We lease a six story office building with approximately 113,000 square feet as our home office in Dallas, Texas. All executive, financial, underwriting, claims management, information technology and other operations are conducted from this office. The only other properties utilized by Company personnel are leased offices which house RHP and a small claims office in Houston, Texas. We believe these facilities will be adequate to accommodate our operations for the foreseeable future.
The following discussion of our financial condition and results of operations should be read in conjunction with our Consolidated and Combined Financial Statements and the notes to those statements included in Item 8. of this annual report on Form 10-K.
Republic Companies Group, Inc. and its direct and indirect subsidiaries and controlled affiliates are collectively known as The Republic Group. Republic Companies Group, Inc. operates as a holding company with one direct subsidiary, Republic Companies, Inc., whose principal insurance subsidiary is Republic Underwriters Insurance Company (“RUIC”). RUIC owns the stock of five insurance subsidiaries and a general business corporation Republic Diversified Services, Inc. (“RDS”) that is the attorney-in-fact for our Texas Lloyds plan insurer Republic Lloyds (RL). Republic Companies, Inc. also owns two managing general agencies (“MGAs”), Eagle General Agency, Inc. (“EGA”) and Republic Home Protectors, Inc. (“RHP”) (80% owned), and Republic Group Number Two Company (“RG2”), a general business corporation that exercises control, through a management agreement, over our Texas county mutual insurer, Southern County Mutual Insurance Company (“SCM”).
Through our network of independent agents and affiliated MGAs, we underwrite select personal and commercial property and casualty insurance primarily for short-tail risks in Texas, Louisiana, Oklahoma and New Mexico. In addition, we manage insurance programs through five unaffiliated MGAs that target niche markets and underwrite short-tail policies on our behalf in the Southwestern United States and in other select states. We also generate fee-based income by using our unique combination of charters and licenses to provide services to MGAs and national and regional insurance carriers that wish to access our markets.
In our Personal Lines segment, we underwrite personal lines insurance distributed through our network of independent agents. We tailor our products to meet the needs of policyholders located within Texas, Oklahoma, Louisiana and New Mexico, with an additional focus on underserved geographic and demographic markets.
These products currently include homeowners and dwelling fire, low-value dwelling, standard auto, nonstandard auto and personal umbrella coverages. Additionally, our personal lines products distributed through our two affiliated MGAs are included in this segment.
One of our key strategies is to target underserved markets that we believe are less sensitive to the cyclical nature of the insurance industry. These cycles are defined by fluctuations in pricing and availability of insurance coverage. Markets with excess underwriting capital suffer from intense price competition and erosion of underwriting discipline resulting in poor operating performance. These market conditions usually lead to a period of diminished underwriting capacity as insurance companies exit unprofitable lines, exhibit greater underwriting discipline, increase premium rates and implement more restrictive policy terms and conditions.
Our strong performance in the period leading up to the year 2000 reflects the success of our geographically focused strategy, in what we considered to be an unfavorable underwriting environment. Our underwriting performance deteriorated in 2000, 2001 and 2002 as the result of court imposed property mold contractual liability that did not previously exist in Texas and losses from several commercial lines products that were subsequently discontinued. After the 2003 Acquisition, our insurance operations returned to profitability following a series of initiatives undertaken by our current management team, which included introducing redesigned personal lines products that addressed mold contractual liability, re-underwriting our entire commercial lines book of business and targeting underserved rural and small to medium-size metropolitan markets.
Our program contemplated coverage for two named storms. After Katrina and before Rita, we purchased additional reinsurance for a third and fourth large severity event at a combined cost of $4.1 million. (See additional comments later in Management’s Discussion and Analysis of Financial Condition and Results of Operations.)
Net realized gains (losses). Net realized gains and losses on invested assets are reported separately from net investment income. We earn realized gains when invested assets are sold for an amount greater than their cost or amortized cost and recognize realized losses when investment securities are sold for an amount less than their cost or amortized cost or written down as a result of other-than-temporary impairments.
Other income. Our other income primarily includes fronting fees. Our insurance companies charge fronting fees to insurance carriers for whom we provide fronting services. We also charge fronting fees to some of our unaffiliated MGAs in connection with the policies that they underwrite on our behalf. Other income also includes installment billing fees collected from insureds who elect to pay their insurance premiums on an installment billing plan.
Net losses and LAE incurred. Net losses and LAE incurred represent our largest expense item and include the following, net of paid or anticipated salvage and subrogation: (1) claim payments; (2) estimates for future claim payments and changes in those estimates for current and prior periods; (3) internal and external costs associated with adjusting, investigating and defending claims; and (4) estimates for future LAE and changes in those estimates for current and prior periods.
Underwriting, acquisition and operating expenses. Our underwriting, acquisition and operating expenses are those that we incur to acquire and underwrite insurance risks. These consist of commission expenses and other underwriting, acquisition and operating expenses, both of which are included in the same line item in our financial statements.
Other underwriting, acquisition and operating expenses. Other underwriting, acquisition and operating expenses consist of general underwriting and administrative expenses, such as salaries, underwriting reports, rent, postage, depreciation and all other operating expenses not otherwise classified separately, including boards, bureaus and assessments of statistical agencies for policy service and administration items, such as rating manuals, rating plans and experience data. We also pay state and local taxes based on premiums, licenses and fees, and assessments and contributions to involuntary risk pools and state regulatory bodies. Historically, certain installment billing fees were recorded as a reduction of operating expense. In 2005, we elected to reclassify such fees as Other Income and reclassify these installment fees for all periods presented. This had the impact of increasing Other Income and Other Underwriting, Acquisition and Operating Expenses; however, there was no impact on net income (see additional comments under-Reclassifications below).
Income tax expense. We pay federal income taxes based on income.
Gross written premiums. Gross written premiums are the total of direct written premium plus any assumed premiums written, before the effect of reinsurance. This is the most direct measure of the Company’s volume of business written and the basis on which we assess growth and business activity.
Included in net losses are catastrophe losses. A catastrophe loss is a single or series of closely related incidents causing severe insured losses. Catastrophes are by their nature unpredictable. The frequency and severity of catastrophic losses we experience in any year affect our results of operations and financial position. In analyzing the underwriting performance of our independent agency segments, we evaluate performance both including and excluding catastrophe losses. The Insurance Services Office (“ISO”), a supplier of property and casualty statistical data, defines as catastrophes those events that cause $25.0 million or more in industry wide
direct insured losses to property and that affect a number of insureds and insurers. We use this definition, but we also include as catastrophes those events we believe are, or will be, material to our operations (i.e., weather or other catastrophic events with losses aggregating at least $400,000 within the normal 72 or 96 hour catastrophe period). Portions of our catastrophe losses may be recoverable under our catastrophe reinsurance agreements. Thus, our net loss ratio consists of one component excluding catastrophe losses and another component representing only catastrophe losses.
Net catastrophe loss ratio (expressed as a percentage) is the ratio of net losses incurred from industry designated catastrophic events or other weather events with losses aggregating at least $400,000, divided by the net insurance premiums earned. This ratio is net of amounts ceded to reinsurers. This ratio is meaningful in evaluating our management of our exposure to weather catastrophes and effective use of reinsurance to mitigate catastrophic losses.
Net combined ratio. Net combined ratio (expressed as a percentage) is the sum of the net loss ratio and the net expense ratio and measures a company’s overall underwriting profit. If an insurance company’s net combined ratio is above 100%, the company has incurred an underwriting loss on its book of business and cannot be profitable without investment income (which may or may not be sufficient to offset underwriting losses). We use the net combined ratio in evaluating our overall underwriting profitability on a consolidated and a segment basis and as a measure for comparing our profitability to the profitability of our competitors. Net combined ratios for post-acquisition periods may not be comparable with net combined ratios for pre-acquisition periods because of the lack of comparability of expense ratios described above. The net combined ratio was affected by the amortization of certain fair value adjustments recognized pursuant to SFAS No. 141 for the twelve months following the 2003 Acquisition as more fully described above under-Net loss ratio and-Net expense ratio. Where appropriate, the impact of these adjustments has been disclosed.
Recognition of losses and LAE. Losses and LAE are the sum of paid losses and LAE plus estimates of amounts needed in the future to pay claims and related expenses for insured events that have already occurred. Liabilities for losses and LAE represent our estimate at a particular point in time of the ultimate unpaid losses and LAE incurred, including settlement and administration of losses based on facts and circumstances then known and including losses that have been incurred but not yet been reported. The process of establishing the liability for unpaid losses and LAE is complex, requiring the use of informed estimates and judgments. The amount of liabilities for losses and LAE for reported claims is based primarily upon a case-by-case evaluation of coverage, liability, injury severity and other information considered pertinent to estimating the exposure presented by the claim. The amount of liabilities for losses and LAE for unreported or underreported claims is estimated based upon actuarial methodologies, including judgments relative to claims severity and frequency based upon historical company and industry experience of ultimate net loss ratios, product mix, underwriting standards, claims settlement practices, the length of time before losses will develop to their ultimate level, changes in the law and other external factors that are often beyond our control and estimates of salvage and subrogation. We determine the amount of liabilities for losses and LAE by line of insurance both before and after the impact of losses and LAE ceded to reinsurers.
extraordinarily large scale events with widespread damage, inaccessibility to properties and increases in the cost of repairs due to labor and materials shortages following catastrophic weather events, such as experienced in 2004 and 2005 with repeated major hurricanes;
unexpected policy coverage issues, such as experienced in 2001 and 2002 from judicial decisions regarding mold coverages on personal property policies;
changes in the development patterns of accident injuries, such as resulted from an increase in the number of larger vehicles in use;
general changes in policyholders’ claims behavior, such as experienced in 2003 and 2004 when real property owners became more reluctant to file mold claims due to a growing reticence of subsequent potential buyers to buy properties which had been the subject of these claims; and
We regularly review and update our liability estimates, considering these and other factors, and include resulting adjustments of liability estimates in the current period’s results. Liabilities are estimated using information and data available at the date of estimation. Sometimes the information and data are incomplete or are related to dynamic factors that may change after the liability estimation date. In the subsequent period when more complete information and data are available, the liabilities are adjusted with favorable or unfavorable development.
Our general actuarial reserving methodology has remained consistent for a number of years. This methodology uses several approaches in estimating the ultimate incurred losses including a historical review of paid and case incurred experience and a Bornhuetter-Ferguson review of paid and case incurred experience, which uses expected loss ratios. The selected ultimate incurred loss is determined after factoring in the nature of the line of business, the number of years of experience, the age of the accident year, the loss reporting pattern and other factors. Using this method we compute a point estimate of liabilities by segment and by general lines of business within the segments. We do not currently compute estimated ranges of loss liabilities. We apply our
initiating new or expanding upon existing lines of business where we must rely more heavily on industry data rather than internal historical patterns in establishing liabilities for losses and loss adjustment expenses. For example, we expanded our commercial lines of business in our Commercial Lines segment in the latter 1990s. As we accumulated internal historical claims experience over several years we were able to better estimate the liability than when we relied on industry claims experience to establish such liabilities;
additions or termination of MGA programs such as the addition of a nonstandard auto and a commercial auto program in late 2002, which increased liabilities for the Program Management segment in 2003, and the termination of three programs in 2003 and 2004, which decreased liabilities for the Program Management segment in 2004 and 2005 as the pending claims were settled. The effect of MGA program additions and terminations coupled with the effect of higher retentions on certain MGA programs can have a significant impact on the level of liabilities in the Program Management segment; and
changes in internal claims department structure and claims systems impacting the establishment of case based liabilities, such as experienced in 2003 when we consolidated our internal claims department into one unit, which impacted our Personal Lines segment and our Commercial Lines segment.
We closely monitor our liabilities for losses and loss adjustment expenses and recompute liabilities periodically using the most recent information on reported claims. Changes in information after the liabilities are estimated are reflected in the liability computation of the subsequent period when the changed information is available. Specifically, at least quarterly, we review, by line of business, existing liabilities, new claims, changes to existing case estimates and paid losses with respect to the current and prior years.
See Notes 3 and 8 to our audited Consolidated and Combined Financial Statements included in Item 8 in this annual report on Form 10-K.
Recoverability of certain assets. In the ordinary course of business, we enter into reinsurance contracts to protect against the impact of large, irregularly-occurring losses, to limit our maximum losses and to support our Program Management and Insurance Services segments. The financial reporting for a contract with a reinsurer depends upon whether the contract terms for risk transfer, incurred losses, claim reimbursement and other fund flows are appropriate for treatment as reinsurance in accordance with GAAP. The Company’s reinsurance contracts meet the risk transfer requirements in accordance with GAAP. The Company has no finite risk reinsurance arrangements. Assets for balances due from reinsurance companies and for prepaid reinsurance premiums are recorded for reinsurance contracts. Such assets include the ceded portion of paid losses and LAE, ceded recoverables for losses and LAE and ceded unearned premiums. These are reported on our balance sheet
Valuation of investments. Our investments are recorded at fair value, which is typically based on publicly available quoted prices. Unrealized appreciation or depreciation of investments held available for sale is shown as a separate component of shareholders’ equity as accumulated other comprehensive income, net of the related income tax effect. The cost of investments sold is determined using the specific identification method. Impairment of investments results in a charge to earnings when a market decline below cost is deemed to be other-than-temporary. We regularly review our investment portfolio to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. We consider a number of criteria during this process, including, but not limited to, the current fair value as compared to cost or amortized cost, as appropriate, of the security, the length of time the security’s fair value has been below cost or amortized cost, as appropriate, and specific credit issues related to the issuer and current economic conditions. We focus particular attention on securities having fair values of less than 80% of their cost or amortized cost, as appropriate, for six or more consecutive months. Other-than-temporary impairment losses result in a permanent reduction of the cost basis of the underlying investment and a recognized capital loss. See Item 1. Business-Investments and Notes 3 and 5 to our audited consolidated and combined financial statements included in this annual report.
We recognize our investment in Atlas on an equity basis of accounting due to our 30% ownership interest, board seats and certain contractual governance rights. The Mexican-based financial statements are converted to a
U.S. GAAP basis and adjusted for foreign currency exchange rates. We utilize the assistance of professional accountants and actuaries familiar with the requirements of U.S. GAAP and Mexican accounting to help us convert the financial statements. The carrying value of Atlas is also adjusted for the value of the Mexican peso with the change reflected as foreign currency translation gain or loss, net of related deferred income tax, as a component of other comprehensive income within shareholders’ equity. See Item 1. Business-Investments and Note 5 to our audited consolidated and combined financial statements included in this annual report.
Accounting for business combinations. We adopted SFAS No. 141 and SFAS No. 142, Goodwill and Other Intangible Assets, effective August 29, 2003, with our purchase of RUIC and certain subsidiaries and affiliates. The 2003 Acquisition was accounted for using the purchase method of accounting with the purchase price for the 2003 Acquisition allocated to the assets acquired and the liabilities assumed based on their estimated fair values. The excess of the net fair values over the purchase price resulted in negative goodwill. Certain noncurrent nonfinancial assets were written down due to the negative goodwill and the remaining negative goodwill was recognized as an extraordinary gain in accordance with SFAS No. 141. Management believes the negative goodwill occurred in large measure due to the seller’s desire to exit certain North American insurance markets. See Note 2 to our audited consolidated and combined financial statements included in this annual report.
Accounting for stock-based compensation. In March 2004, we adopted a stock plan enabling the Company to award shares or options to officers, directors, key employees and other designated parties, and we granted restricted stock awards that will vest over three to five years. We adopted SFAS No. 123, Accounting for Stock-Based Compensation in 2004, and recorded $4.3 million as the fair market value of the total stock awards granted and recorded non-cash stock compensation expense of $1.1 million, which represented the portion of awards vested during 2004. At the time, our common stock was not traded in a public market. Therefore, judgment was required in estimating the fair value of the stock. Our estimated fair value was based on several factors including market multiples of comparable publicly-traded companies. Additionally, stock option awards were granted in 2005 subsequent to our IPO, and we recorded total stock compensation expense of $1.2 million in 2005. See Notes 3 and 18 to our audited consolidated and combined financial statements included in this annual report. In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (Revised), Share-Based Payment, which will replace SFAS No. 123, effective for us in 2006; however, we do not anticipate that the implementation of SFAS No. 123R, in 2006 will have a significant impact on our results of operations.
The estimated long-term rate of return that we assume on pension plan assets affects our pension expense during a particular period. We perform an analysis of expected long-term rates of return based on the allocation of our pension plan assets and recent economic conditions to develop an expected long-term rate of return. For 2005 and 2004, we utilized an expected rate of return of 8.0% on our pension assets in arriving at these costs. As of December 31, 2005, approximately 60% of the plan assets were invested in common stock and 40% were invested fixed income securities. The plan assets constituted 90.7% of the projected benefit obligation as of December 31, 2005.
We also have a nonqualified noncontributory defined benefit pension restoration plan for a select group of management employees. This plan restores the benefit lost by these employees as the result of cap limits on the qualified plan. This plan is also accounted for in accordance with SFAS No. 87. The plan assumptions are the same as the qualified plan. The nonqualified plan is funded with a Rabbi Trust with assets comprising 73.0% of the projected benefit obligation as of December 31, 2005. This plan incurred a pension cost of $0.1 million in 2005 and is expected to require an estimated contribution of $0.1 million in 2006.
Income statement information and key financial measures are presented by segment on a consolidated basis for three post-acquisition periods, the years ended December 31, 2005 and 2004 and the period from August 29, 2003 to December 31, 2003 (“2003 Stub Period”). Income statement information and key financial measures are also presented by segment on a combined basis for the pre-acquisition period January 1, 2003 to August 28, 2003 (“2003 Cutoff Period”). Year-to-year comparisons of 2003, which aggregate the 2003 Cutoff Period and the 2003 Stub Period, are referred to as “2003 Total” and are included only for income statement components and metrics that reasonably can be aggregated after the change in the basis of accounting. We have provided limited period-to-period comparisons, where appropriate, for those income statement components and key financial measures that are not affected by the change in the basis of accounting. You should read this discussion in conjunction with the accompanying consolidated and combined financial statements and notes included elsewhere in this annual report.
Impact of the Amortization of the Purchase-GAAP Fair Value Adjustment of the Unearned Premium Liability
Note: Pre and Post amortization balances have been adjusted for the reclassification of policy fees and installment billing fees (see-Reclassifications later in this section).
Our Program Management and Insurance Services segments include fronting programs in which the producers may charge a policy fee to the insured. Such fees are generally not retained by us and are returned to the producers through a policy fee commission or ceded to the reinsurer. Historically, we have included these fees in our written and earned premium and the offsetting policy fee commission has been included in Commissions for the Program Management segment and in Underwriting, Acquisition and Operating Expenses for the Insurance Services segment. To better reflect the contractual nature of these fees, the revenue and expense components are being reclassified to reflect the net financial statement impact. Since these fees are not compensation for assuming underwriting risks, we believe that the fees are more appropriately offset against the related policy fee commission or expense. Therefore, starting in 2005, we have netted the policy fees against the related policy fee commission expense within Other Income. This has the effect of reducing written and earned premium and Underwriting, Acquisition and Operating Expenses; however, there is no impact on Net Income from this reclassification and we have reclassified all years presented in this annual report to be consistent with the current year presentation. The table below summarizes the dollar impact on each financial statement caption for the years included in this annual report.
Our independent agency business allows policyholders the option to pay their insurance premiums on an installment basis. Participation in one of our payment plans generally results in an installment fee in lieu of a finance charge to help offset the cost of administering the billing plans. Historically, we have recorded installment fees that we receive from policyholders as a reduction of the related expense. Starting in 2005, we have elected to reclassify the installment fees received as Other Income. This results in increasing Other Income and increasing Underwriting, Acquisition and Operating Expenses for the Personal and Commercial Lines segments. There is no impact on Net Income from this reclassification and we have reclassified all years presented in this annual report to be consistent with the current year presentation. The table below summarizes the dollar impact on each financial statement caption for the years included in this annual report.
Consolidated and Combined Results of Operations for the Years Ended December 31, 2005 and 2004 and the Periods August 29 to December 31, 2003, January 1 to August 28, 2003
Consolidated net income from continuing operations increased 3.6% in 2005 to $22.7 million from $21.9 million in 2004 compared to income of $8.7 million in the 2003 Stub Period and a loss of ($6.1) million for the 2003 Cutoff Period. Underwriting results remained strong despite large scale catastrophe losses in 2005, which were minimized due to reinsurance recoveries. Gross written premiums grew by 6.9% in 2005 compared to 2004 and our ex-catastrophe loss experience continued to show improvement in most lines of business reflecting new underwriting and marketing initiatives implemented after the 2003 Acquisition. Investment income increased 42.1% in 2005 as compared to 2004 as the result of a higher asset base and rising interest rates.
losses compared to 3.2% in 2004. The biggest insurance story of the year relates to the occurrence of three very destructive hurricanes that struck the U.S. mainland in 2005. Hurricane Katrina ranks as the most costly hurricane on record in terms of insured damages and Hurricanes Rita and Wilma will also be in the top ten of most costly natural disasters in the U.S. Two of these hurricanes, Katrina and Rita, struck in areas where we have significant numbers of insured properties. Our gross losses for these two events, including LAE but before reinsurance recoveries, were approximately $92.5 million. However, after reinsurance recoveries, our net losses from these storms were only $5.0 million. Our catastrophe reinsurance program functioned as it was designed in spite of two hugely destructive storms striking our operating area within four weeks of each other. Our net catastrophe losses and catastrophe ratio for 2005 were in line with our five year average catastrophe experience. We had four weather events that produced losses in excess of $1.0 million on a gross basis. Over the past five years, we have averaged three to five weather events annually with losses in excess of $1.0 million, before reinsurance. The year 2005 saw the highest weather-related catastrophe losses with Hurricanes Katrina and Rita. However, our reinsurance program resulted in net losses being in line with our five year average. More than 90% of the hurricane losses in 2005 occurred in our Personal Lines segment. Less than ten percent occurred in the Commercial Lines segment. Our reported catastrophe loss experience does not include catastrophe losses that might be experienced within the Program Management segment; however, these amounts were not material to the 2005 results of operations.
It should be noted that the amortization of the fair value adjustment for the unearned premium liability from the 2003 Acquisition resulted in a reduction of net insurance premiums earned during 2004 and 2003. This had the effect of slightly increasing the net loss ratio for the purpose of historical comparison. Eliminating the impact of the fair value adjustment would have resulted in a consolidated net loss ratio of 58.5% (compared to the actual 62.6%) in 2004 and 71.1% (compared to the actual 73.3%) for 2003 Total
Underwriting, acquisition and operating expenses-The net expense ratio was 36.9% for 2005, 29.7% for 2004, 28.8% for the 2003 Stub Period and 33.7% for the 2003 Cutoff Period. Underwriting, acquisition and operating expenses in 2004 and the 2003 Stub Period reflected the amortization of the fair value adjustment for unearned premium liability related to the 2003 Acquisition of $15.7 million and $7.8 million, respectively, and resulted in a lower ratio in these periods. The expense ratios excluding the impact of the amortization of the fair value adjustment would have been 34.3% and 35.4% in 2004 and the 2003 Stub Period, respectively. The higher ratio in 2005 is due to higher costs of being a public company following our IPO, principally in anticipation of compliance with the requirements of the Sarbanes-Oxley Act of 2002 (“SOX”) related to the documentation and
testing of internal controls over financial reporting. Additionally, we are incurring higher technology costs related to our new billing system, the new farm and ranch program and a new policy rating and administration system for our commercial lines business.
Net investment income increased 42.1% to $11.7 million in 2005 compared to $8.2 million in 2004. This reflects a growing invested asset base where our total investments, excluding our investment in Atlas, as of December 31, 2005 were 15.4% higher than our total investments as of December 31, 2004, and the year-end balance at 2004 was 10.0% higher than total investments at December 31, 2003. The continuing increase in our invested asset balances, combined with rising market interest rates, contributed to the increased investment income. The increase in invested assets was driven by available cash generated by operations and by timely reimbursements from reinsurers following the recent hurricanes in 2005. Through August 2004, net investment income included certain expenses associated with operating and holding our real estate investment. We recorded costs associated with our investment in real estate as investment expenses. After the 2003 Acquisition, we reclassified our home office building as held for sale and stopped recording depreciation charges relating to the building. The building was sold to an unrelated party in August 2004 and we relocated to new leased facilities in February 2005. The proceeds from the sale of the building provided additional funds to invest in fixed income securities and the elimination of real estate expenses have resulted in increased investment income.
Net investment yield on average invested assets, excluding our investments in Atlas and real estate, for 2005, 2004, and 2003 Total was 3.4%, 2.9% and 2.4%, respectively. The increase over these time frames is largely attributable to the rise in interest rates. In the period following the 2003 Acquisition, we followed a strategy of investing in more short-term instruments in order to be better positioned to take advantage of interest rates when they rose.
Net realized (losses) gains were ($0.3) million in 2005, $1.1 million in 2004, $1.2 million for the 2003 Stub Period and $2.4 million for the 2003 Cutoff Period. More than 90% of our total investments as of December 31, 2005 and 2004 were bonds and short-term cash equivalents. We rebalanced our investment portfolio after the 2003 Acquisition from a broad U.S. Treasury fixed maturity-based portfolio to a portfolio that included a target mix of high quality corporate, mortgage-backed, and U.S. Treasury fixed-maturity investments. We realized capital gains in the 2003 Stub Period and in 2004 from these rebalancing efforts. Since that time, our investment strategy has included maintaining a high quality portfolio, limiting trading activity and accumulating new cash flows into short-term investments to avoid incurred losses on our fixed maturity portfolio during the anticipated increasing interest rate environment. Accordingly, fewer capital gains and losses were realized in 2005 and 2004
Other income primarily represents fronting fees earned by our insurance companies on policies written through unaffiliated MGAs in our Program Management segment and fronting fees from the insurance carriers in our Insurance Services segment. Fronting fees, net of related expenses, were $4.3 million in both 2005 and 2004 and $5.3 million in 2003 Total. Other income also includes installment billing fee income from our independent agency segments of $1.8 million in 2005, $2.1 million in 2004 and $2.4 million in 2003 Total. These fees are primarily derived from our nonstandard auto business and the decline from 2003 parallels the decline in the related premium volume. Other income also includes immaterial amounts of miscellaneous income, such as gain on sale of fixed assets.
Interest expense was $3.3 million in 2005, $2.2 million in 2004 and $0.4 million in the 2003 Stub Period. The interest expense in 2004 and 2003 related to the two series of trust preferred securities issued in 2003 after the 2003 Acquisition. The $1.1 million increase in 2005 occurred due to the addition of $20 million of senior bank debt in February 2005. See Note 13 to our audited consolidated and combined financial statements included in this annual report.
Income (loss) from continuing operations before income taxes was $29.2 million for 2005, $30.9 million for 2004, $12.7 million for the 2003 Stub Period and ($10.2) million for the 2003 Cutoff Period. Income declined 5.5% in 2005 from 2004. Total net consolidated losses were lower in 2005 despite catastrophe losses that were almost double those of 2004. Lower losses were offset by higher operating expenses associated with being a public company, higher technology costs and higher interest expense. As described above, the results of the pre- and post-acquisition periods are not generally comparable due to the differences between purchase GAAP and historical GAAP. Historically, our first and fourth quarters have experienced favorable operating results, while the second and third quarters have been impacted by weather-related catastrophe events. In 2004, income from continuing operations before income taxes was impacted by various factors including significant product, geographic mix, agent management and expense reduction initiatives implemented after the 2003 Acquisition, substantially higher investment income and favorable overall catastrophe experience. The 2003 Cutoff Period loss from continuing operations before tax was primarily related to loss development for prior periods and changes in the estimated collectibility of certain receivables.
We pay federal income tax at a 35% effective rate. Pursuant to our tax allocation agreement, which encompasses all of our subsidiaries and controlled affiliates, except our controlled affiliate SCM, the consolidated tax is allocated to each company based upon the specific company’s taxable income. At the time of the 2003 Acquisition, certain pre-acquisition net operating loss carryforwards were allocated to our companies. Utilization of the pre-acquisition net operating loss carryforwards is limited by the Internal Revenue Code and the regulations thereunder. Since we believe that we will ultimately be able to utilize all of our net operating loss carryforwards, we record a deferred tax asset for the unused portion of our net operating loss carryforwards.
Income tax expense does not include expense resulting from the equity in earnings of our unconsolidated foreign insurance company or expense for the excess of the carrying value over the tax basis of our investment in the unconsolidated foreign insurance company. Approximately $2.5 million of taxes related to this difference are not recognized (see note 5 to our Consolidated and Combined Financial Statements).
The equity in earnings of our unconsolidated foreign insurance company includes our share of the income of Atlas of $4.2 million in 2005, $3.0 million in 2004, $0.7 million in the Stub Period and $1.7 million in the 2003 Cutoff Period. The improvement in Atlas’ earnings in 2005 was primarily related to increased investment results outpacing reduced underwriting results. The 2005 results were also favorably impacted by a decline in the Mexican peso to U.S. dollar exchange rate during 2005. We record our equity in the earnings of Atlas based on the third quarter results of operations and record a true-up adjustment in the following year for the fourth quarter results. In 2005, we recorded a $2.6 million true-up adjustment for the fourth quarter of 2004. We have not recognized a deferred tax liability for the excess of the carrying value over the tax basis of our investment in Atlas. The unrecognized deferred tax liability is treated as a permanent difference as prescribed by SFAS No. 109, Accounting for Income Taxes, which is consistent with the criteria of indefinite reversal described in APB No. 23, Accounting for Income Taxes-Special Areas. Accordingly, approximately $2.5 million of deferred tax expense and deferred tax liability are not recognized in our financial statements.
Minority interest is related to our 80% owned MGA, Republic Home Protectors, Inc., our affiliated MGA that manages our low-value dwelling program. The remaining 20% is owned by the president of the MGA.
The $32.6 million extraordinary gain in the 2003 Stub Period resulted from the application of SFAS No. 141, Business Combinations, to the negative goodwill resulting from the 2003 Acquisition. The negative goodwill was the excess of estimated fair value of net assets acquired in the 2003 Acquisition over the purchase price paid after reduction for acquisition costs. See Note 2 to our audited consolidated and combined financial statements included in this annual report.
Shareholders’ equity as of December 31, 2005 of $164.5 million was down from $169.4 million as of December 31, 2004. The principal elements offsetting the $22.7 million income earned during the year were: a $20.0 million partial redemption of preferred stock as accreted prior to our IPO; an increase in net-of-tax unrealized losses of $3.3 million from our investment portfolio as a result of rising interest rates; an increase in the net-of-tax additional minimum pension liability of $2.3 million as a result of a reduction in the year-end discount rate; a $1.0 million net-of-tax foreign currency translation benefit resulting from a decline in the value of the U.S. dollar relative to the Mexican peso; and common stock dividends totaling $3.4 million declared in the third and fourth quarters.
Liabilities for losses and LAE increased $47.6 million in 2005 principally due to the actual and estimated losses associated with Hurricanes Katrina and Rita.
The Personal Lines segment accounted for 28.3%, 28.5% and 32.9% of our gross written premiums in 2005, 2004 and 2003 Total, respectively. This segment also accounted for 52.8%, 56.3% and 54.4% of our net insurance premiums earned in 2005, 2004 and 2003 Total, respectively. In 2005, this segment generated $12.3 million of our $22.7 million of consolidated net income. Gross written premiums for the segment for each line of business were as follows:
The table below summarizes our historical results of operations for the Personal Lines segment and illustrates certain operating results and key measures we use in monitoring and evaluating our operations. The information is intended to summarize and supplement information contained in our consolidated and combined financial statements and to assist the reader in gaining a better understanding of our results of operations.
Despite the higher catastrophe experience, our total loss ratio declined in 2005 to 54.4% from 62.3% in 2004 and 74.2% for 2003 Total. Excluding catastrophe losses, the loss ratios for 2005, 2004 and 2003 Total are 44.7%, 57.8% and 64.2%, respectively. The improvement in 2005 resulted from the changing mix of business
(growing volume in the higher-margin low value dwelling business and declining volume in the compressing-margin nonstandard personal auto business) and a $6.6 million reduction in IBNR liabilities for losses and LAE (resulting primarily from the declining nonstandard personal auto book and the favorable development of mold loss estimates of prior accident years). Even eliminating the impact of the liability reduction would still have resulted in an ex-catastrophe net loss ratio in 2005 of 49.9%, still a noticeable improvement over 2004. The improvement is attributable to a stronger underwriting emphasis on quality business, including improved loss experience in standard and nonstandard auto in 2005. The comparison of net loss ratios between 2004 and 2003 Total was also influenced by the increase in liabilities for IBNR losses and LAE of $7.6 million in 2003. These increases included $5.9 million for auto liability lines and $1.7 million for increased estimates associated with mold losses. Due in part to favorable loss development trends in personal property and personal auto lines in 2004, liabilities for IBNR losses and LAE were reduced by $2.6 million.
Underwriting, acquisition and operating expenses-The expense ratio for this segment was 35.1% in 2005 compared to 26.9% in 2004, 27.7% in the 2003 Stub Period and 32.0% in the 2003 Cutoff Period. The lower ratio in 2004 and in the 2003 Stub Period is attributable in part to the amortization of the fair value adjustment of unearned premium in the 2003 Acquisition of $9.5 million and $5.1 million, respectively. This adjustment had the effect of reducing expenses during those periods. Eliminating the impact of this adjustment would have resulted in ratios of 32.1% in 2004 and 35.2% in the 2003 Stub Period. Since the fair value adjustment was fully amortized in 2004, the expense ratio should be more stable in future periods. Operating expenses in 2005 have increased primarily due to new information technology initiatives and the additional costs associated with compliance with SOX. Expenses will likely continue to increase due to the additional costs of being a public company; however, additional earned premium from the growing low-value dwelling program will have a positive impact on our expense ratio.
Underwriting income increased significantly in 2004 for our Personal Lines business. This was due in part to a 11.9 point reduction in the net total loss ratio from 74.2% in 2003 Total to 62.3% in 2004 driven by the continued strength in personal property market conditions and other factors. Both personal property and personal auto underwriting results were also positively impacted in 2004 by various agency management actions, including the appointment of new agents and the termination of historically unprofitable agents, changes in the geographic mix and expense reduction initiatives. Underwriting income for this segment was also favorably impacted by the comparatively fewer catastrophic events in 2004.
The Commercial Lines segment accounted for 16.6%, 15.1% and 15.2% of our gross written premiums in 2005, 2004 and 2003 Total, respectively. This segment also accounted for 28.0%, 23.4% and 24.7% of our net insurance premiums earned in 2005, 2004 and 2003 Total, respectively. In 2005, this segment generated $1.7 million of our $22.7 million of consolidated net income. To better monitor our commercial book, we divide the premiums in this segment into five general subgroups, based upon lines of business with similar risk characteristics: commercial property; commercial auto; commercial casualty; workers’ compensation; and farm and ranch. The property portion of our package policies accounted for 87.0% of the commercial property subgroup and monoline property risks accounted for the remaining 13.0%. The casualty portion of our package policies accounted for 74.0% of the commercial casualty subgroup and umbrella and monoline casualty risks accounted for the remaining 26.0%. The farm and ranch book includes property, casualty and inland marine risks associated with rural farm and ranch owners. We provide package, auto and umbrella coverages for specific policyholders with or without workers’ compensation. As anticipated, after the re-underwriting initiatives of 2004, Commercial Lines improved significantly in 2005, producing growth in gross written premiums and improvement in the combined ratio.
The Commercial Lines segment involved gross written premiums by line of business as follows:
The table below summarizes our historical results of operations for the Commercial Lines segment and illustrates certain operating results and key measures we use in monitoring and evaluating our operations. The information is intended to summarize and supplement information contained in our consolidated and combined financial statements and to assist the reader in gaining a better understanding of our results of operations.
were 1.6% lower than the $71.6 million in 2003 Total. Although premium writings continued to decrease through the first nine months of 2004 as a result of the continued execution of initiatives undertaken in 2003 (described below), this trend reversed in the fourth quarter of the year due to new business written through newly appointed agents and the assumption of a book of farm and ranch business that expanded our rural market focus.
a phase out of certain historically unprofitable classes of business (including habitational and multi-tenant coverages and roofing contractors);
agency management actions, which included the termination of certain unprofitable relationships and appointment of various new agents with whom our current management team had favorable prior experience;
changes in geographic mix of business away from areas more heavily prone to weather catastrophes, including managing our coastal exposures;
a cessation of the writing of workers’ compensation in Oklahoma; and
Net written premiums in 2005 were $70.8 million, or 18.7% higher than the $59.6 million in 2004, with the growth paralleling the growth in the gross written premiums. Net written premiums of $59.6 million in 2004 were 5.5% lower than the $63.1 million in 2003 Total. Changes in excess per risk reinsurance programs and pricing accounted for most of the differences between the percentage changes in gross written premiums and the percentage changes in net written premiums between 2004 and 2003.
Commercial property rates appear to be firming in coastal areas; however, they remain soft in other areas. Commercial liability and auto rates are also highly competitive in most markets and increased rates are not expected in the near-term.
Net losses and LAE incurred-The net total loss ratio for 2005 was 61.5% compared to 78.7% for 2004. The catastrophe loss ratio of 2.8% in 2005 for the Commercial Lines segment was similar to the 3.0% ratio in 2004. This similarity resulted despite the large hurricanes in 2005 primarily because the Company has fewer commercial risks along the Louisiana coast and “tier-one counties” of Texas. Over the past two years, the Company intentionally reduced its Texas coastal wind-exposed commercial policy base by more than 40.0% and has minimal wind-exposed commercial risks in the Louisiana coastal parishes.
The ex-catastrophe loss ratio for 2005 was 58.7% compared to 75.7% in 2004. The 2005 loss ratio also includes the impact of $3.8 million of additional liabilities for IBNR losses and LAE primarily related to commercial liability lines. The improvement in loss ratios came as the result of improvement in the commercial property, commercial auto and workers compensation lines, where considerable improvement occurred in our ex-catastrophe experience. We had a significant reduction in large ex-catastrophe losses over $250,000 in 2005 compared to 2004 (eight in 2005 compared to 19 in 2004). We attribute this reduction to the re-underwriting and agency initiatives noted above. Commercial liability continues to grow organically and develop from prior years,
thus the additional liabilities in 2005. The farm and ranch program experienced higher catastrophe losses than the other commercial lines primarily due to wind losses for irrigation equipment.
The net total loss ratio was 78.7% for 2004, 66.0% for the 2003 Stub Period and 81.3% for the 2003 Cutoff Period. A comparison of the net loss ratios between the periods is also influenced by increases in liabilities for IBNR losses and LAE of $7.5 million in 2003 Total primarily related to changes in estimates on workers’ compensation liabilities, mold-related liabilities and commercial casualty LAE liabilities. We increased commercial lines liabilities for IBNR losses and LAE in 2004 by $2.0 million primarily for the casualty and auto bodily injury lines to address runoff of the classes of business that we phased out in late 2003 and 2004.
Underwriting income for this segment was also favorably impacted by comparatively fewer catastrophes in 2004. Catastrophe losses have historically accounted on average for 4.8 points of the loss ratio for this segment over the past five years and contributed 7.8 points of the 2003 Total net loss ratio, compared to 3.0 points of the 2004 net loss ratio. Historically, our second and third quarters are most heavily impacted by weather-related catastrophes. The contribution of catastrophes to the second quarter net loss ratios over the past five years was on average 8.6 points while the contribution of catastrophes to the other three quarters was on average only 3.4 points. The third quarter net loss ratio over the past five years on average included 7.5 points for catastrophe events and is the quarter most exposed to hurricane events.
Underwriting, acquisition and operating expenses-The net expense ratio for 2005 was 40.7% compared to 32.9% for 2004, 27.8% for the 2003 Stub Period and 35.9% for the 2003 Cutoff Period. Underwriting, acquisition and operating expenses for 2004 and the 2003 Stub Period included amortization of the adjustment for the fair value of unearned premium liability from the 2003 Acquisition of $4.5 million and $2.5 million, respectively. Removing the impact of this adjustment would result in expense ratios of 38.4% and 36.2% for 2004 and the 2003 Stub Period, respectively. Various underwriting, acquisition and operating expense reduction initiatives were also implemented after the 2003 Acquisition to improve the workflows and operational efficiencies of the Commercial Lines segment. These include implementing an electronic imaging system for files and workflows to replace the former paper-laden process, a new rating and processing system and a new billing system. The net expense ratio for 2005 was 7.8 points higher than in 2004 primarily because the Company has not yet realized the productivity benefits of the new policy issuing and processing system, the new billing system and the farm and ranch system developed to handle this new line.
Underwriting income-The net combined ratio for the Commercial Lines segment was 102.2% for 2005 compared to 111.6% in 2004, an improvement of 9.4 points. The improvement is the result of underwriting gains in several commercial lines following new underwriting and marketing initiatives begun in late 2003. The combined ratio for the 2003 Stub Period was 93.8%, which reflected the favorable results typical of the fourth quarter with little catastrophe activity. The net combined ratio for the 2003 Cutoff Period was 117.2% and can largely be explained by the liability increases mentioned above prior to the 2003 Acquisition.
The Program Management segment accounted for 26.8%, 31.4% and 34.0% of our consolidated gross written premiums in 2005, 2004 and 2003 Total, respectively. This segment also accounted for 19.2%, 20.4% and 20.9% of our consolidated net insurance premiums earned in 2005, 2004 and 2003 Total, respectively. In 2005, this segment generated $4.5 million of our $22.7 million of consolidated net income. We retain all or a portion of the underwriting risks written through our unaffiliated MGAs and, in cases where quota share reinsurance is placed, we receive a fronting fee for writing the business.
The table below summarizes our historical results of operations for the Program Management segment and illustrates certain operating results and key measures we use in monitoring and evaluating our operations. The information is intended to summarize and supplement information contained in our consolidated and combined financial statements and to assist the reader in gaining a better understanding of our results of operations.
(1) We allocate assets to our segments through our return on average equity model. See-Key Financial Measures above.
(2) Net underwriting leverage by segment is a product of our return on average equity model based on net written premiums and allocated equity by segment.
Premiums-The 2005 gross written premiums of $133.5 million were 8.9% lower than in 2004. Gross written premiums of $146.5 million in 2004 were 8.9% lower than the $160.8 million in 2003 Total. The decrease in 2005 and 2004 was primarily due to the termination of three unaffiliated MGA programs that no longer met our financial criteria (a short-term nonstandard personal auto program that had gross written
The business in the Program Management segment represents programs administered by unaffiliated MGAs where Republic participates in the net premiums and underwriting results to a specified extent ranging from 10% to 100%. The portion not retained by Republic is ceded to highly rated reinsurers approved by Republic. We retained 40% of the business produced by TGA, our largest MGA, in 2005 compared to 20% in 2004 and 10% in 2003. Two of the three programs terminated over the past two years were 100% retained. Net written premiums in this segment increased from $46.1 million in 2004 to $57.4 million in 2005 after declining 13.1% in 2004 from $53.0 million in 2003 Total. Net insurance premiums earned of $45.7 million in 2005 were only marginally higher than in 2004 because the earned impact of the higher 2005 participation in the business produced by TGA was offset by the lost premiums of the terminated programs. Net insurance premiums earned on the largest program increased 96.8% in 2005; however, that was insufficient to offset the loss of earned premium from the terminated programs. In 2004, net insurance premiums earned declined 15.5%. The decrease in 2004 in the net written premiums was partially mitigated by our increased net retention in the business produced by TGA in 2004. In the TGA program, net written premiums increased 99.5% and net insurance premiums earned increased 57.9% during 2004. In our Program Management segment, we periodically adjust our net retentions based upon available capital, program profitability and other considerations.
Net losses and LAE incurred-The net loss ratio for 2005 was 56.6% compared to 44.9% in 2004 and 67.0% in 2003 Total. The 2003 Total loss ratio was unfavorably impacted by $9.3 million in increases in liabilities for losses and loss adjustment expenses primarily associated with two programs that were subsequently terminated. The 2004 loss ratio of 44.9% was favorably impacted by 7.3 points from a reduction in liabilities primarily related to the favorable runoff of two terminated MGA programs. After factoring out the favorable loss development in 2004, the 2005 net loss ratio was approximately 4.4 points higher primarily due to higher commercial auto losses from our largest MGA program during 2005. This business also was minimally affected in 2005 by Hurricane Rita, although the amounts of catastrophe claims are not recorded separately for the program business.
Underwriting, acquisition and operating expenses-Generally, our MGA agreements provide a sliding scale commission based upon the profitability of the business produced. Accordingly, as the loss ratio declines, the expense ratio will generally increase due to the higher sliding scale commissions. This is reflected in the increased expense ratio for 2004 as compared to the prior periods. After factoring out the impact of the amortization of the fair value adjustment of the unearned premium, the expense ratio was approximately 2.0 points higher in 2004 than in 2005, reflecting the impact of the lower loss ratio in 2004.
Other income primarily represents fronting fees retained for unaffiliated MGA programs and is presented net of our expenses associated with producing the business. Fronting fees in 2005 were $3.0 million, less fronting fee expense of $0.8 million for a net total of $2.3 million. Fronting fees in 2004 were $3.6 million, less fronting fee expense of $1.1 million for a net total of $2.5 million. Other income declined 10.0% in 2005 and 32.0% in 2004. These declines are primarily related to the reduced premium volume associated with the three MGA programs that were terminated in 2004 and 2003.
The Insurance Services and Corporate segment accounted for 28.3%, 24.9% and 17.9% of our consolidated gross written premiums in 2005, 2004 and 2003 Total, respectively. In 2005, this segment generated $4.2 million of our $22.7 million of consolidated net income. The gross written premiums in this segment are fronted by our companies on behalf of other insurers who wish to access markets through our unique combination of licenses and charters. We retain a fronting fee on these premiums and cede 100% of the underwriting risk to the sponsoring insurance carrier. As such, this business does not result in net written or earned premiums, losses or commissions. In addition, the unallocated holding company overhead and expenses, all of our interest expense on our senior secured credit facility and our trust preferred securities and the equity in our share of the earnings of Atlas are accounted for in this segment. Because all of the business we conduct in this segment is fee-based, underwriting income, net loss ratio, net expense ratio, net combined ratio and net underwriting leverage ratio are not relevant measures for this segment.
The table below summarizes our historical results of operations for the Insurance Services segment and illustrates certain operating results and key measures we use in monitoring and evaluating our operations. The information is intended to summarize and supplement information contained in our consolidated and combined financial statements and to assist the reader in gaining a better understanding of our results of operations.
Gross written premiums of $140.8 million in the Insurance Services and Corporate segment in 2005 were 21.4% higher than in 2004 reflecting higher premium volume from the fronting programs of two national carriers. The largest of these programs generated $62.5 million in gross written premiums in 2005 compared to $37.8 million in 2004 and $4.1 million in 2003 Total. The second largest program generated $39.5 million in gross written premiums in 2005, which was comparable to their 2004 and 2003 writings. The third largest program generated $13.1 million in gross written premiums in 2004, $14.2 million in 2004 and $5.2 million in 2003. Total gross written premiums fronted on behalf of other carriers increased 37.1% in 2004 primarily due to the expansion of two new fronting programs with large national carriers for personal auto in Texas. These programs started in late 2003 and accounted for $52.0 million of gross written premiums in 2004 compared to $9.3 million in 2003 Total. Other active accounts have grown in sufficient volume to offset declines in several older programs that continue to be phased out.
Other income primarily represents fronting fees retained for fronting programs from other national or regional insurance carriers. This is net of our expenses associated with producing the business. . Fronting fees in 2005 were $2.7 million, less fronting fee expense of $0.6 million for a net total of $2.1 million. Fronting fees in 2004 were $2.6 million, less fronting fee expense of $0.8 million for a net total of $1.8 million. Other income was 8.8% higher in 2005 compared to 2004 primarily due to the higher fronted premium volume. Other income increased 22.9% in 2004 over 2003 Total primarily due to the growth associated with the two new fronting programs described above.
Income (loss) from continuing operations before income taxes was $0.05 million in 2005, $2.0 million in 2004, ($1.0) million for the 2003 Stub Period and $1.0 million for the 2003 Cutoff Period. Income from fronting fees and allocated investment income largely offset the interest expense of the corporate debt and holding company expenses.
Our operating subsidiaries’ primary sources of funds are net premiums received, commission and fronting fee income, net investment income and the proceeds from the sale and maturity of investments. We use these funds to pay claims and operating expenses, purchase investments and pay dividends to our holding company. Our assets and ongoing cash inflows are invested in a manner to provide an appropriate matching between asset liquidity and liability payments. Due to the short-tailed nature of our insurance policies, more than 96% of claims are paid within four years. To help satisfy claim payments and protect against cash outflow uncertainties, the average duration of our bond portfolio is less than four years (at December 31, 2005 the average duration was 3.3 years). During the catastrophe-prone second quarter, we generally maintain higher levels of cash in anticipation of satisfying cash outflows to pay claims from catastrophic events. Our investment portfolio is structured in a manner to yield substantial cash flows within relatively short periods. As of December 31, 2005, our investment portfolio is expected to produce cash inflows from interest and principal repayments of $79.1 million in 2006 and $42.6 million in 2007. As of December 31, 2005 and 2004, we held cash and short-term investments of $68.5 million and $39.4 million, respectively. This focus on liquidity helps protect us from unanticipated capital gains or losses on the sale of investments to meet liquidity needs.
Net cash used in investment activities amounted to $63.0 million for the year ended December 31, 2005 compared to net cash used in investment activities of $32.7 million for the year ended December 31, 2004, $26.6 million for the 2003 Stub Period and $23.7 million for the 2003 Cutoff Period. The increase in cash used in investment activities $30.3 million for the year ended December 31, 2005 compared to the prior year is primarily due to the increase in short-term investments related to the timing of the receipt of funds from reinsurers following the hurricanes in the third quarter. The comparison of cash used in investment activities between 2005, 2004 and 2003 was impacted by the receipt of $19.6 million for the sale of the home office building in 2004.
We maintain sufficient liquidity to pay claims, operating expenses, debt service, dividends and other obligations. At December 31, 2005 and 2004, we held $68.5 million and $39.4 million, respectively, in cash, cash equivalents and short-term-investments. We monitor our expected claims payment needs and maintain a sufficient portion of our invested assets in cash and cash equivalents to enable us to fund our claims payments without having to sell longer-duration investments. We adjust our holdings of short-term investments and cash and cash equivalents to provide sufficient liquidity to respond to changes in the anticipated pattern of claims payments. Given our historical cash flow, we believe that cash flow from operating activities will provide sufficient liquidity for our ongoing operations, including satisfying debt service obligations, supporting our holding company operations, paying other operating expenses and paying dividends to our stockholders. We anticipate that we will be able to meet our cash requirements for the foreseeable future.
We completed our IPO effective August 8, 2005 with the issuance of 6,000,000 shares of new common stock at a price to the public of $14.00. The $84.0 million of proceeds were used to pay accrued preferred dividends and to redeem a portion of our Series A preferred stock as well as pay underwriters commissions and other expenses of the offering. Only a nominal amount of the proceeds were available for general corporate purposes.
reducing the total adjusted surplus of our subsidiary RUIC below the greater of $125 million and 250% of risk-based capital at any quarter end;
paying dividends (unless, both prior to and after giving effect to the dividend, we and our subsidiaries are in compliance with all of the financial covenants under the credit facility and we provide advance written notice to the lenders); and
any governmental authority allegation of or commencement of any action for any securities laws violation that could reasonably be expected to result in a material adverse change; or
the occurrence of a material weakness in or fraud in our “disclosure controls and procedures” or “internal controls over financial reporting” as described in Rule 13a-15 or Rule 15d-15 under the Securities Exchange Act of 1934 (the “Exchange Act”) that could be expected to result in a material adverse change.
Trust preferred securities. In September and October 2003, we, through our trust subsidiaries, RIG Capital Trust I and RIG Capital Statutory Trust II, issued an aggregate of $30.0 million of trust preferred securities with stated maturities of 30 years in two private offerings. We have the option to call the securities at par beginning five years from the date of issuance. The interest rate on the first $10.0 million of trust preferred securities is adjusted quarterly to the three-month LIBOR plus 4.0%. The interest rate in effect for this issue at December 31, 2005 was 8.02%. If these trust preferred securities are redeemed prior to the first call date of September 30, 2008, the holders will be paid the principal plus a premium of 7.5% in addition to the accrued interest. The interest rate on the remaining $20.0 million of trust preferred securities is 7.7% during the no call period of five years, after which the interest rate will be adjusted quarterly to the three-month LIBOR rate plus 3.85%.
Under the terms of both series of the trust preferred securities, an event of default will occur upon our:
bankruptcy or liquidation or that of either of the financing trusts through which the trust preferred securities were issued.
Each of the trusts is a statutory business trust organized for the sole purpose of issuing trust securities and investing the proceeds in our junior subordinated notes. The trust preferred securities of each trust represent preferred beneficial interests in the assets of the respective trusts and are subject to mandatory redemption upon payment of the junior subordinated notes held by the trust. We own all of the common securities of each trust. Each trust’s ability to pay amounts due on the trust preferred securities is solely dependent upon our making payment on the related junior subordinated notes. The notes, which are the only assets of each trust, are subordinate and junior in right of payment to all of our present and future senior indebtedness. We have fully and unconditionally guaranteed each trust’s obligations under the trust preferred securities issued by each respective trust. If an event of default under the terms of our trust preferred securities occurs, continues beyond any applicable grace period, and is not waived by the holders of at least a majority in liquidation amount of the trust preferred securities, the entire principal and the interest accrued thereon may be declared to be due and payable immediately. At December 31, 2005, we are in compliance with all of the financial and restrictive covenants associated with the trust preferred securities.
The following table summarizes information about our contractual obligations and commitments. The minimum payments under these agreements as of December 31, 2005 were as follows:
(1) Amounts include interest payments associated with our senior credit facility and the debt issued to related party trusts using applicable interest rates as of December 31, 2005. In connection with the adoption of FASB Interpretation No. 46R, Consolidation of Variable Interest Entities, we do not consolidate the trusts established in connection with the issuance of our trust preferred securities. As a result, we report as a component of long-term debt the junior subordinated debentures that our subsidiary, Republic Companies, Inc., pays to the trusts.
(2) Operating lease obligations consist primarily of the lease on our home office building and various other smaller operating leases of field offices-also see note 16 to our audited consolidated and combined financial statements.
(3) Payments of benefits under our frozen defined benefit plans are funded from plan assets. See Note 14 to our audited consolidated and combined financial statements included in this annual report.
The loss and LAE payments due by period in the table above are based upon the loss and LAE estimates as of December 31, 2005 and are not contractual liabilities with specified times of payment. Our contractual liability is to provide benefits under our policies. As a result, our calculation of loss and LAE payments due by period is subject to the same uncertainties associated with determining the level of liabilities for unpaid loss and LAE generally and to the additional uncertainties arising from the difficulty of predicting when claims (including claims that have not yet been reported to us) will be paid. For a discussion of our process for estimating liabilities for unpaid loss and LAE, see Item 1. Business-Liabilities for Unpaid Losses and LAE. Actual payments of losses and LAE by period will vary, perhaps materially, from the above table to the extent that current estimates of loss and LAE vary from actual ultimate claims and amounts and as a result of variations between expected and actual payout patterns. See Item 1.A. Risk Factors for a discussion of the uncertainties associated with estimating unpaid losses and LAE. If our actual loss and LAE exceed our liability for losses, our financial condition and results of operations could be adversely affected.
We regularly evaluate our investment portfolio to identify other-than-temporary impairments of individual securities. We consider many factors in determining if an other-than-temporary impairment exists, including:
the financial condition and near-term prospects of the issuer of the security; and
Accordingly, when a decline in the value of a specific investment is considered to be “other-than-temporary,” a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other-than-temporary impairment could be material to results of operations in a future period. Management believes it is not likely that future impairment charges will have a significant effect on our liquidity.
Inflation can have a significant impact on property and casualty insurers because premium rates are established before the amount of losses and loss expenses are known. When establishing rates, the Company attempts to anticipate increases from inflation subject to the limitations of modeling economic variables. General inflation, as measured by the Consumer Price Index (“CPI”), has been relatively modest over the last several years; however, the price inflation of the goods and services purchased by insurance companies in settling claims has been steadily increasing. In particular, repair costs for homes, autos and commercial buildings and medical care costs, have risen disproportionately over the last few years. We continue to adjust our pricing projections as loss cost trends change in order to ensure premiums keep pace with inflation in all lines of business.
We also consider inflation when estimating liabilities for losses and LAE. The liabilities for losses and LAE are management’s best estimates of the ultimate net cost of underlying claims and expenses and are not discounted for the time value of money. In times of high inflation, the normally higher yields on our investments partially offset potentially higher claims and expenses.
The FASB has issued FASB Staff Position (“FSP”) No. 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The FSP requires recognition of an impairment loss on a debt security no later than when the investor deems the impairment is other-than-temporary, even if the investor has not decided to sell the security. This standard replaces current guidance in Emerging Issues Task Force Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The new standard is effective January 1, 2006. We do not expect that adoption of this FSP will have a material impact on our consolidated financial position and results of operations.
The Consolidated and Combined Financial Statements, including Notes to Consolidated and Combined Financial Statements and the Reports of Independent Registered Public Accounting Firm are as follows:
The consolidated financial statements of Republic Companies Group, Inc. (RCGI) and its wholly owned subsidiaries and certain affiliates, who are controlled through various management agreements, have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). All significant intercompany balances and transactions have been eliminated in consolidation and combination. Certain 2004 and 2003 balances have been reclassified to conform to the 2005 presentation.
RCGI is an insurance holding company and its subsidiaries and affiliates include Republic Companies, Inc. (RCI), Eagle General Agency (EGA), Republic Group No. Two Company (RG2), Republic Diversified Services, Inc. (RDSI), Republic Underwriters Insurance Company (RUIC), Republic-Vanguard Insurance Company, Southern Vanguard Insurance Company, Southern Insurance Company, Republic Fire and Casualty Insurance Company, Southern Underwriters Insurance Company, Republic Lloyds, Southern County Mutual Insurance Company (SCM), and Republic Home Protectors, Inc. (RHP) (80% owned) (collectively, the Company). The Company markets and underwrites personal and commercial property and casualty risks located primarily in the southwestern United States.
On May 9, 2003, RCGI and RCI agreed to acquire from Republic Financial Services, Inc. (RFSI), an indirect subsidiary of Winterthur Swiss Insurance Company (the Acquisition), all of the issued and outstanding common stock of the Subject Companies for $127.0 million adjusted for actual GAAP equity on the closing date. The Subject Companies are providers of property and casualty insurance primarily in the southwestern United States. Regulatory approvals were completed in August 2003 and the Acquisition closed on August 29, 2003. In January 2004, agreement was reached between RCGI and RFSI on a final purchase price of $113.8 million. In addition to the purchase price of $113.8 million, the Company incurred acquisition costs of $4.5 million. In connection with the Acquisition, an allocation of the purchase price of $113.8 million was made to the fair values of the assets acquired and the liabilities assumed as of the Acquisition date as follows:
The assets acquired and liabilities assumed were adjusted to their estimated fair values as of the Acquisition date. The excess of estimated fair value of net assets over the purchase price of $113.8 million created negative goodwill. Certain noncurrent nonfinancial assets were written down by the negative goodwill and the remaining negative goodwill was recorded as an extraordinary gain in accordance with Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations. See note 3 for the methodology used in determining the fair value of certain assets, unearned premium liabilities and the liabilities for losses and loss adjustment expenses.
The $92 million of intangible assets acquired included identified amortizable intangible assets of $87 million and nonamortizable intangible assets of $5 million. Various methods were used to determine the estimated fair value of these assets including discounted income flow and replacement cost. The amortizable intangible assets included policyholder/agent lists of $80 million with a three year average life, unique company charters of $5 million with a twenty year life, noncompetition agreements of $1 million with a one year life, and software of $1 million with a five year life. The nonamortizable intangible assets included the value of insurance licenses and trade names. Approximately $4 million of the acquired intangible assets are expected to be deductible for tax purposes. None of the intangible assets were deemed impaired at the date of acquisition. All of these intangible assets were written down by the negative goodwill.
Management believes the negative goodwill occurred in large measure due to the seller’s desire to exit the Texas insurance market, combined with the seller’s need for additional capital for its ongoing business units.
Fixed maturity and equity securities are considered as available for sale and reported at fair value. Unrealized appreciation (depreciation) of fixed maturities and equity securities available for sale is shown as a separate component of shareholders’ equity as accumulated other comprehensive income net of the related tax effect, and is not included in the determination of net income.
Loan-backed bonds and structured securities are amortized using the interest method and significant changes in estimated cash flows from the original purchase assumptions are accounted for using the retrospective method. Valuations are based on the structure of the deals as well as cash flows projected based on prepayment and loss assumptions using financial modeling.
The Company’s investment in an unconsolidated foreign insurance company represents the Company’s 30% interest in Seguros Atlas, S.A. (Atlas), a Mexican insurer, which is accounted for under the equity method. The Company’s 30.0% ownership, board representation, and certain voting rights enable the Company to exercise significant influence over Atlas. Under the equity method of accounting, Atlas’ accounts are not included within the Company’s consolidated balance sheets and statements of operations; however, the Company’s equity in Atlas’ income or loss is included in the consolidated and combined statements of operations.
Since the Acquisition, the Company does not invest in derivative financial instruments. However, prior to August 29, 2003, the Company periodically used put options and futures contracts for the purpose of
reducing the market risk from a drop in value of the overall equity market, as measured by the S&P 500 Index. All use of derivative instruments ceased prior to August 29, 2003.
Costs of investments sold are determined using the specific identification method.
Premiums receivable are carried at cost, which approximates fair value. Management provides an allowance for uncollectible accounts in the period that collectibility is deemed impaired.
adjusted to fair value. The total adjustment of $23,540,000 was fully amortized in 2003 and 2004 due to the short-term nature of the related policies.
As part of purchase accounting, the carrying value of property and equipment was recorded at fair value. SFAS No. 141 required the write-down of certain nonfinancial assets by the negative goodwill resulting from the Acquisition (note 2). The net impact was to decrease assets by $4.1 million.
Leasehold improvements (or real estate improvements prior to the Acquisition), furniture and equipment (including electronic data processing equipment and related software) are reported at cost less accumulated depreciation and amortization. Depreciation and amortization are calculated on a straight-line basis generally using the shorter of the useful life or lease term: leasehold improvements and furniture-up to 12 years; and equipment and software-3 to 5 years. Prior to the Acquisition, real estate improvements were depreciated up to 20 years and furniture up to 10 years. Expenditures for maintenance and repairs are charged to operations as incurred. Upon disposition, the asset cost and related depreciation/amortization are removed from the accounts and the resulting gain or loss is included in net income.
premiums earned. Such fees are generally returned in their entirety to the respective producers in the form of additional commission and were not a part of our net income. Since these policy fees are charged and retained by the producing unaffiliated MGA or insurer, we elected in 2005 to net these fees and the related commission within Other Income and to reclassify the presentation in prior periods to be consistent with the 2005 presentation. The impact is to reduce written and earned premiums and to reduce commission or acquisition expense, although there is no net income effect.
Other income also includes installment billing fees collected from insureds that elect to pay their insurance premiums on an installment billing plan (see comments in paragraph (d) above concerning classification of installment billing fees) and any net gain or loss on sale of fixed assets.
The process of establishing claims liabilities is an imprecise science and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. The actual emergence of claims and claim adjustment expenses may vary, perhaps materially, from the Company’s estimate thereof, because (1) estimates of claims and claim adjustment expense liabilities are subject to large potential errors of estimation as the ultimate disposition of claims incurred prior to the financial statement date, whether reported or not, is subject to the outcome of events that have not yet occurred (e.g., jury decisions, court interpretations, legislative changes that broaden liability and policy definitions and increase the severity of claims obligations, subsequent damage to property, changes in the medical condition of claimants, public attitudes and social/economic conditions such as inflation), (2) estimates of losses do not make provision for extraordinary future emergence of new classes of losses or types of losses not sufficiently represented in the Company’s historical data base or
In the ordinary course of business, the Company purchases reinsurance to protect against the impact of large, irregularly-occurring losses, thus limiting the Company’s maximum loss. Such reinsurance reduces the magnitude of sudden and unpredictable changes in net income and the capitalization of the Company’s insurance operations. The Company reinsures its risks generally on an excess per risk or catastrophe basis with other insurance companies which are principally rated “A” or higher by A.M. Best. The Company also participates in reinsurance arrangements through its unaffiliated managing general agency and fronting program business whereby 20% to 100% of written premiums and associated losses and expenses are passed through to unaffiliated reinsurers which are principally rated “A-” or higher by A.M. Best. An allowance has been established for amounts deemed uncollectible.
Reinsurance does not relieve the Company of its primary obligation to the policyholder. Amounts recoverable from reinsurers are estimated in a manner consistent with the determination of losses and loss adjustment expenses.
The Company uses the asset and liability method of accounting for income taxes specified under SFAS No. 109, Accounting for Income Taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Additionally, the Company is subject to assessments from state FAIR Plans (Fair Access to Insurance Requirements). Plans such as the Louisiana Citizens Property Insurance Corporation and Texas Windstorm Insurance Association have levied assessments against several of our insurance subsidiaries following Hurricanes Katrina and Rita and additional assessments may follow. The total of such assessments in 2005 was $1.7 million. These assessments are generally recoverable from the Company’s catastrophe reinsurers. Such assessments may also be recoverable through surcharges to policyholders, wherein any recoveries would be reimbursed to the reinsurers.
In March 2004, the Company adopted a Stock Plan enabling the Company to award shares or options to officers, directors, key employees and other designated parties. Additional stock-based compensation plans were adopted in 2005. The Company has adopted the measurement and recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation. Under SFAS No. 123, compensation expense is recognized over the stock award vesting period based on the fair value at the date the awards were granted (also see note 18). The Company had no stock based compensation plans in effect prior to 2004, therefore, there are no stock based compensation transition issues from prior periods.
The financial position and results of operations of Atlas are measured using Mexican local currency as the functional currency and are adjusted to reflect U.S. GAAP. Revenues and expenses of Atlas have been translated into U.S. dollars at average exchange rates prevailing in the period. Assets and liabilities have been translated at the exchange rate on the balance sheet date. Translation gains or losses, net of applicable tax, are credited or charged directly to a separate component of other comprehensive income.
In December 2004, the FASB issued SFAS No. 123 (Revised), Share Based Payment. SFAS No. 123R, which replaces SFAS No. 123, Accounting for Stock-Based Compensation, supersedes Accounting Procedures Board Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123R is similar to the approach described in SFAS No. 123. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values (i.e., pro forma disclosure is no longer an alternative to financial statement recognition). SFAS No. 123R is effective for public companies at the beginning of the first annual period beginning after June 15, 2005. The Company adopted the provisions of SFAS No. 123 in 2004 and uses the fair value method for expensing stock-based compensation. The Company will adopt SFAS No. 123R effective January 1, 2006 and does not anticipate that this statement will have a significant impact on its financial position or results of operations.
The FASB has issued FASB Staff Position (FSP) No. 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The FSP requires recognition of an impairment loss on a debt security no later than when the investor deems the impairment is other-than-temporary, even if the investor has not decided to sell the security. This standard replaces current guidance in Emerging Issues Task Force Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The new standard is effective January 1, 2006. We do not expect that adoption of this FSP will have a material impact on our consolidated financial position and results of operations.
The FASB has issued SFAS No. 154, Accounting Changes and Error Corrections, as a replacement of APB No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 requires restatement of all prior period financial statements if a company makes an accounting change or corrects an error. The standard is effective January 1, 2006. The Company will apply the standard, if applicable, in the future.
Estimates of fair values are made at a specific point in time, based on relevant market prices and information about the financial instrument. The estimated fair values of financial instruments presented below are not necessarily indicative of the amounts the Company might realize in actual market transactions. The carrying amount and estimated fair value for the financial instruments at period end are summarized as follows:
Fair value for long-term debt is estimated based on the quoted market price for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities.
The amortized cost and estimated fair values of investments as of December 31, 2005 and 2004 are as follows:
The amortized cost and estimated fair value of fixed maturities at December 31, 2005 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because issuers of such securities may have the right to call or prepay obligations with or without call or prepayment penalties. Mortgage and asset-backed securities are classified below as having no single maturity date.
Proceeds from the sales and maturities of fixed maturities, including short-term bonds, and equity securities available for sale, and derivative instruments, including hedging put options assets and hedging futures liabilities, and the related realized gross gains and losses and realized losses related to other-than-temporary declines in value are as follows for 2005, 2004, and 2003:
The Company’s insurance subsidiaries had bonds with fair values totaling $12,185,000 and $12,078,000 at December 31, 2005 and 2004 on deposit with regulatory authorities under statutory requirements.
During the years ended December 31, 2005, 2004, and 2003 investment income was earned in the following investment categories:
* September 30, 2003 was the closest date for which GAAP financial statements were available. Net income for the period January 1 to August 28, 2003 was prorated based on the September 30, 2003 amounts.
As of December 31, 2005, retained earnings included $7.9 million related to the undistributed earnings of the Company’s unconsolidated foreign insurance company.
The Company’s insurance subsidiaries assume reinsurance from and cede reinsurance to other insurance companies, primarily under treaty reinsurance agreements.
Reinsurance does not discharge or diminish the primary liability to insureds of the companies as direct insurers. However, it does permit the companies to recover losses from the reinsurer. To the extent that reinsuring companies are unable to meet obligations arising under reinsuring agreements, the Company would remain liable.
The effect of reinsurance on premiums written and earned and losses and loss adjustment expenses for the years ended December 31, 2005 and 2004 and the periods August 29 to December 31, 2003 and January 1 to August 28, 2003 was as follows:
Ceding commissions, which are netted with acquisition costs in the consolidated and combined statements of operations were $42.9 million, $58.7 million, $15.5 million and $43.1 million for the years ended December 31, 2005 and 2004 and the periods August 29 to December 31, 2003 and January 1 to August 28, 2003, respectively.
The table below shows the components of balances due from reinsurance companies as of December 31, 2005 and 2004.
The Company has unsecured aggregate reinsurance balances at December 31, 2005 and 2004 which exceed 10% of the Company’s shareholders’ equity as of December 31, 2005 and 2004 with the following individual reinsurers or groups:
Property and equipment is included in Other Assets and summarized as follows as of December 31, 2005 and 2004:
The carrying value of property and equipment at the Acquisition date was reduced by $4.1 million in accordance with SFAS No. 141 (see note 2). Depreciation expense was $1,118,000, $284,000, $27,000 and $1,347,000 for the years ended December 31, 2005 and 2004, the periods August 29 to December 31, 2003 and January 1 to August 28, 2003, respectively.
Activity in the liability for unpaid claims and claim adjustment expenses is summarized as follows:
Liabilities are recognized for known claims (including the cost of litigation) when specific information has been developed to indicate the involvement of a specific insurance policy and management can reasonably estimate its liability. Liabilities have also been established to cover exposures on incurred but not reported claims. Estimates of the liabilities are reviewed and updated continually. Due to the inherent uncertainty that exists on these exposures, development patterns are uncertain and adverse development could occur.
In the third quarter of 2005, Hurricanes Katrina and Rita struck the coasts of Louisiana and Texas and significantly affected properties insured by the Company. Gross losses and loss adjustment expenses before reinsurance include approximately $92.5 million for these events. This represents the Company’s best estimate and is based on claims received to date plus assumptions involving industry loss estimates, estimates from industry and proprietary models, coverage and contract language, and estimates for anticipated assessments from various state facilities, among other factors. The estimates may be influenced by claims yet to be reported and increased costs due to the effects of increased demand for services and supplies in the affected areas. Cost escalation could occur at a higher level than estimated.
The capitalization shown in the combined statement of net assets for the predecessor basis entity prior to August 29, 2003 reflects the aggregation of common stock, additional paid-in capital, accumulated other comprehensive income (loss) and retained earnings (deficit) for the Subject Companies as of the dates shown. Following the Acquisition, these balances ceased to exist.
Prior to the IPO, the Company’s Certificate of Incorporation as amended authorized the following classes of capital stock: Class A Voting Common Stock of 9,625,000 shares, Class B Non-Voting Common Stock of 2,200,000 shares, and Series A Redeemable Preferred Stock of 605,000 shares.
Effective August 8, 2005, the Company completed the IPO of its common stock with the sale of 6,000,000 shares of Common Stock at a price to the public of $14 per share. The majority of the proceeds from the IPO were used to pay all accrued and unpaid dividends totaling $7.1 million on the Series A Preferred Stock and to redeem 69,268 shares of the Series A Preferred Stock at their liquidation value. All shares of Class A and Class B Common Stock were converted into shares of Converted Common Stock and the remaining shares of Series A Preferred Stock were converted into 2,726,024 shares of Converted Common Stock. On September 3, 2005, the over-allotment option granted to the underwriters in the IPO expired. Underwriting discounts and other offering expenses totaling $8.3 million were deducted from the proceeds of the offering.
All outstanding Class A and Class B shares at the IPO date were converted into the Converted Common Stock.
The Series A Preferred Stock ranked senior to all classes of common stock with regard to payment of dividends, redemptions, liquidations, or any other distribution from the Company. The Series A Preferred Stock was entitled to receive 12% cumulative dividends and had a $1,000 liquidation and dividend accrual value. The first 1,500 shares of Series A Preferred Stock were issued as part of the stock dividend described above. In connection with the Acquisition (note 2), the Company issued 105,000 shares of Series A Preferred Stock. To the extent that the dividends were not paid, they accrued in arrears. At December 31, 2004 and 2003, the Company had accrued $18.8 million (approximately $174 per share) and $4.5 million (approximately $42 per share), respectively, in dividends in arrears on these shares. At December 31, 2004, there were 107,825 and 107,531 shares issued and outstanding, respectively. At December 31, 2003, there were 106,500 shares issued and outstanding. The total liquidation value of the Series A Preferred Stock at December 31, 2004 was $126,286,000.
In January 2004, 294 shares of the preferred stock were redeemed at the liquidation value plus accrued dividends of $14,000. In February 2005, 98 shares of the preferred stock were redeemed at the liquidation value plus accrued dividends of $18,000. In February 2005, the Company paid $20 million of accrued preferred dividends with the proceeds from a senior bank credit facility as described in note 13 below.
All preferred shares (including accrued dividends of $7,101,000) were redeemed and/or converted into the new Converted Common Stock on the IPO effective date.
The Company’s insurance subsidiaries, domiciled in the States of Texas, Arizona, and Oklahoma, prepare statutory financial statements in accordance with the accounting practices prescribed or permitted by the Department of Insurance of the domiciliary state. Prescribed statutory accounting practices are those practices that are incorporated directly or by reference in state laws, regulations, and general administrative rules applicable to all insurance enterprises domiciled in a particular state. Permitted statutory accounting practices include practices not prescribed by the domiciliary state but allowed by the domiciliary state. Additionally, the current version of the National Association of Insurance Commissioners (NAIC) Accounting Practices and Procedures Manual has been adopted as a component of the prescribed and permitted practices of each state.
Following are per share amounts for the years ended December 31, 2005 and 2004 and the period August 29, 2003 to December 31, 2003:
In assessing the realization of deferred taxes, management considers whether it is more likely than not that all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Management believes it is more likely than not that the Company will realize the remaining benefits of these deductible differences in the foreseeable future; therefore, no valuation allowance is necessary.
The Company completed the placement of two capital securities with liquidation value of $30 million and received net proceeds of $30.9 million. The issuance cost of the subordinated debentures was $0.9 million. The Company used $22.0 million of the proceeds to rescind the temporary capital (see note 9(b)).
The Company has fully and unconditionally guaranteed the payment by the Trust of distributions and other amounts under the Capital Securities to the extent that the Trust has funds available for such payments. The Trust must redeem the Capital Securities when the Debentures are paid at maturity or upon any earlier prepayment of the Debentures. The Debentures may be prepaid if certain events occur, including a change in the tax status or regulatory capital treatment of the Capital Securities or a change in existing laws that require the Trust to register as an investment company. Under the provisions of the Debentures, the Company has the right to defer payment of interest on the Debentures at any time, or from time to time, for up to twenty consecutive quarterly periods. If interest payments on the Debentures are deferred, the distributions on the Capital Securities will also be deferred. Interest of $762,588 was paid and expensed in 2005.
On October 29, 2003, the Company completed the private placement of 20,000 floating rate capital securities (the Capital Securities II) with an aggregate liquidation value of $20 million through its newly formed Connecticut statutory business trust, RIG Capital Statutory Trust II (the Statutory Trust). The Statutory Trust invested the proceeds from the sale of the Capital Securities II, together with the proceeds from the sale by the Statutory Trust of its common securities to the Company, in an equivalent amount of the Company’s Floating Rate Junior Subordinated Debt Securities due 2033 (the Debentures). The Debentures will mature on October 29, 2033, which date may be shortened to a date not earlier than October 29, 2008 if certain conditions are met, including any required regulatory approvals. The Debentures, which are the only assets of the Statutory Trust, are subordinate and junior in right of payment to all present and future senior indebtedness (as defined in the Indenture dated October 29, 2003) of the Company. For the first five years (through October 28, 2008), the Debentures accrue interest at a rate of 7.70%, payable quarterly on January 29, April 29, July 29, and October 29 of each year. After October 28, 2008 and for their remaining life, the Debentures accrue interest at a floating rate
In accordance with FASB Interpretation No. 46R, Consolidation of Variable Interest Entities, the Trusts established for the sole purpose of issuing the subordinated debentures are not consolidated. The liability and the terms of the debt payable to the Trusts are exactly the same as those issued by the Trusts.
The aggregate maturities for all of the Company’s subordinated debentures and senior credit facility, not including interest, for each of the five years after December 31, 2005 are as follows:
Prior to August 29, 2003, the employees of the Subject Companies participated in a defined benefit plan sponsored by its former upstream parent, RFSI. On August 29, 2003, this plan was transferred from RFSI to the Company. Subsequent to that date, the plan was frozen with benefits accrued through December 31, 2003.
The status of the plan as of and for the years ended December 31, 2005 and 2004 was as follows:
The accumulated benefit obligation is equal to the projected benefit obligation.
The Company intends to make annual contributions equal to or greater than the minimum required contribution as defined in the actuarial valuation report. In no event, however, will the Company make a contribution in excess of the maximum deductible contribution. No contribution was required in 2005 and the Company made a required contribution of $1.6 million in 2004. The Company’s estimated contribution requirement for 2006 is zero.
Following are estimated future benefit payments to be paid from plan assets:
The plan has been funded using a Rabbi trust. At December 31, 2005 and 2004, the asset balance in this trust is $1,652,000 and $1,698,000, leaving a net unfunded liability of $614,000 and $461,000, respectively.
The Company intends to make annual contributions equal to or greater than the minimum required contribution as defined in the actuarial valuation report. In no event, however, will the Company make a contribution in excess of the maximum deductible contribution. The Company’s required contribution in both 2005 and 2004 was $85,000 and is estimated to be $92,000 in 2006.
Following are estimated future benefit payments to be paid from trust assets:
The changes in the components of accumulated other comprehensive (loss) income net of income taxes for the years ended December 31, 2005 and 2004 and the period August 29 to December 31, 2003, and the period January 1 to August 28, 2003 were as follows:
As discussed in notes 6 and 8 regarding reinsurance and losses and loss adjustment expenses, the Company was heavily impacted by two major hurricanes in the third quarter of 2005. Hurricanes Katrina and Rita are among the most costly hurricanes on record and many of the losses, especially from Katrina, were caused by rising water from the unusually high storm surge as well as flooding from broken levees along lakes and rivers in Louisiana. Our loss and loss adjustment expense estimates from hurricane losses are determined in accordance with the coverage provided in the respective policies. The Company’s homeowners policies specifically exclude coverage for losses caused by flood, but generally provide coverage for damage caused by wind and wind driven rain. The estimates for homeowners losses, therefore, do not include estimates for losses caused by flood.
The Company is subject to assessments from state FAIR Plans. Plans such as the Louisiana Citizens Property Insurance Corporation and Texas Windstorm Insurance Association have levied assessments against several of our insurance subsidiaries following Hurricanes Katrina and Rita and additional assessments may follow. The total of such assessments in 2005 was $1.7 million. These assessments are generally recoverable from the Company’s catastrophe reinsurers. Such assessments may also be recoverable through surcharges to policyholders, wherein any recoveries would be reimbursed to the reinsurers.
The Company leases its home office and other office space under various noncancelable operating leases that expire through February 2017. Rental expense was $2,270,000, $814,000, $90,000 and $134,000 for the years ended December 31, 2005 and 2004, the periods August 29 to December 31, 2003 and January 1 to August 28, 2003, respectively. The future minimum rental payments are as follows:
The Company has no agreements involving contingent rental payments. Certain leases provide for various rent escalations based on increases in operating expenses, taxes or other costs at intervals specified in the lease; however, the Company accounts for lease expense on a straight-line basis. The Company has not entered into any sale/leaseback arrangements.
The following table sets forth the Company’s gross premiums for the period written by geographic area for the periods indicated:
The Company’s insurance subsidiaries and affiliates distribute its insurance products through a combination of independent agencies and unaffiliated managing general agencies (MGA) and specialty producers. One unaffiliated MGA in our Program Management segment accounted for 23.4%, 24.4%, and 22.1% of gross written premiums and 13.2%, 7.2%, and 3.9% of net insurance premium earned in 2005, 2004 and 2003, respectively. In 2005, 2004, and 2003, no one independent agency accounted for more than 1.5% of total gross written premium.
The 2005 Equity-Based Compensation Plan (the “2005 Plan”) was approved by the Company’s shareholders in May 2005 to be effective immediately prior to the IPO. The purposes of the 2005 Plan are to promote the success and enhance the value of the Company and its subsidiaries by linking the personal interests of officers, directors, consultants, insurance agents, and key employees to those of the Company’s shareholders, and by providing such individuals with an incentive for outstanding performance that contributes to the Company’s growth and success. The 2005 Plan primarily provides for grants of (1) incentive stock options qualified as such under U.S. federal laws, (2) stock options that do not qualify as incentive options (i.e., “nonstatutory options”), (3) stock appreciation rights, (4) restricted stock awards, (5) phantom stock rights, or (6) any combination of such awards.
The Employee Stock Purchase Plan (the “ESPP”) was approved by the Company’s shareholders in May 2005 to be effective immediately following the IPO. The purpose of the ESPP is to encourage employees to
The Company expenses the cost of stock awards using the fair value based method of recording stock-based compensation in accordance with SFAS No. 123 (see note 3(m)). The total cost of the Company’s 2004 stock awards, which will be reflected in earnings over the vesting periods through 2008, was estimated to be $4.3 million before tax. The fair value was estimated to be approximately $8.37 per share, computed as book value of the shares in the month of the grant adjusted for book-to-market multiples of selected peer companies. Based on the fair value of the Company’s common stock on the date these awards were granted and prorating the value based on the vesting period, the Company recorded $1.11 and $1.05 million as stock compensation expense in 2005 and 2004, respectively relating to these restricted stock awards.
The Company uses the Black-Scholes model to determine fair value of the options it grants. This model values options based on the stock price at the grant date, the expected life of the option, the estimated volatility of the stock, the expected dividend payments and the risk-free interest rate over the expected life of the option. The assumptions used in the Black-Scholes model for these stock options granted in 2005 were:
On March 18, 2005, options to purchase 58,124 shares of the Company’s common stock were granted to certain officers at an exercise price of $10.00 per share. In July 2005, the Company granted additional options to certain officers totaling 1,347 shares of common stock at an exercise price of $10.00 per share. These options vest ratably over three to five years and expire ten years from the date of grant.
The weighted average fair values of options granted were as follows:
The Company classifies its business into the following segments: Independent Agents-Personal Lines, Independent Agents-Commercial Lines, Program Management, and Insurance Services and Corporate. Segments are designated based on the respective similarities in distribution systems, internal processing and management reporting systems and organizational management structure.
In the Independent Agents-Personal Lines segment, the Company underwrites personal lines of insurance distributed through a network of independent agencies. The Company tailors its products to meet the needs of policyholders located in underserved geographic and demographic markets within the Southwest region. These products currently include homeowners, dwelling fire, low-value dwelling, standard auto, nonstandard auto and personal umbrella coverages. Additionally, personal lines products distributed through the Company’s two affiliated managing general agents (MGAs) are included in this segment.
In the Independent Agents-Commercial Lines segment, the Company underwrites commercial lines of insurance distributed through an independent agency network. The Company’s products target specific classes of business in industries that the Company believes are underserved by the insurance industry. These products currently include commercial package policies, casualty, property, auto, workers’ compensation, farm and ranch and commercial umbrella coverages.
In the Program Management segment, the Company distributes personal and commercial insurance policies through contractual programs established with unaffiliated MGAs. These MGAs provide the underwriting, claims handling and management for the Company’s products in targeted niche markets. The Company writes the policies produced through these MGAs, retains all or a portion of the business and cedes any remaining premium to highly-rated reinsurers. The Company received a fronting fee on programs where quota share reinsurance is placed in addition to sharing in the underwriting results of each program. The Company requires various contractual, operational, financial and other oversight controls on the business of each MGA to protect its surplus and reputation. These relationships are based on years of experience with the MGA principals and an understanding of the products, markets and distribution of the programs. Through these unaffiliated MGA programs, the Company currently underwrites nonstandard auto, commercial auto, light commercial casualty, prize indemnification, lender’s collateral protection and employers’ nonsubscriber policies.
In the Insurance Services and Corporate segment, the Company provides fronting services through its Texas county mutual insurance company and other insurance subsidiaries and controlled affiliates to national and regional insurance carriers seeking to utilize the Company’s charters and licenses to access insurance markets in Texas and other states. These companies establish programs whereby the Company underwrites risks that are entirely ceded back to the carriers in exchange for a fronting fee. The Company’s principal fronting programs are
for personal and commercial auto policies. The Insurance Services and Corporate segment also reflects the revenue and expenses that are not allocated to any particular segment, including general corporate overhead and interest expenses and the equity in the earnings of Atlas.
The only transactions between reportable segments are the intercompany leasing of certain fixed assets. Generally, depreciation and lease expenses are allocated to the Independent Agents and Program Management segments and lease income is recognized in the form of an expense reduction in the Insurance Services and Corporate segment. All intercompany leasing income and expenses are eliminated in consolidation.
Summary financial information about the Company’s operating segments is presented in the following table. Income (loss) before income taxes by segment consists of revenues, including allocated investment income, less expenses related to the respective segment’s operations. Investment income includes realized gains and losses allocated on the same basis as investment income. Taxes are allocated to each segment at the Company’s effective tax rate. Identifiable assets by segment are those assets used in or allocated to the operation of each segment.