We own two buildings (a five-story office building and an eight-story office building in which part of the first floor is leased to tenants) and related parking facilities in Cedar Rapids, Iowa, that we use as our home office. The two buildings are connected by a skywalk. We also lease additional adjacent office space in Cedar Rapids. Our regional locations in Westminster, Colorado, and Galveston, Texas, conduct operations in leased office space. Our claims office in Metairie, Louisiana, also operates in leased office space. The table below shows a brief description of our owned and leased office space.
o Deferred Policy Acquisition Costs - Property and Casualty Insurance Segment
o Loss and Loss Settlement Expenses - Property and Casualty Insurance Segment
o Future Policy Benefits and Losses, Claims and Loss Settlement Expenses - Life Insurance Segment
We operate property and casualty and life insurance businesses, marketing our products through independent agents. Although we maintain a broad geographic presence that includes most of the United States, more than half of our property and casualty premiums are written in Iowa, Texas, Colorado, Louisiana and Missouri. Approximately three-fourths of our life insurance premiums are written in Iowa, Minnesota, Wisconsin, Nebraska and Illinois.
Our business is cyclical in nature and is influenced by many factors, including price competition, economic conditions, interest rates, weather-related events and other catastrophes including natural (for example hurricanes and tornados) and man-made disasters, state regulations, court decisions and changes in the law.
In 2007, we attained record net income of $111.4 million, compared to $88.1 million in 2006 and $9.0 million in 2005. The strength of our underwriting and overall financial results in 2007 can be attributed to a relatively low level of claim activity related to catastrophes during the year. We also emphasized writing quality business - one of our company’s core objectives - and had favorable results in our non-catastrophe claim activity in each of the past three years. Our results in 2005 were significantly impacted by losses from Hurricane Katrina. Additional development on Hurricane Katrina losses continued to impact our results in 2006.
Beginning in 2005, the property and casualty industry entered into a soft market, characterized by increased price competition and excess underwriting capacity. During the three years ended 2007, we have experienced an increasing rate of competition, which has resulted in decreasing levels of premium pricing in many of our lines of insurance and in many of the geographic areas in which we write, with the exception of coastal areas. The significant losses that the insurance industry suffered due to Hurricane Katrina created hard market conditions in the Gulf Coast region in both personal and commercial lines. However, many insurers, ourselves included, also experienced an increase in prices for property catastrophe reinsurance coverage.
We anticipate that the soft market and more competitive pricing environment will continue through 2008 and beyond. In order to mitigate the effects of a soft insurance market, we will focus on retaining good business and writing quality new business. We intend to capitalize on the strength of our existing agency relationships by emphasizing our highly educated and experienced underwriting staff and our ability and willingness to underwrite and accept unique risks. To aid in policy retention, we provide our agents with superior customer service, which includes personally answering the telephone instead of forcing agents to wade through a series of automated telephone prompts. We will continue to foster personal relationships with our agents by offering cost effective loss control programs and computer systems automation that simplifies and speeds up the process of quoting and writing policies. In 2007, our top 500 agencies generated approximately 88 percent of our underwriting profits. Therefore, the majority of our efforts will be focused on these most profitable agents. In 2008, we will evaluate the potential benefits of entering into additional niche markets.
A lingering challenge from Hurricane Katrina remains policyholder litigation. United Fire & Casualty Company and our Louisiana property and casualty insurance subsidiary, Lafayette Insurance Company, along with many other insurers in the Louisiana market, are named defendants in litigation generated by this catastrophe. Refer to Part I, Item 3 “Legal Proceedings” for a discussion of this litigation and its potential impact to our operations.
In 2007, we continued formalizing our ERM processes. We employ a multi-disciplinary approach to risk identification and evaluation - from claims to underwriting to financial to investments. Members of our ERM committee include our chief executive officer, chief financial officer, executive vice president, vice president of claims, vice president of corporate underwriting, chief investment officer and vice president/chief operating officer of our life insurance subsidiary (United Life Insurance Company), and United Life Insurance Company’s independent actuary. This committee met several times during the year to review the structure for our risk management process.
Our overall operating results have improved over the past three years. In 2007, we experienced a lower-than-normal level of catastrophe losses and continued to experience favorable results in most of our lines of business. Results in 2006 and 2005 were negatively impacted by Hurricane Katrina losses. The results in 2006 and 2005 without the impact of Hurricane Katrina were favorable, attesting to the quality of our core book of business. In addition, our life segment provided a steady stream of pre-tax income in each of the three years; $20.3 million in 2007, $21.9 million in 2006 and $21.4 million in 2005.
There has been slow growth in our net premiums earned over the past three years. Moderate increases in property and casualty premiums have been offset by moderate decreases in life insurance premiums. In the property and casualty segment, competitive market conditions have led to pricing reductions. Premium writings also decreased in 2007 as a result of our planned reduction of property exposures in Louisiana. However, some of this decrease was offset by pricing increases, specifically in hurricane-exposed regions.
The commercial lines pricing environment continues to be competitive, with an average of mid-single digit percentage decreases in premium. In nearly every geographic location in which we do business, we are experiencing pricing pressure on renewal accounts, especially midsize and large accounts. The personal lines pricing environment also continues to be very competitive both in the auto and homeowners lines of business, with an average of mid-single digit percentage decreases in non-catastrophe exposed states.
In the five years prior to 2005, our average catastrophe net losses incurred each year were approximately $21.0 million. In 2005, we incurred $197.1 million in catastrophes. Of this, $178.2 million was attributable to Hurricane Katrina. In 2006, our catastrophe losses totaled $59.8 million, with $31.7 million related to Hurricane Katrina development. In 2007, we incurred $14.1 million in catastrophe losses, with $6.3 million from Hurricane Katrina. In the months following Hurricane Katrina, we made the decision to reduce our property exposures along the Gulf Coast. Due to regulatory constraints, we were required to wait until 2007 to initiate our plan. In 2007, we exceeded our goal of reducing our property exposures in Louisiana, reducing the exposure by one-third. This planned reduction contributed to the flat growth in premium revenue between 2006 and 2007. In addition, premium growth was mitigated due to pricing declines, as a result of soft market conditions. Over the past two years, competitive pressure has led to pricing reductions in many of our lines of business, and in most areas in which we write, with the exception of catastrophe exposed areas. Since Hurricane Katrina, we have significantly increased our pricing in hurricane-exposed regions.
Without the impact of catastrophes, our results have been favorable. Over the past three years, there has been some deterioration in our combined ratio (without catastrophes), due primarily to pricing conditions. Also negatively impacting our non-catastrophe results in 2007 was an increase in claims frequency in the commercial auto line of business and an increase in claims severity in the other liability line of business. Further discussion about these lines as well as our other lines of business, are included in subsequent sections of this report.
Net investment income is discussed on a consolidated basis in a following section of this report.
During 2006 and 2007, despite the soft market conditions, our retention rates of quality accounts have remained high. We attribute this success to our relationships with our agents and a superior level of customer service. We also sought to increase our level of business through new policyholders. We initiated and increased writings in four southern states in 2007 and added many new accounts in some of our Midwestern states. The new business has been generated through our existing independent agency force. In 2007, we targeted the workers’ compensation line of business for growth and were able to increase revenues for this line. We are working on a program of new underwriting tools, to be implemented in 2008 that we anticipate will contribute to the profitability in the workers’ compensation line of business.
loss reinsurance increased substantially because of the significant losses incurred by reinsurers as a result of Hurricane Katrina and other catastrophes. Pricing of ceded reinsurance did not increase materially in 2007. Rather, the reduction in ceded premiums written in 2007, was due to the lower level of direct premiums written.
In 2006, loss and loss settlement expenses incurred were $278.5 million, with $303.5 million of loss and loss settlement expenses that occurred in 2006 and a redundancy of $25.0 million ($62.2 million without the adverse development on Hurricane Katrina claims) on losses that occurred prior to 2006, which resulted from settling or re-estimating claims for less than reserved for at December 31, 2005. Due to Hurricane Katrina, our homeowners, allied lines and commercial multiple peril lines of business experienced a reserve deficiency, while our remaining lines of business experienced reserve redundancies for the year.
In 2005, loss and loss settlement expenses incurred were $375.9 million, which was comprised of $453.4 million that was attributable to losses that occurred in 2005 as offset by a $77.5 million redundancy on losses that occurred prior to 2005. This redundancy resulted from settling or re-estimating claims for less than reserved for at December 31, 2004. We experienced a reserve redundancy in each of our lines of business, with the exception of fidelity and surety.
We discuss our reserving process, which contributed to the favorable development of loss reserves in 2007, 2006 and 2005, under “Critical Accounting Estimates.” The majority of our business consists of short duration contracts. However, we consider our workers’ compensation and other liability lines of business to be long-tail lines of business due to the length of time that may elapse before claims are finally settled. Therefore, we may not know our final development on individual claims for many years. Our estimates for losses, particularly in these long-tail lines, are dependent upon many factors, such as the legal environment, inflation and medical costs. We consider all of these factors, as well as others, in estimating our loss reserves. As conditions or trends with respect to these factors change, we change our estimate for loss reserves accordingly.
(1) “Other liability” is business insurance covering bodily injury and property damage arising from general business operations, accidents on the insured’s premises and products manufactured or sold.
The net loss ratio in our commercial lines of business was 51.8 percent in 2007, 57.8 percent in 2006 and 71.7 percent in 2005. In our commercial property lines, the improvement was due primarily to the lower catastrophe losses experienced in 2007 and 2006 as compared to the losses experienced from Hurricane Katrina in 2005. The 2006 results in these lines were impacted by further development from Hurricane Katrina losses. Our commercial liability lines of business were not impacted materially by Hurricane Katrina. Across all of our commercial lines, pricing reductions impacted our results over the past three years, to varying degrees.
Our commercial automobile insurance covers physical damage to an insured’s vehicle, as well as liabilities to third parties. Automobile physical damage insurance covers loss or damage to vehicles from collision, vandalism, fire, theft, flood or other causes. Automobile liability insurance covers bodily injury, damage to property resulting from automobile accidents caused by the insured, uninsured or underinsured motorists and the legal costs of defending the insured against lawsuits. Our company policy is to write only standard automobile insurance and we do not write coverage for large fleets of automobiles. Our net loss ratio in commercial automobile was 64.1 percent in 2007, 58.1 percent in 2006 and 45.1 percent in 2005. The deterioration in this line during 2007 was primarily due to a 3.8 percent increase in claim frequency as compared to 2006. The deterioration in this line during 2006 was primarily due to an increase in claim severity.
Our net loss ratio in the workers’ compensation line of business was 67.0 percent in 2007, 74.1 percent in 2006 and 62.9 percent in 2005. We consider our workers’ compensation business to be a companion product; we rarely write stand-alone workers’ compensation policies. Our workers’ compensation insurance covers primarily small- to mid-size accounts. The improvement in results in 2007 was due to lower severity, a slight decrease in our frequency and improvements in our medical review programs. The deterioration in workers’ compensation in 2006 was primarily due to an increase in claim severity.
During 2007, we introduced our workers’ compensation business into states where we had not previously written our workers’ compensation line and increased premium writings in states where we were already offering workers’
In our personal lines business, the net loss ratio was 60.7 percent in 2007, 81.2 percent in 2006 and 170.4 percent in 2005. The improvement in the 2007 results is due primarily to the effect that Hurricanes Katrina and Rita had on our 2006 and 2005 results. The competitive market conditions also impacted our results in each of these years. During 2007, premium pricing in our personal auto line of business decreased, while in 2006 and 2005, pricing decreased in each of our lines of personal insurance business. In both fire and allied lines (including homeowners) and automobile, our policy counts decreased in both 2007 and 2006. In our homeowners business, the premium reduction due to the loss of business was more than offset by the significant increases in premium pricing in hurricane-exposed regions.
Our other underwriting expenses increased between 2007 and 2006, which was attributable to an increase in benefit expenses, an increase in accounts receivable charged off and a fixed level of operating expenses on flat premium revenue growth.
Our life insurance segment produced a steady stream of pre-tax income since 2005; however, revenues and expenses decreased in all three years. Net premium earned decreased in 2006 and 2007 due to a decrease in the sales of single premium whole life insurance and the run-off of credit life insurance. We intend to continue offering single premium whole life insurance and are developing a plan to give more focus to the marketing of this product. Net investment income also decreased in each of the three years presented, due to both declining invested assets and market interest rates. Investment results are discussed on a consolidated basis in a following section of this report.
The fixed annuity deposits that we collect are not reported as net premiums earned under GAAP. Instead, we invest annuity deposits and record them as future policy benefits. The revenue that is generated from fixed annuity products consists of policy surrender charges and investment income earned. The difference between the yield we earn on our investment portfolio and the interest we credit on our fixed annuities is known as the investment spread. The investment spread is a major driver of the profitability for all of our annuity products.
The increase in amortization of deferred policy acquisition costs in 2007 was due primarily to changes in our annuity assumptions, with the largest component attributable to a change in our policy lapse assumption. We increased our assumption in response to the increased level of annuity surrenders in recent years and our expectations about the interest rate environment. Amortization of deferred policy acquisition costs decreased in 2006 compared to 2005, due to a decrease of volume in our credit life and health insurance. We stopped writing new business in these lines of insurance in 2004. Refer to “Critical Accounting Estimates” in this section for a more detailed discussion of our life segment’s deferred policy acquisition costs.
Over the past three years, our investment income has increased by 3.0 percent as a result of a 7.4 percent increase in the average invested assets which has offset the depressed market interest rates and the contraction of our annuity business during this period. More than 80.0 percent of our investment income originates from interest on fixed maturities. We derive our remaining investment income from dividends on equity securities, income from other long-term investments, interest on mortgage loans, interest on policy loans, interest on short-term investments and cash and cash equivalents and rent earned from tenants in our home office. The average investment yield, which is investment income divided by average invested assets, was 5.5 percent in 2007, 5.7 percent in 2006 and 5.8 percent in 2005.
Net realized investment gains in 2007 were primarily due to cash received as a result of transactions that impacted companies whose securities we held. The increase in net realized gains in 2006, compared to 2005, is primarily attributable to the sale of our property and casualty insurance subsidiary, American Indemnity Company, in 2006, which resulted in a realized gain of $3.4 million.
particularly in our holdings in financial equity securities. We attribute the decreased stock prices to general market conditions.
Changes in unrealized gains do not affect net income and earnings per common share but do impact comprehensive income, stockholders’ equity and book value per common share. We record unrealized losses subsequently identified as other-than-temporary impairments as a component of net realized investment gains. The amounts reported as net realized investment gains in 2007, 2006 and 2005 included other-than-temporary impairments of $.1 million, $.4 million and $1.2 million, respectively. Refer to “Critical Accounting Estimates” in this section for a presentation of our impairment policy.
Our effective federal income tax expense rate of 30.1 percent for 2007, 29.8 percent for 2006 and federal income tax benefit rate of 37.9 percent for 2005 varied from the applicable federal income tax expense rate of 35.0 percent, due primarily to our portfolio of tax-exempt securities and, in 2007 and 2006, the reduction in valuation allowance resulting from the utilization of a portion of the net operating loss related to American Indemnity Financial Corporation.
As of December 31, 2007, we have net operating loss carryforwards (“NOL”) totaling $17.2 million, all of which was acquired as part of our purchase of American Indemnity Financial Corporation in 1999. Such net operating losses are currently available to offset future taxable income of our property and casualty companies. NOLs totaling $.8 million and $5.5 million expire in 2010 and 2011, respectively.
Our main objectives, while maintaining an acceptable level of risk, in managing our investment portfolio are to maximize both after-tax investment income and total investment returns. We develop our investment strategies based on a number of factors, including estimated duration of reserve liabilities, short- and long-term liquidity needs, projected tax status, general economic conditions, expected rates of inflation and regulatory requirements. We manage our portfolio based on investment guidelines approved by our management, which comply with applicable statutory regulations.
The composition of our investment portfolio at December 31, 2007, is presented in the following table.
Our sources of cash inflows are premiums, annuity deposits, sales, calls or maturity of investments, and investment income. Historically, we have generated substantial cash inflows from operations because cash from premium payments is usually received in advance of cash payments made to settle losses. When investing the cash generated from operations, we invest in securities with maturities that approximate the anticipated timing of payments for losses and loss settlement expenses of the underlying insurance policies. The majority of our assets are invested in fixed maturities.
Liquidity measures our ability to generate sufficient cash flows to meet our short- and long-term cash obligations. We have significant cash inflows from sales of investments and scheduled and unscheduled investment security maturities, redemptions and prepayments. These investing cash flows totaled $408.0 million, $372.1 million and $289.2 million in 2007, 2006 and 2005, respectively, which together with cash flows from operations were sufficient for our cash flow needs in both years.
If our operating and investing cash flows had not been sufficient to support our operations, we may also borrow up to $50.0 million on a bank line of credit. Under the terms of our credit agreement, interest on outstanding notes is payable at the lender’s prevailing prime rate, minus 1.0 percent. We did not utilize our line of credit in 2007 or 2006, other than to secure letters of credit utilized in our reinsurance operations. As of December 31, 2007 and 2006, $.2 million of the line of credit was allocated for that purpose.
Our cash flow activity for the past three years is summarized in the following table.
Net cash provided by operations varies with our underwriting profitability. Favorable underwriting results in each year contributed to an increase in our cash position. Additional increases to cash in 2006 included tax refunds and reinsurance recoveries received which related to Hurricanes Katrina and Rita.
Net cash outflows from investing activities have decreased each year since 2005. In May 2006, we received $107.0 million in net proceeds from the issuance of 4,025,000 shares of common stock. We subsequently invested a portion of these funds, keeping some of the proceeds in cash and cash equivalents. In 2007, we repurchased 497,500 shares of common stock, which reduced our investing purchase activity, compared to 2006.
Net cash flows from financing activities have been impacted by a combination of factors. Cash outflows associated with our life insurance segment’s annuity portfolio have increased in connection with the increased level of surrenders and withdrawals experienced in recent years. Net cash used in these activities totaled $61.7 million, $76.5 million and $1.3 million for 2007, 2006 and 2005, respectively. The increase in withdrawals is described in the “Life Insurance Segment” section. During 2007, pursuant to Board authorization, we repurchased 497,500 shares of common stock, which used cash totaling $16.1 million. Dividend payments to our common shareholders totaled $15.3 million in 2007, compared with $13.2 million in 2006 and $12.0 million in 2005, as we have increased the amount of our dividend per common share each year. Additionally, in 2006, we had proceeds (net of underwriting expenses) of $107.0 million due to the completion of our common stock offering.
equity included dividends paid of $15.3 million, a reduction in net unrealized appreciation on investments of $7.9 million, net of tax, and the change in underfunded status of our employee benefit plans of $3.9 million, net of tax. Book value per share at December 31, 2007, was $27.63, compared with $24.62 at December 31, 2006.
As of December 31, 2007, we had authorization from the Board of Directors to repurchase an additional 189,667 shares of our common stock. On February 15, 2008, our Board of Directors authorized us to repurchase up to an additional 500,000 shares of common stock. As of February 15, 2008, our repurchase authorization is 689,667 shares.
The table below shows our contractual obligations and commitments, including our estimated payments due by period at December 31, 2007.
Payment amounts for future policy benefit reserves must be actuarially estimated and are not determinable from the contract. The projected payments illustrated above are based on the assumption that the holders of our annuities and life insurance policies will withdraw their account balances from our company upon the expiration of their contracts. Actual cash withdrawals could differ significantly from these estimates, depending upon the interest rate environment at the time of the contract expirations.
The amounts presented are estimates of the dollar amounts and time periods in which we expect to pay out our gross loss and loss settlement expense reserves. These amounts are based upon historical payment patterns and may not represent the actual future payments because the actual timing of the estimated future payments may vary from the stated contractual obligation. See “Critical Accounting Estimates: Loss and Loss Settlement Expenses - Property and Casualty Insurance Segment” in this section for further discussion.
Consolidated Financial Statements, we must make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the reporting period. We evaluate our estimates on an ongoing basis. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates. We believe that our most critical accounting estimates are as follows.
In most cases, we use quoted market prices to determine the fair value of fixed maturities, trading securities, equity securities and short-term investments. Where quoted market prices are not available, we base fair value on estimated realizable value. For other long-term investments that primarily consist of holdings in limited partnership funds, we use the value determined by the various fund managers. We exclude unrealized appreciation or depreciation on investments carried at fair value, with the exception of trading securities, from net income and report it, net of applicable deferred income taxes, as a component of accumulated other comprehensive income in stockholders’ equity.
We record an asset for deferred policy acquisition costs, such as commissions, premium taxes and other variable costs incurred in connection with the writing of our property and casualty lines of business. As of December 31, 2007 and 2006, we reported $58.3 million in deferred policy acquisition costs. This asset is amortized over the life of the policies written, generally one year. We assess the recoverability of deferred policy acquisition costs on a quarterly basis by line of business. This assessment is performed by comparing recorded unearned premium to the sum of unamortized deferred policy acquisition costs and estimates of expected losses and loss settlement expenses. If the sum of these costs exceeds the amount of recorded unearned premium, that is, the line of business is expected to generate an operating loss, the excess is recognized as an offset against the asset established for deferred policy acquisition costs. This offset is referred to as a premium deficiency charge. If the amount of the premium deficiency charge is greater than the unamortized deferred policy acquisition cost asset, a liability will be recorded for the excess.
The following table illustrates the hypothetical impact on the premium deficiency charge recorded at December 31, 2007 of reasonably likely changes in the assumed loss and loss settlement expense ratio utilized for purposes of this calculation. The entire impact of these changes would be recognized through income as other underwriting expenses. The base amount indicated below is the actual premium deficiency charge recorded as of December 31, 2007.
We record a deferred asset for our life insurance segment’s policy acquisition costs. At December 31, 2007, we had $70.7 million in deferred policy acquisition costs related to our life insurance segment, compared to $77.4 million at December 31, 2006. Substantially the entire asset relates to our universal life and investment (i.e. annuity) contracts, hereafter referred to as non-traditional business.
A material change in these critical assumptions could have a negative or positive effect on our reported deferred policy acquisition cost asset, earnings and stockholders’ equity.
Reserves for losses and loss settlement expenses are established for all incurred claims without discounting for the time value of money. Before credit for reinsurance recoverables, these reserves were $496.1 million in 2007 and $518.9 million in 2006. We purchase reinsurance to mitigate the impact of large losses and catastrophic events. Loss reserves ceded to reinsurers was $38.8 million in 2007 and $40.6 million in 2006. Our reserves by line of business as of December 31, 2007, were as follows.
(2) “Other liability” is business insurance covering bodily injury and property damage arising from general business operations, accidents on the insured’s premises and products manufactured or sold.
(3) “Fire and allied lines” includes fire, allied lines, homeowners and inland marine.
Estimating case reserves is subjective and complex and requires us to make estimates about the future payout of claims, which is inherently uncertain. When we establish and adjust reserves, we do so based on our knowledge of
Our loss reserves include amounts related to both short-tail and long-tail lines of business. “Tail” refers to the time period between the occurrence of a loss and the ultimate settlement of the claim. A short-tail insurance product is one where ultimate losses are known and settled comparatively quickly; ultimate losses under a long-tail insurance product are sometimes not known and settled for many years. The longer the time span between the incidence of a loss and the settlement of the claim, the more the ultimate settlement amount can vary from the reserves initially established. Accordingly, long-tail insurance products can have significant implications on the reserving process.
Incurred but not reported (“IBNR”) reserves are estimated liabilities, which we establish because claims are not always reported promptly upon occurrence and because the assessment of existing known claims may change over time with the development of new facts, circumstances and conditions.
For both our short-tail and long-tail lines of business, we establish our reserves for IBNR claims by applying a factor to our current pool of in-force premium. This factor has been developed through a historical analysis of company experience as to what level of IBNR should be established to achieve an adequate IBNR reserve relative to our existing loss exposure base. Unique circumstances or trends which are evident as of the end of a given period may require us to refine our IBNR reserve calculation. This methodology for establishing our IBNR reserve has consistently resulted in aggregate reserve levels that management believes are reasonable in comparison to the reserve estimates prepared by Regnier Consulting Group, an independent actuary which we utilize.
Generally, the loss settlement expense reserves for long-tail lines are a greater portion of the overall reserves, as there is often substantial legal fees and other costs associated with the complex liability claims that are associated with long-tail lines. Because short-tail lines settle much more quickly and the costs are easier to determine, loss settlement expense reserves for short-tail claims constitute a smaller portion of the total reserves.
• To our knowledge, there are no new latent trends that would impact our case-basis reserves;
We are unable to reasonably quantify the impact of changes in our key assumptions utilized to establish individual case-basis reserves on our total reported reserve because the impact of these changes would be unique to each specific case-basis reserve established. However, based on historical experience, we believe that aggregate case-basis reserve volatility levels of five percent and ten percent can be attributed to the ultimate development of our case-basis reserves. The table below details the impact of this development volatility on our reported case-basis 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.
Our key assumptions are subject to change as actual claims occur and as we gain additional information about the variables that underlie our assumptions. Accordingly, management reviews and updates these assumptions periodically to ensure that the assumptions continue to be valid. If necessary, management makes changes not only in the estimates derived from the use of these assumptions, but also in the assumptions themselves. Due to the inherent uncertainty caused by using assumptions, loss and loss settlement expense reserve estimates are not exact, and using assumptions can result in estimated losses and loss settlement expenses that may differ materially from the actual losses and loss settlement expenses that subsequently emerge. These differences may be favorable or unfavorable.
As an example, if our reserve for loss and loss settlement expenses of $496.1 million as of December 31, 2007, is 10 percent inadequate, we would experience a reduction in future earnings of up to $49.6 million, before federal income taxes. This reduction could be recorded in one year or multiple years, depending on when we identify the deficiency. The deficiency would also affect our financial position in that our equity would be reduced by an amount equivalent to the reduction in net income. Any deficiency is recognized in the reserve for loss and loss settlement expenses and, accordingly, it usually does not have a material effect on our liquidity because the claims have not been paid. Conversely, if our estimates of ultimate unpaid loss and loss settlement expense liabilities prove to be redundant, our future earnings and financial position would be improved.
Over the course of the last 10 years, our net reserves for losses and loss settlement expenses have exceeded our net incurred losses and loss settlement expenses.
• Assuming that we have liability for all claims, even though the issue of liability may in some cases be resolved in our favor.
• Promoting claims management services to encourage return-to-work programs, case management by nurses for serious injuries and management of medical provider services and billings.
• Using programs and services to help prevent fraud and to assist in favorably resolving cases.
Based upon our comparison of carried reserves to actual claims experience over the last several years, we believe that using company historical premium and claims data to establish reserves for losses and loss settlement expenses results in adequate and reasonable reserves. Based upon this comparison, we believe that our total recorded loss reserves at December 31, 2007, are unlikely to vary by more than 10 percent of the recorded amounts, either positively or negatively. Historically, our reserves have had an average variance of less than 10 percent of recorded amounts, with our reserves booked as of December 31, 2006 and 2005, generating reserve redundancies of 9.4 percent and 4.5 percent in 2007 and 2006, respectively. These redundancies are discussed in detail in the “Results of Operations” section.
business that have historically been most susceptible to significant volatility in reserve development have been shown separately and utilize hypothetical levels of volatility of five percent and ten percent. Our other, less volatile, lines have been aggregated and utilize hypothetical levels of volatility of three percent and five percent.
Regnier Consulting Group uses four projection methods in its actuarial analysis by line of our loss and loss settlement expense reserves. Based on the results of the projection methods, the actuaries select a point estimate of the reserves. They then compare this point estimate to our carried reserves to obtain an estimate of the adequacy of the carried reserves and to validate the reasonableness of the carried reserves. The four methods utilized by Regnier Consulting Group are: paid loss development; reported loss development; Bornhuetter-Ferguson based on paid losses; and Bornhuetter-Ferguson based on reported losses.
Based on the results of the four different projection methods, a reasonable range of net reserves from $394.5 million to $497.3 million has been calculated. Our net reserves for losses and loss settlement expenses as of December 31, 2007 were $457.3 million.
Our reserves for universal life and deferred annuity contracts are based upon the policyholders’ current account value. Acquisition expenses are amortized in relation to profits forecast based upon current best estimates of anticipated premium income, investment earnings, benefits and expenses.
Annually, we review our estimates of unearned revenue liabilities and deferred policy acquisition cost assets and compare them with actual experience. Differences between actual experience and the assumptions that we used in the pricing of policies, guarantees and riders and in the establishment of the related reserves result in variances in profit and could result in losses. The effects of the changes in such estimated reserves are included in the results of operations in the period in which the changes occur.
(1) The change in net unrealized appreciation is net of reclassification adjustments and income taxes.
Certain costs of underwriting new business, principally commissions, premium taxes and variable underwriting and policy issue expenses, have been deferred. Such costs are being amortized as premium revenue is being recognized. Policy acquisition costs deferred in 2007, 2006 and 2005 were $123,362,000, $124,307,000 and $111,802,000, respectively. Amortization of deferred policy acquisition costs in 2007, 2006 and 2005 totaled $123,420,000, $118,756,000 and $106,348,000, respectively. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, losses and expenses to be incurred and certain other costs expected to be incurred as the premium is earned.
Investments in held-to-maturity fixed maturities are recorded at amortized cost. We have the ability and positive intent to hold these investments until maturity. Available-for-sale fixed maturities, trading securities, equity securities and other long-term investments are recorded at fair value. Mortgage loans are recorded at cost. Policy loans are recorded at the outstanding loan amount due from policyholders. Included in investments at December 31, 2007 and 2006, are securities on deposit with, or available to, various regulatory authorities as required by law, with fair values of $1,356,649,000 and $1,389,654,000, respectively.
In 2007, 2006 and 2005, we impaired certain holdings in our investment portfolio as a result of other-than-temporary declines in market value and recorded a pre-tax realized loss of $105,000, $406,000 and $1,208,000, respectively. We continue to review all of our investment holdings for appropriate valuation on an ongoing basis. Refer to Note 2 “Summary of Investments” in this item for a discussion of our accounting policy for impairment recognition.
We made payments for income taxes of $50,513,000, $25,306,000 and $37,903,000 during 2007, 2006 and 2005, respectively. In addition, we received refunds totaling $7,783,000 and $27,844,000 in 2007 and 2006, respectively, due to carryback of losses and the overpayment of 2005 tax. There were no significant payments of interest in 2007, 2006 and 2005, other than interest credited to policyholders’ accounts.
Property and equipment is carried at cost less accumulated depreciation. Depreciation is computed primarily by the straight-line method over the estimated useful lives of the underlying assets. Depreciation expense totaled $3,513,000, $3,418,000 and $3,687,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
We file income tax returns under U.S. federal and various state jurisdictions. We are no longer subject to U.S. federal income tax examination by tax authorities for years before 2004 and state income tax examination for years before 2002. There are no ongoing examinations of income tax returns by federal or state tax authorities.
any portion of such damage was caused by a covered peril, even if the principal cause of the loss was an excluded peril. Other cases challenge the scope or enforceability of the water damage exclusion in the policies.
Several actions pending against various insurers, including us, were consolidated for purposes of pretrial discovery and motion practice under the caption In re Katrina Canal Breaches Consolidated Litigation, Civil Action No. 05-4182 in the United States District Court, Eastern District of Louisiana. On November 27, 2006, the Federal District Court issued an Order in these consolidated cases denying our motion to dismiss. The Court held that the flood exclusions utilized in the forms of homeowners and commercial lines policies issued by us and a number of other insurance carriers were ambiguous because such exclusions did not specify that they applied to flooding caused by negligent acts or omissions as well as to flooding caused by natural incidents such as Acts of God. The plaintiffs in these cases claim, among other things, that the efficient proximate cause of their losses was the third-party negligence of Orleans Levee District. They also claim that the Levee District was negligent in the maintenance of the canal walls or in its failure to warn the plaintiffs and others of the impending water intrusion. On August 2, 2007 the United States Court of Appeals, Fifth Circuit, issued an opinion reversing the District Court and finding the water damage exclusion to be unambiguous and enforceable. The plaintiffs in these cases have sought review in the United States Supreme Court.
Cases interpreting the water damage exclusion are also proceeding in the Louisiana state court system. A state trial court decision that adopted the legal reasoning of the (now reversed) Federal District Court was upheld by a divided Louisiana Court of Appeals. That court agreed with the trial court that the flood damage exclusion in a commercial property policy was ambiguous. The Louisiana Supreme Court has accepted this case for review. Activity in much of the hurricane-related litigation is at a standstill pending a decision by the Louisiana Supreme Court.
We utilize the Black-Scholes option pricing method to establish the fair value of options granted under our stock option plans. Our determination of the fair value of stock-based payment awards on the date of grant using this option-pricing model is affected by our stock price, as well as assumptions regarding a number of complex and subjective variables. These variables include the expected volatility in our stock price, the expected dividends to be paid over the term of the awards, the risk-free interest rate and actual and projected employee stock option exercise activity. Any changes in these assumptions may materially affect the estimated fair value of the award.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” which requires the recognition of the overfunded or underfunded status of pension plans and other postretirement plans as an asset or liability on the balance sheet, with changes occurring during future years reflected as a component of accumulated other comprehensive income, net of tax, effective December 31, 2006. However, SFAS No. 158 does not change the amount of net periodic benefit cost to be recognized as a component of current period operations.
The underfunded status of our employee benefit plans increased by $5,746,000 in 2007, which resulted in a decrease of $3,938,000 (net of tax of $2,121,000) to accumulated other comprehensive income as of December 31, 2007.
In February 2007, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS No. 159 permits entities to choose to measure and report many financial instruments and certain other assets and liabilities at fair value. The objective of SFAS No. 159 is to improve financial reporting by providing entities the opportunity to reduce the complexity in accounting for financial instruments and to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We have elected not to report any financial assets or liabilities at fair value under SFAS No. 159 on January 1, 2008.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosure requirements regarding fair value measurement. Where applicable, SFAS No. 157 simplifies and codifies previously issued guidance on fair value. Although SFAS No. 157 does not require any new fair value measurements, its application may, in certain instances, change current practice. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. Our adoption of SFAS No. 157 effective January 1, 2008, will not have any impact on the amounts reported in our Consolidated Financial Statements. However, we are currently evaluating the impact that the adoption of SFAS No. 157 will have on the disclosures made in our Consolidated Financial Statements.
A reconciliation of the amortized cost (cost for equity securities) to fair values of investments in held-to-maturity and available-for-sale fixed maturity and equity securities as of December 31, 2007 and 2006, is as follows:
The amortized cost and fair value of held-to-maturity, available-for-sale and trading securities at December 31, 2007, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Our investment portfolio includes trading securities with embedded derivatives. These securities, which are primarily convertible redeemable preferred debt securities, are recorded at fair value. Income or loss, including the change in the fair value of these trading securities, is recognized currently in earnings as a component of realized investment gains. Our portfolio of trading securities had a fair value of $10,793,000, at December 31, 2007 and $11,577,000 at December 31, 2006.
Proceeds from the sale of trading securities were $5,815,000, $995,000 and $11,140,000 in 2007, 2006 and 2005, respectively. Gross gains of $2,081,000, $232,000, and $482,000 and gross losses of $29,000, $42,000 and $106,000 were realized on these sales in 2007, 2006 and 2005, respectively. Additional gross gains (losses) of $(480,000), $1,367,000 and $(491,000) were realized in 2007, 2006 and 2005, respectively, which were attributable to the change in fair value of these securities.
Other long-term investments consist primarily of holdings in limited partnership funds that are valued by the various fund managers. In management’s opinion, these values represent fair value at December 31, 2007 and 2006.
Reinsurance is a contract by which one insurer, called the reinsurer, agrees to cover under certain defined circumstances, a portion of the losses incurred by a primary insurer if a claim is made under a policy issued by the primary insurer. We have several programs that provide reinsurance coverage. This reinsurance coverage limits the risk of loss that we retain by reinsuring direct risks in excess of our retention limits. The following table provides a summary of our primary reinsurance treaties. Retention amounts reflect the accumulated retentions and co-participation of all layers within a treaty.
Historically, we have acted as a reinsurer, assuming both property and casualty reinsurance from other insurance or reinsurance companies. Most of the business we have assumed is property reinsurance, with an emphasis on catastrophe coverage. The majority of our assumed reinsurance business expired on or before December 31, 2000. Late in 2006, we made the decision to cancel one of the largest remaining assumed contracts. This decision was made in response to an exposure base that was in excess of our risk tolerance levels as compared to the premium we were able to collect. We limit our exposure on our remaining assumed reinsurance contracts through selective renewal. However, we still have exposure related to the assumed reinsurance contracts that we have elected to continue writing and those that are in runoff status.
In addition, in the event that we incurred catastrophe losses covered by our reinsurance programs, our catastrophe reinsurance program would provide one guaranteed reinstatement at 100.0 percent of the original premium. We also purchase reinsurance from the Florida Hurricane Catastrophe Fund. The level of reinsurance protection obtained through this fund is immaterial to our operations.
United Life Insurance Company has purchased reinsurance to limit the dollar amount of any one risk of loss. On standard individual life cases where the insured is age 65 or younger, our retention is $200,000. On standard individual life cases where the insured is age 66 or older, our retention is $80,000. Our accidental death benefit rider on an individual policy is reinsured at 100 percent up to a maximum benefit of $250,000. Our group coverage, both life and accidental death and dismemberment, is reinsured at 50 percent. Catastrophe excess coverage applies when three or more insureds die in a catastrophic accident. For catastrophe excess claims, we retain the first $1,000,000 of ultimate net loss and the reinsurer agrees to indemnify us for the excess up to a maximum of $5,000,000. We supplement this coverage when appropriate with “known concentration” coverage. Known concentration coverage is typically tied to a specific event and time period, with a threshold of a minimum number of lives involved in the event, minimum event deductible (company’s retention) and a maximum payout.
From 2002 to 2004, the life insurance segment assumed portions of credit life and accident and health insurance business from other insurance companies. We continue to have exposure related to our assumed reinsurance contracts that are in a runoff status.
Statutory capital and surplus in regards to policyholders at December 31, 2007, 2006 and 2005 and net income for the years then ended are as follows:
(1) Because United Fire & Casualty Company owns United Life Insurance Company, the property and casualty statutory capital and surplus includes life, accident and health statutory capital and surplus and therefore represents our total consolidated statutory capital and surplus.
The significant components of the net deferred tax liability at December 31, 2007 and 2006, are as follows:
The table below provides a reconciliation of the changes in benefit obligations and fair value of plan assets for both plans and a statement of the plans’ funded status for 2007 and 2006.
Our accumulated pension benefit obligation was $55,993,000 and $49,670,000 at December 31, 2007 and 2006, respectively. The unrecognized prior service cost and the unrecognized actuarial loss are being amortized on a straight-line basis over an average period of approximately 10 years. This period represents the average remaining employee service period until the date of full eligibility. We anticipate amortization of prior service costs and net losses for 2008 to be $108,000 and $1,206,000, respectively.
The table below provides the components of net periodic benefit cost for the plans for 2007, 2006 and 2005.
We have a profit-sharing plan in which employees who meet service requirements are eligible to participate. The amount of our contribution is discretionary and is determined annually, but cannot exceed the amount deductible for federal income tax purposes. Our contribution to the plan for the years ended December 31, 2007, 2006 and 2005, was $4,107,000, $3,892,000 and $1,364,000, respectively.
We have a nonqualified nonemployee director stock option and restricted stock plan that authorizes United Fire to grant restricted stock and nonqualified stock options to purchase 150,000 shares of United Fire’s common stock, with 100,003 options available for future issuance at December 31, 2007. The board has the authority to determine which nonemployee directors receive options, when options and restricted stock shall be granted, the option price, the option expiration date, the date of grant, the vesting schedule of options or whether the options shall be immediately vested, the terms and conditions of options and restricted stock (other than those terms and conditions set forth in the plan) and the number of shares of common stock to be issued pursuant to an option agreement or restricted stock agreement. The board may also take any action it deems necessary and appropriate for the administration of the plan.
Intrinsic value is the difference between our share price on the last day of trading, December 31, 2007 and the price of the options when granted and represents the value that would have been received by option holders had they exercised their options on December 31, 2007. These values change based on the fair market value of our shares. The intrinsic value of options exercised totaled $774,000, $448,000 and $845,000 in December 31, 2007, 2006 and 2005, respectively.
The following table summarizes information regarding the stock options outstanding and exercisable at December 31, 2007:
The following table set forth our net premiums earned and other considerations by segment before intersegment eliminations.
Total revenue by segment includes sales to outside customers and intersegment sales that are eliminated to arrive at the total revenues as reported in the accompanying Consolidated Statements of Income. We account for intersegment sales on the same basis as sales to outside customers. The following table sets forth certain data for each of our business segments and is reconciled to our Consolidated Financial Statements. Depreciation expense and property and equipment acquisitions for the years ended December 31, 2007, 2006 and 2005, are reported in the property and casualty insurance segment.
We determine the dilutive effect of our convertible preferred stock using the “if-converted” method. Under this method, we add to the denominator of the earnings per share calculation a number determined by multiplying the number of convertible preferred shares by the appropriate conversion rate. We also add the amount of preferred dividends and accretions back to the numerator of the earnings per share equation due to the assumed conversion of all the convertible preferred stock to common stock at the beginning of the reporting period. If the effect of the if-converted method is anti-dilutive, the effect on diluted earnings per share of our convertible preferred stock is disregarded. The preferred stock had an anti-dilutive effect in 2005.
We determine the dilutive effect of our stock options outstanding using the “treasury stock” method. Under this method, we assume the exercise of all of the outstanding options whose exercise price is less than the weighted-average fair market value of our stock during the period. This method also assumes that the proceeds from the hypothetical stock option exercises are used to repurchase shares of common stock at the weighted-average fair market value of the stock during the period. The net of the assumed options exercised and assumed common shares repurchased represent the number of dilutive common shares, which we add to the denominator of the earnings per share calculation.
Outstanding options to purchase shares of common stock (in all years presented) and preferred dividends and accretions (in 2005 only) that were excluded from the diluted earnings per share calculation because the effect of including them would have been anti-dilutive.
Comprehensive income (loss) includes changes in equity during a period except those resulting from investments by shareholders and dividends to shareholders. The following table sets forth the components of comprehensive income (loss) and the related tax effects for the years ended December 31, 2007, 2006 and 2005.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of United Fire & Casualty Company at December 31, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As of December 31, 2007, United Fire & Casualty Company’s management assessed the effectiveness of internal control over financial reporting based on the criteria for effective internal control over financial reporting established in “Internal Control - Integrated Framework,” issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on the assessment, United Fire & Casualty Company’s management determined that effective internal control over financial reporting is maintained as of December 31, 2007, based on those criteria.
Ernst & Young LLP, the independent registered public accounting firm that audited the consolidated financial statements of United Fire & Casualty Company included in this Annual Report on Form 10-K, has audited the effectiveness of internal control over financial reporting as of December 31, 2007. Their report, which expresses an unqualified opinion on the effectiveness of United Fire & Casualty Company’s internal control over financial reporting as of December 31, 2007, is included in this item under the heading “Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting.”
We have audited the internal control over financial reporting of United Fire & Casualty Company (United Fire) as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). United Fire’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on United Fire’s internal control over financial reporting based on our audit.
(3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
In our opinion, United Fire & Casualty Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based onthe COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balances sheets of United Fire & Casualty Company as of December 31, 2007 and 2006, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007, and our report dated February 27, 2008, expressed an unqualified opinion thereon.