The following table summarizes 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, 2007 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, 2007 and 2006 and for each of the periods in the three-year period ended December 31, 2007, and KPMG LLP’s report thereon, are included elsewhere in this 10-K filing. 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.”
ProCentury is a holding company that underwrites selected property and casualty and surety insurance through its subsidiaries collectively known as Century Insurance Group®. As a specialty company, we offer insurance products designed to meet specific insurance needs of targeted insured groups. The excess and surplus lines market provides an alternative market for customers with hard-to-place risks and risks that insurance companies licensed by the state in which the insurance policy is sold, which are also referred to as “admitted insurers,” typically do not cover. As an underwriter within the excess and surplus lines market, we are selective in the lines of business and types of risks we choose to write. We develop these specialty insurance products through our own experience or knowledge or through proposals brought to us by agents with special expertise in specific classes of business.
We evaluate our insurance operations by monitoring key measures of growth and profitability. The following provides further explanation of the key financial measures that we use to evaluate our results:
Written and Unearned Premium. Written premium is recorded based on the insurance policies that have been reported to us and, beginning in the fourth quarter of 2006, the policies that have been written by agents but not yet reported to us. We must estimate the amount of written premium not yet reported based on judgments relative to current and historical trends of the business being written. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current period’s results. An unearned premium reserve is established to reflect the unexpired portion of each policy at the financial reporting date. For additional information regarding our written and unearned premium refer to Note 4 to our audited consolidated financial statements included in this report.
Loss and Loss Expense Ratio. Loss and loss expense ratio is the ratio (expressed as a percentage) of losses and loss expenses incurred to premiums earned. Our net loss and loss expense is meaningful in evaluating our financial results, which are net of ceded reinsurance, as reflected in our audited consolidated financial statements.
Expense Ratio. Expense ratio is the ratio (expressed as a percentage) of net operating expenses to premiums earned and measures a company’s operational efficiency in producing, underwriting and administering its insurance business. Interest expense is not included in the calculation of the expense ratio.
Combined Ratio. Combined ratio is the sum of the loss and loss expense ratio and the expense ratio and measures a company’s overall underwriting profit. If the combined ratio is at or above 100, an insurance company cannot be profitable without investment income (and may not be profitable if investment income is insufficient). We use the combined ratio in evaluating our overall underwriting profitability and as a measure for comparing our profitability relative to the profitability of our competitors.
Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of other-than-temporary declines in the fair value of investments, the determination of loss and loss expense reserves, the net realizable value of reinsurance recoverables, the recoverability of deferred policy acquisition costs, and the determination of federal income taxes. 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 reflected in current operations.
Loss and Loss Expense Reserves. 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. We use actuarial methodologies to assist us in establishing these estimates, including judgments relative to estimates of future claims severity and frequency, length of time to develop to ultimate resolution, and consideration of new judicial decisions in tort and insurance law, emerging theories or liabilities and other factors 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. Additional information regarding our loss and loss expense reserves can be found in Note 3 to our audited consolidated financial statements included in this report.
For fixed-maturity and equity securities that can not be contractually prepaid or otherwise settled, an other-than-temporary impairment charge is taken when we do not have the ability and intent to hold the security until the forecasted recovery or if it is no longer probable that we 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; our intent to hold or dispose of the security; and current economic conditions. Other-than-temporary impairment losses result in a permanent reduction to the cost basis of the underlying investment.
During 2007, credit markets experienced reduced liquidity, higher volatility and widening credit spreads across asset classes mainly as a result of marketplace uncertainty arising from higher defaults in sub-prime and Alt-A residential mortgage loans. In connection with this uncertainty, we believe investors and lenders have retreated from many investments in asset-backed securities including those associated with sub-prime and Alt-A residential mortgage loans, as well as types of debt investments with weak lender protections or those with limited transparency and/or complex features which hindered investor understanding. At the same time, investors shifted emphasis towards safety pushing up the demand for U.S. Treasury instruments. The current credit market conditions resulted in an unfavorable liquidity environment for issuers of financial instruments including commercial paper, long-term debt and asset-backed securities.
Valuation of Investments. The Company’s investments in fixed maturities, which include bonds and redeemable preferred stock and certain equity securities, which include common and non-redeemable preferred
Federal Income Taxes. We provide for federal income taxes based on amounts we believe we 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 or the realization of certain tax credits differs from estimates, we 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.
We utilize the asset and liability method of accounting for income tax. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established when necessary to reduce the deferred tax assets to the amounts more likely than not to be realized. See Note 7 to our audited consolidated financial statements included in this report.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. Net income was $20.9 for the year ended December 31, 2006, compared to net income of $10.2 for the year ended December 31, 2005. The increase in net income for the year ended December 31, 2006 was primarily attributable to a 24.4% increase in total revenue in 2006 as a result of higher net earned premium and net investment income. The impact of the increase in revenue on net income was also supplemented by a 4.9 percentage points decrease in the total combined ratio in 2006 as compared to 2005. The lower combined ratio is primarily due to a decrease in losses that were incurred related to prior years and hurricanes when comparing 2006 to 2005.
In addition to our net earned premium growth, our net investment income grew by 33.7% in 2006 compared to the same period in 2005. This growth was due to continued favorable cash flows from operations during the year ended December 31, 2006 and higher investment yields which on a tax equivalent basis increased to 5.8% for the year ended December 31, 2006 from 5.2% for the same period in 2005.
Higher expenses that resulted from an increase in net loss and loss expenses and amortization of deferred acquisition costs partially offset the increase in total revenue. This increase in overall expenses is a direct result of the growth in the volume of business produced in 2006 and is partially offset by an increase in the profitability of the business written as seen in an overall decrease in the 2006 combined ratio as compared to the combined ratio in 2005. This decrease in the overall combined ratio is a direct result of a 4.7 percentage point decrease in the loss and loss expense ratio that decreased to 61.9% for the year ended December 31, 2006 from 66.6% for the same period in 2005. As previously stated, the decrease in the loss and loss expense ratio for year ended December 31, 2006 compared to the same periods in 2005 resulted from higher net incurred loss and loss expenses in 2005 due to $5.4 million of unfavorable development in 2005 related to prior accident years and a significantly worse hurricane season in 2005 than in 2006 that resulted in $8.3 million of additional losses. We recorded $1.1 million favorable prior year development in 2006.
Gross written premiums, net written premiums and premiums earned were $20.9 million higher, $18.2 million higher and $4.1 million higher, respectively.
Net income was higher by $216,000 or $0.02 per diluted share.
Written premiums are the total amount of premiums billed to the policyholder less the amount of premiums returned, generally because of cancellations, during a given period. Written premiums become premiums earned as the policy ages. Barring premium changes, if an insurance company writes the same mix of business each year, written premiums and premiums earned will be equal, and the unearned premium reserve will remain constant. During periods of growth, the unearned premium reserve will increase, causing premiums earned to be less than written premiums. Conversely, during periods of decline, the unearned premium reserve will decrease, causing premiums earned to be greater than written premiums.
We have historically relied on quota share, excess of loss, and catastrophe reinsurance primarily to manage our regulatory capital requirements and to limit our exposure to loss. Generally, we have ceded a significant portion of our premiums to unaffiliated reinsurers in order to maintain net written premiums to statutory surplus ratio of less than 2-to-1.
Our property and 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.
The following table presents our gross written premiums in our primary segments and provides a summary of gross, ceded and net written premiums and net premiums earned for the periods indicated.
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 the current book of business. It may not be comparable to the definition of net writings ratio used by other companies.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005. Gross written premiums increased 30.9% for the year ended December 31, 2006 compared to the same period in 2005. This fluctuation for the 2006 year was the result of growth in the property and casualty segment from all of our product lines, but primarily from an increase in volume from our specialty program unit and an increase in our casualty book of
business from growth in our contractor business written on a claims-made form. Our program unit introduced an auto physical damage program in mid-2005 that has increased our property business by $10.9 million throughout 2006. In addition, in January 2005, we stopped writing contractors business written on an occurrence form and began to offer contractors liability coverage on a claims-made form. The claims-made contractors’ coverage has a significantly shorter claim reporting period, which should result in less reserve variability and more predictable results. The initial impact of ceasing to write contractors on an occurrence form caused a decrease in premium writings on our contractors book in 2005. The market for contractors written on a claims-made form did, however, begin to improve late in 2005 and into 2006 causing an increase in our casualty premiums of $8.4 million during 2006. The growth in our property and casualty segment was slightly offset by minimal rate decline in property business while casualty rates remained stable. In addition, our gross written premiums for the year ended December 31, 2006, includes an adjustment of $20.9 million related to the initial booking of policies that have been written by agents but not yet reported to us, as discussed above.
Net written premiums represented 85.5% of gross written premiums for year ended December 31, 2007, compared to 87.6% for the same period in 2006. The lower relationship of net written premiums to gross written premiums for the year ended December 31, 2007 reflects an increase in ceded premiums in the current year, as noted above.
The ratio of premiums earned to net written premiums for the year ended December 31, 2007 and 2006 was 106.8% and 88.3%, respectively. The relationship of premiums earned to net written premiums during the year ended December 31, 2007 was higher compared to the same period in 2006, reflecting a decrease in the growth rate of premiums in 2007 compared to the same period in 2006.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006. Net investment income was $22.1 million for the year ended December 31, 2007, compared to $19.4 million for the same period in 2006. The increase was primarily due to an increase in assets available for investment, including cash. Invested assets, including cash, increased by $31.2 million to $467.3 million as of December 31, 2007 from $436.1 million as of December 31, 2006. The pre-tax investment yield for the years ended December 31, 2007 and 2006 was 5.1%. Our taxable equivalent yield for the year ended December 31, 2007 was 5.7% compared to 5.8% for the same period in 2006.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006. We realized net investment losses of $2.0 million for the year ended December 31, 2007 compared to net investment gains of $80,000 for the year ended December 31, 2006. Other-than-temporary losses of $4.5 million were realized during the year ended December 31, 2007. These losses related to 38 asset-backed securities that were written down in accordance with EITF 99-20 and six preferred stocks for the year ended December 31, 2007. Other-than-temporary losses of $1.4 million were realized during the year ended December 31, 2006.
We exercise a considerable degree of judgment in evaluating the numerous factors involved in the estimation of reserves. Different actuaries will choose different assumptions when faced with such uncertainty, based on their individual backgrounds, professional experiences and areas of focus. Hence, the estimate selected by various actuaries may differ materially. We consider this uncertainty by examining our historic reserve accuracy.
The amount by which estimated losses differ from those originally recorded for a period is known as “development.” Development is unfavorable when the losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for increasing loss reserves on unresolved claims. Development is favorable when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on unresolved claims. We reflect favorable or unfavorable developments of loss reserves in the results of operations for the period in which the estimates are changed.
We record two categories of loss and loss expense reserves - case-specific reserves and incurred but not reported (“IBNR”) reserves.
increase or decrease the estimate of the ultimate value of the claim. We may determine that it is appropriate to pay portions of the reserve to the claimant or related settlement expenses before final resolution of the claim. The amount of the individual claim reserve would then be adjusted accordingly based on the most recent information available.
We establish IBNR reserves to estimate the amount we will have to pay for claims that have occurred, but have not yet been reported to us; claims that have been reported to us that may ultimately be paid out differently than expected by our case-specific reserves; and claims that have been paid and closed, but may reopen and require future payment. Case reserves and IBNR reserves comprise the total loss and loss expense reserves.
The following table presents our incurred losses and loss expenses (net of the effects of reinsurance) from the most current accident year and from re-estimation of ultimate losses on prior accident years and provides a summary of losses incurred to premiums earned (loss and loss expense ratio) for the periods indicated:
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006. Our gross reserves for loss and loss expenses were $279.3 million (before the effects of reinsurance) and $238.4 million (after the effects of reinsurance) at December 31, 2007, as estimated through our actuarial analysis. At December 31, 2006, our gross reserves for loss and loss expenses were $250.7 million (before the effects of reinsurance) and $214.6 million (after the effects of reinsurance), as estimated through our actuarial analysis. In 2007, we concluded through our actuarial analysis that the December 31, 2006 reserve for losses and loss expenses of $214.6 million (after the effects of reinsurance) was redundant by $9.1 million, primarily due to favorable development in our casualty reserves.
Net loss and loss expenses incurred were $125.9 million for the year ended December 31, 2007, compared to $135.5 million for the year ended December 31, 2006. In 2007, we recorded $135.0 million of incurred losses and loss expenses attributable to the 2007 accident year, which were partially offset by favorable development of $9.1 million attributable to events of prior years. In 2006, we recorded $136.6 million of incurred losses and loss expenses attributable to the 2006 accident year and $1.1 million of favorable prior year development. Net loss and loss expense ratios were 57.9% and 61.9% for the years ended December 31, 2007 and 2006, respectively.
other casualty business based on loss experience that emerged during the year. Due to the reduction of these long-term loss ratio expectations and loss development factors, the indicated ultimate loss ratios produced by certain actuarial methods were lower as of December 31, 2007 than they were as of December 31, 2006. As a result, during the year, management reduced the selected ultimate loss ratios for casualty business for accident years 2004 through 2006. The reduction in losses for casualty business discussed above was partially offset by increases in legal and settlement costs related to litigation on construction defect claims. In total, this resulted in favorable development of $6.1 million for the year ended December 31, 2007. In addition, 2007 we experienced favorable case reserve development in the property line for accident years 2005 and 2006, resulting in a reduction in losses of $2.7 million during 2007.
Net loss and loss expenses incurred were $135.5 million for the year ended December 31, 2006, compared to $118.3 million for the year ended December 31, 2005. In 2006, we recorded $136.6 million of incurred losses and loss expenses attributable to the 2006 accident year and $1.1 million of favorable prior year development. In 2005, we recorded $112.9 million of incurred losses and loss expense attributable to the 2005 accident year and $5.4 million of unfavorable prior year development. Net loss and loss expense ratios were 61.9% and 66.6% for the years ended December 31, 2006 and 2005, respectively.
Our changes in the reserve estimates related to prior accident years for the years ended December 31, 2006 and 2005 for the casualty lines resulted in reserve increases of $6.2 million and $7.4 million, respectively. A significant portion of our casualty reserve development relates to construction defect claims with loss dates prior to 2001 in certain states. Reserves and claim frequency on this business have been impacted by decisions by courts in
California and other states affecting insurance law and tort law and by legislation enacted in California, which generally provides consumers who experience construction defects a method other than litigation to obtain reimbursement for construction defect repairs. These legal developments impact claim severity, frequency and time to settlement assumptions underlying our reserves. Starting with California in December 2000, we began to exit contractors’ liability business written on an occurrence form. By the end of the first quarter of 2001, we had significantly reduced our contractors’ liability written on an occurrence form in Arizona, California, Colorado, Hawaii, Louisiana, Nevada, New Jersey, North Carolina, Oregon, South Carolina and Washington. Although we reduced our exposure to construction defect claims and, accordingly, the magnitude of our adverse development in this business has declined since 2000, our ultimate liability may exceed or be less than current estimates due to these legal actions among other variables.
Our net loss and loss expense reserves for construction defects as of December 31, 2007, 2006 and 2005 were $15.6 million, $16.5 million and $17.7 million, respectively. The re-estimation of construction defect reserves for the years ended December 31, 2007, 2006 and 2005 primarily affected the 1996 and 1997 accident years and the 1999 to 2001 accident years.
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
At the low end of the range, the parameters of the IBNR estimate were varied as follows:
claim reporting patterns were reduced by amounts ranging from 10% to 1%;
close with payment ratios by accident year were not varied; and
These factors produced IBNR estimates that, when added to case reserves, were 12.8% below the best estimate reserves.
hurricane activity, we believed that there was a potential risk that case reserves would not be set as quickly as they would be with normal case loads. Accordingly, we considered this potential risk in setting our expected payment pattern and case incurred pattern for property business resulting in a higher reserve estimate than would have been normally set absent this risk. At the end of 2005, we held property IBNR for loss and loss expenses of $13.8 million. We expected $8.6 million of reported incurred losses and loss expenses for the year 2006. During 2006, actual reported incurred loss and loss expense reserves were $3.4 million. As a result of the significantly better than expected loss emergence during 2006, the selected payment patterns and case incurred patterns were revised downward. As a result of the better than expected loss emergence and the revision to payment and case incurred patterns, the IBNR reserve for accident years 2005 and prior as of December 31, 2006 decreased to $1.8 million. These results, coupled with a corresponding reduction in claim handling costs yielded the overall reduction of $9.3 million in losses and loss expense in 2006. For 2007 and 2005, the changes in reserves primarily relate to changes in the selected development patterns on multiple accident years, as the number of claims and claim severity were below expectations at December 31, 2007 and 2005.
Our internal actuaries apply multiple actuarial techniques utilizing the same factors discussed above under “Casualty” to determine loss and loss expense reserve estimates for property claim liabilities. 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 that considers assumptions and factors, as discussed above, that influence ultimate claim costs. As of December 31, 2007, for property lines the low end of the range of techniques was 19.0% below the actuarial best estimate and the high end of the range of techniques was 5.7% 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. The range presented herein represents neither the full range of reasonably likely outcomes nor the full range of possible outcomes.
We also decreased the commissions paid to the agent from 21% to 17%. These changes were designed to increase the profitability of this program to meet our expectations.
We have historically filed a consolidated federal income tax return that has included all of our subsidiaries. The statutory rate used in calculating our tax provision was 35.0% in 2007, 2006 and 2005. Income tax expense differed from the amounts computed at the statutory rate as demonstrated in the following table:
Our insurance subsidiaries are required by law to maintain a certain minimum level of surplus on a statutory basis. Surplus is calculated by subtracting total liabilities from total admitted assets. The National Association of Insurance Commissioners (“NAIC”) has a risk-based capital standard designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of each insurer’s assets and liabilities and its mix of net written premiums. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. As of December 31, 2007, the statutory surplus of Century (which includes Century’s investment in PIC) was in excess of the prescribed risk-based capital requirements that correspond to any level of regulatory action. Century’s statutory surplus (including PIC’s surplus) at December 31, 2007 was $153.5 million and the authorized control level was $31.1 million.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006. Consolidated net cash provided by operating activities was $45.4 million for the year ended December 31 2007, compared to $64.0 million for the same period in 2006. The majority of the decrease is due to the lower amount of growth in premiums for the year ended December 31, 2007 compared to the year ended December 31, 2006.
Consolidated net cash used in investing activities was $41.2 million for the year ended December 31, 2007, compared to $63.9 million for the same period in 2006. The decrease resulted from a lower amount of operational cash available for investing during 2007 compared to 2006.
Year ended December 31, 2006 compared to Year ended December 31, 2005. Consolidated net cash provided by operating activities was $64.0 million for the year ended December 31, 2006, compared to $63.7 million for the year ended December 31, 2005. The increase is due to our growth of gross written premiums and investment income, which was partially offset by an increase in the amount of claim payments as a result of the 2005 hurricane season and quicker claim payouts related to the auto physical damage program, as it has a much shorter tail than our other property and casualty business.
The following table summarizes information about our contractual obligations and commercial commitments. The minimum payments under these agreements as of December 31, 2007 were as follows:
Amounts include interest payments associated with these obligations using applicable interest rates as of December 31, 2007.
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 and one related party investment manager, all which operate under investment guidelines approved by our investment committee. Our investment committee meets at least quarterly and reports to our 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
At December 31, 2007, our fixed-maturity portfolio of $407.5 million represented 87.3% of the carrying value of our total of cash and investments. Standard & Poor’s Rating Services (“Standard & Poor’s”) or Moody’s Investors Service, Inc. (“Moody’s”) rated 95.3% of these securities “A” or better. Equity securities, which consist of preferred and common shares and bond mutual funds, totaled $43.2 million or 9.2% of total cash and investments. The following is a summary of the credit quality of the fixed-maturity portfolio at December 31, 2007:
At December 31, 2007, the investment portfolio contained $154.7 million of mortgage-backed, asset-backed and collateralized mortgage obligations. Of these securities, 96.2% were rated “AA” or better and 95.3% were rated “AAA” by Standard & Poor’s or the equivalent rating by Moody’s. These securities are publicly registered and had fair values obtained from brokers. Changes in estimated cash flows due to changes in prepayment assumptions from the original purchase assumptions are revised based on current interest rates and the economic environment. We had no derivative financial instruments, real estate or mortgages in the investment portfolio at December 31, 2007.
Additionally, for certain securitized financial assets with contractual cash flows (including asset-backed securities), FASB Emerging Task Force (EITF) 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets,” requires us to periodically update its best estimate of cash flows over the life of the security. If management determines that the fair value of a securitized financial asset is less than its carrying amount and there has been a decrease in the present value of the estimated cash flows since the last revised estimate, considering both timing and amount, then an other-than-temporary impairment is recognized.
the total of $150,000, which was included in net realized investment gains (losses) in the consolidated statements 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, 2007 and 2006, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2007, 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.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 17, 2008 expressed an adverse opinion on the effectiveness of the Company’s internal control over financial reporting.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. A material weakness related to determining the assumptions for projected cash flows for asset-backed securities in connection with management’s assessment of other-than-temporary impairment has been identified and included in Management’s Report on Internal Control over Financial Reporting. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2007 and 2006, and the related consolidated statements of operations, shareholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2007. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2007 consolidated financial statements, and this report does not affect our report dated March 17, 2008, which expressed an unqualified opinion on those consolidated financial statements.
Following is a description of the significant risks facing the Company:
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. In addition, the Company may be likely to experience realized investment losses to the extent its liquidity needs require the disposition of fixed-maturity securities in unfavorable liquidity or credit spread environments.
Ratings Risk is the risk that rating agencies change their outlook or group rating of Century and PIC. The rating agencies generally utilize proprietary capital adequacy models in the process of establishing group ratings for Century and PIC. Century and PIC are at risk to changes in these models and the impact that changes in the underlying business that it is engaged in can have on such models.
Significant Business Concentrations: As of December 31, 2007, 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 could cause a severe impact to the Company’s financial position. The Company did, however, have a concentration of business transactions with a particular customer. See Note 11(c).
Realized gains or losses represent the difference between the amortized cost 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 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; management’s intent to hold or dispose of the security; and current economic conditions. Other-than-temporary impairment losses result in a permanent reduction to the cost basis of the underlying investment.
Premiums in course of collection include amounts due from agents, and beginning in 2006, including an estimate of the policies that have been written by agents but not yet reported to us, and amounts relating to assumed reinsurance. These balances are stated net of certain commission payable amounts, prepaid agents’ balances, and allowance for uncollectible premiums in course of collection. The Company evaluates the collectibility of premiums in course of collection based on a combination of factors. In circumstances in which the Company is aware of a specific customer’s inability to meet its financial obligations to the Company, a specific allowance for bad debt against amounts due is recorded to reduce the net receivable to the amount believed to be collectible. For all remaining balances, allowances are recognized for bad debts based on the length of time the receivables are past due using the Company’s historical experience of write-offs. The allowance for uncollectible premiums in course of collection was $142,000 and $156,000, at December 31, 2007 and 2006, respectively.
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 payments and reserves, respectively, that are ceded to reinsurers and are reported separately as assets, net of any valuation allowance. 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 losses at December 31, 2007 and 2006 was $3.4 million and $4.1 million, respectively.
On June 1, 2005, Century acquired 100% of the outstanding shares of the Fireman’s Fund of Texas (FFTX) for $5.9 million. FFTX is a Texas domiciled property and casualty company licensed in Texas, Oklahoma and California, Arizona, Arkansas, Indiana, Kansas, Louisiana, Michigan, Missouri, Nevada, New Mexico, North Dakota, Oregon, South Carolina, Utah and West Virginia. The acquisition is part of the Company’s long-term plan to develop business that requires admitted status, as well as its continued focus on growing its excess and surplus lines business. On August 16, 2005, FFTX was renamed ProCentury Insurance Company. The total purchase price of the acquisition was allocated to the assets and the liabilities acquired based upon the respective fair values as of the date of acquisition. Intangible assets included in the purchase were valued at $375,000. The excess of the fair value of the net identifiable assets acquired over the purchase price was $240,000 and was recorded as non-deductible goodwill. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” the amortization of goodwill and indefinite-lived intangible assets is not permitted. Goodwill and indefinite-lived intangible assets remain on the balance sheet and are tested for impairment on an annual basis, or when there is reason to suspect that their values may have been diminished or
The Company utilizes the asset and liability method of accounting for income tax. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under this method, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established when necessary to reduce the deferred tax assets to the amounts which are more likely than not to be realized.
Comprehensive income encompasses all changes in shareholders’ equity (except those arising from transactions with shareholders) and includes net income and changes in net unrealized investment gains and losses on fixed maturity investments classified as available-for-sale and equity securities, net of taxes.
If the Company recorded compensation expense for its share option grants based on the “fair value method,” the Company’s net income and earnings per share for the year ended December 31, 2005 would have been adjusted to the pro forma amounts as indicated in the following table:
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS No. 157”), which clarifies that the term fair value is intended to mean a market-based measure, not an entity-specific measure and gives the highest priority to quoted prices in active markets in determining fair value. SFAS No. 157 requires disclosures about (1) the extent to which companies measure assets and liabilities at fair value, (2) the methods and assumptions used to measure fair value, and (3) the effect of fair value measures on earnings. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of adopting
In July 2006, the Financial Accounting Standards Board (“FASB”) released FASB Interpretation No. (FIN) 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109.” FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS 109, “Accounting for Income Taxes.” The Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. It also provides guidance on derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We adopted FIN 48 effective January 1, 2007 and it did not have a material impact on our consolidated financial condition or results of operations.
The Company invests primarily in investment-grade fixed maturities. The amortized cost, gross unrealized gains and losses and estimated fair value of fixed maturity securities classified as held-to-maturity were as follows:
At December 31, 2007, the Company had 141 fixed-maturity securities and seven equity securities that have been in an unrealized loss position for one year or longer. Of the fixed-maturity securities, 121 are investment grade, and 116 of these securities are rated A1/A or better (including 84 securities which are rated AAA). The 20 remaining non-investment grade fixed-maturity securities have an aggregate fair value equal to 65.2% of their book value as of December 31, 2007. The majority of this unrealized loss related to sub prime bonds, a sector which has experienced significant illiquidity and price dislocation. Each of these sub prime bonds was tested under the application of EITF 99-20 and it was determined none of these bonds was other than temporarily impaired. Three of the equity securities that have been in an unrealized loss position for one year or longer relate to investments in open ended bond funds. Each of these investments continues to pay its regularly scheduled monthly dividend and there have been no material changes in credit quality of any of these funds over the past twelve months. Finally, the four
The estimated fair value, related gross unrealized loss, and the length of time that the securities have been impaired for available-for-sale securities that were considered temporarily impaired at December 31, 2007 were as follows:
Proceeds from the sale of fixed maturity securities available-for-sale were $201.8 million, $71.6 million, and $48.3 million for the years ended December 31, 2007, 2006 and 2005, respectively.
Century and PIC held fixed maturity securities with a carrying value of $9.9 million and $9.4 million on deposit with regulatory authorities as required by law at December 31, 2007 and 2006, respectively.
Loss and loss expense reserves represent our best estimate of ultimate amounts for losses and related expenses from claims that have been reported but not paid, and those losses that have occurred but have not yet been reported to us. Loss reserves do not represent an exact calculation of liability, but instead represent our estimates, generally utilizing individual claim estimates, actuarial expertise and estimation techniques at a given accounting date. The loss reserve estimates are expectations of what ultimate settlement and administration of claims will cost upon final resolution. These estimates are based on facts and circumstances then known to us, a review of historical settlement patterns, estimates of trends in claims frequency and severity, projections of loss costs, expected
The favorable development during the year ended December 31, 2007 primarily relates to the 2004 through 2006 accident years. At the beginning of 2005, the Company began writing certain contractors’ liability business on a claims made form, replacing the occurrence form which had previously been utilized through 2004. The Company wrote a significant volume of claims made contractor liability business in both 2005 and 2006, and this business has continued to perform better than expected. The Company continues to write contractors’ liability business on an occurrence form, in certain jurisdictions and for certain classes of business. The ultimate loss ratios for the 2005 and 2006 accident years were reduced during 2007 due in part to the continued favorable experience on the claims made contractor liability business. In addition, management reduced its long-term loss ratio expectations and loss development factors for other casualty business based on loss experience that emerged during the year that was more favorable than our initial expectations. Due to the reduction of these long-term loss ratio expectations and loss development factors, the indicated ultimate loss ratios produced by certain actuarial methods were lower as of
December 31, 2007 than they were as of December 31, 2006. As a result, during the year, management reduced the selected ultimate loss ratios for casualty business for accident years 2004 through 2006. The reduction in losses for casualty business discussed above was partially offset by increases in legal and settlement costs related to litigation on construction defect claims. In total, this resulted in favorable development of $6.1 million for the year ended December 31, 2007. In addition, during the year the Company experienced favorable case reserve development in the property line for accident years 2005 and 2006, resulting in a reduction in losses of $2.7 million during the year.
Management believes the loss and loss expense reserves make a reasonable provision for expected losses; however, ultimate settlement of these amounts could vary significantly from the amounts recorded.
property and casualty, workers’ compensation, and commercial automobile lines of business and Evergreen assumed all of Century’s traditional surety lines of business.
At December 31, 2007 and 2006, the Company’s allowance for uncollectible reinsurance was $3.4 million and $4.1 million, respectively. Management believes that the reserves for uncollectible reinsurance constitute a reasonable provision for expected costs and recoveries related to the collection of the recoverables on these claims; however, actual legal costs and settlements of these claims could vary significantly from the current estimates recorded.
The following table displays net reinsurance balances recoverable, from our top ten reinsurers, as of December 31, 2007. All other reinsurance balances recoverable, when considered by individual reinsurer, are less than 3 percent of shareholders’ equity.
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 16, 2008, respectively. Holders of the Trust Preferred Securities are entitled to receive
The Company has a $10.0 million line of credit with a maturity date of September 30, 2009, and interest only payments due quarterly based on LIBOR plus 1.2% of the outstanding balance. All of the outstanding shares of Century are pledged as collateral. At December 31, 2007, the outstanding borrowings on the line of credit were $4.7 million. During the year ended 2007, the Company made draws totaling $650,000 on the line of credit for general corporate purposes. Interest expense for the year ended December 31, 2007 was $324,000. The Company had borrowings outstanding under the line of credit at December 31, 2006 of $4.0 million. Interest expense for the year ended December 31, 2006 was $6,000.
Effective January 1, 2007, the Company FIN 48, which clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements. FIN 48 requires companies to determine whether it is “more likely than not” that a tax position will be sustained upon examination by the appropriate taxing authorities before any pare to the benefit can be recorded in the financial statements. It also provides guidance on the recognition, measurement and classification of income tax uncertainties, along with any related interest and penalties. Previously recorded income tax benefits that no longer meet this standard are required to be charged to earnings in the period that such determination is made. There was no change in the liability for unrecognized tax benefits resulting from the implementation of FIN 48 and , therefore, the Company did not recognize a cumulative effect adjustment to the balance of retained earnings as of January 1, 2007. The Company does not have a liability for tax exposure reserves as of December 31, 2007 and 2006, and does not anticipate any material change in the total amount of unrecognized tax benefits over the subsequent 12-month period. The adoption did not have an initial impact on the Company’s consolidated financial statements.
operations. There was no valuation allowance at December 31, 2006. Management periodically evaluates the adequacy of related valuation allowances, taking into account our open tax return positions, tax assessments received and tax law changes. The process of evaluating allowance accounts involves the use of estimates and a high degree of management judgment. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities and reserves.
The Company’s estimates are reviewed continuously to ensure reasonableness. However, the amounts the Company may ultimately realize could differ from such estimated amounts.
We are party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Certain of the lawsuits, arbitrations and other proceedings involve claims under policies that we underwrite as an insurer, the liabilities for which we believe have been adequately included in our loss and loss adjustment expense reserves. Also, from time to time, we are party to lawsuits, arbitrations and other proceedings that relate to disputes over contractual relationships with third parties or that involve alleged errors and omissions on the part of our insurance subsidiaries. We provide accruals for these items to the extent we deem the losses probable and reasonably estimable.
The outcome of litigation is subject to numerous uncertainties. Although the ultimate outcome of pending matters cannot be determined at this time, based on present information, we believe the resolution of these matters will not have a material adverse effect on our financial position, results of operations or cash flows.
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 to employees and qualified board members that do not qualify as tax-favored incentive share options (non-qualified options), time-based restricted shares that vest solely on service provided and restricted shares that vest based on achieved performance metrics. The Company accounts for this plan in accordance with FAS 123R. Any compensation cost recorded in accordance with FAS 123R is recorded in the same captions as the salary expense of the employee (i.e. the compensation cost for the Chief Investment Officer is recorded in net investment income). The Company will issue authorized but unissued shares or treasury shares to satisfy restricted share awards or the exercise of share options.
For both non-qualified and qualified options, the option exercise price equals the stock’s fair market value on the date of the grant. Compensation expense is measured on the grant date at fair value using a Black Scholes model. The compensation cost is recognized over the respective service period, which typically matches the vesting period.
The Company may grant awards for up to 1.2 million shares under the plan. Through December 31, 2007, the Company had granted 311,000 non-qualified options, 292,500 qualified options, 156,000 time-based restricted shares, 132,353 performance-based restricted shares, and 8,661 non-restricted shares under the share plan.
The fair market value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in 2007, 2006 and 2005:
A summary of all employee performance-based restricted share activity during the year ended December 31, 2007 is as follows:
Transitional Administrative Agreement. Prior to the Evergreen and Continental dispositions, the Company provided Evergreen and Continental with all executive, managerial, supervisory, administrative, technical, claims handling, investment management, regulatory affairs, legal, accounting, financial reporting, professional and clerical services necessary to operate their respective businesses. In order to provide Evergreen and Continental
with a transition period before the cessation of these services, the Company entered into a Transitional Administrative Agreement with Evergreen and Continental pursuant to which the Company continued to provide these services to Evergreen and Continental for an initial term of 18 months in exchange for an annual fee of $900,000. This agreement was renewed for one six-month term to expire on December 31, 2005, without any changes in the terms thereof. On December 29, 2005, the agreement was amended to extend the term thereof to June 30, 2006, reduce the administrative fee to $75,000 per calendar quarter payable during the first month of each quarter and providing for termination upon not less than thirty (30) days advance written notice to the Company. On October 13, 2006, the agreement was amended retroactively to July 1, 2006 to extend the term thereof to March 31, 2007 and reduce the administrative fee to $10,000 per calendar quarter. On April 25, 2007, the agreement was amended retroactively to April 1, 2007 to extend the term thereof to June 30, 2007 and reduce the administrative fee to $5,000 per calendar quarter. In all other respects the agreement remained unchanged. The agreement was terminated as of June 30, 2007. For the year ended December 31, 2007, 2006, and 2005, the Company received $15,000, $170,000, and $690,000 under this agreement, respectively.
Reinsurance Agreements. The Company entered into loss portfolio transfer reinsurance contracts that provided for Century to reinsure Evergreen and Continental for business that was written in Century’s name prior to December 31, 2003 and transferred to one of the other companies in connection with the termination of an intercompany pooling agreement among the parties and for Evergreen to reinsure Century in the same manner. For example, Century will reinsure property business transferred to it in connection with the termination of the intercompany pooling agreement that had been written for it in Evergreen’s name. These contracts will remain in force until all outstanding loss and assignable loss adjustment expense covered has been settled or commuted in accordance with the provisions of the applicable contract. The Company ceded $435,000 of reserves and assumed $2.8 million of reserves under this contract in 2007. During the year ended December 31, 2006, the Company ceded $362,000 of reserves and assumed $3.1 million of reserves under the contract.
On August 1, 2006, the Company became a participant on Evergreen’s Landfill Variable Quota Share Treaty. The Company will assume 10% of all landfill bonds written by Evergreen and Continental which have exposures in excess of $1,200,000. The Company recorded assumed premium of $1.9 million in 2007. The Company recorded assumed premium of $390,000 in 2006. In addition, the Company assumed a 10% share, or $677,000, of unearned premium rolled forward from the previous treaty which was terminated on July 31, 2006.
The following table summarizes information about contractual obligations and commercial commitments. The minimum payments under these agreements as of December 31, 2007 were as follows:
ProCentury did not make any contributions to Century in 2007. ProCentury contributed $2.5 million to Century in 2006. There were no such contributions in 2005.
The Company operates in the Property and Casualty Segment (including general liability, multi-peril, commercial property, garage liability and auto physical damage).
The Company considers many factors, including economic similarity, the nature of the underwriting unit’s insurance products, production sources, distribution strategies and regulatory environment in determining how to aggregate operating segments.
Since the weighted-average shares for the quarters are calculated independently of the weighted-average shares for the year, quarterly income per share may not total to annual income per share.
If the 30-day volume-weighted average price of the Meadowbrook common stock preceding the election date, which will be at least five days before the closing of the transaction, is between $8.00 and $10.50, the exchange ratio will result in stock consideration having a value of $20.00 per ProCentury common share based on such 30-day volume-weighted average price. Above or below this range for Meadowbrook’s stock price, the exchange ratio will be fixed as if the 30-day volume-weighted average price preceding the election date equaled $10.50 or $8.00, as applicable. Outstanding options to purchase ProCentury common shares will become fully vested and option
The Merger is subject to customary closing conditions, including the approval of Meadowbrook and ProCentury shareholders, regulatory approvals, the absence of any law or order prohibiting the closing, the effectiveness of the Form S-4 registration statement relating to the Meadowbrook common stock to be issued in the Merger, the accuracy of the representations and warranties of the other party (subject to the standards set forth in the Merger Agreement), compliance of the other party with its covenants in all material respects and the delivery of opinions relating to the U.S. federal income tax code treatment of the Merger. If the merger is not consummated as a result of certain events, we will be required to pay a termination fee of $9.5 million to Meadowbrook.