The following tables include the complete loss development history of the direct gross loss and loss adjustment expense or LAE reserves of Potomac Insurance Company of Illinois, or Potomac. Effective January 1, 2004, Potomac entered into a transfer and assumption agreement with its parent company, OneBeacon, which reinsured all its direct liabilities to OneBeacon. Therefore, effective January 1, 2004, Potomac had no net liabilities for unpaid Losses and LAE. On November 23, 2004, we purchased Potomac and subsequently received approval from the Illinois Department of Insurance to rename the company SUA Insurance Company. SUA Insurance Company remains liable for the Loss and LAE reserves generated from its predecessor’s (Potomac’s) direct business should OneBeacon be unable to honor its reinsurance obligation in the future.
We were formed on April 3, 2003 for the purpose of offering products in the specialty commercial property and casualty insurance market by using an innovative business model. Specialty insurance typically serves niche groups of insureds that require highly specialized knowledge of a business class to achieve underwriting profits. This segment has traditionally been underserved by most standard commercial property and casualty insurers, due to the complex business knowledge and the investment required to achieve attractive underwriting profits. Competition in this segment is based primarily on client service, availability of insurance capacity, specialized policy forms, efficient claims handling and other value-based considerations, rather than just price.
Our business model is also designed to realign the interests of carriers, agents and insureds. Each of our partner agents are required to enter into agreements with us which provide that in exchange for marketing and pre-qualifying business for us, our partner agents receive an up-front commission designed to cover their costs and an underwriting profit-based commission paid over several years. In addition, each partner agent is required to purchase Class B Shares, which further aligns their interests with us and that of our shareholders. In return, we provide our partner agents with a five-year exclusive arrangement (generally allowing partner agents to offer other companies’ products if we decline to offer coverage to a prospective insured) covering a specific class of business and territory. Further, we have implemented a centralized information system designed to reduce processing and administrative time. Lastly, we are a stable, dedicated source of specialty program commercial property and casualty insurance capacity.
On November 23, 2004 we completed our IPO and concurrent private placements and completed the acquisition of Potomac. After giving effect to the acquisition, we changed the name of Potomac to SUA Insurance Company. On January 1, 2005 we commenced our insurance operations.
The following table summarizes our results of operations for the years ended December 31, 2007, 2006 and 2005, respectively:
Gross written premiums increased 4.7% from $153.2 million for 2006 to $160.4 million for 2007. The increase in premiums was primarily driven by growth within our existing programs, along with the addition of one of our new partner agents, Flying Eagle Insurance Service, Inc. and a new program writing small workers’ compensation with Appalachian Underwriters, Inc.
We continue to increase our number of partner agents. On October 1, 2007 we signed First Light Program Managers, Inc. as a partner agent, writing commercial general liability, commercial automobile and physical damage for selected customer classes in the trucking industry in the southeastern region. Also, we continue to add new programs such as temporary staffing with Risk Transfer Holdings, Inc.
Although more diversified in 2007 than in 2006, our premiums in 2007 remained concentrated in California, Florida and, to a lesser extent, Texas. Our gross written premiums for 2007 and 2006 by state were as follows:
Our workers’ compensation business was impacted by rate decreases in Florida and California and could be further impacted by future decreases in these states and others. Florida approved a rate decrease recommended by the National Council for Compensation Insurance, or the NCCI, of 15.7% effective January 1, 2007 and a 16.5% decrease effective January 1, 2008. We matched the recommended rate decrease in Florida. The California Insurance Commissioner recommended a 9.5% decrease in advisory pure premium rates on new and renewal policies effective on or after January 1, 2007. On May 29, 2007, the California Insurance Commissioner recommended a 14.2% decrease in rates effective July 1, 2007. On September 20, 2007, the WCIRB submitted a filing with the California Insurance Commissioner recommending a 4.2% increase in advisory pure premium rates on new and renewal policies effective on or after January 1, 2008. The filing was based on a review of loss and loss adjustment experience through June 30, 2007. On October 19, 2007, the WCIRB amended its filing, increasing the proposed rate increase to 5.2% based on the projected impact of Assembly Bill No. 338 (AB 338) that was signed into law on October 13, 2007. AB 338 increases the period of time, from two years to five years, from the date of injury during which disability benefits, limited to a maximum of 104 weeks, may be provided. The California Insurance Commissioner has declined to recommend the increase. As of January 1, 2008 our rates matched the California Insurance Commissioner’s recommended rate.
Our net loss and loss adjustment expense ratio by line of business for the years ended December 31, 2007 and December 31, 2006 was as follows:
Other operating expenses were $22.6 million for the year ended December 31, 2007, which consisted of salaries and benefit costs of $7.0 million, $3.2 million of professional and consulting fees, $5.0 million of depreciation and amortization expense, $1.1 million of stock based compensation expense and $6.3 million of other expenses. For the year ended December 31, 2006, other operating expenses were $19.9 million, which consisted of salaries and benefit costs of $6.1 million, $4.2 million of professional and consulting fees, $2.6 million of depreciation and amortization, $1.1 million of stock based compensation expense and $5.9 million of other expenses. We remain committed to operating efficiently and increasing staff only as our business volume requires. The increase in salaries and benefit costs in 2007 was offset by a decrease in professional and consulting services as we continued to bring previously outsourced services in-house.
Gross written premiums increased 69.1% from $90.6 million for 2005 to $153.2 million for 2006.
Earned premiums grew 316.9% to $110.9 million for 2006 compared to $26.6 million for 2005. Premiums are earned ratably over the terms of our insurance policies, which is generally 12 months.
Net investment income was $6.1 million for 2006 versus $3.6 million for 2005. The increase in net investment income reflects a significant growth in our cash and invested assets from $108.3 million at December 31, 2005 to $166.4 million at December 31, 2006. The net investment yield for average invested assets for 2006 was 4.6%. For 2005, the net investment yield on average invested assets was 3.5%. Realized gains were $0.3 million in 2006 and $0 million in 2005.
Loss and loss adjustment expenses were $62.7 million for the year ended December 31, 2006, compared to $19.1 million for the year ended December 31, 2005. Acquisition expenses were $26.0 million for the year ended December 31, 2006, compared to acquisitions expenses of $6.2 million for the year ended December 31, 2005. The increase in loss and loss adjustment expenses and acquisition expenses was driven by an increase in earned premium from 2005 to 2006.
Our workers’ compensation business was impacted by rate decreases in Florida and California and could be further impacted by future decreases in these states and others.
Our net loss and loss adjustment expense ratio has improved for the year ended December 31, 2006 compared to the year ended December 31, 2005. For 2006, our loss and loss adjustment expense ratio was 57.2% on a direct basis (before reinsurance) and 56.5% on a net basis (after reinsurance). We experienced favorable prior year loss development of $0.9 million. For 2005, our loss and loss adjustment expense ratio was 66.7% on a direct basis and 71.8% on a net basis. The improved loss and loss adjustment expense ratio in 2006 reflects more favorable terms under our reinsurance contracts, as well as our adherence to conservative pricing and underwriting and an improved unallocated loss adjustment expense ratio arising from increased earned premium. Our ratio of all other expenses to gross written premiums also improved due to increased premiums.
Our net loss and loss adjustment expense ratio by line of business for the years ended December 31, 2006 and December 31, 2005 were as follows:
Our investment portfolio consists of marketable fixed maturity and short-term investments. All fixed maturity investments are classified as available for sale and are reported at their estimated fair value based on prices obtained from independent third-party pricing services. Realized gains and losses are credited or charged to income in the period in which they are realized. Changes in unrealized gains or losses are reported as a separate component of
comprehensive income, and accumulated unrealized gains or losses are reported as a separate component of accumulated other comprehensive income in stockholders’ equity.
The liquidity requirements of SUA relate primarily to the liabilities associated with its products and its operating costs as well as the payments of dividends, if any, and taxes to us. Historically cash flows from earned premiums and investment income have provided sufficient funds to meet these requirements without requiring the sale of investments. If our cash flows change from our historical patterns, for example, as a result of a decrease in earned premiums or an increase in claims paid or operating expenses, we may be required to sell securities before their maturity, possibly at a loss. SUA generally holds a significant amount of highly liquid, short-term investments to meet its liquidity needs. Funds received in excess of SUA’s liquidity requirements are generally invested in additional marketable securities. The ability of our operating subsidiary to pay dividends or make other distributions to stockholders is subject to statutory and regulatory restrictions under Illinois law, including restrictions imposed as a matter of administrative policy, which are applicable generally to any insurance company in its state of domicile that limit such payments or distributions without prior approval by regulatory authorities. For information regarding restrictions on the payment of dividends by SUA, see the discussion under the heading “ITEM 1. BUSINESS - Insurance Regulation” in PART I of this annual report.
Capital Requirements of SUA Insurance Company. While insurance regulation differs by location, each jurisdiction requires that minimum levels of capital be maintained in order to write insurance business. Factors that affect capital requirements generally include premium volume, the extent and nature of loss and loss adjustment expense reserves, the type and form of insurance business underwritten and the availability of reinsurance protection from adequately rated reinsurers on acceptable terms. SUA is required to maintain certain minimum levels of capital and risk-based capital, the calculation of which includes numerous factors as specified by the respective insurance regulatory authorities and the related insurance regulations. We have capitalized our insurance operations in excess of the minimum regulatory requirements so that we may maintain adequate financial ratings. Our current level of capital is sufficient, but would need to be augmented to further expand our business strategy, enter new business lines, and manage our expected growth or to deal with higher than expected expenses or poorer than expected results.
“Long-Term Debt Obligation” means: (i) a payment obligation (included in the Company’s consolidated financial statements) under long-term borrowings referenced in FASB Statement of Financial Accounting Standards No. 47, “Disclosure of Long-Term Obligations,” (March 1981), as may be modified or supplemented, and (ii) interest payment obligations related to such long-term borrowings.
Short term securities and cash equivalents are valued at their book value. Other fixed maturities are valued at prices obtained from independent third-party pricing services, and as a result, there is no management involvement in determining fair value. The independent third-party services employ various models that take into consideration such factors as recent sales, the credit rating of the issuer, duration of the security, yields on comparably rated publicly traded securities and risk-free yield curves to estimate the value of these investments. Unrealized appreciation or depreciation of available-for-sale investments carried at fair value are excluded from net income and credited or charged directly to accumulated other comprehensive income, a separate component of stockholders’ equity. The change in unrealized appreciation or depreciation is reported as a component of other comprehensive income.
We establish an asset for certain acquisition expenses such as up-front commissions, premium taxes and other variable costs incurred in connection with writing our lines of business. These acquisition expenses are deferred and amortized over the period of coverage of the policies written which is 12 months. Acquisition expenses that do not vary with premium production are expensed immediately. We assess the recoverability of deferred acquisition expenses which are limited to the estimated amounts recoverable from future income after providing for losses and expenses included in future income that are expected to be incurred, based upon historical and current experience. If such costs are estimated to be unrecoverable, they will be expensed. Judgments as to ultimate recoverability of such
deferred acquisition expenses is highly dependent on future estimates of loss costs associated with unearned premium. The process of establishing loss reserves is complex and judgmental, as it must take into consideration many variables that are subject to the outcome of future events. There have been no historical changes in the recoverability of our deferred acquisition expenses. We do not believe that any reasonably likely change in our loss development will affect the recoverability of acquisition expenses. See the heading “Losses, Claims and Settlement Expenses” below.
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 best estimates of the total cost of claims that were reported to us, but not yet paid, referred to as case reserves, and the cost of claims “incurred but not yet reported” to us, referred to as IBNR Reserves.
mortality trends of injured workers with lifetime benefits and medical treatment or dependents entitled to survivor benefits;
Paid loss development methods use historical loss payments over discrete periods of time to estimate losses. Historical paid loss development methods assume that the ratio of losses paid to ultimate loss in one period to the ratio of losses paid to ultimate loss in earlier periods will remain reasonably consistent.
In September 2006, the FASB issued FAS No. 157, “Fair Value Measurements,” or FAS 157. FAS 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and expands disclosures about fair value pronouncements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within the year of adoption. Based on the Company’s current use of