Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in Part I, Item 1A “Risk Factors” of this document.
During 2007, we began writing workers’ compensation in states where we had previously not offered this line of insurance. Currently, workers’ compensation insurance premiums account for approximately 10.0 percent of our direct premiums. In 2008, we plan to increase our writing of workers’ compensation business as a companion line to our other commercial insurance policies. We are developing new underwriting tools and loss control services that will allow us to more effectively evaluate and mitigate risks, improving profitability in this line of business.
(2) “Fire and allied lines” includes fire, allied lines, commercial multiple peril and inland marine.
For each of our lines of business, with respect to reported claims, we establish reserves on a case-by-case basis. Our experienced claims personnel estimate these case-based reserves using adjusting guidelines established by management. Our goal is to set the case-based reserves at the ultimate expected loss amount as soon as possible after information about the claim becomes available.
Loss settlement expense reserves include amounts ultimately allocable to individual claims, as well as amounts required for the general overhead of the claims handling operation that are not specifically allocable to individual claims. We do not establish loss settlement expense reserves on a claim-by-claim basis. Instead, we examine the ratio of loss settlement expenses paid to losses paid over the most recent three-year period, by line. We use these factors and apply them to open reserves, including IBNR reserves. We develop these factors annually, each December and use them throughout the year, unless development patterns or emerging trends warrant adjustments to the factors.
Due to the formula-based nature of our IBNR and loss settlement expense reserve calculations, changes in the key assumptions utilized to generate these reserves can result in a quantifiable impact on our reported results. It is not possible to isolate and measure the potential impact of just one of these factors, and future loss trends could be partially impacted by all factors concurrently. Nevertheless, it is meaningful to view the sensitivity of the reserves to potential changes in these variables. To demonstrate the sensitivity of reserves to changes in significant assumptions, the following example is presented. The amounts reflect the pre-tax impact on earnings from a hypothetical percentage change in the calculation of IBNR and loss settlement expense reserves. The impact to pre-tax earnings would be a decrease if the reserves were to be adjusted upwards. The impact to pre-tax earnings would be an increase if the reserves were to be adjusted downwards. We believe that the changes presented are reasonably likely based upon an analysis of our historical IBNR and loss settlement expense experience.
Significant change to the estimated reserves could have a material impact to our results of operations or financial position. An increase or decrease in reserve estimates would result in a corresponding decrease or increase in financial results. The following table details the pre-tax impact on our property and casualty insurance segment’s financial results and financial condition of reasonably likely changes in our reserve development. Our lines of
(3) The recognition of the underfunded status of employee benefit plans is net of reclassification adjustments and income taxes.
The costs of acquiring new life business, principally commissions, certain variable underwriting, agency and policy issue expenses, have been deferred. These costs are amortized to income over the premium-paying period of the related traditional policies in proportion to the ratio of the expected annual premium revenue to the expected total premium revenue and over the anticipated lives of non-traditional policies in proportion to the ratio of the expected annual gross profits to the expected total gross profits. Policy acquisition costs deferred in 2007, 2006 and 2005 were $10,511,000, $9,295,000 and $6,648,000, respectively. Amortization of deferred policy acquisition costs in 2007, 2006 and 2005 totaled $13,385,000, $8,142,000 and $9,125,000, respectively. The expected premium revenue and gross profits are based upon the same mortality and withdrawal assumptions used in determining future policy benefits. For non-traditional policies, changes in the amount or timing of expected gross profits result in adjustments to the cumulative amortization of these costs. The effect on the amortization of deferred policy acquisition costs for revisions to estimated gross profits is reported in earnings in the period such estimated gross profits are revised.
We have recognized no liability for unrecognized tax benefits at January 1, 2007 or at any time during 2007. In addition, we have not accrued for interest and penalties related to unrecognized tax benefits. However, if interest and penalties would need to be accrued related to unrecognized tax benefits, such amounts would be recognized as a component of federal income tax expense.
We intend to vigorously defend the flood exclusion matter and other cases related to losses incurred in connection with Hurricane Katrina. While we believe that the flood exclusion at issue is unambiguous and enforceable, the Louisiana Supreme Court could rule that our flood exclusions do not exclude losses from flooding caused by third-party negligence, that such negligence was the efficient proximate cause of such flooding, or that such an exclusion is inapplicable where any portion of a loss is attributable to a covered peril. Such a ruling would likely have a material adverse effect on our financial position, as well as on our results of operations. We have established our loss and loss settlement expense reserves on the assumption that the flood exclusion will be found to be enforceable and effective to exclude losses caused by third-party negligence, as well as by Acts of God, and that the application of the Valued Policy Law will not result in our having to pay damages for perils not otherwise covered. We believe that, in the aggregate, these reserves should be adequate. However, our evaluation of these claims and the adequacy of recorded reserves may change if we encounter adverse developments in the further defense of these claims.
Prior to the adoption of SFAS No. 123(R), we presented the tax benefit of stock option exercises as an operating cash flow. Upon the adoption of SFAS No. 123(R), tax benefits resulting from tax deductions in excess of compensation cost recognized for those options are classified as financing cash flows. This change in presentation did not have a material impact on the amounts reported in the accompanying consolidated statement of cash flows.
We and our property and casualty and life insurance subsidiaries prepare our statutory-basis financial statements in conformity with accounting practices prescribed or permitted by the insurance department of the applicable states of domicile. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (“NAIC”), as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed.