The Company designs, markets, and underwrites specialty commercial and personal property and casualty insurance products for select markets or niches by offering differentiated products through multiple distribution channels. 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 multi-peril package, commercial automobile and specialty property and inland marine insurance products; The Specialty Lines Underwriting Group, which has underwriting responsibility for the professional and management liability insurance products; and The Personal Lines Group, which has responsibility for personal property and casualty insurance products for the homeowners and manufactured housing markets. The Company operates solely within the United States through its 13 regional and 25 field offices.
The Company generates most of its revenues through the sale of commercial and personal property and casualty insurance policies. The commercial insurance policies are sold through the Company’s five distribution channels which include direct sales, retail insurance agents/open brokerage, wholesalers, preferred agents and the Internet. The Company believes that consistency in its field office representation has created excellent relationships with local insurance agencies across the country. The personal insurance policies are almost exclusively sold over the Internet via the Company’s proprietary In-Touch system.
Increased premium rate competition for specialty lines segment products and for the specialty property product;
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.
The 2005 calendar year also included $29.9 million of favorable development on prior accident years net loss and loss adjustment expense. The favorable net loss and loss adjustment expense development occurred primarily in the commercial and specialty lines segment in accident years 2004 and 2002. This favorable development is primarily attributed to better than expected claim frequency for commercial package business and better than expected case incurred development for professional liability business for accident year 2004. For accident year 2002, the favorable development resulted from decreased loss estimates across most commercial and specialty lines of business due to better than expected case incurred loss development. The following table illustrates the 2005 calendar year and accident year loss ratios by segment.
The Company recorded a $25.7 million impairment charge related to the write down of the entire amount of goodwill arising from the acquisition of its personal lines segment based upon its annual impairment test. The write down was a result of changes to the personal lines segment business plan due to various factors, including, among others: the forecasted weather pattern of increased hurricane activity and the disruption in the Florida marketplace due to the 2004 and 2005 hurricane activity.
The following is a comparison of selected Statement of Operations and Comprehensive Income data:
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 securities meeting predetermined thresholds to determine whether such decline is other than temporary. If the Company determines a decline in value to be other than temporary, based upon its detailed review, or if a decline in value for an equity investment has persisted continuously for nine months, the cost basis of the security is written down to its fair value. The factors considered in reaching the conclusion that a decline below cost is other than temporary include, but are not limited to: whether the issuer is in financial distress; the performance of the collateral underlying a secured investment; whether a significant credit rating action has occurred; whether scheduled interest payments have been delayed or missed; whether changes in laws and/or regulations have impacted an issuer or industry; an assessment of the timing of a security’s recovery to fair value; and an ability and intent to hold the security to recovery. The amount of any write down is included in earnings as a realized loss in the period the impairment arose (see Investments). Gross unrealized losses for investments excluding interests in securitized assets at December 31, 2005 were $16.8 million.
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. Pursuant to 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 (see Investments). Gross unrealized losses for investments in securitized assets at December 31, 2005 were $9.7 million.
Ultimate losses are determinable by extrapolation of claim emergence and settlement patterns observed in the past (via loss development factor selection) that can reasonably be expected to persist into the future.
These methods use historical loss payments over discrete periods of time to estimate future losses. Historical paid loss development methods assume that the ratio of losses paid in one period to losses paid in an earlier period will remain constant. These methods necessarily assume that factors that have affected paid losses in the past, such as claim settlement patterns, inflation, or the effects of litigation, will remain constant in the future. Because historical paid loss development methods do not use case reserves to estimate ultimate losses, they can be more reliable than the other methods that use incurred losses in situations where there are significant changes in how case reserves are established by claims adjusters. However, historical paid loss development methods are more leveraged (meaning that small changes in payments have a larger impact on estimates of ultimate losses) than actuarial methods that use incurred losses, because cumulative loss payments can take much longer to converge on the expected ultimate losses than cumulative incurred amounts. In addition, and for similar reasons, historical paid loss development methods are often slow to react to situations when new or different factors arise than those that have affected paid losses in the past.
For most lines of business, given the high level of case reserve adequacy observed in recent calendar periods and the consistent claim reserving practices employed by the Company’s claim staff, loss reserves for older accident years are generally set in accordance with ultimate projections from incurred loss development methods. Projections from paid loss development methods may be selected for these older accident years where very few claims remain open and case reserves held for those claims are low relative to observed historical average severities of similar claims. For two Specialty Lines professional liability products (Corporate Directors and Officers and Lawyers Errors and Omissions), changes in claims handling occurred within the past several years that may invalidate the assumptions underlying the standard incurred loss development method. For these products, indications from adjusted historical incurred loss development methods were utilized in place of the standard method in forming the actuarially determined estimate, as the adjustments made attempt to re-state historical experience as it might have appeared had current claim handling practices been in place throughout.
Due to numerous factors including, but not limited to, trends affecting loss development factors and pricing adequacy, the Company’s key actuarial assumptions may change. Approximately 87% of the Company’s loss reserves are for accident years 2003 through 2005. These accident years are also the period where changes, if any, to the factors underlying the actuarial assumptions would be most likely to occur. The quantification referred to in the next paragraph of the impact that changes to the actuarial assumptions could have are stated without any adjustment for reinsurance and before the effects of taxes.
Changes may occur in the actuarial assumption that ultimate losses are determinable by extrapolation of claim emergence and settlement patterns observed in the past (via loss development factor selection) that can reasonably be expected to persist into the future. Changes may also occur in the actuarial assumption that ultimate loss ratios in the current and most recent accident years can be projected from ultimate loss ratios of prior years. A 5% increase or decrease to the actuarially selected loss development factors and expected loss ratios, in the aggregate, as applicable to all lines of business in accident years 2003 to 2005, would increase or decrease the actuarially determined loss reserve estimate by approximately $69.0 million. The results of aggregate changes in the loss development factors and expected loss ratios are approximately linear over reasonable ranges. A 1% increase or decrease in the loss development factors and expected loss ratios, in the aggregate, would have impacts equal to approximately 20% of the impacts stated above.
Reinsurance receivables from reinsurers under reinsurance contracts are subject to estimation. Reinsurance receivables may prove uncollectible if reinsurers are unable or unwilling to perform under the Company’s reinsurance contracts due to, but not limited to, such factors as the reinsurers’ financial condition or coverage disputes. Reinsurance receivables are reported net of an allowance for estimated uncollectible reinsurance receivables. The allowance is based upon the Company’s regular review of amounts outstanding, length of collection period, changes in reinsurer credit standing and other relevant factors. Reinsurance receivables at December 31, 2005 amounted to $336.7 million, and the allowance for estimated uncollectible reinsurance receivables amounted to $1.0 million.
Premiums: Premium information for the Company’s business segments is as follows (in millions):
Realized average rate increases on renewal business approximating 1.3%, and 17.9% for the specialty and personal lines segments, respectively. Realized rates on renewal business decreased 0.2% for the commercial lines segment.
Liberty American Insurance Group, Inc.’s planned shift in product mix of reducing mobile homeowners product policies and increasing homeowners product policies. As a result, mobile homeowners gross written premium decreased $44.9 million and homeowners gross written premium increased $25.7 million.
In-force policy counts for the personal lines segment decreased 3.8%, resulting from a decrease in the in-force counts for the mobile homeowners product of 70.9% and an increase in in-force policy counts for the homeowners product of 54.7%, as a result of the planned shift in product mix noted above.
Re-underwriting the lawyers’ errors and omissions, professional liability excess and program umbrella books of business, resulting in gross written premiums for the specialty lines segment being reduced by $10.9 million, $4.3 million and $5.6 million, respectively.
Increased pricing competition for specialty lines segment products and for the specialty property product (commercial lines segment).
A reduction in the Company’s net liability cession percentage under its quota share reinsurance agreements, as follows:
As a result of the January 1, 2005 casualty excess of loss treaty renewal, the reinsurance costs by product charged by the reinsurers are at a different level than that charged under the prior treaty to reflect their view of expected treaty experience. Accordingly, the specialty lines segment product reinsurance costs were increased, and the commercial lines segment product reinsurance costs were decreased.
Certain of the Company’s reinsurance contracts have provisions whereby the Company is entitled to a return profit commission based on the ultimate experience of the underlying business ceded to the contracts. Under the terms of these contracts, the Company accrued profit commissions of $4.0 million ($3.4 million for the commercial lines segment and $0.6 million for the specialty lines segment) and $15.6 million ($13.0 million for the commercial lines segment, $2.0 million for the specialty lines segment, and $0.5 million for the personal lines segment) for the years ended December 31, 2005 and 2004, respectively. The profit commissions reduced ceded written and earned premiums and increased net written and earned premiums.
A reduction in accelerated, reinstatement and additional reinsurance premium costs related to the Company’s catastrophe reinsurance coverages:
During the year ended December 31, 2005, the Company experienced catastrophe losses attributable to Hurricanes Dennis, Katrina, Rita and Wilma. These multiple hurricane events resulted in the recognition of reinstatement and accelerated catastrophe reinsurance premium expense of $3.9 million ($0.6 million for the Commercial Lines Segment and $3.3 million for the Personal Lines Segment) during the year ended December 31, 2005 due to the utilization of certain of the catastrophe reinsurance coverages. This recognition of reinstatement and accelerated reinsurance premium expense increased ceded written and earned premiums and reduced net written and earned premiums.
Other Income: Other income approximated $1.5 million and $4.4 million for the years ended December 31, 2005 and 2004, respectively. Other income consists primarily of commissions earned on brokered personal lines business, and to a lesser extent brokered commercial lines business. The decrease in other income is due primarily to reduced commissions earned on brokered personal lines business resulting from the termination of certain brokering agreements during 2004.
Net Loss and Loss Adjustment Expenses: Net loss and loss adjustment expenses increased $27.9 million (5.9%) to $504.0 million for the year ended December 31, 2005 from $476.1 million for the same period of 2004, and the loss ratio decreased to 51.6% in 2005 from 61.8% in 2004.
Reserve actions taken during the year ended December 31, 2005 whereby the estimated net unpaid loss and loss adjustment expenses for accident years 2004 and prior were decreased by $29.9 million vs. reserve actions taken during the year ended December 31, 2004 whereby the estimated net unpaid loss and loss adjustment expenses for accident years 2003 and prior were increased by $35.1 million. Changes in the estimated net unpaid loss and loss adjustment expenses during the year ended December 31, 2005 by accident year were as follows:
The decrease in estimated net loss and loss adjustment expenses was principally due to a lower loss estimate for commercial package policies for the 2004 accident year as a result of better than expected claim frequency, and a lower loss estimate for professional liability policies for the 2004 accident year due to better than expected case incurred development.
Citizens reported incurred losses from the hurricanes that struck Florida during 2004 and a deficit for the 2004 plan year. During 2005, the Board of Governors of Citizens authorized the levying of a regular assessment, and the Florida Office of Insurance Regulation also approved the assessment. Based on the Company’s market share, the Company was assessed and paid $11.9 million in Citizens assessments during 2005. This assessment may be recouped through future insurance policy surcharges to Florida insureds. These surcharges will be recorded in the consolidated financial statements as the related premiums are written.
The Company also recognized and paid an additional $0.6 million related to this Citizens assessment pursuant to a quota share reinsurance agreement whereby the Company assumed a 50% participation from an unaffiliated Florida insurer.
During the fourth quarter of 2005, Citizens announced that it was projecting the maximum ten percent regular assessment allowed under Florida law plus an additional emergency assessment of approximately one percent to be assessed during 2006 due to the hurricanes that struck Florida in 2005. As of December 31, 2005, the Company has accrued $12.4 million for the Company’s estimated share of the projected regular assessment. Of this amount, $10.4 million is recoverable from certain of the Company’s catastrophe reinsurers under its 2005 catastrophe reinsurance program and from one of the Company’s quota share reinsurers, resulting in a $2.0 million net assessment expense being recognized during 2005 for Citizens assessments accrued as of December 31, 2005. Companies are required to collect any emergency assessments from residential property policyholders and remit them to Citizens as they are collected, therefore, the Company has not recorded a liability related to the projected emergency assessment.
Income Tax Expense: The Company’s effective tax rate for the years ended December 31, 2005 and 2004 was 34.9% and 29.6%, respectively. The effective rate for 2005 differed from the 35% statutory rate principally due to investments in tax-exempt securities, offset by the non-deductible goodwill impairment loss. The effective tax rate for 2004 differed from the 35% statutory rate principally due to investments in tax-exempt securities.
Premiums: Premium information relating to the Company’s business segments is as follows (dollars in millions):
The displacement of certain competitor property and casualty insurance companies and their independent agency relationships continues to result in new agency relationship opportunities for the Company. These relationship opportunities have resulted in additional policyholders and premium writings for the Company’s commercial and specialty lines segments.
The insurance subsidiaries of Liberty American Insurance Group, Inc. (a subsidiary of the Company) have recently commenced writing a previously brokered homeowners product on a direct basis due to a recent termination of a brokerage agreement. Gross written premiums from this homeowners product approximated $17.1 million for the year ended December 31, 2004.
Realized average rate increases on renewal business approximating 2.2%, 2.7%, and 7.1% for the commercial, specialty and personal lines segments, respectively.
Of the $199.4 million of net written premiums ceded during the year ended December 31, 2003, $63.5 million represents 22% of the Company’s April 1, 2003 unearned premium reserve which was ceded upon entering into the quota share agreement. This cession of the unearned premium reserve reduced net written premiums which approximated the following by segment: commercial lines ($44.0 million), specialty lines ($13.3 million), and personal lines ($6.2 million).
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).
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 evaluation.
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.
Acquisition Costs and Other Underwriting Expenses: Acquisition costs and other underwriting expenses increased $51.5 million (31.6%) to $214.4 million for the year ended December 31, 2004 from $162.9 million for the same period of 2003, and the expense ratio decreased to 27.8% in 2004 from 28.4% in 2003. This increase in acquisition costs and other underwriting expenses was due primarily to the 34.1% growth in net earned premiums. The decrease in the expense ratio is due primarily to an increase in ceding commissions earned and an increase in the ceding commission percentage earned under a quota share reinsurance agreement (see Premiums). This decrease was offset in part by the accelerated recognition of $26.0 million in catastrophe reinsurance expense which reduced net earned premiums. For the years ended December 31, 2004 and 2003, the Company ceded $132.5 million and $116.8 million, respectively, of net earned premiums and earned $61.5 million and $46.7 million, respectively, in ceding commission under a
Income Tax Expense: The Company’s effective tax rate for the years ended December 31, 2004 and 2003 was 29.6% and 30.7%, 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 2005 the Company’s gross loss on the sale of fixed maturity and equity securities amounted to $0.9 million and $5.5 million, respectively. The fair value of the fixed maturity and equity securities at the time of sale was $63.6 million and $56.5 million, respectively. 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.
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, 2005 and 2004. The selected hypothetical changes do not indicate what could be the potential best or worst case scenarios. The information is presented in U.S. dollar equivalents, which is the Company’s reporting currency.
The Company used $2.8 million of net cash from financing activities during 2005. Cash provided from financing activities consisted of $23.7 million from the Company’s stock purchase plans; $11.4 million in proceeds from Federal Home Loan Bank of Pittsburgh (“FHLB”) borrowings; $4.6 million from the exercise of stock options issued under the Company’s performance based compensation plan and $2.3 million from the collection of notes receivable associated with the Company’s employee stock purchase plans. Cash used by financing activities consisted of $44.8 million of repayments of FHLB loans.
Under certain reinsurance agreements, the Company is required to maintain investments in trust accounts to secure its reinsurance obligations (primarily the payment of losses and loss adjustment expenses on business it does not write directly). At December 31, 2005, the investment and cash balances in such trust accounts totaled approximately $1.7 million. In addition, various insurance departments of states in which the Company operates require the deposit of funds to protect policyholders within those states. At December 31, 2005, the balance on deposit for the benefit of such policyholders totaled approximately $15.1 million.
Represents open commitments under certain limited partnership agreements, information technology development agreements, and corporate sponsorship agreements.
As of December 31, 2005, the Company has recorded a $2.0 million liability for a bonus amount due to the Company’s founder and Chairman under the terms of his employment agreement with the Company. This payment is due to be paid six months after the date of the termination of his employment with the Company. Since his date of termination is uncertain, this payment has been excluded from the above table.
Certain information included in this report and other statements or materials published or to be published by the Company are not historical facts but are forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new and existing products, expectations for market segment and growth, and similar matters. In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, the Company provides the following cautionary remarks regarding important factors which, among others, could cause the Company’s actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company’s forward-looking statements. The risks and uncertainties that may affect the operations, performance, development, results of the Company’s business, and the other matters referred to above include, but are not limited to: (i) changes in the business environment in which the Company operates, including inflation and interest rates; (ii) changes in taxes, governmental laws, and regulations; (iii) competitive product and pricing activity; (iv) difficulties of managing growth profitably; (v) claims development and the adequacy of the Company’s liability for unpaid loss and loss adjustment expenses; (vi) severity of natural disasters and other catastrophe losses; (vii) adequacy of reinsurance coverage which may be obtained by the Company; (viii) ability and willingness of the Company’s reinsurers to pay; (ix) future terrorist attacks; (x) the outcome of the Securities and Exchange Commission’s industry-wide investigation relating to the use of non-traditional insurance products, including finite risk reinsurance arrangements; and (xi) the outcome of industry-wide investigations being conducted by various insurance departments, attorneys-general and other authorities relating to the use of contingent commission arrangements. The Company does not intend to publicly update any forward looking statement, except as may be required by law.
Consolidated Statements of Operations and Comprehensive Income - For the Years Ended December 31, 2005, 2004 and 2003
Condensed Financial Information of Registrant As of December 31, 2005 and 2004 and For Each of the Three Years in the Period Ended December 31, 2005
We have completed integrated audits of Philadelphia Consolidated Holding Corp. and Subsidiaries’ 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its 2003 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.
Share information restated to reflect a three-for-one split of the Company’s common stock distributed on March 1, 2006, see Note 20.
The carrying amount for the Company’s investments approximates their estimated fair value. The Company measures the fair value of investments based upon quoted market prices or by obtaining quotes from third party broker-dealers. Material assumptions and factors utilized by such broker-dealers in pricing these securities include: future cash flows, constant default rates, recovery rates and any market clearing activity that may have occurred since the prior month-end pricing period. For mortgage and asset-backed securities (“structured securities”) of high credit quality, changes in expected cash flows are recognized using the retrospective method. For structured securities where the possibility of credit loss is other than remote, changes in expected cash flows are recognized on the prospective method over the remaining life of the securities. Cash flow assumptions for structured securities are obtained from broker dealer survey values or internal estimates consistent with the current interest rate and economic environments. These assumptions represent the Company’s best estimate of the amount and timing of estimated principal and interest cash flows based on current information and events that a market participant would use in determining the current fair value of the security. The Company’s total investments include $3.4 million in securities for which there is no readily available independent market price.
Equity securities are carried at market value with the change in unrealized appreciation (depreciation) credited or charged directly to shareholders’ equity, net of applicable deferred income taxes.
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 such securities, except interests in securitized assets, meeting predetermined thresholds to determine whether such decline is other than temporary. If the Company determines a decline in value to be other than temporary, the cost basis of the security is written down to its fair value with the amount of the write down included in earnings as a realized loss in the period the impairment arose. This evaluation resulted in non-cash realized investment losses of $2.2 million, $2.5 million and $1.0 million for the years ended December 31, 2005, 2004 and 2003, respectively.
The Company held no derivative financial instruments, nor embedded financial derivatives, as of December 31, 2005 and 2004.
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, 2005, the related adjustments could have a material adverse impact on the Company’s financial condition and results of operations.
Basic earnings per share has been calculated by dividing net income by the weighted-average common shares outstanding. Diluted earnings per share has been calculated by dividing net income by the weighted-average common shares outstanding and the weighted-average share equivalents outstanding. Basic and diluted earnings per share and share equivalents outstanding have been retroactively restated to reflect the increased number of common shares resulting from a three-for-one stock split that was announced in February 2006 and distributed to shareholders on March 1, 2006. A total of 46,504,434 additional shares were issued as a result of the stock split. The par value of the Company’s stock remained unchanged.
In December 2004, the FASB revised Statement No. 123 (SFAS 123R), “Share-Based Payment,” which requires companies to expense the estimated fair value of employee stock options and similar awards, for all options vesting, granted, or modified after the effective date of this revised statement. The accounting provisions of SFAS 123R were to become effective for interim periods beginning after June 15, 2005. However, in April 2005, the Securities and Exchange Commission (SEC) adopted a final rule amending Rule 4-01(a) of Regulation S-X regarding the compliance date for SFAS 123R. The effect of this ruling is to delay the effective date of SFAS 123R to the first interim or annual reporting period of the registrant’s first fiscal year beginning on or after June 15, 2005. As a result, the accounting provisions of SFAS 123R will become effective for the Company’s financial statements beginning in 2006.
Restated to reflect a three-for-one split of the Company’s common stock distributed on March 1, 2006.
On March 29, 2005, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 107 (“SAB 107”), which provides guidance on accounting for share-based payments. SAB 107 summarizes the views of the SEC regarding the interaction between Statement of Financial Accounting Standards No. 123 (revised 2004) (“SFAS 123R), “Share-Based Payment” and certain SEC rules and regulations and provides the SEC’s views regarding the valuation of share-based payment arrangements for public companies. The Company will utilize the guidance provided by SAB 107 when implementing SFAS 123R.
On April 14, 2005, the SEC announced the adoption of a new rule that amends the compliance dates for the adoption of SFAS 123R. Under SFAS 123R, public companies would have been required to implement the standard as of the beginning of the first interim or annual period that begins after June 15, 2005. The SEC’s new rule allows public companies to implement SFAS 123R at the beginning of the next fiscal year after June 15, 2005. The Company intends to adopt the provisions of SFAS 123R effective January 1, 2006.
Under SAP, policy acquisition costs, such as commissions, premium taxes, fees, and other costs of underwriting policies are charged to current operations as incurred, while under GAAP, such costs are deferred and amortized on a pro rata basis over the period covered by the policy.
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.
Financial Information: The combined statutory capital and surplus of the Insurance Subsidiaries as of December 31, 2005 and 2004 was $691.0 million and $503.7 million, respectively. Combined statutory net income for the years ended December 31, 2005, 2004 and 2003 was $155.5 million, $48.2 million, and $49.9 million, respectively. The Company made capital contributions of $27.0 million and $9.5 million to the Insurance Subsidiaries for the years ended December 31, 2005 and 2004, respectively.
The Company invests primarily in investment grade fixed maturities which possessed a weighted average quality of AAA at December 31, 2005. In addition, 99.97% of the Insurance Subsidiaries’ fixed maturity securities (cost basis) consisted of U.S. government securities or securities rated “1” (“highest quality”) or “2” (“high quality”) by the NAIC at December 31, 2005. The cost, gross unrealized gains and losses and estimated market value of investments as of December 31, 2005 and 2004 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 securities, except interests in securitized assets, meeting predetermined thresholds to determine whether such decline is other than temporary. If the Company determines a decline in value to be other than temporary, based upon its detailed review, or if a decline in value for an equity investment has persisted continuously for nine months, the cost basis of the security is written down to its fair value. The factors considered in reaching the conclusion that a decline below cost is other than temporary include, but are not limited to: whether the issuer is in financial distress; the performance of the collateral underlying a secured investment; whether a significant credit rating action has occurred; whether scheduled interest payments have been delayed or missed; whether changes in laws and/or regulations have impacted an issuer or industry; an assessment of the timing of a security’s recovery to cost; and an ability and intent to hold the security to recovery. The amount of any write down is included in earnings as a realized loss in the period the impairment arose. This evaluation resulted in non-cash realized investment losses of $2.2 million, $2.5 million and $1.0 million for the years ended December 31, 2005, 2004 and 2003, respectively. The Company attributes these other than temporary declines in fair value primarily to issuer specific conditions, except for as noted in the following paragraph.
The cost and estimated market value of fixed maturity securities at December 31, 2005, by remaining contractual maturity, are shown below. Expected maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
The sources of net investment income for the years ended December 31, 2005, 2004, and 2003 are as follows (in thousands):
Realized pre-tax investment gains (losses) for the years ended December 31, 2005, 2004, and 2003 are as follows (in thousands):
PIIC and PIC are required to hold a certain minimum amount of Federal Home Loan Bank of Pittsburgh common stock as a requirement of membership in the Federal Home Loan Bank of Pittsburgh. The required minimum amount of common stock is based on the amount of PIIC’s and PIC’s outstanding borrowings plus the unused maximum borrowing capacity, as defined by the Federal
The Company’s share of the investments in the trust accounts is included in investments and cash equivalents, as applicable, in the accompanying consolidated balance sheets.
Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended, requires that derivatives be recorded on the balance sheet as either assets or liabilities measured at fair value. Changes in the fair value of derivatives are recorded either through current earnings or as other comprehensive income, depending on the type of hedge transaction. Gains and losses on the derivative instrument reported in other comprehensive income are reclassified into earnings in the periods in which earnings are impacted by the variability of the cash flow of the hedged item. The ineffective portion of all hedge transactions is recognized in current period earnings.
Subsequent to the purchase of the cash flow hedge, the Company decided against the issuance of a debt offering. As a result, the cash flow hedge became an ineffective hedge and the change in fair value of the hedge was reported as a component of earnings immediately. The cash flow hedge settled on May 9, 2005. For the year ended December 31, 2005, the Company has recorded the change in fair value of $3.2 million as a reduction to net realized investment gain. The Company does not hold any other derivative instruments.
The following table summarizes property and equipment at December 31, 2005 and 2004 (dollars in thousands):
The following table sets forth a reconciliation of beginning and ending reserves for unpaid loss and loss adjustment expenses, net of amounts for reinsured losses and loss adjustment expenses, for the years indicated.
During the year ended December 31, 2005, net loss and loss adjustment expense payments for claims attributable to prior years are lower by $64.3 million than they otherwise would have been due to the Company’s commutation of its 2003 Whole Account Net Quota Share Reinsurance Agreement (See Note 10).
The changes in the net ultimate losses and loss adjustment expenses for prior accident years during 2005 was primarily attributable to the following:
For accident years 2002, the decrease in estimated net unpaid loss and loss adjustment expenses and prior was principally due to decreased loss estimates across most commercial and specialty lines of business due to better than expected case incurred loss development.
During 2003, the Company increased the liability for unpaid loss and loss adjustment expenses by $51.7 million ($44.6 million net of reinsurance recoverables), primarily for accident years 1997 through 2001. This increase in the liability for unpaid loss and loss adjustment expense, net of reinsurance recoverables, was primarily due to the following:
Adverse trends further deteriorating in both claims frequency and severity for leases expiring in 2003. During the second quarter of 2003, the Company engaged a consulting firm to aid in evaluating the ultimate potential loss exposure under these policies. Based upon the study and subsequent evaluation by the Company, the Company changed its assumptions relating to future frequency and severity of losses, and increased the estimate for unpaid loss and loss adjustment expenses 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 and 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 uncertain economic conditions.
$19.6 million ($13.7 million net of reinsurance recoverables) of development in claims made professional liability products as a result of case reserves developing greater than anticipated from the year-end 2002 ultimate loss estimate; $18.1 million ($11.1 million net of reinsurance recoverables) of development in the automobile and general liability coverages for commercial package products due to the frequency and severity of the losses developing beyond the underlying pricing assumptions; and $5.8 million ($6.0 million net of reinsurance recoverables) of development in the
The decrease in unpaid loss and loss adjustment expenses in accident year 2002 is principally attributable to:
Effective April 1, 2003, the Company entered into a quota share reinsurance agreement. Under this agreement, the Company ceded 22% of its net written premiums and loss and loss adjustment expenses for substantially all of the Company’s lines of business on 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 and thereafter. The Company receives a provisional commission of 33.0% adjusted pro-rata based upon the ratio of losses incurred to premiums earned. Pursuant to this reinsurance agreement the Company withholds the reinsurance premium due the reinsurers reduced by the reinsurers’ expense allowance, and the Company’s ceding commission allowance in a Funds Held Payable to Reinsurer account. This Funds Held Payable to Reinsurer account is also reduced by ceded paid losses and loss adjustment expenses under this agreement, and increased by an interest credit. In addition, the agreement allows for a profit commission to be paid to the Company upon commutation. Effective January 1, 2005, the Company entered into a Reinsurance Commutation and Release Agreement with respect to the 2003 Whole Account Net Quota Share Reinsurance contract. As a result of this commutation, the Funds Held Payable to Reinsurer liability was reduced by approximately $77.9 million, offset by an increase to net Unpaid Loss and Loss Adjustment Expenses of $64.3 million, an increase to net Unearned Premiums of $0.2 million and a reduction to the profit commission receivable by approximately $13.4 million. No gain or loss was realized as a result of this commutation.
Activity for the Funds Held Payable to Reinsurer is summarized as follows (in thousands):
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 $7.0 million and $16.7 million as of December 31, 2005 and 2004, respectively. The profit commission reduces ceded written and earned premiums and increases net written and earned premiums.
Based on the Company’s federal tax loss and capital loss carryback availability, expected levels of future pre-tax financial statement income and federal taxable income, the Company believes that it is more likely than not that the existing deductible temporary differences will reverse during periods in which net federal taxable income is generated or have adequate federal carryback availability. As a result, no valuation allowance is recognized for deferred income tax assets as of December 31, 2005 or 2004.
In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure (“SFAS No. 148”) which amends SFAS Statement No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”). The objective of SFAS No. 148 is to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 does not change the provisions of SFAS No. 123 that permit entities to continue to apply the intrinsic value method of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”). In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company continues to maintain its accounting for stock-based compensation in accordance with APB No. 25, but has adopted the disclosure provisions of SFAS No. 148.
The Company’s shareholders, at the 2005 Annual Meeting of Shareholders, approved the adoption of the Philadelphia Consolidated Holding Corp Amended and Restated Employees’ Stock Incentive and Performance Based Compensation Plan (the “Plan”) as an amendment and restatement of the stock option plan (formerly known as Philadelphia Consolidated Holding Corp. Stock Option Plan) as means for the provision of incentives and awards to those employees and members of the Board (“participants”) largely responsible for the long term success to the Company.
The adoption of the amendment and restatement of the plan, among other things, allows for the provision of the incentive awards and increased the maximum number of shares of the Company’s common stock which may be subject to stock options, Stock Appreciation Rights (“SARS”), and awards granted under the Plan to 18,750,000 (restated to reflect a three-for-one split of the Company’s common stock distributed on March 1, 2006), and permits (but does not require) the grant of restricted stock awards under conditions meeting the “performance based” compensation requirements of Section 162(m) of the Internal Revenue Code. The maximum number of shares includes all shares previously available for grants under the stock option plan prior to the adoption of this Amended and Restated Plan. As of December 31, 2005, 5,631,210 shares of common stock remain reserved for future issuance pursuant to stock options, SARS and awards granted under the Plan. As of December 31, 2005, stock options and restricted stock awards have been granted to employees pursuant to the Plan.
Compensation expense for restricted stock awards is recognized ratably over the vesting period (“Restriction Period”). Stock subject to restricted stock awards granted during 2005 generally become free of the risk of forfeiture (i.e., become vested) after the expiration of five years following the grant date (the applicable Restriction Period). Generally, if a participant terminates employment prior to
the expiration of the Restriction Period, the award will lapse and all shares of common stock still subject to the restriction shall be forfeited.
The following table presents certain information regarding stock options outstanding at December 31, 2005.
Initial grant of restricted stock awards pursuant to the Plan occurred during 2005
The Company has established the following stock purchase plans (all share and purchase rights granted amounts have been restated to reflect a three-for-one split of the Company’s common stock which was distributed on March 1, 2006):
Employee Stock Purchase Plan (the “Stock Purchase Plan”): The aggregate maximum number of shares that may be issued pursuant to the Stock Purchase Plan as amended is 3,000,000. Shares may be purchased under the Stock Purchase 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
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 3,000,000. 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 1,263,600 and 390,822 shares in 2005 and 2004, respectively. The weighted-average fair value of those purchase rights granted in 2005 and 2004 was $4.03 and $2.79, respectively.
Directors Stock Purchase Plan (“Directors Plan”): The Directors Plan has been established for the benefit of non-employee Directors. The aggregate maximum number of shares that may be issued pursuant to the Directors Plan is 150,000. Non-employee Directors, during monthly offering periods, may designate a portion of his or her fees to be used for the purchase of shares under the terms of the Directors 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 Directors Plan, the Company issued 8,883 and 15,627 shares in 2005 and 2004, respectively. The weighted-average fair value of those purchase rights granted in 2005 and 2004 was $3.90 and $2.81, respectively.
In the normal course of business, the Company has entered into various reinsurance contracts with unrelated reinsurers. The Company participates in such agreements for the purpose of limiting loss exposure and diversifying business. Reinsurance contracts do not relieve the Company from its obligation to policyholders. The loss and loss adjustment expense reserves ceded under such arrangements were $304.8 million and $324.9 million as of December 31, 2005 and 2004, respectively.
At December 31, 2005 the Company has open commitments of $3.7 million under certain limited partnership, information technology and corporate sponsorship agreements.
Florida Citizens also reported losses from Hurricane Wilma in 2005, which followed the deficit for the 2004 plan year. Florida Citizens announced that a future assessment as a result of Citizens’ current financial deficit is both probable and can be reasonably estimated. As of December 31, 2005, the Company has accrued its estimated assessment of $12.4 million, which represents its portion of the maximum regular assessment available to Citizens. Of this amount, $10.4 million is recoverable from certain of the Company’s reinsurers, resulting in a $2.0 million net assessment expense being recognized during 2005 for Citizens assessments accrued as of December 31, 2005.
The Company and other insurance companies writing residential property policies in Florida must participate in the Florida Hurricane Catastrophe Fund (“FHCF”). If the FHCF does not have sufficient funds to pay its ultimate reimbursement obligations to participating insurance companies, it has the authority to issue bonds, which are funded by assessments on generally all property and casualty premiums in Florida. By law, these assessments are the obligation of insurance policyholders, which insurance companies must collect. The FHCF assessments are limited to 6% of premiums per year beginning the first year in which reimbursements require bonding, and up to a total of 10% of premiums per year for assessments in the second and subsequent years, if required to fund additional bonding. Upon the order of the Florida Office of Insurance Regulation, companies are required to collect the FHCF assessments directly from residential property policyholders and remit them to the FHCF as they are collected.
Net Realized Investment Gain (Loss) for the three months ended March 31, 2005, June 30, 2005, September 30, 2005 and December 31, 2005 includes non-cash realized losses of $0.1 million, $0.1 million, $0.1 million, and $1.9 million, respectively, as a result of impairment evaluations.
Net Realized Investment Gain (Loss) for the three months ended March 31, 2004, June 30, 2004, September 30, 2004 and December 31, 2004 includes non-cash realized losses of $1.0 million, $1.7 million, $5.7 million, and $1.5 million, respectively, as a result of impairment evaluations.
The segments follow the same accounting policies used for the Company’s consolidated financial statements as described in the summary of significant accounting policies. Management evaluates a segment’s performance based upon premium production and the associated loss experience which includes paid losses, an amount determined on the basis of claim adjusters’ evaluation with respect to insured events that have occurred and an amount for losses incurred that have not been reported. Investments and investment performance including investment income and net realized investment gain; acquisition costs and other underwriting expenses including commissions, premium taxes and other acquisition costs; and other operating expenses are managed at a corporate level by the corporate accounting function in conjunction with other corporate departments and are included in “Corporate”.
On February 7, 2006, the Board of Directors approved a three-for-one split of the Company’s common stock payable to shareholders of record on February 20, 2006 for distribution on March 1, 2006. Weighted average common shares outstanding, equivalents outstanding, basic earnings per share and diluted earnings per share have been restated for all periods presented to reflect this stock split.