We lease office space in Duluth, Georgia; Honolulu, Hawaii; Mechanicsburg, Pennsylvania; St. Thomas in the United States Virgin Islands; and Bluffton, South Carolina. These leases account for approximately 17,500 square feet of office space. These leases expire within fifty-five months. The monthly rents, exclusive of operating expenses, to lease these facilities currently total approximately $28,500. We believe that these leases could be renewed or replaced at commercially reasonable rates without material disruption to our business.
Book value per common share is computed using only unrestricted outstanding common shares. As of December 31, 2008 and 2007 total unrestricted common shares were 19,295,000 and 19,205,000, respectively. There were no unvested restricted shares prior to 2007.
The 2004 data includes a $15.0 million note payable to Great American, junior subordinated debt and bank debt.
The P/C insurance industry is cyclical, with periods of rising premium rates and shortages of underwriting capacity (“hard market”) followed by periods of substantial price competition and excess capacity (“soft market”). The P/C insurance industry experienced a continued soft market in 2008, resulting in an anticipated industry wide decrease in premiums written which will constitute the first back-to-back decrease in premiums since 1932-33. According to A.M. Best, the decline in premiums in 2008, as well as the sizable and frequent weather-related losses are expected to lead to an underwriting loss for the industry in 2008. A.M. Best’s estimated industry combined ratio of 105.1% is based upon the overall industry statutory combined ratio for the first nine months of 2008. The industry faces several unfavorable trends in the coming year such as, but not limited to, a heightened level of investment risk, price stabilization, claims inflation risk and expense control.
During 2008, like most of the P/C insurance industry, our results were negatively impacted by net realized losses from investments, including write-downs required by the other-than-temporary impairment accounting guidelines, related to the turmoil in the investment markets. We have historically maintained a conservative investment portfolio, focusing primarily on high quality fixed income and preferred stock investments. Our 2008 purchases have been concentrated in U.S. Government and government agencies, state and local government obligations (“muni bonds”) and agency backed collateralized mortgage obligations. Although we cannot provide any assurances, at December 31, 2008, with over 90% of our investment portfolio comprised of investment grade fixed income, investment grade preferred stock and cash, we believe we remain properly positioned as we head into 2009.
We approach investment and capital management with the intention of supporting insurance operations by providing a stable source of income to offset underwriting risk and growing income to offset inflation. The priority of goals of our investment policy are to preserve principal while optimizing income. We follow a formal investment policy and the Board reviews the portfolio performance quarterly for compliance with the established guidelines. Like other insurance companies in 2008, our investment portfolio was negatively impacted by the turmoil in the investments market resulting in a $22.4 million pre-tax net realized loss on investments. However, at December 31, 2008 over 90% of our investment portfolio is in investment grade fixed income and preferred stock investments and cash. Given the economic conditions still existing today, we cannot predict if and when future losses may occur.
Losses and LAE are a function of the amount and type of insurance contracts we write and of the loss experience of the underlying risks. We record losses and LAE based on an actuarial analysis of the estimated losses we expect to be reported on contracts written. We seek to establish case reserves at the maximum probable exposure based on our historical claims experience. Our ability to estimate losses and LAE accurately at the time of pricing our contracts is a critical factor in determining our profitability. The amount reported under losses and LAE in any period includes payments in the period net of the change in the value of the reserves for unpaid losses and LAE between the beginning and the end of the period.
Our December 31, 2008 and 2007 net earnings from operations, net realized losses from investments and net income are as follows:
In addition to the alternative risk transfer component, the specialty personal lines component increased $3.9 million in 2008 compared to 2007, primarily due to additional policies in force in our commercial vehicle product from expanded marketing initiatives and product enhancements. Due to increased competition in a soft market, both our transportation ($3.7 million) and Hawaii and Alaska ($2.6 million) components decreased in 2008 as compared to 2007. Our underwriting approach is to price our products to achieve an underwriting profit even if we forgo volume as a result. Our retention rates for traditional transportation are comparable between 2008 and 2007; however, we are continuing to experience a trend of competitive pricing on larger traditional accounts impacting premium to a greater degree than in prior periods. In 2008, we maintained relatively flat rate levels on renewing commercial insurance business and, as a result, our renewal hit ratios have continued to deteriorate to historic levels from the elevated levels we had in 2003 and 2004.
Our premiums earned increased $33.2 million, or 12.9%, to $290.7 million during the year ended December 31, 2008 compared to $257.5 million for the year ended December 31, 2007. Our alternative risk transfer component increased 28.0% during 2008 compared to the same period in 2007, primarily due to expanded insurance offerings in one of our larger captives, new participants in existing captive programs and the addition of new truck captive programs in 2008. Our alternative risk transfer business remains our fastest growing component. Our specialty personal lines component increased 5.8% in 2008 compared to 2007, due to growth in our commercial vehicle product. The transportation component remained relatively constant in 2008 compared to 2007, as we are still experiencing a slight decline in renewal rate increases due to the current soft 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 $1.2 million, or 17.6%, to $5.5 million in 2008.
Our underwriting approach is to price our products to achieve an underwriting profit even if we forego volume as a result. From 2000 through 2006, our insurance subsidiaries increased their premium rates to offset rising losses and reinsurance costs. In both 2008 and 2007, we experienced a slight decline in rate levels on renewal business due to the continued softening market.
2008 compared to 2007. Losses and LAE increased $38.6 million, or 25.8%, for 2008 compared to 2007. The loss and LAE ratio for the year ended December 31, 2008 was 64.7% compared to 58.0% for the year ended December 31, 2007. The increase in the loss and LAE ratio in 2008 of 6.7 percentage points is primarily due to an increase in large loss severity in our small fleet charter operations that we experienced during the first three quarters of 2008. These large losses contributed approximately 4.4 percentage points to our 2008 loss and LAE ratio. During the third quarter of 2008, we began the process of reviewing most of our large fleet charter transportation book and our entire in-force small fleet book of charter transportation business to ensure that our high underwriting standards are in place and identified specific accounts that require action. We have also implemented other initiatives, centered on risk selection and pricing adequacy relative to the entire charter transportation product.
For the years ended December 31, 2008 and 2007, we had favorable development from prior years’ loss reserves of $0.9 million and $5.7 million, respectively. The favorable development for both years was primarily related to the settlements below the established case reserves and revisions to our estimated future settlements on an individual case by case basis. This savings represents only 0.4% and 3.1% for 2008 and 2007, respectively, of the prior year reserves. The increase in the loss and LAE ratio from 2007 to 2008 also reflects the impact of modestly lower renewal rates that we are experiencing from the softening market.
Commissions and other underwriting expenses consist principally of brokerage and agent commissions reduced by ceding commissions received from assuming reinsurers, and vary depending upon the amount and types of contracts written and, to a lesser extent, premium taxes. The underwriting expense ratio was 24.7% and 22.9% for the years ended December 31, 2008 and 2007, respectively. The 1.8 percentage point increase to our 2008 expense ratio is primarily due to a change in our overall mix of business, including high premium growth in products that tend to have higher commission rates.
2007 compared to 2006. Net investment income increased $4.6 million, or 26.0%, to $22.1 million in 2007 compared to 2006. The net investment income improvement reflects higher average invested assets due to continued strong cash flows from operations as well as the higher yield of the portfolio. During 2007 higher yields on our short-term portfolio compared to 2006 favorably impacted our net investment income. Also favorably impacting our yields, during 2007 we diversified our portfolio into agency guaranteed collateralized mortgage obligations which did not expose us to the subprime lending sector.
2007 compared to 2006. Other income increased $1.8 million, or 73.3%, to $4.1 million for 2007 compared to $2.4 million in 2006. This increase is primarily attributable to an increase in rental income associated with space leased in the building we acquired in 2006 as part of our corporate campus expansion and a $0.8 million lease buyout that we received in the third quarter of 2007 from one of our tenants.
2008 compared to 2007. Commissions and other underwriting expenses for the year ended December 31, 2008 increased $11.2 million, or 22.0%, to $62.1 million from $50.9 million in the comparable period in 2007. The increases relate to an increase in net commission expense due to growth and a change in our business mix as well as a decrease in ceding commission. Our various products have different commission rates; therefore, commission
expense can vary based on the product mix written during the period. During 2008, our premium growth has typically been in products that have higher commission rates. In addition to a change in our overall mix of business, we recorded an approximate $1.3 million charge for a one-time state guarantee fund in the third quarter of 2008, which was also a contributing factor to the increase in our commission and other underwriting expenses.
2007 compared to 2006. Commissions and other underwriting expenses for the year ended December 31, 2007 increased $8.3 million, or 19.3%, to $50.9 million from $42.7 million in the comparable period in 2006. The increases are a direct result of our written premium growth, including an increase in commission expense and premium taxes. The higher commission expense is largely attributable to higher commission rates on our assigned risk business.
In addition, a portion of the increase in the other operating and general expenses is related to an increase in facilities expenses from office space that we lease to others; however, this increase is partially offset by an increase in rental income, included in “Other” revenue during the same period.
2008 compared to 2007. We invest funds in the participant loss layer for several of the alternative risk transfer programs. We receive investment income and incur an equal expense on the amounts owed to alternative risk transfer. “Expense on amounts withheld” represents investment income that we remit back to alternative risk transfer participants. The related investment income is included in our “Net investment income” line on our Consolidated Statements of Income. For the year ended December 31, 2008 the expense on amounts withheld increased $0.6 million over the same period in 2007. The increase is directly attributable to the continued growth in our alternative risk transfer component.
2008 compared to 2007. The 2008 effective tax rate was 58.6%, increasing 25.3% from a rate of 33.3% in 2007. The change in the effective tax rate is primarily due to a valuation allowance of $7.5 million that was taken on our realized losses, primarily impairment charges which increased the 2008 effective tax rate 29.3 percentage points. See Note 7 to our audited consolidated financial statements for further analysis of items affecting our effective tax rate.
2007 compared to 2006. The 2007 effective tax rate of 33.3% was relatively flat, increasing 0.4% from a rate of 32.9% in 2006.
At December 31, 2008, our investment portfolio contained $447.9 million in fixed maturity securities, $38.5 million in equity securities and $84.7 million in securities lending collateral, 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, 2008, we had pretax net unrealized losses of $0.7 million on fixed maturities, $10.0 million on securities lending collateral and $5.5 million on equity securities. Our investment portfolio allocation is driven by our investment policy, which is weighted towards high quality fixed maturity investments. Although we are focused on maintaining a high quality portfolio, we remain exposed to future market fluctuations, especially given the current global financial crisis.
Fixed maturity investments are generally invested in securities with short and intermediate-term maturities. At December 31, 2008, the weighted average maturity of our fixed maturity investments was approximately 4.3 years. At December 31, 2008, 99.7% 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. Although we cannot provide any assurances given current turbulence in the markets, we believe that, in normal market conditions, our high quality investment portfolio should generate a stable and predictable investment return.
On January 1, 2008, we adopted SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Under SFAS No. 157, we must determine the appropriate level in the fair value hierarchy for each fair value measurement. The fair value hierarchy in SFAS No. 157 prioritizes the inputs, which refer broadly to assumptions market participants would use in pricing an asset or liability, into three levels. It gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The level in the fair value hierarchy within which a fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety.
Capital Ratios. The NAIC’s model law for RBC provides formulas to determine the amount of capital and surplus that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2008 and 2007, the capital and surplus of all our insurance companies substantially exceeded the RBC requirements.
Sources of Funds. The liquidity requirements of our insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and payments of dividends and taxes to us from insurance
subsidiaries. Historically, cash flows from premiums and investment income have provided more than sufficient funds to meet these requirements without requiring the sale of investments. If our cash flows change dramatically from historical patterns, for example as a result of a decrease in premiums or an increase in claims paid or operating expenses, we may be required to sell securities before their maturity and possibly at a loss. Our insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments to meet their liquidity needs. Funds received in excess of cash requirements are generally invested in additional marketable securities. Continuing volatility in the capital markets presents challenges to us as we seek to manage our portfolio and our capital position. See Item 1A, “Risk Factors for a discussion of certain matters that may affect our portfolio and capital position. Our historic pattern of using receipts from current premium writings for the payment of liabilities incurred in prior periods has enabled us to slightly extend the maturities of our investment portfolio beyond the estimated settlement date of our loss reserves.
Net cash used in investing activities was $63.3 million, $69.1 million and $65.8 million for the years ended December 31, 2008, 2007 and 2006, respectively. The $5.8 million decrease in cash used in investing activities in 2008, as compared to 2007, was primarily related to a $212.4 million increase in the purchase of fixed maturity investments in 2008, which was offset by a $176.4 million increase in the proceeds from sales and maturities of investments and a decline of $42.1 million in the purchase of equity securities. The increase in both purchases and redemptions of fixed maturities during 2008, compared to the prior period was directly influenced by current market conditions. As interest rates continued to decline, many of our high yielding U.S. government agency bonds were called and replaced with purchases of lower yielding agency bonds. Additionally, the decrease in the purchases of equity securities is directly related to the current turmoil in the market. The $3.3 million increase in cash used in investing activities in 2007 compared to 2006 was primarily related to a $99.3 million increase in the purchase of investments in 2007 offset by a $94.1 million increase in the proceeds from sales and maturities of investments.
We utilized net cash from financing activities of $3.9 million, $3.2 million and $2.9 million, respectively, for the years ended December 31, 2008, 2007 and 2006. The $0.7 million increase in cash used in financing activities in 2008 versus 2007 is primarily from an increase in our dividends paid on common shares to shareholders. We increased our quarterly dividend from $0.05 per common share in 2007 to $0.06 per common share in 2008. This increase in the dividend resulted in a $0.8 million increase in dividends paid in 2008. The increase in cash used from financing activities in 2007 from 2006 of $0.3 million is also primarily attributable to a $0.8 million increase in dividends paid to shareholders.
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 parent company cash dividend and other 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 2008 is $19.0 million. Our insurance subsidiaries paid no dividends in 2008 and $4.0 million in dividends in 2007, without the need for regulatory approval.
Under tax allocation and cost sharing agreements among the Company and its subsidiaries, taxes and expenses are allocated among the entities. The federal income tax provision of our individual subsidiaries is computed as if the subsidiary filed a separate tax return. The resulting provision (or credit) is currently payable to (or receivable from) us.
The Credit Agreement requires us to maintain specified financial covenants measured on a quarterly basis, including consolidated net worth, fixed charge coverage ratio and debt to capital ratio. In addition, the Credit Agreement contains certain affirmative and negative covenants, including negative covenants that limit or restrict our ability to, among other things, incur additional indebtedness, effect mergers or consolidations, make investments, enter into asset sales, create liens, enter into transactions with affiliates and other restrictions customarily contained in such agreements. The Credit Agreement will terminate on December 19, 2012.
Following is a discussion of certain critical variables affecting the estimation of loss reserves in our more significant lines of business. Many other variables may also impact ultimate claim costs. An important assumption underlying reserve estimates is that the cost trends implicitly built into development patterns will continue into the future. An unexpected change in cost trends 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. It is not possible to isolate and measure the potential impact of just one of these variables and future cost trends could be partially impacted by several such variables. However, it is reasonable to address the sensitivity of the reserves to a potential impact from changes in these variables by measuring the effect of a possible overall 1% change in future cost trends that may be caused by one or more variables. The sensitivity of recorded reserves to a potential change of 1% in the future cost trends is shown below. Utilizing the effect of a 1% change in overall cost trends enables changes greater than 1% to be estimated by extrapolation. The estimated cumulative unfavorable impact that this 1.0% change would have on our 2008 net income is shown below:
The following discussion describes key assumptions and important variables that materially affect the estimate of the reserve for loss and LAE of our two most significant lines of business, which represent 87.4% of our total reserves and explains what caused them to change from assumptions used in the preceding period. Management has not made changes in key assumptions used in calculating current year reserves based on historical changes or current trends observed.
We recorded unfavorable development of $1.3 million in 2008 for this line of business as actual claim severity was higher than previously anticipated. We recorded favorable development of $1.4 million in 2007 and $4.1 million in 2006 as actual claim severity, driven by favorable negotiated settlements and jury awards, was significantly lower than previously anticipated. We continually monitor development trends in each line of business as a component of estimating future ultimate loss and related LAE liabilities. Management has not made any changes to the key assumptions used in calculating current year reserves in the commercial auto liability line of business.
A significant portion of our workers’ compensation business is written in California. Significant reforms passed by the California state legislature in 2003 and in 2004 reduced employer premiums and set treatment standards for injured workers. We recorded favorable prior year loss development of $0.5 million in 2008, $3.0 million in 2007 and $2.3 million in 2006 due primarily to the impact of the legislation on medical claim costs being more favorable than previously anticipated. As claims incurred from 2003 through 2005 are now reaching a higher percentage of settlement and maturity, management is able to estimate the ultimate costs of these claims with more precision.
We closely monitor each investment that has a market value that is below its amortized cost and make a determination each quarter for other-than-temporary impairment for each of those investments. During the year ended December 31, 2008, we recorded $20.2 million in other-than-temporary impairments. Of the $20.2 million of other-than-temporary impairments taken during 2008, $7.0 million related to securities issued by Fannie Mae, Freddie Mac and Lehman Brothers Holdings Inc. and $8.7 million related to exchange traded funds. The remaining $4.5 million is a further reflection of the credit crisis. We will continue to monitor our portfolio to assess the impact of the recent government actions, including the “Troubled Asset Relief Program” and its impact on market valuations. While it is not possible to accurately predict if or when a specific security will become impaired, given the current turmoil and uncertainty in the market, charges for other-than-temporary impairment could be material to net income in subsequent quarters. Management believes it is not likely that future impairment charges will have a significant effect on our liquidity. We recorded a $1.0 million impairment adjustment in 2007 and no impairment adjustments in 2006. See “Management’s Discussions and Analysis of Financial Condition and Results of Operations - Investments.”
A summary of the significant accounting policies applied in the preparation of the consolidated financial statements follows.
Net investment income is adjusted for amortization of premiums to the earliest of the call date or maturity date and accretion of discounts to maturity. Realized gains and losses credited or charged to income are determined by the specific identification method. Estimated fair values for investments are determined based on published market quotations or where not available, based on broker quotations or other independent sources. When a decline in fair market value is deemed to be other-than-temporary, a provision for impairment is charged to earnings (included in realized gains (losses)) and the cost basis of that investment is reduced. Interest income is recognized when earned and dividend income is recognized when declared.
Property and equipment are reported at cost less accumulated depreciation and amortization. Property and equipment are depreciated or amortized over the estimated useful lives on a straight-line basis. The useful lives range from 3 to 5 years for computer equipment, 20 to 40 years for buildings and improvements and 5 to 7 years for all other property and equipment. Property and equipment include capitalized software developed or acquired for internal use. Upon sale or retirement, the cost of the asset and related accumulated depreciation are eliminated from their respective accounts and the resulting gain or loss is included in operations. Repairs and maintenance are charged to operations when incurred. The Company recorded depreciation expense of $1.5 million, $1.2 million and $1.1 million for the years ended December 31, 2008, 2007 and 2006, respectively.
continuously reviewed and any resulting adjustments are reflected in operations currently. Although considerable variability is inherent in such estimates, management believes that the liabilities for unpaid losses and LAE are adequate. These liabilities are reported net of amounts recoverable from salvage and subrogation.
On January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Under SFAS No. 157, the Company must determine the appropriate level in the fair value hierarchy for each fair value measurement. The fair value hierarchy in SFAS No. 157 prioritizes the inputs, which refer broadly to assumptions market participants would use in pricing an asset or liability, into three levels. It gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The level in the fair value hierarchy within which a fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety.
In August 2006, the Company entered into a securities lending program whereby certain fixed maturity and equity securities from the Company’s investment portfolio are loaned to other institutions for short periods of time. The Company requires collateral equal to 102% of the market value of the loaned securities plus accrued interest. The collateral is invested by the lending agent generating investment income, net of applicable fees. The Company is not permitted to sell or re-pledge the collateral on the securities lending program. The Company accounts for this program as a secured borrowing and records the collateral held and corresponding liability to return the collateral on the Company’s Consolidated Balance Sheets at fair value. The securities loaned remain a recorded asset of the Company. Prior to 2008, collateral could be invested in investments with maturities beyond the loan term, including asset backed securities and corporate obligations. However, in light of the recent market turmoil, beginning in 2008, new cash collateral is only invested in overnight investments.
Amortized cost and fair value of the fixed maturities in our investment and securities lending portfolios are as follows:
The gross unrealized losses on the Company’s fixed maturities, equity securities and securities lending portfolio increased during 2008, due primarily to the widespread deteriorating economic conditions. At December 31, 2008, the unrealized losses of $13.2 million on the Company’s fixed maturities and preferred securities portfolio were primarily related to financial institutions and fixed maturity floating rate securities, which had unrealized losses of $9.6 million and $1.9 million, respectively. There were no unrealized losses on the common stock portfolio at December 31, 2008. The $9.6 million in unrealized losses related to financial institutions were comprised of 27 fixed maturity holdings with a total unrealized loss of $4.5 million and 34 preferred stock holdings with a total unrealized loss of $5.1 million. In the fourth quarter of 2008, the Company began treating its perpetual preferred stocks similar to a debt security for assessing other-than-temporary impairments. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 99% of all fixed maturity and 94.1% of all perpetual preferred stock securities unrealized losses.
At December 31, 2008, the unrealized losses of $10.0 million on the securities lending collateral portfolio were primarily caused by turmoil in the housing and credit markets. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 95.8% of the fixed maturity unrealized losses.
Based on cash flow projections, independent credit ratings and other facts and analysis, management believes that the Company will recover its cost basis in all securities with unrealized losses at December 31, 2008.
On December 19, 2007, the Company replaced its $2.0 million credit agreement with a $50 million five-year unsecured Credit Agreement (the “Credit Agreement”), which includes a sublimit of $10 million for letters of credit. The Company has the ability to increase the line of credit to $75 million subject to the Credit Agreement’s accordion feature. Amounts borrowed bear interest at either (1) a rate per annum equal to the greater of the administrative agent’s prime rate or 0.5% in excess of the federal funds effective rate or (2) rates ranging from
Federal income taxes paid for 2008, 2007 and 2006 were $17.9 million, $22.0 million and $14.4 million. At December 31, 2008 and 2007, income taxes payable were $1.6 million and $2.6 million, respectively. Management has reviewed the recoverability of the deferred tax asset and believes that with the exception of unrealized losses on investments and realized losses, the amount will be recoverable against future earnings. The gross deferred tax assets have been reduced by a valuation allowance on unrealized losses on equity investments of $0.1 million and a valuation allowance on net realized losses of $7.5 million, primarily impairment charges.
The Company files income tax returns in the U.S. federal jurisdiction and various state and U.S. territory jurisdictions. The Company is no longer subject to U.S. federal or state income tax examination for years before 2005. There are no ongoing examinations of income tax returns by federal or state tax authorities.
The Company grants options and other stock awards to officers and key employees of the Company under the LTIP. At December 31, 2008, there were 824,156 of the Company’s common shares reserved for issuance under the LTIP and options for 607,050 shares were outstanding. In 2007, the Company granted restricted stock awards and a stock bonus award under the LTIP. There were no restricted stock awards or stock bonuses granted in 2008. Treasury shares are used to fulfill the options exercised and other awards granted. Options and restricted shares vest pursuant to the terms of a written grant agreement. Options must be exercised no later than the tenth anniversary of the date of grant. As set forth in the LTIP, the Compensation Committee of the Board of Directors may accelerate vesting and exercisability of options.
For the years ended December 31, 2008, 2007 and 2006, respectively, the Company recognized stock-based compensation expense of $1.3 million, $1.2 million and $0.8 million. The 2008 expense includes $0.5 million for restricted stock awards and the 2007 expense includes $0.4 million for a stock bonus and restricted stock awards. Related income tax benefits were approximately $0.3 million, $0.2 million and $0.1 million for 2008, 2007 and 2006, respectively. The Company has included stock-based compensation expense with the “Other operating and general expenses” line item in the Consolidated Statements of Income.
Employees of the Company may participate in the National Interstate Savings and Profit Sharing Plan (the “Savings Plan”). Contributions to the profit sharing portion of the Savings Plan are made at the discretion of the Company and are based on a percentage of employees’ earnings after their eligibility date. Company contributions made prior to December 31, 2006 vest after five years of service and contributions made subsequent to December 31, 2006 vest after three years of service. Profit sharing expense was $0.3 million, $0.6 million and $0.3 million for the years ended December 31, 2008, 2007 and 2006, respectively.
For the year ended December 31, 2008 and 2006, there were 274,315 and 285,000, respectively, outstanding options excluded from dilutive earnings because they were anti-dilutive. There were no outstanding options excluded from dilutive earnings because they were anti-dilutive in 2007.
The Company’s principal insurance subsidiary, NIIC, is involved in both the cession and assumption of reinsurance. NIIC is a party to a reinsurance agreement, and NIIA, a wholly-owned subsidiary of the Company, is a party to an underwriting management agreement with Great American. As of December 31, 2008, Great American owned 52.6% of the outstanding shares of the Company. The reinsurance agreement calls for the assumption by NIIC of all of the risk on Great American’s net premiums written for public transportation and recreational vehicle risks. NIIA provides administrative services to Great American in connection with Great American’s underwriting of these risks. The Company also cedes premiums through reinsurance agreements with Great American to reduce exposure in certain of its property and casualty insurance programs.
The table below summarizes the reinsurance balances and activity with Great American:
Great American or its parent, American Financial Group, Inc., performs certain services for the Company without charge including, without limitation, actuarial services and on a consultative basis, as needed, internal audit, legal, accounting and other support services. If Great American no longer controlled a majority of the Company’s common shares, it is possible that many of these services would cease or, alternatively, be provided at an increased cost to us. This could impact our personnel resources, require us to hire additional professional staff and generally increase our 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 Company cedes premiums through reinsurance agreements with reinsurers to reduce exposure in certain of its property and casualty insurance programs. Ceded losses and loss adjustment expense recoveries recorded for the years ended December 31, 2008 and 2007 were $38.1 million and $34.5 million in 2006. 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.
The foregoing reconciliation shows decreases of $0.9 million, $5.7 million and $7.5 million in the years ended December 31, 2008, 2007 and 2006, respectively, representing favorable development in claims incurred in years prior to 2008, 2007 and 2006, 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 (“IBNR”) losses 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.
For the years ended December 31, 2008, 2007 and 2006 balances related to alternative risk transfer programs were as follows:
The Company’s insurance subsidiaries report to various insurance departments using SAP prescribed or permitted by the applicable regulatory agency of the domiciliary commissioner. The statutory capital and surplus and statutory net income of NIIC, NIIC-HI and TCC were as follows:
NIIC, NIIC-HI and TCC are subject to insurance regulations that limit the payment of dividends without the prior approval of their respective insurance regulators. Without prior regulatory approval, the maximum amount of dividend that may be paid by NIIC to the Company based on the greater of 10% of prior year surplus or net income is $19.0 million. NIIC-HI’s maximum distribution to NIIC based on the greater of 10% of prior year surplus or net income is $1.0 million. TCC’s maximum distribution to NIIC based on the lesser of 10% of prior year surplus or net income is $0.4 million.
On August 3, 2007, the Company was informed that the jury in a case pending in the Superior Court of the State of California for the County of Los Angeles (the “Court”), had issued, on August 2, 2007, a special verdict adverse to the Company’s interests in a pending lawsuit against one of the Company’s insurance companies. The Court entered a formal judgment on October 25, 2007 and Company received notice of that formal judgment on November 5, 2007. The current net exposure to the Company for this judgment approximates $7.0 million and, as required by the Court, the Company secured the judgment amount with a surety bond. However, the Company believes that it has a strong appellate case and strategy and is vigorously pursuing the appellate process. The Company believes the matter will be resolved in a manner that will not have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows. As of December 31, 2008, the Company had not established a case reserve for this claim but has and will continue to closely monitor this case with counsel. The Company has consistently established litigation expense reserves to account for the cost associated with the defense of the Company’s position, which it will continue to reserve for throughout the appeal process.
As a direct writer of insurance, the Company receives assessments by state funds to cover losses to policyholders of insolvent or rehabilitated companies and other authorized fees. These mandatory assessments may be partially recovered through a reduction in future premium taxes in some states over several years. For both the years ended December 31, 2008 and 2007, the liability for such assessments was $3.6 million and will be paid over several years as assessed by the various state funds.
The following are quarterly results of operations for the years ended December 31, 2008 and 2007: