YEAR ENDED DECEMBER 31, (In thousands except per share data and ratios)
The information in the following discussion should be read in conjunction with the Company’s consolidated financial statements and notes thereto included elsewhere in this Report. All amounts and percentages are rounded.
Net earnings for the year ended December 31, 2003 increased to $7.4 million, or $1.42 per diluted share, from $2.5 million, or $.51 per diluted share for the same period of 2002. The Company’s net earnings are detailed as follows (in thousands):
Insurance Operations $7,076 $3,618 Real Estate Operations 2,218 1,900 Other, including realized gains and (losses) 2,020 (566) Earnings before Impairment of Note 11,314 4,952 Receivable Impairment of Note Receivable (3,900) (2,468) Net Earnings $ 7,414 $2,484
Excess and Surplus. Our excess and surplus lines continue to capitalize on current market conditions, specifically, the lack of insurance capacity for certain construction risks. As our growth allows for increased capacity in this unit, we strive to diversify our risk portfolio both geographically and by class of business. We continue to work with a small core group of producers to identify selected risks for our portfolio. Renewal premium rate increase of 15% or more was not uncommon. Our calendar year policy count rose from 189 in 2001 to 263 in 2002 to 425 in 2003. We have maintained our underwriting discipline while growing our book of business.
Programs. Our program business is seeing growth in net premiums earned through modifications to our underlying program model. Historically, we have not retained significant portions of risk (<10%) in this line; however, as we see opportunities to generate underwriting profits on existing programs, we are poised to take advantage of those opportunities. Hence, effective in 2002, we took significant risk (70%) on a pest control operators program and in 2002 and 2003 ave expanded our risk position in other programs (10-25%). Based on the opportunities available in the marketplace, we will continue to look for specialty niche program opportunities where we can take more significant risk positions. These increased retentions have driven the substantial increases in earned premiums.
Other. The decrease in other premium earnings is attributable to our exiting specific lines of business that no longer fit in our business model. During the first quarter of 2003, we made the decision to only offer renewal policies for workers’ compensation business; that line will be in full run-off mode starting in the second quarter of 2004. In 2001 and 2002, we exited the employee leasing and staffing workers’ compensation line, exited habitational/manufacturing commercial lines, and substantially reduced surety writings due to adverse loss experience and the lack of affordable reinsurance.
As a result of the historically low interest rate environment of early 2003, we chose in the second quarter to realize certain interest sensitive gains in our bond portfolio. This sale of bonds contributed $3 million of our total net realized gains for the year.
Real estate income was $58 million in 2003, $52 million in 2002, and $28 million in 2001. This revenue is generated from closings of condominium units and boat slips at our real estate project known as Harbour Village. We do not recognize revenue until a closing occurs and title passes to the buyer. The following chart shows the number of condominium units and boat slips that were closed each year:
2001 2002 2003 Condominium Units 102 160 197 Boat Slips 59 62 17 Total 161 222 214
Real estate expenses were $54 million in 2003, $49 million in 2002, and $25 million in 2001. The majority of real estate expenses (variable costs) are recognized at the same time as revenue is recognized. General and administrative expenses (fixed costs) are expensed as incurred once the project begins closing units. The following chart shows the components of costs (in millions):
We meet our cash requirements and finance our growth principally through cash flows generated from operations. Since 2000 we have operated in a hardening market with increased insurance premium rates for general liability coverages and increased fees for program business opportunities. Our primary sources of short-term cash flow are premium writings, investment income and income from real estate development sales. Our short-term cash requirements relate to claims payments, reinsurance premiums, commissions, salaries, employee benefits, real estate development expenses, and other operating expenses. Due to the uncertainty regarding the timing and amount of settlements of unpaid claims, our future liquidity requirements may vary; therefore, we have structured our investment portfolio maturities to allow for variations in those factors. We believe our current cash flows are sufficient for the short-term needs of our insurance business and our invested assets are sufficient for the long-term needs of our insurance business.
To further provide for the capital requirements associated with our current growth strategy, during 2003, we entered into the following arrangements. In May 2003, in conjunction with American Safety Capital Trust, a non-consolidated 100%-owned subsidiary, we issued a 30-year trust preferred obligation in the amount of $8 million. This obligation bears interest at London InterBank Offer Rate (“LIBOR”) plus 4.2% and is payable on a quarterly basis, and can be called solely at our option in five years. We also entered into an interest rate swap which sets the interest rate at 7.1% for the first five years. In September 2003, in conjunction with American Safety Capital Trust II, a non-consolidated 100%-owned subsidiary, we issued a 30-year trust preferred obligation in the amount of $5 million. This obligation bears interest at LIBOR plus 3.95%, is payable on a quarterly basis, and may be called at our option in five years. We also entered into an interest rate swap which sets the interest rate at 7.6% for the first five years. In November 2003, we completed a secondary offering of over 2.1 million common shares whereby we received approximately $27 million of additional capital.
Harbour Village is being developed in three phases with projected completion in 2005. At December 31, 2003, we had outstanding borrowings of $17.4 million, down from an initial $37 million development and construction loan facility. The estimated completion cost for the remainder of Harbour Village is approximately $14.2 million. Management believes that the bank credit facility, together with anticipated cash flows from marketing and sales operations, will meet the liquidity needs for the construction and development of Harbour Village. There can be no assurance, however, that the amounts available from our sources of liquidity, exclusive of the bank credit facility for the project, will be sufficient or available to meet our future capital needs for the project. See Exhibit 99 for further information regarding Harbour Village.
Less than 1 1-3 3-5 More than 5 Total year Years Years Years --------------- --------------- --------------- ---------------- --------------- --------------- --------------- --------------- ---------------- --------------- Long term debt $ 30,441 $ 17,561 $ - $ - $ 12,880 Operating leases 1,929 468 974 487 - --------------- --------------- --------------- ---------------- --------------- --------------- --------------- --------------- ---------------- --------------- Total Contractual Obligations $ 32,370 $ 18,029 $ 974 $ 487 $ 12,880
Contractual Obligations For these purposes we have excluded routine purchase of services, including insurance, that are expected to be used in the ordinary course of our business. More information about our contractual obligations is in Note 9 to our consolidated financial statements.
o Percentage decline in value and the length of time during which the decline has occurred, o Recoverability of principal and interest, o Market conditions, o Ability to hold the investment to maturity, o A pattern of continuing operating losses of the issuer, o Rating agency actions that affect the issuer's credit status, o Adverse changes in the issuer's availability of production resources, revenue sources, technological conditions, and Adverse changes in the issuer’s economic, regulatory or political environment.
Reserves. Certain of our insurance policies and reinsurance assumed, including general and pollution liability policies covering environmental remediation, excess and surplus, and workers' compensation risks, may be subject to claims brought years after an incident has occurred or the policy period has ended. We are required to maintain reserves to cover the unpaid portion of our ultimate liability for losses and loss adjustment expenses with respect to (i) Reported claims and (ii) incurred but not Reported claims. A full actuarial analysis is performed to provide this estimate of all unpaid loss and loss adjustment expense obligations of the Company under the terms of its contracts and agreements. In evaluating whether the reserves make a reasonable provision for unpaid loss and loss adjustment expense, it is necessary to project future loss and loss adjustment expense payments. It is certain that the actual future losses and loss adjustment expenses will not develop exactly as projected and may, in fact, vary significantly from the projections.
In establishing reserves, several methods are employed in determining ultimate losses: the expected loss ratio method; the Bornhuetter-Ferguson method based on expected loss ratios, paid losses and Reported losses; and the loss development method based on paid and Reported losses. The first method uses industry expected losses adjusted for our experience while the last method relies on industry payment and Reporting patterns to develop our actual losses. The Bornhuetter-Ferguson method is a combination of the other two methods, using expected loss ratios to produce expected losses, then applying loss payment and Reporting patterns to the expected losses to produce the expected IBNR. We review the ultimate projections from all three methods and, based on the merits of each method, determine our estimated ultimate losses.
However, the establishment of appropriate loss reserves is an inherently uncertain process, and there can be no assurance that such ultimate payments will not materially exceed our reserves.
Construction Accounting. We recognize revenue on Harbour Village when title to each condominium unit and boat slip transfers to the purchaser. When title transfers, we recognize revenue using a percentage of completion method based on actual costs to total estimated costs (including allocated common costs). The estimated future common costs of amenities at December 31, 2003 were $1.4 million, of which $493,000 related to condominium units that were closed in 2003. As the percentage of completion method is based upon future estimated costs and actual costs may vary greatly from those total cost estimates, adjustments could be recorded in future periods.
Property and casualty insurance premiums are established before the amounts of losses and loss adjustment expenses are known and therefore before the extent by which inflation may affect such expenses is known. Consequently, we attempt, in establishing our premiums, to anticipate the potential impact of inflation. However, for competitive and regulatory reasons, we may be limited in raising premiums consistent with anticipated inflation, in which event we, rather than our insureds, would absorb inflation costs. Inflation also affects the rate of investment return on our investment portfolio with a corresponding effect on our investment income.
This Report contains forward-looking statements within the meaning of United States’ securities laws which are intended to be covered by the safe harbors created thereby. Such statements include the Company’s estimations of future insurance claims and losses, and the Company’s expectations with respect to the outcome of the Principal Management acquisition rescission litigation, and the future profitability and value of the Harbour Village real estate project, as reflected in the Company’s consolidated financial statements and Exhibit 99 to this Report. In addition, all statements, other than statements of historical facts, included or incorporated by reference in this Report that address activities, events or developments that the Company expects or anticipates will or may occur in the future constitute forward-looking statements.
Forward-looking statements involve risks and uncertainties which may cause actual results to differ materially, and are subject to change based on various insurance industry factors, including, without limitation, competitive conditions in the insurance industry, levels of new and renewal insurance business, unpredictable developments in loss trends, adequacy and changes in loss reserves, timing or collectibility of reinsurance receivables, market acceptance of new coverages and enhancements, changes in reinsurance costs and availability, potential adverse decisions in litigation and arbitration proceedings, and changes in levels of general business activity and economic conditions. In addition, the risk factors described under Item 1 of this Report could cause results to differ materially. With respect to the development of the Harbour Village project, such forward-looking statements involve risks and uncertainties which may cause actual results to differ materially, and are subject to change based on various real estate development industry factors, including competitive housing conditions in the local market area, risks inherent in real estate development and new construction, increases in construction costs, construction delays, weather, zoning, litigation, changes in interest rates and the availability of mortgage financing for prospective purchasers of condominium units and boat slips, and changes in local and national levels of general business activity and economic conditions. An adverse outcome of the Principal Management acquisition rescission litigation would have a material adverse effect on the operating results of the Company. See discussion in Item 3. of this Report as to these matters.
The Company's consolidated financial statements required under this Item 8. are included as part of Item 14. of this Report.