Underwriting agencies, which supply centralized infrastructure and personnel required to design and service insurance policies that are distributed through retail agencies; and
Statutory accounting practices. We are required to report our results of operations and financial position to various state regulatory authorities based upon statutory accounting practices (“SAP”). One key difference under SAP, as compared to GAAP, is that we are required to expense all sales and other policy acquisition costs as they are incurred rather than capitalizing and amortizing them over the expected life of the policy. The immediate charge off of sales and acquisition expenses and other conservative valuations under SAP generally cause a lag between the sale of a policy and the emergence of reported earnings. Because this lag can reduce our gain from operations on a SAP basis, it can have the effect of reducing the amount of funds available for dividends from our insurance companies. In addition, we are required to file quarterly and annual financial reports with states using SAP, which reflect our insurance company subsidiaries on a going concern basis. In keeping with the intent to assure policyholder protection, SAP is used by state regulators and is generally based on a liquidation concept.
The largest component of our revenues is net premiums earned on insurance policies issued by our three affiliated insurance carriers. Net premiums earned for the year ended December 31, 2006 were $288.1 million, a decrease of $9.7 million, or 3.3%, as compared to $297.8 million in the prior year. Since insurance premiums are earned over the service period of the policies, our revenue in the current period includes premiums earned on insurance products written through our three distribution channels in both current and previous periods. As shown in the table below, net premiums earned on policies sold through our affiliated distribution channels (retail and independent agencies) increased by $5.9 million, or 2.4%. This increase reflects our increased retention of policies written by our insurance carriers in the last year, as compared to the higher level of reinsurance used in prior periods. Net premiums earned on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $15.6 million, or 27.9% as compared to the prior year. For strategic reasons we have chosen to reduce our emphasis on the unaffiliated underwriting agencies distribution channel.
During 2005, we recognized expenses in relation to unusual events including $2.7 million in severance for three former executives, $2.4 million for the write-off of the BRT enterprise system and $0.2 million incurred for a retained search for a replacement executive. Other selling, general and administrative expenses for the year ended December 31, 2005 were $78.6 million and $73.4 million excluding the significant events in 2005, or 49.3% of earned premium.
As of December 31, 2006, we employed 942 employees as compared to 1,182 as of December 31, 2005.
The largest component of our revenues is net premiums earned on insurance policies issued by our affiliated insurance carriers. Net premiums earned for the year ended December 31, 2005 were $297.8 million, an increase of $103.5 million, or 53.2%, as compared to $194.3 million in the prior year. Since insurance premiums are earned over the service period of the policies, our revenue in the current period includes premiums earned on insurance products written through our three distribution channels in both current and previous periods. As shown in the table below, net premiums earned on insurance products sold through the unaffiliated underwriting agency distribution channel for 2005 were $55.8 million, a decrease of $12.7 million or 18.5%, as compared to $68.4 million in the prior year. Net premiums earned on policies sold through our affiliated distribution channels (retail and independent agency) were $242.0 million, an increase of $116.2 million or 92.3%, for the year ended December 31, 2005 as compared to $125.9 million in the prior year. This increase reflects our increased retention of policies written by our insurance carriers in the last year, as compared to the higher level of reinsurance used in prior periods.
Selling, general and administrative expenses for the year ended December 31, 2005 were $153.8 million, an increase of $5.7 million, or 3.9%, as compared to $148.1 million for the same period in 2004, largely due to the growth in our business as well as increased retention. As shown in the table below, selling, general and administrative expenses include the cost of policy acquisition (amortization of deferred policy acquisition costs). Policy acquisition costs, primarily commissions, premium taxes and underwriting expenses related to issuing a policy, are deferred and charged against income ratably over the remaining service periods of the policies produced. Accordingly, amortization of deferred policy acquisition costs is correlated with earned premium. Earned premiums are up 53.2% for the year ended December 31, 2005 as compared to the prior year, so amortization of deferred policy acquisition costs is up commensurately. In 2005, the amortization of deferred policy acquisition costs were 25.2% of earned premiums as compared to 24.5% in the prior year. The following table displays the change in capitalized deferred acquisition costs as well as the impact that amortization of the deferred acquisition costs has on selling, general and administrative expenses:
Our operating subsidiaries’ primary sources of funds are premiums received, commission income and fees, investment income and the proceeds from the sale and maturity of investments. Funds are used to pay claims and operating expenses, to purchase investments and to pay dividends to our holding company.
Effective July 9, 2004, the date of our initial public offering, we terminated our tax allocation agreement with VIG and have filed separate federal income tax returns from that date forward. Prior to July 9, 2004, we were included in the consolidated income tax return with VIG with our provision for income taxes having been recorded as if we filed a separate federal income tax return. Deferred federal income taxes reflect the future tax differences between the tax basis of assets and liabilities and amounts recorded for financial reporting purposes. Recorded amounts will be adjusted to reflect changes in income tax rates for the period in which the change is enacted.
Our business is the design, sale, underwriting and servicing of non-standard personal automobile insurance policies. Our parent company is a holding company, with no revenues and only interest expense on corporate debt. Our subsidiaries consist of several types of legal entities: insurance companies, underwriting agencies, retail agencies, and a service company where all employees are paid. Our insurance companies possess the certificates of authority and capital necessary to transact insurance business and issue policies, but they rely on both affiliated and unaffiliated underwriting agencies to design, distribute and service those policies. Our underwriting agencies primarily design, distribute and service policies issued or reinsured by our insurance companies and that are distributed by our retail entities and by independent agents.
In November 2005, the FASB issued Staff Position (FSP) FAS 115-1 and FAS 124-1, which nullifies certain provisions of EITF Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, and completely supersedes EITF Topic D-44, Recognition of Other Than Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value, addresses (1) determining when an investment should be considered impaired, (2) determining whether an impairment should be deemed other than temporary, and (3) measuring impairment loss. Combined FSP Nos. FAS 115-1 and FAS 124-1 were applied to the realignment of a portion of our investment portfolio as discussed in Note 3 to our consolidated financial statements.
On July 19, 2005, we acquired the assets of IPA, an underwriting agency with operations in Michigan. IPA generates approximately $20.0 million in premiums annually. We paid $600,000 at closing to the owners of IPA, assumed certain liabilities for processing of claims and providing of customer service from existing business, and may pay up to an additional $1.3 million if certain performance criteria are met. During 2005 and 2006, we paid $246,000 and $502,400, respectively, of the $1.3 million to the previous owners of IPA for meeting certain performance criteria.
Depreciation expense was $2.9 million, $3.3 million, and $3.5 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Our Credit Agreement required us to provide the bank with written notification and documents related to certain events. On August 12, 2005 we entered into a First Amendment to Credit Agreement and Waiver of Defaults to the credit facility which amended and waived certain notice requirements of the Credit Agreement and waived all existing defaults and all events of default related to written notice requirements related to certain acquisitions of business in December 2004 and January, February, and July 2005, the repurchase of shares in June of 2005, and the issuance of trust preferred securities in December of 2004 and June of 2005.
Effective January 1, 2006, we account for our stock-based compensation in accordance with FASB Statement No. 123R (“SFAS 123R”), Share-Based Payment.
Discussion and Analysis and several other issues. We applied the principles of SAB 107 in conjunction with our adoption of SFAS 123R.
2. A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either (a) all periods presented or (b) prior interim periods of the year of adoption.
We sponsor a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code. The plan covers substantially all employees who meet specified service requirements. Under the plan, we may, at our discretion, match 100% of each employee’s contribution, up to 3% of the employee’s earnings, plus 50% of each employee’s contribution for the next 2% of the employee’s salary. We made $1.0 million in contributions to the plan during 2006, $1.0 million in 2005 and $1.1 million in 2004.
The carrying amount of and estimated fair values of our financial instruments at December 31, 2006 and 2005 are as follows (dollars in thousands):