The following discussion and analysis of Penn-America Group, Inc. (“PAGI”) and subsidiaries (collectively “Penn-America” or the “Company”) should be read in conjunction with the Company’s Consolidated Financial Statements and related Notes included in Item 8, “Financial Statements and Supplementary Data”, and cautionary remarks included in the section entitled “Risk Factors” of Item 1, “Business”, of this report on Form 10-K.
Net written premiums, which are gross written premiums less ceded written premiums, increased 31.0% to $176.5 million for 2003 compared with $134.7 million for 2002. The increase in net written premiums was consistent with the increase in gross written premiums, but was partially offset by higher reinsurance costs.
Amortization of deferred policy acquisition costs (“ADAC”) increased 32.7% to $38.5 million for 2003 from $29.0 million for 2002 due primarily to the growth in premiums earned.
The Company previously disclosed in its third quarter 2003 report on Form 10-Q that the Eighteenth Circuit Court in the State of Michigan entered a judgment of $4.9 million against one of the Company’s insureds, which judgment the Company had appealed. In February 2004, the Company settled this claim for $2.975 million. The Company’s reinsurance program provided coverage for $2.725 million of this total settlement. The Company’s liability, net of reinsurance, was $0.25 million and was included in its estimate for unpaid loss and loss adjustment expense reserves at December 31, 2003.
The Company increased its estimate in 2001 for the commercial multi-peril liability line of business by $1.8 million due to the development of outstanding claim reserves on claims occurring primarily in 1998 and 1999. In 2001, incurred losses on the 1998 and 1999 accident year were approximately $1.3 million more than anticipated based on historical development patterns. The increase is attributed primarily to higher than expected average settlement costs per claim for the 1998 and 1999 accident years. This increase was offset almost entirely by a reduction in the Company’s estimate for the non-standard personal automobile line of business due to favorable settlements on closed claims. The decrease was attributed primarily to lower than expected average settlement costs per claim for the 1998 and 1999 accident years.
As a result of the provisions of the Act and the reinsurance protection provided by the Company’s reinsurance treaties and the federal program, the following represents the Company’s retention relating to certified acts of terrorism for 2004:
Proceeds from the sale of these securities by the Trust II were used to acquire $15.0 million of Floating Rate Junior Subordinated Deferrable Interest Rate Debentures issued by the Company. These junior subordinated debentures have the same terms with respect to maturity, payments, and distributions as the floating rate trust preferred securities issued by the Trust II. The proceeds from these debentures will be used to support growth in the Company’s insurance operations and for general corporate purposes.
Liquidity. PAGI’s principal source of cash to meet short-term and long-term liquidity needs, including the payment of dividends to stockholders, corporate expenses and interest on its junior subordinated debentures, is dividends from Penn-America Insurance Company. PAGI has no planned capital expenditures that could have an impact on its long-term liquidity needs.
In accordance with SFAS 133, the Company formally documents the cash flow hedging relationship between the hedging instrument and the hedged item, the risk management objective and strategy for undertaking the hedge, and how the effectiveness of hedging the exposure to variability in interest rates will be assessed. At inception, the Company determined its cash flow hedge to be highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge, as it meets the criteria for assuming “no ineffectiveness”, pursuant to SFAS 133.
All investments in fixed-maturity securities were income-producing during 2003, 2002 and 2001. Net realized investment gain (loss) is as follows:
In the first quarter of 2003, the Company received an unexpected increase in the number of new claims reported relating to four policies issued to a single insured between January 1, 1980 and April 1, 1983. The insured was a manufacturer of safety equipment including industrial masks and the new claims reported allege existing and potential bodily injury due to a medical condition called silicosis. The original policies covered products and completed operations only and were issued with a $500,000 indemnity policy aggregate limit of liability. At December 31, 2003, the Company believes that its ultimate obligations for these claims are included in its estimate for unpaid loss and loss adjustment expense reserves.
The fair value of options is estimated on the grant date using the Black-Scholes option pricing model. The model assumes the following: expected annual dividend rates of 2.0% for 2003, 2002 and 2001; risk-free interest rates of 2.4% for 2003, 3.6% for 2002 and 4.9% for 2001; weighted-average expected life of the options of 4 years for 2003 and 4.8 years for 2002 and 2001; and expected stock price volatility of 28% for 2003 and 22% for 2002 and 2001.