We own two adjacent buildings that house our corporate headquarters and the surrounding real estate located in Richfield, Ohio. The buildings consist of approximately 164,000 square feet of rentable office space on 17.5 acres. We occupy approximately 143,000 square feet and lease the remainder to unaffiliated tenants.
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 this Form 10-K entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Book value per common share is computed using only unrestricted outstanding common shares. As of December 31, 2015 and 2014 total unrestricted common shares were 19,909,000 and 19,793,000, respectively.
Our specialty property and casualty insurance companies are licensed in all 50 states, the District of Columbia and the Cayman Islands. Our goal is to generate underwriting profits by providing what we view as specialty 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 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 (“ART”) programs (56.7% of 2015 gross premiums written), property and casualty insurance for transportation companies (32.6%), specialty personal lines, primarily recreational vehicle (4.9%) and transportation and general commercial insurance in Hawaii and Alaska (3.1%). 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.
We operate in multiple markets with multiple distribution approaches to attempt to reduce the probability that an adverse competitive response in any single market will have a significant impact on our overall business. We also attempt to maintain several new products, product line extensions or product distribution approaches in active development status so we are able to take advantage of market opportunities. We select from potential new product ideas based on our stated new business criteria and the anticipated competitive response.
The property/casualty (“P/C”) insurance industry is cyclical, with periods of rising premium rates and shortages of underwriting capacity (“hard market”) followed by periods of substantial price competition and excess capacity (“soft market”). Despite several years of sustained improvement in premiums written, the P/C insurance industry experienced a slower pace of premium growth in 2015 as market competition continues to place downward pressure on rates, specifically for high quality large commercial accounts. According to A.M. Best, the P/C insurance industry is expected to report its third consecutive year of underwriting profit in 2015 as lower catastrophic events have contributed positively to this segment's sustained profitability. These results are despite deterioration in the overall industry combined ratio as rate increases continue to moderate and the level of favorable development of prior years' loss reserves decline. While remaining profitable, overall operating results for the P/C insurance industry are also expected to reflect lower investment yields. However, the industry's invested asset base continues to grow and slightly offsets the impact of lower reinvestment yields. The industry is also experiencing lower realized capital gains, especially in the fourth quarter, in light of poor performance in the equity markets late in 2015.
The industry's commercial auto liability line of business continued to have unfavorable results compared to the P/C insurance industry as a whole. Contributing to these results are increased levels of loss frequency and severity, as well as adverse prior year reserve development. Loss cost trends have also increased due in part to accelerating medical inflation, fraudulent activity, litigation costs and a shortage of qualified drivers coupled with an aging workforce. However, in contrast to most other commercial lines, commercial auto rates increased during 2015 as a result of recent negative loss trends. The outlook for the industry's commercial auto liability line of business continues to face several unfavorable trends in the coming years such as, but not limited to, continued competitive market conditions, a moderation in price increases on renewal business, loss ratios that are expected to remain elevated due to increased frequency and severity, potential unfavorable development on prior year loss and LAE reserves and the effect of industry consolidation on this line of business.
Since our inception in 1989, we have placed a consistent emphasis on underwriting profit. In 2014 and 2015 our results did not meet our expectations and were impacted by commercial auto liability industry trends. Our five-year average GAAP combined ratio of 99.9% has been consistently better than or in line with industry results, and we believe the following factors contribute to our performance:
To succeed as a transportation and personal lines underwriter, we must understand and be able to quantify the different characteristics of the risks we consider quoting. Certain coverages are more stable and predictable than others, and we must recognize the various components of the risks we assume when we write any specific class of insurance business. Examples of trends that can change and, therefore, impact our profitability are loss frequency, loss severity, geographic loss cost differentials, societal and legal factors impacting loss costs (such as tort reform, punitive damage inflation and increasing jury awards) and changes in regulation impacting the insurance relationship. Any changes in these factors that are not recognized and priced for accordingly will affect our future profitability.
There are distinct differences in the timing of premiums written in traditional transportation insurance compared to the majority of our ART 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 ART programs, all members of the group share a common renewal date. These common renewal dates are scheduled throughout the calendar year. Any new ART program participant that joins after the common date will be written for other than a full annual term so its next renewal date coincides with the common expiration date of the program it has joined. Several of our larger group programs have common renewal dates during the first six months of the year, but as we have added new ART programs in recent years, we now experience renewal dates that occur throughout the calendar year. The ART component of our business accounted for 56.7% of total gross premiums written during 2015 as compared to 54.3% in 2014.
The projected profitability from traditional transportation accounts and transportation ART programs are substantially comparable. Increased investment income opportunities generally are available with traditional insurance, but the lower acquisition expenses and persistence of the ART programs generally provide for lower operating expenses from these programs. The lower expenses associated with our ART programs generally offset the projected reductions in investment income potential. From a projected profitability perspective, we are ambivalent as to whether a transportation operator elects to purchase traditional insurance or one of our ART program options.
All of our transportation products, traditional or ART, 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
We approach investment and capital management with the intention of supporting insurance operations by providing a stable source of income to supplement underwriting income and mitigate underwriting losses. The goals of our investment policy are to protect capital, optimize investment income and capital appreciation and to maintain appropriate liquidity. We follow a formal investment policy and the Board reviews the portfolio performance at least quarterly for compliance with the established guidelines. In 2015, market interest rates increased and credit spreads widened, which contributed to an overall decrease in the fair value of our holdings. We recorded a $3.3 million pre-tax net realized loss on investments in 2015 as compared to a pre-tax net realized gain of $6.8 million in 2014. Included in these pre-tax net realized losses and gains are other-than-temporary impairment charges of $7.8 million and $2.0 million, respectively.
Losses and loss adjustment expenses (“LAE”) are a function of the amount and type of insurance contracts we write and of the loss experience of the underlying risks. We record losses and LAE based on management's best estimate of losses we expect to be reported on policies written. We seek to establish case reserves at the maximum probable exposure based on our historical claims experience. Our ability to estimate losses and LAE accurately at the time of pricing our contracts is a critical factor in determining our profitability. The amount reported under losses and LAE in any period includes payments in the period net of the change in the value of the reserves for unpaid losses and LAE between the beginning and the end of the period.
Commissions and other underwriting expenses consist principally of brokerage and agent commissions and to a lesser extent premium taxes and assessments. The brokerage and agent commissions are reduced by ceding commissions received from assuming reinsurers that represent a percentage of the premiums on insurance policies and reinsurance contracts written and vary depending upon the amount and types of contracts written.
Our 2014 results include transaction expenses we incurred related to the February 5, 2014 Great American unsolicited tender offer to acquire all of our remaining outstanding common shares not already owned by Great American. Transaction expenses primarily consisted of financial advisory and legal services incurred in connection with the tender offer and related litigation. Great American withdrew the tender offer on March 16, 2014.
As part of our ART programs, we analyze, on a quarterly basis, members’ loss performance on a policy year basis to determine if there would be an assessment premium (loss results are unfavorable to expectations) or if there would be a return of premium (loss results are favorable to expectations) to participants. Assessment premium and return of premium are recorded as adjustments to premiums written (assessments increase premiums written; returns of premium reduce premiums written). For the years ended 2015 and 2014, we recorded net premium assessments of $7.7 million and $12.1 million, respectively.
Our premiums earned increased $31.6 million, or 6.0%, to $557.3 million during the year ended December 31, 2014 compared to $525.7 million for the year ended December 31, 2013. The increase was primarily attributable to our ART and transportation components, which grew $17.2 million, or 6.1%, and $19.1 million, or 11.1%, respectively, and was partially offset by a $10.2 million, or 22.6%, decrease in our specialty personal lines component. The ART component growth in premiums earned was primarily associated with our existing group ART programs, due to rate increases and increased exposures on renewal business as well as the addition of new customers. This growth was partially offset by the impact of ending business relationships with two agents within the program portion of our ART component, which occurred in late 2012 and 2013, as well as taking rate actions and non-renewing unprofitable business during 2013 and 2014. The increase in the transportation component reflected our continued growth from new business written as well as rate and exposure increases on renewed business experienced throughout 2013 and 2014. The decrease in our specialty personal lines component was primarily due to our decision to stop selling our commercial vehicle product during the third quarter of 2013.
Our underwriting expense ratio includes commissions and other underwriting expenses and other operating and general expenses, offset by other income. Commissions and other underwriting expenses consist principally of brokerage and agent commissions reduced by ceding commissions received from reinsurers, and vary depending upon the amount and types of contracts written and, to a lesser extent, premium taxes.
Our underwriting approach is to price our products to achieve an underwriting profit even if we forgo volume as a result. We continue to see overall rate level increases on renewal business, which averaged approximately 5% in 2015 and 7% in 2014. In both 2015 and 2014, several of our products achieved double-digit rate level increases and we continue to apply the same pricing
The table below presents our accident year loss and LAE ratio for 2015, 2014 and 2013 as of December 31, 2015:
2015 compared to 2014. Our loss and LAE ratio for the year ended December 31, 2015 improved 3.2 combined ratio points to 80.6% compared to 83.8% for the year ended December 31, 2014. This improvement reflects less adverse development recorded in 2015 than in the prior year. For the year ended December 31, 2015, we had unfavorable development from prior years’ loss reserves of $14.4 million, or 2.5 combined ratio points, compared to $30.6 million, or 5.5 combined ratio points, for the same period last year. The unfavorable development that occurred in the current year included reserve strengthening of $9.7 million primarily related to the commercial auto liability line of business for the 2012 and 2013 accident years and is indicative of emerging claims severity on these accident years. The remaining portion of the unfavorable development in the current year is concentrated in our commercial auto liability line of business and primarily attributable to products we no longer offer or customers which we no longer insure, as well as from assigned risk policies that we are obligated to write as part of the involuntary insurance market. The 2014 adverse development largely consisted of $20.0 million related to reserve strengthening predominantly in our commercial auto liability line of business for accident years 2011, 2012 and 2013.
Specific to our commercial auto liability results in recent years, industry trends indicated that commercial auto policies written during the prolonged soft market conditions were at rates below those required to keep pace with changing economic and societal influences related to claims settlements. These influences, such as increased litigation costs, lower spending on safety measures and increased fraud have resulted in adverse industry trends of prior year reserves in the commercial auto liability line. Similar to the industry, we had experienced unfavorable prior year claim development for seven consecutive quarters through June 30, 2014. Though such development appeared to be subsiding in the first quarter of 2014, as compared to the previous three quarters, during the 2014 second quarter actual incurred claims developed higher than expected by approximately $8.1 million, primarily related to accident years 2010, 2011 and 2012 for the commercial auto coverages. In consideration of the continued adverse prior year claims development, we engaged a leading independent global actuarial firm to conduct a review of our loss and LAE reserves. We used this additional actuarial data as well as various data inputs and other factors including, but not limited to, claims processing procedures, our historic loss experience and that of the industry, and loss development factors as well as actuarial analysis as routinely provided by Great American when establishing our best estimate for loss reserves for the second quarter of 2014. As a result of our review and analysis of the various data points discussed above we increased our loss and LAE reserves related to prior periods by $20.0 million in the second quarter of 2014. During the fourth quarter of 2015 emerging prior year claim severity in our commercial auto liability line of business resulted in an additional $9.7 million of reserve strengthening primarily on accident years 2012 and 2013.
2014 compared to 2013. Our loss and LAE ratio for the year ended December 31, 2014 increased 2.1 combined ratio points to 83.8% compared to 81.7% during the same period in 2013. This increase over the prior period was primarily attributable to adverse development on prior years' loss reserves, inclusive of $20.0 million in reserve strengthening recorded during the second quarter of 2014, as well as an elevated current accident year loss and LAE ratio compared to the undeveloped prior year loss and LAE ratio. For the year ended December 31, 2014, we had unfavorable development from prior years’ loss reserves of $30.6 million, or 5.5 combined ratio points, compared to unfavorable development of $23.1 million, or 4.4 combined ratio points, for the prior period. Unfavorable development is primarily related to settlements above the established case reserves and revisions to our estimated future settlements on an individual case by case basis.
In 2013, we exited several unprofitable businesses including the commercial vehicle product, and we priced away or chose not to renew over $65 million of business. Applying the same disciplines, in 2014 we shed approximately $40 million in business through non-renewals or rate actions.
2015 compared to 2014. In 2015, we had pre-tax net realized losses of $3.3 million compared to pre-tax net realized gains of $6.8 million for 2014. The pre-tax net realized losses for the year ended December 31, 2015 were primarily generated from other-than-temporary impairment charges of $7.8 million on both equity and fixed maturity securities, which were primarily common stock securities concentrated within the energy and financial services sectors. In addition, other invested assets produced net losses of $1.7 million as these investments were impacted by turmoil in the energy sector during 2015. Partially offsetting these losses were gains generated from the sales or redemptions of securities of $6.2 million. The pre-tax net realized gains for the year ended December 31, 2014 were primarily generated from the sales or redemptions of securities of $5.4 million, as well as net gains associated with other invested assets of $3.3 million. Offsetting these gains were other-than-temporary impairment charges of $2.0 million primarily concentrated within the energy and financial services sectors.
2014 compared to 2013. Commissions and other underwriting expenses for the year ended December 31, 2014 increased $2.2 million, or 2.4%, to $94.4 million from $92.2 million in the comparable period in 2013, primarily due to the premium growth experienced in 2014. As a percentage of premiums earned, commissions and other underwriting expenses decreased to 16.9% for the year ended December 31, 2014 as compared to 17.5% for the same period in 2013. Such decrease is attributable to changes in the business mix written, resulting in a lower net commissions expense structure, over an increase in earned premiums during 2014 as compared to 2013.
2015 compared to 2014. We invest funds in the participant loss layer for several of our ART programs. We earn investment income and generate realized gains or losses, and incur an equal expense on the amounts owed to ART participants. “Expense on amounts withheld” represents both investment income and realized gains or losses that we remit back to ART participants. The related investment income and realized gains or losses are included in our “Net investment income” and “Net realized (losses) gains on investments” lines, respectively, on our Consolidated Statements of Income. For the year ended December 31, 2015, the expense on amounts withheld was flat, increasing $48 thousand, or 0.7%, compared to the same period in 2014.
At December 31, 2015, our investment portfolio contained $1.1 billion in fixed maturity securities and $81.6 million in equity securities, all carried at fair value, with unrealized gains and losses reported as a separate component of shareholders’ equity and $47.9 million in other invested assets, which are limited partnership investments accounted for in accordance with the equity method. At December 31, 2015, we had pre-tax net unrealized gains of $12.8 million on fixed maturities and pre-tax net unrealized losses of $0.3 million on equity securities. Consistent with the guidelines in our investment policy, our investment portfolio allocation is based on diversification among primarily high quality fixed maturity investments.
Included in fixed maturities at December 31, 2015 were $316.4 million of state and local government obligations, which represented approximately 30.1% of our fixed maturity portfolio, with approximately $275.5 million, or 87.1%, of our state and local government obligations held in special revenue obligations and the remaining amount held in general obligations. Our state and local government obligations portfolio is high quality, as 98.9% of such securities were rated investment grade at December 31, 2015. We had no state and local government obligations for any state, municipality or political subdivision that comprised 10% or more of the total amortized cost or fair value of such obligations at December 31, 2015.
Summary information for securities with unrealized gains or losses at December 31, 2015 is shown in the following table. Approximately $8.8 million of fixed maturities and $4.7 million of equity securities had no unrealized gains or losses at December 31, 2015.
Investment grade of AAA to BBB- by nationally recognized rating agencies.
The table below sets forth the scheduled maturities of available for sale fixed maturity securities at December 31, 2015, based on their fair values. Other debt obligations, which are primarily comprised of asset-backed securities other than those related to mortgages and other securities with sinking funds, are categorized based on their average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
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 on securities sold, including net (losses) gains on other invested assets, and charges for other-than-temporary impairment on securities held were as follows:
Level 1 inputs are quoted prices (unadjusted) in active markets for identical securities that the reporting entity has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices within Level 1 that are observable for the security, either directly or indirectly. Level 2 inputs include quoted prices for similar securities in active markets, quoted prices for identical or similar securities that are not active and observable inputs other than quoted prices, such as interest rate and yield curves. Level 3 inputs are unobservable inputs for the asset or liability.
Level 1 primarily consists of publicly traded equity securities and highly liquid, direct obligations of the U.S. Government 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 agency securities, fixed maturity investments and nonredeemable preferred stocks that are not actively traded. At December 31, 2015, Level 2 included $219.8 million of securities, which are valued based upon a non-binding broker quote and validated with other observable market data by management. 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. We believe these estimates reflect fair value, but we are unable to verify inputs to the valuation methodology. We obtained at least one quote or price per instrument from brokers and pricing services for all Level 3 securities and did not adjust any quotes or prices that we obtained. Our internal and affiliated investment professionals review these broker quotes using any recent trades, if such information is available, or market prices of similar investments. We primarily use the market approach valuation technique for all investments.
Capital Ratios. The National Association of Insurance Commissioners’ model law for risk-based capital (“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, 2015 and 2014, the capital and surplus of all our insurance companies substantially exceeded the RBC requirements.
Sources of Funds. The liquidity requirements of our insurance subsidiaries relate primarily to the liabilities associated with their products, as well as operating costs and payments of dividends and taxes to us from insurance subsidiaries. Historically, cash flows from premiums and investment income have provided sufficient funds to meet these requirements, without requiring significant liquidation of investments. If our cash flows change dramatically from historical patterns, for example as a result of a decrease in premiums, an increase in claims paid or operating expenses, or financing an acquisition, we may be required to sell securities before their maturity and possibly at a loss. Our insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments or cash and cash equivalents to meet their liquidity needs. Our historic pattern of using receipts from current premium writings for the payment of liabilities incurred in prior periods provides us with the option to extend the maturities of
our investment portfolio beyond the estimated settlement date of our loss reserves. Funds received in excess of cash requirements are generally invested in additional marketable securities.
Net cash used in financing activities was $8.5 million, $7.0 million and $7.5 million for the years ended December 31, 2015, 2014 and 2013, respectively. The increase in net cash used in financing activities in 2015, as compared to 2014, was primarily due to an increase in dividends paid to shareholders, as well as a decrease in proceeds received from the issuance of common shares from treasury upon exercise of stock options. The decrease in net cash used in financing activities in 2014, as compared to 2013, was primarily due to an increase in proceeds received from the issuance of common shares upon the exercise of options which was partially offset by an increase in dividends paid to shareholders.
The Credit Agreement requires us to maintain specified financial covenants measured on a quarterly basis, including minimum consolidated net worth and a maximum debt to capital ratio. In addition, the Credit Agreement contains certain affirmative and negative covenants customary for facilities of this type, including negative covenants that limit or restrict our ability to, among other things, pay dividends, 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, 2015, we were in compliance with all covenants.
Contractual Obligations. The following table summarizes our long-term contractual obligations as of December 31, 2015:
Limited partnership agreements have expiration dates up to five years whereby the entire amounts or a portion thereof could be required to be funded at any time prior to the expiration dates. The commitment amounts are presented using the expiration dates of the agreements.
For purposes of computing the recorded loss and LAE reserves, management utilizes various data inputs as noted below, including analysis that is derived from our internal actuary, as well as a review of quarterly results performed by actuaries employed by Great American. In addition, on an annual basis, actuaries from Great American provide a Statement of Actuarial Opinion, required annually in accordance with state insurance regulations, on the statutory reserves recorded by National Interstate Insurance Company (“NIIC”), Vanliner Insurance Company (“VIC”), National Interstate Insurance Company of Hawaii, Inc. (“NIIC-HI”) and Triumphe Casualty Company (“TCC”). The actuarial analysis of NIIC’s, VIC’s, NIIC-HI’s and TCC’s net reserves as of December 31, 2015 and 2014 reflected point estimates that were within 1% of management’s recorded net reserves as of such dates. Using this actuarial data along with its other data inputs, management concluded that the recorded reserves appropriately reflect management’s best estimates of the liability as of each year end.
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. Management seeks to establish reserves at the maximum probable exposure based on our historic claims experience. 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. Claims that management views as potentially significant are subject to a rigorous review process involving the adjuster, claims management and executive management.
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. IBNR reserves are adjusted monthly based on historic patterns and current trends and exposures. Management monitors IBNR reserves monthly with actuaries from Great American.
The changes we have recorded in our reserves in the past three years illustrate the potential for revisions inherent in estimating reserves. In 2015, we experienced unfavorable development of $14.4 million (1.8% of total net reserves) from claims incurred prior to 2015. In 2014, we experienced unfavorable development of $30.6 million (4.3% of total net reserves) from claims incurred prior to 2014. In 2013, we experienced unfavorable development of $23.1 million (3.6% of total net reserves) from claims incurred prior to 2013. The development reflected settlements that differed from the established case reserves, changes in the case reserves based on new information for that specific claim or the differences in the timing of actual settlements compared to the payout patterns assumed in our accident year IBNR reductions. The types of coverages we offer and risk levels we retain have a direct influence on the development of claims. Specifically, short duration claims and lower risk retention levels generally are more predictable and normally have less development. Future favorable or unfavorable development of reserves from past development experience should not be assumed or estimated. The reserves reported in the financial statements are our best estimate.
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) by our statutory lines of business:
The judgments and uncertainties surrounding management’s reserve estimation process and the potential for reasonably possible variability in management’s most recent reserve estimates may also be viewed by looking at how recent historical estimates of reserves for all lines of business have developed. If our December 31, 2015 reserves (net of reinsurance) developed at the same rate as the average development of the most recent five years, the effect on net earnings would be a decrease of $11.1 million.
The level of detail at which data is analyzed varies among the different lines of business. Generally, data is analyzed by major product or coverage, using countrywide data. The appropriate segmentation of the data is determined based on data volume, data credibility, mix of business and other actuarial considerations. Point estimates are selected by the actuaries based on test indications and judgment.
We recorded unfavorable prior year development of $22.3 million, $29.0 million, and $32.5 million in 2015, 2014 and 2013, respectively, for this line of business. We have experienced significantly higher than expected claim severity and case development from accident years 2011 through 2014. We continue to pay particular attention to the commercial auto liability line of business and are taking the necessary steps to restore our historically profitable underwriting results, including responding with rate increases, non-renewals or other corrective actions, as necessary. We continually monitor development trends in each line of business as a component of estimating future ultimate loss and related LAE liabilities.
the length of time and the extent to which the market value has been below amortized cost;
the extent to which the unrealized loss is credit-driven or a result of changes in market interest rates;
The independent registered public accounting firm of Ernst & Young LLP, as auditors of the Company’s consolidated financial statements, has issued an attestation report on the effectiveness of the Company’s internal control over financial reporting.
In our opinion, National Interstate Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2015, based on the COSO criteria.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Interstate Corporation and subsidiaries at December 31, 2015 and 2014, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2015, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), National Interstate Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated March 9, 2016 expressed an unqualified opinion thereon.
The consolidated financial statements include the accounts of the Company and its subsidiaries (NIIC, VIC, NIIC-HI, HIL, TCC, Hudson Management Group, Ltd., National Interstate Insurance Agency, Inc. (“NIIA”), American Highways Insurance Agency,
Inc., TransProtection Service Company, Explorer RV Insurance Agency, Inc. and Safety, Claims and Litigation Services, LLC) since their formation or acquisition. Significant intercompany transactions have been eliminated.
The Company accounted for the contingent consideration associated with the contractual obligations of the 2010 acquisition of Vanliner in accordance with ASC 805, Business Combinations. As part of the Purchase Agreement (the “Agreement”), UniGroup, Inc. (“UniGroup”) agreed to provide NIIC with comprehensive financial guarantees, including a four and a half year balance sheet guaranty effective through December 31, 2014, whereby both favorable and unfavorable developments related to specified line items on the closing balance sheet, as defined in sections 2.06 and 2.07 of the Agreement, inured to UniGroup. The Company and UniGroup reached a final settlement related to the balance sheet guarantee in the third quarter of 2015, as discussed further below.
The total sum of the difference between acquired amounts and actual or expected settlement amounts for the balance sheet line items which were contractually guaranteed by UniGroup is the calculated contingent consideration. The Company determined the fair value of the contingent consideration that existed at December 31, 2014 based on the present value of expected cash flows associated with the balance sheet line items contractually guaranteed by UniGroup. The estimate of fair value of the contingent consideration required subjective assumptions to be made regarding future business results, discount rates and probabilities assigned to various potential business result scenarios. This amount was discounted based on the appropriate treasury yield curve rate to obtain the discounted fair value at the balance sheet date. At December 31, 2014, the Company had a short-term receivable recorded at fair value for contingent consideration of $1.2 million. In 2015, the Company reached final settlement and received payment from UniGroup in the amount of $5.7 million. As a result, no contingent consideration interests are included on the Company's Consolidated Balance Sheet at December 31, 2015.
In accordance with accounting guidance for other-than-temporary impairments, if management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will be required to sell the security before recovery of its amortized cost basis, then an entity may separate the other-than-temporary impairment into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive (loss) income). The credit related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge recorded in earnings is required to reduce the amortized cost of that security to fair value. Additional disclosures required by this guidance are contained in Note 4 - “Investments.”
The liabilities for unpaid losses and LAE represent management's best estimate and are based on estimates of policy claims reported and estimates of unreported claims established using historical and industry data. The estimates of policy claim amounts are continuously reviewed and any resulting adjustments are reflected in current operations. Although considerable variability is inherent in such estimates, management believes that the liabilities for unpaid losses and LAE are adequate. These liabilities are reported net of amounts recoverable from salvage and subrogation.
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the periods in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided if it is more likely than not that some or all of the deferred tax assets will not be realized. Management evaluates the realizability of the deferred tax assets and assesses the need for a valuation allowance quarterly. The Company recognizes the tax benefits of uncertain tax positions only when the position is more likely than not to be sustained under examination by the appropriate taxing authority. Management considers the accumulated earnings of the Company's foreign subsidiary to be indefinitely reinvested pursuant to a specific plan for reinvestment. As a result, management has not recorded a deferred tax liability of approximately $2.7 million on approximately $8.7 million of undistributed earnings of the Company's foreign subsidiary. Should the Company decide to repatriate the foreign earnings, in the form of dividends or otherwise, it would be subject to both U.S. income taxes and withholding taxes payable to the foreign jurisdiction.
The Company grants options and other share awards to officers under its Long Term Incentive Plan (“LTIP”). The LTIP and share-based compensation are more fully described in Note 7 - “Share-Based Compensation.” Compensation expense is recognized for options and restricted share awards issued on a straight-line basis over their vesting periods based on the fair value of these awards at the date of grant. The Company uses the Black-Scholes pricing model to measure the fair value of employee options, while the market price of the Company's common stock on December 31 is used for restricted share awards.
In May 2015, the FASB issued ASU No. 2015-09, Financial Services - Insurance (Topic 944): Disclosures about Short-Duration Contracts (“ASU 2015-09”). The FASB issued ASU 2015-09 to enhance disclosure requirements for short-duration insurance contracts and to increase transparency regarding significant estimates made in measuring liabilities for unpaid claims and claim adjustment expenses. The ASU is also intended to improve comparability by requiring consistent disclosure information as well as provide financial statement users with additional information to facilitate analysis of the amount, timing, and uncertainty of claims cash flows. The new disclosures will be effective for fiscal years beginning after December 15, 2015 and interim periods within annual periods beginning after December 15, 2016. The Company will incorporate the required disclosures upon adoption with its annual financial statements as of December 31, 2016 and interim statements beginning with the first quarter of 2017. The new guidance does not affect the existing recognition or measurement guidance and therefore will have no impact on the Company's financial condition or results of operations.
In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Topic 825), which, among other things, will require all equity securities currently classified as "available-for-sale" to be reported at fair value, with holding gains and losses recognized in net income instead of accumulated other comprehensive income ("AOCI"). The Company will be required to adopt this guidance effective January 1, 2018.
Level 1 primarily consists of publicly traded equity securities and highly liquid, direct obligations of the U.S. Government 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 agency securities, fixed maturity investments and nonredeemable preferred stocks that are not actively traded. At December 31, 2015, Level 2 included $219.8 million of securities, which are valued based upon a non-binding broker quote and validated with other observable market data by management. 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. The Company believes these estimates reflect fair value, but the Company is unable to verify inputs to the valuation
methodology. The Company obtained at least one quote or price per instrument from its brokers and pricing services for all Level 3 securities and did not adjust any quotes or prices that it obtained. The Company’s internal and affiliated investment professionals review these broker quotes using any recent trades, if such information is available, or market prices of similar investments. The Company primarily uses the market approach valuation technique for all investments.
The following table presents the Company’s investment portfolio, categorized by the level within the fair value hierarchy in which the fair value measurements fell as of December 31, 2014:
The tables above exclude other invested assets of $47.9 million and $46.8 million at December 31, 2015 and 2014, respectively. Other invested assets include investments in limited partnerships which are accounted for under the equity method. Equity method investments are not reported at fair value.
The table above excludes other invested assets of $47.9 million and $46.8 million at December 31, 2015 and 2014, respectively. Other invested assets include investments in limited partnerships which are accounted for under the equity method. Equity method investments are not reported at fair value.
State and local government obligations represented approximately 30.1% of the Company’s fixed maturity portfolio at December 31, 2015, with approximately $275.5 million, or 87.1%, of the Company’s state and local government obligations held in special revenue obligations and the remaining amount held in general obligations. The Company’s state and local government obligations portfolio is high quality, with 98.9% of such securities rated investment grade (as determined by nationally recognized agencies) at December 31, 2015. The Company had no state and local government obligations for any state, municipality or political subdivision that comprised 10% or more of the total amortized cost or fair value of such obligations at December 31, 2015.
The amortized cost and fair value of fixed maturities at December 31, 2015, by contractual maturity, are shown below. Other debt obligations, which are primarily comprised of asset-backed securities other than mortgage-backed securities, and other securities
Partially offsetting these losses for 2015, and contributing to the gains on investments in 2014 and 2013, were net realized gains associated with the sales or redemptions of securities of $6.2 million, $5.4 million and $5.2 million for the years ended December 31, 2015, 2014 and 2013, respectively.
The gross unrealized losses on the Company’s fixed maturities and equity securities portfolios increased from $5.1 million at December 31, 2014 to $16.3 million at December 31, 2015. The increase in gross unrealized losses was driven primarily by an increase in interest rates and credit spreads, as well as the continued downturn in the energy and energy related sectors, leading to lower valuations. The $11.0 million in gross unrealized losses at December 31, 2015 on fixed maturity securities was primarily on holdings in corporate obligations and to a lesser extent, other debt obligations and residential mortgage-backed securities. Investment grade securities represented 88.8% of all fixed maturity securities with unrealized losses. The gross unrealized losses on equity securities at December 31, 2015 consist of $4.9 million of common stocks that have been in an unrealized loss position for less than twelve months as well as $0.3 million of primarily investment grade nonredeemable preferred stocks, all of which are considered to be temporary.
At December 31, 2015, corporate obligations, with gross unrealized losses of $7.3 million, had 99 securities that were in an unrealized loss position of $5.7 million for less than 12 months and 5 securities with gross unrealized losses of $1.6 million for 12 months or more. Investment grade securities represented 75.2% of all corporate obligations with unrealized losses. At December 31, 2015, other debt obligations, with gross unrealized losses of $2.1 million, had 131 securities that were in an unrealized loss position of $1.9 million for less than 12 months and 11 securities with unrealized losses of $0.2 million for 12 months or more. Investment grade securities represented 99.4% of all other debt obligations with unrealized losses.
At December 31, 2015, residential mortgage-backed securities, with gross unrealized losses of $1.2 million, had 28 securities that were in an unrealized loss position of $0.3 million for less than 12 months and 31 securities with gross unrealized losses of $0.9 million for 12 months or more. Based on historical payment data and analysis of expected future cash flows of the underlying collateral, independent credit ratings and other facts and analysis, management believes that, based upon information currently available, the Company will recover its cost basis in all of these securities.
Management concluded that no additional charges for other-than-temporary impairment were required on the fixed maturity and equity holdings at December 31, 2015 based on several 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, 2015 and 2014, the carrying value of all deposits with state insurance departments was $119.4 million and $104.8 million, respectively. These deposits consisted of fixed maturity investments, certificates of deposit and money market funds.
Long-term debt outstanding was $12.0 million at December 31, 2015 and December 31, 2014.
Interest paid on long-term debt during the years ended December 31, 2015, 2014 and 2013 was $0.2 million, $0.1 million and $0.2 million, respectively.
The Company files income tax returns in the U.S. federal jurisdiction and various state and U.S. territory jurisdictions. With limited exceptions, the Company is no longer subject to U.S. federal or state income tax examination for years before 2012.
For both years ended December 31, 2015 and 2014 there were 97,870 outstanding options and restricted shares excluded from dilutive earnings because they were anti-dilutive. For the year ended December 31, 2013 there were 100,000 outstanding options and restricted shares excluded from dilutive earnings because they were anti-dilutive.
The Company has an agreement with American Money Management Corporation (“AMMC”), a wholly-owned subsidiary of AFG, whereby AMMC manages approximately 58.0% of the Company’s investment portfolio at an annual cost of 15 basis points of the portfolio’s fair value. Fees for such services were approximately $1.0 million for the year ended December 31, 2015 and $0.9 million for both years ended December 31, 2014 and 2013.
On April 18, 2014, the Company entered into an agreement with Alan R. Spachman, whereby the Company agreed to reimburse Mr. Spachman for a portion of the legal fees and expenses that he incurred personally in connection with the tender offer by Great American to purchase all the publicly traded shares of the Company that Great American did not already own. The agreement provided that the Company pay $0.6 million to Mr. Spachman. Such amount is included in the "Transaction expenses" line item on our Consolidated Statements of Income. The Company recognized the expense in the first quarter and remitted the payment of $0.6 million on April 25, 2014.
The Company cedes premiums through reinsurance agreements with reinsurers to reduce exposure in certain of its property-casualty insurance programs. Ceded losses and loss adjustment expense recoveries recorded for the years ended December 31, 2015, 2014 and 2013 were $55.0 million, $60.8 million and $66.6 million, respectively. 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
The foregoing reconciliation shows unfavorable prior year development of $14.4 million, $30.6 million, and $23.1 million for the years ended December 31, 2015, 2014, and 2013, respectively. The unfavorable development and reserve strengthening reported in each of these three years was predominately in the commercial auto liability line of business. In both 2014 and 2015, the unfavorable development, while related to several accident years, was more prominent in accident years 2011 through 2013. Included in the $14.4 million of unfavorable development in 2015 is $9.7 million related to reserve strengthening primarily for accident years 2012 and 2013, recorded during the fourth quarter of 2015. Included in the $30.6 million of unfavorable development in 2014 is $20.0 million related to reserve strengthening for accident years 2011 through 2013 recorded during the second quarter of 2014. The $23.1 million of unfavorable development in 2013 was predominately related to accident years 2010 and 2011, of which a portion is related to commercial auto business that is no longer in force, and includes $6.0 million related to reserve strengthening in accident year 2011 recorded during the second quarter of 2013.
In 2015, the Company recorded unfavorable development on the Vanliner reserves acquired in 2010, compared to no development in 2014 and favorable reserve development in 2013. The development recorded in 2013 and 2015 was subject to a contractual balance sheet guaranty that expired on December 31, 2014 with the final settlement of such contractual amounts occurring during 2015. Accordingly, offsetting charges to loss and LAE expense were recorded in the Consolidated Statements of Income to record the $7.0 million relating to the development in 2015 as a receivable from the guarantor and the $20.8 million relating to the unfavorable development in 2013 as a payable to the guarantor. 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.
The Company invests funds in the participant loss layer for several of the ART programs. The Company has investment income and realized gains or losses, and incurs an equal expense on the amounts owed to ART participants. “Expense on amounts withheld” represents both investment income and realized gains or losses that the Company remits back to ART participants. The related investment income and realized gains or losses are included in the Company’s “Net investment income” and “Net realized (losses)gains on investments” lines, respectively, on its Consolidated Statements of Income.
The Company’s insurance subsidiaries report to various insurance departments using SAP prescribed or permitted by the applicable regulatory agency of the domiciliary commissioner. The statutory capital and surplus and statutory net income of NIIC, VIC, TCC and NIIC-HI were as follows:
The statutory capital and surplus of VIC, TCC and NIIC-HI is included in the statutory capital and surplus of NIIC for reporting purposes.
NIIC, VIC, TCC and NIIC-HI are subject to insurance regulations that limit the payment of dividends without the prior approval of their respective insurance regulators. Without prior regulatory approval, the maximum amount of dividend that may be paid in 2016 by NIIC to the Company based on the greater of 10% of prior year surplus or net income is $29.6 million. VIC’s maximum distribution to NIIC based on the greater of 10% of prior year surplus or net income, excluding realized gains, is $13.1 million. TCC's and NIIC-HI’s maximum distribution to NIIC based on the greater of 10% of prior year surplus or net income is $1.9 million and $1.3 million, respectively.
NIIC paid no dividends to the Company in 2015 and paid $10.0 million to the Company in both 2014 and 2013. Also, in accordance with statutory restrictions each of the insurance companies’ subsidiaries must meet minimum Risk-Based Capital (“RBC”) levels. At December 31, 2015, NIIC, VIC, TCC and NIIC-HI exceeded the minimum RBC levels and are well in excess of minimum capital requirements set forth by the companies’ respective states of domicile.
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 the Company’s LAE reserves. In addition, regulatory bodies, such as state insurance departments, the SEC, the Department of Labor
The Company has investments in limited partnerships which are included in the “Other invested assets” line on the Consolidated Balance Sheets. Relative to such limited partnerships the Company has contractual agreements to invest up to an additional $14.8 million. These limited partnership contractual agreements have expiration dates up to five years whereby the entire amounts or a portion thereof could be required to be funded at any time prior to the expiration dates.
The following are quarterly results of operations for the years ended December 31, 2015 and 2014:
The following table presents amounts related to unrealized gains and losses on available-for-sale securities which were reclassified out of AOCI during the years ended December 31, 2015, 2014, and 2013 categorized by the respective affected line items in the Consolidated Statements of Income:
On March 7, 2016, AFG announced that it had submitted a proposal to the Company to acquire all of the outstanding shares of Common Stock of the Company (“Common Stock”) not already owned by AFG’s wholly-owned subsidiary, Great American, at