FPIC leases approximately 25,000 square feet for the Group’s west coast operations in Rocklin, California. FPIC owns 2.9 acres of land adjacent to its office building, carried at $1.3 million. FPIC also owns a townhouse, used for corporate purposes, in Rocklin, California carried at $0.4 million.
Earnings per share data reflect only net loss for the period from December 16, 2003, the date of the Conversion, through December 31, 2003. Net loss during this period was ($477,000).
The 2007 results include a non-recurring refund of state premium retaliatory taxes, plus interest, in the after-tax amounts of $2.8 million, or $0.44 per diluted share. See footnote 15 to the consolidated financial statements.
difficult to predict. For these lines of business, more sophisticated actuarial methods, such as the Bornhuetter-Ferguson loss development methods (see “Methods” below) are employed to project an ultimate loss expectation, and then the related loss history must be regularly evaluated and loss expectations updated, with the possibility of variability from the initial estimate of ultimate losses. A substantial portion of the business written by FPIC is this type of longer-tailed casualty business.
accident year from one maturity point to the next. We then selected appropriate age-to-age loss development factors based on these historical factors and use the selected factors to project the ultimate losses.
The paid loss development method is mechanically identical to the incurred loss development method described above with the exception that paid losses replace reported losses. The paid method does not rely on case reserves or their adequacy in making projections.
The Bornhuetter-Ferguson expected loss projection method based on reported loss data relies on the assumption that remaining unreported losses are a function of the total expected losses rather than a function of currently reported losses. The expected losses used in this analysis are selected judgmentally based upon the historical relationship between premiums and losses for more mature accident years, adjusted to reflect changes in average rates and expected changes in claims frequency and severity. The expected losses are multiplied by the unreported percentage to produce expected unreported losses. The unreported percentage is calculated as one minus the reciprocal of the selected incurred loss development factors. Finally, the expected unreported losses are added to the current reported losses to produce ultimate losses.
For the property lines of business (special property, personal auto physical damage, and commercial auto physical damage) the results of the reserve calculations were similar and we generally rely on an averaging of the methods utilized.
FPIC evaluates commercial multi-peril liability reserves by segregating pre- and post-Montrose activity as well as segregating contractor versus non-contractor experience. An inception to date ground-up incurred loss database was created as the basis for this new analysis. The pre-Montrose activity is evaluated on a report year basis
which eliminates the accident year development distortions caused by the effects of the Montrose Decision. For policy years 1997 and later, the reserves are analyzed using the more traditional accident year analysis.
For the casualty lines (commercial multi-peril liability, other liability, personal auto liability, commercial auto liability, workers’ compensation) the paid loss development method yielded less than reliable results for the immature years and we did not use the method in selecting ultimate losses and reserves. For these lines we primarily relied on the incurred Bornhuetter-Ferguson method for the most recent accident years and both of the incurred loss development methods for the remaining years.
Reserves are estimates because there are uncertainties inherent in the determination of ultimate losses. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past as well as create uncertainties regarding future loss cost trends. Accordingly, the ultimate liability for unpaid losses and loss settlement expenses will likely differ from the amount recorded at December 31, 2007.
The Group’s consulting actuaries’ determined range of loss and loss adjustment expense reserves on a net basis range from a low of $153.5 million to a high of $200.3 million as of December 31, 2007. The Group’s net loss and loss adjustment expense reserves are carried at $192.0 million as of December 31, 2007. Management’s point estimate of reserves is at the higher end of its actuarially determined range in recognition of the inherent uncertainty in assessing the potential ultimate liabilities given legal developments as well as the evolution in its operations. The evolution in its operations include such things as changes in coverage and pricing in response to market opportunity as well as higher reinsurance retentions and geographic and product diversification all of which affect management’s reserve estimates.
The chart below displays case and IBNR reserves for the Group as of December 31, 2007 and 2006 by line of business:
the near term. In the years ended December 31, 2007, 2006 and 2005, we recorded a pre-tax charge to earnings of $138,000, $121,000 and $517,000, respectively, for write-downs of other than temporarily impaired securities. In 2007, these charges related to common stocks, in 2006 these charges related to fixed income securities, and in 2005 these charges related to preferred stocks and fixed income securities. Adverse investment market conditions, poor operating performance, or other adversity encountered by companies whose stock or fixed maturity securities we own could result in impairment charges in the future. The Group’s policy on impairment of value of investments is as follows: if a security has a market value below cost it is considered impaired. For any such security a review of the financial condition and prospects of the company will be performed by the Investment Committee to determine if the decline in market value is other than temporary. If it is determined that the decline in market value is “other than temporary”, the carrying value of the security will be written down to “realizable value” and the amount of the write down accounted for as a realized loss. “Realizable value” is defined for this purpose as the market price of the security. Write down to a value other than the market price requires objective evidence in support of that value.
We defer policy acquisition costs, such as commissions, premium taxes and certain other underwriting expenses that vary with and are primarily related to the production of business. These costs are amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, loss and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected loss and loss adjustment expenses, may require acceleration of the amortization of deferred policy acquisition costs. If the estimation of net realizable value indicates that the acquisition costs are unrecoverable, further analyses are completed to determine if a reserve is required to provide for losses that may exceed the related unearned premiums.
Revenue and income by segment is as follows for the years ended December 31, 2007, 2006 and 2005. In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:
Our results of operations are influenced by factors affecting the property and casualty insurance industry in general. The operating results of the United States property and casualty insurance industry are subject to significant variations due to competition, weather, catastrophic events, regulation, the availability and cost of satisfactory reinsurance, general economic conditions, judicial trends, fluctuations in interest rates and other changes in the investment environment.
The availability of reinsurance at reasonable pricing is an important part of our business. Effective, January 1, 2007, the Group increased its retention to $750,000 (from a maximum retention of $500,000 in 2006) on the casualty, property and workers’ compensation lines of business. As the Group increases the net retention of the business it writes, net premiums written and earned will increase and ceded losses will decrease. The impact of increased retentions under our reinsurance program in 2007 was offset in part by a decline in direct written premium due to the increasingly competitive marketplace. As older reinsurance treaties run off, the impact described above of the new reinsurance program will become more evident in net premiums written and net premiums earned.
YEAR ENDED DECEMBER 31, 2007 COMPARED TO YEAR ENDED DECEMBER 31,
of business, but with no net change in cost allocated to personal lines and commercial lines in the aggregate. Related 2006 and 2005 amounts have been reclassified to reflect this change in allocation methodology:
The Group’s GAAP combined ratio for 2007 was 95.8%, as compared to a combined ratio for the prior year of 97.0%. On a pro-forma basis, after removing the effect of the non-recurring retaliatory tax refund described above, the GAAP combined ratio for 2007 was 98.3%. The statutory combined ratio for 2007 and 2006 was 94.4% and 95.2%, respectively. See discussion below relating to commercial and personal lines performance.
Net investment income increased $3.0 million or 29.6% to $13.1 million in 2007 as compared to $10.1 million in 2006. Included in this increase is $720,000 attributable to the non-recurring impact of the retaliatory taxes described above. The balance of the increased investment income is due to increased cash and invested assets, resulting from operating cash flow and the reduced premium ceded to reinsurers in 2007, as well as a favorable interest rate environment.
Realized investment gains amounted to $24,000 in 2007 as compared to $151,000 in 2006, driven in part by changes in the fair value of the interest rate swaps for the floating rate trust preferred securities. Other revenue of
Charts and discussion relating to each of our segments (commercial lines underwriting, personal lines underwriting, and the investment segment) follow with further discussion below. Changes have been made to the 2006 presentation of the commercial and personal lines segments to conform to the allocation methodology used for the 2007 commercial and personal lines results.
Total revenues for 2007 increased $11.8 million or 7.8% to $161.7 million as compared to $149.9 million in 2006. This increase was due primarily to an increase in net premiums earned and net investment income. Net premiums earned totaled $146.7 million in 2007 as compared to $137.7 million in 2006, representing a 6.5% or $9.0 million increase. Net premiums written increased $13.9 million or 9.5% to $159.7 million as compared to $145.8 million in 2006. Net premiums written and net premiums earned were impacted in 2007 by the volume of audit premium recorded, which is earned immediately upon recording, and by changes in reinsurance arrangements (see discussion below).
Commercial multiple peril policies constitute a majority of the business written in FPIC’s contractor book of business. The premium on these policies is estimated at policy inception based on a prediction of the volume of the insured’s business operations during the policy period. In addition to endorsing the policy throughout the policy period based on known information, at policy expiration FPIC conducts an audit of the insured’s business operations in order to adjust the policy premium from an estimate to actual. Contractor liability policy premium tends to vary with local construction activity as well as changes in the nature of the contractor’s operations. The decline in construction related activity has impacted both the volume of premium for the contractor in-force book of business (and related exposures) and the related audit premium on expiring policies. Audits, primarily of construction related policies, generated $3.1 million of premium in 2007, representing a decline of $8.9 million as compared to $12.0 million of premium that was generated in 2006.
Dividend income declined $0.2 million or 37.9% to $0.3 million in 2007, from $0.5 million in 2006. The decline in dividend income is primarily attributable to a decline in dividends received relating to an equity security held in a reinsurance company. Excess Reinsurance Company paid a special dividend to the Group in 2007 and 2006 in the amount of $1,000 and $228,000, respectively. Interest income on cash and cash equivalents increased $0.6 million or 67.9% to $1.4 million in 2007, as compared to $0.9 million in 2006, primarily as a result of the
$720,000 of non-recurring interest received on the retaliatory tax refund. Investment expenses decreased $0.3 million or 12.1% to $2.1 million in 2007, from $2.3 million in 2006.
Net realized gains for 2007 were $24,000, as compared to $151,000 in 2006. In 2007, net realized gains of $24,000 included a loss on the mark-to-market valuation on the interest rate swaps of $774,000, write-down of securities determined to be other than-temporarily impaired of $138,000, and gains of $936,000 on the sale of equity investments. Securities determined to be other-than-temporarily impaired were written down to our estimate of fair market value at the time of the write-down. The Group has entered into four interest rate swap agreements to hedge against interest rate risk on its floating rate trust preferred securities. The estimated fair value of the interest rates swaps is obtained from the third-party financial institution counterparties. The Group marks the investments to market using these valuations and records the change in the economic value of the interest rate swaps as a realized gain or loss in the consolidated statement of earnings.
Among its portfolio holdings, the Group’s only subprime exposure consists of asset-backed securities within the home equity subsector. The ABS home equity subsector totaled $1.7 million (book value) on December 31, 2007, representing 10.4% of the ABS holdings, 2.0% of the total structured product holdings, and 0.5% of total fixed income holdings. The subprime related exposure consists of five individual securities, two of which have a 100% credit enhancement, based on insurance against default as to principal and interest. In the case that the monoline insurance companies were to be downgraded, the ratings on the ABS securities would receive the equivalent rating. Among the three securities without credit enhancement, two are rated Aaa/AAA and one is rated Aa2/AA by Moody’s and S&P. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the subsection entitled “Quantitative and Qualitative Information about Market Risk.”
In 2007, our commercial lines net premiums written increased by $15.5 million, or 12.5%, to $139.4 million as compared to net premiums written in 2006 of $123.8 million. Net premiums earned in 2007 increased 8.6%, or $10.0 million, to $125.4 million from $115.5 million in 2006. See additional discussion above in the 2007 vs. 2006 Revenue discussion.
In the commercial lines segment for 2007, we had underwriting income of $6.0 million, a GAAP combined ratio of 95.2%, a GAAP loss and loss adjustment expense ratio of 60.8% and a GAAP underwriting expense ratio of 34.4%, compared to underwriting income of $4.2 million, a GAAP combined ratio of 96.5%, a GAAP loss and loss
In 2007, personal lines direct premiums written declined to $22.9 million, representing a decline of $1.3 million or 5.3% from $24.2 million in 2006. Our personal lines have been impacted by increased competition, similar to our commercial lines. Net premiums written also declined to $20.3 million in 2007, as compared to $22.0 million in 2006, representing a decline of $1.7 million or 7.5%. Personal lines net premiums earned in 2007 declined 4.3% or $1.0 million to $21.2 million from $22.2 million in 2006.
In the personal lines segment for 2007, we had underwriting income of $0.2 million, a GAAP combined ratio of 98.9%, a GAAP loss and loss adjustment expense ratio of 70.1% and a GAAP underwriting expense ratio of 28.8%, compared to an underwriting loss of $0.1 million, a GAAP combined ratio of 100.3%, a GAAP loss and loss adjustment expense ratio of 63.8% and a GAAP underwriting expense ratio of 36.5% in 2006. Our personal lines loss ratio for 2007 reflects a frequency and severity of losses reported which falls generally within a normal range of our expectations.
Underwriting expenses increased by $3.4 million, or 7.3%, to $49.3 million in 2007, as compared to $45.9 million in 2006. The increase in 2007 underwriting expenses reflects the inclusion of the non-recurring retaliatory tax refund, which reduced other underwriting expenses by $3.6 million in 2007. Offsetting that refund, other underwriting expenses increased due to an increase in salary expense from additions in staff Group-wide to support strategic initiatives, and other increased operating expenses. In addition, the amortization of deferred acquisition costs is lower in 2006 as compared to 2007 due to the fact that when FPIG was purchased on October 1, 2005, the accounting for the business combination required the Group to begin accruing deferred acquisition costs from the date of acquisition. Lastly, underwriting expenses are impacted by the previously discussed changes in the 2007 and 2006 reinsurance program whereby less ceded premium is being recorded and accordingly less ceding commission is received on treaties in runoff, and most of the treaties effective January 1, 2007 do not provide for ceding commission, which increases underwriting expenses and net acquisition costs.
Charts and discussion relating to each of our segments (commercial lines underwriting, personal lines underwriting, and the investment segment) follow with further discussion below. Changes have been made to the 2005 presentation of the commercial and personal lines segments to conform to the allocation methodology used for the 2006 commercial and personal lines results.
Net investment income increased $5.6 million or 125.4% to $10.1 million in 2006 as compared to $4.5 million in 2005, primarily as a result of the acquisition of FPIG in addition to higher short-term and long-term interest rates in 2006. Realized investment gains amounted to $151,000 in 2006 as compared to $1.3 million in 2005. The higher level of realized gains in 2005 was attributable to the disposition of securities in anticipation of funding the acquisition of FPIG on October 1, 2005 for $41.1 million (including acquisition costs). Other revenue, which is primarily service charges recorded on insurance premiums, increased $1.2 million or 162.7% to $1.9 million in 2006 as compared to $0.7 million in 2005, reflecting the impact of the acquisition of FPIG. Interest expense of $1.2 million in 2006 and $0.3 million in 2005 represents the inclusion of the trust preferred obligations of FPIG and their related interest charges for the year ending December 31, 2006 and the quarter ending December 31, 2005.
In 2006, direct premiums written increased $93.5 million or 101.4% to $185.7 million in 2006 as compared to $92.2 million in 2005. FPIC contributed $120.1 million and $27.9 million in direct written premium for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively.
In 2006, net investment income increased $5.6 million or 125.4% to $10.1 million in 2006 as compared to $4.5 million in 2005. Our investment income benefited in 2006 from higher short-term and long-term interest rates, an increase in average cash and invested assets to $294.4 million in 2006 from $155.8 million in 2005, and increased largely due to the inclusion of the net investment income of FPIG for the entire year of 2006 compared to inclusion of net investment income of FPIG for only the fourth quarter in 2005. FPIG contributed $6.3 million and $1.4 million in net investment income for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively.
In 2006, investment income on fixed income securities increased $5.8 million or 112.6% to $11.0 million in 2006 as compared to $5.2 million in 2005. This was driven by an increase in long-term interest rates, an increase in the average invested assets and the inclusion of FPIG for the entire year of 2006. The Group’s tax equivalent yield (yield adjusted for tax-benefit received on tax-exempt securities) on fixed income securities increased to 5.14% in 2006 compared to 4.57% in 2005. Since the acquisition of FPIG, a much larger proportion of the Group’s premium writings relate to casualty, or longer-tail, business. By its nature, longer-tail business requires more time for losses to manifest themselves, with the result that claims tend to be paid later on casualty claims than on other types of claims. The later payment of claims associated with casualty reserves provides a company with the opportunity to use the funds, which will ultimately be paid out as claims, for a longer period of time, thus generating a larger relative portfolio of fixed income securities and higher investment income.
Net realized gains for 2006 were $0.2 million, as compared to $1.3 million in 2005. As noted above, the 2005 gains were taken as part of the process of funding the acquisition of FPIG. In 2006, net realized investment gains of $0.2 million included gains on securities sales of $1.0 million, offset by losses on securities sales of $0.6 million, $0.1 million from the write-down of a fixed-income security determined to be other-than-temporarily impaired and a loss of $0.1 million relating to the mark-to-market valuation on the interest rate swaps. Securities determined to be other-than-temporarily impaired are written down to our estimate of fair market value. The Group has entered into five interest rate swap agreements to hedge against interest rate risk on its floating rate trust preferred securities. The estimated fair value of the interest rates swaps is obtained from the third-party financial institution counterparties.
The Group marks the investments to market using these valuations and records the change in the economic value of the interest rate swap as a realized gain or loss in the consolidated statement of earnings.
The following table summarizes the period of time that equity securities sold at a loss during 2006 had been in a continuous unrealized loss position:
In 2006, our commercial lines direct premiums written increased by $93.9 million or 138.6% to $161.6 million as compared to direct written premium in 2005 of $67.7 million. This increase was due primarily to inclusion of the direct premiums written of FPIC for the entire year of 2006 compared to inclusion of direct premiums written of FPIC for only the fourth quarter in 2005. FPIC contributed $120.1 million and $27.9 million in direct premiums written for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively. Net premiums earned increased $63.2 million or 120.9% to $115.5 million in 2006 from $52.3 million in 2005, of which FPIC contributed $77.3 million and $13.9 million of net premiums earned for the year ending December 31, 2006 and fourth quarter ending December 31, 2005, respectively.
Effective January 1, 2006, FPIC restructured its property reinsurance agreement covering the first $2,000,000 of loss from an 80% quota share to a $1,650,000 excess of $350,000 excess of loss contract to take advantage of the Group’s capital. The restructuring also included the assumption of ceded unearned premium at January 1, 2006 by FPIC from the 2005 property quota share and casualty excess of loss agreements. These assumed premiums were then ceded into the respective 2006 treaties, which due to the reduced ceding rates, resulted in a $5.6 million increase in net written and earned premium for the year ending December 31, 2006.
Results of our Personal Lines segment were as follows. In 2007, the Group evaluated its methodology for allocating costs to its lines of business and adopted changes to such methodology in order to more accurately reflect the allocation of joint costs. This resulted in allocating less joint cost to the personal lines of business and more joint cost to the commercial lines of business, but with no net change in cost allocated to personal lines and commercial
Personal lines direct premiums written remained stable at $24.2 million and $24.5 million in 2006 and 2005, respectively. Net premiums written and earned also remained stable at $22.0 million and $22.2 million, respectively in 2006 compared to $22.6 million and $22.5 million, respectively in 2005.
Underwriting expenses increased by $18.3 million, or 66.3%, to $45.9 million in 2006, as compared to $27.6 million in 2005. The 66.3% increase in underwriting expenses primarily reflects the 84.2% increase in net premiums earned, offset by the inclusion of FPIC which operates at a lower expense ratio than that of the balance of the Group.
Effective January 1, 2006, the Group adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123R “Share-Based Payment” (SFAS 123R), using the modified-prospective-transition method. As a result of adopting SFAS 123R on January 1, 2006, the Group’s 2006 underwriting expenses included a pre-tax charge of $711,000 to recognize the compensation cost of unvested stock options granted under the Group’s plan and the impact of SFAS 123R on the computation of expense relating to grants of restricted stock. In addition to the charge relating to the transition to SFAS 123R, the Group’s 2006 underwriting expenses included a pre-tax
charge of $687,000 associated with grants of restricted stock. During 2005, underwriting expenses included a pre-tax charge of $693,000 associated with grants of restricted stock.
As part of the funding of the acquisition of FPIG, MIC entered into a loan agreement with MIG, by which it advanced on September 30, 2005, a loan of $10 million with a 20-year note and a fixed interest rate of 4.75%, repayable in 20 equal annual installments. MIG has no special limitations on its ability to take periodic dividends from its insurance subsidiaries except for normal dividend restrictions administered by the respective domiciliary state regulators as described above. The Group believes that the resources available to MIG will be adequate for it to meet its obligation under the note to MIC, the line of credit and its other expenses.
On October 20, 2004, the Group’s Board of Directors authorized the repurchase of up to 250,000 additional shares of its common stock (in addition to the 250,000 share repurchase authorized June 16, 2004 and previously completed). The repurchase of the additional 250,000 shares was completed on March 2, 2005. The repurchased shares will be held as treasury shares available for issuance in connection with the Group’s 2004 Stock Incentive Plan. In the aggregate, 500,000 shares have been repurchased in the open market since the Conversion, at an aggregate cost of $6.3 million, or $12.53 per share, with 2005 purchases totaling $3.2 million, or $13.18 per share. In addition, 2,301 and 1,950 shares of stock were repurchased from employees in 2007 and 2006, respectively, in order to pay the required tax withholdings on the vesting of restricted stock under the stock incentive plan.
Pursuant to the protests, the Group has received $4.3 million in 2007 as a reimbursement of protested payments of retaliatory tax, including accrued interest, previously made by the Group for the periods 1999-2004. The refund has been recorded, after reduction for Federal income tax, in the amount of $2.8 million in the 2007 consolidated statement of earnings, with $2.5 million recorded in the quarter ended June 30, 2007, and $0.3 million recorded in the quarter ended September 30, 2007.
In June 2006, the FASB issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes” which clarifies the accounting for income tax reserves and contingencies recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. On January 1, 2007, the Group adopted FIN 48. As a result of adoption, the Group recognized a previously unrecognized tax benefit of approximately $0.2 million relating to merger-related expenses for the FPIG acquisition that took place October 1, 2005. The application of FIN 48 for this unrecognized tax benefit resulted in a corresponding reduction to goodwill relating to the FPIG acquisition of $0.2 million. The adoption of FIN 48 did not result in any adjustments to beginning retained earnings, nor have a significant effect on operations, financial condition or liquidity. As of January 1, 2007, the Group has no unrecognized tax benefits.
operating lease obligations. Projected cash disbursements pertaining to these obligations at December 31, 2007, are as follows:
The timing of the amounts for gross property and casualty insurance reserves are an estimate based on historical experience and expectations of future payment patterns. However, the timing of these payments may vary significantly from the amounts state above.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercer Insurance Group, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.
The preparation of the accompanying financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates include liabilities for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance, deferred income tax assets and investment valuation and assessment of other than temporary impairment of investments. Actual results could differ from those estimates.
The Group’s business is subject to concentration risk with respect to geographic concentration. Although the Group’s operating subsidiaries are licensed collectively in twenty two states, direct premiums written for three states, California, New Jersey and Pennsylvania, constituted 55%, 27% and 7% of the 2007 direct premium written, 53%, 28% and 8% of the 2006 direct premium written, and 25%, 54%, and 16% of the 2005 direct premium written. Consequently, changes in the California, New Jersey or Pennsylvania legal, regulatory or economic environment could adversely affect the Group.
For the year ending December 31, 2007 and 2006, there were no agents in the Group that individually produced greater than 5% of the Group’s direct written premiums. For the year ending December 31, 2005, approximately 17% of the Group’s direct premiums written were produced by two agents, including one who is a related party (see Note 16 for information about related party transactions).
Cash and cash equivalents, and short-term investments are carried at cost which approximates fair value. The Group considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.
Cash and cash equivalents, and short-term investments - The carrying amounts reported in the consolidated balance sheet for these instruments approximate their fair values.
The Group cedes insurance to, and assumes insurance from, unrelated insurers to limit its maximum loss exposure through risk diversification. Ceded reinsurance receivables and unearned premiums are reported as assets; loss and loss adjustment expense reserves are reported gross of ceded reinsurance credits, unless the reinsurance contract includes a right of offset. Premiums receivable is recorded gross of ceded premiums payable. An allowance for estimated uncollectible reinsurance is recorded based on an evaluation of balances due from reinsurers and other available information.
Acquisition costs such as commissions, premium taxes, and certain other expenses which vary with and are primarily related to the production of business, are deferred and amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated net realizable value, which gives effect to premiums to be earned, anticipated investment income, loss and loss adjustment expenses, and certain other maintenance costs expected to be incurred as the premiums are earned. Future changes in estimates, the most significant of which is expected losses and loss adjustment expenses, may require adjustments to deferred policy acquisition costs. If the estimation of net realizable value indicates that the acquisition costs are unrecoverable, further analyses are completed to determine if a reserve is required to provide for losses that may exceed the related unearned premium.
The Group makes grants of qualified (ISO’s) and non-qualified stock options (NQO’s), and non-vested shares (restricted stock) under its stock incentive plan. Stock options are granted at prices that are not less than market price at the date of grant, vest over a period of three or five years, and are outstanding for a period of ten years for ISO’s and ten years and one month for NQO’s. Restricted stock grants vest over a period of three to five years.
The Group adopted SFAS No. 123R on January 1, 2006 with no impact upon adoption. The compensation expense recorded (after tax benefit) in the consolidated statements of earnings for stock options (net of forfeitures) for the years ended December 31, 2007 and 2006 was $439 and $555, respectively. The compensation expense recorded (after tax benefit) in the consolidated statements of earnings for restricted stock (net of forfeitures) for the years ended December 31, 2007 and 2006 was $336 and $442, respectively. There would have been no charge to
earnings for stock option grants if the Group had continued to account for stock-based compensation under APB 25 for unvested stock options. SFAS No. 123R also eliminated the presentation of the contra-equity account “Unearned restricted stock compensation,” resulting in a reclass of $1,654 to Additional paid-in capital upon adoption.
The following table shows the pro-forma effect on the consolidated statement of earnings and earnings per share as if the Group had applied SFAS No. 123 to stock options granted under its plan prior to the adoption of SFAS No. 123R on January 1, 2006.
The Group uses the asset and liability method of accounting for income taxes. Deferred income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax bases of the Group’s assets and liabilities and operating loss carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of the enactment date.
The Group accounts for its interest rate swaps in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities”. The Group has designated the interest rate swaps as non-hedge instruments. Accordingly, the Group recognizes the fair value of the interest rate swaps as assets or liabilities on the consolidated balance sheets with the changes in fair value recognized in the consolidated statement of earnings. The estimated fair value of the interest rate swaps is based on valuations received from the financial institution counterparties.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - including an amendment of FASB Statement No. 115.” SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value at specified election dates. Upon adoption, an entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Most of the provisions apply only to entities that elect the fair value option. However, the amendment to SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” applies to all entities with available for sale and trading securities. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Group does not expect that the adoption of SFAS No. 159 will have a significant effect on operations, financial condition or liquidity.
The cost and estimated market value of available-for-sale fixed-income and equity investment securities at December 31, 2007 and 2006 are shown below.
There are 16 common stock securities that are in an unrealized loss position at December 31, 2007. All of these securities have been in an unrealized loss position for less than six months. There are 7 preferred stock securities that are in an unrealized loss position at December 31, 2007. Five preferred stock securities have been in an unrealized loss position for less than six months. One preferred stock security has been in an unrealized loss position for more than six months but less than twelve months and one preferred stock security has been in an unrealized loss position for more than twelve months. The Group believes these declines are not other than temporary as a result of reviewing the circumstances of each such security in an unrealized position. The Group currently has the ability and intent to hold these securities until recovery.
Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At December 31, 2006 the Group has 198 fixed maturity securities with unrealized losses for more than twelve months. Of the 198 securities with unrealized losses for more than twelve months, 192 of them have fair values of no less than 96% or more of cost and the other 6 securities have a fair value greater than 93% of cost. The fixed income portfolio is invested 100% in investment grade securities, with the exception of one fixed maturity investment held with a value of $0.5 million, as of December 31, 2006, and these unrealized losses primarily reflect the current interest rate environment. The Group does not believe theses declines are other than temporary due to the credit quality of the holdings. The Group currently has the ability and intent to hold these securities until recovery.
The amortized cost and estimated fair value of fixed-income securities at December 31, 2007, by contractual maturity, are shown below (note that mortgage-backed securities in the below table include securities backed by the U.S. government and agencies). Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The gross realized investment losses included write-downs for the other than temporary impairment of securities totaling $138, $121 and $517 for the years ended 2007, 2006 and 2005, respectively.
In the ordinary course of business, the Group seeks to limit its exposure to loss on individual claims and from the effects of catastrophes by entering into reinsurance contracts with other insurance companies. Reinsurance is ceded on excess of loss and pro-rata bases with the Group’s retention in 2007 not exceeding $750 per occurrence and in 2006 and 2005 not exceeding $500 per occurrence. Insurance ceded by the Group does not relieve it of its primary liability as the originating insurer.
Effective January 1, 2006, FPIC restructured its property reinsurance agreement covering the first $2,000 of loss from an 80% quota share to a $1,650 excess of $350 excess of loss contract to take advantage of the Group’s capital. The restructuring also included the assumption of ceded unearned premium at January 1, 2006 by FPIC from the 2005 property quota share and casualty excess of loss agreements. These assumed premiums were then ceded into the respective 2006 treaties, which due to the reduced ceding rates, resulted in a $5.6 million increase in net written and earned premium for the year ended December 31, 2006. There was no similar impact in 2007 relating to this restructuring.
During the third quarter of 2006, the Group commuted all reinsurance agreements with Alea North America Insurance Company (Alea). These reinsurance agreements included participation in the property quota share and casualty excess of loss treaties. As a result of the commutation, the Group received a cash payment of $4.5 million, and recorded a pre-tax net loss on commutation of $160.
The effect of reinsurance with unrelated insurers on premiums written and earned is as follows:
The Group sponsored the FPIG 401(k) Plan for employees of FPIG effective with the acquisition of FPIG on October 1, 2005 (see note 11). All employees of FPIC, as defined in the FPIG 401(k) Plan, who have completed six months of service were eligible for participation in the Plan. The Group matched 100% of the employee’s pre-tax contribution up to $2, on an annual basis. In the fourth quarter of 2005, the Group recognized a cost of $19 for the FPIG 401(k) Plan. Effective January 1, 2006, the FPIG 401(k) Plan was terminated and all eligible employees were rolled into the Group’s 401(k) Plan described in the preceding paragraph.
The Group has an unfunded noncontributory defined benefit plan for its directors. The plan provides for monthly payments for life upon retirement, with a minimum payment period of ten years. The net periodic benefit cost for this plan amounted to $166, $145, and $115 for 2007, 2006, and 2005 respectively. Assumptions used in estimating the projected benefit obligation of the plan are the discount rate (6.3% in 2007 and 6.0% in 2006) and retirement age (65). Benefit payments for the plan were $34 in 2007 and 2006. Costs accrued under this plan amounted to $1,301 and $897 at December 31, 2007 and 2006, respectively.
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management believes it is more likely than not the Group will realize the benefits of the deferred tax assets at December 31, 2007 and 2006.
On January 1, 2007, the Group adopted FIN 48. As a result of adoption, the Group recognized a previously unrecognized tax benefit of approximately $0.2 million relating to merger-related expenses for the FPIG acquisition that took place October 1, 2005. The application of FIN 48 for this unrecognized tax benefit resulted in a corresponding reduction to goodwill relating to the FPIG acquisition of $0.2 million. The adoption of FIN 48 did not result in any adjustments to beginning retained earnings, nor have a significant effect on operations, financial condition or liquidity. As of December 31, 2007, the Group has no unrecognized tax benefits. The Group’s policy is to account for interest and penalties as a component of other expenses. The Group files income tax returns in the federal jurisdiction and various states. The tax years 2004 through 2007 were open for federal tax examination as of December 31, 2007.
The NAIC has risk-based capital (RBC) requirements that require insurance companies to calculate and report information under a risk-based formula which measures statutory capital and surplus needs based on a regulatory definition of risk in a company’s mix of products and its balance sheet. All of the Group’s insurance subsidiaries have an RBC amount above the authorized control level RBC, as defined by the NAIC.
On October 1, 2005, the Group acquired all of the outstanding common stock of FPIG for $41,107 in cash (including related transaction costs), and its results of operations have been included in the consolidated financial statements of the Group since that date (see note 1(a)). The acquisition was made through a merger whereby FPIG Acquisition Corp, a Delaware corporation wholly owned by the Group, merged with and into FPIG, which then became the surviving entity operating under the Certificate of Incorporation and Bylaws of FPIG Acquisition Corp. as a wholly owned subsidiary of the Group. Accordingly, this transaction has been accounted for as a purchase business combination by applying fair value estimates to the acquired assets, liabilities and commitments of FPIG as of October 1, 2005.
The acquisition was made to further the Group’s goal of achieving additional product and geographic diversity and expansion of its commercial lines book.
Represents the value of the agency force through which FPIC products are sold.
Amortization expense for intangible assets subject to amortization was $54, $54 and $14 in 2007, 2006 and 2005. Estimated amortization expense for 2008 and future years is as follows:
over a historical period. The weighted average assumptions used in applying the Black-Scholes-Merton model are shown below:
The weighted-average fair value of options granted under the Plan was $11.05 and $4.44 for 2006 and 2005, respectively. There were no options granted in 2007.
Information regarding unvested restricted stock activity in the Plan is below:
As of December 31, 2007, the Group occupied office space and leased equipment and vehicles under various operating leases that have remaining noncancelable lease terms in excess of one year. Operating leases extending beyond 2009 represent two five-year lease option extensions relating to the FPIG office building in Rocklin, California. Although these options are cancelable, the Group currently intends on exercising these lease extension options. A summary of minimum future lease commitments, including the options on the FPIG building, as of December 31, 2007 follows:
Rental expenses of approximately $437 and $474 for the years ended December 31, 2007 and 2006, respectively, has been charged to income in the accompanying consolidated statement of earnings.
Pursuant to the protests, the Group has received $4.3 million in 2007 as a reimbursement of protested payments of retaliatory tax, including accrued interest, previously made by the Group for the periods 1999-2004. The refund has been recorded, after reduction for Federal income tax, in the amount of $2.8 million in the 2007 consolidated statement of earnings, with $2.5 million recorded in the quarter ended June 30, 2007, and $0.3 million recorded in the quarter ended September 30, 2007. The allocation of the refund to pre-tax earnings included an increase to net investment income of $720,000, with $687,000 of that amount recognized in the quarter ended June 30, 2007, and $33,000 recognized in the quarter ended September 30, 2007, for the interest received on the refund, and $3.6 million as a reduction to Other Expense to recognize the recovery of amounts previously charged to Other
Thomas, Thomas & Hafer of Harrisburg, PA is a law firm the Company uses for claims handling assistance. The brother of the Chief Executive Officer of the Group is a partner of the firm. Fees to Thomas, Thomas & Hafer amounted to $60, $73 and $52 in 2007, 2006 and 2005, respectively.
As of December 31, 2007 and 2006, FPIG owed $3,000 under a $5,000 and $4,000 bank line of credit, respectively. The line of credit bears interest at the bank’s base rate or an optional rate based on LIBOR. The effective annual interest rate as of December 31, 2007 and 2006 was 7.25% and 8.25%, respectively. The line of credit includes covenants to maintain certain financial requirements including a minimum A.M. Best rating and minimum statutory surplus. All covenants were in compliance as of December 31, 2007 and 2006.
Financial Pacific Statutory Trust I (Trust I) is a Connecticut statutory business trust. The Trust issued 5,000 shares of the Trust preferred securities at a price of $1 per share for $5,000. The Trust purchased $5,155 in
Junior Subordinated Debentures from the Group that mature on December 4, 2032. The annual effective rate of interest at December 31, 2007 is 9.13%.
Financial Pacific Statutory Trust III (Trust III) is a Delaware statutory business trust. The Trust issued 7,500 shares of the Trust preferred securities at a price of $1 per share for $7,500. The Trust purchased $7,740 in Junior Subordinated Debentures from the Group that mature on September 30, 2033. The annual effective rate of interest at December 31, 2007 is 9.28%.
The Group has the right, at any time, so long as there are no continuing events of default, to defer payments of interest on the Junior Subordinated Debentures for a period not exceeding 20 consecutive quarters; but not beyond the stated maturity of the Junior Subordinated Debentures. To date no interest has been deferred. FPIG entered into an interest rate swap agreement to hedge the floating interest rate on the Junior Subordinated Debentures (note 19).
The Trust preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the Junior Subordinated Debentures at maturity or their earlier redemption. The Group has the right to redeem the Junior Subordinated Debentures after December 4, 2007 for Trust I, after May 15, 2008 for Trust II and after September 30, 2008 for Trust III. The Group has not exercised these rights as of December 31, 2007.
The Group had the following interest rate swaps outstanding as of December 31, 2007:
The Group has interest-rate related hedging instruments to manage its exposure on its debt instruments. The type of hedging instruments utilized by the Group are interest rate swap agreements (swaps). Interest differentials to be paid or received because of swap agreements are reflected as an adjustment in the consolidated statement of earnings over the swap period. By using hedging financial instruments to hedge exposures to changes in interest rates, the Group exposes itself to market risk.
Market risk is the adverse effect on the value of a financial instrument that results from a change in interest rates. Credit risk is the failure of the counterparty to perform under the terms of the contract. When the fair value of a contract is positive, the counterparty owes the Group, which creates credit risk for the Group. When the fair value of a contract is negative, the Group owes the counterparty and, therefore, it does not possess credit risk. The Group minimizes the credit risk in hedging instruments by entering into transactions with high-quality counterparties whose credit rating is higher than Aa.
the Group to variability in interest payments due to changes in interest rates. Management believes it is prudent to limit the variability of a portion of its interest payments. To meet this objective, management enters into swap agreements to manage fluctuations in cash flows resulting from interest rate risk. These swaps change the variable-rate cash flow exposure on the debt obligations to fixed-rate cash flows. Under the terms of the interest rate swaps, the Group makes fixed interest rate payments and receives variable interest rate payments, thereby creating the equivalent of fixed-rate debt.
As of December 31, 2007 and 2006 the Group was party to interest-rate swap agreements with an aggregate notional principal amount of $28,000. For the year ended December 31, 2007 and 2006, the Group recognized the change in the economic value of the interest rate swap agreements which is recognized in the consolidated statement of earnings as a realized loss of $774 and $94, respectively. The estimated fair value of the interest-rate swap agreements included in other assets was $(379) and $395 as of December 31, 2007 and 2006, respectively.