•The adequacy of our reserves established for Hurricanes Katrina and Rita, which are based on management estimates.
•Developments in domestic and global financial markets that could affect our investment portfolio and financing plans.
•Additional government and NASDAQ policies relating to corporate governance, and the cost to comply.
These are representative of the risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from what is expressed in forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report or as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission (the “SEC”), we do not have any intention or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
We conduct our operations through two distinct segments: property and casualty insurance and life insurance. We manage these segments separately because they generally do not share the same customer base, and they each have different pricing and expense structures. We evaluate segment profit or loss based upon operating and investment results. Segment profit or loss described in the following sections of the Management’s Discussion and Analysis is reported on a pre-tax basis.
East Coast. Four of this season's five hurricanes - Florence, Gordon, Helene and Isaac - started to track westward across the Atlantic toward the United States, only to be turned northward and sent out to sea to dissipate.
Even though we experienced a less active than predicted 2006 hurricane season, the financial effects of Hurricanes Katrina and Rita continued to impact us during 2006. We incurred pre-tax charges of approximately $32.0 million related to those storms during the year.
As previously discussed, we are making several changes to address our catastrophe exposure in the Gulf Coast region. We have no plans to withdraw completely from the Gulf Coast market, however we are taking steps to
Our stockholders’ equity as of December 31, 2006, includes an after-tax charge of $10.2 million related to the impact of a new benefit plan accounting standard issued by the Financial Accounting Standards Board (“FASB”) during 2006. SFAS No. 158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans” requires us to recognize the funded status of our defined benefit pension and other postretirement plans in our statement of financial position effective December 31, 2006. For a more detailed discussion of the adoption of SFAS No. 158, refer to Part II, Item 8, Note 1 “Significant Accounting Policies.”
During its meetings in 2006, the ERM committee discussed the risks that our company faces, as well as the controls that are in place to mitigate those risks. These are not new ideas - management has actively and successfully managed risks throughout our company’s history. The committee’s initial efforts were directed at enhancing the documentation of risks and controls. Collectively, the committee has identified two broad categories of risk faced by our company - insurance risk and operational risk. Types of insurance risks generally include, but are not limited to,
those risks associated with geographical concentrations of property insured, business mix, catastrophe modeling, underwriting practices, reserving practices, policy pricing, and the actions of our competitors. Types of operational risks we face generally include, but are not limited to, those risks associated with business continuity planning, information technology, executive succession planning, regulatory and legal compliance, diversification of investments and accounting policies and procedures. The committee also identified certain steps that it can take to further enhance the ERM process.
In 2006, we reported net income of $88.1 million, or $3.37 per share, compared to net income in 2005 of $9.0 million, or $.22 per share (after providing for the dividend and accretion on convertible preferred stock). Net income in 2004 was $78.8 million, or $3.68 per share (after providing for the dividend and accretion on convertible preferred stock). Diluted earnings were $3.36 per share, $.22 per share and $3.34 per share for 2006, 2005 and 2004, respectively.
The deterioration in the 2005 results compared to 2004 and the improvement in net income from 2005 to 2006 was primarily due to the significant impact Hurricane Katrina and Hurricane Rita had on our loss experience during 2005.
Assumed premiums written increased over the past three years, with $19.0 million recorded in 2006, $15.1 million recorded in 2005 and $11.3 million recorded in 2004. The increase in assumed premiums written is attributable to a larger amount of written premium collected from the ceding insurer due to implementation of rate increases.
In 2005, losses and loss settlement expenses incurred were $375.9 million, which was comprised of $453.4 million that was attributable to losses that occurred in 2005 as offset by a $77.5 million redundancy on losses that occurred prior to 2005. This redundancy resulted from settling or re-estimating claims for less than reserved for at December 31, 2004. We experienced a loss reserve redundancy in each of our lines of business, with the exception of fidelity and surety.
Our redundancy is attributable to both the payment of claims in amounts other than the amounts reserved and changes in loss reserves due to additional information on individual claims that we received after the reserves for those claims had been established. The additional information we consider is unique to each claim. Such information may include facts that reveal we have no coverage obligation for a particular claim, changes in applicable laws that reduce our liability or coverage exposure on a particular claim, facts that implicate other parties as being liable on a particular claim and favorable court rulings that decrease the likelihood that we would be liable for a particular claim. Also, additional information relating to severity is unique to each claim. For example, we may learn during the course of a claim that bodily injuries are less severe than originally believed or that damage to a structure is merely cosmetic instead of structural.
The net loss ratio in our commercial lines of business improved from 71.7 percent in 2005 to 57.8 percent in 2006. In 2005, the net loss ratio deteriorated from 56.3 percent in 2004 to 71.7 percent. These fluctuations were primarily attributable to increased losses from Hurricanes Katrina and Rita in 2005.
Our other liability line of insurance covers businesses for bodily injury liability and property damage arising from general business operations, accidents on their premises and products manufactured or sold. We reported a net loss ratio in this line of 29.7 percent in 2006, 31.1 percent in 2005 and 66.5 percent in 2004. We experienced significant growth in net premiums earned of 7.3 percent in 2006, 8.9 percent in 2005 and 15.0 percent in 2004 due to premium rate increases each year. Further contributing to the improvement in this line has been the decreased level of loss frequency we have experienced over this period.
Commercial fire and allied lines insurance covers losses to an insured’s property, including its contents, from weather, fire, theft or other causes. We provide this coverage through a variety of business policies. The net loss ratio for our commercial fire and allied lines was 85.6 percent in 2006, 140.5 percent in 2005 and 48.4 percent in 2004. The 2005 and 2006 results were impacted by losses from Hurricane Katrina and Hurricane Rita. Hurricanes Katrina and Rita resulted in net catastrophe losses and loss settlement expenses totaling $126.1 million and $19.6 million in this line of business during 2005 and 2006, respectively. Also, premium rates in our commercial property lines of business have also decreased during 2006 and 2005.
Our commercial automobile insurance covers physical damage to an insured’s vehicle, as well as liabilities to third parties. Automobile physical damage insurance covers loss or damage to vehicles from collision, vandalism, fire, theft, flood or other causes. Automobile liability insurance covers bodily injury, damage to property resulting from automobile accidents caused by the insured, uninsured or underinsured motorists and the legal costs of defending the insured against lawsuits. Our company policy is to write only standard automobile insurance and we do not write coverage for large fleets of automobiles. Our net loss ratio in commercial automobile was 58.1 percent in 2006, 45.1 percent in 2005 and 55.4 percent in 2004. The deterioration in this line during 2006 was primarily due to an increase in claim severity experienced in 2006 over 2005. The improvement in this line during 2005 resulted primarily from a reduction in loss frequency.
While we purchase catastrophe reinsurance to protect ourselves against severe hurricanes, Hurricane Katrina resulted in a level of damage that we did not foresee and did not consider when we evaluated our reinsurance coverage for 2005. This resulted in a level of reinsurance coverage that did not adequately protect us from the devastation of Hurricane Katrina. During 2006, in addition to strengthening our underwriting guidelines in the Gulf Coast region, we also evaluated and modified our catastrophe reinsurance coverage to lessen the impact of future catastrophes in this region. Refer to Part I, Item 1, “Reinsurance,” for a more detailed discussion of our reinsurance programs.
traditional premium and a runoff of our credit life business, which we ceased writing in 2004; and a decrease in investment income, which reflects the impact that recent increases in the level of annuity surrenders and withdrawals has had on our level of assets available for investment. The increase in income for 2005, as compared with 2004, was due mainly to an increase in net premiums earned which was the result of marketing initiatives pursued in 2005 and 2004, that led to increased sales of single premium whole life and term products.
We do not report annuity deposits collected as net premiums earned. Instead, we invest annuity deposits and record them as future policy benefits. Revenues for fixed annuity products consist of policy surrender charges and investment income earned. In 2006, annuity deposits were $145.3 million, compared with $65.4 million in 2005 and $50.8 million in 2004. The increased level of annuity deposits is primarily due to an increase in renewals of existing annuities during 2006, resulting from an increase in our interest rates that enhanced the desirability of our annuities compared to other investment options available to our annuitants. The increase in the life insurance segment’s annuity deposits were more than offset by surrenders and withdrawals of $159.6 million in 2006, $96.6 million in 2005 and $72.8 million in 2004. The increase is due to the perceived attractiveness of other interest rate products, primarily bank CDs.
The increases in investment income we have experienced are attributable primarily to the increases in our invested assets. More than 80 percent of our investment income originates from interest on fixed maturities. We derive our remaining investment income from dividends on equity securities, interest on other long-term investments, interest on mortgage loans, interest on policy loans, interest on short-term investments and rent earned from tenants in our home office. The average investment yield, which is investment income divided by average invested assets, was 5.7 percent in 2006, 5.8 percent in 2005 and 5.7 percent in 2004.
Changes in unrealized gains do not affect net income and earnings per common share but do impact comprehensive net income, stockholders’ equity and book value per common share. We record unrealized losses subsequently identified as other-than-temporary impairments as a component of net realized investment gains and losses. We recorded net realized investment gains on securities of $10.0 million in 2006, $4.5 million in 2005 and $4.1 million in 2004. The significant increase in realized gains on securities in 2006 compared to 2005 and 2004 is primarily attributable to the sale of our property and casualty insurance subsidiary, American Indemnity Company in 2006, which resulted in a realized gain of $3.4 million, or $0.08 per share, after-tax.
The 2006, 2005 and 2004 amounts reported as net realized investment gains included other-than-temporary impairments of $.4 million, $1.2 million and $.3 million, respectively. Refer to “Critical Accounting Policies” in this section for a presentation of our impairment policy.
As of December 31, 2006, we have a deferred tax asset for net operating loss carryforwards totaling $18.8 million, all of which was acquired as part of our purchase of American Indemnity Financial Corporation. These net operating loss carryforwards expire from 2009 through 2018, with $11.1 million expiring from 2009 through 2011. We are required to establish a valuation allowance for any portion of the gross deferred tax asset that we believe may not be realized. At December 31, 2006, we recorded a valuation allowance of $6.2 million that relates to those net operating loss carryforwards that can only be used to offset future income of the property and casualty insurance segment. As we determine that the benefit of these net operating losses can be realized, we will record the related reduction in the deferred tax asset valuation allowance as a reduction to our current income tax expense.
(1) Available-for-sale fixed maturities are carried at fair value, while held-to-maturity fixed maturities are carried at amortized cost.
(1) Pursuant to GAAP, changes in the fair value of both our portfolio of trading securities and limited liability partnership investments are recognized currently in earnings.
Net cash provided by financing activities for 2006 was $17.9 million, compared with net cash used of $12.7 million for 2005. This increase was the result of a combination of factors. The completion of our common stock offering in May 2006 resulted in proceeds (net of underwriting expenses) of $107.0 million. Offsetting this is an increase in the amount of net cash outflows resulting from surrenders and withdrawals, of our fixed annuities and universal life contracts. Net cash used in these activities totaled $76.5 million and $1.3 million for 2006 and 2005, respectively. The increase in withdrawals is described in the life insurance segment discussion. Dividend payments to our common shareholders totaled $13.2 million in 2006, compared with $12.0 million paid to common and preferred shareholders in 2005. The increase in dividend payments in 2006 compared to 2005 is due to an increased number of shares outstanding as a result of our common stock offering and an increase in the dividend amount paid per share in the fourth quarter of 2006.
We do not discount loss and loss settlement expense reserves, which represent our estimate, based upon our historical payout patterns, of the amount and timing of the ultimate settlement and administration of claims. Both the timing and amount of actual payments may vary from the payments as indicated.
Our operating lease obligations are primarily for the rental of office space, vehicles, computer equipment and office equipment.
Critical accounting policies are defined as those that are representative of significant judgments and uncertainties and that potentially may result in materially different results under different assumptions and conditions. We base our discussion and analysis of our results of operations and financial condition on the amounts reported in our Consolidated Financial Statements, which we have prepared in accordance with GAAP. As we prepare these Consolidated Financial Statements, we must make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the reporting period. We evaluate our estimates on an ongoing basis. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates. We believe that our most critical accounting policies are as follows.
We continually monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition requires us to record other-than-temporary impairment charges when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security or that the anticipated recovery in market value of the equity security will not occur in a reasonable amount of time. We include impairment charges on investments in net realized gains and losses based on the fair value of the investments at the measurement date. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which the fair value has been less than cost; the financial conditions and near-term prospects of the issuer; and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery. As of December 31, 2006, we had a number of securities where fair value was less than our cost. The total unrealized depreciation on these securities totaled $14.2 million at December 31, 2006, compared with $16.6 million at December 31, 2005. Our rationale for not recording other-than-temporary impairments on these securities is discussed in Part II, Item 8, Note 2, “Summary of Investments.”
We defer and amortize policy acquisition costs, with interest, on traditional life insurance policies, over the anticipated premium-paying period of the applicable policies.
We defer and amortize policy acquisition costs related to non-traditional business; we amortize these policy acquisition costs in proportion to the present value of estimated expected gross profits. The components of gross profit include investment spread, mortality and expense margins and surrender charges. We periodically review estimates of expected profitability and evaluate the need to “unlock” or revise the amortization of the deferred acquisition cost asset. The primary assumptions utilized when estimating future profitability relate to interest rate spread, mortality experience and policy lapse experience. The table below illustrates the impact that a reasonably likely change in our assumptions used to estimate gross profit would have on the deferred policy acquisition cost asset for our non-traditional business recorded as of December 31, 2006. The entire impact of the changes illustrated would be recognized through income as an increase or decrease to amortization expense.
A material change in these critical assumptions, could negatively or positively affect our reported deferred policy acquisition cost asset, earnings and stockholders’ equity.
The deferred policy acquisition costs in connection with our non-traditional business are adjusted with respect to estimated gross profits as a result of changes in the net unrealized gains or losses on available-for-sale fixed maturity securities allocated to support the block of fixed annuities and universal life policies. That is, because we carry fixed maturity securities available-for-sale at aggregate fair value, we make an adjustment to deferred policy acquisition costs equal to the change in amortization that would have been recorded if we had sold such securities at their stated aggregate fair value and reinvested the proceeds at current yields. We include the change in this adjustment, net of tax, as a component of accumulated other comprehensive income. This adjustment offset deferred policy acquisition costs by $4.1 million at December 31, 2006, compared with $13.3 million at December 31, 2005.
individual claim facts (including type of coverage and severity of loss), company historical loss experience and trends in general economic conditions (including changes in replacement costs, medical costs and inflation).
For short-tail lines of business, the estimation of case-basis loss reserves is less complex than for long-tail lines because claims are generally reported and settled shortly after the loss occurs and because the claims relate to tangible property. Because of the relatively short time from claim occurrence to settlement, actual losses typically do not vary greatly from reserve estimates.
For both our short-tail and long-tail lines of business, we establish our reserves for IBNR claims by applying a factor to our current pool of in-force premium. This factor has been developed through a historical analysis of company experience as to what level of IBNR should be established to achieve an adequate IBNR reserve relative to our existing loss exposure base. Unique circumstances or trends which are evident as of the end of a given period may require us to refine our IBNR reserve calculation. For example, as of December 31, 2005 we refined our IBNR reserve calculation to consider the impact of Hurricane Katrina. This methodology for establishing our IBNR reserve has consistently resulted in aggregate reserve levels that management believes are reasonable in comparison to the reserve estimates prepared by Regnier Consulting Group, our independent consulting actuary.
Loss settlement expense reserves include amounts ultimately allocable to individual claims, as well as amounts required for the general overhead of the claims handling operation that are not specifically allocable to individual claims. We do not establish loss settlement expense reserves on a by claim basis. Instead, we examine the ratio of loss settlement expenses paid to losses paid over the most recent three-year period, by line. We use these factors and apply them to open reserves, including IBNR reserves. We develop these factors annually, each December and use them throughout the year, unless development patterns or emerging trends warrant adjustments to the factors.
Generally, the loss settlement expense reserves for long-tail lines are a greater portion of the overall reserves, as there is often substantial legal fees and other costs associated with the complex liability claims that are associated
with long-tail lines. Because short-tail lines settle much more quickly and the costs are easier to determine, loss settlement expense reserves for short-tail claims constitute a smaller portion of the total reserves.
•To our knowledge, there are no new latent trends that would impact our case-basis reserves;
•The company’s historical ratio of loss settlement expenses (“LAE”) paid to losses paid is consistent and will continue to be consistent.
Due to the inherent uncertainty in the loss reserving process, management believes that there is a reasonable chance that the key assumptions listed above could individually, or in aggregate, result in reserve levels that are misstated either above or below the actual amount for which the related claims will eventually settle.
Due to the formula based nature of our IBNR and LAE reserve calculations, changes in the key assumptions utilized to generate these reserves can result in a quantifiable impact on our reported results. The tables below illustrate how reasonably likely changes in each of these key assumptions could individually impact our pre-tax reported results and financial position. The impact of concurrent changes in the assumptions utilized is not illustrated. We believe the changes presented are reasonably likely based upon an analysis of our historical IBNR and LAE experience.
As an example, if our reserve for loss and loss settlement expenses of $518.9 million as of December 31, 2006, is 10 percent inadequate, we would experience a reduction in future earnings of up to $51.9 million, before federal income taxes. This reduction could be recorded in one year or multiple years, depending on when we identify the deficiency. The deficiency would also affect our financial position in that our equity would be reduced by an amount equivalent to the reduction in net income. Any deficiency is typically recognized in the reserve for loss and loss settlement expenses and, accordingly, it usually does not have a material effect on our liquidity because the claims have not been paid. Conversely, if our estimates of ultimate unpaid loss and loss settlement expense liabilities prove to be redundant, our future earnings and financial position would be improved.
care regarding additional insured endorsements and stricter underwriting guidelines on the writing of residential contractors.
Included in the other liability line of business are gross reserves for asbestos and other environmental losses and loss settlement expenses. At December 31, 2006, we had $3.4 million in asbestos and environmental loss reserves, compared with $4.2 million at December 31, 2005. The estimation of loss reserves for environmental claims and claims related to long-term exposure to asbestos and other substances is one of the most difficult aspects of establishing reserves, especially given the inherent uncertainties surrounding such claims. Although we record our best estimate of loss and loss settlement expense reserves, the ultimate amounts paid upon settlement of such claims may be more or less than the amount of the reserves, because of the significant uncertainties involved and the likelihood that these uncertainties will not be resolved for many years.
The existence of certain airborne mold spores resulting from moisture trapped in confined areas has been alleged to cause severe health and environmental hazards. We have current and potential future exposure to mold claims in both our commercial and personal lines of business. While mold is a potential problem in several states, Texas has been at the forefront of mold insurance issues. Our Texas Homeowners policies contain a mold exclusion, and our Texas commercial property policies include a $15,000 limitation with respect to mold claims arising from origins other than fire or lightning. We have a total mold exclusion for our commercial general liability policies. As market conditions permit, we plan to implement any coverage reforms permitted by the Texas Department of Insurance that would enable us to reduce our exposure in Texas to claims related to mold. We believe that it is unlikely that losses due to mold claims would have a material adverse effect on our financial condition or our cash flows. However, due to the uncertainty of future changes in Texas regulation, we cannot estimate our future probable liability for mold claims. Also, as case law expands, we may be subject to mold-related losses beyond those intended by policy coverage and not addressed by exclusionary or limiting language. Loss reserve additions arising from future unfavorable judicial trends cannot be reasonably estimated at the present time.
•Establishing reserves that are appropriate and reasonable, but assuming a pessimistic view of potential outcomes.
•Promoting claims management services to encourage return-to-work programs, case management by nurses for serious injuries and management of medical provider services and billings.
•Using programs and services to help prevent fraud and to assist in favorably resolving cases.
Based upon our comparison of carried reserves to actual claims experience over the last several years, we believe that using company historical premium and claims data to establish reserves for loss and settlement expenses results in adequate and reasonable reserves. Based upon this comparison, we believe that our total recorded loss reserves at December 31, 2006, are unlikely to vary by more than 10 percent of the recorded amounts, either positively or negatively. Historically, our reserves have had an average variance of less than 10 percent of recorded amounts, with our reserves booked as of December 31, 2005 and 2004, generating reserve redundancies of 4.5 percent and 17.8 percent in 2006 and 2005, respectively. These redundancies are discussed in detail in the “Results of Operations” sections of this discussion.
Significant change to the estimated reserves could have a material impact to our results of operations or financial position. An increase or decrease in reserve estimates would result in a corresponding decrease or increase in financial results. The following table details the pre-tax impact on our property and casualty insurance segment’s financial results and financial condition of reasonably likely changes in our reserve development. Our lines of business that have historically been most susceptible to significant volatility in reserve development have been shown separately below and utilize hypothetical levels of volatility of five percent and ten percent. Our other, less volatile, lines have been aggregated and utilize hypothetical levels of volatility of three percent and five percent.
We are required by state law, to engage an independent actuarial firm to render opinions as to the reasonableness of the statutory reserves we establish. There are no material differences between our statutory reserves and those established under GAAP.
During 2005 and 2006, we engaged the services of Regnier Consulting Group, Inc. as our “independent actuarial firm” for the property and casualty insurance segment. We anticipate that this engagement will continue in 2007.
an extensive review of loss and loss settlement expense reserves at year end using generally accepted actuarial guidelines to ensure that the recorded loss reserves appear reasonable. If the carried reserves are deemed unreasonable, we would adjust reserves. In 2006 and 2005, after considering the actuary’s range of reasonable point estimates, management believed that carried reserves were reasonable and therefore did not make adjustments to reserves.
Based on the results of the four different projection methods, a reasonable range of reserves from $473.1 million to $538.3 million has been calculated. Our carried reserves for losses and loss settlement expenses as of December 31, 2006 were $518.9 million.
We do not view the result of a single projection method as superior over the results of a combination of projection methods. That is, our actuary has not selected one method to determine the reserves. The results of Regnier Consulting Group’s use of various methods, in conjunction with their actuarial judgment, leads to the actuarially-determined estimate of the reserves. The impact of reasonably likely changes in the reserving variables is implicitly considered in Regnier Consulting Group’s use of several reserving methods.
Despite strict oversight by state insurance regulators, insurance companies occasionally become insolvent. Each of our insurance companies is required to participate in state guaranty fund associations, whose purpose is to protect the policyholders of insolvent insurance companies. Guaranty fund associations assess solvent insurers to pay the claims of insolvent insurers. The assessments are based proportionately upon each solvent insurance company’s share of written premiums in the applicable state. Most state guaranty fund associations allow solvent insurers to
recoup the assessments paid through rate increases, surcharges or premium tax credits. However, there is no assurance that we will ultimately recover these assessments. At December 31, 2006, we have a $1.0 million accrual for state guaranty fund assessments.
An insurer’s solvency rating is one of the primary factors evaluated by those in the market to purchase insurance. A poor rating would indicate that there is an increased likelihood that the insurer could become insolvent and therefore not be able to fulfill its obligations under the insurance policies it issues. The level of an insurer’s solvency rating can affect its level of premium writings, the lines of business it can write and the market value of its shares of stock.
Refer to Part II, Item 8, Note 1 “Significant Accounting Policies” for a description of recently issued accounting pronouncements not effective for reporting purposes at December 31, 2006. We believe that the new accounting pronouncements, when adopted, will not materially affect our financial condition or results of operations.
Net premiums written: Net premiums written is a statutory accounting measure representing the amount of premiums charged for policies issued during the period. We report these premiums as revenue as they are earned over the underlying policy period. We report net premiums written applicable to the unexpired term of a policy as unearned premium. We evaluate net premiums written as a measure of business production for the period under review.
Catastrophe losses: A catastrophe loss is a single incident or series of closely related incidents causing severe insured losses. Catastrophes are, by their nature, unpredictable. The frequency and severity of catastrophic losses we experience in any year affect our results of operations and financial position. In analyzing the underwriting performance of our property and casualty insurance segment, we evaluate performance both including and excluding catastrophe losses. The Insurance Services Office (ISO), a supplier of property and casualty statistical data, defines as catastrophes those events that cause $25.0 million or more in industry-wide direct insured losses to property and that affect a significant number of insureds and insurers (“ISO catastrophes”). We use this definition, but we also include as catastrophes those events we believe are, or will be, material to our operations, either in amount or in number of claims made. For the years ended December 31, 2006 and 2005, losses from non-ISO catastrophes totaled $.9 million and $.6 million, respectively. Portions of our catastrophe losses may be recoverable under our catastrophe reinsurance agreements.
The 2004 amounts reflect the retroactive effects of our December 15, 2004, one-for-one stock dividend.
The accompanying Consolidated Financial Statements include United Fire & Casualty Company and its wholly owned subsidiaries: United Life Insurance Company, Lafayette Insurance Company, Addison Insurance Company, American Indemnity Financial Corporation, United Fire & Indemnity Company and Texas General Indemnity Company. United Fire Lloyds, an affiliate of United Fire, has also been included in consolidation. All intercompany balances have been eliminated in consolidation.
reporting period. Actual results could differ from those estimates. The financial statement categories that are most dependent on management estimates and assumptions include investments, deferred policy acquisition costs and future policy benefits and losses, claims and loss settlement expenses.
Certain costs of underwriting new business, principally commissions, premium taxes and variable underwriting and policy issue expenses, have been deferred. Such costs are being amortized as premium revenue is being recognized. Policy acquisition costs deferred in 2006, 2005 and 2004 were $124,307,000, $111,802,000 and $100,944,000, respectively. Amortization of deferred policy acquisition costs in 2006, 2005 and 2004 totaled $118,756,000, $106,348,000 and $98,579,000, respectively. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, losses and expenses to be incurred and certain other costs expected to be incurred as the premium is earned.
The costs of acquiring new life business, principally commissions, certain variable underwriting, agency and policy issue expenses, have been deferred. These costs are amortized to income over the premium-paying period of the related traditional policies in proportion to the ratio of the expected annual premium revenue to the expected total premium revenue and over the anticipated lives of non-traditional policies in proportion to the ratio of the expected annual gross profits to the expected total gross profits. Policy acquisition costs deferred in 2006, 2005 and 2004 were $9,295,000, $6,648,000 and $7,780,000, respectively. Amortization of deferred policy acquisition costs in 2006, 2005 and 2004 totaled $8,142,000, $9,125,000 and $12,384,000, respectively. The expected premium revenue and gross profits are based upon the same mortality and withdrawal assumptions used in determining future policy benefits. For non-traditional policies, changes in the amount or timing of expected gross profits result in adjustments to the cumulative amortization of these costs. The effect on the amortization of deferred policy acquisition costs for revisions to estimated gross profits is reported in earnings in the period such estimated gross profits are revised.
The change in the effect on deferred policy acquisition costs that results from assumed realization of unrealized gains (losses) is recognized with an offset to unrealized investment appreciation (depreciation) as of the balance sheet dates. As of December 31, 2006, 2005 and 2004, pretax adjustments increased deferred policy acquisition costs by $9,188,000, $27,669,000 and $5,229,000, respectively.
estimates on individual claims and estimates of unreported claims based on past experience. Liabilities for universal life and investment contracts are stated at policyholder account values before surrender charges. Liabilities for traditional immediate annuities are based primarily upon future anticipated cash flows using statutory mortality and interest rates, which produce results that are not materially different from GAAP. Liabilities for deferred annuities are carried at the account value.
Property and equipment is carried at cost less accumulated depreciation. Depreciation is computed primarily by the straight-line method over the estimated useful lives of the underlying assets. Depreciation expense totaled $3,418,000, $3,687,000 and $3,849,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
Our intangibles are composed entirely of agency relationships, which are being amortized by the straight-line method over periods of up to 10 years. We regularly review the carrying value of our intangibles for impairment in the recoverability of the underlying asset, with any impairment being charged to operations in the period that the
Amortization expense totaled $60,000 for each of the three years ended December 31, 2006, 2005 and 2004. We reduced the carrying value of our intangibles by $512,000 in 2004 as a result of an adjustment to the deferred tax asset valuation allowance related to the acquisition of American Indemnity Financial Corporation. Refer to Note 8 “Federal Income Tax” in this item for further discussion.
We have established reserves for all claims in litigation commensurate with our evaluation of the potential outcome of those claims. We believe that, in the aggregate, these reserves should be adequate. However, the wave of litigation faced by us and other insurers is unprecedented so it is difficult to accurately predict an outcome. Additionally, many of the persons who will be involved in the determination of factual and legal issues were themselves affected by Hurricane Katrina, complicating the defense of these claims. Our evaluation of these claims and the adequacy of our recorded reserves may change should we encounter adverse developments in the defense of these claims.
As allowed by SFAS No. 123(R), we have continued to utilize the Black-Scholes option pricing method to establish the fair value of options granted under our stock option plans. Our determination of fair value of stock-based payment awards on the date of grant using this option-pricing model is affected by our stock price, as well as assumptions regarding a number of complex and subjective variables. These variables include the expected volatility in our stock price, the expected dividends to be paid over the term of the awards, the risk-free interest rate and actual and projected employee stock option exercise activity. Any changes in these assumptions may materially affect the estimated fair value of the equity-based award.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosure requirements regarding fair value measurement. Where applicable, SFAS No. 157 simplifies and codifies fair value related guidance previously issued within GAAP. Although SFAS No. 157 does not require any new fair value measurements, its application may, in certain instances, change current practice. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We are currently reviewing SFAS No. 157 to determine its impact on our Consolidated Financial Statements upon adoption.
Proceeds from sales of available-for-sale securities during 2006, 2005 and 2004 were $2,400,000, $5,720,000 and $11,541,000, respectively. Gross gains of $235,000, $2,249,000 and $1,139,000 and gross losses of $16,000, $1,135,000 and $2,579,000 were realized on those sales in 2006, 2005 and 2004, respectively.
Our investment portfolio includes trading securities with embedded derivatives. These securities, which are primarily convertible redeemable preferred debt securities, are recorded at fair value. Income or loss, including the change in the fair value of these trading securities, is recognized currently in earnings as a component of realized investment gains. Our portfolio of trading securities had a fair value of $11,577,000 at December 31, 2006 and $4,881,000 at December 31, 2005.
Proceeds from the sale of trading securities were $995,000, $11,140,000 and $3,992,000 in 2006, 2005 and 2004, respectively. Gross gains of $232,000, $482,000 and $399,000 and gross losses of $42,000, $106,000 and $11,000 were realized on these sales in 2006, 2005 and 2004, respectively. Additional gross gains (losses) of $1,367,000, $(491,000) and $63,000 were realized in 2006, 2005 and 2004, respectively, which were attributable to the change in fair value of these securities.
There were no sales of held-to-maturity securities during 2006, 2005 or 2004.
Net investment income for the years ended December 31, 2006, 2005 and 2004, is composed of the following.
On the following page is a summary of fixed maturity and equity securities that were in an unrealized loss position at December 31, 2006. We have the ability and positive intent to hold the securities until such time as the value recovers or the securities mature. Further, we believe the deterioration in value of our fixed maturity portfolio is primarily attributable to changes in market interest rates and not the credit quality of the issuer. We attribute the deterioration in value of our equity security portfolio to usual market volatility and not to any permanent financial hardships encountered by the underlying companies in which we are invested. Therefore, we have concluded that our unrealized losses are temporary in nature.
The estimated fair value of mortgage loans is based upon discounted cash flows, utilizing the market rate of interest for similar loans in effect at the valuation date. Other long-term investments consist primarily of holdings in limited partnership funds that are valued by the various fund managers. In management’s opinion, these values represent fair value at December 31, 2006 and 2005.
The fair value of the liabilities for annuity products that are in a benefit payment phase, guaranteed investment contracts and structured settlements is based on a discount rate of 5.75 percent and 6.25 percent at December 31, 2006 and 2005, respectively. The fair value of annuities currently in an accumulation phase is based on the net cash surrender value.
Reinsurance is a contract by which one insurer, called the reinsurer, agrees to cover under certain defined circumstances, a portion of the losses incurred by a primary insurer if a claim is made under a policy issued by the primary insurer. We have several programs that provide reinsurance coverage. This reinsurance coverage limits the risk of loss that we retain by reinsuring direct risks in excess of our retention limits. The following table provides a summary of the primary reinsurance treaties. Retention amounts reflect the accumulated retentions and co-participation of all layers with a treaty.
In addition, in the event that we incurred catastrophe losses covered by our reinsurance programs, our catastrophe reinsurance program would provide one guaranteed reinstatement at 100 percent of the original premium. We also purchase reinsurance from the Florida Hurricane Catastrophe Fund (“FHCF”). The level of reinsurance protection obtained through this fund is immaterial to our operations.
Our reinsurance assumed from foreign insurance companies is primarily accounted for using the periodic method, whereby premiums are recognized as revenue over the policy term and claims, including an estimate of IBNR claims, are recognized as they occur. The amount of reinsurance business assumed from foreign insurance companies is not material to our Consolidated Financial Statements.
Premiums, losses and loss settlement expenses related to our ceded and assumed business is displayed in the table below.
As of December 31, 2006 and 2005, United Life Insurance Company purchased reinsurance to limit the dollar amount of any one risk of loss. On standard individual life cases where the insured is age 65 or less, our retention is $200,000. On standard individual life cases where the insured is age 66 or older, our retention is $80,000. Our accidental death benefit rider on an individual policy is reinsured at 100 percent up to a maximum benefit of $250,000. Our group coverage, both life and accidental death and dismemberment, is reinsured at 50 percent. Catastrophe excess coverage applies when three or more insureds die in a catastrophic accident. For catastrophe excess claims, we retain the first $1,000,000 of ultimate net loss and the reinsurer agrees to indemnify us for the excess up to a maximum of $5,000,000. We supplement this coverage when appropriate with “known concentration” coverage. Known concentration coverage is typically tied to a specific event and time period, with a threshold of a minimum number of lives involved in the event, minimum event deductible (company’s retention) and a maximum payout.
We and our property and casualty and life insurance subsidiaries prepare our statutory-basis financial statements in conformity with accounting practices prescribed or permitted by the insurance department of the applicable state of domicile. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (“NAIC”), as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed.
A reconciliation of income tax expense (computed at the applicable federal tax rate of 35 percent in 2006, 2005 and 2004, respectively) to the amount recorded in the accompanying Consolidated Financial Statements is as follows.
The significant components of the net deferred tax liability at December 31, 2006 and 2005, are as follows.
As of December 31, 2006, we have a gross deferred tax asset for net operating loss carryforwards totaling $18,780,000, all of which was acquired as part of our purchase of American Indemnity Financial Corporation. These
net operating loss carryforwards expire from 2009 through 2018, of which carryforwards of $11,085,000 expire from 2009 through 2011. We are required to establish a valuation allowance for any portion of the gross deferred tax asset that we believe may not be realized. At December 31, 2006, we recorded a valuation allowance of $6,195,000, which relates to those net operating loss carryforwards that can only be used to offset future income of the property and casualty insurance segment. As we have determined that the benefit of these net operating losses can be realized, the related reduction in the deferred tax asset valuation allowance was recorded as a reduction to our intangible asset for agency relationships, which resulted in the elimination of the carrying value of the intangible asset related to the acquisition of American Indemnity Financial Corporation in 2004. Beginning in 2006, these adjustments have been recognized as a reduction to current federal income tax expense.
We offer a noncontributory defined benefit pension plan in which all of our employees are eligible to participate after they have completed one year of service, attained 21 years of age and have met the hourly service requirements. Under our pension plan, retirement benefits are based on the number of years of service and level of compensation. Our policy is to fund this plan on a current basis to the extent that the contribution is deductible under existing tax regulations. We estimate that we will contribute approximately $4,000,000 to the plan in 2007.
We offer a health and dental benefit plan to all of our eligible employees and retirees. The plan is composed of two programs: (1) the self-funded retiree health and dental benefit plan and (2) the self-funded employee health and dental benefit plan. The plan provides health and dental benefits to our employees and retirees (and covered dependents) who have met the service and participation requirements stipulated by the plan. The plan’s contract administrators are responsible for making medical and dental care benefit payments. The plan requires participants to submit claims for reimbursement or payment to the claims administrator within 365 days after the end of the calendar year in which the charges were incurred. The plan’s benefit obligation relates primarily to our postretirement benefit program.
The following actuarial assumptions were used to determine the reported plan benefit obligations at December 31, 2006.
We also have an employee stock ownership plan for the benefit of eligible employees and their beneficiaries. All employees are eligible to participate in the plan upon completion of one year of service, meeting the hourly requirements with United Fire and attaining age 21. Contributions to this plan are made at our discretion. These contributions are based upon a percentage of the total payroll and are allocated to participants on the basis of compensation. We make contributions in stock or cash, which the trustee uses to acquire shares of United Fire stock to allocate to participants’ accounts. As of December 31, 2006, 2005 and 2004, the Employee Stock Ownership Plan owned 248,764, 249,978 and 250,922 shares of United Fire common stock, respectively. Shares owned by the Employee Stock Ownership Plan are included in shares issued and outstanding for purposes of calculating earnings per share and dividends paid on the shares are charged to retained earnings. We made contributions to the plan of $650,000, $250,000 and $30,000 in 2006, 2005 and 2004, respectively.
option expiration date, the date of grant, the vesting schedule of options or whether the options shall be immediately vested, the terms and conditions of options and restricted stock (other than those terms and conditions set forth in the plan) and the number of shares of common stock to be issued pursuant to an option agreement or restricted stock agreement. The board may also take any action it deems necessary and appropriate for the administration of the plan. The analysis below details the activity of our stock option plans for the year ended December 31, 2006. Information on the options outstanding at December 31, 2006, is also presented.
Intrinsic value is the difference between our share price on the last day of trading, December 31, 2006 and the price of the options when granted and represents the value that would have been received by option holders had they exercised their options on December 31, 2006. These values change based on the fair market value of our shares. The intrinsic value of options exercised totaled $448,000, $845,000 and $575,000 in December 31, 2006, 2005 and 2004, respectively.
Total revenue by segment includes sales to outside customers and intersegment sales that are eliminated to arrive at the total revenues as reported in the accompanying Consolidated Statements of Income. We account for intersegment sales on the same basis as sales to outside customers. The table on the following page sets forth certain data for each of our business segments and is reconciled to our Consolidated Financial Statements. Depreciation expense and property and equipment acquisitions for the years ended December 31, 2006, 2005 and 2004, are reported in the property and casualty insurance segment.
(1) The sum of the quarterly reported amounts may not equal the full year as each is computed independently.
We determine the dilutive effect of our stock options outstanding using the “treasury stock” method. Under this method, we assume the exercise of all of the outstanding options whose exercise price is less than the weighted-average fair market value of our stock during the period. This method also assumes that the proceeds from the hypothetical stock option exercises are used to repurchase shares of common stock at the weighted-average fair market value of the stock during the period. The net of the assumed options exercised and assumed common shares repurchased represents the number of potentially dilutive common shares, which we add to the denominator of the earnings per share calculation.
The components of basic and diluted earnings per share are displayed in the table below. The 2004 amounts reflect the retroactive effects of our December 15, 2004, one-for-one stock dividend.
Cash dividends per common share of $.495, $.48 and $.42 were declared in 2006, 2005 and 2004, respectively.
Comprehensive income (loss) includes changes in equity during a period except those resulting from investments by shareholders and dividends to shareholders. The primary components of our comprehensive income (loss) are net income and the change in net unrealized gains and losses on available-for-sale securities as adjusted for amounts that have been reclassified as realized gains and losses. The following table sets forth the components of comprehensive income (loss) and the related tax effects for the years ended December 31, 2006, 2005 and 2004.
At December 31, 2006, we were obligated under noncancelable operating lease agreements for office space, vehicles, computer equipment and office equipment. Most of our leases include renewal options, purchase options or both. These provisions may be exercised by us upon the expiration of the related lease agreements. Rental expense under our operating lease agreements was $4,714,000, $4,558,000 and $2,355,000 for the years ended December 31, 2006, 2005 and 2004, respectively. Our most prominent lease arrangement is for office space through which we conduct the insurance operations of our Galveston, Texas, location. This lease was initiated in December 2004, with a lease term of 10 years. The annual lease payment for this office space is approximately $2,100,000.
During the second quarter of 2006, we completed an offering of shares of our common stock priced at $28.00 per share. Pursuant to this offering, we issued 4,025,000 shares of our $3.33 par value common stock, resulting in proceeds (net of $5,738,000 million in underwriting expenses) of $106,962,000.
We have audited the accompanying consolidated balance sheets of United Fire & Casualty Company (United Fire) as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules of United Fire listed in Item 15(2). These financial statements and schedules are the responsibility of United Fire’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
During 2006, United Fire changed its method of accounting for the recognition of stock-based compensation expense and the recognition of the funded status of its defined benefit pension and postretirement plans, which has been discussed in Note 1 to the consolidated financial statements.
Ernst & Young LLP, the independent registered public accounting firm that audited the consolidated financial statements of United Fire & Casualty Company included in this Annual Report on Form 10-K, has issued an attestation report on management’s assessment of the effectiveness of internal control over financial reporting as of December 31, 2006. The report, which expresses unqualified opinions on management’s assessment and on the effectiveness of United Fire & Casualty Company’s internal control over financial reporting as of December 31, 2006, is included in this item under the heading “Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting.”
We have audited management’s assessment, included in the accompanying Management Report on Internal Control Over Financial Reporting, that United Fire & Casualty Company (United Fire) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). United Fire’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of United Fire’s internal control over financial reporting based on our audit.
In our opinion, management’s assessment that United Fire & Casualty Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, United Fire & Casualty Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balances sheets of United Fire & Casualty Company as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006, and our report dated February 28, 2007, expressed an unqualified opinion thereon.