The outcome of the Securities and Exchange Commission’s industry-wide investigation relating to the use of non-traditional insurance products, including finite risk reinsurance arrangements.
Our GAAP basis combined ratio was 74.8% for 2007, which was substantially lower than the combined ratio of the property and casualty industry as a whole. 2007 calendar year results included an $85.8 million pre-tax benefit from a decrease in net unpaid loss and loss adjustment expenses due to favorable trends in prior years’ claim emergence. The favorable net loss and loss adjustment expense development occurred primarily in the Commercial and Specialty Lines segments for accident years 2003 through 2006. This favorable development is primarily attributable to better than expected case incurred loss development for professional liability, management liability and commercial coverages.
For mortgage and asset-backed securities (“structured securities”) of high credit quality, changes in expected cash flows are recognized using the retrospective method. Under the retrospective method, the effective yield on a security is recalculated each period based upon future expected and past actual cash flows. The security’s book value is restated based upon the most recently calculated effective yield, assuming such yield had been in effect from the security’s purchase date. The retrospective method results in an increase or decrease to investment income (amortization of premium or discount) at the time of each recalculation. Future expected cash flows consider various prepayment assumptions, as well as current market conditions. These assumptions include, but are not limited to, prepayment rates, default rates, and loss severities.
Changes may occur in the actuarial assumption that ultimate losses are determinable by extrapolation of claim emergence and settlement patterns observed in the past (via loss development factor selection) that can reasonably be expected to persist into the future. Changes may also occur in the actuarial assumption that ultimate loss ratios in the current and most recent accident years can be projected from ultimate loss ratios of prior years. The first chart below illustrates the impact to the actuarially determined loss reserve estimates as of December 31, 2007 applicable to all lines of business from selected combinations of reasonably likely changes to the loss development factor and expected loss ratio assumptions. Although the chart displays the impacts from selected combinations of reasonably likely changes to the assumptions, the range of all possible combinations of changes to the loss development factor and expected loss ratio assumptions are greater than those reasonably likely to occur.
The expected term of stock options and SARS represents the weighted-average period the stock options and SARS are expected to remain outstanding. The expected term is based on the observed and expected time to post-vesting exercise and forfeitures of options by our employees. Upon the adoption of SFAS 123(R), the expected term of stock options and SARS was determined based on the demographic grouping of employees. Prior to January 1, 2006, the expected term of stock options was determined based on a single grouping of employees. Upon adoption of SFAS 123(R), historical volatility was utilized in deriving the expected volatility assumption as allowed under SFAS 123(R). Prior to January 1, 2006, the historical stock price volatility in accordance with SFAS 123 for purposes of the Company’s pro forma information was utilized. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant appropriate for the expected life of the Company’s stock options and SARS. The dividend yield assumption is based on the history and the expectation of no dividend payouts.
The introduction of several new niche product offerings, most notably the antique/collector vehicle commercial auto product, as well as the health and wellness business owner, professional sports and entertainment, religious organizations, camp operators and affordable housing products in the commercial package product grouping. These new product offerings accounted for approximately $84.6 million of the $218.8 million total Commercial Lines segment gross written premiums increase.
The differing percentage changes in net written premiums and/or net earned premiums versus gross written premiums and/or gross earned premiums for the commercial lines, specialty lines and personal lines segments during the year results primarily from the following:
Other Income: Other income approximated $3.6 million and $2.6 million for the years ended December 31, 2007 and 2006, respectively. Other income consists primarily of commissions earned on brokered personal and commercial lines business, and fees earned on servicing personal lines business.
Our taxable equivalent book yield on our fixed income holdings approximated 5.4% at December 31, 2006, compared to 4.8% at December 31, 2005. Net investment income was reduced by $1.5 million for the year ended December 31, 2005 due to the interest credit on the Funds Held Account balance pursuant to our quota share reinsurance agreement.
We regularly perform impairment reviews with respect to our investments. For investments other than interests in securitized assets, these reviews include identifying any security whose fair value is below its cost and an analysis of securities meeting predetermined impairment thresholds to determine whether such decline is other than temporary. If we do not intend to hold a security to maturity or determine a decline in value to be other than temporary, the cost basis of the security is written down to its fair value with the amount of the write down reflected in our earnings as a realized loss in the period the impairment arose. These evaluations resulted in non-cash realized investment losses of $7.9 million and $8.8 million, respectively, for the years ended December 31, 2007 and 2006. Our impairment review also includes an impairment evaluation for interests in securitized assets conducted in accordance with the guidance provided by the Emerging Issues Task Force of the Financial Accounting Standards Board. There were no non-cash realized investment losses recorded for the years ended December 31, 2007 or 2006 as a result of our impairment evaluations for investments in securitized assets.
Our fixed maturity portfolio amounted to $2,659.2 million and $2,129.6 million, as of December 31, 2007 and 2006, respectively, of which 99.9% of the portfolio was comprised of investment grade securities as of December 31, 2007 and 2006. We had fixed maturity investments with gross unrealized losses amounting to $7.0 million and $18.1 million as of December 31, 2007 and 2006, respectively. Of these amounts, interests in securitized assets had gross unrealized losses amounting to $3.0 million and $9.3 million as of December 31, 2007 and 2006, respectively.
The industry concentration as a percentage of the total gross unrealized loss primarily represents investments in equity securities issued by companies in the Diversified Financial Services industry. The unrealized losses on these securities are generally attributable to the recent correction in the Financial Services industry primarily caused by the deterioration of credit conditions in the marketplace during the third and fourth quarters of 2007. As of December 31, 2007, these equity securities were evaluated for other than temporary impairment in accordance with the Company’s impairment policy and the Company concluded that these securities were not other than temporarily impaired.
Our impairment evaluation as of December 31, 2006 for interests in securitized assets resulted in the following conclusions:
Four property and casualty insurance companies, Philadelphia Indemnity Insurance Company (“PIIC”) and Philadelphia Insurance Company (“PIC”), which are domiciled in Pennsylvania; and Liberty American Select Insurance Company (“LASIC”) and Liberty American Insurance Company (“LAIC”), which are domiciled in Florida (collectively the “Insurance Subsidiaries”);
The Insurance Subsidiaries are subject to state guaranty fund assessments, which provide for the payment of covered claims or other insurance obligations from insurance company insolvencies, and other assessments from state insurance facilities. Each state has enacted legislation establishing guaranty funds and other insurance activity related assessments resulting in a variety of assessment methodologies. Expense for guaranty fund and other state insurance facility assessments are recognized when it is probable that an assessment will be imposed, the obligatory event has occurred, and the amount of the assessment is reasonably estimatable. Any related policyholder surcharge receivable is accrued as the related premium is written.
The unrealized losses on the Company’s long term investments in Corporate bonds which have ratings from Baa3/BBB to Aaa/AAA are attributable to the spread widening. Of the 73 investment positions held, approximately 79.5% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investments. Therefore, it is expected that the securities would not be settled at a price less than the amortized cost of the investments.
$21.6 million of structured securities backed by pools of ALT A loans (loans with low documentation and borrowers with FICO scores in the approximate range of 650 to the low 700’s); and
$6.0 million of structured securities backed by pools of sub-prime loans (loans with low documentation, higher combined loan-to-value ratios and borrowers with FICO scores capped at approximately 650).
During the year ended December 31, 2005, net loss and loss adjustment expense payments for claims attributable to prior years are lower by $64.3 million due to the Company’s commutation of its 2003 Whole Account Net Quota Share Reinsurance Agreement.
During 2006, the Company decreased the estimated net unpaid loss and loss adjustment expenses for accident years 2005 and prior by the following amounts:
The changes in the estimated net unpaid loss and loss adjustment expenses for prior year accident years during 2006 were primarily attributable to the following:
The following quarterly financial information for each of the three months ended March 31, June 30, September 30 and December 31, 2007 and 2006 is unaudited. However, in the opinion of management, all adjustments (consisting of normal recurring adjustments) necessary to present fairly the results of operations for such periods, have been made for a fair presentation of the results shown (in thousands, except share and per share data):
The segments follow the same accounting policies used for the Company’s consolidated financial statements as described in the summary of significant accounting policies. Management evaluates a segment’s performance based upon premium production and the associated loss experience which includes paid losses, an amount determined on the basis of claim adjusters’ evaluation with respect to insured events that have occurred and an amount for losses incurred that have not yet been reported. Investments and investment performance including investment income and net realized investment gain; acquisition costs and other underwriting expenses including commissions, premium taxes and other acquisition costs; and other operating expenses are managed at a corporate level by the corporate accounting function in conjunction with other corporate departments and are included in “Corporate.”
On February 26, 2008, the Company received a complaint filed on February 14, 2008 with the U.S. District Court for the Southern District of Florida by seven individuals. These individuals purported to act on behalf of a class of similarly situated persons who had been issued insurance policies by Liberty American Select Insurance Company, formerly known as Mobile USA Insurance Company (“LASIC”). The complaint, which is alleged to be a “class action complaint”, was filed against Philadelphia Insurance and its subsidiaries, LASIC, Liberty American Insurance Company and Liberty American Insurance Group, Inc. The complaint requests an unspecified amount of damages “in excess of $5,000,000” and equitable relief to prevent the defendants from committing what are alleged to be unfair business practices. The plaintiffs allege that from the period from at least as early as September 1, 2003 through December 31, 2006 they and other policyholders sustained property damage covered under policies issued by LASIC, and that LASIC improperly denied or paid only a portion of the policyholders’ claims for which they were entitled to be reimbursed.