We own two buildings (a five-story office building and an eight-story office building in which part of the first floor is leased to tenants) and related parking facilities in Cedar Rapids, Iowa that we use as our home office. The two buildings are connected by a skywalk. We also lease additional adjacent office space in Cedar Rapids. Our Westminster, Colorado and Galveston, Texas regional locations conduct operations solely through the use of leased office space.
The selected financial data herein has been derived from the consolidated financial statements of United Fire and its subsidiaries and affiliate. The data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the “Consolidated Financial Statements and Related Notes.” All share and per share amounts reflect the retroactive effects of our December 15, 2004 one-for-one stock dividend.
This discussion may contain forward-looking statements about our operations, anticipated performance and other similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. The forward-looking statements are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. Such forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry in which we operate, management’s beliefs and assumptions made by management. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “continues,” “seeks,” “estimates,” “predicts,” “should,” “could,” “may,” “will continue,” “might”, “hope” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed in such forward-looking statements. Among the factors that could cause our actual outcomes and results to differ are the following: inherent uncertainties with respect to loss reserving; the occurrence of catastrophic events or other insured or reinsured events with a frequency or severity exceeding our estimates; the actual amount of new and renewal business and demand for our products and services; the competitive environment in which we operate, including price, product and service competition; developments in domestic and global financial markets that could affect our investment portfolio and financing plans; impact of regulatory actions on our Consolidated Financial Statements; uncertainties relating to government and regulatory policies; additional government and NASDAQ policies relating to corporate governance, and the cost to comply; legal developments; changing rates of inflation, interest rates and other economic conditions; a continuation or worsening of global economic conditions; a slow recovery from the United States recession; our relationship with our agencies; the valuation of invested assets; the recovery of deferred acquisition costs; the resolution of legal issues pertaining to the World Trade Center catastrophe; or our relationship with our reinsurers. These are representative of the risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from what is expressed in forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
During 2004, the investment environment experienced a slow recovery. Despite modest interest rate increases, property and casualty insurers’ net investment income should increase over 2003 levels due to growth in invested assets. Insurers have grown their investment portfolios during 2004 due to positive cash flow from insurance underwriting operations. While the interest rate environment impacts the profitability of our property and casualty insurance segment, it is an even more significant determinant of our life insurance segment’s operations and profitability.
Some insurance industry observers continue to voice concern about the adequacy of property and casualty insurers’ reserves, particularly in the areas of asbestos and other environmental exposures. A.M. Best Company estimates that the industry is under reserved by as much as $33.5 billion for asbestos and other environmental exposure reserves. As of December 31, 2004, we have established a reserve of $3.0 million for asbestos and other environmental losses and settlement expenses.
Over a six-week period during the third quarter of 2004, four major hurricanes made landfall in parts of the southern United States. The state of Florida was the hardest hit, as three of the four hurricanes made landfall within that state. A.M. Best Company estimates that these four hurricanes will cost insurers $20.5 billion. We incurred approximately $12.6 million in catastrophe losses related to the four hurricanes.
In December 2004, the second of three scheduled trials related to the World Trade Center tragedy ended with the jury concluding that two distinct occurrences had taken place when the towers were destroyed. Our exposure to the terrorist attacks is through assumed reinsurance. Since 2004, we incurred $7.8 million for the September 11, 2001 losses. Based upon information currently available to us, we estimate that our pre-tax losses could increase by approximately $3.0 million due to the recent court decision. We have considered this information in our reserving process. We have not been notified by our reinsurance brokers that we owe additional losses for the World Trade Center catastrophe. We believe that due to appeals, the final conclusion of the one-event versus two-event controversy may not be resolved for a number of months, perhaps years.
During 2004, the New York Attorney General issued numerous subpoenas to members of the insurance industry in his investigation into allegations of price-fixing, bid-rigging and other unlawful conduct by certain insurers and brokers. Several other state regulators have also issued subpoenas and inquiries seeking information about these same issues and about contingent commission arrangements. We are in the process of producing documents and information in response to one subpoena and several inquiries from certain state regulatory agencies.
In 2004 we reported record net income of $78.8 million, or $3.68 per share (after providing for the dividend on convertible preferred stock), which included net realized investment gains (before tax) of $4.1 million. Net income in 2003 was $55.6 million, or $2.53 per share (after providing for the dividend on convertible preferred stock), which included net realized investment losses (before tax) of $1.7 million. Diluted earnings were $3.34 per share and $2.36 per share for 2004 and 2003, respectively.
The improvement in results was driven primarily by growth in property and casualty premiums earned. Also contributing to the increase in net income between years was a reduction in losses and settlement expenses and a decrease in other-than-temporary investment impairments recorded between years.
Losses and settlement expenses decreased by $15.8 million, or 5.5 percent, between 2003 and 2004. While losses and settlement expenses increased between years in some of our lines of business, significant improvement in our automobile and workers’ compensation lines of business led to the overall improvement between years. We attribute the improvement to a decrease in claim frequency.
We conduct our operations through two distinct segments: property and casualty insurance and life insurance. We manage these segments separately because they generally do not share the same customer base, and they each have different pricing and expense structures. We evaluate segment profit based upon operating and investment results. Segment profit or loss as described in the following sections of the Management’s Discussion and Analysis is pre-tax. Detailed segment information is presented in Note 12 to the Consolidated Financial Statements.
The property and casualty insurance segment reported pre-tax income of $98.4 million in 2004, compared with $66.9 million in 2003. Growth in net premiums earned and a decrease in losses and settlement expenses drove this increase in pre-tax income and led to improvement in our combined ratios calculated in accordance with both statutory accounting principles and GAAP.
Our property and casualty insurance segment compared favorably with the property and casualty industry. Our statutory combined ratio was 86.4 percent in 2004, compared with 93.1 percent in 2003. Like the industry as a whole, our underwriting profitability benefited from premium rate increases that began in 2001 and continued in 2002 and 2003. While pricing has leveled in 2004, we continue to realize the impact of the prior year premium rate increases as the related premium is earned. We attribute the reduction in losses and settlement expenses, which was concentrated in our automobile and workers’ compensation lines of business, to a decrease in loss frequency and continued adherence to disciplined underwriting standards.
In 2004, premiums earned increased to $456.9 million, as compared with $435.0 million in 2003. The increase in earned premium is attributable to the rate increases implemented in recent years, while our policy count decreased between 2003 and 2004. In 2004, we continued to de-emphasize our personal lines of business, which resulted in a reduction in personal lines premiums earned. We intend to continue concentrating on our commercial lines of business, which is where we have historically been most profitable. In 2004, premiums earned from our commercial lines of business accounted for 87.7 percent of net premiums earned, compared with 84.9 percent in 2003.
Net premiums written grew to $462.0 million in 2004, compared with $450.5 million in 2003. Premiums written on a direct basis constitutes the most significant portion of premiums written. In 2004 direct premiums written were $478.8 million, compared with $469.0 million in 2003. The following states provided 55 percent of the total direct premium written in the property and casualty insurance segment in 2004: Texas (13.6%), Iowa (13.3%), Louisiana (11.1%), Colorado (8.8%) and Missouri (8.2%).
Losses and settlement expenses incurred in 2003 totaled $271.6 million, reflecting losses and settlement expenses of $283.9 million resulting from losses that occurred in 2003 and loss redundancy of $12.3 million on losses that occurred prior to 2003. The overall loss redundancy in a majority of our lines of business more than offset the loss deficiencies in our other liability and workers’ compensation lines of business. The adverse development in our other liability line of business was due to several large claims that were reported to us in 2003. As in 2004, this line of business was negatively affected by the emergence of construction defect losses, as well as higher than anticipated legal costs. The adverse development in our workers’ compensation line of business was due to an increase in our reserves for older accident years.
In 2004, our $38.6 million net loss redundancy was attributable to the following factors: savings of approximately $1.5 million from workers’ compensation medical bill reviews, compared with approximately $1.1 million in 2003; savings of approximately $12.5 million from the use of alternative dispute resolution in 2004, compared with approximately $7.3 million in 2003; recoupment of approximately $4.4 million from salvage and subrogation in 2004, compared with approximately $5.8 million in 2003 and additional savings of approximately $20.2 million in 2004 attributable to both the payment of claims in amounts other than the amounts reserved and from changes in loss reserves due to additional information on individual claims that we received after the reserves for those claims had been established, compared with a small deficiency offest of approximately $1.9 million in 2003. The additional information we consider is unique to each claim. Such information includes facts that reveal we have no coverage obligation for a particular claim, changes in applicable laws that reduce our liability or coverage exposure on a particular claim, facts that implicate other parties as being liable on a particular claim and favorable court rulings that decrease the likelihood that we would be liable for a particular claim. Also, additional information relating to severity is unique to each claim. For example, we may learn during the course of a claim that bodily injuries are less severe than originally believed or that damage to a structure is merely cosmetic instead of structural, as originally reported.
We define catastrophes to include events that cause $25.0 million or more in industry-wide, direct-insured losses to property and that affect a significant number of insureds and insurers. This is the same definition utilized by the Insurance Services Office, a supplier of property and casualty statistical data. We also include in our catastrophe totals those other events we believe are, or will be, material to our operations, either in amount or in number of claims made. We include these amounts in our catastrophe totals due to the possibility that a portion of these incurred losses may be recoverable under our catastrophe reinsurance agreements. These amounts totaled $3.9 million and $4.0 million for the years ended December 31, 2004 and 2003, respectively.
We review our net loss ratio to measure our profitability by line and make pricing and underwriting decisions based upon these results. Our net loss ratio was 56.1 percent in 2004, 62.4 percent in 2003 and 71.9 percent in 2002. In the following table, we present the net loss ratio for each of the last three years for each of our lines of business. The information in the table below is presented in accordance with GAAP.
Commercial fire and allied lines insurance covers losses to an insured’s property, including its contents, as a result of weather, fire theft or other causes. We provide this coverage through a variety of business policies. The net loss ratio in our commercial fire and allied lines was 48.4 percent in 2004, compared with 41.6 percent in 2003. Catastrophe losses in this line were $12.8 million in 2004, compared with $13.3 million in 2003. Our results in 2004 were less favorable than in 2003, due primarily to the slowing of premium rate increases in 2004. We anticipate that 2005 premium rates will be flat to decreasing in the commercial property lines of business.
Our other liability line of insurance covers businesses for liability for bodily injury and property damage arising from general business operations, accidents on their premises and products manufactured or sold. We reported a net loss ratio in this line of 66.5 percent in 2004 compared with 71.8 percent in 2003. We experienced significant net premium growth in both 2003 and 2004 due to premium rate increases. Net premiums earned grew by 15 percent in 2004 and by 16 percent in 2003. Our loss frequency in the other liability line decreased in 2004 from 2003, and our cost of settlement expenses decreased. We attribute the decrease in settlement expenses to specific improvements that we initiated in our underwriting guidelines.
Our commercial automobile insurance covers physical damage to an insured’s vehicle as well as liabilities to third parties. Automobile physical damage insurance covers loss or damage to vehicles from collision, vandalism, fire, theft, flood or other causes. Automobile liability insurance covers bodily injury, damage to property resulting from automobile accidents caused by the insured or uninsured or underinsured motorists and the legal costs of defending the insured against lawsuits. Our policy is to write only standard automobile insurance, and we do not write coverage for large fleets of automobiles. Our net loss ratio in commercial automobile was 55.4 percent in 2004 compared with 65.4 percent in 2003. The improvement in this line resulted from a combination of net premium growth and a reduction in loss frequency. The net premium growth was driven by premium rate increases.
While the results in our workers’ compensation line of business improved from a loss ratio of 104.6 percent in 2003 to 81.5 percent in 2004, the loss ratio is still unsatisfactory. The challenges facing workers’ compensation insurance providers include some state regulatory climates that make it difficult to obtain appropriate rate increases, inflationary medical costs and the slow economic recovery in the United States. We were able to implement moderate rate increases during 2004, which contributed to the improvement in results. We consider our workers’ compensation business to be a companion product; we do not write stand-alone workers’ compensation policies. Our workers’ compensation insurance covers primarily small to mid-size accounts.
Our surety products guarantee the performance and payment of our bondholders. Our contract bonds protect owners from failure to perform on the part of our principals. Also, material suppliers and subcontractors are protected from nonpayment by our contractors. In 2004, the net loss ratio in this line was 21.7 percent, compared with 19.8 percent in 2003. Premiums earned was relatively flat between 2003 and 2004, increasing by $1.3 million to $25.3 million, while losses increased by 15 percent to $5.5 million. In 2003, we saw losses incurred in this line more than double from 2002 losses. We attribute the increased level of losses in 2003 and 2004 to the slow economic recovery in the United States, which has greatly reduced the number of public construction projects. Typically, the surety business is characterized by infrequent but potentially high severity losses. When losses occur, our loss is determined by estimating the cost to complete the remaining work and to pay the contractor’s unpaid bills, offset by contract funds due to the contractor, reinsurance and the value of any collateral to which we may have access.
Our underwriting expense ratio determined on a GAAP basis was 29.2 percent in 2004, compared with 29.1 percent in 2003. During 2004, we recorded one-time expenses related to the consolidation of underwriting offices in New Orleans and Galveston. We believe that the office consolidation will result in improvement in the expense ratio in future years. Offsetting this and other cost savings measures, we anticipate continued increases in legal and professional fees related to corporate governance.
Net investment income increased by $3.0 million, or 2.7 percent, to $111.5 million between 2003 and 2004. More than 90 percent of our investment income originates from interest on fixed maturities. Our remaining investment income is derived from dividends on equity securities, interest on other long-term investments, interest on mortgage loans, interest on policy loans, interest on short-term investments and rent earned from tenants in our home office. The average investment yield, which is investment income divided by average invested assets, was 5.7 percent in 2004, compared with 5.9 percent in 2003. We attribute the decrease between years to the reinvestment of proceeds from maturing fixed maturities and the investment of new funds at lower investment yields during 2004 due to current market conditions.
The property and casualty insurance segment reported pre-tax income of $66.9 million in 2003, compared with $20.9 million in 2002. The growth in premiums earned and the decrease in losses and settlement expenses drove this increase in pre-tax income and led to improvement in our combined ratios calculated in accordance with statutory accounting principles and GAAP.
In 2003, premiums earned increased to $435.0 million, as compared with $389.4 million in 2002. We increased our premium rates throughout 2002 and 2003 in several lines of business and in several states, while our policy count decreased between 2002 and 2003. In 2003, we continued to de-emphasize our personal lines of business, which resulted in a reduction in personal lines premiums earned. In 2003, premiums earned from our commercial lines of business accounted for 85 percent of net premiums earned, compared with 82 percent in 2002.
We also assumed insurance business from other insurance companies. Assumed premiums written remained relatively flat between 2002 and 2003, with $12.9 million recorded in 2003 compared with $10.8 million recorded in 2002.
In 2003, our $12.3 million net loss redundancy was attributable to savings of approximately $1.1 million from workers’ compensation medical bill reviews, compared with approximately $1.9 million in 2002; savings of approximately $7.3 million from the use of alternative dispute resolution in 2003, compared with approximately $2.8 million in 2002; recoupment of approximately $5.8 million from salvage and subrogation in 2003, compared with approximately $3.4 million in 2002 and a small deficiency offset of approximately $1.9 million in 2003 attributable to both the payment of claims in amounts other than the amounts reserved and from changes in loss reserves due to additional information on individual claims that we received after the reserves for those claims had been established, compared with a savings of approximately $3.0 million in 2002.
We review our net loss ratio to measure our profitability by line and make pricing and underwriting decisions based upon these results. Our net loss ratio was 62.4 percent in 2003, compared with 71.9 percent in 2002.
The net loss ratio in our commercial lines of business improved from 67.0 percent in 2002 to 59.6 percent in 2003. Pricing initiatives contributed to the growth in commercial lines premiums earned, which increased from $318.2 million in 2002 to $369.1 million in 2003. We continued in 2003 to obtain premium rate increases in the double digits in many of our commercial lines and in many of the states where we write commercial accounts. The most significant improvement was in fire and allied lines, where losses and expenses incurred decreased between 2002 and 2003 by $12.7 million. The loss ratio in this line improved from 62.3 percent in 2002 to 41.6 percent in 2003. We attributed this improvement to several factors. In addition to pricing initiatives, we believed that results in the commercial property lines of business were improved because we increased deductibles and improved our insurance-to-value on many of our commercial accounts. We had noted a leveling of premium rates in the property commercial lines, starting in the later part of 2003.
Our second largest commercial line of business, measured by premiums earned, was other liability. This line showed slight improvement in the loss ratio, decreasing from 73.9 percent in 2002 to 71.8 percent in 2003. Pricing activities drove an increase of $13.0 million, or 16.0 percent, in the premiums earned in this line of business. Losses and loss adjustment expenses incurred were up $7.6 million. New construction defect claims and higher-than-anticipated legal costs deterred better improvement in this line of business. From a pricing standpoint, we believed that prices would remain firm, and that we would be able to continue to pursue adequate pricing in our commercial liability lines of business. To control claims activity, we were being more selective in the general contractors that we insure because construction defect claims against general contractors generally tend to be associated with elevated legal costs.
We experienced unfavorable results in our workers’ compensation line of business in 2003 and 2002. The challenges facing workers’ compensation insurance providers include some state regulatory climates that makes it difficult to obtain rate increases, inflationary medical costs and the slow economic recovery in the United States. We consider our workers’ compensation business to be a companion product; we do not write stand-alone workers’ compensation policies. Our workers’ compensation insurance covers primarily small to mid-size accounts. The loss ratio in this line deteriorated to 104.6 percent in 2003, compared with 101.4 percent in 2002. While frequency of losses had decreased, a few large losses reported to us in 2003 contributed to the continued unfavorable experience in the workers’ compensation line of business. Our experience has shown that it takes longer to obtain approval from the appropriate state insurance departments to charge higher rates for our workers’ compensation lines of business than for other lines of business that we write. We believed that the underwriting experience in this line would begin to see some pricing relief in the near future, as we received approval for rate increases. We had adopted additional measures to improve our results in the workers’ compensation line, such as a reduction in premium volume in states where other workers’ compensation markets are available to our insureds, utilizing a tiered system of pricing and reducing or eliminating the policyholder dividends that we pay on workers’ compensation policies.
In 2003, our loss ratio for our fidelity and surety business was 19.8 percent, up from 8.5 percent in 2002. Premiums earned grew by 10 percent, from $21.9 million to $24.0 million. Our premium growth came mainly from our surety line; partly from existing accounts and partly from new accounts. Our growth in 2003 was spread between our Midwestern and Southern states. We did not issue bonds to companies operating in the energy trading sector.
Surety losses incurred more than doubled in 2003, increasing from $1.9 million in 2002 to $4.8 million in 2003. Typically, the surety business is characterized by infrequent but potentially high severity losses. When losses occur, our loss is determined by estimating the cost to complete the remaining work and pay the contractor’s unpaid bills, offset by contract funds due to the contractor, reinsurance and the value of any collateral we may have access to. The increase in losses incurred between 2002 and 2003 resulted from an increase in the frequency of claims reported to us. We attributed this change to the slow economic recovery in the United States, which had greatly reduced the amount of public construction projects. Our exposure came from a small number of accounts that were experiencing cash flow problems or that were in various stages of bankruptcy proceedings. We had responded to this condition by conducting a more thorough underwriting process, which involves more fact gathering, as we make our risk selections.
Personal auto improved slightly in 2003, with a loss ratio of 79.1 percent versus 83.7 percent in 2002. Earned premium decreased by 10 percent, or $3.5 million, due to our efforts to reduce the size of our personal lines business, relative to our total book of business. Despite the decrease in total premiums earned, we achieved rate increases averaging 8 percent in 12 states in which we write personal auto coverages. Additional rate increases were scheduled for the first quarter of 2004. We believed that we could further improve results in this line of business, and we were undertaking measures in addition to the rate adjustments in an effort to achieve better profitability in this line of business.
Our underwriting expense ratio on a GAAP basis improved to 29.1 percent, compared with 29.9 percent in 2002. In 2003, we implemented cost savings measures that had the effect of lowering the ratio. However, offsetting these improvements were increases in commissions that we paid or will pay to our agents. In 2003 we incurred $18.7 million in profit-sharing commissions, compared with $13.1 million incurred in 2002. Profit-sharing commissions reward our agents for placing profitable business with us. Also offsetting cost savings measures were increases in legal and professional fees related to compliance with new corporate governance matters.
Net premiums earned by the life insurance segment in 2003 totaled $29.6 million, compared with $27.9 million in 2002. Annuity deposits collected are not reported as net premiums earned. Annuity deposits are invested and recorded as future policy benefits. Revenues for fixed annuity products consist of policy surrender charges and investment income earned. In 2003, annuity deposits were $69.1 million, compared with $223.5 million in 2002.
The decrease in fixed annuities written was due primarily to the low interest rates prevalent in the United States in 2003. Low interest rates lead to fewer dollars being invested in annuities and to difficulty finding suitable investment vehicles, in terms of duration and quality, to fit our asset-liability matching needs. During the first part of 2003, we accumulated significant amounts of cash. While this accumulation improved our liquidity, it also resulted in negative spreads on new business. From July 1, 2003 through December 31, 2003, we temporarily suspended the sale of all new fixed annuity business. Beginning in 2004, we believed that suitable investment vehicles would be more readily available, leading to more appropriate opportunities to invest our cash. Effective January 1, 2004, we resumed our sale of new fixed annuity business.
Net investment income increased by $3.0 million, or 3.0 percent, to $108.5 million between 2002 and 2003. More than 90 percent of our investment income originates from interest on fixed maturities. Our remaining investment income is derived from dividends on equity securities, interest on other long-term investments, interest on mortgage loans, interest on policy loans and rent earned from tenants in our home office. The average investment yield, which is investment income divided by average invested assets, was 5.9 percent in 2003, compared with 6.4 percent in 2002. We attributed the decrease between years to the reinvestment of proceeds from maturing fixed maturities and the investment of new funds at lower investment yields during 2003 due to market conditions.
As of December 31, 2003, we had recorded net unrealized gains, after-tax, of $90.6 million compared with net unrealized gains, after-tax, of $52.7 million at December 31, 2002. The growth was driven by the increase in the fair value of our equity security portfolio. Included within the 2003 net unrealized gain were unrealized losses of $6.8 million on our fixed maturity portfolio and $1.1 million on our equity portfolio. We believed that the unrealized losses related to our fixed maturity portfolio resulted primarily from changes in interest rates, not from changes in the credit quality of the issuers of these securities. We considered the unrealized losses to be temporary, and we had the intent and ability to hold our fixed maturity securities for a period of time that is sufficient to allow for the recovery in fair value that we expected to occur. We also believed that the unrealized losses on our equity portfolio were temporary. As of December 31, 2003, the largest unrealized loss, after-tax, on any single investment security was $1.0 million.
At December 31, 2003, we had $23.5 million of net operating loss carryforwards that we acquired in the purchase of American Indemnity Financial Corporation in August 1999. The utilization of these net operating losses is limited by the Internal Revenue Code. The net operating losses began to expire prior to our purchase of American Indemnity Financial Corporation and will continue to expire in various future years through 2018.
Due to uncertainty of the realizable value of the deferred tax asset, we recorded a valuation allowance, which totaled $7.8 million at December 31, 2003. The valuation allowance recorded on our deferred tax asset decreased by $.5 million from 2002, due primarily to the utilization of net operating loss carryforwards. In the future, if we could use the net operating losses acquired in the purchase of American Indemnity Financial Corporation, the related reduction in the valuation allowance would be recorded as a reduction to our intangible asset recorded in conjunction with the purchase of American Indemnity Financial Corporation until the intangible asset has been eliminated, at which time the reduction in the allowance would reduce federal income tax expense.
Our main objectives in managing our investment portfolio are to maximize after-tax investment income and total investment returns. We develop our investment strategies based on a number of factors, including estimated duration of reserve liabilities, short- and long-term liquidity needs, projected tax status, general economic conditions, expected rates of inflation and regulatory requirements. We manage our portfolio based on investment guidelines approved by our management. The composition of our investment portfolio at December 31, 2004 is presented in the following table in accordance with GAAP:
As of December 31, 2004, our cash and cash equivalents totaled $305.6 million, compared with $265.1 million at December 31, 2003. Several factors led to this increase. Net cash provided by operations varies with our underwriting profitability. As our profitability from insurance operations increased between 2003 and 2004, our net cash from operations has increased. The change in our investment activity between 2003 and 2004 somewhat offset this increase in cash and cash equivalents. During 2004, our purchases of investment securities totaled $431.9 million, compared with $322.9 million in 2003. The investment environment during 2004 made it beneficial for us to increase our level of investment activity.
Financing activities contributed $9.0 million to the overall increase in cash. We generate cash from the sale, less withdrawals, of our fixed annuities and universal life contracts. In 2004 net cash from these activities totaled $23.2 million, compared with $65.3 million in 2003. This decrease is described in the life insurance segment discussion. Dividend payments to our common and preferred shareholders totaled $14.9 million in 2004, compared with $10.0 million in 2003. If a significant number of preferred stock are converted (at the holders’ option), this would reduce the cash required for the payment of stock dividends.
Stockholders’ equity increased from $373.9 million at December 31, 2003, to $452.2 million at December 31, 2004, an increase of 20.9 percent. Increases to stockholders’ equity included net income of $78.8 million and an increase in net unrealized investment appreciation of $13.1 million, after tax. We issued 47,172 shares of common stock as the result of the exercise of stock options, which increased stockholders’ equity by $.6 million. Common and preferred stockholder dividends and preferred stock accretion of $13.2 million decreased stockholders’ equity. Book value per share at December 31, 2004 was $22.46, compared with $18.62 at December 31, 2003. As of December 31, 2004 we had authorization granted by the board of directors to repurchase 87,167 shares of our common stock. In 2004 we repurchased 445 shares of our common stock, all of which were distributed to employees as awards. We did not retire any shares of our common stock in 2004.
All investment securities are classified upon acquisition as held-to-maturity, trading or available-for-sale. Investments in held-to-maturity fixed maturities are recorded at amortized cost. Available-for-sale fixed maturities, trading securities, equity securities and other long-term investments are recorded at fair value. Mortgage loans and short-term investments are recorded at cost. Policy loans are recorded at the actual amount loaned to the policyholder.
We also defer and amortize policy acquisition costs related to investment contracts and universal life contracts; we amortize these policy acquisition costs in proportion to the present value of expected gross profits from investment, mortality and expense margins and surrender charges. Actual gross profits can vary from our estimates, resulting in increases or decreases in the rate of amortization. We periodically review these estimates and evaluate the recoverability of the deferred acquisition cost asset. When appropriate, we revise our assumptions on the estimated gross profits of these contracts, and we re-estimate and adjust accumulated amortization for our books of business by a cumulative charge or credit to income.
A material adverse deviation in certain critical assumptions, including surrender rates, mortality experience, or investment performance, would negatively affect our reported deferred policy acquisition cost asset, earnings and stockholders’ equity.
At December 31, 2004, we have $41.9 million in deferred policy acquisition costs related to our life insurance segment, as compared with $41.3 million at December 31, 2003. The deferred policy acquisition costs with respect to our fixed annuities and universal life products are adjusted with respect to estimated gross profits as a result of changes in the net unrealized gains or losses on available-for-sale fixed maturity and equity securities allocated to support the block of fixed annuities and universal life policies. That is, because fixed maturity and equity securities available-for-sale are carried at aggregate fair value, an adjustment is made to deferred policy acquisition costs equal to the change in amortization that would have been recorded if such securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. The change in this adjustment, net of tax, is included with the change in net unrealized gains and losses on available-for-sale fixed maturity securities and equity securities that is credited or charged directly to comprehensive income. This adjustment offset deferred policy acquisition costs by $41.0 million at December 31, 2004, compared with $46.2 million at December 31, 2003.
Future Policy Benefits and Losses, Claims and Settlement Expenses-Property and Casualty Insurance Segment
Our most significant estimates relate to our reserves for property and casualty losses and loss adjustment expenses. We establish reserves for the estimated total unpaid cost of losses and loss adjustment expenses for events that have already occurred. These reserves reflect our estimates of the total cost of claims that are reported to us, but not yet paid (“case” reserves), and the cost of claims “incurred but not yet reported” to us.
For losses that are incurred but not yet reported, we estimate the amount of reserves for each line of business on the basis of historical and statistical information. We consider historical patterns of paid and reported claims, industry data, and the probable number and nature of losses arising from claims that have occurred but have not yet been reported for a given accident year.
Over the course of the last 10 accident years, our net reserves for losses and loss adjustment expenses have exceeded our net incurred losses and loss adjustment expenses. Because establishing reserves is inherently uncertain, an analysis of factors affecting reserves can produce a range of reasonable estimates. Our philosophy is to establish reserves that are appropriate and reasonable, but assume a pessimistic view of potential outcomes. Generally, our best estimate of reserves is slightly above the mid-point of a range of reasonable estimates. We believe that in determining reserves, it is appropriate and reasonable to establish a best estimate within a range of reasonable estimates, especially when we are reserving for claims for bodily injury, disabilities and similar claims, for which settlements and verdicts can vary widely. Our reserving philosophy may result in favorable development in future years that will decrease loss and loss adjustment expenses for prior year claims in the year of adjustment. While we realize that this philosophy, coupled with what we believe to be aggressive and successful claims management and settlement practices, has resulted in year-to-year redundancies in reserves, we believe our approach is better than experiencing year-to-year uncertainty as to the adequacy of our reserves.
When we establish reserves, we do so based on our knowledge of the circumstances and claim facts. We continually review our reserves, and as experience develops and additional information becomes known, we adjust the reserves. Such adjustments are recorded through operations in the period identified.
As required by state law, we engage an independent actuary to render opinions as to the adequacy of the statutory reserves we establish. We file the actuarial opinions in those states where we are licensed. There are no material differences between our statutory reserves and those established under GAAP.
The estimation of assumed and ceded reinsurance loss and loss adjustment expense reserves is subject to the same factors as the estimation of insurance loss and loss adjustment expense reserves. In addition to those factors, which give rise to inherent uncertainties in establishing insurance loss and loss adjustment expense reserves, there exists a delay in our receipt of reported claims due to the procedure of having claims first reported through one or more intermediary insurers or reinsurers.
The existence of certain airborne mold spores resulting from moisture trapped in confined areas has been alleged to cause severe health and environmental hazards. We have current and potential future exposure to mold claims in both our commercial and personal lines of business. While mold is a potential problem in several states, Texas has been at the forefront of mold insurance issues. Our Texas homeowners policies contain a mold exclusion, and our Texas commercial property policies include a $25,000 limitation with respect to claims arising from mold. We have a total mold exclusion for our commercial general liability policies. As market conditions permit, we plan to implement any coverage reforms permitted by the Texas Department of Insurance that would enable us to reduce our exposure in Texas to claims related to mold. We believe that it is unlikely that any such loss would have a material adverse effect on our financial condition or our cash flows. However, due to the uncertainty of future changes in Texas regulation, we cannot estimate our future probable liability for mold claims. Also, as case law expands, we may be subject to mold-related losses beyond those intended by policy coverage and not addressed by exclusionary or limiting language. Loss reserve additions arising from future unfavorable judicial trends cannot be reasonably estimated at the present time.
The reserves reported in our Consolidated Financial Statements are calculated in accordance with GAAP. We account for our annuity and universal life policy deposits in accordance with Statement of Financial Accounting Standards No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses on the Sale of Investments.” Under Statement No. 97, a benefit reserve is established at the time of policy issuance in an amount equal to the deposits received. Subsequently, the benefit reserve is adjusted for any additional deposits, interest credited and partial or complete withdrawals. Statutory reserves for the life insurance segment are based upon applicable Iowa insurance laws. Reserves determined for statutory purposes are based upon mortality rates and interest rates specified by state law. Our life insurance subsidiary’s reserves meet or exceed the minimum statutory requirements. All of our reserves are developed and analyzed annually by independent consulting actuaries. At December 31, 2004, we recorded future policy benefits of $1,255.7 million, compared with $1,210.8 million at December 31, 2003.
We are required to establish a valuation allowance for the portion of any deferred tax asset that management believes may not be realized. We have recorded a valuation allowance of $7.8 million for deferred tax assets, of which $7.3 million relates to American Indemnity Financial Corporation net operating loss carryforwards that can only be used to offset future taxable income of the property and casualty insurance segment.
We have elected to account for our employee and director stock options under Accounting Principles Board Opinion No. 25. Under Accounting Principles Board Opinion No. 25, no compensation expense is recognized for grants of options to employees and directors at an exercise price equal to or greater than the market price of the stock on the date of grant. Accordingly, based on our grants in 2004 and 2003, no compensation expense has been recognized.
We account for our noncontributory defined benefit pension plan in accordance with Statement of Financial Accounting Standard No. 87, “Employers’ Accounting for Pensions,” and we account for our retiree medical plan in accordance with Statement No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” Statement No. 87 and Statement No. 106 require that the cost of pension and retiree medical benefits be accrued over the period during which an employee provides service.
At December 31, 2004, we recorded liabilities for employee benefits of $13.0 million, compared with $12.5 million at December 31, 2003. A majority of the increase was driven by a reduction in the discount rate. In 2004 we recorded pension and retiree medical benefits expense of $4.2 million, compared with $4.6 million in 2003.
We annually determine the assumptions used to calculate our benefit plan obligations. We establish the discount rate based upon published investment grade, long-term corporate bond yields and considering the duration of the employees’ service and retirement. In 2004, we lowered the discount rate to 6.0 percent (from 6.5 percent in 2003 and 6.75 percent in 2002).
We are subject to regulation and supervision in each of the states where our insurance companies are domiciled and licensed to conduct business. State insurance department commissioners regulate such matters as licenses, standards of solvency, premium rates, policy forms, investments, security deposits, accounting policy, form and content of financial statements, reserves for unpaid loss and loss adjustment expenses, reinsurance, minimum capital and surplus requirements, dividends to shareholders, periodic examinations and annual and other report filings. In general, such regulation is for the protection of policyholders rather than shareholders.
We are not aware of any other current recommendations by the National Association of Insurance Commissioners, federal, or other regulatory authorities in the states in which we conduct business that, if or when implemented, would have a material effect on our liquidity, capital resources or operations.
(1) All share and per share amounts reflect the retroactive effects of our December 15, 2004 one-for-one stock dividend.
United Fire & Indemnity Company provides all of the statutory capital necessary for the formation of the Texas Lloyds plan by contributing capital to each of the trustees. The trust agreements require the trustees to become underwriters of the Lloyds plan, to contribute the capital to the Lloyds plan, to sign the articles of agreement and to appoint the attorney-in-fact. The trust agreements also require the trustees to pay to United Fire & Indemnity Company all of the profits and benefits received by the trustees as underwriters of the Lloyds plan, which means that United Fire & Indemnity Company has the right to receive 100 percent of the gains and profits from the Lloyds plan. The trustees serve at the pleasure of United Fire & Indemnity Company, which may remove a trustee and replace that trustee at any time. Termination of a trustee must be accompanied by the resignation of the trustee as an underwriter, so that the trustee can obtain the capital contribution from the Lloyds plan to reimburse United Fire & Indemnity Company. By retaining the ability to terminate trustees, United Fire & Indemnity Company possesses the ability to name and remove the underwriters.
Certain costs of underwriting new business, principally commissions, premium taxes and variable underwriting and policy issue expenses, have been deferred. Such costs are being amortized as premium revenue is being recognized. Policy acquisition costs deferred in 2004, 2003 and 2002 were $100,944,000, $95,728,000 and $78,022,000, respectively. Amortization of deferred policy acquisition costs in 2004, 2003 and 2002 totaled $98,579,000, $87,320,000 and $70,764,000, respectively. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, losses and expenses to be incurred, and certain other costs expected to be incurred as the premium is earned.
To establish loss and loss adjustment expense reserves, we make estimates and assumptions about the future development of claims. Actual results could differ materially from those estimates, which are subjective, complex and inherently uncertain. When we establish and adjust reserves, we do so given our knowledge of the circumstances and facts of known claims. To the extent that we have over- or under-estimated our loss and loss adjustment expense reserves, we adjust the reserves in the period the over- or under-estimate is determined.
Premiums earned and losses and settlement expenses incurred are reported net of reinsurance ceded. Ceded insurance business is accounted for on a basis consistent with the original policies issued and the terms of the reinsurance contracts.
We made net payments for income taxes of $32,714,000, $19,602,000 and $7,302,000 during 2004, 2003 and 2002, respectively. There were no significant payments of interest in 2004, 2003 or 2002, other than interest credited to policyholders’ accounts.
Property and equipment is carried at cost less accumulated depreciation. Depreciation is computed primarily by the straight-line method over the estimated useful lives of the underlying assets. Depreciation expense totaled $3,849,000, $3,724,000 and $3,281,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
In 2004, we consolidated the underwriting operations of our New Orleans office into our Galveston office. Subsequent to this consolidation, we sold a two story building in New Orleans, Louisiana, that served as the home office for Lafayette Insurance Company. The sale was closed in October of 2004 and resulted in a gain of approximately $390,000.
We also sold our buildings in Galveston, Texas, that served as the home office for American Indemnity Company. The sale was closed in December 2004 and resulted in a loss of approximately $66,000. We are leasing portions of the building back from the buyer in order to accommodate the operations of our Gulf Coast branch. The lease term is 10 years. Refer to Note 16 for additional information on our lease commitments.
These building sales affected only our property and casualty insurance segment.
We have a stock-based compensation plan, which is described more fully in Note 10. Pursuant to Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation,” we elected to apply Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” and related interpretations in accounting for our stock options, which prescribe the use of the intrinsic value method of accounting for employee and director stock-based compensation awards. Accordingly, we have not recognized compensation expense for stock options issued to our employees and directors. Refer to Note 10 for the presentation of the amount of compensation cost that would have been recognized during 2004, 2003 and 2002 under the fair value method of accounting prescribed by Statement No. 123.
In 2004, the board of directors declared a one-for-one common stock dividend, which was distributed on December 15, 2004, to shareholders of record as of December 2, 2004. The par value of our common stock after the stock dividend remained at $3.33 1/3 per share, and retained earnings were reduced by the par value of the additional common shares issued. The rights of our common shareholders were unchanged by the stock dividend. The terms of the United Fire & Casualty Company convertible preferred stock adjusted automatically to accommodate this stock dividend. All share, per share and market value information related to our common shares outstanding and authorized under employee stock plans presented in this annual report on Form 10-K has been adjusted for the retroactive effects of our December 15, 2004 one-for-one stock dividend.
In March 2004, the Emerging Issues Task Force reached a consensus on the other-than-temporary impairment recognition provisions of Issue 03-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” A three-step impairment model stipulated by Issue 03-1 must be applied to investment securities subject to Statement of Financial Accounting Standard No. 115 “Accounting for Certain Investments in Debt and Equity Securities.” The three step model details the determination of whether an investment is impaired, the evaluation of whether an impairment is other-than-temporary and the recognition of an impairment loss equal to the amount of impairment. Issue 03-1 initially required us to adopt and apply its provisions prospectively, effective for reporting periods beginning after June 15, 2004. However, the Financial Accounting Standards Board subsequently issued Staff Position 03-1-1, which delays the effective date for the measurement and recognition guidance contained in paragraphs 10-20 of Issue 03-1. During the period of the delay, we are required to continue to apply relevant “other-than-temporary” guidance. Staff Position 03-1-1 will be superseded upon the final issuance of proposed Staff Position EITF Issue 03-1-a “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1,” which is expected to occur during 2005. We believe the adoption of Staff Position EITF Issue 03-1-a will not have a material impact on our Consolidated Financial Statements.
In May 2004, the Financial Accounting Standards Board issued Staff Position 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” which supersedes Staff Position 106-1. This Staff Position is effective for interim or annual periods beginning after June 15, 2004. This Staff Position provides guidance on the accounting and disclosure requirements for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 on employers that sponsor post-retirement health care plans that provide prescription drug benefits to plan participants. This Act provides for a prescription drug benefit under Medicare Part D as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. Our self-funded post-retirement health care plan does provide a prescription drug benefit. In consideration of recent legislation regarding the implementation of Medicare Part D, our benefit actuaries have determined that the prescription drug benefit provided by our plan will likely be the actuarial equivalent of Medicare Part D. The expected subsidy reduced our accumulated post-retirement benefit obligation by approximately $873,000, which we recorded as an unrecognized actuarial gain during 2004. This gain will be amortized as an offset to future postretirement benefit expense over the average remaining service life of the plan participants. Current year and future year expense will also be decreased by reductions in service cost and interest cost, which are attributable to the impact of the subsidy. The subsidy reduced our 2004 postretirement benefit expense by $128,000.
Proceeds from the sale of trading securities were $3,992,000, $3,261,000 and $2,604,000 in 2004, 2003 and 2002, respectively. Gross gains of $399,000, $192,000 and $9,000 were realized on these sales in 2004, 2003 and 2002, respectively. Gross losses of $11,000, $447,000 and $306,000 were realized on these sales in 2004, 2003 and 2002, respectively. Additional gross gains of $63,000 and $639,000, which were attributable to the change in fair value of these securities, were realized during 2004 and 2003, respectively, compared with an additional gross loss of $227,000 realized during 2002.
There were no sales of held-to-maturity securities during 2004, 2003 or 2002.
Net investment income for the years ended December 31, 2004, 2003 and 2002 is comprised of the following.
We continually monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition requires other-than-temporary impairment charges be recorded when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security or that the anticipated recovery in market value of the equity security will not occur in a reasonable amount of time. Impairment charges on investments are recorded based on the fair value of the investments at the measurement date and are included in net realized gains and losses. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which the fair value has been less than cost; the financial conditions and near-term prospects of the issuer; and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery.
Provided below is a summary of fixed maturity and equity securities that were in an unrealized loss position at December 31, 2004 and 2003. We have the ability and intent to hold these securities until such time as the value recovers or the securities mature. Further, we believe the deterioration in value of our fixed maturity portfolio is primarily attributable to changes in market interest rates and not the credit quality of the issuer. We attribute the deterioration in value of our equity security portfolio to usual market volatility and not to any permanent financial hardships encountered by the underlying companies invested in. Therefore, we have concluded that our unrealized losses are temporary in nature.
Our reinsurance assumed from foreign insurance companies is primarily accounted for using the periodic method, whereby premiums are recognized as revenue over the policy term, and claims, including an estimate of claims incurred but not reported, are recognized as they occur. The amount of reinsurance business assumed from foreign insurance companies is not material to our Consolidated Financial Statements.
The ceding of reinsurance does not legally discharge United Life Insurance Company from primary liability under its policies. United Life Insurance Company must pay the loss if the reinsurer fails to meet its obligations. United Life Insurance Company had ceded insurance in force of $479,409,000 and $445,985,000 at December 31, 2004 and 2003, respectively. Earned premiums ceded were $1,355,000, $1,340,000 and $1,515,000 for the years ended December 31, 2004, 2003 and 2002, respectively. Approximately 80 percent of ceded life insurance in force as of December 31, 2004 has been ceded to three reinsurers. We believe all reinsurance receivables are collectable. Ceded losses incurred were $2,313,000, $2,110,000 and $1,234,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
Conditions and trends that have affected the reserve development for a given year may change. Therefore, such development can not be used to extrapolate future reserve redundancies or deficiencies.
We are directed by the state insurance departments’ solvency regulations to calculate required minimum capital and surplus based on insurance risk factors. The risk-based capital results are used by the National Association of Insurance Commissioners and state insurance departments to identify companies that merit regulatory attention or the initiation of regulatory action. At December 31, 2004, both United Life Insurance Company and United Fire had statutory capital and surplus in regards to policyholders well in excess of their required levels.
We offer a noncontributory defined benefit pension plan in which all of our employees are eligible to participate after they have completed one year of service, attained 21 years of age and met the hourly service requirements with the company. Under our pension plan, retirement benefits are primarily a function of the number of years of service and the level of compensation. Our policy is to fund this plan on a current basis to the extent that the contribution is deductible under existing tax regulations. We estimate that we will contribute approximately $5,500,000 to the plan in 2005. At December 31, 2004, 62.5 percent of the plan assets was invested in common stock, 26.1 percent of the plan assets was invested in an annuity purchased from our life insurance company ($9,933,000), and the remainder of the plan assets was held in cash and cash equivalents. Eighteen percent of the plan assets was invested in our own common stock (202,058 shares with a market value of $6,811,000). Dividends on shares of United Fire common stock totaled approximately $85,000 during 2004. The annuity fund maintained by United Life Insurance Company is credited with compound interest on the average fund balance for the year. The interest rate will be equivalent to the ratio of net investment income to mean assets of United Life Insurance Company.
The preparation of financial statements in conformity with GAAP requires us to make various estimates and assumptions that affect the reporting of net periodic benefit cost, plan assets, and plan obligations at the date of the financial statements. Actual results could differ from these estimates. One significant estimate relates to the calculation of the benefit plan obligations. We annually establish the discount rate used to determine the present value of the plan benefit obligations as of December 31. The discount rate is an estimate of the interest rate at which the plan benefits could be effectively settled. In estimating the discount rate, we look to rates of return on high-quality, fixed-income investments currently available and expected to be available during the period to maturity of the plan benefit obligations. We estimate the duration of the weighted average period to maturity of the plan benefit obligations through actuarial techniques that project expected benefit payments. Another significant assumption utilized is the expected long-term rate of return on the invested pension plan assets. The expected long-term rate of return is an assumption as to the average rate of earnings expected on the pension plan funds invested or to be invested to provide for the settlement of benefits included in the projected pension benefit obligation. Investment securities, in general, are exposed to various risks, such as fluctuating interest rates, credit standing of the issuer of the security and overall market volatility. Annually, we perform an analysis of expected long-term rates of return based on the composition and allocation of our pension plan assets and recent economic conditions.
At December 31, 2004, we have recorded a minimum pension liability of $1,932,000 (before tax), which represents the amount that we recognized to cover a $2,465,000 deficit occurring as a result of the fair value of plan assets being less than our accumulated benefit obligation. This deficit is comprised of the unfunded accumulated benefit obligation and prepaid pension costs. The amount of this deficit is offset by an intangible asset of $533,000 related to unrecognized prior service cost to arrive at the additional pretax minimum pension liability required to be recognized as a component of accumulated other comprehensive income in our Consolidated Financial Statements. We had no minimum pension liability as of December 31, 2003.
The following table summarizes the expected benefit payments to be made from our plans over the next ten years.
We have a profit-sharing plan in which employees who meet service requirements are eligible to participate. The amount of our contribution is discretionary and is determined annually, but cannot exceed the amount deductible for federal income tax purposes. Our contribution to the plan for the years ended December 31, 2004, 2003 and 2002, was $3,402,000, $3,545,000 and $1,320,000, respectively.
We have elected to account for our stock options under Opinion No. 25 and its related interpretations. As such, no compensation cost is recognized because the exercise price of United Fire’s stock options is equal to the market price of the underlying stock on the date of the grant. If the stock options had been accounted for under Statement No. 123, compensation cost would have been recorded based on the grant-date fair value attributable to the number of options that eventually vest. This cost is recognized over the period in which the options vest, with the amount recognized at any date being at least equal to the value of the vested portion of the award at that date.
In accordance with the disclosure requirements of Statement No. 123, the pro forma effects of recognizing compensation expense on net income and income per share, had we applied the fair value method of accounting for stock options is as follows:
Issuance costs in connection with our preferred stock offering totaled $4,116,000. We accrete these costs over a 12-year period. Through December 31, 2004, we have accreted $915,000 related to the preferred stock issuance costs. We review the accretion period annually to determine if we need to accelerate the accretion.
The preferred stock is convertible at the option of the holder at any time, unless previously redeemed, into shares of common stock at a conversion price of $20.13 per share of common stock, which is equivalent to 1.242 shares of common stock for each share of preferred stock converted. This conversion price reflects our December 15, 2004 one-for-one common stock dividend. The conversion price is subject to adjustment upon the occurrence of certain events.
The property and casualty insurance segment markets most forms of commercial and personal property and casualty insurance products, including surety bonds and reinsurance. The business is generated through approximately 950 independent agencies and brokers in 41 states. The following states provided 55 percent of the direct premium volume in this segment in 2004: Texas (13.6%), Iowa (13.3%), Louisiana (11.1%), Colorado (8.8%) and Missouri (8.2%).
The life insurance segment underwrites and markets life (primarily universal life), annuity (primarily single premium fixed annuity) and credit life products to individuals and groups through approximately 1,110 independent agencies in 27 states. The following states provided more than 70 percent of the direct premium volume in this segment in 2004: Iowa (34.2%), Wisconsin (11.5%), Nebraska (10.2%), Illinois (8.3%) and Minnesota (7.4%).
Total revenue by segment includes sales to outside customers and inter-segment sales that are eliminated to arrive at the total revenues as reported in our Consolidated Statements of Income. We account for inter-segment sales on the same basis as sales to outside customers. The table on the following page sets forth certain data for each of our business segments reported on a GAAP basis and is reconciled to our Consolidated Financial Statements. Depreciation expense and property and equipment acquisitions for the years ended December 31, 2004, 2003 and 2002, are reported in the property and casualty insurance segment.
The following table sets forth our selected unaudited quarterly financial information. All per share amounts reflect the retroactive effects of our December 15, 2004 one-for-one stock dividend.
We compute earnings per share in accordance with Statement of Financial Accounting Standard No. 128, “Earnings per Share.” Accordingly, we compute basic earnings per share by dividing net income or loss available to common shareholders (net income or loss less dividends to preferred shareholders and accretions of preferred stock issuance costs) by the weighted-average number of common shares outstanding during the period. Diluted earnings per share gives effect to all potentially dilutive common shares outstanding during the period. The potentially dilutive shares we consider in our diluted earnings per share calculation relate to our convertible preferred stock outstanding as well as our outstanding stock options.
Cash dividends per common share of $.42, $.39 and $.37 were declared in 2004, 2003 and 2002, respectively.
Comprehensive income includes all changes in equity during a period except those resulting from investments by shareholders and dividends to shareholders. The primary components of our comprehensive income are net income and the change in net unrealized gains and losses on available-for-sale securities as adjusted for amounts that have been reclassified as realized gains and losses. The following table sets forth the components of other comprehensive income, and the related tax effects, for the years ended December 31, 2004, 2003 and 2002.
At December 31, 2004, we were obligated under noncancelable operating lease agreements for office space, vehicles, computer equipment and office equipment. Most of our leases include renewal options, purchase options or both. These provisions may be exercised by us upon the expiration of the related lease agreements. Rental expense under our operating lease agreements was $2,355,000, $1,983,000 and $2,494,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
At December 31, 2004, our future minimum rental payments are as follows (dollars in thousands).
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of United Fire & Casualty Company at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of United Fire & Casualty Company’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 28, 2005, expressed an unqualified opinion thereon.