimates of reported amounts. The Company’s critical accounting policies most sensitive to estimates include the valuation of investments, the valuation of property and casualty insurance reserves, the valuation of life insurance reserves, the valuation of the reserve for loan losses, the assessment of recoverability of goodwill, and the valuation of postretirement benefit obligations. These critical accounting policies are more fully described in the Company’s Management’s Discussion and Analysis of Results of Operations and Financial Condition presented in its Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (“SEC”) for the year ended December 31, 2003.
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Earned Premiums:
Personal Lines:
Personal Automobile
Homeowners
Total Personal Lines
Commercial Lines:
Commercial Property and Liability
Commercial Automobile
Total Commercial Lines
Total Earned Premiums
Underwriting Profit (Loss) :
Personal Lines
Commercial Lines
Total Underwriting Profit (Loss)
Operating Profit
Ratio Based on Earned Premiums
Incurred Loss Ratio (excluding Catastrophes)
Incurred Catastrophe Loss Ratio
Total Incurred Loss Ratio
Incurred Expense Ratio
Combined Ratio
Earned Premiums in the Multi Lines Insurance segment decreased by $23.0 million for the three months ended March 31, 2004, compared to the same period in 2003. Personal lines earned premiums in the Multi Lines Insurance segment decreased by $1.7 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to lower premium volume, partially offset by higher premium rates. Commercial lines earned premiums in the Multi Lines Insurance segment decreased by $21.3 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to lower premium volume, partially offset by higher premium rates. The Company attributes the lower commercial lines volume largely to its efforts to re-underwrite that book of business which resulted in a significant reduction in policies in force. The Company has substantially completed such re-underwriting activities. The Company anticipates that commercial lines earned premiums in the Multi Lines Insurance segment will continue to decline in 2004 compared to 2003, due primarily to the extensive re-underwriting.
Net Investment Income in the Multi Lines Insurance segment increased by $1.3 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to higher levels of investments.
17
Multi Lines Insurance (continued)
Operating Profit in the Multi Lines Insurance segment increased by $7.6 million before-tax for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to improved premium rate adequacy in both personal lines and commercial lines, partially offset by higher commercial lines expenses as a percentage of earned premiums. Although the Company has substantially completed its extensive re-underwriting of its commercial lines business, the Company anticipates that commercial lines expenses as a percentage of earned premiums in the Multi Lines Insurance segment will be higher in 2004 due to the lower expected volume due to the re-underwriting. Catastrophe losses in the Multi Lines Insurance segment were $1.3 million for the three months ended March 31, 2004, an increase of $0.5 million compared to the same period in 2003.
Net Income in the Multi Lines Insurance segment increased by $5.1 million after-tax due to the higher operating profit. The Multi Lines Insurance segment’s effective income tax rate increased from 10.5% for the three months ended March 31, 2003, to 23.7% for the three months ended March 31, 2004, due primarily to higher pre-tax operating profit which results in lower levels of tax-exempt investment income as a percentage of pre-tax operating profit.
Underwriting Profit (Loss):
Total Underwriting Profit
18
Specialty Lines Insurance (continued)
Earned Premiums in the Specialty Lines Insurance segment decreased by $2.1 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to lower premium volume in personal automobile, partially offset by higher premium volume in commercial automobile and higher premium rates in both personal automobile and commercial automobile. The lower premium volume of personal automobile was due primarily to management’s decision to eliminate certain programs in California and Texas. The higher premium volume of commercial automobile is primarily due to increases in heavier weight class vehicles and higher policy limits in Texas and California. The Company anticipates increasing premium rates in 2004, but to a lesser extent than the increases in 2003.
Operating Profit in the Specialty Lines Insurance segment increased by $5.9 million before-tax for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to lower losses and expenses as a percentage of earned premiums on personal automobile insurance. Losses decreased as a percentage of earned premiums in the Specialty Lines Insurance segment due primarily to improved premium rate adequacy and favorable loss reserve development. Expenses decreased as a percentage of earned premiums in the Specialty Lines Insurance segment due primarily to improved premium rate adequacy.
Net Income increased $4.0 million after-tax for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to the higher operating profit.
Premiums Written
(Increase) Decrease in Unearned Premiums
Incurred Losses
Operating Profit (Loss)
Income Tax Benefit (Expense)
Net Income (Loss)
Ratio Based on Earned Premiums:
In June 2002, the Company acquired the personal lines property and casualty insurance business of KIC. Pursuant to the agreements among the parties, KIC retained all liabilities for policies issued by Kemper Auto and Home (“KAH”) prior to the closing, while Trinity Universal Insurance Company (“Trinity”), a subsidiary of Unitrin, is entitled to premiums written for substantially all policies issued or renewed by the Kemper Auto and Home segment after the closing and is liable for losses and expenses incurred thereon.
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Kemper Auto and Home (continued)
Premiums Written, which reflect the total amount of premiums to be received over a policy’s term, in the Kemper Auto and Home segment increased by $1.2 million for the three months ended March 31, 2004, compared to the same period in 2003. Earned Premiums, which relate to the lapsed portion of each policy’s term, in the Kemper Auto and Home segment increased by $46.8 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to the completion of a full annual cycle of writing and issuing policies following the acquisition. The Kemper Auto and Home segment is administering on behalf of KIC all policies issued prior to the closing and certain policies issued or renewed after the closing, but excluded from the acquisition. Other Income decreased by $7.2 million for the three months ended March 31, 2004, compared to the same period in 2003, due to lower volume of administered policies and related claims. Net Investment Income increased by $2.9 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to higher levels of investments.
The Kemper Auto and Home segment recorded Operating Profit of $3.6 million before-tax for the three months ended March 31, 2004, compared to an Operating Loss of $14.1 million before-tax for the same period in 2003. Operating results improved in the Kemper Auto and Home segment due primarily to lower incurred losses as a percentage of earned premiums and lower insurance expenses as a percentage of earned premiums. Incurred losses as a percentage of earned premiums in the Kemper Auto and Home segment decreased due primarily to improved premium rate adequacy and favorable loss reserve development. Catastrophe losses in the Kemper Auto and Home segment for the three months ended March 31, 2004 were $3.2 million, compared to catastrophe losses of $3.9 million for the same period in 2003. Insurance Expenses as a percentage of earned premiums in the Kemper Auto and Home segment decreased due primarily to higher levels of earned premiums, lower volume of policies administered on behalf of KIC and lower transition expenses. The Kemper Auto and Home segment recorded Net Income of $3.3 million after-tax for the three months ended March 31, 2004, compared to a Net Loss of $8.8 million after-tax for the same period in 2003. Net Income in the Kemper Auto and Home segment increased due primarily to the increase in pre-tax operating results. The effective income tax rate in the Kemper Auto and Home segment was 8.9% for the three months ended March 31, 2004. The effective income tax rate in the Kemper Auto and Home segment differs from the federal statutory rate due primarily to net investment income from tax-exempt investments.
At the acquisition date, Unitrin’s property and casualty insurance subsidiaries were not licensed in all the states where the KAH business is written nor were certain computer and data processing modifications completed to allow for the migration of the KAH business to the Company’s property and casualty insurance subsidiaries. Accordingly, to facilitate the transition of such business to Unitrin’s property and casualty insurance subsidiaries, KIC and Trinity entered into a quota share reinsurance agreement whereby Trinity reinsured, on a 100% indemnity basis, substantially all of the KAH business written or renewed by KIC after the acquisition date. KIC’s financial condition deteriorated rapidly after the acquisition, and accordingly, Unitrin accelerated its plans to transition the business directly to its property and casualty insurance subsidiaries. As of March 31, 2004, Unitrin’s property and casualty insurance subsidiaries have obtained all necessary licenses, have completed all computer and data processing modifications and approximately 75% of the in-force KIC personal lines policies had been renewed directly by Unitrin’s property and casualty insurance subsidiaries and renewal notices for an additional 10% had been sent to policyholders. Unitrin expects that approximately 92% of the in-force KIC personal lines policies at the end of the second quarter of 2004 will have been renewed directly by Unitrin’s property and casualty insurance subsidiaries and renewal notices will have been sent to an additional 5% of policyholders.
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Unitrin Direct, the Company’s direct marketing automobile insurance unit, markets personal automobile insurance directly to customers primarily through direct mail and the Internet using web insurance portals, click-thrus and its own website, “unitrindirect.com”. Unitrin Direct began actively marketing personal automobile insurance in 2001 and continues to build economies of scale as shown by its growth in written premium in the table below:
New Business
Renewal Business
Total Premiums Written
Premiums Written, which reflect the total amount of premiums to be received over the policy term, in the Unitrin Direct segment increased by $11.7 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to higher volume of insurance.
Premiums are recognized as revenues in the Company’s financial statements not when written, but rather as earned over the life of the policy. Earned Premiums relates to the elapsed portion of each policy’s term. The difference between Premiums Written and Earned Premiums relating to the remaining portion of each policy’s term is recorded as a deferred revenue liability referred to as Unearned Premiums in the Company’s Condensed Consolidated Balance Sheet. Results of the Unitrin Direct segment recognized in the Company’s financial statements for the three months ended March 31, 2004 and 2003 were:
Increase in Unearned Premiums
Operating Loss
Income Tax Benefit
Net Loss
Earned Premiums in the Unitrin Direct segment increased by $8.6 million for the three months ended March 31, 2004, compared to the same period in 2003, due to higher volume of insurance and higher premium rates. Net Investment Income in the Unitrin Direct segment increased by $1.0 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to higher levels of investments.
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Unitrin Direct (continued)
For the three months ended March 31, 2004, the Unitrin Direct segment recorded an Operating Loss of $3.3 million before-tax, compared to an Operating Loss of $7.9 million before-tax for the same period in 2003. The Unitrin Direct segment’s Operating Loss decreased due primarily to lower incurred losses as a percentage of earned premiums reflecting increased premium rate adequacy and lower insurance expenses as a percentage of earned premiums reflecting the Unitrin Direct segment’s progress toward achieving economies of scale. The Company anticipates that the Unitrin Direct segment will reach profitability on a discrete quarter basis in the second half of 2004, but that it will likely not reach profitability for a full year until 2005. For the three months ended March 31, 2004, the Unitrin Direct segment recorded a Net Loss of $1.8 million after-tax, compared to a Net Loss of $5.1 million after-tax for the same period in 2003. The Unitrin Direct segment’s Net Loss decreased due primarily to the decrease in the Unitrin Direct segment’s pre-tax Operating Loss.
For the three months ended March 31, 2004 and 2003, the Unitrin Direct segment did not record any losses from catastrophes.
Life
Accident and Health
Property
Earned Premiums in the Life and Health Insurance segment increased by $2.8 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to higher accident and health insurance premium rates and higher volume of property insurance sold by the Life and Health Insurance segment’s career agents, partially offset by lower volume of accident and health insurance. Net Investment Income in the Life and Health Insurance segment increased by $1.3 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to higher levels of investments, partially offset by lower yields on investments.
Operating Profit in the Life and Health Insurance segment increased by $4.7 million before-tax for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to improved results on property insurance sold by the Life and Health Insurance segment’s career agents, a change in the Company’s estimate of the cost to resolve certain legal matters, improved results from accident and health insurance products and the higher net investment income, partially offset by higher life insurance benefits. Life insurance benefits increased primarily due to a change in estimate of reserves resulting from the conversion of certain business to a new computer system and also due to higher mortality. Net Income in the Life and Health Insurance segment increased by $3.0 million after-tax for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to the higher operating profit.
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Interest, Loan Fees and Earned Discount
Interest Expense on Investment Certificates and Savings Accounts
General and Administrative Expenses
Consumer Finance Loan Originations
Percentage of Consumer Finance Receivables Greater than Sixty Days Past Due
Ratio of Reserve for Loan Losses to Gross Consumer Finance Receivables
Weighted-Average Interest Yield on Investment Certificates and Savings Accounts
Interest, Loan Fees and Earned Discount in the Consumer Finance segment increased by $3.3 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to a higher level of loans outstanding. Net Investment Income in the Consumer Finance segment decreased by $0.5 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to lower yields on investments.
Operating Profit in the Consumer Finance segment decreased by $1.3 million for the three months ended March 31, 2004, compared to the same period in 2003. Provision for Loan Losses increased by $2.1 million for the three months ended March 31, 2004, compared to the same period in 2003, due to a higher estimated rate of ultimate loan losses. Interest Expense on Investment Certificates and Savings Accounts decreased by $0.5 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to lower interest rates on Investment Certificates and Savings Accounts, partially offset by higher levels of deposits. General and Administrative Expenses, as a percentage of Interest, Loan Fees and Earned Discount, increased from 35.9% for the three months ended March 31, 2003, to 39.1% for the three months ended March 31, 2004, due primarily to an increase in the size of the collection department and higher collection incentive pay. The Company’s increased collection effort contributed to the decrease in the percentage of receivables greater than 60 days past due from 3.4% at December 31, 2003 to 2.8% at March 31, 2004. Net Income in the Consumer Finance segment decreased by $0.8 million after-tax for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to the lower operating profit.
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Equity in Net Income (Loss) of Investee was a loss of $0.1 million and income of $0.4 million for the three months ended March 31, 2004 and 2003, respectively. Unitrin accounts for its investment in its investee, UNOVA, Inc. (“UNOVA”), under the equity method of accounting using the most recent and sufficiently timely publicly-available financial reports and other publicly-available information, which generally results in a three month delay in inclusion of UNOVA’s results in Unitrin’s consolidated financial statements. Prior to the periods presented in the Condensed Consolidated Financial Statements, Unitrin determined that a decline in the fair value of its investment in UNOVA was other than temporary under applicable accounting standards. Accordingly, Unitrin reduced the carrying value of its investment in UNOVA to its then current estimated realizable value and allocated the reduction to Unitrin’s proportionate share of UNOVA’s non-current assets. Accordingly, Unitrin’s reported equity in the net income of UNOVA differs from Unitrin’s proportionate share of UNOVA’s reported results to the extent that such results include depreciation, amortization or other charges related to such non-current assets. The fair value of Unitrin’s investment in UNOVA subsequently recovered such that the fair value exceeded the carrying value of Unitrin’s investment in UNOVA by $207.6 million and $225.8 million at March 31, 2004 and December 31, 2003, respectively. In accordance with applicable accounting standards, such excess is not included in the Condensed Consolidated Financial Statements.
Corporate Investments
The Company considers the management of certain investments, including Northrop common and preferred stock, Baker Hughes, Inc. (“Baker Hughes”) common stock, and UNOVA common stock to be a corporate responsibility. Accordingly, the Company does not allocate dividend income from these investments to its operating segments. Dividend income from these investments for the three months ended March 31, 2004 and 2003 was:
Northrop Preferred Stock
Northrop Common Stock
Baker Hughes Common Stock
Total Unallocated Dividend Income
The changes in fair values of Corporate Investments for the three months ended March 31, 2004 are summarized below:
UNOVA Common Stock
Total Fair Value of Corporate Investments
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Net Realized Investment Gains (Losses)
Net Realized Investment Gains (Losses) for the three months ended March 31, 2004 and 2003 were:
Net Realized Investment Gains was $18.5 million for the three months ended March 31, 2004, compared to $5.9 million for the same period in 2003. Net Realized Investment Gains for the three months ended March 31, 2004 includes pre-tax gains of $8.3 million from sales of a portion of the Company’s investment in Northrop common stock, pre-tax gains of $4.1 million from sales of a portion of the Company’s investment in Baker Hughes common stock and pre-tax gains of $3.2 million resulting from sales of a portion of the Company’s investment in Hartford Financial Services Group, Inc. (“Hartford”) common stock. The fair value of the Company’s remaining investments in Northrop common stock, Baker Hughes common stock and Hartford common stock was $591.3 million, $84.1 million and $19.7 million, respectively, at March 31, 2004. During the period from April 1, 2004 to April 29, 2004, the Unitrin parent company sold Northrop common stock generating gross proceeds of $42.9 million. The Company cannot anticipate when or if similar investment gains may occur in the future.
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Other Items
Interest and Other Expenses increased by $5.1 million for the three months ended March 31, 2004, compared to the same period in 2003, due primarily to higher levels of debt outstanding and higher corporate expenses.
Liquidity and Capital Resources
At March 31, 2004, the Company had approximately 3.5 million shares remaining under the existing common stock repurchase authorization. The Company does not anticipate repurchasing significant amounts of its common stock during 2004.
The Company has a $360 million unsecured revolving credit agreement, expiring on August 30, 2005, with a group of banks. Proceeds from advances under the agreement may be used for general corporate purposes. There were no borrowings outstanding under the revolving credit agreement at March 31, 2004 and December 31, 2003.
On July 1, 2002, the Company issued its 5.75% senior notes due July 1, 2007 with an aggregate principal amount of $300 million (the “5.75% Senior Notes”). The 5.75% Senior Notes are unsecured and may be redeemed in whole at anytime or in part from time to time at the Company’s option at specified redemption prices. Interest expense from the 5.75% Senior Notes was $4.5 million for the three months ended March 31, 2004. Interest expense from the 5.75% Senior Notes was $4.5 million for the three months ended March 31, 2003.
On October 30, 2003, the Company issued its 4.875% senior notes due November 1, 2010 with an aggregate principal amount of $200 million (the “4.875% Senior Notes”). The 4.875% Senior Notes are unsecured and may be redeemed in whole at anytime or in part from time to time at the Company’s option at specified redemption prices. Interest expense from the 4.875% Senior Notes was $2.5 million for the three months ended March 31, 2004.
During the first three months of 2004, one of Unitrin’s subsidiaries (Fireside Securities Corporation) paid $4.0 million in dividends to Unitrin. During 2003, Unitrin made capital contributions totaling $192.8 million to its property and casualty insurance subsidiaries. The Company believes that its property and casualty insurance subsidiaries are sufficiently capitalized at March 31, 2004 to fund future premium growth and to pay dividends to Unitrin out of future operating earnings.
The Company has no other significant commitments for capital expenditures. The Company’s subsidiaries maintain levels of cash and liquid assets sufficient to meet ongoing obligations to policyholders and claimants, as well as ordinary operating expenses. The Company’s reserves are set at levels expected to meet contractual liabilities. The Company maintains adequate levels of liquidity and surplus capacity to manage the risks inherent with any differences between the duration of its liabilities and invested assets. As further discussed in Note 7 to the Condensed Consolidated Financial Statements, some of Unitrin’s subsidiaries hold collateral totaling $132.3 million, at March 31, 2004, from unrelated parties pursuant to securities lending agreements whereby unrelated parties borrow securities from the subsidiaries’ accounts. The subsidiaries are required to return such collateral upon return of the loaned security. Accordingly, the amount of such collateral would not be available to meet ongoing obligations to policyholders and claimants, as well as ordinary operating expenses. Unitrin and its subsidiaries have not formed special purpose entities or similar structured financing vehicles to access capital and/or manage risk.
The Company’s management believes that it has sufficient resources to maintain the payment of dividends to its shareholders at the present level. Sources for future shareholder dividend payments and the payment of interest on Unitrin’s senior notes include the receipt of dividends from Unitrin’s operating subsidiaries, the receipt of dividends from its investments in Northrop, borrowings under the revolving credit agreement, and monetization of a portion of the Unitrin parent company’s Northrop holdings. At March 31, 2004, the Unitrin parent company directly held investments in Northrop common and preferred stock with a market value totaling $349.0 million. During the period from April 1, 2004 to April 29, 2004, the Unitrin parent company sold Northrop common stock generating gross proceeds of $42.9 million. The Company may continue to sell down its Northrop holdings depending on future market prices and other capital needs.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
Pursuant to the rules and regulations of the SEC, the Company is required to provide the following disclosures about Market Risk.
Quantitative Information About Market Risk
The Company’s Condensed Consolidated Balance Sheets include five types of financial instruments subject to material risk disclosures required by the SEC: (1) Investments in Fixed Maturities, (2) Investments in Equity Securities, (3) Consumer Finance Receivables, (4) Investment Certificates and Savings Accounts and (5) Senior Notes Payable. Investments in Fixed Maturities, Consumer Finance Receivables, Investment Certificates and Savings Accounts and Senior Notes Payable are subject to material interest rate risk. The Company’s investments in Equity Securities include common and preferred stocks, which are subject to material equity price risk and interest rate risk, respectively.
For purposes of this disclosure, market risk sensitive financial instruments are divided into two categories: financial instruments acquired for trading purposes and financial instruments acquired for purposes other than trading. The Company’s market risk sensitive instruments are classified as held for purposes other than trading. The Company has no significant holdings of derivatives.
The Company measures its sensitivity to market risk by evaluating the change in its financial assets and liabilities relative to fluctuations in interest rates and equity prices. The evaluation is made using instantaneous changes in interest rates and equity prices on a static balance sheet to determine the effect such changes would have on the Company’s market value at risk and the resulting pre-tax effect on Shareholders’ Equity. The changes chosen reflect the Company’s view of adverse changes that are reasonably possible over a one-year period. The selection of the changes chosen should not be construed as the Company’s prediction of future market events, but rather as an illustration of the impact of such events.
For the interest rate sensitivity analysis presented below, the Company assumed an adverse and instantaneous increase of 100 basis points in the yield curve at March 31, 2004 and December 31, 2003, respectively, for Investments in Fixed Maturities. Such 100 basis point increase in the yield curve may not necessarily result in a corresponding 100 basis point increase in the interest rate for all investments in fixed maturities. For example, a 100 basis point increase in the yield curve for risk-free, taxable investments in fixed maturities may not result in a 100 basis point increase for tax-exempt investments in fixed maturities. For Investments in Fixed Maturities the Company also anticipated changes in cash flows due to changes in the likelihood that investments would be called or pre-paid prior to their contractual maturity. All other variables were held constant. For preferred stock equity securities and Consumer Finance Receivables, the Company assumed an adverse and instantaneous increase of 100 basis points in market interest rates from their levels at March 31, 2004 and December 31, 2003, respectively. All other variables were held constant. For Investment Certificates and Savings Accounts and Senior Notes Payable, the Company assumed an adverse and instantaneous decrease of 100 basis points in market interest rates from their levels at March 31, 2004 and December 31, 2003, respectively. All other variables were held constant. The Company measured equity price sensitivity assuming an adverse and instantaneous 10% decrease in the Standard and Poor’s Stock Index (the “S&P 500”) from its levels at March 31, 2004 and December 31, 2003, with all other variables held constant. The Company’s investments in common stock equity securities were correlated with the S&P 500 using the portfolio’s weighted-average beta of 0.37 and 0.33 at March 31, 2004 and December 31, 2003, respectively. The portfolio’s weighted-average beta was calculated using each security’s beta for the five-year periods ended March 31, 2004 and December 31, 2003, respectively, and weighted on the fair value of such securities at March 31, 2004 and December 31, 2003, respectively. Beta measures a stock’s relative volatility in relation to the rest of the stock market, with the S&P 500 having a beta coefficient of 1.00.
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Quantitative Information About Market Risk (continued)
The estimated adverse effects on the market value of the Company’s financial instruments using these assumptions were:
March 31, 2004
Assets
Investments in Fixed Maturities
Investments in Equity Securities
Consumer Finance Receivables
Liabilities
Investment Certificates and Savings Accounts
Senior Notes Payable
December 31, 2003
The market risk sensitivity analysis assumes that the composition of the Company’s interest rate sensitive assets and liabilities, including but not limited to credit quality, and equity price sensitive assets existing at the beginning of the period remains constant over the period being measured. It also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the time to maturity. Interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Also, any future correlation, either in the near term or the long term, between the Company’s common stock equity securities portfolio and the S&P 500 may differ from the historical correlation as represented by the weighted-average historical beta of the common stock equity securities portfolio. Accordingly, the market risk sensitivity analysis may not be indicative of, is not intended to provide, and does not provide, a precise forecast of the effect of changes of market rates on the Company’s income or shareholders’ equity. Further, the computations do not contemplate any actions the Company may undertake in response to changes in interest rates or equity prices.
To the extent that any adverse 100 basis point change occurs in increments over a period of time instead of instantaneously, the adverse impact on fair values would be partially mitigated because some of the underlying financial instruments would have matured. For example, proceeds from any maturing assets could be reinvested and any new liabilities would be incurred at the then current interest rates.
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Qualitative Information About Market Risk
Market risk is a broad term related to economic losses due to adverse changes in the fair value of a financial instrument and is inherent to all financial instruments. SEC disclosure rules focus on only one element of market risk—price risk. Price risk relates to changes in the level of prices due to changes in interest rates, equity prices, foreign exchange rates or other factors that relate to market volatility of the rate, index, or price underlying the financial instrument. The Company’s primary market risk exposures are to changes in interest rates and certain exposures to changes in equity prices. The Company manages its interest rate exposures with respect to Investments in Fixed Maturities by investing primarily in investment-grade securities of moderate duration. The interest rate risks with respect to the fair value of Consumer Finance Receivables should be partially offset by the impact of interest rate movements on Investment Certificates and Savings Accounts which are issued to fund its receivables.
At March 31, 2004 and December 31, 2003, $820.7 million and $854.8 million of the Company’s Investments in Equity Securities, which exclude the Company’s Investment in Investee, was concentrated in the common and preferred stock of Northrop. Northrop stated in its 2003 Annual Report on Form 10-K that it “provides technologically advanced innovative products, services, and solutions in defense and commercial electronics, nuclear and non-nuclear shipbuilding, information technology, mission systems, systems integration, and space technology.” Additionally, Northrop stated that it “is subject to the usual vagaries of the market-place, it is also affected by the unique characteristics of the defense industry and by certain elements peculiar to its own business mix.” At March 31, 2004 and December 31, 2003, respectively, the Company’s Investments in Equity Securities included $84.1 million and $82.2 million of Baker Hughes common stock. Baker Hughes stated in its 2003 Annual Report on Form 10-K that it “is engaged in the oil field services industry,” and in addition, it “is a major supplier of wellbore-related products and technology services and systems to the oil and natural gas industry.” Accordingly, the Company’s Investments in Equity Securities is sensitive to the nature of Northrop and Baker Hughes’ industry segments.
Caution Regarding Forward-Looking Statements
Management’s Discussion and Analysis of Results of Operations and Financial Condition, Quantitative and Qualitative Disclosures About Market Risk and the accompanying Condensed Consolidated Financial Statements (including the notes thereto) may contain or incorporate by reference information that includes or is based upon forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements give expectations or forecasts of future events. The reader can identify these statements by the fact that they do not relate strictly to historical or current facts. They use words such as “believe(s),” “goal(s),” “target(s),” “estimate(s),” “anticipate(s),” “forecast(s),” “project(s),” “plan(s),” “intend(s),” “expect(s),” “might,” “may” and other words and terms of similar meaning in connection with a discussion of future operating or financial performance. In particular, these include statements relating to future actions, prospective services or products, future performance or results of current and anticipated services or products, sales efforts, expenses, the outcome of contingencies such as legal proceedings, trends in operations and financial results.
Any or all forward-looking statements may turn out to be wrong, and, accordingly, readers are cautioned not to place undue reliance on such statements, which speak only as of the date of this Quarterly Report on Form 10-Q. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Many such factors will be important in determining the Company’s actual future results. These statements are based on current expectations and the current economic environment. They involve a number of risks and uncertainties that are difficult to predict. These statements are not guarantees of future performance; actual results could differ materially from those expressed or implied in the forward-looking statements. Among factors that could cause actual results to differ materially are:
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Caution Regarding Forward-Looking Statements (continued)
No assurances can be given that the results contemplated in any forward-looking statements will be achieved or will be achieved in any particular timetable. The Company assumes no obligation to publicly correct or update any forward-looking statements as a result of events or developments subsequent to the date of this Quarterly Report on Form 10-Q. The reader is advised, however, to consult any further disclosures the Company makes on related subjects in reports to the SEC.
Item 4. Controls and Procedures
(a) Evaluation of disclosure controls and procedures.
The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information relating to the Company (including its consolidated subsidiaries) required to be disclosed by the Company in reports that it files or submits under the Exchange Act.
(b) Changes in internal controls.
There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Information concerning pending legal proceedings is incorporated herein by reference to Note 14 to the Condensed Consolidated Financial Statements (Unaudited) in Part I of this Form 10-Q.
Item 6. Exhibits and Reports on Form 8-K
2.1
3.1
3.2
4.1
4.2
4.3
4.4
4.5
10.1
10.2
10.3
31
10.4
10.5
10.6
Richard C. Vie (Chairman and Chief Executive Officer)
Donald G. Southwell (President and Chief Operating Officer)
David F. Bengston (Vice President)
John M. Boschelli (Treasurer)
Eric J. Draut (Executive Vice President and Chief Financial Officer)
Edward J. Konar (Vice President)
Scott Renwick (Senior Vice President, General Counsel and Secretary)
Richard Roeske (Vice President and Chief Accounting Officer)
10.7
10.8
10.9
10.10
10.11
10.12
10.13
31.1
31.2
32
32.1
32.2
(b) Reports on Form 8-K.
None.
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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.
Date: April 29, 2004
/s/ Richard C. Vie
/s/ Eric J. Draut
/s/ Richard Roeske
Vice President and Chief Accounting Officer
(Principal Accounting Officer)
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