In 1998, we purchased land in Southfield, Michigan for a cost of $3.2 million. In 2004, the construction of our new corporate headquarters was completed on half of this land. On December 6, 2004, we relocated to the new office building. This new building is approximately 72,000 square feet. The total construction cost of the building approximated $12.0 million, which was paid in full at the closing on January 19, 2005. Previously, we leased our corporate offices from an unaffiliated third party. In 2004, we paid rent for those offices in the amount of approximately $1.5 million.
In 2003, we entered into a Purchase and Sale Agreement, whereby we agreed to sell the remaining portion of the land to an unaffiliated third party for the purpose of constructing an office building adjacent to our new corporate headquarters. In exchange for a land contract, this third party agreed to pay $2.1 million for the land, $1.2 million for their share of the costs related to the common areas, and other related costs of approximately $226,000. A deposit on this transaction was placed into escrow on July 29, 2004, subject to the conveyance of certain land by the City of Southfield and filing of the revised land description with the register of deeds. The transaction is expected to be completed in 2005.
This Form 10-K may provide information including certain statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These include statements regarding the intent, belief, or current expectations of management, including, but not limited to, those statements that use the words “believes”, “expects”, “anticipates”, “estimates”, or similar expressions. You are cautioned that any such forward-looking statements are not guarantees of future performance and involve a number of risks and uncertainties. Results could differ materially from those indicated by such forward-looking statements. Among the important factors that could cause actual results to differ materially from those indicated by such forward-looking statements are: the frequency and severity of claims; uncertainties inherent in reserve estimates; catastrophic events; a change in the demand for, pricing of, availability or collectibility of reinsurance; increased rate pressure on premiums; obtainment of certain rate increases in current market conditions; investment rate of return; changes in and adherence to insurance regulation; actions taken by regulators, rating agencies or lenders; obtainment of certain processing efficiencies; changing rates of inflation; general economic conditions and other risks identified in our reports and registration statements filed with the Securities and Exchange Commission. We are not under any obligation to (and expressly disclaim any such obligation to) update or alter our forward-looking statements whether as a result of new information, future events or otherwise.
On June 6, 2002, we sold 18,500,000 shares of newly issued common stock at $3.10 per share in a public offering. On June 21, 2002, the underwriters exercised their over-allotment option to acquire 2,775,000 of additional shares of our common stock. After deducting underwriting discounts, commissions, and expenses, we received net proceeds from the offering of $60.5 million. We utilized $57.5 million of the $60.5 million raised in the public offering to pay down our line of credit by $20.0 million and contributed $37.5 million to the surplus of our Insurance Company Subsidiaries. The remaining proceeds were used for general corporate purposes.
On April 29 and May 26, 2004, we issued senior debentures in the amount of $13.0 million and $12.0 million, respectively. The senior debentures mature in thirty years. We contributed $9.9 million of the proceeds from the senior debentures to our Insurance Company Subsidiaries as of December 31, 2004. The
We categorize our programs into three categories: managed, risk-sharing, and fully insured. With managed programs, we earn service fee revenue by providing management and other services to a client’s risk-bearing entity, but generally do not share in the operating results. With risk-sharing programs, we participate with the client or producer in the operating results of the programs through the utilization of a captive, rent-a-captive or similar structure, which are reinsurance companies and are accounted for under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts”. With risk-sharing programs, we derive revenues from net earned premiums, fee revenue and commissions, and investment income. In addition, we may benefit from any margin built into the ceding commissions for services we render on behalf of the risk-sharing partner for the program. With fully insured programs, we provide commercial insurance coverage and derive revenue from net earned premiums and investment income. Fully insured programs are developed in response to a specific market opportunity and generally when we believe there is potential to evolve into a risk-sharing program.
When a claim is reported to one of our Insurance Company Subsidiaries, our claims personnel establish a case reserve for the estimated amount of the ultimate payment. The amount of the reserve is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding each claim, and the policy provisions relating to the type of losses. The estimate reflects the informed judgment of such personnel based on general insurance reserving practices, as well as the experience and knowledge of the claims person. Until the claim is resolved, these estimates are revised as deemed necessary by the responsible claims personnel based on subsequent developments and periodic reviews of the claims.
In addition to case reserves and in accordance with industry practice, we maintain estimates of reserves for losses and LAE incurred but not yet reported. We project an estimate of ultimate losses and LAE at each reporting date. The difference between: (i) projected ultimate loss and LAE reserves and (ii) case loss reserves and LAE reserves thereon is carried as the IBNR reserve. By using both estimates of reported claims and IBNR determined using generally accepted actuarial reserving techniques, we estimate the ultimate liability for losses and LAE, net of reinsurance recoverables.
In our risk-sharing programs, we are subject to credit risk with respect to the payment of claims by our clients’ captive, rent-a-captive, large deductible programs, indemnification agreements, and on the portion of risk exposure either ceded to the captives, or retained by the clients. The capitalization and credit worthiness of prospective risk-sharing partners is one of the factors we consider upon entering into and renewing risk-sharing programs. Generally, we collateralize balances due from our risk-sharing partners through funds withheld trusts or letters of credit. We have historically maintained an allowance for the potential
At December 31, 2004 and 2003, we had 124 and 56 securities that were in an unrealized loss position, respectively. These investments all had unrealized losses of less than ten percent. At December 31, 2004, two investments, with an aggregate $75,000 unrealized loss, have been in an unrealized loss position for more than eighteen months. At December 31, 2003, one investment, with a $71,000 unrealized loss, was in an unrealized loss position for more than eighteen months. As of December 31, 2004 and 2003, gross unrealized losses on available for sale securities were $1.3 million and $893,000, respectively.
We recognize premiums written as earned on a pro rata basis over the life of the policy term. Unearned premiums represent the portion of premiums written that are applicable to the unexpired terms of policies in force. Provisions for unearned premiums on reinsurance assumed from others are made on the basis of ceding reports when received and actuarial estimates. In addition, certain premiums are subject to retrospective premium adjustments. Premium is recognized over the term of the insurance contract.
Commission income, which includes reinsurance placement, is recorded on the later of the effective date or the billing date of the policies on which they were earned. Commission income is reported net of sub-producer commission expense. Commission and other adjustments are recorded when they occur and we maintain an allowance for estimated policy cancellations and commission returns.
We review, on an ongoing basis, the collectibility of our receivables and establish an allowance for estimated uncollectible accounts. As of December 31, 2004 and 2003, the allowance for uncollectibles on receivables was $4.3 million and $4.7 million, respectively.
We are subject at times to various claims, lawsuits and proceedings relating principally to alleged errors or omissions in the placement of insurance, claims administration, consulting services and other business transactions arising in the ordinary course of business. Where appropriate, we vigorously defend such claims, lawsuits and proceedings. Some of these matters seek damages, including consequential, exemplary or punitive damages, in amounts that could, if awarded, be significant. We continually evaluate the likelihood on any adverse development to theses matters and their potential impact on our financial statements. There can be no assurance, however, that the actual outcomes will be consistent with our evaluations. On the basis of current information, we do not expect the outcome of the claims, lawsuits and proceedings to which we are subject to, either individually, or in the aggregate, will have a material adverse effect on our financial condition. However, it is possible that future results of operations or cash flows for any particular quarter or annual period could be materially affected by an unfavorable resolution of any such matters. Most of the claims, lawsuits and proceedings arising in the ordinary course of business are covered by errors and omissions insurance or other appropriate insurance. In terms of deductibles associated with such insurance, we have established provisions against these items, which we believe to be adequate in light of current information and legal advice.
Goodwill represents the excess of the purchase price over the fair value of net assets of subsidiaries acquired. As required by SFAS No. 142 “Goodwill and Other Intangible Assets”, we no longer amortize goodwill and, at least annually, we test all existing goodwill for impairment using a fair value approach, on a reporting unit basis. We test for impairment more frequently if events or changes in circumstances indicate that there may be an impairment to goodwill. We carry goodwill on two reporting units within the agency operations segment in the amount of $4.0 million and three reporting units within the specialty risk management operations segment in the amount of $25.0 million. Based on our most recent evaluation of goodwill impairment, we determined that no impairment to goodwill exists.
During 2004, we continued to experience an improved earnings pattern. Our underwriting results strengthened as a result of the controlled growth in earned premium in profitable programs. Our net income for 2004, demonstrates our commitment to continued underwriting discipline, our focus on growing our profitable specialty and fee-for-service programs, rate increases, and our on-going plan to leverage fixed costs. In addition, we continued to achieve operational efficiencies and enhancements. As a result, our generally accepted accounting principles (“GAAP”) combined ratio improved 3.0 percentage points to 101.4% in 2004 from 104.4% in 2003.
Claim fees decreased $1.6 million, or 10.5%, to $13.2 million, from $14.8 million for the comparable period in 2003. This decrease reflects a similar anticipated shifting of revenue previously generated from the multi-state claims run-off service contract, to internally generated fee revenue that is eliminated upon consolidation. The transition of such fees is directly related to the previously mentioned renewal rights
Net earned premiums increased $5.8 million, or 4.0%, to $151.2 million in the year ended December 31, 2003, from $145.4 million in the comparable period in 2002. This increase reflects net earned premiums from new business written in 2003 of $22.7 million. This includes $1.5 million of net earned premium from the conversion of existing business into an insured program within the one of our underwriting subsidiaries. The increase in net earned premiums is also the result of growth in existing business of $19.7 million primarily related to rate increases. Offsetting the increase in net earned premiums is a $36.6 million reduction in net earned premium related to programs discontinued in 1999 and programs terminated for leverage ratio purposes.
Claim fees increased $6.7 million, or 82.7%, to $14.8 million from $8.1 million for the comparable period in 2002. This increase in claim fees reflects revenue from new fee-for-service agreements of $9.0 million. As anticipated, as this claims fee-for-service agreement expires, the related revenue will decrease. This increase is partially offset by a decrease in discontinued programs and the impact of the conversion of an existing fee-based program into an insured program within the one of our underwriting subsidiaries. Those fees are now intercompany fees and are eliminated upon consolidation.
Net investment income decreased $474,000, or 3.4%, to $13.5 million in 2003, from $14.0 million in 2002. Average invested assets increased $41.7 million, or 16.0%, to $301.6 million in 2003, from $259.9 million in 2002. The average investment yield for 2003 was 4.5% compared to 5.4% in 2002. The current pre-tax book yield was 4.2% and current after tax book yield was 2.9%. The current pre-tax reinvested yield was 3.2%. The decrease in investment yields reflects the accelerated prepayments in the mortgage-backed securities, and reinvestment of cashflows in municipal bonds and other securities in an interest rate environment where interest rates are still relatively low compared with recent history. The average increase in invested assets reflects $37.5 million in proceeds from the public offering in June 2002 and cash flows from underwriting.
At December 31, 2004, our best estimate for the ultimate liability for loss and LAE reserves, net of reinsurance recoverables, was $227.0 million. We established a reasonable range of reserves of approximately $212.0 million to $241.1 million. This range was established primarily by considering the various indications derived from standard actuarial techniques and other appropriate reserve considerations. The following table sets forth this range by line of business (in thousands):
In accordance with FIN 46(R), we performed an evaluation of our business relationships and determined that our wholly owned subsidiary, American Indemnity, did not meet the tests for consolidation, as neither we, nor our subsidiary Star, are the primary beneficiaries of American Indemnity. Therefore, effective January 1, 2004, we deconsolidated American Indemnity on a prospective basis in accordance with the provisions of FIN 46(R). The adoption of FIN 46(R) and the deconsolidation of American Indemnity did not have a material impact on our consolidated balance sheet or consolidated statement of income. Refer to Recent Accounting Pronouncements of Management’s Discussion and Analysis.
The projected net ultimate loss estimate for the workers’ compensation line of business excluding residual markets increased $2.7 million, or 3.0% of net workers’ compensation reserves. This increase reflects the result of a $1.2 million and a $445,000 unfavorable impact related to the previously mentioned commutation of the 2000 and 2001 surplus relief reinsurance agreement and the reclassification between losses and expenses on one inactive program, respectively. Excluding the impact from the commutation and the reclassification, the net ultimate loss estimate for the workers’ compensation line of business, would have increased $981,000, or 1.1% of net workers’ compensation reserves. This net overall increase reflects an increase of $3.8 million in accident year 2003 from higher than expected emergence of claim activity related to an Alabama program, a Florida program, a Massachusetts program, and an inactive South Carolina program. In addition, there were net increases in the ultimate estimated losses for 1998 and 1997 of $360,000 and $315,000, respectively. These increases reflect higher than expected claims activity. In addition, there was a $536,000 increase in net ultimate loss estimates for 1996 driven by development on two cases within Florida. This net overall increase also reflects an additional $722,000 increase due to the acceleration of amortization of prepaid claims handling costs. These increases were partially offset by reductions of $1.2 million, $1.5 million, $645,000, and $1.6 million in the ultimate loss estimate for accident years 2002, 2001, 2000, and 1999, respectively. The decrease in the ultimate loss estimate for 2002 reflects better than expected experience on our core workers’ compensation programs, primarily in Massachusetts and Tennessee. The decrease in 1999 reflects a re-allocation of estimated reserves between accident years 2000 and 1999. In addition, the improvement in the 2000 and 2001 accident years reflects lower than expected development in case reserves across many programs. The change in ultimate loss estimates for all other accident years was insignificant.
The other lines of business had a decrease in net ultimate loss estimates of $670,000, or 4.2% of net reserves on the other lines of business. The net decrease reflects a decrease of $374,000, $135,000 and $136,000 in accident years 2001, 2000 and 1999, respectively. The improvement in these accident years reflects better than expected claims activity in several different programs. The change in ultimate loss estimates for all other accident years was insignificant.
Other administrative expenses increased $2.8 million, or 11.8%, to $26.0 million, from $23.2 million for the comparable period in 2003. This increase is primarily attributable to an increase in policyholder dividends for 2004 as opposed to a $1.8 million reduction in anticipated policyholder dividends reflected in 2003, due to management’s evaluation of the appropriateness of dividend payments in conjunction with overall
Other administrative expenses increased $620,000, or 2.7%, to $23.2 million in 2003, from $22.6 million for the comparable period in 2002. The increase in administrative expenses is primarily attributable to new fee-for-service agreements.
depreciation, and amortization, between our regulated and non-regulated subsidiaries, which reconciles to our consolidated statement of income and statement of cash flows (in thousands):
Cash flow provided by operations was $70.7 million in 2004, compared to $47.5 million in 2003. Cash flow provided by operations in 2002 was $1.8 million. On a consolidated basis, the increase in cash flow from operations in 2004 primarily reflects growth in written premiums and improved underwriting results. The increase in cash flow in 2003 primarily reflects an increase in earnings, growth in written premiums, growth in fee-for-service revenue, and collections of reinsurance recoverables.
Non-regulated subsidiaries’ cash flow provided by operations for the year ended December 31, 2004, was $8.6 million, compared to $17.9 million for the comparable period in 2003. The decrease in non-regulated cash flow from operations primarily reflects the inflow of cash related to the previously mentioned limited duration administrative services contract and a multi-state claims run-off contract entered into at the beginning of 2003. At inception, these contracts resulted in a higher inflow of cash during the first quarter of 2003. As anticipated, for the duration of the remaining life of these contracts, there will be a decrease in the associated inflow of cash in comparison to prior periods. In addition, the decrease in cash flow from operations is also the result of intercompany tax payments made during 2004 to the regulated subsidiaries in accordance with the tax sharing agreement. These intercompany tax payments were made to compensate the regulated subsidiaries for the utilization of our net operating loss carryforward. These intercompany tax payments also contributed to the increase in regulated cash flow from operations. Although the non-regulated cash flow from operations significantly decreased in comparison to 2003, which was mainly the result of timing variances associated with the inflow of cash; net income, excluding interest, depreciation, and amortization, increased $2.4 million in comparison to 2003. This improvement reflects the acceleration of the previously mentioned deferred revenue recognition, net of expenses, relating to the termination of a specific multi-state claims run-off contract and an increase in intercompany fees from growth in risk bearing programs.
On April 29, 2004, we issued senior debentures in the amount of $13.0 million. The senior debentures mature in thirty years and provide for interest at the three-month LIBOR, plus 4.00%, which is non-deferrable. The senior debentures are callable at par after five years from the date of issuance. Associated with this transaction we incurred $390,000 of commissions paid to the placement agents. These issuance costs have been capitalized and are included in other assets on the balance sheet, which will be amortized over seven years as a component of interest expense.
On May 26, 2004, we issued senior debentures in the amount of $12.0 million. The senior debentures mature in thirty years and provide for interest at the three-month LIBOR, plus 4.20%, which is non-deferrable. The senior debentures are callable at par after five years from the date of issuance. Associated with this transaction we incurred $360,000 of commissions paid to the placement agents. These issuance costs have been capitalized and are included in other assets on the balance sheet, which will be amortized over seven years as a component of interest expense.
We contributed $9.9 million of the proceeds from the senior debentures to our Insurance Company Subsidiaries as of December 31, 2004. The remaining proceeds from the issuance of the senior debentures may be used to support future premium growth through further contributions to our Insurance Company Subsidiaries and general corporate purposes.
On November 12, 2004, we successfully executed a replacement credit facility. The new agreement is a revolving line of credit for up to $25.0 million. The revolving line of credit replaces our previous line of credit and expires on November 11, 2007. We have drawn approximately $9.0 million on this new revolving line of credit to pay off our term loan on the former credit agreement. We will use the revolving line of credit to meet short-term working capital needs.
At December 31, 2004, we had an outstanding balance of $9.0 million on the new revolving line of credit. At December 31, 2003, we had an outstanding balance of $14.0 million on our former term loan and no outstanding balance on our former revolving line of credit. As part of the new loan agreement, we and certain of our non-regulated subsidiaries pledged a continuing and unconditional first priority security interest in all of our property and named subsidiaries, excluding certain assets.
Our non-insurance premium finance subsidiary maintains a line of credit with a bank, which permits borrowings up to 75% of the accounts receivable, which collateralize the line of credit. At December 31, 2004 and 2003, this line of credit had an outstanding balance of $3.1 million and $3.5 million, respectively. The terms of this line of credit were amended May 7, 2004. The amendments to the line of credit agreement included a change in the permitted borrowings from 80% to 75% of the accounts receivable, an increase in the line of credit from $6.0 million to $8.0 million, and amendments to the interest rates. The interest terms were amended to interest at the Prime Rate minus 0.5%, or a LIBOR-based rate option, plus 2.0%. At
At December 31, 2004 and 2003, one letter of credit was outstanding in the amount of $100,000, which was provided as collateral for an insurance subsidiary’s obligations under a reinsurance agreement. The letter of credit is collateralized by a certificate of deposit for the same amount.
Shareholders’ equity increased to $167.5 million, or a book value of $5.76 per common share, at December 31, 2004, compared to $155.1 million, or a book value of $5.34 per common share, at December 31, 2003.
Our Board of Directors did not declare a dividend in 2004 or 2003. Our Board of Directors considers whether a dividend will be declared based on a variety of factors, including but not limited to, our cash flow, liquidity needs, results of operations and financial condition. As a holding company, the ability to pay cash dividends is partially dependent on dividends and other permitted payments from our subsidiaries. We did not receive any dividends from our Insurance Company Subsidiaries in 2004 or 2003.
Our Insurance Company Subsidiaries are required to maintain certain deposits with regulatory authorities, which totaled $109.5 million and $102.4 million at December 31, 2004 and 2003, respectively.
The following table is a summary of our contractual obligations and commitments as of December 31, 2004 (in thousands):
Consists of rental obligations under real estate leases related to branch offices. In addition, includes amounts related to equipment leases.
The National Association of Insurance Commissioners (“NAIC”) has adopted a risk-based capital (“RBC”) formula to be applied to all property and casualty insurance companies. The formula measures required capital and surplus based on an insurance company’s products and investment portfolio and is used as a tool to evaluate the capital of regulated companies. The RBC formula is used by state insurance regulators to monitor trends in statutory capital and surplus for the purpose of initiating regulatory action. In general, an insurance company must submit a report of its RBC formula to the insurance department of its state of domicile as of the end of the previous calendar year. These laws require increasing degrees of regulatory oversight and intervention as an insurance company’s RBC declines. The level of regulatory oversight ranges from requiring the insurance company to inform and obtain approval from the domiciliary insurance commissioner of a comprehensive financial plan for increasing its RBC to mandatory regulatory intervention
In 2004, our Insurance Company Subsidiaries generated certain ratios that varied from the “usual value” range. The variations and reasons for these variations are set forth below:
The increase in Star’s net written premium in 2004 reflected anticipated growth from premium rate increases, the conversion of existing controlled programs to our subsidiary’s paper in 2003 and controlled growth related to select new business.
The decrease in the investment yield is the result of a substantial amount of principal payments on mortgage-backed securities due to low interest rates and a strong mortgage refinance market in 2004. Cash flows were reinvested in short and long-term securities in an interest rate environment where interest rates are still relatively low. Also contributing to the decrease is a shift in investment strategy toward greater allocation to municipal bonds, which have lower yields than taxable bonds.
The Two-Year Overall Operating Ratio on Savers in 2004 was 110%. Certain liability occurrence programs insured by Savers experienced larger loss reserve development than historically realized. The results of these programs have caused Savers to re-underwrite the programs as well as implement substantial rate increases. These programs have historically been profitable for Savers, and, although
Ameritrust’s loss reserves from 2000 and prior accident years were impacted by two factors, both of which contributed to the increase in the Two-Year Reserve Development to Surplus ratio. First, some large claims increased to amounts that would have been ceded to Reliance Insurance Company. A re-evaluation of reinsurance recoveries was made due to Reliance being placed into liquidation, the result of which was a write-down of these ceded loss reserves. The other factor impacting this ratio was reserve strengthening on claims incurred in older accident years that resulted from a claims audit performed during 2004.
On June 26, 2002, A.M. Best upgraded our Insurance Company Subsidiaries financial strength rating to a “B+” (Very Good) with a positive outlook. A positive outlook is placed on a company’s rating if its financial and market trends are favorable, relative to its current rating level. The upgrade reflects A.M. Best’s positive assessment of our improved financial condition as a result of the issuance of new common shares and our debt reduction and indicates the potential for a near term upgrade. We believe that as a result of our improved balance sheet and operating performance our rating will remain at least at its current level, if not at an upgraded level. However, there can be no assurance that A.M. Best will not change its rating of our Insurance Company Subsidiaries in the future.
In January 2003, the Financial Accounting Standards Board (“FASB”) issued Financial Accounting Standards Board Interpretation Number (“FIN”) No. 46, “Consolidation of Variable Interest Entities.” The primary objective of FIN No. 46 is to provide guidance on the identification of, and financial reporting for, entities over which control is achieved through means other than voting rights; such entities are known as variable interest entities. FIN No. 46 requires variable interest entities to be consolidated by the primary beneficiary of the variable interest entities and expands disclosure requirements for both variable interest entities that are consolidated as well as those within which an enterprise holds a significant variable interest. In accordance with FIN 46, we performed an evaluation of our business relationships and determined that Meadowbrook Capital Trust I (“Trust”) is a variable interest entity; however, the Trust did not meet the qualifications for consolidation as the Trust equity was deemed to not be at risk. The adoption of FIN No. 46 did not have a material impact on our consolidated balance sheet and had no impact on our consolidated statement of income. Refer to Note 6 - Debt for additional information regarding the unconsolidated subsidiary trust.
In November 2003, FASB issued Emerging Issues Task Force (“EITF”) 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. EITF Issue 03-1 requires that when the fair value of an investment security is less than its carrying value, an impairment exists for which the determination must be made as to whether the impairment is other-than-temporary. EITF Issue 03-1 applies to all investment securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and to investment securities accounted for under the cost method to the extent an impairment indicator exists. Under the guidance, the determination of whether an impairment is other-than-temporary and therefore would result in a recognized loss depends on market conditions and management’s intent and ability to hold the securities with unrealized losses for a period sufficient for recovery of such losses. In September 2004, FASB approved FASB Staff Position (“FSP”) EITF Issue 03-1-1, which delays the effective date for measurement and recognition guidance contained in paragraphs 10-20 of EITF 03-1 until certain issues are resolved. The delay of the recognition and measurement provisions is expected to be superceded concurrently with the issuance of a FSP, which will provide additional implementation guidance. We will evaluate the impact this guidance will have on our financial statements and will adopt the guidance at the time it is issued. We have previously implemented the disclosure requirements of EITF 03-1.
On December 16, 2004, FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which replaces SFAS No. 123, “Accounting for Stock Issued to Employees.” SFAS 123R requires all share-based payments to employees to be recognized in the financial statements based on their fair values, beginning with the first interim or annual period after June 15, 2005, with early adoption encouraged. The pro forma disclosures previously permitted under SFAS 123, no longer will be an alternative to financial statement recognition. Starting in the first quarter of 2003, we have been expensing the fair value of all stock options granted since January 1, 2003 under the prospective method. Under SFAS 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at the date of adoption. The transition methods include prospective and retroactive adoption options. Under the retroactive options, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded at the beginning of the first quarter of adoption of SFAS 123R for all unvested stock options and restricted stock based upon the previously disclosed SFAS 123 methodology and amounts. The retroactive methods would record compensation expense beginning with the first period restated for all unvested stock options and restricted stock. We are currently evaluating the requirements of SFAS 123R and have not yet determined the method of adoption or impact SFAS 123R will have on our financial statements.
In addition, the real estate consultant was paid a total of $23,698 in 2004 for real estate consulting services relating to the relocation and leasing of our Montgomery, Alabama and Grand Rapids, Michigan offices.
The amounts paid to the above mentioned real estate consultant related to these transactions were reviewed and approved by the Finance and Governance and Nominating Committees, as well as the Board of Directors and are commensurate with current market prices for such services.
We relocated to our new headquarters on December 6, 2004, under a temporary certificate of occupancy. We had a due diligence period of thirty days in which we had the ability to identify and have the developer resolve any conditions or defects that required adjustments prior to settlement. We closed on January 19, 2005, with a cash settlement of $11.6 million. Accordingly, we recorded the building and a corresponding accrued liability as of December 31, 2004. Total depreciation expense during 2005 is expected to increase approximately $300,000. In addition, related other administrative expenses are expected to increase approximately $530,000. These increases will be offset by a decrease in other administrative expenses as a result of the expiration of the former corporate headquarters lease.
We establish reserves for losses and expenses related to the adjustment of losses under the insurance policies we write. We determine the amount of these reserves based on our best estimate and judgment of the losses and costs we will incur on existing insurance policies. Our Insurance Company Subsidiaries obtain an annual statement of opinion from an independent actuary firm on these reserves. While we believe that our reserves are adequate, we base these reserves on assumptions about past and future events. The following factors could have a substantial impact on our future loss experience:
The success of our business is dependent on our ability to retain and motivate our senior management and key management personnel. The loss of the services of any of our executive officers or other key employees could have a material adverse effect on our business, financial condition, and results of operations. We have existing employment agreements with some of our executive officers. We maintain “key person” life insurance policies on our key personnel.
As part of our overall risk and capacity management strategy, we purchase reinsurance for significant amounts of risk underwritten by our Insurance Company Subsidiaries, especially for the excess-of-loss and severity risks. Market conditions beyond our control determine the availability and cost of the reinsurance we purchase, which may affect the level of our business and profitability. Our reinsurance facilities are generally subject to annual renewal. We may be unable to maintain our current reinsurance facilities or to obtain other reinsurance in adequate amounts and at favorable rates. If we are unable to renew our expiring facilities or to obtain new reinsurance, either our net exposure to risk would increase or, if we are unwilling to bear an increase in net risk exposures, we would have to reduce the amount of risk we underwrite.
We cannot guarantee that our reinsurers will pay in a timely fashion, if at all, and, as a result, we could experience losses.
The results of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties. Our industry’s profitability can be affected by:
rising levels of actual costs that are not known by companies at the time they price their products;
volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks;
fluctuations in interest rates, inflationary pressures and other changes in the investment environment, which affect returns on invested assets and may impact the ultimate payout of losses; and
The demand for property and casualty insurance can also vary significantly, rising as the overall level of economic activity increases and falling as that activity decreases. The property and casualty insurance industry historically is cyclical in nature. These fluctuations in demand and competition could produce underwriting results that would have a negative impact on our financial condition and results of operations.
We compete with a large number of other companies in our selected lines of business. We compete, and will continue to compete, with major United States, foreign, and other regional insurers, as well as mutual companies, specialty insurance companies, underwriting agencies, and diversified financial services companies. Many of our competitors have greater financial and marketing resources than we do. Our profitability could be adversely affected if we lose business to competitors offering similar or better products at or below our prices. In addition, a number of new, proposed or potential legislative or industry developments could further increase competition in our industry. New competition from these developments could cause the demand for our products to fall, which could adversely affect our profitability.
changing practices created by the internet, which has increased competition within the insurance business.
delegate regulatory, supervisory and administrative authority to state insurance departments. This system of regulation covers, among other things:
restrictions on the types of terms that we can include in the insurance policies we offer;
We believe that we maintain adequate amounts of cash and short-term investments to pay claims, and do not expect to have to sell securities prematurely for such purposes. We may, however, decide to sell securities as a result of changes in interest rates, credit quality, the rate or repayment or other similar factors. A significant increase in market interest rates could result in a situation in which we are required to sell securities at depressed prices to fund payments to our insureds. Since we carry debt securities at fair value, we expect that these securities would be sold with no material impact on our net equity. However, if these securities are sold, future net investment income may be reduced if we are unable to reinvest in securities with similar yields.
Our Insurance Company Subsidiaries cede insurance to other insurers under pro rata and excess-of-loss contracts. These reinsurance arrangements diversify our business and minimize our exposure to large losses or from hazards of an unusual nature. The ceding of insurance does not discharge the original insurer from its
In addition, with our risk-sharing programs, we are subject to credit risk with respect to the payment of claims by our clients’ captive, rent-a-captive, large deductible programs, indemnification agreements, and on the portion of risk exposure either ceded to the captives, or retained by our clients. The capitalization and credit worthiness of prospective risk-sharing partners is one of the factors we consider upon entering into and renewing risk-sharing programs. Generally, we collateralize balances due from our risk-sharing partners through funds withheld trusts or letters of credit. To date, we have not, in the aggregate, experienced material difficulties in collecting balances from our risk-sharing partners. No assurance can be given, however, regarding the future ability of any of our risk-sharing partners to meet their obligations. The inability of our risk-sharing partners to meet their obligations could adversely affect our profitability.
We are also subject to the laws of various states, such as Michigan, Missouri, California, and Florida, governing insurance holding companies. Under these laws, a person generally must obtain the applicable Insurance Department’s approval to acquire, directly or indirectly, five to ten percent or more of the outstanding voting securities of our Insurance Company Subsidiaries. An Insurance Department’s determination of whether to approve an acquisition would be based on a variety of factors, including an evaluation of the acquiror’s financial stability, the competence of its management, and whether competition in that state would be reduced. These laws may prevent, delay or defer a change of control of us or our Insurance Company Subsidiaries.
Our ability to write business is most influenced by our rating from A.M. Best. A.M. Best ratings are designed to assess an insurer’s financial strength and ability to meet continuing obligations to policyholders. Currently, our rating from A.M. Best is “B+” (Very Good), with a positive outlook. A positive outlook is