UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
for the quarterly period ended September 30, 2004
Commission File Number 2-39621
UNITED FIRE & CASUALTY COMPANY
(Exact name of registrant as specified in its charter)
118 Second Avenue, S.E.
Cedar Rapids, Iowa
Registrant’s telephone number, including area code: (319) 399-5700
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 Act). YES x NO ¨
As of November 4, 2004, 10,064,428 shares of common stock were outstanding.
UNITED FIRE & CASUALTY COMPANY AND SUBSIDIARIES
INDEX
Part I. Financial Information
Item 1.Financial Statements
Consolidated Balance Sheets as of September 30, 2004 (unaudited) and December 31, 2003
Consolidated Statements of Income (unaudited) for the three-month periods ended September 30, 2004 and 2003
Consolidated Statements of Income (unaudited) for the nine-month periods ended September 30, 2004 and 2003
Consolidated Statements of Cash Flows (unaudited) for the nine-month periods ended September 30, 2004 and 2003
Notes to Unaudited Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.Quantitative and Qualitative Disclosures about Market Risk
Item 4.Controls and Procedures
Part II. Other Information
Item 6.Exhibits and Reports on Form 8-K
Signatures
PART I: FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
(In thousands)
ASSETS
Investments
Fixed maturities
Held-to-maturity, at amortized cost (fair value $99,712 in 2004 and $134,281 in 2003)
Available-for-sale, at fair value (amortized cost $1,550,330 in 2004 and $1,424,828 in 2003)
Equity securities, at fair value (cost $42,995 in 2004 and $37,858 in 2003)
Trading securities, at fair value (amortized cost $6,745 in 2004 and $7,687 in 2003)
Mortgage loans
Policy loans
Other long-term investments
Short-term investments
Cash and Cash Equivalents
Accrued Investment Income
Premiums Receivable
Deferred Policy Acquisition Costs
Property and Equipment
Reinsurance Receivables
Prepaid Reinsurance Premiums
Intangibles
Income Taxes Receivable
Other Assets
TOTAL ASSETS
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
Future policy benefits and losses, claims and settlement expenses
Property and casualty insurance
Life insurance
Unearned premiums
Accrued expenses and other liabilities
Deferred income taxes
TOTAL LIABILITIES
Redeemable Preferred Stock
6.375% cumulative convertible preferred stock - Series A, no par value
Stockholders’ Equity
Common stock
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income, net of tax
TOTAL STOCKHOLDERS’ EQUITY
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
The Notes to Unaudited Consolidated Financial Statements are an integral part of these statements.
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UNAUDITED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data and number of shares)
Revenues
Net premiums earned
Investment income, net of investment expenses
Realized investment gains (losses)
Other income
Benefits, Losses and Expenses
Losses and settlement expenses
Increase in liability for future policy benefits
Amortization of deferred policy acquisition costs
Other underwriting expenses
Interest on policyholders’ accounts
Income before income taxes
Federal income tax expense
Net income
Less preferred stock dividends and accretions
Earnings available to common shareholders
Weighted average common shares outstanding
Basic earnings per common share
Diluted earnings per common share
Cash dividends declared per common share
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Interest on policyholders' accounts
4
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash Flows From Operating Activities
Adjustments to reconcile net income to net cash provided by operating activities:
Net bond discount accretion
Depreciation and amortization
Realized investment (gains) losses
Net cash flows from trading investments
Deferred income tax benefit
Changes in:
Accrued investment income
Premiums receivable
Deferred policy acquisition costs
Reinsurance receivables
Prepaid reinsurance premiums
Income taxes receivable
Other assets
Other, net
Total adjustments
Net cash provided by operating activities
Cash Flows From Investing Activities
Proceeds from sale of available-for-sale investments
Proceeds from call and maturity of held-to-maturity investments
Proceeds from call and maturity of available-for-sale investments
Proceeds from short-term and other investments
Purchase of held-to-maturity investments
Purchase of available-for-sale investments
Purchase of short-term and other investments
Purchase of property and equipment
Net cash used in investing activities
Cash Flows From Financing Activities
Policyholders’ account balances:
Deposits to investment and universal life contracts
Withdrawals from investment and universal life contracts
Issuance of common stock
Payment of cash dividends
Net cash provided by financing activities
Net Change in Cash and Cash Equivalents
Cash and Cash Equivalents at Beginning of Period
Cash and Cash Equivalents at End of Period
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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Basis of Presentation
The terms “United Fire,” “we,” “us,” or “our” refer to United Fire & Casualty Company or United Fire & Casualty Company and its consolidated subsidiaries and affiliate, as the context requires. In the opinion of the management of United Fire, the accompanying unaudited Consolidated Financial Statements contain all adjustments (consisting of normal recurring adjustments) necessary to present fairly the financial position, the results of operations and cash flows for the periods presented. The results for the interim periods are not necessarily indicative of the results of operations that may be expected for the year. The Consolidated Financial Statements contained herein should be read in conjunction with our annual report on Form 10-K for the year ended December 31, 2003. The review report of Ernst & Young LLP as of and for the three and nine-month periods ending September 30, 2004 accompanies the unaudited Consolidated Financial Statements included in Item 1 of Part I.
We maintain our records in conformity with the accounting practices prescribed or permitted by the insurance departments of the states in which we are domiciled. To the extent that certain of these practices differ from U.S. generally accepted accounting principles (“GAAP”), we have made adjustments to present the accompanying Consolidated Financial Statements on the basis of GAAP.
To prepare our Consolidated Financial Statements in conformity with GAAP, we make estimates and assumptions that affect the amounts of assets and liabilities reported in our Consolidated Financial Statements, the disclosure of contingent assets and liabilities at the date of our Consolidated Financial Statements and the amounts of revenues and expenses during the reporting period reported in our Consolidated Financial Statements. Actual results could differ from the results reported.
We are a defendant in legal actions arising from normal business activities. Management, after consultation with legal counsel, is of the opinion that any liability resulting from these actions will not have a material impact on our financial position and operating results.
For purposes of reporting cash flows, cash and cash equivalents include cash, money market accounts and non-negotiable certificates of deposit with original maturities of three months or less. We made net payments for income taxes of $24.0 million and $14.8 million for the nine-month periods ended September 30, 2004 and 2003, respectively. We made no significant payments of interest for the nine month periods ended September 30, 2004 and 2003, other than interest credited to policyholders’ accounts.
Note 2. New Accounting Standards
In March 2004 the Emerging Issues Task Force reached a consensus on the other-than-temporary impairment recognition provisions of Issue 03-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” A three-step impairment model stipulated by Issue 03-1 should be applied to investment securities subject to Statement of Financial Accounting Standard No. 115. The three step model details the determination of whether an investment is impaired, the evaluation of whether an impairment is other-than-temporary and the recognition of an impairment loss equal to the amount of impairment. We were originally required to adopt and apply the provisions of Issue 03-1 prospectively, effective for reporting periods beginning after June 15, 2004. However, the Financial Accounting Standards Board subsequently issued Staff Position 03-1-1, which delays the effective date for the measurement and recognition guidance contained in paragraphs 10–20 of Issue 03-1. During the period of the delay, an entity holding investments should continue to apply relevant “other-than-temporary” guidance. Staff Position 03-1-1 will be superseded upon the final issuance of proposed Staff Position EITF Issue 03-1-a “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1”, which is expected to occur during the fourth quarter of 2004. We do not believe the adoption of Staff Position EITF Issue 03-1-a will have a material impact on our Consolidated Financial Statements.
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In May 2004 the Financial Accounting Standards Board issued Staff Position 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003”, which supersedes Staff Position 106-1. This Staff Position is effective for interim or annual periods beginning after June 15, 2004. This Staff Position provides guidance on the accounting and disclosure requirements for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 on employers that sponsor post-retirement health care plans that provide prescription drug benefits to plan participants. This act provides for a prescription drug benefit under Medicare Part D as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. Our self-funded post-retirement health care plan does provide a prescription drug benefit. Our actuaries have not yet determined whether or not the prescription drug benefit provided by our plan is the actuarial equivalent of Medicare Part D. They will make this determination in connection with the year-end 2004 valuation. We do not believe that the final implementation of this staff position will have a material impact on our Consolidated Financial Statements.
Note 3. Stock Options
We have a nonqualified employee stock option plan that authorizes the issuance of up to 500,000 shares of United Fire common stock to employees. Through September 30, 2004 we have granted options for 168,521 shares of United Fire common stock, of which options for 28,161 shares have been exercised. Pursuant to Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation,” we elected to apply Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations in accounting for stock options issued under our stock-based compensation plan. Opinion No. 25 prescribes the use of the intrinsic value method of accounting for our employee and director stock-based compensation awards. Accordingly, we have not recognized compensation expense for these awards. We have determined that the unrecognized compensation expense for the nine-month periods ended September 30, 2004 and 2003 determined upon application of Statement No. 123 has an immaterial impact on the net income and earnings per share as reported in our Consolidated Financial Statements.
Note 4. Employee Benefit Plans
Among the employee benefit plans we offer, the two most significant plans are a non-contributory defined benefit pension plan and an employee/retiree health and dental benefit plan.
All of our employees are eligible to participate in the non-contributory defined benefit pension plan after they have completed one year of service and attained twenty-one years of age. Under our pension plan, retirement benefits are a function of the number of years of service and the level of compensation. Our policy is to fund this plan on a current basis to the extent that the contribution is deductible under existing tax regulations.
We offer the health and dental benefit plan to all of our eligible employees and retirees. The plan is composed of two programs: (1) the Self-Funded Retiree Health and Dental Benefit Plan and (2) the Self-Funded Employee Health and Dental Benefit Plan. The employee plan provides health and dental benefits to our employees who are regularly scheduled to work for us for 24 or more hours per week and their covered dependents. The retiree plan provides health and dental coverage benefits to retired employees and their covered dependents provided the retired employees have attained at least age 55 and have continuously participated in the employee plan for at least 10 consecutive years immediately prior to retirement. Both health care plans provide a prescription drug benefit.
Net periodic pension cost totaled $1.4 million for the first nine months of 2004, consisting for the most part of service cost of $1.4 million and interest cost of $1.7 million, offset by expected return on plan assets of $1.9 million. Net periodic post-retirement benefit cost totaled $1.2 million for the first nine months of 2004, consisting largely of service cost of $.5 million and interest cost of $.6 million.
In the first nine months of 2003, net periodic pension cost and net periodic post-retirement benefit cost totaled $1.6 and $1.1 million, respectively.
We previously disclosed in our annual report on Form 10-K for the year ended December 31, 2003 that we expected to contribute $5.2 million to our pension plan in 2004. In the first nine months of 2004 we contributed $4.3 million to the pension plan. We do not anticipate that the total contribution for 2004 will vary significantly from the expected contribution.
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Note 5. Segment Information
We have two reportable business segments in our operations: property and casualty insurance and life insurance. Our property and casualty insurance segment conducts business from our home office in Cedar Rapids, Iowa and from two other locations. All three locations are aggregated because they target a similar customer base, market the same products and use the same marketing strategies. The life insurance segment operates from our home office in Cedar Rapids, Iowa. Because all of our insurance products are sold only domestically, we allocate no revenue to foreign operations. Our management evaluates the two segments both on the basis of accounting practices prescribed by our states of domicile and on the basis of GAAP. We analyze results based on a variety of factors, including profitability, expenses and return on equity. The bases we use to determine and analyze segments and to measure segment profit have not changed from that reported in our annual report on Form 10-K for the year ended December 31, 2003.
We report the following analysis on the basis of GAAP. We have reconciled the analysis to our unaudited Consolidated Financial Statements to adjust for inter-segment eliminations.
Nine Months Ended September 30, 2004
Inter-segment Eliminations
Total Revenues
Net Income
Assets
Nine Months Ended September 30, 2003
Note 6. Trading Securities
Our investment portfolio includes trading securities with embedded derivatives. These securities, which are primarily convertible redeemable preferred debt securities, are recorded at fair value. Income or loss, including the change in the fair value of these trading securities, is recognized currently in earnings as a component of realized investment gains (losses). Our portfolio of trading securities had a market value of $7.0 million at September 30, 2004, compared to $8.1 million at December 31, 2003.
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Note 7. Comprehensive Income
Comprehensive income includes all changes in equity during a period except those resulting from investments by shareholders and dividends to shareholders. The major components of our comprehensive income are net income and the change in net unrealized gains and losses on available-for-sale securities as adjusted for amounts that have been reclassified as realized gains and losses. Comprehensive income was $66.3 million and $67.9 million for the nine months ended September 30, 2004 and 2003, respectively. Comprehensive income was $37.8 million and $11.9 million for the three months ended September 30, 2004 and 2003, respectively.
Note 8. Escrow Agreement
During the third quarter of 2001 we presented claims against an escrow account held for the deferred payment of $1.00 per share to prior shareholders of American Indemnity Financial Corporation, which we acquired in August 1999. The amount of this escrow totaled approximately $2.0 million. During 2003 we filed a lawsuit to enforce the payment to us of the amount of our claims. In the first quarter of 2004 we achieved a favorable settlement of this lawsuit, which resulted in the payment to us of approximately $1.9 million of the funds that were held in the escrow account.
Note 9. Earnings Per Share
We compute earnings per share in accordance with Statement of Financial Accounting Standard No. 128, “Earnings per Share.” Accordingly, we compute basic earnings per share by dividing net income or loss available to common stockholders (net income or loss less dividends to preferred stockholders and accretions of preferred stock issuance costs) by the weighted-average number of common shares outstanding during the period. Diluted earnings per share gives effect to all potentially dilutive common shares outstanding during the period. The potentially dilutive shares we consider in our diluted earnings per share calculation relate to our convertible preferred stock and our outstanding stock options.
We determine the dilutive effect of our convertible preferred stock using the “if-converted” method. Under this method, we add to the denominator of the earnings per share calculation a number determined by multiplying the number of convertible preferred shares outstanding by the stated conversion rate. We add to the numerator of the earnings per share equation the amount of preferred dividends and accretions to reflect the assumed conversion to common stock of all the convertible preferred stock. If the effect of the if-converted method is anti-dilutive, the effect on diluted earnings per share of our convertible preferred stock is disregarded. The effect of the if-converted method was dilutive for the three and nine-month periods ended September 30, 2004 and 2003, and was therefore included in the respective calculations of diluted earnings per share.
We determine the dilutive effect of our outstanding stock options using the “treasury stock” method. Under this method, we assume the exercise of all of the outstanding options whose exercise price is less than the weighted-average fair market value of our common stock during the reporting period. This method assumes that the proceeds from the hypothetical stock option exercises are used to repurchase shares of common stock at the weighted-average fair market value of the stock during the period. The net of the assumed options exercised and assumed common shares repurchased represents the number of potentially dilutive common shares, which we add to the denominator of the earnings per share calculation.
The components of basic and diluted earnings per share are as follows:
(In thousands, except per share data)
Potentially dilutive common shares
Weighted average common and potential shares outstanding
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders of
United Fire & Casualty Company
We have reviewed the consolidated balance sheet of United Fire & Casualty Company as of September 30, 2004, and the related consolidated statements of income for the three-month and nine-month periods ended September 30, 2004 and 2003, and the consolidated statements of cash flows for the nine-month periods ended September 30, 2004 and 2003. These financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the consolidated interim financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of United Fire & Casualty Company as of December 31, 2003, and the related consolidated statements of income, stockholders’ equity, and cash flows for the year then ended, not presented herein, and in our report dated February 13, 2004, we expressed an unqualified opinion on those consolidated financial statements.
/s/ Ernst & Young LLP
October 21, 2004
Chicago, Illinois
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD LOOKING STATEMENT
This discussion may contain forward-looking statements about our operations, anticipated performance and other similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Act of 1934 for forward-looking statements. The forward-looking statements are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. Such forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry in which we operate, management’s beliefs and assumptions made by management. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “continues,” “seeks,” “estimates,” “predicts,” “should,” “could,” “may,” “will continue,” “will be,” “will promote,” “might,” “hope,” “encouraging,” “optimistic” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed in such forward-looking statements. Among the factors that could cause our actual outcomes and results to differ are the following: inherent uncertainties with respect to loss reserving; the occurrence of catastrophic events or other insured or reinsured events with a frequency or severity exceeding our estimates; the actual amount of new and renewal business and demand for our products and services; the competitive environment in which we operate, including price, product and service competition; developments in domestic and global financial markets that could affect our investment portfolio and financing plans; impact of regulatory actions on our Consolidated Financial Statements; uncertainties relating to government and regulatory policies; additional government and stock exchange policies relating to corporate governance, and the cost to comply; legal developments; changing rates of inflation, interest rates and other economic conditions; a continuation or worsening of domestic and global economic conditions; our relationship with our agencies; the valuation of invested assets; the recovery of deferred acquisition costs; or our relationship with our reinsurers. These are representative of the risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from what is expressed in forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
REGULATION G COMPLIANCE MEASURES
In response to disclosure regulations adopted by the Securities and Exchange Commission as part of its implementation of the Sarbanes-Oxley Act of 2002 (specifically Regulation G, which became effective in March 2003), measures used in this discussion that are not based on GAAP (Non-GAAP) are defined and reconciled to the most directly comparable GAAP measures and operating measures in the “Non-GAAP Financial Measures” section at the end of this discussion.
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties and that potentially may result in materially different results under different assumptions and conditions. Our discussion and analysis of our results of operations and financial condition are based upon our Consolidated Financial Statements, which we have prepared in accordance with GAAP. As we prepare these financial statements, we must make 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. We evaluate our estimates on an on going basis. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates. Our critical accounting policies most sensitive to estimates include the valuation of investments, the valuation of reserves for losses, claims and settlement expenses, the valuation of reserves for future policy benefits, the calculation of the deferred acquisition cost asset, and the valuation of pension and post-retirement benefit obligations. These critical accounting policies are more fully described in our Management’s Discussion and Analysis of Results of Operations and Financial Condition presented in our annual report on Form 10-K for the year ended December 31, 2003.
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RESULTS OF OPERATIONS
Net income for the third quarter of 2004 was $21.7 million, or $2.04 per share (after providing for the dividend on convertible preferred stock), which includes net realized investment gains (before tax) of $2.3 million. Net income for the third quarter of 2003 was $14.3 million, or $1.31 per share (after providing for the dividend on convertible preferred stock), which included net realized investment losses (before tax) of $.3 million. Third quarter diluted earnings were $1.83 per share and $1.22 per share for 2004 and 2003, respectively.
Despite an increase in catastrophe activity, we achieved improvement in third quarter net income resulting from growth in premiums earned and a decrease in non-catastrophe claims.
Total revenues were $156.8 million in the third quarter of 2004, an increase of $10.7 million, or 7.3 percent, over the third quarter of 2003. Net premiums earned increased 6.7 percent to $126.5 million in the third quarter of 2004, compared to $118.5 million in the third quarter of 2003. Net realized investment gains were $2.3 million in the third quarter of 2004, compared to net realized investment losses of $.3 million in the third quarter of 2003. Investment income was $27.9 million in the third quarter of 2004, a 1.2 percent increase from the third quarter of 2003.
For the first nine months of 2004 net income was $60.2 million, or $5.64 per share (after providing for the dividend on convertible preferred stock). For the nine months ended September 30, 2003 net income was $38.9 million, or $3.52 per share (after providing for the dividend on convertible preferred stock). Diluted earnings for the first nine months of 2004 was $5.10 per share. Diluted earnings for the first nine months of 2003 was $3.31 per share. Net realized investment gains (before tax) were $3.3 million through September 30, 2004, compared to net realized investment losses (before tax) of $3.1 million for the first nine months of 2003.
Property and Casualty Insurance Segment
In the third quarter of 2004, our property and casualty insurance segment’s pre-tax income was $24.8 million, compared to $17.2 million in the third quarter of 2003. Growth in premiums earned, decreased non-catastrophe claims and a decrease in other underwriting expenses significantly contributed to the improvement in pre-tax income. This improvement was offset to some extent by an increase in catastrophe activity and amortization of the deferred acquisition cost asset. The amortization of deferred policy acquisition costs has increased as a result of significant increases in the deferred policy acquisition cost asset in recent years. Deferred policy acquisition costs are amortized to expense as the related premiums are earned.
Net premiums written in the third quarter of 2004 were $113.8 million compared to $112.7 million in the third quarter of 2003. Net premiums earned in the third quarter of 2004 were $116.8 million compared to $111.0 million in the third quarter of 2003. The growth in net premiums earned achieved during 2004 is attributable to pricing and other underwriting initiatives pursued in recent years. In the two year period preceding 2004 we have implemented premium rate increases in several of our lines of business. While these pricing increases have leveled in 2004, we continue to realize the impact of the prior year premium rate increases as the related premium is earned.
Pre-tax catastrophe losses, net of reinsurance, of $12.5 million for the third quarter of 2004 added 10.7 percentage points to the combined ratio, resulting in an after-tax earnings reduction of $.81 per share. In comparison, pre-tax catastrophe losses, net of reinsurance, of $4.1 million for the third quarter of 2003 added 3.7 percentage points to the combined ratio, resulting in an after-tax earnings reduction of $.27 per share. The series of hurricanes that hit the southern United States in recent months accounted for third quarter pre-tax losses totaling $10.3 million. Of this amount, Hurricane Charley accounted for approximately $5.5 million. During the quarter we also incurred pre-tax losses of $1.5 million related to a severe hailstorm that hit Kansas.
Pre-tax catastrophe losses for the nine months ended September 30, 2004, net of reinsurance, were $17.8 million, which added 5.3 percentage points to the combined ratio. These catastrophe losses resulted in an after-tax earnings impact of $1.15 per share. For the same period of 2003, pre-tax catastrophe losses were $17.0 million, which added 5.3 percentage points to the combined ratio. These catastrophe losses resulted in an after-tax earnings impact of $1.10 per share.
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We analyze our property and casualty financial results through the review and comparison of financial measures common to the insurance industry, which include the loss and loss adjustment expense ratios (collectively referred to as the “net loss ratio”), the underwriting expense ratio (the “expense ratio”) and the combined ratio. The ratios used in this discussion have been prepared on the basis of GAAP.
The combined ratio, a commonly used financial measure of underwriting performance, is the sum of the net loss ratio and the expense ratio. A combined ratio below 100 percent indicates a profitable book of business. Our combined ratio for the third quarter of 2004 was 85.5 percent, compared to 91.2 percent for the third quarter of 2003. Our combined ratio for the first nine months of 2004 was 84.3 percent, compared to 91.3 percent for the same period in 2003.
The catastrophe losses discussed previously negatively impacted these combined ratios. Without the effect of catastrophes, our combined ratios would have been as follows: third quarter of 2004 – 74.8 percent; third quarter of 2003 – 87.5 percent; nine month period ended September 30, 2004 – 79.0 percent; and nine month period ended September 30, 2003 – 86.0 percent.
We review the net loss ratio to measure our profitability by line. We make pricing and underwriting decisions based upon these results. Our net loss ratio was 58.8 percent for the third quarter of 2004 versus 62.3 percent for the third quarter of 2003. Our net loss ratio was 55.8 percent for the first nine months of 2004 versus 62.7 percent for the first nine months of 2003. The improvement in the net loss ratio is primarily attributable to the underwriting initiatives pursued in recent years and a decrease in non-catastrophe claims frequency. The commercial lines net loss ratios (including reinsurance) were as follows: third quarter of 2004 – 57.4 percent; third quarter of 2003 – 59.2 percent; nine month period ended September 30, 2004 – 55.5 percent; and nine month period ended September 30, 2003 – 59.8 percent. The personal lines net loss ratios were as follows: third quarter of 2004 – 70.6 percent; third quarter of 2003 – 83.5 percent; nine month period ended September 30, 2004 – 58.1 percent; and nine month period ended September 30, 2003 – 80.9 percent.
Nine-month periods ended September 30,
(Dollars in Thousands)
Commercial lines:
Fire and allied lines
Other liability
Automobile
Workers’ compensation
Fidelity and surety
Miscellaneous
Total commercial lines
Personal lines:
Total personal lines
Reinsurance
Total
Our expense ratio was 26.7 percent for the third quarter of 2004, compared to 29.0 percent for the third quarter of 2003. The expense ratio was 28.5 percent for the first nine months of 2004, compared to 28.6 percent for the first nine months of 2003. The significant improvement in the quarterly expense ratio is attributable to an increase in the proportion of policy acquisition costs deferred in the third quarter of 2004 when compared to the third quarter of 2003. This increase was the result of the improved underwriting experience achieved in the third quarter of 2004 when compared to the third quarter of 2003.
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Life Insurance Segment
In the third quarter of 2004 our life insurance segment recorded pre-tax income of $6.9 million, compared to $3.4 million for the third quarter of 2003. The improvement was the result of a combination of several factors. The most significant factor was growth in net premiums earned, which increased to $9.7 million in the third quarter of 2004 compared to $7.6 million in the third quarter of 2003. This increase was the result of marketing initiatives pursued in the last year, which have led to an increase in the sales of single premium whole life and term products. Net realized investment gains were $1.6 million in the third quarter of 2004, compared to net realized investment gains of $.1 million in the third quarter of 2003. Losses and settlement expenses were $4.0 million in the third quarter of 2004, compared to $5.6 million in the third quarter of 2003. These improvements in our life insurance segment’s quarterly results were offset to some extent by a $3.0 million increase in the provision for liability for future policyholder benefits. This deterioration was driven by the increase in future policy benefits resulting from the increased sales levels of single premium whole life and term products.
Despite the growth in the sales of our single premium whole life and term products, overall net premiums written have decreased due to the discontinuance of our credit life business earlier this year.
Historically, the principal product of our life insurance segment has been the single premium deferred annuity. Pursuant to GAAP, annuity deposits are not reported as net premiums earned. Rather, annuity deposits are recorded as liabilities for future policyholder benefits. Revenues for annuities consist of policy surrender charges and investment income earned on policyholder deposits. In the third quarter of 2004 annuity deposits were $11.7 million compared to $6.9 million in the third quarter of 2003. These quarterly annuity deposit results are much lower than the results we achieved prior to the temporary suspension of the sale of all fixed annuity business that went into effect on June 30, 2003. We temporarily suspended the sale of fixed annuities in consideration of the difficulty we had in finding investment vehicles suitable in duration and quality to fit our asset-liability matching needs. The difficulty in finding suitable investment vehicles resulted in the accumulation of significant amounts of cash, which improved our liquidity, but also resulted in negative spreads on new business.
As a result of the improving investment environment, we re-entered the fixed annuity marketplace in most of our licensed states effective January 1, 2004. The annuity deposits recognized during the suspension of new fixed annuity business were the result of business written prior to the suspension. Since our re-entry into the fixed annuity marketplace our annuity deposit levels have gradually recovered, but they have not yet returned to pre-suspension levels.
Investment Results
We recorded net investment income (before tax) of $83.0 million for the nine-month period ended September 30, 2004, compared to $80.3 million for the nine-month period ended September 30, 2003. Our invested assets grew from $1,832.1 million at December 31, 2003 to $1,984.9 million at September 30, 2004.
Net realized investment gains (before tax) for the nine-month period ended September 30, 2004 totaled $3.3 million, versus a $3.1 million net realized investment loss (before tax) for the nine-month period ended September 30, 2003. The improvement is primarily attributable to a decrease in other-than-temporary investment impairments between periods. During the first nine months of 2004, we recorded no investment write-downs, compared to $6.4 million for the same period in 2003.
We continually monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition requires other-than-temporary impairment charges to be recorded when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security or that the anticipated recovery in market value of the equity security will not occur in a reasonable amount of time. Impairment charges on investments are recorded based on the fair value of the investments at the measurement date and are included in net realized investment gains and losses. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which the fair value has been less than cost; the financial conditions and near-term prospects of the issuer; and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery.
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The composition of our investment portfolio at September 30, 2004 is presented in the following table in accordance with GAAP:
Fixed maturities(1)
Equity securities
Trading securities
FINANCIAL CONDITION
At September 30, 2004 our consolidated total assets were $2,534.8 million, compared to $2,405.2 million at December 31, 2003. Invested assets, comprised primarily of fixed maturity securities, increased $152.8 million, or 8.3 percent, from December 31, 2003. The increase in invested assets we have experienced this year is attributable to improvements in the investment environment. As interest rates have increased, we have realized an increase in the suitable investment opportunities available to us. As a result, we have purchased investments during the first nine months of the year at a rate exceeding sales, calls and maturities of investments. The increase in invested assets resulting from the increase in investment activity during the first nine months of 2004 was accompanied by an increase in the unrealized appreciation recognized on our investment portfolio. The net unrealized gain from these investments is reported net of tax as a separate component of stockholders’ equity. The changes in our total reported invested asset balance are summarized by the following table:
(In Thousands)
Invested Assets at December 31, 2003
Purchases
Sales
Calls / Maturities
Realized gain on sale
Mark to market adjustments (1)
Change in unrealized gain
Change in carrying value of invested assets
Invested Assets at September 30, 2004
At September 30, 2004 $1,642.5 million, or 94.2 percent, of our fixed income security portfolio was classified as available-for-sale, compared to $1,519.4 million, or 91.9 percent, at December 31, 2003. We classify our remaining fixed maturities as held-to-maturity and report them at amortized cost. Our trading securities consist primarily of convertible redeemable preferred debt securities, which are recorded at fair value, with any changes in fair value recognized in earnings. At September 30, 2004, cash and cash equivalents totaled $224.8 million compared to $265.1 million at December 31, 2003. The decrease was the result of our increased level of investment activity in the first nine months of 2004.
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Our deferred policy acquisition costs increased $6.3 million, or 7.2 percent, to $92.5 million at September 30, 2004 from the deferred policy acquisition costs at December 31, 2003. Our property and casualty insurance segment’s deferred policy acquisition costs increased $6.1 million, or 13.6 percent, to $51.1 million at September 30, 2004 from the deferred policy acquisition costs at December 31, 2003. Our life insurance segment’s deferred policy acquisition costs increased $.1 million, to $41.4 million at September 30, 2004 from the deferred policy acquisition costs at December 31, 2003. The deferred policy acquisition costs related to universal life and annuity business is affected by unrealized gains and losses resulting from certain available-for-sale securities. The impact of unrealized investment gains and losses on our life insurance segment’s deferred acquisition costs was a reduction of deferred acquisition costs by $43.8 million at September 30, 2004, compared to a reduction of $46.3 million at December 31, 2003.
Cash flow and liquidity is derived from three sources: 1)operating activities; 2)investing activities; and 3)financing activities.
Net cash provided by our operating activities was $102.3 million for the nine months ended September 30, 2004 compared to $74.2 million for the nine months ended September 30, 2003. The increase in cash provided by operating activities was primarily due to the improvement in underwriting results between periods.
We also have significant cash flows from sales of investments and from scheduled and unscheduled investment security maturities, redemptions and prepayments. These cash flows totaled $235.1 million through September 30, 2004 and $211.0 million through September 30, 2003. We invest in fixed maturities that mature at regular intervals in order to meet our scheduled obligations to pay policy benefits, claims and claim adjusting expenses.
Financing activities provided cash of $7.9 million through the first nine months of 2004 compared to $55.8 million through the first nine months of 2003. Cash provided by financing activities included annuity and universal life deposits, less withdrawals, of $18.7 million through September 30, 2004 compared to $64.8 million for the same period of 2003. The decrease between periods is attributable to the slow recovery from the temporary suspension of new fixed annuity business in place for the second half of 2003.
If our operating, investment and financing cash flows are not sufficient to support our operations, we have additional short-term investments that we could utilize for this purpose. At September 30, 2004, our consolidated invested assets included $52.2 million of short-term investments, which consist primarily of fixed maturities that mature within a year. We may also borrow up to $20 million on a bank line of credit. Under the terms of our credit agreement, interest on outstanding debt is payable at the lender’s prevailing prime rate, minus one percent. We did not utilize our line of credit during 2003 or in the first nine months of 2004.
Stockholders’ equity increased from $373.9 million at December 31, 2003 to $431.3 million at September 30, 2004 an increase of 15.3 percent. The increases in stockholders’ equity included net income of $60.2 million, net unrealized appreciation of investments totaling $6.1 million and proceeds from the issuance of common stock pursuant to our employee stock option plan totaling $.6 million. The decreases to stockholders’ equity included stockholder dividends of $9.3 million and preferred stock issuance cost accretion totaling $.3 million. At September 30, 2004, book value was $42.85 per common share compared to $37.23 per common share at December 31, 2003.
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Non-GAAP Financial Measures
We believe that investor understanding of our financial performance is enhanced by disclosure of certain non-GAAP financial measures. The non-GAAP financial measures we utilize in this report are net premiums written, catastrophe losses and statutory combined ratio. These are statutory financial measures prepared in accordance with statutory accounting rules as prescribed by the National Association of Insurance Commissioners’ Accounting Practices and Procedures Manual.
Net premiums written: Net premiums written is a statutory accounting measure representing the amount of premiums charged for policies issued during the period. These premiums are reported as revenue as they are earned over the underlying policy period. Net premiums written applicable to the unexpired term of a policy are recorded as unearned premium. We evaluate net premiums written as a measure of business production for the period under review.
Third quarter
2004
2003
Year to date
Catastrophe losses: A catastrophe loss is a single incident or series of closely related incidents causing severe insured losses. Catastrophes are by their nature unpredictable. The frequency and severity of catastrophic losses we experience in any year impacts our results of operations and financial position. In analyzing the underwriting performance of our property and casualty insurance segment, we evaluate performance both including and excluding catastrophe losses. We define catastrophes to include events that cause $25.0 million or more in industry-wide direct insured losses to property and that affect a significant number of insureds and insurers. This is the same definition utilized by the Insurance Services Office, a supplier of property and casualty statistical data. At United Fire, we also include in our catastrophe totals those events we believe are, or will be, material to our operations, either in amount or in number of claims made. A portion of these losses may be recoverable under our catastrophe reinsurance agreements. These amounts totaled $4.2 million and $3.8 million for the nine-month periods ended September 30, 2004 and 2003, respectively.
Statutory combined ratio: The combined ratio is a commonly used financial measure of underwriting performance. A combined ratio below 100 percent indicates a profitable book of business. The combined ratio is the sum of two separately calculated ratios, the loss and loss adjustment expense ratio (referred to as the “net loss ratio”) and the underwriting expense ratio (the “expense ratio”). When prepared in accordance with GAAP, the net loss ratio is calculated by dividing the sum of losses and loss adjustment expenses by net premium earned. The expense ratio is calculated by dividing non-deferred underwriting expenses and amortization of deferred policy acquisition costs by net premiums earned. When prepared in accordance with statutory accounting principles, the net loss ratio is calculated by dividing the sum of losses and loss adjustment expenses by net premium earned. The expense ratio is calculated by dividing underwriting expenses by net premiums written.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We have exposure to market risk arising from potential losses due to adverse changes in interest rates and market prices. Our primary market risk exposure is changes in interest rates, although we have some exposure to changes in equity prices and limited exposure to foreign currency exchange rates.
Active management of market risk is integral to our operations. Our investment guidelines define the overall framework for managing our market and other investment risks, including accountability and controls. In addition, each of our subsidiaries has specific investment policies that delineate the investment limits and strategies that are appropriate given each entity’s liquidity, surplus, product and regulatory requirements. We respond to market risk by rebalancing our existing asset portfolio and by managing the character of future investment purchases.
There have been no material changes in our market risk or market risk factors from that reported in our annual report on Form 10-K for the year ended December 31, 2003.
ITEM 4. CONTROLS AND PROCEDURES
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this report were designed and functioning effectively to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. We believe that a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.
As required by Rule 15d-15(e) under the Securities Exchange Act of 1934, our management, including our Chief Executive Officer and Chief Financial Officer, evaluated our internal control over financial reporting to determine whether any changes occurred during our third fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on this evaluation, no such change in our internal control over financial reporting occurred during our third fiscal quarter of 2004.
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PART II - OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
3.1
3.2
3.3
10.1
10.2
10.3
31.1
31.2
32.1
32.2
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
(Registrant)
November 4, 2004
(Date)
/s/ John A. Rife
John A. Rife
President, Chief Executive Officer
/s/ Kent G. Baker
Kent G. Baker
Vice President, Chief Financial Officer and Principal Accounting Officer
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