In 2003, we entered into a Purchase and Sale Agreement, whereby we agreed to sell the remaining portion of the land to an unaffiliated third party for the purpose of constructing an office building adjacent to our corporate headquarters. Under the Purchase and Sale Agreement, the third party agreed to pay $2.1 million for the land, $1.2 million for their share of the costs related to the common areas of the building, and other related costs of approximately $226,000. In May 2005, we closed on the transaction.
The unaffiliated third party had until July 2007 to pay the principal balance, however we negotiated an extension through May 1, 2009. Subsequent to the expiration of the extension, it was determined the unaffiliated third party did not intend to pay the remaining principal balance. Therefore, in 2010 we foreclosed on the property, and retained all previous payments made by the third-party. Also, we now have legal title to the property.
(2) The accident year combined ratio is the sum of the expense ratio and accident year loss ratio. The accident year loss ratio measures loss and LAE occurring in a particular year, regardless of when they are reported and does not take into consideration changes in estimates in loss reserves from prior accident years.
The merger with ProCentury was completed following the close of business on July, 31, 2008. Therefore, the above table includes only five months of financial results for ProCentury for the year ended December 31, 2008 and twelve months of financial results for the years ended December 31, 2009 and 2010.
Through our retail property and casualty agencies, we also generate commission revenue, which represents 1.5% of our total consolidated revenues. Our agencies are located in Michigan, California, and Florida and produce commercial, personal lines, life and accident and health insurance that is placed with more than fifty unaffiliated insurance carriers. These agencies produce a minimal amount of business for our affiliated Insurance Company Subsidiaries.
We establish a liability for losses and LAE, which represents case based estimates of reported unpaid losses and LAE and actuarial estimates of incurred but not reported (“IBNR”) losses and LAE. Such liabilities, by necessity, are based upon estimates and, while we believe the amount of our reserves is adequate, the ultimate liability may be greater or less than the estimate. As of December 31, 2010 and 2009, we have accrued $1,065.1 million and $949.2 million of gross loss and LAE reserves, respectively.
The following table sets forth our gross and net reserves for losses and LAE based upon an underlying source of data, at December 31, 2010 (in thousands):
The completeness and accuracy of data received from cedants on assumed business that we do not manage directly is verified through monthly reconciliations to detailed statements, inception to date rollforwards of claim data, actuarial estimates of historical trends, field audits and a series of management oversight reports on a program basis.
This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. In particular, the development factor based methods all have as a key assumption that the development of losses in the future will follow a pattern similar to those measured by past experience and as adjusted either explicitly or by actuarial judgment. There is no precise method for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual deficiency or redundancy is affected by multiple and varied factors. With respect to the ultimate estimates for losses and LAE, the key assumptions remained consistent for the years ended December 31, 2010 and 2009.
One implicit assumption underlying development patterns is that the claims inflation trends will continue into the future similar to their past patterns. To estimate the sensitivity of the estimated ultimate loss and settlement expense payments to an unexpected change in inflationary trends, our actuarial department derives expected payment patterns separately for each major line of business. These patterns were applied to the December 31, 2010 loss and settlement expense reserves to generate estimated annual incremental loss and settlement expense payments for each subsequent calendar year. Then, for the purpose of sensitivity testing, an explicit annual inflationary variance of one percent was added to the inflationary trend that is implicitly embedded in the estimated payment pattern, and revised incremental loss and settlement expense payments were calculated. General inflation trends have been fairly stable over the past several years but there have been fluctuations of one to two percent over the past ten years and therefore we used a one percent annual inflation variance factor. The effect differed by line of business but overall was a three and a half percent change in reserve adequacy or approximately $17.6 million effect on after tax net income. A variance of this type would typically be recognized in loss and settlement expense reserves and, accordingly, would not have a material effect on liquidity because the claims have not been paid.
Our range of loss and LAE reserves table shows that presently we estimate them as going from favorable development of 8.8% to unfavorable of 6.2%. The range was evaluated based on the ultimate loss estimates from the actuarial methods described above.
The sensitivity around our commercial automobile reserves primarily reflects the speed of reporting of the underlying losses, as well as the maturity of the case law surrounding automobile liability.
The sensitivity around the other lines of business primarily reflects the size of the underlying book of business. Our other reserves represent 5% of total reserves at December 31, 2010. A large portion of these reserves represent professional liability programs which tend to be claims-made and reinsured at lower limits, therefore reducing the volatility that is inherent in a smaller book of business. Another large portion represents property claims, which have a shorter reporting and payout pattern than liability and workers’ compensation claims.
Gross written premium increased $113.2 million, or 16.4%, to $801.9 million in 2010, compared to $688.7 million in 2009. Our growth strategy has been to develop specialty niche expertise in a range of select areas. Through this approach, we have developed a book of business that is broadly diversified by line of business, customer, and geography. Current year growth is largely from workers’ compensation initiatives that were implemented in the second half of 2009 primarily in the Midwest and Western United States, and the expansion of our transportation business in the Southeast. The majority of the new business we wrote in 2009 had a historical and proven track record of producing an underwriting profit, and we have been able to achieve rate increases on top of what had previously been charged.
During 2010 we re-evaluated our operating segments. As a result of this re-evaluation, we concluded that the previously reported Agency Operations segment should no longer be considered a separate segment as Agency Operations now represents less than 2% of our consolidated revenues and less than 1% of our consolidated pre-tax profits. As such, we will only report one operating segment - Specialty Insurance Operations.
Net income for the year ended December 31, 2010, was $59.7 million, or $1.10 per dilutive share, compared to net income of $52.7 million, or $0.92 per dilutive share, for the comparable period of 2009. Net operating income, a non-GAAP measure, increased $4.7 million, or 8.8%, to $58.2 million, compared to net operating income of $53.5 million in 2009; this equates to an increase in operating income per share of 15.1% to $1.07 per dilutive share, compared to $0.93 per dilutive share in 2009, on lower weighted average shares outstanding. Total weighted average shares outstanding for the year ended December 31, 2010, were 54,289,131, compared to 57,413,391 for the comparable period in 2009. This decrease reflects the impact of our Share Repurchase Plan (the “Plan”) in which we repurchased 2.5 million shares during 2010. We currently have approximately 2.5 million more shares within the Plan authorized for repurchase.
We use net operating income and net operating income per share as components to assess our performance and as measures to evaluate the results of our business. We believe these measures provide investors with valuable information relating to our ongoing performance that may be obscured by the net effect of realized gains and losses as a result of our market risk sensitive instruments, which primarily relate to fixed income securities that are available for sale and not held for trading purposes. Realized gains and losses may vary significantly between periods and are generally driven by external economic developments, such as capital market conditions. Accordingly, net operating income excludes the effect of items that tend to be highly variable from period to period and highlights the results from our ongoing business operations and the underlying profitability of our business. Therefore, we believe that it is useful for investors to evaluate net operating income and net operating income per share, along with net income and net income per share when reviewing and evaluating our performance.
Revenues for the year ended December 31, 2010, increased $122.5 million, or 19.5%, to $750.1 million, from $627.6 million for the comparable period in 2009. This increase primarily reflects overall growth within our existing programs and new business that was implemented in 2009 and 2010.
We use the accident year loss ratio as one component to assess our current year performance and as a measure to evaluate, and if necessary, adjust our pricing and underwriting. Our net loss and LAE ratio is based on calendar year information. Adjusting this ratio to an accident year loss ratio allows us to evaluate information based on the current year activity. We believe this measure provides investors with valuable information for comparison to historical trends and current industry estimates. We also believe that it is useful for investors to evaluate the accident year loss ratio and net loss and LAE ratio separately when reviewing and evaluating our performance.
Policy acquisition and other underwriting expenses increased $51.9 million, to $227.0 million for the year ended December 31, 2010, from $175.1 million for the same period in 2009. Our expense ratio increased 1.9 percentage points to 34.4% for the year ended December 31, 2010, from 32.5% for the same period in 2009. This increase reflects the reclassification impact described above as well as an increase in external cost, primarily net commission expense, relating to new business added in the second half of 2009 for which the agent performs certain policy issuance functions.
General, selling and administrative costs decreased $7.1 million, to $22.5 million for the year ended December 31, 2010, from $29.6 million for the same period in 2009. This decrease reflects the reclassification impact described above as well as our ability to further leverage fixed costs.
General corporate expenses decreased $0.3 million, to $5.7 million for the year ended December 31, 2010, from $6.0 million for the same period in 2009. The decrease is driven primarily by certain non-recurring legal expenses that were incurred in 2009.
Federal income tax expense for the year ended December 31, 2010 was $22.9 million, or 28.7% of income before taxes, compared to $20.9 million, or 28.8% of income before taxes for the same period in 2009. Income tax expense on capital gains (losses) and the change in our valuation allowance for other than temporary impairments and loss carryforwards from prior years where there are not any realized gains to offset the realized capital losses, was $426,000 and $640,000 for the years ended December 31, 2010 and 2009, respectively. Excluding the tax impact of realized gains (losses), the effective income tax rate would have been 28.8% and 27.8% for the years ended December 31, 2010 and 2009, respectively. The current year rate increase reflects a $477,000 adjustment to our current tax expense relating to a return to provision analysis completed on the closing tax return of ProCentury. Excluding this adjustment, the effective tax rate on net operating income, a non-GAAP measure, for the year ended December 31, 2010 would have been 28.2% compared to 27.8% for the same period in 2009. The increase in our effective tax rate is primarily due to a shift in new purchases in our investment portfolio away from tax exempt municipal bonds. Tax exempt income as a percentage of total taxable income has therefore declined, resulting in an increased effective tax rate.
Net earned premiums increased $169.9 million, or 46%, to $539.6 million for the year ended December 31, 2009, from $369.7 million in the comparable period in 2008. This increase was primarily the result of $114.2 million related to our Century operations and the remaining $55.7 million was primarily the result of overall growth within our existing programs and new business we implemented in 2008 and 2009.
Management fees decreased $1.3 million, or 6.2%, to $19.7 million for the year ended December 31, 2009, from $21 million for the comparable period in 2008. This decrease primarily relates to two programs we previously managed where the client is now performing their own policy administration services, as well as a decrease in fees related to a reduction in fees derived from self-insured programs, caused by a decrease in premium volume from continued competition, economic conditions, and higher unemployment.
Net realized (losses) improved by $11.2 million, to a ($0.2) million loss for the year ended December 31, 2009, from a ($11.4) million loss for the comparable period in 2008. The realized losses recognized in the year related to impairment charges related to specific securities, offset by realized gains from sales of certain securities for tax planning purposes. The realized loss in 2008 related to the other than temporary impairments recognized in the fourth quarter of 2008, which related to securities within the investment portfolio acquired with the ProCentury merger.
Policy acquisition and other underwriting expenses increased $58.1 million, to $175.1 million for the year ended December 31, 2009, from $117.0 million for the same period in 2008. Our expense ratio increased 0.9 percentage points to 32.5% for the year ended December 31, 2009, from 31.6% for the same period in 2008. This increase reflects higher average direct commission rates associated with Century’s business, which includes twelve months of these costs for 2009 and only five months in 2008.
Interest expense for the year ended December 31, 2009, increased $2.9 million, to $10.6 million, from $7.7 million for the comparable period in 2008. Interest expense is primarily attributable to our debentures, which are described within the Liquidity and Capital Resources section of Management’s Discussion and Analysis, as well as our term loan. The overall increase in 2009 compared to 2008, primarily relates to interest expense related to the term loan we used to finance a portion of the purchase price for the Merger. In addition, the increase in interest expense was partially related to the interest attributable to the trust preferred debt instruments as a result of the ProCentury merger. The average interest rate for the year ended December 31, 2009 was 7.07%, compared to 7.13% for the comparable period in 2008. This slight decrease reflects the impact of a lower cost of debt associated with the term loan, which had an average interest rate of 5.95% in 2009.
Federal income tax expense for the year ended December 31, 2009 was $20.9 million or 28.8% of income before taxes compared to $16.1 million or 37.3% of income before taxes for the same period in 2009. The decrease in the effective tax rate from 2008 to 2009, primarily relates to a decrease in our fee-based and underwriting income as a percentage of pre-tax income. This decrease was slightly offset by an increase in the valuation allowance related to impairment charges. The effective tax rate on net operating income, a non-GAAP measure, for the year ended December 31, 2009 would have been 27.8% compared to 28.2% for the same period in 2008.
At December 31, 2010, our best estimate for the ultimate liability for loss and LAE reserves, net of reinsurance recoverables, was $784.2 million. We established a reasonable range of reserves of approximately $715.3 million to $832.9 million. This range was established primarily by considering the various indications derived from standard actuarial techniques and other appropriate reserve considerations. The following table sets forth this range by line of business (in thousands):
The key assumptions used in our selection of ultimate reserves included the underlying actuarial methodologies, a review of current pricing and underwriting initiatives, an evaluation of reinsurance costs and retention levels, and a detailed claims analysis with an emphasis on how aggressive claims handling may be impacting the paid and incurred loss data trends embedded in the traditional actuarial methods. With respect to the ultimate estimates for losses and LAE, the key assumptions remained consistent for the year ended December 31, 2010, and the year ended December 31, 2009.
The projected net ultimate loss estimate for the commercial automobile line of business decreased $9.9 million, or 9.4% of net commercial automobile reserves. This net overall decrease reflects decreases in the net ultimate loss estimate of $6.3 million and $4.2 million for accident years 2009 and 2008, respectively. The decreases in the net ultimate loss estimates for these accident years were because of less than expected claim emergence in four California based programs, a New Jersey program, a garage program, and an excess liability program. This decrease was partially offset by an increase of $1.3 million for accident year 2007. This increase in the net ultimate loss estimates for this accident year was due to greater than expected claim emergence in a garage program and a California program. The change in ultimate loss estimates for all other accident years was insignificant.
The workers’ compensation residual market line of business had a decrease in net ultimate loss estimate of $3.2 million, or 14.8% of net reserves. This decrease reflects reductions of $904,000, $618,000, $499,000, and $732,000 in accident years 2009, 2008, 2007, and 2006, respectively. We record loss reserves as reported by the National Council on Compensation Insurance (“NCCI”), plus a provision for the reserves incurred but not yet analyzed and reported to us due to a two quarter lag in reporting. These changes reflect a difference between our estimate of the lag incurred but not reported and the amounts reported by the NCCI in the year. The change in ultimate loss estimates for all other accident years was insignificant.
A significant portion of our consolidated assets represents assets of our Insurance Company Subsidiaries that may not be transferable to the holding company in the form of dividends, loans or advances in accordance with state insurance laws. These laws generally specify that dividends can be paid only from unassigned surplus and only to the extent that all dividends in the current twelve months do not exceed the greater of 10% of total statutory surplus as of the end of the prior fiscal year or 100% of the statutory net income for the prior year, less any dividends paid in the prior twelve months. Using these criteria, the available ordinary dividend available to be paid from the Insurance Company Subsidiaries during 2010 was $52.0 million without prior regulatory approval. In addition to ordinary dividends, the Insurance Company Subsidiaries had the capacity to pay $108.2 million of extraordinary dividends in 2010, subject to prior regulatory approval. The Insurance Company Subsidiaries’ ability to pay future dividends without advance regulatory approval is dependent upon maintaining a positive level of unassigned surplus, which in turn, is dependent upon the Insurance Company Subsidiaries generating net income. Total ordinary dividends paid from our Insurance Company Subsidiaries to our holding company were $42.0 million and $39.5 million as of December 31, 2010 and 2009, respectively. We remain well within our targets as they relate to our premium leverage ratios, even taking into consideration the dividends paid by our Insurance Company Subsidiaries. Our targets for gross and net written premium to statutory surplus are 3.0 to 1.0 and 2.5 to 1.0, respectively. As of December 31, 2010, on a trailing twelve month statutory consolidated basis, the gross and net premium leverage ratios were 2.2 to 1.0 and 1.9 to 1.0, respectively. The ordinary dividends paid in 2010 and 2009 were funded from current financial earnings.
We also generate operating cash flow from non-regulated subsidiaries in the form of commission revenue, outside management fees, and intercompany management fees. These sources of income are used to meet debt service, shareholders’ dividends, and other operating expenses of the holding company and non-regulated subsidiaries. Earnings before interest, taxes, depreciation, and amortization from non-regulated subsidiaries were approximately $11.0 million for the year ended December 31, 2010.
Cash flows provided by operations were $174.5 million and $127.7 million for the years ended December 31, 2010 and 2009, respectively. The increase in cash flows from operations reflects growth in underwriting profits, growth in investment income, and a slight lengthening of our loss and LAE reserve duration. We maintain a strong balance sheet with geographic spread of risks, high quality reinsurance, and a high quality investment portfolio.
During the year ended December 31, 2010, we entered into two $10 million interest rate swaps to hedge the $20 million Junior Subordinate Debenture. These were forward starting interest rate swaps that replaced the $20 million interest rate swap and were effective September 16, 2010. The fixed rate on the new $10 million interest rate swaps is approximately 6.17%; the fixed rate on the expired $20 million interest rate swap was 8.34%.
Refer to Note 7 ~ Debt for additional information specific to our credit facilities and debentures.
In general, we believe our overall investment portfolio is conservatively invested. The effective duration of the investment portfolio at December 31, 2010 and 2009, was 5.0 years and 5.1 years, respectively. Our current pre-tax book yield is 4.2% compared to 4.4% in 2009. The current after-tax yield is 3.1%, compared to 3.4% in 2009. Approximately 98.5% of our fixed income investment portfolio is investment grade.
At our regularly scheduled Board of Directors meeting on February 12, 2010, the Board authorized management to purchase up to 5.0 million shares of the Company’s common stock in market transactions for a period not to exceed twenty-four months. This share repurchase plan replaced the existing share repurchase plan authorized in July 2008. For the year ended December 31, 2010, we purchased and retired 2.5 million shares of common stock for a total cost of approximately $19.6 million, respectively. For the year ended December 31, 2009, we purchased and retired 1.9 million shares of common stock for a total cost of approximately $13.9 million.
A significant portion of our consolidated assets represents assets of our Insurance Company Subsidiaries that may not be transferable to the holding company in the form of dividends, loans or advances in accordance with state insurance laws. These laws generally specify that dividends can be paid only from unassigned surplus and only to the extent that all dividends in the current twelve months do not exceed the greater of 10% of total statutory surplus as of the end of the prior fiscal year or 100% of the statutory net income for the prior year, less any dividends paid in the prior twelve months. Using these criteria, the available ordinary dividend available to be paid from the Insurance Company Subsidiaries during 2010 was $52.0 million without prior regulatory approval. In addition to ordinary dividends, the Insurance Company Subsidiaries had the capacity to pay $108.2 million of extraordinary dividends in 2010, subject to prior regulatory approval. The Insurance Company Subsidiaries’ ability to pay future dividends without advance regulatory approval is dependent upon maintaining a positive level of unassigned surplus, which in turn, is dependent upon the Insurance Company Subsidiaries generating net income. Total ordinary dividends paid from our Insurance Company Subsidiaries to our holding company were $42.0 million and $39.5 million as of December 31, 2010 and 2009, respectively.
Our Insurance Company Subsidiaries are required to maintain certain deposits with regulatory authorities, which totaled $118.2 million and $98.5 million at December 31, 2010 and 2009, respectively.
(4) For a description of our term loan and its interest rate terms, as well as actual rates in accordance with our interest rate swap transaction, refer to Note 7 ~ Debt and Note 8 ~ Derivative Instruments.
(5) Consists of rental obligations under real estate leases related to branch offices. In addition, includes amounts related to equipment leases.
Insurance operations are subject to various leverage tests (e.g., premium to statutory surplus ratios), which are evaluated by regulators and rating agencies. Our targets for gross and net written premium to statutory surplus are 3.0 to 1.0 and 2.5 to 1.0, respectively. As of December 31, 2010, on a statutory consolidated basis, gross and net premium leverage ratios were 2.2 to 1.0 and 1.9 to 1.0, respectively.
In 2010, our Insurance Company Subsidiaries generated ratios that varied from the “usual value” range. The variations and reasons are set forth below:
Adjusted Liabilities to Liquid Assets on Star is outside the usual range primarily as a result of our Intercompany Reinsurance Pooling Agreement. The Adjusted Liabilities include the gross amount of reinsurance payables related to the pool and does not allow an offset to those payables for any reinsurance recoverables related to the pool. In addition, the reinsurance recoverables are not included in the Liquid Assets portion of the formula. This causes the ratio results to appear much higher due to the timing of the settlement of the pool balances. Pool balances between the entities are settled in the month following the completion of the pooling. Once the balances are settled, the ratio will be 96%, which is within the usual range.
The Gross Agents’ Balances to Policyholders’ Surplus on Star, Williamsburg and Century Surety were impacted by our Intercompany Reinsurance Pooling Agreement. The assumed premium receivable increased as a result of the pooling agreement. Excluding the intercompany pooling, this ratio would have been within the usual range for 2010.
We seek to manage the risk exposure of our Insurance Company Subsidiaries, including those insurance company subsidiaries we acquired in the ProCentury merger, and our clients through the purchase of excess-of-loss and quota share reinsurance. Our reinsurance requirements are analyzed on both a specific program and line of business basis to determine the appropriate retention levels and reinsurance coverage limits. We secure this reinsurance based on the availability, cost, and benefits of various reinsurance alternatives.
In regard to our excess-of-loss reinsurance, we manage our credit risk on reinsurance recoverables by reviewing the financial stability, A.M. Best rating, capitalization, and credit worthiness of prospective or existing reinsurers. We generally do not seek collateral where the reinsurer is rated “A−” or better by A. M. Best, has $500 million or more in surplus, and is admitted in the state of Michigan. The following table sets forth information relating to our five largest unaffiliated excess-of-loss reinsurers based upon ceded premium as of December 31, 2010:
(1) Effective January 1, 2010, a novation was completed that transferred all the ceded premium and reinsurance recoverables between us and Motors Insurance Corporation to Maiden Reinsurance Company (Maiden Re). All reinsurance transactions and related collateral and trust accounts are now with Maiden Re, which has an A.M. Best rating of “A-”.
As of December 31, 2010, we have no off-balance sheet arrangements as defined in Item 303(a) (4) of Regulation S-K.
In May 2010, we amended our existing $6.0 million convertible note receivable with an unaffiliated insurance agency. The effective interest rate of the convertible note is equal to the three-month LIBOR, plus 5.2% and is due June 30, 2014. The insurance agency has been a producer for us for several years. As security for the loan, the borrower granted us a security interest in its accounts, cash, general intangibles, and other intangible property. Also, pledged as collateral are 100% of the common shares of the holding company and its subsidiary insurance agencies, the common shares owned by the shareholder in another agency, and the shareholder also executed a personal guaranty. This note is convertible upon our option based upon a pre-determined formula.
In January 2010, the FASB issued Accounting Standards Update (“ASU”) 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. Effective for interim and annual reporting periods beginning after December 15, 2009, ASU 2010-06 requires additional disclosures for financial instrument transfers in and out of Levels 1 and 2; and clarifies existing disclosure requirements around the level of disaggregation and for the inputs and valuation techniques. These additional disclosures are provided in Note 4 ~ Fair Value Measurements.