We segregate our business into insurance operations and other, with the insurance operations being further classified into four segments: excess and surplus lines (E&S), alternative risk transfer (ART), assumed reinsurance (Assumed Re) and runoff. E&S is further classified into seven business lines: environmental, construction, products liability, excess, property, surety and healthcare. ART is further classified into two business lines: specialty programs and fully funded. In our Assumed Re segment, the Company assumes specialty property and casualty business from affiliated and unaffiliated insurers and reinsurers. Run-off includes lines of business that we no longer write.
Within the E&S sub segment, our environmental insurance coverages protect against general liability and environmental exposures for contractors and consultants in the environmental remediation industry and property owners. Construction provides commercial general liability insurance, generally for residential and commercial contractors. Products liability offers general liability and product liability coverages for smaller manufacturers and distributors, non-habitational real estate and certain real property owner, landlord and tenant risks. Excess provides excess and umbrella liability coverages over our own and other carriers’ primary casualty polices, with a focus on construction risks. Our property coverage encompasses non-standard, surplus lines commercial property business and commercial multi-peril (CMP) policies. The casualty focus of our CMP products is premises liability. Surety provides payment and performance bonds primarily to the environmental remediation and construction industries. Our healthcare line provides customized liability insurance solutions for long-term care facilities.
Our assumed reinsurance segment offers primarily casualty reinsurance products in the form of treaty and facultative contracts. We provide this coverage on an excess of loss and quota share basis. Casualty business includes general casualty, commercial auto, professional liability and workers’ compensation. The Company’s primary focus is traditional and structured reinsurance for small specialty insurers, risk retention groups and captives.
Net earnings for the year ended December 31, 2008 were $0.3 million, or $0.03 per diluted share, compared to net earnings of $28.2 million, or $2.56 per diluted share, for 2007. Net earnings for 2008 were negatively impacted by $14.3 million of net realized losses on investments, $5.4 million of prior year adverse reserve development, $1.6 million reinsurance reinstatement premium and a $2.5 million provision to increase the valuation allowance on reinsurance recoverables. The 2007 results were negatively impacted by $2.2 million of prior year reserve development and $2.3 million of additional ceded reinsurance.
Net premiums earned totaled $174.5 million in 2008, compared to $148.8 million in 2007, an increase of 17.3%. Net premiums earned by line of business are described below:
Construction. Net premiums earned decreased 43.8% to $37.4 million for the year ended December 31, 2008 compared to $66.5 million for 2007, primarily due to our exercise of underwriting discipline in a soft insurance market, coupled with the softening in the housing market and lower revenue of insureds. The housing market has been negatively impacted by the credit crisis and economy resulting in very little new construction activity throughout the country.
Products Liability. The Company’s products liability line began production in July 2006 producing $5.0 million of net premiums earned in 2008 compared to $2.4 million in 2007. The products liability business is offered to small and middle market accounts. The Company does not intend to write certain high severity classes of risks such as invasive medical products, pharmaceuticals and nutraceuticals.
Excess. Net premiums earned increased to $0.8 million for the year ended December 31, 2008 from $0.5 million for the same period in 2007. The Company’s excess product offering is focused primarily in the construction and products liability area. During 2006, we expanded our product to write over other carriers’ primary policies and to offer umbrella liability coverage. In 2007, the Company increased the available policy limits to $10 million.
Property. In 2007, the Company hired an experienced underwriting team to write property and CMP liability coverage with a focus on fire exposed premises liability risks with limited catastrophe exposure, primarily in the eastern United States. For the year ended December 31, 2008, net premiums earned from the property business line was $4.9 million compared to $0.5 million in 2007.
Healthcare. The Company continued its diversification strategy in 2008 through the acquisition of 100% of the membership interests of LTC Risk Management, LLC and LTC Insurance Services, LLC (“LTC Group”). The LTC Group, now known as ASI Healthcare, provides insurance and risk management solutions for the long-term care industry. Net premiums earned for the period ended December 31, 2008 were $3.6 million.
Specialty Programs. Net premiums earned increased 39.5% to $38.7 million for the year ended December 31, 2008 compared to $27.7 million for 2007. Net premiums earned increased primarily due to the full year impact of the July 1, 2007 casualty reinsurance treaty that increased retention levels on selected programs increasing its earnings potential from underwriting profits. During 2008, the Company added four (4) new programs and had fifteen (15) active programs as of December 31, 2008 compared to twelve (12) active programs at December 31, 2007. The Company’s focus on its specialty programs business line is on insurance programs that allow the Company to participate in underwriting profits, while also earning fee income as the policy issuer.
Payroll and other underwriting expenses increased 25.6% to $33.9 million for 2008, compared to $27.0 million for 2007. The increase is due to normal salary increases, increased headcount primarily from the addition of new product lines and acquisitions added with the Company’s product diversification strategy, the increase in the allowance established for reinsurance recoverables and higher depreciation, amortization and software maintenance expenses.
Interest expenses decreased to $3.2 million for the year ended December 31, 2008 from $3.3 million for 2007. The decrease was primarily related to lower interest rates experienced in 2008.
Net earnings increased 37.3% to $28.2 million for the year ended December 31, 2007, compared to $20.5 million for 2006. Total revenues increased 5.6% to $181 million, as net premiums earned increased 1.4% to $148.8 million and net investment income increased 39.1% to $30.3 million. The increase in net investment income related to a 20.9% increase in average invested assets and a 13.3% increase in the
average yield to 5.1%. Net realized losses on the investment portfolio before taxes were $311,000 compared to a gain of $1.2 million in 2006.
The 2007 combined ratio was 97.4% composed of a loss ratio of 61.3% and an expense ratio of 36.1%. Unfavorable reserve development for the year totaled $2.2 million, increasing the loss ratio by 1.5 percentage points. The 2006 combined ratio was 97.5% composed of a loss ratio of 62.9% and an expense ratio of 34.6%. The 2006 combined ratio was impacted by unfavorable reserve development of $2.6 million and reinsurance reinstatement premiums of $3.7 million.
The property and casualty insurance market has softened significantly and the number of insurers competing for premium in the excess and surplus lines market has increased. These competitors include several start-up companies as well as larger excess and surplus lines and standard market insurers looking to capture market share by moving from the admitted market to the excess and surplus lines market. This increased competition has caused rates to decline in our targeted markets, in some cases, significantly. Despite this softening trend, we believe there are profitable growth opportunities from which we can benefit, resulting from our diversification into new geographic locations and lines of business.
Excess. Net premiums earned remained relatively level at $0.5 million for the year ended December 31, 2007. The Company’s excess product offering is focused primarily in the construction and products liability area. During 2006, we expanded our product to write over other carriers’ primary policies and to offer umbrella liability coverage. In 2007 the Company increased the available policy limits to $10 million.
Specialty Programs. Net premiums earned increased 44.1% to $27.7 million for the year ended December 31, 2007 compared to $19.3 million for 2006. Net premiums earned increased primarily due to increased retention levels on selected programs thereby allowing the Company the opportunity to increase its earnings potential from underwriting profits. During 2007 the Company added 3 new programs and had 11 active programs as of December 31, 2007. The Company’s focus on its specialty programs business line is on insurance programs that allow the Company to participate in underwriting profits, while also earning fee income as the policy issuer.
The Company began writing third party assumed reinsurance in 2007. Treaties written in 2007 include professional liability for accountants and lawyers, general liability for small grocery stores, auto liability, international and domestic D&O and small participation in an international property/catastrophe treaty. Net earned premium for the year ended December 31, 2007 totaled $9.4 million.
Fee income earned on fully funded polices increased 27.3% to $2.1 million for the year ended December 31, 2007 compared to $1.7 million for 2006. The Company has seen some adverse impact from the overall market softening on its production efforts in this line as traditional insurance provides a cost effective alternative to self-insurance.
Losses and loss adjustment expenses totaled $91.2 million or 61.3% of net premiums earned for the year ended December 31, 2007 compared to $92.3 million and 62.9% in 2006. Due to the impact of rate decreases in the soft insurance market, the Company increased its accrued losses in its environmental line for the 2007 accident year from 53% in 2006 to 63% in 2007.
Payroll and other underwriting expenses increased to $27.0 million for the year ended December 31, 2007 from $25.0 million for 2006. The change is primarily due to an increased number of employees which was 178 at December 31, 2007 compared to 145 at the same date 2006.
Interest expense decreased to $3.3 million for the year ended December 31, 2007 from $3.4 million for 2006.
Corporate and other expenses were $3.0 million and $2.3 million for the periods ended December 31, 2007 and 2006 respectively.
Income tax expense totaled $0.7 million or 2.6% of pre-tax earnings for the year ended December 31, 2007, compared to $2.3 million or 10.1% of pre-tax earnings for 2006. The reduction in expense is primarily the result of the prior year reserve development which reduced taxable income in our U.S. subsidiaries. Included in tax expense for 2006, is the establishment of a valuation allowance for American Safety RRG of $1.1 million and 2005 provision to return adjustments for permanent differences in the 2005 federal and state income tax returns of $483,000. The establishment of the valuation allowance is reflected in minority interest on the consolidated financial statements. Absent these adjustments, the effective tax rate for 2006 would have been 5.1%. The reduction in the effective rate is due to lower earnings from U.S. operations from the impact of reinstatement premiums and prior-year loss development.
Net Income. Net income from Bermuda operations increased to $26.2 million for the year ended December 31, 2007, compared to $17.0 million for 2006, due to higher investment income as a result of increased invested assets from our $53.0 million secondary offering in 2006 and the addition of the third party assumed reinsurance business in 2007. Net income from U.S. operations decreased to $2.0 million for the year ended December 31, 2007, compared to $3.5 million for 2006, primarily due to prior year loss development and accrued ceded reinsurance reinstatement premium.
Level 2: inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the instrument
Change in net unrealized gains relating to assets still held at reporting date
The Company meets its cash requirements and finances its growth principally through cash flows generated from operations. Due to the soft market, the Company has experienced a reduction in premium rates due to the entrance of new insurance competitors and overall market conditions. The Company’s primary sources of short-term cash flow are premium writings and investment income. Short-term cash requirements relate to claims payments, ceded reinsurance premiums, commissions, salaries, employee benefits and other operating expenses. Due to the uncertainty regarding the timing and amount of settlements of unpaid claims, the Company’s future liquidity requirements may vary; therefore, the Company has structured its investment portfolio maturities to help mitigate the variations in those factors. The Company believes its current cash flows are sufficient for the short-term needs of its business and its invested assets are sufficient for the long-term needs of its insurance business.
Net cash used in financing activities was $7.1 million for the year ended December 31, 2008. The use of cash was due to the repurchase of 472,700 shares of the Company’s common stock for $7.3 million, or a weighted average price of $15.41 partially offset by funds received from stock option exercises of $0.5 million. During the corresponding 2007 period, there were stock option exercises of $1.5 million and 27,300 share repurchases of the Company’s stock for $0.5 million, or a weighted average price of $18.75.
Our ability to pay future dividends to shareholders will depend, to a significant degree, on the ability of our subsidiaries to generate earnings from which to pay dividends. The jurisdiction in which we and our insurance and reinsurance subsidiaries are domiciled places limitations on the amount of dividends or other distributions payable by insurance companies in order to protect the solvency of insurers. Given our growth and the capital requirements associated with that growth, we do not anticipate paying dividends on the common shares in the near future.
Our contractual obligations (in thousands of dollars) as of December 31, 2008 were:
(2) The above table includes the expected settlement of our gross loss reserves. The Company relies on reinsurance to reduce current risk exposures. The expected payoff of gross loss reserves net of reinsurance recoverables is as follows (dollars in thousands): total $393,309; $100,923 less than a year, $215,140, 1-3 years, $35,123, 3-5 years and $42,123, more than 5 years. More information about our unpaid loss and loss adjustment expenses appears in Note 13 to our consolidated financial statements.
For these purposes, routine purchases of services, including insurance, that are expected to be used in the ordinary course of the Company’s business have been excluded. More information about our contractual obligations appears in Notes 9 and 12 to our consolidated financial statements.
Investments. We routinely review our investments that have experienced declines in fair value to determine if the decline is other than temporary. These reviews are performed with consideration of the facts and circumstances of an issuer in accordance with the Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 59, Accounting for Non-Current Marketable Equity Securities; Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities; and Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments; FASB Staff Position No. FAS 115-1 and related guidance. The identification of
distressed investments and the assessment of whether a decline is other than temporary, involve significant management judgment and require evaluation of factors including but not limited to:
The Company had impairment charges of $7.7 million and $1.4 million realized loss due to the sale of investments in the third quarter and $6.0 million in the fourth quarter of 2008. The Company in conjunction with its investment advisor, monitors its investments for potential impairments. See “Business-Investments” for information as to the credit quality of its investment portfolio. At December 31, 2008, 94.5% of the investment portfolio was rated A or better by S&P and Moody’s, with 54.1% being rated AAA.
Level 1: quoted price (unadjusted) in active markets for identical assets
Level 3: inputs to the valuation methodology are unobservable for the asset or liability
SFAS 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.
Reserves. Claims made policies provide coverage for claims that are incurred and reported during the policy period. Occurrence form policies provide coverage for claims that occur during the policy period regardless of when they are reported. Certain of our insurance policies and reinsurance assumed are occurrence policies and therefore may be subject to claims brought years after an incident has occurred or the policy period has ended. We are required to maintain reserves to cover the unpaid portion of our ultimate liability for losses and loss adjustment expenses with respect to (i) reported claims and (ii) incurred but not reported (IBNR) claims. A full actuarial analysis is performed annually to estimate all of our unpaid losses and loss adjustment expenses under the terms of our contracts and agreements. In evaluating whether the reserves are adequate for unpaid losses and loss adjustment expenses, it is necessary to project future losses and loss adjustment expenses payments. It is certain that the actual future losses and loss adjustment expenses will not develop exactly as projected and may, in fact, vary materially from the projections.
The Company does not write a material amount of short-tail business. Short-tail business is defined as business for which claims are received and settled within one year. Total net reserves for short tail business are not material and as of December 31, 2008 were approximately 1.4% of total net reserves. In the aggregate, our primary long-tail lines are construction, where we offer general liability insurance to construction contractors and environmental where we offer general liability and professional liability insurance to environmental contractors and consultants.
Because the Company primarily writes long-tail business, the current year ultimate loss reserve is developed using the expected loss ratio method. The method is appropriate because there are very few claims reported from the most recent accident year for long-tail lines of business. The expected loss ratio is determined based on the review of the projected ultimate loss ratios for the prior accident years. At December 31, 2008 the carried loss and loss adjustment reserves for accident years prior to 2008 were determined largely based on the indications produced by the Bornhuetter-Ferguson method because of the additional claims experience gained as the business line matures.
On a quarterly basis, the Company’s in-house internal actuary performs a review of our major lines of business with significant net exposure. The evaluation entails the examination of our current actuarial assumptions compared to actual claim activity. If there is a material deviation from actual emerged losses and the actuarially determined expected losses, further research is completed to determine the cause. Discussions with the claims staff and the underwriting staff about these deviations, in some cases, reveal trends that warrant modifications of the current assumptions about loss development patterns and or expected loss ratios. Based on these latest loss reserve projections, management establishes revised estimates of loss reserves primarily due to increased paid case reserves related to accident years 2002 through 2006 for environmental contractor business written in New York, as well as increases in the runoff line related to increased estimates of workers’ compensation claims related to site cleanup activities following the terrorist attack in New York on 9/11. In 2008, the Company decided to exit the New York contractor business. The adverse development is partially offset by decreases in specialty programs primarily related to the pest control program.
(2) Represents 33 different programs with diverse risks. Some programs are in runoff.
(2) Represents 30 different programs with diverse risks. Some programs are in runoff.
The following table displays the resulting range of potential deviation of the net carried reserves for each line of business at December 31, 2008 (in thousands of dollars):
(1) Represents 33 different programs with diverse risks. Some programs are in runoff. Each individual program is not material to our total net carried reserves therefore no variability has been shown.
Effective September 1, 2008 the Company renewed its excess of loss reinsurance treaty on our casualty lines of business. The cost of the reinsurance provided by the renewal varies based on premium and the area of coverage. The renewal provides four areas of coverage on essentially an as expiring basis, summarized as follows:
Casualty Lines - $4.5 million excess of $500,000, covering all casualty lines other than surety, commercial umbrella and excess. The treaty also provides excess coverages of $6.0 million excess of $5.0 million atop the environmental lines layer with 100% of the risk ceded to the reinsurers.
Effective September 1, 2008, the Company renewed the treaty providing protection from claims associated with bad faith allegations, improper claims handling and multiple insured being involved in the same occurrence. This reinsurance provides limits of $5.0 million per occurrence, subject to an aggregate limit of $15 million.
Effective September 1, 2007 the Company entered a consolidated property reinsurance treaty providing $10 million of limits with a $500,000 per occurrence retention by the Company. The treaty also provides protection for multiple losses arising out of one occurrence, with limits totaling $20.5 million across all layers. Loss adjustment expense is provided on a prorated basis in addition to the treaty limits shown above. The renewal date of this has been extended to April 1, 2009.
We are incorporated under the laws of Bermuda and, under current Bermuda law, are not obligated to pay any taxes in Bermuda based upon income or capital gains. We have received an undertaking from the Minister of Finance in Bermuda pursuant to the provisions of the Tax Protection Act, which exempts us and our shareholders, other than shareholders ordinarily resident in Bermuda, from any Bermuda taxes computed on profits, income or any capital asset, gain or appreciation, or any tax in the nature of estate, duty or inheritance until March 28, 2016. Exclusive of our U.S. subsidiaries, we do not consider ourselves to be engaged in a trade or business in the U.S. and accordingly do not expect to be subject to direct U.S. income taxation. Our U.S. subsidiaries are subject to taxation in the U.S.
In July 2006, the FASB issued a Staff Position Number FIN 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement Number 109, Accounting for Income Taxes. This interpretation prescribes a recognition threshold and measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.