The selected historical consolidated financial and other data presented below for the period from January 1, 2005 through August 16, 2005 (Predecessor), for the period from August 17, 2005 through December 31, 2005 (Successor), and for the years ended December 31, 2006 (Successor), December 31, 2007 (Successor), December 31, 2008 (Successor) and December 31, 2009 (Successor) have been derived from our audited consolidated financial statements.
On June 27, 2008, the Company sold all of the outstanding capital stock of American Risk Pooling Consultants, Inc. (“ARPCO”). The results of ARPCO’s operations are presented as Discontinued Operations in the Consolidated Statements of Income.
Loss ratio is defined as the ratio of incurred losses and loss adjustment expenses to net earned premiums.
CoverX markets, produces and binds insurance policies pursuant to guidelines that we establish and for which we retain risk and receive premiums. As a wholesale insurance broker, CoverX markets our insurance policies through a nationwide network of wholesale and retail insurance brokers who then distribute these policies through retail insurance brokers. CoverX also provides services with respect to the insurance policies it markets in that it reviews the applications submitted for insurance coverage, decides whether to accept all or part of the coverage requested and determines applicable premiums based on guidelines that we provide. CoverX receives commissions from affiliated insurance companies, reinsurers, and non-affiliated insurers as well as policy fees from wholesale and retail insurance brokers.
FMIC and FMCC are two of our insurance subsidiaries. FMIC writes substantially all the policies produced by CoverX. FMCC provides reinsurance to FMIC. FMIC and FMCC have entered into an intercompany pooling reinsurance agreement wherein all premiums, losses and expenses of FMIC and FMCC, including all past liabilities, are combined and apportioned between FMIC and FMCC in accordance with fixed percentages. FMIC also provides claims handling and adjustment services for policies produced by CoverX and directly written by third parties.
On June 27, 2008, the Company sold all of the outstanding capital stock of American Risk Pooling Consultants, Inc. (“ARPCO”). The results of ARPCO’s operations are presented as Discontinued Operations in the Consolidated Statements of Income. ARPCO provided third party administrative services for risk sharing pools of governmental entity risks, including underwriting, claims, loss control and reinsurance services. ARPCO was solely a fee-based business and received fees for these services and commissions on excess per occurrence insurance placed in the commercial market with third party companies on behalf of the pools.
Gross written premiums. While net earned premiums is the related GAAP measure used in the statements of earnings, gross written premiums is the component of net earned premiums that measures insurance business produced before the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an overall gauge of gross business volume in our insurance underwriting operations with some indication of profit potential subject to the levels of our retentions, expenses, and loss costs.
Combined ratio. This ratio is a common insurance industry measure of profitability for any underwriting operation, and is calculated in two components. First, the loss ratio is losses and loss adjustment expenses divided by net earned premiums. The second component, the expense ratio, reflects the sum of policy acquisition costs and insurance operating expenses, net of insurance underwriting commissions and fees, divided by net earned premiums. The sum of the loss and expense ratios is the combined ratio. The difference between the combined ratio and 100 reflects the per-dollar rate of underwriting income or loss. For example, a combined ratio of 85 implies that for every $100 of premium we earn, we record $15 of pre-tax underwriting income.
The estimation of ultimate liability for losses and loss adjustment expenses is an inherently uncertain process, requiring the use of informed estimates and judgments. Our loss and loss adjustment expense reserves do not represent an exact measurement of liability, but are our estimates based upon various factors, including:
analysis of other factors, such as variables in claims handling procedures, economic factors, and judicial and legislative trends and actions.
Most or all of these factors are not directly or precisely quantifiable, particularly on a prospective basis, and are subject to a significant degree of variability over time. In addition, the establishment of loss and loss adjustment expense reserves makes no provision for the broadening of coverage by legislative action or judicial interpretation or for the extraordinary future emergence of new types of losses not sufficiently represented in our historical experience or which cannot yet be quantified. Accordingly, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimated reserves are included in the results of operations in the period in which the estimate is revised.
When a claim is reported to us, our claims process includes completing a case-basis valuation and establishing a case reserve for the estimated amount of the ultimate payment as soon as practicable after receiving notice of a claim and after it has sufficient information to form a judgment about the probable ultimate losses and loss adjustment expenses associated with that claim.
Our claims process includes updating the case-basis valuations continuously to incorporate new information. We also use actuarial analyses to estimate both the costs of losses and allocated loss adjustment expenses that have been incurred but not reported to us and the expected development of costs of losses and loss adjustment expenses on reported cases.
Our reserves for losses and loss adjustment expenses at December 31, 2009, 2008, and 2007, gross and net of ceded reinsurance were as follows:
The Cape Cod Method - expected losses for one accident year being estimated based on the loss results for the other accident years, trended to the level of the accident year being estimated; and
Our estimates give different weight to each of these methods based upon the amount of historical experience data we have and our judgments as to what method will result in the most accurate estimate. The application of each method for our various classes may change in the future if we determine a different emphasis for each method would result in more accurate estimates.
We apply these methods to net paid and incurred loss and loss adjustment expense and net earned premium information after ceding reinsurance to determine ultimate net loss and loss adjustment expense and net IBNR reserves. We determine our ceded IBNR
reserves applicable to quota share reinsurance based on the ultimate net loss and loss adjustment expense ratios determined in the estimation of our net IBNR reserves. Ceded IBNR reserves applicable to excess of loss reinsurance are based on industry and company experience factors applicable to the excess coverage layers. Ceded case reserves are allocated based on monthly or quarterly reinsurance settlement reports prepared in accordance with the reporting and settlement terms of the ceded reinsurance contracts.
For security classes where we have many years of historical experience data, we perform quarterly analyses of the payment and reporting patterns of losses and loss adjustment expenses as well as reported and closed claims by accident year for security guard, alarm, and safety equipment sub-classes. We have generally relied primarily on the Loss Development Method in calculating ultimate losses and loss adjustment expenses for the more mature accident years, applying our historical loss and loss adjustment expense reporting patterns to paid and incurred losses and loss adjustment expenses reported to date by accident year to estimate ultimate loss and loss adjustment expense reserves. Our reserve estimates for the more recent, less mature accident years have relied more on the Bornhuetter-Ferguson and Cape Cod Methods to calculate ultimate loss and loss adjustment expense and IBNR reserves. Although we have calculated the results from the Expected Loss Ratio Method for the less mature years, we have not relied significantly on this method due to the more meaningful results of the other methods we have used for security classes.
Our reserve analysis determines a point estimate rather than a range of reserve estimates. We do not compute estimated ranges of loss reserves.
We review loss and loss adjustment expense reserves on a quarterly basis. Actuarial loss reserves analyses and reports are prepared and are reviewed by management for all business classes and accident years on a quarterly basis. Annual actuarial Statements of Opinion on the reserves of our insurance subsidiaries are also prepared as of December 31, in accordance with insurance regulatory requirements. The carried reserves reflect management’s best estimate of the outstanding losses and loss adjustment expense liabilities after review of the actuarial analyses and Statements of Actuarial Opinion.
potential net reserve change and the impact on 2009 reported pre-tax income and on net income and stockholders’ equity at December 31, 2009. We do not believe it is appropriate to sum the illustrated amounts as it is not reasonably likely that each accident year’s reserve estimate assumptions will vary simultaneously in the same direction to the full extent of the sensitivity factor.
circumstances (“unobservable inputs”). The estimated fair values of the Company’s fixed income securities, convertible bonds, and equity securities are based on prices provided by an independent, nationally recognized pricing service. The prices provided by this service are based on quoted market prices, when available, non-binding broker quotes, or matrix pricing. The independent pricing service provides a single price or quote per security and the Company does not adjust security prices, except as otherwise disclosed. The Company obtains an understanding of the methods, models and inputs used by the independent pricing service, and has controls in place to validate that amounts provided represent fair values, consistent with this standard. The Company’s controls include, but are not limited to, initial and ongoing evaluation of the methodologies used by the independent pricing service, a review of specific securities and an assessment for proper classification within the fair value hierarchy. The hierarchy level assigned to each security in our available-for-sale, hybrid securities, and alternative investments portfolios is based on our assessment of the transparency and reliability of the inputs used in the valuation of such instrument at the measurement date. The three hierarchy levels are defined as follows:
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement, and involve management judgment.
With respect to securities where the decline in value is determined to be temporary and the security’s value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are made within the context of overall risk monitoring, changing information and market conditions. Management of the Company’s investment portfolio is outsourced to third party investment managers which is directed and monitored by our investment committee. While these
The Company determines the fair value of the reporting unit for goodwill impairment testing based on a discounted cash flow model. The Company determines the fair value of its indefinite-lived trade-name through the relief from royalty income valuation approach. The Company determines the fair value of its indefinite-lived state insurance licenses through the market valuation approach. The impairment analyses for goodwill and indefinite-lived intangibles indicated that impairment was not avoided by a narrow margin.
The following table summarizes our results for the years ended December 31, 2009 and 2008:
Direct written premiums decreased 1% and direct earned premiums increased $20.5 million, or 7%, primarily due to increases in production from the Company’s FM Emerald, Contract Underwriting and Other underwriting platforms offset by decreases in premium production from the Company’s Security and Specialty underwriting platforms during the year ended December 31, 2009.
Insurance underwriting commissions and fees increased $4.2 million or 317% from the year ended December 31, 2008 to the year ended December 31, 2009. This increase was primarily due to $4.1 million of negative profit sharing commission recorded during the year ended December 31, 2008. Insurance services commissions and fees increased $6.8 million, or 35%, due to an increase in AMC commissions and fees of $5.1 million including a previously disclosed, non-recurring contingent commission adjustment for $1.3 million, and an increase of $1.7 million related to our workers’ compensation service program for the year ended December 31, 2009.
During the year ended December 31, 2009, net investment income was $29.3 million, a $7.7 million, or 36%, increase from $21.6 million reported during the year ended December 31, 2008. The increase was primarily due to the increase in invested assets over the period and an increase in the book yield of the portfolio. At December 31, 2009, invested assets were $699.5 million, a $156.5 million or 29% increase over $543.0 million of invested assets at December 31, 2008. This increase was due to cash flows from net written premiums and from the cash retained on our quota share reinsurance contracts on a “funds withheld” basis. The annualized investment yield (net of investment expense) was 5.2% and 4.3% at December 31, 2009 and December 31, 2008, respectively. The tax equivalent investment yield was 5.7% and 5.0% at December 31, 2009 and December 31, 2008, respectively.
During the year ended December 31, 2009, net realized gains were $28.0 million compared to net realized losses of $16.6 million during the year ended December 31, 2008. Net realized gains for the year ended December 31, 2009 were principally due to the mark to market increase in securities carried at market of approximately $22.5 million and net gains on the sale of certain securities of $5.0 million. Those securities that are marked to market include convertible securities held both as individually-owned securities and an investment in a limited partnership, and an investment in a structured finance limited partnership. Convertible bond prices are a function of the underlying equity and the fixed income component whose values changed with the stock market and changes in spread of corporate bonds, respectively. The structured finance limited partnership is valued based on a portfolio of non-agency mortgage securities, and the hedges that may accompany those positions. The value of these components in the limited partnership changed in value for a variety of reasons including, but not limited to, changes in spread for mortgage product, changes in prepayment rates, default rates, severity rates, changes in the overall level of rates and the corresponding value of the underlying loans, and changes in the value of the properties by which these loans are collateralized.
Other-Than-Temporary Impairment Losses on Investments. During the year ended December 31, 2009, other-than-temporary impairment losses on investments were $0.7 million compared to other-than-temporary impairment losses on investments of $4.1 million during the year ended December 31, 2008. The decrease in other-than-temporary impairment losses on investments is primarily attributable to the stabilization of the capital markets.
Losses and loss adjustment expenses incurred increased $40.5 million, or 38%, for the year ended December 31, 2009 compared to the year ended December 31, 2008. This increase was primarily due to the increase in net earned exposures reflected in the 20% increase in net earned premiums, an increase in the accident year loss and loss adjustment expense ratio from decreased premium rates, $2.4 million of storm-related losses experienced during the second quarter of 2009, and $5.2 million of higher than anticipated 2009 commercial property fire and other losses and loss adjustment expenses during the second quarter of 2009, partially offset by favorable claims trends in the current and prior accident years. Losses and loss adjustment expenses for the year ended December 31, 2009 included approximately $5.7 million of favorable development of December 31, 2008 prior years’ loss and loss adjustment expense reserves. Favorable development of $2.4 million in our Security general liability classes in the 2001, 2006 and 2007 accident years and $3.6 million in our Specialty general liability classes in the 2006 through 2007 accident years was due to lower than expected claim frequency and lower than expected severity. There was $0.5 million of unfavorable development in our Specialty general liability classes in the 2000 accident year. Net favorable development of $0.2 million in unallocated loss adjustment expenses was recorded for the 2006 through 2007 accident years.
Losses and loss adjustment expenses for the year ended December 31, 2008 included approximately $4.8 million in favorable development of December 31, 2007 prior years’ loss and loss adjustment expense reserves and $2.9 million from the impact of Hurricane Ike. The $4.8 million in net favorable development included $6.0 million in our Specialty general liability classes in the 2007 accident year due to favorable claims trends, unfavorable development of $1.4 million in our Contract Underwriting liability classes in accident years 2005 through 2007 due to higher than expected severity in the 2006 and 2007 accident years reduced by lower than expected severity in the 2005 accident year and net favorable development of $0.2 million in unallocated loss and loss adjustment expenses for the 2005 through 2007 accident years.
During the year ended December 31, 2009, other operating expenses increased $23.9 million, or 32%, from the year ended December 31, 2008. Amortization of deferred acquisition expenses increased by $13.4 million, or 33% due to increased acquisition expenses on new underwriting initiatives and the impact of purchasing less quota share reinsurance in 2008, partially offset by purchasing more quota share reinsurance in 2009. Ceded reinsurance commissions decreased $0.2 million, or 1%, principally due lower ceding commissions related to profit sharing on ceded written premiums, partially offset by the effect of purchasing more quota share reinsurance during the year ended December 31, 2009 compared to the year ended December 31, 2008. Other underwriting and operating expenses, which consist of commissions, other acquisition costs, and general and underwriting expenses, net of acquisition cost deferrals, increased by $10.3 million, or 15%. The increase was principally due to higher commissions and other acquisition costs of $6.4 million, higher corporate expenses of $1.8 million and an increase of $2.1 million in general and underwriting expenses related to our insurance services operations, which are unrelated to premiums, principally due to having a full year of AMC results compared to eleven months during the period ended December 31, 2008 due to the closing of the AMC acquisition on February 1, 2008 and increased premium production for unaffiliated carriers by our services operations.
Interest expense decreased 14% from the year ended December 31, 2008 compared to the year ended December 31, 2009. This decrease was primarily due to a $0.7 million decrease in the change in fair value of the interest rate swaps on junior subordinated debentures as discussed in “Liquidity and Capital Resources” below.
On June 27, 2008, the Company sold all of the outstanding capital stock of American Risk Pooling Consultants, Inc. (“ARPCO”). The results of ARPCO’s operations are presented as Discontinued Operations in the Consolidated Statements of Income. For the year ended December 31, 2008, income from discontinued operations consisted principally of the $20.9 million gain, net of taxes, on the sale of ARPCO.
Ceded written premiums decreased $14.6 million, or 13%, and ceded earned premiums increased $29.4 million, or 39%, for the year ended December 31, 2008 compared to the year ended December 31, 2007. Ceded written premiums decreased principally due to purchasing 10% quota share reinsurance during the first quarter of 2008 and purchasing 15% quota share reinsurance during the remainder of 2008, while the Company purchased 35% quota share reinsurance from January 1, 2007 through September 30, 2007 and 25% quota share reinsurance from October 1, 2007 through December 31, 2007, offset somewhat by the purchase of 50% quota share reinsurance on a portion of the new niche specialty premiums and by the cutoff of two of the Company’s quota share reinsurance contracts whereby the reinsurers returned approximately $6.0 million in ceded unearned premiums. Ceded earned premiums increased primarily due to ceded written premiums continuing to be earned on the Company’s 2007 35% quota share reinsurance treaties, which were amended to 25% on October 1, 2007, while there were no ceded earned premiums related to the Company’s 2006 50% reinsurance treaties during the year ended December 31, 2007 due to the termination of the 2006 50% quota share reinsurance treaties on a “cutoff” basis at December 31, 2006. The effect of the December 31, 2006 50% quota share cut-off reinsurance termination was to reduce ceded earned premiums for the year ended December 31, 2007 by approximately $39.6 million, and to increase net earned premiums by the same amount.
Earned but unbilled premiums decreased $3.2 million, or 93%, primarily due to a modest increase in net premiums earned subject to audit for the year ended December 31, 2008 compared to a more significant increase in net premiums earned subject to audit during the year ended December 31, 2007.
Insurance underwriting commissions and fees decreased $4.0 million or 75% from the year ended December 31, 2007 to the year ended December 31, 2008. This was primarily the result of decreases in commissions on fronted premiums. Insurance services commissions and fees, which were principally AMC income and not related to premiums produced, increased $19.7 million as the result of the acquisition of AMC.
During the year ended December 31, 2008, net investment income earned was $21.6 million, a $5.3 million, or 33%, increase from $16.3 million reported during the year ended December 31, 2007. The increase was primarily due to the increase in invested assets over the period. At December 31, 2008, invested assets were $543.0 million, an $83.7 million or 18% increase over $459.3 million of invested assets at December 31, 2007. This increase was due to increases in net written premiums, from the cash retained on our quota share reinsurance contracts on a “funds withheld” basis and the proceeds from the sale of ARPCO. The annualized investment yield (net of investment expense) was 4.3% and 4.1% at December 31, 2008 and December 31, 2007, respectively. The tax equivalent investment yield was 5.0% and 4.8% at December 31, 2008 and December 31, 2007, respectively.
Other-Than-Temporary Impairment Losses on Investments. During the year ended December 31, 2008, other-than-temporary impairment losses on investments were $4.1 million compared to other-than-temporary impairment losses on investments of $0.2 million during the year ended December 31, 2007.
Interest expense increased $1.1 million, or 22%, from 2007 to 2008. This increase was primarily due to a $1.4 million increase in interest expense related to junior subordinated debentures of $20.6 million which were issued in September 2007 offset somewhat by a $0.3 million decrease in the change in fair value of the interest rate swap on junior subordinated debentures as is discussed in “Liquidity and Capital Resources” below.
The primary uses of our insurance subsidiaries’ cash include the payment of claims and related adjustment expenses, underwriting fees and commissions, taxes, making investments and paying dividends. Because the payment of individual claims cannot be predicted with certainty, our insurance subsidiaries rely on our paid claims history and industry data in determining the expected payout of claims and estimated loss reserves. To the extent that FMIC, FMCC and AUIC have an unanticipated shortfall in cash, they may either liquidate securities held in their investment portfolios or obtain capital from FMFC. However, given the cash generated by our insurance subsidiaries’ operations and the relatively short duration of their investment portfolios, we do not currently foresee any such shortfall.
Net cash provided by operating activities from continuing operations for the years ended December 31, 2009 and December 31, 2008 was primarily from cash received on net written premiums and less cash disbursed for operating expenses and losses and loss adjustment expenses. Net cash provided by operating activities from continuing operations for the year ended December 31, 2007 was primarily from cash received on net written premiums and cash received for the unearned premiums related to the 2006 50% quota share reinsurance contract terminated on a “cut-off” basis on December 31, 2006 less cash disbursed for operating expenses and losses and loss adjustment expenses. Cash received from net written premiums for the years ended December 31, 2009, 2008 and 2007 was retained on a “funds withheld” basis in accordance with quota share reinsurance contracts.
Net cash provided by operating activities from discontinued operations for the years ended December 31, 2008 and 2007 was primarily from cash received on commissions and service fees less cash disbursed for operating expenses.
For 2009, net cash used in investing activities from continuing operations totaled $95.3 million, and was primarily invested in short-term, debt and equity securities. The $43.3 million decrease in net cash used in investing activities from continuing operations for the year ended December 31, 2009 compared to the year ended December 31, 2008 was the result of a decrease of $23.9 million in our net investment in short-term, debt and equity securities, and $18.9 million due to the acquisition of AMC in 2008.
There were no cash flows from investing activities from discontinued operations for the years ended December 31, 2007.
For 2009, net cash used in financing activities resulted from the purchase of common stock under the Company’s Share Repurchase Plan (Note 12), the payment of shareholders’ dividends, and the purchase of common stock by the Company to be held in a rabbi trust for the benefit of the Company’s Supplemental Executive Retirement Plan, partially offset by net short-term borrowings of $4.0 million on the Company’s $30.0 million revolving credit facility.
For 2007, the $32.4 million of net cash provided by financing activities resulted primarily from the issuance of common stock in a secondary offering discussed below as well as from proceeds from the issuance of trust preferred securities discussed below.
made under the credit facility is September 2011. At December 31, 2009, there were $4.0 million of borrowings under the agreement. The credit agreement also contains various restrictive covenants that relate to the Company’s shareholders’ equity, leverage ratio, fixed charge coverage ratio, surplus and risk based capital, and A.M. Best Ratings of its insurance subsidiaries. At December 31, 2009, the Company was in compliance with all of the covenants related to the credit agreement. On February 22, 2010, the Company received a temporary waiver of any event of default as of March 31, 2010 related to the fixed charge coverage ratio covenant in the Company’s credit agreement through May 1, 2010. The Company determined the temporary waiver was required as it related to the special cash dividend declared by the Company’s Board of Directors on February 22, 2010 since the Company intends to a fund a portion of the special dividend through borrowings under this credit agreement. If the Company does not renegotiate its credit agreement by May 1, 2010 or receive an extension of the temporary waiver of event of default, the Company will be in default under the terms of the credit agreement.
The reserve for losses and loss adjustment expenses payment due by period in the table above are based on the reserve of loss and loss adjustment expenses as of December 31, 2009 and actuarial estimates of expected payout patterns by type of business. As a result, our calculation of the reserve of loss and loss adjustment expenses payment due by period is subject to the same uncertainties associated with determining the level of the reserve of loss and loss adjustment expenses and to the additional uncertainties arising from the difficulty in predicting when claims, including claims that have been incurred but not reported to us, will be paid. Actual payments of losses and loss adjustment expenses by period will vary, perhaps materially, from the above table to the extent that current estimates of the reserve for loss and loss adjustment expenses vary from actual ultimate claims amounts and as a result of variations between expected and actual payout patterns. See “Risk Factors” for a discussion of the uncertainties associated with estimating the reserve for loss and loss adjustment expenses.
On February 22, 2010, the Company received a temporary waiver of any event of default as of March 31, 2010 related to the fixed charge coverage ratio covenant in the Company’s credit agreement through May 1, 2010. The Company determined the temporary waiver was required as it related to the special cash dividend declared by the Company’s Board of Directors on February 22, 2010 since the Company intends to a fund a portion of the special dividend through borrowings under this credit agreement. If the Company does not renegotiate its credit agreement by May 1, 2010 or receive an extension of the temporary waiver of event of default, the Company will be in default under the terms of the credit agreement which could result in the acceleration of amounts due under the credit agreement.
Our invested assets consist of fixed maturity securities, convertible securities, money market funds and alternative investments. At December 31, 2009, our investments had a market value of $699.5 million and consisted of the following investments:
The majority of our portfolio consists of AAA or AA rated securities with a Standard and Poor’s weighted average credit quality of A+ at December 31, 2009. The fixed income portfolio had a weighted average credit quality of AA- at December 31, 2009. The majority of the investments rated BBB and below are convertible securities and opportunistic investments in high yield credit and non-agency mortgage securities. Consistent with our investment policy, we review any security if it falls below BBB- and assess whether it should be held or sold. The following table shows the ratings distribution of our fixed income portfolio as of December 31, 2009 as a percentage of total market value.
At December 31, 2009, the Company held CMOs classified as available-for-sale with a fair value of $87.9 million. Approximately 50.0% of those CMO holdings were guaranteed by or fully collateralized by securities issued by a full faith and credit agency such as GNMA, or government sponsored enterprises (“GSE”) such as FNMA or FHLMC. In addition, at December 31, 2009, the Company held $58.1 million of mortgage-backed pass-through securities issued by one of the GSE’s and classified as available-for-sale.
The Company’s fixed maturity investment portfolio included asset-backed securities and collateralized mortgage obligations collateralized by sub-prime mortgages and alternative documentation mortgages (“Alt-A”) with market values of $9.2 million and $19.3 million at December 31, 2009, respectively. Included in these securities is a recent allocation made to a manager who specializes in opportunities in the non-agency mortgage sector. The Company defines sub-prime mortgage-backed securities as investments with weighted average FICO scores below 650. Alt-A securities are defined by above-prime interest rates, high loan-to-value ratios, high debt-to-income ratios, low loan documentation (e.g., limited or no verification of income and assets), or other characteristics that are inconsistent with conventional underwriting standards employed by government-sponsored mortgage entities. The average credit rating on these securities and obligations held by the Company at December 31, 2009 was B-.
The Company’s fixed maturity investment portfolio at December 31, 2009 included securities issued by numerous municipalities with a total carrying value of $207.3 million. Approximately $21.3 million, or 10.3%, were pre-refunded (escrowed with Treasuries). Approximately $92.6 million, or 44.7%, of the securities were enhanced by third-party insurance for the payment of principal and interest in the event of an issuer default. Such insurance, prior to the downgrades of many of the third party insurers, resulted in a rating of AAA being assigned by independent ratings agencies to those securities. The downgrade of credit ratings of insurers of these securities could result in a corresponding downgrade in the ratings of the securities from AA+ to the underlying rating of the respective security without giving effect to the benefit of insurance. Of the total $92.6 million of insured municipal securities in the Company’s investment portfolio at December 31, 2009, 98.8% were rated A- or above, and approximately 80.7% were rated at AA- or above, without the benefit of insurance. The average underlying credit rating of the entire municipal bond portfolio was AA at December 31, 2009. The Company believes that a loss of the benefit of insurance would not result in a material adverse impact on the Company’s results of operations, financial position or liquidity, due to the underlying credit strength of the issuers of the securities, as well as the Company’s ability and intent to hold the securities.
Cash and cash equivalents consisted of cash on hand of $14.3 million at December 31, 2009.
At December 31, 2009 there were 135 unrealized loss positions with a total unrealized loss of $4.0 million. This represents approximately 0.7% of year end available-for-sale assets of $599.4 million. This unrealized loss position is a function of the purchase of specific securities in a lower interest rate or spread environment than what prevails as of December 31, 2009. Some of these losses are due to the increase in spreads of select corporate bonds or structured securities. We have viewed these market value declines as being temporary in nature. Our portfolio is relatively short as the duration of the core fixed income portfolio excluding cash, convertible securities, limited partnerships and equity is approximately 3.7 years, and 3.5 years on a taxable equivalent basis. We do not intend to sell and it is not expected we will need to sell these temporarily impaired securities. In light of our growth over the past 24 months, liquidity needs from the portfolio are minimal. As a result, we would not expect to have to liquidate temporarily impaired
securities to pay claims or for any other purposes. There have been certain instances over the past year, where due to market based opportunities; we have elected to sell a small portion of the portfolio. These situations were unique and infrequent occurrences and in our opinion, do not reflect an indication that we do not have the intent and ability to hold these securities until they mature or recover in value.
Loss Development. Below is a table showing the development of our reserves for unpaid losses and loss adjustment expenses for us for report years 1999 through 2009. The table portrays the changes in the loss and loss adjustment expenses reserves in subsequent years relative to the prior loss estimates based on experience as of the end of each succeeding year, on a GAAP basis.
The next section of the table sets forth the re-estimates in later years of incurred losses, including payments, for the years indicated. For example, as reflected in that section of the table, the original reserve of $31.6 million was re-estimated to be $30.1 million at December 31, 2009. The increase/decrease from the original estimate would generally be a combination of factors, including:
During 2009, the Company experienced approximately $5.7 million of favorable development in net prior year reserves, with substantially all of the favorable development in the 2006 and 2007 accident years. The favorable development was due to lower than expected loss and allocated loss adjustment expense emergence on the 2006 and 2007 accident years.
For policies written from the middle of 2002 through the present, historical experience for security classes has improved due to the underwriting initiatives taken in response to the deterioration in loss experience for the 1999 through 2001 accident years, especially in the safety equipment installation and service class.
Our insurance subsidiaries cede insurance risk to reinsurers to diversify their risks and limit their maximum loss arising from large or unusually hazardous risks or catastrophic events. Additionally, our insurance subsidiaries use reinsurance in order to limit the amount of capital needed to support their operations and to facilitate growth. Reinsurance involves a primary insurance company transferring, or ceding, a portion of its premium and losses in order to control its exposure. The ceding of liability to a reinsurer does not relieve the obligation of the primary insurer to the policyholder. The primary insurer remains liable for the entire loss if the reinsurer fails to meet its obligations under the reinsurance agreement.
Effective January 1, 2009, we purchased quota share reinsurance for our primary casualty business which covers the majority of the casualty classes underwritten in the Security, Specialty, Contract Underwriting, and FM Emerald platforms. For our Security and Specialty classes, we purchased 25.75% quota share reinsurance coverage. For our Contract Underwriting and FM Emerald classes, we purchased 31.5% quota share reinsurance coverage. In addition, for these classes, we purchased $0.5 million excess of $0.5 million per occurrence for 2009. This coverage was 80% placed for our Security and Specialty classes and 100% placed for our Contract Underwriting and FM Emerald classes. Lastly, on our legal professional liability class, we purchased $1.5 million excess of $0.5 million per occurrence for 2009, which was 70% placed. On our umbrella and excess casualty business in 2009, we maintained quota share reinsurance treaties that provide for a quota share of 90% of this business, up to a limit of $10.0 million per occurrence. On our property business, we renewed our property excess per risk program at July 1, 2009. We placed 100% of $4.0 million excess of $1.0 million per risk and 90% of $0.7 million excess of $0.3 million per risk. We also purchased property catastrophe protection for our property business effective July 1, 2009. The program has limits of $35.0 million in excess of $5.0 million of ultimate net loss per occurrence, which represents our modeled one in 250 year event exposure.
that we insure is stable in both capacity and pricing. In addition, we do not anticipate structural changes to our reinsurance strategies, but rather will continue to adjust our level of quota share and excess of loss reinsurance based on our premiums produced, level of capitalization and risk appetite. As a result, we believe that we will continue to be able to execute our reinsurance strategies on a basis consistent with our historical and current reinsurance structures.
The following table illustrates our direct and ceded written premiums for the years ended December 31, 2009, 2008 and 2007:
Our net cash flows relating to ceded reinsurance activities (premiums paid less losses recovered and ceding commissions received) were approximately $27.4 million net cash paid for the year ended December 31, 2009 compared to net cash paid of $43.8 million for the year ended December 31, 2008. We paid approximately $33.9 million for the year ended December 31, 2007.
- substantially all other reinsurers carry an A.M. Best rating of “A” and above.
In May 2009, the FASB issued new accounting guidance related to subsequent events. This new guidance establishes general standards of accounting for and disclosures of events that occur after the balance sheet date but before the financial statements are issued or are available to be issued. It provides direction for the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements and the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. We adopted the new guidance during 2009, and its application had no impact on our consolidated financial statements.
On July 1, 2009, the FASB issued Topic 105, “Generally Accepted Accounting Principles” which established the “Accounting Standards Codification” (ASC) as the single official source of authoritative U.S. accounting and reporting standards for nongovernmental entities, in addition to guidance issued by the Securities and Exchange Commission (SEC). All other nongrandfathered, non-SEC accounting literature not included in the ASC is deemed nonauthoritative. The ASC supersedes all existing, non-SEC accounting and reporting standards applied by nongovernmental entities in the preparation of financial statements in conformity with generally accepted accounting principles (GAAP). The ASC is effective for interim and annual reporting periods ending after September 15, 2009. As the ASC reorganizes GAAP literature but does not change GAAP, the implementation of the ASC did not have a material impact on the Company’s financial statements.
In June 2009, the FASB issued updated guidance on the accounting for variable interest entities that eliminates the concept of a qualifying special-purpose entity and the quantitative-based risks and rewards calculation of the previous guidance for determining which company, if any, has a controlling financial interest in a variable interest entity. The guidance requires an analysis of whether a company has: (1) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and (2) the obligation to absorb the losses that could potentially be significant to the entity or the right to receive benefits from the entity that could potentially be significant to the entity. An entity is required to be re-evaluated as a variable interest entity when the holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights to direct the activities that most significantly impact the entity’s economic performance. Additional disclosures are required about a company’s involvement in variable interest entities and an ongoing assessment of whether a company is the primary beneficiary. The guidance is effective for all variable interest entities owned on or formed after January 1, 2010. The Company does not expect that the provisions of the guidance will have a material effect on its results of operations, financial position or liquidity.
In January 2010, the FASB issued an update to the Accounting Standards Codification (ASC) related to fair value measurements and disclosures. This ASC update provides for additional disclosures requirements to improve the transparency and comparability of fair value information in financial reporting. Specfically, the new guidance requires separate disclosure of the amounts of significant transfers in and out of Levels 1 and 2, as well as the reasons for the transfers, and separate disclosure for the purchases, sales, issuances and settlement activity in Level 3. In addition, this ASC update requires fair value measurement disclosure for each class of assets and liabilities, and disclosures about the input and valuation techniques used to measure fair value for both recurring and nonrecurring fair value measurements in Levels 2 and 3. The new disclosures and clarifications of existing disclosures are effective
for annual or interim reporting periods beginning after December 15, 2009, except for the requirement to provide Level 3 activity detail which will become effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. Early adoption is permitted. These amendments do not require disclosures for earlier periods presented for comparative purposes at intital adoption. The Company is currently evaluating the potential impact of the adoption of this standard on its financial statements.
We have audited the accompanying consolidated balance sheets of First Mercury Financial Corporation and Subsidiaries as of December 31, 2009 and 2008 and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2009. In connection with our audits of the financial statements, we have also audited the financial statement schedules listed in the accompanying index. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Mercury Financial Corporation and Subsidiaries as of December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), First Mercury Financial Corporation and Subsidiaries’ internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 16, 2010 expressed an unqualified opinion thereon.
Interest Rate Risk is the risk that interest rates will change and cause a decrease in the value of an insurer’s investments or an increase in the Company’s interest expense due on its long-term debt. The Company mitigates this risk related to investments by attempting to match the maturity schedule of its assets with the expected payout of its liabilities. To the extent that liabilities come due more quickly than assets mature, the Company would have to sell assets prior to maturity and recognize a gain or loss. The Company mitigates this risk related to its floating rate junior subordinated debentures by entering into interest rate swap agreements, which fix the interest rate on long-term debt (see Note 8).
Our marketable investment securities, including fixed maturity and equity securities, and short-term investments, are classified as available-for-sale and, as a result, are reported at market value. The changes in the fair value of these investments are recorded as a component of Other comprehensive income (loss). Convertible securities are accounted for under the accounting guidance for hybrid securities whereby changes in fair value are reflected in Net realized gains (losses) on investments in the Consolidated Statements of Income. Alternative investments consist of our investments in limited partnerships, which invest in high yield convertible securities and distressed structured finance products. At the date of inception, we elected the fair value accounting option for these alternative investments in accordance with FASB guidance, whereby changes in fair value are reflected in Net investment income and Net realized gains (losses) on investments in the Consolidated Statements of Income.
If the inputs used to measure fair value fall in different levels of the fair value hierarchy, a financial security’s hierarchy level is based upon the lowest level of input that is significant to the fair value measurement. A number of our investment grade corporate bonds are frequently traded in active markets and traded market prices for these securities existed at December 31, 2009. These securities were classified as Level 2 at December 31, 2009 because our third party pricing service uses valuation models which use observable market inputs in addition to traded prices.
In accordance with FASB accounting guidance for the impairment or disposal of long-lived assets, the carrying value of long-lived assets, including amortizable intangibles and property and equipment, are evaluated whenever events or changes in circumstances indicate that a potential impairment has occurred relative to a given asset or assets. Impairment is deemed to have occurred if projected undiscounted cash flows associated with an asset are less than the carrying value of the asset. The estimated cash flows include management’s assumptions of cash inflows and outflows directly resulting from the use of that asset in operations. The amount of the impairment loss recognized is equal to the excess of the carrying value of the asset over its then estimated fair value.
All of the Company’s goodwill is allocated to the reporting unit of AMC since AMC has its own distinct business platform with discrete financial information. The Company acquired AMC to gain access to an established and experienced specialty admitted underwriting franchise with a definable niche market. The expertise of AMC’s specialty admitted underwriting franchise is not significantly correlated to our existing underwriting operations and we did not allocate any goodwill to our existing insurance underwriting operations based on this fact.
Components of intangible assets at December 31, 2009 and 2008 consist of the following:
Our non-amortizing intangible assets consist of the trade name for CoverX and the state/jurisdiction licenses to conduct insurance operations, as it is expected that these intangibles will contribute to cash flows indefinitely. The trade name and the state/jurisdiction licenses have been in existence for many years and there is no foreseeable limit on the period of time over which they are expected to contribute cash flows. Aggregate amortization expense related to intangible assets was $2.2 million, $2.0 million, and $0.7 million for the years ended December 31, 2009, 2008, and 2007, respectively. Approximately $0.3 million, and $0.5 million of amortization expense for the years ended December 31, 2008, and 2007, respectively, was reclassified to Discontinued Operations. The weighted-average remaining useful life is 12.9 years. Estimated amortization expense for each of the next five years is as follows:
The reserves for losses and loss adjustment expenses represent the accumulation of individual case estimates for reported losses and loss adjustment expenses, and actuarial estimates for incurred but not reported losses and loss adjustment expenses. The reserves for losses and loss adjustment expenses are intended to cover the ultimate net cost of all losses and loss adjustment expenses incurred but unsettled through the balance sheet date. The reserves are stated net of anticipated deductibles, salvage and subrogation, and gross of reinsurance ceded. Reinsurance recoverables on paid and unpaid losses are reflected as assets. The reserve estimates are continually reviewed and updated; however, the ultimate liability may be more or less than the current estimate. The effects of changes in the estimated reserves are included in the results of operations in the period in which the estimate is revised.
Premiums are recognized as earned using the daily pro rata method over the terms of the policies. Unearned premiums represent the portion of premiums written that relate to the unexpired terms of policies-in-force.
The Company underwrote a retroactive loss portfolio transfer (“LPT”) contract during 2009 in which the insured loss events occurred prior to the inception of the contract. This contract was evaluated to determine whether it met the established criteria for reinsurance accounting. When reinsurance accounting is appropriate, written premiums are fully earned and corresponding losses and loss expenses are recognized at the inception of the contract. These contracts can cause significant variances in gross written premiums, net written premiums, net earned premiums, and net incurred losses in the years in which they are written. Reinsurance contracts sold not meeting the established criteria for reinsurance accounting are recorded using the deposit method. The Company has no LPT contracts that are accounted for using the deposit method.
Wholesale agency commissions and fee income from unaffiliated companies are earned at the effective date of the related insurance policies produced or as services are provided under the terms of the administrative and service provider contracts. Related commissions to retail agencies are concurrently expensed at the effective date of the related insurance policies produced. Profit sharing commissions due from certain insurance and reinsurance companies, based on losses and loss adjustment expense experience, are earned when determined in accordance with the applicable contract.
Federal income taxes are calculated using the liability method as specified by current FASB accounting guidance.
The Company assesses the likelihood that deferred tax assets will be realized based on available taxable income in carryback periods and in future periods when the deferred tax assets are expected to be deducted in the Company’s tax return. A valuation allowance is established if it is deemed more-likely-than-not that all or a portion of the deferred tax assets will not be realized.
Basic net income per share is computed by dividing net income by the weighted-average number of shares of common stock outstanding for the period. Diluted net income per share reflects the potential dilution that could occur if common stock equivalents were issued and exercised.
On January 1, 2009, we adopted new FASB accounting guidance which requires that unvested restricted stock with a nonforfeitable right to receive dividends be included in the two-class method of computing earnings per share. The adoption of this guidance did not have a material impact on our reported earnings per share amounts.
The Company has entered into three interest rate swap agreements. These agreements have been designated and qualify as cash flow hedges. To the extent the hedges are effective, changes in fair value are included in Other comprehensive income until earnings are affected by the variability of cash flows of the hedged transaction. Any hedge ineffectiveness is recorded in the Consolidated Statements of Income. There was no such ineffectiveness since the inception of these hedges through 2009. The fair value of the interest rate swaps are included in Other Assets or Other Liabilities on the Consolidated Balance Sheets and represent the estimated amount that the Company would receive (pay) to terminate the derivative contract at the reporting date.
For those derivative instruments that are designated and qualify as hedging instruments, the Company formally documents all relationships between the hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as cash flow hedges to specific assets and liabilities on the balance sheet. The Company also formally assesses (both at the hedge’s inception and on an ongoing basis) whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the cash flows of hedged items and whether those derivatives may be expected to remain highly effective in the future periods. When it is determined that a derivative is not (or has ceased to be) highly effective as a hedge, the Company discontinues hedge accounting prospectively, as discussed below.
Prior to 2009, the Company had entered into two interest rate swap agreements that had not been identified as hedging transactions. For these agreements, the change in the fair value was included in the Change in Fair Value of Derivative Instruments in the Consolidated Statements of Income for the periods ended December 31, 2009, 2008 and 2007. Both of these swap agreements expired in August 2009.
The Company manages its business on the basis of one operating segment, Insurance Underwriting and Services Operations, in accordance with the qualitative and quantitative criteria established by current FASB guidance. The Company’s chief operating decision maker (“CODM”) manages the capital and resources of the Underwriting and Services Operations and assesses performance of the Underwriting and Services Operations in the aggregate. Our Underwriting Operations and our Services Operations are substantially identical. The Company’s Underwriting Operations provide underwriting and claims handling services on policies sold through our underwriting operations that we produce for affiliated insurance companies. The Company’s Services Operations provide underwriting and claims handling services on policies sold through our services operations that we produce for unaffiliated insurance companies. We view the premiums underwritten by our Underwriting and Services Operations as premiums controlled by the Company since we control and determine whether the ultimate placement of those premiums is either with our affiliated insurance companies or with unaffiliated insurance companies to optimize the use of the Company’s capital and resources in the aggregate. It is on this basis the CODM manages our business and therefore we have one reportable segment.
In December 2007, the FASB issued accounting guidance related to noncontrolling interests in consolidated financial statements. This guidance established accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest, and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. It also established disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners, and is effective for fiscal years beginning after December 15, 2008. The adoption of this standard in the first quarter of 2009 did not have a material effect on the Company’s results of operations, financial position or liquidity.
In April 2009, the FASB issued new accounting guidance which requires disclosures about the fair value of financial instruments in interim and annual financial statements. The new guidelines require disclosure of qualitative and quantitative information about the fair value of financial instruments including methods and significant assumptions used to estimate fair value during interim and annual reporting periods. The adoption of this guidance in 2009 is included in Note 5, “Fair Value Measurements” to the consolidated financial statements.
In April 2009, the FASB issued new accounting guidance for the recognition and presentation of other-than-temporary impairments on investments. The new guidance modifies the existing other-than-temporary impairment guidance to require the recognition of an other-than-temporary impairment when an entity has the intent to sell a debt security or when it is more-likely-than-not an entity will be required to sell the debt security before its anticipated recovery. Additionally, the new guidance changes the presentation and amount of other-than-temporary losses recognized in the income statement for instances when the Company determines that there is a credit loss on a debt security but it is more-likely-than-not that the entity will not be required to sell the security prior to the anticipated recovery of its remaining cost basis. For these debt securities, the amount representing the credit loss will be reported as an impairment loss in the Consolidated Statements of Income and the amount related to all other factors will be reported in Accumulated other comprehensive income (loss). It also requires the presentation of other-than-temporary impairments separately from realized gains and losses on the face of the income statement. In addition to the changes in measurement and
The amortized cost, gross unrealized gains and losses, and market value of marketable investment securities classified as available-for-sale at December 31, 2009 by major security type were as follows:
At December 31, 2009 and 2008, our insurance subsidiaries had marketable securities approximating $9.5 million and $9.3 million, respectively, on deposit with various states for regulatory purposes.
On January 1, 2007, the Company adopted the fair value provisions of the FASB guidance for accounting for hybrid financial instruments for all of its convertible securities which were previously accounted for as embedded derivatives in accordance with the FASB guidance for derivative instruments and hedging activities. The Company adopted the new guidance in order to simplify the
accounting for these convertible securities. It permits entities to account for financial instruments with an embedded derivative at fair value, thus negating the need to bifurcate the instrument between its host and the embedded derivative.
As of December 31, 2009 and December 31, 2008, the market value of convertible securities accounted for as hybrid instruments was $69.5 million and $43.5 million, respectively. Convertible bonds and bond units had a market value of $61.4 million and $39.0 million and were included in Debt securities in the Consolidated Balance Sheets at December 31, 2009 and December 31, 2008, respectively. Convertible preferred stocks had a market value of $8.2 million and $4.5 million and were included in Equity securities and other in the Consolidated Balance Sheets at December 31, 2009 and December 31, 2008, respectively. The Company recorded an increase in the fair value of the hybrid instruments of $16.6 million in Net realized gains (losses) on investments for the year ended December 31, 2009. Prior to December 31, 2008, the Company had a security that converted into common stock. The common stock had a market value of $0.1 million at December 31, 2008 and was included in Equity securities and other in the Consolidated Balance Sheet. The Company recorded a reduction in the fair value of the hybrid instruments of $9.6 million in Net realized gains (losses) on investments for the year ended December 31, 2008. The Company recorded an increase in the fair value of the hybrid instruments of $1.0 million in Net realized gains (losses) on investments for the year ended December 31, 2007. As of December 31, 2009, 2008 and 2007 there were no convertible securities that were not accounted for as hybrid instruments in accordance with FASB accounting guidance.
The Company has $17.0 million invested in a limited partnership, which invests in high yield convertible securities. The market value of this investment was $18.2 million at December 31, 2009. In addition, the Company invested $10.0 million in another limited partnership, which invests in distressed structured finance products. The market value of this investment was $12.4 million at December 31, 2009. The Company elected the fair value option for these investments in accordance with FASB accounting guidance. The change in fair value of these investments is recorded in Net investment income and Net realized gains (losses) in investments in the Consolidated Statements of Income. For the year ended December 31, 2009, the Company recorded $2.0 million in Net investment income and $5.9 million in Net realized gains (losses) on investments related to these alternative investments. These investments are recorded in Equity securities and other in the Consolidated Balance Sheet.
Under current accounting standards, an OTTI write-down of debt securities, where fair value is below amortized cost, is triggered in circumstances where (1) an entity has the intent to sell a security, (2) it is more-likely-than-not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security. If an entity intends to sell a security or if it is more-likely-than-not the entity will be required to sell the security before recovery, an OTTI write-down is recognized in earnings equal to the difference between the security’s amortized cost and its fair value. If an entity does not intend to sell the security or it is not more-likely-than-not that it will be required to sell the security before recovery, the OTTI write-down is separated into an amount representing the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recognized in Other comprehensive income.
The following table presents a roll-forward of the credit component of OTTI on debt securities recognized in the Consolidated Statements of Income for which a portion of the OTTI was recognized in Other comprehensive income for the period April 1, 2009 (effective date of the new accounting guidance in ASC 320-10) through December 31, 2009:
The Company determines the credit loss component of fixed maturity investments by utilizing discounted cash flow modeling to determine the present value of the security and comparing the present value with the amortized cost of the security. If the amortized cost is greater than the present value of the expected cash flows, the difference is considered a credit loss and recognized in the Consolidated Statements of Income.
At December 31, 2009, there were 135 unrealized loss positions with a total unrealized loss of $4.0 million. This represents approximately 0.7% of year end available-for-sale assets of $599.4 million. This unrealized loss position is a function of the purchase of specific securities in a lower interest rate or spread environment than what prevails as of December 31, 2009. Some of these losses are due to the increase in spreads of select corporate bonds or structured securities. We have viewed these market value declines as being temporary in nature. Our portfolio is relatively short as the duration of the core fixed income portfolio excluding cash, convertible securities, and equity is approximately 3.8 years, and 3.4 years on a taxable equivalent basis. We do not intend to sell and it is not expected we will need to sell these temporarily impaired securities before maturity. In light of our growth over the past 24 months, liquidity needs from the portfolio are minimal. As a result, we would not expect to have to liquidate temporarily impaired securities to pay claims or for any other purposes. There have been certain instances over the past year, where due to market based opportunities we have elected to sell a small portion of the portfolio. These situations were unique and infrequent occurrences and in our opinion, do not reflect an indication that we intend to sell or will be required to sell these securities before they mature or recover in value.
The table below illustrates the breakdown of impaired securities by investment grade and non-investment grade as well as the duration that these sectors have been trading below amortized cost. The average duration of the impairment has been greater than 12 months. The unrealized loss of impaired securities as a percent of the amortized cost of those securities is 7.7% as of December 31, 2009.
The majority of these securities are “AAA” or “AA” rated. Of the $1.9 million of unrealized loss within non-investment grade, Alt-A and subprime home equity asset-backed securities accounted for 50.0% of this loss. The next highest percent of the loss within non-investment grade were CMOs at 30.5% of the loss. Within CMOs 42.0% were collateralized by prime loans with the balance in Alt-A and subprime. The remaining portion of the loss, or 19.5% within non-investment grade was 99.7% comprised of one financial corporate issue rated BB+ by Standard and Poors. These issues are continually monitored and may be classified in the future as being other-than-temporarily impaired.
FASB guidance establishes a three-level hierarchy for fair value measurements that distinguishes between market participant assumptions developed based on market data obtained from sources independent of the reporting entity (“observable inputs”) and the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (“unobservable inputs”). The estimated fair values of the Company’s fixed income securities, convertible bonds, and equity securities are based on prices provided by an independent, nationally recognized pricing service. The prices provided by this service are based on quoted market prices, when available, non-binding broker quotes, or matrix pricing. The independent pricing service provides a single price or quote per security and the Company does not adjust security prices, except as otherwise disclosed. The Company obtains an understanding of the methods, models and inputs used by the independent pricing service, and has controls in place to validate that amounts provided represent fair values, consistent with this standard. The Company’s controls include, but are not limited to, initial and ongoing evaluation of the methodologies used by the independent pricing service, a review of specific securities and an assessment for proper classification within the fair value hierarchy. The hierarchy level assigned to each security in
our available-for-sale, hybrid securities, and alternative investments portfolios is based on our assessment of the transparency and reliability of the inputs used in the valuation of such instrument at the measurement date. The three hierarchy levels are defined as follows:
The following table presents our investments measured at fair value on a recurring basis as of December 31, 2009 classified by the fair value measurements standard valuation hierarchy (as discussed above):
The Company uses derivatives to hedge its exposure to interest rate fluctuations. For these derivatives, the Company used quoted market prices to estimate fair value and included the estimate as a Level 2 measurement.
The Company has arranged for the sale of trust preferred securities (“Trust Preferred Securities”) through First Mercury Capital Trust I, First Mercury Capital Trust II, First Mercury Capital Trust III, and First Mercury Capital Trust IV (each a “Trust”; collectively the “Trusts”). Each trust was created solely for the purpose of issuing Trust Preferred Securities. In accordance with FASB guidance for the consolidation of variable interest entities, the Trusts have not been consolidated with the Company in these financial statements.
Each Trust used proceeds from the sale of its Trust Preferred Securities to purchase the Company’s floating rate junior subordinated debentures (the “Junior Subordinated Debt”) issued to the Trust under an indenture (each an “Indenture”; collectively the “Indentures”). The Junior Subordinated Debt is the sole asset of each Trust, and the Trust Preferred Securities are the sole liabilities of each Trust. The Company purchased all of the outstanding common stock of the Trusts, and the Company’s investment in the Trusts is included in Other assets in the accompanying Consolidated Balance Sheets.
At December 31, 2009, the three months LIBOR was equal to 0.25%.
Interest payable is included in accrued expenses on the accompanying Consolidated Balance Sheets.
The Company has a $30.0 million revolving credit agreement with a financial institution. At December 31, 2009, borrowings under the credit agreement bear interest at our election as follows: (i) at a rate per annum equal to the greater of the lender’s prime rate and the federal funds rate less 0.5%, each minus 0.75%; or, (ii) a rate per annum equal to LIBOR plus an applicable margin which is currently 0.75% or 1.0% based on our leverage ratio. On February 22, 2010, in connection with receipt of a temporary waiver of any event of default through May 1, 2010, the interest rate on borrowings under the credit agreement was changed to equal the greater of: (i) the prime rate, (ii) a rate per annum equal to the greater of the lender’s prime rate and the federal funds rate plus 0.5% and (iii) a rate per annum equal to LIBOR plus an applicable margin which is currently 2.0% plus 1.0%; or, with respect to certain other borrowings, a rate per annum equal to LIBOR plus an applicable margin which is currently 2.0%. The obligations under the credit agreement are guaranteed by the Company’s material non-insurance subsidiaries. The maturity date of borrowings made under the credit agreement is September 2011. At December 31, 2009, there were $4.0 million of borrowings under the agreement.
The credit agreement also contains various restrictive covenants that relate to the Company’s shareholders’ equity, leverage ratio, fixed charge coverage ratio, surplus and risk based capital, and A.M. Best Ratings of its insurance subsidiaries. At December 31, 2009, the Company was in compliance with all of the covenants related to the credit agreement. On February 22, 2010, the Company received a temporary waiver of any event of default as of March 31, 2010 related to the fixed charge coverage ratio covenant in the Company’s credit agreement through May 1, 2010. The Company determined the temporary waiver was required as it related to the special cash dividend declared by the Company’s Board of Directors on February 22, 2010 since the Company intends to fund a portion of the special dividend through borrowings under this agreement. If the Company does not renegotiate its credit agreement by May 1, 2010 or receive an extension of the temporary waiver of event of default, the Company will be in default under the terms of the credit agreement.
Prior to 2009, the Company had entered into two interest rate swap agreements with a combined notional amount of $20.0 million in order to fix the interest rates on its junior subordinated debentures, and thereby reduce the exposure to interest rate fluctuations. Both of these agreements expired in August 2009. The Company did not account for these swaps as a cash flow hedge, thus the change in the fair value of these agreements was included in the Change in Fair Value of Derivative Instruments on the Consolidated Statements of Income, which was not a significant amount in the 2009, 2008, or 2007 periods presented.
During 2009, the Company experienced approximately $5.7 million of favorable development in net prior year reserves, with substantially all of the favorable development occurring in the 2006 and 2007 accident years.
Reinsurance contracts do not relieve the Company from its primary obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible. The Company evaluates the financial condition of its reinsurers and monitors the concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. Based upon management’s evaluation, we have concluded the reinsurance agreements entered into by the Company transfer both significant timing and underwriting risk to the reinsurer and, accordingly, are accounted for as reinsurance under the provisions set forth in the FASB guidance for accounting and reporting for reinsurance for short-duration and long-duration contracts.
The Company manages its credit risk on reinsurance recoverables by reviewing the financial stability, A.M. Best rating, capitalization, and credit worthiness of prospective and existing risk-sharing partners. The Company customarily collateralizes reinsurance balances due from non-admitted reinsurers through funds withheld trusts or stand-by letters of credit issued by highly rated banks. The largest unsecured reinsurance recoverable is due from an admitted reinsurer with an A.M. Best rating of “A+” and accounts for 31.2% of the total recoverable from reinsurers.
The Company’s 2009 and 2008 ceded reinsurance program includes quota share reinsurance agreements with authorized reinsurers that were entered into and are accounted for on a “funds withheld” basis. Under the funds withheld basis, the Company records the ceded premiums payable to the reinsurer, less ceded paid losses and loss adjustment expenses receivable from the reinsurer, less any amounts due to the reinsurer for the reinsurer’s margin, or cost of the reinsurance contract, as a liability, and reported $71.7 million and $49.4 million as Funds held under reinsurance treaties in the accompanying Consolidated Balance Sheets at December 31, 2009 and December 31, 2008, respectively. As specified under the terms of the agreements, the Company credits the funds withheld balance at stated interest crediting rates applied to the funds withheld balance. If the funds withheld liability is exhausted, interest crediting would cease and additional claim payments would be recoverable from the reinsurer.
Interest cost on reinsurance contracts accounted for on a funds withheld basis is incurred during all periods in which a funds withheld liability exists or as otherwise specified under the terms of the contract and is included in Underwriting, agency and other expenses. The amount subject to interest crediting rates was $22.8 million and $21.6 million at December 31, 2009 and 2008, respectively.
American Constantine Insurance Company (“ACIC”) does not carry an A.M. Best rating. The related reinsurance recoverables from ACIC at December 31, 2009 are fully collateralized by a grantor trust and irrevocable letter of credit.
In connection with the Company’s initial public offering, the Company increased the number of authorized shares of par value $0.01 Series A Convertible Preferred Stock to 10,000,000. None of these shares were issued or outstanding at December 31, 2009 or 2008.
On February 22, 2010, the Company’s Board of Directors declared a one-time, special cash dividend of $2.00 per share to be paid March 31, 2010 to shareholders of record at the close of business on March 15, 2010. The special dividend will be funded in part from borrowings under the Company’s credit agreement. The Company anticipates the special dividend to be approximately $34.5 million.
The Company’s insurance company subsidiaries, FMIC, FMCC and AUIC, are limited in their ability to pay dividends to FMFC. FMIC may declare and pay dividends according to the provisions of the Illinois Insurance Holding Company Systems Act, which provides that, without prior approval of the Illinois Insurance Department, dividends may not exceed the greater of 10% of FMIC’s policyholders’ surplus on the most recent annual statutory financial statement filed with the State of Illinois or net income after taxes for the current year. In 2010, FMIC’s dividends may not exceed approximately $25.6 million.
FMCC may declare and pay dividends according to the provisions of the Minnesota Insurance Holding Company Systems Act, which provides that, without prior approval of the Minnesota Department of Commerce, dividends may not exceed the greater of 10% of FMCC’s policyholders’ surplus on the most recent annual statutory financial statement filed with the State of Minnesota or net income, excluding capital gains, for the current year. FMCC can pay dividends of approximately $3.5 million in 2010.
AUIC may declare and pay dividends according to the provisions of the Arkansas Insurance Holding Company Systems Act, which provides that, without prior approval of the Arkansas Insurance Department, dividends may not exceed the greater of 10% of
AUIC’s policyholders’ surplus on the most recent annual statutory financial statement filed with the State of Arkansas or net income, excluding capital gains, for the current year. AUIC can pay dividends of approximately $0.5 million in 2010.
The 1998 Stock Compensation Plan (as amended, the “1998 Plan”) was established September 3, 1998. Under the terms of the plan, directors, officers, employees and key individuals may be granted options to purchase the Company’s common stock. Option and vesting periods and option exercise prices are determined by the Compensation Committee of the Board of Directors, provided no stock options shall be exercisable more than ten years after the grant date. All outstanding stock options under the plan became fully vested on August 17, 2005 under the change in control provision in the plan. Of the 4,625,000 shares of the Company’s common stock initially reserved for future grant under the 1998 Plan, shares available for future grant totaled 2,443,387 at December 31, 2009. On May 13, 2009, the Company adopted an amendment to the 1998 Plan prohibiting the issuance of any additional awards under the 1998 Plan.
During the year ended December 31, 2009, the Company granted 222,500 stock options and 118,500 shares of restricted stock to employees under the Omnibus Plan. The stock options and shares of restricted stock awarded during such period vest in three equal installments over a period of three years. Stock-based compensation will be recognized over the expected vesting period of the stock options and shares of restricted stock. During the year ended December 31, 2009, the Company granted 19,704 shares of restricted stock to non-employee directors under the Omnibus Plan. These shares of restricted stock vested immediately, but are not transferable for one year after the grant date, and stock-based compensation was recognized immediately. During the year ended December 31, 2008, the Company granted 386,500 stock options and 55,500 shares of restricted stock to employees under the Omnibus Plan. The stock options and shares of restricted stock vest in three equal installments over a period of three years. Stock-based compensation will be recognized over the expected vesting period of the stock options and shares of restricted stock. During the year ended December 31, 2008, the Company granted 12,124 shares of restricted stock to non-employee directors under the Omnibus Plan. These shares of restricted stock vested immediately, but are not transferable for one year after the grant date, and stock-based compensation was recognized immediately. Shares available for future grants under the Omnibus Plan totaled 1,813,036 at December 31, 2009.
The expected term of options was determined based on the simplified method per FASB accounting guidance for stock compensation. Expected stock price volatility was based on an average of the volatility factors utilized by companies within the Company’s peer group with consideration given to the Company’s historical volatility. The risk-free interest rate is based on the yield of U.S. Treasury securities with an equivalent remaining term.
FMIC was originally formed in 1996 as an Illinois Domestic Stock Property and Casualty Insurer operating on an admitted basis in Illinois, which required maintaining minimum capital and surplus of $2.0 million. On July 15, 2004, FMIC received approval from the Illinois Department of Insurance and became an Illinois Domestic Stock Surplus Lines Insurer. With this change in status Illinois now requires a minimum $15.0 million in surplus of which $1.0 million must be paid in capital to qualify for domestic surplus lines status. FMIC was in compliance with the applicable requirements at December 31, 2009, 2008, and 2007.
The Company maintains an employer-sponsored 401(k) plan. All employees are eligible to participate in the plan on the first day of the calendar quarter following 30 days of service and having attained 21 years of age. Employer contributions are voluntary and are allocated based upon the participants’ compensation and contribution levels. Vesting in the plan is immediate. The Company’s expense for this plan was approximately $0.4 million for the year ended December 31, 2009, $0.5 million for the year ended December 31, 2008, and $0.3 million for the year ended December 31, 2007.
On June 27, 2008, the Company sold all of the outstanding shares of capital stock of ARPCO Holdings, Inc. and its subsidiaries (“ARPCO”) for a purchase price of $43.0 million. The net assets disposed of in the transaction were $7.2 million and were principally intangible assets. The Company incurred costs related to the transaction of $2.9 million and recorded a gain, net of income taxes, of $20.9 million which is included in Income From Discontinued Operations in the Consolidated Statements of Income. During the third quarter, the Company recorded an adjustment of $0.4 million, net of income taxes, to the gain related to the finalization of the analysis of the state income tax impact of the transaction.