We lease our headquarters in Chicago, Illinois. Our headquarters have approximately 34,004 square feet and our lease expires in 2020. We believe that our facility will support our future business requirements or that we will be able to lease additional space, if needed, on reasonable terms.
The following table includes the loss development history of loss and loss adjustment expense reserves of Specialty Underwriters’ Alliance, Inc. for business generated subsequent to its acquisition of Potomac Insurance Company of Illinois on November 23, 2004. The Company commenced its operations in 2005.
On November 23, 2004 we completed our initial public offering, or IPO, and concurrent private placements and completed the acquisition of Potomac Insurance Company of Illinois, or Potomac. After giving effect to the acquisition, we changed the name of Potomac to SUA Insurance Company.
The historical results of Potomac, our accounting predecessor, reflect Potomac’s operations as a member of the OneBeacon Insurance Company, or OneBeacon, inter-company pooling arrangement, or Pool, under which Potomac ceded all of its insurance business into the Pool and assumed 0.5% of the Pool’s insurance business. On April 1, 2004, effective January 1, 2004, Potomac ceased its participation in the Pool and entered into reinsurance agreements whereby it ceded all of its business to OneBeacon. As a result, Potomac did not, and will not share in any favorable or unfavorable development of prior losses recorded by it or the Pool after January 1, 2004, unless OneBeacon fails to perform on its reinsurance obligations.
Net income for the year ended December 31, 2006 was $8.4 million, compared to a net loss for the year ended December 31, 2005 of $18.0 million. Earnings per share for 2006 was $0.55 versus a net loss per share of $1.22 for 2005.
the year ended December 31, 2005. The increase in loss and loss adjustment expenses and amortization of deferred acquisition costs was driven by an increase in earned premium from 2005 to 2006.
Other operating expenses were $20.3 million for the year ended December 31, 2006, which consisted of salaries and benefit costs of $6.1 million (excluding $4.4 million of salary and benefit costs classified as loss adjustment expenses and acquisition expenses), $4.2 million of professional and consulting fees, $2.6 million of depreciation and amortization and $7.4 million of other expenses. For the year ended December 31, 2005, other operating expenses were $14.2 million, comprised of salaries and benefit costs of $5.2 million (excluding $2.9 million of salary and benefit costs classified as loss adjustment expenses and acquisition expenses), $3.0 million of professional and consulting fees, $1.8 million of depreciation and amortization and $4.2 million of other expenses. Other operating expenses for 2006 also included $1.1 million associated with our stock option program. This expense represents a change in our accounting policy through the adoption of FAS No. 123 (revised 2004), “Share-Based Payment,” or FAS 123R, whereby we recognize compensation expense for stock options. Prior to the first quarter of 2006 we followed the accounting principles under the intrinsic value method of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25. For 2006, we did not incur any service company fees because we terminated our service company contract effective December 31, 2005. In 2005, we incurred $8.8 million of service company fees. We have assumed the responsibilities previously provided by our service company, which expenses are included in other operating expenses. We remain committed to operating efficiently and increasing staff only as our business volume requires.
Although more diversified in 2006 than in 2005, our premiums in 2006 were primarily concentrated in Florida and California. Florida approved a rate decrease of 15.7% effective January 1, 2007. California approved rate decreases of 29.2% for 2006 and 9.5% for 2007. These decreases were in response to an improvement in loss experience caused by recent workers’ compensation reforms. Given the recent reforms, we still believe that Florida and California are attractive workers’ compensation markets. However, future experience may lead us to conclude otherwise. Our gross written premiums for 2006 and 2005 by state were as follows:
Although more diversified in 2006 than in 2005, our business written for the year ended December 31, 2006 was heavily weighted in workers’ compensation. Our gross written premiums by line of business as a percentage of total gross written premiums for the years ended December 31, 2006 and 2005 were as follows:
We reported a net loss of $18.0 million for the year ended December 31, 2005, compared to a net loss of $8.1 million for the year ended December 31, 2004. The net loss in 2005 was attributable to lower than expected premium volume in our first year of operations, whereas the net loss in 2004 was the result of our incurring start-up costs while not recording any operating revenues.
As a holding company, we have continuing funding needs for general corporate expenses, the payment of principal and interest on future borrowings, if any, taxes and the payment of other obligations. Funds to meet these obligations come primarily from dividends and other statutorily permissible payments from our operating subsidiary. The ability of our operating subsidiary to pay dividends or make other payments to us is limited by the applicable laws and regulations of Illinois. See “Business - Regulation” for more information.
For the year ended December 31, 2006 net cash from operating activities was $60.3, principally consisting of premium and deposit collections exceeding losses and expenses paid out. This amount compares to net cash from operating activities of $8.4 million for the year ended December 31, 2005, which also consisted principally of premium and deposit collections exceeding losses and expenses paid out. The increase in net cash provided by operating activities reflects the growth in our premium cash receipts for 2006 compared to 2005 which exceeded the growth in cash disbursed for operating expenses and losses and loss adjustment expenses. Our insurance operations commenced in early 2005 and as a result cash flows were negative for the majority of 2005 and first became positive in the fourth quarter of 2005. For the year ended December 31, 2004, our increase in cash was $8.8 million. Cash used for operating activities during the period from January 1, 2004 to December 31, 2004 totaled $8.0 million and was primarily related to our initial start-up costs.
While insurance regulation differs by location, each jurisdiction requires that minimum levels of capital be maintained in order to write insurance business. Factors that affect capital requirements generally include premium volume, the extent and nature of loss and loss adjustment expense reserves, the type and form of insurance business underwritten and the availability of reinsurance protection from adequately rated reinsurers on terms that are acceptable to us.
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 have capitalized our insurance operations in excess of the minimum regulatory requirements so that we may maintain adequate financial ratings. Higher financial ratings would enable us to write more business. Maintaining adequate capital consistent with business objectives is critical to any insurer’s future, and particularly important to start-up companies such as ours. We believe that our current level of capital is sufficient, but would need to be augmented 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. We are presently evaluating a variety of financing alternatives that could provide capital for future growth.
On November 23, 2004, Specialty Underwriters’ Alliance, Inc. acquired Potomac and subsequently renamed the company SUA Insurance Company. Prior to the acquisition, Potomac entered into a transfer and assumption agreement with OneBeacon, whereby all of its liabilities existing as of the acquisition, including all direct liabilities under existing insurance policies, were ceded to and assumed by OneBeacon. We will not experience any gains or losses with respect to such legacy policies unless OneBeacon fails to honor its reinsurance obligation. To date, OneBeacon continues to handle, adjudicate and pay all claims that have arisen from such legacy policies.
Net premiums written consist of direct premiums written less ceded premiums. The components of net premiums written are recognized as revenue over the period that coverage is provided. When premium rates increase, the effect of those increases will not immediately affect earned premium. Rather, those increases will be recognized ratably over the period of coverage. Unearned premiums and prepaid reinsurance premiums, which are recorded on the balance sheets, will represent that portion of premiums written that are applicable to the unexpired terms of policies in force. Certain policies are subject to adjustment based on changes in exposure units over the period of coverage, such as payroll increases/decreases and changes in risk classifications and therefore the direct written premiums are estimated during the policies term until final audit of the policy occurs.
deferred policy acquisition costs. Deferred policy acquisition costs are limited to the estimated amounts recoverable from future income after providing for losses and expenses included in future income that are expected to be incurred, based upon historical and current experience. If such costs are estimated to be unrecoverable, they will be expensed. Judgments as to ultimate recoverability of such deferred policy acquisition costs are highly dependent on future estimates of loss costs associated with unearned premium. The process of establishing loss reserves is complex and judgmental, as it must take into consideration many variables that are subject to the outcome of future events. Due to our limited operating history, there have been no historical changes in the recoverability of our deferred policy acquisition costs. We do not believe that any reasonably likely change in our loss development will affect the recoverability of deferred policy acquisition costs. See “Losses, Claims and Settlement Expenses.”
Our most significant estimates relate to our reserves for property and casualty losses and loss adjustment expenses. We establish reserves for the estimated total unpaid cost of losses and loss adjustment expenses for events that have already occurred. These reserves reflect our best estimates of the total cost of claims that were reported to us, but not yet paid, referred to as Case Reserves, and the cost of claims “incurred but not yet reported” to us, or IBNR, referred to as IBNR Reserves.
The estimate of these reserves is subjective and complex and requires us to make estimates about the future payout of claims, which is inherently uncertain. We establish and adjust reserves based on our knowledge of the circumstances and facts of claims. Upon notice of a claim, we establish a Case Reserve for losses based on the claims information reported to us at that time. Subsequently, we conduct an investigation of each reported claim, which allows 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 refine and adjust our estimates of Case Reserves. When we establish reserves, we do so based on our knowledge of the circumstances and claim facts. We continually review our reserves, and as experience develops and additional information becomes known, we adjust the reserves. Such adjustments are recorded through operations in the period identified. To evaluate and refine our overall reserving process, we track and monitor all claims until they are settled and paid in full and all salvage and subrogation claims are resolved.
Loss and LAE reserves, by line of business at December 31, 2006 and 2005 for our primary insurance operations were as follows:
On November 23, 2004, Specialty Underwriters’ Alliance, Inc. acquired Potomac, and subsequently renamed the company SUA Insurance Company. Prior to the acquisition, Potomac entered into a transfer and assumption agreement with OneBeacon, whereby all of its liabilities existing as of the acquisition, including all direct liabilities under existing insurance policies, were ceded to and assumed by OneBeacon. We will not experience any gains or losses with respect to such legacy policies unless OneBeacon fails to honor its reinsurance obligation. To date, OneBeacon continues to handle, adjudicate and pay all claims that have arisen from such legacy policies.
Workers’ compensation is generally considered a long-tail coverage, as it takes a relatively long period of time to finalize claims from a given accident year even though most claims are reported early. While certain characteristics, such as initial medical treatment or temporary wage replacement for the injured worker are known early on, some others are discovered over the course of several years, such as permanent partial injuries. In addition, some characteristics can run as long as the injured worker’s life, such as permanent disability benefits and ongoing medical care.
Expected loss ratio methods are based on the assumption that ultimate losses vary proportionately to premiums. Expected loss ratios are typically developed based upon the information used in pricing, such as certain industry information and bureau analysis, and are multiplied by the total amount of premiums earned to calculate ultimate losses.
Management meets with its actuaries and evaluates the methods and factors previously discussed affecting each line of business in determining its reserves. Management uses its discretion in considering these methods and factors without discretely measuring the impact of any factor. We do not believe that it is reasonably likely that any change or changes in any factor or combination of factors would result in a material adjustment to our reserves.
We determined the range of reserve estimates by summing the high and low estimates of the various actuarial methods applied to each line of business. The probability that ultimate losses will fall outside of the ranges of estimates by line of business is higher for each line of business individually than it is for the sum of the estimates for all lines taken together due to the effects of diversification. The diversification effects result from the fact that losses across our different lines of business are not completely correlated. Although we believe our reserves are reasonably stated, ultimate losses may deviate, perhaps materially, from the recorded reserve amounts and could be above the high end of the range of actuarial projections. This is because ranges are developed based on known events as of the valuation date, whereas the ultimate disposition of losses is subject to the outcome of events and circumstances that may be unknown as of the valuation date.
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty of Income Taxes, an interpretation of SFAS No. 109,” or FIN 48. FIN 48 provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on the related derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition of uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company believes that implementation of this new interpretation will have no material impact on its financial statements.