UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2003
-------------
OR
[ ] Transition Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
Commission File Number 001-13672
---------
THE COMMERCE GROUP, INC.
------------------------------------------------------
(Exact name of registrant as specified in its charter)
Massachusetts 04-2599931
---------------------------- -------------------
(State or other jurisdiction (IRS Employer
of Incorporation) Identification No.)
211 Main Street, Webster, Massachusetts 01570
- ---------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (508) 943-9000
--------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes X No
----- -----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes X No
----- -----
As of July 30, 2003, the number of shares outstanding of the
Registrant's common stock (excluding Treasury Shares) was
31,962,952
Page 1 of 35
The Commerce Group, Inc.
Table of Contents
Page No.
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Part I - Financial Information
Item 1. Financial Statements
Consolidated Balance Sheets at
June 30, 2003 (Unaudited) and December 31, 2002 3
Consolidated Statements of Earnings and Comprehensive Income for the
Three and Six Months Ended June 30, 2003 and 2002 (Unaudited) 4
Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 2003 and 2002 (Unaudited) 5
Consolidated Statements of Cash Flows - Reconciliation of Net Earnings
to Net Cash Provided by Operating Activities for the Six Months
Ended June 30, 2003 and 2002 (Unaudited) 6
Notes to Unaudited Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis
General 14
Results of Operations - Three Months Ended June 30, 2003 15
Results of Operations - Six Months Ended June 30, 2003 20
Liquidity and Capital Resources 25
Forward-Looking Statements 27
Item 3. Quantitative and Qualitative Disclosures about Market Risk 29
Item 4. Controls and Procedures 29
Part II - Other Information
Item 1. Legal Proceedings 30
Item 2. Changes in Securities and Use of Proceeds 30
Item 3. Defaults Upon Senior Securities 30
Item 4. Submission of Matters to a Vote by Security Holders 30
Item 5. Other Information 30
Item 6. Exhibits and Reports on Form 8-K 31
Signature 31
- 2 -
Part I - Financial Information
------------------------------
Item 1. Financial Statements
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Thousands of Dollars)
June 30, December 31,
2003 2002
---- ----
(Unaudited)
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ASSETS
Investments:
Fixed maturities, at market (cost: $898,972 in 2003 and
$666,910 in 2002) $ 918,793 $ 683,811
Preferred stocks, at market (cost: $329,748 in 2003 and
$301,141 in 2002) 349,075 305,057
Common stocks, at market (cost: $58,762 in 2003 and
$81,602 in 2002) 69,454 99,818
Preferred stock mutual funds, at equity (cost: $244,799
in 2003 and $294,192 in 2002) 259,403 270,616
Mortgage loans on real estate and collateral notes receivable
(less allowance for possible loan losses of $387 in 2003 and
$418 in 2002) 19,135 26,754
Cash and cash equivalents 111,040 169,946
Other investments, at equity (cost: $40,093 in 2003 and
$35,015 in 2002) 24,749 21,068
---------- ----------
Total investments (cost: $1,702,936 in 2003 and
$1,575,978 in 2002) 1,751,649 1,577,070
Accrued investment income 15,820 13,959
Premiums receivable (less allowance for doubtful receivables of
$1,660 in 2003 and $1,661 in 2002) 392,743 297,610
Deferred policy acquisition costs 157,247 138,241
Property and equipment, net of accumulated depreciation 51,552 51,509
Residual market receivable 179,628 164,476
Due from reinsurers 111,679 98,403
Current income taxes - 662
Deferred income taxes 34,912 30,728
Receivable from securities sold 21,505 366
Non-compete agreement, net of accumulated amortization 1,954 2,129
Other assets 10,693 7,535
---------- ----------
Total assets $2,729,382 $2,382,688
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Unpaid losses and loss adjustment expenses $ 893,248 $ 815,626
Unearned premiums 822,727 687,148
Current income taxes 15,270 -
Deferred income 7,730 8,421
Contingent commissions accrued 21,192 32,550
Payable for securities purchased 52,361 -
Other liabilities and accrued expenses 56,700 44,785
---------- ----------
Total liabilities 1,869,228 1,588,530
---------- ----------
Minority interest 4,228 4,106
---------- ----------
Stockholders' equity
Preferred stock, authorized 5,000,000 shares at $1.00 par value;
none issued in 2003 and 2002 - -
Common stock, authorized 100,000,000 shares at $.50 par value;
38,356,822 shares issued in 2003 and 38,281,627 in 2002 19,178 19,141
Paid-in capital 42,140 39,570
Net accumulated other comprehensive income, net of income taxes
of $17,421 in 2003 and $13,603 in 2002 32,353 25,264
Retained earnings 941,544 877,308
---------- ----------
Total stockholders' equity before treasury stock 1,035,215 961,283
Treasury stock 6,401,792 shares in 2003 and 6,165,392 shares in 2002 (179,289) (171,231)
---------- ----------
Total stockholders' equity 855,926 790,052
---------- ----------
Total liabilities, minority interest and stockholders' equity $2,729,382 $2,382,688
========== ==========
The accompanying notes are an integral part of these consolidated financial
statements.
- 3 -
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS AND COMPREHENSIVE INCOME
Three and Six Months Ended June 30, 2003 and 2002
(Thousands of Dollars Except Per Share Data)
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
------------------------- -------------------------
2003 2002 2003 2002
---- ---- ---- ----
(Restated) (Restated)
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Revenues
Direct premiums written $ 415,787 $ 348,212 $ 864,581 $ 731,929
Assumed premiums 29,769 34,898 57,752 59,053
Ceded premiums (60,081) (48,614) (109,823) (88,945)
---------- ---------- ---------- ----------
Net premiums written 385,475 334,496 812,510 702,037
Increase in unearned premiums (35,206) (38,086) (124,254) (124,863)
---------- ---------- ---------- ----------
Earned premiums 350,269 296,410 688,256 577,174
Net investment income 23,108 24,858 45,812 47,762
Premium finance and service fees 6,915 5,065 13,245 9,997
Net realized investment gains (losses) 65,864 (31,545) 60,020 (34,992)
Other income - - - 7,000
---------- ---------- ---------- ----------
Total revenues 446,156 294,788 807,333 606,941
---------- ---------- ---------- ----------
Expenses
Losses and loss adjustment expenses 269,211 222,975 543,605 439,551
Policy acquisition costs 86,268 77,053 155,770 142,072
---------- ---------- ---------- ----------
Total expenses 355,479 300,028 699,375 581,623
---------- ---------- ---------- ----------
Earnings (loss) before income taxes (benefits),
minority interest and change in accounting principle 90,677 (5,240) 107,958 25,318
Income tax (benefit) 19,080 (3,787) 23,485 4,048
---------- ---------- ---------- ----------
Net earnings (loss) before minority interest and
change in accounting principle 71,597 (1,453) 84,473 21,270
Minority Interest in net (earnings) loss of subsidiary (124) 153 (80) 163
---------- ---------- ---------- ----------
Net earnings (loss) before change in
accounting principle 71,473 (1,300) 84,393 21,433
---------- ---------- ---------- ----------
Cumulative effects of change in accounting principle net
of tax - - - 11,237
---------- ---------- ---------- ----------
NET EARNINGS (LOSS) $ 71,473 $ (1,300) $ 84,393 $ 32,670
========== ========== ========== ==========
COMPREHENSIVE INCOME $ 75,057 $ 8,242 $ 91,482 $ 46,336
========== ========== ========== ==========
NET EARNINGS (LOSS) PER COMMON SHARE BEFORE
CUMULATIVE EFFECTS OF CHANGE IN ACCOUNTING PRINCIPLE:
BASIC $ 2.24 $ (0.04) $ 2.64 $ 0.65
========== ========== ========== ==========
DILUTED $ 2.22 $ (0.04) $ 2.62 $ 0.64
========== ========== ========== ==========
NET EARNINGS (LOSS) PER COMMON SHARE FROM THE
CUMULATIVE EFFECTS OF CHANGE IN ACCOUTING PRINCIPLE:
BASIC $ - $ - $ - $ 0.34
========== ========== ========== ==========
DILUTED $ - $ - $ - $ 0.34
========== ========== ========== ==========
NET EARNINGS (LOSS) PER COMMON SHARE:
BASIC $ 2.24 $ (0.04) $ 2.64 $ 0.99
========== ========== ========== ==========
DILUTED $ 2.22 $ (0.04) $ 2.62 $ 0.98
========== ========== ========== ==========
CASH DIVIDENDS PAID PER COMMON SHARE $ 0.32 $ 0.31 $ 0.63 $ 0.61
========== ========== ========== ==========
WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING:
BASIC 31,930,507 32,968,368 31,986,847 33,025,426
========== ========== ========== ==========
DILUTED 32,156,738 33,334,199 32,187,013 33,355,669
========== ========== ========== ==========
The accompanying notes are an integral part of these consolidated financial
statements.
- 4 -
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Six Months Ended June 30, 2003 and 2002
(Thousands of Dollars)
(Unaudited)
2003 2002
---- ----
(Restated)
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Cash flows from operating activities:
Premiums collected $ 729,696 $ 621,840
Net investment income received 44,603 45,611
Premium finance and service fees received 13,245 9,997
Losses and loss adjustment expenses paid (489,543) (394,070)
Policy acquisition costs paid (181,216) (177,796)
Federal income tax payments (15,554) (21,890)
Other income - 7,000
--------- ---------
Net cash provided by operating activities 101,231 90,692
--------- ---------
Cash flows from investing activities:
Proceeds from maturity of fixed maturities 79,510 19,542
Proceeds from sale of fixed maturities 247,668 58,709
Proceeds from sale of equity securities 138,744 18,511
Proceeds from sale of preferred stock mutual funds 51,746 2,524
Proceeds from sale of other investments 518 102
Payments received on mortgage loans and collateral notes receivable 8,181 5,712
Purchase of fixed maturities (522,607) (87,403)
Purchase of equity securities (129,783) (59,283)
Purchase of preferred stock mutual funds - (4,543)
Purchase of other investments (5,250) (7,188)
Mortgage loans and collateral notes originated (531) (625)
Purchase of property and equipment (3,287) (8,361)
Other investing activities 562 480
--------- ---------
Net cash used in investing activities (134,529) (61,823)
--------- ---------
Cash flows from financing activities:
Dividends paid to stockholders (20,157) (20,165)
Purchase of treasury stock (8,058) (17,211)
Capital stock issued 2,607 7,858
--------- ---------
Net cash used in financing activities (25,608) (29,518)
--------- ---------
Decrease in cash and cash equivalents (58,906) (649)
Cash and cash equivalents at beginning of period 169,946 148,630
--------- ---------
Cash and cash equivalents at the end of period $ 111,040 $ 147,981
========= =========
The accompanying notes are an integral part of these consolidated financial
statements.
- 5 -
THE COMMERCE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Reconciliation of Net Earnings to Net Cash Provided by Operating Activities
Six Months Ended June 30, 2003 and 2002
(Thousands of Dollars)
(Unaudited)
2003 2002
---- ----
(Restated)
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Cash flows from operating activities:
Net earnings $ 84,393 $ 32,670
Adjustments to reconcile net earnings to net cash provided by
operating activities:
Premiums receivable (95,133) (85,096)
Deferred policy acquisition costs (19,006) (20,919)
Residual market receivable (15,152) (24,352)
Due to/from reinsurers (13,276) (10,619)
Losses and loss adjustment expenses 77,622 59,701
Unearned premiums 135,579 134,955
Current income taxes 15,932 (5,059)
Deferred income taxes (8,001) (12,783)
Deferred income (691) 1,019
Contingent commissions (11,358) (6,392)
Other assets (2,983) (4,250)
Other liabilities and accrued expenses 11,915 4,296
Net realized investment (gains) losses (60,020) 34,992
Change in accounting principle - (11,237)
Minority interest 122 4,449
Other - net 1,288 (683)
-------- --------
Net cash provided by operating activities $101,231 $ 90,692
======== ========
The accompanying notes are an integral part of these consolidated financial
statements.
- 6 -
The Commerce Group, Inc. and Subsidiaries
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Thousands of Dollars Except Per Share Data)
1. The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with accounting principles generally
accepted in the United States ("GAAP") for interim financial information and
with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes
required by GAAP for complete financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals)
considered necessary for a fair presentation have been included. Certain
previously reported 2002 account balances have been reclassified to conform
to the current period's presentation and other balances have been restated
as indicated in Note 10. Results for the three and six month periods ended
June 30, 2003 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2003.
The balance sheet at December 31, 2002 has been derived from the
audited financial statements at that date but does not include all of the
information and footnotes required by GAAP for complete financial
statements. For further information, refer to the consolidated financial
statements and footnotes thereto included in the Company's annual report on
Form 10-K for the year ended December 31, 2002.
2. This Form 10-Q contains some statements that are not historical facts
and are considered "forward-looking statements" as defined in the Private
Securities Litigation Reform Act of 1995. Such forward-looking statements
involve opinions, assumptions and predictions, and no assurance can be given
that the future results will be achieved since events or results may differ
materially as a result of risks facing the Company. These include, but are
not limited to, those risks and uncertainties in its business, some of which
are beyond the control of the Company, that are described in the Company's
Forms 10-K and 10-Q, Schedules 13D and 13G, and other documents filed with
the SEC, including the possibility of adverse catastrophe experience and
severe weather, adverse trends in claim severity or frequency, adverse state
and federal regulation and legislation, adverse state judicial decisions,
litigation risks, interest rate risk, rate making decisions for private
passenger automobile policies in Massachusetts, potential rate filings
outside of Massachusetts, adverse impacts related to consolidation
activities, heightened competitions concentration of business within
Massachusetts, dependence on certain principal employees, as well as
economic, market or regulatory conditions and risks associated with entry
into new markets and diversification. The Commerce Group, Inc. is not under
any obligation to (and expressly disclaims any such obligations to) update
or alter its forward-looking statements, whether as a result of new
information, future events or otherwise.
3. Legal Proceedings - As is common with property and casualty insurance
companies, the Company is a defendant in various legal actions arising from
the normal course of its business, including claims based on Massachusetts
Chapters 176D and 93A. Similar provisions exist in other states where the
Company does 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 position of the Company.
The Company previously disclosed that a purported class action lawsuit
was pending in Massachusetts state court against The Commerce Insurance
Company ("Commerce Insurance"). The lawsuit, titled "Elena Given,
individually and as a representative of all persons similarly situated v.
The Commerce Insurance Company," alleges damages as a result of the alleged
inherent diminished value to vehicles that are involved in accidents. In
April 2002, the trial judge in that case entered partial summary judgment
for the plaintiff on the issue of whether the Massachusetts automobile
policy covers her claim, ruling that the plaintiff would be entitled to
reimbursement under the policy if the plaintiff were able both to prove that
her vehicle suffered "inherent diminished value" in the accident and to
quantify the amount of such diminution in value. Subsequently the
Massachusetts Division of
- 7 -
The Commerce Group, Inc. and Subsidiaries
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Thousands of Dollars Except Per Share Data)
(Continued)
Insurance issued an Advisory ruling in which it stated, among other things,
its position that the policy does not cover claims for "inherent diminished
value." In July of 2002, the trial judge stayed the trial and granted the
Company's motion to have the appellate court review the issue of whether the
Massachusetts automobile policy provides coverage for inherent diminished
value. During the third quarter of 2002, the Company applied for direct
appellate review of this issue by the Supreme Judicial Court of
Massachusetts ("SJC"), and this application was granted. Another Superior
Court judge in Massachusetts ruled, in a similar case brought by the same
plaintiff counsel against another insurer, that claims for diminution of
value are not covered by the Massachusetts automobile insurance policy. The
Company's and the other insurer's cases were paired and oral arguments were
heard at the SJC on March 4, 2003. A decision has not been announced by the
SJC and the Company is unable to anticipate a decision date. If the SJC
agrees with the Given trial judge's interpretation of the Massachusetts
personal automobile insurance policy, then the case will be remanded to the
trial court, where the Company would vigorously oppose class certification.
No reserve has been established for the potential liability in connection
with this case because the Company is unable to estimate the potential
exposure of this purported class action lawsuit. However, if there is a
final decision certifying that a relatively large class of the Company's
policyholders is entitled to recover damages based upon the inherent
diminished value theory, the Company may have to increase materially its
loss and loss adjustment expense reserves as a result. Other insurance
companies face similar suits in cases outside of Massachusetts.
4. Disclosure of Statement of Financial Accounting Standards No. 130 -
Reporting Comprehensive Income:
Six Months Ended
June 30,
-----------------------
2003 2002
---- ----
(Restated)
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Net earnings $ 84,393 $ 32,670
-------- --------
Other comprehensive income (loss), net of taxes
(benefits):
Change in unrealized gains, net of income taxes
of $9,661 in 2003 and $7,244 in 2002 17,942 13,454
Reclassification adjustment, net of income taxes
(benefits) of ($5,844) in 2003 and $114 in 2002 (10,853) 212
-------- --------
Other comprehensive income 7,089 13,666
-------- --------
Comprehensive income $ 91,482 $ 46,336
======== ========
Three Months Ended
June 30,
-----------------------
2003 2002
---- ----
(Restated)
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Net earnings $ 71,473 $ (1,300)
-------- --------
Other comprehensive income (loss), net of taxes
(benefits):
Change in unrealized gains, net of income taxes
of $6,883 in 2003 and $5,154 in 2002 12,782 9,571
Reclassification adjustment, net of income tax
benefits of $4,953 in 2003 and $16 in 2002 (9,198) (29)
-------- --------
Other comprehensive income 3,584 9,542
-------- --------
Comprehensive income $ 75,057 $ 8,242
======== ========
- 8 -
The Commerce Group, Inc. and Subsidiaries
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Thousands of Dollars Except Per Share Data)
(Continued)
5. Disclosure of Statement of Financial Accounting Standards No. 131 -
Disclosures about Segments of an Enterprise and Related Information:
Earnings (Losses)
Before Income Taxes (Benefits)
Change in Accounting
Principle and Identifiable
Revenue Minority Interest Assets
------- ------------------------------ ------------
<s> <c> <c> <c>
Six Months Ended June 30, 2003
Property and casualty insurance
Massachusetts $696,654 $107,767 $2,373,840
Other than Massachusetts 109,833 3,730 319,943
Real estate and commercial lending 845 845 20,209
Corporate and other 1 (4,384) 15,390
-------- -------- ----------
Consolidated $807,333 $107,958 $2,729,382
======== ======== ==========
Six Months Ended June 30, 2002 (Restated)
Property and casualty insurance
Massachusetts $529,863 $ 38,302 $2,053,485
Other than Massachusetts 75,862 (7,489) 261,763
Real estate and commercial lending 1,216 1,216 35,003
Corporate and other - (6,711) 12,882
-------- -------- ----------
Consolidated $606,941 $ 25,318 $2,363,133
======== ======== ==========
Earnings (Losses)
Before Income Taxes (Benefits)
Change in Accounting
Principle and Identifiable
Revenue Minority Interest Assets
------- ------------------------------ ------------
<s> <c> <c> <c>
Three Months Ended June 30, 2003
Property and casualty insurance
Massachusetts $385,105 $ 91,246 $2,373,840
Other than Massachusetts 60,685 4,685 319,943
Real estate and commercial lending 366 366 20,209
Corporate and other - (5,620) 15,390
-------- -------- ----------
Consolidated $446,156 $ 90,677 $2,729,382
======== ======== ==========
Three Months Ended June 30, 2002 (Restated)
Property and casualty insurance
Massachusetts $256,006 $ 3,816 $2,053,485
Other than Massachusetts 38,215 (5,954) 261,763
Real estate and commercial lending 567 567 35,003
Corporate and other - (3,669) 12,882
-------- -------- ----------
Consolidated $294,788 $ (5,240) $2,363,133
======== ======== ==========
6. Liabilities for unpaid losses and loss adjustment expenses ("LAE") at
June 30, 2003 and December 31, 2002 consist of:
June 30, December 31,
2003 2002
-------- ------------
<s> <c> <c>
Net voluntary unpaid losses and LAE $702,470 $650,892
Voluntary salvage and subrogation recoverable (89,312) (88,108)
Assumed unpaid losses and LAE from CAR 149,331 138,355
Assumed salvage and subrogation recoverable from CAR (22,790) (22,790)
-------- --------
Total voluntary and assumed unpaid losses and LAE 739,699 678,349
Adjustment for ceded unpaid losses and LAE 162,549 146,277
Adjustment for ceded salvage and subrogation recoverable (9,000) (9,000)
-------- --------
Total unpaid losses and LAE $893,248 $815,626
======== ========
- 9 -
The Commerce Group, Inc. and Subsidiaries
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Thousands of Dollars Except Per Share Data)
(Continued)
7. SFAS No. 113 "Accounting and Reporting for Reinsurance of Short-
Duration and Long-Duration Contracts" effect:
In accordance with SFAS No. 113, included in the unpaid losses and loss
adjustment expenses and the unearned premiums reported numbers are amounts
for ceded reinsurance recoverable. At June 30, 2003 and December 31, 2002,
respectively, $153,549 and $137,277 were included in the unpaid losses and
loss adjustment expense amounts. At June 30, 2003 and December 31, 2002,
respectively, $111,128 and $99,802 were included in the unearned premium
liability amounts.
8. Stock-Based Compensation
During 2002, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standard ("SFAS") No. 148, "Accounting for Stock-
Based Compensation-Transition and Disclosure", which provides alternative
methods of accounting for stock-based compensation and amends SFAS No. 123,
"Accounting for Stock-Based Compensation". The Company measures stock-based
compensation expense (for the employee stock options granted in 1999 and
2000) under the variable accounting method in accordance with Accounting
Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
Employees", and its related interpretations. As allowed by SFAS No. 148,
the Company has elected to continue to apply variable accounting for the
stock options granted in 1999 and 2000. The Company continues to comply
with APB Opinion No. 25 and related interpretations in applying fixed
accounting for the employee stock options granted in 2001. Under the
provisions of APB Opinion No. 25, no expense has been recognized for these
2001 employee stock options in the second quarter 2003 and 2002. The
Company has adopted the disclosure requirements of SFAS No. 123, as amended
by SFAS 148. If compensation expense for all employee stock options had
been measured under the fair value based method prescribed by SFAS No. 123,
as amended, net earnings would have been changed to the pro-forma amounts
set forth below:
Six Months Ended
June 30,
---------------------
2003 2002
---- ----
<s> <c> <c>
Net earnings as reported $ 84,393 $ 32,670
Adjust for employee stock-based compensation expense
(income) included in reported net earnings, net of taxes (634) 2,501
Adjust for employee stock-based compensation (expense)
determined under the fair value method for all employee
stock options, net of tax (905) (1,371)
-------- --------
Pro-forma net earnings $ 82,854 $ 33,800
======== ========
Basic earnings per share:
As reported $ 2.64 $ 0.99
Pro-forma $ 2.59 $ 1.02
Diluted earnings per share:
As reported $ 2.62 $ 0.98
Pro-forma $ 2.57 $ 1.01
- 10 -
The Commerce Group, Inc. and Subsidiaries
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Thousands of Dollars Except Per Share Data)
(Continued)
Three Months Ended
June 30,
--------------------
2003 2002
---- ----
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Net earnings (loss) as reported $71,473 $(1,300)
Adjust for employee stock-based compensation expense
(income) included in reported net earnings, net of taxes 1,014 1,055
Adjust for employee stock-based compensation (expense)
determined under the fair value method for all employee
stock options, net of tax (319) (684)
------- -------
Pro-forma net earnings (loss) $72,168 $ (929)
======= =======
Basic earnings (loss) per share:
As reported $ 2.24 $ (0.04)
Pro-forma $ 2.26 $ (0.03)
Diluted earnings (loss) per share:
As reported $ 2.22 $ (0.04)
Pro-forma $ 2.24 $ (0.03)
The fair value of each employee stock option is estimated on the date
of the grant using the Black-Scholes option-pricing model with the following
assumptions:
Six and
Three Months Ended
June 30,
--------------------
2003 2002
---- ----
<s> <c> <c>
Dividend yield * *
Expected volatility 28.90% 28.50%
Risk-free interest rate 2.41% 3.81%
Expected option life in years 3 3
<FN>
* - 0% for employee stock options granted in 1999 and 2000 and 3.51% and
3.12% for employee stock options granted in 2001 for 2003 and 2002,
respectively.
</FN>
9. Earnings Per Share:
Net earnings per basic common share are computed by dividing net
earnings by the weighted average number of basic common shares outstanding.
The weighted average number of basic common shares outstanding for the six
months ended June 30, 2003 and 2002 were 31,986,847 and 33,025,426,
respectively. Weighted average number of basic common shares outstanding is
determined by taking the average of the following calculation for a
specified period of time: The daily amount of (1) the total issued
outstanding common shares minus (2) the total Treasury Stock purchased.
Earnings per diluted common share are based on the weighted average
number of diluted common shares outstanding during each period. The
weighted average number of diluted common shares outstanding for the six
months ended June 30, 2003 and 2002 were 32,187,013 and 33,355,669,
respectively. The Company's only potentially dilutive instruments are stock
options outstanding and dilution from these is not significant.
10. 2002 Restatement for Stock Options:
As disclosed in the Company's 2002 Form 10-K, in the fourth quarter of
2002, the Company changed its method of accounting for stock options and
began applying variable accounting treatment for stock options issued in
1999 and 2000. Accordingly, the Company restated its 2002 quarterly
results. The impact of the restatement for the six months ended June 30,
2002 resulted in a decrease to net earnings of $2.5 million or $0.07 per
diluted share. The comparable amount for the six months ended June 30, 2003
resulted in an increase to net earnings of $0.6 million or $0.02 per diluted
share. The impact of the restatement for the three months ended June 30,
2002 resulted in a decrease to net earnings of $1.1 million or $0.03 per
diluted share. The comparable amount for the three months ended June 30,
2003 resulted in a decrease to net earnings of $1.0 million or $0.03 per
diluted share.
- 11 -
The Commerce Group, Inc. and Subsidiaries
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Thousands of Dollars Except Per Share Data)
(Continued)
11. Contingencies Related to Commonwealth Automobile Reinsurers ("CAR"):
Member companies of CAR have joint and several liabilities for the
obligations of CAR. If one member of CAR fails to pay its assessments, the
remaining members of CAR will be required to pay the pro-rata share of the
member who fails to pay its obligations. At the present time, the Company
is not aware of any CAR member company who has failed to meet its
obligations.
In a letter to the Massachusetts Insurance Commissioner (the
"Commissioner") dated June 25, 2002, the Massachusetts Attorney General
reported that, based on his examination of available information, he
"believes that the CAR plan for providing access to insurance in the
residual market does not comply with the CAR enabling statute, and must be
changed to produce a fair and equitable market". The Attorney General's
letter describes several factors that he believes support his findings and
which he believes should be corrected in order to comply with Massachusetts
law governing CAR. The Attorney General's letter calls on the Commissioner
to work with him to address these issues. It is uncertain whether and to
what extent the issues raised by the Attorney General will be addressed by
the Commissioner. The Company cannot be certain whether changes, if any,
would have a material impact on the Company.
12. Preferred Stock Mutual Funds:
The following table reflects the shares held, percentage of ownership,
carrying value at equity, cost, and quoted market value, by fund at June 30,
2003 and December 31, 2002:
June 30, 2003
-------------
Fund Carrying Quoted
Fund Shares % of Value Market
Symbol(1) Held Ownership at Equity Cost Value
--------- ------ --------- --------- ---- ------
<s> <c> <c> <c> <c> <c>
PGD 2,303,100 27.6% $ 30,055 $ 25,626 $ 29,894
PPF 1,978,200 27.3% 27,022 21,696 26,330
PDF 4,251,500 28.2% 38,646 38,510 38,902
PDT 4,846,700 32.3% 54,138 52,481 54,089
DIV 3,170,600 31.9% 43,532 44,054 46,671
PFD 2,095,200 20.8% 32,958 31,126 34,257
PFO 2,639,943 23.2% 33,052 31,306 33,263
--------- -------- --------
Total $ 259,403 $244,799 $263,406
========= ======== ========
December 31, 2002
-----------------
Fund Carrying Quoted
Fund Shares % of Value Market
Symbol(1) Held Ownership at Equity Cost Value
--------- ------ --------- --------- ---- ------
<s> <c> <c> <c> <c> <c>
PGD 2,571,100 30.8% $ 29,259 $ 28,358 $ 29,568
PPF 2,373,800 32.7% 26,777 26,298 28,367
PDF 4,696,100 31.3% 37,851 42,489 39,306
PDT 5,506,500 36.7% 53,743 59,507 53,413
DIV 3,635,600 36.7% 44,536 50,492 47,481
PFD 2,799,500 27.9% 38,185 41,882 42,273
PFO 3,756,043 33.1% 40,265 45,166 45,861
--------- -------- --------
Total $ 270,616 $294,192 $286,269
========= ======== ========
<FN>
<F1> John Hancock Patriot Global Dividend Fund ("PGD"), John Hancock
Patriot PreferredDividend Fund ("PPF"), John Hancock Patriot Premium
Dividend I Fund ("PDF"), John Hancock Patriot Premium Dividend II Fund
("PDT"), John Hancock Patriot Select Dividend Fund ("DIV"), Preferred
Income Fund ("PFD"), Preferred Income Opportunity Fund ("PFO").
</FN>
- 12 -
The Commerce Group, Inc. and Subsidiaries
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Thousands of Dollars Except Per Share Data)
(Continued)
13. Reinsurance Changes to Become Effective on July 1, 2003
The Company's 75% quota-share reinsurance agreement, which provided
reinsurance on its other than automobile business, terminated effective June
30, 2003. The quota-share program was incepted on July 1, 1998 and
established for a five year period. The Company has negotiated a 65% quota-
share agreement for one year with modified terms. The new program became
effective July 1, 2003. In the event of a catastrophe, recovery is limited
to 65% of the loss with a maximum recovery estimated at $225 million.
Several limitations were added to the new contract regarding losses related
to nuclear, chemical, and biological terrorist events. The Company's
maximum loss recovery in case of these types of events is estimated at $26
million. The Company's 100 and 250 year probable maximum loss events have
been estimated at approximately $180 million and $290 million, respectively,
based on policies in force at December 31, 2002.
14. New Relevant Accounting Developments
FIN. 46 - Consolidation of Variable Interest Entities - An
Interpretation of ARB No. 51.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation
of Variable Interest Entities" ("FIN 46"), which addresses consolidation
issues surrounding special purpose entities, often termed variable interest
entities ("VIE"), to which the usual condition for consolidation does not
apply because the VIE either has no voting interests or otherwise is not
subject to financial control through ownership of voting interest. Under
FIN 46, the primary beneficiary of a VIE is required to consolidate the VIE.
FIN 46 is required to be adopted by the end of fiscal periods beginning
after June 15, 2003. At June 30, 2003 and December 31, 2002, the Company
held investments in preferred stock mutual funds that, for purposes of FIN
46, are being evaluated to determine whether such investments should be
consolidated or disclosed as a variable interest entity in the Company's
future financial statements.
FAS. 150 - Accounting for Certain Financial Instruments with
characteristics of both liabilities and equity.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity"
("SFAS No. 150"), which requires an issuer of certain classes of
freestanding financial instruments, as set out in the statement, to classify
such instruments as a liability and, in most instances, measure the
instruments at fair value. SFAS No. 150 is effective for all financial
instruments entered into or modified after May 31, 2003, and otherwise shall
be effective at the beginning of the first interim period after June 15,
2003 for financial instruments that were in existence prior to May 31, 2003.
For financial instruments created before the issuance date of SFAS No. 150
and still existing at the beginning of the interim period of adoption,
transition shall be achieved by initially measuring the financial
instruments at fair value and reporting the difference between the fair
value and the previous carrying value as the cumulative effect of a change
in accounting principle. The Company does not expect that the impact of
adopting this statement will be material.
15. Book Value Awards
A total of 1,408,676 book value awards were issued under the Amended
and Restated Incentive Compensation Plan during the second quarter of 2003
as compared to 1,268,784 book value awards issued during the second quarter
of 2002. Book value awards outstanding at June 30, 2003 and 2002 totaled
3,152,001 and 2,240,010, respectively. Expenses relating to book value
awards were $4,612 and $2,442 for the quarters ended June 30, 2003 and 2002,
respectively, and $4,706 and $2,883 for the six months ended June 30, 2003
and 2002, respectively.
16. Income Taxes
The 2003 effective tax rate was positively impacted by $6.3 million
and $3.9 million, respectively, for the three and six months ended June 30,
2003, representing the Company's ability to utilize previously unrecognized
tax benefits associated with capital loss carry-forwards.
- 13 -
Item 2. Management's Discussion and Analysis
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Thousands of Dollars Except Per Share Data)
General
The Commerce Group, Inc. (the "Company") was incorporated in 1976.
The Company is engaged in providing personal and commercial property and
casualty insurance primarily in Massachusetts through its principal
subsidiary, The Commerce Insurance Company ("Commerce Insurance"), which was
incorporated in 1971 and began writing business in 1972. The Company's
predominant insurance line is motor vehicle insurance, primarily covering
Massachusetts personal automobiles. The Company also offers commercial
automobile, homeowners, inland marine, fire, general liability, commercial
multi-peril and personal and commercial umbrella insurance. The Company
also writes insurance in California and Oregon through Commerce West
Insurance Company ("Commerce West"), located in Pleasanton, California,
which primarily focuses on personal automobile insurance and also writes
commercial automobile insurance. Additionally, the Company writes insurance
through American Commerce Insurance Company ("American Commerce"), which
writes primarily personal automobile insurance and also writes homeowner
insurance. Located in Columbus, Ohio, American Commerce is a wholly-owned
subsidiary of ACIC Holding Co., Inc. with policies in 24 states and licenses
in several others. Through its subsidiaries combined insurance activities,
the Company is ranked as the 22nd largest personal automobile insurance
group in the country by Risk Information, Inc., based on 2002 direct written
premium information.
2002 Restatement for Stock Options
As disclosed in the Company's 2002 Form 10-K, in the fourth quarter of
2002, the Company changed its method of accounting for employee stock
options and began applying variable accounting treatments for employee stock
options granted in 1999 and 2000. Accordingly, the Company restated its
2002 quarterly results. The impact of the restatement for the six months
ended June 30, 2002 resulted in a decrease to net earnings of $2.5 million
or $0.07 per diluted share. The comparable amount for the six months ended
June 30, 2003 resulted in an increase to net earnings of $0.6 million or
$0.02 per diluted share. The impact of the restatement for the three months
ended June 30, 2002 resulted in a decrease to net earnings of $1.1 million
or $0.03 per diluted share. The comparable amount for the three months
ended June 30, 2003 resulted in a decrease to net earnings of $1.0 million
or $0.03 per diluted share.
- 14 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
Three months ended June 30, 2003 compared to
three months ended June 30, 2002
(Thousands of Dollars Except Per Share Data)
Results of Operations
Premiums
The following table compares direct premiums written, net premiums
written and earned premiums for the three months ended June 30, 2003 and
2002:
Three Months Ended June 30,
-----------------------------------------------
2003 2002 $ Change % Change
---- ---- -------- --------
<s> <c> <c> <c> <c>
Direct Premiums Written:
Personal Automobile (Massachusetts) $298,489 $257,653 $40,836 15.8%
Personal Automobile (All other states) 46,942 35,771 11,171 31.2
Commercial Automobile (Massachusetts) 22,203 17,731 4,472 25.2
Commercial Automobile (All other states) 2,164 1,206 958 79.4
Homeowners (Massachusetts) 26,441 21,270 5,171 24.3
Homeowners (All other states) 9,684 7,242 2,442 33.7
Other lines (Massachusetts) 9,616 7,138 2,478 34.7
Other lines (All other states) 248 201 47 23.4
-------- -------- ------- -----
Total Direct Premiums Written $415,787 $348,212 $67,575 19.4%
======== ======== ======= =====
Net Premiums Written:
Personal Automobile (Massachusetts) $299,149 $265,930 $33,219 12.5%
Personal Automobile (All other states) 47,763 35,754 12,009 33.6
Commercial Automobile (Massachusetts) 23,999 21,776 2,223 10.2
Commercial Automobile (All other states) 2,078 1,170 908 77.6
Homeowners (Massachusetts) 6,882 5,939 943 15.9
Homeowners (All other states) 2,874 1,753 1,121 63.9
Other lines (Massachusetts) 2,647 2,116 531 25.1
Other lines (All other states) 83 58 25 43.1
-------- -------- ------- -----
Total Net Premiums Written $385,475 $334,496 $50,979 15.2%
======== ======== ======= =====
Earned Premiums:
Personal Automobile (Massachusetts) $249,315 $212,921 $36,394 17.1%
Personal Automobile (All other states) 46,350 35,318 11,032 31.2
Commercial Automobile (Massachusetts) 16,723 13,375 3,348 25.0
Commercial Automobile (All other states) 1,642 633 1,009 159.4
Homeowners (Massachusetts) 5,915 5,084 831 16.3
Homeowners (All other states) 2,220 1,258 962 76.5
Other lines (Massachusetts) 1,748 2,202 (454) (20.6)
Other lines (All other states) 74 49 25 51.0
Assumed from CAR 25,779 25,493 286 1.1
Assumed (Other) 503 77 426 553.2
-------- -------- ------- -----
Total Earned Premiums $350,269 $296,410 $53,859 18.2%
======== ======== ======= =====
Earned Premiums (Massachusetts) $273,701 $233,582 $40,119 17.2%
Earned Premiums (Assumed) 26,282 25,570 712 2.8
Earned Premiums (All other states) 50,286 37,258 13,028 35.0
-------- -------- ------- -----
Total Earned Premiums $350,269 $296,410 $53,859 18.2%
======== ======== ======= =====
- 15 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Continued)
The $40,836, or 15.8% increase, in Massachusetts personal automobile
direct premiums written during the second quarter of 2003 resulted primarily
from a 7.7% increase in average written premium per written exposure coupled
with an 8.0% increase in the number of exposures written. The Company
attributes the growth in exposures to increased penetration of its
independent agents' books of business as the overall number of exposures in
Massachusetts has had minimal growth during this period. The increase in
other than Massachusetts personal automobile and homeowners business was
primarily attributable to book transfers in various states, increased
retention on existing business and additional rate per policy.
Additionally, the increase in homeowners in other states is impacted by
contraction of authority to write homeowner business by competitors.
The Company's increase in Massachusetts commercial automobile premium
is directly related to an effort to increase writings in this line of
business and from increases in the average rate per policy. The Company's
increase in Massachusetts homeowner premium is primarily related to an
increased number of agents, fewer carriers writing homeowner business, the
Company's pricing position in the marketplace and agents writing more
homeowner business to achieve a homeowner discount for their customer when
the Company also insures the customer's automobile.
The $53,859, or 18.2% increase, in total earned premiums during the
second quarter of 2003 as compared to the second quarter of 2002 was
primarily attributable to increases in personal and commercial automobile
business.
Investment Income
Net investment income is affected by the composition of the Company's
investment portfolio and yields on those investments. The following table
summarizes the composition of the Company's investment portfolio, at cost,
at June 30, 2003 and 2002:
June 30,
-------------------------------------------------
% of % of
2003 Invest. 2002 Invest.
---- ------- ---- -------
<s> <c> <c> <c> <c>
Fixed maturities (GNMA & FNMA mortgage-
backed bonds, corporate bonds, U.S.
Treasury bonds and notes and tax-
exempt state and municipal bonds) $ 898,972 52.8% $ 627,754 41.4%
Preferred stocks 329,748 19.4 290,573 19.1
Common stocks 58,762 3.4 85,701 5.6
Preferred stock mutual funds 244,799 14.4 296,801 19.6
Mortgages and collateral loans 19,522 1.1 35,075 2.3
Cash and cash equivalents 111,040 6.5 147,981 9.7
Other investments 40,093 2.4 35,324 2.3
---------- ----- ---------- -----
Total investments $1,702,936 100.0% $1,519,209 100.0%
========== ===== ========== =====
The Company's investment objective continues to focus primarily on
maximizing after-tax investment income through investing primarily in high
quality securities coupled with acquiring equity investments, which may
forgo current investment yield in favor of potential higher yielding capital
appreciation in the future. During the second quarter the Company shortened
the overall duration of its investment portfolio by reducing its holdings in
certain long term fixed income instruments, equities and closed end mutual
funds. This change in strategy resulted in the realization of significant
investment gains with a minimal adverse impact on future investment income.
If market conditions warrant, the Company will continue to reduce the
duration of the investment portfolio in order to continue to protect itself
from anticipated future increases in overall interest rates.
- 16 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Continued)
As depicted in the following table, second quarter 2003 net investment
income decreased $1,750 or 7.0%, compared to the same period in 2002,
principally as a result of a decrease in yield offset by an increase in
average invested assets at cost. The decrease in yield is primarily due to
lower short-term yields coupled with an environment of lower long-term
yields and higher yielding investment securities being called. The Company
continues to monitor interest rates on medium and long-term securities and
intends to maintain its relatively high cash position until such time as the
Company believes medium and long-term rates have appropriately firmed. Net
investment income as an annualized percentage of total average investments
was 5.6% in the second quarter of 2003 compared to 6.3% for the same period
in 2002. After tax net investment income as an annualized percentage of
total average investments was 4.4% and 5.0% in the second quarter of 2003
and 2002, respectively.
Investment Return Quarter Ended June 30,
-------------------------
2003 2002
---- ----
(Restated)
<s> <c> <c>
Average month-end investments (at cost) $1,665,040 $1,568,410
Net investment income 23,108 24,858
Net investment income after-tax 18,403 19,762
Annualized net investment income as a percent-
age of average net investments (at cost) 5.6% 6.3%
Annualized net investment income after-tax as
a percentage of average net
investments (at cost) 4.4% 5.0%
Investment Gains and (Losses)
Net realized investment gains totaled $65,864 or $1.53 per diluted
share, during the second quarter of 2003 as compared to net realized
investment losses of $31,545, or $0.69 per diluted share, during the same
period in 2002 as detailed below.
Net realized gains (losses) by category for the quarter ended June 30,
are as follows:
2003 2002
---- ----
<s> <c> <c>
Fixed maturities $ 12,652 $ (760)
Preferred stocks 8,131 (4)
Common stocks 13,485 (158)
Preferred stock mutual funds:
Due to change in equity value 34,136 (18,085)
Due to sales (1,524) 308
Venture capital fund investments (463) (1,043)
Other (60) (69)
Writedowns of investments for other-than-
temporary impairment of value (493) (11,734)
-------- --------
Net realized investment gains (losses)
before tax 65,864 (31,545)
Income (tax) benefit:
At 35% (23,052) 11,041
Impact of valuation allowance on deferred
taxes 6,316 (2,503)
-------- --------
Net realized investment gains (losses)
after taxes $ 49,128 $(23,007)
======== ========
Per diluted share net realized investment
gains (losses) after-tax (benefit) $ 1.53 $ (0.69)
======== ========
- 17 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Continued)
The 2003 realized gains were primarily impacted by improvement in the
market values of underlying securities held by closed-end preferred stock
mutual funds, which resulted in a change in equity of $34,136 and sales of
securities. The Company reflects the increases in equity value through
realized gains because its significant level of ownership requires the use
of the equity method of accounting for these funds. The Company did not
receive any cash as a result of these gains. In addition, during the
second quarter the Company shortened the overall duration of its investment
portfolio by reducing its holdings in certain long term fixed income
instruments, equities and closed end mutual funds. This change in strategy
resulted in the realization of significant investment gains with a minimal
adverse impact on future investment income. If market conditions warrant,
the Company will continue to reduce the duration of the investment portfolio
in order to continue to protect itself from anticipated future increases in
overall interest rates.
Loss and Loss Adjustment Expenses
Loss and loss adjustment expenses incurred (on a statutory basis) as a
percentage of insurance premiums earned ("loss ratio") increased to 76.1%
for the second quarter of 2003 compared to 74.7% for the second quarter of
2002. The Company utilizes the statutory loss ratio which is essentially
the same as if it were calculated on a GAAP basis. The increase was
primarily the result of less favorable loss reserve development compared to
the second quarter of last year offset by a slight decrease in claim
frequency of 2.8% for bodily injury and 3.8% for collision claims.
Policy Acquisition Costs
As a percentage of net premiums written, underwriting expenses for the
insurance companies (on a statutory basis) decreased to 22.7% for the second
quarter of 2003 as compared to 24.2% for the same period a year ago. The
Company utilizes the statutory underwriting ratio which is essentially the
same as if it were calculated on a GAAP basis. The improvement was
primarily a result of decreased expenses assumed from the Massachusetts
residual market mechanism, commonly known as CAR, as a result of a true-up
of estimated expense to actual and higher ceding commissions received on the
Company's other than automobile quota-share reinsurance agreement.
Combined Ratios
The combined ratio of losses and expenses (on a statutory basis) was
98.8% in the second quarter of 2003 compared with 98.9% for the same period
a year ago. The Company utilizes the statutory combined ratio which is
essentially the same as if it were calculated on a GAAP basis. The slight
decrease in the combined ratio was primarily the result of a decrease in the
underwriting ratio offset by an increase in the loss ratio.
Income Taxes
The overall effective tax rate for the three months ended June 30,
2003 was 21.0%. The income tax benefit for the three months ended June 30,
2002 was impacted by the magnitude of the realized investment losses during
the quarter. In both years, the effective rate was lower than the statutory
rate of 35% primarily due to tax-exempt interest and the corporate dividends
received deduction. The 2003 effective rate was also positively impacted by
$6.3 million as a result of the Company's ability to utilize previously
unrecognized tax benefits associated with capital loss carry-forwards.
- 18 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Continued)
Net Earnings
The Company's net earnings for the quarter ended June 30, 2003 were
$71,473 compared to net losses of $1,300 for the quarter ended June 30,
2002. The increase primarily resulted from a $97,409 increase in
its realized investment gains to $65,864 for the quarter ended June 30, 2003
compared to a realized investment loss of $31,545 for the comparable period
of 2002. The after-tax realized gains for the quarter ended June 30, 2003
amounted to $49,128 compared to an after-tax realized loss of $23,007. The
Company's net realized investment gains increased primarily because of (1)
a change in its investment strategy to shorten the overall duration of
its investment portfolio, and (2) the favorable impact of the decline in
interest rates during the second quarter on the net asset value of seven
closed end mutual funds that the Company must reflect in its realized
investment gains using the equity method of accounting.
During the second quarter of 2003, the Company decided to shorten the
overall duration of its investment portfolio by reducing its holdings of
long-term fixed investments, equities and closed-end mutual funds.
Primarily as a result of these sales, the Company realized net investment
gains of $32,744 or $21,284 after taxes in those categories for the quarter
ended June 30, 2003 compared to a net realized investment loss of $614 or
$399 after taxes on sales of securities in those categories during the
quarter ended June 30, 2002.
The Company recognized net realized investment gains of $34,136 or
$22,188 after taxes for the quarter ended June 30, 2003 attributable to the
change in the net asset value of seven closed end mutual funds in which the
Company owned 20% or more as of June 30, 2003. Whenever the Company owns
20% or more of a closed-end fund, the Company must account for its
investment in that fund using the equity method of accounting, which
requires the Company to recognize as a realized investment gain (loss) the
change in the net asset value of that fund as compared to the end of its
immediately preceding fiscal quarter. For the quarter ended June 30, 2003,
the net realized investment gains attributable to the fund investments that
the Company must account for using the equity method was $34,136 or $22,188
after taxes, as compared to a net realized investment loss of $18,085 or
$11,755 after taxes for that category of investments for the comparable
period of 2002. The closed-end mutual funds that the Company accounted for
using the equity method primarily invest in preferred stock, and therefore
the decline in interest rates during the second quarter of 2003 caused a
significant increase in the net asset value of those funds and, as a direct
consequence, an increase in the net realized investment gains that the
Company recognized for those investments for the quarter ended June 30, 2003.
As of July 31, 2003, the Company still has five fund investments that
the Company accounts for using the equity method. If interest rates are
higher at September 30, 2003 than they were at June 30, 2003, the respective
net asset values of those funds would be less than they were at June 30,
2003, and the Company would recognize a net realized investment loss for
those fund investments. As of July 31, 2003, ten and thirty year treasury
note interest rates were significantly higher and the net asset values of
those five funds had decreased by approximately $12.0 million compared to
June 30, 2003. The Company expects that if those conditions persist through
September 30, 2003, the Company will recognize a net realized investment
loss on those fund investments that may have a material adverse effect on
its net earnings for the period ending September 30, 2003.
- 19 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
Six months ended June 30, 2003 compared to
six months ended June 30, 2002
(Thousands of Dollars Except Per Share Data)
Results of Operations
Premiums
The following table compares direct premiums written, net premiums
written and earned premiums for the six months ended June 30, 2003 and 2002:
Six Months Ended June 30,
-----------------------------------------------
2003 2002 $ Change % Change
---- ---- -------- --------
<s> <c> <c> <c> <c>
Direct Premiums Written:
Personal Automobile (Massachusetts) $639,819 $558,310 $ 81,509 14.6%
Personal Automobile (All other states) 94,411 71,346 23,065 32.3
Commercial Automobile (Massachusetts) 46,945 38,801 8,144 21.0
Commercial Automobile (All other states) 4,149 1,992 2,157 108.3
Homeowners (Massachusetts) 44,787 35,868 8,919 24.9
Homeowners (All other states) 16,876 12,540 4,336 34.6
Other lines (Massachusetts) 17,139 12,724 4,415 34.7
Other lines (All other states) 455 348 107 30.7
-------- -------- -------- -----
Total Direct Premiums Written $864,581 $731,929 $132,652 18.1%
======== ======== ======== =====
Net Premiums Written:
Personal Automobile (Massachusetts) $641,997 $569,058 $ 72,939 12.8%
Personal Automobile (All other states) 94,382 71,314 23,068 32.3
Commercial Automobile (Massachusetts) 50,041 42,787 7,254 17.0
Commercial Automobile (All other states) 3,982 1,930 2,052 106.3
Homeowners (Massachusetts) 12,476 10,330 2,146 20.8
Homeowners (All other states) 4,357 3,020 1,337 44.3
Other lines (Massachusetts) 5,133 3,491 1,642 47.0
Other lines (All other states) 142 107 35 32.7
-------- -------- -------- -----
Total Net Premiums Written $812,510 $702,037 $110,473 15.7%
======== ======== ======== =====
Earned Premiums:
Personal Automobile (Massachusetts) $492,160 $417,186 $ 74,974 18.0%
Personal Automobile (All other states) 88,587 67,815 20,772 30.6
Commercial Automobile (Massachusetts) 32,755 26,237 6,518 24.8
Commercial Automobile (All other states) 3,018 1,081 1,937 179.2
Homeowners (Massachusetts) 12,140 10,244 1,896 18.5
Homeowners (All other states) 3,875 2,423 1,452 59.9
Other lines (Massachusetts) 3,436 3,856 (420) (10.9)
Other lines (All other states) 135 93 42 45.2
Assumed from CAR 51,009 48,046 2,963 6.2
Assumed (Other) 1,141 193 948 491.2
-------- -------- -------- -----
Total Earned Premiums $688,256 $577,174 $111,082 19.2%
======== ======== ======== =====
Earned Premiums (Massachusetts) $540,491 $457,523 $ 82,968 18.1%
Earned Premiums (Assumed) 52,150 48,239 3,911 8.1
Earned Premiums (All other states) 95,615 71,412 24,203 33.9
-------- -------- -------- -----
Total Earned Premiums $688,256 $577,174 $111,082 19.2%
======== ======== ======== =====
- 20 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Continued)
The $81,509, or 14.6% increase, in Massachusetts personal automobile
direct premiums written during the first six months of 2003 resulted
primarily from an 8.0% increase in average written premium per written
exposure coupled with a 6.1% increase in the number of exposures written.
The Company attributes the growth in exposures to increased penetration of
its independent agents' books of business as the overall number of exposures
in Massachusetts has had less than 1% growth during this period. The
increase in other than Massachusetts personal automobile and homeowners
business was primarily attributable to book transfers in various states,
increased retention on existing business and additional rate per policy.
Additionally, the increase in homeowners in other states is impacted by
contraction of authority to write homeowner business by competitors.
The Company's increase in Massachusetts commercial automobile premium
is directly related to an effort to increase writings in this line of
business and from increases in the average rate per policy. The Company's
increase in Massachusetts homeowner premium is primarily related to an
increased number of agents, fewer carriers writing homeowner business, the
Company's pricing position in the marketplace and agents writing more
homeowner business to achieve a homeowner discount for their customer when
the Company also insures the customer's automobile.
The $111,082, or 19.2% increase, in total earned premiums for the
first six months of 2003 as compared to the same period in of 2002 was
primarily attributable to increases in personal and commercial automobile
business.
Investment Income
Net investment income is affected by the composition of the Company's
investment portfolio and yields on those investments. The following table
summarizes the composition of the Company's investment portfolio, at cost,
at June 30, 2003 and 2002:
June 30,
-------------------------------------------------
% of % of
2003 Invest. 2002 Invest.
---- ------- ---- -------
<s> <c> <c> <c> <c>
Fixed maturities (GNMA & FNMA mortgage-
backed bonds, corporate bonds, U.S.
Treasury bonds and notes and tax-
exempt state and municipal bonds) $ 898,972 52.8% $ 627,754 41.4%
Preferred stocks 329,748 19.4 290,573 19.1
Common stocks 58,762 3.4 85,701 5.6
Preferred stock mutual funds 244,799 14.4 296,801 19.6
Mortgages and collateral loans 19,522 1.1 35,075 2.3
Cash and cash equivalents 111,040 6.5 147,981 9.7
Other investments 40,093 2.4 35,324 2.3
---------- ----- ---------- -----
Total investments $1,702,936 100.0% $1,519,209 100.0%
========== ===== ========== =====
The Company's investment objective continues to focus primarily on
maximizing after-tax investment income through investing primarily in high
quality securities coupled with acquiring equity investments, which may
forgo current investment yield in favor of potential higher yielding capital
appreciation in the future. During the second quarter the Company shortened
the overall duration of its investment portfolio by reducing its holdings in
certain long term fixed income instruments, equities and closed end mutual
funds. This change in strategy resulted in the realization of significant
investment gains with a minimal adverse impact on future investment income.
If market conditions warrant, the Company will continue to reduce the
duration of the investment portfolio in order to continue to protect itself
from anticipated future increases in overall interest rates.
As depicted in the following table, the first six months of 2003 net
investment income decreased $1,950, or 4.1%, compared to the same period in
2002, principally as a result of a decrease in yield offset by an increase
in average invested assets at cost. The decrease in yield is primarily due
to lower short-term yields coupled with an environment of lower long-term
yields and higher yielding investment securities being called. The Company
continues to monitor interest rates on medium and long-term securities and
intends to maintain its relatively high cash position until such time as the
Company believes medium and long-term rates have appropriately firmed. Net
investment income as an annualized percentage of total average
- 21 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Continued)
investments was 5.5% in the first six months of 2003 compared to 6.1% for
the same period in 2002. After tax net investment income as an annualized
percentage of total average investments was 4.4% and 4.8% in the first six
months of 2003 and 2002, respectively.
Investment Return Six Months Ended June 30,
-------------------------
2003 2002
---- ----
(Restated)
<s> <c> <c>
Average month-end investments (at cost) $1,653,489 $1,557,120
Net investment income 45,812 47,762
Net investment income after-tax 36,706 37,611
Annualized net investment income as a percent-
age of average net investments (at cost) 5.5% 6.1%
Annualized net investment income after-tax as
a percentage of average net
investments (at cost) 4.4% 4.8%
Investment Gains and (Losses)
Net realized investment gains totaled $60,020 or $1.33 per diluted
share, during the first six months of 2003 as compared to net realized
investment losses of $34,992, or $0.76 per diluted share, during the same
period in 2002 as detailed below.
Net realized gains (losses) by category for the six months ended June
30, are as follows:
2003 2002
---- ----
<s> <c> <c>
Fixed maturities $ 16,025 $ (955)
Preferred stocks 9,112 (51)
Common stocks 13,752 (167)
Preferred stock mutual funds:
Due to change in equity value 39,747 (19,361)
Due to sales (1,566) 336
Venture capital fund investments (1,051) (2,974)
Other (50) (86)
Writedowns of investments for other-than-
temporary impairment of value (15,949) (11,734)
-------- --------
Net realized investment gains (losses)
before tax 60,020 (34,992)
Income (tax) benefit:
At 35% (21,007) 12,247
Impact of valuation allowance on deferred
taxes 3,936 (2,503)
-------- --------
Net realized investment gains (losses)
after-taxes (benefit) $ 42,949 $(25,248)
======== ========
Per diluted share net realized investment
gains (losses) after-tax (benefit) $ 1.33 $ (0.76)
======== ========
The 2003 realized gains were primarily impacted by improvement in the
market values of underlying securities held by closed-end preferred stock
mutual funds, which resulted in a change in equity of $39,747 and sales of
securities, offset by other-than-temporary writedowns. The Company reflects
the increases in equity value through realized gains because its significant
level of ownership requires the use of the equity method of accounting for
these funds. The Company did not receive any cash as a result of these
gains. In addition, during the second quarter the Company shortened
the overall duration of its investment portfolio by reducing its holdings in
certain long term fixed income instruments, equities and closed end mutual
funds. This change in strategy resulted in the realization of significant
investment gains with a minimal adverse impact on future investment income.
If market conditions warrant, the Company will continue to reduce the
duration of the investment portfolio in order to continue to protect itself
from anticipated future increases in overall interest rates. These gains
were partially offset by write-downs for other-than-temporary declines in
the market value of certain fixed maturities, preferred stocks and common
stocks totaling $15,949. The other-than-temporary writedowns consisted
primarily of $2,433 for 1 municipal bond, $6,495 for 2 corporate bonds, and
$7,014 for 3
- 22 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Continued)
preferred stocks. The Company reviews all security holdings on a quarterly
basis with regard to other-than-temporary declines in market value pursuant
to FASB 115 ("Accounting for Certain Investments in Debt and Equity
Securities") and other applicable guidance. As part of this process, the
Company considers any significant market declines in the context of the
overall market and also in relation to the outlook for the specific issuer
of the security. From a quantitative standpoint, the Company reviews all
securities that have fallen more than 20% below book price and have remained
so for two quarters as potentially in need of a writedown. In addition, any
other security that the Company views as impaired either for a significant
period of time or due to negative changes in the issuers financial or
operational situations is also a candidate for a writedown, even if the
percentage decline is less than 20%.
Loss and Loss Adjustment Expenses
Loss and loss adjustment expenses incurred (on a statutory basis) as a
percentage of insurance premiums earned ("loss ratio") increased to 78.7%
for the first six months of 2003 compared to 75.8% for the same period a
year ago. The Company utilizes the statutory loss ratio which is
essentially the same as if it were calculated on a GAAP basis. The increase
was primarily driven by increased claim frequency of approximately 20% in
the Massachusetts automobile line and approximately 50% in the Massachusetts
homeowner line, both occurring in the first quarter of this year as a result
of the severe winter.
Policy Acquisition Costs
As a percentage of net premiums written, underwriting expenses for the
insurance companies (on a statutory basis) improved to 21.3% for the first
six months of 2003 as compared to 22.6% for the same period a year ago. The
Company utilizes the statutory underwriting ratio which is essentially the
same as if it were calculated on a GAAP basis. The improvement was
primarily due to a reduction in accrued contingent commissions as a result
of the high loss ratio mentioned previously, decreased expenses assumed from
CAR as a result of a true-up of estimated expenses to actual, coupled with
premium growth exceeding growth in underwriting expenses.
Combined Ratios
The combined ratio of losses and expenses (on a statutory basis) was
100.0% for the first six months of 2003 compared with 98.4% for the same
period a year ago. The Company utilizes the statutory combined ratio which
is essentially the same as if it were calculated on a GAAP basis. The
increase in the combined ratio was primarily the result of an increase in
the loss ratio, offset by a decrease in the underwriting ratio.
Income Taxes
The overall effective tax rate for the six months ended June 30, 2003
was 21.8% as compared to 16.0% for the six months ended June 30, 2002. In
both years, the effective rate was lower than the statutory rate of 35%
primarily due to tax-exempt interest and the corporate dividends received
deduction. The 2003 effective rate was also positively impacted by $3.9
million as a result of the Company's ability to utilize previously
unrecognized tax benefits associated with capital loss carry-forwards. The
income tax rate for the six months ended June 30, 2002 was impacted by the
magnitude of the realized losses during that period.
- 23 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Continued)
Net Earnings
The Company's net earnings for the six months ended June 30, 2003 were
$84,393 compared to net earnings of $32,670 for the six months ended June
30, 2002. The increase primarily resulted from a $95,012 increase
in its realized investment gains to $60,020 for the six months ended June
30, 2003 compared to a realized investment loss of $34,992 for the
comparable period of 2002. The after-tax realized gains for the six months
ended June 30, 2003 amounted to $42,949 compared to an after-tax realized
loss of $25,248. The Company's net realized investment gains increased
primarily because of (1) a change in its investment strategy to shorten the
overall duration of its investment portfolio, and (2) the favorable impact
of the decline in interest rates during the second quarter on the net asset
value of seven closed end mutual funds that the Company must reflect in its
realized investment gains using the equity method of accounting.
During the second quarter of 2003, the Company decided to shorten the
overall duration of its investment portfolio by reducing its holdings of
long-term fixed investments, equities and closed-end mutual funds.
Primarily as a result of these sales, the Company realized net investment
gains of $37,323 or $24,260 after taxes in those categories for the six
months ended June 30, 2003 compared to a net realized investment loss of
$837 or $544 after taxes on sales of securities in those categories during
the six months ended June 30, 2002.
The Company recognized net realized investment gains of $39,747 or
$25,836 after taxes for the six months ended June 30, 2003 attributable to
the change in the net asset value of seven closed end mutual funds in which
the Company owned 20% or more as of June 30, 2003. Whenever the Company
owns 20% or more of a closed-end fund, the Company must account for its
investment in that fund using the equity method of accounting, which
requires it to recognize as a realized investment gain (loss) the change in
the net asset value of that fund as compared to the end of its immediately
preceding fiscal quarter. For the six months ended June 30, 2003, the net
realized investment gains attributable to the fund investments that the
Company must account for using the equity method was $39,747 or $25,836
after taxes, as compared to a net realized investment loss of $19,361 or
$12,585 after taxes for that category of investments for the comparable
period of 2002. The closed-end mutual funds that the Company accounts for
using the equity method primarily invest in preferred stock, and therefore
the decline in interest rates during the second quarter of 2003 caused a
significant increase in the net asset value of those funds and, as a direct
consequence, an increase in the net realized investment gains that the
Company recognized for those investments for the six months end June 30, 2003.
As of July 31, 2003, the Company still has five fund investments that
the Company accounts for using the equity method. If interest rates are
higher at September 30, 2003 than they were at June 30, 2003, the respective
net asset values of those funds would be less than they were at June 30,
2003, and the Company would recognize a net realized investment loss for
those fund investments. As of July 31, 2003, ten and twenty year treasury
note interest rates were significantly higher and the net asset values of
those five funds had decreased by approximately $12.0 million compared to
June 30, 2003. The Company expects that if those conditions persist through
September 30, 2003, the Company will recognize a net realized investment
loss on those fund investments that may have a material adverse effect on
its net earnings for the period ending September 30, 2003.
- 24 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Continued)
Liquidity and Capital Resources
The focus of the discussion of liquidity and capital resources is on
the Consolidated Balance Sheets on page 3 and the Consolidated Statements of
Cash Flows on pages 5 and 6. Stockholders' equity increased by $65,874
during the first six months of 2003 as compared to December 31, 2002. The
increase resulted from net earnings of $84,393, a $7,089 increase in other
comprehensive income, net of income taxes on fixed maturities and preferred
and common stocks, and a $2,607 increase which resulted from the issuances
of capital stock offset by dividends paid to stockholders of $20,157 and
treasury stock purchases of $8,058. Total assets at June 30, 2003 increased
$346,694 or 14.6% to $2,729,382 as compared to total assets of $2,382,688 at
December 31, 2002. Invested assets, at market value and equity, increased
$174,579 or 11.1%, as a result of increased investments and improvements in
market values. Premiums receivable increased $95,133, or 32.0%, as compared
to $85,096 or 34.6% for the same period last year. The increase in premiums
receivable from December 31, 2002, was primarily attributable to increases
in the Company's business, coupled with the seasonality of the policy
effective dates of the Company's business. This occurs because the total
amount of a policy's premium is recorded as written premium on the first day
the policy is effective, however, the policy premium is billed over the
ensuing year. Deferred policy acquisition costs increased $19,006 or 13.7%
as a result of increased business. The residual market receivable increased
$15,152 or 9.2% over 2002 due to increased business assumed from CAR. Due
from Reinsurers increased $13,276 or 13.5% to $111,679, the increase being
primarily due to the increase in direct business for other than automobile
lines of business. The increase in direct business for other than
automobile directly correlates to the amounts due from reinsurers.
The Company's liabilities totaled $1,869,228 at June 30, 2003 as
compared to $1,588,530 at December 31, 2002. The $280,698 or 17.7% increase
was primarily comprised of increases in unpaid losses and loss adjustment
expenses, unearned premiums and a payable for securities purchased. The
liability for losses and loss adjustment expense reserves increased $77,622
or 9.5% primarily as a result of increased business. Unearned premiums
increased $135,579 or 19.7%, due primarily to increases in the Company's
business, coupled with the seasonality of the policy effective dates of the
Company's business. Payable for securities purchased totaled $52,361 at
June 30, 2003 as compared to $0 at December 31, 2002. This was the result
of securities purchased with trade dates in June of 2003 that were not
settled until July of 2003.
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 sale of investments as reflected in the
Consolidated Statements of Cash Flows on pages 5 and 6.
The Company's operating activities provided cash of $101,231 in the
first six months of 2003 as compared to $90,692 during the same period a
year ago, representing an increase of $10,539 or 11.6%. Premiums collected
less loss and policy acquisition cost payments were $8,963 higher in 2003
compared to 2002. The primary reason for this increase was that the increase
in premiums collected outpaced the increase in losses and LAE paid and the
policy acquisition cost paid. This occurs when a company has significant
increases in business as claims paid tend to lag premiums collected.
Additionally, premium finance and service fees collected increased $3,248 or
32.5% primarily as the result of increased business and a service fee
increase on Massachusetts new and renewal business from three dollars to
four dollars per installment payment, for policies with effective dates of
July 1, 2002 and forward. These increases were offset by the $7,000
decrease in other income which resulted in the first quarter of 2002 for an
agreement to offer to write the business from Berkshire Mutual Insurance
Company.
- 25 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Continued)
For the first six months of 2003 and 2002 net cash flows from
investing activities used cash of $134,529 and $61,823, respectively. The
majority of the $72,706 difference was a $505,704 increase in the purchases
of fixed and equity securities, partially offset by an increase in the
proceeds from the sales of fixed maturities, equities and Preferred Stock
Mutual Funds totaling $418,382. During the second quarter the Company
shortened the overall duration of its investment portfolio by reducing its
holdings in certain long term fixed income instruments, equities and closed
end mutual funds. This change in strategy resulted in the realization of
significant investment gains with minimal adverse impact on future
investment income, which provides flexibility in making future investment
decisions. The Company will continue to reduce the duration of the
investment portfolio in order to continue to protect itself from anticipated
future increases in overall interest rates. Investing activities were
funded by the accumulation of cash and cash provided by operating
activities. 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 and equity) of
total investments at June 30, 2003 was $1,751,649. At June 30, 2003, the
Company held cash and cash equivalents of $111,040. These funds provide
sufficient liquidity for the payment of claims and other short-term cash
needs.
Cash flows used in financing activities totaled $25,608 during the
first six months of 2003 compared to $29,518 during the same period a year
ago. The 2003 cash flows used in financing activities consisted of
dividends paid to stockholders of $20,157, coupled with $8,058 used to
purchase 236,400 shares of treasury stock under the Company's stock buyback
program, offset by $2,607 from the issuance of capital stock. The 2002 cash
flows used in financing activities consisted of dividends paid to
stockholders of $20,165 and $17,211 used to purchase 438,644 shares of
treasury stock under the company's stock buyback program offset by $7,858
from the issuance of capital stock, as a result of the Company's stock
option plan.
The Company's 75% quota-share reinsurance agreement, which provides
reinsurance on its other than automobile business, terminated effective June
30, 2003. The quota-share program was incepted on July 1, 1998 and
established for a five year period. The Company has negotiated a 65% quota-
share agreement for one year with modified terms. The new program became
effective July 1, 2003. In the event of a catastrophe, recovery is limited
to 65% of the loss with a maximum recovery estimated at $225 million.
Several limitations were added to the new contract regarding losses related
to nuclear, chemical, and biological terrorist events. The Company's
maximum loss recovery in case of these types of events is estimated at $26
million. The Company's 100 and 250 year probable maximum loss events have
been estimated at approximately $180 million and $290 million, respectively,
based on policies in force at December 31, 2002.
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 twelve
month rolling statutory premiums to surplus ratio was 2.12 to 1.00 and 1.79
to 1.00 for the period ended June 30, 2003 and 2002, respectively.
New Relevant Accounting Developments
FIN. 46 - Consolidated of Variable Interest Entities - An
Interpretation of ARB No. 51.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation
of Variable Interest Entities" ("FIN 46"), which addresses consolidation
issues surrounding special purpose entities, often termed variable interest
entities ("VIE"), to which the usual condition for consolidation does not
apply because the VIE either has no voting interests or otherwise is not
subject to financial control through ownership of voting interest. Under
FIN 46, the primary beneficiary of a VIE is required to consolidate the VIE.
FIN 46 is required to be adopted by the end of fiscal periods beginning
after June 15, 2003. At June 30, 2003 and December 31, 2002, the Company
held investments in preferred stock mutual funds that, for purposes of FIN
46, are being evaluated to determine whether such investments should be
consolidated or disclosed as a variable interest entity in the Company's
future financial statements.
- 26 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Continued)
FAS. 150 - Accounting for Certain Financial Instruments with
characteristics of both liabilities and equity.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity"
("SFAS No. 150"), which requires an issuer of certain classes of
freestanding financial instruments, as set out in the statement, to classify
such instruments as a liability and, in most instances, measure the
instruments at fair value. SFAS No. 150 is effective for all financial
instruments entered into or modified after May 31, 2003, and otherwise shall
be effective at the beginning of the first interim period after June 15,
2003 for financial instruments that were in existence prior to May 31, 2003.
For financial instruments created before the issuance date of SFAS No. 150
and still existing at the beginning of the interim period of adoption,
transition shall be achieved by initially measuring the financial
instruments at fair value and reporting the difference between the fair
value and the previous carrying value as the cumulative effect of a change
in accounting principle. The Company does not expect that the impact of
adopting this statement will be material.
Stock Buyback and Dividends
The Company purchased 236,400 shares of Treasury stock under the
buyback program through June 30, 2003 at an average cost of $34.09. At June
30, 2003, the Company had the authority to purchase 741,456 additional
shares of common stock under the current Board of Directors' stock re-
purchase authorization.
On June 12, 2003, the Company paid a quarterly dividend of $0.32 to
stockholders of record as of June 1, 2003. The Company increased its
quarterly dividend to stockholders from $0.31 to $0.32 during the second
quarter.
Effects of Inflation and Recession
The Company generally is unable to recover the costs of inflation in
its personal automobile insurance line since the premiums it charges are
subject to state regulation. Additionally, 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 may 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.
Forward-Looking Statements
This Form 10-Q contains some statements that are not historical facts
and are considered "forward-looking statements" as defined in the Private
Securities Litigation Reform Act of 1995. Such forward-looking statements
involve opinions, assumptions and predictions, and no assurance can be given
that the future results will be achieved since events or results may differ
materially as a result of risks facing the Company. These include, but are
not limited to, those risks and uncertainties in its business, some of which
are beyond the control of the Company, that are described in the Company's
Forms 10-K and 10-Q, Schedules 13D and 13G, and other documents filed with
the SEC, including the possibility of adverse catastrophe
- 27 -
The Commerce Group, Inc. and Subsidiaries
MANAGEMENT'S DISCUSSION AND ANALYSIS
(Continued)
experience and severe weather, adverse trends in claim severity or
frequency, adverse state and federal regulation and legislation, adverse
state judicial decisions, litigation risks, interest rate risk, rate making
decisions for private passenger automobile policies in Massachusetts,
potential rate filings outside of Massachusetts, adverse impacts related to
consolidation activities, heightened competition, concentration of business
within Massachusetts, dependence on certain principal employers, as well as
the economic, market or regulatory conditions and risks associated with
entry into new markets and diversification. The Commerce Group, Inc. is not
under any obligation to (and expressly disclaims any such obligations to)
update or alter its forward-looking statements, whether as a result of new
information, future events or otherwise.
Additional Financial Information Available on Company Website
Additional supplemental financial information is available on the
Company's website at http://www.commerceinsurance.com, under the "Links"
section of the "News & Investors" tab.
- 28 -
The Commerce Group, Inc. and Subsidiaries
Item 3. Quantitative and Qualitative Disclosures about Market Risk
The Company's investment strategy emphasizes investment yield while
maintaining investment quality. The Company's investment objective
continues to focus primarily on maximizing after-tax investment income
through investing in 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 market risk by focusing on higher quality
equity and fixed income investments, by periodically monitoring the credit
strength of 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. Although the Company has significant holdings of various
closed-end preferred stock mutual funds, these funds are comprised primarily
of preferred and common stocks traded on national stock exchanges, thus
limiting exposure to any one investment. The Company's exposure to interest
rate changes at June 30, 2003 was estimated as follows: A 200 basis point
increase results in a $74,520 decrease in the market value of the fixed
maturities and preferred stocks. A 200 basis point decrease results in a
$59,053 increase in the market value of the same securities.
Item 4. Controls and Procedures
Disclosure Controls and Procedures
Under the supervision and with the participation of its management,
including its Chief Executive Officer and Chief Financial Officer, the
Company evaluated the effectiveness of its disclosure controls and
procedures (as defined in Rule 13a-14(c) and 15d-14(c) under the Exchange
Act) as of June 30, 2003. Based upon that evaluation, the Chief Executive
Officer and Chief Financial Officer concluded that, as of the June 30, 2003
evaluation date, its disclosure controls and procedures are effective to
ensure that information required to be disclosed in the reports that the
Company files or submits under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported, within the time periods
specified in the Securities and Exchange Commission's rules and forms.
Internal Controls Over Financial Reporting
There have been no changes in the Company's internal control over
financial reporting that occurred during the Company's last fiscal quarter
that have materially affected, or are reasonably likely to materially affect
the Company's internal control over financial reporting.
- 29 -
The Commerce Group, Inc. and Subsidiaries
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Please refer to Note 3 located in "Part I, Item 1 - Financial
Statements Notes to Unaudited Consolidated Financial Statements" section.
Item 2. Changes in Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submissions of Matters to a Vote by Security Holders
On May 16, 2003, at the Annual Meeting of the stockholders of the
Company, the number of directors was fixed at 17 and the slate of Directors
as presented in the Annual Proxy was approved. The votes as tabulated by
EquiServe Trust Company were as follows:
Total Vote For Total Vote Withheld
Each Director From Each Director
-------------- -------------------
<s> <c> <c>
Herman F. Becker 28,705,005 94,156
Joseph A. Borski, Jr. 28,668,827 130,334
Eric G. Butler 28,731,777 67,384
Henry J. Camosse 28,732,029 67,132
Gerald Fels 28,730,949 68,212
David R. Grenon 28,710,391 88,770
Robert W. Harris 28,732,191 66,970
Robert S. Howland 28,731,777 67,384
John J. Kunkel 28,731,615 67,546
Raymond J. Lauring 28,732,191 66,970
Normand R. Marois 28,690,652 108,509
Suryakant M. Patel 28,710,229 88,932
Arthur J. Remillard, Jr. 28,247,629 551,532
Arthur J. Remillard, III 28,717,909 81,252
Regan P. Remillard 28,718,738 80,423
Gurbachan Singh 28,731,615 67,546
John W. Spillane 28,731,133 68,028
Item 5. Other Information
None
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Page No.
(a) Exhibit 31.1 - CEO Certification Statement Under Section 302
of The Sarbanes-Oxley Act of 2002 32
31.2 - CFO Certification Statements Under Section 302
of The Sarbanes-Oxley Act of 2002 33
Exhibit 32.1 - CEO Certification Statements Under Section 906
of The Sarbanes-Oxley Act of 2002 34
32.2 - CFO Certification Statements Under Section 906
of The Sarbanes-Oxley Act of 2002 35
(b) Reports on Form 8-K
(1) On April 30, 2003, the Company filed a form 8-K. The purpose was
to comply with Item 9, Regulation FD disclosure, which required the
furnishing of the Company's press release regarding first quarter earnings.
(2) On June 23, 2003, the Company filed a form 8-K. The purpose was
to comply with Item 4, which was for notification of a change in the
Registrant's Certifying Accountant.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934 as
amended, the registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.
THE COMMERCE GROUP, INC.
/s/ Randall V. Becker
------------------------
Randall V. Becker
Treasurer and
Chief Accounting Officer
Dated this 13th day of August, 2003.
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