Please refer to “Forward-Looking Statements” following the Index in front of this 10-K.
We write insurance for various sizes of transportation fleets. Because of the amount of smaller fleets nationwide, we have more opportunities to write smaller risks than larger ones. When general economic conditions improve, entrepreneurs are encouraged to start new transportation companies, which typically commence operations as a smaller risk and a potential traditional insurance customer for us. During periods of economic downturn, such as immediately following September 11, 2001, smaller risks are more prone to failure due to a decrease in leisure travel and consolidation in the industry. An increase in the number of larger risks results in more prospective captive insurance customers. We do not believe that smaller fleets that generate annual premiums of less than $100,000 are large enough to retain the risks associated with participation in one of the captive programs we currently offer.
The property and casualty insurance industry is cyclical. Historically, the industry has been characterized by periods of price competition and excess capacity (soft market) followed by periods of high premium rates and shortages of underwriting capacity (hard market). Since 2004, we believe that the commercial transportation market has been in the part of the cycle that can best be described as softening as compared to the peak of the hard market in 2002 and 2003. The cyclical nature of the industry impacts our business operations. Our business may be affected by the risks impacting the property and casualty insurance industry related to severe weather conditions, explosions, terrorist attacks and riots. For passenger transportation, distressed operators (whether distressed due to being insured by other insurance companies that have raised rates or exited the market, or due to having less than desirable risk characteristics) continue to be heavily marketed to us by brokers causing an increase in our new business declination rates. In addition, insurance rates for renewing policies for all transportation business remains relatively flat when compared to 2005 and lower than the increases attained from mid-2001 through 2004. Although the current condition of the market can be characterized as softening, the extent of the price competition we are currently experiencing is neither as significant nor as severe as we have previously experienced in other softening markets (e.g. 1999-2000).
Increased rate levels beyond those necessary to keep up with inflation and achieve our planned financial targets prior to 2004 and relatively flat pricing since 2004 have resulted in us attaining combined ratios better than our corporate objective of maintaining a combined ratio of 96.0% or lower. While our combined ratio may fluctuate from year to year, over the past five years we have exceeded our underwriting profit objective by achieving an average GAAP combined ratio of 84.2%. Our GAAP combined ratio was 83.5% in 2006, 82.6% in 2005, 83.5% in 2004, 80.3% in 2003 and 91.3% in 2002. We believe the following factors have contributed to this performance:
Our ability to attract and retain some of the best transportation companies in the industries we serve into our captive programs.
Our transportation insurance business in particular also is affected by cost trends that negatively impact profitability such as inflation in vehicle repair costs, vehicle replacement parts costs, used vehicle prices, fuel costs and medical care costs. We routinely obtain independent data for vehicle repair inflation, vehicle replacement parts costs, used vehicle prices, fuel costs and medical care costs and adjust our pricing routines to attempt to more accurately project the future costs associated with insurance claims. Historically, these increased costs have not had a material adverse impact on our results. Of course, we would expect a negative impact on our future results if we fail to properly account for and project for these inflationary trends. Increased litigation of claims may also negatively impact our profitability.
To succeed as a transportation underwriter and personal lines underwriter, we must understand and be able to quantify the different risk characteristics of the operations we consider quoting. Certain coverages are more stable and predictable than others and we must recognize the various components of the risks we assume when we write any specific class of insurance business. Examples of trends that can change and, therefore, impact our profitability are loss frequency, loss severity, geographic loss cost differentials, societal and legal factors impacting loss costs (such as tort reform, punitive damage inflation and increasing jury awards) and changes in regulation impacting the insurance relationship. Any changes in these factors that are not recognized and priced for accordingly will affect our future profitability. We believe our product management organization provides the focus on a specific risk class needed to stay current with the trends affecting each specific class of business we write.
There are distinct differences in the timing of written premiums in traditional transportation insurance and our alternative risk transfer (captive) insurance components. We write traditional transportation insurance policies throughout all 12 months of the year and commence new annual policies at the expiration of the old policy. Under most captive programs, all members of the group share a common renewal date. These common renewal dates are scheduled throughout the calendar year. Any new captive program participant that joins after the common date will be written for other than a full annual term so its next renewal date coincides with the common expiration date of the captive program it has joined. Historically, most of our group captives had common renewal dates in the first six months of the year, but with the growth from new captive programs, we are now experiencing renewal dates
Our net earnings for 2006 were $35.7 million or $1.85 per share (diluted), compared to $30.3 million or $1.60 per share (diluted) recorded in 2005. Our earnings increased $5.4 million, or 17.9%, compared to the same period in 2005. There are several factors that contributed to the increase in net earnings, including continued growth in earned premium of $22.9 million, or 11.8%, primarily due to the addition of new captive programs and an increase in the number of participants in our existing captive programs. We also had favorable losses and LAE for 2006, which is evidenced by our 2006 loss and LAE ratio of 59.6%, a decrease from prior year of 0.8 percent. The current year losses and LAE include favorable development from prior years of $7.5 million. Also contributing to the increase in our net earnings in 2006 was an increase in investment income of $5.1 million, or 40.3%, due to higher interest rates available on our fixed income investments and growth in our cash flow from operations.
We operate our business as one segment - property and casualty insurance. We manage this segment through a product management structure. The following table sets forth an analysis of gross premiums written by business component during the periods indicated:
The group captive programs, which focus on specialty or niche insurance businesses, provide various services and coverages tailored to meet specific requirements of defined client groups and their members. These services include risk management consulting, claims administration and handling, loss control and prevention, and reinsurance placement, along with providing various types of property and casualty insurance coverage. Insurance coverage is provided primarily to associations or similar groups of members and to specified classes of business of our agent partners.
component’s written premium. Exclusive of this $4.1 million reduction to gross written premium, the captive business would have shown an increase in growth over 2005 of $35.9 million, or 35.4%.
Also contributing to the increase in the gross premiums written in 2006 was an increase in the specialty personal lines component of $6.1 million or 13.3% as compared to 2005. The increase is primarily related to a moderate rate increase as well as an increase in the number of policies in force associated with the recreational and companion auto vehicle programs.
Due primarily to an increase in our Alaska business in 2006, our Hawaii and Alaska component increased $0.8 million for the year ended December 31, 2006 compared to 2005. Our Other component is primarily related to assigned risk policies that we receive from involuntary state insurance plans and over which we have no control. This component decreased $1.8 million from 2005.
Our premiums earned increased $22.9 million, or 11.8%, to $217.3 million during the year ended December 31, 2006 compared to $194.4 million for the year ended December 31, 2005. Our alternative risk transfer component increased 25.7% during 2006 compared to the same period in 2005, primarily due to new captive programs that were written in 2006 and the fourth quarter of 2005 and new participants in existing group captive programs. Our Alternative Risk Transfer business remains our fastest growing component. Due to moderate rate increases and an increase in the number of policies in force primarily from expanded distribution, our specialty personal lines component increased 20.4% in 2006 compared to 2005. The transportation component remained relatively constant in 2006 compared to 2005. In the transportation component, we are still feeling the effects from a $0.7 million decline in premium from a reinsurance arrangement involving primarily physical damage coverage on trucks and seeing a decline in renewal rate increases due to the current softening market. Our Other component, which is comprised primarily of premium from assigned risk plans from the states in which our insurance company subsidiaries operate, and over which we have no control, decreased $2.0 million, or 19.8%, to $8.2 million in 2006.
Commissions and other underwriting expenses consist principally of brokerage and agent commissions that represent a percentage of the premiums on insurance policies and reinsurance contracts written, and vary depending upon the amount and types of contracts written, and ceding commissions paid to ceding insurers and excise taxes. The commissions and other underwriting expenses increased $6.9 million for 2006 compared to 2005. This increase in the commissions and other underwriting expenses is primarily due to an increase in commissions, premium taxes and other related expenses which are directly impacted by the growth in gross written premiums, and by two reclassifications that were made in 2005, which reduced the commissions and other underwriting expenses in that year, as noted below.
The underwriting expense ratio for the year ended December 31, 2006 increased 1.7 percent to 23.9% compared to 22.2% for the year ended December 31, 2005. The increase in the expense ratio is due to an increase in other operating and general expenses such as increased audit fees due to the audit of our insurance companies coordinated by the Ohio Department of Insurance ($0.2 million), the impact of stock based compensation expense recognized in 2006 ($0.8 million) and other costs associated with our growth and with being a publicly traded corporation. Also impacting the change in the expense ratio were two items that occurred in 2005 i) a reduction in estimated expenses for insolvencies and other state fees and ii) classifying business related to our assigned risks on a gross basis. These items reduced the 2005 expense ratio by 1.5 percent and are discussed in further detail below. When taking these items into consideration the expense ratio remained consistent from 2005 to 2006.
The underwriting expense ratio for the year ended December 31, 2005 decreased 2.7 points to 22.2% compared to 24.9% for the year ended December 31, 2004. The decrease in the underwriting expense ratio is primarily a result of four factors: increased risk retention, continued leverage of our fixed expense, a reduction in our estimated expenses for insolvencies and other state fees and recording of assigned business. In November 2004, we increased our risk retention on public transportation products, which contributes to a decrease in our expense ratio as the additional retained written premium is earned. While expenses are higher in response to building our infrastructure and other related expenses of operating as a public entity, our overall increase in fixed expenses was lower than the revenue growth for the year ended December 31, 2005. Using data available from the National Conference of Insurance Guarantee Funds, we reduced our estimated expenses for insolvencies and other state fees during the third quarter of 2005. The reduction in estimated expenses reduced our underwriting expense ratio by 0.7 percent. We record our assigned risk premium quarterly based on reports from various states and agencies that manage the plans. The assignments are based on our written premium for specific coverages in certain states. We have written workers’ compensation insurance in several states beginning in 2004. Due to the lack of sufficient detail because the plans report to us on a lag, our estimated net share of the assigned risks were charged to commissions and other underwriting expenses, with a like amount recorded as assessments and fees payable in the correct periods. During the third and fourth quarter of 2005, sufficient information was obtained to enable us to classify the business on a gross basis, including premiums earned and losses and LAE. While this had no impact on net income, it reduced our underwriting expense ratio by 0.8 percent.
2006 compared to 2005. Net investment income increased $5.1 million, or 40.3%, to $17.6 million for the year ended December 31, 2006 compared to the same period in 2005. The increase is primarily related to a growth in average cash and invested assets over the same period and a higher yield on the fixed income portfolio. The growth in cash and invested assets is due to positive cash flow from operations and the reinvestment of earnings.
2006 compared to 2005. Net realized gains increased $0.9 million to $1.2 million for 2006 compared to net realized gains of $0.3 million for 2005. Realized gains are taken when opportunities arise. The realized gains in 2006 and 2005 were primarily generated from sales of equity holdings. When evaluating fixed maturity sales opportunities, we do not have any specific thresholds that would cause us to sell these securities prior to maturity. We consider multiple factors, such as reinvestment alternatives and specific circumstances of the investment currently held. Credit quality, portfolio allocation and other-than-temporary impairment are other factors that may encourage us to sell a fixed maturity security prior to maturity at a gain or loss. Historically, and during the most recent extended low interest rate period, we have not had the need to sell our investments to generate liquidity.
2005 compared to 2004. Net realized gains decreased $1.4 million to $0.3 million for 2005 compared to net realized gains of $1.7 million for 2004. The net realized gain in 2005 was partially offset by an other-than-temporary impairment adjustment of $0.3 million recognized in 2005. The decrease in net realized gains in 2005 was due to fewer sales opportunities in the fixed income market in 2005.
At December 31, 2006, our investment portfolio contained $327.4 million in fixed maturity securities and $34.1 million in equity securities, all carried at fair value with unrealized gains and losses reported as a separate component of shareholders’ equity on an after-tax basis. At December 31, 2006, we had pretax net unrealized losses of $5.1 million on fixed maturities and pretax unrealized gains of $0.6 million on equity securities.
At December 31, 2006, 99.1% of the fixed maturities in our portfolio were rated “investment grade” (credit rating of AAA to BBB) by Standard & Poor’s Corporation. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or non-investment grade.
Net cash used in investing activities was $65.8 million and $107.8 million for the years ended December 31, 2006 and 2005, respectively. The $42.0 million decrease in cash used in investing activities was primarily related to a $22.0 million decrease in the purchase of investments in 2006 and an $11.5 million increase in the proceeds from sales and maturities of investments as compared to 2005. Also impacting investing activities was the purchase, by NIIC, of an office building adjacent to our headquarters in Richfield, Ohio. The building was purchased for $7.0 million. An additional payment of $1.2 million was also made on January 3, 2006 for the remaining balance of the purchase price associated with the acquisition of TCC. As part of this acquisition, we acquired $5.6 million in cash and cash equivalents.
We utilized net cash from financing activities of $2.9 million and provided net cash of $22.9 million, respectively, for the years ended December 31, 2006 and 2005. The $25.8 million decrease in cash generated from financing activities primarily relates to the initial public offering completed in February 2005 whereby we sold 3,350,000 shares of common stock, generating approximately $40.4 million of net proceeds. We used the net proceeds for the repayment in full of a $15.0 million loan plus the accrued interest from Great American, our majority shareholder, and the remainder is currently being used as needed for general corporate purposes and potential growth opportunities.
We will have continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, shareholder dividends and taxes. Funds to meet these obligations will come primarily from dividend and tax payments from our insurance company subsidiaries and from our line of credit. Under the state insurance laws, dividends and capital distributions from our insurance companies are subject to restrictions relating to statutory surplus and earnings. The maximum amount of dividends that our insurance companies could pay to us without seeking regulatory approval in 2006 is $26.6 million. Our insurance subsidiaries paid $3.0 million and $0 in dividends in 2006 and 2005, respectively, without the need for regulatory approval.
At December 31, 2005, we had $11.7 million held in an escrow account for the purchase of TCC from Triumphe Insurance Holdings LLC by NIIC. The $11.7 million that was held in an escrow account is shown on the December 31, 2005, Consolidated Balance Sheet in “Other Assets.” On January 3, 2006, the first business day after the January 1 effective date of the purchase, the funds were released from the escrow account. We made a second payment of $1.2 million for the remaining balance of the purchase price.
Contractual Obligations. The following table summarizes our long-term contractual obligations as of December 31, 2006:
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of that loss to us and our final payment of that loss, and its related LAE. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities. At December 31, 2006 and 2005, we had $266.0 million and $223.2 million, respectively, of gross losses and LAE reserves, representing management’s best estimate of the ultimate loss. Management records on a monthly and quarterly basis its best estimate of loss reserves. For purposes of computing the recorded reserves, management utilizes various data inputs, including analysis that is derived from a review of prior quarter results performed by actuaries employed by Great American. In addition, on an annual basis, actuaries from Great American review the recorded reserves for NIIC, NIIC-HI and TCC utilizing current period data and provide a Statement of Actuarial Opinion, required annually in accordance with state insurance regulations, on the statutory reserves recorded by these U.S. insurance subsidiaries. The actuarial analysis of NIIC’s, NIIC-HI’s and TCC’s (for 2006, as we acquired TCC on January 1, 2006) net reserves as of December 31, 2006 and 2005 reflected point estimates that were within 1% of management’s recorded net reserves as of such dates. Using this actuarial data along with its other data inputs, management concluded that the recorded reserves appropriately reflect management’s best estimates of the liability as of each year end.
An important assumption underlying reserve estimates is that the cost trends implicitly built into development patterns will continue into the future. The sensitivity of recorded reserves to an unexpected change in the trends, is estimated by adding 1.0% to the trend that is embedded in the factors used to determine the reserves for ultimate liabilities. This unexpected change could arise from a variety of sources including a general increase in economic inflation, inflation from social programs, new medical technologies, or other factors such as those listed below in connection with our largest lines of business. The estimated cumulative unfavorable impact that this 1.0% change would have on our 2006 net income is shown below:
Commercial Auto Liability. In this line of business, we provide coverage protecting buses, limousines, other public transportation vehicles and trucking for accidents causing property damage or personal injury to others. Some of the important variables affecting our estimation of loss reserves for commercial auto liability include:
Within each line, Great American actuaries review the results of individual tests, supplementary statistical information and input from management to select their point estimate of the ultimate liability. This estimate may be one test, a weighted average of several tests, or a judgmental selection as the actuaries determine is appropriate. The actuarial review is performed each quarter as a test of the reasonableness of management’s point estimate and to
When establishing and reviewing reserves, we analyze historic data and estimate the impact of various loss development factors, such as our historic loss experience and that of the industry, trends in claims frequency and severity, our mix of business, our claims processing procedures, legislative enactments, judicial decisions, legal developments in imposition of damages, and changes and trends in general economic conditions, including the effects of inflation. A change in any of these factors from the assumptions implicit in our estimate can cause our actual loss experience to be better or worse than our reserves, and the difference can be material. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves. Currently established reserves may not prove adequate in light of subsequent actual occurrences. To the extent that reserves are inadequate and are increased or “strengthened,” the amount of such increase is treated as a charge to income in the period that the deficiency is recognized. To the extent that reserves are redundant and are released, the amount of the release is a benefit to income in the period that redundancy is recognized.
Reinsurance Recoverables. We are also subject to credit risks with respect to our third party reinsurers. Although reinsurers are liable to us to the extent we cede risks to them, we are ultimately liable to our policyholders on all these risks. As a result, reinsurance does not limit our ultimate obligation to pay claims to policyholders and we may not be able to recover claims made to our reinsurers. We manage this credit risk by selecting what we believe to be quality reinsurers, closely monitoring their financial condition, timely billing and collecting amounts due and obtaining sufficient collateral when necessary.
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Interstate Corporation and subsidiaries at December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of National Interstate Corporation’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2007, expressed an unqualified opinion thereon.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
The Company is a 53.2% owned subsidiary of Great American Insurance Company (“Great American”), a wholly-owned subsidiary of American Financial Group, Inc. On February 2, 2005, the Company completed an initial public offering, in which it issued 3,350,000 shares and selling shareholders sold 1,074,000 shares at an initial offering price of $13.50 per share and began trading its common shares on the Nasdaq Global Market under the symbol NATL. Prior to the initial public offering, no public market existed for the common shares. Proceeds from the offering totaled approximately $40.4 million after a deduction for the underwriting discount and offering expenses. Net proceeds were used to repay a loan from the Company’s majority shareholder, Great American, and the remainder has been invested to be used in future periods for other general corporate purposes including surplus contributions to the Company’s insurance subsidiaries, as needed.
The accompanying consolidated financial statements of the Company and its subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States, which differ in some respects from statutory accounting principles (“SAP”) permitted by state regulatory agencies (see Note 14).
The consolidated financial statements include the accounts of the Company and its subsidiaries, NIIC, NIIC-HI, HIL, TCC, HMG, National Interstate Insurance Agency, Inc. (“NIIA”), American Highways Insurance Agency, Inc., Safety, Claims, and Litigation Services, Inc., Explorer RV Insurance Agency, Inc. and Safety, Claims, Litigation Services, LLC. Significant intercompany transactions have been eliminated.
The preparation of financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from the estimates and assumptions used.
The costs of acquiring new business, principally commissions and premium taxes and certain underwriting expenses directly related to the production of new business, are deferred and amortized over the period in which the related premiums are earned. Policy acquisition costs are limited based upon recoverability without any consideration for anticipated investment income and are charged to operations ratably over the terms of the related policies. The Company accelerates the amortization of these costs for premium deficiencies. The amount of deferred policy acquisition costs amortized to income during the years ended December 31, 2006, 2005 and 2004 were $37.7 million, $33.5 million and $31.8 million, respectively. There were no premium deficiencies for the years ending December 31, 2006, 2005 and 2004.
The Company has provided for estimated assessments anticipated for reported insolvencies of other insurers and other charges from regulatory organizations. Management has accrued for these liabilities as assessments are imposed or the probability of such assessments being imposed has been determined, the event obligating the Company to pay an imposed or probable assessment has occurred and the amount of the assessment can be reasonably estimated.
Reinsurance premiums, commissions, expense reimbursements, and reserves related to reinsured business are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. A significant portion of the reinsurance is related to excess of loss reinsurance contracts. Premiums ceded are reported as a reduction of premiums earned.
The Company grants stock options to officers under the Long Term Incentive Plan (“LTIP”). The LTIP and stock-based compensation are more fully described in Note 9 “Stock-Based Compensation.” On January 1, 2006, the Company implemented Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment, under the modified prospective method, under which prior year amounts are not restated. Under SFAS No. 123(R), companies must recognize compensation expense for all new share-based awards (including employee stock options), and the nonvested portions of prior awards, based on their calculated “fair value” at the date of grant. Beginning in 2006, all share based grants, that were granted subsequent to the Company’s February 2005 initial public offering, are recognized as compensation expense on a straight line basis over the requisite service period. The Company uses the Black-Scholes pricing model to measure the fair value of employee stock options.
In February 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments - an amendment of SFAS Nos. 133 and 140. SFAS No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133, establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and amends SFAS No. 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Company has not yet determined the impact SFAS No. 155 has on the Company’s financial statements, but expects the impact, if any, to be immaterial.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company does not expect SFAS No. 157 to have a material impact on the Company’s results of operations, financial condition and liquidity.
The amortized cost and fair value of fixed maturities at December 31, 2006, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
During 2006 and 2004, there were no charges to income due to declines in fair market value of fixed maturities or equity securities. In 2005, the Company recorded a charge of $0.3 million for other-than-temporary impairments. Included in the 2005 fixed maturity losses and equity security losses above are charges to income of $0.2 million and $44 thousand, respectively, representing declines in fair market value of fixed maturities and equity securities that the Company has deemed to be other-than-temporary.
At December 31, 2006, the unrealized losses on the Company’s fixed maturities portfolio were primarily caused by interest rate changes. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 99.2% of the fixed maturity unrealized losses, which is an indication of the credit quality of those investments. Approximately 33% of the fixed maturities unrealized losses related to seven structured notes, whose market value has declined because of interest rates. The Company has represented that it will hold these structured notes until recovery, which may not occur until maturity.
At December 31, 2006, none of the securities in the table above were deemed to have any fundamental issues that would lead the Company to believe that they were other-than-temporarily impaired. The Company has the intent and ability to hold the fixed-maturity securities that are adversely impacted by interest rates, to recovery, and will do so, as long as the securities continue to remain consistent with the Company’s investment strategy. If the Company’s strategy was to change or these securities were determined to be other-than temporarily impaired, the Company would recognize a write-down in accordance with its stated policy.
In October 2006, NIIC purchased for $7.0 million an office building adjacent to the Company’s headquarters in Richfield, Ohio. Approximately 80% of the building is currently leased to tenants and the remaining 20% is available for use by the Company. The building was purchased short-term as an investment and long-term for growth expansion. The Company recorded a depreciation expense for the years ended December 31, 2006, 2005 and 2004 of $1.1 million.
Total rental expense (which includes utilities where charged by lessor) charged to operations for the years ended December 31, 2006, 2005 and 2004 were $0.4 million, $0.3 million and $0.4 million, respectively.
In May 2003, the Company formed a business trust that issued mandatorily redeemable preferred capital securities (capital securities). The trust loaned the $15.5 million in proceeds from the issuance of its capital securities and common equity to the Company in the form of debentures. These debentures are the trust’s only assets and mature in 2033. The interest rate is equal to the three-month LIBOR (5.37% at December 31, 2006 and 4.41% at December 31, 2005) plus 420 basis points with interest payments due quarterly. Payments from the debentures finance the distributions paid on the capital securities. The Company has the right to redeem its debentures, in whole or in part, on or after May 23, 2008. In accordance with FASB Interpretation No. 46(R), (and related amendments and interpretations) Consolidation of Variable Interest Entities, the Company determined that the business trust is a variable interest entity for which it is not the primary beneficiary and therefore, did not consolidate the trust with the Company. To the extent the trust does not have funds available to make payments, as guarantor, the Company unconditionally guarantees payment of required distributions on the capital securities, the redemption price when the capital security is redeemed, and amounts due if the trust is liquidated or terminated. The Company recorded its equity interest in the trust as a common stock investment.
The line of credit of $2.0 million (unused at December 31, 2006 and 2005) bears interest at the lending institution’s prime rate (8.25% at December 31, 2006 and 7.25% at December 31, 2005) less 50 basis points and requires an annual commitment fee of $1. In accordance with the terms of the line of credit agreement, interest payments are due monthly and the principal balance is due upon demand. In addition, the Company has agreed to refrain from assigning, conveying or otherwise transferring any security interest in the common shares of NIIC.
Federal income taxes paid for 2006, 2005 and 2004 were $14.4 million, $18.2 million and $11.6 million, respectively. Management has reviewed the recoverability of the deferred tax asset and believes the amount to be recoverable against future earnings.
methodology used for all options granted since the Company’s initial public offering in 2005. The Company has adopted SFAS No. 123(R) using the modified prospective method for awards issued subsequent to the Company’s initial public offering, which provides for no retroactive application to prior periods and no cumulative adjustment to equity accounts. It also provides for expense recognition, for both new and existing stock-based awards, as the required services are rendered. The Company has adopted SFAS No. 123(R) using the prospective method for awards issued prior to the Company’s initial public offering. Awards issued prior to the initial public offering were valued for disclosure purposes using the minimum value method. No compensation cost will be recognized for future vesting of these awards.
As a result of adopting SFAS No. 123(R) on January 1, 2006, the Company’s income before income taxes and net income for the year ended December 31, 2006 are $0.8 million and $0.7 million lower, respectively, than if it had continued to account for share-based compensation under Opinion 25. Basic and diluted earnings per share for the year ended December 31, 2006 are $0.03 lower than if the Company had continued to account for share-based compensation under Opinion 25.
The Company uses the Black-Scholes option pricing model to calculate the fair value of its option grants. The Company uses the SEC’s simplified method of calculating expected term with the grants made in 2006. The fair value of options granted were computed using the following weighted-average assumptions as of grant date:
The aggregate intrinsic value of all options outstanding at December 31, 2006 was $6.2 million. The aggregate intrinsic value of all options that were exercisable at December 31, 2006 was $0.9 million. The intrinsic value of options exercised during the year ended December 31, 2006 was $1.7 million. The total fair value of shares vested during the year ended December 31, 2006 was $0.5 million.
adjustment expense recoveries recorded with Great American were $2.8 million, $14 thousand and $0 for the years ended December 31, 2006, 2005 and 2004, respectively. The Company remains primarily liable as the direct insurer on all risks reinsured and a contingent liability exists to the extent that the reinsurance companies are unable to meet their obligations for losses assumed. To minimize its exposure to significant losses from reinsurer insolvencies, the Company seeks to do business with only reinsurers rated “Excellent” or better by A.M. Best Company and regularly evaluates the financial condition of its reinsurers.
As of December 31, 2006, the Company had reinsurance recoverables (including prepaid reinsurance premiums) due from the following reinsurers that exceeded 3.0% of consolidated shareholders’ equity:
operating expenses. Management believes, based on discussions with Great American, that these services will continue to be provided by the affiliated entity in future periods and the relative impact on operating results is not material.
The following table provides a reconciliation of the beginning and ending reserve balances for unpaid losses and loss adjustment expenses, on a net of reinsurance basis, for the dates indicated, to the gross amounts reported in the Company’s balance sheets.
The foregoing reconciliation shows decreases of $7.5 million, $5.2 million and $2.3 million in the years ended December 31, 2006, 2005 and 2004, respectively, representing favorable development in claims incurred in years prior to 2006, 2005 and 2004, respectively. The favorable development in these three years resulted from the combination of settling cases and adjusting current estimates of case and incurred but not reported losses (“IBNR”) for amounts less than the case and IBNR reserves carried at the end of the prior year for most of the Company’s lines of business. Management of the Company evaluates case and IBNR reserves based on data from a variety of sources including the Company’s historical experience, knowledge of various factors, and industry data extrapolated from other insurers writing similar lines of business.
NIIC paid dividends of $3.0 million to the Company in 2006 and did not pay any dividends in 2005. Also, in accordance with statutory restrictions, NIIC must maintain a minimum balance in statutory surplus of $5.0 million and each of the insurance companies subsidiaries must meet minimum Risk Based Capital (“RBC”) levels. At December 31, 2006 NIIC, NIIC-HI and TCC exceeded the minimum RBC levels.