##### 



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 September 30, 2004 or o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period from __________ to ______________ Commission file number 000-50891 SPECIALTY UNDERWRITERS ALLIANCE, INC.  Delaware
(State or other jurisdiction of incorporation or
organization)
    
    20-0432760
(I.R.S. Employer Identification
Number)222 South Riverside Plaza
Chicago, Illinois
    
    60606(Address of principal executive office)
    
    (Zip Code)
 (888) 782-4672
(Registrants telephone number including area code) Indicate by check x 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 requirement for the past
90 days. Yes o No x Indicate by check mark whether the registrant is an accelerated filer (as defined in
the Exchange Act Rule 12b-2). Yes o No x As of December 23, 2004 there were 14,680,688 shares of common stock, $0.01 par
value, outstanding and 26,316 shares of Class B common stock, $0.01 par value,
outstanding.




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##### 



SPECIALTY UNDERWRITERS ALLIANCE, INC. INDEX Page No.PART I  FINANCIAL INFORMATION
    
    
    3Item 1: Financial Statements
    
    
    3Item 2: Managements Discussion and Analysis of Financial
Condition and Results of Operations
    
    
    30Item 3: Quantitative and Qualitative Disclosures About Market Risk
    
    
    42Item 4: Controls and Procedures
    
    
    43PART II  OTHER INFORMATION
    
    
   43Item 1: Legal Proceedings
    
    
   43Item 2: Unregistered Sales of Equity Securities and Use of Proceeds
    
    
   43Item 3: Defaults Upon Senior Securities
    
    
   46Item 4: Submission of Maters to a Vote of Security Holders
    
    
   46Item 5: Other Information
    
    
   46Item 6: Exhibits and Reports on Form 8-K
    
    
   46Signatures
    
    
   47
 2




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##### 



Note that the financial statements covered in this report represent the
results of operations and financial condition of Specialty Underwriters
Alliance, Inc. and its newly acquired subsidiary, Potomac Insurance Company of
Illinois, prior to the consummation of Specialty Underwriters Alliance, Inc.s
initial public offering and the acquisition of Potomac Insurance Company of
Illinois, which occurred on November 23, 2004. Due to the timing of the offering and the acquisition transactions,
we do not believe that the results of operations discussion set forth in this
document are necessarily indicative of our future operating results as a
publicly-held company. The information provided only reflects the operations
of each of the companies for the three and nine-month periods ended September
30, 2004 and 2003, and has no relationship to the Company operations on a going
forward basis. PART I   FINANCIAL INFORMATION Item 1: Financial Statements A. Financial Statements of Specialty Underwriters Alliance, Inc. Specialty Underwriters Alliance, Inc.
Balance Sheets
As of September 30, 2004 (Unaudited) and as of December 31, 2003 September 30,
    
    December 31,2004
    
    2003AssetsCash
    
    $
    253,170
    
    
    $
    199,909Prepaid expenses
    
    
    
    
    
    
    9,643Deferred charges
    
    
    1,160,043
    
    
    
    4,730,372Capitalized software
    
    
    465,516
    
    
    
    Acquisition deposit
    
    
    1,000,000
    
    
    
    Total assets
    
    $
    2,878,729
    
    
    $
    4,939,924Liabilities and Shareholders EquityLiabilitiesShort-term debt
    
    $
    3,900,000
    
    
    $
    700,000Accounts payable
    
    
    4,944,822
    
    
    
    19,636Accrued interest
    
    
    166,660
    
    
    
    2,655Stock warrants
    
    
    3,996,000
    
    
    
    4,795,200Total liabilities
    
    
    13,007,482
    
    
    
    5,517,491Shareholders equityCommon stock and additional paid in capital,
$0.01 par value; 10,000,000 shares authorized,
10 shares issued and outstanding
    
    
    10
    
    
    
    10Less: Stock subscription receivable
    
    
    (10
    )
    
    
    (10
    )Accumulated deficit
    
    
    (10,128,753
    )
    
    $
    (577,567
    )Total shareholders equity
    
    
    (10,128,753
    )
    
    
    (577,567
    )Total liabilities and shareholders equity
    
    $
    2,878,729
    
    
    $
    4,939,924
 The accompanying notes are an integral part of these financial statements. 3




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##### 



Specialty Underwriters Alliance, Inc.
Statements of Operations (Unaudited)
From July 1, 2004 to September 30, 2004 Three months endedSeptember 30, 2004Revenues
    
    $
    ExpensesService company fees
    
    
    2,168,343Legal expenses
    
    
    89,570Consulting fees
    
    
    413,313Financing expenses
    
    
    (702,920
    )Miscellaneous expenses
    
    
    140,488Total expenses
    
    
    2,108,794Loss before income taxes
    
    
    (2,108,794
    )Income taxes
    
    
    Net loss
    
    $
    (2,108,794
    )
 The accompanying notes are an integral part of these financial statements. 4




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##### 



Specialty Underwriters Alliance, Inc.
Statements of Operations (Unaudited)
From January 1, 2004 to September 30, 2004 Nine months endedSeptember 30, 2004Revenues
    
    $
    ExpensesService company fees
    
    
    2,506,590Legal expenses
    
    
    571,732Consulting fees
    
    
    2,205,375Financing expenses
    
    
    4,044,037Miscellaneous expenses
    
    
    223,452Total expenses
    
    
    9,551,186Loss before income taxes
    
    
    (9,551,186
    )Income taxes
    
    
    Net loss
    
    $
    (9,551,186
    )
 The accompanying notes are an integral part of these financial statements. 5




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##### 



Specialty Underwriters Alliance, Inc.
Statements of Changes in Shareholders Equity (Unaudited)
From January 1, 2004 to September 30, 2004 and from July 1, 2004 to September
30, 2004 Commonstock andadditional
    
    Stockpaid in
    
    subscription
    
    Accumulatedcapital
    
    receivable
    
    deficit
    
    TotalBalance at December 31, 2003
    
    $
    10
    
    
    $
    (10
    )
    
    $
    (577,567
    )
    
    $
    (577,567
    )Net loss
    
    
    
    
    
    
    
    
    
    
    (9,551,186
    )
    
    
    (9,551,186
    )Balance at September 30, 2004
    
    $
    10
    
    
    $
    (10
    )
    
    $
    (10,128,753
    )
    
    $
    (10,128,753
    )
 Commonstock andadditional
    
    Stockpaid in
    
    subscription
    
    Accumulatedcapital
    
    receivable
    
    deficit
    
    TotalBalance at June 30, 2004
    
    $
    10
    
    
    $
    (10
    )
    
    $
    (8,019,959
    )
    
    $
    (8,019,959
    )Net loss
    
    
    
    
    
    
    
    
    
    
    (2,108,794
    )
    
    
    (2,108,794
    )Balance at September 30, 2004
    
    $
    10
    
    
    $
    (10
    )
    
    $
    (10,128,753
    )
    
    $
    (10,128,753
    )
 The accompanying notes are an integral part of these financial statements. 6




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##### 



Specialty Underwriters Alliance, Inc.
Statements of Cash Flows (Unaudited)
From January 1, 2004 to September 30, 2004 Nine months endedSeptember 30,2004Cash flows from operating activitiesNet loss
    
    $
    (9,551,186
    )Adjustments to reconcile net loss to net cash used in
operating activitiesNon cash gain on warrant exchange
    
    
    (799,200
    )Change in prepaid expenses
    
    
    9,643Change in deferred charges
    
    
    3,570,329Change in accounts payable
    
    
    4,925,186Change in capitalized software
    
    
    (465,516
    )Change in accrued interest
    
    
    164,005Net cash used in operating activities
    
    
    (2,146,739
    )Cash flows from financing activitiesProceeds from short-term borrowings
    
    
    3,200,000Net cash provided by financing activities
    
    
    3,200,000Cash flows from investment activitiesAcquisition deposit
    
    
    (1,000,000
    )Net cash used in investment activities
    
    
    (1,000,000
    )Increase in cash
    
    
    53,261CashAt beginning of period
    
    
    199,909At end of period
    
    $
    253,170
 The accompanying notes are an integral part of these financial statements. 7




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##### 



Specialty Underwriters Alliance, Inc.
Notes to Financial Statements
From January 1, 2004 to September 30, 2004 and
from April 3, 2003 (Date of Inception) to December 31, 2003 Specialty Underwriters Alliance, Inc. completed an initial public
offering of its common stock on November 23, 2004 concurrently with the
consummation of the acquisition of Potomac Insurance Company of Illinois. The
financial statements covered in this report represent the results of operations
and financial condition of the Company prior to the offering and acquisition.  1.
    
    Organization and Significant Accounting Policies Organization UAI Holdings, Inc., a Delaware holding company, was organized on April 3,
2003. There was no financial activity between the organization date and the
initial funding date of December 12, 2003, therefore no comparative
financial statements for the period ended September 30, 2003 are presented
herein. On November 5, 2003, UAI Holdings, Inc. changed its name to
Specialty Underwriters Alliance, Inc. (the Company). The Company
intends to provide specialty program commercial property and casualty
insurance through wholly owned subsidiaries it intends to acquire.
Management plans to raise additional capital through an initial public
offering of common stock (the IPO). Through September 30, 2004, the Company had incurred costs related to its
planned IPO and initial start-up costs to commence insurance operations.
The Company has not underwritten any insurance business. See subsequent
event footnote 8. Basis of Accounting The accompanying financial statements have been prepared in accordance with
accounting principles generally accepted in the United States. The financial statements include all adjustments considered necessary by
management to fairly present the financial position, results of operations
and cash flows of the Company. The interim financial statements may not be
indicative of financial results for the full year. The preparation of financial statements requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Such estimates and assumptions could
change in the future as more information becomes known, which could impact
the amounts reported and disclosed herein. The valuation of stock warrants
include significant estimates and assumptions. 8




---



##### 



Cash Cash consists of a demand deposit account and is restricted under the terms
of senior and subordinated loan agreements to paying the interim expenses
and interest payments of the Company. Deferred Charges Deferred charges consist of deferred stock issuance costs, primarily legal
and accounting fees, and deferred financing costs, associated with stock
warrants issued to lenders. Deferred financing costs are amortized over
the original term of the debt using the interest method. Deferred stock
issuance costs will reduce the proceeds of the planned IPO. Capitalized Software Capitalized costs are related to computer software that has been developed
for internal use. These costs generally consist of software and licensing
costs. The amortization period for capitalized costs is 3 years.  2.
    
    Short-Term Borrowings On December 12, 2003, the Company entered into a short-term senior loan
agreement with Friedman, Billings, Ramsey Group, Inc. (FBR), an affiliate
of Friedman, Billings, Ramsey & Co., Inc., the underwriter for the
Companys planned IPO. FBR agreed to provide up to $1,250,000 of term
loans, at an interest rate of 12% per year. All outstanding principal and
interest will become due and payable upon the earlier of closing of the
Companys planned IPO or March 31, 2004, at which time FBRs commitment to
provide additional term loans under the short-term subordinated loan
agreement will terminate. If payment is caused by the closing of the
Companys planned IPO, payment will be made in shares based upon the IPO
price (assuming no underwriting fees). On December 12, 2003, the Company also entered into a short-term
subordinated loan agreement with four members of senior management of the
Company (the Subordinated Lenders). The Subordinated Lenders agreed to
provide up to $350,000 in term loans, at an interest rate of 12% per year.
All outstanding principal and interest will become due and payable upon the
earlier of closing of the Companys planned IPO or June 30, 2004, at which
time the Subordinated Lenders commitment to provide additional term loans
under the short-term subordinated loan agreement will terminate. If
payment is caused by the closing of the Companys planned IPO, payment will
be made in shares based upon the IPO price (assuming no underwriting fees). The Company also entered into an intercreditor and subordination agreement
with FBR, as senior lender, and the Subordinated Lenders. Pursuant to the
intercreditor and subordination agreement, any security interest granted
pursuant to the short-term senior loan agreement in any collateral will
have priority over any security interest in such collateral pursuant to the
short-term subordinated loan agreement. 9




---



##### 



On March 26, 2004, the Company amended its short-term senior loan agreement
with FBR. FBR agreed to increase its term loan amount to $1,500,000 and to
extend the maturity date to the earlier of the closing of the Companys
planned IPO or June 30, 2004, at which time FBRs commitment to provide
additional term loans under the loan agreement will terminate. On June 30,
2004, the maturity date was further extended to the earlier of the closing
of the Companys IPO or October 31, 2004. An additional $50,000 was
advanced by a senior member of management on June 23, 2004. On July 23, 2004, the Company entered into an amended and restated
short-term senior loan agreement with FBR and Standard American Insurance
Limited (SAIL and, together with FBR, the Senior Lenders). FBR agreed
to provide an additional $500,000 of term loans and SAIL agreed to provide
up to $1,450,000 both at an interest rate of 12% per year. All outstanding
principal and interest will become due and payable upon the earlier of the
closing of the Companys IPO or October 31, 2004, at which time the Senior
Lenders commitment to provide additional term loans under the senior loan
agreement will terminate. If payment is caused by the Companys planned
IPO, payment to FBR will be made in shares based upon the IPO price
(assuming no underwriting fees). On July 23, 2004, the Company also entered into an amended and restated
short-term subordinated loan agreement with four members of senior
management of the Company (the Subordinated Lenders). The agreement was
amended and restated to reflect an advance previously made by a member of
senior management of $50,000 and an additional commitment of $50,000, at an
interest rate of 12% per year. All outstanding principal and interest will
become due and payable upon the earlier of the closing of the Companys IPO
or October 31, 2004, at which time the Subordinated Lenders commitment to
provide additional term loans under the loan agreement will terminate. If
payment is caused by the Companys planned IPO, payment will be made in shares based upon the IPO price (assuming no underwriting fees). At September 30, 2004, the outstanding principal balance was $3,450,000 and
$450,000 for the senior and subordinated loans, respectively. See
subsequent event footnote 8.  3.
    
    Stock Warrants In connection with the short-term senior and subordinated loan agreements,
the Company issued warrants to FBR and the Subordinated Lenders,
respectively, to purchase for $0.01 per share, the number of shares of
common stock of the Company that would be purchasable in the planned IPO
for $3,750,000 and $1,050,000, respectively, assuming no underwriting
commissions, placement agent fees or similar fees. The warrants will be
automatically exercised on the date of closing of the IPO. A liability for the fair value of the warrants was accrued at the grant
date, offset by a related deferred charge for debt issue costs. The
Company has valued the warrants at their estimated intrinsic value if the
planned IPO is successful because of the inherent subjectivity in
estimating the fair value of the warrants at the date of grant. 10




---



##### 



In connection with the amended and restated short-term senior and
subordinated loan agreements, the Company issued warrants to FBR, SAIL and
the Subordinated Lenders, respectively, to purchase for $.01 per share, the
number of shares that would be purchasable in the planned IPO for
$4,000,000, $2,900,000 and $900,000, respectively, assuming no underwriting
commissions, placement agent fees or similar fees. The warrants will be
automatically exercised on the date of the closing of the IPO. On August 31, 2004, the Company entered into a Warrant Exchange Agreement
with FBR and the Subordinated Lenders. FBR surrendered its existing
warrants in exchange for the number of shares that would be purchasable in
the IPO for $4,500,000, for a price per share at which such shares are sold
to the public, minus all underwriting discounts and commissions. In
consideration of the additional $500,000 provided by FBR, the Company
issued warrants to FBR for the number of shares that would be purchasable
in the IPO for $1,000,000, at $0.01 per share. The Subordinated Lenders
surrendered their existing warrants in exchange for the number of shares
that would be purchasable in the IPO for $1,200,000 for a price per share
at which such shares are sold to the public, minus all underwriting
discounts and commissions. In consideration of the additional $50,000
provided by a senior member of management, the Company issued warrants for
the number of shares that would be purchasable in the IPO for $100,000, at
$0.01 per share. In connection with the warrants issued as a result of the new loans under
the amended and restated short term senior and subordinated loan agreements
and the warrant exchange agreement, the company recorded a reduction in
warrant liability and financing expenses of $799,200. See subsequent event footnote 8.  4.
    
    Capital Common Stock The Company is authorized to issue and have outstanding at any one time
75,000,000 shares of $0.01 par value common stock. At September 30, the
Company had 10 shares of common stock issued and outstanding, with a
related subscription receivable for $10. Class B Convertible Common Stock The Company is authorized to issue and have outstanding at any one time
2,000,000 shares of $0.01 par value class B convertible common stock. At
September 30, 2004, the Company had no shares of class B convertible common
stock issued or outstanding. Preferred Stock The Company is authorized to issue and have outstanding at any one time
1,000,000 shares of $0.01 par value preferred stock. At September 30,
2004, the Company had no shares of preferred stock issued or outstanding. 11




---



##### 



5.
    
    Income Taxes At September 30, 2004, the Company had $6,132,753 of accumulated start-up
and organization expenditures that will be deductible over a period of 60
months once operations commence, resulting in a deferred tax asset of
$2,085,136. The Company has recorded a full valuation allowance against
this deferred tax asset.  6.
    
    Contingencies and Commitments On June 24, 2004, the agreement with MMC Securities Corp. (MMCSC)
requiring a $1 million success fee related to their consulting and advisory
services in connection with the organization of the Company was amended to
pay the success fee at the earlier of (i) June 30, 2004 or (ii) the closing
of the IPO. Payment terms are 60 days. On September 7, 2004, the MMCSC agreement was amended to require the
company to pay the $1 million success fee in cash at the earlier of (i)
November 30, 2004 or (ii) the closing of the IPO. See Subsequent Event
Footnote 8. Under its amended contract, the Company has committed to pay Syndicated
Services Company (SSC), its service company, monthly payments of
approximately $0.7 million for the months of July 2004 through December
2004 for the implementation of the Companys rating, policy administration,
claims and billings and collections systems as well as the approvals of the
Companys regulatory filings. In addition, the Company has committed to
pay SSC monthly payments of approximately $0.7 million until December 2005
for the administration of the Companys policy processing and renewals.  7.
    
    Acquisition On March 22, 2004, the Company entered into a stock purchase agreement to
acquire all of the outstanding shares of Potomac Insurance Company of
Illinois (Potomac), from OneBeacon Insurance Company. Potomac is licensed to conduct insurance business in 41 states and the
District of Columbia. Under the terms of the stock purchase agreement, the
Company will acquire all of the issued and outstanding stock of Potomac for
Potomacs statutory capital and surplus plus $250,000 per license, payable
in cash. The acquisition will occur simultaneously with, and the Companys
obligation and the sellers obligation to close the acquisition will be
conditioned upon, the closing of the planned IPO. After the closing,
Potomac will become a wholly owned subsidiary of the Company. The Company has paid OneBeacon a $1,000,000 non-refundable deposit, which
on closing of the acquisition will be credited to the remaining balance due
to OneBeacon by the Company. 12




---



##### 



8.
    
    Subsequent Events On November 11, 2004, the Company entered into a first amendment to the
amended and restated short-term loan agreement. The agreement was amended
to extend the maturity date to December 15, 2004, to relinquish the
warrants granted in connection with the loan made by the Senior Lenders and
to provide that if payment is caused be the Companys planned IPO, payments
to each of FBR and SAIL will be made in shares based upon the IPO price
(assuming no underwriting fees). At such time, the Company also entered
into a first amendment to the amended and restated short-term subordinated
loan agreement. The agreement was amended to extend the maturity date to
December 15, 2004 and to relinquish the warrants granted in connection with
the loan made by the Subordinated Lenders. On November 17, 2004, MMCSC waived its right to receive the $1,000,000
success fee related to MMCSCs services described in Note 6. The above transactions will result in a non-recurring gain in the fourth
quarter of 2004 of $5.0 million. On November 17, 2004 the Company completed its IPO by selling 12.7 million shares for $9.50 per share ($8.835 per share after underwriting discounts)
for proceeds before expenses of $112.2 million. Concurrent with the IPO, the Company sold to FBR in a private placement 1.0 million shares for
$8.835 per share for proceeds before expenses of $8.8 million. Further, concurrent
with the IPO, the Company sold to its executive officers 90,549 shares at
$8.835 per share for an aggregate purchase price $.8 million. Also,
concurrent with the IPO, the company sold 26,316 shares of Class B common shares to its partner agents at $9.50 per share for $.3 million. Total
offering expenses are estimated to be approximately $2.3 million. Upon closing of the above transactions, on November 23, 2004, the Company
acquired all the outstanding shares of Potomac for $21.8 million consisting
of statutory capital and surplus $11.3 million and $10.5 million for its
licenses, less the acquisition deposit of $1.0 million. The underwriters exercised their over-allotment option on December 17,
2004, resulting in 422,000 additional shares being sold for
$9.50 per share ($8.835 per share after underwriting discounts) for proceeds before
expenses of $3.7 million, which the Company intends to use for general
corporate purposes. 13




---



##### 



B. Financial Statements of Potomac Potomac Insurance Company Of Illinois
Balance Sheets
(Unaudited) September 30,
    
    December 31,(dollars in thousands, except share amounts)
    
    2004
    
    2003AssetsFixed maturity investments, at fair value
(amortized cost: $31,442 and $36,111)
    
    $
    32,153
    
    
    $
    37,093Short-term investments, at amortized cost (which
approximates fair value)
    
    
    8,999
    
    
    
    12,020Total investments
    
    
    41,152
    
    
    
    49,113Cash and cash equivalents
    
    
    4,803
    
    
    
    10,307Insurance premiums receivable
    
    
    
    
    
    
    2,119Reinsurance recoverable on paid and unpaid losses
from OneBeacon (Note 5)
    
    
    111,181
    
    
    
    139,278Deferred acquisition costs
    
    
    
    
    
    
    674Investment income accrued
    
    
    304
    
    
    
    675Other assets
    
    
    1,387
    
    
    
    2,189Total assets
    
    $
    158,827
    
    
    $
    204,355LiabilitiesLoss and loss adjustment expense reserves
    
    $
    111,181
    
    
    $
    154,287Unearned insurance premiums
    
    
    68
    
    
    
    4,835Accounts payable and other liabilities
    
    
    4,495
    
    
    
    2,728Total liabilities
    
    
    115,744
    
    
    
    161,850Contingencies (Note 6)Stockholders equityCommon stock at $14 par value per share -
authorized 800,000 shares; issued and outstanding
300,000 shares
    
    
    4,200
    
    
    
    4,200Paid-in capital
    
    
    36,163
    
    
    
    36,163Retained earnings
    
    
    2,258
    
    
    
    1,504Accumulated other comprehensive income, net of tax
    
    
    462
    
    
    
    638Total common stockholders equity
    
    
    43,083
    
    
    
    42,505Total liabilities and stockholders equity
    
    $
    158,827
    
    
    $
    204,355
 The accompanying notes are an integral part of these financial statements 14




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##### 



Potomac Insurance Company Of Illinois
Statements Of Income And Comprehensive Income
(Unaudited) Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,(in thousands)
    
    2004
    
    2003
    
    2004
    
    2003Revenues:Earned insurance premiums
    
    $
    
    
    
    $
    2,487
    
    
    $
    
    
    
    $
    7,601Net investment income
    
    
    426
    
    
    
    514
    
    
    
    1,218
    
    
    
    1,612Net realized gains (losses)
    
    
    43
    
    
    
    (434
    )
    
    
    (59
    )
    
    
    (466
    )Other revenue
    
    
    1
    
    
    
    219
    
    
    
    1
    
    
    
    219Total revenues
    
    
    470
    
    
    
    2,786
    
    
    
    1,160
    
    
    
    8,966Expenses:Loss and loss adjustment expenses
    
    
    
    
    
    
    1,926
    
    
    
    
    
    
    
    5,341Insurance acquisition expenses
    
    
    
    
    
    
    584
    
    
    
    
    
    
    
    1,249General and administrative expenses
    
    
    
    
    
    
    63
    
    
    
    
    
    
    
    840Accretion of loss and loss
adjustment expenses to fair value
    
    
    
    
    
    
    51
    
    
    
    
    
    
    
    193Total expenses
    
    
    
    
    
    
    2,624
    
    
    
    
    
    
    
    7,623Pretax income
    
    
    470
    
    
    
    162
    
    
    
    1,160
    
    
    
    1,343Federal income tax expense
    
    
    (164
    )
    
    
    (57
    )
    
    
    (406
    )
    
    
    (470
    )Net income
    
    
    306
    
    
    
    105
    
    
    
    754
    
    
    
    873Net change in unrealized gains and
losses for investments held, after
tax
    
    
    240
    
    
    
    (430
    )
    
    
    (214
    )
    
    
    (42
    )Recognition of unrealized gains
and losses for investments sold,
after tax
    
    
    (28
    )
    
    
    282
    
    
    
    38
    
    
    
    303Comprehensive net income
    
    $
    518
    
    
    $
    (43
    )
    
    $
    578
    
    
    $
    1,134
 The accompanying notes are an integral part of these financial statements. 15




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##### 



Potomac Insurance Company Of Illinois
Statements Of Stockholders Equity
(Unaudited) AccumulatedothercomprehensiveStockholders
    
    Common
    
    Paid-in
    
    Retained
    
    income,(in thousands)
    
    equity
    
    stock
    
    capital
    
    Earnings
    
    net of taxBalances at January 1, 2003
    
    $
    41,171
    
    
    $
    4,200
    
    
    $
    36,163
    
    
    $
    145
    
    
    $
    663Net income
    
    
    873
    
    
    
    
    
    
    
    
    
    
    
    873
    
    
    
    Net change in unrealized
gains, net of tax
    
    
    261
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    261Balances at September 30, 2003
    
    $
    42,305
    
    
    $
    4,200
    
    
    $
    36,163
    
    
    $
    1,018
    
    
    $
    924
 AccumulatedothercomprehensiveStockholders
    
    Common
    
    Paid-in
    
    Retained
    
    income,(in thousands)
    
    equity
    
    stock
    
    capital
    
    earnings
    
    net of taxBalances at January 1, 2004
    
    $
    42,505
    
    
    $
    4,200
    
    
    $
    36,163
    
    
    $
    1,504
    
    
    $
    638Net income
    
    
    754
    
    
    
    
    
    
    
    
    
    
    
    754
    
    
    
    Net change in unrealized
gains, net of tax
    
    
    (176
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (176
    )Balances at September 30, 2004
    
    $
    43,083
    
    
    $
    4,200
    
    
    $
    36,163
    
    
    $
    2,258
    
    
    $
    462
 The accompanying notes are an integral part of these financial statements. 16




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##### 



Potomac Insurance Company Of Illinois
Statements Of Cash Flows
(Unaudited) Nine months ended September 30,(in thousands)
    
    2004
    
    2003Cash flows from operations:Net income
    
    $
    754
    
    
    $
    873Charges (credits) to reconcile net income to cash flows from operations:Federal income tax expense
    
    
    406
    
    
    
    470Net realized losses
    
    
    59
    
    
    
    466Net change in:Reinsurance recoverable on paid and unpaid losses
    
    
    28,097
    
    
    
    25,743Loss and loss adjustment expense reserves
    
    
    (43,106
    )
    
    
    (28,404
    )Unearned insurance premiums
    
    
    (4,767
    )
    
    
    (1,382
    )Deferred acquisition costs
    
    
    674
    
    
    
    (19
    )Payable to affiliates
    
    
    4,428
    
    
    
    262Other, net
    
    
    239
    
    
    
    147Net cash flows used for operations
    
    
    (13,216
    )
    
    
    (1,844
    )Cash flows from investing activities:Net decrease (increase) in short-term investments
    
    
    3,021
    
    
    
    (9,273
    )Sales of fixed maturity investments
    
    
    15,031
    
    
    
    261,712Redemptions, calls and maturities of fixed maturity investments
    
    
    13,831
    
    
    
    52,344Purchases of fixed maturity investments
    
    
    (24,171
    )
    
    
    (323,350
    )Unsettled net investment purchases (sales)
    
    
    
    
    
    
    358Net cash flows provided by (used for) investing activities
    
    
    7,712
    
    
    
    (18,209
    )Cash flows provided by financing activities
    
    
    
    
    
    
    Net decrease in cash and cash equivalents during period
    
    
    (5,504
    )
    
    
    (20,053
    )Cash and cash equivalent balances at beginning of period
    
    
    10,307
    
    
    
    33,673Cash and cash equivalent balances at end of period
    
    $
    4,803
    
    
    $
    13,620
 The accompanying notes are an integral part of these financial statements. 17




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##### 



Potomac Insurance Company Of Illinois
Notes to Financial Statements NOTE 1 -  NATURE OF OPERATIONS Potomac Insurance Company of Illinois (Potomac) was incorporated in 1981 and
is principally engaged in property and casualty insurance operations. Potomac
is domiciled in Illinois and is licensed in 41 states and the District of
Columbia at September 30, 2004. Potomac is a wholly-owned subsidiary of OneBeacon Insurance Company
(OneBeacon). On June 1, 2001, White Mountains Insurance Group, Ltd. (White
Mountains), the ultimate parent company, acquired OneBeacon Insurance Group
LLC (OneBeacon Group) which owns OneBeacon. Through December 31, 2003, Potomac was a participant in the OneBeacon Amended
and Restated Reinsurance (Pooling) Agreement (the Pool). Under this
agreement Potomac ceded all of its insurance assets, liabilities, revenues and
expenses into a pool (the Pool) and assumed a 0.5% share of the Pools assets
and liabilities. As of January 1, 2004, Potomac ceased its participation in the
Pool and entered into a transfer and assumption agreement whereby it
transferred all of its direct insurance business written to OneBeacon. The
cessation of the Pool has significantly affected the comparability of the
financial statement information presented herein. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying financial statements of Potomac have been prepared in
conformity with accounting principles generally accepted in the United States
of America (GAAP) for interim financial information. The financial statements include all adjustments considered necessary by
management to fairly present the financial position, results of operations and
cash flows of Potomac. These interim financial statements may not be
indicative of financial results for the full year. The preparation of
financial statements in conformity with GAAP requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates. The acquisition of Potomac on June 1, 2001 was accounted for by the purchase
method of accounting and, therefore, the identifiable assets and liabilities
acquired were recorded at their fair values on June 1, 2001. The process of
determining the fair value of such assets and liabilities acquired, as required
under purchase accounting, was undertaken as follows: (i) the purchase price of
Potomac was preliminarily allocated to the acquired assets and liabilities,
based on their respective estimated fair values at June 1, 2001; (ii) the
excess of acquired net assets over the purchase price was used to reduce the
estimated fair values of all non-current, non- 18




---



##### 



financial assets acquired to zero; and (iii) the remaining excess of the
estimated fair value of net assets over the purchase price was recorded as a
deferred credit. In accordance with the purchase method of accounting, on June 1, 2001, White
Mountains increased the net assets of Potomac by $770 ($499 after tax)
representing adjustments to reflect the estimated fair value of Potomacs
assets and liabilities assumed. This increase was primarily comprised of a
pretax adjustment of $1,500 ($975 after tax) resulting from fair value
adjustments made to Potomacs loss and loss adjustment expense reserves and
related reinsurance recoverables, offset by a pretax adjustment of $730 ($476
after tax) resulting from write-offs of Potomacs non-current, non-financial
assets. Potomacs resulting deferred credit relating to White Mountains
acquisition of Potomac totaled $3,410 at June 1, 2001. Upon the adoption of
Statement of Financial Accounting Standards No. 141, Potomac recognized its
remaining unamortized deferred credit balance of $3,126 as a cumulative effect
of a change in accounting principle on January 1, 2001. Each of these
adjustments was pushed-down to Potomacs books at June 1, 2001. Cash and Investments Cash and cash equivalents include cash on hand, money market funds and
investments with remaining maturities of three months or less, as determined on
the date of purchase. Short-term investments consist of investments with
remaining maturities of more than three months but less than one year, as
determined on the date of purchase. Fixed maturity investments are designated as available-for-sale.
Available-for-sale securities are reported at estimated fair value, with
changes in fair value reflected in other comprehensive income net of applicable
federal income taxes. Estimated fair values are based on quoted values.
Premiums and discounts on fixed maturity investments are accreted to income
over the anticipated life of the investment. Investment securities are regularly reviewed for impairment based on criteria
that include the extent to which cost exceeds market value, the duration of the
market decline, and the financial health of and specific prospects for the
issuer. Investment losses that are other-than-temporary are recognized in
earnings. Investment income is recorded when earned. Realized investment gains and
losses are recognized using the weighted average method. Earned and Unearned Insurance Premiums Premiums are recognized as revenue over the coverage period of policies written
on a daily pro rata basis. Unearned insurance premiums represent the portion
of premiums written relating to the remaining term of each policy. As of January 1, 2004, Potomac ceased participating in the Pool and transferred
its allowances for uncollectible earned premiums to OneBeacon. As of December
31, 2003, Potomac had established allowances for uncollectible earned premiums
of $115. For the three and nine 19




---



##### 



months ended September 30, 2003, Potomac incurred $26 and $48 in write-offs,
respectively, relating to uncollectible earned premiums. Deferred Policy Acquisition Costs Commissions and other costs of acquiring new business that vary with and are
primarily related to the production of new business are generally deferred.
Deferred policy acquisition costs are amortized over the coverage period of the
related insurance policies. Balances of deferred policy acquisition costs are
regularly evaluated for recoverability and amounts not expected to be
recoverable are expensed. As of January 1, 2004 with its withdrawal from the
Pool, Potomac transferred its deferred acquisition costs to OneBeacon. Loss and Loss Adjustment Expenses Liabilities for loss and loss adjustment expenses (LAE) are comprised of case
basis estimates for claims and claim expenses reported prior to period-end and
estimates of incurred but not reported (IBNR) losses and loss expenses, net
of estimated salvage and subrogation recoverable. These estimates are recorded
gross of reinsurance and are continually reviewed and updated with any
resulting adjustments reflected in current operating results. Potomac
discounts certain of its net long-term workers compensation loss and LAE
reserves when such liabilities constitute unpaid but settled claims under which
the payment pattern and ultimate costs are fixed and determinable on an
individual claim basis. Potomac discounts these reserves using a discount rate
which is determined based on the facts and circumstances applicable at the time
the claims are settled (4.7% at December 31, 2003). As of September 30, 2004
and December 31, 2003, the discount on Potomacs net workers compensation loss
and LAE reserves amounted to $0 and $190, respectively. Case reserves are estimated based on the experience and knowledge of claims
staff regarding the nature and potential cost of each claim and are adjusted as
additional information becomes known or payments are made. IBNR reserves are
regarded as the most uncertain reserve segment and are derived by subtracting
paid loss and LAE and case reserves from estimates of ultimate loss and LAE.
Actuaries estimate ultimate loss and LAE using various generally accepted
actuarial methods applied to known losses and other relevant information. Like
case reserves, IBNR reserves are adjusted as additional information becomes
known or payments are made. Ultimate loss and LAE are generally determined by extrapolation of claim
emergence and settlement patterns observed in the past that can reasonably be
expected to persist into the future. In forecasting ultimate loss and LAE with
respect to any line of business, past experience with respect to that line of
business is the primary resource, but cannot be relied upon in isolation.
Potomacs own experience, particularly claims development experience, such as
trends in case reserves, payments on and closings of claims, as well as changes
in business mix and coverage limits, is the most important information for
estimating its reserves. External data, available from organizations such as
statistical bureaus, consulting firms and reinsurance companies, is sometimes
used to supplement or corroborate Potomacs own experience, and can be
especially useful for estimating costs of new business. 20




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##### 



Reinsurance All of Potomacs reinsurance recoverables are due from OneBeacon. See Note 5.
Amounts recoverable from OneBeacon are estimated in a manner consistent with
the claim liability associated with the reinsured policies. The collectibility
of Potomacs reinsurance recoverables is subject to the solvency of OneBeacon. Reinsurance premiums, commissions, expense reimbursements and reserves related
to reinsured business are accounted for on a basis consistent with those used
in accounting for the original policies issued and the terms of the reinsurance
contracts. Premiums ceded to OneBeacon are reported as a reduction of premiums
written. Expense allowances received in connection with reinsurance ceded to
OneBeacon have been accounted for as a reduction of the related policy
acquisition costs and are deferred and amortized accordingly. New York Assigned Risk Market The Pool writes voluntary personal automobile insurance in the State of New
York. As a condition to its license to write automobile business within that
state, the Pool is obligated by statute to accept future assignments from the
New York Automobile Insurance Plan (NYAIP), a residual insurance market that
obtains personal automobile insurance for those individuals who cannot
otherwise obtain it in the voluntary insurance market. The share of
involuntary written premium for policies assigned by the NYAIP to a particular
insurer in a given year is based, in general, on its proportion of the total
voluntary writings in New York two years prior. Therefore, by voluntarily
writing automobile policies in New York, an insurer has an obligation under New
York State insurance laws to provide insurance two years later to individuals
assigned to it from the NYAIP. Alternatively, an insurance company can
contractually satisfy its NYAIP obligation by either transferring its NYAIP
assignments to another insurance company or by utilizing various credits
offered by New York to those insurers who voluntarily write policies for
individuals in the NYAIP. As of September 30, 2004 and December 31, 2003,
Potomacs net reserves for NYAIP assignments was $0 and $175, respectively. Federal Income Taxes Potomac is included in the consolidated U.S. tax return of Fund American
Enterprises Holdings, Inc. (Fund American). Under a written tax sharing
arrangement with Fund American, Potomac is allocated tax based upon the
liability of the group if it had filed its return on a stand-alone basis.
Current federal income taxes are charged or credited to operations based upon
amounts estimated to be payable or recoverable as a result of taxable
operations for the period. Deferred income tax assets and liabilities are recognized based on temporary
differences between financial statement carrying amounts and income tax bases
of assets and liabilities using enacted income tax rates and laws. Potomacs
income tax provision for the periods presented did not differ from the expected
income tax rate of 35% as Potomac did not have any significant items requiring
differing treatment for financial and income tax purposes. 21




---



##### 



Recent Accounting
Pronouncements There are no recent accounting pronouncements that are expected to have a
material effect on Potomac. NOTE 3 - INVESTMENTS The cost or amortized cost and estimated fair values of fixed maturities were
as follows: Cost or
    
    Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    Estimated FairSeptember 30, 2004
    
    Cost
    
    Gains
    
    Losses
    
    ValueU.S. government obligations
    
    
    10,039
    
    
    
    430
    
    
    
    
    
    
    
    10,469Corporate obligations
    
    
    15,411
    
    
    
    299
    
    
    
    (60
    )
    
    
    15,650Foreign government obligations
    
    
    3,498
    
    
    
    82
    
    
    
    
    
    
    
    3,580Asset-backed securities
    
    
    2,494
    
    
    
    
    
    
    
    (40
    )
    
    
    2,454Total fixed maturities
    
    
    31,442
    
    
    
    811
    
    
    
    (100
    )
    
    
    32,153December 31, 2003U.S. government obligations
    
    $
    19,577
    
    
    $
    685
    
    
    $
    (48
    )
    
    $
    20,214Corporate obligations
    
    
    14,203
    
    
    
    335
    
    
    
    
    
    
    
    14,538Asset-backed securities
    
    
    2,331
    
    
    
    10
    
    
    
    
    
    
    
    2,341Total fixed maturities
    
    $
    36,111
    
    
    $
    1,030
    
    
    $
    (48
    )
    
    $
    37,093
 Information relating to Potomacs investments for the three and nine months
ended September 30 is shown below: Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Proceeds from voluntary sales
    
    
    7,842
    
    
    
    127,602
    
    
    
    15,031
    
    
    
    261,712Gross realized gains
    
    
    43
    
    
    
    79
    
    
    
    144
    
    
    
    793Gross realized losses
    
    
    
    
    
    
    (513
    )
    
    
    (203
    )
    
    
    (1,259
    )
 Temporary losses on investment securities are recorded as unrealized losses.
Temporary losses do not impact net income but do reduce comprehensive net
income and shareholders equity. Unrealized losses subsequently identified as
other-than-temporary impairments are recorded as realized losses. Potomacs methodology of assessing other-than-temporary impairment charges on
its investments is based on security-specific facts, circumstances and
intentions as of the balance sheet date. Potomac did not record and
other-than-temporary impairment charges for the three and nine months ended
September 30, 2004 and 2003. The components of net investment income for the three and nine months ended
September 30 were as follows: 22




---



##### 



Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Fixed maturities
    
    
    440
    
    
    
    562
    
    
    
    1,268
    
    
    
    1,668Short-term investments
    
    
    22
    
    
    
    20
    
    
    
    39
    
    
    
    98Other investment income
    
    
    
    
    
    
    9
    
    
    
    11
    
    
    
    23Gross investment income
    
    
    462
    
    
    
    591
    
    
    
    1,318
    
    
    
    1,789Less: investment expenses
    
    
    (36
    )
    
    
    (77
    )
    
    
    (100
    )
    
    
    (177
    )Net investment income
    
    
    426
    
    
    
    514
    
    
    
    1,218
    
    
    
    1,612
 Potomac participates in a securities lending program whereby it loans
investment securities to other institutions for short periods of time. Potomac
receives a fee from the borrower in return for the use of its assets. The
program initially requires collateral equal to 102% of the fair value of the
loaned securities, which is held by a third party. The fair value of the
collateral is evaluated daily and, in the event it falls below 100% of the fair
value of the loaned securities, Potomac has the right to demand that it be
immediately increased to an amount equal to 102% of the fair value of the
loaned securities. All securities loaned can be redeemed on short notice. The
total market value of Potomacs securities on loan at September 30, 2004 was
$5,412 with corresponding collateral of $5,537. NOTE 4  UNPAID LOSS AND LOSS ADJUSTMENT EXPENSES Loss and LAE reserves are estimates of amounts needed to pay claims and related
expenses in the future for insured events that have already occurred. Potomac
establishes estimates of amounts recoverable from its reinsurers in a manner
consistent with the claim liability covered by the reinsurance contracts, net
of an allowance for uncollectible amounts. Net loss and LAE reserves represent
gross loss and LAE reserves reduced by reinsurance recoverable on unpaid
losses. Potomacs Loss and LAE reserves represent managements best estimate
of reserves based on a composite of the results of the various actuarial
methods, as well as consideration of known facts and trends.Potomac believes
that its reserves are reasonably stated; however, since the process of
estimating Loss and LAE reserves involves a considerable degree of judgment by
management, ultimate loss and LAE for past accident years may deviate, perhaps
materially, from the amounts currently reflected. Changes in the liability for unpaid losses and LAE for the three and nine
months ended September 30 were as follows: 23




---



##### 



Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Beginning of period:Gross
    
    
    115,771
    
    
    
    175,163
    
    
    $
    154,287
    
    
    $
    193,672Less reinsurance recoverables
    
    
    (115,771
    )
    
    
    (157,760
    )
    
    
    (139,009
    )
    
    
    (174,463
    )Net
    
    
    
    
    
    
    17,403
    
    
    
    15,278
    
    
    
    19,209Incurred losses and LAE relating to:Current year
    
    
    
    
    
    
    1,472
    
    
    
    
    
    
    
    4,893Prior years
    
    
    
    
    
    
    454
    
    
    
    
    
    
    
    448Total incurred losses and LAE
    
    
    
    
    
    
    1,926
    
    
    
    
    
    
    
    5,341Accretion of loss and LAE reserves to fair value
    
    
    
    
    
    
    51
    
    
    
    
    
    
    
    193Transfer of loss and LAE reserves to OneBeacon
    
    
    
    
    
    
    
    
    
    
    (15,278
    )
    
    
    Paid losses and LAE related to:Current year
    
    
    
    
    
    
    892
    
    
    
    
    
    
    
    2,207Prior years
    
    
    
    
    
    
    2,138
    
    
    
    
    
    
    
    6,186Total paid losses and LAE
    
    
    
    
    
    
    3,030
    
    
    
    
    
    
    
    8,393End of period:Net
    
    
    
    
    
    
    16,350
    
    
    
    
    
    
    
    16,350Plus reinsurance recoverables
    
    
    111,181
    
    
    
    148,918
    
    
    
    111,181
    
    
    
    148,918Gross
    
    
    111,181
    
    
    
    165,268
    
    
    
    111,181
    
    
    
    165,268
 The net unfavorable development on prior year loss and LAE reserves in the
third quarter of 2003 primarily related to construction defect claims as part
of the review of all claims recalled from a third party administrator. In connection with purchase accounting for Potomac, White Mountains was
required to adjust the fair value of Potomacs loss and LAE reserves and the
related reinsurance recoverables by $3,234 and $1,734, respectively, on
Potomacs balance sheet at June 1, 2001. Through December 31, 2003, this
reduction to net loss and LAE reserves was being accreted through an income
statement charge over the period that the claims were expected to be settled.
As a result, Potomac recognized $193 of accretion to loss and LAE reserves
during the nine months ended September 30, 2003. In connection with Potomacs
transfer and assumption agreement, all loss and LAE reserves and related
reinsurance recoverables on which the fair value adjustment was recorded were
transferred to OneBeacon as of January 1, 2004. In connection with the de-pooling on January 1, 2004, Potomac ceded to OBIC net
loss and LAE reserves of $15,278, unearned insurance premiums of $4,097, other
net insurance related liabilities of $77 and short-term investments of $19,298. NOTE 5  RELATED PARTY TRANSACTIONS As of December 31, 2003, Potomac ceased its participation in the Pool and
entered into a transfer and assumption agreement whereby it transferred all of
its direct insurance business written to 24




---



##### 



OneBeacon. As a result, Potomac no longer has any insurance assets or
liabilities on a net basis and will not share in any favorable or unfavorable
development of prior year losses recorded by the Pool after January 1, 2004
unless OneBeacon fails to perform under the transfer and assumption agreement
as a result of insolvency. Potomac recorded a payable from OneBeacon in the amount of $4,453 at
September 30, 2004 which represents a net settlement with OneBeacon resulting
from its cessation from the Pool. Potomac has a service contract with White Mountains Advisors LLC (Advisors),
a wholly-owned subsidiary of OneBeacon. Under this agreement, Advisors
provides investment research and advice, including the execution of orders for
the purchase and sale of securities. The amounts charged to Potomac by
Advisors for such services are based on a fixed fee applied to the month-end
market values of the investments being managed. During the three and nine
months ended September 30, 2004, Potomac incurred a total of $31 and $95 of
fees and expenses, respectively, with Advisors for services
provided. During the three and nine months ended September 30, 2003, Potomac
incurred a total of $46 and $146 of fees and expenses, respectively, with Advisors
for services provided. Potomac believes that the fees and expenses being charged by
Advisors are reasonable and that such amounts do not differ materially from the
amounts that Potomac would expect to pay to an unaffiliated entity for such
services. NOTE 6 - CONTINGENCIES Under existing guaranty fund laws in all states, insurers licensed to do
business in those states can be assessed for certain obligations of insolvent
insurance companies to policyholders and claimants. In accordance with
Statement of Position 97-3, Accounting by Insurance and Other enterprises for
Insurance-Related Assessments (SOP 97-3), Potomac records guaranty fund
assessments when the loss is probable and the assessment amount can be
reasonably estimated. At September 30, 2004 and December 31, 2003, Potomac
recorded $0 and $119 for such assessments, respectively. Potomac is involved in litigation incurred in the normal settlement of claims
liabilities. In the opinion of management, provision has been made in the
financial statements for estimated losses that may result. NOTE 7  SUBSEQUENT EVENT On November 23, 2004, OneBeacon sold Potomac to Specialty Underwriters
Alliance, Inc. for $21,752 in cash. 25




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##### 



C. Pro Forma Financial Statements SUMMARY UNAUDITED PRO FORMA FINANCIAL INFORMATION
(DOLLARS IN THOUSANDS) You should read the summary pro forma financial information set forth below in
conjunction with the financial statements and related notes. The following unaudited pro forma financial information assumes our initial
public offering (IPO) was completed and the net proceeds were applied,
including the purchase of Potomac, as if these actions had occurred as of
September 30, 2004 with respect to the pro forma balance sheet and as of
January 1, 2003 with respect to the pro forma statement of operations for
the period ended December 31, 2003 and for the nine months ended September
30, 2004. UNAUDITED PRO FORMA BALANCE SHEET At September 30, 2004SpecialtyPotomac Historical
    
    Underwriters
    
    Offering
    
    Purchase of Potomac by SUAin thousands
    
    Predecessor (a)
    
    Alliance (b)
    
    Proceeds
    
    (h)
    
    Pro formaAssetsFixed maturity securities, at fair value
    
    $
    32,153
    
    
    $
    
    
    
    
    
    
    
    $
    
    
    
    $
    (32,153
    )
    
    $
    Cash and short-term investments
    
    
    13,802
    
    
    
    253
    
    
    
    (c
    )
    
    
    123,628(f
    )
    
    
    250(g
    )
    
    
    800
    
    
    
    (23,552
    )
    
    
    115,181Reinsurance recoverable on paid and unpaid
losses and unearned premiums
    
    
    111,249
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    111,249Other assets
    
    
    1,623
    
    
    
    1,465
    
    
    
    
    
    
    
    
    
    
    
    (2,623
    )
    
    
    465Deferred charges
    
    
    
    
    
    
    1,160
    
    
    
    (c
    )
    
    
    (1,160
    )
    
    
    
    
    
    
    Intangible assets
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,750
    
    
    
    10,750Total Assets
    
    $
    158,827
    
    
    $
    2,878
    
    
    
    
    
    
    $
    123,518
    
    
    $
    (47,578
    )
    
    $
    237,645$
    Liabilities and shareholders equityLoss and loss adjustment expense reserves
    
    $
    111,181
    
    
    
    
    
    
    
    
    
    
    $
    
    
    
    $
    
    
    
    $
    111,181Unearned insurance premiums
    
    
    68
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    68Short-term debt
    
    
    
    
    
    
    3,900
    
    
    
    (d
    )
    
    
    (3,900
    )
    
    
    
    
    
    
    Accounts payable and other liabilities
    
    
    4,495
    
    
    
    4,945
    
    
    
    
    
    
    
    
    
    
    
    (4,495
    )
    
    
    4,945Accrued interest
    
    
    
    
    
    
    166
    
    
    
    (d
    )
    
    
    (166
    )
    
    
    
    
    
    
    Stock warrants
    
    
    
    
    
    
    3,996
    
    
    
    (e
    )
    
    
    (3,996
    )
    
    
    
    
    
    
    Total liabilities
    
    
    115,744
    
    
    
    13,007
    
    
    
    
    
    
    
    (8,062
    )
    
    $
    (4,495
    )
    
    
    116,194Common shares
    
    
    4,200
    
    
    
    
    
    
    
    (c
    )
    
    
    141(d
    )
    
    
    5(g
    )
    
    
    1
    
    
    
    (4,200
    )
    
    
    147Class B common shares
    
    
    
    
    
    
    
    
    
    
    (f
    )
    
    
    
    
    
    
    
    
    
    
    Additional paid-in capital
    
    
    36,163
    
    
    
    
    
    
    
    (c
    )
    
    
    122,327(d
    )
    
    
    4,061(f
    )
    
    
    250(g
    )
    
    
    799
    
    
    
    (36,163
    )
    
    
    127,437Retained earnings
    
    
    2,258
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,258
    )
    
    
    Accumulated deficit
    
    
    
    
    
    
    (10,129
    )
    
    
    (e
    )
    
    
    3,996
    
    
    
    
    
    
    
    (6,133
    )Accumulated other comprehensive income
    
    
    462
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (462
    )
    
    
    Total shareholders equity
    
    
    43,083
    
    
    
    (10,129
    )
    
    
    
    
    
    
    131,580
    
    
    
    (43,083
    )
    
    
    121,451Total liabilities and shareholders equity
    
    $
    158,827
    
    
    $
    2,878
    
    
    
    
    
    
    $
    123,518
    
    
    $
    (47,578
    )
    
    $
    237,645
 Footnotes following on next page 26




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##### 



(a)
    
    Amounts reflecting the unaudited balance sheet of Potomac at September 30,
2004.(b)
    
    Amounts reflecting the unaudited balance sheet of Specialty Underwriters
Alliance, Inc. at September 30, 2004.(c)
    
    Reflects the proceeds of our IPO, after the exercise of the over-allotment, and the concurrent private placement of
$123.6 million based on (1) 13.1 million shares at the estimated offering price of
$9.50 per share, less the initial purchasers discount/placement fee of $8.7
million and (2) 1 million shares offered in the concurrent private placement at
the initial public offering price of $9.50 per share, less an amount equal to
underwriting discounts and commissions of $0.7 million, and other estimated
offering costs of $2.3 million, including $1.2 million of deferred offering costs
recorded at September 30, 2004.(d)
    
    Upon completion of our IPO, short term-debt and accrued interest was due and
payable to FBR, SAIL and to certain executive officers upon completion of the
offering in stock at the offering price less the underwriting discounts and
commissions.(e)
    
    As of September 30, 2004, warrants for shares valued at $4.0 million with a
strike price of $0.01 per share were held by FBR, SAIL and one executive officer
in conjunction with the short-term debt. Subsequent to September 30, 2004 these
warrants were canceled, resulting in a $4.0 million gain. This gain is not
included in the pro forma summary of operations because it is non-recurring.(f)
    
    Concurrent with the completion of our IPO 26,316 shares of Class B common
shares with a par value of $0.01 per share were issued to partner agents in
exchange for $250,000 in cash.(g)
    
    Concurrent with the completion our IPO, our executive officers purchased
90,549 shares at a purchase price of $8.835 per share for an aggregate price of
$0.8 million. 27




---



##### 



(h)
    
    Prior to the completion of the acquisition, OneBeacon liquidated all of
Potomacs assets other than cash and certain investments backing statutory capital and
surplus, and settled or assumed all Potomacs remaining non-insurance liabilities.
In addition, Potomac made a distribution to OneBeacon prior to closing which
reduced its statutory capital and surplus to $11.3 million. $21.1 million of the
proceeds of the IPO were used to purchase the outstanding shares of Potomac from
OneBeacon. The purchase price consisted of $11.3 million of statutory capital and
surplus and $10.5 million for 42 licenses at $250,000 each, less a deposit of $1.0
million, plus transaction costs. The $23.6 million reduction in cash and
short-term investments in the pro forma balance sheet consists of the $21.1
million paid to OneBeacon at the closing of the acquisition and the $2.5 million
reduction in cash and short-term investments from $13.8 million at September 30,
2004 to $11.3 million at closing. The cost of insurance licenses is an indefinite
life intangible asset because they will remain in effect indefinitely as long as
Potomac complies with relevant state insurance regulations. This intangible asset
will not be amortized, but will be evaluated for impairment at least annually or
upon the occurrence of certain triggering events. Additionally, the pro forma
liabilities include Potomacs direct loss and loss adjustment expense reserves of
$111.2 million and the direct unearned insurance premiums of $0.1 million. Pro
forma assets include an offsetting $111.3 million of reinsurance recoverables due
from OneBeacon. 28




---



##### 



We caution you that the pro forma statement of operations information presented
is neither comparable with nor representative of the results that we expect to
achieve as an operating company after the IPO. The existing in-force insurance
obligations of Potomac have been reinsured to OneBeacon prior to closing the
acquisition of Potomac so there will be no future revenues or losses arising
from Potomacs historical in-force insurance business unless OneBeacon failed
to perform on its reinsurance obligations. The pro forma statement of operations includes adjustments to exclude all
insurance operations of Potomac and net investment income and realized
gains/losses of Potomac to reflect the effect of reinsuring Potomacs
historical in-force insurance to OneBeacon. As an operating company after the completion of our IPO, we intend to begin writing new business with a
core group of partner agents in the specialty commercial insurance market that
will serve niche groups of insureds that require highly specialized business
knowledge of each business class to achieve underwriting profits. The pro
forma statement of operations does not include this future new business. Unaudited Pro Forma Statement of Operations Potomac
    
    SpecialtyHistorical
    
    Underwriters
    
    Purchase ofin thousands
    
    Predecessor (a)
    
    Alliance (c)
    
    Potomac(b)
    
    Pro formaFor the periods ended December 31, 2003:Revenues:Earned insurance premiums
    
    $
    9,961
    
    
    $
    
    
    
    $
    (9,961
    )
    
    $
    Net investment income
    
    
    2,128
    
    
    
    
    
    
    
    (2,128
    )
    
    
    Net realized losses
    
    
    (466
    )
    
    
    
    
    
    
    466
    
    
    
    Other revenue
    
    
    318
    
    
    
    
    
    
    
    (318
    )
    
    
    Total revenue
    
    
    11,941
    
    
    
    
    
    
    
    (11,941
    )
    
    
    Expenses:Loss and loss adjustment expenses
    
    
    7,064
    
    
    
    
    
    
    
    (7,064
    )
    
    
    Insurance acquisition expenses
    
    
    1,843
    
    
    
    
    
    
    
    (1,843
    )
    
    
    Financing expenses
    
    
    
    
    
    
    157
    
    
    
    
    
    
    
    157General and administrative expenses
    
    
    939
    
    
    
    421
    
    
    
    (939
    )
    
    
    421Total expenses
    
    
    9,846
    
    
    
    578
    
    
    
    (9,846
    )
    
    
    578Income before income taxes
    
    
    2,095
    
    
    
    (578
    )
    
    
    (2,095
    )
    
    
    (578
    )Federal income tax expense
    
    
    736
    
    
    
    
    
    
    
    (736
    )
    
    
    Net income/(loss)
    
    $
    1,359
    
    
    $
    (578
    )
    
    $
    (1,359
    )
    
    $
    (578
    )For the nine months ended
September 30, 2004Revenues:Earned insurance premiums
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Net investment income
    
    
    1,218
    
    
    
    
    
    
    
    (1,218
    )
    
    
    Net realized losses
    
    
    (59
    )
    
    
    
    
    
    
    59
    
    
    
    Other revenue
    
    
    1
    
    
    
    
    
    
    
    (1
    )
    
    
    Total revenue
    
    
    1,160
    
    
    
    
    
    
    
    (1,160
    )
    
    
    Expenses:Loss and loss adjustment expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Insurance acquisition expenses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Financing expenses
    
    
    
    
    
    
    4,044
    
    
    
    
    
    
    
    4,044General and administrative expenses
    
    
    
    
    
    
    5,507
    
    
    
    
    
    
    
    5,507Total expenses
    
    
    
    
    
    
    9,551
    
    
    
    
    
    
    
    9,551Income before income taxes
    
    
    1,160
    
    
    
    (9,551
    )
    
    
    (1,160
    )
    
    
    (9,551
    )Federal income tax expense
    
    
    406
    
    
    
    
    
    
    
    (406
    )
    
    
    Net income/(loss)
    
    $
    754
    
    
    $
    (9,551
    )
    
    $
    (754
    )
    
    $
    (9,551
    )
 Footnotes following on next page 29




---



##### 



(a)
    
    Amounts reflecting the audited statement of income of Potomac for the year
ended December 31, 2003 and the unaudited statement of income of Potomac for
the nine months ended September 30, 2004, respectively.(b)
    
    Potomac was a participant in a OneBeacon intercompany pooling arrangement
under which Potomac ceded all of its insurance business into the pool and
assumed a 0.5% of the pools insurance business. Potomac ceased its
participation in the pool effective as of January 1, 2004 and entered into
reinsurance agreements whereby it ceded all of its business to OneBeacon. As a
result, Potomac will not share in any favorable or unfavorable development of
prior losses recorded by it or the pool after January 1, 2004 unless OneBeacon
fails to perform on its reinsurance obligations. Pro forma liabilities include
Potomacs direct loss and loss adjustment expense reserves of $111.2 million
and the direct unearned insurance premiums of $0.1 million. Pro forma assets
include an offsetting $111.3.0 million of reinsurance recoverables due from
OneBeacon.Prior to the completion of the acquisition, OneBeacon liquidated
all of Potomacs assets other than cash and certain investments
and settled or assumed Potomacs remaining non-insurance
liabilities. As a result, Potomacs future earnings will be
limited to investment results on invested assets backing statutory
capital and surplus (before considering revenues and expenses from
insurance business expected to be written by us subsequent to our
acquisition of Potomac).(c)
    
    Amounts reflecting the audited statement of operations of Specialty
Underwriters Alliance, Inc. from April 3, 2003 (Date of Inception) to December
31, 2003 and the unaudited statement of operations of Specialty Underwriters
Alliance, Inc. for the nine months ended September 30, 2004, respectively. Item 2: Managements Discussion and Analysis of Financial Condition and Results
of Operations A. Managements Discussion and Analysis of Financial Condition and Results
of Operations for Specialty Underwriters Alliance, Inc. The following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our financial statements. Much of
the information contained in this discussion and analysis includes
forward-looking statements that involve risks and uncertainties. Many factors
will cause our actual results to differ materially from those anticipated or
implied by these forward-looking statements. Specialty Underwriters Alliance, Inc. General We were formed on April 3, 2003 for the purpose of achieving attractive
returns in the specialty program commercial property and casualty insurance
business by using an innovative business model. Specialty programs typically
serve niche groups of insureds that require highly 30




---



##### 



specialized knowledge of a business class to achieve underwriting profits.
This segment has traditionally been underserved by most standard commercial
property and casualty insurers, due to the complex business knowledge and the
investment required to achieve attractive underwriting profits. Competition in
this segment is based primarily on client service, availability of insurance
capacity, specialized policy forms, efficient claims handling and other
value-based considerations, rather than price. We have not commenced substantive operations. During the period from
January 1, 2004 to September 30, 2004, we incurred costs related to our IPO and
initial start-up costs for infrastructure required to commence insurance
operations generating an accumulated deficit of $10.1 million. Among these
activities, we engaged consultants to assist us in our business selection
process of partner agents, we contracted with SSC to assist us in reviewing the
business of those agents and developing underwriting and pricing guidelines, we
began the development of our key business processing systems with vendors and
consultants, and we began work on the development of our offering documents
together with our underwriter and legal counsel. Effective November 23, 2004,
we completed our IPO and concurrent private placement and concurrently
completed the acquisition of Potomac. Effective with the completion of our
IPO, we are in a position to conduct our intended business activities. We plan
to commence writing insurance utilizing the core group of partner agents
currently assembled. Because we are unlikely to seek to or obtain cancellations
of existing policies produced by our partner agents prior to the end of their
terms, we will seek to transition policies over a 12-month period following the
commencement of our insurance operations. Additionally, we must hire other key
employees, establish operating procedures, obtain facilities and implement new
systems during the remainder of 2004 in order to implement our business
strategy. As of September 30, 2004, we had not underwritten any insurance
business. Our business model stresses a partnership relationship with partner agents designed to better serve the specialty program commercial property and
casualty insurance marketplace by addressing the typical misalignment of
interests between agent and carrier. partner agents will receive up-front
commissions capable of covering their costs and meaningful underwriting
profit-based commissions payable over several years as compensation for writing
business for us. As a result of these commission arrangements, a substantial
amount of our commission expenses will be variable and will depend on the
underwriting profits of the business. Revenues We expect to derive the majority of our revenues from net earned premiums
from policies written by our insurance operations and investment income from
our investment portfolios. The amount of our insurance premiums written will
depend on the number and type of policies we write, as well as prevailing
market prices. We will strive to focus on the profitability over time of our
blocks of policies rather than amount of premiums. As a result, the volume of
premiums written may not be indicative of our ultimate expected profitability. Our investment income will depend on the amount of invested assets in our
investment portfolios and the yield that we earn on those invested assets. Our
investment yield is a function of market interest rates and the credit quality
and maturity period of our invested assets. Although we expect our investment
portfolio to principally include fixed-income securities, as of 31




---



##### 



September 30, 2004 our limited amount of invested assets was comprised
entirely of cash. In addition, we could realize capital gains or losses on
sales of investments as a result of changing market conditions, including
changes in market interest rates and changes in the credit quality of our
invested assets. Expenses We expect that our expenses will consist primarily of loss and loss
adjustment expenses, policy acquisition expenses and general and administrative
expenses. Loss and loss adjustment expenses (LAE) will depend on the number and
type of insurance contracts we write and will reflect our best estimate of
ultimate losses and loss adjustment expenses we expect to incur on each
contract written using various actuarial analyses. Actual loss and loss
adjustment expenses will depend on actual costs to settle insurance claims.
Our ability to accurately estimate ultimate loss and loss adjustment expense at
the time of pricing each insurance contract will be a critical factor in
determining our profitability. Policy acquisition expenses are expected to consist principally of
up-front commissions, fees, brokerage and tax expenses that are directly
related to obtaining and writing insurance contracts. Typically, policy
acquisition expenses are based on a certain percentage of the premiums written
on contracts of insurance. Since our commission expense will include
meaningful underwriting profit-based commission accruals, as well as up-front
commissions, our commission expense is likely to be higher in periods of
greater profitability and lower in periods with poorer underwriting results. We
expect that these expenses will be a function of the number and type of
insurance contracts written. General and administrative expenses will consist primarily of personnel
expenses, payments to providers of outsourced services, professional fees and
other operating overhead. We expect to use various third party service
providers as necessary to administer and manage the insurance business that we
underwrite. Additionally, from time to time we engage legal, accounting, tax
and financial advisors. General and administrative expenses are a function of
the development of our business, including the growth in personnel and the
overall volume of insurance contracts written. We plan to outsource most of our administrative services primarily to a
third-party services provider. Pursuant to these arrangements, we will pay a
fixed payment together with additional amounts based on other factors. As a
result, our administrative expenses generally will vary with the volume of our
business as well as the other factors. Results of Operations from January 1, 2004 to September 30, 2004 We were formed April 3, 2003 and did not have any financial activity until
our initial funding date of December 12, 2003. For the period from January 1, 2004 to September 30, 2004, we reported a
net loss of $9.6 million as a result of initial start-up costs while not
recording any revenues. Total expenses of $9.6 million were primarily
comprised of $4.1 million in financing costs (principally non-cash charges
related to the amortization of debt issue costs arising from the issuance of
warrants to our lenders, which were subsequently canceled), $2.2 million in consulting
fees, $2.5 million in service company fees and $0.6 million in legal expenses. 32




---



##### 



Liquidity and Capital Resources We are organized as a Delaware holding company and, as such, have no
direct operations of our own. Our assets are expected to consist primarily of
investments in our subsidiary, through which we will conduct substantially all
of our insurance operations. As a holding company, we will have continuing funding needs for general
corporate expenses, the payment of principal and interest on future borrowings,
if any, taxes and the payment of other obligations. Funds to meet these
obligations are expected to come primarily from dividends, interest and other
statutorily permissible payments from our operating subsidiary. The ability of
our operating subsidiary to make these payments will be limited by the
applicable laws and regulations of the domicile of the operating subsidiary.
There will be restrictions on the payment of dividends by our insurance
subsidiary to us. Liquidity Requirements Our principal consolidated cash requirements are expected to be the
servicing of future borrowing arrangements, if any, the acquisition of and
investment in operating subsidiaries, expenses to develop and implement our
business strategy, capital expenditures, premiums ceded, losses and loss
adjustment expenses, commissions, policy administration expenses, taxes and
other operating expenses. The potential for a large claim under one of our
insurance contracts means that we may need to make substantial and
unpredictable payments within relatively short periods of time. We currently
do not intend to declare dividends or make any other distributions to our
stockholders. Our board of directors plans to periodically reevaluate our
dividend policy. Our cash requirements also will include the payment of any
future dividends to our stockholders if and when our board of directors
determines to change our dividend policy. We expect to hire additional employees during the remainder of 2004. As a
result, we anticipate that our cash requirements for the payment of salaries
and benefits for these employees will increase in future periods as compared to
the period from January 1, 2004 to September 30, 2004. As of September 30, 2004, we have made capital expenditures of $0.5
million related to information systems. During the remainder of 2004, we intend
to make capital expenditures, principally related to information systems and
furniture and fixtures. In addition to these liquidity requirements, under the stock purchase
agreement with OneBeacon we will be required to pay an additional $9.5
million, plus the amount of Potomacs statutory capital and surplus as of the
closing date of the Acquisition. Sources of Cash Prior to completing our IPO, our sole source of cash was term loans. We
have entered into a short-term senior loan agreement with FBR, an affiliate of
Friedman, Billings, Ramsey & Co., Inc. and SAIL. Under this loan agreement,
the senior lenders agreed to provide term loans 33




---



##### 



of a maximum of $3.5 million at an interest rate of 12% per year. In
connection with this facility, we also agreed to issue warrants to acquire our
common stock to the senior lenders which were subsequently canceled. As of
September 30, 2004, the outstanding principal balance of the loans under these
agreements was $3.5 million. As payment of outstanding principal and interest
due and payable to the senior lenders, we have delivered to FBR and SAIL at the
completion of our IPO such number of shares of our common stock as could be
purchased at the initial public offering price less underwriting discounts and
commissions, for the aggregate amount outstanding under these loans. At such
time, the senior lenders commitment to provide additional loans under the loan
agreement terminated. We also have entered into a short-term subordinated loan agreement with
members of management, as subordinated lenders. Under the loan agreement, the
subordinated lenders agreed to provide term loans of a maximum of $0.4 million
at an interest at a rate of 12% per year. As of September 30, 2004, the
aggregate outstanding principal balance of the loans under this agreement was
$0.4 million. As payment of outstanding principal and interest due and payable
to the subordinated lenders, we have delivered to the subordinated lenders at
the completion of our IPO such number of shares of our common stock as could be
purchased at the initial public offering price less underwriting discounts and
commissions, for the aggregate amount outstanding under the subordinated loan
agreement. At such time, the subordinated lenders commitment to provide
additional loans under the loan agreement terminated. The proceeds of the loans were used to pay our operating expenses and pay
some of our offering expenses. We expect our future sources of funds will consist of net premiums
written, reinsurance ceding commissions and recoveries, investment income and
proceeds from sales and redemptions of investment assets. We do not have any borrowings outstanding as of the completion of our IPO.
Following completion of our IPO and the concurrent private placement, we may
raise additional funds from time to time. For example, we have entered into a
letter agreement with a prospective investor pursuant to which we would sell,
subject to a number of conditions (including acceptance of such securities by
the purchaser), $25 million of trust preferred securities with a maturity of 30
years, or other securities acceptable to such investor, prior to December 31,
2004. Such securities would bear interest at a floating rate based on the
three-month London Interbank Offered Rate, or LIBOR, plus a margin, as adjusted
from time to time. The securities would be redeemable at our option after a
five-year no-call period. However, there can be no assurance that we will issue
such securities on or prior to such time. For the period from January 1, 2004 to September 30, 2004, our increase in
cash was $0.1 million. Cash was provided from increases in borrowing from term
loans of $3.2 million. Net cash used by operating and investment activities
during the period from January 1, 2004 to September 30, 2004 totaled $3.1
million and was primarily related to costs incurred for our IPO, our initial
start-up costs and a non-refundable deposit relating to our acquisition of
Potomac. We have no off-balance sheet arrangements or transactions with
unconsolidated, special purpose entities. 34




---



##### 



Adequacy of Capital While insurance regulation differs by location, each jurisdiction requires
that minimum levels of capital be maintained in order to write new insurance
business. Factors that affect capital requirements generally include premium
volume, the extent and nature of loss and loss adjustment expense reserves, the
type and form of insurance business underwritten and the availability of
reinsurance protection from adequately rated reinsurers on terms that are
acceptable to us. Insurers are required to maintain certain minimum levels of capital and
risk-based capital, the calculation of which includes numerous factors as
specified by the respective insurance regulatory authorities and the related
insurance regulations. We will capitalize our insurance operations in excess
of the minimum regulatory requirements so that we may maintain adequate
financial ratings. Generally, a higher financial rating creates a higher
demand for insurance products. A higher financial rating will enable us to
both write more business and be more selective in the business we underwrite.
Accordingly, allocation of capital sufficient to achieve business objectives is
a critical aspect of any insurance organization, particularly a start-up
insurance operation such as ours. We believe that the proceeds of the IPO and the concurrent private
placement will be sufficient to execute our business strategy for at least the
next 12 months. We may need to raise additional funds to further expand our
business strategy, enter new business lines, and manage our expected growth or
to deal with higher than expected expenses or poorer than expected results. If we cannot maintain or obtain adequate capital to manage our business
strategy and expected growth targets, our business, results of operations and
financial condition may be adversely affected. Critical Accounting Policies Our significant accounting policies, as of December 31, 2003 and September
30, 2004, are described in the notes to our financial statements. After we begin our insurance operations, we expect that our financial
statements will contain certain amounts that are inherently subjective in
nature and require management to make certain judgments and assumptions in the
application of accounting policies used to determine those amounts reported in
the financial statements. The use of different assumptions could produce
materially different estimates of the reported amounts. We believe the
following critical accounting policies will affect significant estimates used
in the preparation of the financial statements after our IPO. Premium Income Net premiums written will consist of direct premiums written less ceded
premiums. The components of net premiums written will be recognized as revenue
over the period that coverage is provided. When premium rates increase, the
effect of those increases will not immediately affect earned premium. Rather,
those increases will be recognized ratably over the period of 35




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coverage. Unearned premiums and prepaid reinsurance premiums, which are
recorded on the balance sheets, will represent that portion of premiums written
that are applicable to the unexpired terms of policies in force. Investments We plan to classify all fixed maturity investment securities upon
acquisition as held-to-maturity, trading or available-for-sale securities.
Investments in held-to-maturity fixed maturities will be recorded at amortized
cost. Available-for-sale fixed maturities, trading fixed maturities and equity
securities will be reported at fair value. Short-term investments will be
recorded at cost. We plan to use quoted market prices in determining the fair value of fixed
maturities, equity securities and short-term investments in most cases. Where
quoted market prices are unavailable, we expect to base the estimate on recent
trading. Unrealized appreciation or depreciation of available-for-sale
investments carried at fair value will be excluded from net income and credited
or charged, net of applicable deferred income taxes, directly to accumulated
other comprehensive income, a separate component of stockholders equity. The
change in unrealized appreciation or depreciation during the year will be
reported as a component of other comprehensive income (loss). We plan to continually monitor the difference between our cost basis and
the estimated fair value of our investments. Our accounting policy for
impairment recognition for fixed maturities will require other-than-temporary
impairment charges to be recorded when we determine that it is probable we will
be unable to collect all amounts due according to the contractual terms of the
investment. Impairment charges on investments should be recorded based on the
fair value of the investments at the balance sheet date, and will be included
in net realized gains and losses. Factors considered in evaluating whether a
decline in value is other than temporary will include: the length of time and
the extent to which the fair value has been less than cost; the financial
conditions and near-term prospects of the issuer; and our intent and ability to
retain the investment for a period of time sufficient to allow for any
anticipated recovery. Deferred Policy Acquisition Costs We will establish an asset for deferred policy acquisition costs such as
up-front commissions, premium taxes and other variable costs incurred in
connection with writing our property and casualty lines of business. Deferred
policy acquisition costs will be amortized over the period of coverage of the
policies written. We will assess the recoverability of deferred policy
acquisition costs on a quarterly basis. We will not consider anticipated
investment income in determining the recoverability of these costs. The loss
and loss adjustment expense ratio we use to estimate the recoverability of
deferred costs is expected to be based primarily on the assumption that the
future loss and loss adjustment expense ratio will include consideration of the
recent experience. Such adjustments will be recorded through operations in the
period identified. Actual results could differ materially from such estimates,
requiring future adjustments to the recorded deferred policy acquisition cost
asset. 36




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Intangible Assets We expect to record an indefinite-life intangible asset for the value of
insurance licenses acquired in connection with the Acquisition based on the
excess of cost over the value of net tangible assets of acquired businesses.
If classified as goodwill or indefinite-lived intangible assets, these assets
will not be subject to amortization. If the aggregate fair value of insurance
licenses declines to an amount less than their book value, an impairment would
be recorded as a realized loss for the excess of book value over fair value.
Intangible assets which have a finite useful life will be subject to
amortization. We expect that the allocation of intangible assets between these
classifications and the determination of estimated useful lives generally will
be based on valuations received from qualified independent appraisers. The
calculations of these amounts are expected to be based on estimates and
assumptions using historical and pro forma data and recognized valuation
methods. The use of different estimates or assumptions could produce different
results. While goodwill and indefinite-lived intangible assets are not amortized,
they will be subject to periodic reviews for impairment (at least annually or
more frequently if impairment indicators arise). We plan to review for
impairment periodically and whenever events or changes in business
circumstances indicate that the carrying value of the assets may not be
recoverable. The determinations of impairment indicators and fair value are
expected to be based on estimates and assumptions related to the amount and
timing of future cash flows and future interest rates. The use of different
estimates or assumptions could produce different results. Losses, Claims and Settlement Expenses Our most significant estimates will likely relate to our reserves for
property and casualty losses and loss adjustment expenses. We will be required
to establish reserves for the estimated total unpaid cost of losses and loss
adjustment expenses for events that have already occurred. These reserves
should reflect our best estimates of the total cost of claims that were
reported to us, but not yet paid, referred to as Case Reserves, and the cost of
claims incurred but not yet reported to us, or IBNR, referred to as IBNR
Reserves. The estimate of these reserves is subjective and complex and will require
us to make estimates about the future payout of claims, which is inherently
uncertain. When we establish and adjust reserves, we will do so based on our
knowledge of the circumstances and facts of claims. Upon notice of a claim, we
will establish a Case Reserve for losses based on the claims information
reported to us at that time. Subsequently, we will conduct an investigation of
each reported claim, which will allow us to more fully understand the factors
contributing to the loss and our potential exposure. This investigation may
extend over a long period of time. As our investigations of claims develop and
as our claims personnel identify trends in claims activity, we plan to refine
and adjust our estimates of Case Reserves. When we establish reserves, we plan
to do so based on our knowledge of the circumstances and claim facts. We plan
to continually review our reserves, and as experience develops and additional
information becomes known, we will adjust the reserves. Such adjustments should
be recorded through operations in the period identified. To evaluate and refine
our overall reserving process, we will track and monitor all claims until they
are settled and paid in full and all salvage and subrogation claims are
resolved. 37




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For IBNR losses, we will estimate the amount of reserves for each line of
business on the basis of historical and statistical information. We plan to
consider historical patterns of paid and reported claims, industry data and the
probable number and nature of losses arising from claims that have occurred but
have not yet been reported for a given accident year. To establish loss and loss adjustment expense reserves, we will need to
make estimates and assumptions that affect the amounts of assets, liabilities,
revenues and expenses reported in our financial statements. Actual results
could differ materially from those estimates. We plan to engage an independent actuary to render opinions as to the
adequacy of the statutory reserves we establish. We will need to file the
actuarial opinions in those states where we are licensed. We do not expect
material differences between our statutory reserves and those established under
GAAP. The estimation of ceded reinsurance loss and loss adjustment expense
reserves will be subject to the same factors as the estimation of insurance
loss and loss adjustment expense reserves. Deferred Income Taxes We may be required to establish a valuation allowance for the portion of
any deferred tax asset that management believes may not be realized. The
establishment and ongoing evaluation of a valuation allowance for deferred tax
assets requires the use of judgment and estimates. Actual results could differ
materially from those estimates. Quantitative and Qualitative Disclosures About Market Risk Market risk can be described as the risk of change in fair value of a
financial instrument due to changes in interest rates, creditworthiness,
foreign exchange rates or other factors. We will seek to mitigate that risk by
a number of actions, as described below. Effects of Inflation Inflation could have a significant effect on our results of operations in
some situations. The effects of inflation could cause the severity of claims
to increase in the future. Our estimates for losses and loss adjustment
expenses will include assumptions, including those relating to inflation, about
future payments for settlement of claims and claims handling expenses. To the
extent inflation causes these costs to increase above our estimated reserves
that will be established for these claims, we will be required to increase
reserves for losses and loss adjustment expenses with a corresponding reduction
in our earnings in the period in which the increase is identified. The actual
effects of inflation on our results cannot be accurately determined until
claims are ultimately settled. Interest Rate Risk Our exposure to market risk for changes in interest rates will be
concentrated in our investment portfolio. We expect that changes in investment
values attributable to interest rate changes will be mitigated, however, by
corresponding and partially offsetting changes in the economic value of our
insurance reserves to the extent we have established such loss reserves. We
will monitor this exposure through periodic reviews of our consolidated asset
and liability positions. We will model and periodically review estimates of
cash flows, as well as the impact of interest rate fluctuations relating to the
investment portfolio and insurance reserves. Credit Risk We expect our portfolio will include primarily fixed income securities and
short-term investments, which will be subject to credit risk. This risk is
defined as default or the potential loss in market value resulting from adverse
changes in the borrowers ability to repay the debt. In our risk management
strategy and investment policy, we plan to earn competitive relative returns
while investing in a diversified portfolio of securities of high credit quality
issuers and to limit the amount of credit exposure to any one issuer. We also may have other receivable amounts subject to credit risk,
including reinsurance recoverables from our reinsurers. To mitigate the risk
of counterparties nonpayment of amounts due under these arrangements, we will
establish business and financial standards for reinsurer approval,
incorporating ratings by major rating agencies and considering then-current
market information. B. Managements Discussion and Analysis of Financial Condition and Results
of Operations for Potomac Insurance Company of Illinois The following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our financial statements. Much of
the information contained in this discussion and analysis includes
forward-looking statements that involve risks and uncertainties. Many factors
will cause our actual results to differ materially from those anticipated or
implied by these forward-looking statements. Results of Operations Three Months Ended September 30, 2004 versus Three Months Ended September 30,
2003 Potomacs pre-tax income for the third quarter of 2004 was $0.5 million,
compared to pre-tax income of $0.2 million for the third quarter of 2003. As of
January 1, 2004, Potomac ceased its participation in the OneBeacon Amended and
Restated Reinsurance (Pooling) Agreement (the Pool). As a result, net written
premiums, net earned premiums, losses and underwriting expenses for the third
quarter of 2004 were $0 and, therefore, are not comparable with the third
quarter of 2003. During the third quarter of 2003, Potomac recorded $0.5
million of net unfavorable development on prior year loss reserves relating to
construction defect claims as part of the review of all claims recalled from a
third party administrator. 38




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Potomacs net investment income decreased by $0.1 million or 17% for the
third quarter of 2004 primarily due to the continued run-off of loss reserves
in the latter part of 2003, as well as reduced interest rates. Net realized
gains increased by $0.5 in the same period. Nine Months Ended September 30, 2004 versus Nine Months Ended September 30,
2003 Potomacs pre-tax income for the first nine months of 2004 was $1.2
million, compared to pre-tax income of $1.3 million for the nine months of
2003. As described above, Potomac ceased its participation in the Pool as of
January 1, 2004. As a result, net written premiums, net earned premiums, losses
and underwriting expenses for the first nine months of 2004 were $0 and,
therefore, are not comparable with the nine month period ended September 30,
2003. Through the nine months ended September 30, 2003, Potomac recorded $0.5
million of net unfavorable development on prior year loss reserves primarily
relating to construction defect claims. Potomacs net investment income decreased by $0.4 million or 24% for the
nine months ended September 30, 2004 primarily due to the continued run-off of
loss reserves in the latter part of 2003, as well as reduced interest rates.
Net realized losses decreased by $0.4 in the same period. Liquidity and Capital Resources As of December 31, 2003, Potomac ceased its participation in the Pool and
entered into a transfer and assumption reinsurance agreement whereby it
transferred all of its direct insurance business written to OneBeacon. As a
result, Potomac no longer has any insurance assets or liabilities on a net
basis and will not share in any favorable or unfavorable development of prior
year losses recorded by the Pool after January 1, 2004 unless OneBeacon fails
to perform under the transfer and assumption agreement as a result of
insolvency. In 2004, Potomacs sources of cash consist primarily of net investment
income and proceeds from sales and maturities of investments. Potomacs uses of
cash are primarily investing expenses and the purchase of investments. Prior
to January 1, 2004, the effective date of Potomacs withdrawal from the Pool,
its sources of cash also included premium collections and its uses included
claim payments and operating expenses. Both internal and external forces influence Potomacs financial condition,
results of operations and cash flows. Investment returns may be impacted by
changing rates of inflation and other economic conditions. Related Party Transactions Potomac has a service contract with White Mountains Advisors LLC, or
Advisors, a wholly-owned subsidiary of OneBeacon. Under this agreement,
Advisors provides investment research and advice, including the execution of
orders for the purchase and sale of securities. The amounts charged to Potomac
by Advisors for such services are based on a fixed fee applied to the month-end
market values of the investments being managed. See Note 5 to the Potomac financial statements. 39




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Critical Accounting Policies and Estimates Managements Discussion and Analysis of Financial Condition and Results of
Operations discusses Potomacs financial statements, which have been prepared
in accordance with GAAP. The financial statements presented herein include all
adjustments considered necessary by management to fairly present the financial
position, results of operations and cash flows of Potomac. The preparation of
financial statements in conformity with GAAP requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. On an ongoing basis, management evaluates its estimates, including those
related to loss and LAE reserves, purchase accounting and related deferred
credits and goodwill and reinsurance transactions. Management bases its
estimates on historical experience and on various other factors that are
believed to be reasonable under the circumstances, the results of which form
the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Management believes that its critical accounting policies affect its more
significant estimates used in the preparation of its financial statements. The
descriptions below are summarized and have been simplified for clarity. Loss and Loss Adjustment Expenses Potomac establishes loss and LAE that are estimates of amounts needed to
pay claims and related expenses in the future for insured events that have
already occurred. Reinsurance is an arrangement in which a reinsurance company
contractually agrees to indemnify an insurance company for all or a portion of
the insurance risks underwritten by the insurance company. Potomac establishes
estimates of amounts recoverable from its reinsurers in a manner consistent
with the claim liability covered by the reinsurance contracts, net of an
allowance for uncollectible amounts. Net insurance loss reserves represent loss
and LAE reserves reduced by reinsurance recoverable on unpaid losses. In a broad sense, loss and LAE reserves have two components: (i) case
reserves, which are reserves established within the claims function for claims
that have been reported to Potomac and (ii) IBNR. Case reserves are estimated
based on the experience and knowledge of claims staff regarding the nature and
potential cost of each claim. OneBeacons claims staff periodically adjusts
case reserves as additional information becomes known or payments are made.
Generally accepted actuarial methods are used to project estimates of IBNR.
Actuaries use a variety of statistical and analytical methods to determine
estimates of IBNR, which are based, in part, on historical claim reporting and
payment patterns. In estimating IBNR, actuaries consider all available
information, including reinsurance protections, inflation and the effects of
legal, social and legislative trends on future claim payments. Management
exercises judgment based upon its knowledge of its business, review of the
outcome of actuarial studies, historical experience and other factors to record
an estimate it believes reflects Potomacs expected ultimate unpaid loss and
LAE and related reinsurance recoverables. 40




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Potomac commenced business in 1982 at which time it was licensed solely in
Illinois and consequently started writing business on a very limited basis.
Potomac expanded its writings as it gradually accumulated licenses in
additional states during the next several years. During this time, the
insurance industry came to recognize its exposure to asbestos and environmental
hazards and took actions to mitigate such exposure through policy exclusions
and underwriting restrictions. Therefore, Potomac has very little direct
exposure to the large latent losses. Potomac was a net participant in the Pool through 2003. The Pool included
several companies that had direct written business in those years when asbestos
and environmental losses were not explicitly excluded by standard policy
language. As a result, through 2003 Potomac did have net exposure to such
losses as a result of its business assumed from the Pool. Effective January 1, 2004, Potomac ceased its participation in the Pool
and no longer has any assumed liabilities, real or contingent. At the time of
de-pooling, Potomac also entered into a transfer and assumption agreement which
effectively transferred all its direct liabilities to OneBeacon. Potomac
remains contingently liable for the insurance liabilities associated with its
former direct business to the extent OneBeacon fails to perform its obligations
under the transfer and assumption agreement. Potomac has stopped writing business and virtually all its policies have
expired. Potomacs contingent direct liabilities were $111.2 million at September
30, 2004 which were fully reinsured by OneBeacon under the transfer and
assumption agreement. Approximately 90% of such liabilities relate to
accident years 1995 through 2000 and are principally risks written on
Commercial Multi-Peril and Workers Compensation policies. For further discussion of Potomacs loss and LAE reserves see Note 4. Reinsurance Transactions OneBeacon has entered into ceded reinsurance contracts from time to time
to protect their businesses from losses due to poor risk diversification, to
manage their operating leverage ratios and to limit ultimate losses arising
from catastrophic events. Amounts recoverable from reinsurers are estimated in
a manner consistent with the claim liability associated with the reinsured
policies. Amounts related to reinsurance contracts are recorded in accordance
with SFAS No. 113, Accounting and Reporting for Reinsurance of Short-Duration
and Long-Duration Contracts. The collectibility of reinsurance recoverables is subject to the solvency
and willingness to pay of the reinsurers. Potomac is selective in regard to its
reinsurers, placing reinsurance principally with those reinsurers with strong
financial condition, industry ratings and underwriting ability. Management
monitors the financial condition and rating of its reinsurers on an ongoing
basis. Purchase Accounting and Related Deferred Credits As of December 31, 2001, Potomac had unamortized deferred credits of $3.1
million. Deferred credits represent the excess of the fair value of the net
assets over the purchase price 41




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paid. These deferred credits resulted from White Mountains pre-July 1,
2001 acquisition activities which were accounted for in accordance with the
treatment of a purchase business combination under Accounting Principles Board
No. 16, Business Combinations, or APB 16. APB 16 calls for the net assets of
the operations acquired to be recorded by White Mountains at their values on
the date of acquisition. As further described in Note 3 to Potomacs Audited
Financial Statements, Potomac fully recognized its existing unamortized
deferred credit balance of $3.1 million on January 1, 2002 as a change in
accounting principle. Quantitative and Qualitative Disclosure About Market
Risk Potomacs balance sheet includes fixed maturity investments whose fair
value is subject to market risk. The term market risk refers to the risk of
loss arising from adverse changes in interest rates and other relevant market
rates and prices. Market risk can have a significant effect on Potomacs
financial position as increases and decreases in prevailing interest rates
generally translate into decreases and increases in fair values of fixed
maturity investments, respectively. Potomac invests in interest rate sensitive securities, primarily debt
securities. Potomacs strategy is to purchase fixed maturity investments that
are attractively priced in relation to perceived credit risks. Potomacs fixed
maturity investments are held as available for sale in accordance with SFAS No.
115, Accounting for Certain Investments in Debt and Equity Securities,
whereby these investments are carried at fair value on the balance sheet with
net unrealized gains or losses reported net of tax in a separate component of
common shareholders equity. Potomac generally manages its interest rate risk
associated with its portfolio of fixed maturity investments by monitoring the
average duration of the portfolio, which allows Potomac to achieve an adequate
yield without subjecting the portfolio to an unreasonable level of interest
rate risk. Potomacs fixed maturity portfolio may also be affected by such factors as
the credit worthiness of the issuer, prepayment options, relative values of
alternative investments, the liquidity of the instrument and other general
market conditions. Item 3: Quantitative and Qualitative Disclosures About Market Risk None. 42




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Item 4: Controls and Procedures As required by SEC rules 13a-15(b) and 15d-15(b), the Company has
evaluated the effectiveness of the design and operation of its disclosure
controls and procedures as of the end of the period covered by this quarterly
report. This evaluation was carried out under the supervision and with the
participation of its management, including its principal executive officer and
principal financial officer. Based on this evaluation, these officers have
concluded that the design and operation of the Companys disclosure controls
and procedures are sufficient. There were no significant changes to the
Companys internal controls or in other factors that occurred during the three
months ended September 30, 2004 that have materially affected, or are
reasonably likely to materially effect, our internal controls over financial
reporting. Disclosure controls and procedures are the Companys controls and
procedures that are designed to ensure that information required to be
disclosed by it in the reports that it files or submits under the Exchange Act
is recorded, processed, summarized and reported, within the time periods
specified in the SECs rules and forms. Disclosure controls and procedures
include, without limitation, controls and procedures designed to ensure that
information required to be disclosed by it in the reports that it files under
the Exchange Act is accumulated and communicated to its management, including
its principal executive officer and principal financial officer, as
appropriate, to allow timely decisions regarding required disclosure. PART II - OTHER INFORMATION Item 1: Legal Proceedings Item 2: Unregistered Sales of Equity Securities and Use of Proceeds Unregistered Sales of Equity Securities: During the quarter ended September 30, 2004, the Company made the
following sales of securities that were not registered under the Securities Act
of 1933, as amended (the Securities Act). Unless otherwise specified, the
securities described below in numbers 1 through 7 were issued in reliance on
the exemption from registration under Section 3(a)(9) of the Securities Act. 1. On
July 23, 2004 the Company amended and restated a warrant it had
previously issued to FBR on December
12, 2003 to entitle FBR to purchase a number of shares of our common stock
equal to $4,000,000 divided by the initial public offering price less
underwriters discounts and commissions. Such warrant has an exercise price of
$0.01 per share. On August 31, 2004, such warrant was exchanged for two new
warrants: (i) a warrant to purchase a number of shares of our common stock
equal to $4,500,000 divided by the initial public offering price less
underwriting discounts and commissions, with an exercise price equal to the
initial public offering price less underwriting discounts and commissions and
(ii) a warrant to purchase a number of shares of our common stock equal to
$1,000,000 divided by the initial public offering price less underwriting
discounts and commissions, with an exercise price equal to $0.01. These
warrants were relinquished on November 23, 2004. 43




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2. On July 23, 2004 the Company amended and restated a warrant it had
previously issued to Courtney C. Smith on December 12,
2003 to entitle Mr. Smith to purchase a number of shares of our common stock equal to $520,000
divided by the initial public offering price less underwriters discounts and
commissions. Such warrant had an exercise price of $0.01 per share. On August
31, 2004, such warrant was exchanged for two new warrants: (i) a warrant to
purchase a number of shares of our common stock equal to $630,000 divided by
the initial public offering price less underwriting discounts and commissions,
with an exercise price equal to the initial public offering price less
underwriting discounts and commissions and (ii) a warrant to purchase a number
of shares of our common stock equal to $100,000 divided by the initial public
offering price less underwriting discounts and commissions, with an exercise
price equal to $0.01. These warrants were relinquished on November 23, 2004. 3. On July 23, 2004 the Company amended and restated a warrant it had
previously issued to Peter E. Jokiel on December 12,
2003 to entitle Mr. Jokiel to purchase a number of shares of our common stock equal to $228,000 divided by
the initial public offering price less underwriters discounts and commissions.
Such warrant had an exercise price of $0.01 per share. On August 31, 2004,
such warrant was exchanged for a new warrant to purchase a number of shares of
our common stock equal to $342,000 divided by the initial public offering price
less underwriting discounts and commissions, with an exercise price equal to
the initial public offering price less underwriting discounts and commissions.
This warrant was relinquished on November 23, 2004. 4. On July 23, 2004 the Company amended and restated a warrant it had
previously issued to William S. Loder on December 12, 2003 to entitle Mr. Loder
to purchase a number of shares of our common stock equal to $90,000 divided by
the initial public offering price less underwriters discounts and commissions.
Such warrant had an exercise price of $0.01 per share. On August 31, 2004,
such warrant was exchanged for a new warrant to purchase a number of shares of
our common stock equal to $135,000 divided by the initial public offering price
less underwriting discounts and commissions, with an exercise price equal to
the initial public offering price less underwriting discounts and commissions.
This warrant was relinquished on November 23, 2004. 5. On July 23, 2004 the Company amended and restated a warrant it had
previously issued to Gary J. Ferguson on December 12, 2003 to entitle Mr.
Ferguson to purchase a number of shares of our common stock equal to $62,000
divided by the initial public offering price less underwriters discounts and
commissions. Such warrant had an exercise price of $0.01 per share. On August
31, 2004, such warrant was exchanged for a new warrant to purchase a number of
shares of our common stock equal to $93,000 divided by the initial public
offering price less underwriting discounts and commissions, with an exercise
price equal to the initial public offering price less underwriting discounts
and commissions. This warrant was relinquished on November 23, 2004. 6. On July 23, 2004, the Company issued a senior secured note with a
principal amount not to exceed $1,450,000 to Standard American Insurance
Limited. The senior secured note was issued in reliance on the exemption from
registration under Section 4(2) of the Securities Act. On November 23, 2004
the Company satisfied the senior secured note. 44




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7. On July 23, 2004, the Company issued a warrant to Standard American
Insurance Limited to purchase a number of shares of our common stock equal to
$2,900,000 divided by the initial public offering price of our common stock
less underwriters discounts and commissions. Such warrant had an exercise
price of $0.01 per share. The warrant was issued in reliance on the exemption
from registration under Section 4(2) of the Securities Act. This warrant was
relinquished on November 23, 2004. Subsequent to September 30, 2004, the Company also made the following
sales of securities that were not registered under the Securities Act. 1. Concurrent with the Companys IPO, certain members of management,
including Messrs. Smith, Jokiel, Loder and Ferguson, purchased directly from
the Company, shares of common stock for $200,000, $300,000, $150,000 and
$150,000, respectively, at the IPO price per share, less underwriting discounts
and commissions, which amounts were paid in cash. 2. Concurrent with the Companys IPO, three partner agents purchased
shares of the Companys Class B common stock for $250,000, at a price equal to
the IPO price. 3. Concurrent
with the Companys IPO, FBR, an affiliate of one of the representatives of the underwriters, purchased
1,000,000 shares of our common stock, at a price of $8.835 per share, in a
private placement. We raised gross proceeds of approximately $8.835 million
from such private placement. Also subsequent to September 30, 2004, on November 23, 2004, we closed the
sale of 12,700,000 shares of our common stock, at a price of $9.50 per share in
a firm commitment underwritten registered IPO. On December 22, 2004 we closed
the sale of an additional 422,000 shares of our common stock as a result of the
underwriters exercising their over-allotment option. The IPO was effected
pursuant to a Registration Statement on Form S-1 (File No. 333-117722), which
the Securities and Exchange Commission declared effective on November 12, 2004. Use of Proceeds: The proceeds obtained from each transaction described in numbers 1 through
7 above were used to finance the business prior to our initial public offering. Of the $124.7 million in gross proceeds raised by us in the initial public
offering and the $8.8 million from the private placement: 1. approximately $8.7 million of the proceeds from our initial public
offering were paid to the underwriters in connection with underwriting
discounts and commissions; 2. approximately $21.8 million was used to fund the acquisition of Potomac
from OneBeacon Insurance Company by purchasing all of Potomacs issued and
outstanding capital stock simultaneously with the closing of the initial public
offering; 45




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3. approximately $95.0 million was contributed as capital to Potomac,
which became our operating subsidiary; 4. approximately $2.3 million was paid or accrued by us in connection with
offering fees and expenses; and 5. the balance has been retained by us for general corporate purposes. Item 3: Defaults Upon Senior Securities None. Item 4: Submission of Maters to a Vote of Security Holders None. Item 5: Other Information Effective as of December 22, 2004, our principal executive offices have
been relocated to 222 South Riverside Plaza, Chicago, Illinois 60606. Our toll
free telephone number is 888-782-4672 and our fax number is 312-577-0973. Item 6: Exhibits and Reports on Form 8-K (a) Exhibits: ExhibitNumber
    
    Description2.6
    
    Amendment No. 5, dated November 16, 2004, to Stock Purchase
Agreement between Registrant and OneBeacon Insurance Company31.1
    
    Certification of Courtney C. Smith pursuant to Section 302 of the
Sarbanes-Oxley Act of 200231.2
    
    Certification of Peter E. Jokiel pursuant to Section 302 of the
Sarbanes-Oxley Act of 200232.1
    
    Certification of Courtney C. Smith pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 200232.2
    
    Certification of Peter E. Jokiel pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002
 (b) Reports on Form 8-K: The Company has not filed any Current Report on Form 8-K with the
Securities and Exchange Commission during the period for which this report is
filed. 46




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SIGNATURES 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. SPECIALTY UNDERWRITERS ALLIANCE, INC.
(Registrant)Dated:  December 23, 2004
    By:
    /s/ Courtney C. SmithName:
    Courtney C. SmithTitle:
    President, Chief Executive Officer and
Director Dated:  December 23, 2004
    By:

/s/ Peter E. JokielName:
    Peter E. JokielTitle:
    Executive Vice President, Chief Financial
Officer, Treasurer and Director 47




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Exhibits Index ExhibitNumber
    
    Description2.6
    
    Amendment No. 5, dated November 16, 2004, to Stock Purchase
Agreement between Registrant and OneBeacon Insurance Company31.1
    
    Certification of Courtney C. Smith pursuant to Section 302 of the
Sarbanes-Oxley Act of 200231.2
    
    Certification of Peter E. Jokiel pursuant to Section 302 of the
Sarbanes-Oxley Act of 200232.1
    
    Certification of Courtney C. Smith pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 200232.2
    
    Certification of Peter E. Jokiel pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002
 48