The Company generates most of its revenues through the sale of commercial and personal property and casualty insurance policies. The commercial insurance policies are sold through the Company’s five distribution channels which include direct sales, retail insurance producers/open brokerage, wholesalers, preferred agents and the Internet. The Company believes that consistency in its field office representation has created excellent relationships with local insurance agencies across the country. The personal insurance policies are processed almost exclusively over the Internet via the Company’s proprietary “In-Touch” system by the Company’s distribution network.
The Company also generates revenue from its investment portfolio, which approximated $2.4 billion at December 31, 2006, and generated $95.4 million in gross pre-tax investment income during 2006. The Company utilizes external independent professional investment managers with the objective of realizing high levels of investment income while generating competitive after-tax total rates of return within specific objectives and guidelines.
The Company’s GAAP basis combined ratio was 69.0% for 2006, which was substantially lower than the combined ratio of the property and casualty industry as a whole. 2006 calendar year results included a $91.4 million pre-tax benefit from a decrease in net unpaid loss and loss adjustment expenses due to favorable trends in prior years’ claim emergence. The favorable net loss and loss adjustment expense development occurred primarily in the Commercial and Specialty Lines segments for accident years 2005, 2004 and 2003. This favorable development is primarily attributable to better than expected case incurred loss development for commercial coverages for accident years 2005 and 2004. For accident year 2003, the favorable development resulted from decreased loss estimates across specialty lines and automobile rental/leasing coverages due to better than expected case incurred loss development. The following table illustrates the 2006 calendar year and accident year loss ratios by segment.
There are certain risks and uncertainties inherent in the Company’s impairment methodology including, but not limited to, the financial condition of specific industry sectors and the resultant effect on any underlying collateral values and changes in accounting, tax and/or regulatory requirements which may have an effect on either, or both, the investor and/or the issuer.
informed estimates and judgments. This liability includes an amount determined on the basis of claim adjusters’ evaluations with respect to insured events that have been reported to the Company and an amount for losses incurred that have not been reported to the Company, including future expected development on claims already reported to the Company. In some cases significant periods of time, up to several years or more, may elapse between the occurrence of an insured loss and the reporting of such to the Company. Estimates for unpaid loss and loss adjustment expenses are based on management’s assessment of known facts and circumstances, review of past loss experience and settlement patterns, and consideration of other factors such as legal, social, and economic developments. These estimates are reviewed regularly and any adjustments resulting therefrom are made in the accounting period in which the adjustment arises.
This assumption implies that historical claim reporting, handling, and settlement patterns are predictive of future activity and can thus be utilized to forecast ultimate liabilities on unpaid claims. Since the many factors that influence claim activity can change over time and are often difficult to isolate or quantify, the rate at which claims arose in the past and the costs to settle them may not always be representative of what will occur in the future. Key objectives in developing estimates of ultimate losses are to identify aberrations and systemic changes occurring within historical experience and to adjust for them so that the future can be projected on a more reliable basis. Various diagnostic tools are employed, (e.g., ratios of claims paid-to-claims incurred and analyses of average claim costs by age of development), and close communication is maintained among the Company’s actuarial, claims and underwriting departments to continually monitor and assess the validity of this assumption.
These methods, like historical paid loss development methods, assume that the ratio of losses in one period to losses in an earlier period will remain constant in the future. However, these methods use incurred losses (i.e., the sum of cumulative historical loss payments plus outstanding case reserves) over discrete periods of time to estimate future losses. Historical incurred loss development methods can be preferable to historical paid loss development methods because they explicitly take into account open cases and the claims adjusters’ evaluations of the cost to settle all known claims. However, historical incurred loss development methods necessarily assume that case reserving practices are consistently applied over time. Therefore, when there have been significant changes in how case reserves are established or material changes in the underlying loss exposures and/or circumstances which may lead to a claim being reported, using incurred loss data to project ultimate losses can be less reliable than other methods.
For most lines of business, given the high level of case reserve adequacy observed in recent calendar periods and the consistent claim reserving practices employed by the Company’s claim staff, loss reserves for older accident years are generally set in accordance with ultimate projections from incurred loss development methods. Projections from paid loss development methods may be selected for these older accident years where very few claims remain open and case reserves held for those claims are low relative to observed historical average severities of similar claims. For two Specialty Lines products (Corporate Directors and Officers and Lawyers Errors and Omissions), changes in claims handling occurred within the past several years that may invalidate the assumptions underlying the standard incurred loss development method. For these products, indications from adjusted historical incurred loss development methods were utilized in place of the standard method in forming the actuarially determined estimate, as the adjustments made attempt to re-state historical experience as it might have appeared had current claim handling practices been in place throughout.
Due to numerous factors including, but not limited to, trends affecting loss development factors and pricing adequacy, the Company’s key actuarial assumptions may change. Approximately 85.6% of the Company’s loss reserves are for accident years 2004 through 2006. These accident years are also the period during which changes, if any, to the factors underlying the actuarial assumptions would be most likely to occur. The quantification referred to in the next paragraph of the impact that changes to the actuarial assumptions could have are stated without any adjustment for reinsurance and before the effects of taxes.
The chart below illustrates the impact to the actuarially determined loss reserve estimates as of December 31, 2006 applicable to all lines of business in accident years 2004 to 2006 from selected combinations of possible increases and decreases to the loss development factor and expected loss ratio assumptions.
For example, a 5% increase in a loss development factor of 1.500 would equal 1.575 (1.500 multiplied by 1.05).
Reinsurance receivables from reinsurers under reinsurance contracts are subject to estimation. Reinsurance receivables may prove uncollectible if reinsurers are unable or unwilling to perform under the Company’s reinsurance contracts due to, but not limited to, such factors as the reinsurers’ financial condition or coverage disputes. The Company seeks to limit the risk of a reinsurer’s default in a number of ways. First, the Company principally contracts with large reinsurers that are rated at least “A” (Excellent) by A.M. Best Company. Additionally, the Company will obtain collateral for balances due from reinsurers that are not approved by the Pennsylvania and/or Florida Insurance Departments due to their foreign domiciliary status, and seeks to collect the obligations of its reinsurers on a timely basis. This collection effort is supported through the regular monitoring of reinsurance receivables. Reinsurance receivables are reported net of an allowance for estimated uncollectible reinsurance receivables. The allowance is based upon the Company’s regular review of amounts outstanding, length of collection period, changes in reinsurer credit standing and other relevant factors. As of December 31, 2006, reinsurance receivables amounted to $272.8 million. Based upon the Company’s continuing monitoring and analysis, it was determined that no allowance for estimated uncollectible reinsurance receivables was required to be established as of December 31, 2006.
Premiums: Premium information for the Company’s business segments is as follows (dollars in millions):
most notably for the Company’s non-profit, condominium association and sports leagues commercial package product lines. These product offerings accounted for approximately $105.3 million of the $209.1 million total Commercial Lines segment gross written premiums increase.
The introduction of several new niche product offerings, most notably religious organizations, professional sports and entertainment commercial package products and the antique/collector vehicle product. These new product offerings accounted for approximately $37.5 million of the $209.1 million total Commercial Lines segment gross written premiums increase.
Certain of the Company’s reinsurance contracts have reinstatement or additional premium provisions under which the Company must pay reinstatement or additional reinsurance premiums to reinstate coverage provisions upon utilization of initial reinsurance coverage. During the years ended December 31, 2006 and 2005, the Company accrued $5.3 million ($2.2 million for the commercial lines segment and $3.1 million for the specialty lines segment) and $3.7 million ($1.6 million for the commercial lines segment and $2.1 million for the specialty lines segment) respectively, of reinstatement or additional reinsurance premium under its casualty excess of loss reinsurance treaties, as a result of changes in ultimate loss estimates. The reinstatement premium increased ceded written and earned premiums and reduced net written and earned premiums.
Net Investment Income: Net investment income approximated $91.7 million in 2006 and $63.7 million in 2005. Total investments grew to $2,433.6 million at December 31, 2006 from $1,935.0 million at of December 31, 2005. The growth in investment income is primarily due to increased investments which arose from investing net cash flows provided from operating activities, during a period in which the general level of interest rates increased and in which the Company increased the average duration of its fixed income portfolio. The Company’s average duration of its fixed maturity portfolio was 4.6 years and 4.0 years at December 31, 2006 and December 31, 2005, respectively. The decision to increase the average duration of the fixed maturity portfolio was based upon enterprise risk management analyses completed during 2006. The analyses indicated the capacity to further refine the risk/return profile of the investment portfolio. Based upon the analyses, the following actions were implemented:
The Company’s taxable equivalent book yield on its fixed income holdings approximated 5.4% at December 31, 2006, compared to 4.8% at December 31, 2005. Net investment income was reduced by $1.5 million for the year ended December 31, 2005 due to the interest credit on the Funds Held Account balance pursuant to the Company’s quota share reinsurance agreement (see Note 10 to the Company’s consolidated financial statements included with this Form 10-K).
The total pre-tax return, which includes the effects of both income and price returns on securities, of the Company’s fixed income portfolio was 4.57% and 2.34% for the years ended December 31, 2006 and 2005, respectively, compared to the Lehman Brothers Intermediate Aggregate Bond Index (“the Index”) total pre-tax return of 4.63% and 2.01% for the same periods, respectively. The Company expects some variation in its portfolio’s total return compared to the Index because of the differing sector, security and duration composition of its portfolio as compared to the Index.
For the year ended December 31, 2005, the Company realized net investment gains of $3.5 million and $11.5 million from the sale of fixed maturity and equity securities, respectively, and $0 million and $2.2 million in non-cash realized investment losses for fixed maturity and equity securities, respectively, as a result of the Company’s impairment evaluation. The $11.5 million net realized gains from the sale of equity securities included approximately $11.0 million of net realized gains as a result of the liquidation of certain of the Company’s equity portfolios following the Company’s decision to change four of its common stock investment managers. Net realized investment gain for the year ended December 31, 2005 was reduced by $3.2 million due to the recognized loss of the change in fair value of a cash flow hedge entered into by the Company for which the anticipated transaction did not occur (see Note 6 to the Company’s consolidated financial statements included with this Form 10-K).
Net Loss and Loss Adjustment Expenses: Net loss and loss adjustment expenses decreased $35.8 million (7.1%) to $468.2 million for the year ended December 31, 2006 from $504.0 million for the year ended December 31, 2005, while the loss and loss adjustment expense ratio decreased to 40.0% in 2006 from 51.6% in 2005.
For accident year 2004, the decrease in estimated net unpaid loss and loss adjustment expenses was principally due to lower estimates for commercial coverages due to better than expected case incurred loss development. The incurred frequency emergence on general liability coverages, and the incurred severity emergence on auto coverages, were less than anticipated.
For accident years 2002 and prior, the decrease in estimated net unpaid loss and loss adjustment expenses was principally due to lower estimates for rental/leasing auto coverages due to better than expected case incurred loss development. The incurred frequency emergence on rental/leasing auto coverages, and the incurred severity emergence on rental supplemental liability coverages, were less than anticipated.
A $24.7 million reduction in hurricane catastrophe losses incurred. During the year ended December 31, 2005, the Company incurred $24.7 million of net loss and loss adjustment expenses related to Hurricanes Dennis, Katrina, Rita and Wilma. The Company incurred no such catastrophe losses during the year ended December 31, 2006.
$7.2 million of share-based compensation expense allocated to underwriting and acquisition expenses which was recognized under SFAS 123(R), which was adopted by the Company on January 1, 2006.
The $1.6 million reduction in expense related to the 2004 assessment is attributable to net policyholder surcharges related to premiums written during 2006. The $1.8 million reduction in expense related to the 2005 assessment is attributable to a reduction in the actual 2005 assessment paid to Citizens, compared to the amount that was estimated by Citizens and accrued by the Company as of December 31, 2005.
Income Tax Expense: The Company’s effective tax rate for the years ended December 31, 2006 and 2005 was 33.5% and 34.9%, respectively. The effective rate for 2006 differed from the 35% statutory rate principally due to investments in tax-exempt securities. The effective tax rate for 2005 differed from the 35% statutory rate principally due to investments in tax-exempt securities, offset by the non-deductible goodwill impairment loss.
The decisions by an automobile leasing customer and an automobile excess liability customer to self-insure business previously written by the Company. As a result, gross written premiums for the commercial lines segment were reduced by approximately $78.0 million.
The respective net written premiums, and net earned premiums for commercial lines, specialty lines and personal lines segments for the year ended December 31, 2005 vs. December 31, 2004 were as follows (in millions):
The Company ceded 22% of its net written and earned premiums and loss and loss adjustment expenses for policies effective April 1, 2003 through December 31, 2003 and 10% of its commercial and specialty lines net written and earned premiums and loss and loss adjustment expenses for policies becoming effective during 2004. During the years ended December 31, 2005 and 2004, the Company ceded $(0.5) million ($0.2 million for the commercial lines segment and $(0.7) million for the specialty lines segment) and $94.5 million ($77.8 million for the commercial lines segment, $16.9 million for the specialty
Net Investment Income: Net investment income approximated $63.7 million in 2005 and $43.5 million in 2004. Total investments grew to $1,935.0 million at December 31, 2005 from $1,428.2 million at December 31, 2004. The growth in investment income is primarily due to increased investments which arose from investing net cash flows provided from operating activities. The Company’s average duration of its fixed income portfolio was 4.0 years and 4.1 years at December 31, 2005 and December 31, 2004, respectively. The Company’s taxable equivalent book yield on its fixed income holdings approximated 4.8% at December 31, 2005, compared to 4.7% at December 31, 2004. The Company’s expectation is that the fixed income security taxable equivalent book yield for funds invested during 2006 will approximate 5.25% to 5.75%. This range is based on current interest rates and a continuation of the
Company’s asset allocation between taxable and tax-exempt fixed income securities. Net investment income was reduced by $1.5 million and $4.9 million for the years ended December 31, 2005 and 2004, respectively, due to the interest credit on the Funds Held Account balance pursuant to the Company’s quota share reinsurance agreement (see Note 10 to the Company’s consolidated financial statements included with this Form 10-K).
This increase to the loss and loss adjustment expenses incurred was offset in part by:
Reserve actions taken during the year ended December 31, 2005 whereby the estimated net unpaid loss and loss adjustment expenses for accident years 2004 and prior were decreased by $29.9 million vs. reserve actions taken during the year ended December 31, 2004 whereby the estimated net unpaid loss and loss adjustment expenses for accident years 2003 and prior were
increased by $35.1 million. Changes in the estimated net unpaid loss and loss adjustment expenses during the year ended December 31, 2005 by accident year were as follows:
Citizens reported incurred losses from the hurricanes that struck Florida during 2004 and a deficit for the 2004 plan year. During 2005, the Board of Governors of Citizens authorized the levying of a regular assessment, and the Florida Office of Insurance Regulation also approved the assessment. Based on the Company’s market share, the Company was assessed and paid $11.9 million in Citizens assessments during 2005. This assessment may be recouped through future insurance policy surcharges to Florida insureds. These surcharges will be recorded in the consolidated financial statements as the related premiums are written. The Company also recognized and paid an additional $0.6 million related to this Citizens assessment pursuant to a quota share reinsurance agreement whereby the Company assumed a 50% participation from an unaffiliated Florida insurer.
Of the $12.5 million in total payments related to the Citizens assessment during 2005, $8.6 million is recoverable from certain of the Company’s catastrophe reinsurers under its 2004 catastrophe reinsurance program and from one of the Company’s quota share reinsurers, resulting in a $3.9 million net assessment expense being recognized during 2005 for Citizens assessments paid during 2005. Any recoupment of the Citizens assessment through future policy surcharges will be allocated between the Company and its reinsurers.
These increases in acquisition costs and other underwriting expenses were partially offset by:
Goodwill Impairment Loss: During the fourth quarter of 2005, the Company recorded a $25.7 million impairment charge related to the write-down of goodwill arising from the acquisition of the Company’s personal lines segment. This loss, which was the same on a pre-tax and after-tax basis, was a result of the Company’s annual evaluation of the carrying value of goodwill. The write-down was determined by comparing the fair value of the Company’s personal lines segment and the implied value of the goodwill with the carrying amounts on the balance sheet. The write-down resulted from changes in business assumptions primarily due to the following: the unprecedented hurricane activity and associated catastrophe losses experienced in 2004 and 2005; the uncertainty of 2006 catastrophe reinsurance renewal rates; the forecasted weather pattern of increased hurricane activity; the decision to change the personal lines segment business model to discontinue writing the mobile homeowners business and target new construction homeowners business; and the disruption in the Florida marketplace.
The Company’s investment objectives are the realization of high levels of after-tax net investment income with competitive after-tax total rates of return subject to established specific guidelines and objectives. The Company utilizes external independent professional investment managers for its fixed maturity and equity investments. These investments consist of diversified issuers and issues, and as of December 31, 2006 approximately 86.0% and 10.4% of the total invested assets (total investments plus cash equivalents) on a cost basis consisted of investments in fixed maturity and equity securities, respectively, versus 90.1% and 8.1%, respectively, as of December 31, 2005.
The following table identifies the period of time securities with an unrealized loss as of December 31, 2006 have continuously been in an unrealized loss position. None of the amounts shown in the table include unrealized losses due to non-investment grade fixed maturity securities. No issuer of securities or industry represents more than 3.5% and 23.6%, respectively, of the total estimated fair value, or 2.8% and 28.7%, respectively, of the total gross unrealized loss included in the table below. The industry concentration represents investments in “AAA” rated Mortgage Backed Securities issued by agencies of the U.S. Government which are collateralized by pools of residential mortgage loans. The unrealized losses on these securities are generally attributable to interest rate increases. The contractual repayment of these securities is guaranteed by agencies of the U.S. Government, and it is therefore expected that the securities would not be settled at a price less than the amortized cost of the Company’s investment. At the present time the Company has the ability and intent to hold these securities until a recovery of fair value, which may be maturity; therefore the Company does not consider these investments to be other than temporarily impaired as of December 31, 2006.
The unrealized losses on the Company’s Aaa/AAA rated investments in U.S. Treasury Securities and Obligations of U.S. Government Agencies are attributable to interest rate increases. Of the 32 investment positions held, approximately 71.9% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investments.
The unrealized losses on the Company’s long term investments in Corporate bonds which have ratings from Baa3/BBB to Aaa/AAA are generally caused by interest rate increases. Of the 114 investment positions held, approximately 87.7% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investments. Therefore, it is expected that the securities would not be settled at a price less than the amortized cost of the investments.
The unrealized losses on the Company’s investments in Collateralized Mortgage Obligations which have ratings of Aa2/AA to Aaa/AAA are generally caused by interest rate increases. Of the 155 investment positions held, approximately 66.5% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the security at a price less than the amortized cost of the investments.
For the year ended December 31, 2006, the Company’s gross loss on the sale of fixed maturity and equity securities amounted to $1.7 million and $7.0 million, respectively. The fair value of the fixed maturity and equity securities at the time of sale was $185.2 million and $40.5 million, respectively. For the year ended December 31, 2005, the Company’s gross loss on the sale of fixed maturity and equity securities amounted to $0.9 million and $5.5 million, respectively. The fair value of the fixed maturity and equity securities at the time of sale was $63.6 million and $56.5 million, respectively. During 2004, the Company’s gross loss on the sale of fixed maturity and equity securities amounted to $1.3 million and $1.9 million, respectively. The fair value of the fixed maturity and equity securities at the time of sale was $30.7 million and $7.5 million, respectively.
The Company’s financial instruments are subject to the market risk of potential losses from adverse changes in market rates and prices. The primary market risks to the Company are equity price risk associated with investments in equity securities and interest rate risk associated with investments in fixed maturities. The Company has established, among other criteria, duration, asset quality and asset allocation guidelines for managing its investment portfolio market risk exposure. The Company’s investments are classified as Available for Sale and consist of diversified issuers and issues.
On June 30, 2006, the Company entered into an unsecured Credit Agreement (the “Credit Agreement”) which establishes a revolving credit facility providing for loans to the Company of up to $50.0 million in principal amount outstanding at any one time, with a maturity date of June 29, 2007. The Credit Agreement contains an annual commitment fee of 8.0 basis points per annum on the unused commitments under the Credit Agreement and provides capacity for working capital and other general corporate purposes. As of December 31, 2006, no borrowings have been made by the Company under the Credit Agreement. Each loan under the facility will bear interest at a per annum rate equal to, at the Company’s option, (i) Libor plus 0.40% or (ii) the higher of the Administrative Agent and Lender’s prime rate and the Federal Funds rate plus 0.50%. The Credit Agreement contains various representations, covenants and events of default typical for credit facilities of this type.
Two of the Company’s insurance subsidiaries are members of the Federal Home Loan Bank of Pittsburgh (“FHLB”). A primary advantage of FHLB membership is the ability of members to access credit products from a reliable capital markets provider. The availability of any one member’s access to credit is based upon its FHLB eligible collateral. The insurance subsidiaries have utilized a portion of their borrowing capacity in the past to purchase a diversified portfolio in investment grade floating rate securities. These purchases were funded by floating rate FHLB borrowings to achieve a positive spread between the rate of interest on these securities and borrowing rates. As of December 31, 2006, the insurance subsidiaries’ unused borrowing capacity was $506.3 million. The borrowing capacity provides an immediately available line of credit.
In the normal course of business, the Company has entered into various reinsurance contracts with unrelated reinsurers. The Company participates in such agreements for the purpose of limiting loss exposure and managing capacity constraints. Reinsurance contracts do not relieve the Company from its obligations to policyholders. To reduce the potential for a write-off of amounts due from reinsurers, the Company evaluates the financial condition of its reinsurers and principally contracts with large reinsurers that are rated at least “A” (Excellent) by A.M. Best Company. Additionally, the Company will obtain collateral for balances due from reinsurers that are not approved by the Pennsylvania and/or Florida Insurance Departments due to their foreign domiciliary status, and seeks to collect the obligations of its reinsurers on a timely basis. This collection effort is supported through the regular monitoring of reinsurance receivables. As of December 31, 2006, approximately 92.4% of the Company’s reinsurance receivables (excluding amounts ceded to voluntary and mandatory pool mechanisms) are either with reinsurers rated “A” (Excellent) or better by A.M. Best Company or are fully collateralized.
The Insurance Subsidiaries, which operate under intercompany reinsurance pooling agreements, must have certain levels of surplus to support premium writings. Guidelines of the National Association of Insurance Commissioners ( “NAIC”) suggest that a property and casualty insurer’s ratio of annual statutory net premium written to policyholders’ surplus should not exceed 3-to-1. The ratio of combined annual statutory net premium written by the insurance subsidiaries to their combined policyholders’ surplus was 1.3-to-1.0 and 1.6-to-1.0 for 2006 and 2005, respectively.
The NAIC’s risk-based capital method is designed to measure the acceptable amount of capital and surplus an insurer should have based on the inherent specific risks of each insurer. The adequacy of a company’s actual capital and surplus is evaluated by a comparison to the risk-based capital results. Insurers failing to meet minimum risk-based capital requirements may be subject to scrutiny by the insurer’s domiciliary insurance department and ultimately rehabilitation or liquidation. As of December 31, 2006, PIIC, PIC, LASIC and LAIC exceeded their minimum risk-based capital requirements of $273.5 million, $14.4 million, $5.6 million and $6.0 million, respectively, by 226%, 341%, 359% and 367%, respectively.
Represents payments based on estimated subject earned premiums under certain reinsurance contracts.
In February 2006, the Financial Accounting Standards Board (“FASB”) issued Statement No. 155 “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”). Subsequently, SFAS No. 155 was modified. Under current generally accepted accounting principles, an entity that holds a financial instrument with an embedded derivative, subject to certain scope exceptions, must bifurcate
In July 2006, the FASB released Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48, which is effective for fiscal years beginning after December 15, 2006, also provides guidance on derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition. The Company adopted FIN 48 on January 1, 2007 and expects that it will not have a material effect on financial condition or results of operations.
Consolidated Statements of Changes in Shareholders’ Equity - For the Years Ended December 31, 2006, 2005 and 2004
Other Than Investments in Related Parties As of December 31, 2006
Reinsurance For the Years ended December 31, 2006, 2005 and 2004
Also, in our opinion, management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
Philadelphia Consolidated Holding Corp. (“Philadelphia Insurance”), and its subsidiaries (collectively the “Company”) doing business as Philadelphia Insurance Companies, include four property and casualty insurance companies, Philadelphia Indemnity Insurance Company (“PIIC”) and Philadelphia Insurance Company (“PIC”), which are domiciled in Pennsylvania; and Liberty American Select Insurance Company (“LASIC”) and Liberty American Insurance Company (“LAIC”), which are domiciled in Florida (collectively the “Insurance Subsidiaries”); an underwriting manager, Maguire Insurance Agency, Inc.; a managing general agency, Liberty American Insurance Services, Inc.; a premium finance company, Liberty American Premium Finance Company; and an investment subsidiary, PCHC Investment Corp. The Company designs, markets, and underwrites specialty commercial and personal property and casualty insurance products for select target industries or niches including, among others, nonprofit organizations; the health, fitness and wellness industry; select classes of professional liability; the rental car industry; automobile leasing industry; and personal property and casualty insurance products for the homeowners and manufactured housing markets. All marketing, underwriting, claims management, investment, and general administration is provided by the underwriting manager and managing general agency.
Goodwill impairment testing requires the evaluation of the fair value of each reporting unit to its carrying value, including the goodwill, and an impairment charge is recorded if the carrying amount of the reporting unit exceeds its estimated fair value. As a result of the impairment analysis performed as of December 31, 2005, the Company recorded a $25.7 million impairment charge during the fourth quarter of 2005 related to the write-down of goodwill arising from the acquisition of the Company’s personal lines segment. (See Note 8)
The liability for unpaid loss and loss adjustment expenses reflects the Company’s best estimate for future amounts needed to pay losses and related settlement expenses with respect to insured events. The process of establishing the ultimate claims liability is necessarily a complex imprecise process, requiring the use of informed estimates and judgments using data currently available. The liability includes an amount determined on the basis of claim adjusters’ evaluations with respect to insured events that have occurred and an amount for losses incurred that have not been reported to the Company. In some cases significant periods of time, up to several years or more, may elapse between the occurrence of an insured loss and the reporting of such to the Company. Estimates for unpaid loss and loss adjustment expenses are based upon management’s assessment of known facts and circumstances, review of past loss experience and settlement patterns and consideration of other factors such as legal, social, and economic developments. These adjustments are reviewed regularly and any adjustments therefrom are made in the accounting period in which the adjustment arises. If the Company’s ultimate losses, net of reinsurance, prove to differ substantially from the amounts recorded at December 31, 2006, the related adjustments could have a material adverse impact on the Company’s financial condition and results of operations.
The Company’s policy with respect to issuance of shares pursuant to its stock based compensation plan is to first utilize any available treasury shares, and then issue new shares as needed.
The Company’s 175 Preferred Agents are eligible to receive profit sharing based upon achieving minimum premium production thresholds and profitability results for their business placed in a contract year with the Company. The ultimate amount of profit sharing may not be known until the final contractual loss evaluation of the profit sharing is completed 6.5 years after the contract year business has been written. The Company estimates the liability for this profit sharing based upon the contractual provisions of the profit sharing agreement and the Company’s actual historical profit sharing payout. As of December 31, 2006, the Company has accrued a profit sharing liability of $21.9 million, of which $20.6 million relates to business written for contract years commencing January 1, 2003 and subsequent.
In February 2006, the Financial Accounting Standards Board (“FASB”) issued Statement No. 155 “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”). Subsequently, SFAS No. 155 was modified. Under current generally accepted accounting principles, an entity that holds a financial instrument with an embedded derivative, subject to certain scope exceptions, must bifurcate the financial instrument, resulting in the host and the embedded derivative being accounted for separately. SFAS No. 155 permits, but does not require, entities to account for financial instruments with an embedded derivative at fair value thus negating the need to bifurcate the instrument between its host and the embedded derivative. SFAS No. 155 is effective as of the beginning of the first annual reporting period that begins after September 15, 2006. The Company will adopt SFAS No. 155 on January 1, 2007 and believes the financial impact of application will not be significant.
Under SAP, policy acquisition costs, such as commissions, premium taxes, fees, and other costs of underwriting policies are charged to current operations as incurred, while under GAAP, such costs are deferred and amortized on a pro rata basis over the same period in which the related premiums are earned.
Under SAP, net deferred income tax assets are admitted following the application of certain criteria, with the resulting admitted deferred tax amount being credited directly to policyholder surplus.
Under SAP, premiums receivable are considered non-admitted if determined to be uncollected based upon aging criteria as defined in SAP.
Under SAP, the costs and related policyholder surcharge receivables for guaranty funds and other assessments are recorded based on management’s estimate of the ultimate liability and related ultimate policyholder surcharge receivable, while under GAAP, such costs are accrued when the liability is probable and reasonably estimatable, and the related policyholder surcharge receivable amount is accrued as the related premium is written.
Financial Information: The combined statutory capital and surplus of the Insurance Subsidiaries as of December 31, 2006 and 2005 was $1,007.5 million and $691.0 million, respectively. Combined statutory net income for the years ended December 31, 2006, 2005 and 2004 was $270.9 million, $155.5 million and $48.2 million, respectively. The Company made no capital contributions to the Insurance Subsidiaries during the year ended December 31, 2006. The Company made capital contributions of $27.0 million to the Insurance Subsidiaries during the year ended December 31, 2005.
Risk-Based Capital: Risk-based capital is a method developed by the National Association of Insurance Commissioners (“NAIC”) designed to measure the acceptable amount of capital and surplus an insurer should have based on the inherent specific risks of each insurer. The adequacy of a company’s actual capital and surplus is evaluated by a comparison to the risk-based capital results. Insurers failing to meet minimum risk-based capital requirements may be subject to scrutiny by the insurer’s domiciliary insurance department and ultimately rehabilitation or liquidation. As of December 31, 2006, PIIC, PIC, LASIC and LAIC exceeded their minimum risk-based capital requirement of $273.5 million, $14.4 million, $5.6 million and $6.0 million, respectively, by 226%, 341%, 359% and 367%, respectively.
The Company invests primarily in investment grade fixed maturities which possessed a weighted average quality of AAA at December 31, 2006. In addition, 99.9% of the Insurance Subsidiaries’ fixed maturity securities (cost basis) consisted of U.S. government securities or securities rated “1” (“highest quality”) or “2” (“high quality”) by the NAIC at December 31, 2006. The cost, gross unrealized gains and losses and estimated market value of investments as of December 31, 2006 and 2005 are as follows (in thousands):
The Company regularly performs impairment reviews with respect to its investments. For investments other than interests in securitized assets, these reviews include identifying any security whose fair value is below its cost and an analysis of securities
meeting predetermined impairment thresholds to determine whether such decline is other than temporary. If the Company determines that it does not intend to hold a security to maturity or determines a decline in value to be other than temporary, the cost basis of the security is written down to its fair value with the amount of the write down included in earnings as a realized investment loss in the period the impairment arose. This evaluation resulted in non-cash realized investment losses of $8.8 million, $2.2 million and $2.5 million for the years ended December 31, 2006, 2005 and 2004, respectively. The Company’s impairment review also includes an impairment evaluation for interests in securitized assets conducted in accordance with the guidance provided by the Emerging Issues Task Force of the Financial Accounting Standards Board. This evaluation resulted in no non-cash realized investment losses for the years ended December 31, 2006 or 2005. For the year ended December 31, 2004, this evaluation resulted in non-cash realized investment losses of $7.3 million.
The unrealized losses on the Company’s long term investments in Corporate bonds which have ratings from Baa3/BBB to Aaa/AAA are generally caused by interest rate increases. Of the 114 investment positions held, approximately 87.7% were in an unrealized loss position. The contractual terms of the investments do not permit the issuer to settle the securities at a price less
than the amortized cost of the investments. Therefore, it is expected that the securities would not be settled at a price less than the amortized cost of the investments.
Realized pre-tax investment gains (losses) for the years ended December 31, 2006, 2005 and 2004 are as follows (in thousands):
The Insurance Subsidiaries have investments, principally U.S. Treasury securities and Obligations of States and Political Subdivisions, on deposit with the various states in which they are licensed insurers. The carrying value of the securities on deposit was $15.1 million as of December 31, 2006 and 2005.
PIIC and PIC are required to hold a certain minimum amount of Federal Home Loan Bank of Pittsburgh (“FHLB”) common stock as a requirement of membership in the FHLB. The required minimum amount of common stock is based on the amount of PIIC’s and PIC’s outstanding borrowings plus the unused maximum borrowing capacity, as defined by the FHLB. At December 31, 2006 and 2005, the carrying value of FHLB common stock was $0.3 million.
Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended, requires that derivatives be recorded on the balance sheet as either assets or liabilities measured at fair value. Changes in the fair value of derivatives are recorded either through current earnings or as other comprehensive income, depending on the type of hedge transaction. Gains and losses on the derivative instrument reported in other comprehensive income are reclassified
into earnings in the periods in which earnings are impacted by the variability of the cash flow of the hedged item. The ineffective portion of all hedge transactions is recognized in current period earnings.
As of December 31, 2006 and 2005, costs incurred for Property and Equipment not yet placed in service amounted to $3.7 million and $1.3 million, respectively. Amortization of costs incurred in developing or purchasing computer software amounted to $4.1 million, $2.6 million and $2.1 million for the years ended December 31, 2006, 2005 and 2004, respectively. Depreciation expense, excluding amortization of computer software, amounted to $3.1 million, $2.1 million and $1.3 million for the years ended December 31, 2006, 2005 and 2004, respectively.
The changes in the net ultimate losses and loss adjustment expenses for prior accident years during 2005 were primarily attributable to the following:
As of December 31, 2005, the Company had accrued a profit commission receivable, which was recorded in the Consolidated Balance Sheet in Other Assets, based upon the experience of the underlying business ceded to this reinsurance agreement, in the amount of $7.0 million. The profit commission reduces ceded written and earned premiums and increases net written and earned premiums. There was no accrued profit commission receivable related to this reinsurance agreement as of December 31, 2006.
Two of the Company’s insurance subsidiaries are members of the Federal Home Loan Bank of Pittsburgh (“FHLB”). A primary advantage of FHLB membership is the ability of members to access credit products from a reliable capital markets provider. The availability of any one member’s access to credit is based upon its FHLB eligible collateral. The insurance subsidiaries in the past have utilized a portion of their borrowing capacity to purchase a diversified portfolio in investment grade floating rate securities. These purchases were funded by floating rate FHLB borrowings to achieve a positive spread between the rate of interest on these securities and borrowing rates. At December 31, 2006 the insurance subsidiaries’ unused borrowing capacity was $506.3 million. The borrowing capacity will provide an immediately available line of credit. The Company had no aggregate borrowings outstanding as of December 31, 2006 or 2005 from the FHLB.
The composition of deferred tax assets and liabilities and the related tax effects as of December 31, 2006 and 2005 are as follows (in thousands):
Based on the Company’s federal tax loss and capital loss carryback availability, expected levels of future pre-tax financial statement income and federal taxable income, the Company believes that it is more likely than not that the existing deductible temporary differences will reverse during periods in which net federal taxable income is generated or have adequate federal carryback availability. As a result, no valuation allowance is recognized for deferred income tax assets as of December 31, 2006 or 2005.
Philadelphia Insurance has entered into tax sharing agreements with each of its subsidiaries. Under the terms of these agreements, the income tax provision is computed as if each subsidiary were filing a separate federal income tax return, including adjustments for the income tax effects of net operating losses and other special tax attributes, regardless of whether those attributes are utilized in the Company’s consolidated federal income tax return. As of December 31, 2006 and 2005, income taxes payable amounting to $6.2 million and $7.8 million, respectively were included in Other Liabilities in the Consolidated Balance Sheets.
During 2006, 30,000 stock settled appreciation rights (“SARS”), which were granted at a hypothetical option price of $39.95 per SAR, were outstanding during the fourth quarter of 2006, but were not included in the computation of earnings per share for 2006 because the SARS’ hypothetical option price was greater than the average market price of the Company’s common shares for 2006. The SARS, which expire on September 28, 2016, were still outstanding as of December 31, 2006.
During 2004, options to purchase 15,000 shares of the Company’s common stock, which were granted at an exercise price of $19.14 per share, were outstanding during the last three quarters of 2004, but were not included in the computation of earnings per share for 2004 because the options’ price was greater than the average market price of the Company’s common shares for 2004. The options, which expire on March 15, 2014, were still outstanding as of December 31, 2004.
During 2006, the Company granted SARS and restricted stock awards to certain employees and granted restricted stock awards to its non-employee directors. All stock options that have been granted have provided for the purchase of common stock at a price not less than the fair market value on the grant date. A SAR grant consists of a right that is the economic equivalent of a stock option that could have been granted under the Plan, except that on the exercise of a SAR, the employee receives shares of the Company’s common stock having a fair market value that is equal to the fair market value of the shares of common stock that would be subject to such hypothetical option, reduced by the amount that would be required to be paid by the employee as the purchase price upon exercise of such hypothetical option. All grants of SARS have provided for a hypothetical option purchase price of not less than the fair market value on the grant date. Stock options and SARS are generally exercisable after the expiration of five years following the grant date and expire ten years following the grant date. Compensation expense for stock options and SARS is recognized ratably over the vesting period. Stock options and SARS are generally forfeited by participants who terminate employment prior to vesting.
The total intrinsic value of options exercised during the years ended December 31, 2006 and 2005 was $29.3 million and $18.6 million, respectively.
The following table presents information regarding SARS transactions during the year ended December 31, 2006. There were no SARS transactions during the years ended December 31, 2005 or 2004.
Employee Stock Purchase Plan (the “Stock Purchase Plan”): The aggregate maximum number of shares that may be issued pursuant to the Stock Purchase Plan, as amended, is 3,000,000. Shares may be purchased under the Stock Purchase Plan by eligible employees during designated one-month offering periods established by the Compensation Committee of the Board of Directors at a purchase price of the lesser of 85% of the fair market value of the shares on the first business day of the offering period or the date the shares are purchased. Shares purchased are restricted for a period of two years from the first day of the offering period. The purchase price of shares may be paid by the employee over six years pursuant to the execution of a promissory note. The promissory note(s) are collateralized by such shares purchased under the Stock Purchase Plan and are interest free. Under the Stock Purchase Plan, the Company issued 180,322 shares and 217,806 shares in 2006 and 2005, respectively. The weighted-average fair value per share of those purchase rights granted in 2006 and 2005 was $5.94 and $4.13, respectively.
offering period. The purchase price of shares may be paid by the employee over nine years pursuant to the execution of a promissory note. The promissory note(s) are collateralized by such shares purchased under the Nonqualified Stock Plan and are interest free. Under the Nonqualified Stock Plan, the Company issued 385,630 shares and 1,263,600 shares in 2006 and 2005, respectively. The weighted-average fair value per share of those purchase rights granted in 2006 and 2005 was $6.55 and $4.03, respectively.
Directors Stock Purchase Plan (“Directors Plan”): The Directors Plan has been established for the benefit of non-employee Directors. The aggregate maximum number of shares that may be issued pursuant to the Directors Plan is 150,000. Non-employee Directors, during monthly offering periods, may designate a portion of his or her fees to be used for the purchase of shares under the terms of the Directors Plan at a purchase price of the lesser of 85% of the fair market value of the shares on the first business day of the offering period or the date the shares are purchased. Under the Directors Plan, the Company issued 8,635 shares and 8,883 shares in 2006 and 2005, respectively. The weighted-average fair value per share of those purchase rights granted in 2006 and 2005 was $6.14 and $3.90, respectively.
SFAS 123(R) requires that share-based compensation cost is recorded in the financial statements in the same classifications as the related employees’ cash compensation. Accordingly, upon adoption of SFAS 123(R), a portion of the share-based compensation cost related to unvested awards and new awards has been capitalized as part of the Company’s Deferred Acquisition Costs. As of December 31, 2006, approximately $2.3 million of share-based compensation cost is included in Deferred Acquisition Costs on the Consolidated Balance Sheet. In the Company’s pro forma information required under SFAS 123 for the periods prior to January 1, 2006, share-based compensation costs were not capitalized.
SFAS 123(R) requires the Company to present pro forma information for the comparative period prior to the adoption as if it had accounted for all of its share-based compensation under the fair value method of SFAS 123. The following table illustrates the pro forma information regarding the effect on net earnings and net earnings per share if the Company had accounted for the share-based employee compensation under the fair value method of accounting:
In the normal course of business, the Company has entered into various reinsurance contracts with unrelated reinsurers. The Company participates in such agreements for the purpose of limiting loss exposure and diversifying business. Reinsurance contracts do not relieve the Company from its obligation to policyholders. The loss and loss adjustment expense reserves ceded under such arrangements were $187.8 million and $304.8 million as of December 31, 2006 and 2005, respectively.
As of December 31, 2006, the Company did not have any aggregate unsecured reinsurance receivables that exceeded 3% of shareholders’ equity from any reinsurers. Unsecured reinsurance receivables include amounts receivable for paid and unpaid losses and loss adjustment expenses and unearned premium less reinsurance receivables secured by collateral.
The future minimum rental payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2006 were as follows (in thousands):
At December 31, 2006 the Company has open commitments of $5.4 million under certain limited partnership, information technology and corporate sponsorship agreements.
deficit or 10% of Florida property premiums industry-wide for the prior year. The portion of the total assessment attributable to the Company is based on its market share. An insurer may recoup a regular assessment through a surcharge to policyholders. If a deficit remains after the regular assessment, Florida Citizens can also fund any remaining deficit through emergency assessments in the current and subsequent years. Companies are required to collect the emergency assessments directly from residential property policyholders and remit to Florida Citizens as collected. In addition, Florida Citizens may issue bonds to further fund a deficit. Participating companies are obligated to purchase any unsold bonds issued by Florida Citizens.
During 2005, Florida Citizens also reported losses from Hurricane Wilma, which followed the deficit for the 2004 plan year, and announced that a future assessment as a result of Florida Citizens’ current financial deficit was both probable and could be reasonably estimated. As of December 31, 2005, the Company accrued its estimated gross (of reinsurance recoveries) assessment of $12.4 million, which represented its portion of the maximum regular assessment available to Florida Citizens, and resulted in a $2.0 million net (of reinsurance recoveries) assessment expense during 2005. During 2006, the Florida legislature approved a $715 million budget appropriation to be used to reduce the Florida Citizens deficit. As a result, during 2006, the Company reduced its accrual of its estimated gross (of reinsurance recoveries) assessment to $2.7 million, which represents its portion of the regular assessment for the Florida Citizens 2005 plan year. During the year ended December 31, 2006, the Company recognized a pre-tax reduction to its net (of reinsurance recoveries) expense related to this assessment of $1.8 million due to the impact of the budget appropriation noted above and changes in related reinsurance recoveries resulting from updated estimates of 2005 hurricane losses reported by Florida Citizens during 2006.
In addition to Florida Citizens, the Company continues to monitor developments with respect to various other state facilities such as the Mississippi Windstorm Underwriting Association and the Texas Windstorm Insurance Association. The ultimate impact of the 2005 hurricane season on these facilities is currently uncertain, but could result in the facilities recognizing a financial deficit or a financial deficit greater than the level currently estimated by the facility. They may, in turn, have the ability to assess participating insurers when financial deficits occur, adversely affecting the Company’s results of operations.
Net Realized Investment Gain (Loss) for the three months ended March 31, 2006, June 30, 2006, September 30, 2006 and December 31, 2006 includes non-cash realized losses of $0.7 million, $0.6 million, $5.7 million, and $1.8 million, respectively, as a result of impairment evaluations.
Net Earned Premiums for the three months ended March 31, 2005, June 30, 2005, September 30, 2005 and December 31, 2005 includes accrued profit commissions on certain reinsurance contracts of $1.3 million, $1.2 million, $0.8 million and $0.7 million, respectively.
The segments follow the same accounting policies used for the Company’s consolidated financial statements as described in the summary of significant accounting policies. Management evaluates a segment’s performance based upon premium production and the associated loss experience which includes paid losses, an amount determined on the basis of claim adjusters’ evaluation with respect to insured events that have occurred and an amount for losses incurred that have not been reported. Investments and investment