Index to Financial Statements On August 25, 2005, the Company announced that it had settled the suit in consideration of a cash payment to Argonaut in the amount of $45.0 million and agreement by the MTA to make future payments to Argonaut out of funds recovered by the MTA from its excess liability insurers for the period covered by the settlement. The $45.0 million cash payment was received by the Company on September 13, 2005.
Consolidated gross written premiums for the years ended December 31, 2005, 2004 and 2003 were also impacted by approximately $51.7 million, $50.4 million and $87.4 million, respectively, from premiums written and assumed under various reinsurance agreements, partially offset by endorsements and cancellations of $8.9 million, $19.1 million and $24.1 million, respectively.
Consolidated net investment income increased 29.9% in 2005 as compared to 2004 and 56.5% as compared to 2003 due to higher invested balances resulting from positive cash flows for 2005, 2004 and 2003, capital raising initiatives and slightly higher yields. Total invested assets were $2,173.0 million, $1,783.9 million and $1,553.2 million as of December 31, 2005, 2004 and 2003, respectively.
Consolidated losses and loss adjustment expenses totaled $427.2 million for the year ended December 31, 2005, compared to $409.7 million in 2004 and $395.3 million in 2003. Improvement in the loss ratio in 2005 as compared to 2004 was primarily attributable to favorable development on prior ultimate losses related to business written in 2004 and prior of approximately $20.3 million which includes the $3.0 million of favorable development related to the 2004 hurricanes. Partially offsetting the favorable development recognized during 2005 was an increase to loss and loss adjustment expenses of $10.0 million associated with certain commutations discussed in Significant Events. Hurricane losses for the years ended 2005 and 2004 were $12.1 million and $17.7 million, respectively. For additional discussion see note 6 “Reserves for Losses and Loss Adjustment Expenses” in the Notes to the Consolidated Financial Statements. Improvement in the consolidated loss ratio in 2004 as compared to 2003 was primarily attributable to the Risk Management segment shifting to loss sensitive policies, partially offset by $17.7 million in losses and loss adjustment expenses related to the 2004 hurricane activity.
Consolidated loss reserves were $1,875.4 million, $1,607.5 million and $1,480.8 million as of December 31, 2005, 2004 and 2003, respectively. Management has recorded its best estimates of the 2005 and 2004 hurricanes and currently does not expect these losses to exceed its property catastrophe reinsurance coverage. Due to the significant uncertainties inherent in the estimation of loss reserves, there can be no assurance that future loss development will not occur. (See “Reinsurance” on page 8).
Excess and Surplus Lines. Excess and surplus lines insurance carriers focus on risks that the standard market is unwilling or unable to underwrite due to the unique risk characteristics of the insureds or the lack if insurers offering such coverage, which may be caused by physical perils, the nature of the business or the insured’s loss experience. The Company, through Colony and Argonaut Specialty, its two separate platforms, is able to underwrite these risks with more flexible policy terms at unregulated premium rates to the extent the business is underwritten on an excess and surplus lines basis. Colony provides commercial liability, commercial property, products liability and environmental liability coverages to commercial enterprises, including restaurants, artisan contractors, day-care centers and manufacturers, and professional liability coverages for health care providers and other professionals. Colony is approved as a non-admitted insurer in 49 states, the District of Columbia and the U.S. Virgin Islands. Argonaut Specialty, the Company’s second excess and surplus lines platform, began operations in the second quarter of 2005. Argonaut Specialty provides primary general liability, excess\umbrella coverage and property lines of business for risks the admitted market chooses not to underwrite. Argonaut Specialty’s risks are typically larger than Colony’s and it utilizes a smaller distribution platform.
Gross written premiums from new business increased to $382.2 million in 2005, compared to $237.1 million in 2004 and $268.0 million for 2003. Gross written premiums from new business for the year ended December 31, 2005, included $123.3 million from a renewal rights acquisition the Company entered into effective April 1, 2005. Also included in gross written premiums from new business during this period was $73.0 in premiums written by Argonaut Specialty, created at the beginning of 2005. The decrease in new business in 2004 as compared to 2003 was primarily attributable to increased competition primarily in property lines and larger casualty risks. Additionally, as a result of the hurricane activity in the third quarter of 2004, the Company did not issue new policies in Florida from August 13, 2004 to September 27, 2004.
Renewal business for the year ended 2005 accounted for $243.5 million of gross written premiums, compared to $203.2 million and $140.7 million for the same periods in 2004 and 2003, respectively. A larger base of expiring premiums continues to be the primary driver for the increase in renewal premiums in 2005. Partially offsetting these increases in gross written premiums were cancellation and endorsements of $5.9 million, $19.1 million and $24.1 million for the years ended December 31, 2005, 2004 and 2003, respectively.
On March 31, 2003, Colony entered into a quota share reinsurance agreement with HCC Insurance Holdings, Inc. (“HCC”). Under the terms of this agreement, the Company cedes 15% of the gross written premiums from the E & S segment, exclusive of Argonaut Specialty and a portion of the renewal rights acquisition, to HCC and HCC will, in turn, assume 15%
Index to Financial Statements of the losses. For the year ended December 31, 2005, the Company ceded $66.0 million of gross written premiums, $64.6 million of earned premiums and $35.6 million in losses and loss adjustment expenses. For the year ended December 31, 2004, the Company ceded $62.0 million of gross written premiums, $58.5 million of earned premiums and $35.7 million in losses and loss adjustment expense. For the year ended December 31, 2003, the Company ceded $41.3 million of gross written premiums, $17.1 million of earned premiums and $10.1 million in losses and loss adjustment expense. The Company receives a ceding commission to offset its acquisition costs related to these premiums. For the years ended December 31, 2005, 2004 and 2003, the Company earned a ceding commission of $13.2 million, $11.6 million and $3.0 million, respectively.
The E & S segment’s loss ratio was 61.6% for 2005 compared to 65.4% for 2004 and 62.0% for 2003. Included in the 2005 loss ratio is $11.2 million in catastrophe losses resulting from the hurricane activity during the latter half of 2005. Offsetting these losses 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 loss development of $4.2 million. Loss reserves for the E & S segment were $703.0 million, $474.2 million and $345.5 million as of December 31, 2005, 2004 and 2003, respectively. Loss reserves as of December 31, 2005 represent management’s best estimate based on current facts and trends within this segment; however, due to the inherent uncertainties in estimating ultimate loss reserves, the potential for future development exists.
The expense ratio increased to 31.0% for the year ended December 31, 2005, which was primarily attributable to start-up costs associated with the April 2005 renewal rights acquisition and the formation of Argonaut Specialty. The expense ratio for the year ended December 31, 2004 was 29.4%, which is consistent with the expense ratio of 29.2% for the same period ending 2003.
Index to Financial Statements The increase in gross written premiums for the year ended December 31, 2005 as compared to the same periods in 2004 and 2003 was primarily attributable to renewal business. Gross written premiums resulting from renewal business were $178.8 million, $120.7 million and $110.6 million for the years ended December 31, 2005, 2004 and 2003, respectively. The increase in renewal business in 2005 as compared to 2004 was primarily due to the transition of Grocers Insurance business from new to renewal since the 2003 renewal rights acquisition. The increase in renewal business in 2004 as compared to 2003 was due to rate increases and to a lesser extent increased exposure relative to payroll on workers’ compensation policies.
Gross written premiums resulting from new business were $69.9 million for the year ended December 31, 2005, compared to $90.7 million and $33.3 million for the same periods ended in 2004 and 2003, respectively. The decrease in new business for the year ended December 31, 2005 as compared to the same period in 2004 was primarily attributable to the transition of Grocers Insurance business discussed above, combined with increased price competition, particularly in the grocery program. This decrease was partially offset by $18.4 million in new business from a program account effective on October 1, 2005. The increase in new business for the year ended December 31, 2004 as compared to the same periods in 2003 was primarily attributable to the Grocers Insurance renewal rights acquisition, which contributed $56.0 million in new business during 2004. Premiums assumed under various reinsurance agreements account for the remaining gross written premiums for each of the three years.
The expense ratio for the years ended December 31, 2005 and 2004 was 30.1% for each year. The leveling of the expense ratio in 2005, as compared to 2004, was the result of the decrease in earned premiums due to reinsurance reinstatement premiums, partially offset by a decline in the start up costs related to the renewal rights agreement in the prior year. The increase in the expense ratio in 2004 to 30.1% as compared to 28.7% for 2003 was primarily due to increased start up costs resulting from the Grocers Insurance renewal rights agreement previously discussed. Renewal rights acquisitions typically result in a higher expense ratio until the earned premium equates to the amount of premium in force.
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 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.
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 $37.6 million in 2005, $28.3 million in 2004 and $14.4 million in 2003.
Gross written premiums assumed from involuntary pools were $4.9 million in 2005, $6.9 million in 2004, and $12.7 million in 2003. The decrease in pool premiums assumed is consistent with lower voluntary premium over the period.
Earned premiums decreased in 2005 primarily due to lower premium volume as a result of the sale of the renewal rights to XL, and were also reduced by $12.9 million of return premiums on retrospectively rated policies. Earned premiums were lower in 2004 compared to 2003 driven by a $31.7 million reduction in earned premiums for products which the Company exited in 2004, primarily small guaranteed cost accounts and large construction wrap up accounts. Partially offsetting these decreases was $15.1 million in additional earned premiums from loss sensitive risk management accounts. The $15.1 million is net of $16.6 million of return premium on retrospectively rated policies. Earned premiums from the HCC directors and officers programs accounted for $5.5 million in 2005, $14.7 million in 2004, and $4.0 million in 2003.
Net investment income increased to $31.9 million for the year ended December 31, 2005, compared to $29.9 million and $27.3 million for the years ended December 31, 2004 and 2003, respectively, primarily due to higher invested assets coupled with increased yields. Invested assets as of December 31, 2005 were $743.4 million, compared to $657.5 million as of December 31, 2004 and $709.0 million as of December 31, 2003. The decline in invested assets in 2004 as compared to 2003 was primarily attributable to claim payments.
For the year ended December 31, 2005, the run-off segment incurred an underwriting loss of $12.5 million, compared to underwriting losses of $0.0 million and $12.7 million for the same periods of 2004 and 2003, respectively (see discussion below).
Argonaut Insurance also assumed risk as a reinsurer for a limited period of time, primarily for the period from 1970 to 1975, a portion of which was assumed from the London market. Argonaut Insurance also reinsured risks on policies written by domestic carriers. Such reinsurance typically provided coverage for limits attaching at a relatively high dollar amount which are payable only after other layers of reinsurance are exhausted. Some of the claims now being filed on policies reinsured by Argonaut Insurance are on behalf of claimants who may have been exposed at some time to asbestos incorporated into buildings they occupied, but have no apparent medical problems resulting from such exposure. Additionally, lawsuits are being brought against businesses that were not directly involved in the manufacture or installation of materials containing asbestos. The Company believes that claims generated out of this population of claimants may result in incurred losses generally lower than the asbestos claims filed over the past decade and could be below the attachment level of Argonaut Insurance.
Index to Financial Statements 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. As of December 31, 2005 and 2004, the Company recorded reserves are within 2% of the best estimate provided by the consulting actuary.
Index to Financial Statements New claims in the reinsurance assumed categories are primarily the result of the Company typically providing coverage for higher limits which are payable only after other layers of reinsurance are exhausted. Additionally, there tend to be long delays in the ceding companies reporting claims to the reinsurers.
The following table represents gross payments on asbestos and environmental claims for each of the years in the three-year period ended December 31, 2005.
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 on 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, payrolls 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.
Index to Financial Statements For the year ended December 31, 2005, net cash provided by operating activities was $331.0 million, compared to $122.9 million for the year ended December 31, 2004 and $182.2 million for the year ended December 31, 2003. 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, reduced tax payments, increased investment income and the collection of a disputed receivable of $45.0 million. The decrease in cash flows from operations in 2004 as compared to 2003 was primarily attributable to a slower growth rate in gross written premiums, coupled with an increase in claims payments in the run-off lines (see “Results of Operation - Run-off lines on pages 34 - 37).
During the first quarter of 2003, the Board of Directors suspended the payment of dividends to common shareholders to support the capital needs of the Company. Cash dividends paid to preferred shareholders totaled $2.2 million, $2.5 million and $1.2 million for the years ended December 31, 2005, 2004 and 2003, respectively.
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 rate 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.
Index to Financial Statements 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, currently 16.0%, 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.
During 2004, the Company entered into a $25 million Credit Facility (the “Revolver Facility”) with LaSalle Bank National Association as Administrative Agent and various other financial institutions as lenders. This Revolver Facility was arranged to meet working capital needs of the Company. The Revolver Facility provides for interest at a variable interest rate based on LIBOR plus a margin ranging from 200 to 250 basis points, as determined by the underlying leverage ratio (debt to total capitalization) of the Company. As of December 31, 2005, no borrowing capacity had been utilized under the Revolver Facility agreement. The Revolver Facility expires on September 22, 2006, and is thereafter renewable on an annual basis. The facility has four significant covenants, including (i) the ratio of total funded debt to total capitalization; (ii) the level of the Company’s consolidated net worth; (iii) interest coverage ratios; and (iv) RBC ratios of the key operating units. The Company is in compliance with all financial covenants of the Revolver Facility as of December 31, 2005.
The Company invests excess cash in a variety of investment securities. As of December 31, 2005, the Company’s investment portfolio consisted of 77.1% fixed maturities, 9.2% equities, 1.1% other long-term investments and 12.6% short-term investments, compared to 82.4% fixed maturities, 10.2% equities, 1.1% other long-term investments and 6.3% short-term investments for the same period in 2004. 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, 2005, the Company had no investment in any one security that exceeded 10% of shareholders’ equity.
Index to Financial Statements The Company’s insurance subsidiaries require liquidity and adequate capital to meet ongoing obligations to policyholders and claimants, and to fund operating expenses. During the three years ended December 31, 2005, the Company’s liquidity generated from operations and investment income were sufficient to meet obligations. Adequate levels of liquidity and surplus are maintained to manage the risks inherent with any differences between the duration of its liabilities and invested assets. The Company believes it maintains sufficient liquidity to pay claims and expenses, as well as satisfy its commitments in the event of unforeseen events such as reinsurer insolvencies, inadequate premium rates, or reserve deficiencies.
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, 2005, 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.
Credit risk is a major factor of the overall enterprise risk within the Company, and the Company has established policies and procedures to evaluate the Company exposure, particularly as respects its investment holdings, and its receivable balances from insureds and reinsurers.
The Company is also exposed to credit risk on losses recoverable from reinsurers and premiums receivable from insureds. Downturns in one sector or market can adversely impact other sectors and may result in higher credit exposure. The Company does not utilize credit default swaps to mitigate its credit exposure from either investments or counterparties.
The pension plan measurement date for purposes of the consolidated financial statements is December 31. The market-related value of plan assets is determined based on their fair value at the measurement date. The projected benefit obligation is determined based on the present value of projected benefit distributions at an assumed discount rate. The discount rate used reflects the rate at which management believes the pension plan obligations could be effectively settled at the measurement date, as though the pension benefits of all plan participants were determined as of that date. At December 31, 2005, the Company used the following assumptions: a discount rate of 5.5% and an expected rate of return on plan assets of 5.5%.
The Company’s current investment strategy is to invest in U.S. Government Agency securities and minimize exposure to the equity market. Management believes this strategy will result in above average short term yields while protecting the portfolio from rising interest rates. As of December 31, 2005, the investment mix of the pension portfolio was 86% U.S Government agencies and 14% short term investments. The fair market value of the investment portfolio as of December 31, 2005 was $28.2 million and included net unrealized losses of $0.5 million.
Effective November 2003, the Company curtailed the pension plan. This curtailment resulted in a reduction of pension expense of $3.9 million, which was recognized in the results of operations for the year ended December 31, 2003. During 2004, the Company did not incur any pension expense. During the year ended December 31, 2005, the Company incurred pension expense of $0.6 million, primarily resulting from current year benefit payments in excess of interest earned. As of December 31, 2005, the Company has a prepaid pension asset of approximately $6.9 million. The projected pension obligation as of December 31, 2005 was $22.4 million. Due to the curtailment in 2003, all participants were vested as of February 2004. Based on the current funding status of the pension plan, the effects of the curtailment, the expected changes in pension plan asset values and pension obligations in 2005, the Company does not believe any significant funding of the pension plan will be required during the year ended December 31, 2006. Management is evaluating formal termination of the pension plans. Termination of the plan may result in additional expense being incurred by the Company. However, as of this time, management is unable to estimate the additional expense, if any.
David Hartoch. Swett & Crawford is one of the largest wholesale insurance brokers in the country, placing nearly $2.6 billion in premium volume in their most recent fiscal year. 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. During 2005, the Company, through its E & S segment, wrote $28.8 million in premiums through Swett & Crawford. Swett & Crawford earned $5.3 million in commissions on this business.
Allan W. Fulkerson. Century Capital Management, LLC (“CCML”), a successor to Century Capital Management, Inc., is the Investment Advisor to two partnerships (Century Capital Partners II, L.P. and CCPIII) that collectively hold a majority ownership interest in Asset Allocation & Management Company, L.L.C. (“AAM”). Allan W. Fulkerson, who is a member of
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, 2005, AAM managed $742 million of the Company’s investments. The Company paid AAM $0.6 million for services provided in 2005, which constituted less than 5% of AAM’s consolidated gross revenues for 2005. It is anticipated that for calendar year 2006 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.
On March 31, 2003, Colony Insurance Company entered into a quota share reinsurance agreement with HCC. For the year ended December 31, 2005, the Company ceded approximately $66.0 million of gross written premiums, $64.6 million of earned premiums and $35.6 million of losses and loss adjustment expenses. The Company earned a ceding commission of $13.2 million.
Effective January 1, 2003, Argonaut Insurance entered into a quota share reinsurance agreement with HCC. Under the original terms of the agreement, the Company assumed 3.33% of the premiums and losses under HCC’s USA Directors and Officers Liability program, and 5.0% of the premiums and losses under HCC’s International Directors and Officers Liability program. Effective January 1, 2004, the percentage assumed by the Company was reduced to 1.5%, and was renewed in 2005. For the year ended December 31, 2005, gross written premiums under this program totaled $6.4 million, earned premiums totaled $5.5 million and losses totaled $3.5 million. For the year ended December 31, 2005, the Company expensed ceding and other commissions of $2.0 million related to this business. The Company committed to renew this agreement in 2006 with 3.0% participation effective January 1, 2006.
(1) Interest only due on Junior Subordinated Debentures through 2008. Interest calculated based on rate in effect at December 31, 2005. Principal due beginning May 2033.
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 47.
Through its subsidiary, Rockwood, the Company has exposure to claims for black lung disease. Those diagnosed with black lung disease are eligible to receive workers’ compensation benefits from various federal and state programs. These programs are continually being reviewed by the governing bodies and may be revised without notice in such a way as to increase the level of the Company’s exposure. Reserves for losses are maintained for these exposures and, in management’s opinion, adequately cover the Company’s risk.
Through its subsidiary, Rockwood, the Company has exposure to claims from lead paint on general liability policies written for certain public housing authorities from the mid 1980’s to the mid 1990’s. Management believes it has recorded its best estimate of the expense related to this exposure based on the trends and facts currently known.
Management believes that the aggregate loss reserves at December 31, 2005 were adequate to cover claims for losses that have occurred, including both known claims and claims yet to be reported. In establishing these reserves, management considers facts currently known and the present judicial and legislative environment. However, given the expansion of coverage and liability by the courts and the legislatures in the recent past and the possibility of similar interpretations in the future, particularly with regard to asbestos and environmental claims, additional loss reserves may develop in future periods. These potential increases cannot be reasonably estimated at the present time. Any increases could have an adverse impact on future operating results, liquidity, risk-based capital ratios and the ratings assigned to the insurance subsidiaries by the nationally recognized insurance rating agencies.
Index to Financial Statements Deferred Tax Assets and Liabilities. Deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities. Deferred tax liabilities are recognized for temporary differences that will result in taxable amounts in future years. Deferred tax assets are recognized for deductible temporary differences and tax operating loss and tax credit carryforwards. The deferred tax assets and liabilities are measured by applying the enacted tax rates and laws in effect for the years in which such differences are expected to reverse. The components of the Company’s deferred tax asset are temporary differences primarily attributable to loss reserve discounting and unearned premium reserves. The Company’s deferred tax liabilities resulted primarily from unrealized gains in the investment portfolio.
The Company will estimate 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.