The following discussion and analysis of financial condition and results of operations should be read together with “Selected Financial Data” and our financial statements and accompanying notes appearing elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements, based on current expectations and related to future events and our future financial performance, that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many important factors, including those set forth under “Risk Factors”, “Forward-Looking Statements” and elsewhere in this Annual Report on Form 10-K.
We have not yet commenced substantive operations. During the period April 3, 2003 to December 31, 2004, we incurred costs related to our initial public offering and initial start-up costs for infrastructure required
Our business model stresses a “partnership” relationship with partner agents designed to better serve the specialty program commercial property and casualty insurance marketplace by addressing the typical misalignment of interests between agent and carrier. Partner Agents will receive up-front commissions capable of covering their costs and meaningful underwriting profit-based commissions payable over several years as compensation for writing business for us. As a result of these commission arrangements, a substantial amount of our commission expenses will be variable and will depend on the underwriting profits of the business.
Our investment income will depend on the amount of invested assets in our investment portfolios and the yield that we earn on those invested assets. Our investment yield is a function of market interest rates and the credit quality and maturity period of our invested assets. In addition, we could realize capital gains or losses on sales of investments as a result of changing market conditions, including changes in market interest rates and changes in the credit quality of our invested assets.
Loss and loss adjustment expenses will depend on the number and type of insurance contracts we write and will reflect our best estimate of ultimate losses and loss adjustment expenses we expect to incur on each contract written using various actuarial analyses. Actual loss and loss adjustment expenses will depend on actual costs to settle insurance claims. Our ability to accurately estimate ultimate loss and loss adjustment expense at the time of pricing each insurance contract will be a critical factor in determining our profitability.
Additionally, from time to time we engage legal, accounting, tax and financial advisors. General and administrative expenses are a function of the development of our business, including the growth in personnel and the overall volume of insurance contracts written.
We plan to outsource most of our administrative services primarily to a third-party services provider. Pursuant to these arrangements, we will pay a fixed payment together with additional amounts based on other factors. As a result, our administrative expenses generally will vary with the volume of our business as well as the other factors.
Results of Operations from January 1, 2004 to December 31, 2004 and from April 3, 2003 to December 31, 2003
We are organized as a Delaware holding company and, as such, have no direct operations of our own. Our assets consist primarily of investments in our subsidiary, through which we will conduct substantially all of our insurance operations.
Our principal consolidated cash requirements are expected to be the servicing of future borrowing arrangements, if any, the acquisition of and investment in operating subsidiaries, expenses to develop and implement our business strategy, capital expenditures, premiums ceded, losses and loss adjustment expenses, commissions, policy administration expenses, taxes and other operating expenses. The potential for a large claim under one of our insurance contracts means that we may need to make substantial and unpredictable payments within relatively short periods of time. We currently do not intend to declare dividends or make any other distributions to our stockholders. Our board of directors plans to periodically reevaluate our dividend policy. Our cash requirements also will include the payment of any future dividends to our stockholders if and when our board of directors determines to change our dividend policy.
Prior to completing our initial public offering, our sole source of cash was $3.9 million in term loans from senior and subordinated lenders. Concurrent with the initial public offering, all outstanding loans, together
with accrued interest of $0.2 million were repaid, through an exchange for common stock. Further, warrants issued in conjunction with the loans were cancelled resulting in a gain in the fourth quarter of $4.0 million.
We expect our future sources of funds will consist of net premiums written, reinsurance ceding commissions and recoveries, investment income and proceeds from sales and redemptions of investment assets.
We do not have any borrowings outstanding as of December 31, 2004.
We have no off-balance sheet arrangements or transactions with unconsolidated, special purpose entities.
Insurers are required to maintain certain minimum levels of capital and risk-based capital, the calculation of which includes numerous factors as specified by the respective insurance regulatory authorities and the related insurance regulations. We will capitalize our insurance operations in excess of the minimum regulatory requirements so that we may maintain adequate financial ratings.
We believe that the proceeds of the initial public offering and the concurrent private placement will be sufficient to execute our business strategy for at least the next 12 months. We would need to raise additional funds to further expand our business strategy, enter new business lines, and manage our expected growth or to deal with higher than expected expenses or poorer than expected results.
After we begin our insurance operations, we expect that our financial statements will contain certain amounts that are inherently subjective in nature and require management to make certain judgments and assumptions in the application of accounting policies used to determine those amounts reported in the financial statements. The use of different assumptions could produce materially different estimates of the reported amounts. We believe the following critical accounting policies will affect significant estimates used in the preparation of the financial statements after the commencement of our insurance operations.
In December 2004, the FASB issued FAS No. 123 (revised 2004), “Share-Based Payment” (“FAS 123R”). FAS 123R replaces FAS No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”) and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”
(“APB 25”). As permitted by FAS 123, our company currently accounts for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognizes no compensation expense for employee stock options. Accordingly, the adoption of FAS 123R’s fair value method will have a significant impact on our result of operations, although it will have no impact on our overall financial position. The impact of adoption of FAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted FAS 123R in prior periods, the impact of that standard would have approximated the impact of FAS 123 as described in the disclosure of pro forma net income and earnings per share in Note 7 to our consolidated financial statements. FAS 123R also requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were zero in 2004, as we had a net operating loss carry forward in 2004 and has never paid any tax.
We will establish an asset for deferred policy acquisition costs such as up-front commissions, premium taxes and other variable costs incurred in connection with writing our lines of business. Deferred policy acquisition costs will be amortized over the period of coverage of the policies written. We will assess the recoverability of deferred policy acquisition costs on a quarterly basis. The loss and loss adjustment expense ratio we use to estimate the recoverability of deferred costs is expected to be based primarily on the
assumption that the future loss and loss adjustment expense ratio will include consideration of the recent experience. Such adjustments will be recorded through operations in the period identified. Actual results could differ materially from such estimates, requiring future adjustments to the recorded deferred policy acquisition cost asset.
The estimate of these reserves is subjective and complex and will require us to make estimates about the future payout of claims, which is inherently uncertain. When we establish and adjust reserves, we will do so based on our knowledge of the circumstances and facts of claims. Upon notice of a claim, we will establish a Case Reserve for losses based on the claims information reported to us at that time. Subsequently, we will conduct an investigation of each reported claim, which will allow us to more fully understand the factors contributing to the loss and our potential exposure. This investigation may extend over a long period of time. As our investigations of claims develop and as our claims personnel identify trends in claims activity, we plan to refine and adjust our estimates of Case Reserves. When we establish reserves, we plan to do so based on our knowledge of the circumstances and claim facts. We plan to continually review our reserves, and as experience develops and additional information becomes known, we will adjust the reserves. Such adjustments will be recorded through operations in the period identified. To evaluate and refine our overall reserving process, we will track and monitor all claims until they are settled and paid in full and all salvage and subrogation claims are resolved.
To establish loss and loss adjustment expense reserves, we will need to make estimates and assumptions that affect the amounts of assets, liabilities, revenues and expenses reported in our financial statements. Actual results could differ materially from those estimates.
The estimation of ceded reinsurance loss and loss adjustment expense reserves will be subject to the same factors as the estimation of insurance loss and loss adjustment expense reserves.
We have established a valuation allowance for the portion of any deferred tax asset that management believes may not be realized. The establishment and ongoing evaluation of a valuation allowance for deferred tax assets requires the use of judgment and estimates. Actual results could differ materially from those estimates.
The following table of contractual obligations includes information with respect to our known contractual obligations as of December 31, 2004.
The table below summarizes the estimated effects of hypothetical increases and decreases in market interest rates on our fixed maturity portfolio:
The following discussion and analysis of financial condition and results of operations should be read together with “Selected Financial Data” and the financial statements and accompanying notes appearing elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements, based on current expectations and related to future events and our future financial performance, that involve risks and uncertainties. The actual results may differ materially from those anticipated in these forward-looking statements as a result of many important factors, including those set forth under “Risk Factors”, “Forward-Looking Statements” and elsewhere in this Annual Report on Form 10-K.
Results of Operations from January 1, 2004 through November 23, 2004 versus Year Ended December 31,
Year Ended December 31, 2003 versus Year Ended December 31, 2002
Potomac’s pre-tax income for 2003 was $2.1 million, compared to pre-tax income of $0.9 million for 2002. Total revenues for 2003 declined by 25% compared to 2002, due principally to a corresponding 26% decline in earned premiums. The decline in earned premiums was due primarily to a reduction in premiums assumed by OneBeacon and the Pool, of which Potomac was a participant, from Liberty Mutual. On November 1, 2001, OneBeacon transferred its regional agency business in 42 states and the District of Columbia to Liberty Mutual. Under the terms of the renewal rights agreement, the underwriting results and cash flows of the renewed policies were shared between OneBeacon and Liberty Mutual over a two year period through a reinsurance agreement whereby OneBeacon assumed two-thirds and one-third of the business renewed in the first and second years, respectively. Total revenues for 2003 were also impacted by realized losses on sales of fixed maturity investments, partially offset by an increase in investment income due to a shift of funds to longer term maturities.
Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses Potomac’s financial statements, which have been prepared in accordance with GAAP. The financial statements presented herein include all adjustments considered necessary by management to fairly present the financial position, results of operations and cash flows of Potomac. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.
Potomac establishes loss and LAE that are estimates of amounts needed to pay claims and related expenses in the future for insured events that have already occurred. Reinsurance is an arrangement in which a reinsurance company contractually agrees to indemnify an insurance company for all or a portion of the insurance risks underwritten by the insurance company. Potomac establishes estimates of amounts recoverable from its reinsurers in a manner consistent with the claim liability covered by the reinsurance contracts, net of an allowance for uncollectible amounts. Net insurance loss reserves represent loss and LAE reserves reduced by reinsurance recoverable on unpaid losses.
through policy exclusions and underwriting restrictions. Therefore, Potomac has very little direct exposure to the large latent losses.
Effective January 1, 2004, Potomac ceased its participation in the Pool and no longer has any assumed liabilities, real or contingent. At the time of de-pooling, Potomac also entered into a transfer and assumption agreement which effectively transferred all its direct liabilities to OneBeacon. Potomac remains contingently liable for the insurance liabilities associated with its former direct business to the extent OneBeacon fails to perform.
OneBeacon has entered into ceded reinsurance contracts from time to time to protect their businesses from losses due to poor risk diversification, to manage their operating leverage ratios and to limit ultimate losses arising from catastrophic events. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. Amounts related to reinsurance contracts are recorded in accordance with SFAS No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts”.