Other Data: Return on average shareholders' equity 6.3% 3.3% 6.9% 14.6% 13.0% Debt to total capitalization ratio 21.5% 26.2% 24.2% 10.7% 24.2% Net premiums written to equity 1.4X 1.4X 1.4X 1.2X 1.2X
During 2005, we changed our segment reporting to coincide with our strategic direction. In our segment reporting for periods prior to the year ended December 31, 2005, we segregated our business into real estate operations, insurance operations and other (which included realized gains and losses on investments and rescission expenses). We continue to segregate our business into real estate operations, insurance operations and other, but the insurance operations segment is further classified into three additional segments: excess and surplus lines, alternative risk transfer and runoff. The excess and surplus lines segment is further classified into three business lines: environmental, construction and surety. The alternative risk transfer segment is further classified into two business lines: specialty programs and fully-funded. Prior year amounts have been reclassified to conform to the current year presentation. Our real estate operations consist solely of our development of the Harbour Village property as described below under “Business - Harbour Village Development.” See Note 10 to our consolidated financial statements for more information on our segment reporting.
The following information is presented on the basis of accounting principles generally accepted in the United States of America (“GAAP”) and should be read in conjunction with “Business "and" Risk Factors,” and our consolidated financial statements and the related notes included elsewhere in this report. All amounts and percentages are rounded.
2003 2004 to to 2003 2004 2005 2004 2005 llars in thousands) Net premiums written:
Excess and Surplus: Environmental $ 22,446 $ 32,152 $ 38,081 43.2% 18.4% Construction 57,379 79,781 81,908 39.0 2.7 Surety 670 1,138 1,148 69.8 0.9 80,495 113,071 121,137 40.5 7.1 Alternative Risk Transfer: Programs 14,068 16,516 18,297 17.4 10.8 Fully Funded - 89 956 - 974.2 14,068 16,605 19,253 18.0 15.9 Runoff 14,771 6,715 (1,854) (54.5) (127.6) Total net premiums earned 109,334 136,391 138,536 24.7 1.6
Net investment income 5,801 9,773 14,316 68.5 46.5 Net realized gains 3,140 208 (54) (93.4) (125.9) Real estate income 57,555 67,967 3,000 18.1 (95.6) Other income 161 318 76 97.5 (76.1) Total Revenues $175,991 $214,657 $155,874 22.0% (27.4)% ======== ======== ======== ===== =======
Year Ended December 31, 2004 compared to Year Ended December 31, 2005
The following table sets forth the Company’s net earnings (in thousands) for the years ended December 31, 2004 and 2005:
Insurance Operations $4,263 $13,618 Real Estate Operations 7,816 209 Other, including realized gains and (losses) from the sale of investments and rescission expenses 2,678 829 Net Earnings $14,757 $14,656 ======= =======
Environmental. Net premiums earned increased 18.4% to $38.1 million for the year ended December 31, 2005 compared to $32.2 million for 2004. Net premiums written increased to $41.5 million for the year ended December 31, 2005 compared to $35.0 million for 2004. Most of the growth in this business line for 2005 was due to an increase in online production, as well as an increase in gross premiums of $2.4 million generated as a result of standard audits that were performed on certain expired policies in order to adjust estimated premiums to actual premiums. The Company believes that these increases were offset by a decline in the State of New York environmental contractor and consultant premiums as a result of changes implemented in its underwriting process in the State of New York, which the Company believes will improve the ultimate profitability of the environmental business line. The Company continues to experience a slight decline in premium rates from 2004 primarily in its middle-market business, which includes environmental accounts with insureds with greater than $3.0 million in annual revenue, due to increased competition and the overall changing pricing conditions in the market place. See “Business-Our Market-Excess and Surplus Lines” for a description of these changing conditions. Premium rates in its ProStar on-line rating and quoting system (“ProStar”) business have remained stable. The Company intends to focus its efforts on expanding ProStar’s capabilities and increasing its market share of insuring environmental risks of small and medium-sized businesses.
Construction. Net premiums earned increased 2.7% to $81.9 million for the year ended December 31, 2005 compared to $79.8 million for 2004. Net premiums written increased 0.2% to $78.0 million for the year ended December 31, 2005 compared to $77.9 million for 2004. During 2005, the Company had $14.3 million of gross premiums written generated as a result of audits. Premium rates on the residential construction business have remained stable. The Company, however, has started to experience a slight decline in premium rates on its renewal book of commercial construction business due to increased competition and a general softening of pricing in the market place. The changing market conditions have resulted in a decline in the Company’s renewal retention rates and new business volume. See “Business- Our Market-Excess and Surplus Lines” for a description of these changing conditions. The Company remains committed to its disciplined underwriting approach and the Company also has not broadened its policy terms and conditions. The Company intends for construction risks to be a focus of its new business efforts as it believes this area continues to offer modest growth opportunities in selected geographic areas. Effective July 1, 2005, the Company discontinued purchasing reinsurance on the primary general liability portion of this business line. The Company made this decision after performing a loss cost and dynamic financial analysis, and concluding that its reinsurance purchases were uneconomical. The Company believes retaining this exposure will enhance its financial results and returns on capital.
Surety. “Surety” is a contract under which an insurer guarantees certain obligations of a second party to a third party. The Company is listed as an acceptable surety on federal bonds, commonly known as a “Treasury-listed” or “T-listed” surety primarily providing contract performance and payment bonds to environmental contractors and general construction contractors in 47 states and the District of Columbia. Net premiums earned remained stable at $1.1 million for the year ended December 31, 2005 and 2004. Net premiums written increased 14.6% to $1.3 million for the year ended December 31, 2005 from $1.2 million for 2004. This increase was attributable to the Company’s efforts to modestly expand its surety business as a supporting product line to the environmental business line.
Specialty Programs. Net premiums earned increased 10.8% to $18.3 million for the year ended December 31, 2005 compared to $16.5 million for 2004. Net premiums written increased 14.1% to $19.7 million for the year ended December 31, 2005 compared to $17.3 million for 2004. The increase in 2005 was due primarily to premiums written from three new programs added in late 2004 and the first half of 2005. The Company had 10 active programs at the end of 2005 as compared to 15 at the end of 2004. The Company has focused its efforts on increasing its retention levels on programs, thereby allowing the Company the opportunity to increase its earnings potential from underwriting profits. 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. These increased retentions, in part, drove the increase in premiums earned in 2005. See “Business-Our Products-Alternative Risk Transfer - Specialty Programs” for additional information on our programs.
Fully Funded Policies. Net premiums earned increased to $0.9 million for the year ended December 31, 2005 as compared to $89,000 for 2004. Net premiums written increased to $2.0 million for the year ended December 31, 2005 as compared to $257,000 for 2004. Fee income earned for the year ended December 31, 2005 increased to $1.2 million from $210,000 for 2004. The Company anticipates continued growth opportunities for this business line in the healthcare and residential construction industries, which were primary drivers for the growth mentioned above and new growth opportunities in the product manufacturing industry.
Net premiums earned decreased to negative $1.9 million for the year ended December 31, 2005 compared to $6.7 million for 2004. Net premiums written decreased to negative $2.0 million for the year ended December 31, 2005 compared to $299,000 for 2004. The decrease in runoff net premiums earned was attributable to the Company’s exit from specific business lines that did not meet its profit or production expectations. In addition, in 2005 net premiums earned and net premiums written decreased due to an accrual of $2.0 million for reinsurance premiums on the discontinued workers compensation business, which was put into runoff in 2004 as a result of the Company’s potential payment of a reinstatement premium to reinstate reinsurance coverage in connection with a certain claim. See “Business-Our Products-Runoff Lines” for additional information about our runoff segment.
Net investment income increased 46.5% to $14.3 million for the year ended December 31, 2005 from $9.8 million for 2004 due to an increase in the Company’s invested assets and higher investment yields. Average invested assets increased to $371.3 million as of December 31, 2005 from $274.7 million as of December 31, 2004, reflecting approximately $70.4 million in cash flows from operations and $24.4 million in net proceeds from the issuance of trust preferred securities in November 2005. The average pre-tax and after tax investment yields were 3.9% and 3.2% compared to 3.6% and 2.8% for the years ended December 31, 2005 and 2004, respectively.
Policy acquisition expenses are amounts that are paid to producers for the production of premium for the Company offset by the ceding commissions we retain from our reinsurers. For our program business, fees typically are earned through ceding commissions and have the effect of lowering our acquisition expenses. Policy acquisition expenses also include amounts paid for premium taxes to the states where we do business on an admitted basis. Policy acquisition expenses increased to $28.5 million for the year ended December 31, 2005 from $26.5 million for 2004. Policy acquisition expenses as a function of net premiums earned increased to 20.6% for the year ended December 31, 2005 from 19.5% for 2004, primarily due to higher earned premiums and lower 2004 acquisition expenses due to the accrual of profit commissions on reinsurance.
Real estate expenses associated with the Harbour Village project decreased to $2.2 million for the year ended December 31, 2005 from $55.5 million for 2004. In 2005, the Company received $980,000 for settlement on roof litigation at Harbour Village. This receipt was applied as a reduction to real estate expenses as it had been expensed previously.
December 31, 2004 U.S. Bermuda Total Income Tax 3,696 - 3,696 Net earnings 5,543 9,214 14,757 Assets 449,322 134,838 584,160 Equity 56,126 52,654 108,780
Net Income. Net income from Bermuda operations increased to $10.3 million for the year ended December 31, 2005 compared to $9.2 million for 2004. Net income from Bermuda operations increased in 2005 due to improved underwriting results in the Company’s insurance operations. Net income from U.S. operations decreased to $4.4 million for the year ended December 31, 2005 compared to $5.5 million for 2004. this decrease is due to lower real estate income offset by improved insurance operations. U.S. insurance earnings increased by $6.5 million to $4.2 million at December 31, 2005 compared to a loss of $2.3 million at December 31, 2004. Real estate income decreased to $209,000 at December 31, 2005 compared to $7.8 million for the same period of 2004.
Assets. Assets from Bermuda operations increased to $167.4 million at the end of 2005 compared to $134.8 million at the end of 2004. This increase resulted from an increase in premium writings assumed from growing U.S. operations. Assets from U.S. operations at the end of 2005 increased to $529.7 million, compared to $449.3 million at the end of 2004. This increase is a result of the Company issuing a trust preferred security in 2005 raising approximately $25 million and the growth in the Company’s core business lines offset by a decrease in real estate assets as the Harbour Village project is substantially complete.
The following table sets forth the Company’s net earnings (in thousands) for the years ended December 31, 2003 and 2004:
Net earnings from insurance operations for the year ended December 31, 2004 include reserve development of $14.4 million relating to prior accident years. The increase in net earnings from real estate operations was due to closings of units at Harbour Village with higher profit margins. Earnings from other items include a $2.6 million payment received by the Company in settlement of an impaired note receivable that was written off in the fourth quarter of 2003. Total revenues for the year ended December 31, 2004 increased 22.0% to $214.7 million compared to 2003 as a result of increased net premiums earned and real estate and investment income. Net premiums earned for the year ended December 31, 2004 increased 24.8% to $136.4 million from 2003 due to increased production in the Company’s core business lines. Net investment income increased 68.5% to $9.8 million compared to 2003 as a result of an increase in invested assets of $104.6 million excluding real estate. Net cash flow from operations increased to $89.8 million for the year ended December 31, 2004 from $80.2 million for 2003.
Environmental. Net premiums earned increased 43.2% to $32.2 million for the year ended December 31, 2004 compared to $22.4 million for 2003. Net premiums written increased 28.6% to $35.0 million for the year ended December 31, 2004 compared to $27.2 million for 2003. This growth was attributable primarily to growth in premiums in ProStar as well as increased business written in our middle-market offices which target environmental accounts with insureds with greater than $3.0 million in revenue. Gross premiums written through ProStar increased 35.8% to $12.9 million for the year ended December 31, 2004 compared to $9.5 million for 2003.
Net investment income increased 68.5% to $9.8 million for the year ended December 31, 2004 from $5.8 million for 2003 due to an increase in the Company’s invested assets and higher investment yields. Average invested assets increased to $274.7 million as of December 31, 2004 from $167.2 million as of December 31, 2003. The average pre-tax and after tax investment yields were 3.6% and 2.8% compared to 3.5% and 2.7% for the years ended December 31, 2004 and 2003, respectively.
2003 2004 Condominium Units 197 203 Boat Slips 17 4 Total 214 207 === ===
The Company had an increase in real estate income in 2004 as compared to 2003 resulting from increased closings of condominium units and higher priced unit closings at the Harbour Village project. The average sales price of condominiums closed in 2004 was $297,000 as compared to $275,000 in 2003.
Excess & Surplus lines Environmental $ (457) $ 94 Construction 1,602 7,700 Surety (791) 37 354 7,831 Alternative Risk Transfer Programs 191 1,496 Runoff 4,691 5,075 Total $ 5,236 $ 14,402 ========== ===========
Of this amount, $7.7 million was attributable to certain New York contractor risks, which were significantly reduced during 2002 and 2003. In response to this development and management’s concern that existing reserves for this line might be inadequate, the Company commenced an actuarial reserve evaluation of this line. Following completion of this evaluation, the Company changed actuarial reserving methodologies and recorded $3.0 million of additional reserves for the construction line.
Policy acquisition expenses increased to $26.5 million for the year ended December 31, 2004 from $21.8 million for 2003 due to higher net premium volume. Policy acquisition expenses as a function of net premiums earned decreased to 19.5% for the year ended December 31, 2004 from 20.0% for 2003 primarily due to a shift in business mix toward business with lower acquisition costs.
December 31, 2004 U.S. Bermuda Total Income tax 3,696 - 3,696 Net earnings 5,543 9,214 14,757 Assets 449,322 134,838 584,160 Equity 56,126 52,654 108,780
Net Income. Net Income from Bermuda operations increased to $9.2 million for the year ended December 31, 2004 compared to $1.6 million for 2003. This increase is attributable to the Company collecting $2.6 million as final settlement of a note receivable for which an allowance was established in 2003 and the remainder of the increase is due to growth in insurance operations. Net income from U.S. operations decreased to $5.5 million for the year ended December 31, 2004 compared to $5.8 million in 2003. The overall decrease in U.S. operations primarily resulted from a decrease in insurance operations resulting from adverse loss development offset by an increase in real estate income. U.S. insurance earnings decreased to a loss of $2.3 million at December 31, 2004 compared to $3.6 million at December 31, 2003. Real estate income increased to $7.8 million at December 31, 2004 compared to $2.2 million for the same period of 2003.
The Company substantially completed the Harbour Village project in 2005. The estimated completion cost for the remainder of Harbour Village is approximately $1.7 million and represents amounts needed to complete construction of a beach club and manage remaining warranty claims on closed condominium units. An accrual of this amount has been established. Management believes that cash on hand at Harbour Village will meet the remaining liquidity needs of Harbour Village.
To further provide for the capital requirements associated with our current growth strategy, the Company entered into the following arrangements. In May 2003, in conjunction with American Safety Capital Trust, a non-consolidated 100%-owned subsidiary, the Company issued a 30-year trust preferred obligation in the amount of $8.0 million. This obligation bears interest at the three-month London Interbank Offer Rate (“LIBOR”) plus 4.2%, is payable on a quarterly basis and may be called solely at our option after five years. In order to hedge this obligation for the first five years, the Company entered into an interest rate swap with a fixed interest rate of 7.1% for five years. In September 2003, in conjunction with American Safety Capital Trust II, a non-consolidated 100%-owned subsidiary, the Company issued a 30-year trust preferred obligation in the amount of $5.0 million. This obligation bears interest at three-month LIBOR plus 3.95%, is payable on a quarterly basis and may be called solely at our option after five years. In order to hedge this obligation for the first five years, the Company entered into an interest rate swap with an interest rate of 7.6% for five years. In November 2003, the Company completed a secondary offering of over 2.1 million common shares whereby the Company received $27.2 million of additional capital. Additionally, in November 2005, in conjunction with American Safety Capital Trust III, the Company issued a 30-year trust preferred obligation in the amount of $25.0 million. This obligation bears a fixed interest rate of 8.31% for the first five years, and a floating rate of three-month LIBOR plus 3.4% thereafter. At the current time, the Company does not anticipate entering into an interest rate swap with respect to this issuance. Interest is payable on a quarterly basis and the securities may be called solely at the Company’s option after five years.
For these purposes routine purchase 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 is in Note 8 to our consolidated financial statements
The accounting policies described below are those we consider critical in preparing our financial statements. These policies include significant estimates made by management using information available at the time the estimates are made. However, as described below, these estimates could change materially if different information or assumptions were used.
In establishing reserves, we employ several methods in determining our ultimate losses: (i) the expected loss ratio method; (ii) the loss development method based on paid and reported losses; and (iii) the Bornhuetter-Ferguson method based on expected loss ratios, paid losses and reported losses. The expected loss ratio method incorporates industry expected losses which are adjusted for our historical loss experience. The loss development method relies on industry payment and reporting patterns to develop our estimated losses. The Bornhuetter-Ferguson method is a combination of the other two methods, using expected loss ratios to produce expected losses, then applying loss payment and reporting patterns to our expected losses to produce our expected IBNR losses. We review the ultimate projections from all three methods and, based on the merits of each method, determine our estimated ultimate losses.
In response to the reserve development experienced in the first two quarters of 2004 in our excess and surplus lines segment and management’s concern that existing reserves for this segment might be inadequate, we commenced an actuarial reserve evaluation. This evaluation analyzed reserves by specific risk categories within our excess and surplus lines segment, such as general liability for building owners and California contractors in addition to analyzing by a single risk category for the entire excess and surplus lines segment. The results of the specific risk analysis were then compared to the single risk analysis in determining the final carried reserves. The establishment of appropriate loss reserves is an inherently uncertain process, and there can be no assurance our ultimate liabilities will not materially exceed our reserves. For more information on our reserves, see “Business Losses and Loss Adjustment Expenses Reserves”.
Reinsurance. Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not relieve us of our legal liability to our policyholders.
Deferred Income Taxes. We are required to establish a valuation allowance for the portion of any deferred tax asset, that we believe will not be realized. The majority of our deferred tax assets associated with the Harbour Village project were realized in 2005. The majority of our deferred taxes associated with our premium writings will be realized over the policy period and payout of related claims. We believe it is more likely than not that we will realize the full benefit of our deferred tax assets; therefore no valuation allowance has been established. See Note 6 to the Company’s consolidated financial statements for additional information on deferred tax assets.
Recognition of Premium Income. General liability premiums are estimated based upon the annual revenues of the underlying insureds. Additional or return premiums are recognized for differences between provisional premiums billed and estimated ultimate general liability premiums due when the final audit is complete after the policy has expired. General liability, surety, commercial auto, other commercial lines and workers’ compensation premiums are recorded ratably over the policy period with unearned premium calculated on a pro rata basis over the lives of the underlying coverages.
Property and casualty insurance premiums are established before the amounts of losses and loss adjustment expenses are known and therefore before the extent by which inflation may affect these expenses is known. Consequently, we attempt, in establishing our premiums, to anticipate the potential impact of inflation. However, for competitive and regulatory reasons, we may be limited in raising premiums consistent with anticipated inflation, in which event we, rather than our insureds, would absorb inflation costs. Inflation also affects the rate of investment return on our investment portfolio with a corresponding effect on our investment income.
This report contains forward-looking statements. These forward-looking statements reflect the Company’s current views with respect to future events and financial performance, including insurance market conditions, premium growth, acquisitions and new products and the Harbour Village real estate development project. Forward-looking statements involve risks and uncertainties which may cause actual results to differ materially, including competitive conditions in the insurance industry, levels of new and renewal insurance business, developments in loss trends, adequacy and changes in loss reserves and actuarial assumptions, timing or collectibility of reinsurance recoverables, market acceptance of new coverages and enhancements, changes in reinsurance costs and availability, potential adverse decisions in court and arbitration proceedings, the integration and other challenges attendant to acquisitions, and changes in levels of general business activity and economic conditions. For additional factors, which could influence the Company’s operating and financial performance, see the Company’s filings with the Securities and Exchange Commission.
The Company’s consolidated financial statements required under this Item 8 are included as part of Item 15 of this report.