Risk Management segment as the sale of those renewal rights was executed in the third quarter of 2005. During 2005 the Risk Management segment accounted for $72.3 million of gross written premiums and for 2006 the same segment’s gross written premiums were $2.2 million. Pre-tax income was also positively impacted by net favorable development associated with prior year loss reserves of $44.9 million. Lastly, during 2006 catastrophe losses and related expenses totaled $4.3 million as compared to $12.1 million and $17.7 million in 2005 and 2004, respectively. See the segment discussion for additional discussion.
Consolidated gross written premiums from renewal business increased $571.7 million for the year ended December 31, 2006 as compared to $534.8 million and $470.0 million for 2005 and 2004, respectively. The increases in 2005 and 2006 were primarily attributable to a higher base of expiring policies available for renewal partially offset by a reduction in renewal premiums for the Risk Management segment.
Included in consolidated gross written premiums were $73.5 million, $51.4 million and $47.9 million for the years ended December 31, 2006, 2005 and 2004, respectively, from premiums written and assumed under various reinsurance agreements. Reducing the gross written premiums for the years ended December 31, 2006, 2005 and 2005 were cancellations, endorsements and other adjustments of $2.1 million, $7.3 million and $16.6 million, respectively.
$1.8 million, $2.2 million and $2.1 million for the years ended December 31, 2006, 2005 and 2004, respectively. Included in consolidated gross realized losses for the years ended December 31, 2006, 2005 and 2004 were write downs of approximately $1.2 million, $1.0 million and $0.1 million, respectively, from the recognition of other-than-temporary impairments on certain investment securities.
underwriting and investing results before consideration of realized gains or losses from the sales of investments. Management excludes realized gains for the evaluation of segment results, as decisions regarding the sales of investments are made at the corporate level. Although this measure of profit (loss) does not replace net income (loss) computed in accordance with accounting principles generally accepted in the United States as a measure of profitability, management utilizes this measure of profit (loss) to evaluate its segments which excludes realized gains and losses on sales of investments.
The increase in earned premiums over the three year period ended December 31, 2006 was the result of growth in gross written premiums. This growth was primarily attributable to development and integration of the business acquired through the renewal rights acquisition and growth within Argonaut Specialty. Colony’s gross written premiums from new business, inclusive of premiums written through the renewal rights agreement, increased to $329.8 million for the year ended December 31, 2006, compared to $309.2 million and $237.1 million for the years ended December 31, 2005 and 2004, respectively. Argonaut Specialty contributed gross written premiums from new business of $113.8 million for the year ended December 31, 2006 compared to $73.0 million for the same period ended in 2005.
Included in gross written premiums for the year ended December 31, 2006 was $8.3 million for premiums assumed under a reinsurance agreement, effective in January 2006. The Company recognized $4.1 million in earned premiums under this program. Gross written premiums were offset by cancellations, endorsements and other adjustments of approximately $3.8 million, $5.9 million and $19.1 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Losses and loss adjustment expenses for the year ended December 31, 2006 resulted in a loss ratio of 57.6%, compared to 61.6% and 65.4% for the same periods in 2005 and 2004, respectively. Included in losses and loss adjustment expense for the year ended December 31, 2006 was favorable development of $33.7 million which was mainly caused by lower than expected loss emergence on the 2004 and 2005 accident years resulting from lower loss frequency. Partially offsetting the favorable development related to prior year loss reserves, during 2006 the Company added $24.3 million in losses for the most recent accident year. Of the $24.3 million, $11.1 million was related to higher than expected property losses and the remainder was associated with casualty business resulting from increased severity, rate changes and an increased net retention. Included in the 2005 loss ratio is $11.2 million in catastrophe losses resulting from the hurricane activity during the latter half of 2005. Partially offsetting the hurricane losses in 2005 was favorable development on prior year losses of $12.7 million, including $5.1 million related to 2004 hurricanes and $7.6 million related to favorable development on property and casualty lines of business written in 2004 and prior. Losses of $15.4 million related to hurricane activity during 2004 were included in the 2004 loss ratio, as was prior year adverse loss development of $4.2 million, which resulted in a higher loss ratio as compared to 2005 and 2006. Loss reserves for the Excess and Surplus Lines segment were $897.6 million, $703.0 million and $474.2 million as of December 31, 2006, 2005 and 2004, respectively.
The increase in the expense ratios to 31.3% for the year ended December 31, 2006 as compared to 31.0% for the same period in 2005 was due primarily to an increase in admitted business (due to the renewal rights acquisition), which typically has higher acquisition costs than non-admitted business, in 2006 as compared to 2005. The increase in the expense ratio in 2005 as compared to 2004 was primarily attributable to start-up costs associated with the April 2005 renewal rights acquisition and the formation of Argonaut Specialty.
The increase in net investment income for the year ended December 31, 2006 as compared to 2005 and 2004 was primarily attributable to higher invested assets resulting from increased cash flows and a $37.0 million capital contribution, coupled with higher yields. Invested assets were $1,132.1 million, $818.5 million and $640.5 million as of December 31, 2006, 2005 and 2004, respectively.
The Company has entered into various quota share reinsurance programs to assume premiums and losses written by the insurance subsidiaries of HCC. Under the terms of these programs, the Company assumes 1.5% to 3.0% of the business written by HCC. For the year ended December 31, 2006, the Company assumed gross written premiums of $14.1 million, earned premiums of $10.0 million and losses and loss adjustment expense of $6.4 million. For 2005, the Company assumed gross written premiums of $6.4 million, earned premiums of $5.5 million and losses and loss adjustment expense of $3.5 million. For 2004, the Company assumed gross written premiums of $9.1 million, earned premiums of $14.7 million and losses and loss adjustment expense of $9.3 million.
Included in gross written premiums are workers compensation premiums for insurance programs marketed by certain state funds in jurisdictions where the state funds are not licensed. The Company receives a ceding commission and cedes 100% of the premiums and related losses to the respective state fund. Gross written premiums for state fund business were $47.8 million in 2006, $37.6 million in 2005 and $28.3 million in 2004.
Losses and loss adjustment expenses for the year ended December 31, 2006 resulted in a loss ratio of 63.0%, compared to 64.9% and 67.8% for 2005 and 2004 respectively. Included in losses and loss adjustment expenses for the year ended December 31, 2006, was favorable development on prior accident years of $4.1 million primarily attributable to a $3.0 million reduction in a lead paint reserves due to claims settlements and $4.0 million of favorable loss development from ongoing actuarial reviews, offset by unfavorable prior year development of $2.3 million from the unwinding of workers compensation discount and $0.6 million of unallocated loss adjustment expenses. Partially offsetting this net favorable development was a $2.4 million addition due to higher than expected property losses for the current accident year. The decrease in the loss ratio for the year ended December 31, 2005 as compared to 2004 was primarily the result of refinement of the underwriting profile and improved terms and conditions. Included in losses and loss adjustment expenses for the year ended December 31, 2005, was $0.6 million in catastrophe losses resulting from the hurricanes that made landfall during 2005. Included in losses and loss adjustment expense for the year ended 2004 was $3.5 million of adverse development related to prior accident years. This development was primarily attributable to reserve strengthening as a result of the actuarial analysis completed in the fourth quarter of 2004 coupled with the impact of the reserve discount related to the workers compensation reserves. The Select Market segment’s loss reserves were $353.7 million, $315.8 million and $254.8 million as of December 31, 2006, 2005 and 2004, respectively.
Public Entity. Trident, a wholly owned subsidiary of the Company, functions as a managing general underwriter, dedicated to servicing the insurance needs of preferred small to intermediate sized governmental entities and school districts throughout the United States. Trident offers a comprehensive insurance package, including property, inland marine, crime, general liability, public officials’ liability, law enforcement liability, automobile liability, automobile physical damage and excess liability coverages. Trident currently underwrites the majority of its products through Great Central and Argonaut Insurance.
Index to Financial Statements The decrease in net investment income was primarily attributable to lower invested balances due to the lower premium base during 2006 as compared to 2005. Net invested assets were $110.7 million, $116.5 million and $104.5 million as of December 31, 2006, 2005 and 2004, respectively.
Risk Management. The Company announced on August 29, 2005 that it sold the renewal rights to a substantial portion of its risk management business to XL America, Inc. (XL). Under the agreement, XL began offering renewal quotes to selected risk management clients beginning in September 2005. The Risk Management segment has not written any new or renewal policies since the sale of the renewal rights. Activity for the year ended December 31, 2006 was primarily the result of the run-off of policies written prior to the renewal rights sale, coupled with the run-off of claims.
The following table summarizes the results of operation for the Risk Management segment:
Earned premiums decreased to $15.4 million for the year ended December 31, 2006 as compared to $70.8 million and $101.3 million for the same periods in 2005 and 2004, respectively. The decrease in earned premiums is the result of the decrease in gross written premiums due to the sale of the renewal rights in 2005. Earned premiums in 2006 were the result of premiums written in 2005 continuing to earn out through 2006. Partially offsetting the 2006 earned premiums was a $4.8 million increase in return premiums for retrospectively rated policies.
Losses and loss adjustment expenses of $10.3 million for the year ended December 31, 2006 were offset by an equal amount of favorable development on prior accident year reserves. Favorable development consisted of $7.0 million in the workers compensation line due to continued improvement in the 2001 through 2005 accident years due to the impact of California Benefit Reform. The Company recognized $2.6 million in favorable development on involuntary pool losses, and other lines had $0.7 million of favorable development.
Index to Financial Statements Beginning in the first quarter of 2007, the results of the Risk Management segment will be included in the Run-off Lines segment.
The Company, through its subsidiary Argonaut Insurance Company, is exposed to asbestos liability at the primary level through claims filed against its direct insureds, as well as through its position as a reinsurer of other primary carriers. Argonaut Insurance has direct liability arising primarily from policies issued from the mid 1970s to early 1980s which pre-dated policy contract wording that excluded asbestos exposure. During 2004 the Company settled a large direct exposure for $29.8 million (see discussion below). The majority of the direct policies were issued on behalf of small contractors or construction companies. The Company believes that the frequency and severity of asbestos claims for such insureds is typically less than that experienced for large, industrial manufacturing and distribution concerns.
Index to Financial Statements Annually the Company reviews its loss and loss adjustment expense reserves for its Run-off Lines of business, inclusive of its asbestos and environmental claims. The process is initiated at the end of the second quarter and is typically completed in the third quarter of the calendar year. The Company continually monitors the status of the claims, and may make adjustments outside of the annual review period. The review entails a detailed analysis of the Company’s direct and assumed exposure. The Company engages a consulting actuary to provide its best estimate of ultimate losses and management evaluates that estimate in assessing the adequacy of the Run-off Lines loss and loss adjustment expense reserves.
For the year ended December 31, 2006, the Company strengthened loss reserves for the asbestos and environmental claims by $12.2 million. The Company also increased its unallocated loss adjustment expense reserves by $4.7 million to reserve for the cost to handle and run-off these claims. Partially offsetting these increases was a reduction to the medical malpractice reserves (within “other run-off lines” in the table above) of $7.0 million. During the year ended December 31, 2006, the last two open traditional medical malpractice claims were closed. Only one potential class action suit is still open, and management believes that current reserves adequately represent the Company’s total liability. The Company is beyond the statutes of limitations for filing new medical malpractice claims in all jurisdictions.
In 2005, the Company recorded an additional $0.1 million in reserves and the Company strengthened its unallocated loss adjustment expense reserves by $4.1 million based upon this analysis. Losses and loss adjustment expense for the year ended December 31, 2005 include a $2.0 million increase to the allowance for doubtful accounts related to certain reinsurance treaties from prior accident years. In addition, the 2005 underwriting loss includes a $6.0 million increase to the allowance for doubtful accounts for paid reinsurance balances recoverable to reflect management’s best estimate based on its regular review of these balances.
Total reserves for Run-off Lines as of December 31, 2006 were $176.4 million, net of reinsurance, including reserves for asbestos and environmental claims of $156.8 million. Management uses various actuarial methods to determine its best estimate of losses for the Run-off Lines in total, which resulted in a range of potential ultimate liability, net of reinsurance, of
Index to Financial Statements Because of the types of coverages within the Run-off Lines of business still being serviced by Argonaut Insurance, a significant amount of subjectivity and uncertainty exists in establishing the reserves for losses and loss adjustment expenses. Factors that increase these uncertainties are: (1) lack of historical data, (2) inapplicability of standard actuarial projection techniques, (3) uncertainties regarding ultimate claim costs, (4) coverage interpretations, and (5) the judicial, statutory and regulatory environments under which these claims may ultimately be resolved. Significant uncertainty remains as to the ultimate liability to the Company due to the potentially long waiting period between exposure and emergence of any bodily injury or property damage and the resulting potential for involvement of multiple policy periods for individual claims. Additionally, recent industry trends show an increasing number of claims being filed by individuals who claim asbestos exposure, but who have no apparent symptoms of asbestos-related disease. Due to these uncertainties, the current trends may not be indicative of future results. Although management has determined and recorded its best estimate of the reserves for losses and loss adjustment expenses for Run-off Lines, current judicial and legislative decisions continue to broaden liability, expand policy scopes and increase the severity of claims payments. As a result of these and other recent developments, the uncertainties inherent in estimating ultimate loss reserves are heightened, further complicating the already complex process of determining loss reserves. The industry as a whole is involved in extensive litigation over these coverages and liability issues, and must contend with the continuing uncertainty in its effort to quantify these exposures.
The Company’s principal cash flow sources are premiums and investment income. The primary cash outflows are claim payments and operating expenses. The nature of insurance is that cash collected for premiums written is invested, interest and dividends are earned thereon, and loss and settlement expenses are paid out over a period of years. This period of time varies by line of business and by the circumstances surrounding each claim. A substantial portion of the Company’s loss and loss expenses are paid out over more than one year. Additional cash outflow occurs through payments of underwriting and acquisition costs such as commissions, taxes, payroll and general overhead expenses. Management believes that cash receipts from premiums and investment income are sufficient to cover cash outflows in the foreseeable future. Should the need for additional cash arise, the Company has access to additional sources of liquidity.
For the year ended December 31, 2006, net cash provided by operating activities was $299.0 million, compared to $333.2 million for the year ended December 31, 2005 and $128.0 million for the year ended December 31, 2004. The decrease in cash flows from operations in 2006 as compared to 2005 was primarily attributable to tax payments of $42.3 million for the year ended December 31, 2006 compared to tax payments of $12.1 million for the same period in 2005. Additionally, interest paid on the junior subordinate debentures increased $3.9 million for the year ended December 31, 2006 as compared to 2005 due to higher interest rates. The increase in cash flows from operations in 2005 as compared to 2004 was largely due to increased premiums volumes within the Excess and Surplus Lines segment, increased investment income and the collection of a disputed receivable of $45.0 million.
During the year ended December 31, 2005, the Company received principal payments on real estate notes receivable totaling approximately $19.7 million, including an $18.7 million payoff of one of the notes. During the year ended December 31, 2006, the Company received $18.1 million as full payment of the remaining note receivable. Additionally, in the third quarter of 2006, the Company sold a property in California, resulting in cash received of $7.7 million.
The initial interest rate on the Debentures and the Capital Securities issued by Trust X is fixed at 7.75% for the first 5 years. After 5 years, the interest rate is equal to 3-month LIBOR plus 3.40%, which is reset quarterly. The Debentures are unsecured and subordinated in right of payment to all of the Company’s existing and future senior indebtedness. After September 15, 2010, the Company will have the right to redeem the Debentures, in whole or in part, but in all cases in a principal amount in integral multiples of $1,000, at a price equal to 100% of the principal amount of the Debentures, plus accrued and unpaid interest to the date of redemption. The Company also has the right to redeem all of the Debentures prior to September 15, 2010 upon the happening of specified events at the greater of (i) 107.5% of the principal amount of the Debentures, plus accrued and unpaid interest to the date of redemption, or (ii) the sum of (a) the discounted present value of the principal amount of the Debentures, (b) the discounted present value of the interest payable on the Debentures during the fixed rate period remaining life, and (c) the accrued and unpaid interest on the Debentures through the redemption date.
During 2004, the Company, through a series of statutory trusts, sold $83.0 million of Floating Rate Capital securities (the Capital Securities) (liquidation amount $1,000 per Capital Security) in a series of private sales. In conjunction with the sales of the Capital Securities, the trusts sold $2.6 million of Floating Rate Common Securities to the Company. The trusts used the proceeds from these sales to purchase $85.6 million of Floating Rate Junior Subordinated Debentures (the Debentures) from the Company. The interest rates on the Debentures and the Capital Securities are equal to the 3-Month LIBOR plus a margin ranging from 3.55% to 3.85%, reset quarterly. For selected Debentures, the interest rates are not to exceed 12.5% prior to the coupon cap date, which is approximately 5 years after the issuance date. The remaining debentures have interest rates that are not to exceed the highest rate permitted by New York Law prior to the coupon cap date. The Debentures are unsecured and are subordinate in right of payment to all of the Company’s future senior indebtedness. The Debentures are due 30 years after issuance, but may be redeemed after the five-year anniversary at a price equal to 100% of the principal amount of the Debentures, plus accrued and unpaid interest on the date of redemption. The Debentures may be redeemed prior to the five-year anniversary date upon the occurrence of specific events at a price equal to 107.5% to 101% plus accrued and unpaid interest to the date of redemption.
On March 6, 2006, the Company entered into a Credit Agreement (the Credit Agreement) with JPMorgan Chase Bank, N.A., as administrative agent, and the other lenders thereto. The Credit Agreement provides for an initial $75 million revolving credit facility, and the commitments thereunder shall expire on the third anniversary of the Credit Agreement. The borrower shall have the option to seek on up to three occasions an increase in the facility to provide for an additional aggregate amount of availability of up to $50 million. As of December 31, 2006, no borrowing capacity has been utilized under the Credit Agreement. Borrowings by the Company under the Credit Agreement may be used for general corporate purposes, including working capital and permitted acquisitions. The Credit Agreement contains certain affirmative and negative covenants. The Company is in compliance with all covenants of the Credit Agreement as of December 31, 2006.
Index to Financial Statements The Company invests excess cash in a variety of investment securities. As of December 31, 2006, the Company’s investment portfolio consisted of 80.6% fixed maturities, 10.3% equities, 0.6% other investments and 8.5% short-term investments, compared to 77.1% fixed maturities, 9.2% equities, 1.1% other investments and 12.6% short-term investments for the same period in 2005. The Company classifies its investment portfolio as available for sale; therefore all investments are reported at fair market value, with unrealized gains and losses, net of tax, being reported as a component of shareholders’ equity. As of December 31, 2006, the Company had no investment in any one security that exceeded 10% of shareholders’ equity.
Concerns over terrorist activity have both curtailed the availability of reinsurance for terrorism related risks and increased the cost of obtaining such reinsurance where it is still available. The effect on the Company’s insurance subsidiaries varies by line of business, but reinsurance coverage for terrorist acts involving nuclear, biological and chemical agents is no longer available or cost prohibitive in some instances, thus preventing ceding of these risks through reinsurance. The Company’s insurance subsidiaries consider the exposure to these risks as well as other risks in order to make appropriate decisions on policy exclusions, pricing and renewals, although laws in many states (and particularly those relating to workers compensation insurance) place limits on the ability of insurers to effectively limit these risks by contract.
In addition, regulators and rating agencies utilize a risk based capital (RBC) test designed to measure the acceptable amount of surplus an insurer should maintain, based on specific inherent risks of each insurer. Insurers failing to meet this benchmark level may be subject to scrutiny by the insurer’s domiciliary insurance department and potentially result in rehabilitation or liquidation. At December 31, 2006, the total adjusted capital of each of the Company’s insurance subsidiaries exceeded the minimum levels required under RBC. The Company continually monitors the RBC ratios and will implement strategies to maintain ratios above the regulatory minimums.
In the fourth quarter of 2006, management decided to transfer the management of the plan assets to an outside investment advisor. As of December 31, 2006, the investments consisted primarily of cash and short-term investments, as the portfolio’s long-term investments were allowed to mature without reinvestment in anticipation of the transaction. Functional transfer of control to the new advisor is expected to occur in the first half of 2007, with a target allocation of 50% equity and 50% fixed maturity investments in order to align the portfolio’s risk composition with the maturity of the benefit obligations. The fair market value of the investment portfolio as of December 31, 2006 was $27.0 million and included net unrealized losses of $0.2 million.
Fayez Sarofim. The Company utilizes Fayez Sarofim & Co. to manage approximately $252.9 million of its investment portfolio, for which an investment advisory fee is paid. Fayez Sarofim & Co. is wholly owned by Sarofim Group, Inc., of which Fayez Sarofim, a member of the Company’s Board of Directors, is the majority shareholder. Total fees for services paid to Fayez Sarofim & Co. were approximately $0.5 million, $0.4 million and $0.4 million for the years ended December 31, 2006, 2005 and 2004, respectively. The Company believes that this transaction has been entered into on terms no less favorable than could have been negotiated with non-affiliated third parties.
David Hartoch. Swett & Crawford is one of the oldest independent wholesale insurance brokers in the country, placing nearly $3.0 billion in premium volume annually. David Hartoch, who is a member of the Company’s Board of Directors, was the Chairman and Chief Executive Officer of Swett & Crawford from 1997 to 2003. From 2003 to 2005, Mr. Hartoch served as a consultant to Swett & Crawford. On April 1, 2005, Mr. Hartoch was re-appointed as acting Chairman and Chief Executive Officer of Swett & Crawford and on November 15, 2005, Mr. Hartoch was appointed Chairman of Swett & Crawford. During 2006, the Company, through its Excess and Surplus Lines segment, wrote $37.7 million in premiums through Swett & Crawford. Swett & Crawford earned $6.8 million in commissions on this business.
The Company and AAM are parties to the AAM Investment Management Agreement, dated as of March 1, 2004, pursuant to which AAM agrees to make investment decisions with respect to and otherwise manage certain funds deposited by the Company for that purpose guided by the Investment Policy and Guidelines Statement approved by the Company’s Board of Directors. As of December 31, 2006, AAM managed $880.9 million of the Company’s investments. The Company paid AAM $0.7 million for services provided in 2006, which constituted less than 5% of AAM’s consolidated gross revenues for 2006. It is anticipated that for calendar year 2007 revenue generated from the Company under the AAM Investment Management Agreement will again comprise less than 5% of the gross consolidated revenues of AAM. The AAM Investment Management Agreement does not have a specified term but is terminable by either party at any time on 30 days advance written notice.
The Company has no material obligations under a guarantee contract. The Company has no material retained or contingent interests in assets transferred to an unconsolidated entity. The Company has no material obligations, including contingent obligations, under contracts that would be accounted for as derivative instruments. The Company has no unrecorded obligations, arising out of a variable interest in an unconsolidated entity held by, and material to, the Company, where such entity provides financing, liquidity, market risk or credit risk support to, or engages in leasing, hedging or research and development services with the Company. Accordingly, the Company has no material off-balance sheet arrangements, other than operating leases.
(1) Interest only due on Junior Subordinated Debentures through 2008. Interest calculated based on rate in effect at December 31, 2006. Principal due beginning May 2033.
(2) Purchase obligations consist primarily of software servicing and licensing fees.
(4) 6% annual dividends on 500,000 shares of convertible preferred stock, based on the number of shares outstanding as of February 16, 2007. Obligation calculated assuming outstanding preferred stock will convert on 10 year anniversary date.
The discussion of the adoption and pending adoption of recently issued accounting policies is included in Note 1 - Business and Significant Accounting Policies in the Notes to the Consolidated Financial Statements, included in Item 8 “Financial Statements and Supplementary Data” on page 53.
The relevant factors and methodologies used to estimate loss reserves vary significantly by product line due to differences in loss exposure and claim complexity. Much of the Company’s business is written on an occurrence basis, meaning that there may be a significant time lag between the event which gives rise to a claim and the date on which the claim is reported to the Company, which can also result in additional time being required to resolve the claim. During these time lags, which can span over several years for complex claims, new facts and information specific to the claim become known to the Company, and general econometric and societal trends continue to change, requiring the Company to refine its loss reserve estimates on a regular basis. The Company applies a strict regimen to assure that review of these facts and trends occurs on a timely basis so that this information can be factored into its estimate of future liabilities. However, due to the number and potential magnitude of these variables, actual paid losses in future periods may differ materially from the Company’s estimates as reflected in current reserves. These differences can be favorable or unfavorable. More precise estimation of loss reserves is also hindered by the effects of growth in a line of business and uncertainty as to how new business performs over time. In addition to reserving for known claim events, the Company also establishes loss reserves for IBNR. Loss reserves for IBNR are set using the Company’s actuarial estimates for events that have occurred as of the balance sheet date but have yet to be reported to the Company. Estimation of IBNR loss reserves are subject to significant uncertainty.
The Company evaluates and sets its loss reserves by line of business. Following is a summary of gross loss reserves recorded by the Company by line of business as of December 31, 2006 and 2005:
The Company utilizes a variety of actuarial techniques and methods to determine loss reserves for all lines of business. Each such method has its own set of assumptions and outputs, and each has strengths and weaknesses in different areas. No single estimation method is superior to another method in all situations. Because the Company writes business in multiple product lines in various locations, the methods and assumptions used to project loss reserves will vary by line of business. The Company utilizes what it believes to be the best and most appropriate set of actuarial methods and assumptions for each product line grouping. The estimation methods utilized reflect those methods that the Company believes will produce the most accurate and reliable indication of ultimate claim liabilities at the balance sheet date for the claim liabilities being evaluated. While the loss projection methods may vary by product line, the general approach for calculating IBNR remains the same: ultimate losses and LAE are forecasted first, and that amount is reduced by the amount of cumulative paid claims and by case reserves.
alone are an insufficient measure of the ultimate loss costs. Therefore, an additional case development reserve estimate is established, usually as a percentage of the case reserve. In general, case reserve factors are selected by retrospective analyses of the overall adequacy of historical case reserves. Case reserve factors are reviewed and revised periodically. Due to the variability in the timing of receipt and completeness of case reserve data, the Company generally waits approximately 60 to 72 months after the beginning of an accident year to assign greater credibility to the paid and incurred reserve evaluation methods. Until that time, case reserve factors are partially based on ultimate loss ratio assumptions through the application of the BF methods.
For the Company’s Run-off Lines segment long tail loss reserves, there is significant uncertainty involved in estimating reserves for asbestos, environmental, and other latent injury claims. The Company utilizes a report year method which estimates loss reserves based on the pattern and magnitude of reported claims, and a survival ratio method which compares the Company’s level of loss reserves and loss payments to that of the industry for similar exposures. A ground-up analysis is also done which relies on studies of individual policy terms and conditions. The combination of the methods produces a range of outcomes from which management evaluates and selects its best estimate given the available facts at the balance sheet date. The Company applies greatest weight to the report year method and the ground-up analyses because those methodologies best capture the unique claim reporting and claim severity characteristics of the underlying exposures and loss development potential.
Each business segment is analyzed individually, with development characteristics for each short tail and long tail line of business identified and applied accordingly. In comparing loss reserve methods and assumptions utilized at December 31, 2006 as compared with methods and assumptions utilized at December 31, 2005, management has not changed or adjusted methodologies or assumptions in any significant manner.
In conducting its actuarial analyses, the Company generally assumes that past patterns demonstrated in the data will repeat themselves, and that the data provides a basis for estimating future loss reserves. In the event that the Company becomes aware of a material change that may render past experience inappropriate for the purpose of estimating current loss reserves, the Company will attempt to quantify the effect of the change and utilize informed management judgment to adjust loss reserve forecasts appropriately. There were no significant assumptions made at December 31, 2006 in estimating loss reserves that were premised on future emergence that were inconsistent with historical patterns or experience.
The major causes of uncertainty will vary for each product line reviewed. For short tailed property lines of business, the Company is exposed to catastrophe losses, both natural and manmade. Due to the nature of certain catastrophic loss events, such as hurricanes, earthquakes, or terrorist attacks, the Company’s normal claims resolution processes may be impaired due to factors such as difficulty in accessing impacted areas and other physical, legal, and regulatory impediments. These factors can make establishment of accurate loss reserve estimates difficult and render such estimates subject to greater uncertainty. Additionally, if the catastrophe occurs near the end of a financial reporting period, there are additional uncertainties in loss reserve estimates due to the lack of sufficient time to conduct a thorough analysis. Long tailed casualty lines of business also present challenges in establishing appropriate loss reserves, particularly in the event of changes in the legal environment over time which may broaden the Company’s liability or scope of policy coverage and increase the magnitude of claim payments. The possibility of future adverse changes in the legal environment heightens the uncertainty inherent in estimating the ultimate claim costs on the basis of past claims costs, further complicating the already complex loss reserving process.
In all lines, final claim payments may differ from the established loss reserve, particularly when resolution of a claim takes several years. Due to the uncertainties discussed above, the ultimate losses may vary materially from current loss reserves and could have a material adverse effect on the Company’s future financial condition, results of operations and cash flows. Any adjustments to loss reserves are reflected in the results for the year during which the adjustments are made.
Index to Financial Statements In addition to the previously described general uncertainties encountered in estimating loss reserves, there are significant additional uncertainties in estimating the amount of the Company’s potential losses from asbestos and environmental claims. Loss reserves for asbestos and environmental claims cannot be estimated with traditional loss reserving techniques that rely on historical accident year development factors due to the uncertainties surrounding these types of claims. Among the uncertainties impacting the estimation of such losses are: (1) potentially long waiting periods between exposure and emergence of any bodily injury or property damage; (2) difficulty in identifying sources of environmental or asbestos contamination; (3) difficulty in properly allocating responsibility and/or liability for environmental or asbestos damage; (4) changes in underlying laws and judicial interpretation of those laws; (5) potential for an environmental or asbestos claim to involve many insurance providers over many policy periods; (6) long reporting delays from insureds to insurance companies; (7) historical data concerning asbestos and environmental losses, which is more limited than historical information on other types of claims; (8) questions concerning interpretation and application of insurance coverage; and (9) uncertainty regarding the number and identity of insureds with potential asbestos or environmental exposure. Case reserves and expense reserves for costs of related litigation have been established where sufficient information has been developed. Additionally, IBNR has been established to cover additional exposure on known and unknown claims.
for a given accident year closed within 5 to 7 years, while others are characterized by extreme time lags for both reporting and payment of claims. In addition, this line includes asbestos and environmental claims, which are reviewed separately because of the unique character of these exposures. Allocated loss adjustment expenses in this line consist primarily of legal costs, and may exceed the total amount of the indemnity loss on some claims.
The Company uses several loss reserving methods to capture development characteristics within this line of business. Paid and incurred loss development, paid and incurred Bornhuetter-Ferguson methods, and a loss frequency/severity method are utilized in deriving management’s best estimate of loss reserves. In addition to these approaches, which are used across all general liability categories of business, the Company considers additional analytic measures in deriving its loss reserve estimates that consider the Claims and Book of Business risk factors noted above.
the injured worker, are generally disbursed quickly. Other payments are made over the course of several years, such as awards for permanent partial injuries. Some payments continue to take place throughout the injured worker’s life, such as permanent disability benefits and on-going medical care. Although long tail in nature, claims generally are not subject to long reporting lags, settlements are generally not complex, and most of the liability exposure is characterized by high frequency and moderate severity. The largest reserve risks are generally associated with low frequency, high severity claims that require lifetime coverage for medical expense arising from a worker’s injury.
The Company uses several loss reserving methods to capture development characteristics within this line of business. Paid and incurred loss development, paid and incurred Bornhuetter-Ferguson methods, and a loss frequency/severity method are utilized in deriving management’s best estimate of loss reserves. In addition to these approaches, which are used across all workers compensation categories of business, the Company considers additional analytic measures based upon the Claims and Book of Business workers compensation risk factors noted above in deriving its loss reserve estimate.
Commercial multiple peril lines insure a combination of property and liability exposures, and therefore include both short and long tail coverages. Property coverage claims are generally resolved in a short period of time, while liability coverages
claims generally require more time to resolve. These lines include package polices issued to a limited number of well defined industry sectors, including grocery stores, restaurants, dry cleaners and religious institutions. The risk of fluctuation in loss reserves for this line is predominately associated with liability coverage, with risk factors similar to other general liability lines described above.
The commercial automobile liability product line is a long tail coverage, mainly due to exposures arising out of bodily injury claims. Losses in this line associated with bodily injury claims generally are more difficult to accurately estimate, more complex, and take longer to resolve. Claim reporting lags also can be lengthy. Examples of loss and LAE risk factors that can change over time and result in adjustments to commercial automobile liability loss reserves include, but are not limited to, the following:
Index to Financial Statements A significant portion of the Company’s commercial automobile liability is related to automobiles that are stationary for significant periods of time, such as automobile sales lots. In addition, the Company insures commercial automobiles that travel within a very short radius of the primary insured location, such as shuttle buses. Based on the Company’s targeted markets and their specific loss characteristics, the Company seeks to utilize methods and analytics that reflect the particular exposure to loss for these markets.
The following discussion includes disclosure of possible variations from current estimates of loss reserves due to a change in certain key assumptions. Each of the impacts described below is estimated individually, without consideration for any correlation among other key assumptions or among lines of business. Therefore, it would be inappropriate to take each of the amounts described below and add them together in an attempt to estimate volatility for the Company’s reserves in total. The estimated variations in reserves due to changes in key assumptions discussed below are a reasonable estimate of possible variations that may occur in the future, likely over a period of several calendar years. It is important to note that the variations discussed herein are not meant to be a worst or best case scenario, and therefore, it is possible that future variations may be more than amounts discussed below.
With respect to asbestos and environmental general liability losses, the Company wrote several different categories of insurance contracts that may cover asbestos and environmental claims. First, the Company wrote primary policies providing the first layer of coverage in an insured’s liability program. Second, the Company wrote excess policies providing higher layers of coverage for losses that exhaust the limits of underlying coverage. Third, the Company acted as a reinsurer assuming a portion of those risks assumed from other insurers writing primary, excess and reinsurance coverages. Fourth, subsidiaries of the Company participated in the London Market, writing both direct insurance and assumed reinsurance business. With regard to both environmental and particularly asbestos claims, significant uncertainty limits the ability of insurers and reinsurers to estimate the ultimate reserves necessary for unpaid losses and related expenses. Traditional actuarial reserving techniques cannot reasonably estimate the ultimate cost of these claims, particularly during periods where theories of law are in flux. The degree of variability of reserve estimates for these exposures is significantly greater than for other more traditional exposures. In particular, the Company believes there is a high degree of uncertainty inherent in the estimation of asbestos loss reserves.
Given the factors and emerging trends described above, the Company believes the actuarial tools and other techniques it employs to estimate the ultimate cost of claims for more traditional kinds of insurance exposure are more difficult with regard to estimating reserves for its asbestos and environmental exposures. For this reason, the Company relies on exposure-based analysis to estimate the ultimate costs of these claims and regularly evaluates new information in assessing its potential asbestos and environmental exposures.
no payment and the expense to indemnity ratio. The uncertainty with respect to the underlying reserve assumptions for asbestos and environmental adds a greater degree of variability to these reserve estimates than reserve estimates for more traditional exposures. While this variability is reflected in part in the size of the range of reserves developed by the Company, that range may still not be indicative of the potential variance between the ultimate outcome and the recorded reserves. The process of estimating asbestos and environmental reserves, which are detailed in Note 13 of Notes to Consolidated Financial Statements, remain subject to a wide variety of uncertainties. Due to these uncertainties, further developments could cause the Company to change its estimates and ranges of its asbestos and environmental reserves, and the effect of these changes could be material to the Company’s consolidated operating results, financial condition and liquidity.
As of December 31, 2006, there was $15.3 million of total unrecognized compensation cost related to non-vested stock compensation arrangements granted by the Company, which will be amortized into expense over the vesting period, typically two to five years. The weighted-average period over which this unrecognized expense is expected to be recognized is 2.9 years. Additionally, as of December 31, 2006, the Company had $7.9 million of total unrecognized compensation cost related to stock option grants outstanding. The weighted-average period over which this unrecognized expense is expected to be recognized is 2.1 years. The vesting period for the options is typically four years; however, the majority of this cost will be recognized over the next two years, in accordance with vesting provisions. In 2006, the Company adjusted the mix of its share-based payment awards, granting a higher percentage of non-vested shares than in previous years.
The Company estimates the value of employee stock options using the Black-Scholes option pricing model. Assumptions necessary for the calculation of fair value include expected term and expected volatility. These assumptions are management’s best estimate of the characteristics of the options. Additionally, forfeiture rates are estimated based on prior option vesting experience. If the estimates of employees’ forfeiture rates are not correct at the end of the term of the option, the Company will record either additional expense or a reduction in expense in the period it completely vests. This adjustment may be material to the period in which it is recorded. In addition, option fair value is based on estimates of volatility as determined by management. Many methods are available to determine volatility, so the determination is subjective. Applying a different method to determine volatility could impact earnings.