On November 23, 2004 we completed our initial public offering, or IPO, and concurrent private placements and completed the acquisition of Potomac Insurance Company of Illinois, or Potomac. After giving effect to the acquisition, we changed the name of Potomac Insurance Company of Illinois to SUA Insurance Company.
Prior to our IPO, all activities consisted of start-up activities related to our IPO and costs to establish the infrastructure required to commence insurance operations.
The historical results of Potomac, our accounting predecessor, reflects Potomac’s operations as a member of the OneBeacon Insurance Company, or OneBeacon, inter-company pooling arrangement, or Pool, under which Potomac ceded all of its insurance business into the Pool and assumed 0.5% of the Pool’s insurance business. On April 1, 2004, effective January 1, 2004, Potomac ceased its participation in the Pool and entered into reinsurance agreements whereby it ceded all of its business to OneBeacon. As a result, Potomac did not, and will not share in any favorable or unfavorable development of prior losses recorded by it or the Pool after January 1, 2004, unless OneBeacon fails to perform on its reinsurance obligations.
Results of Operations for Specialty Underwriters’ Alliance, Inc. (Successor) for the Years Ended December 31, 2005, December 31, 2004, and for the Period from April 3, 2003 to December 31, 2003 and for Potomac Insurance Company of Illinois (Predecessor) for the Period from January 1, 2004 to November 23, 2004 and for the Year Ended December 31, 2003
On January 1, 2005 we commenced our insurance operations. However, due to the lead times necessary to quote and place business, we did not effectively begin writing policies until March 2005. The Company is still in early stages of developing its operations and introducing its products through its partner agents to the insurance marketplace. During these early stages of development, insurance revenues and investment income were not sufficient to absorb the company’s operating expenses and operating losses resulted. Further, the benefits of tax losses generated will not be recognized until the Company’s operating results and future outlook produce sufficient taxable income.
Gross written premiums for the year ended December 31, 2005 were $90.6 million.
Appalachian Underwriters, Inc., or AUI, specializes in providing commercial general liability and commercial auto liability to residential and small commercial contractors in mid-south and central states. AUI signed a partner agent program agreement with us in October 2005 and began writing business in December 2005. Total written premiums for the year ended December 31, 2005 were $0.3 million.
We expect that premium volume from our existing agents will continue to increase. Our business written for 2005 was approximately 69% workers’ compensation and our longer term goal is to have a more even balance between workers’ compensation, general liability and commercial auto. We are also continuing to explore the appointments of new partner agents to increase our volume and balance our book of business.
Total revenues consisted of earned premium of $26.6 million and investment income of $3.6 million. Total expenses were $48.2 million consisting of loss and loss adjustment expense of $19.1 million, amortization of deferred acquisition cost of $6.1 million, service company fees of $8.8 million and other operating expenses of $14.2 million. Other operating expenses include $5.2 million of salaries and benefit costs (excluding $2.9 million of salary and benefit costs classified as loss adjustment expenses and acquisition expenses), $3.0 million of professional and consulting fees, $1.8 million of depreciation and amortization and $4.2 million of other expenses. For the year ended December 31, 2005 we reported a net loss of $18.0 million.
Our loss and loss adjustment expense ratio was 66.7% on a direct basis (before reinsurance) and 71.8% on a net basis (after reinsurance). Our net loss and loss adjustment expense ratio was 5.1% higher than our direct loss ratio due to the fact that we paid minimum premiums to reinsurers that were in excess of the actual premiums expected when the reinsurance was originally priced. Further, our loss experience in the excess layers reinsured (typically losses above $1 million) was better than the loss experience in the lower layers
Due to the lower than expected premium volume in our first year of operations, our expense levels were disproportionate to our earned premium. As we increase our future premium volume through existing and newly appointed partner agents we expect that our expense ratio will improve. Further, we were unable to achieve a satisfactory resolution with Syndicated Services, Inc., or SSC, our service company, and have mutually agreed to terminate our relationship effective December 31, 2005. The contract with SSC required us to pay $8.8 million for 2005 services. We have substantially completed the transition process through both internal hiring and outsourcing. We anticipate an expense reduction associated with these back office activities of at least 50% in 2006 and beyond.
Also, as part of our infrastructure strategy, we finalized our technology plans for policy administration by contracting for a new system that will allow us to comprehensively process and issue policies for all lines of business. We believe this new system and resultant technology improvements will provide the ability to write business more efficiently. As a result of this new system direction, approximately $0.4 million of capitalized software will no longer be used and was expensed.
We were formed on April 3, 2003 and did not have any financial activity until our initial funding date of December 12, 2003. For the period April 3, 2003 to December 31, 2003, we reported a net loss of $0.6 million.
Funds to meet these obligations are expected to come primarily from dividends and other statutorily permissible payments from our operating subsidiary. The ability of our operating subsidiary to make payments to us will be limited by the applicable laws and regulations of Illinois. There will be restrictions on the payment of dividends by our insurance subsidiary to us.
For the year ended December 31, 2005 net cash from operating activities was $8.4 million principally consisting of premium and deposit collections exceeding losses and expenses paid out. Further cash used in investment activities was $13.6 million principally representing increases in investments and additions to equipment and capitalized software. Further, we had cash flows from financing activities of $1.5 million from sales of Class B shares to partner agents.
For the year ended December 31, 2004, our increase in cash was $8.8 million. Cash was provided from the net proceeds of our initial public offering of $123.5 million and $3.2 million from term loans. Net cash used for investment activities during the twelve month period ended December 31, 2004 totaled $110.0 million and was primarily related to the acquisition of Potomac and subsequent purchases of investments with the proceeds from the initial public offering. Cash used for operating activities during the period from January 1, 2004 to December 31, 2004 totaled $7.9 million and was primarily related to our initial start-up costs.
For the period from April 3, 2003 to December 31, 2003, our increase in cash was $0.2 million generated from short term loans of $0.7 million net of start-up costs of $0.5 million.
The aggregate fair market value of our fixed maturity investments at December 31, 2005 was $94.1 million compared to amortized cost of $95.8 million. The aggregate fair market value of our fixed maturity investments at December 31, 2004 was $50.5 million compared to amortized cost of $50.5 million.
“Purchase Obligation” means an agreement to purchase goods or services that is enforceable and legally binding on the registrant that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of
Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our financial statements, which have been prepared in accordance with generally accepted accounting principals, or GAAP. The financial statements presented herein include all adjustments considered necessary by management to fairly present the financial position, results of operations and cash flows of the Company. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.
In December 2004, the FASB issued FAS No. 123 (revised 2004), “Share-Based Payment,” or FAS 123R. FAS 123R replaces FAS No. 123, “Accounting for Stock-Based Compensation,” or FAS 123 and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25. As permitted by FAS 123, our company currently accounts for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognizes no compensation expense for employee stock options. Accordingly, the adoption of FAS 123R’s fair value method will have a significant impact on our result of operations, although it will have no impact on our overall financial position. The impact of adoption of FAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted FAS 123R in prior periods, the impact of that standard would have approximated the impact of FAS 123 as described in the disclosure of pro forma net income and earnings per share in Note 7 to our consolidated financial statements. FAS 123R also requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were zero in 2005 and 2004, as we had a net operating loss carry forwards and have never paid any tax.
The estimate of these reserves is subjective and complex and require us to make estimates about the future payout of claims, which is inherently uncertain. We establish and adjust reserves based on our knowledge of the circumstances and facts of claims. Upon notice of a claim, we establish a Case Reserve for losses based on the claims information reported to us at that time. Subsequently, we conduct an investigation of each reported claim, which allows us to more fully understand the factors contributing to the loss and our potential exposure. This investigation may extend over a long period of time. As our investigations of claims
develop and as our claims personnel identify trends in claims activity, we refine and adjust our estimates of Case Reserves. When we establish reserves, we do so based on our knowledge of the circumstances and claim facts. We continually review our reserves, and as experience develops and additional information becomes known, we adjust the reserves. Such adjustments are recorded through operations in the period identified. To evaluate and refine our overall reserving process, we track and monitor all claims until they are settled and paid in full and all salvage and subrogation claims are resolved.
For IBNR losses, we estimate the amount of reserves for each line of business on the basis of historical and statistical information. We consider historical patterns of paid and reported claims, industry data and the probable number and nature of losses arising from claims that have occurred but have not yet been reported for a given accident year. The utilization of company specific loss experience will increase over time, which will reduce the inherent uncertainty that exists in reserving for our newer book of business. The actual future development of our loss reserves may have a material adverse impact on our financial condition and results of operation.