We established an allowance for doubtful reinsurance receivables of $44.0 million in 2002, which resulted in a 27.0 percentage point increase in our 2002 underwriting expense ratio.
Our underwriting expense ratio for the period January 1, 2003 to September 5, 2003 includes a 4.7 percentage point increase attributable to a $4.2 million expense for stock appreciation rights and retention payments made to certain key executives upon completion of the acquisition and a $1.8 million allowance for doubtful reinsurance receivables.
Our insurance operating ratios are non-GAAP financial measures that are generally viewed as indicators of underwriting profitability. The net losses and loss adjustment expense ratio is the ratio of net losses and loss adjustment expenses to net premiums earned. The underwriting expense ratio is the ratio of acquisition costs and other underwriting expenses to net premiums earned. The combined ratio is the ratio of the sum of net losses, loss adjustment expenses, acquisition costs, and other underwriting expenses to net premiums earned.
Our net losses and loss adjustment expense ratios for 2005 and 2004 include $8.0 million and $1.7 million, respectively, of catastrophic losses related to hurricanes.
Our combined ratios for 2005 and 2004 include $8.0 million and $1.7 million, respectively, of catastrophic losses related to hurricanes. Our combined ratio for the period September 6, 2003 to December 31, 2003 includes $0.9 million of deferred compensation option expense. Our combined ratio for 2002 includes a 43.9 percentage point increase attributable to our $71.4 million reserve strengthening and a 27.0 percentage point increase attributable to establishment of a $44.0 million allowance for doubtful reinsurance receivables.
No cash dividends were declared on common stock in any year presented in the table.
In the fourth quarter of 2005, our Non-U.S. Insurance Operations discontinued offering direct third party excess and surplus lines insurance in order to focus on third party reinsurance products. As part of this strategy, on February 15, 2006, our Board of Directors approved a plan, subject to regulatory approval, to consolidate our Non-U.S. Insurance Operations into a single Bermuda based company, which will operate under the name Wind River Reinsurance Company, Ltd. We expect that Wind River Reinsurance Company, Ltd. will begin offering third party reinsurance products by year-end 2006. For a discussion of the risks associated with this strategy, see the risk factor regarding the business plan of our Non-U.S. Insurance Operations in Item 1A of this report.
In connection with our merger with Penn-America Group, Inc. and our acquisition of Penn Independent Corporation, we manage our business through two business segments. Our Insurance Operations segment includes the operations of our United National Insurance Companies, Penn-America Insurance Companies and Non-U.S. Insurance Operations. Our Agency Operations segment consists solely of the operations of Penn Independent Group.
We distribute our insurance products through a group of approximately 150 professional general agencies that have limited quoting and binding authority, and that in turn sell our insurance products to insureds through retail insurance brokers.
We derive our revenues primarily from premiums paid on insurance policies that we write, from commissions, and service fees of our Agency Operations and from income generated by our investment portfolio, net of fees paid for investment management and investment accounting services. The amount of
insurance premiums that we receive is a function of the amount and type of policies we write, as well as of prevailing market prices.
In managing the business and evaluating performance, our management focuses on measures such as premium growth, rate level changes, loss ratio, expense ratio, combined ratio, return on equity, growth in book value per share, and operating income, which we define as net income excluding after-tax realized investment gains (losses) and extraordinary items that do not reflect overall operating trends. Our management focuses on operating income as a useful measure of the net income attributable to the ongoing operations of the business. Operating income is not a substitute for the net income determined in accordance with GAAP, and investors should not place undue reliance on this measure.
Our consolidated financial statements are prepared in conformity with GAAP, which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods (see Note 4 of the “Notes to Consolidated Financial Statements”) contained in Item 8 of this Report. Actual results could differ from those estimates and assumptions. We believe that of our significant accounting policies, the following may involve a higher degree of judgment and estimation.
The method for determining our liability for unpaid losses and loss adjustment expenses includes, among other things, reviewing past loss experience and considering other factors such as legal, social and economic developments.
We use a variety of techniques to establish our liabilities for unpaid losses and loss adjustment expenses within each segment, all of which involve significant judgments and assumptions. Losses generated by business with common characteristics are aggregated into groups as losses are evaluated. For recent years, we generally combine actual loss data with losses that we anticipate to develop if the expected loss ratio is correct. For older years, we employ a variety of paid and incurred loss development tests. All of these techniques include detailed statistical analysis of past claim reporting, settlement activity, claim frequency and severity data, internal loss experience, the experience of policyholders and industry experience. More judgmental techniques are used in lines when statistical data is insufficient or unavailable. Estimates reflect implicit or explicit assumptions regarding the effects of external factors that include economic and social inflation, judicial decisions, law changes and recent trends in these factors. The information obtained from the evaluation of each segment is used by management to select its best point estimate for loss and loss expense reserves.
We continually review these estimates and, based on new developments and information, we include adjustments of the probable ultimate liability in the operating results for the periods in which the adjustments are made. The establishment of loss and loss adjustment expense reserves makes no provision for the possible broadening of coverage by legislative action or judicial interpretation, or the emergence of new types of losses not sufficiently represented in our historical experience or that cannot yet be quantified. We regularly analyze our reserves and review pricing and reserving methodologies so that future adjustments to prior year reserves can be minimized. However, given the complexity of this process, reserves will require continual updates and the ultimate liability may be higher or lower than previously indicated. Change in estimates for loss and loss adjustment expense reserves, as required by SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” is recorded in the period that the change in these estimates is made. We do not discount our loss reserves.
The significant uncertainties and estimates relating to A&E claims on insurance policies written are discussed under “Business - Asbestos and Environmental Disclosure.”
The carrying amount of our investments approximates their estimated fair value. We regularly perform various analytical procedures with respect to our investments, including identifying any security where the fair value is below its cost. Upon identification of such securities, we perform a detailed review to determine whether the decline is considered other than temporary. This review includes an analysis of several factors, including but not limited to, the credit ratings and cash flows of the securities, and the magnitude and length of time that the fair value is below cost. The factors considered in reaching the conclusion that a decline below cost is other than temporary include, among others, whether (1) the issuer is in financial distress, (2) the investment is secured, (3) a significant credit rating action occurred, (4) scheduled interest payments were delayed or missed, and (5) changes in laws or regulations have affected an issuer or industry. If the fair value of an investment falls below its cost and the decline is determined to be other than temporary, the amount of the decline is included in earnings as a realized loss in the period in which the impairment arose.
The following table contains an analysis of our securities with gross unrealized losses, categorized by the period that the securities were in a continuous loss position as of December 31, 2005:
Subject to the risks and uncertainties in evaluating the impairment of a security’s value, the impairment evaluation conducted by us as of December 31, 2005, concluded the unrealized losses discussed above are not other than temporary impairments.
During the years ended December 31, 2005, 2004, and 2003, we recorded other than temporary losses of $0.8 million, $0.2 million, and $0.7 million, respectively, on our common stock portfolio.
was reviewed for impairment in accordance with SFAS 142 and SFAS 144. Recoverability under SFAS 142 is determined by management by applying a price earnings ratio of comparable companies to the expected earnings. Impairment is recognized if the carrying amount of the company is less than the product of expected earnings multiplied by the price earnings ratio. Under SFAS 142, impairment is recognized only if the carrying amount of the intangible asset is not recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and the fair value of the asset. In accordance with SFAS 142, we are required to perform a test for impairment of goodwill and other indefinite lived assets at least annually. We performed our annual impairment review of goodwill and other indefinite lived assets during the fourth quarter of 2005. Nothing was noted that would indicate that goodwill and other indefinite lived assets were impaired as of December 31, 2005.
Year Ended December 31, 2005 Compared with the Year Ended December 31, 2004
Gross premiums written, which represent the amount received or to be received for insurance policies written without reduction for acquisition costs, reinsurance costs or other deductions, were $622.9 million for 2005, compared with $409.1 million for 2004, an increase of $213.8 million or 52.3%. A breakdown of gross premiums written by product class is as follows:
Professional liability gross premiums written were $84.4 million for 2005, compared with $86.5 million for 2004, a decrease of $2.1 million or 2.4%. This decrease primarily resulted from more conservative underwriting practices and pricing actions in response to market conditions.
Net premiums written, which equal gross premiums written less ceded premiums written, were $519.7 million for 2005, compared with $280.2 million for 2004, an increase of $239.5 million or 85.5%. The ratio of net premiums written to gross premiums written was 83.4% for 2005 and 68.5% for 2004. A breakdown of net premiums written by product class is as follows:
Property and general liability net premiums written were $447.3 million for 2005, compared with $217.2 million for 2004, an increase of $230.1 million or 105.9%. The increase in property and general liability net premiums written primarily resulted from the merger with Penn-America Group, Inc. and reduced reinsurance cessions. Net premiums written for 2005 are net of $1.8 million of ceded premium to purchase second event catastrophe coverage as a result of Hurricane Katrina (“Katrina”).
Professional liability net premiums written were $72.4 million for 2005, compared with $63.0 million for 2004, an increase of $9.5 million or 15.0%. This increase primarily resulted from more conservative underwriting practices and pricing actions in response to market conditions in addition to ceding less premium to third party reinsurers in 2005.
Net premiums earned were $475.4 million for 2005, compared with $230.1 million for 2004, an increase of $245.3 million or 106.6%. Net premiums earned for 2005 are net of $1.8 million of ceded premium to purchase second event catastrophe coverage as a result of Katrina.
Agency commission and fee revenues generated by our Agency Operations segment were $41.0 million and $38.4 million before and after intercompany eliminations, respectively, for 2005. As part of the acquisition of Penn Independent Corporation in January 2005, contingent commission income of $1.3 million was included as a purchase accounting adjustment to goodwill. This amount is not included as revenue in our 2005 results of operations. Penn Independent Group is a wholesale insurance broker and underwriting manager for all types of commercial and industrial accounts. Penn Independent Group specializes in property, casualty, transportation, public entity, professional, excess and umbrella, specialty, and personal lines. The majority of Penn Independent Group’s business is written on an excess and surplus lines basis. Additionally, Penn Independent Group provides claims administration services for policies written by professional liability providers and premium financing for insureds of property and casualty retail brokers. Prior to the acquisition of Penn Independent Corporation in January 2005, we had no agency commission and fee revenues.
Gross investment income, excluding realized gains and losses, was $53.0 million for 2005, compared with $24.3 million for 2004, an increase of $28.7 million or 117.8%. The increase was primarily due to additional investment income in 2005 from Penn-America Group and an increase in income related to limited partnership investments. Cash and invested assets grew to $1,424.2 million as of December 31, 2005, from $924.3 million as of December 31, 2004, an increase of $499.9 million.
The average duration of our fixed income investments approximated 4.14 years as of December 31, 2005, compared with 3.80 years as of December 31, 2004. Our imbedded pre-tax book yield on our fixed income investments was 4.36% at December 31, 2005, compared with 4.16% at December 31, 2004.
Katrina’s first landfall caused estimated gross losses of $1.3 million and estimated net losses of $0.6 million. Katrina’s second landfall caused estimated gross losses of $30.6 million and estimated net losses of $2.4 million. Hurricane Rita (“Rita”) made landfall on the Texas and Louisiana borders on September 24, 2005. Rita caused estimated gross losses of $3.4 million and net losses of $3.0 million. Hurricane Wilma (“Wilma”) made landfall on southern Florida on October 24, 2005. Wilma caused estimated gross losses of $7.7 million and net losses of $2.0 million. As of December 31, 2005, the majority of losses have been examined. Our projected estimate is primarily based on actual claims in combination with modeling for unadjusted claims. A total of $8.0 million of net losses were recognized as a result of the hurricanes.
Our current catastrophe reinsurance treaties provide for one reinstatement. The Penn-America Catastrophe Reinsurance Treaty provided $3.0 million in excess of $2.0 million of property catastrophe coverage. We recorded ceded catastrophe losses of $3.0 million on this treaty as a result of Katrina’s second landfall and Rita. We purchased reinstatement coverage on the Penn-America Catastrophe Reinsurance Treaty after those events. As a result of Wilma, we recorded additional ceded catastrophic losses of $3.0 million on the Penn-
Our current property writings create exposure to catastrophic events, and our casualty writings create exposure to casualty clash events. Casualty clash exposure arises when two or more insureds are involved in the same loss occurrence. To protect us from these exposures, we have purchased $55.0 million in excess of $5.0 million of property catastrophe coverage for events occurring in 2006 and $10.0 million in excess of $3.0 million of casualty clash coverages, both of which are on a per occurrence basis. To the extent that we may have increased catastrophe or casualty clash exposure in the future we may increase our reinsurance protection for these exposures commensurately.
Acquisition costs and other underwriting expenses were $151.6 million, net of intercompany eliminations, for 2005, compared with $74.7 million for 2004, an increase of $76.8 million. This increase can be primarily attributed to a $50.6 million increase in acquisition costs and $26.2 million increase in other underwriting expenses:
The $50.6 million increase in acquisition costs was primarily the result of additional costs in 2005 from the merger with Penn-America Group, Inc. and a decrease in the deferral of acquisition costs.
The $26.2 million increase in other underwriting expenses was primarily due to additional costs in 2005 from the merger with Penn-America Group, Inc. and an increase in costs from our Non-U.S. Insurance Operations.
Corporate and other operating expenses consist of outside legal fees, other professional fees, directors’ fees, management fees, and taxes incurred which are not directly related to operations. Corporate and other operating expenses were $7.4 million for 2005, compared with $6.6 million for 2004, an increase of $0.8 million. The increase is primarily due to an increase in corporate expenses of $1.9 million and an increase in state income taxes of $0.2 million offset by a gain on the extinguishment of debt of $1.3 million. The gain was recorded as a result of the prepayment of $72.8 million in principal and related interest under senior notes issued by Wind River Investment Corporation (“Wind River”) to the Ball family trusts in September 2003. The terms of the prepayment agreement required the Ball family trusts to reimburse Wind River for $0.3 million of the issuance costs of the new senior notes plus $1.0 million of the incremental interest costs that we are estimated to incur under the new senior notes.
Equity in net earnings of partnerships was $1.1 million for 2005, compared with $1.5 million for 2004, a decrease of $0.4 million. The decrease is attributable to the performance of a limited partnership investment that invests mainly in convertible bonds and equities.
The extraordinary gain of $1.4 million for 2005 represents the recognition of tax benefits derived from acquisition costs incurred in connection with the Wind River Acquisition in 2003, which are currently considered to be deductible for federal tax purposes.
The factors described above resulted in net income of $65.6 million for 2005, compared to net income of $37.0 million for 2004, an increase of $28.5 million or 77.1%. Operating income was $64.0 million for 2005,
compared with operating income of $34.1 million for year ended December 31, 2004, an increase of $29.9 million or 87.7%. Operating income is a non-GAAP financial measure used by management as a measure of our performance. It is calculated as net income less after-tax realized investments gains and losses less any extraordinary gains or losses. Operating income for 2005 is equal to 2005 net income less $0.1 million for after-tax realized investment gains and $1.4 million for an extraordinary gain recorded in connection with the Wind River Acquisition. Operating income for 2004 is equal to 2004 net income less $1.7 million for after-tax realized investment gains and $1.2 million for an extraordinary gain recognized from the tax benefits derived from acquisition costs incurred in connection with the Wind River Acquisition.
The results of operations for the year ended December 31, 2004 reflect the performance of the United America Indemnity. The results of operations for the year ended December 31, 2003 reflect the combined financial performance of United America Indemnity and the Predecessor, Wind River Investment Corporation.
Professional liability gross premiums written were $86.5 million for 2004, compared with $90.5 million for 2003, a decrease of $4.0 million or 4.5%. The decrease was primarily the result of the reduction of premium from certain products, offset by rate increases of approximately 14%.
Net premiums written, which equal gross premiums written less ceded premiums written, were $280.2 million for 2004, compared with $200.4 million for 2003, an increase of $79.8 million or 39.8%. The ratio of net premiums written to gross premiums written increased to 68.5% for 2004, from 30.0% for 2003. Net premiums written relative to terminated products were $2.6 million for 2004, compared with $20.7 million for 2003. A further breakdown of net premiums written is as follows:
Professional liability net premiums written were $63.0 million for 2004, compared with $34.7 million for 2003, an increase of $28.3 million or 81.5%. The ratio of net premiums written to gross premiums written was 72.9% for 2004, compared with 38.3% for 2003. The increase in net premiums written was largely due to these increases in retentions and to rate increases of approximately 14%.
Net premiums earned were $230.1 million for 2004, compared with $180.2 million for 2003, an increase of $49.9 million or 27.7%.
The $35.7 million increase in acquisition costs was primarily the result of an increase in net commission expense of $44.8 million offset by an increase in the deferral of acquisition costs of $9.1 million. The increase in net commission expense was due to a decrease in ceded premiums written as we increased our level of retention and a reduction in direct commission consistent with the reduction in gross premiums written. While increased retentions have the impact of increasing acquisition costs, our underwriting profit nonetheless increased based upon an improvement in our loss experience.
Our expense ratio, which is calculated by dividing the sum of acquisition costs and other underwriting expenses and provisions for doubtful reinsurance receivables by premiums earned, was 32.4% for 2004, compared with 25.0% for 2003. The expense ratio for 2004 and 2003, excluding the impact of purchase accounting adjustments, would have been 34.5% and 25.2%, respectively. The expense ratio for 2004 was impacted by the changes to commissions and other underwriting expenses described above. The expense ratio for 2003 was impacted by changes to commissions and other underwriting expenses. As discussed above, our underwriting profit increased due to the improved loss experience. Part of our strategy is to continue to retain a higher percentage of our premiums. To the extent that we are able to accomplish this, we expect the net commission component of our expense ratio to increase.
Our combined ratio was 90.6% for 2004, compared with 93.7% for 2003. This improvement was primarily the result of the increase in our level of premium retention and an improvement in our loss experience resulting from continuing rate increases in 2004.
The United National Insurance Companies and the Penn-America Insurance Companies are restricted by statute as to the amount of dividends that they may pay without the prior approval of regulatory authorities. The United National Insurance Companies and the Penn-America Insurance Companies may pay dividends without advance regulatory approval only out of unassigned surplus. In 2005, United National Insurance Companies and Penn-America Insurance Companies declared and paid dividends of $18.0 million and $5.2 million, respectively. For 2006, the maximum amount of distributions that could be paid by the United National Insurance Companies as dividends under applicable laws and regulations without regulatory approval
Each company in our U.S. Insurance Operations is required by law to maintain a certain minimum level of policyholders’ surplus on a statutory basis. Policyholders’ surplus is calculated by subtracting total liabilities from total assets. The NAIC adopted risk-based capital standards designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of each insurer’s assets and liabilities and mix of net premiums written. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. Based on the standards currently adopted, the policyholders’ surplus of each company in our U.S. Insurance Operations is in excess of the prescribed minimum company action level risk-based capital requirements.
Net cash was provided by operating activities in 2005, 2004, and 2003 of $168.0 million, $59.3 million and $40.4 million, respectively. In 2005, we were able to realize a net increase in cash flows of approximately $108.7 million primarily as a result of the following items: 1) an increase in net premiums collected of $278.4 million; 2) an increase in net losses and loss adjustment expense payments of $102.0 million; 3) an increase in acquisition costs and other underwriting expenses of $82.6 million; 4) an increase in net investment income collected of $33.5 million; 5) an increase in agency commission and fee revenues of $32.4 million; 6) an increase in agency commission and operating expenses of $39.3 million; and 7) an increase in income tax expenses of $9.8 million. In 2004, we were able to realize an increase of approximately $18.9 million in cash flows primarily as a result of the following items: 1) a decrease in gross premiums collected of $207.8 million, offset by a decrease in reinsurance premiums paid of $287.6 million; 2) an increase in gross losses of $165.2 million offset, by an increase in ceded losses of $168.9 million; 3) an increase in acquisition costs and other underwriting expenses of $40.3 million; 4) a decrease in the amount of federal income taxes recovered of $17.5 million; and 5) a decrease in other miscellaneous items of $6.8 million.
Penn Independent Corporation and Penn-America Group, Inc. at the time of the acquisition. The remaining increase in cash used for investing activities in 2005 and the increase in cash used for investing activities in 2004 and 2003 is primarily due to investing cash realized from operating activities. The decrease in cash used for investing activities in 2004 from 2003 was primarily due to an additional $60.9 million of cash proceeds from the sales of bonds and stocks in 2004, offset against $14.7 million of additional purchases of bonds and stocks in 2004.
Each company in our U.S. Insurance Operations and our Non-U.S. Insurance Operations maintains sufficient liquidity to pay claims through cash generated by operations and investments in liquid investments. At December 31, 2005, United America Indemnity had cash and cash equivalents of $220.1 million.
There are two intercompany pooling agreements in place for the United National Insurance Companies. The first pooling agreement governs policies that were written prior to July 1, 2002. The second pooling agreement governs policies that are written on or after July 1, 2002. The method by which intercompany reinsurance is ceded is different for each pool. In the first pool, the United National Insurance Companies cede all business to United National Insurance Company. United National Insurance Company cedes in turn to external reinsurers. The remaining net premiums retained are allocated to the companies in the group according to their respective pool participation percentages. In the second pool, each company in the group first cedes to external reinsurers. The remaining net is ceded to United National Insurance Company where the net premiums written of the group are pooled and reallocated to the group based on their respective participation percentages. The second pool requires less trust funding by United National Insurance Company as a result of it assuming less business from the other group members. United National Insurance Company only has to fund the portion that is ceded to it after cessions have occurred with external reinsurers. United National Insurance Company retains 80.0% of the risk associated with each pool.
The Penn-America Insurance Companies participate in an intercompany pooling arrangement whereby premiums, losses, and expenses are shared pro rata among the members of the group. These parties are not authorized reinsurers in all states. As a result, any losses and unearned premium that are ceded to Penn-Star Insurance Company by the other group members must be collateralized. The state insurance departments that regulate the parties to the intercompany pooling agreements require Penn-Star Insurance Company to place assets on deposit subject to trust agreements for the protection of other group members.
The United National Insurance Companies have entered into a quota share arrangement with Wind River Barbados and Wind River Bermuda. This reinsurance arrangement resulted in 45% and 15% of the United National Insurance Companies’ net retained insurance liability on new and renewal business bound January 1, 2004 through April 30, 2004 being ceded to Wind River Barbados and Wind River Bermuda, respectively. The agreement also stipulates that 45% and 15% of the United National Insurance Companies’ December 31, 2003 net unearned premium be ceded to Wind River Barbados and Wind River Bermuda, respectively.
The Penn-America Insurance Companies have entered into a quota share arrangement with Wind River Bermuda. This reinsurance arrangement resulted in 30% of the Penn-America Insurance Companies’ net retained insurance liability on new and renewal business bound after February 1, 2005 and later being ceded to Wind River Bermuda. This agreement also stipulates that 30% of Penn-America Insurance Companies’ February 1, 2005 net unearned premium be ceded to Wind River Bermuda.
Wind River Bermuda and Wind River Barbados have each established independent reinsurance trust accounts for the benefit of each of the U.S. Insurance Subsidiaries. We invest the funds in securities that have durations that closely match the expected duration of the liabilities assumed. We believe that each of Wind River Bermuda and Wind River Barbados will have sufficient liquidity to pay claims prospectively.
We expect that in 2006 our U.S. Insurance Operations and our Non-U.S. Insurance Operations will have positive cash flow and will have sufficient liquidity to pay claims. We monitor our portfolios to assure liability and investment durations are closely matched.
We have access to various capital sources including dividends from insurance subsidiaries, invested assets in our Non-U.S. Subsidiaries, undrawn capacity under United National Insurance Company’s discretionary
In 2005, United National Insurance Companies and Penn-America Insurance Companies declared and paid dividends of $18.0 million and $5.2 million, respectively. For 2006, the maximum amount of distributions that could be paid by the United National Insurance Companies as dividends under applicable laws and regulations without regulatory approval is approximately $36.0 million. For 2006, the maximum amount of distributions that could be paid by the Penn-America Insurance Companies as dividends under applicable laws and regulations without regulatory approval is approximately $22.0 million, including $7.2 million that would be distributed to United National Insurance Company or its subsidiary Penn Independent Corporation based on the December 31, 2005 ownership percentages.
U.A.I. (Luxembourg) Investment S.ar.l. holds promissory notes of $175.0 million and $110.0 million from United America Indemnity Group, which have interest rates of 6.64% and 6.20%, respectively, and mature in 2018 and 2020, respectively. It is anticipated that interest on both notes will be paid yearly. The ability of United America Indemnity Group to generate cash to repay the notes is dependent on dividends that it receives from its subsidiaries. On September 14, 2005, U.A.I. (Luxembourg) Investment S.ar.l. gifted $11.6 million to its direct subsidiary U.A.I. (Ireland) Limited. On that same day, U.A.I. (Ireland) Limited made an $11.6 million interest free loan back to U.A.I. (Luxembourg) Investment S.ar.l. United America Indemnity Group has no operations.
On January 24, 2006, U.A.I. (Luxembourg) Investment S.ar.l. loaned $4.4 million to United America Indemnity, Ltd. The loan is a demand loan and bears interest at a rate of 4.38%. United America Indemnity, Ltd. is using the funds to satisfy outstanding obligations and pay operating expenses. United America Indemnity, Ltd. is dependent on dividends from subsidiaries to satisfy its cash needs. It is currently anticipated that Wind River Bermuda will begin to pay dividends to United America Indemnity, Ltd. by 2007.
On September 30, 2003, United National Group Capital Trust I (“UNG Trust I”), a business trust subsidiary formed by American Insurance Service, Inc. (“AIS”), issued $10.0 million of floating rate capital securities (“Trust Preferred Securities”). These securities have a thirty-year maturity, with a provision that allows the Company to call these securities at par after five years from the date of issuance. Cash distributions are paid quarterly in arrears at a rate of 405 basis points over three month London Interbank Offered Rates (“LIBOR”). Distributions on these securities can be deferred for up to five years, but in the event of such deferral, AIS may not declare or pay cash dividends on its common stock. AIS guarantees all obligations of UNG Trust I with respect to distributions and payments of these securities.
Proceeds from the sale of the Trust Preferred Securities of $10.0 million and $0.3 million of floating rate common securities issued to AIS by UNG Trust I were used to acquire $10.3 million of floating rate junior subordinated deferrable interest rate debentures issued by AIS. These junior subordinated debentures have the same terms with respect to maturity, payments, and distributions as the Trust Preferred Securities issued by UNG Trust I. The proceeds from these junior subordinated debentures are being used to support growth in the Company’s insurance subsidiaries and for general corporate purposes.
We have commitments in the form of operating leases, revolving line of credit, senior notes payable, junior subordinated debentures and unpaid losses and loss expense obligations. As of December 31, 2005, contractual obligations related to United America Indemnity’s commitments, including any principal payments, were as follows:
On July 20, 2005, United America Indemnity Group sold $90.0 million of guaranteed senior notes, due July 20, 2015. These notes have an interest rate of 6.22%, payable semi-annually. On July 20, 2011 and on each anniversary thereafter to and including July 20, 2014, United America Indemnity Group is required to prepay $18.0 million of the principal amount. On July 20, 2015, United America Indemnity Group, Inc is required to pay any remaining outstanding principal amount on the notes. The notes are guaranteed by United America Indemnity, Ltd. Proceeds from the notes were used to prepay $72.8 million in principal together with related interest due as of July 20, 2005 under senior notes issued by Wind
River to the Ball family trusts in September 2003. The terms of the prepayment agreement required the Ball family trusts to reimburse Wind River for $0.3 million of the issuance costs of the new senior notes plus $1.0 million of the incremental interest costs that United America Indemnity Group is estimated to incur under the new senior notes. The total amount of these reimbursements of $1.3 million was recorded as a gain on the early extinguishment of debt.
See discussion in Liability for Unpaid Losses and Loss Adjustment Expenses.
We have no off balance sheet arrangements other than the Trust Preferred Securities and floating rate common securities discussed in the “Capital Resources” section of “Liquidity and Capital Resources”.
Also, in our opinion, management’s assessment, included in “Management’s Report on Internal Control over Financial Reporting” appearing under Item 9A of the Company’s Form 10-K, that the Company maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
As discussed below in Note 2, the Company acquired all of the outstanding common stock of Wind River Investment Corporation and its subsidiaries (“Wind River” or the “Predecessor”) on September 5, 2003 (the “Acquisition”). As a result of the Acquisition, the capital structure and basis of accounting of the Company differ from those of Wind River prior to the Acquisition. Therefore, the financial data with respect to periods prior to the Acquisition (“Predecessor” period) may not be comparable to data for periods subsequent to the Acquisition (“Successor” period).
$1.9 million of floating rate common securities. The sole assets of the Company’s business trust subsidiaries are $61.9 million of junior subordinated debentures issued by the Company, which have the same terms with respect to maturity, payments and distributions as the Trust Preferred Securities and the floating rate common securities.
In July 2005, Wind River Barbados, through a series of tax-exempt transactions, contributed the Company’s U.S. Subsidiaries to U.A.I. (Luxembourg) Investment S.ar.l.
In December 2003, the Company consummated an IPO of 10,750,000 Class A common shares, including 1,000,000 Class A common shares issued in connection with the exercise of part of the underwriters’ overallotment option, at a price of $17.00 per share. Proceeds of the offering less underwriting discounts of $12.8 million were $170.0 million. Expenses for the IPO totaled $4.4 million, resulting in net proceeds to the company of $165.6 million (the “IPO Proceeds”). The Company used $150.0 million of the IPO Proceeds to fund the redemption of all its Series A preferred shares. In January 2004, the Company issued 462,500 Class A common shares in connection with the underwriter’s remaining overallotment option at a price of $17.00 per share. Proceeds to the Company, net of underwriting discounts of $0.5 million, were $7.3 million.
United America Indemnity was organized by affiliates of Fox Paine & Company, LLC (“Fox Paine & Company”) on August 26, 2003, for the purpose of acquiring the Company’s predecessor, Wind River. On September 5, 2003, Fox Paine & Company made a capital contribution of $240.0 million to the Company, in exchange for 10.0 million Class B common shares and 14.0 million Series A preferred shares.
On September 5, 2003, the Company acquired 100% of the outstanding common stock of Wind River from a group of family trusts affiliated with the Ball family of Philadelphia, Pennsylvania (the “Ball Family Trusts”) for a purchase price of $250.4 million. The purchase price for Wind River consisted of $100.0 million in cash, the issuance to the Ball Family Trusts of 2.5 million Class A common shares valued at $10.00 per share, the issuance to the Ball Family Trusts of 3.5 million Series A preferred shares valued at $10.00 per share and the issuance of senior notes by Wind River having an aggregate principal amount of approximately $72.8 million, which have since been paid off. The fair market valuations of the Class A common shares and Series A preferred shares were determined by using the GAAP book value of the shares on September 5, 2003, since the Company received its initial capitalization on that date.
The transaction was accounted for using the purchase method of accounting in accordance with Statement of Financial Accounting Standards No. 141, Business Combinations (“SFAS No. 141”). The $46.4 million excess of the estimated fair value of net assets over purchase price was recognized as an extraordinary gain in the consolidated statement of operations for the period September 6, 2003 to December 31, 2003.
potentially uncollectible reinsurance receivables as of the acquisition date. The factor (3) did not affect net reinsurance receivables materially because Wind River had recorded an allowance for uncollectible reinsurance, which was considered a reasonable estimate of the credit risk inherent in the reinsurance receivables as of the acquisition date.
As a result of these two adjustments, the fair values of the reserve for losses and loss adjustment expenses and reinsurance receivables were reduced by $49.4 million as of the acquisition date. Based on the nature of Wind River’s reinsurance program and expected future payout patterns.
Acquisition of Penn Independent Corporation and Merger with Penn-America Group, Inc.
The $98.6 million purchase price, which includes transaction related expenses, was allocated to the estimated fair values of the acquired assets and liabilities as follows (dollars in thousands):
The transaction was accounted for using the purchase method of accounting. In connection with the acquisition of Penn Independent Group, the assets and liabilities acquired by the Company were adjusted to estimated fair value. The $17.1 million excess of cash and acquisition costs over the estimated fair value of assets acquired was recognized as goodwill.
On January 24, 2005, in a series of related transactions, the Company acquired all shares of Penn-America Group, Inc. common stock owned by members of the Saltzman family, including all shares of common stock issued upon the exercise of vested options to acquire shares of Penn-America Group, Inc. common stock, for $13.53 a share in cash. The Saltzman family and trusts controlled by them constituted 100% of the Penn Independent Corporation shareholders prior to the acquisition by United America Indemnity.
On January 24, 2005, the Company acquired 67.3% of the voting equity interest of the Penn-America Group, Inc., a specialty property and casualty insurance holding company, for $15.3 million in cash and approximately 7.9 million Class A common shares of United America Indemnity in a transaction classified as a merger. Under the terms of the merger agreement, Penn-America Group, Inc. shareholders received $15.375 of value for each share of Penn-America Group, Inc. common stock as follows: 1) 0.7756 of a Class A common share of United America Indemnity, based on $13.875 divided by the volume weighted average sales price of United America Indemnity’s Class A common shares for the 20 consecutive trading days ending January 21, 2005, which was $17.89, and 2) $1.50 per share in cash. Penn-America Group’s results of operations are included in the Company’s results of operations subsequent to the date of the merger.
In connection with the merger of Penn-America Group, Inc., the assets and liabilities acquired by the Company were adjusted to fair value. Accordingly, the fair values of the reserve for unpaid losses and loss adjustment expenses and reinsurance receivables were estimated by (1) discounting the gross reserve for unpaid losses and loss adjustment expenses and reinsurance receivables, (2) applying a risk margin to the gross reserves and reinsurance receivables and (3) reducing gross reinsurance receivables by an amount equal to an estimate of potentially uncollectible reinsurance receivables as of the acquisition date. The factor (3) did
Penn-America Group, Inc. discounted the reserve for unpaid losses and loss adjustment expenses and reinsurance receivables based on the present value of the expected underlying cash flows using a risk-free interest rate of 3%, which approximated the U.S. Treasury rate on the acquisition date. The discounting pattern was developed by Penn-America Group, Inc.’s actuarial department based on historical loss data.
As a result of these two adjustments, the fair value of the reserve for losses and loss adjustment expenses and reinsurance receivables was reduced by $19.5 million as of the acquisition date.
As of the acquisition date, Penn-America Group, Inc. adjusted its gross and net unearned premium reserves to fair value by (1) discounting the unearned premium reserves and (2) applying a risk margin to the unearned premium reserves. The risk margin utilized to record the gross unearned premium reserves at fair value was 25%. A slightly lower 20% risk margin was utilized to calculate the net unearned premium reserves because of the shorter period of the underlying exposures, which produces a lower degree of variability in the imbedded future profits. Penn-America Group, Inc. discounted the unearned premium reserves based on the present value of the expected underlying cash flows using a risk-free interest rate of 3%, which approximated the U.S. Treasury rate on the acquisition date. The discounting pattern was developed by Penn-America Group, Inc.’s actuarial department based on historical loss data.
The Company’s investments in bonds, preferred stock, and common stock are classified as available for sale and are carried at their fair value. The difference between amortized cost and fair value of these investments, excluding the derivative components, net of the effect of deferred income taxes, is reflected in accumulated other comprehensive income in shareholders’ equity and, accordingly, has no effect on net income other than for impairments deemed to be other than temporary. The difference between amortized cost and fair value of the derivative components of the bonds is included in income.
At December 31, 2005, the Company held $19.4 million of convertible bonds and $4.4 million of convertible preferred stock. The convertible bonds include convertible options with a market value of $3.6 million and the convertible preferred stocks include convertible options with market value of $0.6 million. The change in the difference between the amortized cost and the market value of the options is included in income as a component of net realized investments gains/(losses). The Company realized a $1.2 million loss, a $0.3 million gain, and a $1.1 million gain for the years ended December 31, 2005 and 2004 and for the periods from September 6, 2003 to December 31, 2003, respectively, due to market value changes related to options. The Company realized a $0.5 million gain for the period from January 1, 2003 to September 5, 2003 on its trading portfolio, which included convertible bonds, preferred stocks, and common stocks.
As a result of the purchase price allocation, as discussed above in Note 2, all of the Predecessor’s investments at September 5, 2003 were adjusted to their fair value on that date
As a result of the purchase price allocation, as disclosed above in Note 3, the amortized costs of all of the investments of the Predecessor, Penn Independent Corporation and Penn-America Group, Inc. at January 24, 2005 were adjusted to their fair value on their acquisition dates.
The Company’s investments in other invested assets are comprised primarily of limited liability partnership interests and uncollateralized commercial loans. Partnership interests of 3% ownership or greater are accounted for using the equity method. The change in the difference between amortized cost and fair value of partnership interests of 3% ownership or greater, net of the effect of deferred income taxes, is reflected in income. Partnership interests of less than 3% ownership are carried at their fair value. The change in the difference between amortized cost and fair value of partnership interests of less than 3% ownership, net of the effect of deferred income taxes, is reflected in accumulated other comprehensive income in shareholders’ equity and, accordingly, has no effect on net income other than for impairments deemed to be other than temporary. Uncollateralized commercial loans are stated at unpaid principal balances, net of any allowances. Several of the limited partnerships invest solely in securities that are publicly traded and are stated at the net asset value as reported by the investment manager. The estimated fair value of such securities is determined by the general partner of each limited partnership based on comparisons to transactions involving similar investments. Material assumptions and factors utilized in pricing these securities include future cash flows, constant default rates, recovery rates and any market clearing activity that may have occurred since the prior month-end pricing period. The Company’s investments in other invested assets, including investments in several limited partnerships, were valued at $52.4 million and $53.8 million as of December 31, 2005 and 2004, respectively. As of December 31, 2005 and 2004, respectively, the Company’s other invested assets portfolio included $13.1 million and $20.4 million in securities for which there is no readily available independent market price.
Fair value is defined as the amount at which the instrument could be exchanged in a current arms-length transaction with willing parties. The fair values of the Company’s investments in bonds and stocks are determined on the basis of quoted market prices. The fair values of the Company’s investments in limited partnerships are determined by the general partner of each limited partnership based on comparisons to transactions involving similar investments. Several of these partnerships invest solely in securities that are publicly traded and are valued at the net asset value as reported by the investment manager. Material assumptions and factors utilized in pricing these securities include future cash flows, constant default rates, recovery rates and any market clearing activity that may have occurred since the prior month-end pricing period.
As of December 31, 2005, the Company holds a single derivative instrument, an interest rate swap, which is included in “Other assets” on the balance sheet. In accordance with SFAS 133, the interest rate swap is designated as a cash flow hedge, and is recorded on the balance sheet at fair value. Change in fair value is recorded in other comprehensive income and is reclassified to earnings in the same period during which the hedged item affects earnings.
The primary objective of the Company’s interest rate swap was to hedge risk arising from interest rate volatility related to $15.0 million of Trust Preferred Securities issued by Penn Trust I. The Company has
designated the $15.0 million of junior subordinated debentures issued by Penn-America Group, Inc. to Penn Trust I as the hedged item. The junior subordinated debentures have the same terms with respect to maturity, payment, and distributions as the Trust Preferred Securities issued by Penn Trust I. The Company’s strategy is to convert distributions based on a floating rate on its junior subordinated debentures with Penn Trust I to a fixed-rate basis.
In the normal course of business, the Company seeks to reduce the loss that may arise from events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with reinsurers. Amounts receivable from reinsurers are estimated in a manner consistent with the reinsured policy. The Company analyzes its reinsurance contracts to ensure they meet the risk transfer requirements of SFAS No. 113, “Accounting for Reinsurance of Short Duration and Long Duration Contracts” (“SFAS 113”) and regularly reviews the collectibility of reinsurance receivables. SFAS 113 requires that the reinsurer must assume significant insurance risk under the reinsured portions of the underlying insurance contracts and that there must be a reasonably possible chance that the reinsurer may realize a significant loss from the transaction. Any allowances resulting from this review are included in income during the period in which the determination is made.
During 2005, a provision for doubtful reinsurance receivables of $0.2 million has been established by Penn-America Group, Inc. The Predecessor recorded a provision for doubtful reinsurance receivables of $1.8 million during the period from January 1, 2003 through September 5, 2003.
The costs of acquiring new and renewal insurance and reinsurance contracts include commissions, premium taxes and certain other costs that are directly related to and vary directly with the production of business. The excess of the Company’s costs of acquiring new and renewal insurance and reinsurance contracts over the related ceding commissions earned from reinsurers is capitalized as deferred acquisition costs and amortized over the period in which the related premiums are earned. In accordance with SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” the method followed in computing such amounts limits them to their estimated realizable value that gives effect to the premium to be earned, related investment income, losses and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. The amortization of deferred acquisition costs for the years ended December 31, 2005 and 2004, the period from September 6, 2003 to December 31, 2003, and the period from January 1, 2003 to September 5, 2003 were $107.4 million, $53.2 million, $4.7 million, and $12.0 million, respectively.
The carrying amounts reported in the balance sheet approximate its fair value.
The liability for unpaid losses and loss adjustment expenses represents the Company’s best estimate of future amounts needed to pay losses and related settlement expenses with respect to events insured by the Company. This liability is based upon the accumulation of individual case estimates for losses reported prior to the close of the accounting period with respect to direct business, estimates received from ceding companies with respect to assumed reinsurance and estimates of unreported losses.
The Company accounts for stock-based compensation in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation,” which established a fair value-based method of accounting for stock-based compensation plans.
In November 2005, the FASB issued FASB Staff Position (“FSP”) 115-1 and FSP 124-1, “The Meaning of Other-Than-Temporary Impairment and Application to Certain Investments” (“FSP 115-1”). FSP 115-1 is effective for fiscal years beginning December 15, 2005 or later. The disclosure requirements of FSP 115-1 are the same as those in EITF 03-01. In addition, FSP 115-1 provides guidance to determine if an impairment is other than temporary. This statement is not expected to have a material impact on the Company’s financial position.
In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment” (“SFAS 123R”), which revises the original SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). The Company has previously adopted the requirements of SFAS 123, which require companies to expense the estimated fair value of employee stock options and similar awards. The accounting provisions of SFAS 123R will be effective for the next fiscal year beginning after December 15, 2005. The Company is in the process of determining how the new method of valuing stock-based compensation as prescribed in SFAS 123R will be applied to valuing stock-based awards granted, modified or vested and the impact on compensation expense related to such awards in the consolidated financial statements.
In May 2005, SFAS 154 “Accounting Changes and Error Corrections” (“SFAS 154”), replaced APB Opinion No. 20 “Accounting Changes” (“APB 20”) and FASB Statement No. 3 “Reporting Accounting Changes in Interim Financial Statements”, and changed the requirements for the accounting for and reporting of a change in an accounting principle. SFAS 154 applies to all voluntary changes in accounting principles. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions.
APB 20 previously required that most voluntary changes in an accounting principle be recognized by including in net income for the period of the change the cumulative effect of changing to the new accounting principle. SFAS 154 requires retrospective application to prior periods’ financial statements of changes in an accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. When it is impracticable to determine the period-specific effects of an accounting change on one or more individual prior periods presented, SFAS 154 requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period rather than being reported in an income statement. SFAS 154 also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in an accounting estimate effected by a change in an accounting principle.
The Company holds several investments in limited partnerships where it owns less than 3% of the limited partnerships. Changes in the value of these partnerships are included in accumulated other comprehensive income as a component of shareholders’ equity. The market value and amortized cost of these investments are as follows:
The following table contains an analysis of the Company’s securities with gross unrealized losses, categorized by the period that the securities were in a continuous loss position as of December 31, 2005:
During the year ended December 31, 2005, the Company recorded other than temporary impairment losses of $0.8 million on its common stock portfolio. During the year ended December 31, 2004, the Company recorded other than temporary impairment losses of $0.2 million on its common stock portfolio. No such losses were incurred during the period from September 6, 2003 to December 31, 2003. During the period from January 1, 2003 to September 5, 2003, the Predecessor recorded other than temporary impairment losses of $1.9 million on its fixed income portfolio and $0.7 million on its investments in limited partnerships.
Accumulated comprehensive income as of December 31, 2004 is comprised of $10.1 million of net unrealized gains from partnerships where the Company owns less than a 3.0% interest, $12.8 million of net unrealized gains from the Company’s available-for-sale portfolio, and $7.4 million of deferred taxes related to the unrealized gains.
Proceeds from the sales of bonds classified as available-for-sale resulting in net realized investment gains (losses) for the years ended December 31, 2005 and 2004, the period from September 6, 2003 to
Proceeds from the sales of equity securities classified as available-for-sale resulting in net realized investment gains (losses) for the years ended December 31, 2005 and 2004, and the period from September 6, 2003 to December 31, 2003 were $76.1 million, $31.6 million, and $11.7 million, respectively. There were no equity securities classified as available-for-sale for the period from January 1, 2003 to September 5, 2003.
Certain cash balances, cash equivalents and bonds available for sale were deposited with various governmental authorities in accordance with statutory requirements or were held in trust pursuant to intercompany reinsurance agreements. The estimated fair market value of bonds available for sale and on deposit or held in trust were as follows as of December 31, 2005 and December 31, 2004:
During 2005, the Company’s unpaid losses and loss adjustment expenses and related reinsurance receivables were decreased by $253.7 million. Of this amount, $142.3 million was due to the Company’s review of unpaid loss and loss adjustment expenses and related reinsurance receivables, and the remainder was due to the payment of losses in the ordinary course of business. At the Wind River Acquisition date, discounts and risk margins were applied to reinsurance recoverables related to ceded loss reserves. During 2005, the Company decreased its discount and risk margin purchase adjustment by $28.2 million due to (1) reductions in ceded loss reserves that existed as of the Wind River Acquisition date and (2) decreases to the amount of discount due to the passage of time. This adjustment equally affected reinsurance recoverables and loss reserves and had no impact on the net income of the Company during 2005.
At December 31, 2005 and December 31, 2004, the Company held collateral securing its reinsurance receivables of $691.7 million and $705.6 million, respectively. Prepaid reinsurance premiums were $41.7 million and $42.6 million at December 31, 2005 and December 31, 2004, respectively. Reinsurance receivables, net of collateral held, were $586.4 million and $826.3 million at December 31, 2005 and December 31, 2004, respectively.
Since the Acquisition date, an allowance for uncollectible reinsurance of $0.2 million has been established as a result of the Company’s regular review of the collectibility of recorded reinsurance receivables due from its external non-affiliated reinsurers.
In 2005, the Non-U.S. Insurance Operations commenced offering reinsurance to the Penn-America Insurance Companies through a quota share arrangement. This reinsurance arrangement resulted in 30% of Penn-America Insurance Companies’ net retained insurance liability on new and renewal business bound after February 1, 2005 being ceded to Wind River Bermuda, an affiliated company. The agreement also stipulated that 30% of Penn-America Insurance Companies’ February 1, 2005 net unearned premium be ceded to Wind River Bermuda.
On October 29, 2003, the Company commuted a reinsurance agreement with Trenwick America Reinsurance Corporation (“Trenwick”). As a part of the commutation, the Company received $5.7 million in cash, which equaled the Company’s estimated net realizable value of amounts that were due from Trenwick. Accordingly, there was no gain or loss recognized as a result of this commutation. The commutation released Trenwick from all future obligations under the agreement.
Under current Cayman Islands law, the Company is not required to pay any taxes in the Cayman Islands on its income or capital gains. The Company has received an undertaking that, in the event of any taxes being imposed, the Company will be exempted from taxation in the Cayman Islands until the year 2023. Under current Bermuda law, the Company and its Bermuda subsidiaries are not required to pay any taxes in Bermuda on its income or capital gains. The Company has received an undertaking from the Minister of Finance in Bermuda that, in the event of any taxes being imposed, the Company will be exempt from taxation in Bermuda until March 2016. Under current Barbados law, the Company and its Barbados subsidiary are not required to pay any taxes in Barbados on its income or capital gains. The Company has received an undertaking that in the event of any taxes being imposed, the Company will be exempted from taxation in Barbados until the year 2033.
The Luxembourg subsidiaries of the Company are subject to income taxes imposed by the Grand Duchy of Luxembourg and file Luxembourg tax returns. In addition, the Gibraltar shareholders of the Luxembourg companies would be subject to Luxembourg capital gains tax on a sale of the Luxembourg companies in which they hold a participation in the nominal paid up share capital of more than 10%, unless their holding period in the shares was at least six months.
The Company is not subject to taxation other than as stated above. There can be no assurance that there will not be changes in applicable laws, regulations or treaties, which might require the Company to change the way it operates or become subject to taxation.
The weighted average expected tax provision has been calculated using income (loss) before income taxes in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. The Company’s income before income taxes in 2005 of $65.7 million represents $44.1 million from foreign operations and $21.6 million from domestic operations. The following table summarizes the differences between the tax provision for financial statement purposes and the expected tax provision at the weighted average tax rate:
The tax effects of temporary differences that give rise to significant portions of the net deferred tax assets at December 31, 2005 and 2004 are presented below:
Management believes it is more likely than not that the deferred tax assets will be completely utilized in future years. As a result, there is no valuation allowance at December 31, 2005 and 2004.
The federal tax returns for the Company’s U.S. operations are open to review by the IRS. Management believes that adequate provisions have been made in the financial statements to cover any potential audits and tax related matters for all years for which the statute of limitation has not expired. The statute of limitations has not yet expired for years 2002 through 2004.
Prior to 2001, the Company underwrote multi-peril business insuring general contractors, developers, and sub-contractors primarily involved in residential construction that has resulted in significant exposure to construction defect (“CD”) claims. Management believes its reserves for CD claims ($41.6 million and $28.5 million as of December 31, 2005 and 2004, net of reinsurance, respectively) are appropriately established based upon known facts, existing case law and generally accepted actuarial methodologies. However, due to the inherent uncertainty concerning this type of business, the ultimate exposure for these claims may vary significantly from the amounts currently recorded.
The Company had 48 and 37 direct claims related to the September 11th, 2001 terrorist attacks as of December 31, 2005 and 2004, respectively. The majority of these claims are first party property claims while a few stem from event interruption. Estimated direct indemnity exposure as of December 31, 2005 and 2004, was $4.7 million and $5.0 million, respectively. Reinsurance to non-affiliates as of December 31, 2005 and 2004 totaled $4.4 million and $4.6 million, respectively. Net indemnity exposure as of December 31, 2005 and 2004 was $0.3 million and $0.4 million, respectively. As of December 31, 2005, 12 of the Company’s claims were still open. The Company does not anticipate any additional material impact to its financial statements, nor does it expect any future obligations related to this tragedy.
The Company has exposure to asbestos and environmental (“A&E”) claims. The asbestos exposure primarily arises from the sale of product liability insurance, and the environmental exposure arises from the sale of general liability and commercial multi-peril insurance. In establishing the liability for unpaid losses and loss adjustment expenses related to A&E exposures, management considers facts currently known and the current state of the law and coverage litigation. Liabilities are recognized for known claims (including the cost of related litigation) when sufficient information has been developed to indicate the involvement of a specific insurance policy, and management can reasonably estimate its liability. In addition, liabilities have been established to cover additional exposures on both known and unasserted claims. Estimates of the liabilities are reviewed and updated continually. Developed case law and claim history do not exist for such claims, especially because significant uncertainty exists about the outcome of coverage litigation and whether past claim experience will be representative of future claim experience. Included in net unpaid losses and loss adjustment expenses as of December 31, 2005 and 2004 were IBNR reserves of $7.5 million and $8.2 million,
respectively, and case reserves of approximately $4.0 million and $3.6 million, respectively, for known A&E-related claims.
On May 15, 2003, Penn Trust II, a business trust subsidiary formed by Penn-America Group, Inc., issued $15.0 million of Trust Preferred Securities. These securities have a thirty-year maturity, with a provision that allows the Company to call these securities at par after five years from the date of issuance. Cash distributions are paid quarterly in arrears at a rate equal to three-month LIBOR plus 4.10%. Distributions on these securities can be deferred for up to five years, but in the event of such deferral, Penn-America Group, Inc. may not declare or pay cash dividends on its common stock. Penn-America Group, Inc. guarantees all obligations of Penn Trust II with respect to distributions and payments of these securities.
On September 30, 2003, AIS, a wholly owned indirect subsidiary of the Company, sold $10.0 million (aggregate liquidation amount) of floating rate trust preferred securities to Dekania CDO I, Ltd., an exempted company incorporated with limited liability under the law of the Cayman Islands, in a private placement through AIS’ wholly owned statutory trust, UNG Trust I.
AIS, through UNG Trust I, together with other insurance companies and insurance holding companies, issued trust preferred securities to the collateralized debt obligation pool organized by Dekania Capital Management LLC, which in turn, issued its securities to institutional and accredited investors. UNG Trust I issued 10,000 trust preferred securities, having a stated liquidation amount of $1,000 per security, that mature on September 30, 2033 and bear a floating interest rate, reset quarterly, equal to three-month LIBOR plus 4.05%. AIS, through UNG Trust I, has the right to call the trust preferred securities at par after September 30, 2008, five years from the date of issuance.
The entire proceeds from the sale of the trust preferred securities, including the proceeds from the sale of common securities of UNG Trust I to AIS, were used to fund the purchase of $10.3 million (in principal amount) of junior subordinated deferrable interest notes issued by AIS under an indenture, dated as of September 30, 2003, between AIS and JPMorgan Chase Bank, as trustee.
On October 29, 2003, AIS sold $20.0 million (aggregate liquidation amount) of floating rate trust preferred securities to I-Preferred Term Securities III, Ltd., an exempted company incorporated with limited liability under the law of the Cayman Islands, in a private placement through AIS’s wholly owned statutory trust, UNG Trust II.
AIS, through UNG Trust II, has the right to call the trust preferred securities at par after October 29, 2008, five years from the date of issuance.
Notes payable and term loans assumed through the acquisition of Penn Independent Corporation is comprised of a $4.5 million revolving line of credit which expires on November 30, 2006, bearing interest at the bank’s prime rate less 1.25% payable monthly. The outstanding amount due on the line of credit as of December 31, 2005 is $2.9 million. The Company has agreed to a security agreement granting the bank a first priority perfected lien on finance receivables of Penn Independent Financial Services, Inc. (“PIFSI”). On December 29, 2005, AIS entered into a guaranty and suretyship agreement with the bank whereby AIS will unconditionally jointly and severally guarantee the timely payment of any and all indebtedness owed to the bank by PIFSI. Interest expense resulting from the line of credit was $0.2 million for 2005.
Loans payable of $3.6 million as of December 31, 2005 are comprised of six loans payable to vendors, a minority shareholder, and former minority shareholders. The current portion of these loans that will be payable in 2006 is $0.6 million. Interest expense related to loans payable was $0.1 million for the 2005.
In November 2005, management fees of $1.5 million in the aggregate were made to Fox Paine & Company and The AMC Group, L.P. (“The AMC Group”), both of which are affiliates. The management fees cover the period from September 5, 2005 through September 4, 2006 and will be recognized ratably over that period. In November 2004, management fees of $1.5 million in the aggregate were made to Fox Paine & Company and The AMC Group, covering the period from September 5, 2004 through September 4, 2005 and recognized ratably over that period. On September 5, 2003, management fees of $1.5 million in the aggregate were made to Fox Paine & Company and The AMC Group, covering the period from September 5, 2003 through September 4, 2004 and recognized ratably over that period.
The following describes the minority equity interests in the Penn Independent Group subsidiaries:
On February 24, 1993, Apex Insurance Agency, Inc. issued ten shares of common stock to a minority shareholder. In April 2005, Apex Insurance Agency, Inc. issued a note payable for $1.7 million, due in equal installments over 84 months, to repurchase the ten shares of common stock it issued to the minority shareholder and to meet certain contracted compensation arrangements. As of December 31, 2005, PIC Holdings owns 100% of the outstanding common stock of Apex Insurance Agency, Inc.
The Insurance Operations and the Agency Operations are, from time to time, involved in various legal proceedings in the ordinary course of business. The Company purchases insurance and reinsurance policies covering such risks in amounts that it considers adequate. However, there can be no assurance that the insurance and reinsurance coverage that the Company maintains is sufficient or will be available in adequate amounts or at a reasonable cost. The Company does not believe that the resolution of any currently pending legal proceedings, either individually or taken as a whole, will have a material adverse effect on the Company’s business, results of operations or financial condition.
There is a greater potential for disputes with reinsurers who are in a runoff of their reinsurance operations. Some of the Company’s reinsurers are in a runoff of their reinsurance operations, and therefore, the Company closely monitors those relationships. The Company anticipates that, similar to the rest of the insurance and reinsurance industry, it will continue to be subject to litigation and arbitration proceedings in the ordinary course of business.
On November 29, 2004, Diamond State received an award in the arbitration matter between Diamond State and Partner Reinsurance Company, Ltd. and Partner Reinsurance Company of the U.S. (collectively “Partner Re”). In the arbitration, Diamond State sought recovery under a reinsurance agreement with Partner Re relative to loss and expenses incurred by Diamond State in litigation brought by Bank of America N.A. and Platinum Indemnity Limited, which was resolved by Diamond State in January 2004. On December 2, 2004, Partner Re paid Diamond State approximately $19.5 million representing payment in full of the arbitration award, including approximately $2.8 million for legal fees and expenses. On December 6, 2004, Diamond State made a payment to Partner Re in the amount of approximately $1 million that had been held by Diamond State as an offset against the amount claimed to be owed to Diamond State by Partner Re. There was approximately $0.6 million of interest income and no gain or loss recognized as a result of this award.
On September 5, 2003, as part of the Acquisition, the Company entered into a management agreement with Fox Paine & Company and The AMC Group, an affiliate. In the management agreement, the Company agreed to pay to Fox Paine & Company an annual management fee of $1.2 million subject to certain adjustments and to The AMC Group an annual management fee of $0.3 million subject to certain adjustments. In 2006, a management fee of $1.5 million is payable on November 1.
$1.0 million for restricted stock and $3.8 million for options to purchase the Company’s Class A common stock during the year ended December 31, 2005, respectively. Shareholders’ Equity increased by $2.1 million as a result of 241,878 options exercised during the year ended December 31, 2005, respectively.
In accordance with the Penn-America Group, Inc. Stock Incentive Plan, the merger with United America Indemnity on January 24, 2005 caused immediate vesting of all Penn-America Group, Inc.’s unvested stock options. As of January 24, 2005, Penn-America Group, Inc. had 203,635 stock options outstanding, all of which were exercisable. Each holder of the Penn-America Group, Inc. stock options received converted stock options of United America Indemnity. In exchange for outstanding options to purchase Penn-America Group, Inc.’s Class A common shares, the Company granted 175,007 stock options at the acquisition date. The modification of converting the options to purchase Penn-America Group, Inc.’s Class A common shares to options to purchase United America Indemnity’s Class A common shares had no impact on earnings.
During the period from September 5, 2003 to December 31, 2003, the Company granted 579,201 Time-Based Options and 883,489 Performance-Based Options under the Plan. The Time-Based Options vest in 20% increments over a five-year period, with any unvested options forfeitable upon termination of employment for any reason, and expire 10 years after the grant date. The first vesting period ended on December 31, 2004. The Performance-Based Options vest in 25% increments and are conditioned upon the Company achieving various operating targets or Fox Paine & Company’s holdings in United America Indemnity achieving an agreed upon rate of return, and expire 10 years after the grant date.
The weighted average fair value of options granted under the Plan was $4.69 and $3.03 in 2005 and 2004, respectively, using a Black-Scholes option-pricing model and the following weighted average assumptions:
The following tables summarize the range of exercise prices of options outstanding at December 31, 2005 and 2004:
During 2005, the Company granted an aggregate of 79,756 Class A common shares, subject to certain restrictions, to key employees of the Company under the Plan (“Restricted Shares”). Of this grant, 4,148 Restricted Shares have since been cancelled, 35,757 Restricted Shares were forfeited, 3,042 Restricted Shares vested immediately upon issuance and the remainder will vest in 20% increments over a five-year period. During 2005, an aggregate of 36,918 Class A common shares with a weighted average grant date value of
$17.55 per share were granted, subject to certain restrictions, to the non-employee directors of the Company under the Plan (“Director Restricted Shares”). Due to an amendment to the Directors’ Compensation Plan, effective June 30, 2005, all of these Director Restricted Shares have vested. As a result of this amendment, 17,331 units were converted into 14,977 Director Restricted Shares, which vested immediately, subject to certain holding requirements, and 10,590 Director Restricted Shares granted in 2004 and prior to June 2005 vested immediately, subject to certain holding requirements.
In May 2005, shareholders approved the Amended and Restated United America Indemnity, Ltd. Annual Incentive Awards Program (the “Awards Program”). The purpose of the Awards Program is to encourage increased efficiency and profitability and reward employees’ contributions to corporate success. All employees of the Company and its subsidiaries are eligible to participate in the Awards Program, and Program participants are selected by the Compensation Committee of the Board of Directors (the “Committee”). Incentive awards under the Awards Program are determined and paid in cash and/or restricted stock based upon objective performance-based criteria as determined by the Committee. The criteria relate to certain performance goals, such as net income, combined ratio, return on equity, and individual performance expectations as established by the Committee, except that certain specific performance targets will be approved by the Section 162(m) Committee with respect to the executives covered by Section 162(m) of the Internal Revenue Code (“Section 162(m)”). It is the Company’s intent that any compensation paid pursuant to the Awards Program comply with Section 162(m).
The Company maintains two 401(k) defined contribution plans covering substantially all U.S. employees.
For the U.S. Subsidiaries, exclusive of Penn Independent Corporation, Penn-America Group, Inc. and their subsidiaries, the Company matches 75% of the first 6% contributed by the employee. In addition, the Company contributes 1% of the employee’s salary regardless of whether the employee contributes to the plan. Eligible employees are vested in the Company’s contribution and relative investment income after three years of service. Total expenses related to this plan for the years ended December 31, 2005 and 2004, the period from September 6, 2003 to December 31, 2003, and the period from January 1, 2003 to September 5, 2003 were $0.7 million, $0.9 million, $0.2 million, and $0.2 million, respectively.
The Predecessor maintained a 401(k) defined contribution plan covering substantially all U.S. employees. Prior to September 5, 2003, American Manufacturing Corporation had managed the Predecessor’s 401(k) plan. This 401(k) plan covered substantially all full-time employees. Eligible employees could defer up to 15% of their salary. The Predecessor matched 50% of employees’ contributions up to 6% of their salary. Eligible employees were vested in the Predecessor’s contribution and related investment income after five years of service. As a result of the Acquisition, all employees who participated in the plan were immediately vested.
The Company’s U.S. insurance subsidiaries are required by law to maintain certain minimum surplus on a statutory basis, and are subject to regulations under which payment of a dividend from statutory surplus is restricted and may require prior approval of regulatory authorities. Applying the current regulatory restrictions as of December 31, 2005, the maximum amount of distributions that could be paid by the United National Insurance Companies and the Penn-America Insurance Companies as dividends under applicable laws and regulations without regulatory approval is approximately $36.0 million and $22.0 million, respectively. The Penn-America Insurance Companies limitation includes $7.2 million that would be distributed to United National Insurance Company or its subsidiary Penn Independent Corporation based on the December 31, 2005 ownership percentages. For 2005, United National Insurance Companies and Penn-America Insurance Companies declared and paid dividends of $18.0 million and $5.2 million, respectively.
The NAIC’s RBC model provides a tool for insurance regulators to determine the levels of statutory capital and surplus an insurer must maintain in relation to its insurance and investment risks, as well as its reinsurance exposures, to assess the potential need for regulatory attention. The model provides four levels of regulatory attention, varying with the ratio of an insurance company’s total adjusted capital to its authorized control level RBC (“ACLRBC”): (a) if a company’s total adjusted capital is less than or equal to 200%, but greater than 150% of its ACLRBC (the “Company Action Level”), the company must submit a comprehensive plan to the regulatory authority proposing corrective actions aimed at improving its capital position; (b) if a company’s total adjusted capital is less than or equal to 150%, but greater than 100% of its ACLRBC (the “Regulatory Action Level”), the regulatory authority will perform a special examination of the company and issue an order specifying the corrective actions that must be followed; (c) if a company’s total adjusted capital is less than or equal to 100%, but greater than 70% of its ACLRBC (the “Authorized Control Level”), the regulatory authority may take any action it deems necessary, including placing the company under regulatory control; and (d) if a company’s total adjusted capital is less than or equal to 70% of its ACLRBC (the “Mandatory Control Level”), the regulatory authority must place the company under its control. Based on the standards currently adopted, the capital and surplus of the United National Insurance Companies and the Penn-America Insurance Companies are above the prescribed Company Action Level RBC requirements of $192.8 million and $61.7 million, respectively, as of December 31, 2005.
The following is selected information for the Company’s and the Predecessor’s U.S. Insurance Subsidiaries, net of intercompany eliminations, where applicable, as determined in accordance with SAP:
In connection with the Acquisition, the Company issued 2.5 million Class A common shares and 3.5 million Series A preferred shares to the Ball Family Trusts. Additionally, Wind River Investment Corporation issued $72.8 million of senior notes payable to the Ball Family Trusts, which have since been paid off. In September 2003, 2,500,000 Series A preferred shares were exchanged for 2,687,500 Class B common shares, including 187,500 Class B common shares, for payment of preferred stock dividends of $1.9 million. In December 2003, 1,610,295 Class A common shares were issued for payment of preferred stock dividends of $27.4 million in connection with the redemption of 15,000,000 Series A preferred shares.
On January 23, 2006, the Company announced that the Board of Directors had selected Joseph F. Morris as President. The Company also announced that it will consolidate its U.S. Insurance Operations under a single United America Insurance Group management structure, to be led by William F. Schmidt, as its