The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and the notes to those statements included elsewhere in this annual report. The discussion and analysis below includes forward-looking statements that are subject to risks, uncertainties and other factors described in “Factors That May Affect our Business, Future Operating
Our premiums before the Acquisition are generally not comparable to our premiums after the Acquisition because we acquired renewal rights and not the underlying policies as of the date of the Acquisition. Aspects of our business that are comparable with the business of our predecessor include the loss ratio and expense ratio. We believe that our loss ratio is comparable to that of our predecessor because we are insuring accounts with the same type of risk exposure in essentially the same jurisdictions as our predecessor, and we are using the same risk selection rules, underwriting guidelines and pricing models that our predecessor used. We believe that our expense ratio is comparable to that of our predecessor because we acquired the work force and substantially all of the operating assets of our predecessor, and we are following the same business model as our predecessor, which was developed by our current management. Aspects of our business that are not comparable with the business of our predecessor include: premiums earned, investment income and service income. For example, our net premiums earned for the periods immediately following the Acquisition were lower than the net premiums earned for the periods immediately prior to the Acquisition because we did not earn any premium on any of our predecessor’s policies that were in force at September 30, 2003. Our investment income is not comparable to the investment income of our predecessor because our predecessor had a significant portion of investments in cash and cash equivalents for the years presented in the selected financial information
Underwriting, Acquisition and Insurance Expenses. Our predecessor’s underwriting, acquisition and insurance expenses were $3.7 million for the year ended December 31, 2002, compared to $3.4 million for the year ended December 31, 2001. The increase in underwriting expenses in 2002 was primarily attributable to increased expenses, as our predecessor’s gross premiums written grew from $73.2 million in 2001 to $106.1 million in 2002. However, the underwriting expense ratio dropped to 21.6% in 2002 compared to 27% in 2001, as our predecessor reduced staffing and contained expense spending levels.
Change in Accounting Principle. Our predecessor adopted the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” as of January 1, 2002. Under SFAS No. 142, goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but are instead tested for impairment at least annually in accordance with the provisions for SFAS No. 142. An impairment loss of $4,731,000 related to goodwill was recognized upon adoption of SFAS No. 142. Prior to the adoption of SFAS No. 142, goodwill was amortized on a straight-line basis over 10 years. The recorded goodwill was periodically assessed for recoverability by determining whether the amortization of the goodwill balance over its remaining life could be recovered through undiscounted future operating cash flows of the acquired operation as compared to the fair valve method required under SFAS No. 142.
We used net cash of $54.3 million for investing activities for the year ended December 31, 2004, compared to $41.2 million for the three months ended December 31, 2003. The difference between periods is primarily attributable to the fact that we invested the net proceeds of $30.0 million from our initial capital infusion immediately after the Acquisition, as well as proceeds of $5.2 million from the sale of additional shares of convertible preferred stock in June 2004.
The loss and loss adjustment expense payments due by period in the table above are based upon the loss and loss adjustment expense estimates as of December 31, 2004 and actuarial estimates of expected payout patterns and are not contractual liabilities as to time certain. Our contractual liability is to provide benefits under the policies. As a result, our calculation of loss and loss adjustment expense payments due by period is subject to the same uncertainties associated with determining the level of unpaid loss and loss adjustment expenses generally and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our unpaid loss and loss adjustment expense process, see the heading “Loss Reserves” in Part I, Item 1 of this annual report. Actual payments of loss and loss adjustment expenses by period will vary, perhaps materially, from the above table to the extent that current estimates of loss and loss adjustment expenses vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See the discussion under the heading “Factors That May Affect Our Business, Future Operating Results and Financial Condition - Loss reserves are based on estimates and may be inadequate to cover our actual losses” in Part I, Item 1 of this annual report for a discussion of the uncertainties associated with estimating unpaid loss and loss adjustment expenses.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SeaBright Insurance Holdings, Inc. and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for the year ended December 31, 2004 and for the period from June 19, 2003 (inception) through December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.
Major categories of consolidated net investment income are summarized as follows for the year ended December 31, 2004 and the three month period ended December 31, 2003:
certain assets designated as “nonadmitted” for statutory purposes are charged to surplus, fixed-income securities are reported primarily at amortized cost or fair value based on their rating by the National Association of Insurance Commissioners (“NAIC”), policyholders’ dividends are expensed as declared rather than accrued as incurred, income tax expense reflects only taxes paid or currently payable, and any change in the admitted net deferred tax asset is offset to equity. Following is a summary of the Company’s statutory net loss for the year ended December 31, 2004 and the three month period ended December 31, 2003 and capital and surplus as of December 31, 2004 and 2003:
a. SBIC is subject to guaranty fund and other assessments by the states in which it writes business. Guaranty fund assessments should be accrued at the time premiums are written. Other assessments are accrued either at the time of assessment or in the case of premium-based assessments, at the time the premiums are written, or in the case of loss-based assessments, at the time the losses are incurred. SBIC has accrued a liability for guaranty fund and other assessments of $2.0 million at December 31, 2004 and has no related asset for premium offset or policy surcharges. This amount represents management’s best estimate based on information received from the states in which it writes business and may change due to many factors including the Company’s share of the ultimate cost of current insolvencies. The majority of assessments are paid out in the year following the premium written or the losses are paid.
The Predecessor protects itself from excessive losses by reinsuring certain levels of risk in various areas of exposure with affiliated and nonaffiliated reinsurers. Reinsurance premiums, commissions, expense reimbursements, and unpaid loss and loss adjustment expense related to assumed and ceded business are accounted for on a basis consistent with those used in accounting for original policies issued and the terms of the reinsurance contracts. Premiums assumed from an affiliate are reported as an addition to premiums written and earned. Premiums ceded to other companies are reported as a reduction of premiums written and earned. Reinsurance recoverables are determined based on the terms and conditions of the reinsurance contracts.
EPIC leases certain office space for its regional offices under agreements that are accounted for as operating leases. Lease expense for the nine months ended September 30, 2003 and the year ended December 31, 2002 totaled $131,190 and $135,640, respectively. Future minimum payments required under the agreements are as follows:
Aggregate amortization expense of intangible assets was $5,833 and $10,000 for the nine months ended September 30, 2003 and the year ended December 31, 2002, respectively.