The Company currently leases its corporate offices in Southfield, Michigan from an unaffiliated third party. In 2003, the Company paid rent for its corporate offices in the amount of approximately $1.3 million. The term of the lease for the offices in Southfield expires on September 30, 2004. The Company, through its subsidiaries, is also a party to various leases for locations in which such subsidiaries have offices. The Company does not consider any of these leases to be material.
In 1998, Star purchased land in close proximity to its existing offices. The cost of the land was $3.2 million. On September 30, 2003, the Company purchased the land from Star at fair market value.
On December 3, 2003, the Company entered into a Development Agreement with an unaffiliated third party for the construction of an office building on the above mentioned land for a contract price of $11.0 million. The office building will serve as the new location for the Company’s corporate offices. The office building will consist of approximately 72,000 gross square feet.
Both the loss and loss adjustment expense ratios are calculated based upon unconsolidated insurance company operations. Certain intercompany costs directly related to policy acquisition and other underwriting expenses are classified as salary and employee benefit expenses in the consolidated financial statements. The following table sets forth the intercompany fees, which are eliminated in consolidation.
The cumulative effect of the change in accounting principle in 1999 reflects the adoption of SOP 97-3, “Accounting by Insurance and Other Enterprises for Insurance - Related Assessments.”
On June 6, 2002, the Company sold 18,500,000 shares of newly issued common stock at $3.10 per share in a public offering. On June 21, 2002, the underwriters exercised their over-allotment option to acquire 2,775,000 of additional shares of the Company’s common stock. After deducting underwriting discounts, commissions, and expenses, the Company received net proceeds from the offering of $60.5 million. The Company utilized $57.5 million of the $60.5 million raised in its public offering to pay down its line of credit by $20.0 million and to contribute $37.5 million to the surplus of Star.
The specialty risk management operations segment focuses on specialty or niche insurance business in which the Company provides various services and coverages that are tailored to meet the specific requirements of defined client groups and their members. This includes, but is not limited to, providing services, such as risk management consulting, claims administration and handling, loss control, and reinsurance brokering, along with various types of property and casualty insurance coverage, including workers’ compensation, commercial multiple peril, general liability, commercial auto liability, and inland marine. Insurance coverage is provided primarily to associations or similar groups of members and to specified classes of business of the Company’s agent-partners. The Company recognizes revenue related to the services and coverages the specialty risk management operations provides within seven categories: net earned premiums, management fees, claims fees, loss control fees, reinsurance brokerage, investment income, and net realized gain (loss) on investments.
The Company categorizes its programs into three categories: managed, risk-sharing, and fully insured. In managed programs, the Company earns service fee revenue by providing management and other services to a client’s risk-bearing entity, but generally does not share in the operating results. In risk-sharing programs, the Company participates with the client or producing agent in the operating results of the programs through the utilization of a captive, rent-a-captive or similar insured vehicles, which are reinsurance companies and are accounted for under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts”. In risk-sharing programs, the Company derives revenues from net earned premiums, fee revenue and commissions, and investment income. In addition, the Company may benefit from any margin built into the ceding commissions for services it renders on behalf of the risk-sharing partner for the program. In fully insured programs, the Company provides commercial insurance coverage and derives revenue from net earned premiums and investment income. Fully-insured programs are developed in response to a specific market opportunity and generally when the Company believes there is potential to subsequently create a risk-sharing program.
The Company earns commissions through the operation of its retail property and casualty insurance agency, which was formed in 1955. The agency has grown to be one of the largest agencies in Michigan and, with acquisitions, has expanded into California. The agency operations primarily produce commercial insurance, as well as personal property, casualty, life and accident and health insurance, with more than fifty insurance carriers.
The revenue included in reconciling items relates to interest income in the holding company.
upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding each claim and the policy provisions relating to the type of losses. The estimate reflects the informed judgment of such personnel based on general insurance reserving practices, as well as the experience and knowledge of the claims person. Until the claim is resolved, these estimates are revised as deemed necessary by the responsible claims personnel based on subsequent developments and periodic reviews of the claims.
During the three years ended December 31, 2001, 2000, and 1999, the Company took actions to eliminate a limited group of unprofitable programs that were not aligned with its alternative risk management strategy. The Company also established strict corporate program guidelines that identify the following criteria as unacceptable:
The underwriting losses associated with these programs were $12.8 million, $29.0 million, and $12.0 million, for the years ended December 31, 2001, 2000, and 1999, respectively. All premiums related to these programs were fully earned during the first half of 2002. In addition, at December 31, 2003, the uncertainty of future reserve development on these discontinued programs appears to have been reduced as a result of aggressive claims handling and reserve strengthening. While the Company believes it has adequate reserves, there can be no assurances that there will not be additional losses in the future related to these programs.
At December 31, 2003 and 2002, the net goodwill was $29.0 million. Amortization expense in relation to goodwill in 2001 was $2.3 million. In accordance with SFAS No. 142, there was no amortization expense recorded in relation to goodwill in 2003 or 2002.
Also during the first quarter of 2003, the Company completed an asset purchase related to the renewal rights of a book of business. The total purchase price of this agreement was determined based on a percentage of estimated gross written premium collected by the Company. The actual purchase price is contingent upon actual written premium collected over a three year period. As of December 31, 2003, the total purchase price was estimated at $2.3 million, consisting of $1.3 million of fixed assets and $994,000 recognized as an other intangible asset being amortized over a five year period.
At December 31, 2003 and 2002, the gross carrying amount of other intangible assets was $1.8 million and $221,000, respectively, and the accumulated amortization was $368,000 and $15,000, respectively. Amortization expense related to other intangible assets was $353,000 for 2003 and $15,000 for 2002. Amortization expense for the five succeeding years is as follows (in thousands):
As of December 31, 2003 and 2002, gross unrealized gains on available for sale securities were $12.2 million and $13.5 million, respectively.
The Company’s investment portfolio is primarily invested in debt securities classified as available for sale, with a concentration in fixed income securities of a high quality. The Company’s investment philosophy is to maximize after-tax earnings and maintain significant investments in tax-exempt bonds. The Company’s policy for the valuation of temporarily impaired securities is to determine impairment based on analysis of the following factors: market value less than amortized cost for a six month period; rating downgrade or other credit event, e.g., failure to pay interest when due; financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology or discontinuance of a business segment; prospects for the issuer’s industry segment; and intent and ability of the Company to retain the investment for a period of time sufficient to allow for anticipated recovery in market value. The Company evaluates its investments in securities to determine other than temporary impairment, no less than quarterly. Investments which are deemed impaired are written down to their estimated net realizable value and the related losses recognized in income.
In 2003, the Company reported consistent, profitable financial results and continued to achieve operational efficiencies and enhancements.
Since raising capital in June 2002, the Company remained focused on a systematic deployment of the proceeds with controlled growth of historically profitable underwriting programs. The Company successfully integrated new fee-for-service agreements and $70.0 million, or 38%, growth in gross written premiums. This growth in gross written premiums is related to programs which have long-term statistically proven profitable experience and, for which, the Company has the underwriting expertise. With this growth, the Company has leveraged fixed costs, and maximized statutory surplus and cash flows.
The Company’s combined ratio improved 4.2 percentage points to 104.4% in 2003 from 108.6% in 2002. This improvement is the result of continued rate increases, the growth of fee-for-service contracts, and on-
going expense control initiatives. These efforts have allowed for growth with a limited increase in fixed costs, thus improving profit margins and return on equity.
Results from operations improved $8.4 million from a net income of $1.7 million, or $0.08 per diluted share, in 2002 to net income of $10.1 million, or $0.35 per diluted share, in 2003. This improvement reflects the addition of new fee-for-service agreements, the absence of reserve strengthening on discontinued programs, and continued expense controls. The new fee revenue and expense controls have allowed the Company to leverage its fixed costs. This improvement in net income also reflects the impact of rate increases achieved in 2003 and 2002 of 13.6% and 15.7%, respectively.
Results from operations improved $8.2 million from a net loss of ($6.5) million, or ($0.76) per dilutive share, in 2001 to net income of $1.7 million, or $0.08 per dilutive share, in 2002. This improvement reflects the impact of the run-off of the previously mentioned unprofitable discontinued programs, an overall shift in the mix of business towards the workers’ compensation line of business, and the impact of rate increases achieved in 2002 and 2001 of 15.7% and 18.2%, respectively. The workers’ compensation line of business had an accident year loss ratio of 67.4% in 2002 and represented 55.6% of net earned premium in 2002, compared to 42.4% of net earned premium in 2001. This improvement is the result of the continuing rate increases and expense management initiatives, which included reductions in salary and benefit levels. This improvement is also the result of the elimination of amortization of goodwill, which was $2.3 million in 2001.
Revenues from specialty risk management operations increased $17.9 million, or 9.8%, to $201.6 million for the year ended December 31, 2003, from $183.7 million for the comparable period in 2002.
Net earned premiums increased $5.8 million, or 4.0%, to $151.2 million in the year ended December 31, 2003, from $145.4 million in the comparable period in 2002. This increase reflects net earned premiums on
Management fees increased $6.0 million, or 46.9%, to $18.8 million from $12.8 million for the comparable period in 2002. This increase in management fees reflects revenue from new fee-for-service agreements of $5.6 million. The remaining increase is the result of an overall net increase in management fees within the Company’s existing managed programs.
Claim fees increased $6.7 million, or 82.7%, to $14.8 million from $8.1 million for the comparable period in 2002. This increase in claim fees reflects revenue from new fee-for-service agreements of $9.0 million. As anticipated, as this claims fee-for-service agreement expires, the related revenue will decrease. This increase is partially offset by a decrease in discontinued programs and the impact of the conversion of an existing fee-based program into an insured program within the Company’s underwriting subsidiary. Those fees are now intercompany fees and are eliminated in consolidation.
Loss control fees decreased $287,000, or 11.1%, to $2.3 million from $2.6 million for the comparable period in 2002. This decrease is mainly the result of the previously mentioned conversion of an existing fee-based program into an insured program within the Company’s underwriting subsidiary.
Specialty risk management operations generated a pre-tax income of $10.8 million for the year ended December 31, 2003 compared to a pre-tax loss of ($1.1) million for the comparable period in 2002. This improvement reflects the favorable impact of the previously indicated fee-for-service agreements and improved underwriting results. The generally accepted accounting principles (“GAAP”) combined ratio was 104.4% for the year ended December 31, 2003, compared to 108.6% for the comparable period in 2002.
Net loss and LAE decreased $262,000, or 0.3%, to $98.5 million for the year ended December 31, 2003, from $98.7 million for the same period in 2002. The Company’s loss and LAE ratio decreased by 2.0 percentage points to 70.1% for the year ended December 31, 2003, from 72.1% for the same period in 2002. This ratio is the unconsolidated net loss and LAE in relation to net earned premium. This improvement in the loss and LAE ratio reflects continued disciplined underwriting and rate increases. In addition, while the Company had adverse development of $2.9 million, or 1.5% of $193.1 million of net loss and LAE reserves at December 31, 2002, reserves continue to stabilize.
Revenues from specialty risk management operations decreased $20.3 million, or 10.0%, to $183.7 million for the year ended December 31, 2002, from $204.0 million for the comparable period in 2001.
Reinsurance brokerage decreased $924,000, or 74.9%, to $309,000 from $1.2 million. This decrease is the result of a $390,000 decrease in commissions related to the sale of a Bermuda-based subsidiary, effective January 30, 2002. Also contributing to this decrease is an overall decrease in commissions related to existing business.
Net investment income decreased $271,000, or 1.9%, to $14.0 million for the year ended December 31, 2002 from $14.2 million for the comparable period in 2001. This decrease reflects a decrease in the average yield to 5.4% in 2002 from 6.0% in 2001. This decrease is offset by a $23.0 million, or 9.7% increase in average invested assets, from $236.9 million in 2001 to $259.9 million in 2002. The increase in average invested assets reflects net assets invested of $37.5 million from the proceeds received from the public offering in June 2002.
Specialty risk management operations generated a pre-tax loss of ($1.1) million for the year ended December 31, 2002 compared to a pre-tax loss of ($7.6) million for the comparable period in 2001. The Company’s loss and loss adjustment expense ratio improved by 9.0 points to 72.1% for the year ended December 31, 2002, from 81.1% for the comparable period in 2001. This improvement reflects the impact of the discontinued programs, an overall shift in the mix of business towards the workers’ compensation line of business, which had an accident year loss ratio of 67.4% in 2002 and represented 55.6% of net earned premium in 2002, compared to 42.4% of net earned premium in 2001. Also contributing to the improvement was the impact of rate increases achieved in 2002 and 2001 of 15.7% and 18.2%, respectively.
The Company’s expense ratio was 36.5% for the year ended December 31, 2002 compared to 36.0% for the comparable period in 2001. Due to the run-off of discontinued and terminated programs, gross premium is declining and, as a result, fixed costs as a percentage of revenue have temporarily increased the expense ratio.
Revenue from agency operations, which consists primarily of agency commission revenue, decreased $1.4 million, or 8.8%, to $14.3 million for the year ended December 31, 2002, from $15.7 million for the comparable period in 2001. This decrease reflects the sale of a Florida-based agency, effective July 1, 2001. Excluding revenue related to this agency for the twelve months ended December 31, 2001, revenues for the agency operations would have increased 4.6%.
various indications derived from standard actuarial techniques and other appropriate reserve considerations. The following table sets forth this range by line of business.
The other lines of business had an increase in net ultimate loss estimates of $600,000, or 4.1% of net reserves on the other lines of business. The change reflects reductions of $400,000 and $600,000 in accident years 2002 and 2001, respectively, primarily from the property and inland marine lines of business. This decrease in ultimate loss estimates reflects lower than expected emergence in claim activity during the twelve months ended December 31, 2003. This was offset by an increase in net ultimate loss estimates of $700,000 in accident year 2000 primarily in the medical line of business and $600,000 in accident year 1995 primarily from legal expenses related to the recovery of losses on the surety line of business. The change in ultimate net loss estimates for all other accident years was insignificant.
The workers’ compensation residual markets line of business had a decrease in net ultimate loss estimates of $200,000, or 2.2% of net reserves. The change reflects a reduction of $400,000 in accident year 2001. This decrease in ultimate loss estimates reflects lower than expected emergence in claim activity during the twelve months ended December 31, 2003. This was partially offset by an increase in net ultimate loss estimates of $100,000 in accident year 2002. The change in ultimate net loss estimates for all other accident years was insignificant.
Salary and employee benefits increased $10.5 million, or 28.1%, to $48.2 million in 2003, from $37.7 million for the comparable period in 2002. The increase in 2003 in comparison to 2002 is primarily the result of the hiring of employees to handle new fee-for-service agreements. In addition, this increase reflects both merit pay increases and the accrual of variable performance-based compensation tied to profitability, and a slight increase in staffing levels to support new managed programs.
Other administrative expenses increased $1.5 million, or 6.3%, to $24.5 million in 2003, from $23.0 million for the comparable period in 2002. The increase in administrative expenses is primarily attributable to the new fee-for-service agreements.
Salary and employee benefits and administrative expenses include both corporate overhead and the holding company expenses included in the reconciling items of the Company’s segment information.
Federal income tax expense for 2003 and 2002 was $4.9 million and $431,000, or 32.9%, and 20.7% of income before taxes, respectively. For 2001, the Company reflected a federal income tax benefit of $3.6 million, or 35.6% of loss before taxes. The Company’s effective tax rate differs from the 34% statutory rate primarily due to tax-exempt investment income. Changes in the effective rate over prior periods are related to changes in the proportion of tax-exempt investment income to total underwriting results and elimination of goodwill amortization.
Cash flow provided by operations was $47.5 million in 2003, compared to $1.8 million in 2002. Cash flow used in operations in 2001 was $2.8 million. The increase in cash flow from operations primarily reflects an increase in earnings, growth in written premiums, growth in fee-for-service revenue, and collections of reinsurance recoverables. The increase in cash flow in 2002 primarily reflected an increase in earnings, acceleration of collections on reinsurance recoverables, the cash receipt of $8.2 million associated with the cancellation of the surplus relief treaty in 2002, and increased collections on premium and agent receivable balances.
In conjunction with the offering, the Company issued warrants entitling the holders to purchase an aggregate of 300,000 shares of common stock at $3.10 per share. The warrants may be exercised at any time from June 6, 2003 through June 6, 2005, at which time any warrants not exercised will become void.
The Company has a credit agreement that includes a term loan and a revolving line of credit. This credit agreement consists of a $20.0 million term loan and a revolving line of credit for up to $8.0 million. The
Company uses the revolving line of credit to meet short-term working capital needs. At December 31, 2003, the Company’s term loan had an outstanding balance of $14.0 million. The Company had no outstanding balance on the revolving line of credit at December 31, 2003. At December 31, 2002, the outstanding balance on the term loan and revolving line of credit was $18.8 million and $5.3 million, respectively. The term loan calls for quarterly amortization through July 1, 2006, at which time the term loan will be paid in full. The quarterly amortization requires payments of $1.25 million in 2004, 2005 and 2006, with a final payment of $1.5 million on July 1, 2006. The revolving line of credit will expire on July 1, 2004, and is thereafter renewable on an annual basis. As part of the loan agreement, certain of the Company’s non-regulated subsidiaries guaranteed repayment of the credit facility and the Company pledged the stock of its non-regulated subsidiaries as collateral.
Both the term loan and revolving line of credit provide for interest at a variable rate based, at the Company’s option, upon either the prime rate or eurocurrency based rate. The applicable margin, which ranges from 200 to 300 basis points above eurocurrency based rates, is determined by the level of the fixed charge coverage ratio. Of all the covenants, the most restrictive covenant is the fixed charge coverage ratio. The fixed charge coverage ratio, as defined by the credit facility, is the ratio of the non-regulated earnings before interest and taxes for the four preceding fiscal quarters to the sum of fixed charges which include interest expense, principal payments payable, stock repurchases, and dividends declared during the period. Any unused portion of the revolving credit as of the date of determination reduces the sum of these fixed charges. At December 31, 2003, this ratio was 5.7 to 1.0, compared to the covenant minimum of 1.2 to 1.0. As of December 31, 2003, the Company was in compliance with all debt covenants. The eurocurrency based rate as of December 31, 2003, for the term loan was 3.3%.
In addition, the Company had an outstanding subordinated promissory note payable in the amount of $3.5 million, due June 30, 2003, which bore interest at a rate of 6.673% plus a eurocurrency based margin. On January 14, 2003, the Company paid in full the $3.5 million subordinated promissory note.
As of December 31, 2003 and 2002, the recorded values of the Company’s investment portfolio, including cash and cash equivalents, were $324.2 million and $286.1 million, respectively. The debt securities in the investment portfolio, at December 31, 2003, were 93.7% investment grade A or above bonds as defined by Standard and Poor’s.
Insurance operations are subject to various leverage tests (e.g. premium to statutory surplus ratios), which are evaluated by regulators and rating agencies. The Company’s targets for gross and net written premium to statutory surplus are 3.0 to 1 and 2.0 to 1, respectively. The premium leverage ratios as of December 31, 2003, on a statutory consolidated basis, were 2.54 to 1 and 1.89 to 1 on a gross and net written premium basis, respectively.
The average investment yield for 2003 was 4.5% compared to 5.4% in 2002. The current pre-tax book yield is 4.2% and the current pre-tax reinvestment yield is 3.2%. The decrease in investment yields reflects the accelerated prepayments in the mortgage-backed securities, and reinvestment of cashflows in municipal bonds and other securities in an interest rate environment where interest rates are still relatively low compared with recent history.
The Two-Year Reserve Development to Surplus Ratios primarily relates to development from accident years 1999 and 2001. This development primarily relates to previously discontinued programs.
The growth in Williamsburg’s net written premium related to a managed program that has been converted to an insured program. This program primarily writes commercial auto liability coverage, which the Company has managed since 1997.
and its debt reduction and indicates the potential for a near term upgrade. The Company believes that as a result of its improved balance sheet and operating performance its rating will remain at least at its current level, if not at an upgraded level. However, there can be no assurance that A.M. Best will not change its rating of the Insurance Company Subsidiaries in the future.
In its risk-sharing programs, the Company is also subject to credit risk with respect to the payment of claims by its clients’ captive, rent-a-captive, large deductible programs, indemnification agreements, and on the portion of risk exposure either ceded to the captives, or retained by the clients. The capitalization and credit worthiness of prospective risk-sharing partners is one of the factors considered by the Company in entering into and renewing risk-sharing programs. The Company collateralizes balances due from its risk-sharing partners through funds withheld trusts or letters of credit. At December 31, 2003, the Company had risk exposure in excess of collateral in the amount of $9.5 million, compared to and $11.6 million at December 31, 2002, on these programs, of which the Company has an allowance of $6.4 million at December 31, 2003, compared to $6.8 million at December 31, 2002, related to these exposures. The Company has historically maintained an allowance for the potential uncollectibility of certain reinsurance balances due from some risk-sharing partners, some of which are in litigation with the Company. At the end of each quarter, an analysis of these exposures is conducted to determine the potential exposure to uncollectibility. At December 31, 2003, management believes that this allowance is adequate. To date, the Company has not, in the aggregate, experienced material difficulties in collecting balances from its risk-sharing partners. No assurance can be given, however, regarding the future ability of any of the Company’s risk-sharing partners to meet their obligations. At December 31, 2003 and 2002, the exposure amount in litigation with former risk-sharing partners which is not reserved or collateralized is $1.3 million and $1.9 million, respectively. During the third quarter of 2003, a settlement agreement was reached with a former risk-sharing partner that was previously in litigation. The agreement included receipt of cash and a collateralized note receivable
On May 15, 2003, the FASB issued SFAS No. 150 “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” The statement requires issuers to classify as liabilities (or
assets in some circumstances) three classes of freestanding financial instruments that embody obligations for the issuer. Generally, the statement is effective for financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this standard had no effect on the Company’s financial statements.
In November 2002, the FASB issued FASB Interpretation (“FIN”) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN No. 45 clarifies the requirements of SFAS No. 5, “Accounting for Contingencies”, relating to a guarantor’s accounting for, and disclosure of, the issuance of certain types of guarantees. For certain guarantees issued after December 31, 2002, FIN No. 45 requires a guarantor to recognize, upon issuance of a guarantee, a liability for the fair value of the obligations it assumes under the guarantee. Guarantees issued prior to January 1, 2003 are not subject to liability recognition, but are subject to expanded disclosure requirements. See Note 7 and Note 14 for additional information regarding the effect of the adoption of FIN No. 45.