UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT
OF 1934
For the fiscal year ended December 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE
ACT OF 1934 [NO FEE REQUIRED]
For the transition period from to
.
Commission file number 0-16882
The Commerce Group, Inc.
(Exact name of registrant as specified in its charter)
Massachusetts 04-2599931
(State or other jurisdiction (IRS Employer Identification No.)
of incorporation)
211 Main Street 01570
Webster, Massachusetts (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (508) 943-9000
Securities registered pursuant to Section 12(b) of the Act:
Name of each Exchange
Title of each Class on Which Registered
Common Stock, $.50 Par Value Per Share New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter
period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant
to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. [ ]
The aggregate market value of the voting stock held by non-
affiliates of the registrant as of March 1, 1998, was approximately
$802,587,321.
As of March 1, 1998, the number of shares outstanding of the
registrant's common stock (exclusive of treasury shares) was 36,042,652.
DOCUMENTS INCORPORATED BY REFERENCE
Parts I and II of this Form 10-K incorporate by reference
information from the registrant's annual report to stockholders for the
fiscal year ended December 31, 1997 (the "1997 Annual Report"). The
1997 Annual Report, except for portions thereof which have been
specifically incorporated by reference, shall not be deemed "filed" as
part of this Form 10-K.
Portions of the registrant's definitive Proxy Statement for its
special meeting in lieu of the annual meeting of stockholders which the
Company intends to file within 120 days after the end of the
registrant's fiscal year ended December 31, 1997 are incorporated by
reference into Part III hereof as provided therein.
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TABLE OF CONTENTS
<TABLE>
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Page
Glossary of Selected Insurance
Terms................................................ 3
Part I
<S> <C> <C>
<C>
Item 1.
Business..........................................................
...... 7
A.
General...........................................................
10
B. Commonwealth Automobile
Reinsurers................................ 12
C.
Marketing.........................................................
14
D.
Underwriting......................................................
16
E.
Reinsurance.......................................................
18
F. Settlement of
Claims.............................................. 19
G. Loss and Loss Adjustment Expense
Reserves......................... 20
H. Operating
Ratios.................................................. 23
I.
Investments.......................................................
24
J.
Regulation........................................................
26
K.
Competition.......................................................
31
L. Other
Matters..................................................... 32
Item 2.
Properties........................................................
...... 32
Item 3. Legal
Proceedings.......................................................
32
Item 4. Submission of Matters to a Vote of Security
Holders..................... 33
Item 4A. Executive Officers of the
Registrant.................................... 33
Part II
Item 5. Market for Registrant's Common Stock and Related Stockholder
Matters.... 35
Item 6. Selected Financial
Data................................................. 35
Item 7. Management's Discussion and Analysis of Financial Condition
and
Results of
Operations.................................................. 35
Item 8. Financial Statements and Supplementary
Data............................. 36
Item 9. Changes in and Disagreements with Independent Auditors on
Accounting
and Financial
Disclosure............................................... 36
Part III
Item 10. Directors and Executive Officers of the
Registrant...................... 36
Item 11. Executive
Compensation.................................................. 36
Item 12. Security Ownership of Certain Beneficial Owners and
Management.......... 36
Item 13. Certain Relationships and Related
Transactions.......................... 36
Part IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form
8-K......... 37
Signatures........................................................
...... 38
Index to Financial Statement
Schedules.................................. 40
Index to
Exhibits....................................................... 52
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2
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GLOSSARY OF SELECTED INSURANCE TERMS
Assumed premium.................... Premiums acquired or allocated to an
insurer other than
through its independent agencies.
Best's............................. A.M. Best Company, Inc. is a rating
agency reporting on
the financial condition of insurance
companies. A.M. Best's statistics
cited in this Form 10-K are based
upon information voluntarily
submitted to it by insurers. The
Company is aware of at least one
domestic insurer that has not
submitted data to Best's and
therefore may not be reflected in
Best's market share statistics.
Casualty insurance................. Insurance which is primarily
concerned with the losses
of the insured due to injuries to
other persons and to the property of
others, and the legal liability
imposed on the insured resulting
therefrom.
Catastrophe, catastrophic loss..... A severe loss, usually involving
many risks such as
conflagration, earthquake,
windstorm, explosion and other
similar events.
Combined ratio..................... A combination of the underwriting
expense ratio and the
loss and LAE ratio determined in
accordance with Statutory Accounting
Practices ("SAP"). The underwriting
expense ratio measures the ratio of
underwriting expenses to net
premiums written, determined in
accordance with SAP. The loss and
LAE ratio measures the ratio of
incurred losses and LAE to earned
premiums, determined in accordance
with SAP.
Commissioner....................... The Commissioner of the Division
of Insurance of the
Commonwealth of Massachusetts.
Commonwealth Automobile
Reinsurers ("C.A.R.").............. C.A.R. is a Massachusetts mandated
reinsurance mechanism,
under which all premiums, expenses
and losses on ceded business are
shared by all insurers. It is
similar to a joint underwriting
association because a number of
insurers (41 in 1997) act as
Servicing Carriers for the risks it
insures.
Direct............................. Refers to premiums, losses, LAE and
expenses on policies
which a company writes before
accounting for business ceded and
assumed through reinsurance.
Direct loss ratio.................. The ratio of direct incurred losses
and LAE to direct
earned premiums.
Direct premiums written............ Total premiums for insurance
sold to insureds, as
opposed to, and not including,
reinsurance premiums.
Domestic insurer................... An insurance company that operates
in the state which it
is licensed.
Earned premiums.................... The portion of net premiums written
that is equal to the
expired portion of policies
recognized for accounting purposes
as income during a period. Also
known as premiums earned.
3
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Excess of loss reinsurance.........
Reinsurance which indemnifies the
reinsured against all
or a specified portion of losses
under reinsured policies in excess
of a specific dollar amount or
"retention".
Exclusive representative
producer ("ERP")................... A Massachusetts automobile
insurance agency which does
not have a voluntary agency
automobile insurance relationship
with an insurer, and which is
assigned by C.A.R. to an insurer who
is a Servicing Carrier.
Exposure........................... An insurable unit defined as an
automobile.
Group marketing program............ A "group marketing program" is any
system, design or
plan whereby motor vehicle or
homeowner insurance is afforded to
employees of an employer or to
members of a trade union,
association or organization in
accordance with those provisions of
M.G.L. c. 175, s. 193R,
distinguishing such plans from a
"mass merchandising plan".
Specifically, a group marketing
program contemplates the issuance of
such insurance through other than
standard policies that preclude
individual underwriting, contains an
option to continue coverage by a
standard policy upon termination of
employment or membership, restricts
cancellation, requires the
continuance of certain
participation, in ways not
applicable to standard policies, and
provides for the modification of
rates based upon the experience of
the insured group.
Hard market........................ An insurance market in which the
demand for insurance
exceeds the readily available supply
and premiums are relatively high.
Incurred but not reported
("IBNR") reserves.................. Reserves for estimated losses which
have been incurred
by insureds but not yet reported to
the insurer.
Incurred losses.................... The total losses sustained by an
insurance company under
a policy or policies, whether paid
or unpaid. Incurred losses include a
provision for IBNR.
Inland marine insurance............ As used by the Company, insurance
that provides protec-
tion for specific types of personal
property, such as jewelry, coins and
fine arts, over the limits covered
in a standard homeowners insurance
policy.
Loss adjustment expenses ("LAE")... The expense of settling claims,
including legal and
other fees and the portion of
general expenses allocated to claim
settlement costs.
LAE ratio.......................... The ratio of LAE, net of
reinsurance recoveries, to
earned premiums.
Loss and LAE ratio................. The ratio of incurred losses and
loss adjustment ex-
penses, net of reinsurance
recoveries, to earned premiums.
4
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Loss reserves...................... Liabilities established by insurers
to reflect the esti-
mated cost of claims payments and
the related expenses that the
insurer will ultimately be required
to pay in respect of insurance it
has written. Reserves are
established for losses and for LAE.
Net premiums written............... Direct premiums written for a given
period less premiums
ceded to reinsurers during such
period plus premiums assumed during
such period.
Participation ratio................ A Massachusetts insurer's share of
the C.A.R. deficit
based upon the insurer's market
share of automobile risks not
reinsured through C.A.R., adjusted
for utilization of C.A.R. credits
for voluntarily writing less
desirable business and ceded
exclusions.
Premium-to-surplus ratio........... The ratio of net premiums written
to policyholders'
surplus.
Property insurance................. Insurance that indemnifies a
person with an insurable
interest in tangible property for
loss related to damage to or loss of
use of the subject property.
Pure loss ratio.................... The ratio of net incurred losses,
excluding LAE, to pre-
miums earned.
Quota share reinsurance............ Reinsurance in which the reinsured
shares a proportion
of the original premiums and losses
under the reinsured policy. Also
known as pro rata reinsurance.
Rate deviation..................... A specific state approved departure
from an otherwise
applicable state set rate level
provided to safe drivers.
Rate discount...................... A specific state approved discount
from an otherwise
applicable state set rate level
provided to members of group
marketing programs.
Reinsurance........................ The acceptance by one or more
insurers, called rein-
surers, of all or a portion of the
risk underwritten by another insurer
who has directly written the
coverage. However, the legal rights
of the insured generally are not
affected by the reinsurance
transaction and the insurance
company issuing the insurance policy
remains liable to the insured for
payment of policy benefits.
Safe Driver Insurance Plan ("SDIP") A program mandated by state law
that encourages safe
driving by rewarding drivers who do
not cause an accident, or incur a
traffic law violation and by making
sure that high-risk drivers pay a
greater share of insurance costs.
Under SDIP, drivers incur surcharge
points for traffic violations and
at-fault accidents. Drivers also
earn credit points for each incident
free year. Drivers begin at a
starting or neutral SDIP Step 15.
Drivers can earn credits down to
SDIP Step 9, the lowest step and
incur surcharge points up to SDIP
Step 35, the highest step.
Servicing Carrier.................. An automobile insurer writing
business in
Massachusetts which can reinsure
risks through C.A.R. while remaining
responsible for servicing the
related policies and which must
provide a market for ERPs assigned
to it by C.A.R.
5
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Soft market........................ An insurance market in which the
supply of insurance
exceeds the current demand and
premiums are relatively low.
Statutory accounting practices..... Recording transactions and
preparing financial state-
ments in accordance with the rules
and procedures prescribed or
permitted by an insurer's state
insurance regulatory authority for
the purposes of financial reporting
to regulators, which in general
reflect a liquidating, rather than
going concern, concept of
accounting.
Statutory surplus.................. The excess of admitted assets
over total liabilities
(including loss reserves),
determined in accordance with SAP.
Take-all-comers.................... A phrase used to characterize the
Massachusetts auto-
mobile regulatory system under which
all insurers are required to
underwrite virtually all risks
submitted to them.
Underwriting....................... The insurer's process of reviewing
applications submit-
ted for insurance coverage, deciding
whether to accept all or part of the
coverage requested and determining
the applicable premiums.
Underwriting expenses.............. The aggregate of policy
acquisition costs, including
commissions, and the portion of
administrative, general and other
expenses attributable to
underwriting operations.
Underwriting expense ratio......... The ratio of underwriting expenses
to net premiums writ-
ten determined in accordance with
SAP.
Unearned premiums.................. The portion of a premium
representing the unexpired
amount of the contract term as of a
certain date.
6
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PART I
ITEM 1. BUSINESS
The Commerce Group, Inc. (the "Company"), was incorporated in
1976. The Company is engaged principally in providing personal and
commercial property and casualty insurance in Massachusetts primarily
through it's subsidiary, The Commerce Insurance Company ("Commerce"),
which was incorporated in 1971. The Company's principal insurance line
is motor vehicle insurance, primarily covering personal automobiles.
The Company also offers commercial automobile, homeowners, inland
marine, fire, general liability and commercial multi-peril insurance.
The Company also writes insurance in the state of California through
Western Pioneer Insurance Company ("Western Pioneer"), a personal
automobile insurer located in Pleasanton, California, which was acquired
on August 31, 1995. In addition, the Company originates residential and
commercial mortgages on a limited basis within Massachusetts and
Connecticut and operates an insurance agency dealing in a full line of
insurance products, including those of the Company.
The Company's business strategy is to focus its insurance
activities primarily on the personal automobile market. Presently, the
Company has over 771,000 policies in force, 747,000 of which are in
force throughout the Commonwealth of Massachusetts. The Company,
through Commerce and Citation Insurance Company ("Citation"), wholly-
owned subsidiaries of Commerce Holdings, Inc. ("CHI") which is a wholly-
owned subsidiary of the Company, has been the largest writer of personal
property and casualty insurance in Massachusetts in terms of market
share of direct premiums written since 1990. At year end 1997 and 1996,
the Company's Massachusetts private passenger automobile market share
was 21.8% and 20.8%, respectively. The Company is also one of the
leading writers of commercial automobile insurance in the Commonwealth.
During 1997, 97.9% of the Company's $768,649,000 in direct premiums
written were derived from personal automobile (including Western
Pioneer's direct premiums written of $27,486,000), commercial automobile
and homeowners insurance, its three core lines of business. These lines
represented $661,077,000 , $37,072,000 and $54,256,000, or 86.0%, 4.8%
and 7.1%, respectively, of the Company's direct premiums written.
While the Company's business strategy remains focused on
activities primarily related to personal automobile insurance in the
states of Massachusetts and California, the Company is newly licensed in
the states of Connecticut, Maine, New Hampshire, Rhode Island and
Vermont. The Company began writing in Rhode Island in January 1998 and
is gearing internal operating systems to accommodate the remaining New
England states in the future.
The Company attributes its success primarily to its strong
relationships with professional independent agencies that provide
quality business for the Company. Other factors that have been
important to its success include an in-depth understanding of the
Massachusetts regulatory and underwriting environments, advanced
information systems, an extensive underwriting data base and beginning
in 1995, the ability to compete in a group marketing environment.
Because the Company offers its product lines only through
independent agencies, its relationships with those agencies are critical
to its continued success. The Company believes that it is the preferred
provider for most of its agencies and that as a result of such position
it has gained access to policyholders with average or above-average
underwriting profit characteristics in its personal and commercial
automobile insurance lines. The Company carefully selects and retains
agencies whose premium growth and loss ratio experience meet the
Company's agency criteria, and devotes substantial resources to
fostering and maintaining strong relationships with its existing
agencies. The Company pays its agencies significant compensation in the
form of profit sharing which is based in part on the underwriting
profits of the agency's business written with the Company. Based upon
agency surveys conducted several times a year, the Company believes it
is attentive to the needs and requirements of its agencies. The Company
emphasizes its commitment to the Massachusetts insurance market, its
responsiveness in servicing claims and its internal support for agency
operations, including direct billing of insureds, direct claim
reporting, on-line inquiry systems for its agents and by providing
competitively priced automobile insurance programs and products.
7
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The Company's focus on automobile and homeowners insurance
primarily in Massachusetts has also been a factor in its success. The
terms, conditions and rates of personal automobile insurance are subject
to extensive regulation by the Massachusetts Commissioner of Insurance
("Commissioner"). Because the Company has primarily served the
Massachusetts market, it has both an in-depth understanding of this
market and the ability to respond effectively to shifts in the state's
regulatory and underwriting environments. Currently, the Company is
required to accept virtually all automobile insurance business submitted
to it by its agencies. The Company's ability to underwrite this
business profitably, however, depends on its understanding of the risks
in the business as well as its management of reinsurance through C.A.R.
Beginning in the latter part of 1995, the Company began to
actively pursue group marketing programs. The primary purpose of group
marketing programs is to provide participating groups with a convenient
means of purchasing automobile insurance through associations and
employee groups. Billing is primarily through direct billing with
payroll deduction available. Emphasis is placed on writing larger
groups, although accounts with as few as 25 participants are considered.
Groups are eligible for rate discounts which must be filed annually with
the Division of Insurance. In general, the Company looks for groups
with mature/stable membership, favorable driving records and below
average turnover ratios. Participants who leave the sponsoring group
during the term of the policy are allowed to maintain the policy until
expiration. At expiration, a regular Commerce policy may be issued at
the insured's option.
During the latter part of 1995, Commerce signed group marketing
agreements with the five American Automobile Association Clubs of
Massachusetts ("AAA clubs") offering a 10% discount on automobile
insurance to the clubs' members who reside in Massachusetts. In 1997,
two AAA clubs were consolidated, therefore leaving only four clubs.
Primarily, as a result of the fourth consecutive private passenger rate
reduction, a 6.0% percent AAA club discount was approved for policies
effective as of January 1, 1998. Previously, a 10% discount had been
effective since the latter part of 1995. Membership in these clubs is
estimated to represent approximately one-third of the Massachusetts
motoring public, and has been the primary reason for a 40.6% increase in
the number of personal automobile exposures written by Commerce since
the groups' inception. The Company expects this increase to level off
in 1998 as evidenced by an 8.3% increase in personal automobile
exposures in 1997 as compared to an 29.8% increase in 1996. In 1997,
total direct premiums written attributable to the AAA group business
were $422,074,000 or 54.9% of the Company's total direct premiums
written (66.6% of total Massachusetts personal automobile premiums
written), an increase of 22.6% over 1996. Total exposures attributable
to the AAA clubs group business were 522,098 or 65.8% of total personal
automobile exposures in 1997, an increase of 102,445 or 24.4% over 1996.
Of this amount, approximately 10% was written through insurance agencies
owned by the AAA clubs. The remaining 90% was written through the
Company's network of independent agents.
Initially, the Massachusetts statute governing group marketing
programs required that 35% of the eligible members must participate in a
group marketing program within the first year. Accordingly, Commerce
and the AAA clubs aggressively pursued AAA members for the AAA Group
Marketing Program. At December 31, 1996, Commerce had achieved the
objective of writing more than 35% of the AAA members within the first
year, as over 300,000 AAA members joined the program. The particular
portion of the statute, dealing with achieving the 35% penetration level
in one year, was amended by the Massachusetts Legislature in early 1997
to allow two years to reach the required penetration level. In December
1997, a bill was passed in the Massachusetts Legislature to further
waive for an additional year the requirement that 35% of a group's
members purchase insurance through the group in order for the group to
be renewed during 1998.
Commerce and the AAA clubs have agreed that Commerce shall be
their exclusive underwriter of Massachusetts personal automobile group
programs. This contract may be terminated by the AAA clubs upon written
notice to Commerce, whose termination shall take effect at a minimum of
three years from notice of termination.
In March 1997, the Company was granted approval, for the 1997
calendar year, to offer its customers safe driver deviations of 10
percent to drivers with SDIP classifications of either Step 9 or 10.
These are the two best driver SDIP classifications in Massachusetts,
representing drivers with no at fault accidents and not more than one
minor moving vehicle violation in the last six years. For drivers that
qualified, the Company's group automobile discounts and SDIP deviations
could be combined for up to a 19% reduction from the state mandated
rates. In February 1998, approval of SDIP deviations of 15% for Step 9
and 4% for Step 10 SDIP classifications were granted for the 1998
calendar year. For drivers that qualify, the Company's group automobile
discounts and SDIP deviations can be combined for up to a 20.1%
reduction from the state mandated rates.
8
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In November 1997, the Company received state regulatory approval
to implement an installment fee of $3.00 on each invoice following the
down payment, for all private passenger automobile policies effective
January 1, 1998. The $3.00 installment fee also replaced the 1.25%
finance charge calculation for homeowner and dwelling policies paid on a
10 payment installment basis. Previously, for 1996 and 1997, the
Company eliminated interest based finance fees on personal automobile
insurance policies.
The Company's other than personal automobile products tend to be
derived from its other two core product lines and therefore have had
relatively predictable risk profiles. The Company offers a preferred
risk homeowners product through Citation, which has an alternative
pricing schedule for selected insureds meeting more restrictive
underwriting guidelines. Citation also provides a separate rating tier
for preferred commercial automobile business. Approximately 15.4% of
the voluntary commercial automobile premium produced by its voluntary
agents in 1997 was written by Citation. The Company expects that this
secondary rating tier will continue to assist the Company in retaining
its better commercial automobile accounts, while also further increasing
the percentage of commercial automobile business that can be retained
voluntarily by the Company in 1998 and beyond.
The Company's long-term commitment to providing consistent markets
for Massachusetts independent agencies, coupled with the withdrawal by
several national companies from the Massachusetts personal automobile
market, which occurred during the years 1987 through 1991, has been a
significant factor in enabling the Company to increase its market share
by adding agencies which meet its agency criteria. The Company believes
that Massachusetts agencies are more likely to seek to develop and
expand relationships with domestic insurers, which, like the Company,
have a long-term commitment to the Massachusetts personal automobile
market.
The Company continues to monitor acquisition opportunities with
regard to smaller automobile insurance companies that are in need of
capital, have established management in place and present significant
growth opportunities in their market areas. On August 31, 1995, the
Company completed the acquisition of Western Pioneer, a personal
automobile insurer, located in Pleasanton, California.
The Company's long-term growth objective is to expand its writings
outside of Massachusetts. In continued pursuit of this objective, the
Company became licensed in the states of Connecticut and Rhode Island
during 1996 and in the states of Vermont and New Hampshire in 1997.
License approval in the state of Maine was received in February 1998.
Concurrent with the filings submitted for these licenses, the Company
entered into an agreement with Policy Management Services Corporation,
Inc. ("PMSC") and purchased software which allow for the development of
internal operating systems which will enable the Company to process
policies in states outside of Massachusetts. To facilitate this
development and, at the same time, address the year 2000 processing
issue facing computer system users, the Company has established the Team
2000 and Century Change projects which are corporate-wide efforts to
prepare the Company's systems for the next millennium. These projects
involve internal staff costs as well as consulting expenses to prepare
the systems for the year 2000. Costs to date for the Century Change
project have been approximately $1.1 million (all of which relate to
1997). Administration, programming, testing and implementation of
system applications related to Century Change are expected to cost an
additional $6 million over the next 24 months. Approximately $4 million
is expected to be expensed during 1998 with the remainder through the
end of 1999.
The Company is utilizing both internal and external resources on
the Century Change Project. The Company has a formal plan to address
the Century Change issue and is progressing in accordance with that
plan. Programming changes dealing with policy issuance and maintenance
of same is expected to be completed by year-end 1998. Other internal
changes are scheduled to be completed in accordance with specified
delivery dates as outlined in the plan. The Company's plan has been
designed to, and is proceeding so as to, avoid any adverse business
production issues.
The Company has reviewed the Century Change status of vendors who
perform outside processing for the Company or whose software the Company
uses for internal processing. This review has determined that the
related software used by or provided by these vendors either is
currently century ready or will be ready without any adverse impact on
the Company.
9
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Upon completion of the Century Change project, the Company expects
to focus its efforts on the Team 2000 project which will eventually
replace the Company's existing internal computer systems for
Massachusetts business utilizing software purchased from PMSC. Costs to
date for the Team 2000 effort have been approximately $28 million.
Costs applicable to 1997 were approximately $17 million, of which $15.6
million was expensed during the year. Total Team 2000 project costs
over the next 5 to 7 years have been estimated at approximately $60
million including funds expended to date. This amount includes the
purchase of a main frame computer, license fees and the costs associated
with programming, implementation and training. Systems enabling the
Company to process policies in Rhode Island have been in place since
January 1998. Other states will be brought on-line in the future.
In the past, the Company has devoted substantial time and
resources to the development of its current information systems, which
enhanced both its underwriting and its agency support. Through the use
of several customized software programs, the Company has the ability to
analyze its internal historical underwriting data and use such
information in making, in the Company's belief, more informed
underwriting decisions. In particular, the Company believes that the
amount and extent of detail data accumulated as a result of its share of
the personal automobile market gives the Company a competitive advantage
in determining which automobile risks to reinsure through C.A.R. The
Company's information systems also enable it to provide extensive
support to its agencies. This support includes a direct billing system,
which covers over 97% of the Company's policyholders, an on-line inquiry
system, which allows agencies to ascertain the status of pending claims
and direct bill information and a system which allows Company agencies
to quote premiums for the Company's three core product lines directly to
policyholders. Because the Company emphasizes its commitment to
enhancing and expanding the role of its information systems, it also
recognizes that current systems may not provide the distinct competitive
advantage when looking outside of Massachusetts. The Team 2000 project
will enable the Company to produce management and agency information
necessary to establish similar competitive advantages as it expands.
A. General
Insurance Lines
Commerce and Citation, the Company's Massachusetts property and
casualty insurance subsidiaries, currently have a combined Best's rating
of A (Excellent). Western Pioneer, the Company's California property
and casualty subsidiary, currently has a Best's rating of A-
(Excellent). According to Best's, an insurer with an Excellent rating
has demonstrated, in Best's opinion, excellent overall performance when
compared to standards developed by Best's.
Direct premiums written totalled approximately $768,649,000 in
1997, of which motor vehicle insurance accounted for approximately
$698,149,000, homeowners insurance accounted for approximately
$54,256,000 and commercial multi-peril insurance accounted for
approximately $8,726,000. Western Pioneer produced approximately
$27,486,000 or 3.6% of the Company's total direct premiums written in
1997 of which motor vehicle insurance accounted for approximately
$27,397,000. During 1996, direct premiums written totalled
approximately $731,823,000, of which motor vehicle insurance accounted
for approximately $663,290,000, homeowners insurance accounted for
approximately $52,377,000 and commercial multi-peril insurance accounted
for approximately $9,244,000. Western Pioneer produced approximately
$27,384,000 or 3.7% of the Company's total direct premiums written in
1996 of which motor vehicle insurance accounted for $27,282,000. Earned
premiums are included in total revenues of the Company and represent the
net earned premiums remaining after assumed and ceded reinsurance. In
1997 and 1996, total revenues included insurance premiums earned of
approximately $730,497,000 and $668,716,000, respectively. Motor
vehicle insurance accounted for approximately 94.6% and 94.6%,
homeowners insurance accounted for approximately 4.0% and 4.0% and
commercial multi-peril insurance accounted for approximately 0.9% and
1.0% of total earned premiums, in 1997 and 1996, respectively.
The Company's principal insurance line is personal automobile
insurance. The Company offers automobile policyholders the following
types of coverage: bodily injury liability coverage, including
underinsured and uninsured motorist coverage, property damage liability
coverage and physical damage coverage, including fire, theft and other
hazards specified in the policy. Policies are usually written for one-
year terms. The Company's published liability limits are $500,000 per
person for bodily injury, $1,000,000 per accident and $100,000 for
property damage. Liability limits of $100,000 per person injured,
$300,000 per accident and $100,000 for property damage are the limits
most commonly purchased from the Company.
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Personal automobile insurance is heavily regulated in
Massachusetts and California. Marketing and underwriting strategies for
companies operating in Massachusetts continue to be dominated by
automobile premium rates and commission levels which are mandated by the
Massachusetts Division of Insurance and by current and prospective
legislation affecting the industry. Automobile premium rates in
Massachusetts are among the highest in the nation as a direct result of
high costs incurred by companies which provide this type of protection.
Claims, the costs associated with the processing and settling of claims,
assessments required to subsidize the involuntary market mechanism,
accident rates, bodily injury claims and medical care costs remain among
the highest in the nation. Additionally, traffic density, as defined by
vehicle miles divided by highway miles, is among the highest in the
nation.
During the three-year period from 1995 to 1997, Massachusetts
personal automobile insurance premium rates decreased an average of 5.6%
per year. The Commissioner approved an average 4.0% decrease in
personal automobile premiums for 1998, the fourth decrease in as many
years. Average rates decreased by 6.2%, 4.5% and 6.1% in 1997, 1996 and
1995, respectively. Coinciding with the 1998 rate decrease, the
Commissioner also approved a 7.4% decrease in commission rates to agents
selling private passenger automobile insurance for 1998. The decision
slightly offsets the financial impact of the average 4.0% decrease in
personal automobile premiums for 1998.
Although personal automobile premium rates decreased an average of
6.2% in 1997, the impact upon the Company resulted in only a 1.8%
decrease in the average personal automobile premium per exposure. The
1.8% decrease for the Company is significantly less than the average
rate decrease of 6.2% due to the facts that the rate decision did not
anticipate purchases of new automobiles in the year to which the rate
decision applied and, secondly, the Company's mix of personal automobile
business differs from that of the industry.
The 1997 and 1998 rate decreases were partially driven by
corrections for an industry error that had impacted prior year rate
decisions. The industry error, estimated at $200 million, resulted from
a miscalculation of industry expense allowances that had the effect of
overstating rates from 1991 through 1996. Rates for 1997 were adjusted
to recoup an estimated $50 million from the industry. Rates for 1998
and 1999 have and will be adjusted to recoup the remaining amount
estimated to be $150 million.
Additionally, 1997 and 1998 rates were decreased as a result of
the reconciliation of the Safe Driver Insurance Plan ("SDIP") which is
designed to be revenue neutral. In most recent past years, the SDIP
reconciliation resulted in a deficit which was then added into the rates
for the subsequent years. The 1996 SDIP reconciliation, however,
resulted in a surplus.
The Company had performed an analysis of the 1997 rate decision in
early 1997. The Company estimated the impact of the above two items on
its results assuming its market share remained the same as it was at the
end of 1997. The Company's share of the Massachusetts personal
automobile market increased from 20.8% at the end of 1996 to 21.8% at
the end of 1997. The earned premium impact of the above two items has
been re-estimated at approximately $16.0 million for 1997, $24.1 million
for 1998 and $14.1 million for 1999. The earnings per share after-tax
impact resulting from lower earned premiums was $0.29 for 1997, and is
estimated to be $0.43 and $0.24 for 1998 and 1999, respectively. If the
Company's future market share increases (decreases), a larger (smaller)
financial impact would result.
In June 1997, the Massachusetts Supreme Judicial Court ("Court")
rejected an appeal filed by the Automobile Insurers Bureau of
Massachusetts ("AIB") that challenged the Commissioner's decision to
prospectively decrease future rates for the miscalculation of the
industry expense allowance. (The SDIP reconciliation component was not
challenged.) The AIB's argument was that, according to statute, there
is a prohibition against retroactive rate making in Massachusetts which
effectively bars the examination of past year's data once all involved
parties have agreed to the rate decision. The Court ruled that
retroactive rate making was indeed illegal, but indicated that special
circumstances permitted returning the money in the form of rate
reductions. In a related challenge, the Court rejected on technical
grounds, one insurers claim of an unfair adverse impact related to the
prospective nature of the rate reduction.
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The 1998 rate decision also included a 7.4% reduction in agents'
commission rates from the 1997 commission rates. Again, as in 1997,
companies will calculate commissions on business subject to safe driver
deviations, net of the deviation. After the 1997 rate decision, a suit
was filed by the Massachusetts Association of Insurance Agents ("MAIA")
challenging this method of calculation. In July 1997, the Court upheld
the Commissioner's ruling that agents' commissions on 1997 premiums,
subject to safe driver deviations, would be based on net premium
amounts. The 1996 commissions were based on premium amounts net of
group discounts but gross of safe driver deviations. The Commissioner's
ruling resulted in agents receiving fewer commission dollars on a per
policy basis.
The Company also offers homeowners insurance in Massachusetts,
including a very limited amount of policies in designated coastal areas.
The Company's standard homeowners policy is an all risk, replacement
cost insurance policy covering a dwelling and the contents contained
therein. The Company's published limits of liability for property
damage to a dwelling are a minimum coverage of $60,000 and a maximum
coverage of $600,000, although some policies over this amount are
written on an exception basis. For personal liability, the minimum
coverage is $100,000 and the maximum coverage is $1,000,000. The
average dwelling coverage amount per policy is approximately $140,000,
and generally, the average amount of contents coverage is 70% of the
amount of coverage for the dwelling, with limitations on the amount of
coverage per item placed on securities, cash, jewelry, furs, silverware
and firearms. However, additional coverage for such items can be
purchased on a scheduled personal property basis. The Company also
offers $1,000,000, $2,000,000 and $3,000,000 personal liability umbrella
coverage for homeowners policies requiring certain specified
underwriting coverages which are reinsured through American Reinsurance
Corporation.
The Company offers a preferred homeowners product through Citation
which has higher policy limits and a lower premium structure and is
designed primarily for homes with above-average market values. The
Company also applies more stringent underwriting criteria by, among
other things, limiting the product to homes with modern electrical
systems.
The Company also offers inland marine, fire, general liability and
commercial multi-peril insurance.
Mortgage Operations
Insurance companies are authorized to invest in mortgages and the
Company formed Bay Finance Company, Inc. ("Bay Finance") to originate
and service residential and commercial mortgages in Massachusetts and
Connecticut. During fiscal 1997, 1996 and 1995 the mortgage operations
accounted for approximately $4,448,000, or 0.5%, $4,249,000, or 0.6% and
$3,804,000, or 0.6% of the Company's consolidated total revenues,
respectively.
Insurance Agency
Clark-Prout Insurance Agency, Inc. ("Clark-Prout") is a wholly-
owned insurance agency that writes both for the Company and for other
insurance companies. During fiscal 1997, 1996 and 1995, Clark-Prout's
revenues amounted to $840,000 , or 0.1%, $930,000, or 0.1% and
$1,203,000, or 0.2% of the Company's consolidated total revenues,
respectively. The decrease in Clark-Prout's revenue is due to a change
in how its customers are billed.
B. Commonwealth Automobile Reinsurers
A significant aspect of the Company's automobile insurance
business relates to its interaction with C.A.R. C.A.R. is a state-
mandated reinsurance mechanism, which enables the Company and
approximately 40 other writers of automobile insurance in Massachusetts
("Servicing Carriers") to reinsure any undesirable automobile risk.
Servicing Carriers, which are responsible for over 99.0% of total direct
premiums written for personal automobile insurance in Massachusetts, are
required to offer automobile insurance coverage to all eligible
applicants pursuant to "take-all-comers" regulations, but may reinsure
undesirable business with C.A.R. In addition, Servicing Carriers are
obligated to accept involuntary agencies, known as ERPs, from C.A.R. and
to provide an automobile insurance market in Massachusetts for those
agencies.
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C.A.R. maintains separate pools for liability and physical damage
coverage in personal and commercial automobile risks. All companies
writing automobile insurance in Massachusetts share in the underwriting
results of C.A.R. business for their respective product line or lines,
whether or not they are Servicing Carriers. Since its inception, C.A.R.
has annually generated multi-million dollar underwriting losses in both
the personal and commercial pools. Accordingly, each automobile insurer
attempts to develop and implement underwriting strategies that will
minimize its relative share of the C.A.R. deficit while maintaining
acceptable loss ratios on risks not reinsured through C.A.R.
In general, the C.A.R. reinsurance mechanism operates as follows.
Within established time frames, a Servicing Carrier must identify which
policies it wishes to retain and which policies it wishes to cede to
C.A.R. A Servicing Carrier pays to C.A.R. all of the premiums generated
by the policies it has ceded and also reimburses C.A.R. for the reduced
premium resulting from affinity group marketing discounts. C.A.R.
reimburses Servicing Carriers for all losses incurred on account of
ceded policies, although, as with reinsurance generally, reinsurance of
a policy through C.A.R. does not legally discharge the Servicing Carrier
from its liability to the policyholder for the full amount of the
policy. In addition, Servicing Carriers also receive fees for servicing
ceded policies based upon the expense structure established by C.A.R.
An insurer's proportionate share of the C.A.R. deficit is
allocated on the basis of a formula called a participation ratio, which
can vary significantly between the personal and commercial pools, and
between different policy years. Under current regulations, an insurer's
share of the C.A.R. deficit is based upon its market share for retained
automobile risks for the particular pool, adjusted by a utilization
formula, such that, in general, its participation ratio is
disproportionately and adversely affected if its relative use of C.A.R.
reinsurance exceeds that of the Massachusetts industry and favorably
affected if its relative use of C.A.R. reinsurance is less than that of
the Massachusetts industry. At year end 1997 and 1996, the Company's
Massachusetts private passenger automobile market share was 21.8% and
20.8%, respectively. The current formula also contains a provision
whereby certain high risk business, if reinsured through C.A.R., is
excluded in determining an insurer's participation ratio. Finally, for
the personal automobile C.A.R. pool, an insurer's participation ratio
may be affected by credits received for not reinsuring through C.A.R.
automobile risks in selected underpriced classes and territories. An
insurer's participation ratio will be favorably affected if its relative
use of credits exceeds the Massachusetts industry's.
The Company's objective is to develop and implement underwriting
strategies to obtain the optimum balance between its C.A.R.
participation ratio and the loss ratios on automobile risks not
reinsured through C.A.R. For each automobile risk, the Company makes a
judgment as to whether the projected impact on the Company's
profitability from retaining the risk outweighs the incremental cost of
reinsuring the risk through C.A.R. In determining the incremental cost
of reinsuring a risk through C.A.R., the Company estimates its
participation ratio for a given period by modeling the anticipated
Massachusetts industry-wide C.A.R. trends. Once the Company estimates
its participation ratio, it is then able to compare the incremental
effect on the Company's share of the C.A.R. deficit of either reinsuring
or retaining the particular automobile risks. Finally, the Company
utilizes its internal underwriting database and internally-developed
actuarial reporting and analysis systems to develop for each risk a
projected underwriting loss ratio. It then compares the impact of the
automobile risk on the Company's participation ratio in order to
estimate whether, after taking all C.A.R. and other factors into
account, the Company's profitability will be enhanced by reinsuring or
retaining such risk. The Company believes that, because of its leading
share of the Massachusetts automobile insurance market, it can utilize
statistically credible data for a greater array of underwriting factors
than its competitors, which in turn gives it a competitive advantage in
deciding which automobile risks to reinsure through C.A.R.
The C.A.R. utilization-based participation ratio has been in place
since 1993, and individual companies in the marketplace make minor
yearly changes to find the optimum balance between voluntary and ceded
writings. In 1997, the Company ceded approximately $63,301,000 or
approximately 10.0% of the Company's Massachusetts personal automobile
direct premiums written, a decrease of 10.2% from 1996. The Company's
strategy has been to voluntarily retain more of the types of personal
automobile business that are factored as credits favorably impacting the
utilization formula. As a result, credits impacting the utilization
formula have favorably affected the Company's participation ratio. As
of December 31, 1997, the Company estimates its personal automobile
participation ratio to be approximately 18.0% which is several
percentage points below the Company's estimated 21.8% share of the
Massachusetts personal automobile market. Significant changes in the
industry-wide private passenger cession percentage are not expected for
1998.
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A phase-in of a utilization-based participation formula was
implemented in the Massachusetts commercial automobile market. The
phase-in began in 1992 and ended in 1995. Although commercial
automobile insurance is a relatively smaller portion of the Company's
total insurance writings, the related commercial automobile risk
selection decisions remain an important element in determining
profitability. In 1997, the Company ceded approximately $8,515,000 or
23.0% of the Company's Massachusetts commercial automobile direct
premiums written, a decrease of 31.3% from 1996.
C.A.R. rule changes occur, as C.A.R. adjusts the operations of the
personal and commercial reinsurance mechanisms to address the needs of
the Massachusetts automobile insurance market. Any material change to
the C.A.R. rules in the future will affect the Company. The Company is
not currently aware of any likely future rule changes that could have a
material impact on the Company, but there can be no assurance that such
rule changes will not occur.
C. Marketing
The Company markets its insurance products through a network of
692 licensed independent agencies, 541 throughout Massachusetts (of
which 151 are ERPs) and 151 are in California. These independent
agencies may also represent other insurance companies, some of which may
compete directly with the Company. The independent insurance agencies
are under contract with the Company's subsidiaries and must conduct
their business according to the provisions of their contract. Contracts
for Massachusetts agencies may be terminated by the Company upon 180
days' notice to the agency or at will by the agency.
The Company seeks to establish long-term relationships with
agencies that can generate a sizable volume of business with profitable
underwriting characteristics and for which the Company will be among the
top two or three preferred writers of its core products. The Company
also assesses whether the mix of a prospective agency's business will
expand the Company's presence in one or more of its core product lines.
In 1997, each agency representing the Company in Massachusetts produced
an average of approximately $1,338,000 of Company direct premiums
written. Also in Massachusetts during 1997, 180 agencies produced in
excess of $1.0 million of direct premiums written, an additional 53
agencies produced over $2.0 million, an additional 21 agencies produced
over $3.0 million and lastly, an additional 11 agencies produced over
$4.0 million. The Company's three largest agencies produced
approximately $29.9, $13.5 and $11.2 million of the Company's direct
premiums written, respectively, or approximately 3.9%, 1.8% and 1.5% in
1997. Total direct premiums written attributable to the AAA group
business was $422,074,000 or 54.9% of the Company's total direct
premiums written. Total exposures attributable to the AAA clubs group
business were 522,098 or 65.8% of total personal automobile exposures in
1997, an increase of 102,445 or 24.4% over 1996. Of this amount, 10%
was written through the AAA clubs and 90% was written through insurance
agencies owned by the Company's network of independent agents.
Once appointed, each agency's performance is carefully monitored.
An Agency Evaluation Committee, comprised of representatives of the
Company's Marketing, Underwriting and Premium Accounting departments,
utilizes a host of pre-established criterion (loss ratio, premium
volume, etc.) to continuously evaluate agencies. Generally, the Company
will counsel an agency on how to improve its underwriting and
profitability before any agency will be terminated.
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Company agencies receive commissions on policies written for the
Company and are eligible to receive contingent commissions through a
profit sharing arrangement. The Commissioner annually establishes a
minimum average direct commission for personal automobile insurance,
which in 1997 was 13.9%. With respect to policies reinsured through
C.A.R., the maximum amount of commissions that C.A.R. will reimburse the
Company is fixed at that prescribed rate. Consequently, there is an
incentive for insurers not to permit their direct commission rate to
vary materially from the prescribed rate. The Company's contingent
commissions are tied to the underwriting profit on policies written by
an agency based upon a rolling three year experience methodology. The
Company generally pays up to 45% of the underwriting profit attributable
to the agency's business. The profit sharing plan is a three year
rolling plan, with one third of the current and two prior years profit
years profit or loss, summed to a single payment. To qualify for profit
sharing, a three-year average loss ratio of 50 to 55% is required. CAR
credits for voluntary business written in urban area or credits for
writing youthful operators on a voluntary basis increase the loss ratio
eligibility for profit sharing up to 55% from 50%. Books of business
with no available credits must achieve a lower loss ratio. In 1997,
total commissions paid by the Company to its agencies amounted to 14.6%
of direct premiums written, of which direct commissions and contingent
commissions constituted 14.3% and 0.3%, respectively versus 15.6%, 14.4%
and 1.2% in 1996, respectively. Direct commissions paid are higher than
the personal automobile rates primarily due to higher commission rates
paid on other lines of business. In September 1996, the Company
announced a reduction to 20%, from a maximum of 25%, for the commission
paid on homeowner insurance. This reduction is for policies effective
March 1, 1998 and subsequent. In 1997, the Company's expense for
contingent commissions was $2.2 million versus $9.0 million in 1996.
The Company also occasionally sponsors incentive award programs to
encourage and reward agency profitability and growth. The last such
program occurred during 1996 with trips taking place during the first
few months of 1997. The Company ran such a program resulting in 315
agents earning incentives at a total cost of approximately $4.3 million.
Much of the success of this program was attributable to group marketing
programs.
The Company's information systems enable it to provide extensive
support to its agencies. This support includes a direct billing system,
which covers over 97% of the Company's policyholders, an on-line inquiry
system which allows agents to ascertain quickly the status of pending
claims or direct bill information and a system which allows Company
agents to quote many premiums directly to policyholders. The Company
also emphasizes its commitment to enhancing and expanding the role of
its information systems. The Company has provided agencies with the
ability to generate personal automobile policies from their own offices
and will continue to explore new options in light of the Team 2000
project.
The Company believes that because of its compensation arrangements
and by providing a consistent market with emphasis on service, an
increasing number of the Company's agencies will rely on it as their
principal supplier of insurance products. The Company believes that it
is the preferred provider for most of its agencies. Although the
Company believes, based on annual surveys of its agencies, that its
relationships with its independent agencies are excellent, any
disruption in these relationships could adversely affect the Company's
business.
During the latter part of 1995, Commerce signed group marketing
agreements with the five American Automobile Association Clubs of
Massachusetts ("AAA clubs") offering a 10% discount on automobile
insurance to the clubs' members who reside in Massachusetts. In 1997,
two AAA clubs were consolidated, therefore leaving only four clubs.
Primarily, as a result of the fourth consecutive private passenger rate
reduction, a 6.0% percent AAA club discount was approved for policies
effective as of January 1, 1998. Previously, a 10% discount had been
effective since the latter part of 1995. Membership in these clubs is
estimated to represent approximately one-third of the Massachusetts
motoring public, and has been the primary reason for a 40.6% increase in
the number of personal automobile exposures written by Commerce since
the groups inception. The Company expects this increase to level off in
1998 as evidenced by an 8.3% increase in personal automobile exposures
in 1997 as compared to an 29.8% increase in 1996. In 19970, total
direct premiums written attributable to the AAA group business were
$422,074,000 or 54.9% of the Company's total direct premiums written, an
increase of 22.6% over 1996. Total exposures attributable to the AAA
clubs group business was 522,098 or 65.8% of total personal automobile
exposures in 1997, an increase of 102,445 or 24.4% over 1996. Of this
amount, approximately 10% was written through insurance agencies owned
by the AAA clubs. The remaining 90% was written through the Company's
network of independent agents.
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Initially, the Massachusetts statute governing group marketing
programs required that 35% of the eligible members must participate in a
group marketing program within the first year. Accordingly, Commerce
and the AAA clubs aggressively pursued AAA members for the AAA Group
Marketing Program. At December 31, 1996, Commerce had achieved the
objective of writing more than 35% of the AAA members within the first
year, as over 300,000 AAA members joined the program. The particular
portion of the statute, dealing with achieving the 35% penetration level
in one year, was amended by the Massachusetts Legislature in early 1997
to allow two years to reach the required penetration level. In December
1997, a bill was passed by the Massachusetts Legislature to further
waive for an additional year, the requirement that 35% of a group's
members purchase insurance through the group in order for the group to
be renewed during 1998.
Commerce and the AAA clubs have agreed that Commerce shall be
their exclusive underwriter of Massachusetts personal automobile group
programs. This contract may be terminated by the AAA clubs upon written
notice to Commerce, whose termination shall take effect at a minimum of
three years from notice of termination.
In March 1997, the Company was granted approval, for the 1997
calendar year, to offer their customers safe driver deviations of 10
percent to drivers with SDIP classifications of either Step 9 or 10.
These are the two best driver SDIP classifications in Massachusetts,
representing drivers with no at fault accidents and not more than one
minor moving vehicle violation in the last six years. For drivers that
qualified, the Company's group automobile discounts and SDIP deviations
could be combined for up to a 19% reduction from the state mandated
rates. In February 1998, approval of SDIP deviations of 15% for Step 9
and 4% for Step 10 SDIP classifications was granted for the 1998
calendar year. For drivers that qualify, the Company's group automobile
discounts and SDIP deviations can be combined for up to a 20.1%
reduction from the state mandated rates.
In November 1997, the Company received state regulatory approval
to implement an installment fee of $3.00 on each invoice following the
down payment, for all private passenger automobile policies effective
January 1, 1998. The same $3.00 installment fee also replaced the 1.25%
finance charge calculation for homeowner and dwelling policies paid on a
10-payment installment basis. Previously, for 1996 and 1997, the
Company eliminated interest based finance fees on personal automobile
insurance policies.
D. Underwriting
The Company seeks to achieve an underwriting profit, as measured
by a statutory combined ratio of less than 100, in each of its three
core product lines in both hard and soft markets. The strategy is
designed to achieve consistent profitability with substantial growth in
net premiums written during hard markets and more modest growth during
soft markets. All of the Company's policies have been written on a
"claims incurred basis," meaning that the Company covers claims based on
occurrences that take place during the policy period.
Agencies are authorized to bind the Company on risks as limited by
the Company's written underwriting rules and practices, which set forth
eligibility rules for various policies and coverages, unacceptable
risks, and maximum and minimum limits of liability. With respect to
non-automobile policies, other than umbrella policies, the Company's
agencies have the ability to bind the Company for a limited period,
typically 60 days, during which time the Company reviews all risks to
determine whether it will accept or reject the policy. During this
review period, the Company is obligated to pay any claim which would be
covered under the policy. Violation of the Company's underwriting rules
and practices is grounds for termination of the agency's contract with
the Company.
The Company and each of the approximately 40 other Servicing
Carriers must write all automobile risks submitted to them.
Massachusetts personal automobile insurance rates are fixed annually by
the Commissioner. All companies writing personal automobile policies
are required to use such rates, unless they have received prior approval
from the Commissioner to offer a lower rate. The actual premium paid by
a particular policyholder, however, is adjusted, either up or down,
based upon the SDIP record of the insured operator. Moving violations
and accidents for which the insured was at fault within the most recent
six year period are used to determine each operator's SDIP surcharge or
credit. The Massachusetts personal automobile insurance market which
became more competitive in late 1995 continued throughout 1996 and 1997
with the advent of group marketing programs and safe driver rate
deviations.
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Prices for Massachusetts commercial automobile insurance policies
that are not reinsured through C.A.R. are set competitively subject to
the Commissioner's authority to disapprove such prices. The rate for
commercial automobile risks reinsured through C.A.R. is mandated by the
Commissioner, except for private passenger type non-fleet business. The
Company's rates for other product lines, including homeowners and
commercial lines of general liability and property insurance, are based
in part on loss cost data from the Insurance Services Office ("ISO"),
which is an industry bureau providing policy forms and rate making data,
and in part, on the Company's own experience and industry price levels.
The Company is not obligated by statute to accept every homeowners
risk submitted to it. Accordingly, risks meeting the Company's
underwriting guidelines are accepted, and all other risks are declined
or not renewed. The Company has established an independent rate level
for its homeowners product line, based on its own loss experience and
recognizing the price levels available in the competitive marketplace.
The Company uses ISO policy forms and has added special coverage
features to meet its product needs. Rates and forms are filed with the
Commissioner.
Under Massachusetts law, residential property owners are strictly
liable for damages caused by lead poisoning in children under age six
residing in the premises, unless the property owner has a Letter of
Compliance or a Letter of Interim Control (i.e. has taken or is taking
specific measures to prevent lead poisoning). The Company has reduced
its exposure to lead poisoning by (i) excluding from coverage all intra-
familial claims for bodily injury or medical expenses brought by minors
living in an insured's household, (ii) revising its underwriting
standards for new and renewal business to avoid insuring properties with
lead poisoning hazards and (iii) excluding from homeowners and dwelling
fire liability coverage all lead poisoning perils to children under the
age of six on policies for properties built prior to 1978 that contain
rental units and where strict liability for lead poisoning would
otherwise apply. Effective on March 1, 1998 a similar exclusion is
being added to the Businessowners Program. With regard to the exclusion
described in (iii), policy holders may buy a reinstatement of the
excluded coverage through a policy endorsement for an additional
premium, but very few such endorsements have been written. As a result
of these remedial steps and its historical claims experience, the
Company does not believe that its exposure to lead poisoning claims is
material.
The Company believes that its information systems give it a
competitive advantage in making underwriting decisions, particularly in
deciding which personal automobile risks should be reinsured through
C.A.R. Utilizing data the Company accumulates as a result of its major
market presence in the Massachusetts personal automobile line, the
Company believes that its information systems allow it to make informed
risk assessments and to respond effectively to shifts in the automobile
insurance markets and regulatory environment.
The Company's long-term growth objective is to expand its writings
outside of Massachusetts. In continued pursuit of this objective, the
Company purchased Western Pioneer Insurance Company, a personal
automobile insurer, located in Pleasanton, California in 1995. In
addition, the Company became licensed in the states of Connecticut and
Rhode Island during 1996 and in the states of Vermont and New Hampshire
in 1997. License approval in the state of Maine was received in
February 1998. Concurrent with the filings submitted for these
licenses, the Company entered into an agreement with PMSC and purchased
software which allow for the development of internal operating systems
which will enable the Company to process policies in these five states
and Massachusetts. To facilitate this development and, at the same
time, address the year 2000 processing issue facing computer system
users, the Company established the Team 2000 and Century Change projects
which are corporate-wide efforts to prepare the Company's systems for
the next millennium. These projects involve internal staff costs as
well as consulting expenses to prepare the systems for the year 2000.
Costs to date for the Century Change project have been approximately
$1.1 million (all of which relate to 1997). Administration,
programming, testing and implementation of system applications related
to Century Change are expected to cost an additional $6 million over the
next 24 months. Approximately $4 million is expected to be expensed
during 1998 with the remainder through the end of 1999.
The Company is utilizing both internal and external resources on
the Century Change Project. The Company has a formal plan to address
the Century Change issue and is progressing in accordance with that
plan. Programming changes dealing with policy issuance and maintenance
of same is expected to be completed by year-end 1998. Other internal
changes are scheduled to be completed in accordance with specified
delivery dates as outlined in the plan. The Company's plan has been
designed to, and is proceeding so as to, avoid any adverse business
production issues.
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The Company has reviewed the Century Change status of vendors who
perform outside processing for the Company or whose software the Company
uses for internal processing. This review has determined that the
related software used by or provided by these vendors are century ready.
Upon completion of the Century Change project, the Company expects
to focus its efforts on the Team 2000 project which will eventually
replace the Company's existing internal computer systems for
Massachusetts business utilizing software purchased from Policy
Management Services Corporation, Inc. ("PMSC"). Costs to date for the
Team 2000 effort have been approximately $28 million. Costs applicable
to 1997 were approximately $17 million, of which $15.6 million was
expensed during the year. Total Team 2000 project costs over the next 5
to 7 years have been estimated at approximately $60 million including
funds expended to date. This amount includes the purchase of a main
frame computer, license fees and the costs associated with programming,
implementation and training. Systems enabling the Company to process
policies in Rhode Island have been in place since January 1998. Other
states will be brought on-line in the future.
E. Reinsurance
In addition to participating in C.A.R., the Company reinsures with
other insurance companies on a claims incurred basis, a portion of its
potential liability under the policies it has written, protecting itself
against severe loss under individual policies, or catastrophic
occurrences where a number of claims can produce an extraordinary
aggregate loss. Reinsurance does not legally discharge the Company from
its primary liability to the insured for the full amount of the
policies, but it does make the reinsurer liable to the Company to the
extent of the reinsured portion of any loss ultimately suffered. The
Company seeks to utilize reinsurers which it considers adequately
capitalized and financially able to meet their respective obligations
under reinsurance agreements with the Company. The Company utilizes a
variety of reinsurance mechanisms to protect itself against loss as
described above.
Property and Catastrophe Reinsurance
From the inception, on September 30, 1993, through the third
quarter of 1995, the Company's combined property quota share and excess
loss reinsurance contract was written with five domestic reinsurance
companies. Under the quota share portion of the arrangements, the
reinsurers indemnified the Company for 36% of the loss and LAE, and paid
a commission allowance based on the ratio of losses incurred to premiums
earned. In exchange, the Company paid to the reinsurers 40% of the net
premium pertaining to the related business. The maximum per occurrence
loss reimbursement was $40.0 million and the maximum annual aggregate
occurrence loss reimbursement was $60.0 million. Under the excess loss
reinsurance portion of the arrangements, the Company reinsured each
risk, retaining $125,000 and reinsuring 100% of the next $875,000.
Effective September 30, 1995, the Company increased its coverage
under the combined property quota share and excess loss reinsurance
contract. The contract is now written with six domestic reinsurance
companies. Under the quota share portion of the arrangements, the
reinsurers indemnify the Company for 45% of the loss and LAE, and pay a
commission allowance based on the ratio of losses incurred to premiums
earned. In exchange, the Company pays to the reinsurers 49% of the net
premium pertaining to the related business. The maximum per occurrence
loss reimbursement is $50.0 million and the maximum annual aggregate
occurrence loss reimbursement is $75.0 million. Under the excess loss
reinsurance portion of the arrangements, the Company reinsures each
risk, retaining $125,000 and reinsuring 100% of the next $875,000. This
reinsurance contract is continuous through September 30, 1998, but
cancelable quarterly with ninety days notice. Written premiums ceded in
1997, 1996 and 1995 under the property quota share and excess loss
reinsurance contract were $27.5 million, $26.6 million and $21.5
million, respectively.
Effective March 1, 1995, through February 29, 1996, the Company
had catastrophe reinsurance coverage for that portion of the loss not
covered under the property quota share arrangement. Catastrophe
reinsurance coverage was in force for approximately 88.0% of the amounts
incurred for all property claims arising from a single event or
occurrence up to a maximum loss of $100.0 million, after first
subtracting property quota share losses. Coverage under the catastrophe
program was as follows: a net retention of $5.0 million; 50.0% of the
next $5.0 million; and, 95.0% of the next $90.0 million. Including the
Company's retention, total catastrophe coverage was $100.0 million.
This coverage was placed with a number of reinsurers, both foreign and
domestic.
18
<page
Effective March 1, 1996, through February 28, 1998, the Company's
catastrophe reinsurance program was tailored in conjunction with the
property quota share arrangement to provide catastrophe reinsurance
protection at varying levels of losses. The Company's two separate
catastrophe only programs provide a maximum amount of protection of $18
million and $42 million. These two programs expire on March 1, 1998 and
May 1, 1998, respectively. The table below provides information
depicting the approximate combined recoveries of all property
reinsurance programs (catastrophe and quota share) at various loss
scenarios if a catastrophe were to strike:
<TABLE>
<CAPTION>
Net Loss
Total Reinsurance Retained by
Loss Recovery the Company
<S> <C> <C>
$ 25,000,000 $ 11,300,000 $13,700,000
50,000,000 35,000,000 15,000,000
75,000,000 58,800,000 16,200,000
100,000,000 82,500,000 17,500,000
125,000,000 105,000,000 20,000,000
150,000,000 110,000,000 40,000,000
</TABLE>
Under the above scenario the Company had no reinsurance recoveries
for total loss amounts in excess of $150.0 million. The Company is
currently negotiating with several of its existing quota-share/excess
loss reinsurance providers to expand the quota share portion of the
program. A 75% quota-share reinsurance program is contemplated,
covering all non-automobile property and liability business except
umbrella policies. The excess loss portion of the program would be
reduced on July 1, 1998 and completely eliminated on September 30, 1998.
The Company intends to incept this expanded program on July 1, 1998.
Based on this, the Company's catastrophe reinsurance program will
consist solely of the current quota-share/excess loss reinsurance
contract for a period of time between May 1, 1998 and June 30, 1998.
Casualty Reinsurance
Through December 31, 1996, casualty reinsurance was on an excess
of loss basis for any one event or occurrence with a maximum recovery of
$4.0 million over a net retention of $1.0 million. Effective January 1,
1997, casualty reinsurance is on an excess loss basis for any one event
or occurrence with a maximum recovery of $9.0 million over a net
retention of $1.0 million. This coverage is placed with Swiss
Reinsurance America Corporation, formerly North American Reinsurance
Corporation (rated A by A.M. Best).
Effective January 1, 1995, personal and commercial liability
umbrella policies are reinsured on a 95% quota share basis in regard to
limits up to $1.0 million and 100% quota share basis for limits in
excess of $1.0 million but not exceeding $5.0 million for policies with
underlying automobile coverage of $250,000 and $500,000 or more.
Effective January 1, 1996, the Company added personal liability umbrella
reinsurance coverage for policies with underlying automobile coverage of
$100,000 and $300,000, on a 65% quota share basis in regards to limits
up to $1.0 million and 100% quota share basis for limits in excess of
$1.0 million but not exceeding $3.0 million. These coverages are placed
with Munich American Reinsurance Corporation (rated A+ by A.M. Best).
The Company believes that the terms of its reinsurance contracts
are consistent with industry practice in that they contain standard
terms with respect to lines of business covered, limits, retentions,
arbitration and occurrence. Based on its review of its reinsurers'
financial statements and their reputations in the reinsurance
marketplace, the Company believes that its reinsurers are financially
sound. The Company had no amount of reinsurance receivables more than
90 days past due at December 31, 1997.
F. Settlement of Claims
Claims under insurance policies written by the Company are
investigated and settled primarily by claims adjusters employed by the
Company. The Company employs a staff of 712 people at its claims
department, located in Webster, Massachusetts. In addition to these
individuals, the Company utilizes the services of approximately 36
independent appraisal firms and 9 independent property adjusting
companies who are strategically located throughout the state. The
Company also has a special unit which investigates suspected insurance
fraud and abuse. If a claim or loss cannot be settled and results in
litigation, the Company retains outside counsel to represent it.
19
<page
The Company believes that through its claims staff of experienced
adjusters, appraisers, managers, and administrative staff, it has
achieved lower LAE than the industry average and higher customer
satisfaction than many of its competitors. All claims office staff
members work closely with agents, insureds and claimants with a goal of
settling claims fairly, rapidly and cost effectively.
Certain of the Company's Massachusetts agencies have settlement
authority for claims for other than automobile property losses which are
less than $2,500. The settlement authority of agencies under automobile
policies is limited to claims for towing.
The Massachusetts Unfair Claims Settlement Practices Act ("Chapter
176D") prohibits insurers from engaging in certain claim settlement
practices, including failing to acknowledge and act reasonably promptly
upon communications with respect to claims arising under insurance
policies, refusing to pay claims without conducting a reasonable
investigation based upon all available information, failing to
effectuate prompt, fair and equitable settlements of claims in which
liability has become reasonably clear, and compelling insureds to
institute litigation to recover amounts due under an insurance policy by
offering substantially less than the amounts ultimately recovered in
actions brought by such insureds. An insurer's violation of any of
these obligations expressly violates the Massachusetts Consumer
Protection Act ("Chapter 93A"). Any party, including claimants and
insureds, whose rights are affected by an insurer's violation of Chapter
176D, is entitled to bring a claim against the insurer under Chapter
93A.
The damages available under Chapter 93A may not necessarily be
related to the harm caused by the insurer's violation of Chapter 176D.
Chapter 93A provides in effect that the party bringing the Chapter 93A
claim will be entitled, at a minimum, to the amount of the judgment on
all claims arising out of the same underlying occurrence, regardless of
the limits of the policy issued by insurer. Moreover, Chapter 93A
permits the court to double or triple the party's damages if the
insurer's violation of Chapter 176D was willful or knowing. If the
underlying policy risk was ceded to C.A.R., the Company may seek
reimbursement from C.A.R. for the damages it will be obligated to pay if
it is found liable under Chapter 93A or amounts paid in settlement of
such claim. Such reimbursement is discretionary and C.A.R. may not
reimburse an insurer if C.A.R. determines that the insurer was negligent
in the handling of such claim and such negligence was the cause of
Chapter 93A liability. Additionally, certain time notification
restrictions apply to these judgments, which if not met, could preclude
an insurer from seeking reimbursement from C.A.R. Accordingly, there
can be no assurance that the Company will be reimbursed by C.A.R. in any
particular instance involving a Chapter 93A claim.
In March of 1996, the Company began providing a twenty-four (24)
hour claim reporting service to third-party claimants and insureds of
interested agencies. This service allows customers to report their
first notice of a loss at anytime of the night or day; 365 days a year,
including weekends and holidays. This reporting methodology allows the
Company to improve customer satisfaction by making the initial claim
handling much faster and ultimately reducing indemnity payments such as
rental and storage. As of January 1, 1998, there were 165 agents who
have signed up for this claim reporting methodology; these agents
represent 42.4% of total claim volume. The Company anticipates growth
in this program as it continues to discuss this service with those
agencies who have not yet been solicited to participate.
As the Company expands into the remaining New England states, it
will investigate and settle claims similar to the way it does in
Massachusetts. The claims office staff will work closely with agents
and claimants with a goal of settling claims fairly, rapidly and cost
effectively while trying to achieve higher customer satisfaction than
many of their competitors.
G. Loss and Loss Adjustment Expense Reserves
Significant periods of time can elapse between the occurrence of
an insured loss, the reporting of the loss to the insurer and the
insurer's payment of that loss. To recognize liabilities for unpaid
losses, insurers establish reserves as balance sheet liabilities
representing estimates of amounts needed to pay reported and unreported
losses and LAE. The Company's reserving policy is intended to result in
a small redundancy. Quarterly, the Company reviews these reserves
internally. Regulations of the Division of Insurance require the
Company to obtain annually a certification from either a qualified
actuary or an approved loss reserve specialist that its loss and LAE
reserves are reasonable.
20
<page
When a claim is reported to the Company, its claims personnel
establish a "case reserve" for the estimated amount of the ultimate
payment. The amount of the reserve is primarily based upon an
evaluation of the type of claim involved, the circumstances surrounding
each claim and the policy provisions relating to the loss. The estimate
reflects informed judgment of such personnel based on general insurance
reserving practices and on the experience and knowledge of the claims
person. During the loss adjustment period, these estimates are revised
as deemed necessary by the Company's claims department based on
subsequent developments and periodic reviews of the cases.
In accordance with industry practice, the Company also maintains
reserves for estimated losses incurred but not yet reported ("IBNR").
IBNR reserves are determined on the basis of historical information and
the experience of the Company. Adjustments to IBNR are made
periodically to take into account changes in the volume of business
written, claims frequency and severity, the mix of business, claims
processing and other items that can be expected to affect the Company's
liability for losses and LAE over time.
When reviewing reserves, the Company analyzes historical data and
estimates the impact of various factors such as (i) per claim
information, (ii) the historical loss experience of the Company and
industry and (iii) legislative enactments, judicial decisions, legal
developments in the imposition of damages, changes and trends in general
economic conditions, including the effects of inflation. This process
assumes that past experience, adjusted for the effects of current
developments and anticipated trends, is an appropriate basis for
predicting future events. There is no precise method, however, for
subsequently evaluating the impact of any specific factor on the
adequacy of reserves, because the eventual development of reserves is
affected by many factors.
By using both individual estimates of reported claims and
generally accepted actuarial reserving techniques, the Company estimates
the ultimate net liability for losses and LAE. After taking into
account all relevant factors, management believes that the provision for
losses and LAE at December 31, 1997 is adequate to cover the ultimate
net cost of losses and claims incurred as of that date. The ultimate
liability may be greater or lower than reserves. Establishment of
appropriate reserves is an inherently uncertain process, and there can
be no certainty that currently established reserves will prove adequate
in light of subsequent actual experience. The Company does not discount
to present value that portion of its loss reserves expected to be paid
in future periods. The Company's loss and LAE reserves also includes
its share of the aggregate loss and LAE reserves of all Servicing
Carriers.
For a reconciliation of beginning and ending reserves for losses
and LAE, net of reinsurance, see Note E to the Company's 1997
Consolidated Financial Statements, which is incorporated herein by
reference from pages 34 through 36 of the Company's 1997 Annual Report.
Included in the loss reserve methodologies described above, are
liabilities for unpaid claims and claim adjustment expenses for
environmental related claims such as oil spills and lead paint.
Reserves have been established to cover these claims for both known and
unknown losses. Because of the Company's limited exposure to these
types of claims, Management believes they will not have a material
impact on the consolidated financial position of the Company. Loss
reserves on environmental related claims amounted to $6,924,000 and
$8,783,000 in 1997 and 1996, respectively.
The following table represents the development of reserves, net of
reinsurance, for 1987 through 1997. The top line of the table shows the
reserves at the balance sheet date for each of the indicated years.
This represents the estimated amounts of losses and LAE for claims
arising in all years that were unpaid at the balance sheet date,
including losses that had been incurred but not yet reported to the
Company. The upper portion of the table shows the cumulative amounts
paid as of successive years with respect to that year's current reserve
liability expressed as a percentage. The lower portion of the table
shows the re-estimated amount as a percentage of the previously recorded
reserves based on experience as of the end of each succeeding year,
including cumulative payments made since the end of the respective year.
The estimate changes as more information becomes known about the
frequency and severity of claims for individual years. Favorable loss
development exists when the original reserve estimate is greater than
the re-estimated reserves at December 31, 1997.
21
<page
In evaluating the cumulative information in the table, it should
be noted that each year's amount includes the effects of all changes in
amounts for prior periods. This table does not present accident or
policy year development data. Conditions and trends that have affected
development of the liability in the past may not necessarily occur in
the future. Accordingly, it is not appropriate to extrapolate future
development based on this table.
<TABLE>
Year ended December 31,
1997 1996 1995 1994 1993
1992 1991 1990 1989 1988 1987
($ in thousands)
<CAPTION>
<S> <C> <C> <C> <C> <C> <C>
<C> <C> <C> <C> <C>
Reserves for
losses and loss
adjustment
expenses........ $530,077 $533,980 $493,911 $455,460 $422,224
$316,261 $228,657 $177,657 $138,456 $100,882 $70,457
Paid (cumulative)
as a percentage
of current re-
serves as of:
One year later.. 46.0 45.8 46.2 51.8
50.8 46.2 46.2 46.7 41.7 40.4
Two years later. 66.3 66.2 70.5
76.4 71.1 68.4 69.2 67.8 59.9
Three years
later.......... 78.2 80.7
85.5 87.2 84.6 81.7 82.2 80.4
Four years
later.......... 86.8
90.6 91.1 95.7 90.1 89.1 88.8
Five years later
93.5 93.3 96.3 98.0 92.3 92.2
Six years later.
94.8 95.7 97.9 99.4 93.4
Seven years
later..........
96.7 96.8 99.7 101.3
Eight years
later..........
97.5 97.6 101.7
Nine years
later..........
98.1 98.6
Ten years later.
99.0
Reserves re-estimated
as a percentage of
initial reserves as of:
One year later.. 84.3 82.2 83.6 83.9
87.2 82.3 84.5 92.7 96.9 99.4
Two years later. 74.1 73.2 75.9
78.6 82.8 74.6 82.8 87.7 98.9
Three years
later.......... 68.9 69.4
73.0 77.1 75.1 76.7 80.5 90.1
Four years later 67.3
68.8 72.2 71.7 78.3 76.3 86.2
Five years later
67.0 68.7 68.2 75.6 80.2 83.9
Six years later.
67.8 65.5 74.0 78.0 90.8
Seven years
later.........
64.6 71.8 77.3 88.5
Eight years
later.........
71.3 75.4 87.9
Nine years later
75.5 85.2
Ten years later.
85.3
Redundancy expressed as a
percent of yearend
reserves......... 15.7 25.9 31.1 32.7
33.0 32.2 35.4 28.7 24.5 14.7
</TABLE>
<page
H. Operating Ratios
Loss and Underwriting Expense Ratios
Loss and underwriting expense ratios are used to interpret the
underwriting experience of property and casualty insurance companies.
Losses and LAE are stated as a percentage of premiums earned because
losses may occur over the life of a policy. Underwriting expenses on a
statutory basis are stated as a percentage of net premiums written
rather than premiums earned because most underwriting expenses are
incurred when policies are written and are not spread over the policy
period. Underwriting profit margins are reflected by the extent to
which the combined loss and underwriting expense ratios, the combined
ratio, is less than 100%. The combined ratio is considered the best
simple index of current underwriting performance of an insurer. The
Company's loss ratio and LAE, underwriting expense ratio and combined
ratio, and the industry combined ratio, on a statutory basis, are shown
in the following table. The Company's ratios include lines of insurance
other than automobiles as do the industry combined ratios for all
writers. Data for the property and casualty industry generally may not
be directly comparable to Company data. This is due to the fact that
the Company conducts its business primarily in Massachusetts.
<TABLE>
<CAPTION>
Year Ended
December 31,
1997 1996 1995
1994 1993
<S> <C> <C> <C>
<C> <C>
Company Statutory Ratios (unaudited):
Loss and LAE Ratio.............. 71.4% 70.9% 62.0%
64.6% 68.0%
Underwriting Expense Ratio...... 25.1 27.1 29.0
27.1 25.7
Combined Ratio................. 96.5% 98.0% 91.0%
91.7% 93.7%
Industry combined ratio
(all writers)(1)............... 101.8% 103.1% 102.5%
103.0% 102.9%
</TABLE>
(1) Source: Best's Review (January, 1998), as reported by A.M. Best for
all property and casualty insurance companies and weighted to reflect
the Company's product mix. The 1997 industry information is estimated by
A.M. Best.
Premiums to Surplus Ratio
The following table shows, for the periods indicated, the
Company's and the industry's statutory ratios of net premiums written to
policyholders' surplus. While there is no statutory requirement
applicable to the Company which establishes a permissible net premiums
to surplus ratio, guidelines established by the National Association of
Insurance Commissioners ("NAIC") provide that this ratio should be no
greater than 300%.
<TABLE>
<CAPTION>
Year Ended
December 31,
1997 1996 1995
1994 1993
(dollars in
thousands)
<S> <C> <C> <C>
<C> <C>
Net premiums written by the
Company........................... $741,501 $711,570 $603,421
$589,197 $563,416
Policyholders' surplus of the
Company........................... 516,598 464,739 440,110
349,775 284,631
The Company's ratio................ 143.3% 153.1% 137.1%
168.5% 197.9%
Industry ratio(1).................. 90.0% 110.0% 110.0%
130.0% 130.0%
</TABLE>
__________________________________
(1) Source: Best's Review (January, 1998), for all property and
casualty insurance companies. The 1997 industry information is
estimated by A.M. Best.
23
<page
I. Investments
Investment income is an important source of revenue for the
Company and the return on its investment portfolio has a material effect
on its net earnings. The Company's investment objective is to maintain
high quality diversified fixed maturity investments structured to
maximize after-tax investment income while minimizing risk. See
"Management's Discussion and Analysis of Financial Condition and Results
of Operations" incorporated herein by reference from pages 4 through 18
of the Company's 1997 Annual Report.
The Company's investment portfolio carried at market value as of
December 31, 1997, was $1,242,695,000. Of that amount, 47.5% was
invested in fixed maturities, 12.0% was invested in preferred stocks,
14.3% was invested in common stocks, 17.2% was invested in short-term
investments and 7.0% was invested in mortgage loans and other
investments. Cash and cash equivalents accounted for the remaining
2.0%.
Investments in fixed maturities, which include taxable and non-
taxable bonds, non-redeemable preferred stocks, common stocks and
preferred stock mutual funds, are carried at fair market value.
Unrealized investment gains and losses on stocks and fixed maturities,
to the extent that there is no permanent impairment of value, are
credited or charged directly to stockholders' equity, net of any tax
effect. When investment securities are sold, the realized gain or loss
is determined based on sales proceeds less book value.
The Company's bond portfolio is comprised of Government National
Mortgage Association ("GNMA") mortgage backed bonds (30.7%) and
municipal bonds (69.3%). Of the Company's bonds, 100.0% are rated in
the two highest quality categories provided by the NAIC.
The Company's investment policy, determined in accordance with
guidelines established by the Company's Board of Directors, emphasizes
investment yield while maintaining investment quality. The Board of
Directors reviews and ratifies management's investment decisions on a
quarterly basis. State insurance laws also impose restrictions on the
nature and extent of investments by the Company.
The table below sets forth investments (at cost) and the income
thereon for the five years ended December 31, 1997.
<TABLE>
<CAPTION>
Year Ended
December 31,
1997 1996 1995
1994 1993
(dollars in
thousands)
<S> <C> <C> <C>
<C> <C>
Average net investments.......... $1,181,181 $1,131,760 $1,033,439
$893,628 $766,938
Net realized gains (losses) on
investments.................... 22,770 (7,574) 712
45,612 7,506
Unrealized gains (losses) on
fixed maturities............... 23,813 16,191 13,969
(56,366) 27,477
Unrealized gains (losses) on
preferred stocks............... 364 (801) (377)
(10,500) (336)
Unrealized gains (losses) on
common stocks.................. 17,718 20,116 11,799
1,613 41,136
Net investment income............ 80,794 77,402 71,313
62,901 53,068
Net investment income as a
percentage of total average
investments.................... 6.84% 6.84% 6.90%
7.03% 6.92%
Net investment income after-tax
as a percentage of total
average investments............ 5.53% 5.61% 5.74%
5.27% 5.70%
</TABLE>
24
<page
The following table sets forth an analysis of the fair market
value by the type of investment at December 31, 1993 through 1997:
<TABLE>
<CAPTION>
Year Ended
December 31,
1997 1996 1995
1994 1993
(dollars in
thousands)
<S> <C> <C> <C>
<C> <C>
Type of Investment
GNMA mortgage-backed bonds...... $ 181,069 $ 225,552 $ 221,373 $
233,287 $ 202,403
Tax exempt state and municipal
bonds.......................... 409,528 491,150 593,904
511,723 447,088
Total fixed maturities...... 590,597 716,702 815,277
745,010 649,491
Non-redeemable preferred stocks. 148,499 147,680 111,220
85,574 80,058
Preferred stock mutual funds.... 58,650 29,087 -
- - -
Common stocks................... 119,439 56,954 40,359
9,656 65,863
Total common stocks......... 178,089 86,041 40,359
9,656 65,863
Short-term investments.......... 213,442 - -
- - -
Mortgages and collateral loans
(net of allowance for possible
loan losses)................... 82,839 74,586 75,609
58,590 63,301
Cash and cash equivalents....... 25,446 140,535 52,665
5,485 13,217
Other investments............... 3,783 2,127 1,648
716 1,304
Total investments........... $1,242,695 $1,167,671 $1,096,778 $
905,031 $ 873,234
</TABLE>
The table below sets forth as of December 31, 1997 the composition
of the Company's fixed maturity investments, excluding short-term
investments, by time to maturity at the dates indicated:
<TABLE>
<CAPTION>
Percent
of
Amount
Portfolio
(dollars in thousands)
<S> <C>
<C>
Period from December 31, 1997 to maturity:
One year or less................................. $ -
- - %
More than one year to five years.................
2,200 0.4
More than five years to ten years................
1,324 0.2
More than ten years..............................
587,073 99.4
$590,597 100.0%
</TABLE>
25
<page
At December 31, 1997, the Company's fixed income portfolio, which
represented 47.5% of the Company's total invested assets, had an average
stated maturity of approximately 24.1 years. The calculation of average
stated maturity utilizes the dollar weighted average of the actual
maturity date for a security. In contrast, the Company's weighted
average duration can be significantly less. At December 31, 1997, the
Company's fixed income portfolio had a weighted average duration of 4.8
years. The "duration" of a security is the time-weighted present value
of the security's expected cash flows and is used to measure a
security's price sensitivity to changes in interest rates. The weighted
average duration is short compared to the average stated maturity
because of the relatively large percentage of GNMA and municipal housing
bonds in the fixed maturity portfolio. The duration reflects industry
prepayment assumptions. The municipal housing bonds are similar in
nature to GNMAs in that they paydown principal during the life of the
bond. For these types of bonds, investors are compensated primarily for
reinvestment risk rather than credit quality risk. During periods of
significant interest rate volatility, the underlying mortgages may
prepay more quickly or more slowly than anticipated. If the repayment
of principal occurs earlier than anticipated during periods of declining
interest rates, investment income may decline due to the reinvestment of
these funds at the lower current market rates. In regards to municipal
bonds, the Bloomberg Financial System utilizes optional call dates,
sinking fund requirements and assumes a non-static prepayment pattern in
deriving these averages.
J. Regulation
General
The Company's primary business is subject to extensive regulation
in Massachusetts and California. In Massachusetts the Commissioner who
is appointed by the Governor of Massachusetts, has broad authority to
fix and establish maximum policy rates and minimum agent commission
levels on personal automobile insurance. In addition, the Commissioner
grants and revokes licenses to write insurance, approves policy forms,
sets reserve requirements, determines the form and content of statutory
financial statements and establishes the type and character of portfolio
investments. The Commissioner also approves company submissions
regarding group insurance programs and corresponding discounts along
with SDIP deviations. Consequently, the policies and regulations set by
the Commissioner are an important element of writing insurance in
Massachusetts.
During the three-year period from 1995 to 1997, Massachusetts
personal automobile insurance premium rates decreased an average of 5.6%
per year. The Commissioner approved an average 4.0% decrease in
personal automobile premiums for 1998, the fourth decrease in as many
years, as rates were cut by 6.2%, 4.5% and 6.1% in 1997, 1996 and 1995,
respectively. Coinciding with the 1998 rate decrease, the Commissioner
also approved a 7.4% decrease in commission rates to agents selling
private passenger automobile insurance for 1998. The decision slightly
offsets the financial impact of the average 4.0% decrease in personal
automobile premiums for 1998.
Although personal automobile premium rates decreased on average by
6.2% in 1997, the impact upon the Company resulted in only a 1.8%
decrease in the average personal automobile premium per exposure (each
vehicle insured). The 1.8% decrease for the Company is significantly
less than the average rate decrease of 6.2% due to the fact that the
rate decision did not anticipate purchases of new automobiles in the
year to which the rate decision applies and, secondly, the Company's mix
of personal automobile business differs from that of the industry.
The 1997 and 1998 decreases were partially driven by corrections
for an industry error that had impacted prior year rate decisions. The
industry error, estimated at $200 million, resulted from a
miscalculation of industry expense allowances that had the effect of
overstating rates for 1991 through 1996. Rates for 1997 were adjusted
to recoup an estimated $50 million from the industry. Rates for 1998
and 1999 have and will be adjusted to recoup the remaining amount
estimated to be at $150 million.
26
<page
Additionally, 1997 and 1998 rates were decreased as a result of
the reconciliation of the Safe Driver Insurance Plan ("SDIP") which is
designed to be revenue neutral. In most recent past years, the SDIP
reconciliation resulted in a deficit which was then added into the rates
for the subsequent years. The 1996 SDIP reconciliation, however,
resulted in a surplus. Fifty percent of this surplus was being used to
decrease rates in 1997 and fifty percents is being used in 1998.
The Company had performed an analysis of the 1997 rate decision in
early 1997. The Company estimated the impact of the above two items on
its results assuming its market share remained the same as it was at the
end of 1997. The Company's share of the Massachusetts personal
automobile market increased from 20.8% at the end of 1996 to 21.8% at
the end of 1997. The earned premium impact of the above two items has
been re-estimated at approximately $16.0 million in 1997, $24.1 million
for 1998 and $14.1 million for 1999. The earnings per share after-tax
impact resulting from lower earned premiums was $0.29 for 1997 and is
estimated to be $0.43 and $0.24 for 1998 and 1999, respectively. If the
Company's future market share increases (decreases), a larger (smaller)
financial impact will result.
In June 1997, the Massachusetts Supreme Judicial Court ("Court")
rejected an appeal filed by the Automobile Insurers Bureau of
Massachusetts ("AIB") that challenged the Commissioner's decision to
prospectively decrease future rates for the miscalculation of the
industry expense allowance. (The SDIP reconciliation component was not
challenged.) The AIB's argument was that, according to statute, there
is a prohibition against retroactive rate making in Massachusetts which
effectively bars the examination of past year's data once all involved
parties have agreed to the rate decision. The Court ruled that
retroactive rate making was indeed illegal, but indicated that special
circumstances permitted returning the money in the form of rate
reductions. In a related challenge, the Court rejected on technical
grounds, one insurers claim of an unfair adverse impact related to the
prospective nature of the rate reduction.
The 1998 rate decision also included a 7.4% reduction in agents'
commission rates. Again, as in 1997, companies will calculate
commissions on business subject to safe driver deviations, net of the
deviations. After the 1997 rate decision, a suit was filed by the
Massachusetts Association of Insurance Agents ("MAIA") challenging this
method of calculation. In July 1997, the Court upheld the
Commissioner's ruling that agents' commissions on 1997 premiums, subject
to safe driver deviations, would be based on net premium amounts. The
1996 commissions were based on premium amounts net of group discounts
but gross of safe driver deviations. The Commissioner's ruling resulted
in agents receiving fewer commission dollars on a per policy basis.
The State Divisions of Insurance are responsible for conducting
periodic examinations of insurance companies. Both Commerce and
Citation were last examined for the five year period ended December 31,
1993. Western Pioneer is currently undergoing examination by the
California Division of Insurance for the 5 year period ending December
31, 1996. Western Pioneer was last examined for the three year period
ended December 31, 1991. The concluded examinations produced no
material findings. Massachusetts Division of Insurance regulations
provide that insurance companies will be examined every five years or
more frequently as deemed prudent by the Commissioner. California
Division of Insurance regulations provide that insurance companies will
be examined every three years.
Automobile Insurance Regulation Overview
Massachusetts has required compulsory automobile insurance
coverage since 1925. Under current law, all motorists are required to
carry certain minimum coverages mandated by the state. The Commissioner
fixes and establishes, among other things, the maximum rates insurers
may charge for the compulsory personal automobile coverages. With very
limited exceptions, each insurer writing automobile insurance in
Massachusetts must accept all risks submitted to it for the compulsory
coverage, but is permitted to reinsure these risks (including group
insurance risks) through C.A.R.
27
<page
Compulsory Coverage. Compulsory coverage includes no-fault
coverage, limited bodily injury coverage, property damage coverage and
coverage against uninsured or hit and run motorists. The Massachusetts
no-fault statute provides for personal injury protection ("PIP")
coverage, which entitles a party to be reimbursed directly by the
party's own insurer for certain medical expenses, lost wages and other
defined expenses arising from an automobile accident, up to a specific
amount, even if another party caused the accident.
Rates and Commissions. All Massachusetts personal automobile
insurance rates are fixed and established annually by the Commissioner.
Group insurance programs and rate deviations must be approved by the
Commissioner. For Massachusetts commercial automobile insurance, the
rates for the voluntary market are competitive, with insurers filing
rates for review by the Commissioner based on their own experience. The
rates for the Massachusetts commercial automobile risks reinsured
through C.A.R. are fixed and established by the Commissioner except for
non-fleet, private passenger-type automobiles.
In fixing classifications of risks and establishing rates, the
Commissioner must consider numerous factors including driver and
automobile characteristics and the claim rate in the state's designated
geographical territories. These factors are based upon data which are
two or more years old. The insurer adjusts the premiums it charges to a
policyholder based upon the SDIP record of the operator. Moving
violations and at-fault accidents affect each driver's SDIP record. In
addition, the Extra Risk Rating regulations permit insurers to deny or
charge surcharged rates for physical damage coverage to both high risk
vehicles and insureds with excessive prior loss or violation activity.
The Commissioner sets an average minimum direct agency commission
rate for personal automobile insurance, which in 1997 was 13.9%. With
respect to risks reinsured through C.A.R., the maximum amount of
commissions that C.A.R. will reimburse is fixed at that prescribed rate.
Mandatory Underwriting. Massachusetts law specifies that all
individuals holding a valid driver's license are entitled to purchase
the mandatory automobile insurance coverages regardless of their driving
experience or accident record. The Massachusetts Legislature has also
placed certain restraints on insurers' discretion to refuse to renew
automobile insurance policies. Policyholders are entitled to renew
except in cases of fraud, material misrepresentation, revocation or
suspension of an operator's license or nonpayment of premiums. With
very limited exceptions, Servicing Carriers writing automobile insurance
in Massachusetts must accept every automobile risk submitted to them.
Under the Massachusetts system of rate regulation, it is intended
that some personal automobile insurance risks are underpriced at the
maximum rate permitted by the Commissioner, and therefore, absent state-
intervention, insurers would not ordinarily choose to write those risks.
The C.A.R. reinsurance program described below is intended to mitigate
the burden imposed by the Massachusetts take-all-comers system by
allowing insurers to transfer the exposure for undesirable risks to an
industry pool.
Commonwealth Automobile Reinsurers
General. C.A.R. is a state-mandated reinsurance mechanism, under
which all premiums, expenses and losses on ceded business are shared by
all insurers. It is similar to a joint underwriting association because
a number of insurers (approximately 41, including the Company) act as
Servicing Carriers for the risks it insures.
Agencies. In general, agencies licensed to issue automobile
insurance policies are entitled to be assigned to at least one Servicing
Carrier. There are two categories of agencies: those who have voluntary
agreements with one or more Servicing Carriers and those who do not.
The latter are assigned by C.A.R. to a single Servicing Carrier and are
known as ERPs.
28
<page
C.A.R. Operations. All companies writing automobile insurance in
Massachusetts share in the underwriting results of the C.A.R. business
for their respective product line or lines, whether or not they are
Servicing Carriers. An insurer's share of the C.A.R. deficit is
allocated on the basis of a formula called a participation ratio, which
can vary significantly between the personal and commercial pools, and
between different policy years. See "Business--Commonwealth Automobile
Reinsurers" for a detailed discussion of the method of calculating the
participation ratio.
An insurer may terminate its participation in C.A.R. as of the
close of C.A.R.'s fiscal year by surrendering its license to write
automobile policies in Massachusetts. Termination does not discharge or
otherwise affect liability of an insurer incurred prior to termination.
A withdrawing insurer is assessed a share of C.A.R.'s projected deficits
for future years based on the insurer's prior years' participation in
C.A.R. The assessment paid by the withdrawing insurer is redistributed
to the remaining insurers based upon their participation ratios.
An insurer can transfer its obligations for its personal insurance
policies to another insurer who formally agrees to assume these
obligations. The transferring insurer is thereby relieved of future
C.A.R. obligations which otherwise would have arisen as a consequence of
the business transferred. See "Business--Commonwealth Automobile
Reinsurers."
Insurance Holding Company Structure
As an insurance holding company, the Company is subject to
regulation under the insurance holding company statutes of the states in
which they are domiciled. Because the Company's subsidiaries are
members of an insurance holding company system, they are required to
register with their respective Divisions of Insurance and to submit
reports describing the capital structure, general financial condition,
ownership and management of each insurer and any person or entity
controlling the insurer, the identity of every member of the insurance
holding company system and the material outstanding transactions between
the insurer and its affiliates.
Each member of the insurance holding company system must keep
current the information required to be disclosed by reporting all
material changes or additions within 15 days of the end of the month in
which it learns of such change or addition.
Massachusetts law prohibits a party which is not a domestic
insurer from acquiring "control" of a domestic insurer or of a company
controlling a domestic insurer without prior approval of the
Commissioner. Control is presumed to exist if a party directly or
indirectly holds, owns or controls more than ten percent of the voting
stock of another party, but may be rebutted by a showing that control
does not exist.
In the event of the insolvency, liquidation or other
reorganization of any of the Company's insurance subsidiaries, the
creditors and stockholders of the Company will have no right to proceed
against the assets of those subsidiaries, or to cause the liquidation or
bankruptcy of any company under federal or state bankruptcy laws. State
laws govern such liquidation or rehabilitation proceedings and the
Division of Insurance would act as receiver for the particular company.
Creditors and policyholders of the insurance subsidiaries would be
entitled to payment in full from such assets before the Company, as a
stockholder, would be entitled to receive any distribution therefrom.
Payment of Dividends
Under Massachusetts law, insurers may pay cash dividends only from
earnings and statutory surplus, and the insurer's remaining surplus must
be both reasonable in relation to its outstanding liabilities and
adequate to its financial needs.
29
<page
As Massachusetts domestic insurance companies, neither Commerce
nor Citation may pay an extraordinary dividend or distribution unless
the insurer gives the Commissioner at least 30 days' prior notice of the
declaration and the Commissioner does not disapprove of the plan of
payment prior to the date of such payment. An extraordinary dividend or
distribution is one whose fair market value, together with that of other
dividends or distributions within the preceding twelve-month period
(excluding pro rata distribution of any class of the insurer's own
securities) exceeds the greater of (i) ten percent of the insurer's
statutory surplus as of the preceding December 31 or (ii) the statutory
net income for the twelve-month period ending on the preceding December
31. See "Market for Registrant's Common Stock and Related Stockholder
Matters."
Protection Against Insurer Insolvency
All of the insurers writing the types of insurance covered by The
Massachusetts Insurers Insolvency Fund ("M.I.I.F.") are M.I.I.F.
members. M.I.I.F. is obligated to pay any unpaid claim, up to $300,000,
against an insolvent insurer if the claim existed prior to the
declaration of insolvency or arose within 60 days thereafter. M.I.I.F.
assesses members the amounts necessary to pay both its obligations and
the expenses of handling covered claims. Subject to certain
limitations, assessments are made in the proportion that each member's
net written premiums for the preceding calendar year for all property
and casualty lines of business bore to the corresponding net written
premiums for all members for the same period. The statute that
established M.I.I.F. also provides for the recoupment by insurers of
amounts paid to M.I.I.F. Historically, the Commissioner has allowed
insurers to recoup the amounts they paid M.I.I.F. through rate
increases.
Consistent with industry practice in Massachusetts, it is the
Company's policy to expense all assessments when they are assessed.
M.I.I.F. refunded assessments to Commerce and Citation in the aggregate
amount of $283,000 in 1997. M.I.I.F. assessed Commerce and Citation an
aggregate of $742,000 in 1996 and $338,000 in 1995. The Company
anticipates that there will be additional assessments. By statute, no
insurer may be assessed in any year an amount greater than two percent
of that insurer's net direct written premiums for the calendar year
preceding the assessment. The Company believes that any such additional
assessments should not have a material adverse effect on the
consolidated financial position of the Company, although the timing and
amounts of any such assessments cannot be presently ascertained.
NAIC Guidelines
Insurance Regulatory Information System Ratios. The NAIC
Insurance Regulatory Information System ("IRIS") was developed by a
committee of state insurance regulators and is intended primarily to
assist state insurance regulators in executing their statutory mandates
to oversee the financial condition of insurance companies operating in
their respective states. IRIS identifies eleven industry ratios and
specifies "usual values" for each ratio. Departure from the usual values
on four or more of the ratios can lead to inquiries from individual
state insurance commissioners as to certain aspects of an insurer's
business. For the year ended December 31, 1997, the Company's
consolidated property and casualty operations had no ratios outside the
"normal" range.
Risk-Based Capital ("RBC"). In order to enhance the regulation of
insurer insolvency, the NAIC developed a formula and model law to
implement RBC requirements for property and casualty insurance companies
which are designed to assess capital adequacy and to raise the level of
protection that statutory surplus provides for policyholder obligations.
The RBC model for property and casualty insurance companies measures
three major areas of risk facing property and casualty insurers: (i)
underwriting, which encompasses the risk of adverse loss development and
inadequate pricing; (ii) declines in asset values arising from credit
risk; and (iii) other business risks from investments. Insurers having
less statutory surplus than required by the RBC calculation will be
subject to varying degrees of regulatory action, depending on the level
of capital inadequacy.
30
<page
The Company's subsidiaries, Commerce, Citation, and Western
Pioneer have RBC amounts at December 31, 1997 of $56 million, $2
million, and $3 million, respectively, and they have statutory surplus
of approximately $433 million, $83 million and $24 million,
respectively. The statutory surplus of Commerce, Citation and Western
Pioneer at December 31, 1997 exceeded the RBC Company Action Levels of
$112 million, $5 million and $6 million, respectively, by approximately
$321 million, $78 million and $18 million, respectively. The RBC model
formula proposes four levels of regulatory action. The extent of
regulatory intervention and action increases as the level of surplus to
RBC falls. The first level, the Company Action Level, requires an
insurer to submit a plan of corrective actions to the regulator if
surplus falls below 200% of the RBC amount. The Regulatory Action Level
(as defined by the NAIC) requires an insurer to submit a plan containing
corrective actions and permits the Commissioner to perform an
examination or other analysis and issue a corrective order if surplus
falls below 150% of the RBC amount. The Authorized Control Level (as
defined by the NAIC) allows the regulator to rehabilitate or liquidate
an insurer in addition to the aforementioned actions if surplus falls
below 100% of the RBC amount. The fourth action level is the Mandatory
Control Level (as defined by the NAIC) which requires the regulator to
rehabilitate or liquidate the insurer if surplus falls below 70% of the
RBC amount.
K. Competition
The property and casualty insurance industry is highly cyclical,
characterized by periods of increasing premium rates and limited
underwriting capacity, followed by periods of intensive price
competition and abundant underwriting capacity. This industry also is
highly competitive, with a large number of companies, many of which
operate in more than one state, offering automobile, homeowners,
commercial property and other lines of insurance. Some of the Company's
competitors have larger volumes of business and greater financial
resources. Some sell insurance directly to policyholders rather than
through independent agents.
In 1995, several insurers within the Massachusetts Insurance
Industry began pursuing group marketing as a means of shifting market
share. Arising from this pursuit, additional programs such as safe
driver deviations and the elimination of finance fees have followed. In
March 1997, Commerce was granted approval, for the 1997 calendar year,
to offer safe driver deviations of 10% to customers with SDIP
classifications of either Step 9 or 10. These are the two best SDIP
driver classifications in Massachusetts representing drivers with no at
fault accidents and not more than one minor moving vehicle violation in
the last six years. For drivers that qualified, the Company's
automobile discounts and SDIP deviations could be combined with group
discounts for up to a 19% reduction from the state mandated rates. In
February 1998, approval of SDIP deviations was granted for the 1998
calendar year. However, these discounts are substantially different
from those previously approved. Drivers classified as step 9, the very
best drivers, will receive a discount of 15% in 1998. Those drivers
classified as step 10 will receive a 4% discount. These discounts can
be combined with group discounts for a total discount of up to 23.5% for
some groups in which the general public cannot participate. For the
AAA clubs, the largest group written available to the general public,
the discounts combine to 20.1% for drivers classified as step 9 and
nearly 10% for step 10 drivers.
Because the Company's insurance products are marketed exclusively
through independent agencies--most of whom represent more than one
company--the Company faces competition within each agency. The Company
competes for business within independent agencies by offering a more
attractively priced product to the consumer and by paying agents
significant compensation in the form of commissions and profit sharing
which are based in part on the underwriting profits of the agency
business written with the Company. The Company also provides a
consistent market, the prompt servicing of policyholder claims and
agency support services. Although the Company believes, based upon
regular surveys of its agencies, its relationships with its independent
agencies are excellent, any disruption in these relationships could
adversely affect the Company's business.
31
<page
The Company believes the Massachusetts regulatory environment,
which fixes maximum personal automobile insurance rates, apportions
losses incurred by C.A.R. and establishes minimum agency commissions,
has discouraged certain companies with more diverse geographic markets
and interests from establishing a presence or expanding their market
share in Massachusetts.
L. Other Matters
Human Resources
As of December 31, 1997, the Company and its subsidiaries employed
1,525 people. The Company is not a party to any collective bargaining
agreements and believes its relationship with employees to be good.
The Company offers benefits, compensation and employee relations
programs to assure a productive and positive working environment. The
Company monitors job grades and salary scales of peer companies to
assure that its compensation levels and benefits are competitive both
within the property and casualty industry and geographically within
Central Massachusetts. The Company has been recognized for its
progressive programs designed to meet the needs of a modern-day
workforce. On-site child care has been offered to employees since 1986.
Commerce was one of the first businesses in the region to offer this
benefit. The child care center can currently accommodate over 130
children of our employees with expansion plans to be completed for use
in 1998.
The Company maintains an Employee Stock Ownership Plan
("E.S.O.P."), for the benefit of all employees and former employees
still participating in the E.S.O.P. There were a total of 1,541
participants at December 31, 1997.
ITEM 2. PROPERTIES
The Company conducts its operations from approximately 277,000
square feet of space in several buildings which it owns in Webster,
Massachusetts, which is located approximately 50 miles southwest of
Boston. The Company's principal administrative offices in Webster
consist of recently rehabilitated and newly constructed buildings. Its
data processing and operational departments are housed in modern office
buildings on a separate nine acre site. The Company is presently
constructing a 20,000 square foot child care center located on a
separate 7-acre site in Webster, Massachusetts. The child care center
will enable the Company to serve 200 children of employees. Western
Pioneer currently leases approximately 12,000 square feet of office
space in Pleasanton, California. The Company considers that its
properties are in good condition, are well maintained, and are generally
suitable to carry on the Company's business. For additional information
concerning property, see Note D to the Company's 1997 Consolidated
Financial Statements, which is incorporated herein by reference from
page 34 of the Company's 1997 Annual Report.
ITEM 3. LEGAL PROCEEDINGS
As is common with property and casualty insurance companies, the
Company is a defendant in various legal actions arising from the normal
course of its business, including claims based on Chapter 176D and
Chapter 93A. See "Business - Settlement of Claims". These proceedings
are considered to be ordinary and incidental to operations or without
foundation in fact. Management is of the opinion that these actions
will not have a material adverse effect on the consolidated financial
position of the Company.
32
<page
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders
during the fourth quarter of 1997.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The Company's executive officers are as follows:
<TABLE>
<CAPTION>
Name Age Position with
Company
<S> <C> <C>
Arthur J. Remillard, Jr. 67 Chief Executive Officer,
Director
Gerald Fels 55 Executive Vice
President,
Chief Financial Officer,
Director
Arthur J. Remillard, III 42 Senior Vice President--
Policyholder
Benefits, Assistant
Clerk, Director
Regan P. Remillard 34 Senior Vice President--
General Counsel,
President of Western
Pioneer, Director
David H. Cochrane 44 Senior Vice President--
Underwriting
of Commerce and Citation
Peter J. Dignan 46 Senior Vice President--
Marketing
of Commerce and Citation
Mary M. Fontaine 41 Senior Vice President--
Human Resources
Joyce B. Virostek 55 Senior Vice President--
Management
Information Systems of
Commerce and Citation
</TABLE>
Arthur J. Remillard, Jr. has been the President, Chief Executive
Officer and Chairman of the Board of the Company since 1972 and has been
in the insurance business for more than 30 years. Mr. Remillard, Jr. is
also a member of the Governing Committee, Chairman of the Actuarial
Committee, Vice Chairman of the Governing Committee Review Panel, and is
a member of the Budget and Personnel Committees of C.A.R.
Gerald Fels, a certified public accountant, was elected Executive
Vice President of the Company in 1989. From 1981 to 1989, Mr. Fels had
been Senior Vice President of the Company. Mr. Fels was the Treasurer
of the Company from 1975 to 1995. Mr. Fels has also been Chief
Financial Officer since 1975. Mr. Fels also serves on the C.A.R. Audit
Committee.
Arthur J. Remillard, III was elected Senior Vice President--
Policyholder Benefits in 1988. From 1981 to 1988, Mr. Remillard, III had
been Vice President--Mortgage Operations. In addition, Mr. Remillard,
III has also served on the Board of Governors of the Insurance Fraud
Bureau of the A.I.B. since January, 1991, the C.A.R. Claims Advisory
Committee since June 1990 and the A.I.B. Claims Committee since April
1991.
Regan P. Remillard was elected President of Western Pioneer
Insurance Company in 1996. Mr. Remillard was elected Senior Vice
President--General Counsel in 1995. From 1994 to 1995, Mr. Remillard
was a practicing attorney at Hutchins, Wheeler & Dittmar, a
Massachusetts law firm specializing in corporate law and litigation.
From 1989 to 1993, Mr. Remillard was Government Affairs Monitor of the
Company. Mr. Remillard is a member of the Massachusetts Bar.
33
<page
David H. Cochrane has been the Senior Vice President--Underwriting
of Commerce and Citation since 1988. For approximately four years prior
to that, Mr. Cochrane was the Vice President of Financial Services of
C.A.R. Mr. Cochrane has also served on the C.A.R. Market Review
Committee since 1988.
Peter J. Dignan was elected the Senior Vice President--Marketing
of Commerce and Citation in 1997. From 1989 to 1997, Mr. Dignan was
Vice President--Financial Operations of Commerce and Citation. From
1987 to 1989 Mr. Dignan was Assistant Vice President--Financial
Operations of Commerce and Citation. Mr. Dignan also serves on the
C.A.R. Defaulted Brokers Committee.
Mary M. Fontaine has been the Senior Vice President--Human
Resources of the Company since 1988. From 1982 to 1988, Ms. Fontaine
was Assistant Vice President--Human Resources of Commerce and Citation.
Joyce B. Virostek has been the Senior Vice President--Management
Information Systems of Commerce and Citation since 1988. From 1981 to
1988, Ms. Virostek had been Vice President of Commerce and Citation in
charge of data processing.
The executive officers are elected to hold office until their
successors are elected and qualify.
The only family relationship among the executive officers is that
Arthur J. Remillard, III and Regan P. Remillard are the sons of Arthur
J. Remillard, Jr.
34
<page
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS
The Company's common stock trades on the NYSE, under the symbol
"CGI". The high, low and close prices for shares of the Company's
common stock for 1997 and 1996 were as follows:
<TABLE>
<CAPTION>
1997
1996
High Low Close High
Low Close
<S> <C> <C> <C> <C>
<C> <C>
First Quarter........... $29 $22-7/8 $23-1/4 $20-
3/4 $17-3/4 $19-3/4
Second Quarter.......... 24-3/4 21-3/8 24-5/8 22-
1/2 18-1/2 20-7/8
Third Quarter........... 33-3/8 23-7/8 30-7/8 22-
1/4 20-1/2 22
Fourth Quarter.......... 36 30 32-5/8 25-
3/4 22 25-1/4
</TABLE>
As of March 1, 1998, there were 1,375 stockholders of record of
the Company's Common Stock, not including stock held in "Street Name" or
held in accounts for participants of the Company's Employee Stock
Ownership Plan ("E.S.O.P.").
The Board of Directors of the Company voted to declare four
quarterly dividends to stockholders of record totaling $1.03 per share
and $0.81 per share in 1997 and 1996, respectively. On May 30, 1997,
the Board voted to increase the quarterly stockholder dividend from
$0.25 to $0.26 per share to stockholders of record as of June 6, 1997.
Prior to that declaration, the Company had paid quarterly dividends of
$0.25 per share dating back to May 17, 1996 when the Board voted to
increase the dividend from $0.06 to $0.25 per share.
The purchase of Treasury Stock under the stock buyback program
increased by 20,000 shares during 1997 to 1,957,348 shares at December
31, 1997. The stock buyback program, authorized by the Board in May
1995, enables the Company to purchase up to three million shares of the
Company's common stock. The program is now approximately two-thirds
complete.
A portion of the Company's cash flow consists of dividends
received from CHI, which receives dividends from Commerce and Citation.
The payment of any cash dividends to holders of common stock by the
Company therefore depends on the receipt of dividend payments from CHI.
To the extent Commerce and Citation are restricted from paying dividends
to CHI, CHI will be limited in its ability to pay dividends to the
Company. The payment of dividends by Commerce and Citation is subject
to limitations imposed by Massachusetts law, as discussed under the
caption "Payment of Dividends" in Item 1J of this report.
ITEM 6. SELECTED FINANCIAL DATA
The five-year financial information under the caption "Selected
Consolidated Financial Data" on page 45 of the Company's 1997 Annual
Report is incorporated herein by reference.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The information on pages 4 through 18 of the Company's 1997 Annual
Report is incorporated herein by reference.
35
<page
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's Consolidated Financial Statements for the years
ended December 31, 1997, 1996 and 1995 and the report of its independent
auditors on pages 20 through 44 of the Company's 1997 Annual Report are
incorporated herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH INDEPENDENT AUDITORS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
The disclosure called for by this paragraph was previously
reported (as that term is defined in Rule 126-2 under the Securities
Exchange Act of 1934) in a Form 8-K/A filed by the Company with the
Securities and Exchange Commission on June 11, 1997.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information called for by this Item and not provided in Item
4A will be contained in the Company's Proxy Statement which the Company
intends to file within 120 days after the end of the Company's fiscal
year ended December 31, 1997 and such information is incorporated herein
by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information called for by this Item will be contained in the
Company's Proxy Statement which the Company intends to file within 120
days after the end of the Company's fiscal year ended December 31, 1997
and such information is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information called for by this Item will be contained in the
Company's Proxy Statement which the Company intends to file within 120
days after the end of the Company's fiscal year ended December 31, 1997
and such information is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for by this Item will be contained in the
Company's Proxy Statement which the Company intends to file within 120
days after the end of the Company's fiscal year ended December 31, 1997
and such information is incorporated herein by reference.
36
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
<TABLE>
<CAPTION>
Page
<S><C> <C>
<C>
A. (1) The following financial statements have been incorporated
herein by reference
from the pages indicated below of the Company's 1997 Annual
Report:
Report of Independent
Auditors................................... 20
Consolidated Balance Sheets as of December 31, 1997 and
1996..... 21
Consolidated Statements of Earnings for the years ended
December 31, 1997, 1996 and
1995................................ 22
Consolidated Statements of Stockholders' Equity for the
years
ended December 31, 1997, 1996 and
1995.......................... 23
Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1996 and
1995................................ 24
Consolidated Statements of Cash Flows - Reconciliation of
Net
Income to Net Cash provided by Operating Activities for
the
years ended December 31, 1997, 1996 and
1995.................... 25
Notes to Consolidated Financial
Statements....................... 26
(2) The financial statement schedules are listed in the Index
to Consolidated
Financial Statement Schedules.
(3) The exhibits are listed in the Index to Exhibits.
B. During the quarter ended June 30, 1997, the Company filed a
Form 8-K/A dated June 11, 1997 reporting a change in the
Company's independent auditors. Effective on that date,
the Company engaged the auditing firm Ernst & Young LLP as
independent auditors for the fiscal year ending December
31, 1997. The responsibilities of Coopers & Lybrand
L.L.P. were terminated effective June 11, 1997.
</TABLE>
37
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant has duly caused this
report to be signed on its behalf by the undersigned, thereunto duly
authorized.
Dated: March 27, 1998
THE COMMERCE GROUP, INC.
By
ARTHUR J.
REMILLARD, JR.
(Arthur J.
Remillard, Jr.)
(President, Chief Executive
Officer and Director)
Pursuant to the requirements of the Securities Exchange Act of
1934, this report has been signed by the following persons on behalf of
the registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signature Title
<S> <C>
ARTHUR J. REMILLARD, JR. President, Chief
Executive Officer and (Arthur J. Remillard, Jr.)
Director
GERALD FELS Executive Vice
President, Chief Financial
(Gerald Fels) Officer and Director
ARTHUR J. REMILLARD, III Senior Vice President--
Policyholder (Arthur J. Remillard, III)
Benefits, Assistant Clerk and Director
REGAN P. REMILLARD Senior Vice President --
General Counsel, (Regan P. Remillard) President of
Western Pioneer and Director
JOHN W. SPILLANE Clerk and Director
(John W. Spillane)
RANDALL V. BECKER Treasurer and Chief
Accounting Officer
(Randall V. Becker)
HERMAN F. BECKER Director
(Herman F. Becker)
JOSEPH A. BORSKI, JR. Director
(Joseph A. Borski, Jr.)
Director
(Eric G. Butler)
HENRY J. CAMOSSE Director
(Henry J. Camosse)
38
<PAGE>
DAVID R. GRENON Director
(David R. Grenon)
ROBERT W. HARRIS Director
(Robert W. Harris)
ROBERT S. HOWLAND Director
(Robert W. Howland)
JOHN J. KUNKEL Director
(John J. Kunkel)
RAYMOND J. LAURING Director
(Raymond J. Lauring)
Director
(Roger E. Lavoie)
NORMAND R. MAROIS Director
(Normand R. Marois)
SURYAKANT M. PATEL Director
(Suryakant M. Patel)
ANTRANIG A. SAHAGIAN Director
(Antranig A. Sahagian)
GURBACHAN SINGH Director
(Gurbachan Singh)
</TABLE>
39
<page
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENT SCHEDULES*
<TABLE>
<CAPTION>
Page
<S>
<C>
Ernst & Young LLP Consent of Independent Auditors on Financial
Statement
Schedules.........................................................
41
Coopers & Lybrand, L.L.P. Report of Independent Accountants on
Financial Statement
Schedules............................................... 42
</TABLE>
Schedules
<TABLE>
<CAPTION>
<S> <C>
<C>
II Condensed Financial Information of the Registrant as of and
for the
years ended December 31, 1997, 1996 and
1995...................... 43
III Supplementary Insurance Information for the years ended
December 31, 1997, 1996 and
1995.................................. 48
IV Reinsurance for the years ended December 31, 1997, 1996 and
1995... 49
V Valuation and Qualifying Accounts for the years ended
December 31, 1997, 1996 and
1995.................................. 50
X Supplemental Information Concerning Property-Casualty
Insurance
Operations for the years ended December 31, 1997, 1996 and
1995... 51
</TABLE>
* Financial statement schedules other than those listed are omitted
because they are not required, not applicable or the required
information has been included elsewhere.
40
<page
CONSENT OF INDEPENDENT AUDITORS
ON FINANCIAL STATEMENT SCHEDULES
To the Board of Directors and Stockholders of
The Commerce Group, Inc.
We consent to the incorporation by reference in this Annual Report (Form
10-K) of The Commerce Group, Inc. of our report dated January 23, 1998,
included in the 1997 Annual Report of Stockholders of The Commerce
Group, Inc.
Our audit also included the 1997 financial statement schedules of The
Commerce Group, Inc. listed in Item 14. The accompanying financial
statement schedules for each of the two years in the period ended
December 31, 1996, were audited by other auditors whose report dated
January 24, 1997, expressed an unqualified opinion on those schedules.
These schedules are the responsibility of the Company's management. Our
responsibility is to express an opinion based on our audit. In our
opinion, the 1997 financial statement schedules referred to above, when
considered in relation to the basic financial statements taken as a
whole, present fairly in all material respects the information set forth
therein.
ERNST & YOUNG LLP
Boston, Massachusetts
January 23, 1998
41
<page
REPORT OF INDEPENDENT ACCOUNTANTS
ON FINANCIAL STATEMENT SCHEDULES
To the Board of Directors and Stockholders of
The Commerce Group, Inc.
Our report on the consolidated financial statements of The
Commerce Group, Inc. and Subsidiaries as of December 31, 1996, and for
each of the two years in the period ended December 31, 1996, has been
incorporated by reference in this Form 10-K from Page 18 of the 1996
Annual Report to Stockholders of The Commerce Group, Inc. In connection
with our audits of such financial statements, we have also audited the
related financial statement schedules as of December 31, 1996 and for
each of the two years in the period ended December 31, 1996, listed in
the index on Page 40 of this Form 10-K.
In our opinion, the financial statement schedules referred to
above, when considered in relation to the basic financial statements
taken as a whole, present fairly, in all material respects, the
information required to be included therein.
COOPERS & LYBRAND L.L.P.
Boston, Massachusetts
January 24, 1997
42
<page
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
SCHEDULE II
CONDENSED FINANCIAL INFORMATION
THE COMMERCE GROUP, INC.
(Parent Company Only)
BALANCE SHEETS
December 31,
(Thousands of Dollars)
1997
1996 1995
ASSETS
<TABLE>
<CAPTION>
<S> <C>
<C> <C>
Investments:
Investment in Commerce Holdings, Inc................... $610,854
$551,490 $513,966
Investment in Bay Finance Company, Inc................. 23,750
33,061 30,932
Investment in the Clark-Prout Insurance Agency, Inc.... 566
1,282 1,156
Other investments...................................... -
2,000 1,300
Total investments.................................. 635,170
587,833 547,354
Cash and cash equivalents................................ 2
2 6
Property and equipment, net of accumulated depreciation.. 1,368
1,345 1,465
Receivable from affiliates............................... 30,395
3,767 5,746
Current income taxes..................................... 7,682
3,468 1,459
Other assets............................................. 4,628
2,411 1,811
Total assets....................................... $679,245
$598,826 $557,841
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Accounts payable and accrued expenses.................. $ 23,428
$ 9,506 $ 5,096
Deferred income taxes.................................. 4,691
1,831 752
Other liabilities...................................... 1,330
450 2,279
Total liabilities.................................. 29,449
11,787 8,127
Stockholders' equity:
Capital stock:
Common stock......................................... 19,000
19,000 19,000
Paid-in capital........................................ 29,621
29,621 29,621
Retained earnings...................................... 639,862
576,618 525,452
688,483
625,239 574,073
Treasury stock, 1,957,348, 1,937,348 and 1,263,433
shares in 1997, 1996 and 1995, at cost................. (38,687)
(38,200) (24,359)
Total stockholders' equity......................... 649,796
587,039 549,714
Total liabilities and stockholders' equity......... $679,245
$598,826 $557,841
</TABLE>
The accompanying notes are an integral part of these condensed financial
statements.
43
<page
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
SCHEDULE II
(continued)
CONDENSED FINANCIAL INFORMATION
THE COMMERCE GROUP, INC.
(Parent Company Only)
STATEMENTS OF EARNINGS
Years ended December 31,
(Thousands of Dollars)
1997
1996 1995
<TABLE>
<CAPTION>
<S> <C>
<C> <C>
Revenues
Dividends received from subsidiaries................... $ 47,105
$ 43,470 $ 34,650
Rent income............................................ 397
357 287
Investment income...................................... -
8 11
Total revenues...................................... 47,502
43,835 34,948
Expenses
Depreciation........................................... 242
257 157
Administrative expenses................................ 11,933
5,698 3,571
Total expenses...................................... 12,175
5,955 3,728
Earnings before income tax benefits and equity in
net earnings of subsidiaries over amounts distributed... 35,327
37,880 31,220
Income tax benefits...................................... (5,063)
(2,880) (1,211)
Earnings before equity in net earnings of subsidiaries
over amounts distributed................................ 40,390
40,760 32,431
Equity in net earnings of subsidiaries over amounts
distributed............................................. 55,825
33,204 77,770
Net earnings........................................ $ 96,215
$ 73,964 $110,201
</TABLE>
The accompanying notes are an integral part of these condensed financial
statements.
44
<page
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
SCHEDULE II
(continued)
CONDENSED FINANCIAL INFORMATION
THE COMMERCE GROUP, INC.
(Parent Company Only)
STATEMENTS OF CASH FLOWS
Years ended December 31,
(Thousands of Dollars)
1997
1996 1995
<TABLE>
<CAPTION>
<S> <C>
<C> <C>
Cash flows from operating activities:
Net earnings............................................ $ 96,215
$ 73,964 $110,201
Adjustments to reconcile net earnings to net cash
provided by operating activities:
Dividends received from consolidated subsidiaries..... 47,105
43,470 34,650
Equity in earnings of consolidated subsidiaries....... (102,930)
(76,674) (112,420)
Depreciation and amortization......................... 242
257 157
Other liabilities and accrued expenses................ 25,226
1,281 1,990
Balances with affiliates.............................. (26,628)
1,979 (361)
Income taxes benefits................................. (1,354)
(930) (1,187)
Other--net............................................ (49)
(83) (185)
Net cash provided by operating activities........... 37,827
43,264 32,845
Cash flows from investing activities:
Purchase of property and equipment for company use...... (344)
(186) (285)
Proceeds from sale of property and equipment............ 128
132 298
Net cash provided by (used in) investing activities. (216)
(54) 13
Cash flows from financing activities:
Dividends paid to stockholders.......................... (37,124)
(29,373) (8,635)
Purchase of treasury stock.............................. (487)
(13,841) (24,359)
Net cash used in financing activities............... (37,611)
(43,214) (32,994)
Decrease in cash and cash equivalents..................... -
(4) (136)
Cash and cash equivalents at beginning of year............ 2
6 142
Cash and cash equivalents at end of year.................. $ 2
$ 2 $ 6
</TABLE>
The accompanying notes are an integral part of these condensed financial
statements.
45
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
SCHEDULE II
(continued)
CONDENSED FINANCIAL INFORMATION
THE COMMERCE GROUP, INC.
(Parent Company Only)
NOTES TO CONDENSED FINANCIAL STATEMENTS
(Thousands of Dollars)
The accompanying condensed financial statements should be read in
conjunction with the Consolidated Financial Statements and the
accompanying notes thereto in the Annual Report.
NOTE A--Dividends
The amounts of cash dividends paid to The Commerce Group, Inc.
(Parent only) were as follows:
<TABLE>
<CAPTION>
1997
1996 1995
<S> <C>
<C> <C>
Consolidated insurance subsidiaries................. $47,105
$43,470 $34,650
</TABLE>
See Note K to the Consolidated Financial Statements in the Annual
Report for a description of dividend restrictions applicable to the
Company's subsidiaries.
NOTE B--Federal Income Tax Allocation
As a member of a consolidated group for tax purposes, the Company
and its subsidiaries (said parties constituting an "Affiliated Group" as
defined in and for purposes of the Internal Revenue Code) are jointly
and severally liable for federal income taxes of the Affiliated Group
and have entered into an agreement establishing an allocation of tax
liability and for compensation of the respective members of the
Affiliated Group for use of their tax losses and credits.
The method of allocation, as approved by the Board of Directors,
calls for current taxes to be allocated among all affiliated companies
based on a written tax-sharing agreement. Under this agreement,
allocation is made primarily on a separate return basis with current
payment for losses and other tax items utilized in the consolidated
return. However, to the extent that a payor member of the group has
future net operating losses which it cannot absorb in the year incurred,
other members within the group will refund payments to the payor.
46
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
SCHEDULE II
(continued)
CONDENSED FINANCIAL INFORMATION
THE COMMERCE GROUP, INC.
(Parent Company Only)
NOTES TO CONDENSED FINANCIAL STATEMENTS
(Thousands of Dollars)
NOTE C--Consolidated Financial Statements
In preparing the consolidated financial statements of the Company
and its subsidiaries, the following amounts have been eliminated:
<TABLE>
<CAPTION>
At December 31,
Balance Sheet 1997 1996 1995
<S> <C> <C> <C>
Investment in subsidiaries......... $635,170 $585,833 $546,054
Receivable from affiliates......... 30,395 3,767 5,746
Years Ended December 31,
Statement of Earnings 1997 1996 1995
Dividends from subsidiaries........ $ 47,105 $ 43,470 $ 34,650
Rent income........................ 397 357 287
</TABLE>
47
<page
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
SCHEDULE III
SUPPLEMENTARY INSURANCE INFORMATION
Years Ended December 31, 1997, 1996 and 1995
(Thousands of Dollars)
<TABLE>
<CAPTION>
Future
Policy
Other Benefits, Amortization
Deferred Benefits,
Policy Claims, of Deferred
Policy Claims and
Claims and Net Losses and Policy Other Net
Acquisition Loss Unearned
Benefits Premium Investment Settlement Acquisition Operating
Premiums
Segment Costs Expenses
Premiums Payable Revenue Income(1) Expenses Costs
Expenses Written
<S> <C> <C>
<C> <C> <C> <C> <C> <C>
<C> <C>
1997
Property and casualty insurance.......... $ 85,264 $649,473
$379,599 None $730,497 $ 72,963 $526,127 $187,491
NONE $741,501
Real estate and commercial lending....... - -
- - - 4,448 - -
- -
Corporate and other...................... - -
- - - 3,383 - -
- -
Total.............................. $ 85,264 $649,473
$379,599 $730,497 $ 80,794 $526,127 $187,491
$741,501
1996
Property and casualty insurance.......... $ 82,968 $662,832
$367,991 None $668,716 $ 69,852 $475,231 $181,013
NONE $711,570
Real estate and commercial lending....... - -
- - - 4,249 - -
- -
Corporate and other...................... - -
- - - 3,301 - -
- -
Total.............................. $ 82,968 $662,832
$367,991 $668,716 $ 77,402 $475,231 $181,013
$711,570
1995
Property and casualty insurance.......... $ 67,160 $626,029
$330,454 None $592,590 $ 64,495 $367,552 $166,741 NONE
$603,421
Real estate and commercial lending....... - -
- - - 3,804 - -
- -
Corporate and other...................... - -
- - - 3,014 -
- -
Total.............................. $ 67,160 $626,029
$330,454 $592,590 $ 71,313 $367,552 $166,741
$603,421
</TABLE>
(1) The allocation of net investment income is based upon the specific
identification of activity within the various segments.
<page
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
SCHEDULE IV
REINSURANCE
Years Ended December 31, 1997, 1996 and 1995
(Thousands of Dollars)
<TABLE>
<CAPTION>
Assumed
Percentage
Ceded to From
of Amount
Gross Other
Other Net Assumed
Insurance Premiums Earned Amount Companies
Companies Amount to Net
<S> <C> <C> <C>
<C> <C>
1997
Property and casualty insurance.. $753,184 $105,824 $ 83,137
$730,497 11.4%
1996
Property and casualty insurance.. $698,290 $122,238 $ 92,664
$668,716 13.9%
1995
Property and casualty insurance.. $622,455 $120,720 $ 90,855
$592,590 15.3%
</TABLE>
49
<page
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
SCHEDULE V
VALUATION AND QUALIFYING ACCOUNTS
Years Ended December 31, 1997, 1996 and 1995
(Thousands of Dollars)
<TABLE>
<CAPTION>
Net
addition
(reduction)
Balance charged to
Balance
beginning costs and
at end
of year expenses
Deductions(1) of year
<S> <C> <C> <C>
<C>
1997
Allowance for losses on mortgage loans
and collateral notes receivable........ $2,760 $ 52 $
- - $2,812
Allowance for doubtful premium
receivables............................ $1,500 $1,645
$(1,694) $1,451
1996
Allowance for losses on mortgage loans
and collateral notes receivable........ $3,173 $ (413) $
- - $2,760
Allowance for doubtful premium
receivables............................ $1,103 $1,942
$(1,545) $1,500
1995
Allowance for losses on mortgage loans
and collateral notes receivable........ $3,324 $ (151) $
- - $3,173
Allowance for doubtful premium
receivables............................ $1,120 $ 136 $
(153) $1,103
</TABLE>
(1) Deductions represent net write-offs of amounts determined to be
uncollectible.
50
<page
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
SCHEDULE X
SUPPLEMENTAL INFORMATION CONCERNING
PROPERTY-CASUALTY INSURANCE OPERATIONS
Years Ended December 31, 1997, 1996 and 1995
(Thousands of Dollars)
<TABLE>
<CAPTION>
Claims and Claim
Paid
Adjustment Expenses
Claims
Affiliation Incurred Related to
and Claim
with Current Prior
Adjustment
Registrant Year Years
Expenses
<S> <C> <C>
<C>
1997
Consolidated property-casualty entities...... $609,930 $(83,803)
$530,030
1996
Consolidated property-casualty entities...... $562,997 $(87,766)
$435,162
1995
Consolidated property-casualty entities...... $442,027 $(74,475)
$329,101
</TABLE>
51
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
INDEX TO EXHIBITS(A)
Exhibit
Number Title
3.1 Articles of Organization, as amended(B)
3.2 By-Laws(B)
4 Stock Certificate(B)
10.1 Loan Agreement, Mortgage and Assignment and Trust Agreement
dated February 20,
1981 between Town of Webster, The Commerce Insurance Company
and Mechanics Bank,
as Trustee(B)
10.2 First Supplemental Loan Agreement, Mortgage, Assignment and
Trust Agreement
dated as of August 1, 1984 between Town of Webster, The
Commerce Insurance
Company and Mechanics Bank as Trustee(B)
10.3 Second Supplemental Loan Agreement, Mortgage, Assignment and
Trust Agreement
dated as of October 1, 1985 between Town of Webster, The
Commerce Insurance
Company and Mechanics Bank as Trustee(B)
10.4 Loan Agreement dated December 4, 1985 among Bay Finance
Company, Inc., The
Commerce Group, Inc. and The First National Bank of Boston,
as modified by
Modification No. 1 dated December 18, 1986(B)
10.4A Loan Agreement dated December 4, 1985 among Bay Finance
Company, Inc., The
Commerce Group, Inc. and The First National Bank of Boston,
as modified by
Modification No. 2 dated March 18, 1988(C)
10.5 Loan Agreement dated December 18, 1986 between The Commerce
Group, Inc. and
The First National Bank of Boston(B)
10.6* Form of Stock-Appreciation Right Agreement(B)
10.7* 1996 Stock-Appreciation Right and Book Value Award Agreement
as amended. (G)
10.8* 1994 Management Incentive Plan(F)
10.9 Property Combination Reinsurance Agreement(F)
10.10 Owner-Contractor Agreement dated April 20, 1988 between The
Commerce Group,
Inc. and Lauring Construction Co., Inc.(D)
10.11 Asset Transfer Agreement between Commerce Insurance and
Providence Washington
Insurance Company dated December 23, 1991.(E)
10.12 Asset and Liability Transfer Agreement between Commerce
Insurance and
American Hardware Mutual Insurance Company and American
Merchants Casualty
Company dated November 8, 1991.(E)
10.13 Asset Transfer Agreement between Commerce Insurance and The
Continental
Insurance Company dated October 24, 1991.(E)
52
<page
10.14 Asset Transfer Agreement between Commerce Insurance and Home
Insurance
Company dated October 3, 1991.(E)
10.15 Asset and Liability Transfer Agreement between Commerce
Insurance and New
Hampshire Insurance Company dated August 12, 1991.(E)
10.16 Asset Transfer Agreement between Commerce Insurance, Utica
Mutual Insurance
Company and Graphic Arts Mutual Insurance Company dated June
24, 1991.(E)
13.1 Annual Report for the year ended December 31, 1997 to
Security Holders.
22.1 Subsidiaries of the Registrant filed herewith.
24.1 Power of Attorney(B)
(A) Exhibits other than those listed are omitted because they are not
required or are not
applicable. Copies of exhibits are available without charge by
writing to the Assistant
to the President at 211 Main Street, Webster, MA 01570.
(B) Incorporated herein by reference to the exhibit with the same
exhibit number, filed as
an exhibit to the Registrant's Registration Statement on Form S-18
(No. 33-12533-B).
(C) Incorporated herein by reference to the exhibit with the same
exhibit number, filed as
an exhibit to the Registrant's Registration Statement on Form 8-A.
(D) Incorporated herein by reference to the exhibit with the same
exhibit number, filed as
an exhibit to the Registrant's Form 10-K for the year ended December
31, 1988.
(E) Incorporated herein by reference to the exhibit with the same
exhibit number, filed as
an exhibit to the Registrant's Form 10-K for the year ended December
31, 1993.
(F) Incorporated herein by reference to the exhibit with the same
exhibit number, filed as
an exhibit to the Registrant's Form 10-K for the year ended December
31, 1994.
(G) Incorporated herein by reference to the exhibit with the same
exhibit number, filed as
an exhibit to the Registrant's Form 10-Q for the period ended
September 30, 1997.
* Denotes management contract or compensation plan or arrangement.
53
<page
1997
annual
report
The
CGI
The Commerce Group, Inc.
211 Main Street, Webster, Massachusetts 01570
<PAGE
INDEX TO 1997 ANNUAL REPORT
<TABLE>
<CAPTION>
Page
<S> <C>
Financial Highlights............................................ 1
Letter to Stockholders.......................................... 2
Management's Discussion and Analysis of Financial Condition
and Results of Operations...................................... 4
Common Stock Price and Dividend Information..................... 17
Report of Management............................................ 19
Report of Independent Auditors.................................. 20
Consolidated Balance Sheets at December 31, 1997 and 1996....... 21
Consolidated Statements of Earnings for the Years Ended
December 31, 1997, 1996 and 1995............................... 22
Consolidated Statements of Stockholders' Equity for the Years
Ended December 31, 1997, 1996 and 1995......................... 23
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1997, 1996 and 1995............................... 24
Consolidated Statements of Cash Flows - Reconciliation of Net
Income to Net Cash Provided by Operating Activities for the
years ended December 31, 1997, 1996 and 1995................... 25
Notes to Consolidated Financial Statements...................... 26
Selected Consolidated Financial Data............................ 45
Management's Discussion of Supplemental Information on
Insurance Operations........................................... 46
Directors....................................................... 51
Officers........................................................ 53
Stockholder Information......................................... 54
</TABLE>
<PAGE
FINANCIAL HIGHLIGHTS
(Dollars in Thousands, Except Per Share Amounts)
<TABLE>
<CAPTION>
1997 1996
1995
<S> <C> <C>
<C>
Net premiums written............................ $ 741,501 $
711,570 $ 603,421
Earned premiums................................. $ 730,497 $
668,716 $ 592,590
Net investment income........................... 80,794
77,402 71,313
Premium finance fees............................ 7,074
9,713 19,420
Net realized investment gains (losses).......... 22,770
(7,574) 712
Total revenues............................ $ 841,135 $
748,257 $ 684,035
Earnings before income taxes.................... $ 127,517 $
92,013 $ 149,742
Income taxes.................................... 31,302
18,049 39,541
Net earnings.............................. $ 96,215 $
73,964 $ 110,201
Basic and diluted net earnings per common share. $ 2.67 $
2.04 $ 2.93
Cash dividends paid per share................... $ 1.03 $
0.81 $ 0.23
Weighted average number of common shares
outstanding................................... 36,044,679
36,311,887 37,632,236
Total investments at market value............... $1,242,695
$1,167,671 $1,096,778
Total assets.................................... 1,754,753
1,676,799 1,564,175
Total liabilities............................... 1,104,957
1,089,760 1,014,461
Total stockholders' equity...................... 649,796
587,039 549,714
Total stockholders' equity per share............ 18.03
16.28 14.96
Certain Statutory Financial Ratios (Unaudited):
Loss and LAE ratio............................ 71.4%
70.9% 62.0%
Underwriting expense ratio.................... 25.1
27.1 29.0
Combined ratio............................ 96.5%
98.0% 91.0%
Net premiums written to policyholders'
surplus..................................... 143.3%
153.1% 137.1%
</TABLE>
1
<PAGE
THE COMMERCE GROUP, INC.
March 27, 1998
To Our Stockholders:
In 1997, your Company experienced satisfactory financial results
for the 22nd consecutive year. From the very first day the funding of
The Commerce Insurance Company was accomplished (April 3, 1972) through
December 31, 1997, we have achieved underwriting profit of $228.5
million on total premiums written of $6.0 billion. This underwriting
profit represents 3.8% of total premiums written. These results stand
out in a year that continued to witness changes in the nature and source
of competition within the insurance marketplace.
In 1998, the Massachusetts personal automobile insurance industry
saw state-mandated auto insurance rates drop again for the fourth
consecutive year this past January. Coupled with affinity group
marketing programs and safe driver rate deviations, the Massachusetts
marketplace continues in a highly competitive mode. Through these
evolving conditions, your Company saw its share of the Massachusetts
personal automobile market increase to 21.8% in 1997 versus 20.8% at the
end of 1996.
In California, Western Pioneer Insurance Company has completed its
second full year as a subsidiary of The Commerce Insurance Company with
improved profitability and a bright future. Plans have been implemented
to strengthen the agency force along with establishing an attractive and
competitive rate structure.
As we look to the future, your Company has begun writing insurance
in the state of Rhode Island in January 1998 and maintains licenses to
operate in the states of Connecticut, Maine, New Hampshire and Vermont.
With the use of new technologies, upgraded internal operating systems
and the continued monitoring of acquisition opportunities, we are
realizing our vision of expansion.
Through it all, your Company has continued to grow and prosper.
The Commerce Insurance Company continues to be the largest writer of
Massachusetts private passenger automobile insurance, as well as the
second largest writer of Massachusetts homeowners insurance. Written
premiums, earned premiums, investment income, total assets, total
stockholders' equity and total stockholders' equity per share, as
illustrated in the bar graph on the facing page, are all at new highs.
For those of you who are interested in the details, I draw your
attention to the pages in this report labeled "Management's Discussion
and Analysis of Financial Condition and Results of Operations". Behind
these numbers are an extremely dedicated group of people, both in
Massachusetts and California: Our Policyholders (represented by over
771,000 policies in force); Agents (692); Employees (1,495); Officers
(31); Directors (19); and of course, our Stockholders (over 4,300, not
including our Employee Stock Ownership Plan participants who now number
1,541).
Property-liability insurance remains a good business to be in--and
The Commerce Group, Inc. will continue its efforts to be one of the most
profitable long-term players. Your Company's management continues to
believe that owners' interests are its primary constituency.
Our sincere thanks to those who have helped in this building
process--especially our Agents, Employees, Officers and Board of
Directors. This diverse force of committed, ethical and hard working
people will continue to build on our past successes and look to the
future with excitement and opportunity. Their individual creativity,
energy and professionalism will continue to serve our shareholders well.
Your comments or questions regarding this report, or The Commerce
Group, Inc. affairs in general, are solicited as always, at any time.
Arthur J.
Remillard, Jr.
President
Caring in everything we do.
2
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The bar graph on page 3 illustrates the Company's annual total
stockholders' equity per share value and annual total stockholders'
equity per share value including cumulative cash dividends paid per
share on December 31, over the most recent fifteen year period. The X
axis lists the years beginning with 1983 through 1997. The Y axis lists
the dollar values starting at $0.00 and increasing in one dollar
increments to $21.00. The graph depicts a total stockholders' equity
per share value in 1983 of $0.50; 1984 of $0.67, 1985 of $0.81, 1986 of
$0.95, 1987 of $1.40, 1988 of $1.95, 1989 of $2.53, 1990 of $3.36, 1991
of $4.80, 1992 of $7.42, 1993 of $10.09, 1994 of $10.88, 1995 of $14.96,
1996 of $16.28 and 1997 of $18.03. The graph also depicts the total
stockholders' equity per share value including cumulative dividends paid
per share in 1984 of $0.67, 1985 of $0.81, 1986 of $0.95, 1987 of $1.40,
1988 of $1.95, 1989 of $2.53, 1990 of $3.36, 1991 of $4.80, 1992 of
$7.42, 1993 of $10.09, 1994 of $11.03, 1995 of $15.34, 1996 of $17.47
and 1997 of $20.25.
3
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Thousands of Dollars Except Per Share Data)
General
The property and casualty industry has been and remains highly
cyclical in nature. The financial results of property and casualty
insurance companies are impacted by many forces unique to the market.
Market forces include competition, frequency and severity of losses
resulting from weather conditions, the state of the economy and the
general regulatory environment in those states in which the insurer
operates. During 1997, the industry experienced strong underwriting
results, despite slower premium growth as compared to 1996. The strong
underwriting results were attributable to the absence of severe weather,
improved cost management, safer cars and highways and increased drunk
driver awareness. The improved industry results have intensified
competition among insurers, which when coupled with lower rates,
emphasizes the advantages of operating efficiently. The Commerce Group,
Inc. ("Company") is well positioned to both lead in this environment and
to respond to these prevailing conditions in the market.
The Company, incorporated in 1976, is a regional property and
casualty insurer which, through its subsidiaries, offers predominantly
motor vehicle insurance, covering personal automobiles, in addition to a
broad range of other property and casualty insurance products. These
products are marketed to groups, individuals, families and businesses
through the Company's strong relationships with professional independent
insurance agencies. The Company writes insurance primarily in the state
of Massachusetts through The Commerce Insurance Company ("Commerce") and
Citation Insurance Company ("Citation"), both wholly-owned subsidiaries
of Commerce Holdings, Inc. ("CHI"). The Company also writes insurance
in the state of California through Western Pioneer Insurance Company
("Western Pioneer"), a wholly-owned subsidiary of Commerce.
The Company's business strategy remains focused on activities
primarily related to personal automobile insurance in the states of
Massachusetts and California. The Company has been the largest writer
of personal property and casualty insurance in the state of
Massachusetts in terms of market share of direct premiums written since
1990. The Company's share of the Massachusetts personal automobile
market increased in 1997 to approximately 21.8% from 20.8% in 1996. In
addition to Massachusetts and California, the Company is newly licensed
in the states of Connecticut, Maine, New Hampshire, Rhode Island and
Vermont. The Company began writing in Rhode Island in January 1998 and
is gearing internal operating systems to accommodate the remaining New
England states in the future.
During 1997, direct premiums written totalled $768,649, a 5.0%
increase over 1996. Direct premiums written in Massachusetts, written
through Commerce and Citation amounted to $741,163. Direct premiums
written in California, through Western Pioneer, amounted to $27,486. Of
the total direct premiums written, direct personal automobile premiums
written during 1997 totalled $661,077, an increase of 6.1% over 1996,
and direct homeowners insurance premiums written totalled $54,256, an
increase of 3.6% over 1996. The Company is also the fourth largest
writer of commercial automobile insurance in Massachusetts based on
direct premiums written. During 1997, direct commercial automobile
premiums written totalled $37,075, an 8.3% decrease compared to 1996.
Personal automobile insurance is subject to extensive regulation
in Massachusetts and California. Every owner of a registered automobile
is required to maintain certain minimum automobile insurance coverages.
In Massachusetts, with very limited exceptions, automobile insurers are
required by law to issue a policy to any applicant seeking to obtain
such coverages. Marketing and underwriting strategies for companies
operating in Massachusetts are limited by maximum automobile premium
rates and minimum agency commission levels for personal automobile
insurance which are mandated by the Massachusetts Commissioner of
Insurance ("Commissioner"). In Massachusetts, accident rates, bodily
injury claims, and medical care costs continue to be among the highest
in the nation.
4
<PAGE
During the three-year period from 1995 to 1997, Massachusetts
personal automobile insurance premium rates decreased an average of 5.6%
per year. The Commissioner approved an average 4.0% decrease in
personal automobile premiums for 1998, the fourth decrease in as many
years. Rates decreased 6.2%, 4.5% and 6.1% in 1997, 1996 and 1995,
respectively. Coinciding with the 1998 rate decrease, the Commissioner
also approved a 7.4% decrease in the commissions agents receive from
selling private passenger automobile insurance for 1998. The decision
slightly offsets the financial impact of the average 4.0% decrease in
personal automobile premiums for 1998.
Although personal automobile premium rates decreased an average of
6.2% in 1997, the impact upon the Company resulted in only a 1.8%
decrease in the average personal automobile premium per exposure (each
vehicle insured). The 1.8% decrease for the Company is significantly
less than the average rate decrease of 6.2% due to the facts that the
rate decision did not anticipate purchases of new automobiles in the
year to which the rate decision applied and, secondly, the Company's mix
of personal automobile business differs from that of the industry.
The 1997 and 1998 decreases were partially driven by corrections
for an industry error that had impacted prior year rate decisions. The
industry error resulted from a miscalculation of industry expense
allowances that had the effect of overstating rates for 1991 through
1996. Rates for 1997 were adjusted to recoup an estimated $50 million
from the industry. Rates for 1998 and 1999 have and will be adjusted to
recoup the remaining amount estimated to be $150 million.
Additionally, 1997 and 1998 rates were decreased as a result of
the reconciliation of the Safe Driver Insurance Plan ("SDIP"), which is
designed to be revenue neutral. In most recent past years, the SDIP
reconciliation resulted in a deficit which was then added into the rates
for the subsequent years. The 1996 SDIP reconciliation, however,
resulted in a surplus.
The Company had performed an analysis of the 1997 rate decision in
early 1997. The Company estimated the impact of the above two items on
its results assuming its market share remained the same as it was at the
end of 1997. The Company's share of the Massachusetts personal
automobile market increased from 20.8% at the end of 1996 to 21.8% at
the end of 1997. The earned premium impact of the above two items has
been re-estimated at approximately $16.0 million for 1997, $24.1 million
for 1998 and $14.1 million for 1999. The earnings per share after-tax
impact resulting from lower earned premiums was $0.29 for 1997, and is
estimated to be $0.43 and $0.24 for 1998 and 1999, respectively. If the
Company's future market share increases (decreases), a larger (smaller)
financial impact will result.
In June 1997, the Massachusetts Supreme Judicial Court ("Court")
rejected an appeal filed by the Automobile Insurers Bureau of
Massachusetts ("AIB") that challenged the Commissioner's decision to
prospectively decrease future rates for the miscalculation of the
industry expense allowance. (The SDIP reconciliation component was not
challenged.) The AIB's argument was that, according to statute, there
is a prohibition against retroactive rate making in Massachusetts which
effectively bars the examination of past year's data once all involved
parties have agreed to the rate decision. The Court ruled that
retroactive rate making was indeed illegal, but indicated that special
circumstances permitted returning the money in the form of rate
reductions. In a related challenge, the Court rejected on technical
grounds, one insurers claim of an unfair adverse impact related to the
prospective nature of the rate reduction.
The 1998 rate decision also included a 7.4% reduction in agents'
commission rates. Again, as in 1997, companies will calculate
commissions on business subject to safe driver deviations, net of the
deviations. After the 1997 rate decision, a suit was filed by the
Massachusetts Association of Insurance Agents ("MAIA") challenging this
method of calculation. In July 1997, the Court upheld the
Commissioner's ruling that agents' commissions on 1997 premiums, subject
to safe driver deviations, would be based on net premium amounts. The
1996 commissions were based on premium amounts net of group discounts
but gross of safe driver deviations. The Commissioner's ruling resulted
in agents receiving fewer commission dollars on a per policy basis.
5
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The Company's performance in its personal and commercial
automobile insurance lines is integrally tied to its participation in
the Commonwealth Automobile Reinsurers ("C.A.R."). All companies
writing automobile insurance in Massachusetts share in the underwriting
results of C.A.R. business for their respective product line or lines.
Since its inception, C.A.R. has annually generated multi-million dollar
underwriting losses in both its personal and commercial automobile
pools. A company's proportionate share of the C.A.R. personal or
commercial deficit (its participation ratio) is based upon its market
share of the automobile risks for the particular pool, adjusted by a
utilization formula such that, in general, its participation ratio is
disproportionately and adversely affected if its relative use of C.A.R.
exceeds that of the industry, and favorably affected if its relative use
of C.A.R. is less than that of the industry. Automobile insurers
attempt to develop and implement underwriting strategies that will
minimize their relative share of the C.A.R. deficit while maintaining
acceptable loss ratios on risks not insured through C.A.R.
Significant changes in the utilization of the C.A.R. private
passenger pooling mechanism are not expected for 1998. Various C.A.R.
participation formula changes have been fully implemented since 1993
with only minor changes since then. The Company's strategy has been to
voluntarily retain more of the types of private passenger automobile
business that are factored as credits favorably impacting the
utilization formula. As a result, the credits impacting the utilization
formula have favorably affected the Company's participation ratio. As
of December 31, 1997, the Company estimates it's private passenger
automobile participation ratio to be approximately 18.0% which is
several percentage points below the Company's estimated 21.8% share of
the Massachusetts personal automobile market. The Company continues to
expect the marketplace to make minor yearly adjustments to find the
optimum balance between voluntary and ceded writings.
Starting in 1991, and concluding in 1995, reforms were implemented
into the C.A.R. commercial automobile pooling mechanism. The primary
change was the gradual phase-in of a C.A.R. commercial utilization-based
participation formula, so as to reduce the percentage of commercial
business being ceded to C.A.R. The percentage of commercial premiums
ceded to C.A.R. by the industry has decreased from approximately 56% in
1990 to approximately 26% in 1997, (as estimated by the Company). This
also resulted in significant decreases in the percentage of commercial
automobile business ceded to C.A.R. by the Company, from approximately
68% in 1990 to approximately 24% in 1997. Continued industry-wide
gradual decreases in the percentage of ceded commercial premiums are
expected for 1998, as companies continue to look to increase their
voluntary retention levels. Finally, C.A.R. depopulation, coupled with
C.A.R. rate increases for ceded commercial business, has led to a
reduction in the size of the annual commercial deficits.
The Company intends to continue to respond to the incentives and
disincentives provided by C.A.R. rules, by further adjusting the
percentage of personal and commercial business ceded to C.A.R. in 1998.
The Company provides a separate rating tier for preferred
commercial automobile business through Citation. Approximately 22% of
the commercial automobile premiums produced by its voluntary agents in
1997 were written by Citation. The Company expects that this secondary
rating tier will continue to assist the Company in retaining its better
commercial automobile accounts, while also further increasing the
percentage of commercial automobile business that can be retained
voluntarily by the Company in 1998 and beyond.
Beginning in the latter part of 1995, the Company began to
actively pursue group marketing programs. The primary purpose of group
marketing programs is to provide participating groups with a convenient
means of purchasing private passenger automobile insurance through
associations and employee groups. Emphasis is placed on writing larger
groups, although accounts with as few as 25 participants are considered.
Groups are eligible for rate discounts which must be filed annually with
the Division of Insurance. In general, the Company looks for groups
with mature/stable membership, favorable driving records and below
average turnover ratios. Participants who leave the sponsoring group
during the term of the policy are allowed to maintain the policy until
expiration. At expiration, a regular Commerce policy may be issued at
the insured's option.
6
<PAGE
During the latter part of 1995, Commerce signed group marketing
agreements with the five American Automobile Association Clubs of
Massachusetts ("AAA clubs") offering a 10% discount on private passenger
automobile insurance to the clubs' members who reside in Massachusetts.
In 1997, two AAA clubs were consolidated, therefore leaving only four
clubs. Primarily as a result of the fourth consecutive private
passenger rate reduction, a 6.0% percent AAA club discount was approved
for policies effective as of January 1, 1998. Previously, a 10%
discount had been effective since the latter part of 1995. Membership
in these clubs is estimated to represent approximately one-third of the
Massachusetts motoring public, and has been the primary reason for a
40.6% increase in the number of personal automobile exposures written by
Commerce since the groups inception. The Company expects this increase
to level off in 1998 as evidenced by an 8.3% increase in personal
automobile exposures in 1997 as compared to a 29.8% increase in 1996.
In 1998, total direct premiums written attributable to the AAA group
business were $422,074 or 54.9% of the Company's total direct premiums
written (66.6% of total Massachusetts personal automobile premium), an
increase of 22.6% over 1996. Total exposures attributable to the AAA
clubs group business were 522,098 or 65.8% of total personal automobile
exposures in 1997, an increase of 102,445 or 24.4% over 1996. Of this
amount, approximately 10% was written through insurance agencies owned
by the AAA clubs. The remaining 90% was written through the Company's
network of independent agents.
Initially, the Massachusetts statute governing group marketing
programs required that 35% of the eligible members must participate in a
group marketing program within the first year. Accordingly, Commerce
and the AAA clubs aggressively pursued AAA members for the AAA Group
Marketing Program. At December 31, 1996, Commerce had achieved the
objective of writing more than 35% of the AAA members within the first
year, as over 300,000 AAA members joined the program. The particular
portion of the statute, dealing with achieving the 35% penetration level
in one year, was amended by the Massachusetts Legislature in early 1997
to allow two years to reach the required penetration level. In December
1997, a bill was passed in the Massachusetts Legislature to further
waive, for an additional year, the requirement that 35% of a group's
members purchase insurance through the group in order for the group to
be renewed for 1998.
Commerce and the AAA clubs have agreed that Commerce shall be
their exclusive underwriter of Massachusetts personal automobile group
programs. This contract may be terminated by the AAA clubs upon written
notice to Commerce, whose termination shall take effect at a minimum of
three years from notice of termination.
During 1996 and 1997, the Company was granted licenses in the
states of Connecticut, New Hampshire, Rhode Island, and Vermont.
License approval in the state of Maine was received in February 1998.
Concurrent with the filings submitted for these licenses, the Company
entered into an agreement with Policy Management Services Corporation
("PMSC") and purchased software which will allow for the development of
internal operating systems which will enable the Company to process
policies in states outside of Massachusetts. Additionally, a
significant investment in new computer hardware was made to support this
effort. These systems are in place and the Company began writing
insurance in the state of Rhode Island during January 1998.
Underwriting profit margins are reflected by the extent to which
the combined ratio is less than 100%. This ratio is considered the best
simple index of current underwriting performance of an insurer. During
the five-year period ended December 31, 1997, the property and casualty
industry's combined ratio, as reported by A.M. Best and weighted to
reflect the Company's product mix ("weighted industry average"), has
ranged from a low of 102.6% in 1993 to a high of 104.2% in 1997 on a
statutory accounting principles basis. During this same period of time,
the Company's combined ratio has consistently remained below the
weighted industry average, ranging from as low as 91.0% in 1995 to a
high of 98.0% in 1996. On an average basis, the Company's combined
ratio was 94.2% for the five year period ended December 31, 1997
compared to a weighted industry average of 103.2%.
The Company's total revenues were supplemented in fiscal 1997,
1996 and 1995 by net investment income of $80,794, $77,402 and $71,313,
respectively. Additionally, the Company had realized investment gains
(losses) of $22,770, ($7,574) and $712 in 1997, 1996 and 1995,
respectively.
7
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Regulatory Matters
General
Although the U.S. federal government does not directly regulate
the insurance industry, federal initiatives often have an impact on the
business. Congress and certain federal agencies continue to investigate
the current condition of the insurance industry (encompassing both life
and health and property and casualty insurance) in the United States in
order to decide whether some form of federal role in the regulation of
insurance companies would be appropriate. Congress conducts hearings
relating, in general, to the solvency of insurers and has proposed
federal legislation from time to time on this and other subjects. The
Company is unable to predict whether or in what form initiatives will be
implemented and what the possible effects on the Company would be.
In May 1996, state legislation was passed offering insurers
incentives to write more inner city and coastal homeowners insurance.
The legislation, which arose over concerns of availability and
allegations of redlining, expands coverages and provides various credits
under the Massachusetts Property Insurance Underwriting Association
("Massachusetts Fair Plan").
In December 1996, a United States District Court, acting on a suit
filed in October 1996, ordered the Massachusetts Division of Insurance
to disregard the existing ban on bank sales of life, health and accident
insurance. The decision cited U.S. Supreme Court decisions in the
Barnett and VALIC cases that essentially pre-empt the State of
Massachusetts ban on the licensing of bank-owned insurance agencies.
Also, in December 1996, a bill was filed in the Massachusetts
Legislature that would allow banks to become licensed agents of an
insurance company or brokers of insurance, permitting such things as the
sale of insurance products in distinctly designated bank branch areas
separate and apart from retail deposit areas. The Company is unable to
predict the possible impacts of these issues at this time.
Various forms of automobile insurance reform are continuously
debated in the Massachusetts Legislature. New regulations and
legislation are often proposed with the goal of reducing the need for
premium increases. For further details, please refer to the general
discussion on insurance regulation and premium rates beginning on page
4.
As previously mentioned, beginning in 1995, the Company received
approval for group discounts to members of the AAA clubs. Membership in
these clubs is estimated to represent approximately one-third of the
Massachusetts motoring public. The Company increased its Massachusetts
private passenger automobile insurance writings by 6.3% in 1997
primarily as a result of this program, ending the year with
approximately 21.8% of the Massachusetts private passenger automobile
market as compared to 20.8% in 1996.
Personal Automobile Insurance
In March 1997, the Company was granted approval, for the 1997
calendar year, to offer their customers safe driver deviations of 10
percent to drivers with SDIP classifications of either Step 9 or 10.
These are the two best driver SDIP classifications in Massachusetts,
representing drivers with no at fault accidents and not more than one
minor moving vehicle violation in the last six years. For drivers that
qualified, the Company's group automobile discounts and SDIP deviations
could be combined for up to a 19% reduction from the state mandated
rates. In February 1998, approval of SDIP deviations of 15% for Step 9
and 4% for Step 10 SDIP classifications was granted for the 1998
calendar year. For drivers that qualify, the Company's group automobile
discounts and SDIP deviations can be combined for up to a 20.1%
reduction from the state mandated rates.
In November 1997, the Company received state regulatory approval
to implement an installment fee of $3.00 on each invoice following the
down payment, for all private passenger automobile policies effective
January 1, 1998. The same $3.00 installment fee also replaced the 1.25%
finance charge calculation for homeowner and dwelling policies paid on a
10-payment installment basis. Previously, for 1996 and 1997, the
Company eliminated interest based finance fees on personal automobile
insurance policies.
8
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Risk Based Capital
In order to enhance the regulation of insurer insolvency, the
National Association of Insurance Commissioners ("NAIC") developed a
formula and model law to implement Risk-Based Capital ("RBC")
requirements for property and casualty insurance companies which are
designed to assess capital adequacy and to raise the level of protection
that statutory surplus provides for policyholder obligations. The RBC
model for property and casualty insurance companies measures three major
areas of risk facing property and casualty insurers: (i) underwriting,
which encompasses the risk of adverse loss development and inadequate
pricing; (ii) declines in asset values arising from credit risk; and,
(iii) other business risks from investments. Insurers having less
statutory surplus than required by the RBC calculation will be subject
to varying degrees of regulatory action, depending on the level of
capital inadequacy.
The RBC model formula proposes four levels of regulatory action.
The extent of regulatory intervention and action increases as the level
of surplus to RBC falls. The first level, the Company Action Level,
requires an insurer to submit a plan of corrective actions to the
regulator if surplus falls below 200% of the RBC amount. The Regulatory
Action Level (as defined by the NAIC) requires an insurer to submit a
plan containing corrective actions and permits the Commissioner to
perform an examination or other analysis and issue a corrective order if
surplus falls below 150% of the RBC amount. The Authorized Control
Level (as defined by the NAIC) allows the regulator to rehabilitate or
liquidate an insurer in addition to the aforementioned actions if
surplus falls below 100% of the RBC amount. The fourth action level is
the Mandatory Control Level (as defined by the NAIC) which requires the
regulator to rehabilitate or liquidate the insurer if surplus falls
below 70% of the RBC amount. The Company's subsidiaries, Commerce,
Citation and Western Pioneer, have RBC amounts at December 31, 1997 of
$56 million, $2 million and $3 million, respectively, and they have
statutory surplus of approximately $433 million, $83 million and $24
million, respectively. The statutory surplus of Commerce, Citation and
Western Pioneer at December 31, 1997 exceeded the RBC Company Action
Levels of $112 million, $5 million and $6 million, respectively, by
approximately $321 million, $78 million and $18 million, respectively.
Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
Direct premiums written during 1997 increased $36,826, or 5.0% to
$768,649 as compared to 1996. The increase was primarily attributable
to a $38,223, or 6.1% increase in direct premiums written for personal
automobile insurance to $661,077. This increase was the result of a
$38,109 increase in direct premiums written for Massachusetts personal
automobile insurance and an increase of $114 which was derived from the
Company's California subsidiary, Western Pioneer. The increase in
Massachusetts personal automobile direct premiums written resulted
primarily from an increase of 8.3% in the number of personal automobile
exposures written, offset by a 1.8% decrease in the average personal
automobile premiums written per exposure (each vehicle insured). This
was primarily the result of the Company's affinity group marketing
programs, safe driver rate deviations and the effect of the 1997 state
mandated average rate decrease of 6.2%. In 1997, the Company offered
their customers safe driver deviations of 10% to drivers with SDIP
classifications of either Step 9 or 10. For drivers who qualify, the
Company's group discount and safe driver deviations can be combined for
up to a 20.1% reduction from state mandated rates. Direct premiums
written for commercial automobile insurance decreased by $3,363 or 8.3%,
due primarily to a decrease of approximately 6.7% in the number of
policies written, with the remainder due to a decrease in the average
commercial automobile premium per policy. Direct premiums written for
homeowners insurance (excluding the Massachusetts Fair Plan) increased
by $2,088, or 4.2% due primarily to an increase in the number of
policies written.
Net premiums written during 1997 increased $29,931, or 4.2% as
compared to 1996. The increase in net premiums written was due to the
growth in direct premiums written as described above, offset by the
effects of reinsurance. Written premiums assumed from C.A.R. decreased
$17,172, or 18.3% and written premiums ceded to C.A.R. decreased $11,045
or 13.3% as compared to 1996, both as a result of changes in the
industry's and the Company's utilization of C.A.R. reinsurance.
Premiums ceded to reinsurers other than C.A.R. increased $768 or 2.5% as
compared to 1996.
9
<PAGE
Earned premiums increased $61,781 or 9.2% during 1997 as compared
to 1996. The increase in earned premiums was primarily due to changes
in 1997 and 1996 direct and net premiums written including the increase
in direct premiums written attributable to group marketing programs
during the latter part of 1996 and in 1997, as previously mentioned.
Earned premiums assumed from C.A.R. decreased $9,602 or 10.4% during
1997 compared to 1996. Earned premiums ceded to C.A.R. decreased
$14,000 or 16.3% during 1997 compared to 1996. Earned premiums
attributable to Western Pioneer increased $531 to $28,159 for 1997
compared to 1996.
Net investment income increased $3,392 or 4.4%, compared to 1996,
principally as a result of an increase in average invested assets (at
cost). Net investment income as a percentage of total average
investments was 6.8% in both 1997 and 1996. Net investment income after
tax as a percentage of total average investments was 5.5% in 1997
compared to 5.6% in 1996.
Premium finance fees decreased $2,639 or 27.2% during 1997. The
decrease was primarily attributable to a change from interest based
finance fees to a "late payment" based system for personal automobile
policies with effective dates of January 1, 1997 and forward. The
change was initiated in direct response to competitive forces that
occurred in the Massachusetts marketplace. In 1997, the Company
received state regulatory approval to charge a $3.00 installment on each
invoice following the down payment for all private passenger automobile
and homeowner policies with effective dates on or after January 1, 1998.
The market value of the Company's investment portfolio totaled
$1,242,695, at December 31, 1997 compared to $1,167,671 at December 31,
1996. Management's investment philosophy is to emphasize investment
yield while maintaining investment quality. Fixed maturities comprised
47.5% of the portfolio at December 31, 1997 compared to 61.4% at
December 31, 1996. Equity investments comprised 26.3% at December 31,
1997 compared to 20.0% at December 31, 1996. Cash and short-term
investments comprised 19.2% at December 31, 1997 compared to 12.0% at
December 31, 1996. The decrease in fixed maturities was the result of
the maturities and sales of fixed maturities with proceeds redeployed to
cash and short-term investments. The shift in the mix of investments
was partially driven by the current low interest rate environment and by
the Company's previously announced change in investment strategy. The
Company is seeking greater flexibility to provide for enhanced potential
future capital appreciation. The Company's strategy is to acquire
equity investments, including potential acquisitions, which forgo
current investment yield in favor of potential higher yielding capital
appreciation in the future.
The market value of the fixed maturities, which totaled $590,597
at December 31, 1997, is comprised of 69.3% tax-exempt and 30.7% taxable
investments as compared to total fixed maturities of $716,702, comprised
of 68.5% tax-exempt and 31.5% taxable investments at December 31, 1996.
The market value of equity investments, which totaled $326,588 at
December 31, 1997, is comprised of 45.5% preferred stocks and 54.5%
common stocks as compared to total equity investments of $233,721,
comprised of 63.2% preferred stocks and 36.8% common stocks at December
31, 1996. The increase in equity investments and decrease in fixed
maturities at December 31, 1997 compared to December 31, 1996 was
primarily attributable to a change in the mix of investments from
municipal and government bonds and Government National Mortgage
Association ("GNMA") mortgage-backed bonds to higher yielding preferred
stock mutual funds which are classified as common stocks. Of the common
stock portfolio approximately two-thirds of the balance is comprised of
preferred stock mutual funds versus pure common stocks.
10
<PAGE
Gross realized gains and losses on fixed maturity investments
amounted to $4,306 and $2,887, respectively, for the year ended December
31, 1997 compared to gross realized gains and losses on fixed maturity
investments of $487 and $7,851, respectively, for the year ended
December 31, 1996. Gross realized investment gains and losses on
preferred stocks amounted to $2,688 and $2,682, respectively, for the
year ended December 31, 1997 compared to gross realized gains and losses
on preferred stocks of $22 and $371, respectively, for the year ended
December 31, 1996. Gross realized gains on common stocks amounted to
$21,440 for the year ended December 31, 1997 compared to gross realized
gains on common stocks of $456 for the year ended December 31, 1996.
Net realized investment gains totalled $22,770 during 1997 as compared
to net realized investment losses of $7,574 for 1996. A significant
portion of the realized gains in 1997 was primarily the result of a
merger of a major New England financial corporation and its property and
casualty subsidiary. The merger election and exchange of stock resulted
in realized investment gains of $15,178. Subsequent post merger sales
of this corporation's common stock resulted in additional realized
investment gains of $3,790. The remainder of the realized investment
gains were primarily the result of sales of non-taxable bonds offset by
minimal realized investment losses in the sales of GNMA's and preferred
stocks. Also included were realized losses on mortgage activity of $95
in 1997 compared to $317 in 1996.
Gross unrealized gains and losses on fixed maturity investments
totalled $24,189 and $376, respectively, at December 31, 1997 compared
to $17,890 and $1,699, respectively, at December 31, 1996. The
unrealized gains on fixed maturities increased, despite fewer fixed
maturity holdings, as a result of the favorable bond market in 1997.
Gross unrealized gains and losses on preferred stocks totaled $1,599 and
$1,235, respectively, at December 31, 1997 compared to $2,034 and
$2,837, respectively, at December 31, 1996. Gross unrealized gains and
losses on common stocks totaled $17,888 and $170, respectively, at
December 31, 1997 compared to $20,305 and $187, respectively, at
December 31, 1996.
Losses and loss adjustment expenses ("LAE") incurred as a
percentage of insurance premiums earned ("loss and LAE ratio") was
71.4% in 1997 compared to 70.9% in 1996. The ratio of net incurred
losses, excluding LAE, to premiums earned ("pure loss ratio") on
personal automobile decreased to 61.3% in 1997 compared to 63.9% in
1996. The commercial automobile pure loss ratio decreased to 45.4% in
1997 compared to 46.7% in 1996. For homeowners, the pure loss ratio
decreased to 48.9% in 1997 compared to 72.4% in 1996. The overall
decrease to the homeowner pure loss ratio for 1997 was due to more
normal weather conditions during 1997 as compared to the severe weather
experienced during the first half of 1996, coupled with favorable
development in the homeowners liability area.
Policy acquisition costs expensed increased by 3.6% in 1997,
compared to 8.6% in 1996. The increase in policy acquisition costs was
primarily due to higher volumes of business written during 1997 and
fewer acquisition costs being deferred as compared to 1996. This was
due to a higher rate of growth in 1996 primarily from affinity groups.
As a percentage of net premiums written, underwriting expenses for the
insurance companies (on a statutory basis) were 25.1% during 1997 as
compared to 27.1% for 1996. On a consolidated financial statement
basis, 1997 and 1996 policy acquisition costs, as a percentage of net
written premiums, were approximately equal. This occurred because lower
commission and contingent commission expenses in 1997 were offset by
higher management incentive compensation expenses and computer service
expenses. The higher management compensation expense was the direct
result of the increase in the average three month share price of the
Company's common stock during 1997 as compared to 1996.
The Company's effective tax rate was 24.5% and 19.6% for the years
ended December 31, 1997 and 1996, respectively. In both years the
effective rate was lower than the statutory rate of 35% primarily due to
tax-exempt interest income and the corporate dividends deduction. The
higher 1997 effective tax rate was primarily due to tax exempt interest
comprising a lesser percentage of net income before taxes and more
realized gains in 1997 than in 1996.
Net earnings increased $22,251 or 30.1% to $96,215, during 1997 as
compared to net earnings of $73,964 in 1996, as a result of the factors
previously mentioned.
11
<PAGE
Year Ended December 31, 1996 Compared to Year Ended December 31, 1995
Direct premiums written during 1996 increased $105,157, or 16.8%
to $731,823 as compared to 1995. The increase was primarily
attributable to a $108,212, or 21.0% increase in direct premiums written
for personal automobile insurance to $622,849. This increase was the
result of an $88,527 increase in direct premiums written for
Massachusetts personal automobile insurance and an increase of $19,685
which was derived from the Company's California subsidiary, Western
Pioneer, which was acquired August 31, 1995. The increase in
Massachusetts personal automobile direct premiums written resulted
primarily from an increase of 29.8% in the number of personal automobile
exposures written, offset by a 9.2% decrease in the average personal
automobile premiums written per exposure (each vehicle insured). This
was primarily the result of the Company's affinity group marketing
programs, safe driver rate deviations and the effect of the 1996 state
mandated average rate decrease of 4.5%. In January 1996, the Company
was granted approval to offer its customers safe driver deviations of
10%. For drivers who qualify, the Company's group discount and safe
driver deviations can be combined for up to a 19% reduction from state
mandated rates. Direct premiums written for commercial automobile
insurance decreased by $4,763, or 10.5%, due primarily to a decrease of
approximately 5.6% in the number of policies written, with the remainder
due to a decrease in the average commercial automobile premium per
policy. Direct premiums written for homeowners insurance (excluding the
Massachusetts Fair Plan) increased by $1,926, or 4.0%, due primarily to
an increase in the number of policies written.
Net premiums written during 1996 increased $108,149, or 17.9% as
compared to 1995. The increase in net premiums written was due to the
growth in direct premiums written as described above, as well as to the
effects of reinsurance. Written premiums assumed from C.A.R. increased
$1,454, or 1.6% and written premiums ceded to C.A.R. increased $47 as
compared to 1995, both as a result of changes in the industry's and the
Company's utilization of C.A.R. reinsurance. Premiums ceded to
reinsurers other than C.A.R. decreased $1,602 or 4.9% as compared to
1995.
Earned premiums increased $76,126 or 12.8% during 1996 as compared
to 1995. The increase in earned premiums was primarily due to changes
in direct premiums written and net premiums written as described above.
Earned premiums assumed from C.A.R. increased $1,860 or 2.1% during 1996
compared to 1995. Earned premiums attributable to Western Pioneer
increased $18,794 to $27,628 for 1996 compared to $8,834 for the four
months ended December 31, 1995. The Company acquired Western Pioneer on
August 31, 1995.
Net investment income increased $6,089, or 8.5%, compared to 1995,
principally as a result of an increase in average invested assets (at
cost) of 9.5% when compared to the year ended 1995. Net investment
income as a percentage of total average investments was 6.8% in 1996
compared to 6.9% in 1995. Net investment income after tax as a
percentage of total average investments was 5.6% in 1996 compared to
5.7% in 1995.
Premium finance fees decreased $9,707 or 50.0% during 1996. The
decrease was primarily attributable to a change from interest based
finance fees to a "late payment" based system for personal automobile
policies with effective dates of January 1, 1996 and forward. The
change was initiated in direct response to competitive forces that
occurred in the Massachusetts marketplace.
The market value of the Company's investment portfolio totaled
$1,167,671, at December 31, 1996 compared to $1,096,778 at December 31,
1995. Management's investment philosophy is to emphasize investment
yield while maintaining investment quality. Fixed maturities comprised
61.4% of the portfolio at December 31, 1996 compared to 74.3% at
December 31, 1995. Equity investments comprised 20.0% at December 31,
1996 compared to 13.8% at December 31, 1995.
12
<PAGE
The market value of the fixed maturities, which totaled $716,702
at December 31, 1996, is comprised of 68.5% tax-exempt and 31.5% taxable
investments as compared to total fixed maturities of $815,277, comprised
of 72.8% tax-exempt and 27.2% taxable investments at December 31, 1995.
The market value of equity investments, which totaled $233,721 at
December 31, 1996, is comprised of 63.2% preferred stocks and 36.8%
common stocks as compared to total equity investments of $151,579,
comprised of 73.4% preferred stocks and 26.6% common stocks at December
31, 1995. The increase in equity investments and decrease in fixed
maturities at December 31, 1996 compared to December 31, 1995 is
primarily attributable to a change in the mix of investments from
municipal bonds to higher yielding preferred stocks and preferred stock
mutual funds which are classified as common stocks.
Gross realized gains and losses on fixed maturity investments
amounted to $487 and $7,851, respectively, for the year ended December
31, 1996 compared to $2,389 and $1,912, respectively, for the year ended
December 31, 1995. Gross realized gains and losses on preferred stocks
amounted to $22 and $371, respectively, for the year ended December 31,
1996 compared to $937 and $47, respectively, for the year ended December
31, 1995. Gross realized gains and losses on common stocks amounted to
$456 and $0, respectively, for the year ended December 31, 1996 compared
to $47 and $532, respectively, for the year ended December 31, 1995.
Net realized investment losses totalled $7,574 during 1996 as compared
to net realized investment gains of $712 for 1995. The realized gains in
1996 were primarily the result of sales of municipal bonds and common
stocks, offset by realized losses on sales of Government National
Mortgage Association ("GNMA") mortgage backed bonds, municipal bonds and
preferred stocks. Also included were realized losses on mortgage
activity of $317 in 1996 compared to $215 in 1995.
Gross unrealized gains and losses on fixed maturity investments
totalled $17,890 and $1,699, respectively, at December 31, 1996 compared
to $18,626 and $4,657, respectively, at December 31, 1995. The
unrealized gain on fixed maturities remained fairly consistent with 1995
as a result of stable interest rates during 1996. Gross unrealized
gains and losses on preferred stocks totaled $2,034 and $2,837,
respectively, at December 31, 1996 compared to $1,629 and $2,005,
respectively, at December 31, 1995. Gross unrealized gains and losses
on common stocks totaled $20,305 and $187, respectively, at December 31,
1996 compared to $11,801 and $3, respectively, at December 31, 1995.
The increase in unrealized gain on equity investments was primarily due
to the increase in equity investments, as described earlier, and the
performance of the stock market during 1996 favorably impacting the
market values of common stocks.
Losses and loss adjustment expenses ("LAE") incurred as a
percentage of insurance premiums earned ("loss and LAE ratio") was 70.9%
in 1996 compared to 62.0% in 1995. The ratio of net incurred losses,
excluding LAE, to premiums earned ("pure loss ratio") on personal
automobile increased to 63.9% in 1996 compared to 56.6% in 1995. This
increase was primarily due to the adverse impact of severe weather
conditions experienced in the northeast during the first half of 1996,
adverse loss experience on personal automobile business assumed from
C.A.R. and a decrease in the personal automobile average earned premium
per exposure of approximately 7.9%. This decrease was due to the
effects of affinity group marketing programs, safe driver rate
deviations and the 1996 state mandated average rate decrease of 4.5%.
These factors were offset by improved loss development during 1996. The
commercial automobile pure loss ratio decreased to 46.7% in 1996
compared to 57.4% in 1995. This decrease was primarily due to improved
loss experience on commercial automobile business assumed from C.A.R.
and better loss development on voluntary business. For homeowners, the
pure loss ratio increased to 72.4% in 1996 compared to 49.6% in 1995.
This increase was due primarily to the severe weather during the first
half of 1996, compared to the mild weather experienced during 1995.
13
<PAGE
Policy acquisition costs increased by 8.6% in 1996, compared to
5.9% in 1995. This increase was primarily due to the increase in net
premiums written as described previously, offset by a decrease of $9.5
million in the agents profit sharing compensation resulting from the
impact of adverse weather conditions on the Company's loss and LAE ratio
and the impact of affinity group marketing service fee income. Agents'
profit sharing compensation is based, in part, on the underwriting
profits of agency business written with the Company. As a percentage of
net premiums written, underwriting expenses (on a statutory basis) were
27.1% for 1996, compared to 29.0% in 1995. This decrease was primarily
attributable to the reasons as mentioned above.
The Company's effective tax rate was 19.6% and 26.4% for the years
ended December 31, 1996 and 1995, respectively. In both years the
effective rate was lower than the statutory rate of 35% primarily due to
tax-exempt interest income. The lower 1996 effective tax rate was
primarily due to tax-exempt interest income comprising a higher
percentage of net income before taxes, the dividends received deduction
and lower capital gains in 1996 versus 1995.
Net earnings decreased $36,237 to $73,964 or 32.9%, during 1996,
as compared to net earnings of $110,201 in 1995, as a result of the
factors previously mentioned.
Liquidity and Capital Resources
The focus of the discussion of liquidity and capital resources is
on the Consolidated Balance Sheets on page 20 and the Consolidated
Statements of Cash Flows on pages 24 and 25. Stockholders' equity
increased by $62,757, or 10.7%, in 1997 as compared to 1996. Growth
stemmed from $96,215 in net earnings combined with the change in net
unrealized gains, net of income taxes, on fixed maturities and preferred
and common stocks of $4,153, partially offset by dividends paid to
stockholders of $37,124 and Treasury Stock purchased of $487. Total
assets at December 31, 1997 increased by $77,954, or 4.6%, to $1,754,753
as compared to total assets of $1,676,799 at December 31, 1996. The
majority of this growth was reflected in an increase of invested assets
of $75,024, or 6.4%, an increase in premiums receivable of $11,634, or
7.4%, offset by a decrease in all other assets of $8,704 or 2.5% as
compared to December 31, 1996. The increase in invested assets was
primarily attributable to the Company's growth during 1997. The change
in the mix of the Company's investments is attributable to the
previously announced change in investment strategy. The Company is
seeking greater flexibility to provide the potential for enhanced future
capital appreciation. The Company's strategy is to acquire equity
investments, which can include potential acquisitions, which forgo
current investment yield in favor of potentially higher yielding capital
appreciation. As a result, the Company is carrying $238,888, or 19.2%,
of the investment portfolio in cash and short-term investments which is
an increase of $98,353, or 70.0%, as compared to December 31, 1996. The
increase in premiums receivable was primarily attributable to the
increase in personal automobile business.
The Company's fixed maturity portfolio is comprised of GNMAs
(30.7%) and municipal bonds (69.3%). Of the Company's bonds, 100.0% are
rated in either of the two highest quality categories provided by the
NAIC.
The Company's liabilities totalled $1,104,957 at December 31, 1997
as compared to $1,089,760 at December 31, 1996. Loss and loss
adjustment expense reserves comprised 58.8% of the Company's liabilities
at December 31, 1997 compared with 60.8% at December 31, 1996. Unearned
premiums comprised 34.4% of the Company's liabilities at December 31,
1997 compared with 33.8% at December 31, 1996. All other liabilities
comprised 6.8% of the Company's liabilities at December 31, 1997
compared with 5.4% at December 31, 1996. The $15,197, or 1.4%, increase
in liabilities was primarily due to a decrease of $13,359 or 2.0% , in
losses and loss adjustment expense reserves and $11,851 or 46.1% in
contingent commissions, offset by increases of $11,608, or 3.2%, in
unearned premiums, $11,705 or 266.4% to income tax liabilities and
$5,243 or 9.6%, to all other liabilities.
The primary sources of the Company's liquidity are funds generated
from insurance premiums, premium finance fees, net investment income and
the maturing and sales of investments as reflected in the Consolidated
Statements of Cash Flows on pages 24 and 25.
14
<PAGE
The Company's operating activities provided cash of $80,006 in
1997 as compared to $118,252 in 1996. These cash flows were primarily
impacted by the fact that while premiums collected increased 7.7% in
1997 as compared to 15.9% in 1996, losses and LAE paid increased 20.4%
in 1997 as compared to 30.0% in 1996 and policy acquisition costs paid
decreased 1.4% in 1997 as compared to an increase of 21.6% in 1996. The
increases were primarily the result of a decrease in the personal
automobile premium rate. The average rate decrease was due to the
effects of group marketing programs, safe driver rate deviations and the
1997 state mandated rate decrease of 6.2%. Net loss payments in the
direct personal automobile lines of business increased approximately
21.5% or $71,300 which were offset by a decrease in payments for other
than automobile lines of business of approximately $16,200, compared to
1996. The decrease in other than automobile loss payments was primarily
the result of more normal weather in 1997 versus the severe weather
experienced in 1996. The increase in automobile loss payments was
primarily attributable to three factors: increased payments for
collision coverages; increased payments for bodily injury claims and
increased payments for property damage liability claims. Bodily injury
payments were higher primarily due to increased business writings
coupled with initiatives in the claims department to accelerate the
claims settlement process in an effort to reduce the overall cost of
bodily injury claims in the long run, as well as to reduce the overall
number of open bodily injury claims.
The cash flows used in investing activities were primarily the
result of proceeds from the maturities and sales of fixed maturities
offset by the purchases of fixed maturities, preferred and common stocks
and short-term investments. Investing and financing activities were
funded by the cash provided by operating activities.
Cash flows used in financing activities totalled $37,611 in 1997
compared to $45,115 in 1996. The decease was primarily attributable to
a decrease in Treasury Stock purchases of $15,255 offset by an increase
in dividends paid to stockholders of $7,751.
The Company's funds are generally invested in securities with
maturities intended to provide adequate funds to pay claims without the
forced sale of investments. The carrying value (at market) of total
investments at December 31, 1997 was $1,242,695. At December 31, 1997,
the Company held cash and cash equivalents of $25,446 and short-term
investments of $213,442. These funds provide sufficient liquidity for
the payment of claims and other short-term cash needs. The Company
relies upon dividends from its subsidiaries for its cash requirements.
Every Massachusetts insurance company seeking to make any dividend or
other distributions to its stockholders must file a report with the
Commissioner. An extraordinary dividend is any dividend or other
property, whose fair value together with other dividends or
distributions made within the preceding twelve months exceeds the
greater of ten percent of the insurer's surplus as regards to
policyholders as of the end of the preceding year, or the net income of
a non-life insurance company for the preceding year. No pro-rata
distribution of any class of the insurer's own securities is to be
included. No Massachusetts insurance company shall pay an extraordinary
dividend or other extraordinary distribution until thirty days after the
Commissioner has received notice of the intended distribution and has
not objected. No extraordinary dividends were paid in 1997, 1996 and
1995.
Periodically, sales have been made from the Company's fixed
maturity investment portfolio to actively manage portfolio risks,
including credit-related concerns, to optimize tax planning and to
realize gains. This practice will continue in the future.
The Company continues to monitor acquisition opportunities
consistent with a long-term growth strategy to expand outside
Massachusetts through acquisitions of smaller automobile insurance
companies that are in need of capital, have established management in
place and present significant growth opportunities in their market
areas. On August 31, 1995, the Company completed the acquisition of
Western Pioneer Insurance Company, a personal automobile insurer,
located in Pleasanton, California.
15
<PAGE
The Company's long-term growth objective is to expand its writings
outside of Massachusetts. In continued pursuit of this objective, the
Company became licensed in the states of Connecticut and Rhode Island
during 1996 and in the states of Vermont and New Hampshire in 1997.
License approval in the state of Maine was received in February 1998.
Concurrent with the filings submitted for these licenses, the Company
entered into an agreement with PMSC and purchased software which allows
for the development of internal operating systems which will enable the
Company to process policies in states outside of Massachusetts. To
facilitate this development and, at the same time, address the year 2000
processing issue facing computer system users, the Company established
the Team 2000 and Century Change projects which are corporate-wide
efforts to prepare the Company's systems for the next millennium. These
projects involve internal staff costs as well as consulting expenses to
prepare the systems for the year 2000. Costs to date for the Century
Change project have been approximately $1.1 million (all of which relate
to 1997). Administration, programming, testing and implementation of
system applications related to Century Change are expected to cost an
additional $6 million over the next 24 months. Approximately $4 million
is expected to be expensed during 1998 with the remainder through the
end of 1999.
The Company is utilizing both internal and external resources on
the Century Change Project. The Company has a formal plan to address
the Century Change issue and is progressing in accordance with that
plan. Programming changes dealing with policy issuance and maintenance
of same is expected to be completed by year-end 1998. Other internal
changes are scheduled to be completed in accordance with specified
delivery dates as outlined in the plan. The Company's plan has been
designed to, and is proceeding so as to, avoid any adverse business
production issues.
The Company has reviewed the Century Change status of vendors who
perform outside processing for the Company or whose software the Company
uses for internal processing. This review has determined that the
related software used by or provided by these vendors either is
currently century ready or will be ready without any adverse impact on
the Company.
Upon completion of the Century Change project, the Company expects
to focus its efforts on the Team 2000 project which will eventually
replace the Company's existing internal computer systems for
Massachusetts business utilizing software purchased from PMSC. Costs to
date for the Team 2000 effort have been approximately $28 million.
Costs applicable to 1997 were approximately $17 million, of which $15.6
million was expensed during the year. Total Team 2000 project costs
over the next 5 to 7 years have been estimated at approximately
$60,000,000 including funds expended to date. This amount includes the
purchase of a main frame computer, license fees and the costs associated
with programming, implementation and training. Systems enabling the
Company to process policies in Rhode Island have been in place since
January 1998. Other states will be brought on-line in the future.
Industry and regulatory guidelines suggest that the ratio of a
property and casualty insurer's annual net premiums written to statutory
policyholders' surplus should not exceed 3.00 to 1.00. The Company's
statutory premiums to surplus ratio was 1.43 to 1.00 and 1.53 to 1.00
for the years ended December 31, 1997 and 1996, respectively.
Recent Accounting Developments
In February 1997, the Financial Accounting Standards Board
("FASB") issued Statement of Financial Accounting Standards No. 128,
"Earnings Per Share". This statement is effective for financial
statements issued for periods ending after December 15, 1997, (including
interim periods) with earlier application not permitted. The statement
specifies the computation, presentation and disclosure requirements for
earnings per share. The adoption of this statement has not had a
material impact on the Consolidated Financial Statements.
16
<PAGE
In June 1997, the FASB issued Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income" ("FAS 130")
effective for financial statements issued for periods beginning after
December 15, 1997. FAS 130 requires that a public company report
changes in equity during a period except those resulting from investment
by owners and distributions by owners. The financial information to be
reported includes foreign currency transactions, minimum pension
liability adjustments and unrealized gains and losses on certain
investments in debt and equity securities (i.e. available for sale
securities). The Company believes that the adoption of this statement
will not have a material impact on the consolidated financial
statements.
In June 1997, the FASB issued Statement of Financial Accounting
Standards No. 131, "Disclosures about Segments of an Enterprise and
Related Information" ("FAS 131"), effective for financial statements
issued for periods beginning after December 15, 1997. FAS 131 requires
that a public company report financial and descriptive information about
its reportable operating segments pursuant to criteria that differ from
current accounting practice. The financial information to be reported
includes segment profit or loss, certain revenue and expense items and
segment assets and reconciliations to corresponding amounts in the
general purpose financial statements. The Company believes that the
adoption of this statement will not have a material impact on the
Consolidated Financial Statements.
Effects of Inflation and Recession
The Company generally is unable to recover the costs of inflation
in its personal automobile insurance line since the premiums it charges
are subject to state regulation. The premium rates charged by the
Company for personal automobile insurance are adjusted by the
Commissioner only at annual intervals. Such annual adjustments in
premium rates may lag behind related cost increases. Economic
recessions will also have an impact upon the Company, primarily through
the policyholder's election to decrease non-compulsory coverages
afforded by the policy and decreased driving, each of which tends to
decrease claims.
To the extent inflation and economic recession influence yields on
investments, the Company is also affected. As each of these
environments affect current market rates of return, previously committed
investments may rise or decline in value depending on the type and
maturity of investment.
Inflation and recession must also be considered by the Company in
the creation and review of loss and LAE reserves since portions of these
reserves are expected to be paid over extended periods of time. The
anticipated effect of economic conditions is implicitly considered when
estimating liabilities for losses and LAE. The importance of
continually adjusting reserves is even more pronounced in periods of
changing economic circumstances.
COMMON STOCK PRICE AND DIVIDEND INFORMATION
The Company's common stock trades on the NYSE under the symbol
"CGI". The high, low and close prices for shares of the Company's
Common Stock for 1997 and 1996 were as follows:
<TABLE>
1997 1996
<CAPTION>
High Low Close High
Low Close
<S> <C> <C> <C> <C>
<C> <C>
First Quarter........... $29 $22-7/8 $23-1/4 $20-
3/4 $17-3/4 $19-3/4
Second Quarter.......... 24-3/4 21-3/8 24-5/8 22-
1/2 18-1/2 20-7/8
Third Quarter........... 33-3/8 23-7/8 30-7/8 22-
1/4 20-1/2 22
Fourth Quarter.......... 36 30 32-5/8 25-
3/4 22 25-1/4
</TABLE>
As of March 1, 1998, there were 1,375 stockholders of record of
the Company's Common Stock, not including stock held in "Street Name" or
held in accounts for participants of the Company's Employee Stock
Ownership Plan ("E.S.O.P.").
17
<PAGE
The Board of Directors of the Company voted to declare four
quarterly dividends to stockholders of record totaling $1.03 per share
and $0.81 per share in 1997 and 1996, respectively. On May 30, 1997,
the Board voted to increase the quarterly stockholder dividend from
$0.25 to $0.26 per share to stockholders of record as of June 6, 1997.
Prior to that declaration, the Company had paid quarterly dividends of
$0.25 per share dating back to May 17, 1996 when the Board voted to
increase the dividend from $0.06 to $0.25 per share.
Treasury Stock purchased under the stock buyback program increased
by 20,000 shares during 1997 to 1,957,348 shares at December 31, 1997.
The stock buyback program, authorized by the Board in May 1995, enables
the Company to purchase up to three million shares of the Company's
common stock. The program is approximately two-thirds complete.
18
<PAGE
REPORT OF MANAGEMENT
The management of the Company is responsible for the consolidated
financial statements and all other information presented in this Annual
Report. The financial statements have been prepared in conformity with
generally accepted accounting principles determined by management to be
appropriate in the circumstances and include amounts based on
management's informed estimates and judgments. Financial information
presented elsewhere in this Annual Report is consistent with the
financial statements. The appropriateness of data underlying such
financial information is monitored through internal accounting controls,
an internal audit department, independent auditors and the Board of
Directors through its audit committee.
The Company maintains a system of internal accounting controls
designed to provide reasonable assurance to management and the Board of
Directors that assets are safeguarded and that transactions are executed
in accordance with management's authorization and recorded properly.
The system of internal accounting controls is supported by the selection
and training of qualified personnel combined with the appropriate
division of responsibilities.
Management recognizes its responsibility for fostering a strong
ethical climate so that the Company's affairs are conducted according to
the highest standards of personal and corporate conduct. Management
encourages open communication within the Company and requires the
confidential treatment of proprietary information and compliance with
all domestic laws, including those relating to financial disclosure.
The 1997 consolidated financial statements were audited by the
Company's independent auditors, Ernst & Young LLP, in accordance with
generally accepted auditing standards. Management has made available to
Ernst & Young LLP, all the Company's financial records and related data,
as well as the minutes of stockholders' and directors' meetings.
Furthermore, management believes that all representations made to Ernst
& Young LLP, during its audit were valid and appropriate.
19
<PAGE
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders of
The Commerce Group, Inc.
We have audited the accompanying consolidated balance sheet of The
Commerce Group, Inc. and Subsidiaries as of December 31, 1997, and the
related consolidated statements of earnings, stockholders' equity and
cash flows for the year then ended. These financial statements are the
responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audit.
The accompanying consolidated financial statements of the Company for
each of the two years in the period ended December 31, 1996, were
audited by other auditors whose report dated January 24, 1997, expressed
an unqualified opinion on those statements.
We conducted our audit in accordance with generally accepted
auditing standards. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made
by management, as well as evaluating the overall financial statement
presentation. We believe our audit provides a reasonable basis for our
opinion.
In our opinion, the 1997 financial statements referred to above
present fairly, in all material respects, the consolidated financial
position of The Commerce Group, Inc. and Subsidiaries as of December 31,
1997, and the consolidated results of their operations and their cash
flows for the year ended in conformity with generally accepted
accounting principles.
ERNST &
YOUNG LLP
Boston, Massachusetts
January 23, 1998
20
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31,
(Thousands of Dollars Except Per Share Data)
<TABLE>
1997 1996
ASSETS
<CAPTION>
<S>
<C> <C>
Investments (notes A2, A3, A4 and B)
Fixed maturities, at market (cost: $566,784 in 1997 and $700,511
in 1996).......................................................... $
590,597 $ 716,702
Preferred stocks, at market (cost: $148,135 in 1997 and $148,481
in 1996)..........................................................
148,499 147,680
Common stocks, at market (cost: $160,371 in 1997 and $65,925 in
1996).............................................................
178,089 86,041
Mortgage loans on real estate and collateral notes receivable
(less allowance for possible loan losses of $2,812 in 1997
and $2,760 in 1996)...............................................
82,839 74,586
Short-term investments.............................................
213,442 -
Cash and cash equivalents..........................................
25,446 140,535
Other investments..................................................
3,783 2,127
Total investments..............................................
1,242,695 1,167,671
Accrued investment income............................................
12,237 12,819
Premiums receivable (less allowance for doubtful receivables of
$1,451 in 1997 and $1,500 in 1996).................................
169,469 157,835
Deferred policy acquisition costs (notes A5 and C)...................
85,264 82,968
Property and equipment, net of accumulated depreciation
(notes A6 and D)...................................................
36,280 32,100
Residual market receivable (note F)
Losses and loss adjustment expenses................................
129,137 145,726
Unearned premiums..................................................
51,662 49,487
Due from reinsurers (note F).........................................
18,170 19,659
Other assets.........................................................
9,839 8,534
Total assets...................................................
$1,754,753 $1,676,799
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Losses and loss adjustment expenses (notes A7, E and F)............ $
649,473 $ 662,832
Unearned premiums (note A8)........................................
379,599 367,991
Current income taxes (notes A9 and G)..............................
2,656 171
Deferred income taxes (notes A9 and G).............................
13,443 4,223
Deferred income (notes A10 and F)..................................
7,271 7,974
Contingent commissions accrued.....................................
13,861 25,712
Payable to securities broker.......................................
11,500 -
Other liabilities and accrued expenses.............................
27,154 20,857
Total liabilities..............................................
1,104,957 1,089,760
Stockholders' Equity (notes B, J, K and L)
Preferred stock, authorized 5,000,000 shares at $1.00 par value;
none issued in 1997 and 1996......................................
- - -
Common stock, authorized 100,000,000 shares at $.50 par value;
issued and outstanding 38,000,000 shares in 1997 and 1996.........
19,000 19,000
Paid-in capital....................................................
29,621 29,621
Net unrealized gains on fixed maturities and stocks,
net of income taxes of $14,663 in 1997 and $12,427 in 1996........
27,232 23,079
Retained earnings..................................................
612,630 553,539
688,483 625,239
Treasury Stock, 1,957,348 shares in 1997 and 1,937,348 shares in
1996, at cost (note A12)..........................................
(38,687) (38,200)
Total stockholders' equity.....................................
649,796 587,039
Total liabilities and stockholders' equity.....................
$1,754,753 $1,676,799
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
21
<PAGE
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
For the years ended December 31,
(Thousands of Dollars Except Per Share Data)
<TABLE>
1997
1996 1995
<CAPTION>
<S> <C> <C>
<C>
Revenues
Earned premiums (notes A8 and F)..................... $ 730,497 $
668,716 $ 592,590
Net investment income (note B)....................... 80,794
77,402 71,313
Premium finance fees................................. 7,074
9,713 19,420
Net realized investment gains (losses) (note B)...... 22,770
(7,574) 712
Total revenues.................................. 841,135
748,257 684,035
Expenses
Losses and loss adjustment expenses
(notes A7, E and F)................................. 526,127
475,231 367,552
Policy acquisition costs (notes A5 and C)............ 187,491
181,013 166,741
Total expenses.................................. 713,618
656,244 534,293
Earnings before income taxes.................... 127,517
92,013 149,742
Income taxes (notes A9 and G).......................... 31,302
18,049 39,541
NET EARNINGS.................................... $ 96,215 $
73,964 $ 110,201
BASIC AND DILUTED NET EARNINGS PER COMMON SHARE
(note A11)..................................... $ 2.67 $
2.04 $ 2.93
CASH DIVIDENDS PAID PER SHARE................... $ 1.03 $
0.81 $ 0.23
WEIGHTED AVERAGE NUMBER OF COMMON
SHARES OUTSTANDING............................. 36,044,679
36,311,887 37,632,236
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
22
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
For the years ended December 31,
(Thousands of Dollars)
<TABLE>
Net
Common Paid-in Unrealized Retained
Treasury
Stock Capital Gains/(Losses) Earnings
Stock Total
<CAPTION>
<S> <C> <C> <C> <C>
<C> <C>
Balance January 1, 1995...... $19,000 $29,621 $(42,414) $407,382
$ - $413,589
Net earnings................ 110,201
110,201
Change in unrealized gains
(losses) net of taxes...... 58,918
58,918
Stockholder dividends.......
(8,635) (8,635)
Treasury stock purchased....
(24,359) (24,359)
Balance December 31, 1995.... 19,000 29,621 16,504 508,948
(24,359) 549,714
Net earnings................ 73,964
73,964
Change in unrealized gains
net of taxes............... 6,575
6,575
Stockholder dividends.......
(29,373) (29,373)
Treasury stock purchased....
(13,841) (13,841)
Balance December 31, 1996.... 19,000 29,621 23,079 553,539
(38,200) 587,039
Net earnings................ 96,215
96,215
Change in unrealized gains
net of taxes............... 4,153
4,153
Stockholder dividends.......
(37,124) (37,124)
Treasury stock purchased....
(487) (487)
Balance December 31, 1997.... $19,000 $29,621 $ 27,232 $612,630
$(38,687) $649,796
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
23
<PAGE
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended December 31,
(Thousands of Dollars)
<TABLE>
1997
1996 1995
<CAPTION>
<S> <C>
<C> <C>
Cash flows from operating activities
Premiums collected..................................... $ 727,530 $
675,683 $ 583,230
Net investment income received......................... 81,376
79,269 70,067
Premium finance fees received.......................... 7,074
9,713 19,420
Losses and loss adjustment expenses paid............... (516,130)
(428,541) (329,728)
Policy acquisition costs paid.......................... (198,011)
(200,922) (165,281)
Federal income tax payments............................ (21,833)
(16,950) (43,527)
Net cash provided by operating activities.......... 80,006
118,252 134,181
Cash flows from investing activities
Proceeds from maturity of fixed maturities............. 108,592
170,646 28,479
Proceeds from sale of fixed maturities................. 124,653
122,431 72,287
Proceeds from sale of equity securities................ 224,059
11,326 14,784
Purchase of fixed maturities........................... (98,098)
(200,113) (100,689)
Purchase of equity securities.......................... (296,714)
(85,480) (50,418)
Purchase of other investments.......................... (1,752)
(700) (800)
Net increase in short-term investments, net of
payable to securities broker......................... (201,942)
- - -
Payments received on mortgage loans and collateral
notes receivable..................................... 11,386
8,311 9,892
Mortgage loans and collateral notes originated......... (19,816)
(7,446) (28,667)
Purchase of property and equipment..................... (8,133)
(4,477) (3,664)
Other proceeds from investing activities............... 281
235 2,888
Net cash provided by (used in) investing activities (157,484)
14,733 (55,908)
Cash flows from financing activities
Dividends paid to stockholders......................... (37,124)
(29,373) (8,635)
Purchase of treasury stock............................. (487)
(15,742) (22,458)
Net cash used in financing activities.............. (37,611)
(45,115) (31,093)
Increase (decrease) in cash and cash equivalents......... (115,089)
87,870 47,180
Cash and cash equivalents at beginning of year........... 140,535
52,665 5,485
Cash and cash equivalents at end of year................. $ 25,446 $
140,535 $ 52,665
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
24
<PAGE
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Reconciliation of Net Income to Net Cash Provided by Operating
Activities
For the years ended December 31,
(Thousands of Dollars)
<TABLE>
1997
1996 1995
<CAPTION>
<S> <C>
<C> <C>
Cash flows from operating activities
Net Earnings........................................... $ 96,215 $
73,964 $ 110,201
Adjustments to reconcile net earnings to net cash
provided by operating activities:
Premiums receivable.................................. (11,634)
(30,788) (24,615)
Deferred policy acquisition costs.................... (2,296)
(15,808) (8,094)
Residual market receivable........................... 14,414
4,911 14,694
Due to/from reinsurers............................... 1,489
2,238 (5,005)
Losses and loss adjustment expenses.................... (13,359)
36,803 26,527
Unearned premiums...................................... 11,608
37,537 15,735
Current income taxes................................... 2,485
(1,009) (8,637)
Deferred income taxes.................................. 6,984
2,098 4,650
Deferred income........................................ (703)
(980) (1,497)
Contingent commissions................................. (11,851)
(6,838) 8,100
Other assets, liabilities and accrued expenses......... 4,992
3,017 1,755
Net realized investment (gains) losses................. (22,770)
7,574 (712)
Other - net............................................ 4,432
5,533 1,079
Net cash provided by operating activities......... $ 80,006 $
118,252 $ 134,181
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
25
<PAGE
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE A-Summary of Significant Accounting Policies
1. Basis of Presentation
The consolidated financial statements of The Commerce Group, Inc.
(the "Company") have been prepared in accordance with generally accepted
accounting principles ("GAAP").
The consolidated financial statements include The Commerce Group,
Inc., and its wholly-owned subsidiaries, Bay Finance Company, Inc.,
Clark-Prout Insurance Agency, Inc. and Commerce Holdings, Inc. ("CHI").
The Commerce Insurance Company ("Commerce") and Citation Insurance
Company ("Citation") are wholly-owned subsidiaries of CHI. Western
Pioneer Insurance Company ("Western Pioneer") is a wholly-owned
subsidiary of Commerce. All intercompany transactions and balances have
been eliminated in consolidation. Certain prior year account balances
have been reclassified to conform to 1997 presentation.
The insurance subsidiaries, Commerce, Citation and Western Pioneer
prepare statutory financial statements in accordance with accounting
practices prescribed by the National Association of Insurance
Commissioners ("NAIC"), the Commonwealth of Massachusetts, and the State
of California.
The preparation of financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
2. Investments
All investment transactions have credit exposure to the extent
that a counterparty may default on an obligation to the Company. Credit
risk is a consequence of carrying investment positions. The financial
instruments that potentially subject the Company to credit risk consist
primarily of cash and cash equivalents, premium receivables, investments
and mortgage loans on real estate. Concentrations of credit risk with
respect to premiums receivable result from the fact that the Company's
policyholders are concentrated primarily in one geographic area, as the
Company, the largest writer of personal automobile insurance in the
state of Massachusetts, writes primarily in Massachusetts. To manage
credit risk, the Company focuses on higher quality fixed-income
securities, reviews the credit strength of all companies which it
invests in, limits its exposure in any one investment and monitors the
portfolio quality, taking into account credit ratings assigned by
recognized statistical rating organizations.
Investments in fixed maturities, which include taxable and non-
taxable bonds, and investments in common and non-redeemable preferred
stocks, are carried at fair market value and are classified as available
for sale. Unrealized investment gains and losses on common and non-
redeemable preferred stocks and fixed maturities, to the extent that
there is no permanent impairment of value, are credited or charged to a
separate component of stockholders' equity until realized, net of any
tax effect. When investment securities are sold, the realized gain or
loss is determined based upon specific identification. Fair market
value of fixed maturities and common and non-redeemable preferred stocks
is based on quoted market prices. For other securities held as
investments, fair market value equals quoted market price, if available.
If a quoted market price is not available, fair market value is
estimated using quoted market prices for similar securities. The
Company has not invested more than 7% in fixed maturities of any one
state or political subdivision.
26
<PAGE
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE A-Summary of Significant Accounting Policies - (continued)
The Company originates and holds mortgage loans on real estate
primarily on properties located in the Commonwealth of Massachusetts and
the State of Connecticut. The Company controls credit risk through
credit approvals, credit limits and monitoring procedures. The Company
performs in-depth credit evaluations on all new customers. Bad debt
expenses have not been material in recent years.
Mortgage loans on real estate and collateral notes receivable are
stated at the amount of unpaid principal, less an allowance for possible
loan losses. The adequacy of the allowance for possible loan losses is
evaluated on a regular basis by Management. Factors considered in
evaluating the adequacy of the allowance include previous loss
experience, current economic conditions and their effect on borrowers
and the performance of individual loans in relation to contract terms.
The provision for possible loan losses charged to operating expenses is
based upon Management's judgment of the amount necessary to maintain the
allowance at a level adequate to absorb possible losses. Loan losses
are charged against the allowance when Management believes the
collectibility of the principal is unlikely and recoveries are credited
to the allowance when received.
Interest on mortgage loans is included in income as earned based
upon rates applied to principal amounts outstanding. Accrual of
interest on mortgage loans is discontinued either when reasonable doubt
exists as to the full, timely collection of interest or principal, or
when a loan becomes contractually past due more than ninety days. When
a loan is placed on nonaccrual status, all unpaid interest previously
accrued is reversed against current period earnings.
3. Short-Term Investments
Short-term investments which consist of Commercial Paper, Auction
Rate Preferred Stocks and Variable Rate Municipal Bonds, are carried at
cost, which approximates market value.
4. Cash and Cash Equivalents
Cash and cash equivalents include cash currently on hand to cover
operating expenses. In 1997, the Company held $17,051 in a U.S.
Government Repurchase Agreement at The Bank of New York. In 1996, the
Company held $118,015 in a U.S. Government Repurchase Agreement at The
First National Bank of Boston. When the Company enters into a
repurchase agreement through its custodian, it receives delivery of the
underlying collateral. The amount of collateral, at the time of
purchase and each subsequent business day, is required to be maintained
at such a level that market value is equal to 102% of the resale price.
5. Deferred Policy Acquisition Costs
Policy acquisition costs relating to unearned premiums, consisting
of commissions, premium taxes and other underwriting expenses incurred
at the policy issuance, are deferred and amortized over the period in
which the related premiums are earned, the amount being reduced by any
potential premium deficiency. If any potential premium deficiency
exists, it represents future estimated losses, loss adjustment expenses
and amortization of deferred acquisition costs in excess of the related
unearned premiums. There was no premium deficiency in 1997, 1996 and
1995. In determining whether a premium deficiency exists, the Company
considers anticipated investment income on unearned premiums.
27
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE A-Summary of Significant Accounting Policies - (continued)
6. Property and Equipment
Property and equipment are stated at cost and are depreciated on
the straight line method over the estimated useful lives of the assets
using the following rates:
<TABLE>
Percent
Asset Classification Per
Annum
<CAPTION>
<S>
<C>
Buildings.......................................
2.5
Building improvements (prior to 1992)...........
2.5
Building improvements (1992 and subsequent).....
5.0
Equipment and office furniture..................
10.0
EDP equipment and copiers.......................
20.0
Automobiles.....................................
33.3
</TABLE>
Maintenance and repairs are charged to operations; betterments are
capitalized. The cost of property sold or otherwise disposed of and the
accumulated depreciation thereon are eliminated from the related
property and accumulated depreciation accounts and any resulting gain or
loss is credited or charged to income.
7. Losses and Loss Adjustment Expenses
The liability for unpaid losses and loss adjustment expenses
("LAE") represents the accumulation of individual case estimates for
reported losses and estimates for incurred but not reported ("IBNR")
losses and LAE. Assumed losses and LAE are recorded as reported by the
ceding organization with additional adjustments for IBNR. The liability
for losses and LAE is intended to cover the ultimate net cost of all
losses and loss adjustment expenses incurred through the balance sheet
date. Liability estimates are continually reviewed and updated, and
therefore, the ultimate liability may be more or less than the current
estimate. The effects of changes in the estimates are included in the
results of operations in the period in which the estimates are revised.
8. Premiums
Insurance premiums are recognized as income ratably over the terms
of the policies. Unearned premiums are determined by prorating policy
premiums on a daily basis over the terms of the policies. A significant
portion of the Company's premiums written is derived through the
American Automobile Association Clubs of Massachusetts ("AAA clubs")
group marketing program. Of the Company's total direct premiums
written, the portion attributable to the AAA group business was $422,074
or 55% in 1997 as compared to $344,297 or 47% in 1996. Of these
amounts, 10% and 9% were written through insurance agencies owned by the
AAA clubs and 90% and 91% were written through the Company's network of
independent agents in 1997 and 1996, respectively.
9. Income Taxes
The Company uses an asset and liability approach that requires the
recognition of deferred tax assets and liabilities for the expected
future tax consequences of events that have been recognized in the
Company's financial statements or tax returns. In estimating future tax
consequences, the Company generally considers all expected future events
other than changes in the tax law or rates, unless enacted. Valuation
allowances are established when necessary to reduce deferred tax assets
to the amount expected to be realized.
10. Deferred Income
Income consisting of group marketing service fees and expense
reimbursements which include servicing carrier fees from Commonwealth
Automobile Reinsurers ("C.A.R."), a state-mandated reinsurance
mechanism, on policies written for C.A.R., are deferred and amortized
over the term of the related insurance policies (see note F).
28
<PAGE
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE A-Summary of Significant Accounting Policies - (continued)
11. Net Earnings Per Common Share
In 1997, the Financial Accounting Standards Board issued Statement
No. 128, Earnings per Share. Statement 128 replaced the calculation of
primary and fully diluted earnings per share with basic and diluted
earnings per share. The adoption of this new standard had no effect on
the calculation of earnings per share for any period presented in these
financial statements.
Net earnings per common share is computed by dividing net earnings
by the weighted average number of common shares outstanding. The
weighted average number of common shares outstanding for the years ended
December 31, 1997, 1996 and 1995 was 36,044,679, 36,311,887 and
37,632,236, respectively.
12. Treasury Stock
On May 19, 1995, the Board of Directors of the Company, announced
the approval of a stock buyback program of up to three million shares.
Through December 31, 1997, the Company purchased 1,957,348 shares of
Treasury Stock under this program.
NOTE B-Investments and Investment Income
1. Fixed Maturities
The amortized cost and estimated fair market values of investments
in fixed maturities are as follows:
<TABLE>
Gross
Gross Estimated
Amortized Unrealized
Unrealized Fair Market
Cost Gains
Losses Value
<CAPTION>
<S> <C> <C> <C>
<C>
At December 31, 1997:
GNMA mortgage-backed bonds........... $175,788 $ 5,292 $
(11) $181,069
Obligations of states and
political subdivisions.............. 390,996 18,898
(366) 409,528
Totals.......................... $566,784 $ 24,190 $
(377) $590,597
At December 31, 1996:
GNMA mortgage-backed bonds........... $223,590 $ 2,589 $
(627) $225,552
Obligations of states and
political subdivisions.............. 476,921 15,301
(1,072) 491,150
Totals.......................... $700,511 $ 17,890 $
(1,699) $716,702
</TABLE>
29
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE B-Investments and Investment Income - (continued)
Proceeds from sales of investments in fixed maturities, gross
gains, and gross losses realized on those sales were as follows:
<TABLE>
Proceeds
Gross Gross
From
Realized Realized
Sales
Gains Losses
<CAPTION>
<S> <C> <C>
<C>
For the year ended December 31, 1997:
GNMA mortgage-backed bonds......................... $ - $
- - $ -
Obligations of states and political subdivisions... 124,653
3,994 (390)
Totals........................................ $124,653 $
3,994 $ (390)
For the year ended December 31, 1996:
GNMA mortgage-backed bonds......................... $ - $
- - $ -
Obligations of states and political subdivisions... 122,431
367 (3,685)
Totals........................................ $122,431 $
367 $ (3,685)
For the year ended December 31, 1995:
GNMA mortgage-backed bonds......................... $ - $
- - $ -
Obligations of states and political subdivisions... 72,287
2,340 (695)
Totals........................................ $ 72,287 $
2,340 $ (695)
</TABLE>
The amortized cost and approximate fair market value of fixed
maturities at December 31, 1997 and 1996, by contractual maturity, are
as follows:
<TABLE>
1997
1996
Fair
Fair
Amortized Market
Amortized Market
Cost Value
Cost Value
<CAPTION>
<S> <C> <C>
<C> <C>
Obligations of states and political subdivisions:
Due in one year or less.......................... $ - $ -
$ 508 $ 517
Due after one year through five years............ 2,083 2,200
94 102
Due after five years through ten years........... 1,321 1,324
1,669 1,681
Due after ten years.............................. 387,592 406,004
474,648 488,847
390,996 409,528
476,919 491,147
GNMA mortgage-backed bonds....................... 175,788 181,069
223,592 225,555
Total fixed maturities........................... $566,784 $590,597
$700,511 $716,702
</TABLE>
Expected maturities may differ from contractual maturities because
issuers may have the right to call or prepay obligations.
30
<PAGE
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE B-Investments and Investment Income - (continued)
2. Common Stocks
The cost and approximate fair market value of common stocks at
December 31, 1997 and 1996, are as follows:
<TABLE>
1997
1996
Fair
Fair
Market
Market
Cost Value
Cost Value
<CAPTION>
<S> <C> <C>
<C> <C>
Preferred stock mutual funds................ $115,943 $119,439
$ 28,553 $ 29,087
Common stocks............................... 44,428 58,650
37,372 56,954
$160,371 $178,089
$ 65,925 $ 86,041
</TABLE>
3. Mortgage Loans on Real Estate and Collateral Notes Receivable
At December 31, 1997 and 1996, mortgage loans on real estate and
collateral notes receivable consisted of the following:
<TABLE>
December 31,
1997
1996
<CAPTION>
<S> <C>
<C>
Residential (1st Mortgages)............ $58,430
$58,263
Residential (2nd Mortgages)............ 523
1,077
Commercial (1st Mortgages)............. 14,755
15,805
Commercial (2nd Mortgages)............. 172
196
73,880
75,341
Collateral notes receivable............ 11,771
2,005
85,651
77,346
Allowance for possible loan losses..... (2,812)
(2,760)
Mortgage loans on real estate and
collateral notes receivable....... $82,839
$74,586
</TABLE>
Fair value of the Company's mortgage loans on real estate and
collateral notes receivable is estimated by discounting the future cash
flows using the current rates at which similar loans would be made to
borrowers with similar credit and for the same remaining maturities.
The future cash flows associated with certain non-performing loans are
estimated based on expected payments from borrowers either through work
out arrangements or the disposition of collateral. The fair value of
mortgage loans on real estate and collateral notes receivable at
December 31, 1997 and 1996, prior to the allowance for possible loan
losses, was $87,867 and $78,920, respectively, which was estimated by
discounting the future cash flows of the mortgages.
At December 31, 1997 and 1996, mortgage loans which were on
nonaccrual status were
$2,021 and $2,095, respectively. The reduction in interest income
associated with nonaccrual loans was $207, $152 and $287 for the years
ended December 31, 1997, 1996 and 1995, respectively.
The Company originates and services residential and commercial
mortgages primarily in Massachusetts and generally its exposure is 80%
or less of the appraised value of any collateralized real property. The
ability and willingness of residential and commercial borrowers to honor
their repayment commitments is generally dependent upon the level of
overall economic activity and real estate values.
31
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE B-Investments and Investment Income - (continued)
A summary of the changes in the allowance for possible loan losses
follows:
<TABLE>
Year
ended December 31,
1997 1996
<CAPTION>
<S> <C>
<C>
Balance, beginning of year........................ $
2,760 $ 3,173
Increase (decrease) in provision for possible
loan losses...................................
52 (413)
Loans charged off...............................
- - -
Balance, end of year.............................. $
2,812 $ 2,760
</TABLE>
The following table describes mortgage principal balances by
maturity and discloses over 90 days past due and foreclosure
information:
<TABLE>
1997 1996
<CAPTION>
<S> <C>
<C>
Fixed Rate Mortgages Maturing:
One year or less................................ $
4 $ 632
More than one year to five years................
2,062 2,248
More than five years to ten years...............
4,608 4,700
Over ten years..................................
46,868 42,902
Total Fixed Mortgages...................... $
53,542 $ 50,482
Adjustable Rate Mortgages Maturing:
One year or less................................ $
- - $ -
More than one year to five years................
- - 43
More than five years to ten years...............
498 569
Over ten years..................................
19,840 24,247
Total Adjustable Mortgages................. $
20,338 $ 24,859
Past due over 90 days............................. $
2,021 $ 2,095
Mortgages in Foreclosure.......................... $
1,459 $ 938
</TABLE>
4. Net Investment Income
The components of net investment income were as follows:
<TABLE>
Year ended
December 31,
1997
1996 1995
<CAPTION>
<S> <C> <C>
<C>
Interest on fixed maturities.................. $ 46,449 $
56,034 $ 56,467
Dividends on common and preferred stocks...... 19,799
12,765 8,486
Interest on cash and short-term investments... 10,544
4,022 2,466
Interest on mortgage loans.................... 6,578
6,737 6,141
Other......................................... 122
105 478
Total investment income.............. 83,492
79,663 74,038
Investment expenses........................... 2,698
2,261 2,725
Net investment income................ $ 80,794 $
77,402 $ 71,313
</TABLE>
32
<PAGE
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE B-Investments and Investment Income - (continued)
5. Net Realized and Unrealized Investment Gains (Losses)
Net realized investment gains and the net increases (decreases) in
unrealized investment gains or losses, less applicable income tax
expense, were as follows:
<TABLE>
Year ended
December 31,
1997
1996 1995
<CAPTION>
<S> <C> <C>
<C>
Net realized investment gains (losses):
Fixed maturities................................. $ 1,419 $
(7,364) $ 477
Preferred stocks................................. 6
(349) 890
Common stocks.................................... 21,440
456 (485)
Other............................................ (95)
(317) (170)
Total........................................ $ 22,770 $
(7,574) $ 712
Net increase (decrease) in unrealized gains (losses):
Fixed maturities................................. $ 7,622 $
2,222 $ 70,335
Preferred stocks................................. 1,165
(424) 10,123
Common stocks.................................... (2,398)
8,317 10,185
Related tax benefit (expense).................... (2,236)
(3,540) (31,725)
Total........................................ $ 4,153 $
6,575 $ 58,918
</TABLE>
A summary of accumulated unrealized gains and losses on stocks and
fixed maturity investments in 1997, 1996 and 1995 follows:
<TABLE>
Year ended
December 31,
1997
1996 1995
<CAPTION>
<S> <C> <C>
<C>
Unrealized gains....................... $ 43,675 $
40,227 $ 32,056
Unrealized losses...................... (1,780)
(4,721) (6,665)
Tax benefit (expense).................. (14,663)
(12,427) (8,887)
Net unrealized gains
(losses)........................ $ 27,232 $
23,079 $ 16,504
</TABLE>
NOTE C-Deferred Policy Acquisition Costs
Policy acquisition costs incurred and amortized to income are as
follows:
<TABLE>
Year ended
December 31,
1997
1996 1995
<CAPTION>
<S> <C> <C>
<C>
Balance, beginning of year............. $ 82,968 $
67,160 $ 59,066
Costs deferred during the year......... 189,787
196,821 174,835
Amortization charged to expense........ (187,491)
(181,013) (166,741)
Balance, end of year................... $ 85,264 $
82,968 $ 67,160
</TABLE>
33
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE D-Property and Equipment
A summary of property and equipment at December 31, is as follows:
<TABLE>
1997
1996
<CAPTION>
<S> <C>
<C>
Buildings................................. $ 27,873
$ 27,506
Equipment and office furniture............ 30,286
24,993
Building improvements..................... 828
811
58,987
53,310
Less accumulated depreciation.......
(25,081) (22,015)
33,906
31,295
Land...................................... 934
805
Construction in progress.................. 1,440
- -
$ 36,280
$ 32,100
</TABLE>
Depreciation expense incurred was $4,213, $3,202 and $3,151 for
the years ended December 31, 1997, 1996 and 1995, respectively.
Depreciation expense is allocated between losses and loss adjustment
expenses and policy acquisition costs.
NOTE E-Losses and Loss Adjustment Expenses
Liabilities for unpaid losses and loss adjustment expenses at
December 31, consist of:
<TABLE>
1997
1996
<CAPTION>
<S> <C>
<C>
Unpaid loss and LAE reserves.............. $725,886
$718,593
Salvage and subrogation recoverable.......
(76,413) (55,761)
$649,473
$662,832
</TABLE>
Significant periods of time can elapse between the occurrence of
an insured loss, the reporting of the loss to the insurer and the
insurer's payment of that loss. To recognize liabilities for unpaid
losses, insurers establish reserves as balance sheet liabilities
representing estimates of amounts needed to pay reported and unreported
losses and LAE. Quarterly, the Company reviews these reserves
internally. Regulations of the Division of Insurance require the
Company to obtain annually a certification from either a qualified
actuary or an approved loss reserve specialist that its loss and LAE
reserves are reasonable.
When a claim is reported to the Company, its claims personnel
establish a "case reserve" for the estimated amount of the ultimate
payment. The amount of the reserve is primarily based upon an
evaluation of the type of claim involved, the circumstances surrounding
the claim and the policy provisions relating to the loss. The estimate
reflects the informed judgment of such personnel based on general
insurance reserving practices and on the experience and knowledge of the
claims person. During the loss adjustment period, these estimates are
revised as deemed necessary by the Company's claims department based on
subsequent developments and periodic reviews of the cases.
In accordance with industry practice, the Company also maintains
reserves for estimated IBNR. IBNR reserves are determined on the basis
of historical information and the experience of the Company.
Adjustments to IBNR are made periodically to take into account changes
in the volume of business written, claims frequency and severity, the
mix of business, claims processing and other items that can be expected
to affect the Company's liability for losses and LAE over time.
34
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE E-Losses and Loss Adjustment Expenses - (continued)
When reviewing reserves, the Company analyzes historical data and
estimates the impact of various factors such as (i) per claim
information, (ii) the historical loss experience of the Company and
industry and (iii) legislative enactments, judicial decisions, legal
developments in the imposition of damages, changes and trends in general
economic conditions, including the effects of inflation. This process
assumes that past experience, adjusted for the effects of current
developments and anticipated trends, is an appropriate basis for
predicting future events. There is no precise method, however, for
subsequently evaluating the impact of any specific factor on the
adequacy of reserves, because the eventual development of reserves is
affected by many factors.
By using both individual estimates of reported claims and
generally accepted actuarial reserving techniques, the Company estimates
the ultimate net liability for losses and LAE. After taking into
account all relevant factors, management believes that the provision for
losses and LAE at December 31, 1997 is adequate to cover the ultimate
net cost of losses and claims incurred as of that date. The ultimate
liability, however, may be greater or lower than reserves.
Establishment of appropriate reserves is an inherently uncertain
process, and there can be no certainty that currently established
reserves will prove adequate in light of subsequent actual expeience.
The Company does not discount to present value that portion of its loss
reserves expected to be paid in future periods.
Included in the loss reserve methodologies described above, are
liabilities for unpaid claims and claim adjustment expenses for
environmental related claims such as oil spills and lead paint.
Reserves have been established to cover these claims for both known and
unknown losses. Because of the Company's limited exposure to these
types of claims, management believes they will not have a material
impact on the consolidated financial position of the Company in the
future. Loss reserves on environmental related claims amounted to
$6,924, $8,783 and $10,708 in 1997, 1996 and 1995, respectively.
The following table sets forth a reconciliation of beginning and
ending reserves for losses and loss adjustment expenses, net of
reinsurance deductions from all reinsurers including C.A.R., as shown in
the Company's consolidated financial statements for the periods
indicated.
<TABLE>
Year ended
December 31,
1997
1996 1995
<CAPTION>
<S> <C> <C>
<C>
Reserves for losses and loss adjustment
expenses, beginning of year......................... $533,980
$493,911 $455,460
Incurred losses and loss adjustment expenses:
Provision for insured events of the current year.. 609,930
562,997 442,027
Decrease in provision for insured events of
prior years...................................... (83,803)
(87,766) (74,475)
Total incurred losses and loss adjustment
expenses....................................... 526,127
475,231 367,552
Payments:
Losses and loss adjustment expenses attributable
to insured events of the current year............ 322,882
267,653 184,073
Losses and loss adjustment expenses attributable
to insured events of prior years................. 207,148
167,509 145,028
Total payments.................................. 530,030
435,162 329,101
Loss and loss adjustment expense reserves prior to
effect of ceded reinsurance recoverable.......... 530,077
533,980 493,911
Ceded reinsurance recoverable..................... 119,396
128,852 132,118
Reserves for losses and loss adjustment expenses
at the end of year per financial statements......... $649,473
$662,832 $626,029
</TABLE>
35
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1996, 1995 and 1994
(Thousands of Dollars)
NOTE E-Losses and Loss Adjustment Expenses - (continued)
The provision for loss and LAE reserves relating to prior years
decreased by $83,803, $87,766 and $74,475 in 1997, 1996 and 1995,
respectively due to favorable loss development experienced in both the
voluntary and involuntary private passenger auto business.
The increases in payments and incurred losses primarily resulted
from increases in total loss and loss adjustment expense payments on the
direct personal automobile lines of business of approximately 20.4%.
Net loss payments in the direct personal automobile lines of business
increased approximately 21.5% or $71,300 which were offset by a decrease
in payments for other than automobile lines of business of approximately
$16,200, compared to 1996. The decrease in other than automobile loss
payments was primarily the result of more normal weather in 1997 versus
the severe weather experienced in 1996. The increase in automobile loss
payments was attributable primarily to three factors: increased
payments for collision coverages; increased payments for bodily injury
claims; and increased payments for property damage liability claims.
Bodily injury payments were higher primarily due to increased business
writings coupled with initiatives in the claims department to accelerate
the claims settlement process in an effort to reduce the overall cost of
bodily injury claims in the long run as well as to reduce the overall
number of open bodily injury claims.
The Company's loss and LAE reserves reflect its share of the
aggregate loss and LAE reserves of all Servicing Carriers. The Company
is a defendant in various legal actions arising from the normal course
of its business. These proceedings are considered to be ordinary and
incidental to operations or without foundation in fact. Management is
of the opinion that these actions will not have a material adverse
effect on the consolidated financial statements of the Company.
NOTE F-Reinsurance Activity
The Company has reinsurance contracts for casualty and catastrophe
coverages. These reinsurance arrangements minimize the Company's losses
arising from large risks and protect the Company against numerous losses
from a single occurrence or event. The Company also has a combined
quota share and excess loss reinsurance contract on its other than
automobile property business.
Property and Catastrophe Reinsurance
From the inception, on September 30, 1993, through the third
quarter of 1995, the Company's combined property quota share and excess
loss reinsurance contract was written with five domestic reinsurance
companies. Under the quota share portion of the arrangements, the
reinsurers indemnified the Company for 36% of the loss and LAE, and paid
a commission allowance based on the ratio of losses incurred to premiums
earned. In exchange, the Company paid to the reinsurers 40% of the net
premium pertaining to the related business. The maximum per occurrence
loss reimbursement was $40.0 million and the maximum annual aggregate
occurrence loss reimbursement was $60.0 million. Under the excess loss
reinsurance portion of the arrangements, the Company reinsured each
risk, retaining $125 and reinsuring 100% of the next $875.
Effective September 30, 1995, the Company increased its coverage
under the combined property quota share and excess loss reinsurance
contract. The contract is now written with six domestic reinsurance
companies. Under the quota share portion of the arrangements, the
reinsurers indemnify the Company for 45% of the loss and LAE, and pay a
commission allowance based on the ratio of losses incurred to premiums
earned. In exchange, the Company pays to the reinsurers 49% of the net
premium pertaining to the related business. The maximum per occurrence
loss reimbursement is $50.0 million and the maximum annual aggregate
occurrence loss reimbursement is $75.0 million. Under the excess loss
reinsurance portion of the arrangements, the Company reinsures each
risk, retaining $125 and reinsuring 100% of the next $875. This
reinsurance contract is continuous through September 30, 1998, but
cancelable quarterly with ninety days notice. Written premiums ceded in
1997, 1996 and 1995 under the property quota share and excess loss
reinsurance contract were $27.5 million, $26.6 million and $21.5
million, respectively.
36
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE F-Reinsurance Activity - (continued)
Effective March 1, 1995, through February 29, 1996, the Company
had catastrophe reinsurance coverage for that portion of the loss not
covered under the property quota share arrangement. Catastrophe
reinsurance coverage was in force for approximately 88.0% of the amounts
incurred for all property claims arising from a single event or
occurrence up to a maximum loss of $100.0 million, after first
subtracting property quota share losses. Coverage under the catastrophe
program was as follows: a net retention of $5.0 million; 50.0% of the
next $5.0 million; and, 95.0% of the next $90.0 million. Including the
Company's retention, total catastrophe coverage was $100.0 million.
This coverage was placed with a number of reinsurers, both foreign and
domestic.
Effective March 1, 1996, through February 28, 1998, the Company's
catastrophe reinsurance program was tailored in conjunction with the
property quota share arrangement to provide catastrophe reinsurance
protection at varying levels of losses. The Company's two separate
catastrophe only programs provide a maximum amount of protection of $18
million and $42 million. These two programs expire on March 1, 1998 and
May 1, 1998, respectively. The table below provides information
depicting the approximate combined recoveries of all property
reinsurance programs (catastrophe and quota share) at various loss
scenarios if a catastrophe were to strike:
<TABLE>
Net Loss
Total Reinsurance Retained by
Loss Recovery the Company
<CAPTION>
<S> <C> <C>
$ 25,000 $ 11,300 $13,700
50,000 35,000 15,000
75,000 58,800 16,200
100,000 82,500 17,500
125,000 105,000 20,000
150,000 110,000 40,000
</TABLE>
Under the above scenario, the Company had no reinsurance
recoveries for total loss amounts in excess of $150.0 million. The
Company is currently negotiating with several of its existing quota-
share and excess loss reinsurance providers to expand the quota share
portion of the program. A 75% quota-share reinsurance program is
contemplated, covering all non-automobile property and liability
business except umbrella policies. The excess loss portion of the
program would be reduced on July 1, 1998 and completely eliminated on
September 30, 1998. The Company intends to incept this expanded program
on July 1, 1998. Based on this, the Company's catastrophe reinsurance
program will consist solely of the current quota-share and excess loss
reinsurance contract for a period of time between May 1, 1998 and June
30, 1998.
Casualty Reinsurance
Through December 31, 1996, casualty reinsurance was on an excess
of loss basis for any one event or occurrence with a maximum recovery of
$4.0 million over a net retention of $1.0 million. Effective January 1,
1997, casualty reinsurance is on an excess of loss basis for any one
event or occurrence with a maximum recovery of $9.0 million over a net
retention of $1.0 million. This coverage is placed with Swiss
Reinsurance America Corporation, formerly North American Reinsurance
Corporation (rated A by A.M. Best).
Effective January 1, 1995, personal and commercial liability
umbrella policies are reinsured on a 95% quota share basis in regard to
limits up to $1.0 million and 100% quota share basis for limits in
excess of $1.0 million but not exceeding $5.0 million for policies with
underlying automobile coverage of $250/$500 or more. Effective January
1, 1996, the Company added personal liability umbrella reinsurance
coverage for policies with underlying automobile coverage of $100/$300,
on a 65% quota share basis in regard to limits up to $1.0 million and
100% quota share basis for limits in excess of $1.0 million but not
exceeding $3.0 million. These coverages are placed with Munich American
Reinsurance Corporation (rated A+ by A.M. Best).
37
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE F-Reinsurance Activity - (continued)
C.A.R.
C.A.R., a state-mandated reinsurance mechanism, enables the
Company and approximately 40 other writers of automobile insurance in
Massachusetts ("Servicing Carriers") to reinsure any automobile risk
that the insurer perceives to be underpriced at the premium level
permitted by the Massachusetts Insurance Commissioner (the
"Commissioner"). Servicing Carriers, who are responsible for over 99.0%
of total direct premiums written for personal automobile insurance in
Massachusetts, are required to offer automobile insurance coverage to
all eligible applicants pursuant to "take-all-comers" regulations, but
may reinsure undesirable business with C.A.R.
The Company pays to C.A.R. all of the premiums generated by the
policies it has ceded and C.A.R. reimburses the Company for all losses
incurred on account of ceded policies. In addition, the Company
receives a fee for servicing ceded policies based on the expense
structure established by C.A.R. For the years ended December 31, 1997,
1996 and 1995, these servicing fees amounted to $17,333, $17,127 and
$21,669, respectively.
Since its inception, C.A.R. has annually generated multi-million
dollar underwriting losses in both the personal and commercial pools.
The Company is required to share in the underwriting results of C.A.R.
business for its respective product lines. Under current regulations,
the Company's share of the C.A.R. personal or commercial deficit is
based upon its market share for retained automobile risks for the
particular pool, adjusted by a "utilization" concept, such that, in
general, the Company is disproportionately and adversely affected if its
relative use of C.A.R. reinsurance exceeds that of the industry, and
favorably affected if its relative use of C.A.R. reinsurance is less
than that of the industry. During 1997, 1996 and 1995, the Company's
net participation in the C.A.R. personal automobile pool approximated
18.0%, 19.0% and 16.0%, respectively.
Written premiums, earned premiums, losses incurred and the
liabilities for unearned premiums, unpaid losses ceded to and assumed
from C.A.R. and were as follows:
<TABLE>
Year ended December 31,
1997 1996
1995
Ceded Assumed Ceded Assumed
Ceded Assumed
<CAPTION>
<S> <C> <C> <C> <C> <C>
<C>
Income Statement
Written premiums... $ 71,816 $ 76,530 $ 82,861 $ 93,703 $
82,814 $ 92,249
Earned premiums.... 71,977 82,866 85,977 92,469
92,664 90,609
Losses incurred.... 83,240 89,081 84,074 93,278
75,475 87,786
Balance Sheet
Unearned premiums.. $ 51,662 $ 40,345 $ 49,487 $ 46,681 $
47,045 $ 45,446
Unpaid losses...... 129,137 102,819 145,726 117,237
153,079 110,003
</TABLE>
In accordance with Statement of Financial Accounting Standards No.
113, "Accounting and Reporting for Reinsurance of Short-Duration and
Long-Duration Contracts", the company presents assets and liabilities
gross of reinsurance. The Residual Market Receivable represents the
gross amount of reinsurance recoverable from C.A.R. including unpaid
losses, unearned premiums, paid losses recoverable and unpaid ceded and
assumed premiums.
The current C.A.R. utilization-based participation ratio has been
in place for the personal automobile market since 1993. During 1997,
1996 and 1995 the Company's amount of personal automobile risks it
reinsured through C.A.R. approximated 6.6%, 8.0% and 11.0%,
respectively.
38
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE F-Reinsurance Activity - (continued)
Earned premiums and losses and loss adjustment expenses are stated
in the accompanying consolidated financial statements after deductions
for ceded reinsurance. Those deductions for reinsurance other than
C.A.R. are as follows:
<TABLE>
Year ended
December 31,
1997
1996 1995
<CAPTION>
<S> <C>
<C> <C>
Earned premiums ceded............................. $ 33,847 $
36,261 $ 28,056
Losses and loss adjustment expenses ceded......... 10,616
22,453 21,454
</TABLE>
The Company, as primary insurer, would be required to pay losses
in their entirety in the event that the reinsurers were unable to
discharge their obligations under the reinsurance agreements.
NOTE G-Income Taxes
The Company and its subsidiaries file a consolidated federal
income tax return.
The Federal income tax expense consisted of the following:
<TABLE>
Year ended
December 31,
1997
1996 1995
<CAPTION>
<S> <C>
<C> <C>
Current............................ $ 24,318 $
15,951 $ 34,891
Deferred........................... 6,984
2,098 4,650
$ 31,302 $
18,049 $ 39,541
</TABLE>
Deferred taxes arise from temporary differences in the bases of
assets and liabilities for tax and financial statement purposes. The
sources of these differences and the related tax effects consisted of
the following:
<TABLE>
Year ended
December 31,
1997
1996 1995
<CAPTION>
<S> <C>
<C> <C>
Unearned premiums.................................. $ (769) $
(3,695) $ (1,469)
Discounting of loss reserves....................... 2,421
(2,954) (370)
Bad debt expense................................... 129
131 92
Deferred policy acquisition costs.................. 1,297
6,022 5,087
Salvage and subrogation recoverable................ (406)
425 151
Tax depreciation in excess of book depreciation.... 151
192 205
Book value rights/book value awards/stock
appreciation rights............................... 4,912
1,686 334
Deferred items not included above.................. (751)
291 620
Deferred income tax.......................... 6,984
2,098 4,650
Change in unrealized gains......................... 2,236
3,540 31,726
Change in deferred tax liability............. $ 9,220 $
5,638 $ 36,376
</TABLE>
39
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars Except Per Share Data)
NOTE G-Income Taxes - (continued)
Realization of a deferred tax asset is dependent on generating
sufficient taxable income in future years. Although realization is not
assured, Management believes it is more likely than not that all of the
deferred tax assets will be realized. The amount of the deferred tax
asset considered realizable, however, could be reduced in the near term
if estimates of future taxable income are reduced. Deferred tax
liabilities (assets) were comprised of the following components at
December 31, 1997 and 1996:
<TABLE>
1997 1996
<CAPTION>
<S> <C>
<C>
Unearned premiums................................................
$(20,608) $(19,839)
Discounting of loss reserves.....................................
(21,379) (23,800)
Bad debt allowances..............................................
(772) (901)
Deferred tax assets........................................
(42,759) (44,540)
Deferred policy acquisition costs................................
25,832 24,535
Salvage and subrogation recoverable..............................
2,001 2,407
Tax depreciation in excess of book depreciation..................
2,856 2,705
Book value rights/book value awards/stock appreciation rights....
8,199 3,287
Unrealized gains.................................................
14,663 12,427
Deferred items not included above................................
2,651 3,402
Deferred tax liabilities...................................
56,202 48,763
Net deferred tax liability................................. $
13,443 $ 4,223
</TABLE>
Federal income tax on income is less than the amount computed by
applying the statutory rate of 35% for the years ended 1997, 1996 and
1995 for the following reasons:
<TABLE>
Year ended December 31,
1997 1996
1995
<CAPTION>
<S> <C> <C> <C> <C>
<C> <C>
Tax at statutory rate.. $ 44,631 35.0% $32,205 35.0%
$52,410 35.0%
Tax exempt interest.... (8,036) (6.3) (10,062) (10.9)
(11,067) (7.4)
Dividends paid to ESOP
participants......... (782) (0.6) (1,169) (1.3)
- - -
Dividends received
deduction............ (4,567) (3.6) (3,167) (3.4)
(2,038) (1.4)
Other.................. 56 0.0 242 0.2
236 0.2
Tax at effective rate.. $ 31,302 24.5% $18,049 19.6%
$39,541 26.4%
</TABLE>
NOTE H-Related-Party Transactions
The Company has made loans to insurance agencies and other
organizations with which the Company transacts business on a regular
basis. At December 31, 1997, seven of these loans which had an
aggregate outstanding principal balance of $12,161 were collateralized
by the assets of the agencies. At December 31, 1996, eleven of these
loans which had an aggregate outstanding principal balance of $2,384
were collateralized by the assets of the agencies. Mortgage loans to
agents collateralized by real estate had an aggregate outstanding
balance of $317 at December 31, 1996. There were no such mortgage loans
outstanding at December 31, 1997.
40
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE H-Related-Party Transactions (continued)
During 1992, the Company insured a mortgage note in the principal
amount of $28,750 issued by a corporation to a bank. Two directors of
the Company, were, with others, guarantors of this note. The Company's
liability under this insurance policy, which expired on October 15,
1995, was $12,000. For this insurance, the Company received the full
premium of $1,080 in 1992, which was earned pro-rata through the
expiration date of the policy.
One Director of the Company, is the Chairman Emeritus and
Assistant Clerk of an insurance agency which is one of the Company's
independent insurance agencies. This Director sold his ownership
interest in that agency in 1994, although he remains associated with it
in the above stated capacity. This Director also continues to receive
payments under non-competition and loan agreements. This Director
receives no direct or indirect compensation based on the commissions
paid to the agency by the Company. During the years ended December 31,
1997, 1996 and 1995 the agency received from the Company commissions of
$834, $906 and $885, respectively, in the aggregate, for policies
written. The Company also purchased certain insurance coverages through
the agency and paid premiums for these policies of $367, $360 and $218
in 1997, 1996 and 1995, respectively.
NOTE I-Employee Stock Ownership Plan
The Company offers an Employee Stock Ownership Plan for the
benefit of substantially all employees, including those of the Company's
subsidiaries. The E.S.O.P. is noncontributory on the part of
participants and contributions are made at the discretion of the Board
of Directors. The Company is under no obligation to make contributions
or maintain the Plan for any length of time, and may completely
discontinue or terminate the Plan at any time without liability.
Contributions by the Company and subsidiaries to the Plan for the
years ending December 31, 1997, 1996 and 1995 were $4,841, $6,216 and
$5,729, respectively.
NOTE J-Stockholders' Equity
Book Value Rights, Book Value Awards and Stock Appreciation Rights
Program
The Board of Directors authorized a Book Value Rights Program
which provided for the payment of awards in cash to key employees based
upon increases in the book value of the Company at the end of the
program period, which is December 31st of the third year after the
rights have been granted. The Board of Directors authorized advance
payments of $1,888 in December, 1995 applicable to Book Value Rights
maturing in 1996. Expenses relating to this Book Value Rights Program
were $234 and $3,738 in 1996 and 1995, respectively.
The Management Incentive Plan approved by the Company's
stockholders in May, 1994 provides for the award of incentive stock
options, non-qualified stock options, book value awards, stock
appreciation rights, restricted stock and performance stock units. Up
to 2,500,000 shares of common stock (subject to increase for anti-
dilution adjustments) may be issued under the Plan, including shares
that may be issued pursuant to awards of restricted stock or upon the
exercise of common stock equivalent awards such as stock options and
stock appreciation rights payable in the form of common stock. All
directors, officers and other senior management employees of the Company
or any of its subsidiaries are eligible to participate in this
Management Incentive Plan. Book value awards issued relating to this
Plan totalled 453,488, 468,381 and 606,088 in 1997, 1996 and 1995,
respectively. Stock appreciation rights issued also relating to this
Plan totalled 493,492, 520,625 and 672,358 in 1997, 1996 and 1995,
respectively. The outstanding book value awards and stock appreciation
rights entitle the holders to cash payments based upon the extent to
which, if at all, the per share book value or market value, as
applicable, of the common stock exceeds certain thresholds set at the
time the award was granted. Expenses relating to book value awards were
$3,068, $2,140 and $714 in 1997, 1996 and 1995. Expenses relating to
stock appreciation rights were $15,657, $6,224 and $366 in 1997, 1996
and 1995.
41
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE K-Net Capital Requirements
The insurance companies included in the consolidated financial
statements are subject to the financial capacity guidelines established
by their respective state Divisions of Insurance. Every Massachusetts
insurance company seeking to make any dividend or other distributions to
its stockholders must file a report with the Commissioner. An
extraordinary dividend is any dividend or other property, whose fair
value together with other dividends or distributions made within the
preceding twelve months exceeds the greater of ten percent of the
insurer's surplus as regards policyholders as of the end of the
preceding year, or the net income of a non-life insurance company for
the preceding year. No pro-rata distribution of any class of the
insurer's own securities is to be included. No Massachusetts insurance
company shall pay an extraordinary dividend or other extraordinary
distribution until thirty days after the Commissioner has received
notice of the intended distribution and has not objected. No
extraordinary dividends were paid in 1997, 1996 and 1995.
To the extent Commerce and Citation are restricted from paying
dividends to CHI, CHI will be limited in its ability to pay dividends to
the Company. On this basis, the Company's ability to pay dividends to
its stockholders is limited. During 1997 Commerce and Citation paid
$39,375 and $7,040 in dividends, respectively, to CHI; CHI then paid $
46,305 to the Company in March 1997. During 1996, Commerce and Citation
paid $58,630 and $6,600 in dividends, respectively, to CHI; CHI then
paid $43,470 to the Company in March 1996.
The Board of Directors of the Company voted to declare four
quarterly dividends to stockholders of record totaling $1.03 per share
and $0.81 per share in 1997 and 1996, respectively. On May 30, 1997,
the Board voted to increase the quarterly stockholder dividend from
$0.25 to $0.26 per share to stockholders of record as of June 6, 1997.
Prior to that declaration, the Company had paid quarterly dividends of
$0.25 per share dating back to May 17, 1996 when the Board voted to
increase the dividend from $0.06 to $0.25 per share.
Treasury Stock purchased under the stock buyback program increased
by 20,000 shares during 1997 to 1,957,348 shares at December 31, 1997.
The stock buyback program, authorized by the Board in May 1995, enables
the Company to purchase up to three million shares of the Company's
common stock. The program is approximately two-thirds complete.
42
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE L-Statutory Balances
Following is a GAAP to Statutory reconciliation for both earnings
and policyholders surplus for the combined operations of Commerce,
Citation and effective August 31, 1995, Western Pioneer:
<TABLE>
1997 1996
1995
Earnings Equity Earnings Equity
Earnings Equity
<CAPTION>
<S> <C> <C> <C> <C>
<C> <C>
GAAP............................ $101,528 $609,416 $ 74,432
$550,151 $110,450 $512,875
Deferred income taxes........... 4,039 8,352 929
2,165 4,152 (2,650)
Deferred acquisition costs...... (2,296) (85,264) (15,808)
(82,968) (8,094) (67,160)
Bonds-book versus market........ - (23,812) -
(16,194) - (14,432)
Preferred stock-market versus
book........................... - (429) -
(331) - (1,607)
Deferred income................. (697) 7,071 (963)
7,768 (1,496) 6,766
Deferred service fee income..... 1,784 3,139 1,538
1,538 - -
Deferred reinsurance
commissions.................... (1,267) 4,424 2,082
5,796 2,060 5,614
Statutory reserve over statement
reserves....................... - (8,567) -
(5,397) - (1,940)
Goodwill in subsidiary.......... (291) 2,226 (270)
2,515 (97) 2,806
Difference in GAAP to statutory
net income in subsidiary....... 57 - 416 -
(74) -
Other........................... - 42 4
(304) (4) (162)
Total adjustments.......... 1,329 (92,818) (12,072)
(85,412) (3,553) (72,765)
Statutory....................... 102,857 516,598 62,360
464,739 106,897 440,110
Add back subsidiary net loss
from January 1, 1995 through
August 30, 1995................ - - - -
429 -
Adjusted statutory.............. $102,857 $516,598 $ 62,360
$464,739 $107,326 $440,110
</TABLE>
NOTE M-Segment Information
Selected information by industry segment for 1997, 1996 and 1995 is
summarized as follows:
<TABLE>
Earnings
Before Identifiable
Revenue Income
Taxes Assets
<CAPTION>
<S> <C> <C>
<C>
1997
Property and casualty insurance............ $833,304 $132,544
$1,659,374
Real estate and commercial lending......... 4,448 4,448
83,420
Corporate and other........................ 3,383
(9,475) 11,959
Consolidated........................... $841,135 $127,517
$1,754,753
1996
Property and casualty insurance............ $740,707 $ 91,242
$1,590,695
Real estate and commercial lending......... 4,249 4,249
75,255
Corporate and other........................ 3,301
(3,478) 10,849
Consolidated........................... $748,257 $ 92,013
$1,676,799
1995
Property and casualty insurance............ $677,217 $147,378
$1,479,898
Real estate and commercial lending......... 3,804 3,804
76,642
Corporate and other........................ 3,014
(1,440) 7,635
Consolidated........................... $684,035 $149,742
$1,564,175
</TABLE>
43
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997, 1996 and 1995
(Thousands of Dollars)
NOTE N-Supplement to Consolidated Statements of Cash Flows
During the years ended December 31, 1996 and 1995, the Company
acquired property through foreclosure of mortgages held with remaining
principle balances at the time of foreclosure of $245 and $641,
respectively. No such property was acquired in 1997.
NOTE O-Insolvency Fund Assessments
As provided in the statutes, insurance companies which write
business in Massachusetts are assessed for losses attributable to the
insolvency of other insurance companies by the Massachusetts Insurers
Insolvency Fund ("M.I.I.F."). From its inception, on August 2, 1972
through December 31, 1997, the M.I.I.F. has approved assessments
totaling $133,474, of which the Company's share was approximately
$7,540. It is anticipated that there will be additional assessments
from time to time relating to various insolvencies. By statute, no
insurer may be assessed in any year an amount greater than two percent
of that insurer's net direct written premiums for the calendar year
preceding the assessment. Although the timing and amounts of any such
assessments are not known, Management is of the opinion that such
assessments will not have a material effect on the consolidated
financial position of the Company. The Company's policy is to expense
these assessments as assessed. According to statute, the assessed
insurance companies have the right to recoup amounts paid to the
M.I.I.F., over a reasonable length of time, through premium rates
approved by the Commissioner. The Company's policy is to expense the
recovery of the assessed amounts as received. Refund of assessments by
the M.I.I.F. for the year ended December 31, 1997 was $283. Assessments
by the M.I.I.F. for the years ended December 31, 1996 and 1995 were $742
and $338, respectively.
NOTE P-Quarterly Results of Operations (Unaudited)
An unaudited summary of the Company's 1997 and 1996 quarterly
performance is as follows:
<TABLE>
1997 FIRST SECOND
THIRD FOURTH
QUARTER QUARTER
QUARTER QUARTER
<CAPTION>
<S> <C> <C>
<C> <C>
Total revenues................................. $199,069 $205,561
$225,082 $211,423
Net earnings................................... 16,638 19,971
35,012 24,594
Net earnings per weighted average common
share (basic and diluted).................... 0.46 0.56
0.97 0.68
Cash dividends paid per share.................. 0.25 0.26
0.26 0.26
1996
Total revenues................................. $173,802 $186,448
$192,333 $195,674
Net earnings................................... 14,593 16,265
21,436 21,670
Net earnings per weighted average common
share (basic and diluted).................... 0.40 0.45
0.59 0.60
Cash dividends paid per share.................. 0.06 0.25
0.25 0.25
</TABLE>
NOTE Q-Subsequent Events
The Company was notified in February 1998 that its application for
a license in the State of Maine was approved.
44
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data presented below should be
read in conjunction with the consolidated financial statements of the
Company and the notes thereto. This financial data has been extracted
from financial statements audited by Ernst & Young, LLP in 1997 and by
other auditors in 1993 through 1996. All dollar amounts set forth in
the following tables are in thousands except per share data.
<TABLE>
Year ended
December 31,
1997 1996 1995
1994 1993
<CAPTION>
<S> <C> <C> <C>
<C> <C>
Statement of Earnings Data:
Net premiums written........... $ 741,501 $ 711,570 $ 603,421
$ 589,197 $ 563,416
Increase in unearned premiums.. (11,004) (42,854) (10,831)
(17,144) (14,856)
Earned premiums................ 730,497 668,716 592,590
572,053 548,560
Net investment income.......... 80,794 77,402 71,313
62,901 53,068
Premium finance fees........... 7,074 9,713 19,420
18,497 16,666
Net realized investment gains
(losses)...................... 22,770 (7,574) 712
45,612 7,506
Total revenues............ 841,135 748,257 684,035
699,063 625,800
Losses and loss adjustment
expenses...................... 526,127 475,231 367,552
369,660 373,959
Policy acquisition costs....... 187,491 181,013 166,741
157,415 150,195
Total expenses............ 713,618 656,244 534,293
527,075 524,154
Earnings before income taxes... 127,517 92,013 149,742
171,988 101,646
Income taxes................... 31,302 18,049 39,541
49,405 26,330
Net earnings.............. $ 96,215 $ 73,964 $ 110,201
$ 122,583 $ 75,316
Per Share Data:
Basic and diluted
net earnings per share.. $ 2.67 $ 2.04 $ 2.93
$ 3.23 $ 1.98
Cash dividends paid per
share................... $ 1.03 $ 0.81 $ 0.23
$ 0.15 $ -
Weighted average number of
shares outstanding.............. 36,044,679 36,311,887 37,632,236
38,000,000 38,000,000
</TABLE>
<TABLE>
Year ended
December 31,
1997 1996 1995
1994 1993
<CAPTION>
<S> <C> <C> <C>
<C> <C>
Balance Sheet Data:
Total investments.............. $1,242,695 $1,167,671 $1,096,778
$ 905,031 $ 873,234
Premiums receivable............ 169,469 157,835 127,047
102,432 95,103
Total assets................... 1,754,753 1,676,799 1,564,175
1,382,226 1,298,371
Unpaid losses and loss
adjustment expenses........... 649,473 662,832 626,029
599,502 574,049
Unearned premiums.............. 379,599 367,991 330,454
314,719 283,526
Stockholders' equity........... 649,796 587,039 549,714
413,589 383,348
Stockholders' equity per share. 18.03 16.28 14.96
10.88 10.09
</TABLE>
45
<PAGE
MANAGEMENT'S DISCUSSION OF THE SUPPLEMENTAL INFORMATION
ON INSURANCE OPERATIONS
(Thousands of Dollars)
The following exhibits depict the progress of the insurance
operations of the Company over the past fifteen years. For these years
of operation, net premiums written amounted to $4,783,113. During this
period, the average statutory financial ratios were 67.7% for losses and
loss expenses and 26.8% for underwriting expenses resulting in an
average combined ratio of 94.5%. Total net investment income amounted
to $515,735 or 10.8% of net premiums written. Net realized gains were
$87,868. Stockholders' equity was $11,693 at the beginning of 1983 and
$609,416, at the end of 1997, resulting in an average annual increase in
excess of 30%. The progress of the insurance operations during the most
recent five year period, compared to the two previous five year periods,
can best be illustrated by the following comparison:
<TABLE>
5-Year
Period
1993-97
1988-92 1983-87
<CAPTION>
<S> <C> <C>
<C>
Direct premiums written............................ $3,353,450
$2,029,313 $526,055
Net premiums written............................... 3,209,105
1,305,018 268,990
Net investment income.............................. 345,079
135,579 35,077
Net realized gains................................. 60,831
22,887 4,150
Stockholders' equity at end of period.............. 609,416
265,616 46,081
Statutory Financial Ratios (Unaudited)
Losses and loss expenses to premiums earned...... 67.7%
65.6% 76.7%
Underwriting expenses to net premiums written.... 26.7
27.6 24.8
Combined ratio............................... 94.4%
93.2% 101.5%
Increase in Stockholders' Equity................... 129.4%
476.4% 294.1%
</TABLE>
The insurance operations of the Company include the operating results of
Commerce, its subsidiary company Western Pioneer and Citation. Citation
commenced business in 1981 as a wholly-owned subsidiary of Commerce. On
December 31, 1989, the ownership of Citation was transferred to The
Commerce Group, Inc. Capital stock, paid-in capital and retained
earnings of Commerce and Citation as of January 1, 1989 were combined
due to the effect of the transfer in ownership of Citation to The
Commerce Group, Inc. on December 31, 1989. In September 1993, ownership
of both Commerce and Citation was transferred from The Commerce Group,
Inc. to CHI, a subsidiary of The Commerce Group, Inc. Results of
Western Pioneer are included since its acquisition by Commerce on August
31, 1995. The combined balance sheets of these insurance subsidiaries
appear on pages 47 and 48. The combined statements of earnings of
insurance operations appear on pages 49 and 50.
46
<PAGE>
MANAGEMENT'S DISCUSSION OF THE SUPPLEMENTAL INFORMATION
ON INSURANCE OPERATIONS (continued)
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
COMBINED BALANCE SHEETS OF INSURANCE SUBSIDIARIES
December 31,
(Thousands of Dollars)
<TABLE>
1997 1996 1995
1994 1993
ASSETS
<CAPTION>
<S> <C> <C> <C>
<C> <C>
Cash and short-term investments.... $ 238,685 $ 140,102 $ 52,308
$ 4,560 $ 12,615
Bonds, at market (at amortized cost
prior to 1993).................... 590,597 716,702 815,277
745,010 649,491
Preferred stocks, at market (at
amortized cost prior to 1993)..... 148,499 147,680 111,220
85,574 80,059
Common stocks, at market........... 178,089 86,041 40,359
9,656 47,462
Mortgage loans on real estate...... 57,425 45,398 31,404
35,715 42,042
Other investments.................. 3,783 127 -
- - -
Premium balances receivable........ 169,311 157,673 126,090
101,529 94,333
Investment income receivable....... 12,103 12,655 14,440
13,285 10,205
Residual market receivable......... 180,799 195,213 200,124
214,818 220,312
Reinsurance receivable............. 18,170 19,659 21,897
16,892 12,868
Deferred acquisition costs......... 85,264 82,968 67,160
59,066 53,647
Current income taxes............... - - -
- - -
Deferred income taxes.............. - - 2,100
38,180 -
Real estate, furniture and equipment 29,060 26,011 24,642
25,246 22,371
Total assets................ $1,711,785 $1,630,229 $1,507,021
$1,349,531 $1,245,405
LIABILITIES
Unpaid losses and loss expenses.... $ 637,094 $ 657,854 $ 618,791
$ 592,373 $ 567,797
Unearned premiums.................. 379,599 367,991 330,454
314,719 283,526
Notes payable...................... - - -
- - -
Deferred income.................... 7,271 7,974 8,954
10,451 7,351
Accounts payable, accrued and other
liabilities....................... 60,332 41,368 34,351
43,433 16,564
Current income taxes............... 9,635 2,726 1,596
10,254 4,867
Deferred income taxes.............. 8,438 2,165 -
- - 13,669
Total liabilities........... 1,102,369 1,080,078 994,146
971,230 893,774
STOCKHOLDERS' EQUITY
Capital stock...................... 3,600 3,600 3,450
3,450 3,450
Paid-in capital.................... 45,050 45,050 23,700
23,700 8,700
Retained earnings
Balance, January 1............... 501,501 485,725 351,151
339,481 253,466
Net earnings..................... 101,528 74,432 110,450
113,892 79,837
Unrealized gains (losses) on
investments..................... 4,152 6,574 58,919
(77,622) 21,928
Dividends paid................... (46,415) (65,230) (34,795)
(24,600) (15,750)
Balance, December 31............... 560,766 501,501 485,725
351,151 339,481
Total stockholders' equity.. 609,416 550,151 512,875
378,301 351,631
Total liabilities and
stockholders' equity...... $1,711,785 $1,630,229 $1,507,021
$1,349,531 $1,245,405
</TABLE>
47
<PAGE
MANAGEMENT'S DISCUSSION OF THE SUPPLEMENTAL INFORMATION
ON INSURANCE OPERATIONS (continued)
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
COMBINED BALANCE SHEETS OF INSURANCE SUBSIDIARIES
December 31,
(Thousands of Dollars)
<TABLE>
1992 1991 1990 1989 1988 1987 1986
1985 1984 1983
ASSETS
<CAPTION>
<S> <C> <C> <C> <C> <C> <C> <C>
<C> <C>
$ 25,809 $ 11,190 $ 38,654 $ 84,308 $ 60,885 $ 21,051 $ 10,048 $
11,802 $ 7,953 $ 3,864
505,565 329,935 242,735 153,621 133,867 116,220 88,755
56,985 34,422 22,352
2,261 869 1,010 1,324 1,606 2,295 6,755
9,956 10,837 7,986
43,545 30,055 4,869 2,900 1,921 1,438 149
134 1,494 1,540
60,697 66,122 56,124 52,244 42,882 15,931 -
- - 7,825 5,860
67,876 55,510 57,733 56,713 33,727 19,329 11,817
8,194 6,028 5,430
- - - - - - -
- - - -
9,710 6,063 4,235 3,093 2,889 2,370 2,485
1,722 1,286 887
274,426 277,196 290,440 268,951 198,177 132,725 87,178
50,327 29,187 20,513
365 - - - - - -
- - - -
55,442 33,981 27,273 22,702 15,699 10,898 7,129
5,417 3,968 3,057
- - - 341 266 - 2,209
1,294 - -
- 883 1,666 - - - -
- - - -
23,183 24,163 25,046 23,118 9,684 8,356 7,370
5,648 3,136 2,799
$1,068,879 $835,967 $749,785 $669,315 $501,603 $330,613 $223,895
$151,479 $106,136 $74,288
LIABILITIES
$ 495,800 $439,551 $403,752 $345,020 $270,628 $169,539 $113,513 $
71,525 $ 44,425 $32,860
264,567 192,785 175,334 174,345 118,079 84,876 55,378
36,024 23,585 14,190
- - 1,662 1,837 2,013 2,204 3,772
4,140 2,858 1,313
8,384 12,918 20,264 23,689 23,307 11,058 7,503
4,208 3,173 1,658
20,863 7,677 21,065 27,513 19,350 14,532 8,532
4,162 4,479 2,482
9,249 5,811 3,542 - - 470 -
- - 418 1,487
4,400 - - 1,623 1,021 1,853 3,736
3,623 2,610 2,079
803,263 658,742 625,619 574,027 434,398 284,532 192,434
123,682 81,548 56,069
STOCKHOLDERS' EQUITY
3,450 3,450 3,450 3,450 2,350 2,350 2,350
2,350 2,350 2,250
8,700 8,700 8,700 8,700 6,500 6,500 6,500
6,500 6,500 5,500
165,075 112,016 83,138 62,877 37,231 22,611 18,947
15,738 10,469 5,693
91,980 55,214 32,414 21,966 21,837 15,614 4,362
4,025 6,033 5,213
9,811 2,545 (86) 645 321 (54) 7
(158) (179) 63
(13,400) (4,700) (3,450) (2,350) (1,034) (940) (705)
(658) (585) (500)
253,466 165,075 112,016 83,138 58,355 37,231 22,611
18,947 15,738 10,469
265,616 177,225 124,166 95,288 67,205 46,081 31,461
27,797 24,588 18,219
$1,068,879 $835,967 $749,785 $669,315 $501,603 $330,613 $223,895
$151,479 $106,136 $74,288
</TABLE>
48
<PAGE>
MANAGEMENT'S DISCUSSION OF THE SUPPLEMENTAL INFORMATION
ON INSURANCE OPERATIONS (continued)
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
COMBINED STATEMENTS OF EARNINGS OF INSURANCE OPERATIONS
Year Ended December 31,
(Thousands of Dollars)
<TABLE>
1997 1996 1995
1994 1993
<CAPTION>
<S> <C> <C> <C>
<C> <C>
Underwriting
Direct premiums written.............. $768,649 $731,823 $626,666
$625,023 $601,289
Net premiums written................. $741,501 $711,570 $603,421
$589,197 $563,416
Increase in unearned premiums........ 11,004 42,854 10,831
17,144 14,856
Earned premiums.................. 730,497 668,716 592,590
572,053 548,560
Expenses
Losses and loss expenses............. 521,775 474,173 367,258
369,764 373,243
Underwriting expenses................ 185,146 194,873 171,892
162,446 147,290
(Increase) decrease in deferred
acquisition costs................... (2,296) (15,809) (5,723)
(5,420) 1,796
Total expenses................... 704,625 653,237 533,427
526,790 522,329
Underwriting income (loss)............. 25,872 15,479 59,163
45,263 26,231
Net investment income.................. 81,218 76,867 71,007
63,119 52,868
Premium finance fees................... 7,056 9,666 19,246
18,315 16,486
Net realized investment gains (losses). 22,909 (7,863) 720
32,025 13,040
Earnings before Federal income
taxes and withdrawing companies'
settlements...................... 137,055 94,149 150,136
158,722 108,625
Other income
Withdrawing companies' settlements... - - -
- - -
Earnings before Federal income taxes... 137,055 94,149 150,136
158,722 108,625
Federal income taxes (benefits)........ 35,527 19,717 39,686
44,830 28,788
Earnings before cumulative effect of
change in accounting principle........ 101,528 74,432 110,450
113,892 79,837
Cumulative effect on prior years (to
December 31, 1986) of changing to
different method of accounting for
income taxes.......................... - - -
- - -
NET EARNINGS..................... $101,528 $ 74,432 $110,450
$113,892 $ 79,837
Statutory Financial Ratios (Unaudited)
Losses and loss expenses to
premiums earned..................... 71.4% 70.9% 62.0%
64.6% 68.0%
Underwriting expenses to net
premiums written.................... 25.1 27.1 29.0
27.1 25.7
Combined ratio................... 96.5% 98.0% 91.0%
91.7% 93.7%
Underwriting profit (loss)....... 3.5% 2.0% 9.0%
8.3% 6.3%
</TABLE>
49
<PAGE>
MANAGEMENT'S DISCUSSION OF THE SUPPLEMENTAL INFORMATION
ON INSURANCE OPERATIONS (continued)
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
COMBINED STATEMENTS OF EARNINGS OF INSURANCE OPERATIONS
Year Ended December 31,
(Thousands of Dollars)
<TABLE>
1992 1991 1990 1989 1988 1987 1986
1985 1984 1983
<CAPTION>
<S> <C> <C> <C> <C> <C> <C> <C>
<C> <C>
$525,495 $429,780 $401,077 $366,492 $306,469 $206,231 $131,807
$85,000 $65,699 $37,318
$508,847 $310,999 $219,936 $140,313 $124,923 $ 99,193 $ 60,808
$49,229 $33,943 $25,817
98,353 30,193 34,692 12,655 9,678 13,428 6,775
6,392 2,137 2,258
410,494 280,806 185,244 127,658 115,245 85,765 54,033
42,837 31,806 23,559
271,848 173,901 125,219 88,564 80,203 65,299 44,205
33,548 19,567 15,242
138,669 85,655 55,551 44,181 33,115 25,882 18,460
15,177 11,241 6,532
(21,462) (6,708) (4,571) (7,003) (4,801) (3,769) (1,712)
(1,448) (911) (1,327)
389,055 252,848 176,199 125,742 108,517 87,412 60,953
47,277 29,897 20,447
21,439 27,958 9,045 1,916 6,728 (1,647) (6,920)
(4,440) 1,909 3,112
39,685 32,661 25,978 21,256 15,999 10,896 7,554
6,835 5,684 4,108
13,734 11,165 10,074 8,095 4,592 3,021 1,436
531 324 39
12,368 7,529 74 618 2,298 3,423 185
336 (108) 314
87,226 79,313 45,171 31,885 29,617 15,693 2,255
3,262 7,809 7,573
43,168 - - - - - -
- - - -
130,394 79,313 45,171 31,885 29,617 15,693 2,255
3,262 7,809 7,573
38,414 24,099 12,757 9,919 7,780 2,987 (2,107)
(763) 1,776 2,360
91,980 55,214 32,414 21,966 21,837 12,706 4,362
4,025 6,033 5,213
- - - - - 2,908 -
- - - -
$ 91,980 $ 55,214 $ 32,414 $ 21,966 $ 21,837 $ 15,614 $ 4,362 $
4,025 $ 6,033 $ 5,213
66.2% 61.9% 65.7% 68.0% 69.5% 79.4% 83.5%
79.7% 63.6% 63.8%
28.1 30.0 26.7 26.3 22.0 22.5 24.4
28.1 27.8 23.9
94.3% 91.9% 92.4% 94.3% 91.5% 101.9% 107.9%
107.8% 91.4% 87.7%
5.7% 8.1% 7.6% 5.7% 8.5% (1.9%) (7.9%)
(7.8%) 8.6% 12.3%
</TABLE>
50
<PAGE>
THE COMMERCE GROUP, INC.
DIRECTORS
<TABLE>
<CAPTION>
<S> <C>
Herman F. Becker......................... President and owner,
Sterling Realty and Huguenot
Development Corporation
Joseph A. Borski, Jr..................... Self-employed Certified
Public Accountant
Eric G. Butler........................... Retired Vice President-
General Claims Manager of
Commerce and Citation
Henry J. Camosse......................... Retired President, Henry
Camosse & Son Co., Inc., a
building and masonry supplies company
Gerald Fels.............................. Executive Vice President and
Chief Financial Officer of
the Company
David R. Grenon.......................... Chairman Emeritus and
Assistant Clerk of The
Protector Group Insurance
Agency, Inc., a property
and casualty insurance
agency
Robert W. Harris......................... Retired Treasurer, H.C.
Bartlett Insurance Agency, Inc.
Robert S. Howland........................ Retired Clerk, H.C. Bartlett
Insurance Agency, Inc.
John J. Kunkel........................... President and Treasurer,
Kunkel Buick and GMC
Truck, Treasurer, Kunkel Bus
Company
Raymond J. Lauring....................... Retired President, Lauring
Construction Company
Roger E. Lavoie.......................... Retired President and
Treasurer, Lavoie Toyota-
Dodge, Inc.
Normand R. Marois........................ Retired Chairman of the
Board, Marois Bros., Inc.,
a contracting firm
Suryakant M. Patel....................... Physician specializing in
internal medicine
Arthur J. Remillard, Jr.................. President, Chief Executive
Officer and Chairman
of the Board of the Company
Arthur J. Remillard, III................. Senior Vice President and
Assistant Clerk of
the Company, Senior Vice
President of Commerce
and Citation in charge of
Policyholder Benefits
Regan P. Remillard....................... Senior Vice President -
General Counsel
of the Company, President
and Secretary of
Western Pioneer Insurance
Company
Antranig Sahagian........................ Retired Owner, A. Sahagian
Service Center
Gurbachan Singh.......................... Physician specializing in
general surgery
John W. Spillane......................... Clerk of the Company and
practicing attorney
</TABLE>
51
<PAGE>
DIRECTORS OF
COMMERCE HOLDINGS, INC.
The Commerce Insurance Company
Western Pioneer Insurance Company
Citation Insurance Company
<TABLE>
<CAPTION>
<S> <C>
Arthur J. Remillard, Jr................ President, Chief Executive
Officer and Chairman
of the Board
Gerald Fels............................ Executive Vice President and
Chief Financial Officer
Arthur J. Remillard, III (1)........... Senior Vice President and
Clerk
Regan P. Remillard..................... Senior Vice President -
General Counsel, President
and Secretary of Western
Pioneer Insurance Company
David R. Grenon (1).................... Chairman Emeritus and
Assistant Clerk of The
Protector Group Insurance
Agency
John M. Nelson (1)..................... Chairman and Chief Executive
Officer of Wyman-
Gordon Company
Suryakant M. Patel (1)................. Physician specializing in
internal medicine
William G. Pike (1).................... Executive Vice President and
Chief Financial Officer of
Granite State Bankshares,
Inc.
DIRECTORS OF
BAY FINANCE COMPANY, INC.
Arthur J. Remillard, Jr................ President and Chairman of
the Board
Gerald Fels............................ Executive Vice President and
Chief Financial Officer
John W. Spillane....................... Clerk and practicing
attorney
Arthur J. Remillard, III............... Assistant Clerk
Regan P. Remillard..................... Senior Vice President
DIRECTORS OF
CLARK-PROUT INSURANCE AGENCY, INC.
Arthur J. Remillard, Jr................ President and Chairman of
the Board
Gerald Fels............................ Executive Vice President and
Chief Financial Officer
John W. Spillane....................... Clerk and practicing
attorney
Arthur J. Remillard, III............... Assistant Clerk
Elizabeth M. Edwards................... Vice President
</TABLE>
(1) Commerce Holdings, Inc., The Commerce Insurance Company and
Citation Insurance Company
only.
52
<PAGE>
THE COMMERCE GROUP, INC.
Commerce Holdings, Inc.
The Commerce Insurance Company
Western Pioneer Insurance Company
Citation Insurance Company
Bay Finance Company, Inc.
Clark-Prout Insurance Agency, Inc.
OFFICERS OF THE COMMERCE GROUP, INC.
<TABLE>
<CAPTION>
<S> <C>
President, Chief Executive Officer and Chairman of the Board...
Arthur J. Remillard, Jr.
Executive Vice President and Chief Financial Officer...........
Gerald Fels
Senior Vice President and Assistant Clerk......................
Arthur J. Remillard, III
Senior Vice President and General Counsel......................
Regan P. Remillard
Senior Vice President.......................................... Mary
M. Fontaine
Clerk.......................................................... John
W. Spillane
Treasurer and Chief Accounting Officer.........................
Randall V. Becker
Assistant Treasurer............................................
Thomas A. Gaylord
Assistant Vice President.......................................
Robert E. McKenna
* Officers of Subsidiaries
President, Chief Executive Officer and Chairman of the Board...
Arthur J. Remillard, Jr.
Executive Vice President and Chief Financial Officer...........
Gerald Fels
Senior Vice Presidents.........................................
David H. Cochrane
Peter J. Dignan
Mary
M. Fontaine
Arthur J. Remillard, III
Joyce B. Virostek
Senior Vice President and General Counsel......................
Regan P. Remillard
Vice Presidents................................................
Elizabeth M. Edwards
Michael J. Richards
Angelos Spetseris
Henry R. Whittier, Jr.
Assistant Vice Presidents..............Robert M. Blackmer
Ronald J. Lareau
Stephen R. Clark
Karen A. Lussier
Raymond J. DeSantis
Donald G. MacLean
Warren S. Ehrlich
Robert E. McKenna
John V. Kelly
Robert L. Mooney
Kenneth E. Morrison
Treasurer and Chief Accounting Officer.........................
Randall V. Becker
Assistant Treasurer............................................
Thomas A. Gaylord
Officers of Western Pioneer Insurance Company
President and Secretary........................................
Regan P. Remillard
Chief Financial Officer........................................
Albert E. Peters
Vice President.................................................
Howard M. Dreyfus
Assistant Vice Presidents......................................
Michael J. Berryessa
Robert M. Keppel
Treasurer and Controller....................................... Joan
M. Kelly
</TABLE>
* Officers often hold positions with several operating subsidiaries.
The titles listed
represent their primary office as of March 1, 1998.
53
<PAGE
Stockholder Information
Annual Meeting
The Annual meeting of stockholders will be held at 9:00 a.m. on Friday,
May 15, 1998 at the Company's Underwriting Building, 11 Gore Road (Route
16), Webster, MA.
Form 10-K
Stockholders interested in the detailed information contained in the
Company's annual report on Form 10-K, as filed with the Securities and
Exchange Commission, may obtain a copy without charge, by writing to the
Assistant to the President at 211 Main Street, Webster, MA 01570.
Transfer Agent
The Commerce Group, Inc.
c/o BANKBOSTON, NA
Boston EquiServe, L.P.
P.O. Box 8040
Boston, MA 02266-8040
(781) 575-3100
Executive Offices
211 Main Street
Webster, MA 01570
(508) 943-9000
Trading of Common Stock
The Company's Common Stock trades on the NYSE under the symbol "CGI".
Independent Auditors
Ernst & Young LLP
200 Clarendon Street
Boston, MA 02116
(617) 266-2000
54
<PAGE>
<TABLE> <S> <C>
<ARTICLE> 7
<S> <C> <C>
<PERIOD-TYPE> 12-MOS 12-MOS
<FISCAL-YEAR-END> DEC-31-1997 DEC-31-1996
<PERIOD-END> DEC-31-1997 DEC-31-1996
<DEBT-HELD-FOR-SALE> 0 0
<DEBT-CARRYING-VALUE> 566,784 700,511
<DEBT-MARKET-VALUE> 590,597 716,702
<EQUITIES> 326,588 233,721
<MORTGAGE> 82,839 74,586
<REAL-ESTATE> 0 0
<TOTAL-INVEST> 1,242,695 1,167,671
<CASH> 25,446 140,535
<RECOVER-REINSURE> 18,170 19,659
<DEFERRED-ACQUISITION> 85,264 82,968
<TOTAL-ASSETS> 1,754,753 1,676,799
<POLICY-LOSSES> 649,473 662,832
<UNEARNED-PREMIUMS> 379,599 367,991
<POLICY-OTHER> 0 0
<POLICY-HOLDER-FUNDS> 0 0
<NOTES-PAYABLE> 0 0
0 0
0 0
<COMMON> 19,000 19,000
<OTHER-SE> 630,796 568,039
<TOTAL-LIABILITY-AND-EQUITY> 1,754,753 1,676,799
730,497 668,716
<INVESTMENT-INCOME> 80,794 77,402
<INVESTMENT-GAINS> 22,770 (7,574)
<OTHER-INCOME> 7,074 9,713
<BENEFITS> 526,127 475,231
<UNDERWRITING-AMORTIZATION> 187,491 181,013
<UNDERWRITING-OTHER> 0 0
<INCOME-PRETAX> 127,517 92,013
<INCOME-TAX> 31,302 18,049
<INCOME-CONTINUING> 96,215 73,964
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> 96,215 73,964
<EPS-PRIMARY> 2.67 2.04
<EPS-DILUTED> 2.67 2.04
<RESERVE-OPEN> 533,980 493,911
<PROVISION-CURRENT> 609,930 562,997
<PROVISION-PRIOR> (83,803) (87,766)
<PAYMENTS-CURRENT> (322,882) (267,653)
<PAYMENTS-PRIOR> (207,148) (167,509)
<RESERVE-CLOSE> 649,473 662,832
<CUMULATIVE-DEFICIENCY> 0 0
</TABLE>
