ITEM 1.   BUSINESS

General

21st Century Insurance Group (together with its subsidiaries, referred to hereinafter as the "Company", "we", "us" or "our") is an insurance holding company registered on the New York Stock Exchange (NYSE: TW).

 

We are a direct-to-consumer provider of personal auto insurance covering over 1.5 million vehicles in California and eight other Western, Southwestern and Midwestern states. ¹    We also provide motorcycle and personal umbrella insurance in California. Twenty-four hours per day, 365 days a year, customers have the option to purchase insurance, service their policy or report a claim over the phone directly through our licensed insurance professionals at 1-800-211-SAVE (English) or 1-888-920-2121 (Spanish) or through our full service bilingual Web site at www.21st.com .   We believe that we deliver superior policy features and customer service at a competitive price.

21st Century Insurance Group was founded in 1958 and, effective December 4, 2003, was incorporated under the laws of the State of Delaware. Previously, the Company was incorporated in California. Several subsidiaries of American International Group, Inc. (hereinafter referred to as "AIG") together own approximately 63% of our outstanding common stock.

Copies of our filings with the Securities and Exchange Commission on Form 10-K, Form 10-Q, Form 8-K and proxy statements are available along with copies of earnings releases on the Company's Web site at www.21st.com . Copies may also be obtained free of charge directly from the Company's Investor Relations Department (6301 Owensmouth Avenue, Woodland Hills, California 91367, phone 818-673-3996).

Geographic Concentration of Business

We write private passenger automobile insurance primarily in California (96% of policyholders). We also currently write auto insurance in Arizona, Nevada, Oregon, Washington, Illinois, Indiana, Ohio, and Texas ¹ .

 

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The following table presents a geographical summary of our direct premiums written for the past five years (in millions):

 

The table below summarizes the concentrations of our California vehicles in force for the personal auto lines excluding the Assigned Risk program and personal umbrella and motorcycle coverages as of the end of each of the past five years. Our California market share reflects a weighted distribution that tracks the concentration of households and population. At the end of 2004, 30.3% of the vehicles insured by us were registered in Los Angeles County. In comparison, December 31, 2003 data from the California Department of Motor Vehicles (the most recent available) indicates that 24% of its registrations were for vehicles in Los Angeles County.

Types and Limits of Insurance Coverage

Our private passenger auto insurance contract generally covers: bodily injury liability; property damage; medical payments; uninsured and underinsured motorist; rental reimbursement; uninsured motorist property damage and collision deductible waiver; towing; comprehensive; and collision. All of these policies are written for a six-month term except for policies sold under the Assigned Risk Program, which are for twelve months.

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1	Includes motorcycle and personal umbrella coverages, which are immaterial for all periods presented.

2	Excludes amounts not consolidated prior to our acquisition of a majority of the voting interests in 21st Century Insurance Company of the Southwest (previously named 21st Century Insurance Company of Arizona): $12.8 million in 2001 and $14.7 million in 2000.

3	We no longer have any California homeowner policies in force. See further discussion in Item 7 under the caption Underwriting Results - Homeowner and Earthquake Lines in Runoff .

4

We ceased writing earthquake coverage in 1994, but we have remaining loss reserves from the 1994 Northridge Earthquake that are subject to possible adverse development. See further discussion in Item 7 under the captions Underwriting Results - Homeowner and Earthquake Lines in Runoff,   Critical Accounting Estimates , and in Note 16 to the Notes to Consolidated Financial Statements.

5	Includes the following counties: Imperial, Kern, Orange, Riverside, Santa Barbara, San Bernardino and Ventura.

6	Includes all California counties other than Los Angeles County, San Diego County, and those specified in Footnote 5.

 

 

Minimum levels of bodily injury and property damage are required by state law and typically cover the other party's claims when our policyholder causes an accident. Uninsured and underinsured motorist are optional coverages and cover our policyholder when the other party is at fault and has no or insufficient liability insurance to cover the insured's injuries and loss of income. Comprehensive and collision coverages are also optional and cover damage to the policyholder's automobile whether or not the insured is at fault. In some states, we are required to offer personal injury protection coverage in lieu of the medical payments coverage required in California.

Various limits of liability are underwritten with maximum limits of $500,000 per person and $500,000 per accident. Our most popular bodily injury liability limits in force are $100,000 per person and $300,000 per accident.

Our personal umbrella policy ("PUP") provides a choice of liability coverage limits of $1.0 million, $2.0 million or $3.0 million in excess of underlying automobile liability coverage that we write. Since May 2002, we have required minimum underlying automobile limits, written by us, of $250,000 per person and $500,000 per accident for PUP policies sold. We reinsure 90% of any PUP loss with unrelated reinsurers.

Personal Auto Product Innovations

Starting in May 2002, we began offering motorcycle coverage primarily to our auto policyholders in California. In August 2002, we introduced a new private passenger auto policy in California that does not have certain standard features found in our primary policy. This limited-feature product is similar in most respects to the product offered by many of our competitors, and is positioned as a lower-cost alternative for customers who believe they need less coverage than provided by our standard product. In October 2002, we enhanced our underwriting guidelines allowing us to provide quotes to more customers who do not meet California's statutory "good driver" definition, but who are considered to be insurable risks within our class plan.

The foregoing product innovations account for approximately 14% of new auto policies written in California in 2004. Each innovation was designed to earn an underwriting profit equivalent to the rest of the California auto product (with the exception of the Assigned Risk program). Initial results for each product innovation are in line with expected profit levels.

Marketing

While we offer personal auto policies in nine states, most of our marketing efforts are focused on the larger urban markets in California. Beginning in late 2001, we resumed active marketing in Arizona. We began offering personal auto insurance in Illinois, Indiana and Ohio on January 28, 2004, and in Texas on January 3, 2005.  

Our marketing and underwriting strategy is to appeal to careful and responsible drivers who desire a feature-rich product at a competitive price. We use direct mail, broadcast and print media, outdoor, community events and the Internet to generate inbound telephone calls, which are served by centralized licensed insurance agents. Because our sales agents are centralized, we can deliver a highly efficient and professional experience for our customers 24 hours per day, 365 days per year through a convenient, toll-free 800-211-SAVE telephone number. Customers may also obtain an auto rate quotation and purchase a policy on our Web site at www.21st.com .

Approximately 60% of all Spanish speaking residents in the United States live in the states of California, Arizona, Illinois, and Texas. We are the only significant auto insurer to provide full service in Spanish via our Web site and bilingual professionals 24 hours per day, 365 days per year through a dedicated toll-free telephone number at 888-920-2121. Additionally we utilize Spanish speaking advertising and materials to attract the Spanish speaking community.

 

 

The following table summarizes advertising expenditures (in millions) and total new auto policies written for the past five years:

 

Consumer Advocacy

We have introduced several publications and community events designed to assist customers and potential customers in making choices about their auto insurance and automobile safety. Crash Course in Auto Insurance , available in both English and Spanish, compares coverage and service features of products offered by the Company and its major competitors for California, Arizona, Illinois, Indiana and Ohio. The comparisons are explained in understandable language to help "demystify" the choices consumers must make in selecting their personal auto insurance carrier.

We also publish the Child Safety Seat Guide , Crash Test Ratings Guide , and The Golden Road - Today's Senior Drivers, which we distribute through county fairs, direct mail promotions and other venues.

For the past three years, 21st Century Insurance and the California Highway Patrol ("CHP") have conducted safety fairs in communities throughout California. In the last three years, the CHP has conducted nearly 3,900 inspections, removed and destroyed over 1,900 hazardous child safety seats, and we donated over 2,900 new seats to California families. Based on the success of this program in California, we entered into a partnership in 2004 with the state of Illinois to conduct safety fairs in communities throughout Illinois. In 2004, the state conducted nearly 500 inspections, removed and destroyed over 160 hazardous seats, and we donated 800 new seats to Illinois families. In January 2005, the Company also formed a partnership with the governor of Texas and the Texas Department of Public Safety to conduct safety fairs throughout the state.

 

21st Century Insurance has also partnered with the CHP and the Arizona Department of Public Safety to post billboards around the states encouraging drivers to be safe. Ads in English and Spanish feature lighthearted messages discussing a serious topic - Sober Driving. All of the materials are co-branded by the Company, the CHP and the Arizona Department of Public Safety, as applicable.

Customer Retention and Vehicles in Force

Customer retention in California, measured based on the number of vehicles in force, were as follows as of the end of each of the past five years:

From March 1996 to February 1999, we implemented six rate decreases which resulted in a cumulative reduction in rates of nearly 23% in our California Personal Auto Program. As a result of this series of rate decreases, retention rates rose to record levels for us through 2000. Growth in vehicles in force during this period was modest as our major competitors also lowered their rates. In the year 2000 we recognized that loss costs had stopped declining and were again rising. While our competitors took no action or, in some cases, continued to take rate decreases, we took decisive action to improve our results and resume profitable growth when the marketplace ultimately did react to these adverse trends. In 2000 we curtailed our advertising, adopted stricter underwriting measures, modified our class plan rating system, and increased our California auto program base rate by 6.4%, followed by a further rate increase of 4% in 2001. These actions contributed to a decline in retention and vehicles in force in 2001. Beginning in the latter half of 2001, our major California competitors began implementing rate increases and we restarted active marketing and advertising, both of which contributed to the increases in our retention and vehicles in force in 2002. In January 2003, the Company received approval for a 3.9% rate increase, which we implemented for new and renewal policies effective March 31, 2003. This increase did not significantly impact retention. We took no California rate increases or decreases in 2004.

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1	Includes new PUP and motorcycle policies, which are insignificant for all periods presented.

2	Represents an overall measure of customer retention, including new customers as well as long-time customers. Retention rates for new customers typically are lower than for long-time customers.

3	Includes PUP and motorcycle.

 

 

Underwriting and Pricing

The regulatory system in California requires the prior approval of insurance rates. Within the regulatory framework, we establish our premium rates based primarily on actuarial analyses of our own historical loss and expense data. This data is compiled and analyzed to establish overall rate levels as well as classification differentials.

Our rates are established at levels intended to generate underwriting profits and vary for individual policies based on a number of rating characteristics. These rates are a blend of base rates and class plan filings made with the California Department of Insurance ("CDI"). Base rates are the primary amount projected to generate an adequate underwriting profit. Class plan changes are filings that serve to modify the factors that impact the base rates so that each individual receives a rate that reflects their respective losses and expenses. Class plan changes are generally meant to be revenue neutral to us, but ultimately are done in conjunction with a base rate filing.

California law requires that the primary rating characteristics that must be used for automobile policies are driving record (e.g., history of accidents and moving violations), annual mileage and number of years the driver has been licensed. A number of other "optional" rating factors are also permitted and used in California, which include characteristics such as automobile garaging location, make and model of car, policy limits and deductibles, and gender and marital status.

The following table summarizes increases in our premium rates for each of the past five years:

We are required to offer insurance to any California applicant who meets the statutory definition of a "good driver." This definition includes, but is not limited to, all drivers licensed the previous three years with no more than one violation point count under criteria contained in the California Vehicle Code. These criteria include a variety of moving violations and certain at-fault accidents.

 

We review many of our policies prior to the time of renewal and as changes occur during the policy period. Some mid-term changes may result in premium adjustments, cancellations or non-renewals because of a substantial increase in risk.

Competition

The personal automobile insurance market is highly competitive and is comprised of a large number of well-capitalized companies, many of which operate in more states and offer a wider variety of products than we do. Several of these competitors are larger and have greater financial resources than we do on a stand-alone basis. According to A.M. Best, we were the seventh largest writer of private passenger automobile insurance in California based on direct premiums written for 2003 (latest year for which information is available). Our main competition comes from other major writers who concentrate on the "good driver" market.

 

Market shares in California of the top ten writers of personal automobile insurance, based on direct premiums written, according to A.M. Best, for the past five years were as follows:

 

Servicing of Business

Computerized systems provide the information resources, telecommunications and data processing capabilities necessary to manage our business. These systems support the activities of our marketing, sales, service and claims people who are dedicated to serving the needs of customers. New technology investments have been focused on making it faster and easier for customers to transact business while ultimately lowering our per-transaction costs.

Using our bilingual Web site, most customers are now able to receive and accept quotations, bind policies, pay their bills, inquire about the status of their policies and billing information, make most common policy changes, submit first notice of loss on a claim and access a wealth of consumer information. New technology provides our sales and service agents with integrated knowledge about customer contacts and enables speedier and even more convenient customer service.

Claims

Claims operations include the receipt and analysis of initial loss reports, assignment of legal counsel when necessary, and management of the settlement process. Whenever possible, physical damage claims are handled by our drive-in claims facilities, vehicle inspection centers and Direct Repair Program ("DRP") providers. The claims management staff administers the claims settlement process and oversees the work of the legal and adjuster personnel involved in that process. Each claim is carefully analyzed to provide for fair loss payments, compliance with our contractual and regulatory obligations and management of loss adjustment expenses. Liability and property damage claims are handled by specialists in each area.

We make extensive use of our DRP to expedite the repair process. Our program involves agreements with more than 200 independent repair facilities. We agree to accept the repair facility's damage estimate without requiring each vehicle to be reinspected by our adjusters. All DRP facilities undergo a screening process before being accepted, and we maintain an aggressive inspection audit program to assure quality results. Our inspection teams visit all repair facilities each month and perform a quality control inspection on approximately 45% of all repairable vehicles in this program. The customer benefits by getting the repair process started faster and by having the repairs guaranteed for as long as the customer owns the vehicle. We benefit by not incurring the overhead expense of a larger staff of adjusters and by negotiating repair prices we believe are beneficial. Currently, more than 30% of all damage repairs are handled using the DRP method.

 

Our policy is to use original equipment manufacturer ("OEM") parts for body repairs. As a result, we believe we do not have exposure to the types of class action suits some competitors have drawn over their use of after-market parts.

We have established 12 claims division service offices in areas of major customer concentrations. Our four vehicle inspection centers, located in Southern and Northern California, as well as Arizona, handle total losses, thefts and vehicles that are not drivable.

The claims services division is responsible for subrogation and medical payment claims. We also maintain a Special Investigations Unit as required by the California State Insurance Code, which investigates suspected fraudulent claims. We believe our efforts in this area have been responsible for saving several million dollars annually.

We utilize internal legal staff to handle most aspects of claims litigation. These attorneys handle approximately 80% of all lawsuits against our policyholders. Suits directly against the Company, and those which may involve a conflict of interest, are assigned to outside counsel.

Growth and Profitability Objectives

We have stated that our long-term goal is to build an organization that consistently produces a 96% combined ratio or better, using accounting principles generally accepted in the United States of America ("GAAP"), and at least 15% annual growth in direct written premiums. To achieve these goals, we have undertaken many steps since 1999 including:

·	Continued our multi-state expansion with the addition of Illinois, Indiana and Ohio in 2004, and Texas in 2005;

·	Restored pricing and underwriting discipline;

·	Successfully restarted active advertising for new customers;

·	Introduced product innovations to spur growth and profitability; and

·	Launched numerous initiatives to lower per-transaction costs.

Underwriting Expense Ratio - Personal Auto Lines

Under GAAP, the underwriting expense ratio is defined as underwriting expenses divided by net premiums earned as underwriting expenses are recognized over the period that net premiums are earned.  The statutory underwriting expense ratio is stated as a percentage of premiums written rather then premiums earned because most underwriting expenses are recognized when policies are written. Information extracted from statutory filings by A.M. Best for the top ten California personal automobile insurance companies for 2003, the most recent year available, indicates that our direct statutory underwriting expense ratio for private passenger auto (defined as direct underwriting expenses on a statutory basis divided by direct premiums written) was lower then seven of our nine largest competitors in the markets in which we served for 2003.  Our GAAP underwriting results and ratios are discussed in Item 6. Selected Financial Data and Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations.

 

 

Losses and Loss Adjustment Expense Reserves

The cost to settle a customer's claim is comprised of two major components: losses and loss adjustment expenses ("LAE").

Losses in connection with third party coverages represent damages as a result of an insured's acts that result in property damage or bodily injury. First party losses involve damage or injury to the insured's property or person. In either case, the ultimate cost of the loss is not always immediately known and, over time, may be higher or lower than initially estimated. When establishing initial and subsequent estimates, the amount of loss is reduced for salvage (e.g., proceeds from the disposal of the wrecked automobile) and subrogation (e.g., proceeds from another party who is fully or partially liable, such as the insurer of the driver who caused the accident involving one of our customers).

Loss adjustment expenses represent the costs of adjusting, investigating and settling claims, and are primarily comprised of the cost of our claims department, external inspection services, and internal and external legal counsel. Corporate support areas such as human resources, finance, and information technology provide services to our overall operations, and, accordingly, a portion of their operational costs are also allocated to LAE. The LAE allocable portion of such corporate support costs is reviewed periodically as changes occur in our organization, and we modify the allocation percentages as appropriate. During 2004, such changes effectively decreased our ratio of overhead LAE to earned premium by 2.7 percentage points from 4.4% in 2003 to 1.7% in 2004.

 

 

 

Estimating Losses and LAE for Lines in Runoff. While the personal auto lines represent our core business, we also have losses and LAE relating to development on remaining loss reserves for homeowners and earthquake lines. These lines are said to be "in runoff" because we no longer have policies in force. As discussed in the Notes to Consolidated Financial Statements, we have not written any earthquake policies since 1994 and we exited the homeowners insurance business at the beginning of 2002. Developing reserve estimates for the earthquake line is particularly subjective because most of the remaining earthquake claims are in litigation. Our actuaries evaluate the homeowners reserve requirement on a quarterly basis, while personnel in our legal and claims areas prepare monthly evaluations of the earthquake reserves.

Loss and LAE Reserve Development

Management believes that our reserves are adequate and represent our best estimate based on the information currently available. However, because reserve estimates are necessarily subject to the outcome of future events, changes in estimates are unavoidable in the property and casualty insurance business. These changes sometimes are referred to as "loss development" or "reserve development."

For the personal auto lines, our actuaries prepare a monthly evaluation of loss and LAE indications by accident year, and we assess whether there is a need to adjust reserve estimates. As claims are reported and settled and as other new information becomes available, changes in estimates are made and are included in earnings of the period of the change.

 

The changes in prior accident year estimates of losses and LAE incurred recorded in each of the past five calendar years, net of reinsurance, are summarized below (in thousands):

 

  Positive amounts represent deficiencies in loss and LAE reserves, while negative amounts represent redundancies.

To understand these changes, it is useful to put them in the context of the cumulative reserve development experienced by the Company over a longer time frame. The tables on the following pages present the development of loss and LAE reserves for the personal auto lines (Table 1) and for the homeowner and earthquake lines in runoff (Table 2), for the years 1994 through 2004. The figures in both tables are shown gross of reinsurance.

 

 

In Tables 1 and 2 on the following pages, a redundancy (deficiency) exists when the original reserve estimate is greater (less) than the re-estimated reserves. Each amount in the tables includes the effects of all changes in amounts for prior periods. The tables do not present accident year or policy year development data. Conditions and trends that have affected the development of liabilities in the past may not necessarily occur in the future. Therefore, it would not be appropriate to extrapolate future deficiencies or redundancies based on the table. A detailed discussion of loss and LAE reserve development follows the tables.

 

The top line of each table shows the reserves at the balance sheet date for each of the years indicated. The upper portion of the table indicates the cumulative amounts paid as of subsequent year ends with respect to that reserve liability. The lower portion of the table indicates the re-estimated amount of the previously recorded reserves based on experience as of the end of each succeeding year, including cumulative payments made since the end of the respective year. The estimates change as more information becomes known about the frequency and severity of claims for individual years.

 

TABLE 1 - Auto Lines as of December 31,
(Amounts in thousands, except claims)		1994			1995			1996			1997			1998			1999			2000			2001			2002			2003			2004
Reserves for losses and LAE, direct
		$	552,872		$	506,747		$	468,257		$	403,263		$	329,021		$	261,990		$	286,057		$	301,985		$	333,113		$	419,913		$	489,411
Paid (cumulative) as of:
One year later			329,305			318,273			260,287			253,528			247,317			242,579			268,515			239,099			249,815			280,534
Two years later			403,462			392,420			336,538			319,064			307,797			311,659			332,979			312,909			328,951
Three years later			429,595			416,541			354,854			333,349			324,778			324,740			352,592			333,955
Four years later			435,795			422,393			357,913			340,907			326,932			327,745			358,806
Five years later			437,041			423,429			363,068			341,446			327,418			328,557
Six years later			437,052			427,723			362,824			341,374			327,162
Seven years later			437,015			427,355			362,508			341,076
Eight years later			436,737			427,059			362,216
Nine years later			436,518			426,844
Ten years later			436,307
Reserves re-estimated as of:
One year later			465,934			440,158			365,566			359,262			313,192			309,953			352,709			323,791			348,865			417,225
Two years later			438,672			424,091			366,858			337,258			321,711			340,914			354,720			338,338			354,784
Three years later			439,125			425,404			359,925			335,246			341,695			328,190			361,264			339,965
Four years later			438,895			424,643			357,607			355,605			326,506			329,182			361,068
Five years later			436,397			422,389			377,414			340,537			326,565			329,318
Six years later			435,878			442,024			361,980			340,552			327,626
Seven years later			451,478			426,719			361,865			341,396
Eight years later			448,972			426,636			362,541
Nine years later			436,237			427,093
Ten years later			436,540
Redundancy (Deficiency)		$	116,332		$	79,654		$	105,716		$	61,867		$	1,395		$	(67,328	)	$	(75,011	)	$	(37,980	)	$	(21,671	)	$	2,688
Supplemental Auto Claims Data:
Claims reported during the year for CA only			352,182			324,143			294,615			279,211			295,905			307,403			323,395			298,417			293,955			331,734			354,156
Claims pending at year end for CA only			70,717			63,142			58,172			55,738			56,739			57,134			54,760			50,365			51,488			58,577			59,676

See Note 8 of the Notes to Consolidated Financial Statements.