The Company leases or sub-leases all of the commercial office space in which it conducts its business. The following table summarizes the leased space out of which the Company and its subsidiaries operate as of March 23, 2006:
The Stonewood Insurance lease is renewable at Stonewood Insurance’s option for a period of up to three years. James River has entered into a lease agreement effective April 1, 2006 for the use of an additional 6,379 square feet of commercial office space in Chapel Hill, NC. The approximate annual rent under the lease totals $159,000, and the lease expires in 2010. James River has entered into an agreement to sub-let its existing Chapel Hill, NC office space. We believe that our facilities are adequate for our current needs.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this report. The discussion and analysis below includes certain forward-looking statements that are subject to risks, uncertainties and other factors described in ‘‘Risk Factors’’ under Item 1A and elsewhere in this report that could cause actual results to differ materially from those expressed in, or implied by, those forward-looking statements. See ‘‘Forward-Looking Statements’’.
The largest component of other income for 2005 and 2004 is the interest we earned on notes receivable from employees and directors. The notes have an annual interest rate of 4.5%. Interest on the notes was $52,000 for 2005 and $117,000 for 2004. The decline in interest on notes receivable in 2005 is consistent with the decline in the amount of outstanding notes receivable during the year. In April 2005, the notes receivable from our executive officers and directors totaling $2.0 million were repaid by the borrowers. An additional $10,000 was repaid in August 2005 leaving $535,000 of notes receivable outstanding at December 31, 2005 from our employees who are not executive officers.
Realized investment losses were $252,000 in 2005 and $71,000 in 2004. Realized investment losses for 2005 included a $92,000 write-down on a bond issued by the finance company of a United States automobile manufacturer with impairment in its value that we deemed to be other-than-temporary. There were no write-downs of securities for other-than-temporary impairment in 2004.
Losses and LAE totaled $79.2 million for 2005, up 66.5% compared to losses and LAE of $47.6 million for 2004. The loss ratio (the ratio of losses and LAE to net earned premiums) was 67.4% for 2005 compared to 62.8% for 2004. We incurred $7.9 million of losses and LAE, net of reinsurance, from Hurricane Katrina in 2005. Hurricane Katrina also impacted our loss ratios as a result of the $6.1 million of reinstatement reinsurance premiums that we ceded in 2005, which had the effect of reducing our net earned premiums. Our loss ratio for 2005 benefited from $4.9 million of favorable loss and LAE reserve development related to the 2004 and 2003 accident years that our insurance subsidiaries experienced during 2005. A rollforward of the reserve for losses and LAE, net of reinsurance, is presented below:
An analysis of the gross reserve and the net reserve for losses and LAE by major line of business at December 31, 2005 is presented below:
We have not provided insurance coverage that could reasonably be expected to produce material levels of asbestos claims activity. In addition, we believe we are not exposed to any environmental liability claims other than those which we have specifically underwritten and priced as an environmental exposure. Any asbestos or environmental exposure on policies issued by Fidelity prior to June 30, 2003, the date that we acquired that company, are subject to a reinsurance agreement and a trust agreement with American Empire (see ‘‘- Reinsurance’’).
Net losses paid during 2005 totaled $5.3 million, while net LAE paid totaled $5.0 million, for total net losses and LAE paid of $10.3 million. Net losses paid during 2004 totaled $1.7 million and net LAE paid totaled $2.0 million, for total net losses and LAE paid of $3.7 million. The increase in net losses and LAE paid from 2004 to 2005 is consistent with the growth in our insurance operations.
The expense ratio (the ratio, expressed as a percentage, of other operating expenses to net earned premiums) was 24.2% for 2005 and 27.3% for 2004. Our expense ratio for 2005 was negatively impacted by Hurricane Katrina, whose net impact was to reduce other operating expenses for the year by $1.8 million and reduce net earned premiums for the year by $12.9 million, resulting in an increase in our expense ratio of 1.0 point. Our 2004 expense ratio was negatively impacted by the expense ratio of 76.5% experienced by our Workers' Compensation Insurance segment in Stonewood Insurance's first year of insurance operations. The Workers’ Compensation Insurance segment had an expense ratio of 34.2% for 2005.
Interest expense totaled $2.7 million for 2005 compared to $793,000 for 2004. Interest expense relates to $15.0 million of senior notes and $22.7 million of junior subordinated notes that we issued in May and December 2004. Interest on these notes is paid at a floating rate based on three-month LIBOR (see Liquidity and Capital Resources - ‘‘Senior Notes and Junior Subordinated Notes’’). The increase in interest expense in 2005 is due to the notes being outstanding for a full year in 2005 and only being outstanding for a partial year in 2004 and due to higher three-month LIBOR rates in 2005 than in 2004.
Net earned premiums grew 1,389% from $5.1 million in 2003 to $75.8 million in 2004. Premiums are earned ratably over the terms of our insurance policies, generally 12 months. As a result, net earned premiums in our first six months of insurance operations in 2003 were very low relative to our net written premiums in that period, because premiums earned in 2003 were only a ratable portion of business written in the last six months of that year with no benefit from business written in prior periods.
Net investment income for 2004 was $3.6 million, up 791% from $407,000 in 2003, reflecting the significant growth in our cash and invested assets from $79.3 million at December 31, 2003 to $195.2 million at December 31, 2004. The growth in our cash and invested assets came from net premiums written and our offerings of debt and equity securities. The gross investment yield on average cash and invested assets for 2004 was 3.1%. The gross investment yield on our average fixed maturity security balance in 2004 was 3.5%. We significantly increased our holdings of tax-advantaged state and municipal fixed maturity securities in 2004. Our tax equivalent yield on our average fixed maturity security balance was 3.6% for 2004. The gross investment yield on average cash and invested assets for 2003 was 1.3%. The low investment yield in 2003 reflected the low interest rate environment in that period, particularly on short-term instruments. The majority of our assets were invested in cash equivalents and short-term investments during 2003. We hired investment managers to invest our available funds in high-quality fixed maturity securities in the fourth quarter of 2003, but because these fixed maturity securities were purchased late in the year, they had a minimal impact on our investment yield for the year.
Losses and LAE totaled $47.6 million for 2004 representing a 1,311% increase compared to losses and LAE of $3.4 million for 2003. The loss ratio improved to 62.8% in 2004 from 66.3% in 2003. The loss ratio
for 2004 included the impact of $156,000 of favorable loss and LAE reserve development on the 2003 accident that our Excess and Surplus Insurance segment experienced in 2004. Our loss ratio in 2003 was negatively impacted by fixed costs related to claims administration expenses that were high relative to our low volume of claims activity during the first six months of our insurance operations.
Net losses paid during 2004 totaled $1.7 million, while net LAE paid totaled $2.0 million, for total net losses and LAE paid of $3.7 million. Net losses paid during 2003 totaled $9,000 and net LAE paid totaled $180,000, for total paid net losses and LAE of $189,000.
Interest expense totaled $793,000 in 2004. Interest expense related to $15.0 million of senior notes and $22.7 million of junior subordinated notes that we issued during 2004. There was no interest expense in 2003.
We are organized into three reportable segments which are separately managed business units:
There is an intercompany reinsurance pooling agreement in place between James River Insurance and Stonewood Insurance. This intercompany reinsurance pooling agreement became effective on January 1, 2004. For 2004, the agreement called for a pooling of all business written by the companies on or after January 1, 2004 and an allocation of 70% of the pooled premiums, losses and LAE and operating expenses to James River Insurance and 30% to Stonewood Insurance. Development on the December 31, 2003 reserve for losses and LAE was also allocated 70% to James River Insurance and 30% to Stonewood Insurance. For 2005, James River Insurance has an 80% share and Stonewood Insurance has a 20% share of the intercompany pool. We report all segment information in this ‘‘Management's Discussion and Analysis of Financial Condition and Results of Operations’’ prior to the effects of the intercompany reinsurance pooling agreement because we evaluate the operating performance of our reportable segments on a pre-pooling basis.
The written premium ceding ratio for the Excess and Surplus Insurance segment was 46.4% for 2005, 15.7% for 2004 and 25.4% for 2003. The increase in the written premium ceding ratio for 2005 was driven by the impact of a new quota share reinsurance contract effective January 1, 2005 (see - ‘‘Reinsurance’’). Ceded written premiums related to this quota share treaty for 2005 totaled $40.0 million. We also ceded an additional $6.1 million of reinstatement premiums to our reinsurers to reinstate reinsurance coverage for which we had used our reinsurance limits due to losses from Hurricane Katrina. The effects of this quota share contract and the reinstatement premiums from Hurricane Katrina on our written premium ceding ratio for 2005 were partially offset by the reduction in the written premium ceding ratio resulting from our decision to increase the amount of risk we retain before reinsurance on our primary casualty policies sold by James River Insurance from $405,000 to $1.0 million effective July 1, 2004. Effective July 1, 2005, we increased our retention on our property excess of loss treaty at James River Insurance to $1.0 million. On November 1, 2005, we entered into a quota share reinsurance treaty that reduced our retention on our excess property coverage to $750,000 per risk (15% of the first $5.0 million). In 2004, we adjusted the estimated reinsurance premium ceding rate on one of our retrospective experience rated reinsurance treaties based on the loss experience of the reinsured book of business. The impact of this adjustment was to increase net earned premiums for 2004 by $484,000 for the true-up of premiums earned in 2003 and to increase losses and LAE incurred by approximately $290,000. The written premium ceding ratio for 2003 of 25.4% exceeded the 2004 ratio primarily due to the lower risk that we retained on our primary casualty policies in 2003.
reinstatement premiums, which had the effect of reducing our net earned premiums. The loss ratio for 2005 was impacted by $5.4 million of favorable loss and LAE reserve development on the 2003 and 2004 accident years. This favorable development included $2.5 million and $593,000, respectively, of favorable development in the James River Insurance casualty lines related to the 2004 and 2003 accident years. Favorable development for 2005 also included $2.4 million for the James River Insurance property lines related to the 2004 accident year.
Our Workers’ Compensation Insurance segment began writing business in January 2004, and results of this segment for 2003 consisted only of $5,000 of investment income, $1.2 million of expenses, and a $1.2 million loss before taxes.
Gross written premiums for 2005 increased to $33.6 million from $9.2 million for 2004. Gross written premiums for Stonewood Insurance in 2005 included $4.4 million of assumed premiums from our participation in the involuntary workers’ compensation pool for North Carolina. Since Stonewood Insurance wrote its first insurance policy effective January 1, 2004, results for 2004 did not include any renewal premiums, while direct written premiums for 2005 included $7.6 million of renewal premiums. At December 31, 2005, there were 137 agents in the Workers' Compensation Insurance segment network
compared to 110 at December 31, 2004. Stonewood Insurance did not receive its ‘‘A−’’ (Excellent) rating from A.M. Best until April 2004, and the lack of a rating limited direct written premium production in the first quarter of that year.
Stonewood Insurance’s participation in the involuntary workers’ compensation pool for North Carolina reduced income before taxes by $1.1 million for 2005. Although premium rates on our workers’ compensation policies are fixed, the final premium on a policy will vary based on the difference between the estimated payroll of the customer at the time the policy is written and the final audited payroll of the customer during the policy period. A change in estimate during the second quarter of 2005 related to the premium earned in the Workers’ Compensation Insurance segment as a result of the payroll audit process resulted in an increase in income before taxes of $419,000.
The written premium ceding ratio for 2005 was 14.0% for the Workers' Compensation Insurance segment compared to 15.6% for 2004. We retain $500,000 of risk per occurrence on workers' compensation insurance policies, with the risk in excess of $500,000 up to $20.0 million being ceded to reinsurers. We retain risk of loss for claims above the $20.0 million limit ceded to reinsurers or above $10.0 million for any one life.
Net investment income for the Corporate and Other segment increased from $133,000 for 2004 to $803,000 for 2005. The increase in net investment income from 2004 to 2005 and from 2003 to 2004 reflects the use of a portion of the proceeds from our offerings of senior notes and junior subordinated notes in 2004 to create a bond portfolio at the holding company. We also retained a portion of the proceeds from our initial public offering in cash and invested assets at the holding company. At December 31, 2005, the fair value of cash and invested assets at our holding company totaled $32.3 million. These funds are invested at the holding company until the insurance subsidiaries require additional capital contributions
Other income for the Corporate and Other segment includes interest on notes receivable from employees and directors of $52,000 for 2005, $117,000 for 2004 and $55,000 for 2003. The decline in interest on notes receivable is consistent with a decline in the amount of outstanding notes receivable from $2.6 million at December 31, 2004 to $535,000 at December 31, 2005. Interest on the notes receivable in 2003 reflects the fact that the notes receivable were only outstanding for a portion of 2003.
Other operating expenses of the Corporate and Other segment were $1.2 million for 2005, $879,000 for 2004 and $336,000 for 2003. Other expenses for the Corporate and Other segment include personnel costs associated with the holding company employees, directors' fees, professional fees and various other corporate expenses. A majority of these costs are reimbursed by our subsidiaries and the amount of the reimbursement is included primarily as underwriting expenses in the results of our Excess and Surplus Insurance and Workers' Compensation Insurance segments. The amounts of other expenses of the Corporate and Other segment presented above represent the expenses of the holding company that were not reimbursed by our subsidiaries.
The payment of dividends by our insurance subsidiaries to us is limited by statute. In general, these restrictions require that dividends be paid out of earned surplus and limit the aggregate amount of dividends or other distributions that our subsidiaries may declare or pay within any 12 month period without advance regulatory approval. In Ohio, the domiciliary state of James River Insurance, this limitation is the greater of the statutory net income for the preceding calendar year or 10% of the statutory surplus at the end of the preceding calendar year. In North Carolina, the domiciliary state of Stonewood Insurance, this limitation is the lesser of the statutory net income for the preceding calendar year or 10% of the statutory surplus at the end of the preceding calendar year. In addition, insurance regulators have broad powers to prevent the reduction of statutory surplus to inadequate levels and could refuse to permit the payment of dividends of the maximum amounts calculated under any applicable formula. The maximum amount of dividends available to us from our insurance subsidiaries during 2006 without regulatory approval is $14.5 million.
At December 31, 2005, cash and invested assets at our holding company totaled $32.3 million. To the extent that our insurance subsidiaries require capital in 2006 above the amount available at the holding company, we would anticipate issuing trust preferred securities or other debt at our holding company during 2006.
Our sources of operating funds consist primarily of written premiums, investment income and proceeds from offerings of our debt and equity securities. We use operating cash flows primarily to pay operating expenses and losses and LAE.
Net cash provided by financing activities for 2005 includes the net proceeds of $84.6 million from our initial public offering (see - "Initial Public Offering’’) and repayment of $2.0 million of notes receivable from our executive officers and directors in April 2005 (see - ‘‘Notes Receivable from Employees and Directors’’).
During 2004, net cash provided by financing activities was $37.3 million and included $1.3 million of net proceeds from the issuance of 13,500 shares of Series B Convertible Preferred Stock in May 2004, $14.5 million of net proceeds from the issuance of unsecured, floating rate senior debentures, which we refer to as senior notes, and $21.4 million net proceeds from the issuance of junior subordinated debentures, which we refer to as junior subordinated notes (see - ‘‘Senior Notes and Junior Subordinated Notes’’). We used the proceeds from the senior notes and the junior subordinated notes to provide additional capital to our insurance subsidiaries and working capital for us.
On August 26, 2005, the underwriters of the initial public offering exercised their over-allotment option in which an additional 666,600 shares of Common Stock were issued and sold at the $18.00 initial public offering price per share. Gross proceeds from this transaction were $12.0 million and underwriting costs were $840,000.
On August 8, 2005, we issued 416,895 options for the purchase of our common stock at the initial public offering price of $18.00 per share to certain employees. On September 13, 2005, we issued 35,084 options for the purchase of our Common Stock to our Chief Executive Officer with an exercise price of $21.00 per share, the fair value of the shares at the date of grant.
In May 2004, we issued $15.0 million of senior notes due April 29, 2034, with net proceeds to us of $14.5 million. The senior notes are not redeemable by the holder or subject to sinking fund requirements. Interest accrues quarterly and is payable in arrears at a floating rate per annum equal to three-month LIBOR plus 3.85%. The senior notes are redeemable prior to their stated maturity at our option in whole or in part, on or after May 15, 2009. The terms of the indenture for the senior notes contain certain covenants which, among other things, restrict our assuming senior indebtedness secured by our Common Stock or our subsidiaries’ capital stock or selling or issuing shares of our subsidiaries’ capital stock. We are in compliance with all covenants in the indenture at December 31, 2005.
In May and December of 2004, we sold trust preferred securities through two Delaware statutory business trusts sponsored and wholly-owned by us. Each trust used the net proceeds from the sale of its trust preferred securities to purchase our floating rate junior subordinated notes. The following table summarizes the nature and terms of the junior subordinated notes and trust preferred securities outstanding at December 31, 2005:
At December 31, 2004, we had notes receivable from employees and directors totaling $2.6 million, which were issued in connection with the sale of our Series B Convertible Preferred Stock. These notes
The following table illustrates our contractual obligations and commitments by due date as of December 31, 2005:
The reserve for losses and LAE payments due by period in the table above are based upon the reserve for losses and LAE as of December 31, 2005 and actuarial estimates of expected payout patterns by line of business. As a result, our calculation of the reserve for losses and LAE payments due by period is subject to the same uncertainties associated with determining the level of the reserve for losses and LAE and to the additional uncertainties arising from the difficulty of predicting when claims, including claims that have not yet been reported to us, will be paid. Actual payments of losses and LAE by period will vary, perhaps materially, from the above table to the extent that current estimates of the reserve for losses and LAE vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. At our option, we may redeem our senior notes and our junior subordinated notes in 2009 at 100% of the principal amount. However, the senior notes and junior subordinated notes do not mature until 2034.
The amortized cost and fair value of our investments in fixed maturity securities were as follows:
with unrealized losses has ever missed, or been delinquent on, a scheduled principal or interest payment. At December 31, 2005, 97.7% of our fixed maturity security portfolio was rated ‘‘A−’’ or better by Standard & Poor's or received an equivalent rating from another nationally recognized rating agency. In the fourth quarter of 2005, we concluded that one of the two securities in our portfolio that was not rated investment grade by Standard & Poor’s, a fixed maturity security issued by the finance company of a United States automobile manufacturer, had experienced an impairment that was other-than-temporary, and accordingly, we took an impairment write-down of $92,000 on that security. Our conclusion was due primarily to the difficult operational and industry issues facing the issuer, the fact that the security was downgraded from investment grade to below investment grade by two nationally recognized rating agencies during the fourth quarter of 2005 and because there did not appear to be any imminent events or transactions that would cause the value of the security to increase significantly in the foreseeable future. The other security in our portfolio that is rated below investment grade had an unrealized loss of $72,000 at December 31, 2005, and we have concluded that the security has not experienced an other-than-temporary impairment at December 31, 2005. We have also concluded that none of the other available-for-sale securities with unrealized losses at December 31, 2005 has experienced an other-than-temporary impairment. In determining that securities with unrealized losses at December 31, 2005 had not experienced an other-than-temporary impairment, we considered our intent and ability to hold the securities for a sufficient amount of time to allow for a recovery in value.
Our cash and cash equivalents were $41.0 million at December 31, 2005. The percentage of our cash and invested assets in cash and cash equivalents was 10.8% at December 31, 2005 compared to 10.4% at December 31, 2004. We had a larger percentage of our cash and invested assets in cash and cash equivalents at December 31, 2005 to fund expected property insurance claim payments on Hurricane Katrina.
We enter into reinsurance contracts to limit our exposure to potential losses arising from large risks and to provide additional capacity for growth. Reinsurance refers to an arrangement in which a company called a reinsurer agrees in a contract (often referred to as a treaty) to assume specified risks written by an insurance company (known as a ceding company) by paying the insurance company all or a portion of the insurance company's losses arising under specified classes of insurance policies.
Through June 30, 2004, we retained approximately $500,000 per risk for all coverages under our excess of loss reinsurance contracts except for primary casualty coverages, for which we retained $405,000 per risk. Effective July 1, 2004, we increased the retention on our primary casualty excess of loss reinsurance treaty at James River Insurance to $1.0 million. Effective July 1, 2005, we increased the retention on our property excess of loss reinsurance treaty at James River Insurance to $1.0 million. On November 1, 2005, we entered into a quota share reinsurance treaty that reduced our retention on our excess property coverage to $750,000 per risk (15% of the first $5.0 million). Reinsurance contracts do not relieve us from our obligations to policyholders. Failure of a reinsurer to honor its obligations could result in losses to us,
and therefore, we establish allowances for amounts considered uncollectible. At December 31, 2005, there was no allowance for uncollectible reinsurance recoverables. James River Insurance and Stonewood Insurance generally target reinsurers with A.M. Best financial strength ratings of ‘‘A’’ (Excellent) or better for liability coverages and ‘‘A−’’ (Excellent) or better for property coverages.
At December 31, 2005, we had reinsurance recoverables on unpaid losses of $110.5 million and reinsurance recoverables on paid losses of $11.5 million. Included in reinsurance recoverables on unpaid losses at December 31, 2005 are $44.1 million of recoverables related to Hurricane Katrina losses and $12.2 million of recoverables related to Hurricane Wilma. All but $2.1 million of our total recoverables on paid and unpaid losses at December 31, 2005 are from reinsurers rated ‘‘A’’ or better by A.M. Best, or are collateralized with letters of credit or by a trust agreement with American Empire, and $459,000 of this unsecured December 31, 2005 balance was collected in January 2006.
We entered into a quota share reinsurance contract effective January 1, 2005 that transferred a portion of the risk related to certain property/casualty business written by James River Insurance in 2005 to reinsurers in exchange for a portion of the direct written premiums on that business. By transferring risk to the reinsurers, we also reduced the amount of capital required to support the insurance operations of James River Insurance. Under terms of the agreement, James River Insurance cedes a portion of its other
liability occurrence and primary property business which includes business written by the General Casualty, Manufacturers and Contractors and Primary Property divisions.
James River Insurance receives a ceding commission equal to 25% of ceded earned premium and pays a reinsurer margin equal to 4.5% of ceded earned premium under its quota share reinsurance contract. The reinsurers do not receive a margin when they are in a loss position on the contract. The ceding commission cannot be reduced, but under certain circumstances, based on underwriting results, James River Insurance is entitled to an additional profit contingent commission up to an amount equal to all of the reinsurers’ profits above the margin. We did not earn an additional profit contingent commission in 2005 based on the underwriting results of the business ceded under the treaty. James River Insurance maintains a funds-held account which is credited interest at a fixed rate of 3.75% annually. The funds-held account balance is recorded as a liability on our consolidated balance sheet, and at December 31, 2005, the balance of the account was $22.0 million. The funds-held account balance represents the excess of ceded earned premium and interest credited over ceded paid losses and LAE, the Company’s ceding commission and the reinsurers’ margin. Assets supporting the funds-held liability are not segregated or restricted. The contract has a loss ratio cap of 115%, which means that we cannot cede any losses in excess of a 115% loss ratio to the reinsurer. For 2005, ceded earned premiums related to this quota share treaty were $40.0 million, ceded loss and LAE were $36.5 million, reinsurance ceding commissions were $9.7 million and the reinsurers’ margin was $0.
Underwriting profit (loss) of insurance segments is defined as net earned premiums less losses and LAE and other operating expenses of our two insurance segments, the Excess and Surplus Insurance segment and the Workers' Compensation Insurance segment. Our definition of underwriting profit (loss) may not be comparable to the definition of underwriting profit (loss) for other companies. We evaluate the performance of our insurance segments and allocate resources based primarily on underwriting profit (loss) of insurance segments. We believe that this is a useful measure for investors in evaluating the performance of our insurance segments because our objective is to consistently earn underwriting profits.
The reserve for losses and LAE represents our estimated ultimate cost of all reported and unreported losses and LAE incurred and unpaid at the balance sheet date. We do not discount the reserve for losses and LAE. We estimate the reserve for losses and LAE using individual case-basis valuations of reported claims. We also use statistical analyses to estimate the cost of losses and LAE that have been incurred but not reported to us. Those estimates are based on historical information and on estimates of future trends that may affect the frequency of claims and changes in the average cost of claims that may arise in the future. As a relatively new company, our historical loss experience is limited.
We utilize two primary actuarial methods to arrive at our loss reserve estimates for each line of business. One of the primary methods, the incurred Bornhuetter-Ferguson method, utilizes our initial expected loss ratio (the ratio of losses and LAE incurred to net earned premiums), expected reporting patterns for losses based on industry data and our actual reported losses and LAE to estimate the reserve. The other primary method, the loss ratio method, estimates the reserve by applying an expected loss ratio to net earned premiums by line of business. For both methods, the expected loss ratio is established using judgment, and is based primarily on industry data and the experience of our management team in writing similar insurance coverages. The expected loss ratio used in the loss ratio method is judgmentally adjusted up or down when the level of reported losses for a specific accident year for a line of business leads us to conclude that the ultimate loss ratio will differ from our expected loss ratio. The initial expected loss ratio
We believe that generally selecting the higher of our two primary actuarial methods by line of business as the basis for our best reserve estimates at this early stage in our history is appropriate. Given that our insurance companies have limited historical experience, that our two primary actuarial methods utilize industry data, that losses on our casualty business often take a number of years to develop and that we write difficult classes of business which typically do not meet the risk criteria of standard carriers, we believe that we do not have sufficient evidence at this time to conclude that our ultimate loss ratios will be significantly better than our expected loss ratios, and generally selecting the higher of the two primary actuarial methods as the basis for our best reserve estimates is consistent with that belief. In the future as more information becomes available to us and we develop more experience in our casualty business, we may adjust or change our actuarial methods. Such future methods may not necessarily result in selecting the highest estimate of our actuarial methods.
Reserve estimates derived using the incurred Bornhuetter-Ferguson method are driven by our assumptions related to the expected loss ratio and the expected reporting pattern for losses, while reserve estimates derived using the loss ratio method are driven by our assumptions related to the expected loss ratio and are not sensitive to reporting patterns. Reporting pattern means the estimated percentage of the ultimate losses for a particular line of business that have been reported at the valuation date. The table below quantifies the impact that reasonably likely changes in two variables, the expected loss ratio and the
expected reporting pattern for losses, would have on the recorded reserve for losses and LAE at December 31, 2005. The reporting pattern scenarios below only apply to the incurred Bornhuetter-Ferguson analysis. In the table below, the expected loss ratio and the expected reporting pattern refer to assumptions related to those two variables that we made in calculating the net reserves that we recorded at December 31, 2005.
The sensitivity analysis above was based on the weighted-average assumptions presented in the table below. For the expected loss ratio assumptions, the expected loss ratio represents a weighted-average of the expected loss ratios used for each of our lines of business, with the expected loss ratio for each line weighted based on net earned premiums. For the expected reporting pattern assumptions, the expected reporting pattern represents a weighted-average of the percentage of ultimate losses assumed to be reported to us at December 31, 2005 for each of our lines of business weighted based on net earned premiums.
We believe that loss ratios 5% above or below our expected loss ratio constitute a reasonable range of expectations for each major line of business. In addition, we believe that the adjustments that we made to speed up or slow down the reporting patterns in the sensitivity analysis above are reasonably likely outcomes. Under the incurred Bornhuetter-Ferguson method, slowing the reporting pattern results in an increase in the estimate of reserves, because reported losses are seen as a smaller percentage of the ultimate reported losses, resulting in an increase in estimated unreported losses. Similarly, using a faster reporting pattern results in a decrease in the estimate of reserves. In determining the amounts by which to slow or accelerate the reporting patterns for the sensitivity analysis presented above, we applied judgment to reflect the fact that the variability of reasonably likely reporting pattern outcomes varies by major line of business. There is little variability around our expected reporting patterns for our excess and surplus insurance property lines, because property claims are typically reported relatively quickly. Conversely, there is considerably more variability around our expected reporting patterns for our Excess and Surplus Insurance casualty lines, because losses on casualty business often take a number of years to develop. Reporting patterns for Workers' Compensation Insurance are generally slower than reporting patterns for our Excess and Surplus Insurance property lines and generally faster than reporting patterns for our Excess and Surplus Insurance casualty lines. Accordingly, the variability around our expected reporting patterns for Workers' Compensation Insurance is greater than it is for our excess and surplus insurance property lines and less than it is for our Excess and Surplus Insurance casualty lines. The impact
Our reserve estimates assume that the inflation assumption implicitly built into our expected loss ratio will continue into the future. Unexpected changes in loss cost inflation can occur through changes in general inflationary trends, changes in medical technology and procedures and changes in legal theories of liability. The estimated impact of an additional one percent increase in loss cost inflation as of December 31, 2005 is to increase loss and LAE reserves by approximately $850,000 , decrease net income by $553,000 and reduce stockholders' equity by 0.3%. Such an increase in reserves would not have an immediate impact on our liquidity, but would reduce cash flow over time as those incremental losses are paid.
Although we believe that our reserve estimates are reasonable, it is possible that our actual loss experience may not conform to our assumptions. Specifically, our actual ultimate loss ratio could differ from our initial expected loss ratio or our actual reporting patterns for losses could differ from our expected reporting patterns based on industry data. Accordingly, the ultimate settlement of losses and the related LAE may vary significantly from the estimates included in our consolidated financial statements. We regularly review our estimates and adjust them as necessary as experience develops or new information becomes known to us. Such adjustments are included in current operations.
Losses and LAE for 2005 reflect $4.9 million of favorable development on the reserve for losses and LAE at December 31, 2004. This favorable development consisted of $5.4 million of favorable development in the Excess and Surplus Insurance segment offset by $525,000 of adverse development in the Workers’ Compensation Insurance segment (see - ‘‘Results of Operations’’). Losses and LAE for 2004 reflect $156,000 of favorable development on the reserve for losses and LAE held at December 31, 2003.
We review the need for a valuation allowance related to our deferred tax assets each quarter. We reduce our deferred tax assets by a valuation allowance when we determine that it is more likely than not that some portion or all of the deferred tax assets will not be realized. The assessment of whether or not a valuation allowance is needed requires us to use significant judgment. Our assessment includes consideration of the amount of taxable income generated since we were formed in 2002, trends in earnings and future expectations. Income tax expense for 2004 reflects a reduction in the deferred tax valuation allowance of $1.9 million. We did not establish a valuation allowance against our deferred tax assets at December 31, 2005 or 2004.
Reinsurance premiums, commissions, losses and LAE on reinsured business are accounted for on a basis consistent with that used in accounting for the original policies issued and the terms of the reinsurance contracts. Reinsurance recoverables and prepaid reinsurance premiums are reported as assets. Other amounts payable to reinsurers or receivable from reinsurers are netted where the right of offset exists.
We receive ceding commissions in connection with certain ceded reinsurance. The ceding commissions are recorded as a reduction of other operating expenses.
Statement 123(R) requires all share-based payments to employees, including grants of stock options, to be recognized in the financial statements based on their fair values. Under Statement 123(R), pro forma disclosure is no longer an alternative to financial statement recognition for stock option awards made after our adoption of Statement 123(R). We adopted Statement 123(R) on January 1, 2006.
For 2006, we anticipate achieving an annual return on equity of at least 15% and writing at a combined ratio of between 80% and 90%. We also expect growth in gross written premiums of between 20% and 30% for 2006.
The financial statements and financial statement schedules listed in the accompanying Index to Consolidated Financial Statements and Schedules are filed as part of this report.