Although further premium rate increases were realized during 2004, the increases moderated from those realized in 2003. The increases resulted primarily from the significant property and casualty industry losses as a result of the tragic terrorist attacks of September 11, 2001, lower interest rates, and diminished risk capacity.
During 2004, the Company experienced catastrophe losses attributable to Hurricanes Charley, Frances, Ivan and Jeanne. These catastrophe losses, as noted in the table below, impacted both the Company’s personal and commercial lines segments. Loss estimates may still change in the future due in part to the number of claims which have not yet been completely remediated or for which the property covered by the claim has not been repaired.
Under the Company’s catastrophe reinsurance programs in place for these hurricanes, the Company had a $3.5 million pre-tax per occurrence loss retention for its personal lines catastrophe losses and a $7.0 million pre-tax per occurrence loss retention for its commercial lines catastrophe losses. The Company’s loss retention by hurricane is summarized in the table below:
The Company revised its original estimates as of December 31, 2004 for gross losses due to Hurricanes Charley, Frances, Ivan and Jeanne as noted below (in millions):
The higher loss estimate for Hurricane Frances, which, when combined with the aggregate loss estimates for Hurricanes Charley and Jeanne, resulted in $8.3 million of Hurricane Jeanne losses to be in excess of the aggregate $80.0 million coverage limit available on the $40.0 million excess $50.0 million loss layer of the Company’s catastrophe reinsurance program. This $8.3 million of losses is in addition to the Company’s per occurrence loss retention under its catastrophe reinsurance program. The additional $8.3 million in Hurricane Jeanne losses reduced net income for the fourth quarter 2004 by $5.4 million.
Based upon the current catastrophe loss estimates, recoveries for Hurricane Frances are approaching the limit of the Company’s catastrophe reinsurance program. Catastrophe reinsurance recoveries available to the Company for development on Hurricane Frances beyond current estimates are dollar for dollar for approximately the next $3.5 million of additional increase in catastrophe losses, and 34% of the next $50.0 million of additional increase in catastrophe losses. Because of the interaction of the Florida Hurricane Catastrophe Fund (FHCF) and the Company’s open market reinsurance program, development on Hurricane Charley would reduce the coverage limit available from the FHCF for Hurricane Frances. Additionally since the hurricane losses currently exceed the aggregate $80.0 million coverage limit available on the $40.0 million excess $50.0 million coverage loss layer of the Company’s catastrophe reinsurance program, each dollar of additional development on Hurricane Charley in this layer would diminish coverage available for Hurricane Jeanne losses and result in approximately an additional $.085 of losses being retained by the Company.
possibility of an assessment. As of this date no assessment has been levied, and any such CPIC assessment will be recoverable through policy surcharges.
Gross written premium growth was strong during 2004 across all the Company’s business segments with in-force policy counts increasing 14.7%, 30.0% and 16.0% for the commercial, specialty and
personal lines segments, respectively. Weighted average premium rate increases on renewal business approximated 2.2%, 2.7% and 7.1% for the commercial, specialty and personal lines segments, respectively.
The GAAP combined ratio for the year ended December 31, 2004 was 89.6%, which, once again, was substantially lower than the property and casualty industry as a whole. Included in the 2004 calendar year net loss and loss adjustment expenses was $35.1 million of prior accident year development. The following table illustrates the 2004 calendar year and accident year loss ratios by segment.
The California and Oregon Insurance Departments have also proposed new regulations which would require disclosure of brokerage fees to customers, and would require brokers to advise clients regarding the best available insurer.
A.M. Best Company continually reviews the ratings it assigns to insurance companies and has advised the Company that it must enhance the capital position of its Philadelphia Indemnity Insurance Company and Philadelphia Insurance Company insurance subsidiaries in order for them to maintain their rating. The Company anticipates that it will be able to do so in order to maintain the A.M. Best Company “A+” (Superior) rating for Philadelphia Indemnity Insurance Company and Philadelphia Insurance Company.
The Company’s investment objective is the realization of relatively high levels of after-tax net investment income while generating competitive after-tax total rates of return within a prudent level of risk and within the constraints of maintaining adequate securities in amount and duration to meet cash requirements of current operations and long-term liabilities, as well as maintaining and improving the Company’s A.M. Best rating. The Company utilizes external independent professional investment managers for its fixed maturity and equity investments. These investments consist of diversified issuers and issues, and as of December 31, 2004, approximately 84.9% and 7.3% of
During 2004 the Company’s Investment Committee (The “Committee”) engaged an investment consulting firm under a full service retainer relationship. The Committee initially directed the investment firm to review the Company’s common stock portfolio and managers with respect to style, diversification and performance. Based upon the results of this review and recommendations of the investment firm, the Committee conducted an investment manager search for a large cap growth and large cap value manager. Upon conclusion of the interview process the Committee, in December 2004, decided to change three of its current common stock managers and engaged a new large cap growth and large cap value manager. As a result of this decision $1.4 million in non-cash investment losses was realized in the fourth quarter due to writing down certain common stock securities, for which there was no longer an intent to hold such securities to recovery of cost.
The Company’s fixed maturity portfolio amounted to $1,299.7 million and $1,081.7 million, as of December 31, 2004 and December 31, 2003, respectively, of which 99.3% and 98.6% of the portfolio as of December 31, 2004 and December 31, 2003, respectively, was comprised of investment grade securities. The Company had fixed maturity investments with unrealized losses amounting to $4.9 million and $10.6 million as of December 31, 2004 and December 31, 2003, respectively. Of these amounts, interests in securitized assets had unrealized losses amounting to $1.3 million and $9.2 million as of December 31, 2004 and December 31, 2003, respectively. This decrease in fixed maturity unrealized losses between December 31, 2003 and December 31, 2004 can be largely attributed to the impairment losses on interests in securitized assets recognized in the third quarter of 2004. The remaining unrealized losses are attributable largely to market price changes due to interest rate increases, since the investments were
purchased, and are not considered to be other than temporary impairments, given the ability and intent to hold the securities to recovery. As discussed above, the Company’s impairment evaluation and recognition for interests in securitized assets is conducted in accordance with the guidance provided by the EITF.
The table below provides information about the Company’s financial instruments that are sensitive to changes in interest rates and shows the effect of hypothetical changes in interest rates as of December 31, 2004. The selected hypothetical changes do not indicate what could be the potential best or worst case scenarios (dollars in thousands). Loan balances outstanding under the Company’s borrowing agreement with the Federal Home Loan Bank of Pittsburgh are not included in the table below. Interest rates on the amounts outstanding under this agreement are reset frequently, which limits the impact of changing interest rates. The Company does not have any derivative financial instruments. The information is presented in U.S. dollar equivalents, which is the Company’s reporting currency.
The liability for unpaid loss and loss adjustment expenses (gross basis - $996.7 million and $627.1 million as of December 31, 2004 and 2003, respectively; net basis - $671.7 million and $481.5 million as of December 31, 2004 and 2003, respectively) reflects the Company’s best estimate for future amounts needed to pay losses and related settlement expenses with respect to insured events. Based upon the past ten year experience the estimate for the net liability for unpaid loss and loss adjustment expenses has been redundant by as much as 18.6% and deficient by as much as 45.1%. The process of establishing the liability for property and casualty unpaid loss and loss adjustment expenses is a complex and imprecise process, requiring the use of informed estimates and judgments. This liability includes an amount determined on the basis of claim adjusters’ evaluations with respect to insured events that have occurred and an amount for losses incurred that have not been reported to the Company. In some cases significant periods of time, up to several years or more, may elapse between the occurrence of an insured loss and the reporting of such to the Company. Estimates for unpaid loss and loss adjustment expenses are based on management’s assessment of known facts and circumstances, review of past loss experience and settlement patterns, and consideration of other factors such as legal, social, and economic
The carrying amount of goodwill is subject, at a minimum, to an annual impairment test to identify potential goodwill impairment and measure the amount of a goodwill impairment loss to be recognized (if any). This annual test is performed at December 31 of each year or more frequently if events or circumstance change that require the Company to perform the impairment analysis on an interim basis. Goodwill impairment testing requires the evaluation of the fair value of each reporting unit to its carrying value, including the goodwill, and recording of an impairment charge if the carrying amount of the reporting unit exceeds its estimated fair value. The determination of a reporting unit’s fair value is based on management’s best estimate, which generally considers the unit’s expected future cash flows. The primary assumptions used in the expected future cash flow calculations include premium growth and premium rates, loss ratios, expenses, reinsurance rates and discount rates. Should the assumptions used in the calculation of the expected future cash flows differ substantially from the actual results the estimated fair value of the applicable reporting unit could fall below its carrying value and result in the recognition of an impairment loss. As of December 31, 2004 and 2003, the carrying amount of goodwill was $25.7 million.
The Company has no off-balance sheet arrangements (as that term is defined in Item 303(a) (4) of Regulation S-K) that have or are reasonably likely to have a current or, as of December 31, 2004, future effect on its financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors as of December 31, 2004.
• Consistent prospecting efforts by marketing personnel in conjunction with long term relationships formed by the Company’s marketing Regional Vice Presidents continue to result in additional prospects and increased premium writings, most notably for the Company’s various commercial package and non-profit management liability product lines.
• This growth was offset in part as a result of Liberty American Insurance Group, Inc. suspending the acceptance of applications for new personal lines insurance policies the day prior to Hurricane Charley making landfall in Florida to restrict an increase in exposure during hurricane season. It is estimated that gross written premiums were reduced by approximately $9.5 million due to this restriction. The Company resumed underwriting new preferred homeowners business effective January 1, 2005.
• The Company ceded 22% of its net written premiums and loss and loss adjustment expenses for policies effective April 1, 2003 through December 31, 2003 and 10% of its commercial and specialty lines net written premiums and loss and loss adjustment expenses for policies effective January 1, 2004 through December 31, 2004. During the years ended December 31, 2004 and 2003, the Company ceded $94.5 million and $199.4 million of net written premiums, respectively, and $132.5 million and $116.8 million of net earned premiums, respectively.
Net Investment Income Net investment income approximated $43.5 in 2004 and $38.8 in 2003. Total investments grew to $1,428.2 million at December 31, 2004 from $1,172.1 million at December 31, 2003. The growth in investment income is due to investing net cash flows provided from operating activities. The Company’s average duration of its fixed income portfolio was 4.1 years at December 31, 2004, compared to 4.0 years at December 31, 2003. The Company’s taxable equivalent book yield on its fixed income holdings approximated 4.7% at December 31, 2004, compared to 4.9% at December 31, 2003. Net investment income was reduced by $4.9 million and $2.3 million for the years ended December 31, 2004 and 2003, respectively, due to the interest credit on the Funds Held Account balance pursuant to the Company’s quota share reinsurance agreement (see Premiums).
• Reserve actions taken during the year ended December 31, 2004 wherein the estimated gross and net unpaid loss and loss adjustment expenses for accident years 1996 through 2002 were increased by $84.8 million and $69.4 million, respectively, due principally to continued case reserve development above expectations primarily across various professional liability products in the specialty lines segment and general liability and commercial automobile liability coverages in the commercial lines segment.
• Reserve actions taken during the year ended December 31, 2004 wherein:
• The estimated gross and net unpaid loss and loss adjustment expenses for accident year 2003 were decreased by $37.5 million and $34.3 million, respectively, due principally to continued better than expected claim frequency primarily for general liability and commercial automobile coverages in the commercial lines segment.
Reserve actions taken during the year ended December 31, 2003 wherein the estimated gross and net liability for residual value policies were increased by $38.8 million and a $5.8 million net increase in the estimated gross and net loss reserves for loss and loss adjustment expenses primarily for claims made professional liability and commercial automobile lines of business in prior accident years.
The overall growth in gross written premiums is primarily attributable to the following:
• Further rating downgrades of certain major competitor property and casualty insurance companies have led to their diminished presence in the Company’s commercial and specialty lines business segments and continue to result in additional prospects and increased premium writings, most notably for the Company’s various commercial package and non-profit D&O product lines.
• In-force policy counts have increased 22.8% and 39.7% for the commercial and specialty lines segments, respectively, primarily as a result of the factors discussed above. Policy counts were approximately the same for the personal lines segment as a result of restricting new business and not renewing certain business to manage overall property exposures and the related catastrophe loss considerations. Firming prices in the property and casualty industry resulted in weighted average rate increases on renewal business approximating 4.3%, 10.2%, and 9.4% for the commercial, specialty and personal lines segments, respectively.
• Relatively lower reinsurance costs (ceded premiums) as a result of increasing the Company’s loss retention from $0.5 million to $2.0 million on its commercial lines per-risk property reinsurance treaty and from $0.9 million to $1.0 million on its excess liability reinsurance treaty, effective January 1, 2003.
Net Investment Income Net investment income approximated $38.8 in 2003 and $37.5 million in 2002. Total investments grew to $1,172.1 million at December 31, 2003 from $908.9 million at December 31, 2002. The growth in investment income is due to investing net cash flows provided from operating activities. The Company’s average duration of its fixed income portfolio increased to approximately 4.0 years at December 31, 2003, compared to 3.2 years at December 31, 2002 as a result of investing in overall “AAA” rated intermediate to longer tax exempt fixed income securities due to their perceived relative value to taxable alternatives. The Company’s taxable equivalent book yield on its fixed income holdings declined to 4.9% at December 31, 2003, from 5.2% at December 31, 2002, as a result of investing strong cash inflows due to premium increases at relatively low interest rates during the Federal Reserve’s latest easing cycle. Net investment income was reduced by $2.3 million due to the interest credit on the Funds Held Account balance pursuant to the Company’s quota share reinsurance agreement (see Premiums).
Net Realized Investment Gain (Loss): Net realized investment gains (losses) were $0.8 million for the year ended December 31, 2003 and ($3.4) million for the same period in 2002. The Company realized net investment gains of $7.1 million and $4.0 million from the sale of fixed maturity and equity securities, respectively, for the year ended December 31, 2003, and $4.0 million and $6.3 million in non-cash realized investment losses for fixed maturity and common stock investments, respectively, as a result of the Company’s impairment evaluations.
As of December 31, 2003, the Company has estimated a total liability for gross and net unpaid loss and loss adjustment expenses for the residual value policies of $30.3 million. The residual value policies provide coverage guaranteeing the value of a leased automobile at the lease termination, which can be up to five years from lease inception. As part of the Company’s monitoring and evaluation process, a consulting firm was engaged during the second quarter of 2003 to aid in evaluating the ultimate potential loss exposure under these policies. Based upon the result of the indications and subsequent evaluation by the Company and changes in the Company’s assumptions relating to future frequency and severity of losses, the estimate for unpaid loss and loss adjustment expenses was increased by $33.0 million. The Company primarily attributes this deterioration to the following factors that led to a softening of prices in the used car market subsequent to the September 11, 2001 terrorist attacks: prolonged 0% new car financing rates and other incentives which increased new car sales and the volume of trade-ins, daily rental units being sold into the market earlier and in greater numbers than expected further adding to the oversupply of used cars; and the overall general economic conditions. As of December 31, 2003, approximately 22,000 leases were outstanding under the Company’s residual value policies.
Acquisition Costs and Other Underwriting Expenses: Acquisition costs and other underwriting expenses increased $33.0 million (25.4%) to $162.9 million for the year ended December 31, 2003 from $129.9 million for the same period of 2002. This increase was due primarily to the 37.5% growth in net earned premiums and in part to the Company establishing a $1.4 million allowance for doubtful reinsurance receivables based upon its review of collectibility from its reinsurers. During the year the Company ceded $111.5 million of net earned premium and earned $46.7 million in ceding commission under the quota share reinsurance agreement (see Premiums).
Income Tax Expense: The Company’s effective tax rate for the years ended December 31, 2003 and 2002 was 30.7% and 31.2%, respectively. The effective rates differed from the 35% statutory rate principally due to investments in tax-exempt securities and the relative proportion of tax exempt income to total income before tax.
During 2004, the Company experienced catastrophe losses attributable to Hurricanes Charley, Frances, Ivan, and Jeanne. The catastrophe losses primarily impacted the Company’s personal lines segment and, to a lesser extent, its commercial lines segment. The gross catastrophe loss and loss adjustment expense estimates as a result of these hurricanes was $618.3 million for the personal lines segment and $41.5 million for the commercial lines segment.
Loss estimates may still change in the future due in part to the number of claims which have not yet been completely remediated or for which the property covered by the claim has not been repaired. Under the Company’s catastrophe reinsurance programs in place at the time of these hurricane events, the Company had a $3.5 million pre-tax per occurrence loss retention for its personal lines catastrophe losses and a $7.0 million pre-tax per occurrence loss retention for its commercial lines catastrophe losses. The Company estimates its net aggregate retention losses for the four hurricane events is $46.7 million.
At December 31, 2004 approximately 95.8% of the Company’s reinsurance receivables are either with reinsurers rated “A” or better by A.M. Best Company or are fully collateralized. Approximately $14.5 million of the Company’s reinsurance receivable balances at December 31, 2004 are with Converium Reinsurance North American Inc. (“CRNA”). During the third quarter of 2004, Converium AG (Switzerland), CRNA’s parent company, placed CRNA into an orderly runoff. Of the $14.5 million reinsurance receivable balances with CRNA, $2.5 million are receivables on paid losses and $12.0 million are receivables on case reserves and IBNR. The Company is monitoring CRNA’s ability to pay claims, and at this time, believes that the amounts with CRNA will be collectible.
(1) Although there is typically no minimum contractual commitment with insurance contracts, the cash flows displayed in the table above represent the Company’s best estimate as to amount and timing of such.
(2) Represents payments based on estimated subject earned premiums under certain reinsurance contracts.
payment transactions (including those with employees and non-employees) be recognized in the financial statements. SFAS 123R applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an ESOP) or by incurring liabilities (1) in amounts based (even in part) on the price of the entity’s shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of an entity’s shares or other equity instruments. SFAS 123R is effective for public companies for interim and annual periods beginning after June 15, 2005. The Company will adopt the provisions of SFAS 123R on July 1, 2005 and anticipates a material, but not yet determinable impact on operations and financial position.
In March 2004, the FASB issued EITF No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The standard provides guidance for evaluating whether an investment is other-than-temporarily impaired and was effective for other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004. However, the guidance contained in paragraphs 10-20 of EIFT No. 03-1 has been delayed by FSP EITF Issue 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” posted September 30, 2004. The delay of the effective date for paragraphs 10-20 will be superseded concurrent with the final issuance of proposed FSP EITF Issue 03-1a, “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The disclosures continue to be effective in annual financial statements for fiscal years ending after December 15, 2003, for investments accounted for under Statements 115 and 124. For all other investments within the scope of EITF No 03-1, the disclosures continue to be effective in annual financial statements for fiscal years ending after June 15, 2004. The additional disclosures for cost method investments continue to be effective for fiscal years ending after June 15, 2004.
The Executive Committee of the American Institute of Certified Public Accountants has issued an exposure draft Statement of Position, “Accounting by Insurance Enterprises for Deferred Acquisition Costs on Internal Replacements.” The exposure draft provides guidance on accounting by insurance enterprises for deferred acquisition costs on certain internal replacements other than those specifically described in FASB Statement No. 97. The Company is evaluating the exposure draft and does not presently anticipate a material effect on its operations or financial position as a result of adoption.
Consolidated Balance Sheets - As of December 31, 2004 and 2003
Consolidated Statements of Operations and Comprehensive Income - For the Years Ended
Consolidated Statements of Changes in Shareholders’ Equity - For the Years Ended
Condensed Financial Information of Registrant As of December 31, 2004 and 2003 and For Each of the Three Years in the Period Ended December 31, 2004
Supplementary Information Concerning Property-Casualty Insurance Operations As of and For the Years Ended December 31, 2004, 2003 and 2002
We have completed an integrated audit of Philadelphia Consolidated Holding Corp. and Subsidiaries’ 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Philadelphia Consolidated Holding Corp. (“Philadelphia Insurance”), and its subsidiaries (collectively the “Company”) doing business as Philadelphia Insurance Companies, include four property and casualty insurance companies, Philadelphia Indemnity Insurance Company (“PIIC”) and Philadelphia Insurance Company (“PIC”), which are domiciled in Pennsylvania; and Mobile USA Insurance Company (“MUSA”) and Liberty American Insurance Company (“LAIC”), which are domiciled in Florida (collectively the “Insurance Subsidiaries”); an underwriting manager, Maguire Insurance Agency, Inc.; a managing general agency, Mobile Homeowners Insurance Agencies, Inc; a premium finance company Liberty American Premium Finance Company; and an investment subsidiary, PCHC Investment Corp. The Company designs, markets, and underwrites specialty commercial and personal property and casualty insurance products for select target industries or niches including, among others, nonprofit organizations; the health, fitness and wellness industry; select classes of professional liability; the rental car industry; automobile leasing industry; and personal property and casualty insurance products for the manufactured housing and homeowners markets. All marketing, underwriting, claims management, investment, and general administration is provided by the underwriting manager and managing general agency.
$96.0 million, $229.6 million and $62.6 million, respectively, at December 31, 2004 and $183.0 million, $159.2 million and $53.8 million, respectively, at December 31, 2003. The asset backed, mortgage pass-through and collateralized mortgage obligation securities are amortizing securities possessing favorable prepayment risk and/or extension profiles.
The Company’s impairment evaluation and recognition for interests in securitized assets is conducted in accordance with the guidance provided by the Emerging Issues Task Force of the Financial Accounting Standards Board. Under this guidance, impairment losses on securities must be recognized if both the fair value of the security is less than its book value and the net present value of expected future cash flows is less than the net present value of expected future cash flows at the most recent (prior) estimation date. If these criteria are met, an impairment charge, calculated as the difference between the current book value of the security and its fair value, is included in earnings as a realized loss in the period the impairment arose. Non-cash realized investment losses recorded for the years ended December 31, 2004, 2003 and 2002 were $7.3 million, $9.3 million, and $1.6 million, respectively, as a result of the Company’s impairment evaluation for investments in securitized assets.
The liability for unpaid loss and loss adjustment expenses reflects the Company’s best estimate for future amounts needed to pay losses and related settlement expenses with respect to insured events. The process of establishing the ultimate claims liability is necessarily a complex imprecise process, requiring the use of informed estimates and judgments using data currently available. The liability includes an amount determined on the basis of claim adjusters’ evaluations with respect to insured events that have occurred and an amount for losses incurred that have not been reported to the Company. In some cases significant periods of time, up to several years or more, may elapse between the occurrence of an insured loss and the reporting of such to the Company. Estimates for unpaid loss and loss adjustment expenses are based upon management’s assessment of known facts and circumstances, review of past loss experience and settlement patterns and consideration of other factors such as legal, social, and economic developments. These adjustments are reviewed regularly and any adjustments therefrom are made in the accounting period in which the adjustment arose. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded at December 31, 2004, the related adjustments could have a material adverse impact on the Company’s financial condition, and results of operations.
Premiums are generally earned on a pro rata basis over the terms of the policies. Premiums applicable to the unexpired terms of the policies in-force are reported as unearned premiums. The Company records an allowance for doubtful accounts for premiums receivable balances estimated to be uncollectible. At December 31, 2004 and 2003 the allowance for doubtful accounts amounted to $0.6 million and $2.2 million, respectively.
In the normal course of business, the Company seeks to reduce the loss that may arise from events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with reinsurers. Amounts recoverable from reinsurers are estimated in a manner consistent with the reinsured policy. At December 31, 2004 and 2003 the allowance for uncollectible reinsurance amounted to $1.0 million and $1.2 million, respectively. Amounts for reinsurance assets and liabilities are reported gross.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123R (“SFAS 123R”) “Share-Based Payment”. SFAS 123R replaces SFAS 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion 25, “Accounting for Stock Issued to Employees.” SFAS 123R requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements. SFAS 123R applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an ESOP) or by incurring liabilities (1) in amounts based (even in part) on the price of the entity’s shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of an entity’s shares or other equity instruments. SFAS 123R is effective for public companies for interim and annual periods beginning after June 15, 2005. The Company will adopt the provisions of SFAS 123R on July 1, 2005 and anticipates a material, but not yet determinable impact on operations and financial position.
In March 2004, the FASB issued EITF No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The standard provides guidance for evaluating whether an investment is other-than-temporarily impaired and was effective for other-than-temporary impairment evaluations made in reporting periods beginning after June 15, 2004. However, the guidance contained in paragraphs 10-20 of EIFT No. 03-1 has been delayed by FSP EITF Issue 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” posted September 30, 2004. The delay of the effective date for paragraphs 10-20 will be superseded concurrent with the final issuance of proposed FSP EITF Issue 03-1a, “Implication Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The disclosures continue to be effective in annual financial statements for fiscal years ending after December 15, 2003, for investments accounted for under Statements 115 and 124. For all other investments within the scope of EITF No 03-1, the disclosures continue to be effective in annual financial statements for fiscal years ending after June 15, 2004. The additional disclosures for cost method investments continue to be effective for fiscal years ending after June 15, 2004.
The Executive Committee of the American Institute of Certified Public Accountants has issued an exposure draft Statement of Position, “Accounting by Insurance Enterprises for Deferred Acquisition Costs on Internal Replacements.” The exposure
• Under SAP, certain assets, designated as “Non-admitted Assets” (such as prepaid expenses) are charged against surplus.
• Under SAP, net deferred income tax assets are admitted following the application of certain criteria, with the resulting admitted deferred tax amount being credited directly to policyholder surplus.
• Under SAP, the costs and related recoverables for guaranty funds and other assessments are recorded based on management’s estimate of the ultimate liability and related recoverable settlement, while under GAAP, such costs are accrued when the liability is probable and reasonably estimatable and the related recoverable amount is based on future premium collections or policy surcharges from in-force policies.
• Under SAP, unpaid losses and loss adjustment expenses and unearned premiums are reported net of the effects of reinsurance transactions, whereas under GAAP, unpaid loss and loss adjustment expenses and unearned premiums are reported gross of reinsurance.
Financial Information: The combined statutory capital and surplus of the Insurance Subsidiaries as of December 31, 2004 and 2003 was $503.7 million and $415.9 million, respectively. Combined statutory net income for the years ended December 31, 2004, 2003 and 2002 was $48.2 million, $49.9 million, and $14.5 million, respectively. The Company made capital contributions of $9.5 million and $47.0 million to the Insurance Subsidiaries for the years ended December 31, 2004 and 2003, respectively.
The Company invests primarily in investment grade fixed maturities which possessed a weighted average quality of AAA at December 31, 2004. The cost, gross unrealized gains and losses and estimated market value of investments as of December 31, 2004 and 2003 are as follows (in thousands):
The Company regularly performs various analytical procedures with respect to its investments, including identifying any security whose fair value is below its cost. Upon identification of such securities, a detailed review is performed for all
Additionally, the Company conducts its impairment evaluation and recognition for interests in securitized assets in accordance with the guidance provided by the Emerging Issues Task Force of the Financial Accounting Standards Board (the “EITF”). Under this guidance, impairment losses on securities must be recognized if both the fair value of the security is less than its book value and the net present value of expected future cash flows is less than the net present value of expected future cash flows at the most recent estimation date. If these criteria are met, an impairment charge, calculated as the difference between the current book value of the security and its fair value, is included in earnings as a realized loss in the period the impairment arose. This evaluation resulted in non-cash realized investment losses of $7.3 million and $9.3 million for the years ended December 31, 2004 and 2003, respectively. These non-cash realized investment losses were from investments primarily in collateralized bond obligations which were impacted by recent years’ non investment grade default rates that were higher than historic averages and from investments in other asset backed securities which experienced extension of cash flows on the underlying collateral.
Based upon the Company’s impairment evaluation as of December 31, 2004, it was concluded that the remaining unrealized losses in the table above are not other than temporary.
During 2004 the Company’s gross loss on the sale of fixed maturity and equity securities amounted to $1.3 million and $1.9 million, respectively. The fair value of the fixed maturity and equity securities at the time of sale was $30.7 million and $7.5 million, respectively. During 2003 the Company’s gross loss on the sale of fixed maturity and equity securities amounted to $0.7 million and $0.8 million, respectively. The fair value of the fixed maturity and equity securities at the time of sale was $20.1 million and $4.4 million, respectively. The decision to sell these securities was based upon management’s assessment of economic conditions.
Realized pre-tax investment gains (losses) for the years ended December 31, 2004, 2003, and 2002 are as follows (in thousands):
The Insurance Subsidiaries have investments, principally U.S. Treasury securities, on deposit with the various states in which they are licensed insurers. The carrying value of the securities on deposit was $15.3 million and $15.5 million as of December 31, 2004 and 2003, respectively.
- The Company increased the estimated gross and net loss for unreported claims incurred and related claim adjustment expenses on residual value polices issued during the years 1998 through 2002 by $38.8 million. As of December 31, 2003 the Company’s total liability for gross and net unpaid loss and loss adjustment expenses for these policies is estimated to be $30.3 million. The residual value policies provide coverage guaranteeing the value of a leased automobile at the lease termination, which can be up to five years from lease inception. The increase in the estimated gross and net loss was a result of:
- The decrease in unpaid loss and loss adjustment expenses in accident year 2002 is principally attributable to:
During 2002, the Company increased the estimated loss for unreported claims incurred and related claim adjustment expenses on residual value polices issued during the years 1998 through 2001 by $30.2 million ($20.7 million net of reinsurance). As of December 31, 2001 the Company had estimated a total liability for unpaid loss and loss adjustment expenses for these policies of $14.5 million ($8.7 million net of reinsurance recoverables). During 2002 adverse trends further deteriorated in both frequency and severity on leases expiring in 2002. As part of the Company’s monitoring and evaluation process, consulting firms were engaged during the third quarter of 2002 to aid in evaluating this deterioration and the ultimate potential loss exposure under these policies. As a result of the indications and subsequent evaluation by the Company and changes in the Company’s assumptions relating to future frequency and severity of losses, the estimate for unpaid loss and loss adjustment expenses was increased. The Company primarily attributes this deterioration to the following factors that led to a softening of prices in the used car market subsequent to the September 11, 2001 terrorist attacks: prolonged 0% new car financing rates and other incentives which increased new car sales and the volume of trade-ins, daily rental units being sold into the market earlier and in greater numbers than expected further adding to the over supply of used cars; and the overall uncertain economic conditions.
The Company has also accrued a profit commission receivable, which is recorded in Other Assets, based upon the experience of the underlying business ceded to this reinsurance agreement, in the amounts of $16.7 million and $5.4 million for the year ended December 31, 2004 and 2003, respectively. The profit commission reduces ceded written and earned premiums and increases net written and earned premiums.
The composition of deferred tax assets and liabilities and the related tax effects as of December 31, 2004 and 2003 are as follows (in thousands):
The Company uses the Black-Scholes pricing model to calculate the fair value of the options awarded as of the date of grant.
The Nonqualified Employee Stock Purchase Plan (the “Nonqualified Stock Plan”): The aggregate maximum number of shares that may be issued pursuant to the Nonqualified Stock Plan is 1,000,000. Shares may be purchased under the Nonqualified Stock Plan by eligible employees during designated one-month offering periods established by the Compensation Committee of the Board of Directors at a purchase price of the lesser of 85% of the fair market value of the shares on the first business day of the offering period or the date the shares are purchased. The purchase price of shares may be paid by the employee over nine years pursuant to the execution of a promissory note. The promissory note(s) are collateralized by such shares purchased under the Nonqualified Stock Plan and are interest free. Under the Nonqualified Stock Plan, the Company issued 130,274 and 5,939 shares in 2004 and 2003, respectively. The weighted-average fair value of those purchase rights granted in 2004 and 2003 was $8.37 and $6.00, respectively.
Preferred Agents Stock Purchase Plan (“Preferred Agents Plan”): The Preferred Agents Plan has been established for the benefit of eligible Preferred Agents. The aggregate maximum number of shares that may be issued pursuant to the Preferred Agents Plan is 200,000. Eligible Preferred Agents during designated offering periods may either remit cash or have the Company withhold from commissions or other compensation amounts to be used for the purchase of shares under the terms of the Preferred Agents Plan at a purchase price of the lesser of 85% of the fair market value of the shares on the first business day of the offering period or the date the shares are purchased. Under the Preferred Agents Plan, the Company issued 20,999 and 7,056 shares in 2004 and 2003, respectively. The weighted-average fair value of those purchase rights granted in 2004 and 2003 was $8.37 and $6.00, respectively.
During the three years ended December 31, 2004, the Company repurchased 0.1 million shares for approximately $2.3 million under its stock repurchase authorization. At December 31, 2004, $45.0 million remains under a $75.3 million stock purchase authorization.
The loss and loss adjustment expense reserves ceded under such arrangements were $324.9 million and $145.6 million at December 31, 2004 and 2003, respectively. The Company evaluates the financial condition of its reinsurers to minimize its exposure to losses from reinsurer insolvencies. The percentage of ceded reinsurance reserves (excluding reserves ceded to voluntary and mandatory pool mechanisms) that are with companies rated “A” (Excellent) or better by A.M. Best Company is 95.8% and 99.3% as of December 31, 2004 and 2003, respectively. Additionally, approximately 1%, 1% and 1% of the Company’s net written premiums for the years ended December 31, 2004, 2003, and 2002, respectively, were assumed from an unrelated reinsurance company.
As of December 31, 2004, the Company had aggregate unsecured reinsurance receivables that exceeded 3% of shareholders’ equity from the following reinsurers. Unsecured reinsurance receivables include amounts receivable for paid and unpaid losses and loss adjustment expenses and unearned premium less reinsurance receivables secured by collateral.
The Company has a defined contribution Profit Sharing Plan, which includes a 401K feature, covering substantially all employees. Under the plan, employees may contribute up to an annual maximum of the lesser of 15% of eligible compensation or the applicable Internal Revenue Code limit in a calendar year. The Company makes a matching contribution in an amount equal to 75% of the participant’s pre-tax contribution, subject to a maximum of 6% of the participant’s eligible compensation. The Company may also make annual discretionary profit sharing contributions at each plan year end. Participants are fully vested in the Company’s contribution upon completion of four years of service. The Company’s total contributions to the plan were $1.2 million, $0.9 million and $0.8 million in 2004, 2003, and 2002, respectively.
The Company sponsors an unfunded nonqualified key employee deferred compensation plan. Under the plan deferred compensation benefits are provided through deferrals of base salary and bonus compensation (“Employee Deferrals”) and discretionary contributions by the Company (“Employer Contributions”) for a select group of management and highly compensated employees of the Company and its subsidiaries. Each participant is permitted to specify an investment or investments from among permissible investments which shall be the basis for determining the gain or loss adjustment applicable to such participant’s plan deferral account. A participant’s interest in the portion of his or her plan deferral account that is attributable to Employee Deferrals are fully vested at all times. That portion of a participant’s plan deferral account attributable to Employer Contributions generally will vest over the course of a five year period beginning on the last day of the first year after the plan year for which the Employer Contribution was made. The amounts in each participant’s plan deferral account represent an obligation of the Company to pay the participant at some time in the future. The Company had a deferred compensation obligation pursuant to the plan amounting to $3.2 million and $1.8 million as of December 31, 2004 and 2003, respectively.
The Company also sponsors an unfunded nonqualified executive deferred compensation plan. Under the plan deferred compensation benefits are provided by the Company through deferrals of base salary and bonus compensation for management and highly compensated executives designated by the Board of Directors. Each participant is permitted to specify an investment or investments from among permissible investments which shall be the basis for determining the gain or loss adjustment applicable to such participant’s plan deferral account. A participant’s benefit under the plan is the amount of such participant’s plan deferral amount. The Company had a deferred compensation obligation pursuant to the plan amounting to $1.1 million and $0.8 million as of December 31, 2004 and 2003, respectively.
The following quarterly financial information for each of the three months ended March 31, June 30, September 30 and December 31, 2004 and 2003 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):
Net Earned Premiums for the three months ended March 31, 2004, June 30, 2004, September 30, 2004 and December 31, 2004 includes accrued profit commissions on certain reinsurance contracts of $4.2 million, $4.5 million, $4.6 million and $2.3 million, respectively.
(3) Net Earned Premiums for the three months ended June 30, 2003, September 30, 2003 and December 31, 2003 includes accrued profit commissions on certain reinsurance contracts of $1.9 million, $4.0 million and $4.6 million, respectively.
The Company’s operations are classified into three reportable business segments which are organized around its three underwriting divisions: The Commercial Lines Underwriting Group which has underwriting responsibility for the Commercial Automobile and Commercial Property and Commercial multi-peril package insurance products; The Specialty Lines Underwriting Group which has underwriting responsibility for the professional liability insurance products; and The Personal Lines Group which designs, markets and underwrites personal property and casualty insurance products for the Manufactured Housing and Homeowners markets. Each business segment’s responsibilities include: pricing, managing the risk selection process, and monitoring the loss ratios by product and insured. The reportable segments operate solely within the United States and have not been aggregated.