At December 31, 2002, AFG transferred the NSA Group to Infinity. Financial information for periods prior to the date of transfer represents the combined information of the NSA Group. Infinity also acquired the Assumed Agency Business from GAI through a reinsurance transaction effective January 1, 2003. The historical financial information shown below (in millions) as of and for each of the three years ended December 31, 2000 through 2002 was derived from audited financial statements. The Infinity financial data as of and for the twelve-month periods ended December 31, 2004 and 2003 include the results of the Assumed Agency Business. This information should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes.
(a) The decline in earned premiums during 2001 and 2002 is due primarily to a reinsurance agreement pursuant to which Infinity ceded 90% of the automobile physical damage business written by it as more fully discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Infinity’s profitability continued to improve in 2004. Diluted earnings per share increased 63% from $2.83 for the twelve months ended December 31, 2003 to $4.62 for the same period in 2004. Net earnings also increased substantially from $58.2 million for 2003 to $96.4 million in 2004. Return on equity for 2004 increased to 18.6%, up from 14.7% in 2003.
Investment income in 2004 increased $8.5 million over that in 2003, primarily as a result of lower interest credited to reinsurers on funds held balances. The American Re agreement was commuted on December 31, 2004 and was not renewed for 2005. In addition, average investment balances increased 11%, mostly from cash generated through operations and the proceeds from the July 2003 term loan (Refer to Note 4 to the Consolidated Financial Statements for more information). Offsetting this increase in average investment balances were lower yields on the portfolio, as overall market rates remained at historically low levels. Infinity continued to invest over 95% of its available funds in fixed income and cash equivalent securities. The average duration for the fixed income portfolio fell to 4.1 years as compared with 4.7 years at December 31, 2003.
Book value per share increased 18.8%, from $22.38 at December 31, 2003 to $26.60 at December 31, 2004 from the contribution of earnings in excess of shareholder dividends.
Revenues increased for the twelve months ended December 31, 2004 to $951.8 million, up 23.8% as compared with the same period in 2003. This was a result of lower utilization of reinsurance in 2004, an increase in investment income for reasons cited earlier, and an increase in capital gains from securities sales.
An increase in either frequency or severity of 1% for the 2004 accident year would decrease earnings per share by approximately $0.15.
Management regularly evaluates for potential impairment each security position that (i) has a market value of less than 80% of its book value or (ii) exceeds $100,000, as well as each position held for which one or more impairment charges have been recorded in the past. The process of evaluation includes assessments of each item listed above. Since it is not possible to accurately predict if or when a specific security will become other-than-temporarily impaired, total impairment charges could be material to the results of operations in a future period. Management believes that it is not likely, however, that such impairment charges will have a significant effect on Infinity’s liquidity.
Infinity continually evaluates potential liabilities and reserves for litigation using the criteria established by Statement of Financial Accounting Standard (“SFAS”) No. 5, “Accounting for Contingencies.” Under this guidance, reserves for loss may only be recorded if the likelihood of occurrence is probable and the amount is reasonably estimable. Management considers each legal action using this guidance and records reserves for losses as appropriate. Infinity believes the current assumptions and other considerations used to estimate potential liability for litigation are appropriate. Certain claims and legal actions have been brought against Infinity for which no loss has been accrued, under the rules described above. While it is not possible to know with certainty the ultimate outcome of these claims or lawsuits, management does not expect them to have a material effect on Infinity’s financial condition or liquidity.
The National Association of Insurance Commissioners’ (“NAIC”) model law for risk-based capital (“RBC”) provides formulas to determine the amount of capital that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2004, the capital ratios of all Infinity insurance subsidiaries substantially exceeded the RBC requirements.
Infinity is organized as a holding company with all of its operations being conducted by its insurance subsidiaries. Accordingly, Infinity will have continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, shareholder dividends, share repurchases and taxes.
Administrative expenses at the holding company have averaged approximately $6.4 to $6.9 million annually since 2003.
In 2004 Infinity paid a dividend of $.055 per common share per quarter. In February 2005, Infinity increased the quarterly dividend to $.06 per share. Based on the current number of shares outstanding, this equates to a common stock dividend of approximately $5.0 million per year.
Funds to meet these obligations will come primarily from dividends from the insurance subsidiaries, as well as cash and investments held at the holding company. In 2004, Infinity’s insurance subsidiaries paid Infinity $28.5 million in ordinary dividends. In 2005, they may pay to Infinity up to $62.7 million in ordinary dividends without prior regulatory approval. As of December 31, 2004, Infinity had $88.6 million of cash and investments. Other sources of additional liquidity include an unused line of credit in the amount of $20 million, the potential use of various reinsurance vehicles, and capital funds that could be supplied by additional debt or equity offerings.
Infinity’s insurance subsidiaries generate liquidity to satisfy their obligations, primarily by collecting and investing premiums in advance of paying claims. Infinity’s insurance subsidiaries had positive cash flow from operations of approximately $61 million in 2004, $67 million in 2003, and $45 million in 2002. In addition, Infinity’s insurance subsidiaries have available to pay its obligations an additional $1,260.1 million in fixed maturity securities and $25.0 million in equity securities, all carried at market value with unrealized gains and losses reported as a separate component of shareholder’s equity on an after-tax basis.
The payout pattern for reserves for losses and LAE is based upon historical payment patterns and do not represent actual contractual obligations. The timing and amounts ultimately paid can and will vary from these estimates, as discussed in the Critical Accounting Policies section.
Approximately 94% of the fixed maturities that Infinity held were rated “investment grade” (credit rating of AAA to BBB) by nationally recognized rating agencies at December 31, 2004. The average rating for the fixed income portfolio at December 31, 2004 was AA-. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or non-investment grade. Management believes that a high quality investment portfolio is more likely to generate a stable and predictable investment return.
Market risk represents the potential economic loss arising from adverse changes in the fair value of financial instruments. Infinity’s exposures to market risk relate primarily to its investment portfolio which is exposed to interest rate risk, credit risk and, to a lesser extent, equity price risk.
The fair value of Infinity’s fixed maturity portfolio is directly impacted by changes in market interest rates; generally, the market value of fixed-income investments moves inversely with movements in market interest rates. Infinity’s fixed maturity portfolio is comprised of substantially all fixed rate investments with primarily short-term and intermediate-term maturities. This practice allows flexibility in reacting to fluctuations of interest rates. In addition, the risk of loss in market value is partially mitigated by higher market rates available for new funds available for investment. The portfolios of Infinity’s insurance companies are managed with an attempt to achieve an adequate risk-adjusted return while maintaining sufficient liquidity to meet policyholder obligations.
Credit risk is managed by diversifying the portfolio to avoid concentrations in any single industry group and by maintaining a minimum average credit quality rating on the portfolio.
Equity price risk is the potential economic loss from adverse changes in equity security prices. Although Infinity’s investment in equity securities is only 1.5% of total investments, it is concentrated in a relatively limited number of positions; approximately half of the total is in five investments; two of these five are electric utilities. While this approach allows management to more closely monitor the companies and industries in which they operate, it does increase risk exposure to adverse price declines in a major position.
Since early 2000, Infinity’s insurance subsidiaries have been increasing their premium rates with a goal of achieving underwriting profits, even if it entails foregoing volume. As with all property and casualty companies, the beneficial impact of these price increases is reflected in Infinity’s financial results over time. Infinity implements price increases on its in-force policies as they are renewed, which generally takes between six and twelve months for the entire book of business. Infinity recognizes increased premiums on particular policies as the premiums are earned, generally over the course of the six to twelve months after the policy is effective.
(b) The 2003 Inter-Ocean agreement was commuted in 2004, resulting in a return of unearned premium on the Assumed Agency Business.
The NSA Group’s net earned premiums increased $173.6 million, or 28.7%, as Infinity reduced the amount of earned premiums ceded under the American Re agreement. Excluding the effect of this agreement, earned premiums were essentially unchanged at $832.5 million. The loss and LAE ratio improved 10.4 points from 2003 to 2004. Excluding the effect of the Quota Share Agreements, the loss and LAE ratio decreased by 5.1 points from 72.1% to 67.0% for the twelve months ended December 31, 2003 to the same period in 2004, respectively. Approximately 3.6 points of this improvement resulted from $11 million of favorable loss reserve development in 2004, primarily on Infinity’s California book of business, as compared with $19 million of unfavorable development for the same period in 2003, primarily on its New York business. The underwriting expense ratio increased from 10.3% for the twelve months ended December 31, 2003, as compared with 18.7% for the same period in 2004. Excluding the effects of the American Re agreement, the expense ratio for the twelve months ended December 31, 2004 of 21.4% still showed a slight 0.9 point increase over the 20.5% ratio for the same period in 2003, primarily as a result of increased commissions paid to agents and brokers.
compared to 2002 primarily as a result of savings from consolidation efforts taken. Excluding the effect of the Inter-Ocean agreement, the expense ratio improved 1.6% points from 22.1% in the twelve-month period ended December 31, 2002 to 20.5% in the same period in 2003.
Net investment income decreased $4.1 million for the twelve-month period ended December 31, 2003 versus the comparable 2002 period due to lower yields available for newly invested funds, and to a lesser extent due to a reallocation to tax advantaged securities, partially offset by an increase in average invested assets of 10.4%. Average invested assets increased as a result of the transfer at January 1, 2003 of $125.3 million of securities and cash in conjunction with Infinity’s assumption of insurance liabilities of the Assumed Agency Business, as well as proceeds received in July 2003 from the term loan.
Infinity recorded impairments for unrealized losses deemed other-than-temporary and realized gains on sales and disposals as follows (before tax, in thousands):
Interest expense was accrued at a fixed rate of 8.5% on the $55 million note due to AFG until its repayment in mid-July, 2003 using a portion of the proceeds of the $200 million term loan. The term loan accrued interest at a variable rate, which averaged 3.7% from July 16, 2003, the date of issue through February 18, 2004, at which time it was refinanced with the Senior Notes. The Senior Notes carry a coupon rate of 5.50%, effective yield of 5.55%, require no amortization payment and mature in 2014. The risk of variability in future interest expense was partially hedged by the interest rate swap.
Infinity’s effective tax rate was 25.5% in 2004, 33.4% in 2003, and 35.3% in 2002. The effective tax rate for 2003 fell from that in 2002 as a result of increases in tax-exempt interest on Infinity’s municipal fixed income portfolio. The effective tax rate for 2004 fell from that in 2003 as a result of increases in tax-exempt interest from a larger municipal fixed income portfolio, the release of $2.0 million of tax reserves, and a $7.4 million reduction in the valuation allowance for deferred tax assets. See Note 6 to Infinity’s Consolidated Financial Statements for a detailed analysis of the effective tax rate.