We lease office space in Bermuda, where our principal executive office is located and our casualty reinsurance segment is based. We also lease offices in (1) Raleigh, North Carolina, where our U.S. holding company, James River Group is based, and we conduct business in our Specialty Admitted Insurance segment and (2) Richmond, Virginia, Scottsdale, Arizona and Atlanta, Georgia for the conduct of business in our Excess and Surplus Lines segment. We believe that our facilities are adequate for our current needs and that suitable additional or substitute space will be available as needed.
The ratio, expressed as a percentage, of total indebtedness for borrowed money to the sum of total indebtedness for borrowed money and shareholders’ equity.
The following discussion and analysis contains forward-falooking statements and involves numerous risks and uncertainties, including those described under the heading “Risk Factors.” Actual results may differ materially from those contained in any forward-looking statements. You should read this discussion and analysis together with our audited consolidated financial statements and related notes included elsewhere in this 10-K.
The Excess and Surplus Lines segment offers E&S commercial lines liability and property insurance in every U.S. state and the District of Columbia through James River Insurance and its wholly-owned subsidiary, James River Casualty. James River Insurance and James River Casualty are both non-admitted carriers. Non-admitted carriers writing in the E&S market are not bound by most of the rate and form regulations imposed on standard market companies, allowing them flexibility to change the coverage terms offered and the rate charged without the time constraints and financial costs associated with the filing process. In 2014, the average account in this segment generated annual gross written premiums of approximately $19,000. The Excess and Surplus Lines segment distributes primarily through wholesale insurance brokers. Members of our management team have participated in this market for over three decades and have long-standing relationships with the wholesale agents who place E&S lines accounts. The Excess and Surplus Lines segment produced 48.7% of our gross written premiums for the year ended December 31, 2014.
The Casualty Reinsurance segment consists of JRG Re, our Bermuda domiciled reinsurance subsidiary, which provides proportional and working layer casualty reinsurance to third parties and to our U.S.-based insurance subsidiaries. The Casualty Reinsurance segment’s underwriting results presented
Our Excess and Surplus Lines and Specialty Admitted Insurance segments generally are notified of losses by our insureds or their brokers. Based on the information provided, we establish case reserves by estimating the ultimate losses from the claim, including administrative costs associated with the ultimate settlement of the claim. Our claims department personnel use their knowledge of the specific claim along with internal and external experts, including underwriters and legal counsel, to estimate the expected ultimate losses.
The Company’s gross reserve for losses and loss adjustment expenses at December 31, 2014 was $716.3 million. Of this amount, 71.5% relates to IBNR. The Company’s gross reserve for losses and loss adjustment expenses by segment are summarized as follows:
The process of estimating the reserve for losses and loss adjustment expenses requires a high degree of judgment and is subject to a number of variables. In establishing the quarterly actuarial recommendation for the reserve for losses and loss adjustment expenses, our actuaries estimate an initial expected ultimate loss ratio for each of our product lines by accident year (or for our Casualty Reinsurance segment, on a contract by contract basis). Input from our underwriting and claims departments, including premium pricing assumptions and historical experience, are considered by our actuaries in estimating the initial expected loss ratios. Our actuaries generally utilize five actuarial methods in their estimation process for the reserve for losses and loss adjustment expenses. These five methods utilize, to varying degrees, the initial expected loss ratio, detailed statistical analysis of past claims reporting and payment patterns, claims frequency and severity, paid loss experience, industry loss experience, and changes in market conditions, policy forms, exclusions, and exposures. The five actuarial methods that we use in our reserve estimation process are:
The Bornhuetter-Ferguson Paid Loss Development method is similar to the Bornhuetter-Ferguson Incurred Loss Development Method, except this method divides the projection of ultimate losses into the portion that has already been paid and the portion that has yet to be paid. The portion that has yet to be paid is estimated as the product of premiums earned for the accident year, the initial expected ultimate loss ratio and an estimate of the percentage of ultimate losses that are unpaid at the valuation date.
Different reserving methods are appropriate in different situations, and our actuaries use their judgment and experience to determine the weighting of the methods detailed above to use for each accident year and each line of business and, for each contract in the Casualty Reinsurance segment. For example, the current accident year has very little incurred and paid loss development data on which to base reserve projections. As a result, we rely heavily on the Expected Loss Method in estimating reserves for the current accident year. We generally set our initial expected loss ratio for the current accident year consistent with our pricing assumptions. Since our pricing assumptions are actuarially driven, and we expect to make an acceptable return on the new business that we write, we believe that this is a reasonable and appropriate reserving assumption for the current accident year. If actual loss emergence is better than our initial expected loss ratio assumptions, we will experience favorable development and if it is worse than our initial expected loss ratio assumptions, we will experience adverse development. Conversely, sufficient incurred and paid loss development is available for our oldest accident years, so more weight is given to the Incurred
The table below quantifies the impact of extreme reserve deviations from our expected value at December 31, 2014. The total carried net reserve for losses and loss adjustment expenses is displayed alongside 5th, 50th and 95th percentiles of likely ultimate net reserve outcomes. The estimates of these percentiles are a result of a reserve variability analysis using a simulation approach.
The impact of recording the net reserve for losses and loss adjustment expenses at the highest value from the sensitivity analysis above would be to increase losses and loss adjustment expenses incurred by $50.9 million, reduce net income by $48.7 million, reduce shareholders’ equity by $48.7 million and reduce tangible equity by $48.7 million, in each case at or for the period ended December 31, 2014.
Although we believe that our reserve estimates are reasonable, it is possible that our actual loss experience may not conform to our assumptions. Specifically, our actual ultimate loss ratio could differ from our initial expected loss ratio or our actual reporting and payment patterns could differ from our expected reporting and payment patterns, which are based on our own data and industry data. Accordingly, the ultimate settlement of losses and the related loss adjustment expenses may vary significantly from the estimates included in our consolidated financial statements. We regularly review our estimates and adjust them as necessary as experience develops or as new information becomes known to us. Such adjustments are included in current operations.
A $27.4 million redundancy developed in 2014 on the reserve for losses and loss adjustment expenses held at December 31, 2013. This favorable reserve development included $27.3 million of favorable development in the Excess and Surplus Lines segment. The Excess and Surplus Lines segment favorable development included $7.9 million of favorable development from the 2011 accident year, $5.0 million of favorable development from the 2009 accident year, and $4.2 million of favorable development from the 2007 accident year. This favorable development occurred because our actuarial studies at December 31, 2014 for the Excess and Surplus Lines segment indicated that our loss experience on our maturing casualty business continued to be below our initial expected ultimate loss ratios driven by favorable 2014 calendar
year emergence (33.1% calendar year loss ratio compared to our expected calendar year loss ratio of 42.4%). Favorable reserve development in the Specialty Admitted Insurance segment was $5.9 million, and primarily came from accident years 2007 through 2012, as losses on our workers’ compensation business written prior to 2013 continued to develop more favorably than we had anticipated. In addition, $5.7 million of adverse development occurred in the Casualty Reinsurance segment, with the majority of this adverse development coming from one reinsurance relationship from the 2011 underwriting year that experienced higher loss development in 2014 than expected.
A $37.5 million net redundancy developed during the year ended December 31, 2013 on the reserve for losses and loss adjustment expenses held at December 31, 2012. This favorable reserve development included $40.7 million of favorable development in the Excess and Surplus Lines segment, including $11.7 million of favorable development on casualty lines from the 2009 accident year, $7.5 million of favorable development from the 2007 accident year and $5.7 million of favorable development from the 2008 accident year. This favorable development occurred because our actuarial studies at December 31, 2013 for the Excess and Surplus Lines segment indicated that our loss experience on our maturing casualty business continued to be below our initial expected ultimate loss ratios. The $40.7 million of favorable reserve development for the Excess and Surplus Lines segment was driven by favorable 2013 calendar year emergence (42.0% calendar year loss ratio compared to our expected calendar year loss ratio of 50.0%), significant favorable indications within the 2009 accident year (which had $11.8 million of favorable net reserve development in 2012), and the impact of adjustments to our actuarial assumptions that gave more weight to our own patterns and experience. In addition, we saw a significant reduction in defense and cost containment costs per closed claim in 2013, as a result of a concerted effort by our claims staff to manage costs and consolidate service providers. Favorable reserve development on direct business written in the Specialty Admitted Insurance segment was $1.4 million, including favorable development of  $1.3 million from the 2012 accident year. The reserve strengthening in the Specialty Admitted Insurance segment at December 31, 2012 was in recognition of inadequate premium rate levels in 2012, 2011, and 2010 which ultimately proved to be redundant in 2013. In addition, $4.7 million of adverse development occurred in the Casualty Reinsurance segment, with $1.0 million of adverse development on assumed crop business from the 2012 and 2011 accident years and $3.7 million of adverse development on other assumed business, primarily from the 2011 accident year. Of the $3.7 million of adverse development on non-crop-related assumed business, $3.5 million related to the 2011 and 2012 contracts with one cedent.
Net adverse development of  $1.4 million occurred during the year ended December 31, 2012 on the reserve for losses and loss adjustment expenses held at December 31, 2011. This development included $20.1 million of favorable development in the Excess and Surplus Lines segment, including $7.7 million of favorable development on casualty lines from the 2009 accident year, $4.0 million of favorable development from the 2008 accident year and $3.8 million of favorable development from the 2007 accident year. This favorable development occurred because our actuarial studies for the Excess and Surplus Lines segment at December 31, 2012 indicated that our loss experience on our maturing casualty business continued to be below our initial expected ultimate loss ratios, driven by favorable 2012 calendar year emergence (38.0% calendar year loss ratio compared to our expected calendar year loss ratio of 55.0%). Adverse reserve development on direct business written in the Specialty Admitted Insurance segment was $4.9 million, including adverse development of  $3.6 million from the 2011 accident year and $1.7 million for the 2010 accident year. The adverse development in the Specialty Admitted Insurance segment reflected both the recognition of our inadequate premium rate levels in this segment in 2011 (and to a lesser extent in 2010) and continued high frequency and severity of losses in this segment. Adverse development of   $16.6 million occurred in the Casualty Reinsurance segment, including $9.0 million of adverse development on assumed crop business almost entirely from the 2011 accident year. Adverse development on other assumed business of  $7.6 million including adverse development of  $8.9 million was recognized on the 2009 and 2010 contracts with one cedent covering workers’ compensation business. This contract was not renewed in 2011.
We consider a number of factors in assessing whether an impairment is other-than-temporary, including (1) the amount and percentage that current fair value is below cost or amortized cost, (2) the length of time that the fair value has been below cost or amortized cost and (3) recent corporate developments or other factors that may impact an issuer’s near term prospects. In addition, for fixed maturity securities, we also consider the credit quality ratings for the securities, with a special emphasis on securities downgraded to below investment grade. We also consider our intent to sell available-for-sale fixed maturity securities in an unrealized loss position, and if it is “more likely than not” that we will be required to sell these securities before a recovery in fair value to their amortized cost or cost basis. For equity securities, we evaluate the near-term prospects of these investments in relation to the severity and duration of the impairment, and we consider our ability and intent to hold these investments until they recover their fair value. As a starting point for our evaluation, we compare the fair value of each available-for-sale security to its amortized cost or cost to identify any securities with a fair value less than cost or amortized cost. At December 31, 2014, the Company holds two municipal bonds issued by the Commonwealth of Puerto Rico. These bonds are backed by future sales tax revenues in Puerto Rico. Puerto Rico’s weak economic conditions and heavy debt burden has heightened the risk of default on the bonds. We concluded that the bonds, which have been downgraded to below investment grade, were other-than-temporarily impaired, and we recognized impairment losses of  $1.4 million on these bonds for the year ended December 31, 2014. We concluded that none of the other fixed maturity securities in an unrealized loss position at December 31, 2014 had experienced an other-than-temporary impairment. At December 31, 2013, all but two of our fixed maturity securities (with an aggregate unpaid principal balance of   $4.5 million) had a fair value greater than 81.0% of their cost or amortized cost. We concluded that these two fixed maturity securities were not other-than-temporarily impaired at December 31, 2013 based in part on the fact that they had never missed a scheduled principal or interest payment, and that they were rated investment grade by a nationally recognized statistical rating organization. At December 31, 2012, each of our fixed maturity securities had a fair value greater than 89.0% of its cost or amortized cost. We did not recognize any impairment losses on fixed maturity securities in 2013 or 2012.
We concluded that none of the equity securities in our portfolio at December 31, 2014 or December 31, 2012 had experienced an other-than-temporary impairment. We recognized an impairment loss of  $804,000 for the year ended December 31, 2013 on an equity security in our portfolio, as we had the intent to sell this security at December 31, 2013 and it was in an $804,000 unrealized loss position on that date.
We maintain the allowance for credit losses at a level we believe is adequate to absorb estimated probable credit losses. Our periodic evaluation of the adequacy of the allowance is based on consultations and the advice of our specialized investment manager, known and inherent risks in the portfolio, adverse situations that may affect the borrowers’ ability to repay, the estimated value of any underlying collateral, current economic conditions and other relevant factors. When an observable market price for the loan is available, the Company has recorded an allowance equal to the difference between the fair value and the amortized cost of bank loans that it has determined to be impaired as a practical expedient for an estimate of probable future cash flows to be collected on those bank loans. If an observable market price for the loan
In the determination of the fair value for bank loan participations and certain high yield bonds, the Company’s investment manager endeavors to obtain data from multiple external pricing sources. External pricing sources may include brokers, dealers and price data vendors that provide a composite price based on prices from multiple dealers. Such external pricing sources typically provide valuations for normal institutional size trading units of such securities using methods based on market transactions for comparable securities, and various relationships between securities, as generally recognized by institutional dealers. For investments in which the investment manager determines that only one external pricing source is appropriate or if only one external price is available, the investment is generally recorded based on such price.
At December 31, 2014, we have $181.8 million of goodwill and $40.1 million of net intangible assets on our consolidated balance sheet, primarily resulting from the acquisition of James River Group in December 2007 (the “Acquisition”).
The goodwill reported on the December 31, 2014 balance sheet is an asset of the Excess and Surplus Lines segment only. Goodwill is tested annually for impairment in the fourth quarter of each calendar year, or more frequently if events or changes in circumstances indicate that the carrying amount of the Company’s reporting units, including goodwill, may exceed their fair values. The Company first assesses qualitative factors in determining whether it is necessary to perform the quantitative goodwill impairment test. Only if management determines that it is more likely than not that the fair value of a reporting unit is less than the carrying value based on qualitative factors would it be required to perform the quantitative goodwill impairment test. If management concludes that quantitative goodwill impairment testing is required, the fair value of the reporting units is determined using a combination of a market approach and an income approach which projects the future cash flows produced by the reporting units and discounts those cash flows to their present value. The projection of future cash flows is necessarily dependent upon assumptions about the future levels of income as well as business trends, prospects, market and economic conditions. The results of the two approaches are weighted to determine the fair value of each reporting unit. When the fair value is less than the carrying value of the net assets of the reporting unit, including goodwill, an impairment loss is charged to earnings. To determine the amount of any goodwill impairment, the implied fair value of reporting unit goodwill is compared to the carrying amount of that goodwill. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination is determined. That is, the fair value of a reporting unit is assigned to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. The excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. The Company’s annual testing performed in the fourth quarters of 2014, 2013 and 2012 indicated that no impairment of goodwill had occurred.
undiscounted cash flows expected to result from the use and eventual disposition of the asset or asset group. That assessment is based on the carrying amount of the asset or asset group at the date it is tested for recoverability. An impairment loss is measured as the amount by which the carrying amount of a long-lived asset or asset group exceeds its fair value. Intangible assets for customer and broker relationships that have specific lives and are subject to amortization were reviewed for impairment during the fourth quarters of 2014, 2013 and 2012. There were no impairments recognized in 2014 or 2013. The results of the analysis for 2012 indicated that there were impairments for the Specialty Admitted Insurance segment as a result of recognition of lower projections of operating income, the segment’s lack of profitability during 2012 and 2011, and a lower agency retention rate. Accordingly, the Company recognized impairment losses of  $3.8 million and $169,000, respectively, on the intangible assets for customer and broker relationships for the year ended December 31, 2012 for this segment.
The results of operations for the years ended December 31, 2014 and 2013 included certain non-recurring items that are significant to the operating results of the Company. These items (on a pre-tax basis) include:
The results of operations include $1.3 million of net realized investment losses for the year ended December 31, 2014 and $12.6 million of net realized investment gains for the year ended December 31, 2013. Net realized investment losses in 2014 include $2.0 million of impairment losses related to our $10.3 million investment exposure to fixed maturity securities and bank loan participations issued by entities in the Commonwealth of Puerto Rico. Net realized investment gains in 2013 were primarily from the sale of fixed maturity securities and bank loan participations. We sold fixed maturity securities and bank loan participations in 2013 to fund the $110.8 million repurchase of our common shares and to shorten the duration of our portfolio to reduce our exposure to interest rate risk.
Other expenses for the year ended December 31, 2014 included $14.9 million of expenses associated with our initial public offering expenses including $2.8 million of legal fees, $2.0 million of audit and filing related fees, and $10.2 million associated with a cash bonus pool for certain officers and directors that became effective with the consummation of the offering.
Interest expense for the years ended December 31, 2014 and 2013 includes $659,000 and $663,000, respectively, relating to finance expenses in connection with a minority interest in real estate pursuant to which we are deemed the accounting owner. The debt is nonrecourse to us and was not arranged by us. See Note 1 to the Notes to the Audited Consolidated Financial Statements for additional information with respect to our minority interest.
We define net operating income as net income excluding net realized investment gains and losses, expenses related to due diligence costs for various merger and acquisition activities, costs associated with our initial public offering, severance costs associated with terminated employees, impairment charges on goodwill and intangible assets, gains on extinguishment of debt and interest expense on a leased building that we are deemed to own for accounting purposes. We use net operating income as an internal performance measure in the management of our operations because we believe it gives our management and other users of our financial information useful insight into our results of operations and our underlying business performance. Net operating income should not be viewed as a substitute for net income calculated in accordance with GAAP, and our definition of net operating income may not be comparable to that of other companies.
Our income before taxes and net income for the years ended December 31, 2014 and 2013 reconcile to our net operating income as follows:
Our expense ratio was 33.6% and 35.0% for the years ended December 31, 2014 and 2013, respectively. The reduction in the expense ratio for 2014 from the prior year is primarily attributable to the 20.8% increase in our net earned premiums compared to the prior year without a proportional increase in other operating expenses.
For the Specialty Admitted Insurance segment (which represents 11.5% of our gross written premiums for the year ended December 31, 2014) during the year ended December 31, 2014, gross written premiums increased 188.3% compared to the prior year. Gross written premiums for 2014 included $29.3 million ($9.0 million on a net basis) from program and fronting business where there had been $566,000 of gross written premiums in 2013, as we did not begin writing program and fronting business until the fourth quarter of 2013. We cede a significant portion of the specialty admitted program and fronting business to third-party reinsurers. As a result, neither our net written premiums nor level of assumed risk for this segment has increased at a rate which corresponds to the increase in our gross written premiums. Workers’ compensation gross written premiums also increased 50.4% for 2014 over 2013.
It is our policy to audit payroll for each expired workers’ compensation insurance policy in the Specialty Admitted Insurance segment to determine the difference between the original estimated payroll at the time the policy was written and the final actual payroll of the insured after the policy is completed. Audit premiums increased both written and earned premiums for the year ended December 31, 2014 by $813,000 (in the prior year, audit premiums increased both written and earned premiums by $517,000). Additionally, gross written premiums for the years ended December 31, 2014 and 2013 included $1.7 million and $1.4 million, respectively, of assumed premiums from our allocation of the North Carolina involuntary workers’ compensation pool.
Combined Ratio. The combined ratio of the Excess and Surplus Lines segment for the year ended December 31, 2014 was 82.5%, comprised of a loss ratio of 55.2% and an expense ratio of 27.3%. The combined ratio for the year ended December 31, 2013 was 69.3%, comprised of a loss ratio of 40.4% and an expense ratio of 28.9%.
Expense Ratio. The expense ratio decreased from 28.9% in 2013 to 27.3% in 2014. The decrease in the expense ratio is primarily attributable to the increase in net earned premiums without a proportional increase in the total amount of operating expenses.
Expense Ratio. The expense ratio of 46.5% for the year ended December 31, 2014 decreased from 54.2% in the prior year. The high expense ratio in this segment for both periods relates to infrastructure and personnel costs associated with the ramp up of this segment’s program and fronting business. The gross written premiums on this program and fronting business were $29.3 million for the year ended December 31, 2014 (during the prior year there had been only $566,000). Many of the infrastructure and personnel costs necessary to produce and administer this business (by necessity) precede the production and earning of these premiums. The expense ratio for this segment is expected to decline significantly as this segment increases premium volume in its new businesses and territories during 2015 and in future periods.
Combined Ratio. The combined ratio of the Casualty Reinsurance segment for the year ended December 31, 2014 was 99.6%, comprised of a loss ratio of 66.3% and an expense ratio of 33.3%. This compares to the combined ratio in the prior year of 101.5%, comprised of a loss ratio of 68.4% and an expense ratio of 33.1%.
Expense Ratio. The expense ratio of the Casualty Reinsurance segment increased slightly from 33.1% for the year ended December 31, 2013 to 33.3% for the year ended December 31, 2014.
Other operating expenses for the Corporate and Other segment include personnel costs associated with the Bermuda and U.S. holding companies, professional fees and various other corporate expenses that are included in the calculation of our expense ratio and combined ratio. A portion of these costs are reimbursed by our subsidiaries. These reimbursements are included primarily as underwriting expenses in the results of our operating subsidiaries. Accordingly, other operating expenses of the Corporate and Other segment represent the expenses of both the Bermuda and U.S. holding companies that were not reimbursed by our subsidiaries, including costs associated with potential acquisitions and other strategic initiatives. These costs vary from period to period based on the status of these initiatives.
For the years ended December 31, 2014 and 2013, the total operating expenses of the Corporate and Other segment were $9.1 million and $8.3 million, respectively. The variance from the prior year principally relates to compensation related expenses.
Our cash and invested assets increased $93.5 million or 7.7% in 2014 (from $1,217.1 million at December 31, 2013 to $1,310.6 million at December 31, 2014) due to our profitability, a 38.4% increase in net written premiums, and our positive cash flows from operations. Net investment income was $43.0 million for the year ended December 31, 2014 compared to $45.4 million in the prior year. The reduction in net investment income primarily reflects lower portfolio yields which were impacted by the continuing low interest rate environment in 2014 and the $70.0 million dividend paid to shareholders in 2014 offset in part by positive operating cash flows in 2014.
Net investment income from the Company’s renewable energy investments, included in “other invested assets” above, was $5.2 million and $4.3 million for the years ended December 31, 2014 and 2013, respectively. These investments are interests in certain limited liability companies that are managed by an affiliate of our largest shareholders, the D.E. Shaw Affiliates, and together, the carrying value of these investments was $25.1 million at December 31, 2014. Our interests in these companies are classified as “other invested assets” and the equity method is being used to account for the investments. See “Certain Relationships and Related Party Transactions - Related Party Transactions - Investments with Affiliates of the D. E. Shaw Affiliates.”
Included in our investment portfolio are $239.5 million of bank loan participations, which are classified as held-for-investment and reported at amortized cost, net of an allowance for credit losses of $752,000 related exclusively to Puerto Rico loans as detailed herein (the allowance for credit losses was $242,000 at December 31, 2013). Changes in this credit allowance are included in realized gains or losses. These bank loan participations are primarily senior, secured floating-rate debt which are rated “B” or “BB” by Standard & Poor’s or an equivalent rating from another nationally recognized statistical rating organization, and are therefore below investment grade. Bank loans include assignments of and participations in, performing and non-performing senior corporate debt generally acquired through
primary bank syndications and in secondary markets. They consist of, but are not limited to, term loans, the funded and unfunded portions of revolving credit loans, and similar loans and investments. At December 31, 2014 and 2013, the fair market value of these securities was $231.3 million and $200.6 million, respectively.
At December 31, 2014, the Company holds participations in two loans issued by companies that produce and sell electricity subject to power purchase agreements with the Puerto Rico Electric Power Authority (“PREPA”). PREPA is a public corporation and governmental agency of the Commonwealth of Puerto Rico. To date, the loans are current with respect to contractual payments of principal and interest. However, PREPA’s credit strength has been affected by the economic conditions in Puerto Rico, thus raising doubt about the Company’s continuing ability to collect amounts owed by PREPA in order to continue to make full and timely payments on the debt obligations held by the Company. PREPA has been downgraded by Moody’s to “Caa2” and by S&P to “B-.” PREPA’s debt has recently traded at a significant discount to par with very high yields. Management concluded that the loans were impaired and recorded losses of $607,000 to establish an allowance for credit losses on the loans. The impaired loans have a carrying value of  $7.1 million and unpaid principal of  $8.4 million at December 31, 2014.
At December 31, 2014, our portfolio of fixed maturity securities contained corporate fixed maturity securities (both available-for-sale and trading) with a fair value of  $272.4 million. A summary of these securities by industry segment is shown below as of December 31, 2014:
Corporate fixed maturity securities (both available-for-sale and trading) include public traded securities and privately placed bonds is shown below as of December 31, 2014:
Other expenses for the years ended December 31, 2014 and 2013 were $16.0 million and $677,000, respectively. In 2014, other expenses included $14.9 million of expenses associated with our initial public offering, $600,000 of employee severance costs, $183,000 of due diligence expenses related to an acquisition that was not consummated, and $299,000 of expenses associated with a related party leasing agreement where we were deemed to be the owner for accounting purposes. In 2013, these expenses include $392,000 of due diligence expenses related to an acquisition that was not consummated and $285,000 of expenses associated with a related party leasing agreement.
Interest expense was $6.3 million and $6.8 million for the years ended December 31, 2014 and 2013, respectively. Interest for the James River Capital Trust IV was fixed at 7.51% until March 15, 2013 at which time it became variable at 3-month LIBOR plus 3.1%. Similarly, interest for Franklin Holdings II (Bermuda) Capital Trust I was fixed at 7.97% until June 15, 2013 at which time it became variable at 3-month LIBOR plus 4.0%.
See “- Liquidity and Capital Resources - Sources and Uses of Funds” for information regarding our senior bank debt facility and trust preferred securities.
The Company completed its impairment tests and fair value analyses for goodwill and other intangible assets during the fourth quarter. No impairment was present for the years ended December 31, 2014 or 2013.
We had an underwriting gain of  $28.8 million for the year ended December 31, 2013. This compares to an underwriting loss of  $26.8 million for the prior year. On a consolidated basis, the Company recognized $37.5 million of net favorable reserve development for the year ended December 31, 2013 and $1.4 million of adverse reserve development for the year ended December 31, 2012. The significant improvement in results reflects both increased profitability in our Excess and Surplus Lines segment and improved underwriting in our Specialty Admitted Insurance and Casualty Reinsurance segments. Additionally, the underwriting loss for 2012 includes a $5.7 million underwriting loss from assumed crop reinsurance. We stopped writing crop reinsurance on December 31, 2012. The increased profitability of the Excess and Surplus Lines segment was driven by an increase in the favorable reserve development recognized on prior accident years from $20.1 million in 2012 to $40.7 million in 2013 as well as a 22.3% increase in net earned premiums. The significant favorable reserve development in this segment reflects both benign loss activity and continuing positive loss trends.
Insurance segment recognized $1.4 million of net favorable development for the year ended December 31, 2013 and $4.9 million of adverse reserve development for the year ended December 31, 2012. The improved underwriting results in 2013 reflect the impact of corrective underwriting actions taken during 2012 and 2013, most notably in pricing increases and the termination of a number of unprofitable agency relationships.
The results of operations for the years ended December 31, 2013 and 2012 include $12.6 million and $8.9 million, respectively, of net realized investment gains resulting primarily from the sale of fixed maturity securities for 2013 and from the sale of fixed maturity securities and equity securities for 2012.
The results of operations for the years ended December 31, 2013 and 2012 also include $677,000 and $3.4 million, respectively, of other expenses. For the year ended December 31, 2012, other expenses were comprised principally of   $2.7 million of expense related to bonus shares granted and $432,000 of expenses relating to due diligence for a potential acquisition candidate that we chose not to acquire.
Interest expense for the years ended December 31, 2013 and 2012 includes $663,000 and $662,000, respectively, relating to finance expenses in connection with a minority interest in real estate pursuant to which we are deemed the accounting owner. The debt is nonrecourse to us and was not arranged by us. See Note 1 to the Notes to the Audited Consolidated Financial Statements for additional information with respect to our minority interest.
Additionally, the results of operations for the year ended December 31, 2012 include a $4.3 million impairment relating exclusively to the intangible assets of the Specialty Admitted Insurance segment acquired as part of the Acquisition. This impairment results from a more conservative projection of future operating income than in prior years, recognition of unprofitable agencies terminated during 2012 and the consideration of this segment’s lack of profitability during 2011 and 2012.
Our income before taxes and net income for the years ended December 31, 2013 and 2012 reconcile to our net operating income as follows:
million of favorable reserve development from the Excess and Surplus Lines segment and $1.4 million of favorable reserve development from the Specialty Admitted Insurance segment offset by $4.7 million of adverse development from the Casualty Reinsurance segment.
Our expense ratio was substantially the same for the years ended December 31, 2013 and 2012. The small increase in the expense ratio for 2013 over the prior year is primarily attributable to the 10.0% decrease in our net earned premiums compared to the prior year without a proportional reduction in other operating expenses. Planned premium decreases in the Specialty Admitted Insurance and Casualty Reinsurance segments drove the overall decline in our net earned premium.
Manufacturers and Contractors division (representing 30.4% of this segment’s 2013 business) which increased $11.9 million (or 25.4%) for the year ended December 31, 2013 over the prior year;
General Casualty division (representing 11.8% of this segment’s 2013 business) which increased $10.0 million (or 78.6%) over the prior year. Our TNC business was a component of this increase. Gross written premiums from our TNC business were $2.5 million for 2013 and zero in 2012.
Audit premiums increased both written and earned premiums for the year ended December 31, 2013 by $517,000 (in the prior year, audit premiums increased both written and earned premiums by $1.5 million). Additionally, gross written premiums for the years ended December 31, 2013 and 2012 each included $1.4 million of assumed premiums from our allocation of the North Carolina involuntary workers’ compensation pool.
Effective January 1, 2012, the Specialty Admitted Insurance segment lowered its retention from $5.0 million per occurrence to $1.0 million per occurrence through the use of reinsurance. Effective August 1, 2012, this segment further reduced its retention to $500,000 per occurrence. These reductions in our retention caused a reduction in our net premium retention compared to that of the prior year.
For the Casualty Reinsurance segment (which represents 42.2% of our gross written premiums for the year ended December 31, 2013), gross written premiums decreased 47.6%, from $296.6 million for the year ended December 31, 2012 to $155.5 million for the year ended December 31, 2013.
Additionally, included in total gross written premiums for the Casualty Reinsurance segment is $94.5 million ($22.5 million on a net basis) of assumed crop reinsurance for the year ended December 31, 2012. Due to poor results in 2011, the Casualty Reinsurance segment entered into agreements to cede (through retrocession agreements) 75.0% of its assumed crop business on the 2012 accident year. Moreover, the Company’s total net written premiums were capped under contractual terms at $15.0 million for the 2012
The decline in gross written premiums excluding crop reinsurance for the year ended December 31, 2013 was driven by the non-renewal of several contracts in our Casualty Reinsurance segment which had been included in the written premiums in 2012. These non-renewals were part of a significant, planned decrease in our Casualty Reinsurance segment’s premiums. We achieved the decrease by taking smaller shares on renewal treaties and, continuing to maintain price discipline even when competitors were willing to offer lower pricing. We also focused on certain terms and conditions in our contract negotiations that we believe protect us from losses in our reinsurance book (e.g. down-side protection through use of sliding scale commissions in quota-share treaties). We took these underwriting actions knowing that it would reduce writings in our Casualty Reinsurance segment, but with the goal of increasing underwriting profitability.
The net premium retention for the Company increased from 71.6% to 88.2% for the years ended December 31, 2012 and 2013, respectively. Termination of the crop reinsurance program noted previously contributed to the increase in retention. The net premium retention would have been 83.0% for the year ended December 31, 2012 absent crop reinsurance assumed. The increase in our net retention over the prior year was also driven by our decision not to renew several treaties in the Casualty Reinsurance segment that had significant retrocessions in 2012.
Combined Ratio. The combined ratio of the Excess and Surplus Lines segment for the year ended December 31, 2013 was 69.3%, comprised of a loss ratio of 40.4% and an expense ratio of 28.9%. The combined ratio for the year ended December 31, 2012 was 85.4%, comprised of a loss ratio of 52.6% and an expense ratio of 32.8%.
The loss ratio of 52.6% for the year ended December 31, 2012 includes $20.1 million, or 17.4 percentage points, of net favorable development in our loss estimates for prior accident years.
Expense Ratio. The expense ratio decreased from 32.8% in 2012 to 28.9% in 2013. The decrease in the expense ratio is primarily attributable to the increase in net earned premiums without a proportional increase in the total amount of operating expenses.
Underwriting Profit. As a result of the items discussed above, underwriting profit of the Excess and Surplus Lines segment increased 156.3%, from $17.0 million for the year ended December 31, 2012 to $43.5 million for the year ended December 31, 2013.
Combined Ratio. The combined ratio of the Specialty Admitted Insurance segment for the year ended December 31, 2013 was 121.6%, comprised of a loss ratio of 67.4% and an expense ratio of 54.2%. This compares to the combined ratio in the prior year of 153.8%, comprised of a loss ratio of 118.0% and an expense ratio of 35.8%. The substantial improvement in the loss ratio for the year ended December 31, 2013 reflects a significant increase in premium rates, more selectivity in accounts and classes of business we underwrite and the effects of a ground-up review of our agency network - all of which began in the third quarter of 2012.
segment and recognition that inadequate premium rates had been charged over the past several years. Additionally, this loss ratio of 118.0% includes $4.9 million, or 15.2 percentage points, of net adverse reserve development on direct business primarily for the 2011 and 2010 accident years.
Net Written Premiums. Net written premiums decreased from $195.8 million for the year ended December 31, 2012 to $151.9 million for the year ended December 31, 2013. The Casualty Reinsurance segment had a significant, planned decrease in net written premiums as a result of taking smaller shares on renewal treaties, continuing to maintain price discipline and attempting to improve terms and other features of our reinsurance contracts (e.g. down-side protection through the use of sliding scale commissions in quota share treaties). Additionally, assumed crop reinsurance gross and net premiums written in 2012 were $94.5 million and $22.5 million, respectively. Accordingly, excluding the crop reinsurance assumed, gross written premiums for this segment would have decreased 23.0% from $202.0 million to $155.5 million and net written premiums would have decreased 12.5%, from $173.3 million to $151.6 million for the years ended December 31, 2012 and December 31, 2013, respectively.
Loss Ratio. The loss ratio for the year ended December 31, 2013 included $4.7 million, or 2.8 percentage points, of net adverse reserve development in our loss estimates for the prior accident years. In comparison, the loss ratio for the prior year included $16.6 million, or 7.7 percentage points, of adverse reserve development in our loss estimates for prior accident years.
During the year ended December 31, 2012, our crop-related reinsurance was adversely affected by the severe drought which affected the U.S. This drought was primarily responsible for the $5.7 million underwriting loss, net of reinsurance, which we incurred on our crop-related reinsurance. Absent the crop-related business, the combined ratio of this segment was 106.9%, comprised of a loss ratio of 72.1% and an expense ratio of 34.9%. The loss ratio also includes $7.6 million of net adverse reserve development on non-crop risks for the year ended December 31, 2012, representing 3.5 percentage points of the segment’s loss ratio. The reserve development for crop-related risks was $9.0 million of net adverse development for the year ended December 31, 2012, representing 4.6 percentage points of the segment’s loss ratio.
Underwriting Loss. As a result of the items discussed above, the underwriting results for the Casualty Reinsurance segment improved from an underwriting loss of  $19.1 million for the year ended December 31, 2012 to an underwriting loss of  $2.6 million for the year ended December 31, 2013.
Investment income for 2013 also reflects a lower invested asset base than in the prior year as a result of the $89.1 million of cash utilized to repurchase our shares during April 2013. See “- Liquidity and Capital Resources - Share Repurchase.”
In conjunction with our outside investment managers, the Company performs quarterly reviews of all securities within its investment portfolio to determine whether any impairment has occurred. In connection with this review for the year ended December 31, 2013, the Company determined that no impairment had occurred on any of its fixed maturity securities. We concluded that one of the equity securities with an unrealized loss at December 31, 2013 experienced an other-than-temporary impairment, and accordingly, the Company recorded an impairment loss of   $804,000 in 2013. For our portfolio of bank loan participations, we recognized impairment losses of   $121,000 and $780,000 as of December 31, 2013 and 2012, respectively, on one of the securities in our bank loan participation portfolio.
At December 31, 2013, our available-for-sale investment portfolio of fixed maturity and equity securities had an unrealized gain of  $8.0 million (which was $55.9 million at December 31, 2012), representing 1.1% of the cost or amortized cost of the portfolio. Additionally, at December 31, 2013, 82.5% of our fixed maturity security portfolio was rated “A-” or better by Standard & Poor’s or an equivalent rating from another nationally recognized statistical rating organization. Fixed maturity securities with ratings below investment grade by Standard & Poor’s or another nationally recognized statistical rating organization at December 31, 2013 had an aggregate fair value of  $53.3 million and an aggregate net unrealized gain of  $1.1 million.
The average duration of our investment portfolios, excluding bank loans, decreased from 2012 to 2013. We planned this decrease in duration in furtherance of our cautious interest rate strategy, and we continue to look at trades that will shorten duration while not materially affecting yield. The significant realized gains taken during 2013 were the result of this duration shortening strategy.
For the year ended December 31, 2013, the Company recognized net realized investment gains of  $12.6 million. This amount was comprised primarily of   $11.5 million of net realized gains from the sale of fixed maturity securities and $2.0 million in net realized gains from the sale of bank loan participations, offset by the $804,000 equity impairment loss noted previously.
The amortized cost and fair value of our available-for-sale investments in fixed maturity securities summarized by contractual maturity were as follows:
At December 31, 2013, the Company held two securities with an aggregate market value of  $512,000 in securitizations of alternative-A mortgages, all of which are performing and are rated “investment grade” by the established ratings agencies. The Company has no investments in sub-prime mortgages or collateralized debt obligations at December 31, 2013.
We are organized as a Bermuda holding company with our operations conducted by our wholly-owned subsidiaries. Accordingly, our holding company may receive cash through loans from banks, issuance of equity and debt securities, corporate service fees or dividends received from our insurance subsidiaries and/or other transactions. Our U.S. holding company may receive cash in a similar manner and also through payments from our subsidiaries pursuant to our U.S. consolidated tax allocation agreement.
The payment of dividends by our subsidiaries to us is limited by statute. In general, the laws and regulations applicable to our domestic insurance subsidiaries limit the aggregate amount of dividends or other distributions that they may declare or pay within any 12-month period without advance regulatory approval. Generally, the limitations are based on the greater of statutory net income for the preceding year or 10.0% of statutory surplus at the end of the preceding year. In addition, insurance regulators have broad powers to prevent reduction of statutory surplus to inadequate levels and could refuse to permit the payment of dividends calculated under any applicable formula. See “Certain Regulatory Considerations - U.S. Insurance Regulation - State Regulation” for additional information. Pursuant to Bermuda regulations, the maximum amount of dividend and return of capital available to be paid by a reinsurer is determined pursuant to a formula. Under this formula, the maximum amount of dividends and return on capital available to us from JRG Re in 2015 is calculated to be approximately $80.4 million. However, this dividend amount is subject to annual enhanced solvency requirement calculations which may decrease this available dividend amount. Additionally, the maximum amount of dividends available to the U.S. holding company from our U.S. insurance subsidiaries during 2015 without regulatory approval is $20.8 million.
Our net written premiums to surplus ratio (defined as net written premiums to regulatory capital and surplus) is reviewed by management as well as our rating agency as a component of leverage and efficiency of deployed capital. Our net written premiums to surplus ratio was 0.8x, 0.6x, and 0.6x for the years ended December 31, 2014, 2013, and 2012, respectively.
A $62.5 million secured revolving facility used by JRG Re to issue letters of credit for the benefit of third-party reinsureds. This portion of our credit facility is secured by our investment securities. At December 31, 2014, JRG Re had issued $40.1 million of letters of credit under the facility.
A $62.5 million unsecured revolving facility to meet the working capital needs of the Company. All unpaid principal on the revolver is due at maturity. Interest accrues quarterly and is payable in
arrears at 3-month LIBOR plus a margin of 2.25%, which is subject to change depending upon our total outstanding debt to capitalization. This facility replaced the $20.0 million outstanding under our previous facility and the $22.2 million of promissory notes which were issued in conjunction with the repurchase of our shares in April 2013.
The junior subordinated debt contains certain covenants with which we are in compliance as of December 31, 2014. All of these securities are currently redeemable at par.
Up to $675,000 per occurrence, plus any amounts over $20.0 million per occurrence or above $10.0 million for any one life occurrence
For policies with an occurrence limit of  $1.0 million or higher, the excess casualty treaty is set such that our retention is $1.0 million. For policies where we also write an underlying primary casualty policy, the excess casualty is added to our retention on the primary casualty coverage, which results in a total retention of  $2.0 million on that risk.
Only for policies where we do not write the underlying primary professional liability policy.
purchases a property catastrophe reinsurance program to cover $4.0 million in excess of a $1.0 million retention for its incidental property exposure to approximate a 1,000 year PML; this coverage has one reinstatement in the event we exhaust any of the coverage; and
At December 31, 2014, we had reinsurance recoverables on unpaid losses of  $127.3 million and reinsurance recoverables on paid losses of  $1.7 million. At December 31, 2013, we had reinsurance recoverables on unpaid losses of  $119.5 million and reinsurance recoverables on paid losses of  $1.0 million. All material reinsurance recoverable amounts are from companies with A.M. Best ratings of  “A-” or better, or collateral has been posted by the reinsurer for our benefit.
The following table sets forth our most significant reinsurers by amount of reinsurance recoverables and the amount of reinsurance recoverables pertaining to each such reinsurer as well as its A.M. Best rating as of December 31, 2014:
This reinsurer is unrated, and thus we are collateralized by this reinsurer for the recoverable amount.
Cash provided by investing activities increased in 2013 as investments were sold to generate cash for the Company’s repurchase of its common shares. Cash and cash equivalents comprised 13.0% of total cash and invested assets at December 31, 2013. The financing activities in 2013 include the $110.8 million to repurchase the Company’s common shares. Also, the Company drew $43.0 million on its new senior revolving credit facility to repay the $20.0 million balance outstanding on its previous credit facility and to repay the $22.2 million of promissory notes issued in conjunction with the repurchase of our shares in April 2013.
The A.M. Best financial strength rating for our group’s regulated insurance subsidiaries is “A-” (Excellent), with a “positive outlook.” This rating reflects A.M. Best’s opinion of our insurance subsidiaries’ financial strength, operating performance and ability to meet obligations to policyholders and is not an evaluation directed towards the protection of investors. A.M. Best assigns ratings to both insurance and reinsurance companies, which generally range from “A++” (Superior) to “S” (Suspended). The rating for our operating companies of  “A-” (Excellent) is the fourth highest rating issued by A.M. Best and is assigned to insurers that have, in A.M. Best’s opinion, an excellent ability to meet their ongoing obligations to policyholders.
The reserve for losses and loss adjustment expenses represent management’s estimate of the ultimate cost of settling losses. As more fully discussed in “- Critical Accounting Policies - Reserves for Losses and Loss Adjustment Expenses” above, the estimation of losses is based on various complex and subjective judgments. Actual losses paid may differ, perhaps significantly, from the reserve estimates reflected in our consolidated financial statements. Similarly, the timing of payment of our estimated losses is not fixed and there may be significant changes in actual payment activity. The assumptions used in estimating the likely payments due by period are based on our historical claims payment experience and industry payment patterns, but due to the inherent uncertainty in the process of estimating the timing of such payments, there is a risk that the amounts paid in any such period can be significantly different from the amounts disclosed above.
Financing obligations represent obligations for a build-to-suit lease which expires in 2018. At the termination of the lease, no payment will be required for the Company to settle the obligation. Instead, the Company will surrender the building that is the subject of the lease at lease termination.
The amounts in the above table represent our gross estimates of known liabilities as of December 31, 2014 and do not include any allowance for claims for future events within the time period specified. Accordingly, it is highly likely that the total amounts paid out in the time periods shown will be greater than those indicated in the table.
Interest on debt obligations was calculated using the LIBOR rate as of December 31, 2014 with the assumption that interest rates would remain flat over the remainder of the period that the debt was outstanding.
We define net operating income as net income excluding net realized investment gains and losses, expenses related to due diligence costs for various merger and acquisition activities, severance costs associated with terminated employees, impairment charges on goodwill and intangible assets and gains on extinguishment of debt. We use net operating income as an internal performance measure in the management of our operations because we believe it gives our management and other users of our financial information useful insight into our results of operations and our underlying business performance. Net operating income should not be viewed as a substitute for net income calculated in accordance with GAAP, and our definition of net operating income may not be comparable to that of other companies.
Our income before taxes and net income for the years ended December 31, 2014, 2013 and 2012 reconcile to our net operating income as follows:
One of our key financial measures that we use to assess our longer term financial performance is our percentage growth in tangible equity per share and return on tangible equity. Since our formation in December of 2007 through December 31, 2014, we have increased our tangible equity per share at a compounded rate of 9.4% per year, after giving effect to dividends paid and share repurchases.
We define tangible equity as the sum of shareholders’ equity less goodwill and intangible assets (net of amortization). Our definition of tangible equity may not be comparable to that of other companies, and it should not be viewed as a substitute for shareholders’ equity calculated in accordance with GAAP. We use tangible equity internally to evaluate the strength of our consolidated balance sheet and to compare returns relative to this measure. The following table reconciles shareholders’ equity to tangible equity as of December 31, 2014, 2013 and 2012: