1998
annual
report
The
CGI
The Commerce Group, Inc.
211 Main Street, Webster, Massachusetts 01570
<PAGE>
INDEX TO 1998 ANNUAL REPORT
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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..................... 22
Report of Management............................................ 23
Report of Independent Auditors.................................. 24
Consolidated Balance Sheets at December 31, 1998 and 1997....... 25
Consolidated Statements of Earnings for the Years Ended
December 31, 1998, 1997 and 1996............................... 26
Consolidated Statements of Stockholders' Equity for the Years
Ended December 31, 1998, 1997 and 1996......................... 27
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1998, 1997 and 1996............................... 28
Consolidated Statements of Cash Flows - Reconciliation of Net
Earnings to Net Cash Provided by Operating Activities for the
Years Ended December 31, 1998, 1997 and 1996................... 29
Notes to Consolidated Financial Statements...................... 30
Selected Consolidated Financial Data............................ 50
Management's Discussion of the Supplemental Information on
Insurance Operations........................................... 51
Directors....................................................... 56
Officers........................................................ 59
Stockholder Information......................................... 61
</TABLE>
<PAGE>
FINANCIAL HIGHLIGHTS
(Dollars in Thousands, Except Per Share and Share Amounts)
<TABLE>
<CAPTION>
1998 1997
1996
<S> <C> <C>
<C>
Net premiums written............................ $ 745,048 $
741,501 $ 711,570
Earned premiums................................. $ 745,620 $
730,497 $ 668,716
Net investment income........................... 86,501
80,972 77,402
Premium finance and service fees................ 13,440
7,074 9,713
Net realized investment gains (losses).......... 6,769
22,770 (7,574)
Total revenues............................ $ 852,330 $
841,313 $ 748,257
Earnings before income taxes.................... $ 124,467 $
127,695 $ 92,013
Income taxes.................................... 27,975
31,480 18,049
Net earnings.............................. $ 96,492 $
96,215 $ 73,964
Comprehensive income............................ $ 94,555 $
100,368 $ 80,539
Basic and diluted net earnings per common share. $ 2.68 $
2.67 $ 2.04
Net earnings excluding the after-tax impact of
net realized investment gains (losses)(1)...... $ 92,092 $
81,415 $ 78,887
Basic and diluted net earnings per common
share excluding the after-tax impact of net
realized investment gains (losses)(1).......... $ 2.56 $
2.26 $ 2.18
Cash dividends paid per share................... $ 1.07 $
1.03 $ 0.81
Weighted average number of common shares
outstanding................................... 36,042,652
36,044,679 36,311,887
Total investments at market value............... $1,257,900
$1,242,695 $1,167,671
Total assets.................................... 1,755,983
1,754,753 1,676,799
Total liabilities............................... 1,050,198
1,104,957 1,089,760
Total stockholders' equity...................... 705,785
649,796 587,039
Total stockholders' equity per share............ 19.58
18.03 16.28
Certain statutory financial ratios (unaudited):
Loss and LAE ratio............................ 71.6%
71.4% 70.9%
Underwriting expense ratio.................... 26.5
25.1 27.1
Combined ratio............................ 98.1%
96.5% 98.0%
Net premiums written to policyholders'
surplus..................................... 132.2%
143.3% 153.1%
</TABLE>
(1) The above figures are presented to provide information to the reader
due to the amount
of, and fluctuations in, net realized gains and losses. The amounts
noted, commonly
known as Operating Income, are important measures of corporate
performance.
1
<PAGE>
THE COMMERCE GROUP, INC.
March 26, 1999
To Our Stockholders:
In 1998, your Company experienced satisfactory financial results
for the 23rd consecutive year. From the very first day the funding of
The Commerce Insurance Company was accomplished (April 3, 1972) through
December 31, 1998, we have achieved underwriting profit of $243.5
million on total premiums written of $6.8 billion. This underwriting
profit represents 3.6% of total premiums written.
In January, the 1999 personal automobile insurance rates were
announced by the Massachusetts Insurance Commissioner. Despite the
industry's request for a 15.5% increase, 1999 rates increased only 0.7%.
This slight increase follows four consecutive years of rate decreases.
Although a number of companies modified safe driver deviations and
affinity group discount programs in response to the 1999 rates, the
Massachusetts marketplace continues to be highly competitive. Through
these ongoing competitive conditions, your Company's share of the
Massachusetts personal automobile market has remained stable, and at
year-end, our market share was 21.6%.
Your Company made a significant acquisition in 1999, which will
provide us with a vehicle to grow and expand our business beyond
Massachusetts. In a joint venture with AAA Southern New England, we
purchased the Automobile Club Insurance Company of Columbus, Ohio. This
company writes personal automobile and homeowners insurance in 28 states
through AAA affiliated insurance agencies. Their annual direct written
premium is approximately $100 million. Following the acquisition, the
Company's name was changed to American Commerce Insurance Company
("ACIC"). Together with our California company, Commerce West Insurance
Company, we are poised to grow and expand geographically well beyond the
borders of Massachusetts.
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, including the newest member of our corporate family -
ACIC, are an extremely dedicated group of people: Our Policyholders
(represented by over 894,000 policies in force); Agents (791); Employees
(1,692); Officers (47); Directors (19); and of course, our Stockholders
(over 4,300, not including our Employee Stock Ownership Plan
participants who now number 1,662).
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 stockholders 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, Chief
Executive Officer
and Chairman of the
Board
Caring in everything we do.
2
<PAGE>
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 1984 through 1998. The Y axis lists
the dollar values starting at $0.00 and increasing in one dollar
increments to $24.00. The graph depicts a total stockholders' equity
per share value 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 $10.88, 1995 of $14.96, 1996 of
$16.28, 1997 of $18.03 and 1998 of $19.58. The graph also depicts the
total stockholders' equity per share value adjusted for 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, 1997 of $20.25 and 1998 of $22.87.
3
<PAGE>
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 1998, the industry as a whole, experienced slightly
weaker underwriting results and slower premium growth as compared to
1997. Slightly weaker industry underwriting results were primarily
attributable to competitive markets. Within the property and casualty
industry, personal automobile insurance remains profitable, however
trends have indicated increased claims costs. The frequency of loss
occurrences continue to improve, which reflects the absence of severe
weather, safer cars and highways, enforcement of speeding laws and
continued drunk driver awareness. The severity, or cost per accident,
however, is increasing due to higher medical and automobile repair
costs. Industry results have further intensified competition among
insurers, which when coupled with lower insurance rates, emphasizes the
advantages to companies of operating efficiently. The Commerce Group,
Inc. ("Company") is well positioned to both lead in this environment and
to respond to the prevailing conditions in the market.
The Company, incorporated in 1976, is a holding company for
several property and casualty insurers 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 affinity 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 Commerce West Insurance Company ("Commerce West"),
formerly Western Pioneer Insurance Company, a wholly-owned subsidiary of
Commerce. Commerce formed a joint venture (ACIC Holding Co., Inc.), in
November 1998, with AAA Southern New England to purchase Automobile Club
Insurance Company, located in Columbus, Ohio, a property and casualty
insurer with policies written in 28 states and licensed in several
others. In conjunction with the acquisition, which was completed on
January 29, 1999, the newly acquired company's name was changed to
American Commerce Insurance Company ("ACIC").
The Company's business strategy remains focused on activities
primarily related to personal automobile insurance. 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 remained fairly stable in 1998 at approximately 21.6%,
a slight decrease from the 21.8% in 1997.
During 1998, direct premiums written totalled $796,858, a 3.7%
increase over 1997. Direct premiums written through Commerce and
Citation amounted to $773,463. Direct premiums written in California,
through Commerce West amounted to $23,395. Of the total direct premiums
written, direct personal automobile premiums written during 1998
totalled $687,232, an increase of 4.0% over 1997, and direct homeowners
insurance premiums written totalled $59,761, an increase of 5.4% over
1997. The Company is also the fourth largest writer of commercial
automobile insurance in Massachusetts based on direct premiums written.
During 1998, direct commercial automobile premiums written totalled
$36,299, a 2.1% decrease compared to 1997.
4
<PAGE>
Personal automobile insurance is subject to extensive regulation.
Owners of registered automobiles are generally 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.
Companies in Massachusetts are also assigned agents, known as Exclusive
Representative Producers ("ERPs") based on market share, that have been
unable to get a voluntary contract with an insurance carrier. Marketing
and underwriting strategies for companies operating in Massachusetts are
limited by maximum 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.
During the three-year period from 1996 to 1998, Massachusetts
personal automobile insurance premium rates decreased an average of 4.9%
per year. The Commissioner approved an average 0.7% increase in
personal automobile premiums for 1999, the first increase since 1994.
Average mandated rates decreased 4.0%, 6.2% and 4.5% in 1998, 1997 and
1996, respectively. Coinciding with the 1999 rate increase, the
Commissioner also approved a 1.0% increase in the commissions agents
receive for selling private passenger automobile insurance for 1999.
The decision slightly offsets the financial benefit of the average 0.7%
increase in personal automobile premiums for 1999.
Although average mandated personal automobile premium rates
decreased 4.0% in 1998, the impact upon the Company resulted in a 2.6%
increase in the average personal automobile premium per exposure (each
vehicle insured). The 2.6% increase for the Company was 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, 1998 and 1999 average rate decisions 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. Mandated rates for 1997, 1998 and 1999 include an
adjustment to recoup $176 million from the industry. The adjustment
included in the rate decision to recoup the error was phased in at 40%,
40% and 20% in 1997, 1998 and 1999, respectively.
The estimated earned premium impact of the above item, coupled
with the impact of a previous year imbalance in the SDIP, was
approximately $15.3 million for 1997, $23.9 million for 1998 and is
expected to be approximately $14.0 million for 1999. The earnings per
share after-tax impact resulting from lower earned premiums has been
estimated at $0.28 for 1997, $0.43 for 1998, and is estimated to be
$0.24 for 1999. If the Company's 1999 market share increases
(decreases), a larger (smaller) financial impact will result.
Also factored into the 1999 rate decision were two sanctions
levied by the Commissioner against the Massachusetts personal automobile
insurance industry. One fine, amounting to $6 million, was imposed as a
result of the industry's alleged failure to show that it adhered to
adequate cost containment efforts as identified by the Commissioner. A
second fine of $3 million was allegedly the result of what the
Commissioner termed "incomplete compliance" on the part of the
Automobile Insurers Bureau of Massachusetts ("AIB") with a discovery
order concerning disclosure of certain information as identified by the
Commissioner. The industry and several insurance carriers, including
Commerce, are appealing one or both of the sanctions.
5
<PAGE>
In August 1998, then Acting Massachusetts Governor, Paul Cellucci
("Governor"), signed legislation granting Massachusetts-based insurers,
that choose to participate, $48 million a year in total tax relief in
exchange for a, total industry-wide, $200 million investment commitment
to low income communities over a five-year period. The legislation
amounts to a gradual elimination of the 1.0% gross investment tax for
those insurers choosing to commit funds to these community investments.
The legislation effectively taxes Massachusetts-based insurers at rates
levied equal with out-of-state insurers. Prior to the legislation,
Massachusetts was the only state in the nation to tax domestic insurers
at higher rates than charged to non-domestic insurers. If the overall
$200 million goal is attained, all domestic insurers will benefit from
the lower tax rate. The Company is currently analyzing the potential
benefits of participating in this program.
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 1999. 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 of increased voluntary retention, the
credits impacting the utilization formula have favorably affected the
Company's participation ratio. The Company estimates its private
passenger automobile participation ratio in C.A.R. to be approximately
16.7% at December 31, 1998. This ratio is several percentage points
below the Company's estimated 21.6% 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.
The percentage of commercial automobile premiums ceded to C.A.R.
by the industry has decreased to a Company estimate of 21% in 1998. The
percentage of commercial automobile business ceded to C.A.R. by the
Company, is approximately 19%. C.A.R. depopulation, coupled with C.A.R.
rate increases for ceded commercial business, have led to a reduction in
the size of the annual commercial automobile deficits. The Company
intends to continue to respond to the incentives and disincentives
provided by C.A.R. rules as deemed necessary and appropriate.
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
1998 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 1999 and beyond.
6
<PAGE>
Beginning in the latter part of 1995, the Company began to
actively pursue affinity group marketing programs. The primary purpose
of affinity 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 affinity groups, although accounts with as few as 25
participants are considered. Affinity groups are eligible for rate
discounts which must be filed annually with the Division of Insurance.
In general, the Company looks for affinity 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 affinity 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. In 1998, primarily as a result of four
consecutive private passenger rate reductions, the Company reduced the
AAA clubs discount from 10% to 6%. In 1999, the same 6% percent AAA
club discount was approved for policies effective as of January 1, 1999.
The AAA clubs discount can be combined with safe driver deviations for
up to a 13.5% reduction from the 1999 state mandated rates. Membership
in these clubs is estimated to represent approximately one-third of the
Massachusetts motoring public, and has been the primary reason for a
43.2% increase in the number of personal automobile exposures written by
Commerce since year-end 1995. As expected, this increase leveled off in
1998 as evidenced by the 1.9% increase in personal automobile exposures
as compared to increases of 8.3% in 1997 and 29.8% in 1996. In 1998,
total direct premiums written attributable to the AAA group business
were $457,430 or 57.3% of the Company's total direct premiums written
(68.7% of the Company's total Massachusetts personal automobile
premium), an increase of 8.1% over 1997. Total exposures attributable
to the AAA clubs group business were 547,100 or 67.6% of total
Massachusetts personal automobile exposures in 1998, an increase of
25,002 or 4.8% over 1997. Of the total Massachusetts automobile
exposures written by the Company, approximately 11% were written through
insurance agencies owned by the AAA clubs. The remaining 89% were
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 one year. Accordingly, Commerce, in
coordination with the AAA clubs, aggressively pursued AAA members for
the AAA Affinity 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. This requirement has subsequently been waived by the
Massachusetts Legislature for 1998 and 1999. Waiving the penetration
requirements allows insurance companies to continue offering group
discounts without reaching the 35% level. The waiver of penetration
requirements cannot be predicted for years beyond 1999.
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.
7
<PAGE>
The Company previously announced that it had entered into an
agreement with, and purchased software known as Series III, from Policy
Management Services Corporation ("PMSC") to allow for development of
internal operating systems to enable the Company to first process
policies in states outside of Massachusetts and eventually to replace
the Company's systems for Massachusetts business. Although the Company
began writing business in Rhode Island in early 1998 on the Series III
system, in early 1999 the Company stopped work on all development. The
Company is currently in the process of negotiating with PMSC as to the
future continuation of the Series III system. Costs to date for this
effort have been approximately $47.0 million, of which $18.4 million was
applicable to 1998. Funds expended to date included the purchase of a
main frame computer, license fees and the costs associated with
programming, implementation and training. The vast majority of these
costs were expensed as incurred.
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, 1998, 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 100.1% in 1997 to a high of 103.0% in 1994 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 98.1% in 1998. On an average basis, the Company's combined
ratio was 95.1% for the five year period ended December 31, 1998
compared to a weighted industry average of 102.0%.
The Company's total revenues were supplemented in fiscal 1998,
1997 and 1996 by net investment income of $86,501, $80,972 and $77,402,
respectively. Additionally, the Company had realized investment gains
(losses) of $6,769, $22,770 and ($7,574) in 1998, 1997 and 1996,
respectively.
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 preempt 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 certain 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.
8
<PAGE>
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.
Personal Automobile Insurance
As previously mentioned, beginning in 1995, the Company received
approval for affinity 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 exposures by 1.9%
in 1998 primarily as a result of this program, ending the year with
approximately 21.6% of the Massachusetts private passenger automobile
market.
Since 1996, the Company has been granted approval to offer its
Massachusetts customers safe driver deviations to drivers with Safe
Driver Insurance Plan ("SDIP") classifications of either Steps 9 or 10.
Safe driver deviations are rate discounts based on the customers driving
record and resulting SDIP classification. Steps 9 and 10 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. In January 1999, in response to the
average personal automobile rate decisions over the last several years,
the Company filed for and ultimately received approval to offer SDIP
deviations of 8% for Step 9 and 3% for Step 10 for the 1999 calendar
year. At December 31, 1998, 68.7% of the Company's exposures were
eligible for either Step 9 or Step 10 deviations. For drivers that
qualify, the Company's 1999 affinity group automobile discounts and SDIP
deviations can be combined for up to a 13.5% (Step 9) and 9.8% (Step 10)
reduction from the state mandated rates. This can be compared to the
SDIP deviations of 15% for Step 9 and 4% for Step 10 SDIP
classifications for the 1998 calendar year. For drivers that qualified,
the Company's 1998 affinity group automobile discounts and SDIP
deviations could be combined for up to a 20.1% (Step 9) and 9.8% (Step
10) 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 personal lines policies with effective dates of
January 1, 1998 and beyond. As a result of this change, premium finance
and service fees increased $6,366 or 90.0% in 1998. Previously, for
1997 and 1996, the Company had utilized a "late fee" system.
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.
9
<PAGE>
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 Commerce West, have RBC amounts at December 31, 1998 of $71
million, $2 million and $3 million, respectively, and they have
statutory surplus of approximately $470 million, $93 million and $25
million, respectively. The statutory surplus of Commerce, Citation and
Commerce West at December 31, 1998 exceeded the RBC Company Action
Levels of $142 million, $4 million and $6 million, respectively, by
approximately $328 million, $89 million and $19 million, respectively.
The Company's new acquisition, ACIC, has an RBC amount at December 31,
1998 of $15 million and statutory surplus of approximately $90 million.
The statutory surplus of ACIC at December 31, 1998, exceeded the RBC
company action level of $30 million by approximately $60 million.
Year Ended December 31, 1998 Compared to Year Ended December 31, 1997
Direct premiums written during 1998 increased $28,209, or 3.7% to
$796,858 as compared to 1997. The increase was primarily attributable
to a $26,157, or 4.0% increase in direct premiums written for personal
automobile insurance to $687,232. This increase was the result of a
$30,239 or 4.8% increase in direct premiums written for Massachusetts
personal automobile insurance offset by a $4,082 or 14.9% decrease in
California personal automobile written premiums. The decrease in
California personal automobile direct premiums written resulted
primarily from the increasingly competitive personal automobile market
that has witnessed several new entrants since 1997. The increase in
Massachusetts personal automobile direct premiums written resulted
primarily from an increase of 4.5% in the number of personal automobile
physical damage exposures written (Massachusetts personal automobile
exposures written with liability coverage increased 1.9%), coupled with
a 13.3% increase in average rates for personal automobile physical
damage exposures. The impact of this was partially offset by a 3.2%
decrease in the average rates for liability exposures. These results
were primarily the result of the changes to the Company's affinity group
marketing programs, safe driver rate deviations and the effect of the
1998 state mandated average rate decrease of 4.0%. The combination of
these factors resulted in a 2.6% increase in the average personal
automobile premium (each vehicle insured). Despite the 1998 state
mandated average rate decrease of 4.0%, the Company's increase in the
average personal automobile premium per exposure was primarily due to
the fact that the rate decision does not anticipate purchases of new
automobiles in the year in which the rate decision applies, the
Company's mix of personal automobile business differs from that of the
industry and the factors mentioned previously. In 1998, the Company
offered its customers safe driver deviations of 15% to drivers with SDIP
classifications of Step 9 and 4.0% for Step 10 (10% for both Steps 9 and
10 in 1997).
The AAA affinity group discount for 1998 was established at 6.0%
(10% in 1997). In 1998, for drivers who qualified, the Company's
affinity group discount and safe driver deviations could be combined for
up to a 20.1% reduction from state mandated rates.
Direct premiums written for commercial automobile insurance
decreased by $772 or 2.1%, due primarily to a decrease of approximately
0.2% in the number of policies written, and a 1.9% decrease in the
average commercial automobile premium per policy. Direct premiums
written for homeowners insurance (excluding the Massachusetts FAIR Plan)
increased by $2,862, or 5.2% due primarily to a 1.6% increase in the
number of policies written and a 3.6% increase in the average premium
per policy.
10
<PAGE>
Net premiums written during 1998 increased $3,547, or 0.5% as
compared to 1997. The increase in net premiums written was due to the
growth in direct premiums written as described above, offset by
increased levels of coverage provided by non-automobile reinsurance
treaties resulting in an increase of ceded premiums. Written premiums
assumed from C.A.R. decreased $1,887, or 2.5% and written premiums ceded
to C.A.R. decreased $1,381 or 1.9% as compared to 1997, 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
$24,151 or 75.0% as compared to 1997 as a result of changes to non-
automobile reinsurance discussed in page 41.
Earned premiums increased $15,123 or 2.1% during 1998 as compared
to 1997. The increase was primarily attributable to a $32,407 or 5.2%
increase in earned premiums for Massachusetts personal automobile
insurance offset by a $7,115 decrease in earned premiums for homeowners
insurance, a $3,803 or 9.3% decrease in earned premiums for commercial
automobile insurance, a $3,481 or 12.3% decrease in earned premiums for
California personal automobile insurance and a $2,885 or 29.4% decrease
in earned premiums for all other than automobile lines. Earned premiums
were impacted by increased levels of coverage provided by non-automobile
reinsurance treaties which commenced during the 2nd half of 1998.
Earned premiums assumed from C.A.R. decreased $7,149 or 8.6% during 1998
compared to 1997. Earned premiums ceded to C.A.R. decreased $3,594 or
5.0% during 1998 compared to 1997.
Net investment income increased $5,529 or 6.8%, compared to 1997,
principally as a result of an increase in average invested assets (at
cost). Net investment income as a percentage of total average
investments was 7.0% in 1998 compared to 6.8% in 1997. Net investment
income after tax as a percentage of total average investments was 5.7%
in 1998 compared to 5.5% in 1997. The increase was primarily the result
of increased dividends received on common and preferred stocks.
Premium finance and service fees increased $6,366 or 90.0% during
1998. The increase was primarily attributable to the Company receiving
state regulatory approval to charge a $3.00 installment on each invoice
following the down payment for all personal lines policies with
effective dates of January 1, 1998 and beyond. Previously, in 1996 and
1997, the Company had utilized a "late fee" system.
The market value of the Company's investment portfolio totaled
$1,257,900, at December 31, 1998 compared to $1,242,695 at December 31,
1997. Management's investment philosophy is to emphasize investment
yield while maintaining investment quality. Fixed maturities comprised
49.2% of the portfolio at December 31, 1998 compared to 47.5% at
December 31, 1997. Equity investments comprised 38.3% at December 31,
1998 compared to 26.3% at December 31, 1997. Cash and short-term
investments comprised 6.0% at December 31, 1998 compared to 19.2% at
December 31, 1997. The decrease in cash and short-term investments and
increase in equity investments was partially driven 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 fixed maturities, which totaled $619,267 at
December 31, 1998, is comprised of 81.8% tax-exempt and 18.2% taxable
investments as compared to total fixed maturities of $590,597, comprised
of 69.3% tax-exempt and 30.7% taxable investments at December 31, 1997.
The market value of equity investments, which totaled $481,386 at
December 31, 1998, is comprised of 41.0% preferred stocks and 59.0%
common stocks as compared to total equity investments of $326,588,
comprised of 45.5% preferred stocks and 54.5% common stocks at December
31, 1997. The increase in equity investments was primarily attributable
to a change in the mix of investments resulting primarily from the
maturity of Government National Mortgage Association ("GNMA") mortgage-
backed bonds and the redeployment of cash and short-term investments to
higher yielding preferred stock mutual funds which are classified as
common stocks. Of the common stock portfolio, $172,455 or 60.7% of the
balance, is comprised of preferred stock mutual funds and $111,506 or
39.3% of pure common stocks.
11
<PAGE>
Gross realized gains and losses on fixed maturity investments
totaled $99 and $2,903, respectively, for the year ended December 31,
1998 compared to gross realized gains and losses on fixed maturity
investments of $4,306 and $2,887, respectively, for the year ended
December 31, 1997. Gross realized gains and losses on preferred stocks
totaled $369 and $1,096, respectively, for the year ended December 31,
1998 compared to gross realized gains and losses on preferred stocks of
$2,688 and $2,682, respectively, for the year ended December 31, 1997.
Gross realized gains on common stocks amounted to $9,313 for the year
ended December 31, 1998 compared to gross realized gains on common
stocks of $21,440 for the year ended December 31, 1997.
Net realized investment gains totalled $6,769 during 1998 as
compared to net realized investment gains of $22,770 for 1997. A
significant portion of the net realized gains in 1998 were the result of
sales of common stocks partially offset by net realized losses in the
sales of non-taxable bonds, preferred stocks and in the maturity of
GNMAs, all as detailed in the preceding paragraph. A significant
portion of the realized gains in 1997 were 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 coupled
with subsequent post merger sales of this corporation's common stock
resulted in realized investment gains of $18,968. Also included were
realized gains on mortgage activity of $321 in 1998 compared to realized
losses of $95 in 1997 and realized investment gains in the Conning
Insurance Limited Partnership of $666 in 1998 compared with none in
1997.
Gross unrealized gains and losses on fixed maturity investments
totaled $21,381 and $2,596, respectively, at December 31, 1998 compared
to $24,190 and $377, respectively, at December 31, 1997. The unrealized
gains on fixed maturities decreased despite increased fixed maturity
holdings and declining interest rates in 1998. Gross unrealized gains
and losses on preferred stocks totaled $2,706 and $5,551, respectively,
at December 31, 1998 compared to $1,599 and $1,235, respectively at
December 31, 1997. Gross unrealized gains and losses on common stocks
totaled $24,721 and $2,120, respectively, at December 31, 1998 compared
to $17,888 and $170, respectively, at December 31, 1997. The Company
also recognized gross unrealized gains in the Conning Insurance Limited
Partnership of $375 in 1998 compared with none in 1997.
Losses and loss adjustment expenses ("LAE") incurred (on a
statutory basis) as a percentage of insurance premiums earned ("loss
ratio") was 71.6% in 1998 as compared to 71.4% in 1997. The ratio of
net incurred losses, excluding LAE, to premiums earned ("pure loss
ratio") on personal automobile was 61.4% in 1998 compared to 61.3% in
1997. Although the personal automobile pure loss ratio remained stable,
various components impacted the ratio, primarily in the bodily injury
area. Redundancies from prior year losses realized in the current year,
relating to bodily injury claims, were approximately $18.0 million less
in 1998, as compared to 1997. Approximately $11.0 million of this
amount was attributable to voluntary personal automobile bodily injury
loss reserves and $7.0 million to fewer redundancies from C.A.R. assumed
reserves. The decreased redundancies, however, were offset by better
current year experience, also primarily in the personal automobile
bodily injury area. This improvement was primarily the result of
improved severity of bodily injury claims coupled with slightly improved
claim frequency. The commercial automobile pure loss ratio increased to
52.3% in 1998 compared to 45.4% in 1997. For homeowners, the pure loss
ratio was 31.0% in 1998 compared to 48.2% in 1997. This decrease was
due to favorable weather conditions during 1998 as compared to normal
weather conditions experienced during 1997, coupled with favorable
development in the homeowners liability area. The LAE component of the
loss ratio was primarily impacted by an increase of approximately $3.2
million in computer service expenses, relating to the Year 2000 and PMSC
projects, offset by a decrease of management incentive plan expenses.
On a consolidated financial statement basis, total expenses related to
the Company's management incentive plan included in losses and loss
adjustment expenses were $10,093 lower in 1998 as compared to 1997. Of
this decrease, $3,112 benefited the insurance companies directly with
the remainder benefiting corporate expenses. Corporate expenses are not
included in the calculation of the Company's statutory loss ratio. The
decrease in the Company's management incentive plan expenses was
primarily driven by the average decrease in the market price of the
Company's common stock which directly impacts plan expenses.
12
<PAGE>
Policy acquisition costs expensed increased by $8,943, or 4.8% in
1998, compared to an increase of $6,478, or 3.6% in 1997. The increase
in policy acquisition costs was primarily due to higher contingent
commission accruals, and higher computer service expenses relating to
the Year 2000 and PMSC projects, both offset by lower expenses relating
to the Company's management incentive plan. Specifically, total
expenses related to the Company's management incentive plan included in
policy acquisition costs were $8,764 lower in 1998 as compared to 1997.
Of this decrease, $3,052 benefited the insurance companies directly with
the remainder benefiting corporate expenses. Corporate expenses are not
included in the calculation of the statutory underwriting expense ratio.
The decrease in the Company's management incentive plan expenses was
primarily driven by the average decrease in the market price of the
Company's common stock which directly impacts plan expenses. As a
percentage of net premiums written, underwriting expenses for the
insurance companies (on a statutory basis) were 26.5% during 1998 as
compared to 25.1% for 1997.
The Company's effective tax rate was 22.5% and 24.7% for the years
ended December 31, 1998 and 1997, respectively. The decrease was
primarily attributable to higher dividends on preferred and common stock
coupled with less realized capital gains during 1998 as compared to
1997. 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 comprising a greater portion of net
earnings before taxes.
Net earnings increased to $96,492, during 1998 as compared to
$96,215 in 1997 and operating earnings, which exclude the after-tax
impact of net realized investment gains, increased $10,677, or 13.1% to
$92,092 during 1998 as compared to $81,415 in 1997, both as a result of
the factors previously mentioned.
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, Commerce West. 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
its customers safe driver deviations of 10% to drivers with SDIP
classifications of either Steps 9 or 10. For drivers who qualify, the
Company's affinity group discount and safe driver deviations could be
combined for up to a 19.0% 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 $2,329, or 4.4% 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 $901 or 2.9% as
compared to 1996.
13
<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 affinity 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 Commerce West increased $531 to $28,159 for
1997 compared to 1996.
Net investment income increased $3,570 or 4.6%, 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 and service 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 lines
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. In 1997, the Company
received state regulatory approval to charge a $3.00 installment on each
invoice following the down payment for all personal lines 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 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.
14
<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 GNMAs 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 $24,190 and $377, 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 LAE incurred (on a statutory basis) as a percentage of
insurance premiums earned ("loss 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 24.7% 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 $73,964 in 1996 and operating earnings increased $2,528,
or 3.2% to $81,415 as compared to $78,887 in 1996 both as a result of
the factors previously mentioned.
15
<PAGE>
Liquidity and Capital Resources
The focus of the discussion of liquidity and capital resources is
on the Consolidated Balance Sheets on page 25 and the Consolidated
Statements of Cash Flows on pages 28 and 29. Stockholders' equity
increased by $55,989, or 8.6%, in 1998 as compared to 1997. Growth
stemmed from $96,492 in net earnings partially offset by changes in net
unrealized losses, net of income taxes (known as Other Comprehensive
Income), on fixed maturities and preferred and common stocks of $1,937
and dividends paid to stockholders of $38,566. Total assets at December
31, 1998 increased to $1,755,983 as compared to total assets of
$1,754,753 at December 31, 1997. Although total assets remained
virtually unchanged, certain asset categories changed considerably
during 1998 as reflected in an increase of invested assets of $15,205,
or 1.2%, an increase in deferred policy acquisition costs of $3,495, or
4.1%, and an increase in receivable from reinsurers of $18,517, or
101.9%, offset by a decrease in residual market receivable of $27,579,
or 15.3% and a decrease in all other assets of $8,408, or 3.7% as
compared to December 31, 1997. The increase in receivable from
reinsurers was primarily a result of increased levels of coverage
provided through the new other than automobile quota share reinsurance
treaty which the Company implemented July 1, 1998. The new quota share
contract provides for a 75% cession of other than automobile property
and liability premium and related losses. This contract replaced the
former contract which provided for a 49% cession of other than
automobile property premium, a 45% cession of related losses and an
excess loss component providing 100% reimbursement of property losses in
excess of $125 up to $1,000. The decrease in residual market receivable
was primarily attributable to lower case reserves ceded to C.A.R. in
1998, as compared to 1997.
The Company's fixed maturity portfolio is comprised of GNMAs
(18.2%) and municipal bonds (81.8%). Of the Company's bonds, 100.0% are
rated in either of the two highest quality categories provided by the
NAIC. As of December 31, 1998, the market value of the Company's fixed
maturity portfolio exceeded its book value by $18,785 ($12,210 after
taxes, or $0.34 per share). At December 31, 1997 the market value of
the Company's fixed maturity portfolio exceeded its book value by
$23,813 ($15,478 after taxes, or $0.43 per share). At December 31,
1998, the cost of the Company's preferred stocks exceeded market value
by $2,845 ($1,849 after taxes, or $0.05 per share). At December 31,
1997, the market value of preferred stocks exceeded cost by $364 ($237
after taxes, or $0.01 per share). At December 31, 1998, the market
value of the Company's common stocks exceeded cost by $22,601 ($14,691
after taxes, or $0.41 per share). At December 31, 1997, the market
value of common stocks exceeded cost by $17,718 ($11,517 after taxes, or
$0.32 per share).
Preferred stocks increased $48,926, or 32.9% and common stocks
(primarily composed of closed-end preferred stock mutual funds)
increased $105,872, or 59.4%, during 1998 primarily as a result of the
Company's previously announced change in investment strategy. The
Company's strategy is to acquire equity investments, including potential
acquisitions, which forego current investment yield in favor of future
potentially higher yielding capital appreciation. As a result of these
increases to preferred and common stocks, the Company is now carrying
$75,912 million in cash and short-term investments which is a decrease
of $162,976, or 68.2% as compared to December 31, 1997.
16
<PAGE>
The Company's liabilities totalled $1,050,198 at December 31, 1998
as compared to $1,104,957 at December 31, 1997. Loss and loss
adjustment expense reserves comprised 56.8% of the Company's liabilities
at December 31, 1998 compared with 58.8% at December 31, 1997. Unearned
premiums comprised 37.3% of the Company's liabilities at December 31,
1998 compared with 34.4% at December 31, 1997. All other liabilities
comprised 5.9% of the Company's liabilities at December 31, 1998
compared with 6.8% at December 31, 1997. Although unearned premium and
contingent commission liabilities increased $11,825, or 3.1% and $8,206,
or 59.2%, respectively, the $54,759, or 5.0% decrease in total
liabilities was primarily due to decreases of $52,477, or 8.1%, in
losses and loss adjustment expense reserves, $8,269, or 51.4%, to income
tax liabilities and $14,044, or 30.6% to all other liabilities. The
decrease in the liability for loss and loss adjustment expenses is
attributed primarily to better current year underwriting results coupled
with increased net loss payments during 1998, as described below.
However, $17,353 of the $52,477 decrease in the liability for loss and
loss adjustment expenses relates to the decrease in losses and loss
adjustment expense receivable from the residual market. The increase in
unearned premiums primarily resulted from the increase in Massachusetts
personal automobile direct premiums written and the expected seasonality
impact of policy effective dates.
The primary sources of the Company's liquidity are funds generated
from insurance premiums, net investment income, premium finance and
service fees and the maturing and sales of investments as reflected in
the Consolidated Statements of Cash Flows on
pages 28 and 29. The discussion of these items can be found under "Year
Ended December 31, 1998 Compared to Year Ended December 31, 1997",
herein.
The Company's operating activities provided cash of $65,324 in
1998 as compared to $80,006 in 1997. These cash flows were primarily
impacted by the fact that while premiums collected increased $34,009, or
4.7% in 1998 as compared to an increase of $51,847, or 7.7% in 1997,
losses and LAE paid increased $56,531, or 11.0% in 1998 as compared to
an increase of $87,589, or 20.4% in 1997 and policy acquisition costs
paid decreased $11,142, or 5.6% in 1998 as compared to a decrease of
$2,911, or 1.4% in 1997. The increase in premiums was primarily the
result of higher physical damage exposures written, coupled with average
rate increases in the physical damage side of the business. The impact
of this was partially offset by slight decreases in the average rates
for liability exposures. However, this impact was reduced with the
slight increases of liability exposures written. Federal income tax
payments increased $13,368, or 61.2% in 1998 as compared to an increase
of $4,883, or 28.8% in 1997 due to additional payments made in 1998
applicable to prior years.
The increase in net losses and LAE paid, which includes the change
in the losses and LAE liability, resulted primarily from a decrease in
the loss and loss adjustment expense liability. Additionally, direct
payments on automobile liability claims increased $29,400, or 11.7%.
The remaining amount is primarily the result of increased payments for
the management incentive compensation plan and computer services
expenses associated with claims coupled with increased payments assumed
from C.A.R. Offsetting this, claim payments for other than automobile
lines of business, after reinsurance, decreased in the first half of
1998 versus 1997. The increase in automobile liability loss payments
was primarily attributable to two factors: increased payments for
bodily injury claims and increased payments for property damage
liability claims. The liability payments were higher primarily due to
increased business writings coupled with continued efforts in the claims
department to accelerate the claims settlement process in an effort to
reduce the overall cost and potential build-up of bodily injury claims
in the long run, as well as to reduce the overall number of open
liability claims.
17
<PAGE>
The net cash flows used in investing activities were primarily the
result of purchases of fixed maturities and equity securities offset by
a net decrease in short-term investments and by proceeds from the sale
and maturity of fixed maturities and equity securities. Investing
activities were funded by accumulated cash and cash provided by
operating activities during 1998 and 1997.
Cash flows used in financing activities totaled $38,566 during
1998 compared to $37,611 during 1997. The 1998 cash flows used in
financing activities consisted exclusively of dividends paid to
stockholders. The 1997 cash flows used in financing activities
consisted of $37,124 in dividends paid to stockholders and $487 used to
purchase 20,000 shares of Treasury Stock under the Company's stock
buyback program. There were no Treasury Stock purchases in 1998.
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, 1998 was $1,257,900. At December 31, 1998,
the Company held cash and cash equivalents of $72,243 and short-term
investments of $3,669. These funds provide sufficient liquidity for the
payment of claims and other short-term cash needs. The Company also
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 may, within certain limitations,
pay such dividends and then file a report with the Commissioner.
Dividends in excess of these limitations are called extraordinary
dividends. 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 1998, 1997 and 1996.
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.
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 1.32 to 1.00, 1.43 to 1.00, and
1.53 to 1.00 for the years ended December 31, 1998, 1997 and 1996,
respectively.
The Company's long-term growth objective has been to expand its
writings outside of Massachusetts. In continued pursuit of this
objective Commerce has become licensed in the states of Connecticut,
Rhode Island, Vermont, New Hampshire and Maine.
In keeping with the Company's long-term growth objective to expand
outside Massachusetts, the Company has also monitored potential
acquisition opportunities 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. This objective
has been exemplified by the 1995 acquisition of Commerce West, a
personal automobile insurer, located in Pleasanton, California and, most
recently, by the Company's formation of a joint venture (ACIC Holding
Co., Inc.) in November 1998, and the subsequent acquisition, in January
1999, of ACIC, located in Columbus, Ohio.
ACIC writes automobile and homeowners insurance solely through 38
AAA automobile clubs. Commerce and AAA SNE intend that ACIC will retain
its management team and staff and continue to have its principle office
in Columbus, Ohio.
18
<PAGE>
In early 1999, Commerce, a subsidiary of the Company, invested
$90.8 million in the joint venture (ACIC Holding Co., Inc.) to fund the
ACIC acquisition and to capitalize the joint venture that is owned
together with AAA SNE. Of this $90.8 million, Commerce invested $90
million in the form of preferred stock and an additional $800
representing its 80% common stock ownership. The terms of the preferred
stock call for quarterly cash dividends at the rate of 10% per annum.
AAA SNE invested $200 representing its 20% common stock ownership.
Commerce intends to consolidate ACIC Holding Co., Inc. and it's wholly-
owned subsidiary, ACIC, for financial reporting purposes. Since 1995,
Commerce has maintained an affinity group marketing relationship with
AAA Insurance Agency, Inc., a subsidiary of AAA SNE. AAA Insurance
Agency, Inc. has been an agent of Commerce since 1985.
Internal Software Development Project with PMSC
The Company previously announced that it had entered into an
agreement with, and purchased software, known as Series III, from PMSC
to allow for development of internal operating systems to enable the
Company to first process policies in states outside of Massachusetts and
eventually to replace the Company's systems for Massachusetts business.
Although the Company began writing business in Rhode Island in early
1998 on the Series III system, in early 1999 the Company stopped work on
all development. The Company is currently in the process of negotiating
with PMSC as to the future continuation of the Series III system. Costs
to date for this effort have been approximately $47.0 million, of which
$18.4 million is applicable to 1998. Funds expended to date included
the purchase of a main frame computer, license fees and the costs
associated with programming, implementation and training. The vast
majority of these costs were expensed as incurred.
Year 2000 Compliance
The year 2000 issue exists primarily because most computer
programs were originally coded to recognize only the last two digits in
the date field. If not addressed and corrected, many systems could fail
and produce erroneous results. The impact of this could lead to a
material adverse impact upon the Company's business including policy and
claims processing. As a result, considerable effort has taken place to
assess the impact and determine whether to replace and/or reprogram the
systems in order for the systems to distinguish the intended year. The
Company subsequently initiated the Century Change project to address all
internal/external systems, software, agents, third parties and vendors
in dealing with year 2000 compliance.
The Century Change project, enlisting both a redeployment of
internal resources and additional external consultant resources,
involved the development of a formal plan to address the Year 2000
problem and has progressed in accordance with that plan. The Company's
plan, which was designed to, and is proceeding so as to, avoid any
material adverse business production issues, organized corporate systems
into four sub-categories: Data Exchange, AS400 Systems/Programs, PC
Applications and PC Based Vendor Purchased Application Software.
Different sub-plans were established for each category with the same
Year 2000 objective in mind. As a result of this effort, the majority
of the programming changes dealing with policy issuance, claims
processing and maintenance have been completed as of October 1998.
Other internal changes are expected to be completed in accordance with
specified delivery dates as outlined in the plan. Looking forward, the
project has and will continue to move into the testing phases of the
plan which will primarily conclude at the end of second quarter 1999.
19
<PAGE>
The Company has reviewed the Century Change status of vendors who
perform outside processing, those whose software the Company uses for
internal processing and those third parties with whom the Company does
significant business. Accordingly, the Company has recognized that year
2000 non-compliance could materially adversely affect the financial
position, results of operations and cash flows of the Company. As a
result, the Company has contacted all significant related third parties
in an effort to determine year 2000 compliance. This program includes
sending out questionnaires to our major business partners, including our
agents, regarding their year 2000 readiness. Based on the responses
received to date, the Company does not anticipate any material impact on
its operations or financial condition. If there are instances where the
Company ascertains a potential non-compliance, the Company will seek
alternative year 2000 compliant third parties. This process is on-going
and the Company has started to conduct system testing, as needed, with
such third parties, which will conclude in 1999. While the Company is
taking what it believes are the appropriate safeguards, there can be no
assurances that the failure of such third parties to be year 2000
compliant will not have a material adverse impact on the Company. The
Company expects that the implementation of the contingency plans, if
necessary, will not have a material adverse effect on the Company's
ability to conduct its business or on its operating results or financial
condition.
The Company's Executive Committee, as well as all departments in
the Company, are currently reviewing issues dealing with identifying
possible year 2000 worst case scenarios and the development of
contingency plans to respond to the likelihood of these scenarios.
Contingency Plans will be discussed and developed, where deemed
appropriate, for all material systems and relationships during the first
half of 1999. At a minimum, contingency plans will be developed for the
continuation of policy and claim processing in the event that the
Company's computer systems are not available due to a year 2000 related
failure.
The project to date has involved internal staff costs as well as
consulting expenses to prepare the systems for the year 2000. Total
costs to date for the Century Change project have been approximately
$4.9 million ($3.6 million of which relate to 1998). Costs to date
applicable to internal staff and external consulting have been
approximately $1.6 million and $3.3 million, respectively ($1.1 million
and $2.5 million, respectively, relate to 1998). Administration,
programming, testing and implementation of system applications relating
to the Century Change project are expected to cost an additional $1.9
million in 1999.
Market Risk: Interest Rate Sensitivity and Equity Price Risk
The Company's investment strategy emphasizes investment yield
while maintaining investment quality. The Company's investment
objective is to maintain high quality diversified investments structured
to maximize after-tax investment income while minimizing risk. The
Company's funds are generally invested in securities with maturities
intended to provide adequate funds to pay claims and meet other
operating needs without the forced sale of investments. Periodically
sales have been made from the Company's fixed maturity 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.
In conducting investing activities, the Company is subject to, and
assumes, market risk. Market risk is the risk of an adverse financial
impact from changes in interest rates and market prices. The level of
risk assumed by the Company is a function of the Company's overall
objectives, liquidity needs and market volatility.
The Company manages its overall market risk by focusing on higher
quality equity and fixed income investments, by continuously monitoring
the credit strength of all companies in which investments are made, by
limiting exposure in any one investment and by monitoring the quality of
the investment portfolio by taking into account credit ratings assigned
by recognized rating organizations.
20
<PAGE>
As part of its investing activities, the Company assumes positions
in fixed maturity, equity, short-term and cash equivalents markets.
The Company is, therefore, exposed to the impacts of interest rate
changes in the market value of investments. For 1998, the Company's
exposure to interest rate changes and equity price risk has been
estimated using sensitivity analysis. The interest rate impact is
defined as the effect of a hypothetical interest rate change of plus-or-
minus 200 basis points on the market value of fixed maturities and
preferred stocks. The equity price risk is defined as a hypothetical
change of plus-or-minus 10% in the fair value of common stocks. Changes
in interest rates would result in unrealized gains or losses in the
market value of the fixed maturity and preferred stock portfolio due to
differences between current market rates and the stated rates for these
investments. Based on the results of the sensitivity analysis at
December 31, 1998, the Company's estimated market exposure for a 200
basis point increase (decrease) in interest rates was calculated. A 200
basis point increase results in a $42,665 decrease in the market value
of the fixed maturities and preferred stocks. A 200 basis point
decrease results in a $46,732 increase in the market value of the same
securities. The equity price risk impact at December 31, 1998, based
upon a 10% increase in the fair value of common stocks, would be an
increase of $28,396. Based upon a 10% decrease, common stocks would
decrease $28,396.
Recent Accounting Developments
In 1997, the Accounting Standards Executive Committee ("AcSEC")
issued Statement of Position 97-3 Accounting by Insurance and Other
Enterprises for Insurance-Related Assessments ("SOP 97-3") effective for
financial statements issued for periods ending after December 31, 1998.
This statement provides guidance on accounting by insurance companies on
the timing of recognition, the methods of measurement, and the required
disclosures for guaranty fund and other related assessments. The
Company believes that the adoption of this statement will not have a
material impact on the Consolidated Financial Statements.
In 1998, the AcSEC issued Statement of Position 98-1, Accounting
for Costs of Computer Software Developed or Obtained for Internal Use
("SOP 98-1") effective for financial statements issued for periods
beginning after December 15, 1998. This statement establishes guidance
on accounting for the costs incurred related to internal use software.
The Company expenses these costs as incurred and 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 Massachusetts 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.
21
<PAGE>
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 1998 and 1997 were as follows:
<TABLE>
<CAPTION>
1998
1997
High Low Close High
Low Close
<S> <C> <C> <C> <C>
<C> <C>
First Quarter........... $37-3/8 $31-3/4 $35-1/4 $29
$22-7/8 $23-1/4
Second Quarter.......... 39-5/8 34-3/8 38-3/4 24-
3/4 21-3/8 24-5/8
Third Quarter........... 39 24-7/8 27-5/8 33-
3/8 23-7/8 30-7/8
Fourth Quarter.......... 36-1/2 22-11/16 35-7/16 36
30 32-5/8
</TABLE>
As of March 1, 1999, there were 1,241 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 $1.07 per share
and $1.03 per share in 1998 and 1997, respectively. On May 15, 1998,
the Board voted to increase the quarterly stockholder dividend from
$0.26 to $0.27 per share to stockholders of record as of June 5, 1998.
Prior to that declaration, the Company had paid quarterly dividends of
$0.26 per share dating back to May 30, 1997 when the Board voted to
increase the dividend from $0.25 to $0.26 per share.
The Company purchased no additional Treasury Stock under the stock
buyback program during 1998. The stock buyback program, authorized by
the Board on May 19, 1995, enables the Company to purchase up to
3,000,000 shares of the Company's common stock. As of December 31,
1998, 1,957,348 shares of Treasury Stock were purchased under the
program. Since December 31, 1998, the Company completed its share
purchases under that program. Additionally, under prior Board of
Director authorizations, the Company purchased 143,248 shares through
March 19, 1999.
22
<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 1998 consolidated financial statements were audited by the
Company's independent auditors, Ernst & Young LLP, in accordance with
generally accepted auditing standards. In addition, Ernst & Young LLP
performs reviews of the unaudited quarterly financial statements.
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 were valid and
appropriate.
23
<PAGE>
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders of
The Commerce Group, Inc.
We have audited the accompanying consolidated balance sheets of
The Commerce Group, Inc. and Subsidiaries as of December 31, 1998 and
1997, and the related consolidated statements of earnings, stockholders'
equity and cash flows for each of the two years ended December 31, 1998.
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 audits. The accompanying consolidated
financial statements of the Company for the year ended December 31,
1996, was 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 that our audits provide a reasonable basis for
our opinion.
In our opinion, the 1998 and 1997 financial statements referred to
above present fairly, in all material respects, the consolidated
financial position of The Commerce Group, Inc. and Subsidiaries at
December 31, 1998 and 1997, and the consolidated results of their
operations and their cash flows for each of the two years in the period
ended December 31, 1998 in conformity with generally accepted accounting
principles.
ERNST &
YOUNG LLP
Boston, Massachusetts
January 22, 1999
24
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31,
(Thousands of Dollars Except Per Share Data)
<TABLE>
<CAPTION>
1998 1997
ASSETS
<S>
<C> <C>
Investments (notes A2, A3, A4 and B)
Fixed maturities, at market (cost: $600,482 in 1998 and $566,784
in 1997).......................................................... $
619,267 $ 590,597
Preferred stocks, at market (cost: $200,270 in 1998 and $148,135
in 1997)..........................................................
197,425 148,499
Common stocks, at market (cost: $261,360 in 1998 and $160,371 in
1997).............................................................
283,961 178,089
Mortgage loans on real estate and collateral notes receivable
(less allowance for possible loan losses of $2,301 in 1998
and $2,812 in 1997)...............................................
73,510 82,839
Short-term investments.............................................
3,669 132,700
Cash and cash equivalents..........................................
72,243 106,188
Other investments (cost: $7,450 in 1998 and $3,783 in 1997)........
7,825 3,783
Total investments..............................................
1,257,900 1,242,695
Accrued investment income............................................
13,662 12,237
Premiums receivable (less allowance for doubtful receivables of
$1,450 in 1998 and $1,451 in 1997).................................
162,878 169,469
Deferred policy acquisition costs (notes A5 and C)...................
88,759 85,264
Property and equipment, net of accumulated depreciation
(notes A6 and D)...................................................
35,854 36,280
Residual market receivable (note F)
Losses and loss adjustment expenses................................
111,784 129,137
Unearned premiums..................................................
41,436 51,662
Due from reinsurers (note F).........................................
36,687 18,170
Other assets.........................................................
7,023 9,839
Total assets...................................................
$1,755,983 $1,754,753
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Losses and loss adjustment expenses (notes A7, E and F)............ $
596,996 $ 649,473
Unearned premiums (note A8)........................................
391,424 379,599
Current income taxes (notes A9 and G)..............................
4,061 2,656
Deferred income taxes (notes A9 and G).............................
3,769 13,443
Deferred income (notes A10 and F)..................................
6,948 7,271
Contingent commissions accrued (note A11)..........................
22,067 13,861
Payable for securities purchased...................................
62 11,500
Other liabilities and accrued expenses.............................
24,871 27,154
Total liabilities..............................................
1,050,198 1,104,957
Stockholders' Equity (notes B, J, K and L)
Preferred stock, authorized 5,000,000 shares at $1.00 par value;
none issued in 1998 and 1997......................................
- - -
Common stock, authorized 100,000,000 shares at $.50 par value;
issued and outstanding 38,000,000 shares in 1998 and 1997.........
19,000 19,000
Paid-in capital....................................................
29,621 29,621
Net accumulated other comprehensive income, net of income taxes of
$13,621 in 1998 and $14,663 in 1997...............................
25,295 27,232
Retained earnings..................................................
670,556 612,630
744,472 688,483
Treasury Stock, 1,957,348 shares in 1998 and 1997, at cost
(note A13)........................................................
(38,687) (38,687)
Total stockholders' equity.....................................
705,785 649,796
Total liabilities and stockholders' equity.....................
$1,755,983 $1,754,753
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
25
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
For the years ended December 31,
(Thousands of Dollars Except Share and Per Share Data)
<TABLE>
<CAPTION>
1998
1997 1996
<S> <C> <C>
<C>
Revenues
Earned premiums (notes A8 and F)..................... $ 745,620 $
730,497 $ 668,716
Net investment income (note B)....................... 86,501
80,972 77,402
Premium finance and service fees..................... 13,440
7,074 9,713
Net realized investment gains (losses) (note B)...... 6,769
22,770 (7,574)
Total revenues.................................. 852,330
841,313 748,257
Expenses
Losses and loss adjustment expenses
(notes A7, E and F)................................. 531,429
526,127 475,231
Policy acquisition costs (notes A5 and C)............ 196,434
187,491 181,013
Total expenses.................................. 727,863
713,618 656,244
Earnings before income taxes.................... 124,467
127,695 92,013
Income taxes (notes A9 and G).......................... 27,975
31,480 18,049
NET EARNINGS.................................... $ 96,492 $
96,215 $ 73,964
COMPREHENSIVE INCOME............................ $ 94,555 $
100,368 $ 80,539
BASIC AND DILUTED NET EARNINGS PER COMMON SHARE
(note A12)..................................... $ 2.68 $
2.67 $ 2.04
CASH DIVIDENDS PAID PER SHARE................... $ 1.07 $
1.03 $ 0.81
WEIGHTED AVERAGE NUMBER OF COMMON
SHARES OUTSTANDING............................. 36,042,652
36,044,679 36,311,887
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
26
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
For the years ended December 31,
(Thousands of Dollars)
<TABLE>
<CAPTION>
Net
Accumulated
Other
Common Paid-in Comprehensive Retained
Treasury
Stock Capital Income/(Loss) Earnings
Stock Total
<S> <C> <C> <C> <C>
<C> <C>
Balance January 1, 1996...... $19,000 $29,621 $ 16,504 $508,948
$(24,359) $549,714
Net earnings................ 73,964
73,964
Other comprehensive income:
Net unrealized gains arising
during the period, net of
taxes of $3,540........... 6,575
6,575
Comprehensive income........
80,539
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
Other comprehensive income:
Net unrealized gains arising
during the period, net of
taxes of $2,236........... 4,153
4,153
Comprehensive income........
100,368
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
Net earnings................ 96,492
96,492
Other comprehensive income (loss):
Unrealized holding gains arising
during the period, net
of taxes of $1,455........ 2,702
2,702
Reclassification adjustment
net of tax benefits of
($2,498).................. (4,639)
(4,639)
Other comprehensive loss... (1,937)
(1,937)
Comprehensive income........
94,555
Stockholder dividends....... (38,566)
(38,566)
Balance December 31, 1998.... $19,000 $29,621 $ 25,295 $670,556
$(38,687) $705,785
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
27
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended December 31,
(Thousands of Dollars)
<TABLE>
<CAPTION>
1998
1997 1996
<S> <C>
<C> <C>
Cash flows from operating activities
Premiums collected..................................... $ 761,539 $
727,530 $ 675,683
Net investment income received......................... 85,076
81,376 79,269
Premium finance and service fees received.............. 13,440
7,074 9,713
Losses and loss adjustment expenses paid............... (572,661)
(516,130) (428,541)
Policy acquisition costs paid.......................... (186,869)
(198,011) (200,922)
Federal income tax payments............................ (35,201)
(21,833) (16,950)
Net cash provided by operating activities.......... 65,324
80,006 118,252
Cash flows from investing activities
Proceeds from maturity of fixed maturities............. 64,004
108,592 170,646
Proceeds from sale of fixed maturities................. 34,034
124,653 122,431
Proceeds from sale of equity securities................ 80,420
224,059 11,326
Purchase of fixed maturities........................... (134,540)
(98,098) (200,113)
Purchase of equity securities.......................... (224,896)
(296,714) (85,480)
Purchase of other investments.......................... (3,616)
(1,752) (700)
Net (increase) decrease in short-term investments,
net of payable for securities purchased.............. 117,531
(121,200) -
Payments received on mortgage loans and collateral
notes receivable..................................... 26,788
11,386 8,311
Mortgage loans and collateral notes originated......... (16,450)
(19,816) (7,446)
Purchase of property and equipment..................... (4,293)
(8,133) (4,477)
Other proceeds from investing activities............... 315
281 235
Net cash provided by (used in) investing activities (60,703)
(76,742) 14,733
Cash flows from financing activities
Dividends paid to stockholders......................... (38,566)
(37,124) (29,373)
Purchase of treasury stock............................. -
(487) (15,742)
Net cash used in financing activities.............. (38,566)
(37,611) (45,115)
Increase (decrease) in cash and cash equivalents......... (33,945)
(34,347) 87,870
Cash and cash equivalents at beginning of year........... 106,188
140,535 52,665
Cash and cash equivalents at end of year................. $ 72,243 $
106,188 $ 140,535
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
28
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Reconciliation of Net Earnings to Net Cash Provided by Operating
Activities
For the years ended December 31,
(Thousands of Dollars)
<TABLE>
1998
1997 1996
<S> <C>
<C> <C>
Cash flows from operating activities
Net earnings........................................... $ 96,492 $
96,215 $ 73,964
Adjustments to reconcile net earnings to net cash
provided by operating activities:
Premiums receivable.................................. 6,591
(11,634) (30,788)
Deferred policy acquisition costs.................... (3,495)
(2,296) (15,808)
Residual market receivable........................... 27,579
14,414 4,911
Due from reinsurers.................................. (18,517)
1,489 2,238
Losses and loss adjustment expenses.................. (52,477)
(13,359) 36,803
Unearned premiums.................................... 11,825
11,608 37,537
Current income taxes................................. 1,405
2,485 (1,009)
Deferred income taxes................................ (8,632)
6,984 2,098
Deferred income...................................... (323)
(703) (980)
Contingent commissions............................... 8,206
(11,851) (6,838)
Other assets, liabilities and accrued expenses....... 533
4,992 3,017
Net realized investment (gains) losses............... (6,769)
(22,770) 7,574
Other - net.......................................... 2,906
4,432 5,533
Net cash provided by operating activities......... $ 65,324 $
80,006 $ 118,252
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
29
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(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. Commerce
West Insurance Company ("Commerce West") 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 1998 presentation.
The insurance subsidiaries, Commerce, Citation and Commerce West
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 and preferred stocks, 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 preferred stocks, are
carried at fair market value and are classified as available for sale.
Unrealized investment gains and losses on common and 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, known as "net accumulated other comprehensive
income", 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 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 5% in fixed
maturities of any one state or political subdivision.
The Company originates and holds mortgage loans on real estate 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 mortgage customers. Bad debt expenses
have not been material in recent years.
30
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
NOTE A-Summary of Significant Accounting Policies - (continued)
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. The Company held $13,572 and $27,476 in U.S.
Government Repurchase Agreements at various banks in 1998 and 1997.
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 1998, 1997 and
1996. In determining whether a premium deficiency exists, the Company
considers anticipated investment income on unearned premiums.
31
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(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>
<CAPTION>
Percent
Asset Classification Per
Annum
<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")
affinity group marketing program. Of the Company's total direct
premiums written, the portion attributable to the AAA group business was
$457,430 or 57% in 1998 as compared to $423,243 or 55% in 1997. Of
these amounts, 11% were written through insurance agencies owned by the
AAA clubs and 89% were written through the Company's network of
independent agents in both 1998 and 1997, 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).
32
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
NOTE A-Summary of Significant Accounting Policies - (continued)
11. Contingent Commissions
In addition to state mandated commissions on policies written, the
Company pays certain of its agencies compensation in the form of profit
sharing. This is based, in part, on the underwriting profits of an
individual agent's business written with the Company. This arrangement
utilizes a three year rolling plan, with one third of each of the
current and the two prior years profit or loss calculations, summed to a
single amount. This amount, if positive, is multiplied by the profit
sharing commission rate and paid to the agent.
12. Net Earnings Per Common Share
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, 1998, 1997 and 1996 was 36,042,652, 36,044,679 and
36,311,887, respectively. Weighted average number of common shares
outstanding is determined by taking the average of the following
calculation for a specified period of time: The daily amount of the
total issued and outstanding common shares minus the total Treasury
Stock purchased.
13. Treasury Stock (unaudited)
On May 19, 1995, the Board of Directors of the Company announced
the approval of a stock buyback program of up to 3,000,000 shares.
Through December 31, 1998, the Company had purchased 1,957,348 shares of
Treasury Stock under this program. Since December, 1998, the Company
completed its share repurchases under that program. Additionally, under
prior Board of Director authorizations, the Company purchased 143,248
shares through March 19, 1999.
14. New and Pending Accounting Pronouncements
During the first quarter of 1998, the Company adopted 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 transaction,
minimum pension liability adjustments and unrealized gains and losses on
certain investments in debt and equity securities (i.e. available for
sale securities).
During the first quarter of 1998, the Company adopted 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.
During 1998 the Financial Accounting Standards Board ("FASB")
issued statement of Financial Accounting Standards No. 133, "Accounting
for Derivative Instruments and Hedging Activities" ("FAS 133") effective
for financial statements issued to fiscal years beginning after June 15,
1999. FAS 133 establishes accounting and reporting standards for
derivative instruments, including certain derivative instruments
embedded in other contracts, (collectively referred to as derivatives)
and for hedging activities. It requires that an entity recognize all
derivatives as either assets or liabilities in the balance sheet and
measure those instruments at fair value. The Company had no derivative
or hedging activity in 1998, 1997 or 1996.
33
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
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>
<CAPTION>
Gross
Gross Estimated
Amortized Unrealized
Unrealized Fair Market
Cost Gains
Losses Value
<S> <C> <C> <C>
<C>
At December 31, 1998:
GNMA mortgage-backed bonds........... $109,624 $ 2,965 $
(1) $112,588
Obligations of states and
political subdivisions.............. 490,858 18,416
(2,595) 506,679
Totals.......................... $600,482 $ 21,381 $
(2,596) $619,267
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
</TABLE>
Proceeds from sales of investments in fixed maturities, gross
gains and gross losses realized on those sales were as follows:
<TABLE>
<CAPTION>
Proceeds
Gross Gross
From
Realized Realized
Sales
Gains Losses
<S> <C> <C>
<C>
For the year ended December 31, 1998:
GNMA mortgage-backed bonds......................... $ - $
- - $ -
Obligations of states and political subdivisions... 34,034
25 (435)
Totals........................................ $ 34,034 $
25 $ (435)
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)
</TABLE>
34
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
NOTE B-Investments and Investment Income - (continued)
The amortized cost and approximate fair market value of fixed
maturities at December 31, 1998 and 1997, by contractual maturity, are
as follows:
<TABLE>
<CAPTION>
1998
1997
Fair
Fair
Amortized Market
Amortized Market
Cost Value
Cost Value
<S> <C> <C>
<C> <C>
Obligations of states and political subdivisions:
Due in one year or less.......................... $ - $ -
$ - $ - Due after one year through five years............
2,096 2,177 2,083 2,200
Due after five years through ten years........... 1,748 1,740
1,321 1,324
Due after ten years.............................. 487,014 502,762
387,592 406,004
490,858 506,679
390,996 409,528
GNMA mortgage-backed bonds....................... 109,624 112,588
175,788 181,069
Total fixed maturities.................... $600,482 $619,267
$566,784 $590,597
</TABLE>
Expected maturities may differ from contractual maturities because
issuers may have the right to call or prepay obligations.
2. Common Stocks
The cost and approximate fair market value of common stocks at
December 31, 1998 and 1997, are as follows:
<TABLE>
<CAPTION>
1998
1997
Fair
Fair
Market
Market
Cost Value
Cost Value
<S> <C> <C>
<C> <C>
Preferred stock mutual funds................ $169,394 $172,455
$115,943 $ 119,439
Common stocks............................... 91,966 111,506
44,428 58,650
Total common stocks............. $261,360 $283,961
$160,371 $ 178,089
</TABLE>
3. Mortgage Loans on Real Estate and Collateral Notes Receivable
At December 31, 1998 and 1997, mortgage loans on real estate and
collateral notes receivable consisted of the following:
<TABLE>
<CAPTION>
December 31,
1998
1997
<S> <C>
<C>
Residential (1st Mortgages)............ $59,377
$58,430
Residential (2nd Mortgages)............ 261
523
Commercial (1st Mortgages)............. 13,762
14,755
Commercial (2nd Mortgages)............. 104
172
73,504
73,880
Collateral notes receivable............ 2,307
11,771
75,811
85,651
Allowance for possible loan losses..... (2,301)
(2,812)
Mortgage loans on real estate and
collateral notes receivable....... $73,510
$82,839
</TABLE>
35
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
NOTE B-Investments and Investment Income - (continued)
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, 1998 and 1997, prior to the allowance for possible loan
losses, was $78,382 and $87,867, respectively, which was estimated by
discounting the future cash flows.
At December 31, 1998 and 1997 mortgage loans which were on
nonaccrual status amounted to $1,638 and $2,021, respectively. The
reduction in interest income associated with nonaccrual loans was $205,
$207 and $152 for the years ended December 31, 1998, 1997 and 1996,
respectively.
The Company originates and services residential and commercial
mortgages in Massachusetts and Connecticut. The Company's 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.
A summary of the changes in the allowance for possible loan losses
follows:
<TABLE>
<CAPTION>
Year
ended December 31,
1998 1997
<S> <C>
<C>
Balance, beginning of year........................ $
2,812 $ 2,760
Increase (decrease) in provision for possible
loan losses...................................
(511) 52
Balance, end of year.............................. $
2,301 $ 2,812
</TABLE>
The following table describes mortgage principal balances by
maturity, total mortgages over 90 days past due and total
mortgages in foreclosure:
<TABLE>
<CAPTION>
1998 1997
<S> <C>
<C>
Fixed rate mortgages maturing:
One year or less................................ $
- - $ 4
More than one year to five years................
1,886 2,062
More than five years to ten years...............
7,121 4,608
Over ten years..................................
48,053 46,868
Total fixed mortgages...................... $
57,060 $ 53,542
Adjustable rate mortgages maturing:
One year or less................................ $
- - $ -
More than one year to five years................
67 -
More than five years to ten years...............
395 498
Over ten years..................................
15,831 19,840
Total adjustable mortgages................. $
16,293 $ 20,338
Past due over 90 days............................. $
1,638 $ 2,021
Mortgages in foreclosure.......................... $
979 $ 1,459
</TABLE>
36
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
NOTE B-Investments and Investment Income - (continued)
4. Net Investment Income
The components of net investment income were as follows:
<TABLE>
<CAPTION>
Year ended
December 31,
1998
1997 1996
<S> <C> <C>
<C>
Interest on fixed maturities.................. $ 41,368 $
46,449 $ 56,034
Dividends on common and preferred stocks...... 32,145
19,799 12,765
Interest on cash and short-term investments... 8,683
10,544 4,022
Interest on mortgage loans.................... 6,604
6,578 6,737
Other......................................... 119
122 105
Total investment income.............. 88,919
83,492 79,663
Investment expenses........................... 2,418
2,520 2,261
Net investment income................ $ 86,501 $
80,972 $ 77,402
</TABLE>
5. Net Realized and Unrealized Investment Gains (Losses)
Net realized investment gains (losses) were as follows:
<TABLE>
<CAPTION>
Year ended
December 31,
1998
1997 1996
<S> <C> <C>
<C>
Net realized investment gains (losses):
Fixed maturities................................. $ (2,804) $
1,419 $ (7,364)
Preferred stocks................................. (727)
6 (349)
Common stocks.................................... 9,313
21,440 456
Other............................................ 987
(95) (317)
Total........................................ $ 6,769 $
22,770 $ (7,574)
</TABLE>
6. Other Comprehensive Income (Loss)
Net increases (decreases) in other comprehensive income (loss)
less applicable income
tax expense were as follows:
<TABLE>
>CAPTION>
Year ended
December 31,
1998
1997 1996
<S> <C> <C>
<C>
Other comprehensive income (loss):
Fixed maturities................................. $ (5,028) $
7,622 $ 2,222
Preferred stocks................................. (3,209)
1,165 (424)
Common stocks.................................... 4,883
(2,398) 8,317
Other............................................ 375 -
- -
Tax expense...................................... 1,042
(2,236) (3,540)
Total........................................ $ (1,937) $
4,153 $ 6,575
</TABLE>
A summary of net accumulated other comprehensive income (loss) on
stocks and fixed maturity investments in 1998, 1997 and 1996 follows:
<TABLE>
<CAPTION>
Year ended
December 31,
1998
1997 1996
<S> <C> <C>
<C>
Unrealized gains................................ $ 49,184 $
43,675 $ 40,227
Unrealized losses............................... (10,268)
(1,780) (4,721)
Tax expense..................................... (13,621)
(14,663) (12,427)
Net accumulated other comprehensive
income..................................... $ 25,295 $
27,232 $ 23,079
</TABLE>
37
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
NOTE C-Deferred Policy Acquisition Costs
Policy acquisition costs incurred and amortized to income are as
follows:
<TABLE>
<CAPTION>
Year ended
December 31,
1998
1997 1996
<S> <C> <C>
<C>
Balance, beginning of year............. $ 85,264 $
82,968 $ 67,160
Costs deferred during the year......... 199,929
189,787 196,821
Amortization charged to expense........ (196,434)
(187,491) (181,013)
Balance, end of year................... $ 88,759 $
85,264 $ 82,968
</TABLE>
NOTE D-Property and Equipment
A summary of property and equipment at December 31, is as follows:
<TABLE>
<CAPTION>
1998
1997
<S> <C>
<C>
Buildings................................. $ 30,719
$ 27,873
Equipment and office furniture............ 33,230
30,286
Building improvements..................... 838
828
64,787
58,987
Less accumulated depreciation.......
(29,907) (25,081)
34,880
33,906
Land...................................... 939
934
Construction in progress.................. 35
1,440
$ 35,854
$ 36,280
</TABLE>
Depreciation expense incurred was $4,706, $4,213 and $3,202 for
the years ended December 31, 1998, 1997 and 1996, respectively.
Depreciation expense is allocated evenly 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>
<CAPTION>
1998
1997
<S> <C>
<C>
Unpaid loss and LAE reserves.............. $666,177
$725,886
Salvage and subrogation recoverable.......
(69,181) (76,413)
$596,996
$649,473
</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 annually obtain a certification from either a qualified
actuary or an approved loss reserve specialist that its loss and LAE
reserves are reasonable.
38
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
NOTE E-Losses and Loss Adjustment Expenses - (continued)
When a claim is reported to the Company, 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.
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, 1998 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 experience.
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
$5,687 and $6,924 in 1998 and 1997, respectively.
39
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
NOTE E-Losses and Loss Adjustment Expenses - (continued)
The following table sets forth a reconciliation of beginning and
ending reserves for losses and loss adjustment expense, 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>
<CAPTION>
Year ended
December 31,
1998
1997 1996
<S> <C> <C>
<C>
Loss and loss adjustment expense reserves,
beginning of year, prior to effect of ceded
reinsurance recoverable............................. $530,077
$533,980 $493,911
Incurred losses and loss adjustment expenses:
Provision for insured events of the current year.. 592,796
609,930 562,997
Decrease in provision for insured events of
prior years...................................... (61,367)
(83,803) (87,766)
Total incurred losses and loss adjustment
expenses....................................... 531,429
526,127 475,231
Payments:
Losses and loss adjustment expenses attributable
to insured events of the current year............ 335,047
322,882 267,653
Losses and loss adjustment expenses attributable
to insured events of prior years................. 227,630
207,148 167,509
Total payments.................................. 562,677
530,030 435,162
Loss and loss adjustment expense reserves prior to
effect of ceded reinsurance recoverable.......... 498,829
530,077 533,980
Ceded reinsurance recoverable..................... 98,167
119,396 128,852
Reserves for losses and loss adjustment expenses
at the end of year per financial statements......... $596,996
$649,473 $662,832
</TABLE>
The provision for insured events of the current year is lower for
1998 compared to 1997 primarily due to better loss results in the
Company's bodily injury area mainly due to improved severity of bodily
injury claims coupled with slightly improved claim frequency.
The provision for loss and LAE reserves relating to prior years is
lower in 1998 due primarily to activity in the bodily injury area.
Redundancies from prior year losses realized in the current year,
relating to bodily injury claims, were approximately $18.0 million less
in 1998, as compared to 1997. Approximately $11.0 million of this
amount was attributable to voluntary personal automobile bodily injury
loss reserves and $7.0 million to fewer redundancies from C.A.R. assumed
reserves.
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 11.0%.
Net loss payments in the direct personal automobile lines of business
increased approximately 11.7% or $29,400 which were offset by a decrease
in payments for other than automobile lines of business of approximately
18.2% or $5,748 compared to 1997. The decrease in other than automobile
loss payments was primarily the result of more favorable weather in 1998
versus the weather experienced in 1997. 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.
40
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
NOTE E-Losses and Loss Adjustment Expenses - (continued)
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 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 quota share
reinsurance contract on its other than automobile business.
Property, Catastrophe and Quota Share Reinsurance
From September 30, 1995 through June 30, 1998, the Company had a
combined property quota share and excess loss reinsurance contract which
was written with six reinsurance companies. Under the quota share portion
of the arrangement, the reinsurers indemnified the Company for 45% 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 49% of the net premium pertaining to the related business. The
maximum per occurrence loss reimbursement was $50.0 million and the
maximum annual aggregate occurrence loss reimbursement was $75.0 million.
Under the excess loss reinsurance portion of the arrangement, the Company
reinsured each risk, retaining $125 and reinsuring 100% of the next $875.
Various catastrophe only reinsurance programs were utilized from
1996 through May, 1998 in conjunction with the quota share and excess loss
program noted above.
Effective July 1, 1998, the Company expanded the quota share portion
of the program. A 75% quota-share reinsurance program was incepted,
covering all non-automobile property and liability business, except
umbrella policies. The excess loss portion of the program was reduced on
July 1, 1998 and completely eliminated on September 30, 1998. The
expanded program is split between American Re-Insurance Company, Employers
Reinsurance Corporation, Nationwide Mutual Insurance Company and Swiss
Reinsurance America Corporation. The maximum per occurrence loss
reimbursement is the higher of 350% of premium ceded under the program or
$175.9 million. The maximum annual aggregate occurrence loss
reimbursement is the higher of 450% of premium ceded under the program or
$226.1 million. A sliding scale commission, based on loss ratio, is
utilized under this program. This program provides the Company with
sufficient protection for catastrophe coverage so as to enable the Company
to forego pure catastrophe reinsurance coverage, which was previously
tailored in conjunction with the former quota share arrangement.
41
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
NOTE F-Reinsurance Activity - (continued)
The table below provides information depicting the approximate
recovery under the expanded quota share contract at various loss
scenarios, if a single catastrophe were to strike:
<TABLE>
<CAPTION>
Net Loss
Total Reinsurance Retained by
Loss Recovery the Company
<S> <C> <C> <C>
$ 50,000 $ 37,500 $12,500
100,000 75,000 25,000
150,000 112,500 37,500
200,000 150,000 50,000
250,000 175,875 74,125
</TABLE>
Under the above scenario, the Company has no reinsurance
recoveries for a single event catastrophe in excess of a total loss of
approximately $234.5 million. The Company's estimated total loss on its
other than automobile business for 100 and 250 year storms is $108.6
million and $184.2 million, respectively. The Company estimates were
derived through the services of Swiss Reinsurance America Corporation
who utilized the CLASIC model provided by Applied Insurance Research.
Written premiums ceded in 1998, 1997 and 1996 under the above
referenced programs were $54.0 million, $27.5 million and $26.6 million,
respectively. Ceding commission income is calculated on a ceded earned
premium basis.
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 (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 American Re-
Insurance Company (rated A+ by A.M. Best).
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>
<CAPTION>
Year ended
December 31,
1998
1997 1996
<S> <C>
<C> <C>
Written premiums ceded............................ $56,341
$32,190 $ 31,289
Earned premiums ceded............................. 43,518
33,847 36,261
Losses and loss adjustment expenses ceded......... 16,542
10,616 22,453
</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.
42
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
NOTE F-Reinsurance Activity - (continued)
C.A.R.
C.A.R., a state-mandated reinsurance mechanism, enables the
Company and 45 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, 1998,
1997 and 1996, these servicing fees amounted to $15,574, $17,333 and
$17,127, 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. The Company's strategy has been to
voluntarily retain more types of private passenger automobile business
that are factored as credits, thereby favorably impacting the
utilization formula. As a result of increased voluntary retention, the
credits impacting the utilization formula have favorably affected the
Company's participation ratio. During 1998, 1997 and 1996, the
Company's net participation in the C.A.R. personal automobile pool
approximated 16.7%, 18.0% and 19.0%, respectively.
Written premiums, earned premiums, losses incurred and the
liabilities for unearned premiums, unpaid losses ceded to and assumed
from C.A.R. were as follows:
<TABLE>
<CAPTION>
Year ended December 31,
1998 1997
1996
Ceded Assumed Ceded Assumed
Ceded Assumed
<S> <C> <C> <C> <C> <C>
<C>
Income Statement
Written premiums... $ 70,435 $ 74,644 $ 71,816 $ 76,530 $
82,861 $ 93,703
Earned premiums.... 68,383 75,718 71,977 82,866
85,977 92,469
Losses incurred.... 64,784 95,937 83,240 89,081
84,074 93,278
Balance Sheet
Unearned premiums.. $ 41,436 $ 39,271 $ 51,662 $ 40,345 $
49,487 $ 46,681
Unpaid losses...... 111,784 99,427 129,137 102,819
145,726 117,237
</TABLE>
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 1998,
1997 and 1996 the Company's amount of personal automobile exposures it
reinsured through C.A.R. approximated 6.4%, 6.6% and 8.1%, respectively.
43
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998 1997 and 1996
(Thousands of Dollars)
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>
<CAPTION>
Year ended
December 31,
1998
1997 1996
<S> <C>
<C> <C>
Current............................ $ 36,607 $
24,496 $ 15,951
Deferred........................... (8,632)
6,984 2,098
$ 27,975 $
31,480 $ 18,049
</TABLE>
Deferred taxes arise from temporary differences in the basis 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>
<CAPTION>
Year ended
December 31,
1998
1997 1996
<S> <C>
<C> <C>
Unearned premiums.................................. $ 39 $
(769) $ (3,695)
Discounting of loss reserves....................... 2,782
2,421 (2,954)
Bad debt expense................................... (17)
129 131
Deferred policy acquisition costs.................. (782)
1,297 6,022
Salvage and subrogation recoverable................ (233)
(406) 425
Tax depreciation in excess of book depreciation.... 109
151 192
Book value rights/book value awards/stock
appreciation rights............................... (11,056)
4,912 1,686
Deferred items not included above.................. 526
(751) 291
Deferred income tax.......................... (8,632)
6,984 2,098
Other comprehensive income (loss).................. (1,042)
2,236 3,540
Change in deferred tax liability............. $ (9,674) $
9,220 $ 5,638
</TABLE>
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, 1998 and 1997:
<TABLE>
<CAPTION>
1998 1997
<S> <C>
<C>
Unearned premiums................................................
$(20,569) $(20,608)
Discounting of loss reserves.....................................
(18,597) (21,379)
Book value awards/stock appreciation rights......................
(2,857) -
Bad debt allowances..............................................
(789) (772)
Deferred tax assets........................................
(42,812) (42,759)
Deferred policy acquisition costs................................
25,050 25,832
Salvage and subrogation recoverable..............................
1,768 2,001
Tax depreciation in excess of book depreciation..................
2,965 2,856
Book value awards/stock appreciation rights......................
- - 8,199
Net accumulated comprehensive income.............................
13,621 14,663
Deferred items not included above................................
3,177 2,651
Deferred tax liabilities...................................
46,581 56,202
Net deferred tax liability................................. $
3,769 $ 13,443
</TABLE>
44
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars)
NOTE G-Income Taxes (continued)
Federal income tax on income is less than the amount computed by
applying the statutory rate of 35% for the years ended 1998, 1997 and
1996 for the following reasons:
<TABLE>
<CAPTION>
Year ended December 31,
1998 1997
1996
<S> <C> <C> <C> <C>
<C> <C>
Tax at statutory rate.. $ 43,563 35.0% $44,693 35.0%
$32,205 35.0%
Tax exempt interest.... (8,429) (6.8) (8,036) (6.3)
(10,062) (10.9)
Dividends paid to ESOP
participants......... (762) (0.6) (782) (0.6)
(1,169) (1.3)
Dividends received
deduction............ (6,152) (4.9) (4,567) (3.6)
(3,167) (3.4)
Other.................. (245) (0.2) 172 0.2
242 0.2
Tax at effective rate.. $ 27,975 22.5% $31,480 24.7%
$18,049 19.6%
</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, 1998, eight of these loans, which had an
aggregate outstanding principal balance of $2,738, were collateralized
by the assets of the agencies. 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, 1998
and 1997 there were no mortgage loans outstanding to agents
collateralized by real estate.
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, 1998, 1997 and 1996,
the agency received from the Company commissions of $940, $834 and $906,
respectively, in the aggregate, for policies written. The Company also
purchased certain insurance coverages through the agency and paid
premiums for these policies of $520, $367 and $360 in 1998, 1997 and
1996, respectively.
NOTE I-Employee Stock Ownership Plan and 401(k) Plan
The Company offers an Employee Stock Ownership Plan ("E.S.O.P.")
and 401(k) 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 E.S.O.P. for any length
of time, and may completely discontinue or terminate the E.S.O.P at any
time without liability. Contributions by the Company and subsidiaries
to the E.S.O.P. for the years ending December 31, 1998, 1997 and 1996
were $5,412, $4,841 and $6,216, respectively. The E.S.O.P. owned
3,186,968 and 3,305,986 shares of the Company's common stock at December
31, 1998 and 1997, respectively.
The 401(k) Plan, implemented in September, 1998, enables eligible
employees to contribute up to 15% of eligible compensation on a pre-tax
basis up to the annual maximum limits under federal tax law. The
Company incurs no expenses in the form of matching contributions but
does pay for administration of the Plan.
45
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars Except for Per Share Data)
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 specified 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 were granted. Expenses relating to this Book Value Rights
Program were $234 in 1996. The Book Value Rights Program was replaced
by a Book Value Awards Program in 1994 maturing on December 31, 1996 and
beyond.
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 (not in
the form of cash). 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 482,215, 453,488 and 468,381 in 1998,
1997 and 1996, respectively. Stock appreciation rights issued also
relating to this Plan totalled 509,872, 493,492 and 520,625 in 1998,
1997 and 1996, 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 $470, $3,068 and $2,140 in 1998, 1997 and 1996,
respectively. Expenses (income) relating to stock appreciation rights
were ($656), $15,657 and $6,224 in 1998, 1997 and 1996, respectively.
Aggregate liabilities for the combined programs were $9,609 and $23,426
at year-end 1998 and 1997, respectively.
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 may, within certain limitations, pay such dividends and
then file a report with the Commissioner. Dividends in excess of these
limitations are called extraordinary dividends. 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 1998, 1997 and
1996.
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 1998 Commerce and Citation paid
$43,300 and $8,338 in dividends, respectively, to CHI; CHI then paid
$51,345 to the Company in March 1998. 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.
The Board of Directors of the Company voted to declare four
quarterly dividends to stockholders of record totaling $1.07 per share
and $1.03 per share in 1998 and 1997, respectively. On May 15, 1998,
the Board voted to increase the quarterly stockholder dividend from
$0.26 to $0.27 per share to stockholders of record as of June 5, 1998.
Prior to that declaration, the Company had paid quarterly dividends of
$0.26 per share dating back to May 30, 1997 when the Board voted to
increase the dividend from $0.25 to $0.26 per share.
46
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(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 Commerce West:
<TABLE>
<CAPTION>
1998 1997
1996
Earnings Equity Earnings Equity
Earnings Equity
<S> <C> <C> <C> <C>
<C> <C>
GAAP............................ $ 93,888 $649,751 $101,528
$609,416 $ 74,432 $550,151
Deferred income taxes........... (1,971) 5,423 4,039
8,352 929 2,165
Deferred acquisition costs...... (3,495) (88,759) (2,296)
(85,264) (15,808) (82,968)
Bonds-book versus market........ - (18,786) -
(23,812) - (16,194)
Preferred stock-market versus
book........................... - (1,307) -
(429) - (331)
Deferred income................. (326) 6,744 (697)
7,071 (963) 7,768
Deferred service fee income..... 91 3,411 1,784
3,139 1,538 1,538
Deferred reinsurance
commissions.................... 5,728 10,253 (1,267)
4,424 2,082 5,796
Statutory reserve over statement
reserves....................... - (4,072) -
(8,567) - (5,397)
Goodwill in subsidiary.......... (291) 1,936 (291)
2,226 (270) 2,515
Difference in GAAP to statutory
net income in subsidiary....... 80 - 57 -
416 -
Other........................... - (1,091) -
42 4 (304)
Total adjustments.......... (184) (86,248) 1,329
(92,818) (12,072) (85,412)
Statutory....................... $ 93,704 $563,503 $102,857
$516,598 $ 62,360 $464,739
</TABLE>
NOTE M-Segment Information
The Company has three reportable segments: (1) property and
casualty insurance; (2) real estate and commercial lending; and, (3)
corporate and other. The Company's property and casualty insurance
operations are written through Commerce, Citation and Commerce West and
are marketed to affinity groups, individuals, families and businesses
through the Company's relationships with professional independent
insurance agencies. The Company's real estate and commercial lending
operations are a result of insurance companies having the authorization
to invest in mortgages. The Company's wholly-owned subsidiary, Bay
Finance Company, Inc., originates and services residential and
commercial mortgages in Massachusetts and Connecticut. The corporate
and other segment represents the remainder of the Company's activities,
including those of the parent company.
The Company evaluates performance and allocates resources based
primarily on the property and casualty insurance segment which
represents 99.0% of the Company's total revenue for the past three
years. The accounting policies of the reportable segments are the same
as those described in Note A - Summary of Significant Accounting
Polices.
47
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars Except for Per Share Data)
NOTE M-Segment Information - (continued)
Selected information by industry segment for 1998, 1997 and 1996 is
summarized as follows:
<TABLE>
<CAPTION>
Earnings
Before Identifiable
Revenue Income
Taxes Assets
<S> <C> <C>
<C>
1998
Property and casualty insurance............ $843,798 $117,259
$1,672,999
Real estate and commercial lending......... 5,049 5,049
74,070
Corporate and other........................ 3,483 2,159
8,914
Consolidated........................... $852,330 $124,467
$1,755,983
1997
Property and casualty insurance............ $833,482 $132,722
$1,659,374
Real estate and commercial lending......... 4,448 4,448
83,420
Corporate and other........................ 3,383
(9,475) 11,959
Consolidated........................... $841,313 $127,695
$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
</TABLE>
NOTE N-Supplement to Consolidated Statements of Cash Flows
During the years ended December 31, 1998 and 1997, the Company did
not acquire any property through foreclosure of mortgages. During 1996,
the Company acquired property through foreclosure of mortgages held with
remaining principal balances at the time of foreclosure of $245.
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, 1998, the M.I.I.F. has approved assessments
totaling $126,822, of which the Company's share was approximately
$7,269. 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. 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 has been to
recognize the recovery of the assessed amounts as received. Refunds of
assessments by the M.I.I.F. for the year ended December 31, 1998 and
1997 were $271 and $283, respectively. Assessments by the M.I.I.F. for
the year ended December 31, 1996 were $742.
In 1997, the Accounting Standards Executive Committee ("AcSEC")
issued Statement of Position 97-3 Accounting by Insurance and Other
Enterprise for Insurance-Related Assessments ("SOP 97-3") effective for
financial statements issued for periods ending after December 31, 1998.
This statement provides guidance on accounting by insurance companies on
the timing of recognition, the methods of measurement, and the required
disclosures for guaranty fund and other related assessments. The
Company believes that the adoption of this statement will not have a
material impact on the Consolidated Financial Statements.
48
<PAGE>
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998, 1997 and 1996
(Thousands of Dollars Except for Per Share Data)
NOTE P-Quarterly Results of Operations (Unaudited)
An unaudited summary of the Company's 1998 and 1997 quarterly
performance is as follows:
<TABLE>
<CAPTION>
1998 First Second
Third Fourth
Quarter Quarter
Quarter Quarter
<S> <C> <C>
<C> <C>
Total revenues................................. $214,380 $217,610
$206,060 $214,280
Net earnings................................... 25,235 19,585
29,861 21,811
Comprehensive income........................... 23,953 16,473
32,417 21,712
Net earnings excluding the after-tax impact
of net realized investment gains (losses)(1).. 22,764 18,752
29,862 20,714
Net earnings per weighted average common
share (basic and diluted).................... 0.70 0.54
0.83 0.61
Basic and diluted net earnings per common
share excluding the after-tax impact of net
realized investment gains (losses)(1)........ 0.63 0.52
0.83 0.58
Cash dividends paid per share.................. 0.26 0.27
0.27 0.27
1997
Total revenues................................. $199,069 $205,589
$225,131 $211,524
Net earnings................................... 16,638 19,971
35,012 24,594
Comprehensive income........................... 12,355 30,328
27,722 30,283
Net earnings excluding the after-tax impact
of net realized investment gains (losses)(1).. 16,830 18,531
21,365 24,688
Net earnings per weighted average common
share (basic and diluted).................... 0.46 0.56
0.97 0.68
Basic and diluted net earnings per common
share excluding the after-tax impact of net
realized investment gains (losses)(1)........ 0.47 0.52
0.59 0.68
Cash dividends paid per share.................. 0.25 0.26
0.26 0.26
</TABLE>
(1) The above figures are presented to provide information to the reader
due to the amount of,
and fluctuations in, net realized gains and losses. The amounts
noted, commonly known as
Operating Income, are important measures of corporate performance.
NOTE Q-Subsequent Events (Unaudited)
Commerce, a subsidiary of the Company, formed a joint venture
(ACIC Holding Co., Inc.) in November 1998 with AAA Southern New England
("AAA SNE") and completed the subsequent acquisition of ACIC, located in
Columbus, Ohio. in January 1999. ACIC writes automobile and homeowners
insurance solely through 38 AAA automobile clubs. Commerce and AAA SNE
intend that ACIC will retain its management team and staff and continue
to have its principle office in Columbus, Ohio. In early 1999, Commerce
invested $90.8 million in the joint venture (ACIC Holding Co., Inc.) to
fund the ACIC acquisition and to capitalize the joint venture that will
be owned together with AAA SNE. Of this $90.8 million, Commerce
invested $90 million in the form of preferred stock and an additional
$800 representing its 80% common stock ownership. The terms of the
preferred stock call for quarterly cash dividends at the rate of 10% per
annum. AAA SNE invested $200 representing its 20% common stock
ownership. Commerce intends to consolidate ACIC Holding Co., Inc., and
it's wholly-owned subsidiary, ACIC, for financial reporting purposes.
Since 1995, Commerce has maintained an affinity group marketing
relationship with AAA Insurance Agency, Inc., a subsidiary of AAA SNE.
AAA Insurance Agency, Inc. has been an agent of Commerce since 1985.
49
<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
1998 and 1997 and by other auditors in 1994 through 1996. All dollar
amounts set forth in the following tables are in thousands except per
share data.
<TABLE>
<CAPTION>
Year ended
December 31,
1998 1997 1996
1995 1994
<S> <C> <C> <C>
<C> <C>
Statement of Earnings Data:
Net premiums written........... $ 745,048 $ 741,501 $ 711,570
$ 603,421 $ 589,197
(Increase) decrease in
unearned premiums............ 572 (11,004)
(42,854) (10,831) (17,144)
Earned premiums................ 745,620 730,497 668,716
592,590 572,053
Net investment income.......... 86,501 80,972 77,402
71,313 62,901
Premium finance and service
fees......................... 13,440 7,074 9,713
19,420 18,497
Net realized investment gains
(losses)...................... 6,769 22,770
(7,574) 712 45,612
Total revenues............ 852,330 841,313 748,257
684,035 699,063
Losses and loss adjustment
expenses...................... 531,429 526,127 475,231
367,552 369,660
Policy acquisition costs....... 196,434 187,491 181,013
166,741 157,415
Total expenses............ 727,863 713,618 656,244
534,293 527,075
Earnings before income taxes... 124,467 127,695 92,013
149,742 171,988
Income taxes................... 27,975 31,480 18,049
39,541 49,405
Net earnings.............. $ 96,492 $ 96,215 $ 73,964
$ 110,201 $ 122,583
Comprehensive Income...... $ 94,555 $ 100,368 $ 80,539
$ 169,119 $ 35,941
Per Share Data:
Basic and diluted
net earnings per share.. $ 2.68 $ 2.67 $ 2.04
$ 2.93 $ 3.23
Cash dividends paid per
share................... $ 1.07 $ 1.03 $ 0.81
$ 0.23 $ 0.15
Weighted average number of
shares outstanding.............. 36,042,652 36,044,679 36,311,887
37,632,236 38,000,000
</TABLE>
<TABLE>
<CAPTION>
December 31,
1998 1997 1996
1995 1994
<S> <C> <C> <C>
<C> <C>
Balance Sheet Data:
Total investments.............. $1,257,900 $1,242,695 $1,167,671
$1,096,778 $ 905,031
Premiums receivable............ 162,878 169,469 157,835
127,047 102,432
Total assets................... 1,755,983 1,754,753 1,676,799
1,564,175 1,382,226
Unpaid losses and loss
adjustment expenses........... 596,996 649,473 662,832
626,029 599,502
Unearned premiums.............. 391,424 379,599 367,991
330,454 314,719
Stockholders' equity........... 705,785 649,796 587,039
549,714 413,589
Stockholders' equity per share. 19.58 18.03 16.28
14.96 10.88
</TABLE>
50
<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 $5,502,344. During this
period, the average statutory financial ratios were 68.2% for losses
and loss expenses and 26.8% for underwriting expenses resulting in an
average combined ratio of 95.0%. Total net investment income amounted
to $598,469 or 10.9% of net premiums written. Net realized gains were
$94,199. Stockholders' equity was $18,219 at the beginning of 1984 and
$649,751, at the end of 1998, resulting in an average annual increase
in excess of 26.9%. 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>
<CAPTION>
5-
Year Period
1994-98
1989-93 1984-88
<S> <C> <C>
<C>
Direct premiums written............................ $3,549,019
$2,324,133 $795,206
Net premiums written............................... 3,390,737
1,743,511 368,096
Net investment income.............................. 379,053
172,448 46,968
Net realized gains................................. 54,436
33,629 6,134
Stockholders' equity at end of period.............. 649,751
351,631 67,205
Statutory Financial Ratios (Unaudited)
Losses and loss expenses to premiums earned...... 68.5%
66.1% 75.1%
Underwriting expenses to net premiums written.... 26.8
27.4 23.9
Combined ratio............................... 95.3%
93.5% 99.0%
Increase in Stockholders' Equity................... 84.8%
423.2% 268.9%
</TABLE>
The insurance operations of the Company include the operating results
of Commerce, its subsidiary company, Commerce West, 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. 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
Commerce West are included since its acquisition by Commerce on August
31, 1995. The combined balance sheets of these insurance subsidiaries
appear on pages 52 and 53. The combined statements of earnings of
insurance operations appear on pages 54 and 55.
51
<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>
<CAPTION>
1998 1997 1996
1995 1994
ASSETS
<S> <C> <C> <C>
<C> <C>
Cash and short-term investments..... $ 75,655 $ 238,685 $ 140,102
$ 52,308 $ 4,560
Bonds, at market (at amortized cost
prior to 1993)..................... 619,267 590,597 716,702
815,277 745,010
Preferred stocks, at market (at
amortized cost prior to 1993)...... 197,425 148,499 147,680
111,220 85,574
Common stocks, at market............ 283,961 178,089 86,041
40,359 9,656
Mortgage loans on real estate....... 46,573 57,425 45,398
31,404 35,715
Other investments................... 7,825 3,783 127
- - -
Premium balances receivable......... 162,704 169,311 157,673
126,090 101,529
Investment income receivable........ 13,544 12,103 12,655
14,440 13,285
Residual market receivable.......... 153,220 180,799 195,213
200,124 214,818
Reinsurance receivable.............. 36,687 18,170 19,659
21,897 16,892
Deferred acquisition costs.......... 88,759 85,264 82,968
67,160 59,066
Current income taxes................ 2,773 - -
- - -
Deferred income taxes............... - - -
2,100 38,180
Real estate, furniture and equipment 27,885 29,060 26,011
24,642 25,246
Total assets................. $1,716,278 $1,711,785 $1,630,229
$1,507,021 $1,349,531
LIABILITIES
Unpaid losses and loss expenses..... $ 592,174 $ 637,094 $ 657,854
$ 618,791 $ 592,373
Unearned premiums................... 391,424 379,599 367,991
330,454 314,719
Notes payable....................... - - -
- - -
Deferred income..................... 6,948 7,271 7,974
8,954 10,451
Accounts payable, accrued and other
liabilities........................ 70,558 60,332 41,368
34,351 43,433
Current income taxes................ - 9,635 2,726
1,596 10,254
Deferred income taxes............... 5,423 8,438 2,165
- - -
Total liabilities............ 1,066,527 1,102,369 1,080,078
994,146 971,230
STOCKHOLDERS' EQUITY
Capital stock....................... 3,620 3,600 3,600
3,450 3,450
Paid-in capital..................... 45,050 45,050 45,050
23,700 23,700
Retained earnings
Balance, January 1................ 560,766 501,501 485,725
351,151 339,481
Net earnings...................... 93,888 101,528 74,432
110,450 113,892
Other comprehensive income (loss). (1,935) 4,152 6,574
58,919 (77,622)
Dividends paid.................... (51,638) (46,415) (65,230)
(34,795) (24,600)
Balance, December 31................ 601,081 560,766 501,501
485,725 351,151
Total stockholders' equity... 649,751 609,416 550,151
512,875 378,301
Total liabilities and
stockholders' equity....... $1,716,278 $1,711,785 $1,630,229
$1,507,021 $1,349,531
</TABLE>
52
<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>
<CAPTION>
1993 1992 1991 1990 1989 1988 1987
1986 1985 1984
ASSETS
<S> <C> <C> <C> <C> <C> <C> <C>
<C> <C>
$ 12,615 $ 25,809 $ 11,190 $ 38,654 $ 84,308 $ 60,885 $ 21,051 $
10,048 $ 11,802 $ 7,953
649,491 505,565 329,935 242,735 153,621 133,867 116,220
88,755 56,985 34,422
80,059 2,261 869 1,010 1,324 1,606 2,295
6,755 9,956 10,837
47,462 43,545 30,055 4,869 2,900 1,921 1,438
149 134 1,494
42,042 60,697 66,122 56,124 52,244 42,882 15,931
- - - 7,825
- 67,876 55,510 57,733 56,713 33,727 19,329
11,817 8,194 6,028
94,333 - - - - - -
- - - -
10,205 9,710 6,063 4,235 3,093 2,889 2,370
2,485 1,722 1,286
220,312 274,426 277,196 290,440 268,951 198,177 132,725
87,178 50,327 29,187
12,868 365 - - - - -
- - - -
53,647 55,442 33,981 27,273 22,702 15,699 10,898
7,129 5,417 3,968
- - - - 341 266 -
2,209 1,294 -
- - 883 1,666 - - -
- - - -
22,371 23,183 24,163 25,046 23,118 9,684 8,356
7,370 5,648 3,136
$1,245,405 $1,068,879 $835,967 $749,785 $669,315 $501,603 $330,613
$223,895 $151,479 $106,136
LIABILITIES
$ 567,797 $ 495,800 $439,551 $403,752 $345,020 $270,628 $169,539
$113,513 $ 71,525 $ 44,425
283,526 264,567 192,785 175,334 174,345 118,079 84,876
55,378 36,024 23,585
- - - 1,662 1,837 2,013 2,204
3,772 4,140 2,858
7,351 8,384 12,918 20,264 23,689 23,307 11,058
7,503 4,208 3,173
16,564 20,863 7,677 21,065 27,513 19,350 14,532
8,532 4,162 4,479
4,867 9,249 5,811 3,542 - - 470
- - - 418
13,669 4,400 - - 1,623 1,021 1,853
3,736 3,623 2,610
893,774 803,263 658,742 625,619 574,027 434,398 284,532
192,434 123,682 81,548
STOCKHOLDERS' EQUITY
3,450 3,450 3,450 3,450 3,450 2,350 2,350
2,350 2,350 2,350
8,700 8,700 8,700 8,700 8,700 6,500 6,500
6,500 6,500 6,500
253,466 165,075 112,016 83,138 62,877 37,231 22,611
18,947 15,738 10,469
79,837 91,980 55,214 32,414 21,966 21,837 15,614
4,362 4,025 6,033
21,928 9,811 2,545 (86) 645 321 (54)
7 (158) (179)
(15,750) (13,400) (4,700) (3,450) (2,350) (1,034) (940)
(705) (658) (585)
339,481 253,466 165,075 112,016 83,138 58,355 37,231
22,611 18,947 15,738
351,631 265,616 177,225 124,166 95,288 67,205 46,081
31,461 27,797 24,588
$1,245,405 $1,068,879 $835,967 $749,785 $669,315 $501,603 $330,613
$223,895 $151,479 $106,136
</TABLE>
53
<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>
<CAPTION>
1998 1997 1996
1995 1994
<S> <C> <C> <C>
<C> <C>
Underwriting
Direct premiums written.............. $796,858 $768,649 $731,823
$626,666 $625,023
Net premiums written................. $745,048 $741,501 $711,570
$603,421 $589,197
Increase (decrease) in unearned
premiums............................ (572) 11,004 42,854
10,831 17,144
Earned premiums.................. 745,620 730,497 668,716
592,590 572,053
Expenses
Losses and loss expenses............. 533,523 521,775 474,173
367,258 369,764
Underwriting expenses................ 200,525 185,146 194,873
171,892 162,446
(Increase) decrease in deferred
acquisition costs................... (3,495) (2,296) (15,809)
(5,723) (5,420)
Total expenses................... 730,553 704,625 653,237
533,427 526,790
Underwriting income (loss)............. 15,067 25,872 15,479
59,163 45,263
Net investment income.................. 86,664 81,396 76,867
71,007 63,119
Premium finance fees................... 13,426 7,056 9,666
19,246 18,315
Net realized investment gains (losses). 6,645 22,909 (7,863)
720 32,025
Earnings before Federal income
taxes and withdrawing companies'
settlements...................... 121,802 137,233 94,149
150,136 158,722
Other income
Withdrawing companies' settlements... - - -
- - -
Earnings before Federal income taxes... 121,802 137,233 94,149
150,136 158,722
Federal income taxes (benefits)........ 27,914 35,705 19,717
39,686 44,830
Earnings before cumulative effect of
change in accounting principle........ 93,888 101,528 74,432
110,450 113,892
Cumulative effect on prior years (to
December 31, 1986) of changing to
different method of accounting for
income taxes.......................... - - -
- - -
NET EARNINGS..................... $ 93,888 $101,528 $ 74,432
$110,450 $113,892
Statutory Financial Ratios (Unaudited)
Losses and loss expenses to
premiums earned..................... 71.6% 71.4% 70.9%
62.0% 64.6%
Underwriting expenses to net
premiums written.................... 26.5 25.1 27.1
29.0 27.1
Combined ratio................... 98.1% 96.5% 98.0%
91.0% 91.7%
Underwriting profit (loss)....... 1.9% 3.5% 2.0%
9.0% 8.3%
</TABLE>
54
<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>
<CAPTION>
1993 1992 1991 1990 1989 1988 1987
1986 1985 1984
<S> <C> <C> <C> <C> <C> <C> <C>
<C> <C>
$601,289 $525,495 $429,780 $401,077 $366,492 $306,469 $206,231
$131,807 $85,000 $65,699
$563,416 $508,847 $310,999 $219,936 $140,313 $124,923 $ 99,193 $
60,808 $49,229 $33,943
14,856 98,353 30,193 34,692 12,655 9,678 13,428
6,775 6,392 2,137
548,560 410,494 280,806 185,244 127,658 115,245 85,765
54,033 42,837 31,806
373,243 271,848 173,901 125,219 88,564 80,203 65,299
44,205 33,548 19,567
147,290 138,669 85,655 55,551 44,181 33,115 25,882
18,460 15,177 11,241
1,796 (21,462) (6,708) (4,571) (7,003) (4,801) (3,769)
(1,712) (1,448) (911)
522,329 389,055 252,848 176,199 125,742 108,517 87,412
60,953 47,277 29,897
26,231 21,439 27,958 9,045 1,916 6,728 (1,647)
(6,920) (4,440) 1,909
52,868 39,685 32,661 25,978 21,256 15,999 10,896
7,554 6,835 5,684
16,486 13,734 11,165 10,074 8,095 4,592 3,021
1,436 531 324
13,040 12,368 7,529 74 618 2,298 3,423
185 336 (108)
108,625 87,226 79,313 45,171 31,885 29,617 15,693
2,255 3,262 7,809
- 43,168 - - - - -
- - - -
108,625 130,394 79,313 45,171 31,885 29,617 15,693
2,255 3,262 7,809
28,788 38,414 24,099 12,757 9,919 7,780 2,987
(2,107) (763) 1,776
79,837 91,980 55,214 32,414 21,966 21,837 12,706
4,362 4,025 6,033
- - - - - - 2,908
- - - -
$ 79,837 $ 91,980 $ 55,214 $ 32,414 $ 21,966 $ 21,837 $ 15,614 $
4,362 $ 4,025 $ 6,033
68.0% 66.2% 61.9% 65.7% 68.0% 69.5% 79.4%
83.5% 79.7% 63.6%
25.7 28.1 30.0 26.7 26.3 22.0 22.5
24.4 28.1 27.8
93.7% 94.3% 91.9% 92.4% 94.3% 91.5% 101.9%
107.9% 107.8% 91.4%
6.3% 5.7% 8.1% 7.6% 5.7% 8.5% (1.9%)
(7.9%) (7.8)% 8.6%
</TABLE>
55
<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 and
General Claims Manager
of Commerce and Citation
Henry J. Camosse......................... Retired President, Henry
Camosse & Sons 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 and
General Counsel
of the Company; President and
Secretary of
Commerce West Insurance
Company; President of
ACIC Holding Co., Inc.; Vice
Chairman of the
Board and Chief Executive
Officer of American
Commerce 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>
56
<PAGE>
DIRECTORS OF
COMMERCE HOLDINGS, INC.
The Commerce Insurance Company
Commerce West 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 and General
Counsel; President
and Secretary of Commerce West
Insurance Company
David R. Grenon (1)............... Chairman Emeritus and Assistant
Clerk of The Protector Group
Insurance Agency
John M. Nelson (1)................ Chairman of TJX Companies
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
ACIC Holding Co., Inc.(2)
American Commerce Insurance Company
H. Thomas Rowles.................. Chairman of the Board and Chief
Executive Officer of ACIC Holding
Co., Inc.; Chairman of the Board
of American Commerce Insurance
Company; President, Chief
Executive Officer and Director of
AAA Southern New England
Regan P. Remillard................ President of ACIC Holding Co.,
Inc.; Vice Chairman of the Board
and Chief Executive Officer of
American Commerce Insurance
Company; Senior Vice President
and General Counsel of The
Commerce Group, Inc.; President
and Secretary of Commerce West
Insurance Company
Mark A. Shaw...................... Treasurer of ACIC Holding Co.,
Inc.; Executive Vice
President and Chief Operating
Officer of AAA Southern New
England
Gerald Fels....................... Executive Vice President and
Chief Financial Officer of The
Commerce Group, Inc.
Patrick W. Doherty (3)............ President and Chief Executive
Officer of AAA Oklahoma
Terry R. Farias (3)............... President and Chief Executive
Officer of AAA Hoosier
Motor Club
Roger L. Graybeal (3)............. President and Secretary of AAA
Oregon/Idaho
Gerald P. Hogan(3)................ President and Chief Operating
Officer of American
Commerce Insurance Company
D. James McDowell (3)............. President of AAA Arizona
Peter C. Ohlheiser (3)............ President of Ohio Motorists
Association
(1) Commerce Holdings, Inc., The Commerce Insurance Company and Citation
Insurance Company
only.
(2) Incorporated in November, 1998. 80% owned by The Commerce Insurance
Company and 20%
owned by AAA Southern New England.
(3) American Commerce Insurance Company only, which was acquired in
January 1999.
</TABLE>
57
<PAGE>
DIRECTORS OF
BAY FINANCE COMPANY, INC.
<TABLE>
<CAPTION>
<S> <C>
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............... Senior Vice President and
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............... Senior Vice President and
Assistant Clerk
Elizabeth M. Edwards................... Vice President
</TABLE>
58
<PAGE>
THE COMMERCE GROUP, INC.
Commerce Holdings, Inc.
The Commerce Insurance Company
Commerce West Insurance Company
ACIC Holding Co., Inc.(1)
American Commerce Insurance
Company(2)
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
Vice President and Associate General Counsel..................... James
A. Ermilio
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 Massachusetts Subsidiaries (3)
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
Karen
A. Lussier
Michael J. Richards
Angelos Spetseris
Henry
R. Whittier, Jr.
Vice President and Associate General Counsel..................... James
A. Ermilio
Assistant Vice Presidents.......................David P. Antocci Susan
A. Horan
Robert M. Blackmer John
V. Kelly
Stephen R. Clark Ronald
J. Lareau
Raymond J. DeSantis Donald
G. MacLean
Warren S. Ehrlich Robert
E. McKenna
Richard W. Goodus Robert
L. Mooney
James E. Gow
Kenneth E. Morrison
Emile
E. Riendeau
Treasurer and Chief Accounting Officer...........................
Randall V. Becker
Assistant Treasurer.............................................. Thomas
A. Gaylord
</TABLE>
(1) Incorporated in November, 1998. 80% owned by The Commerce Insurance
Company and 20% owned by AAA
Southern New England.
(2) Acquired by ACIC Holding Co., Inc. in January, 1999.
(3) Massachusetts subsidiaries include The Commerce Insurance Company,
Citation Insurance
Company, Bay Finance Company, Inc. and Clark-Prout. Officers often hold
positions with
several operating subsidiaries. The titles listed represent their
primary office as of
March 1, 1999.
59
<PAGE>
<TABLE>
<CAPTION>
Officers of ACIC Holding Co., Inc.
<S> <C>
Chairman of the Board and Chief Executive Officer............... H.
Thomas Rowles
President....................................................... Regan
P. Remillard
Treasurer....................................................... Mark
A. Shaw
Secretary....................................................... James
A. Ermilio
Officers of American Commerce Insurance Company
Chairman of the Board........................................... H.
Thomas Rowles
Vice Chairman of the Board and Chief Executive Officer.......... Regan
P. Remillard
President and Chief Operating Officer........................... Gerald
P. Hogan
Senior Vice President and Secretary............................. Thomas
E. Berridge
Senior Vice President........................................... Carol
R. Blaine
Vice President, Chief Financial Officer and Treasurer........... Curt
C. Anderson
Vice Presidents.................................................
Timothy M. Montgomery
Thomas
E. Timbrook
Officers of Commerce West Insurance Company
Chairman of the Board........................................... Arthur
J. Remillard, Jr.
President, Chief Executive Officer and Secretary................ Regan
P. Remillard
Chief Financial Officer.........................................
Michael V. Vrban
Chief Reporting Officer......................................... Albert
E. Peters
Investment Officer.............................................. Gerald
Fels
Vice Presidents................................................. Howard
M. Dreyfus
Albert
H. Harris
Tushar
M. Kothare
Assistant Vice President........................................
Michael J. Berryessa
Treasurer and Controller........................................ Joan
M. Kelly
</TABLE>
60
<PAGE>
Stockholder Information
Annual Meeting
The Annual meeting of stockholders will be held at 9:00 a.m. on Friday,
May 21, 1999 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
EquiServe, L.P.
P.O. Box 8040
Boston, MA 02266-8040
(781) 575-3100
http://www.equiserve.com
Executive Offices
211 Main Street
Webster, MA 01570
(508) 943-9000
Company Website
http://www.commerceinsurance.com
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
http://www.ey.com
61
<PAGE>
