The ratio of losses and loss expenses to premiums earned, net of the effects of reinsurance.
We evaluate our insurance operations by monitoring key measures of growth and profitability. The following provides further explanation of the key GAAP measures that we use to evaluate our results:
For other fixed-maturity and equity securities, an other-than-temporary impairment charge is taken when the Company does not have the ability and intent to hold the security until the forecasted recovery or if it is no longer probable that the Company will recover all amounts due under the contractual terms of the security. Many criteria are considered during this process including, but not limited to, the current fair value as compared to amortized cost or cost, as appropriate, of the security; the amount and length of time a security’s fair value has been below amortized cost or cost; specific credit issues and financial prospects related to the issuer; the Company’s intent to hold or dispose of the security; and current economic conditions. Other-than-temporary impairment losses result in a permanent reduction to the cost basis of the underlying investment.
Additionally, for certain securitized financial assets with contractual cash flows (including asset-backed securities), FASB Emerging Task Force (EITF) 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets”, requires us to periodically update our best estimate of cash flows over the life of the security. If management determines that the fair value of a securitized financial asset is less than its carrying amount and there has been a decrease in the present value of the estimated cash flows since the last revised estimate, considering both timing and amount, then an other -than-temporary impairment is recognized.
For additional detail regarding our investment portfolio at December 31, 2005 and 2004, including disclosures regarding other-than-temporary declines in investment value, see “Investment Portfolio” below and Note 2 to our audited consolidated financial statements, both included in this report.
operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established when necessary to reduce the deferred tax assets to the amounts more likely than not to be realized. See Note 9 to our audited consolidated financial statements included in this report.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. We reported net income of $10.2 million for the year ended December 31, 2005 compared to net income of $15.0 million for the same period in 2004. Included in the net income for 2005 is $5.4 million of after tax losses related to the 2005 fall hurricane season. Prior to 2005, hurricane losses have not had a significant impact to net income. Without the impact of the hurricanes, net income would have increased over 2004 as a direct result of our 19.4% growth in our net premiums earned and an increase in our investment income.
More specifically, our net premiums earned increased to $177.6 million in 2005 from $148.7 million in 2004. Included in this increase is growth in our gross written premium from our casualty segment of 17.0% and 0.9% from our property segment. Our casualty business continues to grow profitably with stable rates and a current accident year loss and loss expense ratio of 57.3%. The property market in general did not perform as well as the casualty market given the downward pricing pressure from standard carriers that began in 2004 and continued into 2005. Despite this tighter market, we were still able to grow while only slightly decreasing our average rate. Our current year loss and loss expense ratio for the property business was 77.8%, which included 14.8% related to the 2005 fall hurricane season.
The combined ratio increased to 99.2% in 2005 from 91.8% in 2004. Our loss and loss expense ratio increased 6.7% primarily as a result of the current year hurricane losses and the slight premium rate decrease that resulted late in 2004 and into the first half of 2005. In addition, included in our loss and loss expenses is $5.4 million in incurred amounts related to prior accident years compared to $11.1 million in 2004. Our expense ratio increased 0.7% in 2005 from 31.9% in 2004 to 32.6% at the end of 2005. This increase is a direct result of our efforts in our first year of required compliance with Sarbanes Oxley Section 404.
Our combined ratio also improved from 109.0% in 2003 to 91.8% in 2004. The primary reason for the combined ratio improvement was the decrease in amount of re-estimation of prior accident years’ loss and loss expense reserves that negatively impacted our pre-tax results by $27.0 million in 2003 compared to $11.1 million in 2004 offset by an increase in the current accident year loss and loss expenses. As of December 31, 2004, our current accident year loss and loss expense ratios for accident years 2004 and 2003 were 52.5% and 49.8%, respectively, and reflect the overall rate declines experienced in 2004. The overall expense ratio declined from 34.2% in 2003 to 31.9% in 2004. This decrease in expense ratio is directly attributable to the Company’s cost containment efforts that began in the fourth quarter of 2003.
Our property/casualty segment primarily includes general liability, commercial property and multi-peril insurance for small and mid-sized businesses. The other (including exited lines) segment primarily includes our surety business, including landfill and specialty surety that is written in order to maintain Century’s U.S. Treasury listing, workers’ compensation, which was exited in January 2002, and commercial auto/trucking, which was exited in May 2000.
The ratio of net written premiums (including discontinued operations) to our insurance subsidiaries’ combined statutory surplus. This ratio is not restated to exclude discontinued operations as the insurance subsidiaries’ combined statutory surplus is not allocated by line of business. Therefore, in computing the ratio of net written premiums to our insurance subsidiaries’ combined statutory surplus we did not restate the net written premium for discontinued operations to be consistent with that of the subsidiaries’ combined statutory surplus. Management believes this measure is useful in gauging our exposure to pricing errors in the current book of business. It may not be comparable to the definition of net writings ratio used by other companies.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Gross written premiums increased $24.8 million or 12.9% for the year ended December 31, 2005 compared to the same period in 2004. This increase was due primarily to increased business in our property/casualty segment which increased $21.5 million or 11.3%. The growth in the property/casualty segment resulted principally from an increase in volume in our casualty lines of business of $20.9 million or 17.0%. Our property lines of business increased slightly to $68.2 million in 2005 compared to $67.5 million in 2004. For casualty business, rates increased slightly during 2005.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Gross written premiums increased $41.7 million or 27.9% for the year ended December 31, 2004 compared to the same period in 2003. This increase was due primarily to increased business in our property/casualty segment which increased $39.7 million or 26.3%. The growth in the property/casualty segment resulted principally from an increase in volume in our casualty lines of business of $39.3 million or 46.9%. Our property lines of business remained constant at $67.5 million in 2004 compared to $67.2 million in 2003 due to a rate plateau followed by a
moderate decline that continued throughout much of the year. For casualty business, rates slightly increased throughout 2003 and stabilized in 2004.
In addition, during 2003, we made significant improvements in the collections of premiums in the course of collection. These improvements include hiring additional staff, weekly monitoring of account aging and improved communication with our agents. Due to these improvements we significantly lowered our aged amount, which allowed us to maintain a lower provision for uncollectible accounts despite higher amounts of gross receivables.
We evaluate the collectibility of our agents’ balances both individually and on an aggregate basis. In the event that we determine that an individual agent balance is in question, we will record a provision in part or in whole for that agent’s balance. On an aggregate basis, we evaluate historical write-offs and premium growth rates to determine a general allowance.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Net investment income increased to $14.5 million for the year ended December 31, 2005, compared to $10.0 million for the same period in 2004. The increase was the result of higher investments and cash balances, as well as higher investment yields. Due to an increase in our operating cash flows, the investment portfolio and cash increased to $366.4 million as of December 31, 2005, which is an increase of $51.4 million from December 31, 2004. Our average investment yield for 2005 was 4.6%, compared to 4.1% for the same period in 2004. On a tax equivalent yield basis, our yield increased to 5.2% in 2005 compared to 4.8% in 2004.
supplemented by a slight increase in investment yields. Investments and cash increased 82.5% to $312.4 million as of December 31, 2004 from $171.2 million as of December 31, 2003 as a direct result of the proceeds from the IPO and an increase in our operating cash flows. Our average investment yield for 2004 was 4.1%, compared to 4.0% for the same period in 2003.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. We realized net gains of $50,000 on the sale of securities for the year ended December 31, 2004 and $1.9 million for the same period in 2003. These gains included a realized loss of $87,000 related to adjustments for other-than-temporary impairment of securities for the year ended December 31, 2003 and no impairment losses in 2004.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Net loss and loss expenses increased to $118.3 million for the year ended December 31, 2005 compared to $89.1 for the year ended December 31, 2004, as discussed in more detail below. Net loss and loss expense ratios were 66.6% and 59.9% for the years ended December 31, 2005 and 2004, respectively.
Our reserve for losses and loss expenses (net of the effects of reinsurance) at December 31, 2005 by line was as follows:
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Net loss and loss expenses increased to $89.1 million for the year ended December 31, 2004 from $81.0 million for the same
During 2004, as a result of court decisions that further defined the legal environment in California, the Company decided to enhance its defense strategy in for certain types of construction defect claims. As a result, the Company revised the construction defect defense team by retaining appellate and new trial counsel and restaffing the in-house team responsible for management of the litigation. Once the new legal teams were established late in 2004 and into 2005, it was determined that there were certain cases that should be settled and the defense budgets for the remaining cases had to be revised to reflect the added resources, resulting in higher than expected loss and defense costs in 2005.
During 2004, the Company’s newly reported construction defect claims were 36.9% greater than expected as of December 31, 2003. Based on the Company’s experience during 2004 and industry information, the Company substantially increased its projected ultimate construction defect claim count as of December 31, 2004.
Of our construction defects net loss and loss expense reserves at December 31, 2004, 61.0% was for incurred but not reported losses (which are referred to as IBNR), and 52.5% of our construction defect net loss and loss expense reserves at December 31, 2003 was for IBNR. As of December 31, 2004, we had 566 open claims relating to construction defects, compared to 597 open claims as of December 31, 2003. During 2004, 986 new claims were reported and 1,017 existing claims were settled or dismissed. Our net loss and loss expense reserves for construction defects as of December 31, 2004 were $19.0 million. The re-estimation of construction defect reserves primarily affected the 1996 and 1997 accident years and the 1999 to 2001 accident years.
range of loss and loss expense reserve estimates. From these estimates, the actuaries form a best estimate which considers the assumptions and factors that influence ultimate claim costs, including but not limited to those identified above. As of December 31, 2005, for casualty lines, other than construction defect claims, the low end of the range of techniques was 11.6% below the actuarial best estimate, and the high end of the range of techniques was 1.0% above the actuarial best estimate. These low and high loss and loss expense reserve estimates reflect the fact that the methodologies applied do not produce identical estimates, and these estimates do not constitute the range of all possible outcomes. It is important to note that actual claim costs will vary from the selected estimate, perhaps by substantial amounts, due to the inherent variability of the business written, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated at this time.
As of December 31, 2005, the projected loss and loss expense ratios, after the effects of reinsurance, for the property lines were 77.8%, 54.5% and 47.7% for accident periods 2005, 2004 and 2003, respectively. Included in the 2005 accident year property loss ratio is 14.8% related to the 2005 fall hurricane season.
We began writing commercial automobile/trucking coverage for commercial vehicles and trucks in 1997. In 2000, we exited the commercial automobile line of business due to unsatisfactory underwriting results. At December 31, 2005 and 2004, all of our net loss and loss expense reserves related to commercial automobile
was for case reserves. As of December 31, 2005, we had 21 open claims relating to commercial automobile, compared to 38 open claims as of December 31, 2004. During 2005, two new claims were reported and 19 existing claims were settled or dismissed. Our net loss and loss expense reserves for commercial automobile as of December 31, 2005 were $936,000.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004. Operating expenses increased to $59.9 million for the year ended December 31, 2005 from $49.4 million for the comparable period in 2004. The majority of the increase was due $9.1 million in additional amortization of deferred policy acquisition costs that is a direct result of the growth in our overall book of business. In addition, included in
the ADAC expense for 2004 was an offset of $655,000 of reductions to amortization expense that related to the termination of an inter-company pooling agreement and the implementation of the loss portfolio transfers that occurred on January 1, 2004.
Other operating expenses also increased by 7.3% as a direct result of our first year of expenses related to compliance with Sarbanes Oxley Section 404. In addition, interest expense increased from $1.5 million in 2004 to $1.9 million in 2005. This increase is a direct result of the increase in interest rates on our long-term debt.
In addition, in 2004, we incurred $518,000 of interest expense related to the redemption of our outstanding Class B shares immediately prior to the IPO.
ProCentury is a holding company, the principal asset of which is the common shares of Century. Although we have the capacity to generate cash through loans from banks and issuances of equity securities, our primary source of funds to meet our short-term liquidity needs, including the payment of dividends to our shareholders and corporate expenses, is dividends from Century. Century’s principal sources of funds are underwriting operations, investment income and proceeds from sales and maturities of investments. Century’s primary use of funds is to pay claims and operating expenses, to purchase investments and to make dividend payments to us. ProCentury’s future liquidity is dependent on the ability of Century to pay dividends.
Year ended December 31, 2005 compared to Year ended December 31, 2004
Consolidated net cash provided by operating activities was $81.0 million for the year ended December 31, 2004, compared to $34.3 million for the year ended December 31, 2003. This increase was primarily attributable to the increase in our total premium and investment income growth and payments received from Evergreen and Continental related to the settlement of the termination of the intercompany pooling agreement and the loss portfolio transfers during 2004.
Interest on our debt issued to a related party trust is variable and resets quarterly based on a spread over three-month London Interbank Offered Rates (“LIBOR”). As part of our asset/liability matching program, we have short-term investments, investments in bond mutual funds, as well as available cash balances from
The timing for payment of our estimated losses, net of the effects of reinsurance is determined by periods based on our historical claims payment experience. Due to the uncertainty in estimating the timing of such payments, there is a risk that the amounts paid in any period can be significantly different than the amounts disclosed above.
Given our historical cash flow, we believe cash flow from operating activities in 2006 will provide sufficient liquidity for our operations, as well as to satisfy debt service obligations and to pay other operating expenses. Although we anticipate that we will be able to meet our cash requirements, we can give no assurance in this regard.
At December 31, 2005, our fixed-maturity portfolio of $303.8 million represented 82.9% of the carrying value of our total of cash and investments. Standard & Poor’s Rating Services (“Standard & Poor’s”) or Moody’s Investors Service, Inc. (“Moody’s”) rated 89.3% of these securities “A” or better. Equity securities, which consist of preferred and common shares and bond mutual funds, totaled $44.8 million or 12.2% of total cash and investments. The following is a summary of the credit quality of the fixed-maturity portfolio at December 31, 2005:
The estimated fair value, related gross unrealized losses, and the length of time that the securities have been impaired for available-for-sale securities that are considered temporarily impaired are as follows.
At December 31, 2005, the Company had 104 fixed income securities and 10 equity securities that have been in an unrealized loss position for one year or longer. Of the fixed income securities, 103 are investment grade, of which 101 of these securities are rated A1/ A or better (including 70 securities which are rated AAA). The one remaining non-investment grade fixed income security is rated BB- and has a fair value equal to 99.8% of its book value as of December 31, 2005. One of the equity securities that has been in an unrealized loss position for one year or longer relates to a closed end preferred stock fund, which continues to pay its regular dividend on a monthly basis and has an underlying net asset value per share that exceeds its price per share as of December 31, 2005. One of the equity securities relates to an investment in an open end, high quality short duration bond fund, of which the underlying assets are all rated AAA. Finally, the eight remaining equity securities that have been in an unrealized loss position for one year or longer relate to preferred share investments in issuers each of which has shown an improved financial performance during 2005. In addition, these eight equity securities have an aggregate fair market value of equal to 95.7% of their book value as of December 31, 2005. All one hundred and four of the fixed income securities are current on interest and principal and all ten of the equity securities continue to pay dividends at a level consistent with the prior year. Management believes the declines are temporary and are not indicative of other-than-temporary impairments.
Interest Rate Risk. We had fixed-maturity, preferred shares and bond mutual fund investments with a fair value of $343.9 million at December 31, 2005 that are subject to interest rate risk. We attempt to manage our exposure to interest rate risk through a disciplined asset/liability matching and capital management process. In the management of this risk, the characteristics of duration, credit and variability of cash flows are critical elements. These risks are assessed regularly and balanced within the context of our liability and capital position.
We have audited the accompanying consolidated balance sheets of ProCentury Corporation and subsidiaries (the Company) as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2005, 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 consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
We have audited management’s assessment, included in the accompanying Management Report on Internal Control Over Financial Reporting contained in Item 9A, Controls and Procedures, of ProCentury Corporation and subsidiaries’ (the Company) 2005 Annual Report on 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).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 an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
In addition, on August 5, 2004 and March 22, 2005 the Company issued 54,800 and 55,024, respectively of restricted common shares to certain executives of ProCentury.
On June 1, 2005, Century acquired 100% of the outstanding shares of the Fireman’s Fund of Texas (FFTX) for $5.9 million. FFTX is a Texas domiciled property and casualty company licensed in Texas, Oklahoma and California. On August 16, 2005, FFTX was renamed ProCentury Insurance Company.
Century markets and underwrites general liability, commercial property, multi-peril, garage liability and limited bonding coverages to commercial and individual customers through independent and affiliated agents throughout the United States. The Company writes business on both an admitted and nonadmitted basis in 48 states and the District of Columbia, on an admitted basis only in five states and on a nonadmitted basis only in 42 states and the District of Columbia. Century competes with other property and casualty insurance companies and is subject to the regulations of certain state and federal agencies and undergoes periodic financial examinations by those regulatory authorities.
Interest Rate Risk is the risk that interest rates will change and cause a change in the value of an insurer’s investments. The Company attempts to mitigate this risk by attempting to match the maturity schedule of its assets with the expected payouts of its liabilities. To the extent that liabilities come due more quickly than assets mature, an insurer may have to sell assets prior to maturity and recognize a gain or loss.
Significant Business Concentrations: As of December 31, 2005, the Company did not have a material concentration of financial instruments in a single investee or geographic location. Also, the Company did not have a concentration of business transactions with a particular distribution source, a market or geographic area in which business is conducted that makes it overly vulnerable to a single event which could cause a severe impact to the Company’s financial position. The Company did, however, have a concentration of business transactions with a particular customer. See Note 12(d).
claims, and certain other amounts, which totaled $52.3 million as of December 31, 2005. The ceding of risk does not discharge the original insurer from its primary obligation to the contract holder. The Company is selective in its choice of reinsurers and considers numerous factors, the most important of which are the financial stability of the reinsurer, its history of responding to claims and its overall reputation. In an effort to minimize the Company’s exposure to the insolvency of its reinsurers, the Company evaluates the acceptability and reviews the financial condition of each reinsurer annually. The Company generally uses only those reinsurers that have an A.M. Best rating of “A-” (excellent) or better and that have at least $500 million in policyholders’ surplus, or Lloyds of London syndicates that have an A.M. Best rating of “A-” (excellent) or better. See Note 5.
Catastrophe Exposures: Certain insurance coverages that the Company writes includes exposure to catastrophic events such as hurricanes, tornados, hail storms, winter storms and freezing. As a result, a single catastrophe occurrence or destructive weather pattern could materially adversely affect the results of operations and surplus of our insurance subsidiaries. The Company attempts to mitigate this risk by excluding wind peril on non-mobile properties in Florida and within two counties of the Gulf of Mexico and eastern seaboard. In addition, the Company maintains a property catastrophe reinsurance treaty to mitigate future potential catastrophe loss exposure. The property catastrophe reinsurance coverage in 2005 provided coverage of up to 95% of a loss of $16.0 million in excess of the Company’s loss retention of $4.0 million per occurrence.
Held-to-maturity fixed maturity securities are recorded at amortized cost, adjusted for the amortization or accretion of premiums or discounts to maturity date using the effective interest method. Available-for-sale securities are recorded at fair value. Unrealized gains and losses, net of the related tax effect and minority interest, on available-for-sale securities are excluded from earnings and are reported as a component of accumulated other comprehensive income within shareholders’ equity, until realized.
Premiums in course of collection include amounts due from agents and amounts relating to assumed reinsurance. These balances are stated net of certain commission payable amounts, prepaid agents’ balances, and allowance for uncollectible premiums in course of collection. The Company evaluates the collectibility of premiums in course of collection based on a combination of factors. In circumstances in which the Company is aware of a specific customer’s inability to meet its financial obligations to the Company, a specific allowance for bad debt against amounts due is recorded to reduce the net receivable to the amount believed to be collectible. For all remaining balances, allowances are recognized for bad debts based on the length of time the receivables are past due using the Company’s historical experience of write-offs. The allowance for uncollectible premiums in course of collection was $58,000 and $79,000, at December 31, 2005 and 2004, respectively.
Insurance premiums are earned in proportion to the insurance coverage provided, which is generally on the daily pro-rata basis and are stated after deduction for reinsurance placed with other insurers and reinsurers. The portion of premiums that will be earned in the future are deferred and reported as unearned premiums.
The Company records policies that have fully funded limits as deposit type contracts as they are not considered to transfer insurance risk.
costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses and certain other costs expected to be incurred as the premium is earned. Judgments as to ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the written premiums. The amounts that are not considered realizable are charged as an expense through amortization of deferred policy acquisition costs.
Diluted EPS is the same as Basic EPS for the year ended December 31, 2003 because the Company had no common share equivalents granted during that period.
Cash and short-term investments - The carrying amounts reported approximate their fair value.
Investment securities - Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services. Fair values for equity securities, consisting of preferred and common stocks and bond mutual funds, are based on quoted market prices or independent pricing services. Fair value disclosures for investments are included in Note 2.
Other - The carrying amounts reported for premiums in the course of collection, reinsurance recoverables, accrued investment income, and other assets approximate their fair value. The Company’s long term debt, accrued expenses and other liabilities, collateral, and reinsurance balances payable are either short term in nature or based on current market price, which also approximates fair value.
The Company follows the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), the Financial Accounting Standards Board (“FASB”) Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation (an interpretation of APB Opinion No. 25), and other related accounting interpretations for the Company’s share option and restricted common share plans utilizing the “intrinsic value method.” The Company also follows the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation, for the Company’s share option grants, as amended by SFAS No. 148, Accounting for Stock-Based Compensation - Transition and
Disclosure; an amendment of FASB Statement No. 123. This disclosure requires pro forma net income and earnings per share information, which is calculated assuming the Company has accounted for its stock option plans under the “fair value method” described in SFAS No. 123 and SFAS No. 148.
In March 2004, the FASB issued EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which provides new guidance for assessing impairment losses on debt and equity investments. Additionally, EITF Issue No. 03-1 includes disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF Issue No. 03-1; however, the disclosure requirements remain effective and were adopted for the year ended December 31, 2004.
preferred share investments in issuers each of which has shown an improved financial performance during 2005. In addition, these eight equity securities have an aggregate fair market value of equal to 95.7% of their book value as of December 31, 2005. All one hundred and four of the fixed income securities are current on interest and principal and all ten of the equity securities continue to pay dividends at a level consistent with the prior year. Management believes the declines are temporary and are not indicative of other-than-temporary impairments.
Fixed maturities, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or to prepay obligations with or without call or prepayment penalties.
The components of net investment income in 2005, 2004 and 2003 were as follows:
Century and PIC held fixed maturity securities with a carrying value of approximately $8.7 million and $7.1 million on deposit with regulatory authorities as required by law at December 31, 2005 and 2004, respectively.
(a) The Class A and B shareholders are entitled to receive (on a pro rata basis) the lesser of the total amount of the liquidation proceeds or $25 million.
(c) Any liquidation proceeds remaining after the previous distributions are distributed to the Class A and B and C shareholders on a pro rata basis.
In March 2003, Century sold 299.5 Class A shares and 2,088.5 Class B shares of Evergreen for net proceeds of $2.8 million. Simultaneously, Evergreen issued to the acquirer .5 Class C share for net proceeds of $2.5 million. This transaction resulted in a pretax gain of $312,500, which is included, net of transaction fees of $215,000, in the accompanying 2003 consolidated statement of operations.
Management believes the loss and loss expense reserves make a reasonable provision for expected losses, however, ultimate settlement of this amount could vary significantly from that recorded.
In the ordinary course of business, Century assumes and cedes reinsurance with other insurers and reinsurers. These arrangements provide greater diversification of business and limit the maximum net loss potential on large risks. Excess of loss contracts in effect through December 31, 2005 generally protect against individual property and casualty losses over $500,000. Excess of loss contracts in effect for workers’ compensation losses protect against individual losses over $200,000. Additionally, from January 1, 2001 through June 30, 2001, and from July 1, 2001 through December 31, 2002 the first $200,000 in workers’ compensation losses were 80% and 60% ceded on a quota share basis, respectively. Catastrophe and clash coverage is also maintained. In addition, effective January 1, 2004, Century entered into a loss portfolio transfer and quota share arrangement with Evergreen and Continental whereby Century assumed all of Evergreen and Continental’s property and casualty, workers’ compensation, and commercial automobile lines of business and Evergreen assumed all of Century’s traditional surety lines of business.
Approximately 76.1% of the total reinsurance recoverable on paid and unpaid losses at December 31, 2005 was with reinsurance companies which had an A. M. Best rating of A or higher at December 31, 2005. The amounts of ceded loss and loss expense reserves and ceded unearned premiums would represent a liability of the Company in the event that its reinsurers would be unable to meet existing obligations under reinsurance agreements.
In 1998 and 1999, the Company had both quota share and excess of loss reinsurance agreements with three reinsurance companies related to the workers’ compensation line of business. As of December 31, 2005 and 2004, the Company had approximately $2.9 million of recoverables related to these reinsurance agreements, of which, $1.1 million related to the quota share agreements and $1.8 million related to the excess of loss agreements.
Effective January 1, 2001, Century entered into a retroactive reinsurance treaty with a nonaffiliated reinsurer covering losses occurring on or before January 1, 2001, and unrecoverable reinsurance. The following activity occurred related to this reinsurance treaty:
Amortization of deferred policy acquisition cost for the year ended December 31, 2004 includes a reduction of amortization expense of $2.5 million relating to the transfer of capitalized acquisition costs from Evergreen and Continental for the property and casualty segment, which was partially offset by $1.9 million of capitalized acquisition costs for the surety business that was transferred from Century to Evergreen and Continental. These transactions occurred in conjunction with the termination of the intercompany pooling agreement and the implementation of the loss portfolio agreements discussed in the Company’s Registration Statement on Form S-1 (file No. 333-111794) in “The Evergreen and Continental Transactions.”
On December 4, 2002, ProFinance Statutory Trust I (the “Trust”), a Connecticut statutory business trust formed by the Company, issued 15,000 floating rate capital securities (“Trust Preferred Securities”) generating gross proceeds of $15.0 million. Net proceeds were approximately $14.5 million, after deducting offering costs of $454,000. In addition, on May 15, 2003, ProFinance Statutory Trust II (the “Trust”), a
Connecticut statutory business trust formed by the Company, issued 10,000 floating rate capital securities (“Trust Preferred Securities”) generating gross proceeds of $10.0 million. Net proceeds were approximately $9.7 million, after deducting offering costs of $300,000.
In December 2003, FASB issued Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities - an interpretation of ARB No. 51 (“FIN 46R”), which required all public companies to apply the provisions of FIN 46 or FIN 46R to special purpose entities created prior to February 1, 2003. Once adopted by an entity, FIN 46R replaces FIN 46. Public companies, including the Company, at a minimum, must apply the unmodified provisions of FIN 46 to entities that were considered “special-purpose entities” in practice and under applicable FASB pronouncements or guidance by the end of the first reporting period ending after December 15, 2003. Companies may apply either FIN 46 or FIN 46R to special-purpose entities at the initial effective date on an entity-by-entity basis. The Company has early adopted FIN 46R in its entirety as of December 31, 2003.
for the line of credit. On September 7, 2005, the Company received a waiver from the bank and the ability to draw on the line of credit. The Company does not have any borrowings outstanding under the line of credit at December 31, 2005.
The Company has recorded the deferred tax assets and liabilities using the statutory federal tax rate of 35%. Management believes when these deferred items reverse in future years, our taxable income will be taxed at an effective rate of 35%. The Company is required to establish a valuation allowance for any portion of the gross deferred federal income tax asset that management believes will not be realized. In the opinion of management, it is more likely than not that the Company will realize the benefit of the deferred federal income tax assets through deductions against future earnings and, therefore, no such valuation allowance has been established.
With respect to non-qualified options, an employee or a board member may be granted an option to purchase shares at the grant date fair market value, payable as determined by the Company’s board of directors. An optionee must exercise an option within 10 years from the grant date. Full vesting of options granted occurs at the end of three years.
For both non-qualified and qualified options, the option exercise price equals the stock’s fair market value on the date of the grant. In accordance with APB No. 25, no compensation is recorded for the qualified and non-qualified share options as the market value on the grant dates equals the exercise price.
The Company may grant options for up to 1.2 million shares under the plan. Through December 31, 2005, the Company had granted 287,000 non-qualified options, 95,000 qualified options, 156,000 time-based restricted shares and 55,024 performance based restricted shares under the share plan.
The stock option plan was not effective until 2004 and, accordingly there is no such information to disclose for 2003.
The fair market value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in 2005 and 2004:
A summary of all employee time-based restricted share activity during the years ended December 31, 2005 and 2004 are as follows:
In January 2005 and September 2005, the Company modified two executives time-based restricted share awards in connection with the termination of their employment to accelerate the vesting period. As such, the Company accounted for the modifications as cancellations of a fixed award and a grant of a variable award, which are valued at the fair market value on the monthly vesting date. During 2005, the Company recorded $231,924 of compensation expense related the January modification and $42,617 related to the September modification. All shares related to the January modification have vested and 12,255 shares related to the September modification remain unvested at December 31, 2005.
In March of 2005, the Company granted 37,365 of performance based restricted shares to certain executives that vest annually over a four year period subject to the achievement of certain performance metrics. The Company accounts for these awards as variable awards that are recorded at fair value as of the date of the most recent reporting date. As of December 31, 2005, the fair value of the performance based restricted shares is $400,916 which is earned over the four year service period. During 2005, the Company recorded $150,343 of compensation expense related to the performance based restricted shares and all shares related to the performance based restricted shares remain unvested at December 31, 2005.
Of the performance based restricted share awards granted in March of 2005, an award for 17,659 shares was modified in accordance with the agreement entered into in connection with the termination of an executive officer in September 2005. As such, the award was treated as cancelled on October 1, 2005 due to a modification of the award to accelerate the vesting of the shares, change the vesting from annual vesting to monthly vesting and remove the performance based restrictions. As such, the award is treated as variable award which is valued at the fair market value on the monthly vesting date. During 2005, the Company recorded $46,058 compensation expense related to the restricted shares and 13,244 shares remain unvested at December 31, 2005.
Quota Share Reinsurance Agreements. The Company entered into 100% quota share reinsurance contracts that provided for Century to reinsure Evergreen and Continental for property and casualty business that was written on Evergreen or Continental’s paper for Century in states that Century was not licensed and for Evergreen to reinsure Century in the same manner for bonding business. Under these contracts, the ceding company is entitled to receive a 5% commission and reimbursement of any premium taxes or other direct costs such as boards and bureaus fees. These fronting contracts will remain in force until December 31, 2007. During 2005, the Company assumed $723,000 of premiums and ceded $318,000 of premiums under this contract.
Software License Agreement and Software Support and Maintenance Agreement. Century has entered into a software license agreement with Evergreen and Continental pursuant to which Century granted to Evergreen and Continental a fully paid-up, royalty free, non-exclusive perpetual license to use certain of Century’s proprietary software that relates to underwriting and claims processing and that has been developed for the mutual benefit of the Company, Evergreen and Continental. In addition, Century has entered into a software support and maintenance agreement with Evergreen and Continental, pursuant to which Century provides certain technical support and maintenance services for the software in return for an annual support and maintenance fee. For the year ended December 31, 2005 and 2004, this fee totaled $100,000 and $100,000. On December 29, 2005, the software support and maintenance agreement was amended to adjust the Annual Fee effective January 1, 2006, to be at the rate of $50,000 per calendar quarter payable during the first month of each quarter. In all other respects, the agreement continues unchanged. Evergreen and Continental may terminate the software support and maintenance agreement by providing 90 days’ prior written notice, and Century may terminate the agreement by providing twelve months’ prior written notice.
Century paid Evergreen-UNI (formerly an affiliate through significant shareholders of ProCentury) commissions for business produced for our surety business through an agency agreement of $12.0 million during 2003. There were no amounts due to Evergreen-UNI at December 31, 2003. These amounts are included in discontinued operations. Effective with the IPO, Evergreen-UNI is no longer an affiliate of ProCentury.
In 2004 and 2003, ProCentury paid approximately $484,000 and $1.9 million, respectively in fees relating to various consulting agreements with certain shareholders of ProCentury that were all terminated on December 31, 2003, including the following significant agreements:
Stonehenge Monitoring Agreement. This agreement was entered into as of July 1, 2002. In connection with its investment in the Company, the Company has paid Stonehenge Opportunity Fund, LLC a monitoring fee for the time and effort it expended in monitoring its investment in the Company, which included reviewing and evaluating the financial statements, attending meetings with management and board of directors and consulting with the Company with respect to business and prospects. Pursuant to this agreement the Company paid approximately $85,000 and $342,000 in 2004 and 2003, respectively.
Full Circle Consulting Arrangement. Pursuant to this agreement, the Company paid Full Circle Holdings, LTD fees for managing the investment in the Company made by its members. Pursuant to this agreement the Company paid approximately $158,000 and $625,000 in 2004 and 2003, respectively.
In addition, in 2003, the Company paid a total of $1.3 million of finders fees to two shareholders of ProCentury related to the sale of the minority interest in Evergreen.
Rental expense on the operating leases on facilities for the years ended December 31, 2005, 2004 and 2003 was $1.3 million, $1.2 million, and $934,000, respectively.
The Company is named from time to time as defendants in various legal actions that are incidental to our business and arise out of or are related to claims made in connection with our insurance policies, claims handling, premium finance agreements and other contracts and employment related disputes. The plaintiffs in some of these lawsuits have alleged bad faith or extra contractual damages and some have claimed punitive damages. The resolution of these legal actions is not expected to have a material adverse effect on the Company’s financial position or results of operations.
ProCentury contributed $55.0 million and $9.0 million in 2004 and 2003, respectively, to Century.
The Company considers many factors, including economic similarity, the nature of the underwriting units’ insurance products, production sources, distribution strategies and regulatory environment in determining how to aggregate operating segments.
Segment profit or loss for each of the Company’s operating segments is measured by underwriting profit or loss. The property and casualty insurance industry commonly defines underwriting profit or loss as earned premium net of loss and loss expenses and underwriting, acquisition and insurance expenses. Underwriting profit or loss does not replace operating income or net income computed in accordance with GAAP as a measure of profitability. Segment profit for the Investing operating segment is measured by net investment income and net realized gains or losses. The Company does not allocate assets, including goodwill, to the P/ C and Other operating segments for management reporting purposes. The total investment portfolio and cash are allocated to the Investment operating segment.
The following summary reconciles significant segment items to the Company’s consolidated financial statements:
The following is a summary of segment earned premium by group of products:
On March 13, 2006, the Company’s Board of Directors approved a cash dividend of $0.03 per share, payable on April 17, 2006 to stockholders of record on March 27, 2006.