Our insurance segment reports premiums that we produce as part of our brokerage business. In addition, the insurance segment includes premiums from the traditional and specialty pools that CastlePoint Management manages for our Insurance Subsidiaries. Our insurance services segment records management fee income that we earn as a result of managing the brokerage business on behalf of CastlePoint. When shown in the consolidated results, this amount is included in total revenues. In addition, we plan to assume through a quota share agreement a certain percentage of the business written by CPIC. This business is reported in our reinsurance segment. See “Business-Strategic Relationship and Agreements with CastlePoint and Reinsurance-CastlePoint” for a description of the various agreements between the Company and CastlePoint.
The Insurance Information Institute has projected 2008’s combined ratio to increase to 97.3% with the return to a level of catastrophe losses expected in an average year. However, soft market conditions will prevail in most lines and segments. Catastrophe losses and the potential for ongoing decreased pricing and underwriting discipline provide the greatest threats to the industry’s 2008 underwriting profit results. Slower premium growth, claim frequency and severity trends, litigation, regulatory and legislative issues also will impact 2008.
Net investment income and realized gains and losses on investments. We invest our statutory surplus and the funds supporting our insurance reserves (including unearned premium reserve and the reserves established to pay for losses and loss adjustment expenses) in cash, cash equivalents and securities. Our investment income includes interest and dividends earned on our invested assets. Realized gains and losses on invested assets are reported separately from net investment income. We earn realized gains when invested assets are sold for an amount greater than their amortized cost in the case of fixed maturity securities and cost in the case of equities, and we recognize realized losses when invested assets are written down or sold for an amount less than their amortized cost or cost, as applicable.
Direct and ceding commission expenses. We pay direct commission expense to our producers in our insurance segment for the premiums that they generate for us. Our managing general agency also pays direct commission expense to our producers in our insurance services segment. In addition, TICNY also pays ceding commission expense to TRM’s issuing companies for the reinsurance premiums that we assume in our reinsurance segment. Ceding commission is typically paid on quota share reinsurance agreements, but not on excess of loss reinsurance agreements.
Net investment income and realized gains (losses). Net investment income increased by 59.6% to $36.7 million for 2007 compared to $23.0 for 2006. The increase in net investment income resulted from an increase in cash and invested assets to $696.8 million as of December 31, 2007 compared to $564.6 million as of December 31, 2006. Net cash flows provided by operations of $75.9 million contributed to the increase in invested assets during 2007. The increase in invested assets was also due to cash flow provided by financing activities of $67.5 million as a result of our net proceeds from the issuance of subordinated debentures on January 25, 2007, an equity offering on January 26, 2007 and the exercise of the underwriters’ over-allotment option on February 5, 2007, partially offset by $40 million of funds used to redeem our preferred stock. The acquisition of Preserver added $4.8 million of net investment income in 2007. The net cash flow used in
Net investment income and realized gains. Net investment income increased by 53.7% to $23.0 million in 2006 compared to $15.0 million in 2005. This resulted from an increase in invested assets and cash and cash equivalents to $564.6 million as of December 31, 2006 compared to $395.9 million as of December 31, 2005. Net cash flow provided by operations, including $37.0 million of cash received from PXRE resulting from the commutation and novation transactions, contributed to the $168.7 million increase in invested assets and cash and cash equivalents in 2006. On a tax equivalent basis, the yield was 5.7% as of December 31, 2006 and 5.2% as of December 31, 2005.
Preserver’s contribution to underwriting profit was $4.2 million in 2007. The gross combined ratio was 79.9% for 2007 as compared with 82.4% for 2006. The lower gross combined ratio in 2007 resulted primarily from a lower gross loss ratio in 2007 compared to 2006. The net combined ratio was 83.6% for 2007 as compared to 85.7% for 2006. The decrease in the net combined ratio resulted from a decrease in the net loss ratio, offset in part, by a slight increase in the net underwriting expense ratio. The effects of the commutations reduced underwriting profit in 2006 by $4.8 million and added 2.3 percentage points to the net combined ratio.
The net underwriting expense ratio was 28.1% in 2006 as compared to 29.4% for 2005. The net expense ratio, which reflects ceding commission revenue, was affected by the reduction in ceding commissions of $3.2 million resulting from the commutations with PXRE which added 1.6 percentage points to the net expense ratio. The net expense ratio in 2006 also included the benefit of additional ceding commission revenue due to the additional premiums ceded to CastlePoint Reinsurance as of April 1, 2006.
Direct commission expense. TRM’s direct commission expense rate was 14.9% in 2006 compared to 14.4% for 2005 as the majority of premiums in 2006 are on smaller policies that typically carry a higher commission rate as compared to 2005 when there was a larger proportion of policies with larger premiums and lower commission rates.
requirement by limiting our net retention of premiums while generating ceding commissions in our Insurance Subsidiaries and non-risk bearing revenues in TRM.
The net cash flows used in investing activities for 2007 was $182.9 million as compared to $132.0 million for the same period in 2006. Cash flow used for investing activities in 2007 included the payment of $66.0 million for the acquisition of Preserver Group, Inc. In addition, we paid $4.7 million of Preserver’s direct transaction costs in connection with the acquisition. During 2007, we capitalized $10.8 million for software, principally expenditures for operating systems, hardware and approximately $5.0 million as a result of the Preserver acquisition. In addition, there were increases in investments in municipal securities, corporate bonds, U.S. Treasuries and mortgage-backed investments for 2007 of $107.0 million and net sales in our equity investments of $8.9 million. During 2006, we capitalized $22.9 million for the purchase of fixed assets and entered into a sale leaseback on $5.2 million of these assets. We relocated our New York City corporate headquarters within the same building and capitalized $10.4 million for leasehold improvements, $3.9 million and $6.1 million for furniture and equipment and $6.4 million for computer hardware and software. The landlord provided a $4.8 million build-out allowance that partly financed the $10.4 million of leasehold improvements. In addition, we had net fixed maturity security purchases of $83.2 million and net purchases in our equity investments of $16.8 million. Also in 2006, we invested $14.4 million to start up CastlePoint.
The gross loss reserve payments due by period in the table above are based upon the loss and loss expense reserve estimates as of December 31, 2007 and actuarial estimates of expected payout patterns by line of business. As a result, our calculation of loss reserve payments due by period is subject to the same uncertainties associated with determining the level of reserves 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. The projected gross loss payments presented do not include the estimated ceded reserves recoverable from reinsurers that amounted to $189.6 million which are estimated to be recovered as follows: less than one year, $52.0 million; one to three years, $73.8 million; four to five years, $40.1 million; and after five years, $23.7 million. The interest on the subordinated debentures is calculated using interest rates in effect at December 31, 2007 for variable rate debentures.
The Company manages its operations through three reportable segments: insurance (commercial and personal lines underwriting), reinsurance, and insurance services (managing general agency, claims administration and reinsurance intermediary operations). See “Note 21-Segment Information.”
In April 2006, the Company entered into a master agreement with CastlePoint (the “Master Agreement”). The Master Agreement provides that, subject to the receipt of any required regulatory approvals, CastlePoint will manage the traditional program business and the specialty program business, and the Company will manage the brokerage business. The program managers are required to purchase property and casualty excess of loss reinsurance and property catastrophe excess of loss reinsurance from third party reinsurers to protect the net exposure of the participants. In purchasing the property catastrophe excess of loss reinsurance, the manager may retain risk equating to no more than 10% of the combined surplus of the Company and CastlePoint Insurance Company (referred to as the pooled catastrophe retention).
Under the specialty program business and insurance risk-sharing business quota share reinsurance agreements, which covers business not historically written by the Company, the Company’s Insurance Subsidiaries cede 85% of the Company’s net retention on specialty program business to CastlePoint Reinsurance and receive a ceding commission of 30%, subject to a minimum of 30% and a maximum of 36%.
The components of intangible assets are summarized as follows ($ in thousands):
In April 2007 and December 2007, the Company entered into two sale and leaseback arrangements of certain furniture and equipment in the aggregate amount of $1.3 million. The Company will lease the assets back under a 60 month lease arrangement at an annual cost of $0.3 million. The Company has an early buy-out option for both agreements on the date which is 48 months after the rent commencement date (April 2011 and December 2011) at rates equaling 32.88% and 32.76% of the original sales price. In addition, the Company has an early termination options in October 2009 at a rate of 47.89% and June 2010 at a rate of 47.82% of the original sale price and must return the equipment to the lessor.
The Company accounts for costs incurred to develop computer software for internal use in accordance with Statement of Position (SOP) 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” As required by SOP 98-1, the Company capitalizes the costs incurred during the application development stage, which include costs to design the software configuration and interfaces, coding, installation, and testing. Costs incurred during the preliminary project along with post-implementation stages of internal use computer software are expensed as incurred. Capitalized development costs are amortized over various periods up to three years. Costs incurred to maintain existing product offerings are expensed as incurred. The capitalization and ongoing assessment of recoverability of development costs requires considerable judgment by management with respect to certain external factors, including, but not limited to, technological and economic feasibility, and estimated economic life. For the years ended December 31, 2007 and December 31, 2006, the Company capitalized software development costs of $3.4 million and $0.6 million, respectively. As of December 31, 2007, and December 31, 2006, net capitalized software costs totaled $4.0 million and $0.6 million, respectively.
The total remaining compensation cost related to non-vested stock options and restricted stock awards not yet recognized in the income statement was $4.0 million of which $0.1 million was for stock options and
The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”), on January 1, 2007. As of December 31, 2007, the Company had no material unrecognized tax benefit and no adjustments to liabilities or operations were required.
Contingencies Surrounding the 2006 New York Board of Fire Underwriters Assessment
The New York City Fire Patrol (“Fire Patrol”), which is governed by the New York Board of Fire Underwriters (“NYBFU”), was created to improve fire safety in New York City and was responsible for the salvage and dewatering operations at the scene of fires and water leaks for the purpose of protecting property from loss due to these perils. Fire Patrol’s operations were supported by assessments made by the NYBFU on the insurance company members of the NYBFU and, in some instances, other writers of fire insurance in New York City who had elected not to become members. The NYBFU’s membership voted to discontinue the Fire Patrol on January 31, 2006. Subsequently, the Company received a $506,000 assessment from the Fire Patrol for the 2006 year. The Company does not believe that it is a proper assessment and it has requested additional
Certain amounts related to ceded reinsurance are reported on a net basis within the statutory basis financial statements. GAAP requires these amounts to be shown gross.
The Company manages its operations through three business segments: insurance (commercial and personal lines underwriting), reinsurance, and insurance services (managing general agency, claims administration and reinsurance intermediary operations). The Company considers many factors in determining reportable segments including economic characteristics, production sources, products or services offered and regulatory environment.