The Company currently leases its corporate offices in Southfield, Michigan from an unaffiliated third party. In 2002, the Company paid rent for its corporate offices in the amount of approximately $1.3 million. The term of the lease for the offices in Southfield expires on September 30, 2004. The Company, through its subsidiaries, is also a party to various leases for locations in which such subsidiaries have offices. The Company does not consider any of these leases to be material.
Both the loss and loss adjustment expense ratios are calculated based upon our unconsolidated insurance company operations. The following table sets forth the intercompany fees, which are eliminated in consolidation.
The specialty risk management operations focus on specialty or niche insurance business in which the Company provides services and coverages that are tailored to meet the specific requirements of defined client groups and their members. This includes providing services, such as risk management consulting, claims handling, loss control, and reinsurance brokering, along with various types of property and casualty insurance coverage, including workers’ compensation, general liability, and commercial multiple peril.
The Company categorizes its programs into three categories: managed, risk-sharing, and fully insured. In managed programs, the Company usually assumes no insurance risk and generates fee revenue through program management services. In risk-sharing programs, the Company participates with the client or producing agent in the operating results of the programs through a captive, rent-a-captive or similar insured vehicles, which are reinsurance companies and are accounted for under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts”. In risk-sharing programs, the Company derives revenues from net earned premiums and investment income. In addition, the Company may benefit from any margin built into the ceding commissions for services it renders on behalf of the risk-sharing partner for the program. In fully insured programs, the Company provides commercial insurance coverage and derives revenue exclusively from net earned premiums and investment income. Fully-insured programs are developed in response to a specific market opportunity and generally when the Company believes there is potential to subsequently create a risk-sharing program.
In recent years, the Company has derived its revenue from the following sources (in thousands):
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer’s payment of that loss. To recognize liabilities for unpaid loss and loss expenses, insurers establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported net losses and loss expenses. As of December 31, 2002, the Company had accrued $374.9 million of gross loss and loss adjustment expense reserves compared with $394.6 million at December 31, 2001.
Reserves are reviewed by both internal and independent actuaries for adequacy on a periodic basis. When reviewing reserves, the Company analyzes historical data and estimates the impact of various factors such as (i) per claim information; (ii) Company and industry historical loss experience; (iii) legislative enactments, judicial decisions, legal developments in the imposition of damages, and changes in political attitudes; and (iv) trends in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is not a precise method, however, for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by multiple factors.
The underwriting losses associated with these programs were $12.8 million, $29.0 million, and $12.0 million, for the years ended December 31, 2001, 2000, and 1999, respectively. All premiums related to these programs were fully earned during the first half of 2002. In addition, at December 31, 2002, the uncertainty of future reserve development on these discontinued programs appears to have been reduced as a result of aggressive claims handling and reserve strengthening. However, there can be no certainty that there will not be additional losses in the future associated with these programs.
In its risk-sharing programs, the Company is also subject to credit risk with respect to the payment of claims by its clients’ captive, rent-a-captive, large deductible programs, indemnification agreements, and on the portion of risk exposure either ceded to the captives, or retained by the clients. The capitalization and credit worthiness of prospective risk-sharing partners is one of the factors considered by the Company in entering into and renewing risk-sharing programs. The Company collateralizes balances due from its risk-sharing partners through funds withheld trusts or letters of credit. At December 31, 2002, the Company had risk exposure in excess of collateral in the amount of $11.6 million, compared to $14.1 million at December 31, 2001, on these programs, for which the Company has an allowance of $6.8 million, compared to $6.5 million at December 31, 2001, related to these exposures. The Company has historically maintained an allowance for the potential uncollectibility of certain reinsurance balances due from some risk-sharing partners. At the end of each quarter an analysis of these exposures is conducted to determine the potential exposure to uncollectibility. Management believes that this allowance is adequate. To date, the Company has
not, in the aggregate, experienced material difficulties in collecting balances from its risk-sharing partners. No assurance can be given, however, regarding the future ability of any of the Company’s risk-sharing partners to meet their obligations.
The accident year 2002 loss and LAE ratio was 67.5% on the Company’s continuing business, and there was little adverse development on 2001 and prior reserves related to continuing business as of December 31, 2002;
The Company evaluates existing goodwill for impairment on an annual basis. The Company carries goodwill on two reporting units within the agency operations segment in the amount of $4.0 million and three reporting units within the specialty risk management operations segment in the amount of $25.0 million. The operating results for the reporting units that carry goodwill have historically generated profits and were not impacted by the unprofitable programs that were previously discontinued. Management evaluated the net carrying value of goodwill to determine if there has been any impairment of value. The methodology used for this evaluation included the review of current market values of the reporting units and annual operating performance. Based on this evaluation, management determined there is no impairment to goodwill.
At December 31, 2002 and 2001, the net goodwill was $29.0 million. Amortization expense in relation to goodwill in 2001 and 2000 was $2.3 million and $2.1 million, respectively. In accordance with SFAS No. 142, there was no amortization expense recorded in relation to goodwill in 2002.
At December 31, 2002, gross unrealized depreciation on available for sale securities, which was not impaired, was $648,000. The Company did not hold any securities with market values consistently equal to or less than 80% of amortized cost for a period of six months or more.
Results from operations improved $11.0 million from a net loss of ($17.5) million in 2000 to a net loss of ($6.5) million in 2001. The net loss in 2001 reflects the impact of pre-tax adverse development of $14.4 million on net reserves. The adverse development reflects $5.2 million relating to unprofitable discontinued programs, $4.5 million relating to the provision for uncollectible reinsurance on Connecticut Insurance Company (“CSC”) and HIH America Compensation & Liability Company (“HIH”), and the remaining development related to claims activity on the Company’s automobile liability line of business. CSC is a Connecticut domiciled insurance company, which was seized by the Connecticut Insurance Department, and HIH is a California domiciled insurance company, which was seized by the California Department of
Insurance. In addition, the Company incurred provisions for pre-tax impairments in the investment in CSC surplus notes of $870,000 and recorded a loss of $1.1 million on the sale of a Florida-based agency. The 2000 results also reflected significant adverse development related to the discontinued programs mentioned above.
Net investment income decreased $271,000, or 1.9%, to $13.9 million for the year ended December 31, 2002 from $14.2 million for the comparable period in 2001. This decrease reflects a decrease in the average yield to 5.37% in 2002 from 5.98% in 2001. This decrease is offset by a $23.0 million, or 9.7% increase in average invested assets, from $236.9 million in 2001 to $259.9 million in 2002. The increase in average invested assets reflects net assets invested of $37.5 million from the proceeds received from the public offering in June 2002.
in 2002, compared to 42.4% of net earned premium in 2001. Also contributing to the improvement was the impact of rate increases achieved in 2002 and 2001 of 15.7% and 18.2%, respectively.
This increase in incurred losses on both discontinued and terminated programs reflects a higher level of reported and paid claims, as well as an increase in underlying case reserves on discontinued business. Management believes the increase in incurred losses, which includes both case and paid losses, is the result of recent changes in claims management on these programs that includes claim audits, centralization of claims handling, and the aggressive closing of claim files. These actions caused changes in payment and development patterns which no longer follow the Company’s historical or industry development patterns. Traditional actuarial methods may be causing these actions to be viewed as an indication of a need for higher expected ultimate loss selections, rather than stronger underlying case reserves or acceleration in the payment and reported incurred patterns.
in general economic conditions, including the effects of inflation. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is not a precise method, however, for subsequently evaluating the impact of any specific factor on the adequacy of reserves because the eventual deficiency or redundancy is affected by multiple factors.
Since 1995, the Company’s calendar year development on prior reserves ranged from favorable development of 0.7% in 1995 to adverse development of 17.9% in 1999. Adverse development during years ended December 31, 1998 through December 31, 2002 averaged 11.7%. This unusually high level of adverse development reflects the impact of isolated deviations in the Company’s business model. The deviations included programs that lacked historical loss experience and/or risk sharing and resulted in significant changes in the expected loss ratios as the actual claims emerged. Furthermore, the use of aggregate stop loss provisions, which also deviated from the Company’s business model, had an impact on reserve development. In a program with an aggregate stop loss provision the initial expected loss ratio used in program development and the establishment of premium rates assumed that the projected experience of the program would be below the aggregate attachment point. Since the independent producer of the business was compensated as a percentage of premium and had limited financial risk for underwriting results, these programs experienced rapid growth without meeting the Company’s historical underwriting guidelines. The initial reserves were established based upon these initial expected loss ratios. As claims started to be reported, it became apparent that the expected loss ratios were too low and reserves were adjusted accordingly. As frequency of losses continued to outpace expectations and the aggregate attachment points were exceeded, additional reserve strengthening became necessary. As previously discussed, the Company took actions to discontinue these programs starting in late 1999, and the premiums relating to these programs were fully earned during the first half of 2002. Furthermore, at December 31, 2002, the uncertainty of future reserve development has been reduced as a result of aggressive claims handling and reserve strengthening. As previously discussed, during 2002, the Company’s continuing programs contributed favorable development of $515,000, or 0.6% of reserves related to those programs. However, there can be no certainty that there will not be additional losses in the future associated with these programs.
Revenues from specialty risk management operations increased $19.3 million, or 10.5%, to $204.0 million for the year ended December 31, 2001 from $184.7 million for the comparable period in 2000. This increase reflects 12.1% growth in net earned premiums to $163.7 million in the year ended December 31, 2001 from $146.0 million in the comparable period in 2000, and is the result of growth in existing programs both from increasing policy count and rate increases. These increases were partially offset by the impact of the purchase of a large quota share reinsurance treaty for several workers’ compensation programs and the decline in written premium from discontinued programs. Management fees grew $952,000, or 3.9%, to $25.5 million from $24.5 million. Primarily, this increase resulted from a profit sharing fee of $1.6 million related to the good experience achieved on a loss portfolio transfer and new business growth of $1.0 million, which were partially
offset by the reduction in fees related to discontinued or inactive managed programs. The remaining increase reflects a $513,000, or 3.8%, increase in investment income to $14.2 million in 2001 from $13.7 million in 2000. This increase reflects both a 1.8% increase in average invested assets, from operating cash flows, and a decrease in pre-tax yields to 5.64% in 2001 from 6.23% in 2000.
Agency operations generated pre-tax income of $6.1 million for the year ended December 31, 2002 compared to $5.3 million for the comparable period in 2001. The improvement in the pre-tax margin is the result of rate increases and overall expense reductions.
Agency operations generated pre-tax income of $5.3 million for the year ended December 31, 2001 compared to $4.1 million for the comparable period in 2000. The improvement in agency operations reflects improved margins as a result of expense management initiatives.
On June 6, 2002, the Company sold 18,500,000 shares of newly issued common stock at $3.10 per share in a public offering. On June 21, 2002, the underwriters exercised their over-allotment option to acquire 2,775,000 of additional shares of the Company’s common stock. After deducting underwriting discounts, commissions, and expenses, the Company received net proceeds from the offering of $60.5 million. The Company contributed $37.5 million to the surplus of Star, $20.0 million was used to reduce the outstanding balance on the Company’s line of credit, and the remaining balance will be used for general corporate purposes.
As of December 31, 2002, the Company was in compliance with all debt covenants.
A non-insurance premium finance subsidiary of the Company maintains a line of credit with a bank, which permits borrowings of up to 80% of the accounts receivable, which collateralize the line of credit. The line will expire on May 14, 2003. Management expects to renegotiate the line of credit prior to its expiration. The line bears interest at the Prime Rate, which was 4.25% and 4.75% at December 31, 2002 and 2001, respectively. At December 31, 2002 and 2001, $4.9 million and $3.8 million, respectively, were outstanding under this line of credit.
As of December 31, 2002 and 2001, the recorded values of the Company’s investment portfolio, including cash and cash equivalents, were $286.1 million and $233.7 million, respectively. The debt securities in the
investment portfolio, at December 31, 2002, were 91.7% investment grade A or above bonds as defined by Standard and Poor’s.
As a result of the Company’s public offering, shareholders’ equity increased to $147.4 million, or a book value of $4.98 per common share, at December 31, 2002 compared to $80.3 million, or a book value of $9.44 per common share, at December 31, 2001.
On September 17, 2002, the Company’s Board of Directors authorized management to repurchase up to 1,000,000 shares of the Company’s common stock in market transactions for a period not to exceed twenty-four months. As of December 31, 2002, the Company repurchased and retired 195,700 shares of common stock for a total cost of approximately $455,000. As of March 20, 2003, the Company repurchased and retired an additional 187,300 shares of common stock for a total cost of approximately $448,000.
A significant portion of the Company’s consolidated assets represent assets of the Insurance Company Subsidiaries that at this time cannot be transferred to the holding company in the form of dividends, loans or advances. The restriction on the transferability to the holding company from its Insurance Company Subsidiaries is dictated by Michigan insurance regulatory guidelines, which are as follows: The maximum discretionary dividend that may be declared, based on data from the preceding calendar year, is the greater of each insurance company’s net income (excluding realized capital gains) or ten percent of the insurance company’s surplus (excluding unrealized gains). These dividends are further limited by a clause in the Michigan law that prohibits an insurer from declaring dividends except out of surplus earnings of the company. Earned surplus balances are calculated on a quarterly basis. Since Star is the parent insurance company, its maximum dividend calculation represents the combined insurance companies’ surplus. Based upon the 2002 statutory financial statements, Star may only pay dividends to the Company during 2003 with the prior approval of Michigan Office of Financial and Insurance Services (“OFIS”). Star’s earned surplus position at December 31, 2002 was negative $24.3 million. No dividends were paid in 2002 or 2001.
The Insurance Company Subsidiaries are required to maintain certain deposits with regulatory authorities, which totaled $89.8 million at December 31, 2002, and $71.9 million at December 31, 2001.
The “Company Action Level” is triggered if a company’s total adjusted capital is less than 200% but greater than or equal to 150% of its risk-based capital. At the “Company Action Level,” a company must submit a comprehensive plan to the regulatory authority that discusses proposed corrective actions to improve its capital position. A company whose total adjusted capital is between 250% and 200% of its risk-based capital is subject to a trend test. A trend test calculates the greater of any decrease in the margin (i.e. the amount in dollars by which a company’s adjusted capital exceeds it risk-based capital) between the current year and the prior year and between the current year and the average of the past three years, and assumes that the decrease could occur again in the coming year. If a similar decrease in margin in the coming year would result in a risk-based capital ratio of less than 190%, then “Company Action Level” regulatory action would be triggered.
The “Regulatory Action Level” is triggered if a company’s total adjusted capital is less than 150% but greater than or equal to 100% of its risk-based capital. At the “Regulatory Action Level,” the regulatory authority will perform a special examination of the company and issue an order specifying corrective actions that must be followed.
At December 31, 2002, all of the Insurance Company Subsidiaries were in compliance with RBC requirements. Star reported statutory surplus of $93.8 million and $51.6 million at December 31, 2002 and 2001, respectively. The calculated RBC was $24.8 million in 2002 and $29.7 million in 2001. The threshold requiring the minimum regulatory involvement was $49.7 in 2002 and $59.5 million in 2001.
The NAIC’s Insurance Regulatory Information System (“IRIS”) was developed by a committee of state insurance regulators and is primarily intended to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies twelve industry ratios and specifies “usual values” for each ratio. Departure from the usual values on four or more ratios generally leads to inquiries or possible further review from individual state insurance commissioners.
Statutory net investment income was lower in 2002 due to an $8.2 million decrease in shareholder dividends from subsidiaries. Dividends from subsidiaries totaled $1.8 million in 2002, compared to $10.0 million in 2001. Investment yield was also lower in 2002 due to lower yield rates on securities overall.
Change in Policyholders’ Surplus was favorably impacted by the Company’s public offering of newly issued shares of common stock in June 2002. Of the $60.5 million in total net proceeds, $37.5 million was contributed to the surplus of Star as of June 2002.
business, Williamsburg’s Two-Year Overall Operating Ratio would have been within the usual range at 79%.
The Estimated Current Reserve Deficiency to Policyholders’ Surplus was also impacted by the cancellation of the surplus relief reinsurance treaty. Excluding the effect of the cancellation of this treaty, the Estimated Current Reserve Deficiency to Policyholders’ Surplus would have been within the acceptable range at -28%.
On June 26, 2002, A.M. Best upgraded the Insurance Company Subsidiaries financial strength rating to a “B+” (Very Good) with a positive outlook. A positive outlook is placed on a company’s rating if its financial and market trends are favorable, relative to its current rating level. The upgrade reflects A.M. Best’s positive assessment of the Company’s improved financial condition as a result of the issuance of new common shares and its debt reduction. However, there can be no assurance that A.M. Best will not change its rating of the Insurance Company Subsidiaries in the future.
Effective January 1, 2002, the Company adopted SFAS No. 142 “Goodwill and Other Intangible Assets”. SFAS No. 142, for periods starting December 15, 2001 or thereafter, eliminates the amortization of goodwill. In addition, the Company is required to test, at least annually, all existing goodwill for impairment using a fair value approach, on a reporting unit basis. Also pursuant to SFAS No. 142, the Company is required to test for impairment more frequently if events or changes in circumstances indicate that the asset might be impaired. Upon implementation of SFAS No. 142 in 2002, the Company is no longer amortizing goodwill. Net income would have increased by $1,561,000 and $1,942,000 in 2001 and 2000, respectively, if the amortization of goodwill had ceased as of January 1, 2000.
FASB has issued SFAS No. 148 “Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123”, for periods starting after December 15, 2003 or thereafter. SFAS No. 148 provides three optional transition methods for entities that decide to voluntarily adopt the fair value recognition principles of SFAS No 123, “Accounting for Stock-Based Compensation”, and modifies the disclosure requirements of that Statement. Under the prospective method, stock-based compensation expense is recognized for awards granted after the beginning of the fiscal year in which the change is made. The modified prospective method recognizes stock-based compensation expense related to new and unvested awards in the year of change equal to that which would have been recognized had SFAS No. 123 been adopted as of its effective date, fiscal years beginning after December 15, 1994. The retrospective restatement method recognizes stock compensation costs for the year of change and restates financial statements for all prior periods presented as though the fair value recognition provisions of SFAS No. 123 had been adopted as of its effective date. Management is currently evaluating the alternatives provided under SFAS No. 148.
On March 14, 2003, the Company reported that Joseph C. Henry, Executive Vice President, Chief Operating Officer, and Acting Chief Financial Officer, is leaving the Company. Karen M. Spaun, the Company’s Chief Accounting Officer, has been named Acting Chief Financial Officer. Gregory L. Wilde, Senior Vice President of the Company’s branch operations, has assumed additional corporate and operational responsibilities and will be appointed President of Insurance Company Subsidiaries.