net premiums earned, which comprises the premiums we earn from sales of automobile insurance policies less those premiums that we cede to reinsurers;
We are in the process of deploying a new more segmented point-of-sale product called Select 2.0. We designed this product to be broadly competitive. We have used advanced statistical techniques, most significantly Generalized Linear Models (“GLMs”), to create a new rating algorithm. GLMs are a family of regressions in which different distributions can be examined to determine which is most predictive. Additionally, we are employing our own proprietary credit model and vehicle symbol set in the rating process. During 2006, we launched the Select 2.0 product in 12 states, including six states during the fourth quarter. Preliminary results indicate that the product has been well received. In the 12 states in which we deployed the product, our aggregate written premium in 2006 increased 13% to $307.8 million compared to $273.0 million in 2005. By mid-2007, we expect to have introduced Select 2.0 in 20 of the 22 states in which we operate. We cannot deploy Select 2.0 in California because of regulatory constraints, and in Georgia, we believe that it will take longer to obtain regulatory approval. We are satisfied with this product’s performance to date.
Increasing the number of producers with which we do business is one important aspect of our growth strategy. We attempt to target producers in geographic areas where we are under-represented and where we believe we can write profitable business. During 2006, we increased our total number of producers to 9,141 and our total number of producer locations to 12,391. This compares to 8,701 producers and 11,674 producer locations as of September 30, 2006, and 7,720 producers and 10,361 producer locations as of December 31, 2005. The following table displays our producer representation in our top five states and in all of our other states collectively as of December 31, 2006 and December 31, 2005.
The number of policies in force is a significant driver of our gross earned premium. The table below shows our average number of policies in force and gross earned premium for the years ended December 31, 2006, 2005 and 2004.
The average number of policies in force for 2006 decreased by 8.9% compared to 2005 consistent with a decline in gross earned premium of 8.7% over the same period. Similarly, the average number of policies in force for 2005 declined by 8.5% compared to 2004, while gross earned premium declined by 7.0% over the same period. At December 31, 2006, we had approximately 414,000 policies in force compared to approximately 406,000 at December 31, 2005, an increase of 2.0%, and approximately 481,000 at December 31, 2004, a decrease of 15.6%.
Some companies with which we compete, primarily in California, do not verify certain underwriting information, which has the effect of lowering the premium they charge, and thus attracting more business. In addition, in California and in other states, some companies with which we compete pay incentives to agents and brokers, such as contingent commissions. Also, some competitors spend significant sums on national and local advertising. In all of our markets, we have not relaxed our underwriting standards, we do not pay incentives to agents and brokers, and we do not spend significantly on consumer advertising. In the fourth quarter of 2006, we began to observe a reversal of some of these trends and, as a result, our gross written premium for the quarter ended December 31, 2006 declined by only 4.5% compared to the same quarter of 2005, our best performance of the year.
One of our objectives is to increase our geographic diversification over time. Although California continues to be our largest state, our mix of premium writings has become more geographically diverse. For the year ended December 31, 2006, we derived 40% of our gross written premium from California compared to 46% for the year ended December 31, 2005. California, Florida and Michigan collectively accounted for 70% of our gross written premium for the year ended December 31, 2006, down from 75% for the year ended December 31, 2005. We also look to enter new large non-standard markets with favorable regulatory environments.
Gross written premium by state and in the aggregate before and after the change in the provision for cancellations for the years ended December 31, 2006, 2005, and 2004 are presented below.
Changes in gross written premium, as detailed above, vary significantly by state and are influenced by a variety of factors, including competitive conditions and regulatory environments within each state, our strategies with respect to product pricing, and changes in the number and location of producers. In the aggregate, our gross written premium decreased by 4% in 2006 compared to 2005. Included in these figures is a change in the provision for expected policy cancellations that increased gross written premium by less than 1% in 2006, by 3% in 2005, and by 6% in 2004. We provide for expected policy cancellations in order to adjust written premium to amounts we expect to ultimately collect and earn. Because the cancellation provision adjusts our unearned premium for amounts we expect will not be collected, the changes in the provision are impacted by changes to both the rate of cancellations and the unearned premium reserve. Our cancellation experience has steadily improved in the last three years. The rate of expected cancellation declined to 20.7% as of December 31, 2006 compared to 21.7% as of December 31, 2005 and 24.7% as of December 31, 2004. Decreases to the provision added $1.9 million, $18.9 million and $46.3 million to gross written premium during 2006, 2005 and 2004.
In Florida, our second largest state, gross written premium grew by 16% in 2006, following a decline of 10% in 2005. On August 1, 2006, we deployed our Select 2.0 product in Florida. (See “Overview - Products and Services” above.) We attribute much of the premium growth in Florida during 2006 to the introduction of this new product. Most agents in Florida use third party software that compares rates and, as a result, our new program became available very broadly and very quickly. We continue to observe signs that the rates in the Florida market are firming. As detailed in the table above, these revisions continue the trend of rate increases outnumbering rate decreases among competitors’ rate filings that we first noted during the fourth quarter of 2005.
In Michigan, our third largest state, gross written premium declined by 16% in 2006 and grew by 16% in 2005. We attribute the decline in volume in 2006 principally to rate increases that we implemented in January and April 2006 in response to increasing severity of personal injury protection (“PIP”) claims in Michigan. On October 30, 2006, we introduced our Select 2.0 product in Michigan. (See “Overview - Products and Services” above.) Most agents in Michigan do not use third party software that compares rates, resulting in a slower roll-out of the product in this state. Nevertheless, we have begun to see early indications that the product is making inroads into the marketplace, as processed written premium grew slightly in December 2006 to $5.9 million compared to $5.8 million in December 2005.
The table below shows our gross written premium by state and quarter for the twelve months ended December 31, 2006:
Twelve Months Ended December 31, 2006 compared to Twelve Months Ended December 31, 2005
(2) Amount represents the unearned premium previously ceded under our 2002-2004 quota share reinsurance agreement, which we received as a result of the termination and commutation of this agreement.
Net Earned Premium. Net earned premium declined by 2% to $581.1 million for the twelve months ended December 31, 2006 from $595.1 million for 2005. Net earned premium for the twelve months ended December 31, 2005 included a reduction of $42.5 million for premium ceded pursuant to a 10% quota share reinsurance agreement. We had no quota share reinsurance agreement in effect during 2006. Net earned premium, excluding the effect of the 2005 quota share reinsurance, decreased by $56.5 million, or 9%, for the twelve months ended December 31, 2006 compared to 2005, which is consistent with the decline in gross earned premium of 9% for the same period.
Policy Service Fee Revenue. Policy service fee revenue declined by 12% to $54.7 million for the twelve months ended December 31, 2006 compared to $62.5 million for 2005. Policy fee income generally correlates with gross earned premium. Gross earned premium was lower by 9% for the twelve months ended December 31, 2006. Our fee income as a percentage of gross earned premium declined to 9.3% for the twelve months ended December 31, 2006 from 9.7% for the twelve months ended December 31, 2005. The decline is mostly attributable to a 14% decline in 2006 gross written premium in California, where our fees are higher than for the rest of our business on average, and decreases in our installment fees. A greater percentage of our customers are signing up for electronic funds transfer (“EFT”) payment plans, on which we charge lower installment fees. The EFT business is more persistent, produces lower losses and is less expensive to administer. The portion of our policyholders who utilize EFT increased to 16% for 2006 compared to 7% for 2005.
Other Operating and General Expenses. Other operating and general (“G&A”) expenses were $42.9 million for the twelve months ended December 31, 2006 compared to $40.3 million for 2005, an increase of $2.6 million. Costs associated with governmental investigations concerning our reinsurance agreements added $2.7 million before taxes during the twelve months ended December 31, 2005, while we incurred an insignificant amount of such expenses in 2006. G&A expenses, excluding the expenses related to such regulatory inquiries in 2005, increased by $5.3 million for the twelve months ended December 31, 2006, compared to 2005. The most significant factor contributing to this growth was a change in the allocation of total Company expenses between commissions and other underwriting (“Underwriting”) expenses and G&A expenses. We conduct a periodic review of the allocation of total Company expenses between such categories based upon the mix of activities performed by our various departments. Based on our latest study, we allocated a higher proportion of total Company expenses to G&A expenses and a smaller proportion to Underwriting expenses than we did for the same periods of 2005. Total Company expenses, excluding the expenses related to such regulatory inquiries in 2005, changed insignificantly for the twelve months ended December 31, 2006 compared to 2005.
Interest Expense. Interest expense was $5.7 million for the twelve months ended December 31, 2006 compared to $4.2 million for 2005, an increase of $1.5 million. The increase in interest expense is primarily attributable to the refinancing of our credit facility on July 31, 2006, which increased the amount of our term loan to $100.0 million. In addition, increasing interest rates also contributed to the increase in interest expense. The interest on our credit facility debt is variable and is tied to the London Interbank Offered Rate (“LIBOR”). The average LIBOR rate was higher during the twelve months ended December 31, 2006 than in 2005. The aggregate weighted average interest rate we incurred was 6.5% during the twelve months ended December 31, 2006 compared to 5.0% during 2005. As of December 31, 2006, we had $100.0 million of outstanding credit facility debt as compared to $69.9 million as of December 31, 2005.
Extinguishment of Debt. We refinanced our credit facility, repaid the pre-existing term loan, and increased the amount of our term loan on July 31, 2006. We incurred a non-recurring non-cash pre-tax charge of $1.3 million during the twelve months ended December 31, 2006, resulting from the write-off of the unamortized portion of the deferred financing costs associated with the debt that was repaid.
Ratios. The table below displays the key components of the combined ratio:
The table below displays our gross, ceded, and net underwriting results, as well as the related gross, ceded and net loss, expense and combined ratios:
The following table shows the gross and ceded written and earned premium for the twelve months ended December 31, 2005 and 2004.
* Amount represents the unearned premium previously ceded under our 2002-2004 quota share reinsurance agreement, which we received as a result of the termination and commutation of this agreement.
Net Investment Income and Realized Losses and Gains on Investments. Net investment income was $17.2 million for the twelve months ended 2005 compared to $9.0 million for the same period of 2004. Most of the increase was attributable to a larger invested asset base on average during 2005 compared to 2004. Our initial public offering, which we completed in February 2004, provided $113.4 million of net proceeds and the termination and commutation of our 2002-2004 quota share reinsurance agreement resulted in our receipt of $196.6 million in January 2005. Excluding the proceeds from the reinsurance termination, cash flow from operations aggregated $56.3 million for the twelve months ended December 31, 2005 compared to $45.9 million for the twelve months ended December 31, 2004. The increased cash flow also contributed to the growth in invested assets and increased net investment income. The average pre-tax equivalent investment yield on our investment portfolio increased to 4.52% as of December 31, 2005 from 4.30% as of December 31, 2004.
Losses and LAE Incurred. Losses and LAE incurred increased to $394.6 million for the twelve months ended December 31, 2005 compared to $219.4 million for the same period of 2004. Our loss ratio improved 1.1 points to 66.3% for 2005 from 67.4% for 2004.
The following table provides detail of our commissions and other underwriting expenses before and after reinsurance.
The change in deferred acquisition costs related to Company expenses contributed $4.8 million of the increase in other underwriting expenses. Net amortization was $3.8 million during the twelve months ended December 31, 2005 compared to net capitalization of $1.0 million during the twelve months ended December 31, 2004. Most of the remainder of the increase in other underwriting expenses emanated from the costs associated with increased use of technology principally related to point of sale underwriting.
Ratios. Our combined ratio was 87.6% for the twelve months ended December 31, 2005 compared to 71.5% for same period of 2004. Our combined ratio was only minimally affected by reinsurance during the twelve months ended December 31, 2005, while it was significantly affected by reinsurance during the comparable period of 2004. We ceded only 8% of our gross earned premium in 2005 compared to 53% in 2004. The following table provides information about our combined ratio before and after reinsurance for the twelve months ended December 31, 2005 and 2004.
Our gross expense ratio was 21.5% for the twelve months ended December 31, 2005 compared to 18.1% for the same period of 2004, an increase of 3.4 points. Our lower fee income as a percentage of earned premium accounted for 0.9 points of the increase. The change in the net deferral of Company related underwriting expenses contributed 0.7 points to the increase. The following items accounted for the remainder of the increase: $2.7 million associated with responding to governmental investigations concerning our reinsurance agreements (0.4 points), increased consulting related to Sarbanes Oxley and technology initiatives (0.5 points), and increased software expenses (0.3 points).
We are a holding company without significant operations of our own. Our insurance subsidiaries underwrite the risks associated with our insurance policies. Our non-insurance subsidiaries provide services to our policyholders and our insurance subsidiaries related to the insurance policies we issue. The holding company has continuing cash needs for the payment of interest on borrowings, dividends, taxes and administrative expenses. The non-insurance subsidiaries fund most of these ongoing obligations, while each subsidiary reimburses the holding company for taxes related to the subsidiary’s operations through an inter-company tax allocation agreement.
Our insurance subsidiaries’ primary sources of funds are premiums received, investment income and proceeds from the sale and redemption of investment securities. Our non-insurance subsidiaries’ primary source of funds is the commissions collected from our insurance subsidiaries for services provided under general agency agreements. Our insurance and non-insurance subsidiaries use funds to pay claims and operating expenses, make payments under the tax allocation agreement, purchase investments and pay dividends to us.
There are no restrictions on the payment of dividends by our non-insurance subsidiaries other than customary state corporation laws regarding solvency and the consent of Farmers that is required under the Merger Agreement. Dividends from our insurance subsidiaries are subject to the consent of Farmers that is required under the Merger Agreement and limitations based upon statutory surplus and earnings. See “Item 1. Business-Regulatory Matters.” As of December 31, 2006, our insurance subsidiaries could pay dividends of $32.9 million without seeking regulatory approval. Such dividends, if paid, would be subject to regulatory dividend reporting requirements. Our insurance subsidiaries have not paid any dividends since 1999. Because our non-insurance subsidiaries generate revenues, profits and net cash flows that are generally unrestricted from a regulatory perspective as to their availability for the payment of dividends, we expect to use those funds to service all of our corporate financial obligations (subject to the consent of Farmers that is required under the Merger Agreement).
Effective July 31, 2006, we refinanced our secured credit facility, which had an outstanding balance of $68.0 at the time of the refinancing. We also increased the amount of the term loan portion of the new facility. The new secured credit facility (the “Senior Credit Facility”) consists of: (1) a $100 million term loan, and (2) a $25 million revolving credit facility, which includes up to $15 million of letters of credit. The Senior Credit Facility is pre-payable at any time and is scheduled to expire on July 31, 2011. Borrowings under the Senior Credit Facility bear interest based either upon (1) LIBOR plus an applicable margin (“LIBOR Loans”) or (2) the greater of (a) the applicable prime rate and (b) the Federal funds rate for Federal Reserve System overnight borrowing transactions plus 0.5%, plus an applicable margin (“ABR Loans”). Based on the then existing ratio of our consolidated total debt to our consolidated total capitalization, as defined in the Senior Credit Facility, the applicable margin for determining the interest rate applicable to LIBOR Loans ranges from 0.750% to 1.750%, the applicable margin for determining the interest rate applicable to ABR Loans ranges from 0.000% to 0.50%, and the revolving credit facility commitment fee ranges from 0.150% to 0.375%. The Senior Credit Facility is secured by guarantees by and a pledge of stock of certain of our subsidiaries. The Senior Credit Facility includes negative covenants regarding the maintenance of certain financial ratios. As of, and for the twelve-month period ended December 31, 2006, we were in compliance with all such covenants. As of December 31, 2006, $100 million was outstanding under the term loan portion of the Senior Credit Facility with repayment scheduled for 2011.
In August 2006, we contributed $15 million to the surplus of Coast National Insurance Company (“Coast”), one of our insurance subsidiaries. The purpose of the contribution was to ensure that we would continue to have adequate capital in our insurance subsidiaries to support their “A-” financial strength rating from A.M. Best.
We paid $0.29 per share for a total dividend payout with respect to our Common Stock of $8.5 million during the year ended December 31, 2006 and $0.26 per share for a total dividend payout with respect to our Common Stock of $8.0 million during the year ended December 31, 2005. The declaration and payment of dividends is subject to the discretion of our Board of Directors. The Board considers our financial condition, results of operations, capital and cash requirements, future prospects, regulatory and contractual restrictions on the payment of dividends by our subsidiaries, restrictions under our credit facility and other factors they deem relevant. On February 20, 2007, the Board of Directors approved the declaration of a fourth quarter dividend of $0.08 per common share that will result in a total dividend payout with respect to our Common Stock of approximately $2.3 million from available cash. The dividend was paid on March 13, 2007 to stockholders of record on February 27, 2007. Under the Merger Agreement with Farmers, without Farmer’s prior written consent, the Company is only permitted to pay a regular quarterly dividend with respect to our Common Stock not to exceed $0.08 per share, and our subsidiaries are not permitted to pay dividends.
Net cash provided by operating activities was $57.5 million for the year ended December 31, 2006 compared to $252.9 million for 2005. We terminated quota share reinsurance agreements effective January 1, 2006 and January 1, 2005. The terminations resulted in our receipt of $11.0 million in January 2006 and $196.6 million in January 2005. Cash flow from operating activities, exclusive of the net cash received from the reinsurance terminations, was $46.5 million for the year ended December 31, 2006 compared to $56.3 million for 2005. Most of the decline was caused by an increase in state and federal income tax payments of $14.2 million during the year ended December 31, 2006 compared to 2005.
Net cash used in investing activities was $43.4 million for the year ended December 31, 2006 compared to $189.9 million for 2005. The purchase of high-quality fixed income securities accounted for most of the use of funds for both the year ended December 31, 2006 and 2005. The funds for the investment purchases during the year ended December 31, 2005 came principally from the commutation proceeds of a quota share reinsurance agreement we received in January 2005.
Net cash provided by financing activities was $2.7 million for the year ended December 31, 2006 compared to net cash used in financing activities of $42.2 million for the year ended December 31, 2005. For the year ended December 31, 2006, net cash provided by financing activities consisted primarily of $32.0 million of net proceeds from the refinancing of our credit facility, offset by $19.0 million used for the repurchase of 1,117,277 shares of our Common Stock, $8.5 million for the payment of stockholder dividends, and $2.0 million for the repayment of debt. For the year ended December 31, 2005, cash used in financing activities consisted primarily of $31.0 million for the repurchase of 1,859,823 shares of our Common Stock, $8.0 million for the payment of stockholder dividends, and $3.5 million for the repayment of debt.
The following table displays our contractual obligations by the years in which payments are due as of December 31, 2006.
The payouts of loss and loss adjustment expense reserves by year included in the above table are estimated based upon historical loss payment patterns. Since there are not definitive due dates for the payments, payments by year and in the aggregate are subject to uncertainties. See “Item 1. Business - Loss and Loss Adjustment Expense Reserves” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies - Estimation of Unpaid Losses and Loss Adjustment Expenses.”
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America, or GAAP, requires us to make estimates and assumptions that affect amounts we report in our financial statements. As additional information becomes available, these estimates and assumptions are subject to change and, if changed, would impact amounts we report in the future. We have identified accounting policies involving estimates that we consider to be critical due to the amount of judgment and uncertainty inherent in the application of these policies.
We continually evaluate potential liabilities and reserves for litigation using the criteria established by Statement of Financial Accounting Standards, or SFAS, No. 5, “Accounting for Contingencies.” We have a quarterly monitoring process involving legal and accounting professionals. Legal personnel first identify outstanding corporate litigation and regulatory matters posing a reasonable possibility of loss. Legal personnel then review these matters to evaluate the facts and changes since the last review in order to determine if we should record or adjust a provision for loss, the amount that we should record, and any appropriate disclosure regarding the provision, and communicate such information to accounting personnel. We believe the current assumptions and other considerations we use to estimate our potential liability for litigation are appropriate. While it is not possible to know with certainty the ultimate outcome of these claims or lawsuits, we believe we have adequately reserved for our existing known litigation and that such litigation will not have a material effect on our future financial condition or results of operations. In view of the uncertainties regarding the outcome of these claims or lawsuits, as well as the tax-deductibility of related payments, it is possible that the ultimate cost to us of these claims or lawsuits could exceed the reserves we establish by amounts that would have a material adverse effect on our future financial condition or results of operations in a particular quarter or year.
Pursuant to SFAS No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts” (“SFAS 113”), we are required to review the contractual terms of all our reinsurance purchases to ensure compliance with SFAS 113. SFAS 113 establishes the conditions required for a contract with a reinsurer to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. Contracts that do not result in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed generally do not meet the conditions for reinsurance accounting and must be accounted for as deposits.
SFAS 113 also requires us to disclose the nature, purpose and effect of reinsurance transactions, including the premium amounts associated with reinsurance assumed and ceded. It also requires disclosure of concentrations of credit risk associated with reinsurance receivables and prepaid reinsurance premiums.
We record a liability for estimates of losses and LAE that we will pay on accidents reported to us and we estimate and record a liability for accidents that have occurred but have not been reported to us, which we refer to as incurred but not reported loss and LAE reserves.
An analysis of our losses and LAE for December 31, 2006, 2005 and 2004 is summarized in the following table:
The following table summarizes the gross loss (including case loss and IBNR reserves, as defined below) and LAE reserves as of December 31, 2006 and December 31, 2005:
A provision for claims that have occurred but have not yet been reported to us
A provision for claims that have been reported to us but for which case loss reserves have not yet been established
A provision for supplemental loss development on known case loss reserves
A provision for claims that have been paid and closed but may require future payment
Paid development methods use historical loss or DCC payments over discrete periods of time to estimate future losses or DCC. Paid development methods assume that the pattern of paid losses or DCC occurring in past periods will recur for losses occurring in subsequent periods. For example, if historical paid loss patterns demonstrate that 50% of the ultimate value of loss or DCC liability with respect to losses occurring in a particular period will have been paid at the end of 24 months, it is appropriate to estimate that the ultimate value of loss or DCC liability with respect to losses that occurred exactly 24 months ago is twice the amount that has been paid through the present. Inherently, these methods assume that the factors affecting the payment pattern and the relationship of the ultimate value of loss or DCC liability to the amount paid for any given period after the loss occurs will remain constant over time. Selection of the paid development pattern requires analysis of several factors including, but not limited to, the impact of inflation on claims costs, the rate at which claims professionals make claim payments and close claims, the impact of judicial decisions, the impact of underwriting changes, and the impact of large claim payments. Claim cost inflation itself requires evaluation of changes in the cost of repairing or replacing property, changes in the cost of medical care, changes in the cost of wage replacement, judicial decisions, legislative changes, regulatory changes, and other factors. Changes in any of these factors can impact the results because paid development methods assume that losses are paid at a consistent rate. Paid development methods have the disadvantage of overreacting to changes in closed losses and DCC. For many claims, particularly those with longer-tail exposures such as bodily injury claims, paid loss or DCC data for recent periods may be too immature or erratic for accurate predictions. Paid development methods are more leveraged (meaning that small changes in payments have a larger impact on estimates of ultimate liability) than incurred development methods. In addition, paid development methods are often slow to react to situations when new or different factors arise than those that have affected paid losses or LAE in the past. We typically apply paid development methods to paid pure losses, salvage and subrogation recoveries, and paid DCC.
Frequency and severity methods generally rely on the determination of a ratio of the number of claims reported to the number of insured vehicles (frequency) and ultimate dollars of loss per claim (severity) for each future calendar quarter. These methods may have an advantage if ultimate claim counts can be estimated more quickly and accurately than can ultimate losses. If severity can be accurately estimated, these methods may respond more quickly to changes in loss experience than other methods. However, for severity to be predictable, the claims analyzed must be homogeneous claims for which severity trends from one year to the next are reasonably consistent. We typically apply frequency and severity methods to estimate paid pure losses.
The cost per claim A&O method estimates the cost of handling various types of claims based on assumptions about the relative cost of A&O by coverage group and about the ratio of the costs of opening to the costs of closing a claim. The ratio is based on the assumption that most of the actual work performed on a claim is completed shortly after we open the claim. We use this method to allocate by state, program, coverage group and accident quarter both the current calendar quarter paid A&O and the A&O estimate.
With respect to each of the key assumptions underlying our loss and LAE reserve estimates, our actuarial staff tracks the emergence of loss and LAE data by state, program, coverage group and accident quarter on a daily basis. They analyze this data using a browser-based reporting tool that compares the actual emergence of losses and LAE relative to the expected emergence over time. In conducting quarterly loss and LAE reserve reviews, our actuarial staff applies such data that is relevant to determining whether it is appropriate to revise any assumptions that they will use to develop loss and LAE reserve estimates.
In arriving at each individual point estimate of reserves for IBNR losses and reserves for LAE in each separate data subset, our actuarial staff considers the likely predictive value of the various methodologies employed in light of internal and external variables that may impact the reserves and weigh the credibility of each methodology. For each data subset in each accident quarter, the point estimate selected by our actuarial staff is not necessarily one of the points produced by any particular methodology utilized, but may be another point that takes into consideration each of the points produced by the several loss methodologies used. For example, the current accident quarter may not have enough paid claims data to rely upon, leading our actuarial staff to conclude that an incurred development methodology provides a better estimate than a paid development methodology. In such a case, our actuarial staff may give more weight to an incurred methodology for that particular accident quarter.
The final step in the quarterly reserving process for IBNR losses and LAE involves a comprehensive review of the actuarial indications by senior members of our actuarial staff who apply their collective judgment and, together with senior management, determine the appropriate level of reserves to record. Numerous factors are considered in this determination process, including, but not limited to, the assessed reliability of key loss trends and assumptions that may be significantly influencing the current actuarial indications, changes in internal and external variables that affect the timing of payment or development patterns, the maturity of the accident quarter, pertinent trends observed over the recent past, the level of volatility within a particular data subset, and the improvement or deterioration of actuarial indications in the current period as compared to prior periods. We do not discount any of our loss or LAE reserves to present value.
There is no substantive difference in the process that we use to determine the best estimate of our loss and LAE reserves for annual financial reports compared to the process we use for interim financial reports.
Volatility of Loss and LAE Reserve Estimates and Sensitivity Analysis. Quarterly, for each financial reporting date, we record our best estimate, which is a point estimate, of our overall loss and LAE reserve for both current and prior accident years. Because the underlying processes require the use of estimates and professional actuarial judgment, establishing loss and LAE reserves is an inherently uncertain process. As our experience develops and we learn new information, our quarterly reserving process may produce revisions to our previously reported loss and LAE reserves, which we refer to as “development,” and such changes may be material. We recognize favorable development when we decrease our previously reported loss and LAE reserves, which results in an increase in net income in the period recognized. We recognize adverse development when we increase our previously reported loss and LAE reserves, which results in a decrease in net income in the period recognized. Accordingly, while we record our best estimate, our loss and LAE reserves are subject to potential variability.
It would not be meaningful for us to provide an indication of the potential variability of our aggregate loss and LAE reserves by disclosing separate sensitivity analyses of the reasonably likely changes in the key assumptions underlying each significant point estimate in each data subset that we aggregate to develop our best estimate of the aggregate reserves. See the discussion below under the heading “Data Subset Analysis.”
While the data is available in our information technology (“IT”) systems to prepare such analyses, we determined that disclosing sensitivity analyses for each significant point estimate in all data subsets to provide an indication of the potential variability of our aggregate loss and LAE reserves would be unreasonably lengthy and complex and, therefore, unhelpful to investors.
Aggregated Company Data Analysis. We also concluded that it would not be cost effective for us to produce statistically credible sensitivity analyses of the reasonably likely changes in the key assumptions underlying our aggregate loss and LAE reserves based on macro level evaluation of historical changes reflected in aggregated data from each independent data subset. While significant raw data is available in our IT systems to perform such sensitivity analyses, it would be necessary for us to conduct extensive stochastic analysis of this data to produce a statistically credible indication of the potential variability of our aggregate loss and LAE reserves and the resulting impact on our results of operation, financial condition or liquidity. We do not make macro determinations about the key assumptions underlying our aggregate loss and LAE reserves, for purposes of managing our business or otherwise. Our estimates indicate that the incremental costs we would incur to construct a stochastic model and annually produce such sensitivity analyses would materially outweigh the benefits that our business (and, as a result, our stockholders) would derive from such analyses.
The historical information used to prepare a priori expected loss ratios
The ratio of loss and DCC to earned premium over time
these key assumptions are based on underlying assumptions regarding numerous internal and external factors, which often vary for different states, coverage groups, programs, and accident periods and for different actuarial estimation methodologies.
We do not currently perform macro analyses of the independent, disaggregated data in each data subset simply by aggregating such data either when we establish loss and LAE reserves or when we establish premium levels or structures in any of the states in which we write business. As described above under the heading “Establishing Loss and LAE Reserve Estimates,” our actuarial staff performs individualized quarterly analyses on over 150 unique, homogenous data subsets, establishes separate point estimates for IBNR losses, A&O and DCC with respect to each data subset, and makes individualized key assumptions with respect to each such point estimate. Our actuarial staff does not use actuarial models to quantify at a macro level the impact of reasonably likely changes in one or more of the key assumptions underlying our aggregate loss and LAE reserves or to evaluate at a macro level correlations among the data in each data subset or among the key assumptions underlying the separate point estimates we establish for each data subset.
We estimate that we would incur material costs to perform the macro analyses of the data in each data subset that would be necessary for us to produce a statistically credible indication of the potential variability of our aggregate loss and LAE reserves. Our loss reserving methodology does not currently include a stochastic model that would produce statistically credible sensitivity analyses of reasonably likely changes in one or more of the key assumptions underlying our aggregate loss and LAE reserves. We are also not aware of any generally accepted actuarial practices or procedures for performing such macro analyses with respect to independent, disaggregated data. Accordingly, in order to prepare such macro analyses of the relevant data, we would need to take the following actions:
Any such model also would need to import data from our IT systems. We perform the majority of our reserve calculations in Excel spreadsheets that are not included in our loss reserve databases. These spreadsheets import data from our databases, perform the necessary reserve calculations, and then export the appropriate results to our databases. Much of the data that would be required to populate the stochastic model is contained in these spreadsheets. Accordingly, we would need to upgrade our IT systems to export this additional data from our loss reserve spreadsheets and databases into the model.
Any data to be imported into such a stochastic model would need to include all of the data from our databases and spreadsheets that address the consistencies and trends on which our key assumptions are based. We also expect that the data imported into any such model would need to include additional data related to certain of the assumptions underlying our key assumptions to further support the consistencies and trends on which our key assumptions are based. It would be necessary for us to acquire or independently collect such additional data.
We purchased voluntary reinsurance with respect to certain of the periods reflected in this column. All of the material reinsurance agreements to which we have been a party have been terminated and settled, and the reinsurers have been released from all future liabilities under the agreements. We did not purchase any voluntary reinsurance for 2006 and have not purchased any voluntary reinsurance for 2007. However, we continue to cede premium to the MCCA, a mandatory facility that provides excess of loss coverage for personal injury protection in Michigan. Accordingly, we have presented the information gross of all reinsurance except for loss and LAE ceded to MCCA.
It is important to note that the potential variability reflected in the sensitivity analysis above depicts our historical experience and is not intended to represent a worst-case scenario. Therefore, it is possible that actual future variation may be more than amounts reflected above. Further, the potential variability reflected above does not constitute a statistical range of actuarially determined probable outcomes, nor does it constitute a range of all possible outcomes. The historical analysis reflected above is provided without consideration for any correlation among any of the key assumptions underlying loss and LAE reserve estimates or any correlation among the individual data subsets we evaluate to establish such reserves. The potential variability reflected above is based solely on our historical loss and LAE reserve development experience over the periods discussed and may not be indicative of actual future variability due to a number of internal and external factors that impact key assumptions underlying loss and LAE reserve estimates with respect to each data subset. There can be no assurance that changes in these factors and assumptions will not have a material impact on our loss and LAE reserves. The impact of changes in these factors is difficult to quantify and predict. Accordingly, our actuarial staff must exercise considerable professional judgment in making their actuarial determinations in light of these factors.
Management does not prepare or use, and we do not provide to investors, any statistically credible sensitivity analysis indicating the potential variability of our loss and LAE reserves based on an evaluation of historical changes in the key assumptions that materially affect our estimate of these reserves. As we explain above under the headings entitled “Data Subset Analysis” and “Aggregated Company Data Analysis,” we do not prepare or use such analyses primarily because our cost-benefit analysis indicates that the incremental costs required for us to produce such analyses would materially outweigh the benefits that our business (and, as a result, our stockholders) would derive from such analyses. Accordingly, investors may not have available to them with respect to Bristol West the same tools that other companies provide to do any of the following:
to anticipate reasonably likely changes in the key assumptions that materially affect estimates of reserves for loss and LAE;
to estimate changes in results of operation, financial condition or liquidity that are reasonably likely to result from adverse or favorable development in such reserves.
Based on information generally available to the public, we are aware that other insurance companies provide indications of the potential variability of the aggregate loss and LAE reserves for one or more lines of business by disclosing sensitivity analyses based on aggregated data related to each such line of business. However, we are unable to ascertain from this information the complete analysis supporting the decisions by such companies to perform such sensitivity analyses. One possible scenario that may explain how such companies are able to perform such sensitivity analyses is that some of these companies are sufficiently large to benefit from economies of scale that we do not currently experience which, as a result, causes their cost-benefit analyses to differ from ours. These businesses may be sufficiently large that the fixed costs necessary to construct and operate such a stochastic model may not be material. These companies also may have the ability to utilize a stochastic model across multiple lines of business, thus increasing the potential benefits of building and operating such a model. Another possible scenario is that some of these companies estimate their loss and LAE reserves based on aggregated data. It would be unnecessary for these companies to use a stochastic model to evaluate data from a single data subset.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-including an amendment of SFAS 115” (“SFAS 159”). SFAS 159 allows entities to choose, at specified election dates, to measure eligible financial instruments and certain other items at fair value that are not otherwise required to be measured at fair value. If an entity elects the fair value option for an eligible item, changes in that item’s fair value in subsequent reporting periods must be recognized in current earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the effect, if any, that this statement will have on our Consolidated Financial Statements.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”(“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value under GAAP, and enhances disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007, with earlier application encouraged only in the initial quarter of an entity’s fiscal year. We are currently evaluating the effect, if any, that this statement will have on our Consolidated Financial Statements.
In September 2006, the SEC issued Staff Accounting Bulletin 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance for how errors should be evaluated to assess materiality from a quantitative perspective. SAB 108 permits companies to initially apply its provisions by either restating prior financial statements or recording the cumulative effect of initially applying the approach as adjustments to the carrying values of assets and liabilities as of January 1, 2006 with an offsetting adjustment to retained earnings. SAB 108 is effective for the first annual period ending after November 15, 2006. Adoption of SAB 108 did not have a material effect on our Consolidated Financial Statements.
The evaluation of a tax position in accordance with FIN 48 is a two-step process. The first step is a recognition process whereby the entity determines whether it is more likely than not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. In evaluating whether a tax position has met the more likely than not recognition threshold, the entity should presume that the position will be examined by the appropriate taxing authority that has full knowledge of all relevant information. The second step is a measurement process whereby a tax position that meets the more likely than not recognition threshold is calculated to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement.
The provisions of FIN 48 are effective beginning January 1, 2007, and are to be applied to all tax positions upon initial adoption of this standard. Only tax positions that meet the more likely than not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption of FIN 48. The cumulative effect of applying the provisions of FIN 48 should be reported as an adjustment to the opening balance of retained earnings for that fiscal year. Upon adoption, we estimate the adjustment to the opening balance of retained earnings will not be material, as well as any balance sheet reclassifications from taxes currently payable to the liability for unrecognized tax benefits.
We adopted SFAS 123R in the first quarter of 2006 using the modified prospective method. This transition method applies to new awards and awards modified, repurchased, or cancelled after the effective date of SFAS 123R. We recognized compensation costs of $10,000 after taxes during the twelve months ended December 31, 2006, based on the grant date fair value of its unvested awards and the remaining requisite service period. Results for prior periods have not been restated as provided for under the modified prospective approach. For equity awards granted after the date of adoption, we amortize share-based compensation expense on a straight-line basis over the vesting term.
In November 2005, the FASB released FASB Staff Position Nos. FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP 115-1”), which effectively replaces EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” FSP 115-1 contains a three-step model for evaluating impairments and carries forward the disclosure requirements in EITF Issue No. 03-1 pertaining to securities in an unrealized loss position is considered impaired; an evaluation is made to determine whether the impairment is other-than-temporary; and, if an impairment is considered other-than-temporary, a realized loss is recognized to write the security’s cost or amortized cost basis down to fair value. FSP 115-1 references existing other-than-temporary impairment guidance for determining when an impairment is other-than-temporary and clarifies that, subsequent to the recognition of an other-than-temporary impairment loss for debt securities, an investor shall account for the security using the constant effective yield method. FSP 115-1 is effective for reporting periods beginning after December 15, 2005, with earlier application permitted. Adoption of FSP 115-1 upon issuance did not have a material effect on our Consolidated Financial Statements.