We also lease an aggregate of approximately 20,000 square feet of office space in Phoenix, Arizona, which we first occupied in September 2003. Our lease of this space has an initial term that expires in 2009.
The following table sets forth selected consolidated financial information for the periods ended and as of the dates indicated. The selected data presented below under the captions “Operating Data” and “Balance Sheet Data” for, and as of the end of, each of the periods in the five-year period ended December 31, 2004 are derived from our consolidated financial statements, which financial statements have been audited by KPMG LLP, an independent registered public accounting firm. The consolidated financial statements as of December 31, 2004 and 2003 and for each of the periods in the three-year period ended December 31, 2004, and the report thereon, are included elsewhere in this report. The KPMG report states that we adopted the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangibles” in 2002. These historical results are not necessarily indicative of results to be expected from any future period. You should read this selected consolidated financial information together with our consolidated financial statements and related notes and the section of this report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Immediately prior to the completion of the IPO, the common shares of Evergreen National Indemnity Company (“Evergreen”) and its wholly owned subsidiary, Continental Heritage Insurance Company (“Continental”) were distributed as dividends from Century to ProCentury and then by ProCentury to ProCentury’s existing Class A shareholders. Prior to the dividends, Evergreen was a controlled subsidiary of Century. The operations of Evergreen and Continental consisted of ProCentury’s historical surety and assumed workers’ compensation lines of insurance, which were re-classified (net of minority interest and income taxes) as discontinued operations in the above selected consolidated financial data.
Gross written premiums less the portion of such premiums ceded to (reinsured by) other insurers during a specific period of time.
The ratio of net written premiums to our insurance subsidiaries’ combined statutory surplus. Management believes this measure is useful in gauging our exposure to pricing errors in our current book of business. It may not be comparable to the definition of net writings ratio used by other companies. For periods prior to 2004, this ratio includes discontinued operations, as the insurance subsidiaries’ combined statutory surplus is not allocated by line of business. Therefore, in computing the ratio of net written premiums to our insurance subsidiaries’ combined statutory surplus we do not restate the net written premium for discontinued operations to be consistent with that of the subsidiaries’ combined statutory surplus.
Return on average equity consists of the ratio of net income (loss) to the average of the beginning of period and end of period total shareholders’ equity. For 2004, return on average equity consists of the ratio of net income (loss) to the average equity, which is based on the average of the beginning of period and the end of each quarters’ total shareholders’ equity.
Gross Written Premiums. Gross written premiums is the sum of direct written premiums and assumed written premiums. We use gross written premiums, which excludes the impact of premiums ceded to reinsurers, as a measure of the underlying growth of our insurance business from period to period.
Loss Ratio. Loss ratio is the ratio (expressed as a percentage) of losses and loss expenses incurred to premiums earned. Loss ratio generally is measured on both a gross (direct and assumed) and net (gross less ceded) basis. We use the gross loss ratio as a measure of the overall underwriting profitability of the insurance business we write and to assess the adequacy of our pricing. Our net loss ratio is meaningful in evaluating our financial results, which are net of ceded reinsurance, as reflected in our consolidated financial statements.
For other fixed-maturity and equity securities, an other-than-temporary impairment charge is taken when the Company does not have the ability and intent to hold the security until the forecasted recovery or if it is no longer probable that the Company will recover all amounts due under the contractual terms of the security. Many criteria are considered during this process including, but not limited to, the current fair value as compared to amortized cost or cost, as appropriate, of the security; the amount and length of time a security’s fair value has been below amortized cost or cost; specific credit issues and financial prospects related to the issuer; the Company’s intent to hold or dispose of the security; and current economic conditions. Other-than-
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002. Net income decreased to $314,000 for the year ended December 31, 2003, compared to net income of $6.1 million for the same period in 2002. The decrease in net income was primarily attributable to the re-estimation of prior accident years’ loss and loss expense reserves that negatively impacted our pre-tax results by $27.0 million in 2003 compared to $16.8 million in 2002. This decrease was largely offset by improved underwriting results from decreasing
We have historically relied on quota share, excess of loss, and catastrophe reinsurance primarily to manage our regulatory capital requirements and also to limit our exposure to loss. Generally, we have ceded a significant portion of our premiums to unaffiliated reinsurers in order to maintain a net written premiums to statutory surplus ratio of less than 2-to-1.
Our property/casualty segment primarily includes general liability, commercial property and multi-peril insurance for small and mid-sized businesses. The other (including exited lines) segment primarily includes our surety business, including landfill and specialty surety that is written in order to maintain Century’s U.S. Treasury listing, workers’ compensation, which was exited in January 2002, and commercial auto, which was exited in May 2000.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Gross written premiums increased $41.7 million or 27.9% for the year ended December 31, 2004 compared to the same period in 2003. This increase was due primarily to increased business in our property/casualty segment which increased $39.7 million or 26.3%. The growth in the property/casualty segment resulted principally from an increase in volume in our casualty lines of business of $39.3 million or 46.9%. Our property lines of business remained constant at $67.5 million in 2004 compared to $67.2 million in 2003 due to a rate plateau followed by a moderate decline that continued throughout much of the year. For casualty business, rates slightly increased throughout 2003 and stabilized in 2004.
In addition, gross written premium for the other (including exited lines) segment was $814,000 for 2004, which represents surety premium amounts directly written and assumed by us and then ceded under a 100% quota share agreement with Evergreen. The 2002 and 2003 amounts for the surety were reclassified as discontinued operations as a result of the disposition of Evergreen in 2004.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002. Gross written premiums increased $49.2 million or 48.9% for the year ended December 31, 2003 compared to the same period in 2002. This increase was due primarily to increased market penetration in our property/casualty segments, which was slightly offset by amounts representing returned premiums for our other (including exited lines) segment. During the year ended December 31, 2003, gross written premiums for our property/casualty segment increased $52.6 million or 53.5% due to continued favorable market conditions that have allowed us to increase our premium volume and prices for the third consecutive year. The decrease in written premiums for the other (including exited lines) segment represents returned premium primarily on the workers’ compensation line that we exited in January 2002.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. We realized net gains of $50,000 on the sale of securities for the year ended December 31, 2004 and $1.9 million for the same period in 2003. These gains included a realized loss of $87,000 attributable to adjustments for other-than-temporary impairment of securities for the year ended December 31, 2003 and no impairment losses in 2004.
changes in the legal environment relating to coverage interpretation, theories of liability and jury determinations; and
We performed our first internal actuarial analysis as of September 30, 2003. Since then, we have performed this analysis quarterly. We establish or adjust (for prior accident quarters) our best estimate of the ultimate incurred losses and loss expenses to reflect loss development information and trends that have been updated for the most recent quarter’s activity. As of December 31 of each year, we have an independent actuarial analysis performed of the adequacy of our reserves. Our estimate of ultimate loss and loss expenses is evaluated and re-evaluated by accident year and by major coverage grouping and changes in estimates are reflected in the period the additional information becomes known.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Net loss and loss expenses increased to $89.1 million for the year ended December 31, 2004 from $81.0 million for the same period in 2003, as a result of the factors discussed below. Net loss and loss expense ratios for the year ended December 31, 2004 and 2003 were 59.9% and 74.8%, respectively.
Our reserve for losses and loss expenses (net of the effects of reinsurance) at December 31, 2004 by line was as follows:
Casualty. Our change in reserve estimate related to prior accident years for the year ended December 31, 2004 for the casualty lines was $12.8 million. A significant portion of our casualty reserves relates to construction defect claims in certain states. Starting with California in December 2000, we began to exit contractors’ liability business. By the end of the first quarter of 2001, we had significantly reduced our contractors’ liability underwriting in all states, and completely eliminated construction contractors’ liability underwriting in Arizona, California, Colorado, Hawaii, Louisiana, Nevada, New Jersey, North Carolina, Oregon, South Carolina and Washington. Reserves and claim frequency on this business may also be negatively impacted by legislation recently implemented in California, which generally provides consumers who experience construction defects a method other than litigation to obtain construction defect repairs. In addition, a 2001 California court decision expanded insurers’ duty to defend certain additional insureds under subcontractors’ policies, producing an industry-wide increase in the number of newly reported construction defect claims filed during 2002 and 2003. The recent legislation and court decisions referenced above are believed to have had an impact on the number of claims reported as well as the cost of settling claims; however, their impact cannot be measured directly. These changes in the legal environment are reflected in our reserves to the extent that the changes have impacted the number and cost of claims received to date. It is important to note that changes in the number and cost of claims due to these or other changes in the legal environment could cause our ultimate liability to exceed or be less than current estimates.
2004. The increase in ultimate claim count projections and strengthening of claims pending as of December 31, 2003 accounted for $8.3 million of adverse development incurred during 2004.
During 2003, the Company’s newly reported construction defect claims were 118.8% greater than expected as of December 31, 2002. Based on the Company’s experience during 2003 and industry information, the Company substantially increased its projected ultimate construction defect claim count as of December 31, 2003. The increase in ultimate claim count projections and strengthening of claims pending as of December 31, 2002 accounted for $13.4 million of adverse development incurred during 2003.
During 2002, the Company’s newly reported construction defect claims and severities were greater than expected as of December 31, 2001. The increase in ultimate claim count projections and strengthening of claims pending as of December 31, 2001 accounted for $10.4 million of adverse development incurred during 2002.
Although many factors influence the actual cost of claims and our corresponding reserve estimates, we do not measure and estimate values for all of these variables individually. This is due to the fact that many of the factors that are known to impact the cost of claims cannot be measured directly, such as the impact on claim costs due to economic inflation, coverage interpretations and jury determinations. In most instances, we rely on our historical experience or industry information to estimate values for the variables that are explicitly used in our reserve analyses. We assume that the historical effect of these unmeasured factors, which is embedded in our experience or industry experience, is representative of future effects of these factors. Where we have reason to expect a change in the effect of one of these factors, we perform analysis to quantify the necessary adjustments.
For claim liabilities other than construction defect, our internal actuaries apply multiple traditional actuarial techniques to compute loss and loss expense reserve estimates. Each technique produces a unique loss and loss expense reserve estimate for the line being analyzed. The set of techniques applied produces a range of loss and loss expense reserve estimates. From these estimates, the actuaries form a best estimate which considers the assumptions and factors that influence ultimate claim costs, including but not limited to those identified above. As of December 31, 2004, for casualty lines, excluding construction defect claims, the low end of the actuarial range was 12.7% below the actuarial best estimate, and the high end of the actuarial range was 6.2% above the actuarial best estimate. These low and high loss and loss expense reserve estimates reflect the fact that the methodologies applied do not produce identical estimates, and these estimates do not constitute the range of all possible outcomes. It is important to note that actual claim costs will vary from the selected estimate, perhaps by substantial amounts, due to the inherent variability of the business written, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated at this time.
Property. Our change in reserve estimates for the years ended December 31, 2004, 2003 and 2002 for the property lines resulted in a decrease in incurred losses and loss expenses of $3.2 million for 2004, an increase in incurred losses of $2.3 million for 2003, of which $1.9 million related to the 2002 accident year and $433,000 related to the 2001 accident year and a decrease in reserve estimates of $22,000 for 2002. During 2004, we experienced negative case incurred development on the 2003 accident year. As a result of the 2003 experience, we decreased the loss development factors and initial expected loss ratios used in the December 31, 2003 actuarial loss reserve analysis. During 2003, we experienced significant development on claims pending as of December 31, 2002, most of which was attributable to twelve large claims. This resulted in incurred loss development during 2003 in excess of the levels anticipated as of December 31, 2002. As a result of the 2003 experience, we increased the loss development factors and initial expected loss ratios used in the December 31, 2003 actuarial loss reserve analysis.
As of December 31, 2003, the projected loss and loss expense ratios, after the effects of reinsurance, for the property lines were 58.8%, 50.3% and 57.2% for accident periods 2004, 2003 and 2002, respectively.
At December 31, 2004, all of our net loss and loss expense reserves related to commercial automobile was for case reserves. At December 31, 2003, 0.6% of our commercial automobile net loss and loss expense reserves was for IBNR and 99.4% was for case reserves. As of December 31, 2004, we had 38 open claims relating to commercial automobile, compared to 63 open claims as of December 31, 2003. During 2004, 8 new claims were reported and 33 existing claims were settled or dismissed. Our net loss and loss expense reserves for commercial automobile as of December 31, 2004 were $1.8 million.
Of our net loss and loss expense reserves at December 31, 2003, 0.6% related to commercial automobile IBNR and 1.9% of our net loss and loss expense reserves at December 31, 2002 was for commercial automobile IBNR. As of December 31, 2003, we had 63 open claims relating to commercial automobile compared to 127 open claims as of December 31, 2002. During 2003, 15 new claims were reported and 79 existing claims were settled or dismissed. Our net loss and loss expense reserves for commercial automobile as of December 31, 2003 were $3.5 million.
Of our net loss and loss expense reserves at December 31, 2003, 2.3% related to workers’ compensation IBNR, and 3.4% of our net loss and loss expense reserves at December 31, 2002 were for workers’ compensation IBNR. As of December 31, 2003, we had 414 open claims relating to workers’ compensation compared to 764 open claims as of December 31, 2002. During the year ended 2003, 28 new claims were
Interest expense and interest expense on the redemption of Class B shares are not included in the calculation of the expense ratio.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Operating expenses increased $10.9 million, or 28.2%, to $49.4 million in 2004 from $38.5 million for the same period in 2003. The increase was primarily attributable to a $8.6 million increase in amortized deferred policy acquisition costs, including commission expenses, associated with the increase in the volume of insurance written, and other increases to support future growth. For the year ended December 31, 2004, the increase is offset by $655,000 of reductions to amortization expense that related to the termination of the intercompany pooling agreement and the implementation of the loss portfolio transfers that occurred on January 1, 2004.
Other operating expenses increased to $13.5 million in 2004 compared to $11.8 million for the same period in 2003. This increase is a direct result of the current year growth in overall business. The lower expense ratio in 2004 is due to an increase in operational efficiencies achieved through a focus on expense management. In addition, the year ended December 31, 2004 balance includes $250,000 of expenses related to a non-recurring severance agreement and $105,000 of expenses related to the IPO that could not be capitalized.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002. Operating expenses increased $13.7 million, or 55.2%, to $38.5 million in 2003 from $24.8 million for the same period in 2002. The increase was primarily attributable to a $9.8 million increase in amortized deferred policy acquisition costs, including commission expenses, associated with the increase in the volume of insurance written, an increase in overhead due to the implementation of human resource, legal and internal audit departments, a $919,000
expense for a reserve guarantee to the minority shareholders of Evergreen related to the current year re-estimation of prior year losses, and other increases to support future growth. In addition, interest expense increased due to the $15.0 million trust preferred security that we issued in December 2002 and the $10.0 million additional trust preferred security that we issued in May 2003. The overall decline in the expense ratio was due to an increase in premiums without a corresponding increase in our fixed expenditures.
Century is restricted by statute as to the amount of dividends it may pay without the prior approval of regulatory authorities. Century may pay dividends to ProCentury without advance regulatory approval only from unassigned surplus and only to the extent that all dividends in the current twelve months do not exceed the greater of 10% of total statutory surplus as of the end of the prior fiscal year or statutory net income for the prior year. Using these criteria, the available ordinary dividend payable by Century to ProCentury for 2005 is $13.8 million. Century paid ordinary dividends of $6.0 million in 2004, $3.0 million in 2003 and $1.8 million in 2002. In addition, Century paid $3.1 million of extraordinary dividend in 2004 related to the dividend distribution of Evergreen. Century’s ability to pay future dividends to ProCentury without advance regulatory approval is dependent upon maintaining a positive level of unassigned surplus, which in turn, is dependent upon Century generating net income in excess of dividends to ProCentury.
Year ended December 31, 2004 compared to Year ended December 31, 2003
Consolidated net cash provided by operating activities was $80.4 million for the year ended December 31, 2004, compared to $34.4 million for the year ended December 31, 2003. This improvement was primarily attributable to the increase in our total premium and investment income growth and payments received from Evergreen and Continental related to the settlement of the termination of the intercompany pooling agreement and the loss portfolio transfers during 2004.
The following table summarizes information about contractual obligations and commercial commitments. The minimum payments under these agreements as of December 31, 2004 were as follows:
Amounts include interest payments associated with these obligations using applicable interest rates as of December 31, 2004.
In connection with the adoption of FIN 46R, ProCentury has deconsolidated the trusts established in connection with the issuance of trust preferred securities effective December 31, 2003. As a result, ProCentury reports as a component of long term debt the junior subordinated debentures payable by ProCentury to the trusts. See Note 8(b) to our consolidated financial statements.
Continental Option Agreement. In 2001, Century entered into an option agreement with our bail bond agents. Subject to the terms of the option agreement, the agents had a right to acquire 100% of the issued and outstanding common shares of Continental at statutory book value on the date exercised. The option expired on December 31, 2003.
Our investment strategy is designed to capitalize on our ability to generate positive cash flow from our underwriting activities. Preservation of capital is our first priority, with a secondary focus on maximizing appropriate risk-adjusted return. We seek to maintain sufficient liquidity from operations, investing and financing activities to meet our anticipated insurance obligations and operating and capital expenditure needs. The majority of our fixed-maturity portfolio is rated investment grade to protect investments. Our investment portfolio is managed by two outside independent investment managers that operate under investment guidelines approved by Century’s investment committee. Century’s investment committee meets at least quarterly and reports to Century’s board of directors. In addition, we employ stringent diversification rules and balance our investment credit risk and related underwriting risks to minimize total potential exposure to any one security. In limited circumstances, we will invest in non-investment grade fixed maturity securities that have an appropriate risk-adjusted return, subject to satisfactory credit analysis performed by us and our
investment managers. Our cash and investment portfolio totaled $312.4 million as of December 31, 2004 and is summarized by type of investment as follows:
At December 31, 2004, we had 40 fixed maturity and equity securities that have been in an unrealized loss position for one year or longer. Thirty-eight of these securities are investment grade, of which 35 are rated A1/ A or better (including 23 securities which are rated AAA). The three remaining investment grade securities are rated BBB and have a fair value equal to 99.6% of their book value as of December 31, 2004. The two equity securities are not investment grade and had a fair value equal to 97.0% of their book value as of December 31, 2004. All 40 securities are current on interest and principal. Management believes the declines are temporary and are not indicative of other-than-temporary impairments.
investing, with security selection taking precedence over market timing. We also employ stringent diversification rules that limit our exposure to any individual stock.
Interest Rate Risk. We had fixed-maturity, preferred shares and bond mutual fund investments with a fair value of $298.7 million at December 31, 2004 that are subject to interest rate risk. We manage our exposure to interest rate risk through a disciplined asset/liability matching and capital management process. In the management of this risk, the characteristics of duration, credit and variability of cash flows are critical elements. These risks are assessed regularly and balanced within the context of our liability and capital position.
The table below summarizes our interest rate risk. It illustrates the sensitivity of the fair value of fixed-maturity, preferred share and bond mutual fund investments to selected hypothetical changes in interest rates at December 31, 2004. The selected scenarios are not predictions of future events, but rather illustrate the effect that such events may have on the fair value of the fixed-maturity, preferred share and bond mutual fund portfolio and shareholders’ equity.
In May 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“SFAS 150”). SFAS 150 establishes standards for the classification and measurement of certain freestanding financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. Further, SFAS 150 requires disclosure regarding the terms of those instruments and settlement alternatives. As originally issued, the guidance in SFAS 150 was generally effective for financial instruments entered into or modified after May 31, 2003, and otherwise effective at the beginning of the first interim period beginning
In January 2003, FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities - an interpretation of ARB No. 51 (“FIN 46”). Accounting Research Bulletin No. 51 (“ARB 51”), Consolidated Financial Statements, states that consolidation is usually necessary when a company has a “controlling financial interest” in another company, a condition most commonly achieved via ownership of a majority voting interest. FIN 46 clarifies the application of ARB 51 to certain “variable interest entities” (“VIE”) where the equity investors (1) are not empowered to make sufficient decisions about the entity’s operations, or do not receive expected returns or absorb expected losses commensurate with their equity ownership; or (2) do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. VIEs are consolidated by their primary beneficiary, which is the party having a majority of the entity’s expected losses, expected residual returns, or both. A company holding a significant variable interest in a VIE, but not deemed the primary beneficiary, is subject to certain disclosure requirements specified by FIN 46. FIN 46 applies to entities formed after January 31, 2003 and to VIEs in which an enterprise obtains an interest after that date. In October 2003, FASB delayed the implementation date of FIN 46 for VIEs acquired prior to January 31, 2003 to interim periods ending after December 15, 2003, with earlier adoption permitted.
FIN 46 may be applied on a prospective basis with a cumulative-effect adjustment made as of the date of initial application or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. In December 2003, FASB issued Interpretation No. 46 (revised December 2003) Consolidation of Variable Interest Entities - an interpretation of ARB No. 51(“FIN 46R”), which required all public companies to apply the provisions of FIN 46 or FIN 46R to special purpose entities created prior to February 1, 2003. Once adopted by an entity, FIN 46R replaces FIN 46. Public companies, including the Company, at a minimum, must apply the unmodified provisions of FIN 46 to entities that were considered “special-purpose entities” in practice and under applicable FASB pronouncements or guidance by the end of the first reporting period ending after December 15, 2003. Companies may apply either FIN 46 or FIN 46R to special-purpose entities at the initial effective date on an entity-by-entity basis. We have early adopted FIN 46R in its entirety as of December 31, 2003.
The special purpose entities where we are the primary beneficiary are the trusts that were established in connection with the issuance of mandatorily redeemable preferred securities. As a result of the adoption of FIN 46R, we have deconsolidated these trusts as of December 31, 2003 in the accompanying 2003 consolidated balance sheet. This resulted in our classifying the trust preferred securities as long term debt and recording an increase of $733,000 in other assets and long term debt, both of which were previously eliminated when consolidating the trust. In accordance with FIN 46R transition guidance, prior periods, were not restated. There was no other impact to our consolidated financial statements as a result of the adoption of FIN 46R.
In November 2002, FASB issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others - an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34 (“FIN 45”). FIN 45 requires a guarantor to provide more detailed interim and annual financial statement disclosures about obligations under certain guarantees it has issued. It also requires a guarantor to recognize, at the inception of new guarantees issued or modified after December 31, 2002, a liability for the fair value of the obligation undertaken in issuing the guarantee. Although superseded by FIN 45, the guidance provided in FASB Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others has been incorporated into FIN 45 without change. Our adoption of FIN 45 on January 1, 2003 did not have an impact on our financial position or results of operations.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2004, 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 consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
Immediately prior to the completion of the IPO, the common shares of Evergreen were distributed as dividends from Century to ProCentury and then by ProCentury to ProCentury’s existing Class A shareholders;
The Company granted 101,200 restricted common shares and 364,000 stock options to certain employees of ProCentury;
The Company redeemed all of its outstanding Class B common shares for an aggregate redemption price of $5.0 million and recorded interest expense of $518,000 in connection with the redemption; and
In addition, on August 5, 2004 the Company issued 54,800 of additional restricted common shares to certain employees of Pro-Century.
Credit Risk is the risk that issuers of securities owned by the Company will default or other parties, including reinsurers that owe the Company money, will not pay. The Company minimizes this risk by adhering to a conservative investment strategy and by maintaining reinsurance and credit and collection policies.
Significant Business Concentrations: As of December 31, 2004, the Company did not have a material concentration of financial instruments in a single investee or geographic location. Also, the Company did not have a concentration of business transactions with a particular distribution source, a market or geographic area in which business is conducted that makes it overly vulnerable to a single event which
Reinsurance: The Company has entered into reinsurance contracts to cede a portion of its business. Total amounts recoverable under these reinsurance contracts include ceded reserves, paid and unpaid claims, and certain other amounts, which totaled $40.4 million as of December 31, 2004. The ceding of risk does not discharge the original insurer from its primary obligation to the contract holder. The Company is selective in its choice of reinsurers and considers numerous factors, the most important of which are the financial stability of the reinsurer, its history of responding to claims and its overall reputation. In an effort to minimize the Company’s exposure to the insolvency of its reinsurers, the Company evaluates the acceptability and reviews the financial condition of each reinsurer annually. The Company’s policy is to use only those reinsurers that have an A.M. Best rating of “A-” (excellent) or better and that have at least $500 million in policyholders’ surplus, or Lloyds of London syndicates that have an A.M. Best rating of “A-” (excellent) or better. See Note 5.
In preparing the consolidated financial statements, management is required to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements, and the reported amounts of revenue and expenses for the reporting period. Actual results could differ significantly from those estimates.
Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of loss and loss expense reserves, the recoverability of deferred policy acquisition costs, the determination of federal income taxes, the net realizable value of reinsurance recoverables, and the determination of other-than-temporary declines in the fair value of investments. Although considerable variability is inherent in these estimates, management believes that the amounts provided are reasonable. These estimates are continually reviewed and adjusted as necessary. Such adjustments are generally reflected in current operations.
Realized gains or losses represent the difference between the book value of securities sold and the proceeds realized upon sale, and are recorded on the trade date. The Company uses the specific identification method to determine the cost of securities sold.
For other fixed-maturity and equity securities, an other-than-temporary impairment charge is taken when the Company does not have the ability and intent to hold the security until the forecasted recovery or if it is no longer probable that the Company will recover all amounts due under the contractual terms of the security. Many criteria are considered during this process including, but not limited to, the current fair value as compared to amortized cost or cost, as appropriate, of the security; the amount and length of time a security’s fair value has been below amortized cost or cost; specific credit issues and financial prospects related to the issuer; the Company’s intent to hold or dispose of the security; and current economic conditions.
Prior to May 2003, gains or losses resulting from the sale or issuance of a consolidated subsidiary’s stock are included in the consolidated statements of operations. Beginning in May 2003, such gains or losses are excluded from earnings and are reported within shareholders’ equity. See Note 3.
Loss and loss expense reserves represent an estimate of the expected cost of the ultimate settlement and administration of losses, based on facts and circumstances then known. The Company uses actuarial methodologies to assist in establishing these estimates, including judgments relative to estimates of future claims severity and frequency, length of time to develop to ultimate resolution, judicial theories of liability and other third-party factors that are often beyond our control. Due to the inherent uncertainty associated with the cost of unsettled and unreported claims, the ultimate liability may be different from the original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current period’s results. The loss and loss expense reserves are not discounted.
expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses and certain other costs expected to be incurred as the premium is earned. Judgments as to ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the written premiums. The amounts that are not considered realizable are charged as an expense through amortization of deferred policy acquisition costs.
Reinsurance recoverables are determined based in part on the terms and conditions of reinsurance contracts. Reinsurance recoverables on paid and unpaid losses, net, are established for the portion of our loss and loss expense reserves that are ceded to reinsurers and are reported separately as assets, net of any valuation allowance. Reinsurance recoverables on paid and unpaid losses are accounted for and reported separately as assets, net of any valuation allowance, while ceded premiums payable are reported separately as liabilities. Reinsurance premiums paid and reinsurance recoveries on claims incurred are deducted from the respective revenue and expense accounts. The estimated valuation allowance on reinsurance recoverables on paid and unpaid losses at December 31, 2004 and 2003 was $1.3 million and $1.4 million, respectively.
On October 5, 2000, ProCentury acquired 100% of the outstanding shares of Century and PIA for $30.5 million. The acquisition was accounted for using the purchase method of accounting. The total purchase price of the acquisition was allocated to the assets acquired and liabilities assumed based upon the respective fair values as of the date of acquisition. The excess of the fair value of net identifiable assets acquired over the purchase price, after reducing noncurrent and nontangible assets, was $514,000, which was recorded as negative goodwill. This negative goodwill is a combination of $1.5 million of tax deductible goodwill that was recognized with the purchase of PIA and $2.0 million of unallocated negative goodwill related to the reorganization that occurred on October 5, 2000.
Negative goodwill is the excess of the fair value of the net assets over the price paid to acquire a company, reduced by accretion and any subsequent valuation adjustments. Negative goodwill is accreted on a straight-line basis over the expected periods to be benefited, which is generally 5 years. The accumulated accretion of goodwill was $128,000 at December 31, 2001.
The Company provides for federal income taxes based on amounts the Company believes it ultimately will owe. Inherent in the provision for federal income taxes are estimates regarding the deductibility of certain items and the realization of certain tax credits. In the event the ultimate deductibility of certain items differs from estimates, the Company may be required to significantly change the provision for federal income taxes recorded in the consolidated financial statements. Any such change could significantly affect the amounts reported in the consolidated statements of income.
Basic net income per share excludes dilution and is calculated by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the dilution that could occur if securities or other contracts to issue common shares (common share equivalents) were exercised. When inclusion of common share equivalents increases the
Pursuant to disclosure requirements contained in SFAS No. 128, Earnings per Share, the following information represents a reconciliation of the numerator and denominator of the basic and diluted EPS computations contained in the Company’s consolidated condensed financial statements.
If the Company recorded compensation expense for its share option grants based on the “fair value method,” the Company’s net income (loss) and earnings (loss) per share would have been adjusted to the pro forma amounts as indicated in the following table:
In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123R), which replaces SFAS 123 and supersedes APB 25. SFAS 123R requires companies to expense at fair value all costs resulting from share-based payment transactions, except for equity instruments held by employee share ownership plans. SFAS 123R also amended SFAS No. 95,
Statement of Cash Flows, to require excess tax benefits to be reported as a financing cash inflow rather than as a reduction of taxes paid. SFAS 123R is effective for the Company as of the beginning of the first period that begins after June 15, 2005. As permitted by SFAS 123R, the Company will adopt the Statement effective July 1, 2005 using the modified prospective method. The Company expects to report stock compensation expense of approximately $482,000, net of tax, in the second half of 2005 due to the adoption of SFAS 123R.
Certain 2003 and 2002 amounts have been reclassified in order to conform to the 2004 presentation.
The Company had no held-to-maturity securities with an unrealized loss at December 31, 2004. At December 31, 2004, the Company had 40 fixed maturity and equity securities that have been in an unrealized loss position for one year or longer. Thirty-eight of these securities are investment grade, of which 35 of these securities are rated A1/ A or better (including 23 securities which are rated AAA). The three remaining investment grade securities are rated BBB and have a fair value equal to 99.6% of their book value as of December 31, 2004. The two equity securities are not investment grade and had a fair value equal to 97.0% of their book value as of December 31, 2004. All 40 securities are current on interest and principal. Management believes the declines are temporary and are not indicative of other-than-temporary impairments.
All investments in fixed-maturity securities were income producing during 2004, 2003 and 2002. Net realized investment gains, including other-than-temporary impairments, were as follows:
The Class C shareholders are entitled to receive (on a pro rata basis) the lesser of the amount of liquation proceeds (net of the first distribution as defined in (a) above) or $5 million per Class C share plus 5% per annum simple interest thereon between the date of issuance of such Class C share and the date of the liquidation event.
Any liquidation proceeds remaining after the previous distributions are distributed to the Class A and B and C shareholders on a pro rata basis.
In April 2002, Century sold 599 Class A shares and 4,177 Class B shares of Evergreen for net proceeds of $5.0 million to a nonvoting shareholder of ProCentury. Simultaneously, Evergreen issued to the nonvoting shareholder of ProCentury 1 Class C share for net proceeds of $5.0 million. In December 2002, Century sold 599 Class A shares and 4,177 Class B shares of Evergreen for net proceeds of $5.0 million. Simultaneously, Evergreen issued to the acquirer of the shares 1 Class C share for net proceeds of $5.0 million. These transactions resulted in a pretax gain of $10,109,329, which is included, net of transaction fees of $450,000, in the accompanying 2002 consolidated statement of operations.
shares for net proceeds of $2.8 million. Simultaneously, Evergreen issued to the acquirer .5 Class C share for net proceeds of $2.5 million. These transactions resulted in a pretax gain of $625,000 ($406,250 after tax gain), which is included as additional paid in capital in the accompanying 2003 consolidated balance sheet. In addition, transaction fees related to these sales of $600,000 are recorded in the 2003 consolidated statement of operations. The remaining interest in Evergreen was distributed as a dividend to existing shareholders in 2004.
We began writing commercial automobile coverage for vehicles and light trucks in 1997. The initial estimates for 1998 and 1999 were based on a relatively low level of claims reported to the Company. As of December 31, 1999, the Company’s expectations of claim reporting patterns were based on industry experience, since limited company experience was available. In the second quarter of 2000, the Company exited the commercial automobile line of business due to unsatisfactory underwriting results. In 2002, the Company increased the estimates by approximately $263,000. In 2003, the Company received 15 new claim counts and an increase in claims severity that was above expectation which caused an additional $1.4 million increase in estimates related to the commercial automobile line. In 2004, the Company again experienced an increase in severity above expectations that caused an additional $789,000 increase in estimates related to the commercial automobile line.
We offered workers’ compensation coverage from 1997 through January 2002. In December of 2001, the Company announced that this line of business was being exited due to unsatisfactory underwriting results and the lack of availability of acceptable reinsurance. The Company’s change in reserve estimates for the workers’ compensation line for 2004, 2003, and 2002 was approximately $664,000, $1.2 million and $3.0 million, respectively. These reestimations were due to changes in the selected development patterns on the 2000 to 2002 accident years, as the number of claims, claim severity and the cost to settle the claims were above expectation.
In addition, in 2004, the Company experienced negative case incurred development on the property line which caused favorable changes to the selected development patterns that resulted in $3.3 million of favorable development.
In the ordinary course of business, Century assumes and cedes reinsurance with other insurers and reinsurers. These arrangements provide greater diversification of business and limit the maximum net loss potential on large risks. Excess of loss contracts in effect through December 31, 2004 generally protect against individual property and casualty losses over $500,000. Excess of loss contracts in effect for workers’ compensation losses protect against individual losses over $200,000. Additionally, from January 1, 2001 through June 30, 2001, and from July 1, 2001 through December 31, 2002 the first $200,000 in workers’ compensation losses were 80% and 60% ceded on a quota share basis, respectively. Catastrophe and clash coverage is also maintained. In addition, effective January 1, 2004, Century entered into a loss portfolio transfer and quota share arrangement with Evergreen and Continental whereby Century assumed all of Evergreen and Continental’s property and casualty, workers’ compensation, and commercial automobile lines of business and Evergreen assumed all of Century’s traditional surety lines of business.
The effects of assumed and ceded reinsurance on premiums written, premiums earned and loss and loss expenses incurred were as follows:
During 2001, one of Century’s reinsurers was placed into regulatory rehabilitation due to its financial impairment. In 2002, management estimated its unrecoverable outstanding ceded balances related to
this reinsurer and charged to expense $405,000. No amounts related to this reinsurer were charged to expense in 2004 or 2003.
In 1998 and 1999, the Company had both quota share and excess of loss reinsurance agreements with three reinsurance companies related to the workers’ compensation line of business. As of December 31, 2004, the Company had approximately $2.9 million of recoverables related to these reinsurance agreements, of which, $1.1 million related to the quota share agreements and $1.8 million related to the excess of loss agreements. During 2004, the Company lost binding arbitration with one of the reinsurers. This reinsurer was the only reinsurer on the quota share agreements and was a participant on the excess of loss treaties. The arbitration centered around the quota share agreements and did not fully contemplate evidence related to the excess of loss treaties. As such, the Company is pursuing further litigation on the collection of the excess of loss treaties and has fully reserved the collectibles related to the recoverable amounts on the quota share agreements. In addition, the Company has established an additional $200,000 reserve on the amounts recoverable related to the excess of loss treaties. The Company believes that it will ultimately prevail on the collection of the excess of loss recoverable amounts and are beginning to pursue collection related to the other two reinsurers. In 2003, the Company had $1.4 million reserved related to this matter.
maintained in a funds held account which accrued interest for the benefit of the reinsurer at a contracted annual rate of 6.0% and 4.5% during 2002 and 2001, respectively.
Effective January 1, 2003, the retroactive reinsurance contract was commuted. The commutation resulted in a release of ceded reserves of $13.9 million, which was primarily offset by a release of the funds held account of $11.1 million and the release of the remaining deferred retroactive reinsurance gain of $2.5 million. The net of these transactions resulted in a $285,000 pre-tax loss in 2003, which was recorded as other operating expense in the accompanying 2003 statement of operations.
interest only for the first year at 9.5%, with the first quarterly payment due April 5, 2001. Beginning October 5, 2001, principal and interest payments of $327,889 were due quarterly at a rate adjusted to the prime rate of 5.5%. In April of 2002, the terms of the note were changed from quarterly principal and interest payments to quarterly interest only payments for the April 2002 payment and the next three consecutive quarters.
On December 4, 2002, ProFinance Statutory Trust I (the “Trust”), a Connecticut statutory business trust formed by the Company, issued 15,000 floating rate capital securities (“Trust Preferred Securities”) generating gross proceeds of $15.0 million. Net proceeds were approximately $14.5 million, after deducting offering costs of $454,000. In addition, on May 15, 2003, ProFinance Statutory Trust II (the “Trust”), a Connecticut statutory business trust formed by the Company, issued 10,000 floating rate capital securities (“Trust Preferred Securities”) generating gross proceeds of $10.0 million. Net proceeds were approximately $9.7 million, after deducting offering costs of $300,000.
The Company’s special purpose entities where the Company is the primary beneficiary are the trusts that were established in connection with the issuance of mandatorily redeemable preferred securities. As a result of the adoption of FIN 46R, the Company deconsolidated these trusts as of December 31, 2003 in the accompanying 2003 consolidated balance sheet. This resulted in the Company classifying the trust preferred securities as long term debt and recording an increase of $733,000 in other assets and long term debt, both of which were previously eliminated when consolidating the trusts. In accordance with FIN 46R transition guidance, prior periods, were not restated. There was no other impact to the Company’s consolidated financial statements as a result of the adoption of FIN 46R.
On September 8, 2004, the Company obtained a $5.0 million line of credit. As of December 31, 2004, no draws have been made. Interest on the note is payable quarterly and is based on a floating rate of LIBOR plus 2.5%. The note matures on September 8, 2006. Under the terms of the line of credit, 100% of the common shares of Century are pledge as collateral.
The Company is required to establish a valuation allowance for any portion of the gross deferred federal income tax asset that management believes will not be realized. In the opinion of management, it is more likely than not that the Company will realize the benefit of the deferred federal income tax assets through deductions against future earnings and, therefore, no such valuation allowance has been established.
During 2004, the Company adopted and the shareholders’ approved a stock option plan that provided tax-favored incentive stock options (qualified options), non-qualified share options that do not qualify as tax-favored incentive share options (non-qualified options) and restricted shares to employees. The Company accounts for this plan in accordance with APB Opinion No. 25, under which no compensation cost is recognized until the shares vest.
The restricted share awards are issued as time-based awards. The time-based awards vest in equal installments upon the lapse of a period of time, typically over, four- and five-year periods and include both monthly and annual vesting periods. Compensation expense for restricted share awards is recognized over the respective vesting periods. The current year expense is not representative of the effect on net income for future years since each subsequent year will reflect expense for additional vested awards.
Century paid Evergreen-UNI (formerly an affiliate through significant shareholders of ProCentury) commissions for business produced for our surety business through an agency agreement of $12.0 million, and $7.1 million during 2003 and 2002. There were no amounts due to Evergreen-UNI at December 31, 2003. These amounts are included in discontinued operations. Effective with the IPO, Evergreen-UNI is no longer an affiliate of ProCentury.
Software Agreements. These agreements were entered into in December 2000, as amended in December 2001 and May 2002. Pursuant to these agreements, the Company’s shareholders assisted us in the marketing of certain computer software that performs website building tasks to their customers and clients. These agreements were terminated as of June 30, 2002. Pursuant to these agreements the Company paid approximately $983,000 in 2002.
Accretive Agreements. These agreements were entered into as of July 1, 2002. Pursuant to these agreements, the Company’s shareholders assisted the Company in developing financial products and services to be offered to and through the community banks. These agreements terminated on December 31, 2003. Pursuant to these agreements the Company paid approximately $241,000, $966,000 and $244,000 in 2004, 2003 and 2002, respectively.
Stonehenge Monitoring Agreement. This agreement was entered into as of July 1, 2002. In connection with its investment in the Company, the Company has paid Stonehenge Opportunity Fund, LLC a monitoring fee for the time and effort it expended in monitoring its investment in the Company, which included reviewing and evaluating the financial statements, attending meetings with management and board of directors and consulting with the Company with respect to business and prospects. This agreement was terminated on December 31, 2003. Pursuant to this agreement the Company paid approximately $85,000, $342,000 and $87,000 in 2004, 2003 and 2002, respectively.
For the years ended December 31, 2003 and 2002, the Company recorded insurance premiums (net of commissions) of $1,256,301 and $1,767,193, respectively, related to the bail bond program that is produced by Williams and Parish. With the dividend disposition of Evergreen, Williams and Parrish are no longer a related party to ProCentury.
Century is a party to various lease agreements with unrelated parties, primarily related to the lease of office space. The minimum future rental payments under these operating leases at December 31, 2004 were as follows:
Five of the Company’s 84 agents contributed, on a combined basis, approximately 44.3% of the Company’s 2004 consolidated direct and assumed premiums written. One of the Company’s agents individual contributed an amount greater than 10% of the Company’s direct and assumed premiums written and combined represented approximately 20.2% of the Company’s 2004 consolidated direct and assumed premiums written. There was no concentration of revenue with respect to geographic area as of December 31, 2004.
Century is regulated by its state of domicile, Ohio, and the states in which it does business. Such regulations, among other things, limit the payment of dividends without prior regulatory approval. ProCentury is dependent on dividends from Century for operating expenses and interest and principal on long term debt and the Debentures. The maximum dividend that may be paid without prior approval of the Director of Insurance is limited to the extent that all dividends in the past 12 months do not exceed the greater of the statutory income of the preceding calendar year or 10% of total statutory surplus as of the prior December 31. As a result, the maximum dividend Century may pay to ProCentury in 2005 without prior approval is approximately $13.8 million. Dividends paid to ProCentury from Century were $9.1 million (of which $6.0 million were ordinary dividends and $3.1 million were extraordinary dividends), $3.0 million and $1.8 million in 2004, 2003 and 2002, respectively.
The National Association of Insurance Commissioners (NAIC) has developed property and casualty risked based capital (RBC) standards that relate an insurer’s reported statutory surplus to the risks inherent in overall operations. The RBC formula uses the statutory annual statement to calculate the minimum indicated capital level required to support asset and underwriting risk. The NAIC calls for various levels of regulatory action based on the magnitude of an indicated RBC capital deficiency, if any. Century regularly monitors capital requirements along with the NAIC’s RBC developments. Century has determined that its capital levels are in excess of the minimum capital requirements for all RBC action levels as of December 31, 2004.
Segment profit or loss for each of the Company’s operating segments is measured by underwriting profit or loss. The property and casualty insurance industry commonly defines underwriting profit or loss as earned premium net of loss and loss expenses and underwriting, acquisition and insurance expenses. Underwriting profit or loss does not replace operating income or net income computed in accordance with GAAP as a measure of profitability. Segment profit for the Investing operating segment is measured by net investment income and net realized gains or losses.
The Company entered into a Separation Agreement with Mr. John A. Marazza, Executive Vice President and Chief Operating Officer, effective January 28, 2005, setting forth the terms of his departure from the Company and providing for the payment to Mr. Marazza of the benefits to which he was entitled pursuant to his employment agreement with the Company. Such benefits consist of the payment of Mr. Marazza’s salary through April 2006, performance bonuses for 2004 and 2005, health insurance and related benefits through February 2006, continued payment of the value of whole life insurance premiums (which Mr. Marazza elected to receive in cash in lieu of insurance pursuant to the Employment Agreement) through February 2006 and full vesting of Mr. Marazza’s restricted shares and options to purchase common shares, which options will remain exercisable until the tenth anniversary of the date of grant. Mr. Marazza agreed to provide consulting services to the Company and its subsidiaries for no additional consideration for a period of ninety days following his departure. The Separation Agreement also provides for termination of the employment agreement, except for the ongoing obligations on Mr. Marazza concerning confidentiality, non-solicitation and non-competition contained therein. The total expense that will be incurred in 2005 is $744,000.
See notes to condensed financial information of Parent Company and accompanying
ProCentury Corporation (formerly known as ProFinance Holdings Corporation) (ProCentury or the Company) was formed on July 17, 2000 by Colonial Banc Corp., Richmond Mutual Bancorporation, Inc., DCB Financial Corp., Ohio Heritage Bancorp Inc., Ohio Valley Banc Corp., Stonehenge Opportunity Fund, LLC, and a group of individual investors including members of management. On July 7, 2003, ProFinance Holdings Corporation’s name was changed to ProCentury Corporation.
The Company issued 8,000,000 Class A common shares and received net proceeds (before expenses) of $77.9 million.
The Company granted 101,200 restricted common shares and 364,000 stock options to certain employees of ProCentury.
The Company repaid $8.7 million of bank indebtedness outstanding at the closing of the IPO.
The Company redeemed all of its outstanding Class B common shares for an aggregate redemption price of $5.0 million and recorded interest expense of $518,000 in connection with the redemption.
The Company amended its articles of incorporation to eliminate the authority to issue Class B and Class C common shares.
In addition, on August 5, 2004 the Company issued 54,800 of additional restricted common shares to certain employees of ProCentury.
The accompanying condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP).
Material estimates that are particularly susceptible to significant change in the near-term the determination of other-than-temporary declines in the fair value of investments. Although considerable variability is inherent in these estimates, management believes that the amounts provided are reasonable. These estimates are continually reviewed and adjusted as necessary. Such adjustments are generally reflected in current operations.
The Company provides for federal income taxes based on amounts the Company believes it ultimately will owe. Inherent in the provision for federal income taxes are estimates regarding the deductibility of
certain items. In the event the ultimate deductibility of certain items or the realization of certain tax credits differs from estimates, the Company may be required to significantly change the provision for federal income taxes recorded in the consolidated financial statements. Any such change could significantly affect the amounts reported in the consolidated statements of income.
Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. The Company regularly reviews the fixed maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. A number of criteria are considered during this process including, but not limited to: the current fair value as compared to amortized cost or cost, as appropriate, of the security; the length of time the security’s fair value has been below amortized cost or cost and specific credit issues related to the issuer and current economic conditions. In general, we focus our attention on those securities whose fair value was less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. In evaluating potential impairment, we also consider the
current fair value compared to amortized cost or cost, as appropriate, our intent and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery in value, specific credit issues related to the issuer and current economic conditions. Other-than-temporary impairment losses result in a permanent reduction of the cost basis of the underlying investment. Significant changes in the factors we consider when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the consolidated financial statements.. Realized gains or losses, including any provision for other-than-temporary declines in value, are included in the consolidated statements of operations.
No share option or restricted common share-based compensation expense is included in reported net income (loss) for any period presented for 2003 or 2002, as the Company had no common share equivalents granted during 2003 or 2002.
There are no gross unrealized gains or losses on the Company’s bond mutual funds at December 31, 2004 and 2003. Dividends received on equity securities for the year ended December 31, 2004 were $113,000. No dividends were received for the years ended December 31, 2003 or 2002. Realized losses on equity securities for the year ended December 31, 2004 were $32,000 ($21,000 net of tax). No realized gains or losses were realized for the years ended December 31, 2003 or 2002.
Beginning April 5, 2003, principal payments recommenced with principal and interest payments due quarterly with a maturity date of October 5, 2012. From October 5, 2002 to October 4, 2003, interest on the outstanding principal balance accrued at a floating rate of interest equal to the prime rate of interest at any given time. Beginning on October 4, 2003, the rate is adjusted annually to the current prime rate on October 5 until final maturity of the note on October 5, 2012. All of the stock of Century and PIA secure the loan. Accrued interest at December 31, 2003 was $93,358. The loan was paid in full in April 2004 with a portion of the proceeds from the Company’s IPO.
capital securities (“Trust Preferred Securities”) generating gross proceeds of $10.0 million. Net proceeds were approximately $9.7 million, after deducting offering costs of $300,000.
In December 2003, FASB issued Interpretation No. 46 (revised December 2003) Consolidation of Variable Interest Entities - an interpretation of ARB No. 51 (“FIN 46R”), which required all public companies to apply the provisions of FIN 46 or FIN 46R to special purpose entities created prior to February 1, 2003. Once adopted by an entity, FIN 46R replaces FIN 46. Public companies, including the Company, at a minimum, must apply the unmodified provisions of FIN 46 to entities that were considered “special-purpose entities” in practice and under applicable FASB pronouncements or guidance by the end of the first reporting period ending after December 15, 2003. Companies may apply either FIN 46 or FIN 46R to special-purpose entities at the initial effective date on an entity-by-entity basis. The Company has early adopted FIN 46R in its entirety as of December 31, 2003.
The Company’s special purpose entities where the Company is the primary beneficiary are the trusts that were established in connection with the issuance of mandatorily redeemable preferred securities. As a result of the adoption of FIN 46R, the Company has deconsolidated these trusts as of December 31, 2003 in the accompanying 2003 consolidated balance sheet. This resulted in the Company classifying the trust preferred securities as long term debt and recording an increase of $733,000 in other assets and long term debt, both of which were previously eliminated when consolidating the trusts. In accordance with FIN 46R transition guidance, prior periods, were not restated. There was no other impact to the Company’s consolidated financial statements as a result of the adoption of FIN 46R.
The Trust Preferred Securities have a 30-year maturity and are redeemable by the Company at par on or after December 15, 2007 and May 15, 2008, respectively. Holders of the Trust Preferred Securities are entitled to receive cumulative cash distributions accruing from the date of issuance and payable quarterly in arrears at a rate of 400 and 410 basis points, respectively, over the three-month London Interbank Offered Rates (“LIBOR”). The maximum distribution rate is 12.5% through December 4, 2007 and May 15, 2008, respectively. Under certain circumstances, the Company has the right to defer distributions and interest on the Trust Preferred Securities for up to five years. The obligations of the Trust are guaranteed by the Company with respect to distributions and payments of the Trust Preferred Securities. These distributions are recorded as interest expense in the accompanying consolidated statements of operations, as the Trust Preferred Securities are considered a debt instrument. Interest paid totaled $1.4 million and $1.1 million in 2004 and 2003, respectively. No interest was paid in 2002.
On September 8, 2004, the Company obtained a $5.0 million line of credit. As of December 31, 2004, no draws have been made. Interest on the note is payable quarterly and is based on a floating rate of LIBOR
plus 2.5%. The note matures on September 8, 2006. Under the terms of the line of credit, 100% of the common shares of Century are pledge as collateral.
In addition, in 2003, the Company paid a total of $1.3 million of finders fees to two shareholders of ProCentury related to the sale of the minority interest in Evergreen. Approximately $450,000 of this amount was accrued at December 31, 2002.
Dividends paid to ProCentury from Century were $9.1 million, $3.0 million and $1.8 million in 2004, 2003 and 2002, respectively.
With respect to qualified options, an officer may be granted an option to purchase shares at the grant date fair market value, payable as determined by the Company’s board of directors. An optionee must exercise an option within 10 years from the grant date. Full vesting of options granted occurs at the end of four years.
The Company may grant options for up to 1.2 million shares under the plan. Through December 31, 2004, the Company had granted 269,000 non-qualified options, 95,000 qualified options and 156,000 restricted shares under the share plan. For both non-qualified and qualified options, the option exercise price equals the stock’s fair market value on the date of the grant.
departure from the Company and providing for the payment to Mr. Marazza of the benefits to which he was entitled pursuant to his employment agreement with the Company. Such benefits consist of the payment of Mr. Marazza’s salary through April 2006, performance bonuses for 2004 and 2005, health insurance and related benefits through February 2006, continued payment of the value of whole life insurance premiums (which Mr. Marazza elected to receive in cash in lieu of insurance pursuant to the Employment Agreement) through February 2006 and full vesting of Mr. Marazza’s restricted shares and options to purchase common shares, which options will remain exercisable until the tenth anniversary of the date of grant. Mr. Marazza agreed to provide consulting services to the Company and its subsidiaries for no additional consideration for a period of ninety days following his departure. The Separation Agreement also provides for termination of the employment agreement, except for the ongoing obligations on Mr. Marazza concerning confidentiality, non-solicitation and non-competition contained therein. The total expense that will be incurred in 2005 is $744,000.