The ratio of the net of the sum of commissions and other underwriting expenses, other operating expenses less other income to premiums earned.
The following discussion and analysis of our historical consolidated financial statements should be read in conjunction with our audited consolidated financial statements and the related notes included elsewhere in this Form 10-K.
We write insurance for various sizes of transportation fleets. Because of the amount of smaller fleets nationwide, we have more opportunities to write smaller risks than larger ones. When general economic conditions improve, entrepreneurs are encouraged to start new transportation companies, which typically commence operations as a smaller risk and a potential traditional insurance customer for us. During periods of economic downturn, smaller risks are more prone to failure due to a decrease in leisure travel and consolidation in the industry. An increase in the number of larger risks results in more prospective captive insurance customers. We do not believe that smaller fleets that generate annual premiums of less than $100,000 are large enough to retain the risks associated with participation in one of the captive programs we currently offer.
Despite relatively flat pricing since 2004, improved risk selection and an overall improvement in the risk quality of our book of business have contributed to us attaining combined ratios better than our corporate objective of 96.0% or lower. While our combined ratio may fluctuate from year to year, over the past five years we have exceeded our underwriting profit objective by achieving an average GAAP combined ratio of 81.7%. Our GAAP combined ratio was 80.9% in 2007, 82.5% in 2006, 82.1% in 2005, 83.0% in 2004 and 80.0% in 2003. We believe the following factors have contributed to this performance:
Our ability to attract and retain some of the best transportation companies in the industries we serve and insure them directly or through our captive programs.
The projected profitability from the traditional transportation and transportation captive businesses are substantially comparable. Increased investment income opportunities generally are available with traditional insurance but the lower acquisition expenses and persistence of the captive programs generally provide for lower operating expenses from these programs. The lower expenses associated with our captives generally offset the projected reductions in investment income potential. From a projected profitability perspective, we are ambivalent as to whether a transportation operator elects to purchase traditional insurance or one of our captive program options.
We employ what we consider to be a conservative approach to investment and capital management with the intention of supporting insurance operations by providing a stable source of income to offset underwriting risk and growing income to offset inflation. The priority of goals of our investment policy are to preserve principal, generate income, maintain required liquidity and achieve capital appreciation. We follow a formal investment policy and our Board of Directors reviews the portfolio performance quarterly for compliance with the established guidelines.
Commissions and other underwriting expenses consist principally of brokerage and agent commissions, which are reduced by ceding commissions received from assuming reinsurers, that represent a percentage of the premiums on insurance policies and reinsurance contracts written, and vary depending upon the amount and types of contracts written, and to a lesser extent premium taxes.
As part of our captive programs, we have analyzed, on a quarterly basis, captive members’ loss performance on a policy year basis to determine if there would be a premium assessment to participants or if there would be a return of premium to participants as a result of less than expected losses. Assessment premium and return of premium are recorded as adjustments to written premium (assessments increase written premium; returns of premium reduce written premium). The return of premium for 2007 of $1.9 million was comparable to 2006 and had relatively no impact on the increase in the alternative risk transfer component during 2007.
pricing on larger traditional accounts impacting premium to a greater degree than in prior periods. For 2007 we maintained relatively flat rate levels on renewing commercial insurance business while our renewal hit ratios have been deteriorating to historic levels from the elevated levels we had in 2003 and 2004.
Also contributing to the increase in the gross premiums written in 2007 was an increase in the specialty personal lines component of $3.1 million or 6.0% as compared to 2006. The increase is primarily related to a moderate rate increase as well as an increase in the number of policies in force associated with the recreational and companion auto vehicle programs.
Due primarily to an increase in our Alaska business in 2007, associated with an increase in the number of in force policies, our Hawaii and Alaska component increased $1.9 million for the year ended December 31, 2007 compared to 2006. Our Other component is primarily related to assigned risk policies that we receive from involuntary state insurance plans and over which we have no control. This component increased $1.5 million from 2006.
2007 compared to 2006. The following table shows premiums earned for the years ended December 31, 2007 and 2006 summarized by the broader business component description, which were determined based primarily on similar economic characteristics, products and services:
Our premiums earned increased $40.2 million, or 18.5%, to $257.6 million during the year ended December 31, 2007 compared to $217.3 million for the year ended December 31, 2006. Our alternative risk transfer component increased 38.8% during 2007 compared to the same period in 2006, primarily due to a large transportation captive written in the first quarter of 2007, expanded coverage in two of our captive programs and new participants in existing captive programs. Our alternative risk transfer business remains our fastest growing component. Due to relatively flat rate increases and an increase in the number of policies in force primarily from expanded distribution, our specialty personal lines component increased 9.1% in 2007 compared to 2006. The transportation component remained relatively constant in 2007 compared to 2006. In the transportation component, we are still experiencing a decline in renewal rate increases due to the current softening market. Our Other component, which is comprised primarily of premium from assigned risk plans from the states in which our insurance company subsidiaries operate and over which we have no control, increased $2.8 million, or 34.6%, to $11.0 million in 2007.
2006 compared to 2005. The following table shows premiums earned for the years ended December 31, 2006 and 2005 summarized by the broader business component description, which were determined based primarily on similar economic characteristics, products and services:
The ratio of the sum of commissions and other underwriting expenses, other operating expenses less other income to premiums earned. Beginning in 2007, “Expense on amounts withheld” is presented as a separate income statement line item and no longer included as part of “Other operating and general expenses” or the calculation of the “Underwriting expense ratio.” All prior periods have been reclassified to conform to the current period’s presentation.
2007 compared to 2006. Losses and LAE increased $20.0 million, or 15.5%, for 2007 compared to 2006. The loss and LAE ratio for the year ended December 31, 2007 was 58.0% compared to 59.6% for the year ended December 31, 2006. The decrease in the loss and LAE ratio in 2007 of 1.6 percentage points is primarily due to a decrease in loss severity in 2007 as there was higher than anticipated claims severity in 2006 experienced in many of our larger products. For the year ended December 31, 2007, we had favorable development of $5.7 million from prior years’ loss reserves compared to favorable development in 2006 of $7.5 million. Consistent with prior years, we strive to be accurate, but tend to be conservative with our loss reserving methodology in areas where we are still experiencing significant growth. The favorable development for both years was primarily related to the settlements below the established case reserves and revisions to our estimated future settlements on an individual case by case basis. This savings represents 3.1% and 4.9% for 2007 and 2006, respectively, of the prior year reserves.
The underwriting expense ratio for the year ended December 31, 2006 increased 1.2 percent to 22.9% compared to 21.7% for the year ended December 31, 2005. The increase in the expense ratio is due to an increase in other operating and general expenses reflecting increased audit fees due to the audit of our insurance companies coordinated by the Ohio Department of Insurance ($0.2 million), the impact of stock based compensation expense recognized in 2006 ($0.8 million) and other costs associated with our growth and with being a publicly traded corporation. Also impacting the change in the expense ratio were two items that occurred in 2005 i) a reduction in
estimated expenses for insolvencies and other state fees and ii) classifying business related to our assigned risks on a gross basis. These items reduced the 2005 expense ratio by 1.5 percentage points. When taking these items into consideration the expense ratio remained consistent from 2005 to 2006.
Realized gains are taken when opportunities arise. When evaluating fixed maturity sales opportunities, we do not have any specific thresholds that would cause us to sell these securities prior to maturity. We consider multiple factors, such as reinvestment alternatives and specific circumstances of the investment currently held. Credit quality, portfolio allocation and other-than-temporary impairment are other factors that may encourage us to sell a fixed maturity security prior to maturity at a gain or loss. Historically, we have not had the need to sell our investments to generate liquidity
2007 compared to 2006. Other income increased $1.8 million, or 73.3%, to $4.1 million for 2007 compared to $2.4 million in 2006. This increase is primarily attributable to an increase in rental income associated with space leased in the building we acquired in 2006 as part of our corporate campus expansion and an $0.8 million lease buyout that we received in the third quarter of 2007 from one of our tenants.
2006 compared to 2005. Other income increased $0.4 million to $2.4 million in 2006 compared to $2.0 million in 2005. The increase in other income is directly attributable to our growth in direct written premiums.
2006 compared to 2005. The commissions and other underwriting expenses increased $6.9 million for 2006 compared to 2005. This increase in the commissions and other underwriting expenses is primarily due to an increase in commissions, premium taxes and other related expenses which are directly impacted by the growth in gross premiums written.
2007 compared to 2006. Other operating and general expenses increased $2.7 million, or 28.2% to $12.1 million during the year ended December 31, 2007 compared to $9.5 million for the same period in 2006. These increases were due to several employee related expenses, including an increase of $0.8 million related to our annual bonuses paid in March 2007, a stock bonus award and restricted stock award expense of $0.4 million and an increase in employee headcount that increased our employee wages.
At December 31, 2007, our investment portfolio consisted of $376.3 million, or 83.6% of total investments, in fixed maturity securities, $52.6 million, or 11.7% of total investments, in equity securities and $20.1 million, or 4.7% of total investments in short-term investments. All investments are carried at fair value with unrealized gains and losses reported as a separate component of shareholders’ equity on an after-tax basis. At December 31, 2007, we had pretax net unrealized gains of $0.3 million on fixed maturities and pretax unrealized losses of $5.2 million on equity securities.
The turmoil in the housing and credit markets in the second half of 2007 and continuing into 2008 has caused many companies to record significant asset writedowns. Although these market conditions adversely impacted our investment portfolio, particularly preferred stocks, we have not experienced material losses.
Summary information for securities with unrealized gains or losses at December 31, 2007 follows:
Capital Ratios. The National Association of Insurance Commissioners’ model law for RBC provides formulas to determine the amount of capital and surplus that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2007 and 2006, the capital and surplus of all our insurance companies substantially exceeded the RBC requirements.
Sources of Funds. The liquidity requirements of our insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and payments of dividends and taxes to us from insurance subsidiaries. Historically, cash flows from premiums and investment income have provided more than sufficient funds to meet these requirements without requiring the sale of investments. If our cash flows change dramatically from historical patterns, for example as a result of a decrease in premiums or an increase in claims paid or operating expenses, we may be required to sell securities before their maturity and possibly at a loss. Our insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments to meet their liquidity needs. Funds received in excess of cash requirements are generally invested in additional marketable securities. Our historic pattern of using receipts from current premium writings for the payment of liabilities incurred in prior periods has enabled us to slightly extend the maturities of our investment portfolio beyond the estimated settlement date of our loss reserves.
Net cash used in investing activities was $69.1 million, $65.8 million and $107.8 million for the years ended December 31, 2007, 2006 and 2005, respectively. The $3.3 million increase in cash used in investing activities in 2007 was primarily related to a $99.3 million increase in the purchase of investments in 2007 offset by a $94.1 million increase in the proceeds from sales and maturities of investments as compared to 2006. The $42.0 million decrease in 2006 in cash used in investing activities was primarily related to a $22.0 million decrease in the purchase of investments and an $11.5 million increase in the proceeds from sales and maturities of investments as compared to 2005. Also impacting investing activities was the purchase, by NIIC, of an office building adjacent to our headquarters in Richfield, Ohio. The building was purchased for $7.0 million. An
additional payment of $1.2 million was also made on January 3, 2006 for the remaining balance of the purchase price associated with the acquisition of TCC. As part of this acquisition, we acquired $5.6 million in cash and cash equivalents.
We utilized net cash from financing activities of $3.2 million, $2.9 million and provided net cash of $22.9 million, respectively, for the years ended December 31, 2007, 2006 and 2005. The $0.3 million increase in cash used in financing activities is primarily from an increase in our dividends paid on common shares to shareholders. We increased our quarterly dividend from $0.04 per common share in 2006 to $0.05 per common share in 2007. This increase in the dividend resulted in a $0.8 million increase in dividends paid in 2007. The $25.8 million decrease in 2006 in cash generated from financing activities primarily relates to the initial public offering completed in February 2005 whereby we sold 3,350,000 shares of common stock, generating approximately $40.4 million of net proceeds. We used the net proceeds for the repayment in full of a $15.0 million loan plus the accrued interest from Great American, our majority shareholder, and the remainder is currently being used as needed for general corporate purposes and potential growth opportunities.
Under tax allocation and cost sharing agreements among NIC and its subsidiaries, taxes and expenses are allocated among the entities. The federal income tax provision of our individual subsidiaries is computed as if the subsidiary filed a separate tax return. The resulting provision (or credit) is currently payable to (or receivable from) us.
In May 2003, we purchased the outstanding common equity of a business trust that issued mandatorily redeemable preferred capital securities. The trust used the proceeds from the issuance of its capital securities and common equity to buy $15.5 million of debentures issued by us. These debentures are the trust’s only assets and mature in 2033. The interest rate is equal to the three-month LIBOR (4.70% at December 31, 2007 and 5.37% at December 31, 2006) plus 420 basis points with interest payments due quarterly. Payments from the debentures finance the distributions paid on the capital securities. We have the right to redeem the debentures, in whole or in part, on or after May 23, 2008 and anticipate exercising this right of redemption, in whole, on May 23, 2008.
On December 19, 2007 we replaced our $2.0 million credit agreement with a $50 million five-year unsecured Credit Agreement, which includes a sublimit of $10 million for letters of credit. We have the ability to increase the line of credit to $75 million subject to the Credit Agreement’s accordion feature. Amounts borrowed bear interest at either (1) a rate per annum equal to the greater of the administrative agent’s prime rate or 0.5% in excess of the federal funds effective rate or (2) rates ranging from 0.45% to 0.90% over LIBOR based on our A.M. Best insurance group rating, or 0.65% at December 31, 2007. Commitment fees on the average daily unused portion of the Credit Agreement also vary with our A.M. Best insurance group rating and range from 0.090% to 0.175%, or .125% at December 31, 2007.
In August 2006, our unsecured four-year term loan matured and the balance was paid off.
We believe that the cash and short term investments at December 31, 2007, funds generated from operations and funds available under the Credit Agreement will provide sufficient resources to meet our liquidity requirements
for at least the next 12 months. However, if these funds are insufficient to meet fixed charges in any period, we would be required to generate cash through additional borrowings, sale of assets, sale of portfolio securities or similar transactions. Historically, we have not had the need to sell our investments to generate liquidity. If we were forced to sell portfolio securities early for liquidity purposes rather than holding them to maturity, we could recognize gains or losses on those securities earlier than anticipated. If we were forced to borrow additional funds in order to meet liquidity needs, we would incur additional interest expense which would have a negative impact on our earnings. Since our ability to meet our obligations in the long term (beyond a 12-month period) is dependent upon factors such as market changes, insurance regulatory changes and economic conditions, no assurance can be given that the available net cash flow will be sufficient to meet our operating needs.
Off-Balance Sheet Items. We do not have any off-balance sheet arrangements as such term is defined in applicable Securities and Exchange Commission rules.
The timing for the return of the collateral associated with our securities lending varies, but generally within one year; therefore, the return of collateral is reflected as being due within one year. Management believes there is an active market for securities lending and currently intends to participate in this program beyond just one year.
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of that loss to us and our final payment of that loss and its related LAE. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities. At December 31, 2007 and 2006, we had $302.1 million and $266.0 million, respectively, of gross loss and LAE reserves, representing management’s best estimate of the ultimate loss. Management records, on a monthly and quarterly basis, its best estimate of loss reserves. For purposes of computing the recorded reserves, management utilizes various data inputs, including analysis that is derived from a review of prior quarter results performed by actuaries employed by Great American. In addition, on an annual basis, actuaries
extrapolation. The estimated cumulative unfavorable impact that this 1.0% change would have on our 2007 net income is shown below:
Some of the important variables affecting our estimation of loss reserves for commercial auto liability include:
When establishing and reviewing reserves, we analyze historic data and estimate the impact of various loss development factors, such as our historic loss experience and that of the industry, trends in claims frequency and severity, our mix of business, our claims processing procedures, legislative enactments, judicial decisions, legal developments in imposition of damages and changes and trends in general economic conditions, including the effects of inflation. As of December 31, 2007, management has not made any key assumptions that are inconsistent with historical loss reserve development patterns. A change in any of these aforementioned factors from the assumptions implicit in our estimate can cause our actual loss experience to be better or worse than our reserves and the difference can be material. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves. Currently established reserves may not prove adequate in light of subsequent actual occurrences. To the extent that reserves are inadequate and are increased or “strengthened,” the amount of such increase is treated as a charge to income in the period that the deficiency is recognized. To the extent that reserves
are redundant and are released, the amount of the release is a benefit to income in the period that redundancy is recognized.
Our investments are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation risks. The financial statement risks are those associated with the recognition of impairments and income, as well as the determination of fair values. We evaluate whether impairments have occurred on a case-by-case basis. Management considers a wide range of factors about the security issuer and uses its best judgment in evaluating the cause and amount of decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management’s evaluation of the security are assumptions and
“Selected Quarterly Financial Data” has been included in Note 19 to the consolidated financial statements.
Management has evaluated the effectiveness of its internal control over financial reporting as of December 31, 2007, based on the control criteria established in a report entitled Internal Control - Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on such evaluation, we have concluded that the Company’s internal control over financial reporting is effective as of December 31, 2007.
We have audited the accompanying consolidated balance sheets of National Interstate Corporation and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
As discussed in Notes 2 and 9 to the consolidated financial statements, in 2006 the Company changed its method of accounting for stock-based compensation in accordance with the adoption of Statement of Financial Accounting Standards No. 123(R).
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
In our opinion, National Interstate Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.
The Company is a 52.8% owned subsidiary of Great American Insurance Company (“Great American”), a wholly-owned subsidiary of American Financial Group, Inc. On February 2, 2005, the Company completed an initial public offering (“IPO”), in which it issued 3,350,000 shares and selling shareholders sold 1,074,000 shares at an initial offering price of $13.50 per share and began trading its common shares on the Nasdaq Global Market under the symbol NATL. Prior to the initial public offering, no public market existed for the common shares. Proceeds from the offering totaled approximately $40.4 million after a deduction for the underwriting discount and offering expenses. Net proceeds were used to repay a loan from the Company’s majority shareholder, Great American, and the remainder was invested to be used in future periods for other general corporate purposes including surplus contributions to the Company’s insurance subsidiaries.
The accompanying consolidated financial statements of the Company and its subsidiaries have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”), which differ in some respects from statutory accounting principles (“SAP”) permitted by state regulatory agencies (see Note 16).
The Company offers a range of products and services, but operates as one reportable property-casualty insurance segment.
The Company grants stock options to officers under the Long Term Incentive Plan (“LTIP”). The LTIP and stock-based compensation are more fully described in Note 9, “Shareholders’ Equity and Stock-Based Compensation.” On January 1, 2006, the Company implemented Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment, using the modified prospective method under which prior year amounts are not restated. Under SFAS No. 123(R), companies must recognize compensation expense for all new share-based awards (including employee stock options) and the nonvested portions of prior awards, based on their calculated “fair value” at the date of grant. Beginning in 2006, all share based grants, that were granted subsequent to the Company’s February 2005 initial public offering, are recognized as compensation expense on a straight line basis over the requisite service period. The Company uses the Black-Scholes pricing model to measure the fair value of employee stock options. Awards issued prior to the initial public offering were valued for disclosure purposes using the minimum value method. No compensation cost will be recognized for future vesting of these awards.
The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115
In June 2007, the FASB ratified the consensus reached in Emerging Issues Task Force (“EITF”) 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards. EITF 06-11 applies to entities that have share-based payment arrangements that entitle employees to receive dividends or dividend equivalents on equity-classified nonvested shares when those dividends or dividend equivalents are charged to retained earnings and result in an income tax deduction. Entities that have share-based payment arrangements that fall within the scope of EITF 06-11 will be required to increase additional paid in capital for any realized income tax benefit associated with dividends or dividend equivalents paid to employees for equity classified nonvested equity awards. Any increase recorded to additional paid in capital is required to be included in an entity’s pool of excess tax benefits that are available to absorb potential future tax deficiencies on share-based payment awards. The Company will adopt EITF 06-11 on January 1, 2008 for dividends declared on share-based payment awards subsequent to this date. The impact of adoption will not have a material impact on financial condition, results of operations or liquidity.
The cost or amortized cost and fair value of investments in fixed maturities and preferred and common stocks are as follows:
The amortized cost and fair value of fixed maturities at December 31, 2007, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The average life of mortgage-backed securities is 3.7 years.
The Company recorded a $1.0 million other than temporary impairment charge to income due to declines in fair market value of equity securities in 2007 primarily related to preferred stocks in the financial and real estate sectors. There was no charge to income due to declines in fair market value of fixed maturities in 2007. In 2006 there was no charge to income due to declines in fair market value of fixed maturities or equity securities. In 2005, the Company recorded a charge of $0.3 million for other-than-temporary impairments. Included in the 2005 fixed maturity losses and equity security losses above are charges to income of $0.2 million and $44 thousand, respectively, representing declines in fair market value of fixed maturities and equity securities that the Company has deemed to be other-than-temporary.
In August 2006, the Company entered into a securities lending program whereby certain fixed maturity and equity securities from the Company’s investment portfolio are loaned to other institutions for short periods of time. The Company requires collateral equal to 102% of the market value of the loaned securities plus accrued interest. The collateral is invested by the lending agent generating investment income, net of applicable fees. The Company is not permitted to sell or re-pledge the collateral on the securities lending program. The Company accounts for this program as a secured borrowing and records the collateral held and corresponding liability to return the collateral on the Company’s Consolidated Balance Sheets at fair value. The securities loaned remain a recorded asset of the Company.
In October 2006, NIIC purchased for $7.0 million an office building adjacent to the Company’s headquarters in Richfield, Ohio. The building was originally purchased short-term as an investment and long-term for growth expansion. The Company recorded a depreciation expense of $1.2 million for the year ended December 31, 2007 and a depreciation expense of $1.1 million for both years ended December 31, 2006 and 2005.
The Company conducts operations from its two corporate campus buildings that it owns in Richfield, Ohio. A portion of the space within each building is being leased. One lease runs through 2009, without any renewal options available. The scheduled future minimum revenues under the terms of this non-cancellable lease, through the end of the lease term are $0.8 million. The other lease runs through 2011, with no renewal options available. The scheduled future minimum revenue under the terms of the lease for the tenant at December 31, 2007 is $2.7 million.
Long-term debt was $15.5 million at December 31, 2007 and 2006 and consisted of junior subordinated debentures which mature in 2033. The interest rate on this debt is equal to the three-month LIBOR (4.70% at December 31, 2007 and 5.37% at December 31, 2006) plus 420 basis points with interest payments due quarterly.
In May 2003, the Company formed a business trust that issued mandatorily redeemable preferred capital securities (capital securities). The trust loaned the $15.5 million in proceeds from the issuance of its capital securities and common equity to the Company in the form of debentures. These debentures are the trust’s only assets and mature in 2033. Payments from the debentures finance the distributions paid on the capital securities. The Company has the right to redeem its debentures, in whole or in part, on or after May 23, 2008 and anticipates exercising this right to redemption, in whole, on May 23, 2008. In accordance with FASB Interpretation No. 46(R), (and related amendments and interpretations) Consolidation of Variable Interest Entities, the Company determined that the business trust is a variable interest entity for which it is not the primary beneficiary and therefore, did not
consolidate the trust with the Company. To the extent the trust does not have funds available to make payments, as guarantor, the Company unconditionally guarantees payment of required distributions on the capital securities, the redemption price when the capital security is redeemed and amounts due if the trust is liquidated or terminated. The Company recorded its equity interest in the trust as a common stock investment.
The Credit Agreement requires the Company to maintain specified financial covenants measured on a quarterly basis, including consolidated net worth, fixed charge coverage ratio and debt to capital ratio. In addition, the Credit Agreement contains certain affirmative and negative covenants, including negative covenants that limit or restrict the Company’s ability to, among other things, incur additional indebtedness, effect mergers or consolidations, make investments, enter into asset sales, create liens, enter into transactions with affiliates and other restrictions customarily contained in such agreements. The Credit Agreement will terminate on December 19, 2012. No amounts were borrowed under this Credit Agreement at December 31, 2007.
The tax effects of temporary differences that give rise to significant portions of the net deferred tax assets and liabilities in the Consolidated Balance Sheets were as follows:
Federal income taxes paid for 2007, 2006 and 2005 were $22.0 million, $14.4 million and $18.2 million. At December 31, 2007 and 2006, income taxes payable were $2.6 million and $1.8 million, respectively. Management has reviewed the recoverability of the deferred tax asset and believes that with the exception of unrealized losses on investments, the amount will be recoverable against future earnings. The gross deferred tax assets have been reduced by a valuation allowance on unrealized losses on investments based on limitations set forth in the Internal Revenue Code which restrict the recoverability of taxes.
In June 2006, the FASB issued Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes - an interpretation of SFAS No. 109. FIN 48 clarifies the recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 was effective for fiscal years beginning after December 15, 2006. The Company adopted FIN 48 on January 1, 2007. This interpretation had no impact on the Company’s results of operations, financial condition or liquidity.
Prior to January 1, 2006, the Company accounted for stock-based compensation expense using the intrinsic value method as set forth in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees and as permitted by SFAS No. 123, Accounting for Stock-Based Compensation. No compensation cost for stock options was reflected in net income for 2005, as all options granted had an exercise price equal to the market price of the underlying common stock at date of grant.
The following table illustrates the effect on the prior year’s net income and earnings per share if expense had been measured using the fair value recognition provisions for all outstanding and unvested awards prior to the adoption of SFAS 123(R). The fair value was calculated using the Black-Scholes option pricing method for options granted during 2005.
In addition to the stock options granted under the LTIP in 2007, there were 106,500 nonvested shares of common stock awards granted during 2007 with a weighted-average grant date fair value of $30.70. No such nonvested shares of common stock awards were granted in prior years. None of the nonvested shares granted during 2007 vested during the year and there were no forfeitures related to these awards.
The aggregate intrinsic value of options outstanding at December 31, 2007 and 2006 was $10.7 million and $6.2 million, respectively. The aggregate intrinsic value of all options that were exercisable at December 31, 2007 and 2006 was $3.0 million and $0.9 million, respectively. The intrinsic value of options exercised during the years ended December 31, 2007 and 2006 was $0.7 million and $1.7 million, respectively. The total fair value of shares vested during the years ended December 31, 2007 and 2006 was $0.7 million and $0.5 million, respectively.
Employees of the Company may participate in the National Interstate Savings and Profit Sharing Plan (the “Savings Plan”). Contributions to the profit sharing portion of the Savings Plan are made at the discretion of the Company and are based on a percentage of employees’ earnings after their eligibility date. Company contributions made prior to December 31, 2006 vest after five years of service and contributions made subsequent to December 31, 2006 vest after three years of service. Profit sharing expense was $0.6 million, $0.3 million and $0.5 million for the years ended December 31, 2007, 2006 and 2005, respectively.
On August 7, 2007, the Company filed a Form S-8 registration statement with the SEC registering 250,000 shares to be offered in the Savings Plan. Effective August 2007, participants in the Savings Plan can now choose to invest in the Company’s common shares as an investment option.
The Company’s principal insurance subsidiary, NIIC, is involved in both the cession and assumption of reinsurance. NIIC is a party to a reinsurance agreement, and NIIA, a wholly-owned subsidiary of the Company, is a party to an underwriting management agreement with Great American. As of December 31, 2007, Great American owned 52.8% of the outstanding shares of the Company. The reinsurance agreement calls for the assumption by NIIC of all of the risk on Great American’s net premiums written for public transportation and recreational vehicle risks. NIIA provides administrative services to Great American in connection with Great American’s underwriting of these risks. The Company also cedes premiums through reinsurance agreements with Great American to reduce exposure in certain of its property-casualty insurance programs.
Great American or its parent, American Financial Group, Inc., performs certain services for the Company without charge including, without limitation, actuarial services and on a consultative basis, as needed, internal audit, legal, accounting and other support services. If Great American no longer controlled a majority of the Company’s common shares, it is possible that many of these services would cease or, alternatively, be provided at an increased cost to us. This could impact our personnel resources, require us to hire additional professional staff and generally increase our operating expenses. Management believes, based on discussions with Great American, that these services will continue to be provided by the affiliated entity in future periods and the relative impact on operating results is not material.
In addition, NIIC is party to a reinsurance agreement with Validus Reinsurance, Ltd. The total amount ceded under this agreement was $0.2 million and $0.3 million for the years ended December 31, 2007 and 2006, respectively. The contract terms were negotiated on an arms-length basis. NIIC deems this contract to be immaterial to operations. Validus Reinsurance, Ltd. is a subsidiary of Validus Holdings, Ltd., whose chief financial officer, Mr. Joseph E. (Jeff) Consolino, is one of the Company’s directors and the Company’s Audit Committee Chairman.
On January 17, 2008, Great American filed an Undertaking on Appeal as surety with the Superior Court of the State of California for the County of Los Angeles in the amount of $17.9 million on behalf of NIIC. This surety was purchased from Great American to secure a judgment amount associated with the Company’s pending appellate case as noted in footnote 17.
As of December 31, 2007, the Company had reinsurance recoverables (including prepaid reinsurance premiums) due from the following reinsurers that exceeded 3.0% of consolidated shareholders’ equity:
NIIC paid dividends of $4.0 million and $3.0 million to the Company in 2007 and 2006, respectively. Also, in accordance with statutory restrictions, NIIC must maintain a minimum balance in statutory surplus of $5.0 million and each of the insurance companies’ subsidiaries must meet minimum Risk Based Capital (“RBC”) levels. At December 31, 2007 NIIC, NIIC-HI and TCC exceeded the minimum RBC levels.
investigations concerning our compliance with insurance laws, securities laws, labor laws and the Employee Retirement Income Security Act of 1974, as amended.
Our insurance companies also have lawsuits pending in which the plaintiff seeks extra-contractual damages from us in addition to damages claimed or in excess of the available limits under an insurance policy. These lawsuits, which are in various stages of development, generally mirror similar lawsuits filed against other carriers in the industry. Although we are vigorously defending these lawsuits, the outcomes of these cases cannot be determined at this time. We have established loss and loss adjustment expense reserves for lawsuits as to which we have determined that a loss is both probable and estimable. In addition to these case reserves, we also establish reserves for claims incurred but not reported to cover unknown exposures and adverse development on known exposures. Based on currently available information, we believe that our reserves for these lawsuits are reasonable and that the amounts reserved did not have a material effect on our financial condition or results of operations. However, if any one or more of these cases results in a judgment against or settlement by us for an amount that is significantly greater than the amount so reserved, the resulting liability could have a material effect on our financial condition, cash flows and results of operations.
On August 3, 2007, the Company was informed that the jury in a case pending in the Superior Court of the State of California for the County of Los Angeles (the “Court”), had issued, on August 2, 2007, a special verdict adverse to the Company’s interests in a pending lawsuit against one of the Company’s insurance companies. The Court entered a formal judgment on October 25, 2007 and the Company received notice of that formal judgment on November 5, 2007. The current exposure to the Company for this judgment approximates $9.0 million, net of anticipated reinsurance and, as required by the Court, the Company secured the judgment amount with a surety bond on January 17, 2008. However, the Company believes that it has a strong appellate case and strategy and intends to vigorously pursue the appellate process. Upon appeal, the Company believes the matter will be resolved in a manner that will not have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows. As of December 31, 2007, the Company had not established a case reserve for this claim but has and will continue to closely monitor this case with counsel. The Company has consistently established litigation expense reserves to account for the cost associated with the defense of the Company’s position, which it will continue to reserve for throughout the appeal process.
The following are quarterly results of operations for the years ended December 31, 2007 and 2006: