We lease office space in Honolulu, Hawaii; Mechanicsburg, Pennsylvania; Fenton, Missouri; and St. Thomas in the United States Virgin Islands. These leases account for approximately 62,000 square feet of office space. These leases expire within thirty-one months. The monthly rents, exclusive of operating expenses, to lease these facilities currently total approximately $109,000. We believe that these leases could be renewed or replaced at commercially reasonable rates without material disruption to our business.
The ratio of the net of the sum of commissions and other underwriting expenses, other operating and general expenses less other income to premiums earned.
The ratio of net income to the average of the shareholders’ equity at the beginning and end of the year.
By offering insurance products to all sizes of risks, we believe we have hedged against the possibility that there will be a reduction in demand for the products we offer. We believe that we will continue to have opportunities to grow and profit with both traditional and ART customers based on our assumptions regarding future economic and competitive conditions. We generally incur low start-up costs for new businesses, typically less than $500,000 incurred over several quarters. We believe our flexible processes and scalable systems, along with controlled increase of businesses, allow us to manage costs and match them with the revenue flow.
Effective July 1, 2010, we and our principal insurance subsidiary, National Interstate Insurance Company (“NIIC”), completed the acquisition of Vanliner from UniGroup, Inc. (“UniGroup”) whereby NIIC acquired all of the issued and outstanding capital stock of Vanliner and we acquired certain information technology assets. As part of this acquisition, UniGroup agreed to provide us with comprehensive financial guarantees, including a four and a half-year balance sheet guaranty whereby both favorable and unfavorable balance sheet developments inure to UniGroup. Through the acquisition of Vanliner, NIIC acquired VIC, a market leader in providing insurance for the moving and storage industry. Obtaining a presence in this industry was our primary strategic objective associated with the acquisition. VIC’s moving and storage insurance premiums associated with policies in-force totaled approximately $90 million as of December 31, 2010, representing approximately 78% of its total business. Beginning July 1, 2010, the date we completed the acquisition, Vanliner’s results are included as part of our transportation component, with the exception of VIC’s moving and storage group captive program, which is a part of our alternative risk transfer component. Additional disclosures regarding the Vanliner acquisition are contained in Note 3 - “Acquisition of Vanliner Group, Inc.”
The property/casualty (“P/C”) insurance industry is cyclical, with periods of rising premium rates and shortages of underwriting capacity (“hard market”) followed by periods of substantial price competition and excess capacity (“soft market”). Despite experiencing continued soft market conditions during 2010, the P/C insurance industry generated a year-over-year increase in premiums written for the first time since 2007. The industry’s underwriting results were relatively flat during 2010, as a significant increase in the frequency of low-severity catastrophe-related losses was offset by significant favorable development on prior-year loss reserves according to available industry data compiled by A.M. Best through the first nine months of 2010. The industry faces several unfavorable trends in the coming year such as, but not limited to, prolonged recession-driven pricing instability, diminishing savings from prior-year reserve development and the continuance of relatively low investment returns.
Our business model and bottom line orientation have resulted in disciplined and consistent risk assessment and pricing adequacy.
During 2010, interest rates remained low, which increased the value of many of our fixed income holdings. As such, we sold securities, primarily to generate funds for the Vanliner acquisition, which resulted in realized gains from investments. We have historically maintained a high quality investment portfolio, focusing primarily on investment grade fixed income investments. During 2010, we sold securities, primarily U.S government and government agency obligations, to generate funds to finance the acquisition of Vanliner. Subsequent to the acquisition, we experienced a shift in the mix of our fixed maturities portfolio due to reinvesting Vanliner’s acquired cash balances in corporate obligations, as these securities generally offered the mix of yield and duration that best met our business needs. Although we cannot provide any assurances, at December 31, 2010, with over 92% of our investment portfolio comprised of investment grade fixed income, investment grade preferred stock and cash and cash equivalents, we believe we remain properly positioned as we head into 2011.
probable exposure based on our historical claims experience. Our ability to estimate losses and LAE accurately at the time of pricing our contracts is a critical factor in determining our profitability. Vanliner’s losses and LAE are recorded based on the same manner of actuarial analysis and claims reserving practices as our preexisting (legacy) operations. The amount reported under losses and LAE in any period includes payments in the period net of the change in the value of the reserves for unpaid losses and LAE between the beginning and the end of the period.
In conjunction with the completion of the Vanliner acquisition, we recorded a gain on bargain purchase of $7.5 million ($0.38 per share diluted) as of the July 1, 2010 acquisition date. The purchase price of the acquisition was based on Vanliner’s tangible book value. The fair value of the net assets acquired of $124.2 million was in excess of the total purchase consideration of $116.7 million, primarily due to the recognition of certain intangible assets under purchase accounting, an adjustment to record the acquired loss and allocated loss adjustment expense reserves at fair value, as well as recording management’s best estimate of the contingent consideration due from the seller associated with the balance sheet guaranty. A gain on bargain purchase is a nontaxable transaction and therefore has not been tax-effected in the table above or in our Consolidated Statements of Income.
As previously disclosed, the seller provided us with comprehensive financial guarantees related to the runoff of Vanliner’s final balance sheet whereby both favorable and unfavorable balance sheet development inures to the seller. Additionally, as a result of purchase accounting requirements to determine the fair value of the future economic benefit of the financial guarantees and acquired loss reserves, we have recorded our estimate of future development which impacts the gain on bargain purchase, despite the fact that certain gains and losses related to the financial guaranty will be reflected in operations as they are incurred in future periods. As a result, the recognition of the revenues and expenses associated with the guaranteed runoff business will not occur in the same period and will result in combined ratios which are not consistent with the negotiated combined ratio which was to approximate 100% for the Vanliner guaranteed business. As such, the after-tax impact from the runoff business guaranteed by the seller of $2.1 million for 2010 has been removed from the net after-tax earnings from operations to reflect only those results of the ongoing business.
Gross premiums written includes both direct premium and assumed premium. During 2010, our gross premiums written increased $93.8 million, or 27.2%, compared to 2009. Included in this increase is $50.0 million of gross premiums written related to Vanliner, which are included in the transportation component. Excluding
Vanliner’s gross premiums written, the remaining $43.8 million increase is primarily attributable to our alternative risk transfer component, which grew $36.9 million, or 19.1%, over 2009 primarily due to the addition of six new customers to our large account captive product and growth in existing programs. We also started our first group ART program for Vanliner’s moving and storage business in the fourth quarter of 2010. This growth was partially offset by management’s decision to reduce lines of coverage written in one of our other ART programs beginning in the second quarter of 2009. Exclusive of the Vanliner related premiums, the transportation component increased $7.2 million, or 10.8%, which is primarily attributable to our continued focus on marketing efforts, including the appointment of additional production sources. These actions lead to increased business submissions and therefore premium growth. We have placed additional emphasis on seeking out and quoting preferred truck and passenger transportation accounts, all the while continuing to emphasize and maintain our disciplined underwriting approach. Gross premiums written for both our specialty personal lines and Hawaii and Alaska components were relatively flat in 2010 compared to 2009. The growth in our specialty personal lines component slowed during 2010 reflecting the underwriting and pricing actions related to the commercial vehicle product that were initiated during the fourth quarter of 2009, while the Hawaii and Alaska component continued to be impacted by competitive market conditions.
2010 compared to 2009. The following table shows premiums earned for the years ended December 31, 2010 and 2009 summarized by the broader business component description, which were determined based primarily on similar economic characteristics, products and services:
Our premiums earned increased $79.3 million, or 28.4%, to $358.4 million during the year ended December 31, 2010 compared to $279.1 million for the year ended December 31, 2009. Included in this increase was $64.5 million in premiums earned related to Vanliner, which are included in our transportation component. Excluding Vanliner’s premiums earned, the remaining $14.8 million increase is primarily attributable to the alternative risk transfer component which grew $14.3 million, or 10.1%, over 2009 mainly due to the new ART programs introduced throughout 2009 and 2010. Our specialty personal lines component increased $1.4 million, or 2.5%, resulting from the growth in our commercial vehicle product experienced in 2009. These increases were partially offset by a $1.6 million decrease in the Hawaii and Alaska component resulting from reductions in gross premiums written in
Underwriting profitability, as opposed to overall profitability or net earnings, is measured by the combined ratio. The combined ratio is the sum of the loss and LAE ratio and the underwriting expense ratio. A combined ratio under 100% is indicative of an underwriting profit.
The ratio of the sum of commissions and other underwriting expenses, other operating expenses less other income to premiums earned.
2010 compared to 2009. Losses and LAE increased $86.7 million, or 51.0%, for 2010 compared to 2009. The consolidated loss and LAE ratio for the year ended December 31, 2010 increased 10.7 percentage points to 71.5% compared to 60.8% in the same period in 2009, which is several percentage points higher than our historical annual ratio. The loss and LAE ratio for our ongoing operations, which excludes the impact from the runoff of the guaranteed Vanliner business, was 67.5% for the year ended December 31, 2010. This elevated loss and LAE ratio is primarily due to favorable claims results experienced throughout 2009, higher losses experienced in 2010 by our commercial vehicle product, which is part of the specialty personal lines component, and the impact from several periods of single digit rate decreases in our transportation component. Additionally, we experienced higher than expected claims severity among certain of our trucking products in both our alternative risk transfer and transportation components during 2010.
For the year ended December 31, 2010, we had favorable development from prior years’ loss reserves of $9.6 million, or 2.7 percentage points, compared to favorable development of $1.3 million, or 0.5 percentage points, for the same period in 2009. This favorable development was primarily related to settlements below the established case reserves and revisions to our estimated future settlements on an individual case by case basis. The prior years’ loss reserve development for both periods is not considered to be unusual or significant to prior years’ reserves based on the history of our business and the timing of events in the claims adjustment process.
For the years ended December 31, 2009 and 2008, we had favorable development from prior years’ loss reserves of $1.3 million and $0.9 million, respectively. The favorable development for both years was primarily related to settlements below the established case reserves and revisions to our estimated future settlements on an individual case by case basis. This development represents only 0.5% and 0.4% for 2009 and 2008, respectively, of the prior year reserves.
2009 compared to 2008. In 2009, we had pre-tax net realized gains of $2.6 million compared to pre-tax net realized losses of $22.4 million for 2008. Realized gains of $8.2 million for the year ended December 31, 2009 were partially offset by other-than-temporary impairment charges recognized in earnings of $3.9 million and realized losses of $1.7 million on disposals. In 2008, turmoil in the investment markets resulted in market declines in our portfolio, particularly in our financial and real estate related holdings. This had an adverse impact on our investment portfolio in 2008, as we recognized other-than-temporary impairment charges on investments of $20.2 million for the year ended December 31, 2008.
2010 compared to 2009. Commissions and other underwriting expenses for the year ended December 31, 2010 increased $10.4 million, or 18.2%, to $67.6 million from $57.2 million in the comparable period in 2009. The increase is primarily a result of the growth in gross premiums written, along with our mix of business written during 2010 compared to 2009.
2010 compared to 2009. Other operating and general expenses increased $4.1 million, or 31.5%, to $17.2 million during the year ended December 31, 2010 compared to $13.1 million for the same period in 2009. This increase was primarily due to additional expenses associated with the growth in employee headcount, professional fees and other costs incurred primarily as a result of the Vanliner acquisition.
At December 31, 2010, our investment portfolio contained $907.6 million in fixed maturity securities and $30.5 million in equity securities, all carried at fair value with unrealized gains and losses reported as a separate component of shareholders’ equity on an after-tax basis. At December 31, 2010, we had pretax net unrealized gains of $6.4 million on fixed maturities and $3.3 million on equity securities. Our investment portfolio allocation is based on diversification among primarily high quality fixed maturity investments and guidelines in our investment policy.
Included in the fixed maturities at December 31, 2010 were $196.7 million of residential mortgage-backed securities (“MBS”). We do not have a significant exposure to the subprime lending sector as 96.3% of our residential MBS are backed by US government agencies. MBS are subject to prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be prepaid more rapidly than scheduled as buyers refinance higher rate mortgages to take advantage of declining interest rates. Also included in fixed maturities at December 31, 2010 were $270.0 million of state and local government obligations (“muni bonds”). Approximately 95.6% of our muni bonds are rated “A−” or better, giving no effect to credit enhancement, and the average credit quality is “AA.”
Net realized gains (losses) on securities sold and charges for other-than-temporary impairment on securities held were as follows:
We must determine the appropriate level in the fair value hierarchy for each applicable measurement. The fair value hierarchy prioritizes the inputs, which refer broadly to assumptions market participants would use in pricing an asset or liability, into three levels. It gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The level in the fair value hierarchy within which a fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Fair values for our investment portfolio are reviewed by company personnel using data from nationally recognized pricing services as well as non-binding broker quotes on a limited basis.
Level 1 consists of publicly traded equity securities whose fair value is based on quoted prices that are readily and regularly available in an active market. Level 2 primarily consists of financial instruments whose fair value is based on quoted prices in markets that are not active and include U.S. government and government agency securities, fixed maturity investments, perpetual preferred stock and certain publicly traded common stocks and other equity securities that are not actively traded. Included in Level 2 are $5.6 million of securities, which are valued based upon a non-binding broker quote and validated with other observable market data by management. Level 3 consists of financial instruments that are not traded in an active market, whose fair value is estimated by management based on inputs from independent financial institutions, including non-binding broker quotes, which we believe reflect fair value, but are unable to verify inputs to the valuation methodology. We obtained one quote or price per instrument from brokers and pricing services for all Level 3 securities and did not adjust any quotes or prices obtained. Management reviews these broker quotes using any recent trades, if such information is available, or market prices of similar investments. We primarily use the market approach valuation technique for all investments.
with the Vanliner acquisition. The increase in cash used from financing activities in 2009 from 2008 of $48.1 million is primarily attributable to the aforementioned termination of our securities lending program in 2009.
The Credit Agreement requires us to maintain specified financial covenants measured on a quarterly basis, including consolidated net worth, fixed charge coverage ratio and debt-to-capital ratio. In addition, the Credit Agreement contains certain affirmative and negative covenants, including negative covenants that limit or restrict our ability to, among other things, incur additional indebtedness, effect mergers or consolidations, make investments, enter into asset sales, create liens, enter into transactions with affiliates and other restrictions customarily contained in such agreements. As of December 31, 2010, we were in compliance with all financial covenants.
portfolio securities early for liquidity purposes rather than holding them to maturity, we would recognize gains or losses on those securities earlier than anticipated. If we were forced to borrow additional funds under our Credit Agreement in order to meet liquidity needs, we would incur additional interest expense, which could have a negative impact on our earnings. Since our ability to meet our obligations in the long-term (beyond a 12-month period) is dependent upon factors such as market changes, insurance regulatory changes and economic conditions, no assurance can be given that the available net cash flow will be sufficient to meet our operating needs. We are not aware of any trends or uncertainties affecting our liquidity, including any significant future reliance on short-term financing arrangements.
Off-Balance Sheet Items. We do not have any off-balance sheet arrangements as such term is defined in applicable SEC rules.
extrapolation. The estimated cumulative unfavorable impact that this 1% change would have on our 2010 net income is shown below:
A significant portion of our workers’ compensation business is written in California. Significant reforms passed by the California state legislature in 2003 and in 2004 reduced employer premiums and set treatment standards for injured workers. However, recent judicial decisions are moderating the benefits of these reforms. We recorded favorable prior year loss development of $3.3 million in 2010, whereas we recorded unfavorable prior year loss development of $2.3 million in 2009. In 2008, we recorded favorable prior year loss development of $0.5 million primarily due to the impact of the legislation on medical claim costs being more favorable than previously anticipated.
The changes we have recorded in our reserves in the past three years illustrate the potential for revisions inherent in estimating reserves. In 2010, we experienced favorable development of $9.6 million (1.6% of total net
reserves) from claims incurred prior to 2010. In 2009, we experienced favorable development of $1.3 million (0.5% of total net reserves) from claims incurred prior to 2009. In 2008, we experienced favorable development of $0.9 million (0.4% of total net reserves) from claims incurred prior to 2008. We did not significantly change our reserving methodology or our claims settlement process in any of these years. The development reflected settlements that differed from the established case reserves, changes in the case reserves based on new information for that specific claim or the differences in the timing of actual settlements compared to the payout patterns assumed in our accident year IBNR reductions. The types of coverages we offer and risk levels we retain have a direct influence on the development of claims. Specifically, short duration claims and lower risk retention levels generally are more predictable and normally have less development. Future favorable or unfavorable development of reserves from this past development experience should not be assumed or estimated. The reserves reported in the financial statements are our best estimate.
Under current other-than-temporary impairment accounting guidance, if management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then an entity may separate the other-than-temporary impairments into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive income (loss)). The credit related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are required to be shown in the Consolidated Statements of Income. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge is required to reduce the amortized cost of that security to fair value. Additional disclosures required by this guidance are contained in Note 5 - “Investments.”
On July 1, 2010, the Company completed the acquisition of Vanliner Group, Inc. As permitted by the Securities and Exchange Commission, management excluded the Vanliner operations from its assessment of internal control over financial reporting as of December 31, 2010. Vanliner operations constituted approximately 17.5% of revenues for the year ended December 31, 2010 and approximately 36.6% of total assets at December 31, 2010. Vanliner operations will be included in the Company’s assessment as of December 31, 2011. Refer to Note 3 to the consolidated financial statements for further discussion of this acquisition.
We have audited National Interstate Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). National Interstate Corporation and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
As indicated in the accompanying Management’s Report on Internal Control over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Vanliner Group, Inc., which is included in the 2010 consolidated financial statements of National Interstate Corporation and subsidiaries and constituted $545.1 million and $122.4 million of total and net assets, respectively, as of December 31, 2010 and $69.7 million and $2.0 million of revenues and net income, respectively, for the year then ended. Our audit of internal control over financial reporting of National Interstate Corporation and subsidiaries also did not include an evaluation of the internal control over financial reporting of Vanliner Group, Inc.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of National Interstate Corporation and subsidiaries as of December 31, 2010 and 2009 and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2010 of National Interstate Corporation and subsidiaries and our report dated March 8, 2011 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheets of National Interstate Corporation and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2010. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Interstate Corporation and subsidiaries at December 31, 2010 and 2009, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed in Note 2 to the consolidated financial statements, in 2009 the Company changed its method of accounting for recognizing other-than-temporary impairment charges for its debt securities in connection with the adoption of the revised Financial Accounting Standards Board’s other-than-temporary impairment model.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), National Interstate Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 8, 2011 expressed an unqualified opinion thereon.
National Interstate Corporation (the “Company”) and its subsidiaries operate as an insurance holding company group that underwrites and sells traditional and alternative risk transfer property and casualty insurance products primarily to the passenger transportation industry and the trucking industry, general commercial insurance to small businesses in Hawaii and Alaska and personal insurance to owners of recreational vehicles and commercial vehicles throughout the United States. Effective July 1, 2010, with the acquisition of Vanliner Insurance Company (“VIC”), the Company also now underwrites and sells insurance products for moving and storage transportation companies.
With the acquisition of Vanliner Group, Inc. (“Vanliner”), the Company has five property and casualty insurance subsidiaries, National Interstate Insurance Company (“NIIC”), VIC, National Interstate Insurance Company of Hawaii, Inc. (“NIIC-HI”), Triumphe Casualty Company (“TCC”), Hudson Indemnity, Ltd. (“HIL”) and six active agency and service subsidiaries. The Company writes its insurance policies on a direct basis through NIIC, VIC, NIIC-HI and TCC. NIIC and VIC are licensed in all 50 states and the District of Columbia. NIIC-HI is licensed in Ohio, Hawaii, Michigan and New Jersey. TCC, a Pennsylvania domiciled company, holds licenses for multiple lines of authority, including auto-related lines, in 25 states and the District of Columbia. HIL is domiciled in the Cayman Islands and provides reinsurance for NIIC, VIC, NIIC-HI and TCC primarily for the Company’s alternative risk transfer product. Insurance products are marketed through multiple distribution channels including, independent agents and brokers, program administrators, affiliated agencies and agent internet initiatives. The Company uses its six active agency and service subsidiaries to sell and service the Company’s insurance business. Approximately 13.0% of the Company’s premiums are written in the state of California, and an additional 42.2%, collectively, in the states of Texas, New York, Massachusetts, Florida, North Carolina, Missouri, Hawaii and Pennsylvania.
The consolidated financial statements include the accounts of the Company and its subsidiaries, NIIC, VIC, NIIC-HI, HIL, TCC, Hudson Management Group, Ltd., Vanliner, Vanliner Reinsurance Limited, National Interstate Insurance Agency, Inc. (“NIIA”), American Highways Insurance Agency, Inc., TransProtection Service Company, Safety, Claims and Litigation Services, Inc., Explorer RV Insurance Agency, Inc. and Safety, Claims and Litigation Services, LLC. Significant intercompany transactions have been eliminated.
The Company has accounted for the acquisition of Vanliner in accordance with Accounting Standard Codification (“ASC”) 805, Business Combinations, and the purchase price has been allocated to the assets acquired and liabilities assumed based on their fair value at the acquisition date. See Note 3 - “Acquisition of Vanliner Group, Inc.” for additional discussion regarding the acquisition and the related financial disclosures. The Consolidated Financial Statements as of and for the year ended December 31, 2010 and the Notes to Consolidated Financial Statements reflect the consolidated results of the Company and Vanliner commencing on July 1, 2010.
The Company considers all highly liquid investments with a maturity date of three months or less at the date of acquisition to be cash equivalents.
In April 2009, the Company adopted new accounting guidance relating to the recognition and presentation of other-than-temporary impairments. Under the guidance, if management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then an entity may separate the other-than-temporary impairment into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive income (loss)). The credit related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge is required to reduce the amortized cost of that security to fair value. Additional disclosures required by this guidance are contained in Note 5 - “Investments.”
consideration for anticipated investment income and are charged to operations ratably over the terms of the related policies. The Company accelerates the amortization of these costs for premium deficiencies. The amount of deferred policy acquisition costs amortized during the years ended December 31, 2010, 2009 and 2008 were $58.9 million, $49.1 million and $54.3 million, respectively. There were no premium deficiencies for the years ended December 31, 2010, 2009 and 2008.
The liabilities for unpaid losses and LAE are determined on the basis of estimates of policy claims reported and estimates of unreported claims based on historical and industry data. The estimates of policy claim amounts are continuously reviewed and any resulting adjustments are reflected in operations currently. Although considerable variability is inherent in such estimates, management believes that the liabilities for unpaid losses and LAE are adequate. These liabilities are reported net of amounts recoverable from salvage and subrogation.
The Company offers a range of products and services, but operates as one reportable property and casualty insurance segment.
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the periods in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided if it is more likely than not that some or all of the deferred tax assets will not be realized. Management evaluates the realizability of the deferred tax assets and assesses the need for a valuation allowance quarterly.
The Company grants stock options to officers under the Long Term Incentive Plan (“LTIP”). The LTIP and stock-based compensation are more fully described in Note 8 - “Shareholders’ Equity and Stock-Based Compensation.” The Company uses the Black-Scholes pricing model to measure the fair value of employee stock options. Awards issued prior to the initial public offering were valued for disclosure purposes using the minimum value method. No compensation cost will be recognized for future vesting of these awards.
In January 2010, the FASB issued ASU No. 2010-06, Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends ASC 820, Fair Value Measurements and Disclosures and requires expanded disclosures around significant transfers between levels of the fair value hierarchy and valuation techniques and inputs used in fair value measurements. ASU 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2009. The Company adopted the expanded disclosures required by ASU 2010-06 effective January 1, 2010.
fair value measurement period to be closed as of December 31, 2010, as all information necessary to identify and measure the fair value of all aspects of the business combination has been made available to and obtained by the Company.
The additional future consideration is based on a calculation where the inputs were agreed upon during negotiations and relate to future interest earnings on investments held related to unearned premium on policies in-force on the date of acquisition. There is not expected to be significant variability in this schedule of payments and these payments are not contingent on the results of Vanliner during the period in which these payments will be made. In February 2011, NIIC received $14.3 million from UniGroup for the amounts due under the purchase agreement for the 338(h)(10) election and finalization of the tangible book value.
The gain on bargain purchase of $7.5 million shown in the table above has been recognized as a separate component of revenues in the Company’s Consolidated Statements of Income for the year ended December 31, 2010. Because the purchase price of the acquisition was based on Vanliner’s tangible book value at June 30, 2010 and as certain financial guarantees were included in the agreement, the Company anticipated no goodwill would be recognized after recording the fair value of Vanliner’s assets acquired and liabilities assumed. Accordingly, the fair value of net assets acquired was in excess of the total purchase consideration resulting in the gain on bargain purchase, primarily due to the Company recognizing intangible assets under purchase accounting, adjustments to decrease the fair value of the acquired loss and allocated loss adjustment expense reserves based on management’s best estimate of Vanliner’s reserves as of the acquisition date, as well as recording management’s best estimate of the contingent consideration due from UniGroup associated with the balance sheet guaranty. The gain on bargain purchase was not impacted by the 338(h)(10) election, as the $8.4 million compensation from UniGroup reduced both the purchase price and fair value of net assets acquired by $8.4 million. All changes during the fair value measurement period related to the provisional $0.6 million gain on bargain purchase previously reported in our September 30, Form 10-Q, are required to be retrospectively adjusted as of the acquisition date under purchase accounting. Accordingly, the entire $7.5 million gain on bargain purchase is reflected in operating results for the third quarter of 2010 as disclosed in the Company’s Quarterly Operating Results footnote. The Company has taken certain actions and incurred certain costs associated with the transaction, totaling approximately $1.0 million which are reflected in “Other operating and general expenses” in the Company’s Consolidated Statements of Income for the year ended December 31, 2010.
The valuation of loss and LAE reserves acquired was determined using actuarial cash flow models and payment assumptions rather than an observable market price since a liquid market for such underwriting liabilities does not exist. The valuation model used an estimate of future cash flows related to liabilities for losses and LAE that a market participant would expect to incur as of the date of the acquisition. These future cash flows were adjusted for the time value of money at a risk free rate and a risk margin to compensate an acquiror for bearing the risk associated with the liabilities that exist outside of the financial guarantees from UniGroup. As a result of these analyses, a fair value adjustment of $6.1 million was made to loss and LAE reserves, of which $1.2 million will be amortized over the expected loss and LAE payout pattern and reflected as a component of loss and LAE. The Company amortized $0.2 million for the twelve months ended December 31, 2010.
The following selected financial information summarizes the results of Vanliner from July 1, 2010 that have been included within the Company’s Consolidated Statements of Income (in thousands):
The following unaudited pro forma financial information has been provided to present a summary of the combined results of the Company’s operations with Vanliner’s as if the acquisition had occurred on January 1, 2009. The unaudited pro forma financial information is for informational purposes only and is not necessarily indicative of what the results would have been had the acquisition been completed at the date indicated above. Future changes to the current book of business which have not been contemplated in this unaudited pro forma financial information, such as, but not limited to, the decision to discontinue an insurance product offering, the impact from underwriting decisions, or a change in risk selection or retention rates, could result in a material favorable or unfavorable impact on the Company’s future results of operations and financial position. Additionally, the gain on bargain purchase has not been included in the unaudited pro forma financial information due to its non-recurring nature.
The Company must determine the appropriate level in the fair value hierarchy for each applicable measurement. The fair value hierarchy prioritizes the inputs, which refer broadly to assumptions market participants would use in pricing an asset or liability, into three levels. It gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The level in the fair value hierarchy within which a fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Fair values for the Company’s investment portfolio are reviewed by company personnel using data from nationally recognized pricing services as well as non-binding broker quotes on a limited basis.
Pricing services use a variety of observable inputs to estimate the fair value of fixed maturities that do not trade on a daily basis. These inputs include, but are not limited to, recent reported trades, benchmark yields, issuer spreads, bids or offers, reference data and measures of volatility. Included in the pricing of mortgage-backed securities are estimates of the rate of future prepayments and defaults of principal over the remaining life of the underlying collateral. Inputs from brokers and independent financial institutions include, but are not limited to, yields or spreads of comparable investments which have recent trading activity, credit quality, duration, credit enhancements, collateral value and estimated cash flows based on inputs including, delinquency rates, estimated defaults and losses, and estimates of the rate of future prepayments. Valuation techniques utilized by pricing services and values obtained from brokers and independent financial institutions are reviewed by company personnel who are familiar with the securities being priced and the markets in which they trade to ensure that the fair value determination is representative of an exit price, as defined by accounting standards.
The following table presents the Company’s investment portfolio, categorized by the level within the fair value hierarchy in which the fair value measurements fall as of December 31, 2010:
These amounts are attributable to either principal pay downs, calls or maturities during the year ended December 31, 2010.
The following table presents a reconciliation of the beginning and ending balances for all investments measured at fair value on a recurring basis using Level 3 inputs for the year ended December 31, 2009:
These amounts are attributable to either purchases of securities, principal pay downs, conversions or maturities during the year ended December 31, 2009.
Transfers in and/or (out) of Level 3 relate to the termination of the securities lending program and moving longer-term assets into the investment portfolio during year ended December 31, 2009.
Gains and losses on the sale of these investments, including other-than-temporary impairment charges, were as follows:
Pre-tax net realized gains of $4.3 million during 2010 were primarily generated from net realized gains associated with the sales of securities of $3.6 million and gains associated with an equity partnership investment of $1.6 million. The gains on equity and fixed maturity securities were primarily due to favorable market conditions that increased the value of the securities over book value and include gains from sales to generate funds for the Vanliner acquisition. Offsetting these gains were losses associated with an equity partnership of $0.5 million, other-than-temporary impairment charges of $0.3 million and realized losses of $0.1 million from the sales of fixed maturity securities. The other-than-temporary impairment charge of $0.3 million is primarily due to a $0.2 million charge on one corporate bond that had a decrease in market value below book value and, due to the uncertainty of ultimate recovery, the entire impairment was recorded as a credit loss and a $0.1 million charge that was recorded on a mortgage-backed security, for which a previous impairment charge had been recorded.
Pre-tax net realized gains on investments of $2.6 million during 2009 were primarily generated from gains on an equity partnership of $4.7 million, realized gains from the sales of equity securities of $1.1 million and realized gains from the sales or calls of fixed maturity securities of $2.9 million. The gains on equity and fixed maturity securities were primarily due to favorable market conditions that increased the value of the securities over book value and the Company sold these securities to realize gains. These gains were offset by realized losses of $0.5 million from the sales of fixed maturity securities and $1.7 million on equity securities, primarily from a $1.0 million realized loss on the conversion of a perpetual preferred stock to common stock on a financial institution holding and a $0.5 million loss on an equity partnership. Gross gains were also offset by other-than-temporary impairment charges of $3.7 million on fixed maturity securities, including securities lending, and $0.2 million on equity securities. The other-than-temporary impairment charge on fixed maturities primarily consists of $1.8 million on three corporate notes that experienced credit issues that, in the Company’s estimation, made full recovery of the cost of these investments unlikely and credit only impairments of $1.9 million on four mortgage-backed securities. The mortgage-backed securities were written down to the present value of the expected cash flows and a
The Company has a $50 million unsecured Credit Agreement (the “Credit Agreement”) that terminates in December 2012, which includes a sublimit of $10 million for letters of credit. The Company has the ability to increase the line of credit to $75 million subject to the Credit Agreement’s accordion feature. Amounts borrowed bear interest at either (1) a rate per annum equal to the greater of the administrative agent’s prime rate or 0.5% in excess of the federal funds effective rate or (2) rates ranging from 0.45% to 0.90% over LIBOR based on the Company’s A.M. Best insurance group rating, or 0.65% at December 31, 2010. Commitment fees on the average daily unused portion of the Credit Agreement also vary with the Company’s A.M. Best insurance group rating and range from 0.090% to 0.175%, or 0.125% at December 31, 2010.
During the year ended December 31, 2010, the Company drew $31.5 million from this credit facility, primarily to help fund the purchase of Vanliner. During the third quarter of 2010, the Company used available cash to pay down this credit facility by $26.5 million. As of December 31, 2010, the interest rate under this Credit Agreement is equal to the six-month LIBOR (0.4375% at December 31, 2010) plus 65 basis points, with interest payments due quarterly.
The Credit Agreement requires the Company to maintain specified financial covenants measured on a quarterly basis, including consolidated net worth, fixed charge coverage ratio and debt to capital ratio. In addition, the Credit Agreement contains certain affirmative and negative covenants, including negative covenants that limit or restrict the Company’s ability to, among other things, incur additional indebtedness, effect mergers or consolidations, make investments, enter into asset sales, create liens, enter into transactions with affiliates and other restrictions customarily contained in such agreements. As of December 31, 2010, the Company was in compliance with all financial covenants.
Interest paid on long-term debt during the years ended December 31, 2010, 2009 and 2008 was $0.3 million, $0.4 million and $0.9 million, respectively.
Federal income taxes paid, net of refunds, for 2010, 2009 and 2008 were $17.0 million, $20.1 million and $17.9 million. At December 31, 2010 and 2009, income taxes payable were $8.7 million and $0.3 million, respectively.
Management has reviewed the recoverability of the deferred tax assets and believes that the amount will be recoverable against future earnings. The gross deferred tax assets were reduced by a valuation allowance related to net realized losses on investments of $0.8 million for December 31, 2009, primarily related to impairment charges. There was no such valuation allowance related to net realized losses on investments subsequent to March 31, 2010.
The Company had no liability recorded for unrecognized tax benefits at December 31, 2010 and 2009. In addition, the Company has not accrued for interest and penalties related to unrecognized tax benefits. However, if interest and penalties would need to be accrued related to unrecognized tax benefits, such amounts would be recognized as a component of the provision for federal income taxes.
method of calculating expected term for all grants made in 2010, 2009 and 2008. The fair value of options granted was computed using the following weighted-average assumptions as of grant date:
At December 31, 2010, the aggregate intrinsic value of options outstanding was $1.7 million. At December 31, 2009, the options outstanding had no aggregate intrinsic value and at December 31, 2008 the aggregate intrinsic value of options outstanding was $42 thousand. The aggregate intrinsic value of all options that were exercisable at December 31, 2010, 2009 and 2008 was $1.9 million, $0.6 million and $0.7 million, respectively. The intrinsic value of options exercised during the year ended December 31, 2010 was $0.3 million. There were no options exercised in 2009. The intrinsic value of options exercised during the year ended December 31, 2008 was $1.4 million. The total fair value of shares vested during the year ended December 31, 2010, 2009, and 2008 was $1.0 million, $0.9 million and $0.7 million, respectively.
The Savings Plan also provides for tax-deferred contributions by employees. Participants may elect to have their funds (savings contributions and allocated profit sharing distributions) invested in their choice of a variety of investment vehicles offered by an unaffiliated investment manager. The Savings Plan does not provide for employer matching of participant contributions. The Company does not provide other postretirement and postemployment benefits. Effective August 2007, participants in the Plan can now choose to invest in the Company’s common shares as an investment option.
The Company’s principal insurance subsidiary, NIIC, is involved in both the cession and assumption of reinsurance. NIIC is a party to a reinsurance agreement, and NIIA, a wholly-owned subsidiary of the Company, is a party to an underwriting management agreement with Great American. As of December 31, 2010, Great American owned 52.5% of the outstanding shares of the Company. The reinsurance agreement calls for the assumption by NIIC of all of the risk on Great American’s net premiums written for public transportation and recreational vehicle risks underwritten pursuant to the reinsurance agreement. NIIA provides administrative services to Great American in connection with Great American’s underwriting of these risks. The Company also cedes premium through reinsurance agreements with Great American to reduce exposure in certain of its property and casualty insurance programs.
The Company invests funds in the participant loss layer for several of the alternative risk transfer programs. The Company receives investment income and incurs an equal expense on the amounts owed to alternative risk transfer participants. “Expense on amounts withheld” represents investment income that we remit back to alternative risk transfer participants. The related investment income is included in the Company’s “Net investment income” line on its Consolidated Statements of Income.
For the years ended December 31, 2010, 2009 and 2008 balances related to alternative risk transfer programs were as follows:
Includes the statutory net income of VIC for 2010 only, as the Company’s acquisition of VIC was effective on July 1, 2010. The statutory net income of VIC represents the income for the entire statutory annual period. The Company’s consolidated net income, on a GAAP basis, includes the earnings of VIC since the July 1, 2010. See Note 3 - “Acquisition of Vanliner Group, Inc.” for additional information.
The Company’s subsidiaries also have lawsuits pending in which the plaintiff seeks extra-contractual damages from the Company in addition to damages claimed or in excess of the available limits under an insurance policy. These lawsuits, which are in various stages, generally mirror similar lawsuits filed against other carriers in the industry. Although the Company is vigorously defending these lawsuits, the outcomes of these cases cannot be determined at this time. The Company has established loss and loss adjustment expense reserves for lawsuits as to which the Company has determined that a loss is both probable and estimable. In addition to these case reserves, the Company also establishes reserves for claims incurred but not reported to cover unknown exposures and adverse development on known exposures. Based on currently available information, the Company believes that reserves for these lawsuits are reasonable and that the amounts reserved did not have a material effect on the Company’s financial condition or results of operations. However, if any one or more of these cases results in a judgment against or settlement by the Company for an amount that is significantly greater than the amount so reserved, the resulting liability could have a material effect on the Company’s financial condition, cash flows and results of operations.
The Company operates its business as one segment, property and casualty insurance. The Company manages this segment through a product management structure. The following table shows revenues summarized by the broader business component description, which were determined based primarily on similar economic
characteristics, products and services. VIC’s premiums earned are included in the table below as part of the Company’s transportation component for the year ended December 31, 2010.
Amounts shown in the table above for the 2010 third quarter, fourth quarter and full year include the results of operations for Vanliner from the July 1, 2010 date of acquisition through December 31, 2010. Additionally, the purchase accounting adjustments made within the fair value measurement period during the 2010 fourth quarter affected the provisional gain on bargain purchase of Vanliner and are reflected above in the results of operations for the 2010 third quarter, as the Company is required to retrospectively adjust such amounts as of the acquisition date in accordance with ASC 805. As such, the 2010 third quarter amounts shown above include the full $7.5 million gain on bargain purchase of Vanliner and differ from those originally reported in our September 30, Form 10-Q. See Note 3 - “Acquisition of Vanliner Group, Inc.” for additional information.