Common shares and common share equivalents used in computing net diluted earnings per share
Debt to total capitalization ratio: The debt to total capitalization ratio, is the ratio, expressed as a percentage, of total debt to the sum of total debt and shareholders’ equity. The Company’s total debt consists solely of loans payable.
We are a Bermuda-based specialty insurance and reinsurance company that provides customized products and solutions to small and medium-sized businesses in industries that we believe are underserved by the standard market. For more than twenty years, we have developed specialized coverages and alternative risk transfer products not generally available to our customers in the standard market because of the unique characteristics of the risks involved and the associated needs of the insureds. We specialize in underwriting these products for insureds with environmental risks and construction risks as well as in developing programs for other specialty classes of risks and providing third party reinsurance.
We segregate our business into insurance operations and other, with the insurance operations segment being further classified into four segments: excess and surplus lines (E&S), alternative risk transfer (ART), assumed reinsurance (Assumed Re) and runoff. E&S is further classified into six business lines: environmental, construction, products liability, excess, property, and surety. ART is further classified into two business lines: specialty programs and fully funded. In our Assumed Re segment, the Company assumes specialty property and casualty business from affiliated and unaffiliated insurers and reinsurers.
Run-off includes lines of business that we no longer write. Prior year amounts have been reclassified to conform to the current year presentation.
Within the E&S sub segment, our environmental insurance coverages protect against general liability and environmental exposures for contractors in the environmental remediation industry and property owners. Construction provides commercial casualty insurance coverages, generally for residential and commercial contractors. Products liability offers general liability and product liability coverages for smaller manufacturers and distributors, non-habitational real estate and certain real property owner, landlord and tenant risks. Excess provides excess and umbrella liability coverages over our own and other carriers’ primary casualty polices, with a focus on construction risks. Our property coverage encompasses non-standard, surplus lines commercial property business and commercial multi-peril (CMP) policies. The casualty focus of our CMP products is premises liability. Surety provides payment and performance bonds primarily to the environmental remediation and construction industries.
Our assumed reinsurance segment offers casualty reinsurance products in the form of treaty and facultative contracts. We provide this coverage on an excess of loss and quota share basis. Casualty business includes general casualty, commercial auto, professional liability and workers’ compensation. Target markets include small alternative risk transfer vehicles such as risk retention groups, captive insurance companies, risk purchasing groups and managing general agents.
The Other segment consists of amounts associated with realized gains and losses on investments, certain corporate expenses and real estate operations that were essentially complete in 2005.
Net earnings increased 37.3% to $28.2 million for the year ended December 31, 2007, compared to $20.5 million for 2006. Total revenues increased 5.6% to $181 million, as net premiums earned increased 1.4% to $148.8 million and net investment income increased 39.1% to $30.3 million. The increase net investment income related to a 20.9% increase in average invested assets and a 13.3% increase in the average yield to 5.1%. Net realized losses on the investment portfolio before taxes were $311,000 compared to a gain of $1.2 million in 2006.
The property and casualty insurance market has softened significantly and the number of insurers competing for premium in the excess and surplus lines market has increased. These competitors include several start-up companies as well as larger standard market insurers looking to capture market share by moving from the admitted market to the excess and surplus lines market. This increased competition has caused rates to decline in our targeted markets, in some cases, significantly. Despite this softening trend, we believe there are profitable growth opportunities from which we can benefit, resulting from our diversification into new geographic locations and lines of business.
Environmental. Net premiums earned increased 3.7% to $36.4 million for the year ended December 31, 2007 compared to $35.1 million for 2006. In 2007, $2.3 million of premium was ceded to reinsurers due to adverse loss development. The reserve development and ceded reinsurance adjustments predominantly relate to losses from policies covering New York contractors from accident years 2003 - 2004. The 2006 premium was decreased $3.7 million resulting from the accrual for reinsurance reinstatement premium resulting from one large New York loss. The Company instituted more restrictive policy forms and underwriting guidelines for such business during 2006 and 2007.
Products Liability. The Company’s general and products liability product began production in July 2006 with the acquisition of an underwriting team in Middletown, New Jersey producing $2.4 million of net earned premiums in 2007 compared to $653,000 in 2006. The general and products liability business is offered to small and middle market accounts. The Company does not intend to write certain high severity classes of risks such as invasive medical products, pharmaceuticals and neutraceuticals.
Property. In 2007, the Company hired an experienced underwriting team to write property and CMP liability coverage with a focus on fire exposed premises liability risks with limited catastrophe exposure, primarily in the eastern United States. For the year ended December 31, 2007, net premiums earned from the property business line was $520,000.
Net realized gains and losses from the sale of investments decreased to a net loss of $311,000 for the year ended December 31, 2007 from a gain of $1.2 million for 2006. The Company from time to time may sell securities in response to market conditions or interest rate fluctuations in accordance with its investment guidelines (described under “Business-Investments”) and or to fund the cash needs of individual operating subsidiaries.
See “Business-Losses and Loss Adjustment Expenses Reserves” and Note 12 to the Company’s consolidated financial statements for additional information regarding the Company’s reserves for unpaid losses and loss adjustment expenses.
The 2006 prior year development in the construction line primarily relates to development in layers that were previously reinsured, but the reinsurance treaty was commuted in 2005. The development in the programs primarily relates to an increase in certain case reserves on policies written in 2004 and 2005. This development is partially offset by reserve reductions in our surety and runoff lines.
Real estate expenses associated with the Harbour Village project decreased to $326,000 for the year ended December 31, 2007 from $381,000 for 2006. The Harbour Village project is completed, as the final units were sold during 2005.
Construction. Net premiums earned increased 8.2% to $88.6 million for the year ended December 31, 2006 compared to $81.9 million for 2005. Net premiums earned increased due to the non-renewal of the excess of loss reinsurance treaty for this line in July 2005 as well as an increase in premium writings in non-western states (states other than Arizona, California, Colorado, Nevada and Washington) as a result of the Company’s geographic diversification efforts. Premiums written in non-western states increased to $15.3 million in 2006 from $3.7 million in 2005. This increase was partially offset by decreased premiums in the western states due to lower renewals and rate decreases.
Products Liability. The products liability general liability product began production in July 2006 with the acquisition of an underwriting team in Middletown, New Jersey producing $653,000 of net premiums earned. The Company experienced strong submission and production activity in this line. The product liability general liability business plans to offer both primary and excess
Fee income earned on fully funded polices increased 40.8% to $1.7 million for the year ended December 31, 2006 compared to $1.2 million for 2005. The Company recently added the availability of a fully funded product for property catastrophe exposures due to the limited capacity of affordable insurance for middle market insureds. The Company has seen some adverse impact from the overall market softening on its production efforts in this line as traditional insurance pricing declines provide a cost effective alternative to self-insurance.
Net investment income increased 57.7% to $21.8 million for the year ended December 31, 2006 from $14.3 million for 2005 due to an increase in the Company’s invested assets and higher investment yields. The increase in invested assets was due to $70.7 million of cash flow from operations and $53.0
The table below sets forth the prior year reserve development made for by the Company for the years ended December 31, 2005 and 2006 (in thousands):
In 2005, the Company commuted two excess of loss reinsurance treaties with a former reinsurer. The negotiated commutation price was approximately $1 million less than the recoverable from the reinsurer which was recorded in the second quarter of 2005. Additionally, in the fourth quarter of 2005, the accident year 2001 losses from commercial and residential contractors’ claims other than construction defect risk category developed adversely. The Company engaged an actuarial consulting firm in the fourth quarter of 2005 to provide construction defect claim count development patterns based on a group of companies writing construction contractors business since the early 1990s in California and other
Policy acquisition expenses are amounts that are paid to producers of premium for the Company offset by the ceding commissions we receive from our reinsurers. For our program business, fees typically are earned through ceding commissions and have the effect of lowering our acquisition expenses. Policy acquisition expenses also include amounts paid for premium taxes to the states where we do business on an admitted basis. Policy acquisition expenses decreased to $27.4 million for the year ended December 31, 2006 from $28.8 million for 2005. Policy acquisition expenses as a function of net premiums earned decreased to 18.7% for the year ended December 31, 2006 from 20.8% for 2005, primarily due to increased retention levels which produce higher earned premiums with minimal additional expenses.
Real estate expenses associated with the Harbour Village project decreased to $381,000 for the year ended December 31, 2006 from $2.4 million for 2005. The Harbour Village project is substantially completed, as the final units were sold during 2005.
Payroll expenses increased to $14.9 million for the year ended December 31, 2006 from $12.1 million for 2005. The change is due to an increased number of employees, the inclusion of FASB Statement 123R option expense of approximately $615,000 and normal salary increases.
The effective tax rate increased to 10.1% for the year ended December 31, 2006 from 8.7% for 2005. In 2005, American Safety RRG, reversed $555,000 of its deferred tax asset reserve due to expected
profitability. The effects of this reversal are reflected in minority interest on the Company’s consolidated financial statements. Included in tax expense for 2006, is the establishment of a valuation allowance for American Safety RRG for $1.1 million and 2005 provision to return adjustments for permanent differences in the 2005 federal and state income tax returns of $483,000. The establishment of the valuation allowance is reflected in minority interest on the consolidated financial statements. Absent this adjustment, the effective tax rate for 2006 would have been 5.1%. The reduction in the effective rate is due to lower earnings from U.S. operations from the impact of reinstatement premiums and prior-year loss development. For 2005 and 2006, the reversal and establishment of the valuation allowance has been included in income tax expense with a corresponding offset in minority interest.
The Company operates through its subsidiaries in the U.S. and Bermuda. Significant differences exist in the regulatory environment in each country. The table below describes the Company’s operations by geographic segment for the years ended December 31, 2005 and 2006 (in thousands):
Equity. Equity of the Bermuda operations increased to $129.3 million at the end of 2006 compared to $59.4 million at the end of 2005 due to the secondary offering, higher net income and an improvement in net unrealized gains on the investment portfolio. Equity of U.S. operations increased to $66.9 million at the end of 2006 from $59.0 million at December 31, 2005 due to capital contributions made to support the growth of our U.S. insurance operations and an increase in net unrealized gains on the U.S. insurance operations invested assets.
Net cash provided by operations was $67.0 million for the year ended December 31, 2007, $70.7 million for the year ended December 31, 2006 and $70.4 million for the year ended December 31, 2005. The cash flow from operations decreased in 2007 compared to 2006 primarily due to an increase in accrued premiums in our assumed reinsurance business line partially offset by higher net investment income.
In June 2006 the Company completed a secondary equity offering of 3,680,000 common shares, raising approximately $53.0 million net of underwriting expenses. The proceeds of the offering are being used to support the growth in insurance operations. Additionally, in November 2005, in conjunction with American Safety Capital Trust III, the Company issued a 30-year trust preferred obligation in the amount of $25.0 million. This obligation bears a fixed interest rate of 8.31% for the first five years, and a floating rate of three-month LIBOR plus 3.4% thereafter. Interest is payable on a quarterly basis and the securities may be called solely at the Company’s option after five years.
Our contractual obligations (in thousands of dollars) as of December 31, 2007 were:
(1) The above table includes all interest payments through the expiration of interest rate swaps as discussed in Note 8 to the Company’s consolidated financial statements. At that time the Company may redeem the debt or continue with variable interest payments. All amounts are reflected based on final maturity dates. Variable rate interest obligations are estimated based on current interest rates. As a result of applying current interest rates to the respective LIBOR for each capital trust, the interest rates were 9.3%, 9.1% and 8.5% for American Safety Capital Trust, American Safety Capital Trust II and American
Investments. We routinely review our investments that have experienced declines in fair value to determine if the decline is other than temporary. These reviews are performed with consideration of the facts and circumstances of an issuer in accordance with the Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 59, Accounting for Non-Current Marketable Equity Securities; Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities; and Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments; FASB Staff Position No. FAS 115-1 and related guidance. The identification of distressed investments and the assessment of whether a decline is other than temporary, involve significant management judgment and require evaluation of factors including but not limited to:
• Adverse changes in the issuer’s economic, regulatory or political environment.
The Company did not have any impairment charges during 2007. The Company in conjunction with its investment advisor, monitors its investments for potential impairments. See “Business-Investments” for information as to the credit quality of its investment portfolio. At December 31, 2007, 95.8% of the investment portfolio was rated A or better by S&P and Moody’s, with 60.9% being rated AAA.
If all securities carrying an unrealized loss were determined to be other than temporarily impaired, our future earnings would be reduced by the $4.9 million carried unrealized loss on investments at December 31, 2007. The Company’s portfolio managers routinely monitor and evaluate the difference between the cost and fair value of our investments. Additionally, credit analysis and/or credit rating issues related to specific investments may trigger more intensive monitoring to determine if a decline in market value is other than temporary. For investments with a market value below cost, the process includes evaluating the length of time and the extent to which cost exceeds market value, the prospects and financial condition of the issuer, and evaluation for a potential recovery in market value, among other factors. As a result management concluded that the recoverability of the principal and interest is reasonably assured and no impairment needed to be recognized.
The Company does not write a material amount of short-tail business. Short-tail business is defined as business for which claims are received and settled within one year. Total net reserves for short tail business are not material and as of December 31, 2007 were less than 1% of total net reserves. In the aggregate, our primary long-tail lines are construction, where we offer general liability insurance to construction contractors and environmental where we offer general liability and professional liability insurance to environmental contractors and consultants.
Because the Company writes long-tail business, the current year ultimate loss reserve is developed using the expected loss ratio method. The method is appropriate because there are very few claims reported from the most recent accident year for long-tail lines of business. The expected loss ratio is determined based on the review of the projected ultimate loss ratios for the prior accident years. At December 31, 2007 the carried loss and loss adjustment reserves for accident years prior to 2007 were determined largely based on the indications produced by the Bornhuetter-Ferguson method because of the additional claims experience gained as the business line matures.
On a quarterly basis, the Company’s internal actuary performs a review of lines of business with significant net exposure. The evaluation entails the examination of our current actuarial assumptions compared to actual claim activity. If there is a material deviation from actual emerged losses and the actuarially determined expected losses, further research is completed to determine the cause. Discussions with the claims staff and the underwriting staff about these deviations, in some cases, reveal trends that warrant modifications of the current assumptions about loss development patterns and or expected loss ratios. Based on these latest loss reserve projections, management establishes revised estimates of loss reserves as appropriate.
As part of our year-end process, the Company has an external actuarial firm review the analysis prepared by our internal actuary and issue an actuarial opinion on the insurance operating companies’ reserve adequacy.
Construction defect claims in general had a higher frequency, a lower severity and a longer reporting period then other types of claims. The construction defect exposures in California were analyzed separately from other states because of the state’s relatively longer statute which makes the claim reporting period longer, and the litigious environment, which makes the claims more expensive. Other commercial and residential contractors’ claims tended to be high in severity. The Company wrote New York commercial contractor risks in 1999, 2000 and 2001. Due to the short amount of time we wrote this business and the higher severity in New York claims, the reserves for these exposures are calculated separately. Products liability claims tended to be severe and took a longer time to report. The habitational exposures were mostly slips and falls on the insured premises with low severity and frequency.
A number of assumptions were made in the determination of the best reserve estimates for each line of business at December 31, 2007. The key assumptions among them were the expected loss ratios and loss development patterns. If the actual future losses and loss adjustment expenses develop materially differently from those key assumptions, there could be a potential for significant variation in the development of loss reserves. The effect of any specific assumptions can vary by accident year and line of business. We performed sensitivity analyses that tested the effects on the loss reserve position of using alternative loss ratios and loss development patterns rather than those actually used in determining the net carried reserve at December 31, 2007. The tests addressed each major line of business for which a material deviation to the overall reserve position is believed reasonably possible and used what we believed was reasonably likely range of potential deviation for each line of business. If our net carried reserves were to decrease from our best estimate, this would increase our net earnings, while an increase
Effective July 1, 2007 the Company entered into an excess of loss reinsurance treaty on our casualty lines of business. Under this treaty, the Company retains the first $500,000 of a loss and has a 10% participation in the $4.5 million excess of $500,000 layer for its environmental, construction and products liability lines of business, as well as the general liability portion of its property line. The Company retains the first $250,000 of a loss on certain of its program lines of business, participates 50% of the next $250,000 and 10% of the $4.5 million in excess of $500,000. The treaty provides that the Company retains a 10% quota share on the first $5 million of loss on the excess line of business and provides coverage on policies up to a $10 million limit.
Deferred Income Taxes. We are required to establish a valuation allowance for the portion of any deferred tax asset that we believe will not be realized. The majority of our deferred taxes associated with our premium writings will be realized over the policy period and payout of related claims. We believe it is more likely than not that we will realize the full benefit of our deferred tax assets, except for deferred tax assets associated with American Safety RRG. See Note 6 to the Company’s consolidated financial statements for additional information on deferred tax assets.
In July 2006, the FASB issued a Staff Position Number FIN 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement Number 109, Accounting for Income Taxes. This interpretation prescribes a recognition threshold and measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company has reviewed the pronouncement and based on its analysis upon adoption, FIN 48 does not have a material impact on its operating results.
Property and casualty insurance premiums are established before the amount of losses and loss adjustment expenses, or the extent to which inflation may affect such amounts, is known. The Company attempts to anticipate the potential impact of inflation in establishing its premiums and reserves. Substantial future increases in inflation could result in future increases in interest rates, which, in turn, are likely to result in a decline in the market value of the Company’s investment portfolio and resulting unrealized losses and/or reductions in shareholders’ equity.
Our underwriting experience is best indicated by our GAAP combined ratio, which is the sum of (a) the ratio of incurred losses and settlement expenses to net premiums earned (loss ratio) and (b) the ratio of policy acquisition costs and other operating expenses less fee income to net premiums earned (expense ratio). A combined ratio below 100% indicates that an insurance company has an underwriting profit, and a combined ratio above 100% indicates an insurer has an underwriting loss. Our reported combined ratio excludes certain holding company expenses such as interest expense, real estate expenses and includes a reduction for fee income.
In January 2003, the Financial Accounting Standards Board (the “FASB”) issued FASB Interpretation No. 46 (“FIN 46”). This interpretation requires the consolidation of entities in which an enterprise absorbs a majority of the entity’s expected losses, receives a majority of the expected residual gains, or both, as a result of ownership, contractual or other financial interests in the entity. In December 2003, the FASB issued a revised version of FIN 46, FIN 46(R), which finalized the accounting guidance for VIEs. As a result of adopting FIN 46(R), the Company consolidated its non-subsidiary affiliate American Safety RRG and deconsolidated its trust subsidiaries American Safety Capital Trust, American Safety Capital Trust II and American Safety Capital Trust III.
This report contains forward-looking statements. These forward-looking statements reflect the Company's current views with respect to future events and financial performance, including insurance market conditions, premium growth, acquisitions and new products and the impact of new accounting standards. Forward-looking statements involve risks and uncertainties which may cause actual results to differ materially, including competitive conditions in the insurance industry, levels of new and renewal insurance business, developments in loss trends, adequacy and changes in loss reserves and actuarial assumptions, timing or collectability of reinsurance recoverables, market acceptance of new coverages and enhancements, changes in reinsurance costs and availability, potential adverse decisions in court and arbitration proceedings, the integration and other challenges attendant to acquisitions, and changes in levels of general business activity and economic conditions.
The Company's consolidated financial statements required under this Item 8 are included as part of Item 15 of this Report.