We have completed integrated audits of United America Indemnity, Ltd.’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Also, in our opinion, management’s assessment, included in “Management’s Report on Internal Controls 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 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.
In July 2005, Wind River Barbados, through a series of tax-exempt transactions, contributed the Company’s U.S. Subsidiaries to U.A.I. (Luxembourg) Investment S.à r.l.
Through a series of transactions on January 24, 2005, the Company acquired 100% of the voting equity interest of Penn-America Group, Inc. (together with its subsidiaries, “Penn-America Group”). The Company acquired 67.3% through the merger with Penn-America Group, Inc., 30.5% through the purchase of Penn Independent Corporation, which held common shares of Penn-America Group, Inc., and 2.2% in two separate transactions with individual shareholders.
As stated in Note 4, the Company sold substantially all of the assets of its Agency Operations on September 30, 2006. This Note reflects the disclosures related to the purchase of Penn Independent and its subsidiaries.
In connection with the merger with Penn-America Group, Inc., the acquisition of Penn Independent Corporation, and the transactions with individual shareholders on January 24, 2005, the $249.4 million purchase price, which includes transaction related expenses, was allocated to the estimated fair values of the acquired assets and liabilities as follows (dollars in thousands):
The Company’s investments in bonds, preferred stock, and common stock are classified as available for sale and are carried at their fair value. The difference between amortized cost and fair value of these investments, excluding the derivative components of the Company’s convertible bond and preferred stock portfolios, net of the effect of deferred income taxes, is reflected in accumulated other comprehensive income in shareholders’ equity and, accordingly, has no effect on net income other than for impairments deemed to be other than temporary. The difference between amortized cost and fair value of the derivative components of the bonds is included in income.
At December 31, 2006, the Company held $22.1 million of convertible bonds and $4.4 million of convertible preferred stock. The convertible bonds include convertible options with a market value of $5.5 million and the convertible preferred stocks include convertible options with market value of $0.9 million. The change in the difference between the amortized cost and the market value of the options is included in income as a component of net realized investments gains/(losses). The Company realized a $1.6 million gain, a $1.2 million loss, and a $0.3 million gain for the years ended December 31, 2006, 2005, and 2004, respectively, due to market value changes related to options. See “New Accounting Pronouncements” below for a discussion of the impact of adopting SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140” on accounting for the change in the difference between the amortized cost and the market value of the options.
The Company’s investments in other invested assets are comprised primarily of limited liability partnership interests. Partnership interests of 3% ownership or greater are accounted for using the equity method. The change in the difference between amortized cost and fair value of partnership interests of 3% ownership or greater, net of the effect of deferred income taxes, is reflected in income. Partnership interests of less than 3% ownership are carried at their fair value. The change in the difference between amortized cost and fair value of partnership interests of less than 3% ownership, net of the effect of deferred income taxes, is reflected in accumulated other comprehensive income in shareholders’ equity and, accordingly, has no effect on net income other than for impairments deemed to be other than temporary. Several of the limited partnerships invest solely in securities that are publicly traded and are valued at the net asset value as reported by the investment manager. For the partnerships that do not invest solely in publicly traded securities, the fair value of such securities is determined by the general partner of each limited partnership based on comparisons to transactions involving similar investments. Material assumptions and factors utilized in pricing these securities include future cash flows, constant default rates, recovery rates and any market clearing activity that may have occurred since the prior month-end pricing period. The Company’s investments in other invested assets, including investments in several limited partnerships, were valued at $60.9 million and $52.4 million as of December 31, 2006 and 2005, respectively.
The Company regularly performs various analytical valuation procedures with respect to its investments, including identifying any security where the fair value is below its cost. Upon identification of such securities, a detailed review is performed to determine whether the decline is considered other than temporary. This review
For equity securities, a decline in value is considered to be other than temporary if an unrealized loss has either (1) persisted for more than 12 consecutive months or, (2) the value of the investment has been 20% or more below cost for six continuous months or more. For securities with significant declines in value for periods shorter than six continuous months, the security is evaluated to determine whether the cost basis of the security should be written down to its fair value.
The Company accounts for derivative instruments under Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), as amended, which established accounting reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value.
$15.0 million of junior subordinated debentures issued by Penn-America Group, Inc. to Penn Trust I as the hedged item. The junior subordinated debentures have the same terms with respect to maturity, payment, and distributions as the Trust Preferred Securities issued by Penn Trust I. The Company’s strategy is to convert distributions based on a floating rate on its junior subordinated debentures with Penn Trust I to a fixed-rate basis.
In 2006, the Company included uncashed checks in the Cash and cash equivalents line on the balance sheet, instead of the Other liabilities line where they had been included previously. As a result, the prior year balances of Cash and cash equivalents have been adjusted to conform to the current period presentation. The balances as of December 31, 2005 and 2004 have been reduced by $4.6 million and $3.3 million, respectively.
In accordance with SFAS 142, the Company tests for impairment of goodwill and other indefinite lived assets at least annually and more frequently as circumstances warrant and concluded that there was no impairment as of December 31, 2006.
Other intangible assets that are not deemed to have an indefinite useful life are amortized over their estimated useful lives. The carrying amount of intangible assets that are not deemed to have an indefinite useful life is regularly reviewed for indicators of impairments in value in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Impairment is recognized only if the carrying amount of the intangible asset is considered not to be recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and the estimated fair value of the asset. No impairments of intangible assets that are not deemed to have indefinite life were recognized in the year ended December 31, 2006.
Amortization expense related to the Penn-America Group, Inc. merger for the years ended December 31, 2006 and 2005 was $1.0 million and $1.1 million, respectively. Amortization expense related to the Penn Independent Corporation acquisition for the years ended December 31, 2006 and 2005 was $0.5 million and $0.8 million, respectively.
The costs of acquiring new and renewal insurance and reinsurance contracts include commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of new and renewal insurance and reinsurance contracts. The excess of the Company’s costs of acquiring new and renewal insurance and reinsurance contracts over the related ceding commissions earned from reinsurers is capitalized as deferred acquisition costs and amortized over the period in which the related premiums are earned. In accordance with SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” the method followed in computing such amounts limits them to their estimated realizable value that gives effect to the premium to be earned, related investment income, losses and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. The amortization of deferred acquisition costs for the years ended December 31, 2006, 2005, and 2004 was $145.7 million, $107.4 million, and $53.2 million, respectively.
The carrying amounts reported in the balance sheet approximate fair value.
Certain professional general agencies of the U.S. Insurance Operations are paid special incentives when loss results of business produced by these agencies are more favorable than predetermined thresholds. These costs are charged to other underwriting expenses when incurred.
In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN 48”), which 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 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The provisions of FIN 48 will be effective on January 1, 2007. The Company is currently evaluating the impact that this interpretation will have on its financial results and position.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements, and accordingly, it does not require any new fair value measurements. However, for some entities, the application of SFAS 157 will change current practice. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is in the process of determining the impact, if any, that the implementation of SFAS 157 will have on its consolidated financial condition or results of operations.
The amortized cost and estimated fair value of investments classified as available for sale were as follows as of December 31, 2006 and 2005:
The Company did not hold any debt or equity investments in a single issuer that was in excess of 10% of shareholders’ equity at December 31, 2006 or 2005.
The Company holds several investments in limited partnerships where it owns less than 3% of the limited partnerships. Changes in the value of these partnerships are included in accumulated other comprehensive income as a component of shareholders’ equity. The estimated fair value and cost of these investments are as follows:
The Company is a limited partner in a high yield fund where it owns more than a 3% interest. Changes in the value of this investment are included in equity in earnings of partnerships on the income statement. The market value and amortized cost of that partnership are as follows:
Accumulated comprehensive income of $22.6 million as of December 31, 2006 is comprised of $27.1 million of net unrealized gains from partnerships where the Company owns less than a 3.0% interest, $7.7 million of net unrealized gains from the Company’s available-for-sale portfolio, $0.2 million of net unrealized gains from the Company’s interest rate swap, and $12.4 million of deferred taxes related to the unrealized gains and losses.
At December 31, 2006, the Company had 299 bonds that were in an unrealized loss position for greater than one year. The estimated fair value and amortized cost of these securities was $436.7 million and $447.8 million, respectively. The Company has analyzed these securities and has determined that they are not impaired. The Company has the ability to hold these investments until maturity or until recovery. 99.8% of these securities are investment grade.
There was one non-income producing bond with an estimated fair value of $0.5 million as of December 31, 2006, 2005, and 2004. The Company has evaluated the investment and believes the value will be recouped.
Certain cash balances, cash equivalents and bonds available for sale were deposited with various governmental authorities in accordance with statutory requirements or were held in trust pursuant to intercompany reinsurance agreements. The estimated fair value of bonds available for sale and on deposit or held in trust were as follows as of December 31, 2006 and December 31, 2005:
At December 31, 2006 and 2005, the Company carried reinsurance receivables of $982.5 million and $1,278.1 million, respectively. These amounts are net of two purchase accounting adjustments. The first purchase accounting adjustment is due to discounting the loss reserves to their present value and applying a risk margin to the discounted reserves. This adjustment was $18.5 million and $21.2 million at December 31, 2006 and 2005, respectively. The second purchase accounting adjustment netted uncollectible reinsurance reserves against the reinsurance receivables to properly reflect the reinsurance receivables at their fair value on the date the Company acquired all of the outstanding common stock of Wind River Investment Corporation and its subsidiaries (“Wind River Acquisition date”). This purchase accounting adjustment was $20.5 million and $28.7 million at December 31, 2006 and 2005, respectively. The change includes a reduction of the Company’s reinsurance reserve allowance of $8.6 million, which was recognized as a reduction of net losses and loss adjustment expenses, and recoveries of $0.4 million that were previously charged against the purchase accounting adjustment.
During 2006 and 2005, the Company’s unpaid losses and loss adjustment expenses and related reinsurance receivables were decreased by $295.7 million and $253.7 million, respectively. Of these amounts, $107.1 million and $142.3 million, respectively, were due to the Company’s review of unpaid loss and loss adjustment expenses and related reinsurance receivables, and the remainder was due to the payment of losses in the ordinary course of business. At the Wind River Acquisition date, discounts and risk margins were applied to reinsurance receivables related to ceded loss reserves. During 2006 and 2005, the Company decreased its discount and risk margin purchase adjustment by $2.7 million and $28.2 million, respectively, due to (1) reductions in ceded loss reserves that existed as of the Wind River Acquisition date and (2) decreases to the amount of discount due to the passage of time. This adjustment equally affected reinsurance receivables and loss reserves and had no impact on the net income of the Company during 2006 and 2005.
$41.7 million at December 31, 2006 and 2005, respectively. Reinsurance receivables, net of collateral held, were $339.6 million and $586.4 million at December 31, 2006 and 2005, respectively.
As a result of the Company’s quarterly reviews of unpaid losses and loss adjustment expenses, the Company reduced gross unpaid loss and loss adjustment expenses related to prior periods by $114.1 million and ceded unpaid loss and loss adjustment expenses related to prior periods by $107.1 million, in 2006.
Since the Wind River Acquisition date, an allowance for uncollectible reinsurance of $0.2 million has been established as a result of the Company’s regular review of the collectibility of recorded reinsurance receivables due from its external non-affiliated reinsurers.
As a result of the 2005 hurricane season and the related losses in the insurance industry, the reinsurance market conditions have changed dramatically. In addition to a reduction of capacity for certain geographical zones, carriers saw significant increases in their 2006 reinsurance renewal costs. Prior to the storms of 2005, the Company was able to buy $25.0 million of property catastrophe reinsurance in excess of a $5.0 million retention at a cost of $1.6 million. The post-2005 costs of the same amount of reinsurance capacity with a similar amount and concentration of catastrophe exposed business would have cost $4.3 million. As a result of such dramatic price increases, the Company chose to co-participate in the lower layers of its catastrophe facilities which effectively reduced the ceded premium burden, but did increase the retention for a single catastrophe occurrence from $5.0 million to $7.1 million. Additionally, as a reflection of an increase in risks underwritten, in 2006, the Company purchased an additional $45.0 million of property catastrophe reinsurance capacity above the $30.0 million bought the prior year. In 2007, the Company may look to buy additional property catastrophe reinsurance capacity provided the market bears acceptable rates for such capacity. If the acceptable rates for such capacity are unavailable, the Company will look to either take a larger net risk position or reduce its underwriting risk.
Under current Cayman Islands law, the Company is not required to pay any taxes in the Cayman Islands on its income or capital gains. The Company has received an undertaking that, in the event of any taxes being imposed, the Company will be exempted from taxation in the Cayman Islands until the year 2023. Under current Bermuda law, the Company and its Bermuda subsidiaries are not required to pay any taxes in Bermuda on its income or capital gains. The Company has received an undertaking from the Minister of Finance in Bermuda that, in the event of any taxes being imposed, the Company will be exempt from taxation in Bermuda until March 2016.
The Luxembourg subsidiaries of the Company are subject to income taxes imposed by the Grand Duchy of Luxembourg and file Luxembourg tax returns.
In 2005 and 2004, the Company recognized extraordinary gains of $1.4 million and $1.2 million, respectively, for tax benefits derived from acquisition costs included as a reduction in equity as a result of the Wind River Acquisition, that have been or will be deducted in the future from income for federal tax purposes.
Management believes it is more likely than not that the deferred tax assets will be completely utilized in future years. As a result, there is no valuation allowance at December 31, 2006 and 2005.
As of December 31, 2006, the Company has an alternative minimum tax credit carryover of $2.8 million, which, subject to statutory limitations, can be carried forward indefinitely. As of December 31, 2005, the carryover was $13.0 million. The Company was able to utilize a sizable amount of this carryover during 2006 as a result of the sale of substantially all of the assets of its Agency Operations, the release of prior year loss reserves, and the shift of $194.0 million of its tax-free investments to taxable investments.
The Company’s U.S. operations are open to audit by the IRS. The IRS is currently performing audits of the Company’s federal tax returns for the short period from September 6, 2003 through December 31, 2003 and the year 2004. Management believes that adequate provisions have been made in the financial statements to cover these and any other potential audits and tax related matters for all years for which the statute of limitation has not expired. In
In 2006, the Company decreased its net loss reserve relative to accident years 2005 and prior by $7.0 million due to favorable development relative to construction defect losses as well as primary general liability, umbrella and excess, and asbestos and environmental, and by $8.6 million as a reduction of its reinsurance reserve allowance. In 2005, the Company decreased its net loss reserve relative to accident years 2004 and prior by $1.3 million due to lower than anticipated frequency in its animal mortality program. In 2004, the Company decreased its net loss reserve relative to accident years 2003 and prior by $0.8 million.
Prior to 2001, the Company underwrote multi-peril business insuring general contractors, developers, and sub-contractors primarily involved in residential construction that has resulted in significant exposure to construction defect (“CD”) claims. Management believes its reserves for CD claims ($47.3 million and $41.6 million as of December 31, 2006 and 2005, net of reinsurance, respectively) are appropriately established based upon known facts, existing case law and generally accepted actuarial methodologies. However, due to the inherent uncertainty concerning this type of business, the ultimate exposure for these claims may vary significantly from the amounts currently recorded.
The Company has exposure to asbestos and environmental (“A&E”) claims. The asbestos exposure primarily arises from the sale of product liability insurance, and the environmental exposure arises from the sale of general liability and commercial multi-peril insurance. In establishing the liability for unpaid losses and loss adjustment expenses related to A&E exposures, management considers facts currently known and the current state of the law and coverage litigation. Liabilities are recognized for known claims (including the cost of related litigation) when sufficient information has been developed to indicate the involvement of a specific insurance policy, and management can reasonably estimate its liability. In addition, liabilities have been established to cover additional exposures on both known and unasserted claims. Estimates of the liabilities are reviewed and updated continually. Developed case law and claim history do not exist for such claims, especially because significant uncertainty exists about the outcome of coverage litigation and whether past claim experience will be representative of future claim experience. Included in net unpaid losses and loss adjustment expenses as of December 31, 2006 and 2005 were IBNR reserves of $6.7 million and $7.5 million, respectively, and case reserves of approximately $4.5 million and $4.0 million, respectively, for known A&E-related claims.
As of December 31, 2006, 2005, and 2004, the survival ratio on a gross basis for the Company’s open A&E claims was 7.4 years, 7.1 years, and 9.4 years, respectively. As of December 31, 2006, 2005, and 2004, the survival ratio on a net basis for the Company’s open A&E claims was 10.6 years, 9.6 years, and 17.3 years, respectively. The survival ratio, which is the ratio of gross or net reserves to the 3-year average of annual paid claims, is a non-GAAP financial measure that indicates how long the current amount of gross or net reserves are expected to last based on the current rate of paid claims.
In 2003, trusts formed and owned by the Company issued a total of $30.0 million of trust preferred securities. In 2002 and 2003, trusts formed and owned by Penn-America Group, Inc. issued a total of $30.0 million of trust preferred securities. The funds were used to support growth in operations and general corporate purposes. A summary of the terms related to these trust preferred securities is as follows:
The proceeds from the above offerings were used to purchase junior subordinated interest notes and were used to support the business growth in the insurance subsidiaries and general business needs.
Notes payable and term loans assumed through the acquisition of Penn Independent Corporation is comprised of a $2.5 million revolving line of credit which expires on November 30, 2007, bearing interest at the bank’s prime rate less 1.25% payable monthly. The outstanding amounts due on the line of credit as of December 31, 2006 and 2005 were $1.5 million and $2.9 million, respectively. The Company has agreed to a security agreement granting the bank a first priority perfected lien on finance receivables of Penn Independent Financial Services, Inc. (“PIFSI”). On December 29, 2005, AIS entered into a guaranty and suretyship agreement with the bank whereby AIS will unconditionally jointly and severally guarantee the timely payment of any and all indebtedness owed to the bank by PIFSI. Interest expense resulting from the line of credit was $0.2 million and $0.1 million for 2006 and 2005, respectively.
Loans payable of $2.8 million and $3.6 million as of December 31, 2006 and 2005 were comprised of three and five loans payable, respectively, to vendors, a minority shareholder, and former minority shareholders. There were no minority shareholders at December 31, 2006. The current portion of these loans that will be payable in 2007 is $0.5 million. Interest expense related to loans payable was $0.1 million for 2006 and 2005.
As of December 31, 2006, Fox Paine & Company beneficially owns shares having approximately 84.9% of the Company’s total share voting authority. Two of the Company’s directors, including its Chairman and Chief Executive Officer, are employees of Fox Paine & Company. The Company relies on Fox Paine & Company to provide management services and other services related to the operations of the Company.
On June 30, 2006, DVUA Massachusetts, Inc. repurchased twenty shares of common stock that it issued to a minority shareholder. As a result, DVUA Massachusetts, Inc. is a wholly owned subsidiary of the Company.
On May 25, 2006, the Company, Fox Paine & Company, and Wind River Holdings, L.P, formerly The AMC Group, L.P. (“Wind River Holdings”), entered into Amendment No. 1 (the “Amendment”) to the Management Agreement (the “Agreement”). The Amendment terminated Wind River Holdings’ services as of May 25, 2006, and provided that Wind River Holdings refund $0.04 million to the Company as a net repayment of the Annual Service Fee paid by the Company to Wind River Holdings on November 2, 2005. Furthermore, the Amendment modified the Agreement to reflect the Company’s new 6.22% guaranteed senior notes, which were issued in 2005, as opposed to the 5% senior notes, which were repaid by the Company in 2005 upon the issuance of the guaranteed senior notes. Per terms of the Amendment, the next management fee payment of $1.5 million was payable to Fox Paine & Company and was paid on November 8, 2006.
In 2006 and 2005, the Company directly reimbursed Fox Paine & Company $0.1 million and $0.2 million, respectively, for expenses incurred in providing management services.
In 2006 and 2005, the Company paid $0.2 million and $0.08 million, respectively, to Cozen O’Connor for legal services rendered. Stephen A. Cozen, the chairman of Cozen O’Connor, is a member of the Company’s Board of Directors.
In connection with the merger with Penn-America Group, Inc. and the acquisition of Penn Independent Corporation on January 24, 2005, the Company paid a $6.0 million transaction fee to Fox Paine & Company.
Total rental expense under operating leases for the years ended December 31, 2006, 2005, and 2004 were $3.5 million, $4.0 million, and $2.6 million, respectively. At December 31, 2006, future minimum payments under non-cancelable operating leases were as follows:
The Company has committed to investing into several limited liability partnership funds. As of December 31, 2006, $41.0 million has been invested. The Company has a remaining commitment of $4.1 million. The timing and funding of this remaining commitment has not been determined. As investment opportunities are identified by the partnerships, capital calls will be made.
Shareholders’ equity as of December 31, 2006 and 2005 was $763.3 million and $639.9 million, respectively. The increase of $123.3 million during 2006 was primarily due to net income for the year of $99.4 million,
The adoption of SFAS 123R resulted in a cumulative benefit to equity of $0.4 million in 2006.
The above table excludes 55,000 warrants that were issued, at an exercise price of $10.00 per share, on September 5, 2003 and which expire on September 11, 2008. In addition, the Tranche A options were granted outside of the Plan.
During the period from September 5, 2003 to December 31, 2003, the Company granted 566,661 Time-Based Options and 895,989 Performance-Based Options under the Plan. The Time-Based Options were originally scheduled to vest in 20% increments over a five-year period, with any unvested options forfeitable upon termination of employment for any reason, and expire 10 years after the grant date. The first vesting period ended on December 31, 2004. The Performance-Based Options were originally scheduled to vest in 25% increments and were conditioned upon the Company achieving various operating targets or Fox Paine & Company’s holdings in United America Indemnity achieving an agreed upon rate of return, and expire 10 years after the grant date. On December 31, 2005, the Company modified the 2003 grant of 566,661 Time-Based Options and the 2003 grant of 895,989 Performance-Based Options. Of the 2003 stock option grants, a total of 369,540 and 15,552 were forfeited and exercised, respectively, before the change. The Time Based Options were amended so as to modify the vesting schedule for the remaining unvested options to reflect vesting at the rate of 12% on December 31, 2006, 12% on December 31, 2007, and 36% on December 31, 2008. Also, the performance hurdle with respect to accelerated option vesting upon a change of control was eliminated. The Performance-Based Options were amended to eliminate the performance vesting criteria relating to the annual option vesting and catch-up vesting. Also, the performance hurdle with respect to accelerated option vesting upon a change of control was eliminated. The
remaining unvested options become exercisable at the rate of 10% on December 31, 2006, 10% on December 31, 2007, and 30% on December 31, 2008. As a result of these changes, the Company incurred an additional $2.5 million in stock option expense in 2005.
In accordance with the Penn-America Group, Inc. Stock Incentive Plan, the merger with United America Indemnity on January 24, 2005 caused immediate vesting of all Penn-America Group, Inc.’s unvested stock options. As of January 24, 2005, Penn-America Group, Inc. had 203,635 stock options outstanding, all of which were exercisable. Each holder of the Penn-America Group, Inc. stock options received converted stock options of United America Indemnity. In exchange for outstanding options to purchase Penn-America Group, Inc.’s Class A common shares, the Company granted 175,008 stock options at the acquisition date. The modification of converting the options to purchase Penn-America Group, Inc.’s Class A common shares to options to purchase United America Indemnity’s Class A common shares had no impact on earnings.
Option intrinsic values, which are the differences between the fair market value of $25.33 at December 31, 2006 and the strike price of the option, are as follows:
During 2005, the Company granted an aggregate of 62,046 Class A common shares, subject to certain restrictions, to key employees of the Company under the Plan (“Restricted Shares”) which vest in 20% increments over a five-year period . In addition, an aggregate of 15,686 Class A common shares with a weighted average grant date value of $17.59 per share were granted, subject to certain restrictions, to the non-employee directors of the Company under the Plan (“Director Restricted Shares”). Due to an amendment to the Directors’ Compensation Plan, effective June 30, 2005, all of these Director Restricted Shares have vested. As a result of this amendment, 17,331 units were converted into 14,977 Director Restricted Shares, which vested immediately, subject to certain holding requirements, and 10,590 Director Restricted Shares granted in 2004 and prior to June 2005 vested immediately, subject to certain holding requirements. Prior to January 1, 2006, the Company granted an aggregate of 331,964 Restricted Shares to key employees of the Company and an aggregate of 38,084 fully vested Director Restricted Shares to non-employee directors of the Company under the Plan.
(including 20,000 shares, subject to certain restrictions, which were awarded to several key employees) vest over five years, and 44,719 shares vest over a three-year period.
Directors with respect to the executives covered by Section 162(m) of the Internal Revenue Code (“Section 162(m)”). It is the Company’s intent that any compensation paid pursuant to the Awards Program comply with Section 162(m).
On February 15, 2006, the Compensation Committee of the Company modified certain aspects of the Integration Plan (the “Plan”).
First, the Compensation Committee revised the definition of the “Merger Price” from $15.375 per share to $17.89 per share. This change corrected a typographical error contained within the Plan.
Effective January 1, 2007, all eligible U.S. employees will be covered by a single 401(k) defined contribution plan. Under this plan, the Company will match 100% of the first 6% contributed by an employee. Vesting on contributions made by the Company for new employees will occur pro-rata over a three year period. Contributions made by the Company prior to the January 1, 2007 effective date will continue to vest at the rate set forth in the eligible employees’ previous plan.
GAAP differs in certain respects from Statutory Accounting Principles (“SAP”) as prescribed or permitted by the various U.S. State Insurance Departments. The principal differences between SAP and GAAP are as follows:
The Company’s U.S. insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis, and are subject to regulations under which payment of a dividend from statutory surplus is restricted and may require prior approval of regulatory authorities. Applying the current regulatory restrictions as of December 31, 2006, the maximum amount of distributions that could be paid by the United National Insurance Companies and the Penn-America Insurance Companies as dividends under applicable laws and regulations without regulatory approval is approximately $65.3 million and $19.6 million, respectively. The Penn-America Insurance Companies limitation includes $6.4 million that would be distributed to United National Insurance Company or its subsidiary Penn Independent Corporation based on the December 31, 2006 ownership percentages. For 2006, United National Insurance Companies and Penn-America Insurance Companies declared and paid dividends of $31.0 million and $11.0 million, respectively.
As noted in Note 5, substantially all of the assets of the Agency Operations were sold. The Company continues to manage its business through its Insurance Operations segment. The results of the Agency Operations are now
classified as discontinued operations. The Insurance Operations segment includes the operations of the United America Insurance Group. The Insurance Operations segment and the discontinued Agency Operations segment follow the same accounting policies used for the Company’s consolidated financial statements.
As a result of the amalgamation of the Non-U.S. Insurance Operations into a single Bermuda based entity on September 30, 2006, the Company has a new financial reporting segment, Reinsurance Operations, that offers third party reinsurance products. Reinsurance Operations began offering third party reinsurance in the third quarter of 2006; however, the coverage inception dates for this reinsurance was subsequent to December 31, 2006. As such, the Reinsurance Operations segment is not yet material enough for separate disclosure.
On January 23, 2006, the Company announced that it was combining the operations of United National and Penn-America under a single United America Insurance Group management structure. As a result of this restructuring, the Company recognized severance costs of approximately $0.3 million in the first quarter of 2006.
Effective January 1, 2007, Wind River Reinsurance entered into two limited liability quota share reinsurance agreements with unrelated third parties. To reduce its exposure on these agreements, Wind River Reinsurance has entered into separate quota share retrocession agreements with Validus, which is a related party, and an unrelated third party.
Effective January 1, 2007, each of the quota share agreements between Wind River Reinsurance and the U.S. Insurance Operations expired and was consolidated into a single quota share reinsurance agreement. Under this new agreement, the U.S. Insurance Operations have agreed to cede 50% of their net unearned premiums as of December 31, 2006, plus 50% of the net retained insurance liability of all new and renewal business bound on or after January 1, 2007 to Wind River Reinsurance.