We lease office space in Fenton, Missouri; Honolulu, Hawaii; and Mechanicsburg, Pennsylvania. The leases account for approximately 60,000 square feet of office space. These leases expire within nineteen months. The monthly rents, exclusive of operating expenses, to lease these facilities currently total approximately $101,000. We believe that these leases could be renewed or replaced at commercially reasonable rates without material disruption to our business.
(3) We invest funds in the participant loss layer for several of the alternative risk transfer programs. We receive investment income and incur an equal expense on the amounts owed to alternative risk transfer participants. “Expense on amounts withheld” represents investment income that we remit back to alternative risk transfer participants. The related investment income is included in our “Net investment income” line on our Consolidated Statements of Income.
(7) The ratio of net income to the average of the shareholders’ equity at the beginning and end of the year.
(8) Book value per common share is computed using only unrestricted outstanding common shares. As of December 31, 2011 and 2010 total unrestricted common shares were 19,398,000 and 19,357,000, respectively. There were no unvested restricted shares prior to 2007.
The increase or decrease in the number of new applications we receive. This is influenced by the effectiveness of our marketing activities compared to the marketing activities of our competitors in each market.
The change in our rate structure from period to period. The rates we file and quote are impacted by several factors including: the cost and extent of the reinsurance we purchase; our operating efficiencies; our average loss costs, which reflect the effectiveness of our underwriting; our underwriting profit expectations; and our claims adjusting processes. The difference between our rates and the rates of our competitors is the primary factor impacting the revenue growth of our established product lines.
Despite relatively flat pricing since 2004, improved risk selection and an overall improvement in the risk quality of our book of business have enabled us to attain combined ratios better than our corporate objective of 96.0% or lower. Since our inception in 1989 we have placed a consistent emphasis on underwriting profit. Though 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 88.9%. We believe the following factors contribute to our performance, which is consistently above industry standards:
Our stable operating expenses which have historically been at or below the revenue growth rate.
As noted above, the P/C insurance industry saw a significant upswing in catastrophe-related losses in 2011, including hurricanes, tornadoes, winter storms, wildfires, hail and floods. For weather-related events such as hurricanes, tornados and hailstorms, we conduct an analysis at least annually pursuant to which we input our in-force exposures (vehicle values in all states and property limits in Hawaii) into an independent catastrophe model that predicts our probable maximum loss at various statistical confidence levels. Our estimated probable maximum loss is impacted by changes in our in-force exposures as well as changes to the assumptions inherent in the catastrophe model. Hurricane and other weather-related events have not had a material negative impact on our past results.
As described below, the average revenue dollar per personal lines policy is significantly lower than typical commercial policies. Profitability in the specialty personal lines component is dependent on proper pricing and the efficiency of underwriting and policy administration. We have continued to monitor rate levels and have adjusted them during 2011, as warranted. We continuously strive to improve our underwriting and policy issuance functions to keep this cost element as low as possible by utilizing current technology advances.
To succeed as a transportation underwriter and personal lines underwriter, we must understand and be able to quantify the different risk characteristics of the risks we consider quoting. Certain coverages are more stable
There are distinct differences in the timing of premiums written in traditional transportation insurance compared to the majority of our ART insurance component. We write traditional transportation insurance policies throughout all twelve months of the year and commence new annual policies at the expiration of the old policy. Under most ART programs, all members of the group share a common renewal date. These common renewal dates are scheduled throughout the calendar year. Any new ART program participant that joins after the common date will be written for other than a full annual term so its next renewal date coincides with the common expiration date of the program it has joined. Historically, most of our group programs had common renewal dates in the first six months of the year, but with the growth from new ART programs, we are now experiencing renewal dates throughout the calendar year. The ART component of our business accounted for 54.2% of total gross premiums written during 2011 as compared to 52.4% in 2010.
All of our transportation products, traditional or ART, are priced to achieve targeted underwriting margins. Because traditional insurance tends to have a higher operating expense structure, the portion of the premiums available to pay losses tends to be lower for a traditional insurance quote versus an ART insurance quote. We use a cost plus pricing approach that projects future losses based upon the insured’s historic losses and other factors. Operating expenses, premium taxes and a profit margin are then added to the projected loss component to achieve the total premium to be quoted. The lower the projected losses, expenses and taxes, the lower the total quoted premiums regardless of whether it is a traditional or ART program quotation. Quoted premiums are computed in accordance with our approved insurance department filings in each state.
We approach investment and capital management with the intention of supporting insurance operations by providing a stable source of income to supplement underwriting income. The goals of our investment policy are to protect capital while optimizing investment income and capital appreciation and maintaining appropriate
liquidity. We follow a formal investment policy and the Board reviews the portfolio performance at least quarterly for compliance with the established guidelines. In 2011, investment yields were relatively consistent with those experienced in 2010 due to the continued low interest rate environment, while the value of many of our existing holdings increased. We recorded a $4.5 million pre-tax net realized gain on investments in 2011 as compared to $4.3 million recorded in 2010. Included in these pre-tax net realized gains are impairment charges of $2.1 million and $0.3 million, respectively.
Commissions and other underwriting expenses consist principally of brokerage and agent commissions and to a lesser extent premium taxes. The brokerage and agent commissions 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.
The following table sets forth our 2011, 2010 and 2009 net income from operations and the after-tax impact from the operating results of Vanliner’s guaranteed runoff business, which are non-GAAP financial measures, as well as after-tax net realized gains from investments, change in valuation allowance on deferred tax assets related to net capital losses and the gain on bargain purchase of Vanliner, all of which we believe are useful tools for investors and analysts in analyzing ongoing operating trends.
As discussed above, UniGroup provided us with comprehensive financial guarantees related to the runoff of Vanliner’s final balance sheet whereby both favorable and unfavorable balance sheet development inures to the seller. In accordance with purchase accounting requirements, we were required to determine the fair value of the future economic benefit of the financial guarantees and acquired loss reserves as of the date of acquisition, despite the fact that certain gains and losses related to the financial guaranty would be reflected in operations as they are incurred in future periods. As a result, the recognition of the revenues and expenses associated with the guaranteed runoff business will not occur in the same period and will result in combined ratios which are inconsistent with the negotiated combined ratio which was to approximate 100% for the Vanliner guaranteed business. As such, the after-tax impact from the runoff business guaranteed by the seller for the years ended December 31, 2011 and 2010 of $1.9 million ($0.10 per share diluted) and $2.1 million ($0.11 per share diluted), respectively, has been removed from the net after-tax earnings from operations to reflect only those results of the ongoing business.
After-tax net realized gains from investments of $2.9 million ($0.15 per share diluted) in 2011 were relatively flat compared to the $2.8 million ($0.14 per share diluted) reported for 2010. During the first quarter of 2010, we recorded a reduction of $0.8 million ($0.04 per share diluted) to our valuation allowance related to net realized losses due to both available tax strategies and the future realizability of previously impaired securities. No valuation allowance against deferred tax assets was necessary subsequent to March 31, 2010.
Gross premiums written includes both direct premium and assumed premium. During 2011, our gross premiums written increased $87.7 million, or 20.0%, compared to 2010, primarily attributable to our ART and transportation components. Gross premiums written in our ART component increased by $55.5 million, or 24.2%, due to a combination of growth in existing ART programs including the addition of three new customers to our large account ART product, including one from Vanliner’s moving and storage business, the introduction of the second group ART program for Vanliner’s moving and storage business, a new passenger transportation ART program and near 100% member retention in ART programs renewing during the year. Also contributing to the growth in our ART component are two programs which comprised 7.5% of our gross premiums written during 2011, but which have experienced unacceptable claims results. We have taken certain underwriting actions to improve the performance of one of these programs and terminated the other program during the fourth quarter of 2011, which will likely reduce the premium growth for these programs in future periods. However, we expect the ART component to continue to provide new growth opportunities, including the anticipated expansion of recently incepted ART programs and the development of new products which are continually in the pipeline. Our transportation component grew by $39.1 million, or 31.6%, driven by the Vanliner moving and storage products’ gross premiums written which increased $42.8 million to a total of $92.8 million during 2011. This growth was partially offset by a decrease in certain of our traditional passenger transportation and trucking transportation products, which were impacted by increasingly competitive pricing in the commercial insurance market. The decrease of $7.9 million, or 12.9%, in our specialty personal lines component is primarily related to the pricing and underwriting actions associated with the commercial vehicle product which were first initiated in late 2009 and continued throughout 2011. We also experienced a decrease in our recreational vehicle product due to a decline in the number of agents’ quotes, as we are seeing a trend toward recreational vehicle owners going directly to insurance companies for quotes versus using an agent.
Our premiums earned increased $71.6 million, or 20.0%, to $429.9 million during the year ended December 31, 2011 compared to $358.4 million for the year ended December 31, 2010 primarily attributable to the ART and transportation components. Our ART component grew $48.7 million, or 31.3%, during 2011 compared to 2010 reflecting the growth in gross premiums written experienced in this component throughout 2011, as discussed above. Our transportation component increased $25.8 million, or 20.6%, in 2011 compared to the same period in 2010 mainly due to Vanliner’s moving and storage products. Approximately $25.6 million of the Vanliner premiums earned relate to the runoff of the business covered by the balance sheet guaranty. These increases were partially offset by our specialty personal lines component, which decreased $4.4 million, or 7.7%, during the year ended December 31, 2011 compared to the year ended December 31, 2010 due to the decline in premiums written in our commercial vehicle and recreational vehicle products experienced throughout 2011.
Our premiums earned increased $79.3 million, or 28.4%, to $358.4 million during the year ended December 31, 2010 compared to $279.1 million for the year ended December 31, 2009. Included in this increase was $64.5 million in premiums earned related to Vanliner, which are included in our transportation component. Excluding Vanliner’s premiums earned, the remaining $14.8 million increase was primarily attributable to the alternative risk transfer component which grew $14.3 million, or 10.1%, over 2009 mainly due to the new ART programs introduced throughout 2009 and 2010. Our specialty personal lines component increased $1.4 million, or 2.5%, resulting from the growth in our commercial vehicle product experienced in 2009. These increases were partially offset by a $1.6 million decrease in the Hawaii and Alaska component resulting from reductions in gross premiums written in 2009 and 2010, which were primarily attributable to the 2008-2009 economic downturn and the soft insurance market.
2010 compared to 2009. Losses and LAE increased $86.7 million, or 51.0%, for 2010 compared to 2009. The consolidated loss and LAE ratio for the year ended December 31, 2010 increased 10.7 percentage points to 71.5% compared to 60.8% in the same period in 2009, which was several percentage points higher than our historical annual ratio. The loss and LAE ratio for our ongoing operations was 67.5% for the year ended December 31, 2010. This elevated loss and LAE ratio was primarily due to favorable claims results experienced throughout 2009, higher losses experienced in 2010 by our commercial vehicle product, which is part of the specialty personal lines component, and the impact from several periods of single digit rate decreases in our transportation component. Additionally, we experienced higher than expected claims severity among certain of our trucking products in both our alternative risk transfer and transportation components during 2010.
2010 compared to 2009. In 2010, we had pre-tax net realized gains of $4.3 million compared to $2.6 million for 2009. The pre-tax net realized gains for the year ended December 31, 2010 were primarily generated from net realized gains from the sales of securities of $3.5 million, which include sales to generate funds for the Vanliner acquisition, and net gains associated with an equity partnership investment of $1.1 million. Offsetting these gains were credit loss other-than-temporary impairment charges of $0.3 million. The pre-tax net realized gains for the year ended December 31, 2009 were primarily generated from net realized gains associated with an equity partnership investment of $4.2 million and realized gains associated with the sales of securities of $4.0 million. Offsetting these gains were other-than-temporary impairment charges recognized in earnings of $3.9 million and realized losses of $1.7 million on disposals, including a $1.0 million realized loss on the conversion of a perpetual preferred stock to common stock on a financial institution holding. The two largest components of the $3.9 million credit loss impairment charge were $1.8 million on three corporate notes and $1.9 million related to four mortgage-backed securities.
2010 compared to 2009. Other income increased $0.2 million, or 5.5%, to $3.7 million for 2010 compared to $3.5 million in 2009. This increase is primarily attributable to the growth in the policy-based fee income generated by our personal lines component throughout 2010.
2010 compared to 2009. Commissions and other underwriting expenses for the year ended December 31, 2010 increased $10.4 million, or 18.2%, to $67.6 million from $57.2 million in the comparable period in 2009. The increase was primarily a result of the growth in gross premiums written, partially offset by the favorable impact in 2010 related to adjustments from the fair value recording of Vanliner’s opening balance sheet.
2011 compared to 2010. We invest funds in the participant loss layer for several of the ART programs. We receive investment income and incur an equal expense on the amounts owed to ART participants. “Expense on amounts withheld” represents investment income that we remit back to ART participants. The related investment income is included in our “Net investment income” line on our Consolidated Statements of Income. For the year ended December 31, 2011, the expense on amounts withheld increased $0.4 million, or 13.3%, compared to the same period in 2010, primarily attributable to the growth experienced in our ART component throughout 2011.
2010 compared to 2009. The 2010 effective tax rate was 24.2%, increasing 1.5 percentage points from a rate of 22.7% in 2009. Our 2010 income tax expense was favorably impacted by the $7.5 million gain on bargain purchase of Vanliner. In both 2010 and 2009, we recorded reductions to our valuation allowance related to net realized losses due to both available tax strategies and the future realizability of previously impaired securities. No valuation allowance against deferred tax assets existed subsequent to March 31, 2010. Excluding these items, our effective tax rates for the years ended December 31, 2010 and 2009 were 30.8% and 33.9%, respectively.
investments accounted for in accordance with the equity method. At December 31, 2011, we had pretax net unrealized gains of $26.3 million on fixed maturities and $0.8 million on equity securities. Our investment portfolio allocation is based on diversification among primarily high quality fixed maturity investments and guidelines in our investment policy.
Fixed maturity investments are focused on securities with intermediate-term maturities. At December 31, 2011, the weighted average maturity of our fixed maturity investments was approximately 6.3 years. At December 31, 2011, 90.7% of the fixed maturities in our portfolio were rated “investment grade” (credit rating of AAA to BBB-) by nationally recognized rating agencies. Investment grade securities generally bear lower degrees of risk and corresponding lower yields than those that are unrated or non-investment grade. Although we cannot provide any assurances, we believe that, in normal market conditions, our high quality investment portfolio should generate a stable and predictable investment return.
Included in the fixed maturities at December 31, 2011 were $225.0 million of residential mortgage-backed securities (“MBS”). We do not have a significant exposure to the subprime lending sector as 79.2% of our residential MBS are backed by U.S. government agencies. MBS are subject to prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be prepaid more rapidly than scheduled as buyers refinance higher rate mortgages to take advantage of declining interest rates. Also included in fixed maturities at December 31, 2011 were $340.2 million of state and local government obligations (“muni bonds”). Approximately 88.8% of our muni bonds are rated “A-” or better, 99.5% are rated investment grade and the average credit quality is “AA-.”
Capital Ratios. The National Association of Insurance Commissioners’ model law for risk-based capital (“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, 2011 and 2010, the capital and surplus of all our insurance companies substantially exceeded the RBC requirements.
We believe that our insurance subsidiaries maintain sufficient liquidity to pay claims and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies. Our principal sources of liquidity are our existing cash, cash equivalents and short-term investments. Cash and cash equivalents were $23.7 million at December 31, 2011, a $3.4 million decrease from December 31, 2010. For 2011, 2010 and 2009, we generated consolidated cash flow from operations of $37.5 million, $79.8 million and $51.3 million, respectively. The decrease of $42.3 million in cash flow from operations in 2011 from 2010 is primarily attributable to a large amount of claims payments made during 2011 related to the guaranteed Vanliner business. Cash flow from operations increased $28.5 million in 2010 from 2009 primarily attributable to various fluctuations within our operating activities associated with our growth.
Net cash used in investing activities was $36.2 million, $70.6 million and $57.9 million for the years ended December 31, 2011, 2010 and 2009, respectively. This $34.4 million decrease in cash used in investing activities in 2011, as compared to 2010, was primarily related to a $107.5 million decrease in the purchases of fixed maturity investments, a $48.5 million increase in the proceeds from sales of fixed maturity investments, the net cash outflow associated with the acquisition of Vanliner of $33.4 million in 2010 and receiving the $14.3 million refund in 2011 on the purchase price of Vanliner related to making the election under Section 338(h)(10) of the Internal Revenue Code and the finalization of the tangible book value, which were partially offset by a
$134.9 million decrease in the proceeds from maturities and redemptions of fixed maturity investments and $26.9 million from the purchase of equity investments. The decreases in the purchases of fixed maturities and the proceeds from maturities and redemptions of fixed maturity investments in 2011 as compared to the prior period were primarily due to the positioning of our portfolio which took place during the first six months of 2010 to generate funds to finance the Vanliner acquisition and the subsequent investment of Vanliner’s $94.6 million of cash and cash equivalents acquired in the third quarter of 2010. The increase in the proceeds from sales of fixed maturity investments was driven by the repositioning of our portfolio in 2011 to take advantage of higher yielding securities and locking in capital gains on current holdings. The net purchases of fixed maturities during 2011 were primarily concentrated in residential MBS and state and local government obligations. The net purchases of equity securities during 2011 were mainly concentrated in stocks of “blue chip” companies with histories of strong dividend payouts. The $12.7 million increase in cash used in investing activities in 2010 compared to 2009 was primarily related to the $128.1 million paid on July 1, 2010 to purchase Vanliner, net of $94.6 million of cash and cash equivalents acquired. In order to generate funds to finance the acquisition, we positioned our portfolio to capitalize on maturities and redemptions of investments, as well as increased our sales of fixed maturity securities. These actions resulted in additional proceeds from maturities and redemptions of investments and sales of fixed maturity securities of $131.7 million and $27.9 million, respectively, over the same period in 2009. Additionally, we increased our purchases of fixed maturity securities by $133.2 million over the comparable period in 2009, as we reinvested Vanliner’s excess cash balances and the proceeds from maturities and redemptions of investments which occurred during the period.
We have a $50 million unsecured Credit Agreement (the “Credit Agreement”) that terminates in December 2012, 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. At December 31, 2011 there was $22.0 million drawn on this credit facility. 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, 2011. As of December 31, 2011, the interest rate on this debt is equal to the six-month LIBOR (0.4375% at December 31, 2011) plus 65 basis points, with interest payments due quarterly.
We expect to successfully procure a new line of credit during 2012 to replace the current Credit Agreement prior to its expiration, although potentially at a higher cost. Due to the favorable terms of the Credit Agreement relative to those currently available in the commercial lending marketplace, we do not anticipate executing a new credit facility until the latter half of 2012.
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, 2011 and 2010, we had $776.6 million and $798.6 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 from Great American review the recorded reserves for NIIC, VIC, NIIC-HI and TCC utilizing current period data and provide a Statement of Actuarial Opinion, required annually in accordance with state insurance regulations, on the statutory reserves recorded by these U.S. insurance subsidiaries. The actuarial analysis of NIIC’s, VIC’s, NIIC-HI’s and TCC’s net reserves as of December 31, 2011 and 2010 reflected point estimates that were within 2% of management’s recorded net reserves as of such dates. Using this actuarial data along with its other data inputs, management concluded that the recorded reserves appropriately reflect management’s best estimates of the liability as of each year end.
The period of time from the occurrence of a loss through the settlement of the liability is referred to as the “tail.” Generally, the same actuarial methods are considered for both short-tail and long-tail lines of business because most of them work properly for both. The methods are designed to incorporate the effects of the differing length of time to settle particular claims. For short-tail lines, management tends to give more weight to the Case Incurred and Paid Development methods, although the various methods tend to produce similar results. For long-tail lines, more judgment is involved and more weight may be given to the Bornhuetter-Ferguson method. Liability claims for long-tail lines are more susceptible to litigation and can be significantly affected by changing contract interpretation and the legal environment. Therefore, the estimation of loss reserves for these classes is more complex and subject to a higher degree of variability.
We recorded unfavorable development of $0.8 million and $2.2 million in 2011 and 2010, respectively, for this line of business as actual claim severity was higher than previously anticipated. We recorded favorable development of $0.7 million in 2009 as actual claim severity was lower than previously anticipated. We continually monitor development trends in each line of business as a component of estimating future ultimate loss and related LAE liabilities. Management has not made any changes to the key assumptions used in calculating current year reserves in the commercial auto liability line of business.
Claims we view as potentially significant are subject to a rigorous review process involving the adjuster, claims management and executive management. We seek to establish reserves at the maximum probable exposure based on our historic claims experience. Incurred but not yet reported (“IBNR”) reserves are determined separate from the case reserving process and include estimates for potential adverse development of the recorded case reserves. We monitor IBNR reserves monthly with financial management and quarterly with an actuary from Great American. IBNR reserves are adjusted monthly based on historic patterns and current trends and exposures. When a claim is reported, claims personnel establish a “case reserve” for the estimated amount of ultimate payment. The amount of the reserve is based upon an evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the loss. The estimate reflects informed judgment of our claims personnel based on general insurance reserving practices and on the experience
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, 2011, 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.
The changes we have recorded in our reserves in the past three years illustrate the potential for revisions inherent in estimating reserves. In 2011, we experienced favorable development of $2.7 million (0.5% of total net reserves) from claims incurred prior to 2011. In 2010, we experienced favorable development of $9.6 million (1.6% of total net reserves) from claims incurred prior to 2010. In 2009, we experienced favorable development of $1.3 million (0.5% of total net reserves) from claims incurred prior to 2009. We did not significantly change our reserving methodology or our claims settlement process in any of these years. The development reflected settlements that differed from the established case reserves, changes in the case reserves based on new information for that specific claim or the differences in the timing of actual settlements compared to the payout patterns assumed in our accident year IBNR reductions. The types of coverages we offer and risk levels we retain have a direct influence on the development of claims. Specifically, short duration claims and lower risk retention levels generally are more predictable and normally have less development. Future favorable or unfavorable development of reserves from this past development experience should not be assumed or estimated. The reserves reported in the financial statements are our best estimate.
Management has evaluated the effectiveness of the Company’s internal control over financial reporting as of December 31, 2011, 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, 2011.
We have audited National Interstate Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). National Interstate Corporation and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
In our opinion, National Interstate Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Interstate Corporation and subsidiaries at December 31, 2011 and 2010, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
The Company has five property and casualty insurance subsidiaries: National Interstate Insurance Company (“NIIC”), Vanliner Insurance Company (“VIC”), National Interstate Insurance Company of Hawaii, Inc. (“NIIC-HI”), Triumphe Casualty Company (“TCC”), Hudson Indemnity, Ltd. (“HIL”) and five active agency and service subsidiaries. The Company writes its insurance policies on a direct basis through NIIC, VIC, NIIC-HI and TCC. NIIC and VIC are licensed in all 50 states and the District of Columbia. NIIC-HI is licensed in Ohio, Hawaii, Michigan and New Jersey. TCC holds licenses for multiple lines of authority, including auto-related lines, in 26 states and the District of Columbia. HIL is domiciled in the Cayman Islands and provides reinsurance for NIIC, VIC, NIIC-HI and TCC, primarily for the Company’s alternative risk transfer (“ART”) component. Insurance products are marketed through multiple distribution channels including, independent agents and brokers, program administrators, affiliated agencies and agent internet initiatives. The Company uses its five active agency and service subsidiaries to sell and service the Company’s insurance business. Approximately 14.6% of the Company’s premiums are written in the state of California, and an additional 40.7%, collectively, in the states of Texas, New York, Florida, Pennsylvania, North Carolina, New Jersey, Massachusetts and Missouri.
The consolidated financial statements include the accounts of the Company and its subsidiaries (NIIC, VIC, NIIC-HI, HIL, TCC, Hudson Management Group, Ltd., Vanliner Group, Inc. (“Vanliner”), Vanliner Reinsurance Limited, National Interstate Insurance Agency, Inc. (“NIIA”), American Highways Insurance Agency, Inc., TransProtection Service Company, Safety, Claims and Litigation Services, Inc., Explorer RV Insurance Agency, Inc. and Safety, Claims and Litigation Services, LLC) since their formation or acquisition. Significant intercompany transactions have been eliminated.
The Company accounted for the acquisition of Vanliner in accordance with Accounting Standard Codification (“ASC”) 805, Business Combinations, and the purchase price was allocated to the assets acquired and liabilities assumed based on their fair value at the acquisition date. See Note 3 - “Acquisition of Vanliner Group, Inc.” for additional discussion regarding the acquisition and the related financial disclosures. The Consolidated Financial Statements as of and for the years ended December 31, 2011 and 2010, respectively, and the Notes to Consolidated Financial Statements reflect the consolidated results of the Company and Vanliner commencing on July 1, 2010.
Property and equipment are reported at cost less accumulated depreciation and amortization. Property and equipment are depreciated or amortized over the estimated useful lives on a straight-line basis. The useful lives range from three to five years for computer equipment, 20 to 40 years for buildings and improvements and five to seven years for all other property and equipment. Property and equipment include capitalized software developed or acquired for internal use. Upon sale or retirement, the cost of the asset and related accumulated depreciation are eliminated from their respective accounts and the resulting gain or loss is included in operations. Repairs and maintenance are charged to operations when incurred. In conjunction with the acquisition of Vanliner, the Company acquired $3.0 million of information technology assets from the seller, which are being depreciated over their estimated three-year useful lives. The Company recorded depreciation expense of $3.9 million, $2.9 million and $1.9 million for the years ended December 31, 2011, 2010 and 2009, respectively.
The Company allocated a portion of the purchase price of Vanliner to the intangible assets acquired based on their fair value as required by ASC 805. These intangible assets consist of acquired insurance licenses, with an indefinite life, and an acquired relationship asset relating to renewal rights, trade names, customer relationships and distribution networks. Intangible assets with definite lives are amortized over their estimated useful life, which is five years for the acquired relationship asset and amortization expense during 2011 and 2010 relating to this intangible asset was $0.3 million and $0.1 million, respectively. See Note 3 - “Acquisition of Vanliner Group, Inc.” for additional discussion regarding these intangible assets. All identifiable intangible assets are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. Indefinite lived intangible assets are subject to annual impairment testing, which was performed during the fourth quarter of 2011. Based upon this review, no impairment losses were recognized in 2011.
Basic earnings per common share have been computed based on the weighted average number of common shares outstanding during the period. Diluted earnings per share are based on the weighted average number of common shares and dilutive potential common shares outstanding during the period using the treasury stock method.
In October 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2010-26, Financial Services - Insurance (“ASU 2010-26”). ASU 2010-26 amends ASC 944, Financial Services - Insurance, limiting the capitalization of costs incurred in the acquisition of new and renewal contracts to incremental direct costs of contract acquisition and certain costs related directly to certain acquisition activities performed by the insurer of the contract. ASU 2010-26 is effective for interim and annual reporting periods beginning after December 15, 2011, with retrospective application permitted, but not required. The Company will adopt ASU 2010-26 on January 1, 2012 with retrospective application. This guidance will result in fewer acquisition costs being capitalized by the Company and the cumulative effect through December 31, 2011 will
result in a reduction of the Company’s deferred policy acquisition costs, deferred federal income taxes and shareholders’ equity, after tax by, $2.6 million, $0.9 million and $1.7 million, respectively. The retrospective application will have virtually no impact to the Company’s earnings per share for the past five years when measured on a year-to-date basis.
In June 2011, the FASB issued Accounting Standards Update No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income (“ASU 2011-05”). ASU 2011-05 eliminates the option to report other comprehensive income and its components in the statement of shareholders’ equity. ASU 2011-05 requires that all non-owner changes in shareholders’ equity be presented in either a single continuous statement of comprehensive income which contains two sections, net income and other comprehensive income, or in two separate but consecutive statements. The Company intends to present other comprehensive income in a separate statement. ASU 2011-05 is effective for interim and annual reporting periods beginning after December 15, 2011, with retrospective application required. The Company will adopt ASU 2011-05 on January 1, 2012. The updated guidance only requires a change in the format of information already disclosed; the adoption will not impact the Company’s cash flows, financial condition, net income or comprehensive income.
The acquisition was accounted for in accordance with ASC 805. Purchase accounting, as defined by ASC 805, requires that the assets acquired and liabilities assumed be recognized at their fair values as of the acquisition date. The purchase price was allocated based on the fair value of assets acquired, liabilities assumed and additional consideration expected to be paid. The fair values disclosed herein were determined based on management’s best estimates and the finalization of certain valuation analyses during the fourth quarter of 2010. Provisional fair values were recorded in the Company’s interim consolidated financial statements and notes thereto for the three and nine month periods ending September 30, 2010 as reported on Form 10-Q, as these certain valuation analyses were ongoing as of the date of that filing. In accordance with ASC 805, management deemed the fair value measurement period to be closed as of December 31, 2010, as all information necessary to identify and measure the fair value of all aspects of the business combination had been made available to and obtained by the Company.
The purchase consideration consisted of cash and additional future consideration as follows (in thousands):
The following table presents the fair value allocation of the assets acquired and liabilities assumed relating to the acquisition of Vanliner under the fair value hierarchy level as of July 1, 2010:
338(h)(10) election, as the $8.4 million compensation from UniGroup reduced both the purchase price and fair value of net assets acquired by $8.4 million. All changes during the fair value measurement period related to the provisional $0.6 million gain on bargain purchase previously reported in the Company’s September 30, 2010 Form 10-Q, were required to be retrospectively adjusted as of the acquisition date under purchase accounting. Accordingly, the entire $7.5 million gain on bargain purchase is reflected in operating results for the third quarter of 2010 as disclosed in the Company’s Quarterly Operating Results footnote. The Company took certain actions and incurred certain costs associated with the transaction, totaling approximately $1.0 million which are reflected in “Other operating and general expenses” in the Company’s Consolidated Statements of Income for the year ended December 31, 2010.
The valuation of loss and LAE reserves acquired was determined using actuarial cash flow models and payment assumptions rather than an observable market price since a liquid market for such underwriting liabilities does not exist. The valuation model used an estimate of future cash flows related to liabilities for losses and LAE that a market participant would expect to incur as of the date of the acquisition. These future cash flows were adjusted for the time value of money at a risk free rate and a risk margin to compensate an acquiror for bearing the risk associated with the liabilities that exist outside of the financial guarantees from UniGroup. As a result of these analyses, a fair value adjustment of $6.1 million was made to loss and LAE reserves, of which $1.2 million will be amortized over the expected loss and LAE payout pattern and reflected as a component of loss and LAE. The Company amortized $0.4 million and $0.2 million for the twelve months ended December 31, 2011 and 2010, respectively.
Receivables, other assets and liabilities were valued at fair value which approximated carrying value.
Pricing services use a variety of observable inputs to estimate the fair value of fixed maturities that do not trade on a daily basis. These inputs include, but are not limited to, recent reported trades, benchmark yields, issuer spreads, bids or offers, reference data and measures of volatility. Included in the pricing of mortgage-backed securities are estimates of the rate of future prepayments and defaults of principal over the remaining life of the underlying collateral. Inputs from brokers and independent financial institutions include, but are not limited to, yields or spreads of comparable investments which have recent trading activity, credit quality, duration, credit enhancements, collateral value and estimated cash flows based on inputs including, delinquency rates, estimated defaults and losses, and estimates of the rate of future prepayments. Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by the Company’s internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, the Company’s internal investment professionals compared the valuation received to an independent third party pricing source and considered widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. If the Company believes that significant discrepancies exist, the Company will perform additional procedures, which may include specific inquiry of the pricing service, to resolve the discrepancies.
observable inputs other than quoted prices, such as interest rate and yield curves. Level 3 inputs are unobservable inputs for the asset or liability.
Level 1 consists of publicly traded equity securities and highly liquid, direct obligations of the U.S. Government whose fair value is based on quoted prices that are readily and regularly available in an active market. Level 2 primarily consists of financial instruments whose fair value is based on quoted prices in markets that are not active and include U.S. government agency securities, fixed maturity investments, and perpetual preferred stocks that are not actively traded. Included in Level 2 are $5.2 million of securities, which are valued based upon a non-binding broker quote and validated with other observable market data by management. Level 3 consists of financial instruments that are not traded in an active market, whose fair value is estimated by management based on inputs from independent financial institutions, which include non-binding broker quotes, for which the Company believes reflects fair value, but for which the Company is unable to verify inputs to the valuation methodology. The Company obtained at least one quote or price per instrument from its brokers and pricing services for all Level 3 securities and did not adjust any quotes or prices that it obtained. Management reviews these broker quotes using any recent trades, if such information is available, or market prices of similar investments. The Company primarily uses the market approach valuation technique for all investments.
The tables above exclude investments in limited partnerships accounted for under the equity method of $28.1 million and $13.8 million (included in “other invested assets”) at December 31, 2011 and December 31, 2010, respectively. Equity method investments are not reported at fair value.
(a) Transfers out of Level 3 relate to two residential mortgage-backed securities that have inputs, including quotes, which were consistently observed in an active market during 2010.
(a) Transfers in and/or (out) of Level 3 relate to the termination of the securities lending program and moving longer-term assets into the investment portfolio during year ended December 31, 2009.
Under current other-than-temporary impairment accounting guidance, if management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then an entity may separate the other-than-temporary impairments into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive income (loss)). The credit related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge recorded in earnings is required to reduce the amortized cost of that security to fair value.
Gains and losses on the sale of these investments, including other-than-temporary impairment charges and other investments’ gain or losses, were as follows:
Pre-tax net realized gains of $4.3 million during 2010 were primarily generated from net realized gains associated with the sales of securities of $3.6 million and net gains associated with an equity partnership investment of $1.6 million. The gains on equity and fixed maturity securities were primarily due to favorable market conditions that increased the value of the securities over book value and include gains from sales to generate funds for the Vanliner acquisition. Offsetting these gains were other-than-temporary impairment charges of $0.3 million and realized losses of $0.1 million from the sales of fixed maturity securities. The other-than-temporary impairment charges of $0.3 million are primarily due to a $0.2 million charge on one corporate bond that had a decrease in market value below book value and, due to the uncertainty of ultimate recovery, the entire impairment was recorded as a credit loss and a $0.1 million charge that was recorded on a mortgage-backed security, for which a previous impairment charge had been recorded.
At December 31, 2011, gross unrealized losses on residential mortgage-backed securities were $3.7 million and represented 54.5% of the total gross unrealized losses on fixed maturities. There were 21 holdings with gross unrealized losses of $1.0 million that were in an unrealized loss position for less than 12 months and eight securities with gross unrealized losses of $2.7 million that were in an unrealized loss position for 12 months or more. Four of these securities previously had both credit and non-credit other-than-temporary impairment charges and were in a gross unrealized loss position of $2.6 million at December 31, 2011. Investment grade securities represented 66.3% of all residential mortgage-backed securities with unrealized losses. Based on historical payment data and analysis of expected future cash flows of the underlying collateral, independent credit ratings and other facts and analysis, including management’s current intent and ability to hold these securities for a period of time sufficient to allow for anticipated recovery, management believes that, based upon information currently available, the Company will recover its cost basis in all these securities and no additional charges for other-than-temporary impairments will be required.
At December 31, 2011 and 2010, the carrying value of all deposits with state insurance departments was $79.0 million and $70.7 million, respectively. These deposits consisted of fixed maturity investments, certificates of deposit and money market funds.
The Company has a $50.0 million unsecured Credit Agreement (the “Credit Agreement”) that terminates in December 2012, which includes a sublimit of $10.0 million for letters of credit. The Company has the ability to increase the line of credit to $75.0 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 the Company’s A.M. Best insurance group rating, or 0.65% at December 31, 2011. Commitment fees on the average daily unused portion of the Credit Agreement also vary with the Company’s A.M. Best insurance group rating and range from 0.090% to 0.175%, or 0.125% at December 31, 2011.
The Company expects to successfully procure a new line of credit during 2012 to replace the current Credit Agreement prior to its expiration, although potentially at a higher cost. Due to the favorable terms of the Credit Agreement relative to those currently available in the commercial lending marketplace, the Company does not anticipate executing a new credit facility until the latter half of 2012.
Federal income taxes paid, net of refunds, for 2011, 2010 and 2009 were $28.6 million, $17.0 million and $20.1 million. At December 31, 2011 and 2010, income taxes payable were $0.8 million and $8.7 million, respectively.
Management has reviewed the recoverability of the deferred tax assets and believes that it is more likely than not that the amount will be recoverable.
The Company files income tax returns in the U.S. federal jurisdiction and various state and U.S. territory jurisdictions. With limited exceptions, the Company is no longer subject to U.S. federal or state income tax examination for years before 2008.
The Company grants options and other stock awards to officers and key employees of the Company under the LTIP. At December 31, 2011, there were 746,221 of the Company’s common shares reserved for issuance under the LTIP and options for 601,085 shares were outstanding. In March 2010, the Company granted a restricted share award and a stock bonus award under the LTIP. Treasury shares are used to fulfill the options exercised and other awards granted. Options and restricted shares vest pursuant to the terms of a written grant agreement. Options must be exercised no later than the tenth anniversary of the date of grant. As set forth in the LTIP, the Compensation Committee of the Board of Directors may accelerate vesting and exercisability of options.
At December 31, 2011 and 2010, the aggregate intrinsic value of options outstanding were $3.1 million and $1.7 million, respectively. At December 31, 2009 the options outstanding had no aggregate intrinsic value. The aggregate intrinsic value of all options that were exercisable at December 31, 2011, 2010 and 2009 was $2.7 million, $1.9 million and $0.6 million, respectively. The intrinsic value of options exercised was $0.3 million for both the years ended December 31, 2011 and 2010. There were no options exercised in 2009. The total fair value of shares vested during the year ended December 31, 2011, 2010, and 2009 was $0.8 million, $1.0 million and $0.9 million, respectively.
For the year ended December 31, 2011, 2010 and 2009, there were 247,152, 274,315 and 498,050 respectively, outstanding options and restricted shares excluded from dilutive earnings because they were anti-dilutive.
is a party to an underwriting management agreement with Great American. As of December 31, 2011, Great American owned 52.4% 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 underwritten pursuant to the reinsurance agreement. NIIA provides administrative services to Great American in connection with Great American’s underwriting of these risks. The Company also cedes premium through reinsurance agreements with Great American to reduce exposure in certain of its property and casualty insurance programs.
Great American or its parent, American Financial Group, Inc., perform 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 the Company. This could impact the Company’s personnel resources, require the Company to hire additional professional staff and generally increase the Company’s 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.
The foregoing reconciliation shows decreases of $2.7 million, $9.6 million and $1.3 million in the years ended December 31, 2011, 2010 and 2009, respectively, representing favorable development in claims incurred in years prior to 2011, 2010 and 2009, respectively. The favorable development in these three years resulted from the combination of settling cases and adjusting current estimates of case and incurred but not reported (“IBNR”) losses for amounts less than the case and IBNR reserves carried at the end of the prior year for most of the Company’s lines of business. In 2011, the Company also recorded favorable reserve development on the Vanliner reserves acquired in 2010. As discussed in Note 3 - “Acquisition of Vanliner Group, Inc.,” this favorable development is subject to a balance sheet guaranty. Accordingly, an offsetting charge to loss and LAE expense was recorded in the Consolidated Statement of Income to record the $9.8 million development as a payable to the guarantor. Partially offsetting the $9.8 million reduction in reserves, as well as the associated payable to the guarantor, are approximately $6 million of additional unpaid losses and LAE expenses which are included in “Provision for unpaid losses and LAE for claims net of reinsurance” in the table above. The reserves related to such loss and LAE expenses are also contractually guaranteed. Management of the Company evaluates case and IBNR reserves based on data from a variety of sources including the Company’s historical experience, knowledge of various factors and industry data extrapolated from other insurers writing similar lines of business.
(a) Includes the statutory surplus of VIC for 2011 and 2010 only, as the Company’s acquisition of VIC was effective on July 1, 2010.
(c) No statutory net income is shown for VIC in 2009 due to the Company’s acquisition of VIC, effective on July 1, 2010. The 2010 statutory net income of VIC represents the income for the entire statutory annual period. The Company’s consolidated net income for 2010, on a GAAP basis, includes the earnings of VIC from the July 1, 2010. See Note 3 - “Acquisition of Vanliner Group, Inc.” for additional information.
The Company and its subsidiaries are subject at times to various claims, lawsuits and legal proceedings arising in the ordinary course of business. All legal actions relating to claims made under insurance policies are considered in the establishment of the Company’s LAE reserves. In addition, regulatory bodies, such as state insurance departments, the SEC, the Department of Labor and other regulatory bodies may make inquiries and conduct examinations or investigations concerning the Company’s compliance with insurance laws, securities laws, labor laws and the Employee Retirement Income Security Act of 1974, as amended.