FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For Quarterly Period Ended September 30, 2005
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 ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
68,872,046 shares of common stock, $0.10 par value, were outstanding as of October 26, 2005.
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:
Policyholders’ Benefits and Incurred
Losses and Loss Adjustment Expenses
Insurance Expenses
Consumer Finance Expenses
Interest and Other Expenses
Total Expenses
Income before Income Taxes and Equity in Net Income of Investee
Income Tax Expense
Income before Equity in Net Income of Investee
Equity in Net Income 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.
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CONDENSED CONSOLIDATED BALANCE SHEETS
Investments:
Fixed Maturities at Fair Value (Amortized Cost: 2005 - $4,044.5; 2004 - $3,994.0)
Northrop Grumman Corporation Preferred Stock at Fair Value (Cost: 2005 - $177.5; 2004 - $177.5)
Northrop Grumman Corporation Common Stock at Fair Value (Cost: 2005 - $341.5; 2004 - $341.5)
Other Equity Securities at Fair Value (Cost: 2005 - $313.4; 2004 - $323.7)
Investee (UNOVA, Inc.) at Cost Plus Cumulative Undistributed Earnings (Fair Value: 2005 - $442.8; 2004 - $320.1)
Short-term Investments at Cost which Approximates Fair Value
Other
Total Investments
Cash
Consumer Finance Receivables at Cost (Fair Value: 2005 - $1,093.0; 2004 - $979.2)
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
Certificates of Deposits at Cost (Fair Value: 2005 - $1,043.5; 2004 - $921.9)
Unearned Premiums
Accrued and Deferred Income Taxes
Notes Payable at Amortized Cost (Fair Value: 2005 - $507.0; 2004 - $516.6)
Accrued Expenses and Other Liabilities
Total Liabilities
Shareholders’ Equity:
Common Stock, $0.10 par value, 100 million Shares Authorized; 68,870,527 Shares Issued and Outstanding at September 30, 2005 and 68,828,658 Shares Issued and Outstanding at December 31, 2004
Paid-in Capital
Retained Earnings
Accumulated Other Comprehensive Income
Total Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
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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 of Investee before Taxes
Amortization of Investments
(Increase) 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 Grumman Corporation Common Stock
Sales of Other Equity Securities
Purchases of Equity Securities
Change in Short-term Investments
Acquisition and Improvements of Investment Real Estate
Sales of Investment Real Estate
Change in Other Investments
Change in Consumer Finance Receivables
Net Cash Used by Investing Activities
Financing Activities:
Change in Certificates of Deposits 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 (Decrease) in Cash
Cash, Beginning of Year
Cash, End of Period
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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”). Certain financial information that is normally included in annual financial statements, including certain financial statement footnote disclosures, prepared in accordance with accounting principles generally accepted in the United States of America is not required by the rules and regulations of the SEC and has been condensed or omitted. 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, 2004 (the “2004 Annual Report”).
Effective January 1, 2005, the Company combined the personal lines operations of its former Multi Lines Insurance segment into the Kemper Auto and Home segment. In addition, the Company created a separate, stand-alone business operation, referred to as Unitrin Business Insurance, to manage the commercial lines operations and certain reinsurance programs of the former Multi Lines Insurance segment. Accordingly, segment results for 2004 have been restated to conform to the current management reporting structure.
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:
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Note 2 - Investment in Investee
Equity in Net Income of Investee was $4.7 million and $1.6 million for the nine and three months ended September 30, 2005, respectively. Equity in Net Income of Investee was $2.6 million and $1.0 million for the nine and three months ended September 30, 2004, 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 unaudited 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. During the first quarter of 2005, Unitrin estimated that UNOVA had subsequently fully recognized in its financial statements the amortization, depreciation or write-downs of such non-current assets. Accordingly, for periods beginning after the first quarter of 2005, Equity in Net Income of Investee equals Unitrin’s proportionate share of UNOVA’s results.
The fair value of Unitrin’s investment in UNOVA exceeded the carrying value of Unitrin’s investment in UNOVA by $363.1 million and $248.2 million at September 30, 2005 and December 31, 2004, respectively. In accordance with applicable accounting standards, such excess is not included in the unaudited Condensed Consolidated Financial Statements.
Note 3 - Other Receivables
Other Receivables at September 30, 2005 and December 31, 2004 included reinsurance recoverables of $148.8 million and $180.9 million, respectively, from General Security National Insurance Company (“GSNIC”), a subsidiary of SCOR Reinsurance Company (“SRC”). Under the agreement governing the Company’s 2002 acquisition of certain companies from SRC, SRC and/or GSNIC are responsible for all liabilities of the acquired companies incurred prior to the acquisition. GSNIC is rated “B++” (Very Good) by A.M. Best Co., Inc., the principal insurance company rating agency.
Note 4 – Catastrophes
The Company maintains three separate catastrophe reinsurance programs for its property and casualty insurance businesses. The program covering the Company’s Unitrin Direct, Unitrin Specialty and Unitrin Business Insurance segments provides aggregate coverage of $36 million above retention of $4 million. The program covering the property insurance operations of the Company’s Life and Health Insurance segment provides aggregate coverage of $52 million above retention of $8 million. The program covering the Company’s Kemper Auto and Home segment provides aggregate coverage of $160 million above retention of $20 million. Aggregate coverage for each reinsurance program is provided in three layers. In addition, if the Company should incur catastrophe losses covered by any of its three catastrophe reinsurance programs that exceed the retention for a particular program, the program requires one reinstatement of such coverage. In such an instance, the Company is required to pay a reinstatement premium to the reinsurers to reinstate the full amount of reinsurance available under such program. The reinstatement premium would be a percentage of the original premium based on the ratio of the losses exceeding the Company’s retention to the reinsurers’ aggregate coverage limit. The aggregate annual original premium paid to reinsurers, excluding reinstatement premium, for these three catastrophe reinsurance programs is approximately $15 million. In addition to these programs, the Company purchases reinsurance from the Florida Hurricane Catastrophe Fund (the “FHCF”) for hurricane losses in the state of Florida at retentions lower than those described above.
During the third quarter of 2005, two major hurricanes (Katrina and Rita) made landfall in the United States. Hurricane Katrina is expected to be the most costly hurricane on record in the United States. The Company estimates that, as a
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Note 4 – Catastrophes (continued)
result of Hurricane Katrina’s landfall in Louisiana, Mississippi and Alabama, its Life and Health Insurance segment incurred $43.3 million of losses and loss adjustment expenses (“LAE”) in excess of its retention of $8.0 million and recorded a reinstatement premium of $2.6 million in the third quarter of 2005. In addition, the Life and Health Insurance segment incurred $0.4 million of losses and LAE in Florida which occurred too early to be aggregated with the losses in the other Gulf states under its reinsurance program. The Company estimates that, as a result of Hurricane Katrina’s landfall in Louisiana, Mississippi and Alabama, its Kemper Auto and Home segment incurred $21.5 million of losses and LAE in excess of its retention of $20.0 million and recorded a reinstatement premium of $3.1 million in the third quarter of 2005. In addition, the Kemper Auto and Home segment incurred $0.2 million of losses and LAE in Florida which occurred too early to be aggregated with the losses in the other Gulf states under its reinsurance program. The Company estimates that, as a result of Hurricane Katrina’s landfall in Louisiana, Mississippi and Alabama, the Unitrin Direct, Unitrin Specialty and Unitrin Business Insurance segments together incurred $0.8 million of losses and LAE in excess of their retention of $4.0 million and recorded a reinstatement premium of $0.1 million in the third quarter of 2005. In addition, the Unitrin Direct segment incurred $0.1 million of losses and LAE in Florida which occurred too early to be aggregated with the losses in the other Gulf states under its reinsurance program.
Unitrin’s subsidiary, Trinity Universal Insurance Company (“Trinity”) and Capitol County Mutual Fire Insurance Company (“Capitol”) are parties to a quota share reinsurance agreement whereby Trinity assumes 100% of the business written, net of reinsurance, by Capitol. Capitol is a mutual insurance company and, accordingly, is owned by its policyholders. Capitol is also a participant in the catastrophe reinsurance program covering the Company’s Life and Health Insurance segment. The Company estimates that, as a result of Hurricane Rita’s landfall in Texas and Louisiana, the Life and Health Insurance subsidiaries together with Capitol incurred $4.8 million of losses and LAE in excess of their retention of $8.0 million. The reinsurance program covering the Life and Health Insurance segment is comprised of three layers, with the first layer providing coverage of $12.0 million above retention of $8.0 million. As a result of estimated losses and LAE from Hurricane Rita, the Company estimates that $7.2 million of coverage remains under the first layer. Accordingly, in addition to retaining the first $8.0 million of losses and LAE, the Life and Health Insurance segment would retain any losses and LAE incurred above $15.2 million and below the $20.0 million attachment point for the second layer of reinsurance for any new catastrophe in the Life and Health Insurance segment. The Company estimates that, as a result of Hurricane Rita’s landfall in Texas and Louisiana, the Kemper Auto and Home segment incurred $4.7 million of losses and LAE in excess of its retention of $20.0 million and recorded a reinstatement premium of $0.7 million in the third quarter of 2005. The Company estimates that, as a result of Hurricane Rita’s landfall in Texas and Louisiana, the Unitrin Direct, Unitrin Specialty and Unitrin Business Insurance segments together incurred $1.0 million of losses and LAE in excess of their retention of $4.0 million and recorded a reinstatement premium of $0.1 million in the third quarter of 2005.
Total estimated catastrophe losses and LAE, net of reinsurance recoveries, were $87.7 million and $70.3 million for the nine and three months ended September 30, 2005, respectively, compared to $35.6 million and $20.6 million for the same periods in 2004. The Company recorded significant losses from Hurricanes Katrina and Rita in the third quarter of 2005 and significant losses from Hurricanes Charley, Frances, Ivan and Jeanne in the third quarter of 2004. A summary of the Company’s losses and LAE, net of reinsurance, from Hurricanes Katrina and Rita for the nine and three months ended September 30, 2005 by business segment follows.
(Dollars in Millions)
Kemper Auto and Home
Unitrin Specialty
Unitrin Direct
Unitrin Business Insurance
Life and Health Insurance
Total Loss and LAE, Net of Reinsurance
The Company’s estimates for Hurricanes Katrina and Rita include estimates for both direct losses and LAE and indirect losses from residual market assessments. The process of estimating and establishing reserves for catastrophe losses is inherently uncertain and the actual ultimate cost of a claim, net of actual reinsurance recoveries, may vary materially
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from the estimated amount reserved. The Company’s estimates of direct catastrophe losses are generally based on inspections by claims adjusters and historical loss development experience for areas that have not been inspected or for claims that have not yet been reported. The Company’s estimates of direct catastrophe losses are based on the coverages provided by its insurance policies. The Company’s homeowners insurance policies do not provide coverage for losses caused by floods, but generally provide coverage for physical damage caused by wind or wind driven rain. Accordingly, the Company’s estimates of direct losses for homeowners insurance do not include losses caused by flood. Depending on the policy, automobile insurance may provide coverage for losses caused by flood. Estimates of the number of and severity of claims ultimately reported are influenced by many variables including, but not limited to, repair or reconstruction costs and determination of cause of loss, that are difficult to quantify and will influence the final amount of claim settlements. All these factors, coupled with the impact of the availability of labor and material on costs, require significant judgment in the reserve setting process. A change in any one or more of these factors is likely to result in an ultimate net claim cost different from the estimated reserve. The Company’s estimates of indirect losses from residual market assessments are based on a variety of factors including, but not limited to, actual or estimated assessments provided by or received from the assessing entity, insurance industry estimates of losses, and estimates of the Company’s market share in the assessable states. Actual assessments may differ materially from these estimated amounts. The Company currently believes that it is unlikely that a change in its direct and indirect estimates of losses and LAE for Hurricanes Katrina and Rita will cause it to exceed the coverages provided by its reinsurance programs.
During the third quarter of 2004, four hurricanes (Charley, Frances, Ivan and Jeanne) made landfall in several states along the Gulf Coast and the eastern United States. All four hurricanes made landfall in the state of Florida, the first time in over 100 years that four hurricanes have made landfall in the same state in the same hurricane season. A summary of the Company’s losses and LAE, net of reinsurance, from Hurricanes Charley, Frances, Ivan and Jeanne for the nine and three months ended September 30, 2004 by business segment follows.
Total Losses and LAE, Net of Reinsurance
The Life and Health Insurance segment’s estimated losses and LAE for both the nine and three months ended September 30, 2004 are net of anticipated recoveries of $2.4 million from the FHCF. The Kemper Auto and Home segment’s estimated losses and LAE for both the nine and three months ended September 30, 2004 are net of anticipated recoveries of $0.8 million from the FHCF.
Note 5 - Notes Payable
Total Debt Outstanding at September 30, 2005 and December 31, 2004 was:
Senior Notes at Amortized Cost:
5.75% Senior Notes due July 1, 2007
4.875% Senior Notes due November 1, 2010
Mortgage Note Payable at Amortized Cost
Total Debt Outstanding
7
Note 5 - Notes Payable (continued)
On June 24, 2005, the Company entered into a five-year, $325 million, unsecured, revolving credit agreement, expiring June 30, 2010, with a group of financial institutions. The agreement provides for fixed and floating rate advances for periods up to one year at various interest rates. The agreement also contains various financial covenants, including limits on total debt to total capitalization and minimum risk-based capital ratios for the Company’s largest insurance subsidiaries. The proceeds from advances under the revolving credit facility may be used for general corporate purposes. The new revolving credit agreement replaced the Company’s former $360 million revolving credit agreement which would have expired on August 30, 2005, but was terminated as of June 24, 2005. The Company had no outstanding advances under its unsecured, revolving credit agreements at September 30, 2005 or December 31, 2004.
Interest Paid, including facility fees, for the nine and three months ended September 30, 2005 and 2004 was:
Notes Payable under Revolving Credit Agreements
Mortgage Note Payable
Total Interest Paid
Interest Expense, including facility fees and accretion of discount, for the nine and three months ended September 30, 2005 and 2004 was:
Total Interest Expense
8
Note 6 - Net Income Per Share
Net Income Per Share and Net Income Per Share Assuming Dilution for the nine and three months ended September 30, 2005 and 2004 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 September 30, 2005 and 2004 to purchase 0.6 million shares and 1.2 million shares, respectively, of Unitrin common stock were excluded from the computation of Net Income Per Share Assuming Dilution for the nine months ended September 30, 2005 and 2004, respectively, because the exercise prices exceeded the average market price.
Note 7 - Other Comprehensive Income (Loss)
Other Comprehensive Income (Loss) for the nine and three months ended September 30, 2005 and 2004 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 (Loss) and Other Comprehensive Income (Loss). Total Comprehensive Income for the nine months ended September 30, 2005 and 2004 was $151.8 million and $199.7 million, respectively. Total Comprehensive Loss for the three months ended September 30, 2005 was $39.1 million. Total Comprehensive Income for the three months ended September 30, 2004 was $111.5 million.
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Note 8 - Income from Investments
Net Investment Income for the nine and three months ended September 30, 2005 and 2004 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 Investments
Real Estate
Total Investment Income
Investment Expenses:
Total Investment Expenses
The components of Net Realized Investment Gains for the nine and three months ended September 30, 2005 and 2004 were:
Fixed Maturities:
Gains on Dispositions
Losses on Dispositions
Losses from Write-downs
Northrop Common Stock:
Other Equity Securities:
Real Estate:
Other Investments:
10
Note 8 - Income from Investments (continued)
Net Realized Investment Gains were $53.5 million and $7.8 million for the nine and three months ended September 30, 2005, respectively, compared to $67.2 million and $24.7 million for the same periods in 2004. Net Realized Investment Gains for the nine months ended September 30, 2005 include pre-tax gains of $39.4 million from sales of investment real estate, pre-tax gains of $9.9 million from sales of a portion of the Company’s investment in Baker Hughes, Inc. (“Baker Hughes”) common stock and pre-tax gains of $3.4 million resulting from sales of a portion of the Company’s investment in Hartford Financial Services Group, Inc. (“Hartford”) common stock. Net Realized Investment Gains for the three months ended September 30, 2005 include pre-tax gains of $5.4 million from sales of a portion of the Company’s investment in Baker Hughes common stock and pre-tax gains of $1.1 million resulting from sales of a portion of the Company’s investment in Hartford common stock. The fair values of the Company’s remaining investments in Baker Hughes common stock and Hartford common stock were $49.2 million and $19.2 million, respectively, at September 30, 2005. The Company cannot anticipate when or if similar investment gains may occur in the future.
Net Realized Investment Gains for the nine months ended September 30, 2004 include pre-tax gains of $34.4 million from sales of a portion of the Company’s investment in Northrop Grumman Corporation (“Northrop”) common stock, pre-tax gains of $26.3 million from sales of a portion of the Company’s investment in Baker Hughes common stock and pre-tax gains of $3.6 million resulting from sales of a portion of the Company’s investment in Hartford common stock. Net Realized Investment Gains for the three months ended September 30, 2004 includes pre-tax gains of $2.8 million from sales of a portion of the Company’s investment in Northrop common stock and pre-tax gains of $21.9 million 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 the 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 nine and three months ended September 30, 2005 include pre-tax losses of $6.2 million and $1.0 million, respectively, resulting from other than temporary declines in the fair value of investments. Net Realized Investment Gains for the nine and three months ended September 30, 2004 include pre-tax losses of $4.6 million and $2.7 million, respectively, resulting from other than temporary declines in the fair value of investments. The Company cannot anticipate when or if similar investment losses may occur in the future.
Note 9 - Pension Benefits and Postretirement Benefits Other Than Pensions
The components of Pension Expense for the nine and three months ended September 30, 2005 and 2004 were:
Service Cost Benefits Earned
Interest Cost on Projected Benefit Obligations
Expected Return on Plan Assets
Net Amortization and Deferral
Total Pension Expense
The Company intends to make a voluntary contribution of approximately $30 million to one of its pension plans for the 2005 plan year. No contribution was required for the 2004 plan year.
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Note 9 - Pension Benefits and Postretirement Benefits Other Than Pensions (continued)
The components of Postretirement Benefits Other than Pensions Expense for the nine and three months ended September 30, 2005 and 2004 were:
Total Postretirement Benefits Other than Pensions Expense
Based on the Company’s most recent actuarial valuation, the Company expects to contribute $4.9 million to its postretirement benefits other than pensions plan in 2005.
Note 10 – Income Taxes
At December 31, 2004, the Company had not provided Federal income taxes on approximately $192 million of income earned prior to 1984 by certain of the Company’s life insurance subsidiaries (the “Pre-1984 Undistributed Income”). Under tax laws applicable to years 2004 and prior, such income would not be subject to Federal income taxes under certain circumstances. Federal income taxes could have been incurred on such income if it had been distributed to shareholders or if other limitations were not met. The American Jobs Creation Act of 2004 (“AJCA”) has effectively suspended the taxation of this income for years 2005 and 2006. Furthermore, to the extent qualifying distributions can be made in 2005 and/or 2006 out of the affected life insurance subsidiaries, the Company can eliminate any or all of this income that would potentially be subject to tax in years after 2006. During the first nine months of 2005, United Insurance Company of America (“United”), a direct wholly-owned subsidiary of Unitrin, paid dividends totaling $45 million to Unitrin, which reduced the Pre-1984 Undistributed Income by the same amount. There was no impact on income tax expense for the nine and three months ended September 30, 2005 due to the suspension of taxation described above. The Company anticipates that, subject to regulatory approval, the Company’s affected life insurance subsidiaries will make additional qualifying distributions before December 31, 2006 in order to eliminate all of the remaining Pre-1984 Undistributed Income. The Company currently does not expect to incur income taxes on such qualifying distributions due to the suspension of taxation described above.
Income taxes paid were $62.8 million for the nine months ended September 30, 2005, compared to $201.9 million for the same period in 2004.
Note 11 - 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: Kemper Auto and Home, Unitrin Specialty, Unitrin Direct, Unitrin Business Insurance, Life and Health Insurance and Consumer Finance.
Effective January 1, 2005, the Company combined the personal lines operations of its former Multi Lines Insurance segment into the Kemper Auto and Home segment. In addition, the Company created a separate, stand-alone business operation, referred to as Unitrin Business Insurance, for the commercial lines operations and certain reinsurance programs of the former Multi Lines Insurance segment. Accordingly, segment results for 2004 have been restated to conform to the current management reporting structure.
Kemper Auto and Home provides preferred and standard risk personal automobile and homeowners insurance through independent agents.
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Note 11 - Business Segments (continued)
The Unitrin Specialty segment provides automobile insurance to individuals and businesses in the non-standard and specialty markets 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.
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 incurs lower renewal costs than traditional insurance providers.
The Unitrin Business Insurance segment provides commercial automobile, general liability, commercial fire, commercial multi-peril and workers’ compensation insurance. Its products are designed and priced for those businesses that have demonstrated favorable risk characteristics and loss histories and are sold by independent agents.
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 certificates of deposits.
It is the Company’s management practice to allocate certain corporate expenses to its operating units. The Company considers the management of certain investments, 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.
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Segment Revenues for the nine and three months ended September 30, 2005 and 2004 were:
Sept. 30,
2005
2004
Kemper Auto and Home:
Total Kemper Auto and Home
Unitrin Specialty:
Total Unitrin Specialty
Unitrin Direct:
Total Unitrin Direct
Unitrin Business Insurance:
Total Unitrin Business Insurance
Life and Health Insurance:
Total Life and Health Insurance
Consumer Finance
Total Segment Revenues
Unallocated Dividend Income
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Segment Operating Profit for the nine and three months ended September 30, 2005 and 2004 was:
Segment Operating Profit (Loss):
Total Segment Operating Profit
Other Expense, Net
Income Before Income Taxes and Equity in Net Income of Investee
Segment Net Income for the nine and three months ended September 30, 2005 and 2004 was:
Segment Net Income (Loss):
Total Segment Net Income
Net Income (Loss) From:
Income Before Equity in Net Income of Investee
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Earned Premiums by product line for the nine and three months ended September 30, 2005 and 2004 were:
Life
Accident and Health
Property and Casualty:
Personal Lines:
Automobile
Homeowners
Other Personal
Total Personal Lines
Commercial Lines:
Property and Liability
Workers’ Compensation
Commercial Reinsurance Program
Total Commercial Lines
Total Earned Premiums
Note 12 - 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 plans. 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 September 30, 2005, the Company’s subsidiaries and the Company’s pension plans had $179.5 million and $79.1 million, respectively, in investments managed by FS&C. During the first nine months of 2005, the Company’s subsidiaries and the Company’s pension plans paid $0.5 million in the aggregate to FS&C. During the first nine months of 2004, the Company’s subsidiaries and the Company’s pension plans paid $0.5 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 participants 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 September 30, 2005, participants in the Company’s 401(k) Savings Plan had allocated approximately $27.9 million for investment in the Dreyfus Appreciation Fund, representing 12% of the total amount invested in the Company’s 401(k) Savings Plan.
16
Note 12 - Related Party Transactions (continued)
During the three months ended September 30, 2005, the Company’s Life and Health Insurance segment paid $1.1 million to purchase the next generation of the segment’s hand held computers from Intermac, a subsidiary of UNOVA.
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 14, 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 13 - Legal Proceedings
The Company and its subsidiaries are defendants in various lawsuits incidental to their businesses. The Company believes that there are meritorious defenses to these lawsuits and is defending them vigorously. Certain of the lawsuits are pending in jurisdictions that have a history of awarding damages, including punitive damages, that are disproportionate to the actual economic damages alleged to have been incurred. Additionally, some of these lawsuits seek class action status that, if granted, could expose the Company to potentially significant liability by virtue of the size of the purported classes. The Company believes that resolution of its pending litigation will not have a material adverse effect on the Company’s financial position. However, given the unpredictability of litigation, there can be no assurance that one or more of these lawsuits will not produce a damage award which could have a material adverse effect on the Company’s financial results for any given period.
Note 14 - Relationships with Mutual Insurance 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. 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 certain business written or assumed by FNP. Pursuant to such reinsurance agreement, FNP agrees to arrange for its parent company, First NonProfit Mutual Holding Company (“FNMHC”), to nominate candidates selected by MIC constituting a majority of the FNMHC board of directors. As a result, five employees of the Company selected by MIC serve as directors of FNMHC at September 30, 2005. 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 can be terminated at anytime by any of the parties to the respective agreements, subject to the notice requirements in such agreements.
Trinity and Capitol are parties to a quota share reinsurance agreement whereby, effective August 1, 2005, Trinity assumes 100% of the business written by Capitol. Prior to August 1, 2005, Trinity assumed 95% of the business written by Capitol. Capitol is a mutual insurance company and, accordingly, is owned by its policyholders. Five employees of the Company serve as directors of Capitol’s five member board of directors. Nine employees of the Company also serve as directors of Capitol’s wholly-owned subsidiary’s, Old Reliable Casualty Company’s (“ORCC”), nine member board of directors. The Reliable Life Insurance Company (“Reliable”), a wholly-owned subsidiary of Unitrin, provides certain administrative services to Capitol and its subsidiary, 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. The Company also provides certain investment 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 $168.8 million ($2.44 per common share) and $22.7 million ($0.33 per common share) for the nine and three months ended September 30, 2005, respectively, compared to $166.9 million ($2.44 per common share) and $56.5 million ($0.82 per common share) for the same periods in 2004. As discussed throughout this Management’s Discussion and Analysis of Results of Operations and Financial Condition, Net Income decreased for the three months ended September 30, 2005, due to lower operating results in the Company’s operating segments, principally due to catastrophe losses, and lower Net Realized Investment Gains.
Total Revenues were $2,292.2 million and $2,281.1 million for the nine months ended September 30, 2005 and 2004, respectively, an increase of $11.1 million. Total Revenues were $754.1 million and $778.7 million for the three months ended September 30, 2005 and 2004, respectively, a decrease of $24.6 million.
Earned Premiums were $1,858.8 million and $1,862.5 million for the nine months ended September 30, 2005 and 2004, respectively, a decrease of $3.7 million. Earned Premiums were $620.6 million and $630.7 million for the three months ended September 30, 2005 and 2004, respectively, a decrease of $10.1 million. Earned Premiums decreased for the nine months ended September 30, 2005, primarily in the Unitrin Specialty segment, partially offset by increased Earned Premiums in the Unitrin Direct segment. Earned Premiums decreased for the three months ended September 30, 2005, primarily in the Unitrin Specialty segment and the Kemper Auto and Home segment, partially offset by increased Earned Premiums in the Unitrin Direct segment.
Consumer Finance Revenues increased by $12.6 million and $5.6 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004, due primarily to higher levels of loans outstanding, partially offset by lower portfolio interest rates.
Net Investment Income increased by $20.0 million for the nine months ended September 30, 2005, compared to the same period in 2004, due to higher levels of investments and higher yields on investments. Net Investment Income increased by $1.9 million for the three months ended September 30, 2005, compared to the same period in 2004, due primarily to higher levels of investments.
Net Realized Investment Gains were $53.5 million and $7.8 million for the nine and three months ended September 30, 2005, respectively, compared to $67.2 million and $24.7 million for the same periods in 2004. Net Realized Investment Gains for the nine months ended September 30, 2005 include pre-tax gains of $39.4 million from sales of investment real estate. The Company cannot anticipate when or if similar investment gains 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 reserves for property and casualty incurred losses and loss adjustment expenses (“LAE”), 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, 2004.
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Catastrophes
During the third quarter of 2005, two major hurricanes (Katrina and Rita) made landfall in the United States. Hurricane Katrina is expected to be the most costly hurricane on record in the United States. The Company estimates that, as a result of Hurricane Katrina’s landfall in Louisiana, Mississippi and Alabama, its Life and Health Insurance segment incurred $43.3 million of losses and loss adjustment expenses (“LAE”) in excess of its retention of $8.0 million and recorded a reinstatement premium of $2.6 million in the third quarter of 2005. In addition, the Life and Health Insurance segment incurred $0.4 million of losses and LAE in Florida which occurred too early to be aggregated with the losses in the other Gulf states under its reinsurance program. The Company estimates that, as a result of Hurricane Katrina’s landfall in Louisiana, Mississippi and Alabama, its Kemper Auto and Home segment incurred $21.5 million of losses and LAE in excess of its retention of $20.0 million and recorded a reinstatement premium of $3.1 million in the third quarter of 2005. In addition, the Kemper Auto and Home segment incurred $0.2 million of losses and LAE in Florida which occurred too early to be aggregated with the losses in the other Gulf states under its reinsurance program. The Company estimates that, as a result of Hurricane Katrina’s landfall in Louisiana, Mississippi and Alabama, the Unitrin Direct, Unitrin Specialty and Unitrin Business Insurance segments together incurred $0.8 million of losses and LAE in excess of their retention of $4.0 million and recorded a reinstatement premium of $0.1 million in the third quarter of 2005. In addition, the Unitrin Direct segment incurred $0.1 million of losses and LAE in Florida which occurred too early to be aggregated with the losses in the other Gulf states under its reinsurance program.
Total estimated catastrophe losses and LAE, net, of reinsurance recoveries, were $87.7 million and $70.3 million for the nine and three months ended September 30, 2005, respectively, compared to $35.6 million and $20.6 million for the same periods in 2004. The Company recorded significant losses from Hurricanes Katrina and Rita in the third quarter of
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Catastrophes (continued)
2005 and significant losses from Hurricanes Charley, Frances, Ivan and Jeanne in the third quarter of 2004. A summary of the Company’s losses and LAE, net of reinsurance, from Hurricanes Katrina and Rita for the nine and three months ended September 30, 2005 by business segment follows.
The Company’s estimates for Hurricanes Katrina and Rita include estimates for both direct losses and LAE and indirect losses from residual market assessments. The process of estimating and establishing reserves for catastrophe losses is inherently uncertain and the actual ultimate cost of a claim, net of actual reinsurance recoveries, may vary materially from the estimated amount reserved. The Company’s estimates of direct catastrophe losses are generally based on inspections by claims adjusters and historical loss development experience for areas that have not been inspected or for claims that have not yet been reported. The Company’s estimates of direct catastrophe losses are based on the coverages provided by its insurance policies. The Company’s homeowners insurance policies do not provide coverage for losses caused by floods, but generally provide coverage for physical damage caused by wind or wind driven rain. Accordingly, the Company’s estimates of direct losses for homeowners insurance do not include losses caused by flood. Depending on the policy, automobile insurance may provide coverage for losses caused by flood. Estimates of the number of and severity of claims ultimately reported are influenced by many variables including, but not limited to, repair or reconstruction costs and determination of cause of loss, that are difficult to quantify and will influence the final amount of claim settlements. All these factors, coupled with the impact of the availability of labor and material on costs, require significant judgment in the reserve setting process. A change in any one or more of these factors is likely to result in an ultimate net claim cost different from the estimated reserve. The Company’s estimates of indirect losses from residual market assessments are based on a variety of factors including, but not limited to, actual or estimated assessments provided by or received from the assessing entity, insurance industry estimates of losses, and estimates of the Company’s market share in the assessable states. Actual assessments may differ materially from these estimated amounts. The Company currently believes that it is unlikely that a change in its direct and indirect estimates of losses and LAE for Hurricanes Katrina and Rita will cause it to exceed the coverages provided by its reinsurance programs.
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On January 1, 2005, the Company combined the personal lines insurance operations of its former Multi Lines Insurance segment into the Kemper Auto and Home segment. Amounts for 2004 have been restated to conform to the current management reporting structure. The results of the Kemper Auto and Home segment for the nine and three months ended September 30, 2005 and 2004, as restated, were:
Earned Premiums:
Incurred Losses and LAE
Operating Profit (Loss)
Income Tax Benefit (Expense)
Net Income (Loss)
Ratio Based on Earned Premiums
Incurred Loss and LAE Ratio (excluding Catastrophes)
Incurred Catastrophe Loss and LAE Ratio
Total Incurred Loss and LAE Ratio
Incurred Expense Ratio
Combined Ratio
Personal Automobile
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Kemper Auto and Home (continued)
Loss Reserves:
Case
Incurred but Not Reported
Total Loss Reserves
LAE Reserves
Favorable Loss and LAE Reserve Development, Net (excluding Catastrophes)
Favorable (Adverse) Catastrophe Loss and LAE Reserve Development, Net
Total Favorable Loss and LAE Reserve Development, Net
Loss and LAE Reserve Development as a Percentage of Insurance Reserves at Beginning of Year
Earned Premiums in the Kemper Auto and Home segment decreased by $2.6 million and $6.3 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004. Earned Premiums on automobile insurance decreased by $12.1 million and $6.0 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004, due primarily to lower volume of insurance from assigned risk and involuntary market pools and the effects of a change in the Kemper Auto and Home segment’s estimate of North Carolina premium rate rollbacks in 2004. Earned premiums from such involuntary pools decreased by $8.8 million and $1.6 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004. Earned Premiums in 2004 included income of $2.9 million due to a change in the Kemper Auto and Home segment’s estimate of its North Carolina premium rate rollback. Earned Premiums on homeowners insurance increased by $6.6 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to higher rates, partially offset by reinsurance reinstatement premiums and lower volume. Earned Premiums on homeowners insurance decreased by $1.2 million for the three months ended September 30, 2005, compared to the same period in 2004, due primarily to reinsurance reinstatement premiums and lower volume, partially offset by higher rates. During the third quarter of 2005, the Kemper Auto and Home segment recorded a $3.3 million reduction in homeowners insurance earned premiums and a $0.5 million reduction in automobile insurance earned premiums to reinstate catastrophic reinsurance coverage following Hurricanes Katrina and Rita.
Other Income decreased by $6.3 million and $4.4 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004, due to the continuing run-off of policies and related claims administered for third parties. Net Investment Income increased by $7.1 million for the nine months ended September 30, 2005, compared to the same period in 2004, due to higher levels of investments and to higher yields on investments. Net Investment Income increased by $1.1 million for the three months ended September 30, 2005, compared to the same period in 2004, due primarily to higher levels of investments.
Operating Profit in the Kemper Auto and Home segment decreased by $12.6 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to higher incurred losses and LAE as a percentage of earned premiums and higher insurance expenses, partially offset by higher net investment income. Incurred loss and LAE as a percentage of earned premiums in the Kemper Auto and Home segment increased for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to higher losses and LAE from catastrophes partially offset by favorable loss and LAE reserve development. Catastrophe losses and LAE (including development), net of reinsurance, were $59.2 million for the nine months ended September 30, 2005, compared to $25.4 million for the same period in 2004. Catastrophe losses and LAE for the nine months ended September 30, 2005 included $40.2 million, net of reinsurance, from Hurricanes Katrina and Rita. Catastrophe losses
22
and LAE for the nine months ended September 30, 2004 included $13.1 million from Hurricanes Charley, Frances, Ivan and Jeanne. The Kemper Auto and Home segment recognized favorable loss and LAE reserve development of $46.8 million for the nine months ended September 30, 2005, compared to favorable development of $23.9 million for the same period in 2004. Insurance expenses increased by $10.6 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to restructuring expenses and higher amortization of deferred policy acquisition costs. Restructuring costs recognized in the Kemper Auto and Home segment were $6.0 million for the nine months ended September 30, 2005.
Operating results in the Kemper Auto and Home segment decreased by $33.1 million for the three months ended September 30, 2005, compared to the same period in 2004. Operating results decreased due primarily to higher catastrophe losses and LAE, net of reinsurance, and also due to higher insurance expenses, partially offset by lower non-catastrophe losses and LAE as a percentage of earned premiums and higher net investment income. Catastrophe losses and LAE (including development), net of reinsurance, was $45.6 million for the three months ended September 30, 2005, compared to $13.9 million for the same period in 2004. Catastrophe losses and LAE for the three months ended September 30, 2005 included $40.2 million, net of reinsurance, from Hurricanes Katrina and Rita. Catastrophe losses and LAE for the three months ended September 30, 2004 included $13.1 million from Hurricanes Charley, Frances, Ivan and Jeanne. Non-catastrophe losses and LAE decreased due primarily to favorable loss and LAE reserve development. The Kemper Auto and Home segment recognized favorable loss and LAE reserve development of $20.9 million for the three months ended September 30, 2005, compared to favorable loss and LAE reserve development of $7.1 million for the same period in 2004. Insurance expenses increased by $2.8 million for the three months ended September 30, 2005, compared to the same period in 2004, due primarily to restructuring expenses, partially offset by lower expense related to claims administered for third parties. Restructuring costs recognized in the Kemper Auto and Home segment were $4.3 million for the three months ended September 30, 2005.
In the third quarter of 2004, the Company and Kemper Insurance Companies (“KIC”) agreed to settle and extinguish certain liabilities and obligations arising from the Company’s acquisition of certain businesses from KIC (the “KIC Settlement”). The Company recorded a consolidated charge of $14.9 million before-tax, including a performance bonus of $18.4 million partially offset by certain service fee adjustments, in connection with the KIC Settlement. The performance bonus is included in Insurance Expenses in the Condensed Consolidated Statements of Income, and the service fee adjustments are included in Other Income in the Condensed Consolidated Statements of Income. For management reporting purposes, the Company has not allocated the performance bonus to the Kemper Auto and Home segment, and accordingly, such expense is included in Other Expense, Net (Note 11 of the Condensed Consolidated Financial Statements—Business Segments). The net impact of the KIC Settlement included in the Kemper Auto and Home segment for both the nine and three months ended September 30, 2004 was a gain of $3.5 million before-tax.
Net Income in the Kemper Auto and Home segment decreased by $6.7 million and $21.2 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004, due primarily to the change in operating results. The Kemper Auto and Home segment’s effective income tax rate differs from the federal statutory income tax rate due primarily to tax-exempt investment income. Tax-exempt investment income was $18.2 million and $6.3 million for the nine and three months ended September 30, 2005, respectively, compared to $13.6 million and $4.9 million for the same periods in 2004.
23
Commercial Automobile
Operating Profit
24
Unitrin Specialty (continued)
Catastrophe Loss and LAE Reserve Development, Net
Earned Premiums in the Unitrin Specialty segment decreased by $26.4 million and $9.3 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004, due primarily to lower premium volume in personal automobile insurance, partially offset by higher premium volume in commercial automobile insurance. The lower personal automobile premium volume was due primarily to increased competition. The Unitrin Specialty segment is in the process of reducing personal automobile insurance rates in certain states, where profitability is above the Company’s target levels, to improve its competitive position. Personal automobile premiums also decreased due to Unitrin Specialty’s decision to exit its motorcycle insurance business, which is included in the Unitrin Specialty segment’s personal automobile insurance line. Net Investment Income increased by $2.3 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to higher levels of investments and higher yields on investments.
Operating Profit in the Unitrin Specialty segment decreased by $0.1 million and $2.0 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004. Operating profit from commercial automobile insurance increased by $3.4 million and $0.5 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004, due primarily to higher investment income, lower losses and LAE as a percentage of earned premiums, and the higher premium volume. Operating profit from personal automobile insurance decreased by $4.7 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to the lower premium volume and higher losses and LAE as a percentage of earned premiums, partially offset by the higher investment income. Personal automobile insurance losses and LAE increased as a percentage of earned premiums due primarily to higher losses and LAE, net of reinsurance, from catastrophes and higher severity of losses. Operating profit from personal automobile insurance decreased by $2.5 million for the three months ended September 30, 2005, compared to the same period in 2004, due primarily to the lower premium volume and higher losses and LAE as a percentage of earned premiums. Personal automobile insurance losses and LAE increased as a percentage of earned premiums due primarily to higher losses and LAE, net of reinsurance, from catastrophes and higher severity of losses. Operating profit from other insurance increased by $1.2 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to favorable loss and LAE reserve development, recorded in the second quarter of 2005, on certain reinsurance pools that are in run-off.
Net loss and LAE reserve development had a favorable effect of $12.1 million for the nine months ended September 30, 2005, compared to a favorable effect of $3.2 million for the same period in 2004. Net loss and LAE reserve
25
development had a favorable effect of $3.5 million for the three months ended September 30, 2005, compared to a negligible effect for the same period in 2004. Catastrophe losses and LAE, net of reinsurance, in the Unitrin Specialty segment were $3.6 million and $2.5 million for the nine and three months ended September 30, 2005, respectively, compared to $0.3 million and a negligible amount for the same periods in 2004. Catastrophe losses and LAE, net of reinsurance, in the Unitrin Specialty segment from Hurricanes Katrina and Rita were $2.4 million for both the nine and three months ended September 30, 2005.
Net Income in the Unitrin Specialty segment increased by $0.3 million and decreased by $1.3 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004. The Unitrin Specialty segment’s effective tax rate differs from the statutory tax rate due primarily to tax-exempt investment income. Tax-exempt investment income in the Unitrin Specialty segment was $7.8 million and $2.6 million for the nine and three months ended September 30, 2005, respectively. Tax-exempt investment income in the Unitrin Specialty segment was $6.4 million and $2.3 million for the nine and three months ended September 30, 2004, respectively.
Income Tax Benefit
26
Unitrin Direct (continued)
Earned Premiums in the Unitrin Direct segment increased by $28.3 million and $7.2 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004, due to higher volume and higher premium rates. Premiums are recognized as revenues in the Company’s financial statements as earned over the life of the policy. Written premiums, which report the total amount of premiums to be received over the policy term, may, however, be more indicative of the trend of earned premiums for future periods. Written premiums for the nine months ended September 30, 2005 increased by $11.1 million, compared to the same period in 2004, due to higher volume and rates. However, written premiums for the three months ended September 30, 2005 decreased by $2.3 million, compared to the same period in 2004, due primarily to lower volume. The Unitrin Direct segment reduced its premium writings in certain states while it was implementing certain product changes and rate increases. Net Investment Income in the Unitrin Direct segment increased by $1.6 million for the nine months ended September 30, 2005, compared to the same period in 2004, due to higher levels of investments and, to a lesser extent, higher yields on investments. Net Investment Income in the Unitrin Direct segment increased by $0.2 million for the three months ended September 30, 2005, compared to the same period in 2004, due primarily to higher levels of investments.
For the nine months ended September 30, 2005, the Unitrin Direct segment reported an Operating Profit of $1.5 million, compared to an Operating Loss of $5.6 million for the same period in 2004. For the nine months ended September 30, 2005, the Unitrin Direct segment’s operating results improved due primarily to lower insurance expenses as a percentage of earned premiums, lower catastrophe losses and LAE and higher net investment income. Insurance expenses as a percentage of earned premiums decreased due primarily to improved economies of scale. Losses and LAE from catastrophes were $0.5 million in the Unitrin Direct segment for the nine months ended September 30, 2005, compared to $1.8 million for the same period in 2004. For the nine months ended September 30, 2005, favorable loss and LAE reserve development in the Unitrin Direct segment was $3.1 million, compared to $2.1 million for the same period in 2004.
For the three months ended September 30, 2005, Operating Profit in the Unitrin Direct segment was $0.6 million, compared to an Operating Loss of $0.7 million for the same period in 2004. For the three months ended September 30, 2005, the Unitrin Direct segment’s operating results improved due primarily to lower catastrophe losses and LAE. For the three months ended September 30, 2005, the Unitrin Direct segment recorded losses and LAE from catastrophes of $0.3 million, compared to losses and LAE from catastrophes of $1.6 million for the same period in 2004.
27
For the nine and three months ended September 30, 2005, the Unitrin Direct segment reported Net Income of $2.1 million and $0.7 million, respectively, compared to Net Losses of $2.3 million and $0.1 million for the same periods in 2004. The Unitrin Direct segment’s effective income tax rate differs from the federal statutory income tax rate due primarily to tax-exempt investment income. Tax-exempt investment income was $3.3 million and $1.1 million for the nine and three months ended September 30, 2005, respectively, compared to $2.4 million and $0.9 million for the same periods in 2004. The third quarter of 2005 is the fourth consecutive discrete quarter in which the Unitrin Direct segment reported positive Operating Profit and Net Income. The Company anticipates that Unitrin Direct will reach profitability on a full year basis in 2005.
On January 1, 2005, the Company launched its new stand-alone commercial lines business segment - Unitrin Business Insurance. The Unitrin Business Insurance segment includes the commercial lines operations and certain commercial reinsurance programs of the former Multi Lines Insurance segment. Amounts for 2004 have been restated to conform to the current management reporting structure.
Commercial Property and Liability
28
Unitrin Business Insurance (continued)
Favorable (Adverse) Loss and LAE Reserve Development, Net (excluding Catastrophes)
Total Favorable (Adverse) Loss and LAE Reserve Development, Net
Earned Premiums in the Unitrin Business Insurance segment decreased by $5.1 million and $1.1 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004. Commercial automobile insurance and commercial property and liability insurance earned premiums decreased due primarily to lower premium volume. Workers’ compensation insurance earned premiums decreased slightly due primarily to fewer policies in force, partially offset by increased exposures based on insured payroll. The Unitrin Business Insurance segment’s commercial reinsurance program consists of certain business written and administered by First NonProfit Insurance Company (“FNP”). FNP specializes in providing various forms of commercial insurance to charitable and other non-profit organizations. See Note 14 to the unaudited Condensed Consolidated Financial Statements for additional information about this reinsurance arrangement. Net Investment Income in the Unitrin Business Insurance segment increased by $2.5 million for the nine months ended September 30, 2005, compared to the same period in 2004, due to higher yields on investments and higher levels of investments.
Operating Profit in the Unitrin Business Insurance segment decreased by $2.0 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to higher insurance expenses, partially due to certain restructuring and system migration costs, and higher catastrophe losses, net of reinsurance, partially offset by lower non-catastrophe incurred losses and LAE and the higher net investment income. Incurred losses and LAE, excluding catastrophes, decreased due primarily to the favorable effects of reserve development. Reserve development was $10.3 million favorable for the nine months ended September 30, 2005, compared to $2.2 million favorable for the same period in 2004. Catastrophe losses and LAE were $5.3 million for the nine months ended September 30, 2005, including $5.5 million, net of reinsurance, for Hurricanes Katrina and Rita. For the nine months ended September 30, 2005, the Unitrin Business Insurance segment also recorded favorable development of $1.2 million due to higher subrogation recoveries than previously anticipated from an earlier year catastrophe. Catastrophe losses and LAE were $1.4 million for the nine months ended September 30, 2004. Restructuring costs recognized in the Unitrin Business Insurance segment were $2.9 million for the nine months ended September 30, 2005. The Unitrin Business Insurance segment is in the process of migrating its policy administration and billing systems to a third party provider. Accordingly, the Unitrin Business Insurance segment’s insurance expenses have increased and are expected to remain at higher levels during the migration while certain redundant systems are phased out. The Company anticipates that the redundant costs will decline during the second half of 2006.
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Operating Profit in the Unitrin Business Insurance segment decreased by $6.0 million for the three months ended September 30, 2005, compared to the same period in 2004, due primarily to higher catastrophe losses, net of reinsurance, and higher insurance expenses, partially due to certain restructuring and system migration costs, partially offset by lower non-catastrophe incurred losses and LAE. Incurred losses and LAE, excluding catastrophes, decreased due primarily to the favorable effects of reserve development. Reserve development was $2.2 million favorable for the three months ended September 30, 2005, compared to $1.4 million adverse development for the same period in 2004. Catastrophe losses and LAE were $5.0 million for the three months ended September 30, 2005, including $5.5 million, net of reinsurance, for Hurricanes Katrina and Rita. For the three months ended September 30, 2005, the Unitrin Business Insurance segment also recorded favorable development of $0.9 million due to higher subrogation recoveries than previously anticipated from an earlier year catastrophe. The Unitrin Business Insurance segment reported income from catastrophes of $0.4 million for the three months ended September 30, 2004, as several catastrophes from prior periods developed favorably. Restructuring costs recognized in the Unitrin Business Insurance segment were $0.9 million for the three months ended September 30, 2005.
Net Income in the Unitrin Business Insurance segment decreased by $1.6 million and $3.7 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004. The Unitrin Business Insurance segment’s effective tax rate differs from the statutory tax rate due primarily to tax-exempt investment income and other tax deductions. Tax-exempt investment income in the Unitrin Business Insurance segment was $10.0 million and $3.2 million for the nine and three months ended September 30, 2005, respectively. Tax-exempt investment income was $9.4 million and $3.5 million for the nine and three months ended September 30, 2004, respectively. Net Income for the nine months ended September 30, 2004 included other tax deductions of $2.2 million, with no such other tax deductions in 2005.
Property
Policyholders’ Benefits and Incurred Losses and LAE
Earned Premiums in the Life and Health Insurance segment increased by $2.1 million for the nine months ended September 30, 2005, compared to the same period in 2004. Earned Premiums on life insurance increased by $2.4 million for the nine months ended September 30, 2005, due primarily to increased premium volume. Earned Premiums on property insurance sold by the Life and Health Insurance segment’s career agents, excluding reinsurance reinstatement premium, increased by $2.7 million for the nine months ended September 30, 2005, due almost entirely to increased premium volume. During the third quarter of 2005, the Life and Health Insurance segment recorded a $2.6 million reduction in Earned Premiums to reinstate catastrophic reinsurance coverage following Hurricane Katrina. Earned Premiums on accident and health insurance decreased by $0.4 million for the nine months ended September 30, 2005. Lower volume of accident and health insurance, primarily on limited benefit medical and Medicare supplement products, accounted for approximately $4.6 million of the decrease in accident and health insurance earned premiums
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Life and Health Insurance (continued)
for the nine months ended September 30, 2005, while higher premium rates on those same products accounted for an increase of approximately $4.2 million. Other Income increased by $2.2 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to a gain recognized on the sale of the Career Agency Group’s home office. Net Investment Income in the Life and Health Insurance segment increased by $7.9 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to higher levels of investments.
Earned Premiums in the Life and Health Insurance segment decreased by $0.6 million for the three months ended September 30, 2005, compared to the same period in 2004. Earned Premiums on property insurance sold by the Life and Health Insurance segment’s career agents, excluding reinsurance reinstatement premiums, increased by $1.1 million, for the three months ended September 30, 2005, due almost entirely to increased premium volume. Earned Premiums on life insurance increased by $0.7 million, for the three months ended September 30, 2005, due to increased premium volume. Earned Premiums on accident and health insurance increased by $0.2 million for the three months ended September 30, 2005. Higher premium rates on accident and health insurance, primarily on limited benefit medical and Medicare supplement products, accounted for approximately $1.3 million of the increase in accident and health insurance earned premiums for the three months ended September 30, 2005, while lower volume on those same products accounted for a decrease of approximately $1.1 million. Net Investment Income in the Life and Health Insurance segment decreased by $0.3 million for the three months ended September 30, 2005, compared to the same period in 2004, due to lower yields on investments, partially offset by higher levels of investments.
The Company currently estimates that annual life insurance earned premiums may decrease by $8 million to $12 million and annual property insurance earned premiums may decrease by $1 million to $3 million due primarily to the effects of Hurricane Katrina on the Company’s policyholders and employee agents.
Operating Profit in the Life and Health Insurance segment increased by $2.6 million for the nine months ended September 30, 2005, compared to the same period in 2004. Operating Profit increased due primarily to the higher net investment income, lower insurance expenses and the gain recognized on the sale of the Career Agency Group’s home office, partially offset by higher catastrophe losses and LAE, net of reinsurance, on property insurance sold by the Life and Health Insurance segment’s career agents and higher life insurance benefits. Insurance expenses decreased by $6.9 million, due primarily to lower salaries and fringe benefits. Salary and fringe benefits decreased partially as a result of the Company’s efforts to consolidate back office operations. Policyholders’ benefits for the nine months ended September 30, 2004 included a charge of $5.4 million due to a change in the actuarial estimate of reserves resulting from the conversion of certain business to a new computer system. Excluding the impact of this change in actuarial estimate, policyholders’ benefits increased $8.6 million due primarily to higher mortality and morbidity. Catastrophe losses and LAE (including development), net of reinsurance, on property insurance sold by the Life and Health Insurance segment’s career agents were $19.1 million for the nine months ended September 30, 2005, compared to $6.7 million for the same period in 2004. Catastrophe losses and LAE for the nine months ended September 30, 2005 included $16.4 million, net of reinsurance, from Hurricanes Katrina and Rita. Catastrophe losses and LAE for the nine months ended September 30, 2004 included $5.3 million from Hurricanes Charley, Frances, Ivan and Jeanne. Net Income in the Life and Health Insurance segment increased by $1.4 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to the higher operating profit.
Operating Profit in the Life and Health Insurance segment decreased by $13.3 million for the three months ended September 30, 2005, compared to the same period in 2004. Operating Profit decreased due primarily to higher catastrophe losses and LAE, net of reinsurance, on property insurance sold by the Life and Health Insurance segment’s career agents and higher policyholders’ benefits, partially offset by lower insurance expenses. Catastrophe losses and LAE (including development), net of reinsurance, on property insurance sold by the Life and Health Insurance segment’s career agents were $16.9 million for the three months ended September 30, 2005, compared to $5.5 million for the same period in 2004. Catastrophe losses and LAE for the three months ended September 30, 2005 included $16.4 million, net of reinsurance, from Hurricanes Katrina and Rita. Catastrophe losses and LAE for the three months ended September 30, 2004 included $5.3 million from Hurricanes Charley, Frances, Ivan and Jeanne. Policyholders’ benefits increased due primarily to higher mortality and morbidity. Insurance expenses decreased by $4.4 million, due primarily to lower salaries and fringe benefits. Salaries and fringe benefits decreased, partially as a result of the Company’s efforts to consolidate back office operations. Net Income in the Life and Health Insurance segment decreased by $8.1 million for the three months ended September 30, 2005, compared to the same period in 2004, due primarily to the lower operating profit.
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Following Hurricanes Katrina and Rita, the Company implemented state mandated and certain voluntary moratoriums on the lapsing of insurance policies, including life insurance policies, due to the non-payment of premiums. At September 30, 2005, $0.9 million of life insurance premiums were due on such insurance policies. In addition, as of October 21, 2005, an additional $0.8 million of life insurance premiums were due on such insurance policies. The Company is offering its affected life insurance policyholders a deferred payment program to assist them in paying such past due premiums. Despite the Company’s efforts to retain such affected life insurance policies, if such life insurance policies were to lapse, the Company estimates the amount of life insurance reserves that would be released would exceed the amount of uncollected premiums and any related deferred policy acquisition costs. The amount of such excess could be material to the Company’s financial results in the period that such moratoriums expire and such policies lapse. The number of life insurance claims that the Company has received to date as a result of Hurricane Katrina is not material.
Interest, Loan Fees and Earned Discount
Interest Expense on Certificates of Deposits and Savings Accounts
General and Administrative Expenses
Consumer Finance Loan Originations
Percentage of Consumer Finance Receivables:
30 Days to 59 Days Past Due
60 Days to 89 Days Past Due
90 Days and Greater Past Due
Ratio of Reserve for Loan Losses to Gross Consumer Finance Receivables
Weighted-Average Interest Yield on Certificates of Deposits
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Consumer Finance (continued)
Reserve for Loan Losses - Beginning of Period
Net Charge-off:
Consumer Finance Receivables Charged-off
Recoveries of Amounts Previously Charged-off
Net Charge-off
Reserve for Loan Losses - End of Period
Interest, Loan Fees and Earned Discounts in the Consumer Finance segment increased by $12.0 million and $5.2 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004, due primarily to higher levels of loans outstanding, partially offset by lower interest rates.
Operating Profit increased by $3.6 million for the nine months ended September 30, 2005, compared to the nine months ended September 30, 2004, primarily due to a higher level of loans outstanding. Operating Profit decreased by $0.5 million for the three months ended September 30, 2005, compared to the three months ended September 30, 2004, primarily due to increased Provision for Loan Losses. Provision for Loan Losses increased by $0.2 million for the nine months ended September 30, 2005, compared to the same period in 2004, as a result of a higher level of loans outstanding, partially offset by a change in the Company’s estimate of the rate of ultimate loan losses as a result of higher recoveries and lower charge-offs for loans originated in previous years. Provision for Loan Losses increased by $3.3 million for the three months ended September 30, 2005, compared to the same period in 2004, as a result of a higher level of loans outstanding and a change in 2004 in the Company’s estimate of the rate of ultimate loan losses as a result of higher recoveries and lower charge-offs for loans originated in previous years. Interest Expense on Certificates of Deposits increased by $3.4 million and $1.7 million for the nine and three months ended September 30, 2005, respectively, compared to the same periods in 2004, due primarily to higher interest rates on Certificates of Deposits and higher levels of deposits. General and Administrative Expenses, as a percentage of Interest, Loan Fees and Earned Discounts, increased from 39.9% for the nine months ended September 30, 2004, to 40.3% for the nine months ended September 30, 2005, due primarily to an increase in the size of the collection department.
Equity in Net Income of Investee was $4.7 million and $1.6 million for the nine and three months ended September 30, 2005, respectively. Equity in Net Income of Investee was $2.6 million and $1.0 million for the nine and three months ended September 30, 2004, 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 unaudited 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. During the first quarter of 2005, Unitrin estimated that UNOVA had subsequently fully recognized in its financial statements the amortization,
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Equity in Net Income of Investee (continued)
depreciation or write-downs of such non-current assets. Accordingly, for periods beginning after the first quarter of 2005, Equity in Net Income of Investee equals Unitrin’s proportionate share of UNOVA’s results.
Corporate Investments
The Company considers the management of certain investments, Northrop Grumman Corporation (“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 nine and three months ended September 30, 2005 and 2004 was:
Northrop Preferred Stock
Northrop Common Stock
Baker Hughes Common Stock
Total Unallocated Dividend Income
The changes in the fair value of Corporate Investments for the nine months ended September 30, 2005 are summarized below:
UNOVA Common Stock
Total Fair Value of Corporate Investments
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Net Realized Investment Gains were $53.5 million and $7.8 million for the nine and three months ended September 30, 2005, respectively, compared to $67.2 million and $24.7 million for the same periods in 2004. Net Realized Investment Gains for the nine months ended September 30, 2005 include pre-tax gains of $39.4 million from sales of investment real estate, pre-tax gains of $9.9 million from sales of a portion of the Company’s investment in Baker Hughes common stock and pre-tax gains of $3.4 million resulting from sales of a portion of the Company’s investment in Hartford Financial Services Group, Inc. (“Hartford”) common stock. Net Realized Investment Gains for the three months ended September 30, 2005 include pre-tax gains of $5.4 million from sales of a portion of the Company’s investment in Baker Hughes common stock and pre-tax gains of $1.1 million resulting from sales of a portion of the Company’s investment in Hartford common stock. The fair values of the Company’s remaining investments in Baker Hughes common stock and Hartford common stock were $49.2 million and $19.2 million, respectively, at September 30, 2005. The Company cannot anticipate when or if similar investment gains may occur in the future.
Net Realized Investment Gains for the nine months ended September 30, 2004 include pre-tax gains of $34.4 million from sales of a portion of the Company’s investment in Northrop common stock, pre-tax gains of $26.3 million from sales of a portion of the Company’s investment in Baker Hughes common stock and pre-tax gains of $3.6 million resulting from sales of a portion of the Company’s investment in Hartford common stock. Net Realized Investment Gains for the three months ended September 30, 2004 includes pre-tax gains of $2.8 million from sales of a portion of the Company’s investment in Northrop common stock and pre-tax gains of $21.9 million 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 the 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 nine and three months ended September 30, 2005 include pre-tax losses of $6.2 million and $1.0 million, respectively, resulting from other than temporary declines in the fair value of investments. Net Realized Investment Gains for the nine and three months ended September 30, 2004 include pre-tax losses of $4.6 million and $2.7 million, respectively, resulting from other than
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Net Realized Investment Gains (continued)
temporary declines in the fair value of investments. The Company cannot anticipate when or if similar investment losses may occur in the future.
Liquidity and Capital Resources
At September 30, 2005, there were approximately 2.9 million shares of the Company’s outstanding common stock that could be repurchased under the Company’s Board of Directors’ outstanding repurchase authorization. Common stock can be repurchased in open market or in privately negotiated transactions from time to time subject to market conditions and other factors. During the third quarter of 2005, the Company repurchased 636,300 shares of its common stock at an aggregate cost of $30.2 million in open market transactions.
At September 30, 2005, the Company had $300 million of its 5.75% senior notes due July 1, 2007 outstanding and $200 million of its 4.875% senior notes due November 1, 2010 outstanding. Interest expense on such senior notes was $20.9 million for the nine months ended September 30 for both 2005 and 2004. Interest expense on such senior notes was $7.0 million for the three months ended September 30 for both 2005 and 2004.
At December 31, 2004, the Unitrin parent company held 916,751 shares of Northrop common stock and also held 1,774,812 shares of Northrop preferred stock. In addition, Unitrin’s subsidiary, Trinity Universal Insurance Company (“Trinity”), held 6,998,549 shares of Northrop common stock at December 31, 2004. During the first quarter of 2005, Trinity paid a dividend to the Unitrin parent company, which included 465,722 shares of Northrop common stock with a market value of approximately $25 million. During the second quarter of 2005, Trinity paid a dividend to the Unitrin parent company, which included 465,116 shares of Northrop common stock with a market value of approximately $25 million. Following these transactions, the Unitrin parent company held 1,847,589 shares of Northrop common stock with a market value of $100.4 million at September 30, 2005 and also held 1,774,812 shares of Northrop preferred stock with a market value of $214.7 million at September 30, 2005. Trinity held 6,067,711 shares of Northrop common stock with a market value of $329.8 million at September 30, 2005. During the third quarter of 2005, Trinity paid a cash dividend totaling $26.0 million to Unitrin. Also during the first nine months of 2005, two other subsidiaries of Unitrin (United Insurance Company of America and Fireside Securities Corporation) paid cash dividends totaling $45.0 million and $13.5 million, respectively, to Unitrin.
The primary sources of funds for the Company’s insurance subsidiaries are premiums and investment income. The primary uses of funds are the payment of policyholder benefits under life insurance contracts and claims under property and casualty insurance contracts and accident and health insurance contracts, the payment of commissions and general expenses and the purchase of investments. Generally, there is a time lag between when premiums are collected and when policyholder benefits and insurance claims are paid. Accordingly, during periods of growth, insurance companies typically experience positive operating cash flows and are able to invest a portion of their operating cash flows to fund future policyholder benefits and claims. During periods in which premium revenues decline, insurance companies may experience negative cash flow from operations and may need to sell investments to fund payments to policyholders and claimants. In addition, if the Company’s property and casualty insurance subsidiaries experience several significant catastrophic events over a relatively short period of time, investments may have to be sold in advance of their maturity dates to fund payments which could either result in investment gains or losses. Management believes that its insurance subsidiaries maintain adequate levels of liquidity and surplus capacity to manage the risks inherent with any differences between the duration of their liabilities and invested assets and to provide adequate liquidity in the event that its property and casualty insurance subsidiaries experience several catastrophic events over a relatively short period of
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Liquidity and Capital Resources (continued)
time. The Company does not currently anticipate that it will have to sell investments in advance of their maturity to fund claims from Hurricanes Katrina and Rita. The primary sources of funds for Fireside Bank are customer deposits, repayments of consumer loans, interest on consumer loans and investment income. The primary uses of funds for Fireside Bank are loans made to consumers, repayment of customer deposits, interest paid to depositors and general expenses.
Net Cash Provided by Operating Activities increased by $103.7 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to changes in income taxes and other receivables. Income taxes paid were $62.8 million for the nine months ended September 30, 2005, compared to $201.9 million for the same period in 2004. In the second quarter of 2004, the Company entered into an agreement with White Mountains Insurance Group, Ltd. (“White Mountains”) to settle a certain matter related to the Company’s 1999 acquisition of Valley Group, Inc. White Mountains paid the negotiated settlement to the Company in the second quarter of 2004.
Net Cash Used by Investing Activities is largely dependent on Net Cash Provided by Operating Activities and to a lesser extent cash flow, if any, from Financing Activities. Cash Flow Used by Investing Activities increased by $116.9 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to higher levels of cash from operating activities.
Net Cash Provided by Financing Activities decreased by $15.2 million for the nine months ended September 30, 2005, compared to the same period in 2004, due primarily to lower levels of cash from securities lending and cash used to repurchase common stock in the third quarter of 2005, partially offset by higher levels of certificates of deposits to support growth in the Company’s Consumer Finance segment. The Company’s subsidiaries terminated all such securities lending agreements in the second quarter of 2005.
In 2004, the Company committed to invest $100 million in a limited liability investment company, of which $55 million was unfunded at September 30, 2005. At September 30, 2005, the Company has committed $61.1 million to purchase certain investment real estate.
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, the monetization of a portion of the Unitrin parent company’s Northrop holdings and the issuance of securities under the Company’s shelf registration statement.
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 market risk disclosures required by the SEC: 1) Investments in Fixed Maturities, 2) Investments in Equity Securities, 3) Consumer Finance Receivables, 4) Certificates of Deposits and 5) Notes Payable. Investments in Fixed Maturities, Consumer Finance Receivables, Certificates of Deposits and Notes Payable are subject to material interest rate risk. The Company’s investments in Equity Securities include common and preferred stocks and, accordingly, 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 financial instruments are classified as held for purposes other than trading. The Company has no significant holdings of financial instruments acquired for trading purposes. The Company has no significant holdings of derivatives.
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Quantitative Information About Market Risk (continued)
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 these changes should not be construed as the Company’s prediction of future market events, but rather 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 both September 30, 2005 and December 31, 2004, 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 September 30, 2005 and December 31, 2004, respectively. All other variables were held constant. For Certificates of Deposits and Notes Payable, the Company assumed an adverse and instantaneous decrease of 100 basis points in market interest rates from their levels at September 30, 2005 and December 31, 2004, 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 September 30, 2005 and December 31, 2004, 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 0.45 and 0.45 at September 30, 2005 and December 31, 2004, respectively. The portfolio’s weighted-average beta was calculated using each security’s beta for the five-year periods ended September 30, 2005 and December 31, 2004, respectively, and weighted on the fair value of such securities at September 30, 2005 and December 31, 2004, 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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The estimated adverse effects on the market value of the Company’s financial instruments using these assumptions were:
Interest
Rate Risk
September 30, 2005
Assets
Investments in Fixed Maturities
Investments in Equity Securities
Consumer Finance Receivables
Liabilities
Certificates of Deposits
Notes Payable
December 31, 2004
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 the 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 in 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 (continued)
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 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 of Deposits which are issued to fund its receivables.
At September 30, 2005 and December 31, 2004, respectively, $644.9 million and $664.6 million of the Company’s Investments in Equity Securities, which exclude the Company’s Investment in Investee, were concentrated in the preferred and common stock of Northrop. Northrop stated in its 2004 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.” Accordingly, the Company’s Investments in Equity Securities are sensitive to the nature of Northrop’s 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 unaudited 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. Forward-looking statements, in particular, 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. Forward-looking statements 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 the general factors that could cause actual results to differ materially from estimated results are:
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Caution Regarding Forward-Looking Statements (continued)
Among the factors that could cause the Company’s actual losses from Hurricanes Katrina and Rita to differ materially from estimated results are:
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 filings made with the SEC.
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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.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Information concerning pending legal proceedings is incorporated herein by reference to Note 13 to the Condensed Consolidated Financial Statements (Unaudited) in Part I of this Form 10-Q.
Item 2. Changes in Securities and Use of Proceeds
Period
September 2 - September 30
(1) This number represents purchases made by the Company under its stock repurchase program, which was first announced on August 8, 1990. The repurchase program was subsequently expanded several times, most recently in November 2000, when the Board of Directors expanded the Company’s authority to repurchase the Company’s common stock by an aggregate number of 4,000,000 shares [in addition to approximately 0.86 million shares remaining under its prior authorization]. The repurchase program does not have an expiration date. This table does not include shares withheld or surrendered, either actually or constructively, to satisfy the exercise price and/or tax withholding obligations relating to the exercise of stock options under the Company’s four stock option plans.
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Item 6. Exhibits
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Unitrin is a party to individual severance agreements (the form of which is incorporated herein by reference to Exhibit 10.5 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001), with the following executive officers:
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)
Each of the foregoing agreements is identical except that the severance compensation multiple is 3.0 for Mr. Vie and 2.0 for the other executive officers.
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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.
/s/ Richard C. Vie
/s/ Eric J. Draut
/s/ Richard Roeske
Vice President and Chief Accounting Officer
(Principal Accounting Officer)
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