The following table sets forth selected consolidated financial information for the periods ended and as of the dates indicated. These historical results are not necessarily indicative of the results to be expected from any future period. You should read this selected consolidated financial data together with our consolidated financial statements and the related notes and the section of the Form 10-K entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
The statutory policyholder surplus of NIIC, which includes the statutory policyholder surplus of its subsidiaries, NIIC-HI and TCC.
Please refer to “Forward-Looking Statements” following the Index in front of this Form 10-K.
Our specialty property and casualty insurance companies are licensed in all 50 states, the District of Columbia and the Cayman Islands. We generate underwriting profits by providing what we view as specialized insurance products, services and programs not generally available in the marketplace. While many companies write property and casualty insurance for transportation companies, we believe that few write passenger transportation coverage nationwide and very few write coverage for several of the classes of passenger transportation insurance written by us and our subsidiaries. We focus on niche insurance markets where we offer insurance products designed to meet the unique needs of targeted insurance buyers that we believe are underserved by the insurance industry. These niche markets typically possess what we view as barriers to entry, such as being too small, too remote or too difficult to attract or sustain most competitors. Examples of products that we write for these markets include captive programs for transportation companies that we refer to as our alternative risk transfer programs (55.9% of 2009 gross premiums written), property and casualty insurance for transportation companies (19.3%), specialty personal lines, primarily recreational vehicle and commercial vehicle coverage (17.8%) and transportation and general commercial insurance in Hawaii and Alaska (5.5%). We strive to become a market leader in the specialty markets that we choose and serve by offering what we believe are specialized products, excellent customer service and superior claims response.
The change in percentage of the quotes we issue that are actually sold. We refer to this ratio as the “hit ratio.” Hit ratios are affected by the number of competitors, the prices quoted by these competitors and the degree of difference between the competitors’ pricing, terms and conditions and ours.
Despite relatively flat pricing since 2004, improved risk selection and an overall improvement in the risk quality of our book of business have contributed to us attaining combined ratios better than our corporate objective of 96.0% or lower. Since our inception in 1989 we have placed a consistent emphasis on underwriting profit. Though our combined ratio may fluctuate from year to year, over the past five years we have exceeded our underwriting profit objective by achieving an average GAAP combined ratio of 83.9%. We believe the following factors contribute to our performance which is consistently above industry standards:
During 2009, like most of the P/C insurance industry, we benefited from stabilization in the investment markets as we recorded net realized gains from investments, which included write-downs required by the other-than-temporary impairment accounting guidelines. We have historically maintained a high quality investment portfolio, focusing primarily on investment grade fixed income investments. Our 2009 purchases have been concentrated in U.S. Government and government agencies, state and local government obligations (“muni bonds”), agency backed collateralized mortgage obligations and corporate obligations. Although we cannot provide any assurances, at December 31, 2009, with over 90% of our investment portfolio comprised of investment grade fixed income, investment grade preferred stock and cash and cash equivalents, we believe we remain properly positioned as we head into 2010.
As described below, the average revenue dollar per personal lines policy is significantly lower than typical commercial policies. Profitability in the specialty personal lines component is dependent on proper pricing and the efficiency of underwriting and policy administration. We have continued to monitor rate levels and have adjusted them throughout 2009, as warranted. We continuously strive to improve our underwriting and policy issuance functions to keep this cost element as low as possible by utilizing current technology advances.
There are distinct differences in the timing of premiums written in traditional transportation insurance compared to the majority of our alternative risk transfer (captive) insurance component. We write traditional transportation insurance policies throughout all twelve months of the year and commence new annual policies at the expiration of the old policy. Under most captive programs, all members of the group share a common renewal date.
All of our transportation products, traditional or alternative risk transfer, are priced to achieve targeted underwriting margins. Because traditional insurance tends to have a higher operating expense structure, the portion of the premiums available to pay losses tends to be lower for a traditional insurance quote versus an alternative risk transfer insurance quote. We use a cost plus pricing approach that projects future losses based upon the insured’s historic losses and other factors. Operating expenses, premium taxes and a profit margin are then added to the projected loss component to achieve the total premium to be quoted. The lower the projected losses, expenses and taxes, the lower the total quoted premiums regardless of whether it is a traditional or alternative risk transfer program quotation. Quoted premiums are computed in accordance with our approved insurance department filings in each state.
withheld” are disclosed separately from operating and general expenses. We invest funds in the participant loss layer for several of our alternative risk programs. We receive investment income and incur an equal expense on the amounts owed to alternative risk transfer participants. “Expense on amounts withheld” represents investment income that we remit back to alternative risk transfer participants. The related investment income is included in the “Net investment income” line on our Consolidated Statements of Income.
Our December 31, 2009, 2008 and 2007 net earnings from operations, net realized gains (losses) from investments and net income are as follows:
In 2008, we established a valuation allowance on deferred tax assets related to net realized losses, primarily impairment charges, which increased income tax expense by $7.5 million. In 2009, income tax expense was positively impacted by a $6.7 million reduction in the deferred tax valuation allowance due to both available tax strategies and the future realizability of previously impaired securities.
We had after-tax net realized gains from investments of $1.7 million ($0.09 per share diluted) in 2009 compared to after-tax net realized losses from investments of $14.6 million ($0.75 per share diluted) in 2008. Included in the 2009 after-tax net realized gains are $2.7 million in net realized gains or losses associated with an equity partnership investment and $2.6 million related to sales of securities. Also included in the after-tax net realized gains are other-than-temporary impairment adjustments of $2.5 million and $13.1 million for the years ended December 31, 2009 and December 31, 2008, respectively.
Gross premiums written includes both direct premium and assumed premium. During 2009, our gross premiums written decreased $35.4 million, or 9.3%, compared to 2008. This decrease is primarily attributable to our transportation, alternative risk transfer and Hawaii and Alaska components, which decreased by $20.7 million, $13.4 million and $3.9 million, respectively. The decrease in gross premiums written in these components is due to several factors, including the impact that the current economic environment has had on our commercial customers, particularly through reductions in vehicle counts and mileage-based exposures, the effects of risk selection and pricing adequacy initiatives specific to a few of our products that we put in place in 2008 and the first half of 2009 and the continued overly aggressive pricing from competition in the insurance marketplace. In spite of the obstacles posed by the current economic environment, we have renewed nearly 100% of our captive members at the common renewal dates, maintained our disciplined underwriting approach and have continued to generate new business leads and add new programs and accounts to our existing book of business. This was demonstrated in our alternative risk transfer component, where we added seven new captive programs during 2009, contributing approximately $25.3 million in gross premiums written.
The captive programs, which focus on specialty or niche businesses, provide various services and coverages tailored to meet specific requirements of defined client groups and their members. These services include risk management consulting, claims administration and handling, loss control and prevention and reinsurance placement, along with providing various types of property and casualty insurance coverage. Insurance coverage is provided primarily to companies with similar risk profiles and to specified classes of business of our agent partners.
As part of our captive programs, we have analyzed, on a quarterly basis, captive members’ loss performance on a policy year basis to determine if there would be a premium assessment to participants or if there would be a return of premium to participants as a result of less than expected losses. Assessment premium and return of premium are recorded as adjustments to written premium (assessments increase written premium; returns of premium reduce written premium). For the years ended December 31, 2009, 2008 and 2007, we recorded return of premium of $4.5 million, $5.7 million and $1.9 million, respectively.
Our underwriting approach is to price our products to achieve an underwriting profit even if we forego volume as a result. From 2000 through 2006, our insurance subsidiaries increased their premium rates to offset rising losses and reinsurance costs. In 2009, 2008 and 2007, we experienced a slight decline in rate levels on renewal business due to the continued softening market.
The table below presents our premiums earned and combined ratios for the periods indicated:
Commissions and other underwriting expenses consist principally of brokerage and agent commissions reduced by ceding commissions received from assuming reinsurers, and vary depending upon the amount and types of contracts written and, to a lesser extent, premium taxes. The underwriting expense ratio was 24.0% and 24.7% for the years ended December 31, 2009 and 2008, respectively. The 0.7 percentage point decrease to our 2009 expense
2008 compared to 2007. Losses and LAE increased $38.6 million, or 25.8%, for 2008 compared to 2007. The loss and LAE ratio for the year ended December 31, 2008 was 64.7% compared to 58.0% for the year ended December 31, 2007. The increase in the loss and LAE ratio in 2008 of 6.7 percentage points is primarily due to an increase in large loss severity in our charter passenger transportation products that we experienced during the first three quarters of 2008. These large losses contributed approximately 5.8 percentage points to our 2008 loss and LAE ratio. During the third quarter of 2008, we began the process of reviewing most of our large fleet charter transportation book and our entire in-force small fleet book of charter transportation business to ensure that our high underwriting standards were in place and identified specific accounts that required action. We also implemented other initiatives, centered on risk selection and pricing adequacy relative to the entire charter transportation product.
The underwriting expense ratio was 24.7% and 22.9% for the years ended December 31, 2008 and 2007, respectively. The 1.8 percentage point increase to our 2008 expense ratio is primarily due to a change in our overall mix of business, including high premium growth in products that tend to have higher commission rates.
2009 compared to 2008. Other income increased $0.6 million, or 21.6%, to $3.5 million for 2009 compared to $2.9 million in 2008. This increase is primarily attributable to growth in the policy-based fee income generated by our personal lines component throughout 2009.
2009 compared to 2008. Commissions and other underwriting expenses for the year ended December 31, 2009 decreased $4.9 million, or 7.9%, to $57.2 million from $62.1 million in the comparable period in 2008. The decrease relates to a decline in net commission expense due to a change in our overall mix of business. Our various products have different commission rates; therefore, commission expense can vary based on the product mix written during the period. Additionally, our 2008 commissions and other underwriting expenses included an approximate $1.3 million charge for a one-time state guaranty fund.
2008 compared to 2007. Other operating and general expenses increased $0.5 million, or 3.8%, to $12.6 million during the year ended December 31, 2008 compared to $12.1 million for the same period in 2007. This increase was primarily due to an increase in employee headcount that increased our employee wages over prior year.
2009 compared to 2008. We invest funds in the participant loss layer for several of the alternative risk transfer programs. We receive investment income and incur an equal expense on the amounts owed to alternative risk transfer participants. “Expense on amounts withheld” represents investment income that we remit back to alternative risk transfer participants. The related investment income is included in our “Net investment income” line on our Consolidated Statements of Income. For the year ended December 31, 2009, the expense on amounts withheld decreased $0.8 million over the same period in 2008. The decrease is primarily attributable to lower interest rate yields experienced during 2009 compared to 2008.
2008 compared to 2007. The 2008 effective tax rate was 58.6%, increasing 25.3% from a rate of 33.3% in 2007. The change in the effective tax rate was primarily due to a valuation allowance of $7.5 million that was recorded on our realized losses, primarily impairment charges which increased the 2008 effective tax rate 29.3 percentage points.
At December 31, 2008, we had gross deferred tax assets of $13.6 million related to investment securities. This gross deferred tax asset was reduced by a valuation allowance related to unrealized losses on equity investments of $0.1 million and a valuation allowance related to realized losses on investments of $7.5 million.
Fixed maturity investments are focused on securities with short and intermediate-term maturities. At December 31, 2009, the weighted average maturity of our fixed maturity investments was approximately 4.8 years. At December 31, 2009, 94.6% of the fixed maturities in our portfolio were rated “investment grade” (credit rating of AAA to BBB-) by Standard & Poor’s Corporation. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or non-investment grade. Although we cannot provide any assurances, we believe that, in normal market conditions, our high quality investment portfolio should generate a stable and predictable investment return.
Included in the fixed maturities at December 31, 2009 were $116.7 million of residential mortgage-backed securities (“MBS”). We do not have a significant exposure to the subprime lending sector as 93.1% of our residential MBS are backed by US government agencies. MBS are subject to prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be prepaid more rapidly than scheduled as buyers refinance higher rate mortgages to take advantage of declining interest rates. Also included in fixed maturities at December 31, 2009 were $155.0 million of state and local government obligations (“muni bonds”). Approximately 93.0% of our muni bonds are rated “A−” or better giving no effect to credit enhancement.
Investment grade of AAA to BBB- by Standard & Poor’s Corporation.
When a decline in the value of a specific investment is considered to be “other-than-temporary,” a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced. The determination of whether unrealized losses are “other-than-temporary” requires judgment based on subjective as well as objective factors. Factors considered and resources used by management include those discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Other-Than-Temporary Impairment.”
Net realized gains (losses) on securities sold and charges for “other-than-temporary” impairment on securities held were as follows:
Under fair value accounting, we must determine the appropriate level in the fair value hierarchy for each applicable measurement. The fair value hierarchy prioritizes the inputs, which refer broadly to assumptions market participants would use in pricing an asset or liability, into three levels. It gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The level in the fair value hierarchy within which a fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Fair values for our investment portfolio are reviewed by company personnel using data from nationally recognized pricing services as well as non-binding broker quotes.
The pricing services use a variety of observable inputs to estimate the fair value of fixed maturities that do not trade on a daily basis. These inputs include, but are not limited to, recent reported trades, benchmark yields, issuer spreads, bids or offers, reference data and measures of volatility. Included in the pricing of mortgage-backed securities are estimates of the rate of future prepayments and defaults of principal over the remaining life of the underlying collateral. Valuation techniques utilized by pricing services and prices obtained from independent financial institutions are reviewed by company personnel who are familiar with the securities being priced and the markets in which they trade to ensure that the fair value determination is representative of an exit price, as defined by fair value accounting.
Effective April 1, 2009, we adopted revised accounting guidance on estimating the fair value of an asset or liability when there is no active market and on identifying transactions that are not orderly. This did not change the objective of fair value measurements. Adoption of this change in the accounting guidance did not have a material impact on our consolidated financial position or results of operations.
Level 1 consists of publicly traded equity securities whose fair value is based on quoted prices that are readily and regularly available in an active market. Level 2 primarily consists of financial instruments whose fair value is based on quoted prices in markets that are not active and include U.S. government and government agency securities, fixed maturity investments, perpetual preferred stock and certain publicly traded common stocks that are not actively traded. Included in Level 2 are $6.6 million of securities, which are valued based upon a non-binding broker quote and validated by management by observable market data. Level 3 consists of financial instruments that are not traded in an active market, whose fair value is estimated by management based on inputs from independent financial institutions, which include non-binding broker quotes, for which we believe reflects fair value, but are unable to verify inputs to the valuation methodology. We obtained one quote or price per instrument from its brokers and pricing services and did not adjust any quotes or prices that it obtained. Management reviews these broker quotes using information such as the market prices of similar investments.
Capital Ratios. The NAIC’s model law for RBC provides formulas to determine the amount of capital and surplus that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2009 and 2008, the capital and surplus of all our insurance companies substantially exceeded the RBC requirements.
We believe that our insurance subsidiaries maintain sufficient liquidity to pay claims and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies. Our principal sources of liquidity are our existing cash, cash equivalents and short-term investments. Cash, cash equivalents and short-term investments were $19.4 million at December 31, 2009, a $57.8 million decrease from December 31, 2008. For 2009, 2008 and 2007, we generated consolidated cash flow from operations of $51.3 million, $101.3 million and $93.2 million, respectively. The decrease of $50.0 million in cash flow from operations in 2009 from 2008 is primarily attributable to a large amount of claims payments made during 2009. Cash flow from operations increased $8.1 million in 2008 from 2007 due to an increase in our loss and LAE reserves stemming from an increase in large claim severity that we experienced during the first three quarters of 2008.
Net cash used in investing activities was $57.9 million, $63.3 million and $69.1 million for the years ended December 31, 2009, 2008 and 2007, respectively. This $5.4 million decrease in cash used in investing activities in 2009, as compared to 2008, was primarily related to a $65.3 million increase in the proceeds from the sale of fixed maturity securities and an $11.2 million decrease in the purchase of fixed maturity investments in 2009, which were offset by a $68.6 million decrease in the proceeds from maturities and redemptions of investments. The decrease in both purchases and redemptions of fixed maturity investments in 2009, compared to the prior period was primarily due to a shift in asset allocation from callable U.S. government agency bonds into longer duration state and local government bonds, residential collateralized mortgage-backed securities and corporate obligations. The increase in proceeds from the sale of fixed maturity securities was the result of taking advantage of improving market conditions to realize gains on portions of our fixed maturity portfolio. The $5.8 million decrease in cash used in investing activities in 2008 compared to 2007 was primarily related to a $176.4 million increase in the proceeds from sales and maturities of investments and a decline of $42.1 million in the purchase of equity securities, which was partially offset by a $212.4 million increase in the purchase of fixed maturity investments in 2008. The increase in both purchases and redemptions of fixed maturities during 2008, compared to the prior period was directly influenced by market conditions. As interest rates declined throughout 2008, many of our high yielding U.S. government agency bonds were called and replaced with purchases of lower yielding agency bonds. Additionally, the decrease in the purchases of equity securities is directly related to the market turmoil experienced during 2008.
termination date were retained by us and are included in our fixed maturities portfolio through a non-cash transaction. The increase in cash used from financing activities in 2008 from 2007 of $0.7 million is primarily attributable to a $0.8 million increase in dividends paid to shareholders.
The Credit Agreement requires us to maintain specified financial covenants measured on a quarterly basis, including consolidated net worth, fixed charge coverage ratio and debt-to-capital ratio. In addition, the Credit Agreement contains certain affirmative and negative covenants, including negative covenants that limit or restrict our ability to, among other things, incur additional indebtedness, effect mergers or consolidations, make investments, enter into asset sales, create liens, enter into transactions with affiliates and other restrictions customarily contained in such agreements. As of December 31, 2009, we were in compliance with all financial covenants.
Contractual Obligations. The following table summarizes our long-term contractual obligations as of December 31, 2009:
The following discussion describes key assumptions and important variables that materially affect the estimate of the reserve for loss and LAE of our two most significant lines of business, which represent 88.4% of our total reserves and explains what caused them to change from assumptions used in the preceding period. Management has not made changes in key assumptions used in calculating current year reserves based on historical changes or current trends observed.
Within each line, Great American actuaries review the results of individual tests, supplementary statistical information and input from management to select their point estimate of the ultimate liability. This estimate may be one test, a weighted average of several tests or a judgmental selection as the actuaries determine is appropriate. The actuarial review is performed each quarter as a test of the reasonableness of management’s point estimate and to
Claims we view as potentially significant are subject to a rigorous review process involving the adjuster, claims management and executive management. We seek to establish reserves at the maximum probable exposure based on our historic claims experience. Incurred but not yet reported (“IBNR”) reserves are determined separate from the case reserving process and include estimates for potential adverse development of the recorded case reserves. We monitor IBNR reserves monthly with financial management and quarterly with an actuary from Great American. IBNR reserves are adjusted monthly based on historic patterns and current trends and exposures. When a claim is reported, claims personnel establish a “case reserve” for the estimated amount of ultimate payment. The amount of the reserve is based upon an evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the loss. The estimate reflects informed judgment of our claims personnel based on general insurance reserving practices and on the experience and knowledge of the claims personnel. During the loss adjustment period, these estimates are revised as deemed necessary by our claims department based on developments and periodic reviews of the cases. Individual case reserves are reviewed for adequacy at least quarterly by senior claims management.
The following table shows the breakdown of our gross loss reserves between case reserves (estimated amounts required to settle claims that have already been reported), IBNR reserves (estimated amounts that will be needed to settle claims that have already occurred but have not yet been reported to us, as well as reserves for possible development on known claims) and LAE reserves (estimated amounts required to adjust, record and settle claims, other than the claim payments themselves):
whether the issuer, series of issuers or industry has a catastrophic type of loss;
We closely monitor each investment that has a market value that is below its amortized cost and make a determination each quarter for other-than-temporary impairment for each of those investments. During the year ended December 31, 2009, we recorded $7.0 million in total losses on securities with impairment charges, which consisted of $3.9 million in credit other-than-temporary impairments recognized in earnings and $3.1 million of non-credit impairments recognized in other comprehensive income. The other-than-temporary charges primarily consist of four residential mortgage-backed securities with total impairment charges of $5.0 million, consisting of $1.9 million in credit impairments recognized in earnings and $3.1 million in non-credit impairments. The impairment on these mortgage-backed securities was recorded as the full principal is not expected to be collected and these securities were written down to the present value of the expected cash flows. In addition, we recorded $1.8 million in other-than-temporary impairment on three corporate notes that had experienced credit issues that, in our estimation, made recovery of the cost of our investments unlikely. During the year ended December 31, 2008, we recorded $20.2 million in other-than-temporary impairments. Of the $20.2 million of other-than-temporary impairments taken during 2008, $7.0 million related to securities issued by Fannie Mae, Freddie Mac and Lehman Brothers Holdings Inc. and $8.7 million related to exchange traded funds. The other-than-temporary impairment charge on the exchange traded funds was based on the length of time and the extent to which the market value was below cost and the uncertainty in the equity markets related to any anticipated recovery period, which is unpredictable. The remaining other-than-temporary impairment charge of $4.5 million is related to investments that had experienced credit issues that in our estimation made recovery of the cost of our investments unlikely. We recorded a $1.0 million impairment for the year ended December 31, 2007. In all instances of calculating an other-than-temporary impairment loss we adjusted the cost or amortized cost of the investment down to its fair market value. While it is not possible to accurately predict if or when a specific security will become impaired, given the inherent uncertainty in the market, charges for other-than-temporary impairment could be material to net income in subsequent quarters. Management believes it is not likely that future impairment charges will have a significant effect on our liquidity. See “Management’s Discussions and Analysis of Financial Condition and Results of Operations - Investments.”
We have audited National Interstate Corporation and subsidiaries internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). National Interstate Corporation subsidiaries 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 the Company’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of National Interstate Corporation and subsidiaries as of December 31, 2009 and 2008 and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2009 of National Interstate Corporation and subsidiaries and our report dated March 8, 2010 expressed an unqualified opinion thereon.
The Company is a 52.6% owned subsidiary of Great American Insurance Company (“Great American”), a wholly-owned subsidiary of American Financial Group, Inc.
Certain reclassifications have been made to financial information presented for prior years to conform to the current year’s presentation.
The consolidated financial statements include the accounts of the Company and its subsidiaries, NIIC, NIIC-HI, HIL, TCC, Hudson Management Group, National Interstate Insurance Agency, Inc. (“NIIA”), American Highways Insurance Agency, Inc., Safety, Claims, and Litigation Services, Inc., Explorer RV Insurance Agency, Inc. and Safety, Claims, Litigation Services, LLC. Significant intercompany transactions have been eliminated.
The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from the estimates and assumptions used.
The costs of acquiring new business, principally commissions and premium taxes and certain underwriting expenses directly related to the production of new business, are deferred and amortized over the period in which the related premiums are earned. Policy acquisition costs are limited based upon recoverability without any consideration for anticipated investment income and are charged to operations ratably over the terms of the related policies. The Company accelerates the amortization of these costs for premium deficiencies. The amount of deferred policy acquisition costs amortized during the years ended December 31, 2009, 2008 and 2007 were $49.1 million, $54.3 million and $44.6 million, respectively. There were no premium deficiencies for the years ended December 31, 2009, 2008 and 2007.
Property and equipment are reported at cost less accumulated depreciation and amortization. Property and equipment are depreciated or amortized over the estimated useful lives on a straight-line basis. The useful lives range from 3 to 5 years for computer equipment, 20 to 40 years for buildings and improvements and 5 to 7 years for all other property and equipment. Property and equipment include capitalized software developed or acquired for internal use. Upon sale or retirement, the cost of the asset and related accumulated depreciation are eliminated from their respective accounts and the resulting gain or loss is included in operations. Repairs and maintenance are charged to operations when incurred. The Company recorded depreciation expense of $1.9 million, $1.5 million and $1.2 million for the years ended December 31, 2009, 2008 and 2007, respectively.
In June 2009, the FASB updated ASC 810, Consolidation, that amended the guidance for determining whether an enterprise is the primary beneficiary of a variable interest entity (VIE) by requiring a qualitative analysis to determine if an enterprise’s variable interest results in a controlling financial interest. ASC 810 is effective for annual reporting periods beginning after November 15, 2009 and interim and annual periods thereafter. The Company will adopt ASC 810 on January 1, 2010 and such adoption will not have a material impact on financial condition, results of operations or liquidity.
In June 2009, the Company terminated its securities lending program. During 2009, and prior to the program’s termination, approximately $22.1 million of investments within the Company’s securities lending collateral matured and were used to pay down a corresponding amount of the Company’s securities lending obligation. Upon the program’s termination, the Company used cash on hand and securities lending collateral to pay the
Pricing services use a variety of observable inputs to estimate the fair value of fixed maturities that do not trade on a daily basis. These inputs include, but are not limited to, recent reported trades, benchmark yields, issuer spreads, bids or offers, reference data and measures of volatility. Included in the pricing of mortgage-backed securities are estimates of the rate of future prepayments and defaults of principal over the remaining life of the underlying collateral. Valuation techniques utilized by pricing services and values obtained from independent financial institutions are reviewed by company personnel who are familiar with the securities being priced and the markets in which they trade to ensure that the fair value determination is representative of an exit price, as defined by accounting standards.
Effective April 1, 2009, the Company adopted revised accounting guidance on estimating the fair value of an asset or liability when there is no active market and on identifying transactions that are not orderly. This did not change the objective of fair value measurements. Adoption of this change in the accounting guidance did not have a material impact on the Company’s consolidated financial position or results of operations.
The following table presents the Company’s investment portfolio, categorized by the level within the fair value hierarchy in which the fair value measurements fall as of December 31, 2008:
These amounts are attributable to either purchases of securities or principal pay downs, conversions or maturities during the year ended December 31, 2009.
Transfers in and/or (out) of Level 3 relate to the termination of the securities lending program and moving longer-term assets into the investment portfolio during the year ended December 31, 2009.
The cost or amortized cost and fair value of investments in fixed maturities, preferred and common stocks and securities lending collateral are as follows:
The amortized cost and fair value of fixed maturities at December 31, 2009, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The average life of mortgage-backed securities is 3.6 years in the Company’s investment portfolio.
The gross unrealized losses on the Company’s fixed maturities, equity securities and securities lending portfolios decreased from $23.2 million at December 31, 2008 to $9.8 million at December 31, 2009. The improvement in gross unrealized losses was driven by the partial recovery from December 31, 2008 of the Company’s portfolio as investment markets stabilized during 2009. The $9.8 million in gross unrealized losses at
December 31, 2009 was primarily on residential and commercial mortgage-backed securities that were transferred into the Company’s fixed maturities portfolio from the terminated securities lending portfolio and fixed maturity holdings in state and local governments, corporate obligations and redeemable preferred stocks. The gross unrealized losses on perpetual preferred stocks are minimal and are considered to be temporary. In the fourth quarter of 2008, the Company began treating its investment-grade perpetual preferred stocks similar to a debt security for assessing other-than-temporary impairments. The Company analyzes its perpetual preferred securities by examining credit ratings, contractual payments on these specific issues and other issues of the issuer, company specific data of the issuer and the outlook for industry sectors to ensure that it is appropriate to treat these securities similar to debt securities. Investment grade securities (as determined by nationally recognized rating agencies) represented 89.7% of all fixed maturity securities with unrealized losses as well as the one perpetual preferred stock security with an unrealized loss.
Management concluded that no additional charges for other-than-temporary impairment were required on the fixed maturity holdings based on many factors, including the Company’s ability and current intent to hold these investments for a period of time sufficient to allow for anticipated recovery of its amortized cost, the length of time and the extent to which fair value has been below cost, analysis of company-specific financial data and the outlook for industry sectors and credit ratings. The Company believes these unrealized losses are primarily due to temporary market and sector-related factors and does not consider these securities to be other-than-temporarily impaired. If the Company’s strategy was to change or these securities were determined to be other-than-temporarily impaired, the Company would recognize a write-down in accordance with its stated policy.
At December 31, 2009 and 2008, the carrying value of all deposits with state insurance departments was $36.0 million and $32.9 million, respectively. These deposits consisted of fixed maturity investments, certificates of deposit and money market funds.
In 2008, the Company drew $15 million from its unsecured Credit Agreement (the “Credit Agreement”) to redeem in full its outstanding junior subordinated debentures, replacing higher variable rate debt of LIBOR plus 420 basis points with lower variable rate debt. As of December 31, 2009, the interest rate on this debt is equal to the six-month LIBOR (0.5% at November 27, 2009) plus 65 basis points, with interest payments due quarterly.
Interest paid on long-term debt during the years ended December 31, 2009, 2008 and 2007 was $0.4 million, $0.9 million and $1.5 million, respectively. The aggregate principal amount payable on debt outstanding at December 31, 2009 is due in 2012.
A reconciliation of the provision for income taxes for financial reporting purposes and the provision for income taxes calculated at the statutory rate of 35% is as follows:
Management has reviewed the recoverability of the deferred tax asset and believes that, with the exception of certain realized losses on investments, the amount will be recoverable against future earnings. The gross deferred tax assets were reduced by a valuation allowance related to net realized losses on investments of $0.8 million and $7.5 million for the years ended December 31, 2009 and 2008, respectively, primarily related to impairment charges. The gross deferred tax assets were reduced by a valuation allowance on unrealized losses on equity investments for the year ended December 31, 2008 of $0.1 million.
The Company had no liability recorded for unrecognized tax benefits at December 31, 2009 and 2008. In addition, the Company has not accrued for interest and penalties related to unrecognized tax benefits. However, if interest and penalties would need to be accrued related to unrecognized tax benefits, such amounts would be recognized as a component of the provision for federal income taxes.
The Company uses the Black-Scholes option pricing model to calculate the fair value of its option grants. Due to a lack of historical data, the Company uses the Securities and Exchange Commission’s (the “SEC”) simplified
method of calculating expected term for all grants made in 2009, 2008 and 2007. The fair value of options granted was computed using the following weighted-average assumptions as of grant date:
The following table sets forth the computation of basic and diluted income per share:
For the year ended December 31, 2009 and 2008, there were 498,050 and 358,315 respectively, outstanding options and restricted shares excluded from dilutive earnings because they were anti-dilutive. There were no outstanding options excluded from dilutive earnings because they were anti-dilutive in 2007.
The Company cedes premiums through reinsurance agreements with reinsurers to reduce exposure in certain of its property and casualty insurance programs. Ceded losses and loss adjustment expense recoveries recorded for the year ended December 31, 2009 were $46.3 million and $38.1 million in both 2008 and 2007. The Company remains primarily liable as the direct insurer on all risks reinsured and a contingent liability exists to the extent that the reinsurance companies are unable to meet their obligations for losses assumed. To minimize its exposure to significant losses from reinsurer insolvencies, the Company seeks to do business with only reinsurers rated “Excellent” or better by A.M. Best Company and regularly evaluates the financial condition of its reinsurers.
The following table provides a reconciliation of the beginning and ending reserve balances for unpaid losses and LAE, on a net of reinsurance basis, for the dates indicated, to the gross amounts reported in the Company’s balance sheets.
The foregoing reconciliation shows decreases of $1.3 million, $0.9 million and $5.7 million in the years ended December 31, 2009, 2008 and 2007, respectively, representing favorable development in claims incurred in years prior to 2009, 2008 and 2007, respectively. The favorable development in these three years resulted from the combination of settling cases and adjusting current estimates of case and incurred but not reported (“IBNR”) losses for amounts less than the case and IBNR reserves carried at the end of the prior year for most of the Company’s lines of business. Management of the Company evaluates case and IBNR reserves based on data from a variety of sources including the Company’s historical experience, knowledge of various factors and industry data extrapolated from other insurers writing similar lines of business.
For the years ended December 31, 2009, 2008 and 2007 balances related to alternative risk transfer programs were as follows:
The statutory capital and surplus of NIIC-HI and TCC is included in the statutory capital and surplus of NIIC for reporting purposes.
The Company and its subsidiaries are subject at times to various claims, lawsuits and legal proceedings arising in the ordinary course of business. All legal actions relating to claims made under insurance policies are considered in the establishment of our loss and LAE reserves. In addition, regulatory bodies, such as state insurance departments, the SEC, the Department of Labor and other regulatory bodies may make inquiries and conduct examinations or investigations concerning the Company’s compliance with insurance laws, securities laws, labor laws and the Employee Retirement Income Security Act of 1974, as amended.
The Company’s subsidiaries also have lawsuits pending in which the plaintiff seeks extra-contractual damages from the Company in addition to damages claimed or in excess of the available limits under an insurance policy.
These lawsuits, which are in various stages, generally mirror similar lawsuits filed against other carriers in the industry. Although the Company is vigorously defending these lawsuits, the outcomes of these cases cannot be determined at this time. The Company has established loss and LAE reserves for lawsuits as to which the Company has determined that a loss is both probable and estimable. In addition to these case reserves, the Company also establishes reserves for claims incurred but not reported to cover unknown exposures and adverse development on known exposures. Based on currently available information, the Company believes that reserves for these lawsuits are reasonable and that the amounts reserved did not have a material effect on the Company’s financial condition or results of operations. However, if any one or more of these cases results in a judgment against or settlement by the Company for an amount that is significantly greater than the amount so reserved, the resulting liability could have a material effect on the Company’s financial condition, cash flows and results of operations.
On August 3, 2007, the Company was informed that the jury in a case pending in the Superior Court of the State of California for the County of Los Angeles (the “Supreme Court”), had issued, on August 2, 2007, a special verdict adverse to the Company’s interests in a pending lawsuit against one of the Company’s insurance companies. The Superior Court entered a formal judgment on October 25, 2007 and the Company received notice of that formal judgment on November 5, 2007. This matter, which approximated a net exposure of $7.2 million, was vigorously pursued on appeal and on December 30, 2009, California’s Second Appellate District, Division Eight, reversed the Superior Court’s judgment and remanded the case to that lower court with instructions to enter judgment in the Company’s favor. This matter was resolved in a manner that did not have a materially adverse effect on the Company’s consolidated financial position, results of operations or cash flows.
The Company operates its business as one segment, property and casualty insurance. The Company manages its property and casualty insurance segment through a product management structure. The following table shows revenues summarized by the broader business component description, which were determined based primarily on similar economic characteristics, products and services:
Events or transactions occurring subsequent to December 31, 2009, and prior to the filing date of this Form 10-K, have been evaluated for potential recognition or disclosure herein. No items were identified in this period subsequent to the financial statement date that required adjustment or disclosure.