(3) Net written premiums represent gross written premiums less premiums ceded to (reinsured by) other insurers.
(5) The expense ratio is calculated by dividing amortization of deferred policy acquisition costs and other underwriting expenses by premiums earned.
(7) Book value per share is calculated by dividing total stockholders’ equity by the total number of shares of common stock outstanding as of December 31 of each respective year.
Penn-America distributes its insurance products through a small network of sixty-six (66) high-quality wholesale general agents who serve the needs of the more than 30,000 retail insurance brokers who work directly with Penn-America insureds. Penn-America has about one-half the number of general agents as its nearest competitor. By maintaining strong relationships with a small, select group of agents, a relationship with Penn-America offers true “franchise value” to each general agent by providing relative market exclusivity and a high level of service and support. The Company’s distribution strategy has resulted in strong and consistent growth. From 1992 to 2003, the Company’s commercial gross written premiums grew from $22.6 million to $209.4 million (a 22% annual compounded growth rate). Most of the growth was due to an increase in gross written premiums per agent from $590,000 in 1992 to $3.9 million in 2003.
The Company’s philosophy has been to distribute a portion of the ROE it generates through cash dividends to stockholders. Cash dividend per share increased to $0.185 in 2003, compared to $0.15458 in 2002 and $0.14 in 2001. Through December 31, 2003, the Company has paid cash dividends to stockholders in 35 consecutive quarters totaling over $13.9 million.
The Company utilizes other financial measures to evaluate its operating performance, such as gross written premiums, operating income, GAAP underwriting income (loss), GAAP combined ratio, net income and cash flows provided by operations. These additional financial measures for the years ended December 31, 2003, 2002 and 2001 are more fully described in Results of Operations and Liquidity and Capital Resources in this discussion and analysis.
Compared With 2002. Premiums earned increased 33.9% to $154.1 million for 2003 compared with $115.1 million for 2002 due to growth in net written premiums.
Gross written premiums, which represent the amount received or to be received for insurance policies written without reduction for acquisition costs, reinsurance costs or other deductions, increased 33.0% to $209.4 million for 2003 compared with $157.4 million for 2002. This increase was attributable to rate increases, growth in new business and higher average exposures per policy.
Net realized investment gain was $1.9 million for 2003 and $1.3 million for 2002. The net realized investment gain for 2003 consists of realized gains of $2.4 million on the sale of certain of the Company’s investments in fixed-maturity securities and preferred stocks, partially offset by realized losses of $0.5 million on the sale of certain of the Company’s investments in common stocks. The net realized investment gain for 2002 consisted mainly of realized gains on the sale of certain of the Company’s investments in fixed-maturity securities of $2.9 million, offset by other-than-temporary impairment write-downs on certain of the Company’s investments in fixed-maturity and equity securities of $1.3 million and realized losses of $0.3 million on sales of certain of the Company’s investments equity investments.
The overall GAAP combined ratio, which is the sum of the loss and expense ratios, improved to 92.5 for 2003 from 97.7 for 2002. The loss ratio improved to 61.4 for 2003 from 65.3 for 2002. The GAAP expense ratio, which is calculated by dividing the sum of ADAC and other underwriting expenses by premiums earned, improved to 31.1 for 2003 from 32.4 for 2002. The GAAP combined ratio is a standard measure of underwriting profitability used throughout the property and casualty insurance industry. A ratio below 100.0 generally indicates underwriting profitability.
Underwriting income increased to $11.5 million for 2003 from $2.6 million for 2002. Underwriting income is a non-GAAP financial measure used by the Company, among other measures, to evaluate the performance of its underwriting operations. Underwriting income is equal to premiums earned less losses and loss adjustment expenses, ADAC and other underwriting expenses. The improvement in underwriting income for 2003 was due to growth in earned premiums and improvement in the GAAP combined ratio.
Interest expense increased to $1.7 million for 2003 from $0.2 million for 2002. This increase was due to the interest expense related to the Company’s issuance of junior subordinated debentures in December 2002 and May 2003. For more information regarding junior subordinated debentures, see the section entitled “Liquidity and Capital Resources” of this discussion and analysis beginning on page 38.
Operating income increased to $15.5 million or $1.05 per basic share and $1.04 per diluted share for 2003 from $9.6 million or $0.82 per basic share and $0.81 per diluted share for 2002. Operating income is calculated by subtracting net realized investment gain, after taxes, from net income. Operating income is a non-GAAP financial measure used by the Company, among other measures, to evaluate its performance because the realization of net realized investment gains or losses in a given period is largely discretionary as to timing and could distort the comparability of results. The increase in operating income in 2003 was due to the improvement in underwriting income, after taxes, and growth of investment income, after taxes.
The factors described above resulted in net income for 2003 of $16.7 million or $1.14 per basic share and $1.12 per diluted share compared with net income of $10.5 million or $0.90 per basic share and $0.88 per diluted share for 2002.
2002 Compared With 2001. Premiums earned were $115.1 million for 2002 compared with $88.9 million for 2001. The Company’s core commercial lines premiums earned (excluding exited lines of business) increased 36.5% to $115.0 million, attributable to the increase in net written premiums for 2002 as compared with 2001. The Company exited the commercial automobile line of business in 2000 and the non-standard personal automobile line of business in 1999. Premiums earned for these exited lines of business decreased to $40,000 for 2002, compared with $4.7 million for 2001.
Gross written premiums increased 60.0% for 2002 to $157.4 million compared with $98.4 million for 2001. This increase was attributable to rate increases, strong growth in new business and higher average exposures per policy.
Ceded written premiums increased to $22.8 million for 2002 compared with $11.3 million for 2001. The increase in ceded written premiums was primarily due to growth in gross written premiums and an approximately 40% increase in reinsurance rates on the Company’s multiple-line excess of loss reinsurance treaty.
Losses and loss adjustment expenses increased 23.3% to $75.1 million for 2002 from $60.9 million for 2001. The loss ratio for 2002 was 65.3 compared with 68.5 for 2001. This improvement was attributable to rate increases implemented in 2001 and 2002 and exiting of the commercial automobile line of business, partially offset by $2.4 million in losses and loss adjustment expenses attributable to insured events of prior years. For more information regarding the $2.4 million in losses and loss adjustment expenses attributable to insured events of prior years for 2002, see the section entitled “Critical Accounting Estimates” of this discussion and analysis beginning on page 28.
Amortization of deferred policy acquisition costs (“ADAC”) increased 27.7% to $29.0 million for 2002 from $22.7 million for 2001 primarily due to the growth in premiums earned.
Other underwriting expenses increased 3.4% to $8.3 million for 2002 from $8.0 million for 2001. This increase was mainly attributable to increases in salary and benefit expenses associated with the hiring of additional underwriting and marketing personnel.
The overall GAAP combined ratio improved to 97.7 for 2002 from 103.1 for 2001. The loss ratio improved to 65.3 for 2002 from 68.5 for 2001. The GAAP expense ratio improved to 32.4 for 2002 from 34.6 for 2001.
Operating income increased to $9.6 million or $0.82 per basic share and $0.81 per diluted share for 2002 from $5.7 million or $0.50 per share (basic and diluted) for 2001. The increase in operating income was due to the improvement in underwriting income, after taxes, and growth of investment income, after taxes.
The factors described above resulted in net income for 2002 of $10.5 million or $0.90 per basic share and $0.88 per diluted share compared with net income of $4.9 million or $0.43 per share (basic and diluted) for 2001.
The Company has identified that the establishment of reserves for unpaid losses and loss adjustment expenses and the valuation of certain investments are critical accounting estimates because they involve a high degree of judgment. Although variability is inherent in these estimates, the Company believes the amounts provided in its financial statements are appropriate based upon the facts available at the time. For information related to the valuation of investments, see the section entitled “Investments” in this discussion and analysis beginning on page 35.
The Company is directly liable for losses and loss adjustment expenses under the terms of the insurance policies that it writes. In many cases, several years may lapse between the occurrence of an insured loss, the reporting of the loss to the Company and the Company’s payment of that loss. The Company reflects its liability for the ultimate payment of all incurred losses and loss adjustment expenses by establishing loss and loss adjustment expense reserves as balance sheet liabilities for both reported and unreported claims.
The Company determines loss adjustment expenses as a percentage of expected indemnity losses based on historical patterns adjusted to reflect current experience.
• the economic environment in which property and casualty insurance companies operate.
The Company continually reviews these estimates and, based on new developments and information, the Company includes adjustments of the probable ultimate liability in the operating results for the periods in which the adjustments are made. In general, initial reserves are based upon the actuarial and underwriting data utilized to set pricing levels and are reviewed as additional information, including claims experience, becomes available. The establishment of loss and loss adjustment expense reserves makes no provision for the broadening of coverage by legislative action or judicial interpretation, or the emergence of new types of losses not sufficiently represented in the Company’s historical experience or that cannot yet be quantified. The Company regularly analyzes its reserves and reviews pricing and reserving methodologies so that future adjustments to prior year reserves can be minimized. However, given the complexity of this process, reserves will require continual updates and the ultimate liability may be higher or lower than previously indicated. Change in estimates for loss and loss adjustment expense reserves, as required by Statement of Financial Accounting Standards (“SFAS”) No. 60, Accounting and Reporting by Insurance Enterprises, is recorded in the period that the change in these estimates is made. The Company does not discount its loss reserves.
In the first quarter of 2003, the Company received an unexpected increase in the number of new claims reported relating to four policies issued to a single insured between January 1, 1980 and April 1, 1983. The insured was a manufacturer of safety equipment including industrial masks and the new claims reported allege existing and potential bodily injury due to a medical condition called silicosis. The original policies covered products and completed operations only and were issued with a $500,000 indemnity policy aggregate limit of liability. At December 31, 2003, the Company believes that its ultimate obligations for these claims are included in its best estimate for unpaid loss and loss adjustment expense reserves.
In 2002, the Company increased incurred losses and loss adjustment expenses attributable to insured events of prior years by $2.4 million. The increase was attributable to an increase in estimates for loss and loss adjustment expense reserves by $5.1 million for commercial liability lines of business, partially offset by reductions in estimates by $2.7 million for the commercial property lines of business.
The Company’s change in estimates in 2002 for the commercial liability lines resulted primarily from an increase of $2.3 million due to a lengthening of the selected development patterns on all accident years as closing patterns on claims closed in 2002 varied from the Company’s historical experience. The remainder of the change is due primarily to increases in estimates for claims expenses as paid development patterns during 2002 were in excess of expectations at December 31, 2001.
The following table presents accident year losses and loss adjustment expense ratios (the sum of losses and loss adjustment expenses divided by premiums earned) for the ten most recent accident years (the year in which the loss occurred), as recorded as of December 31 for 1994 through 2003, after giving effect to the increase in losses and loss adjustment expenses relating to changes in estimates of insured events of prior years. These “accident year” loss ratios differ from the loss ratios included in the Company’s financial statements in that the latter loss ratios are based upon the year in which the Company recorded the loss for accounting purposes, regardless of when the loss actually occurred or was reported to the Company.
• exiting the non-standard personal automobile and commercial automobile lines of business which produced a 77.0 loss ratio for accident years 1994 through 2000; and
• developing management information systems to monitor premium rate level changes and underwriting profitability by class of business, state and general agency.
Overview. To reduce its exposure to liability on individual risks and to protect against catastrophic losses, the Company purchases reinsurance through contracts called “treaties” or on a facultative basis. Reinsurance involves an insurance company transferring or “ceding” a portion of its exposure on a risk to another insurer (the “reinsurer”). The reinsurer assumes the exposure in return for a portion of the premium. The ceding of liability to a reinsurer does not legally discharge the primary insurer from its liability for the full amount of the policies on which it obtains reinsurance. The primary insurer will be required to pay the entire loss if the reinsurer fails to meet its obligations under the reinsurance agreement.
Multiple-Line Excess Of Loss. The Company’s multiple-line excess of loss reinsurance treaty is placed with American Reinsurance Company (“American Re”), part of the Munich Re Group. American Re has an A.M. Best rating of “A+” (Superior). The following is a summary of the Company’s multiple-line excess of loss reinsurance treaty for 2003:
For 2004, the Company’s catastrophic loss reinsurance program includes: American Agricultural Insurance Company, Converium Reinsurance (North America) Inc., Converium (UK), Everest Reinsurance Company, Hannover Re (Bermuda) Ltd., PXRE Reinsurance Company, Shelter Reinsurance Company, Sirius International Insurance Corporation and XL Re Ltd. All of these reinsurers have statutory surplus greater than $500 million and an A.M. Best rating of “A” (Excellent) or higher.
Terrorism. On November 26, 2002, President Bush signed the Terrorism Risk Insurance Act of 2002 (“the Act”) into law. The purpose of the Act is to establish a temporary federal program that provides a system of shared public and private compensation for insured losses resulting from certain acts of terrorism. The Act defines an act of terrorism as any violent act that is certified by the Secretary of the Treasury which results in $5.0 million of damage within the United States (or outside the United States in
The Act specifies that the federal share of losses resulting from a certified act of terrorism is 90% of all insured losses above each insurance carrier’s deductible, subject to a maximum federal aggregate liability of $100.0 billion. An insurance carrier’s deductible for certified acts of terrorism is based on a percentage of direct earned premiums for the calendar year prior to the start of each program year. For 2003, the Company’s deductible for certified acts of terrorism was 7% of the Company’s direct earned premium for the year ended December 31, 2002, or $9,300,000. For 2004, the Company’s deductible for certified acts of terrorism is 10% of the Company’s direct earned premium for the year ended December 31, 2003, or $18,260,000.
The Company retains the first $500,000 per property risk, subject to a maximum of $3,000,000 per occurrence/aggregate, and the first $500,000 per general liability occurrence, subject to a maximum of $2,500,000 per occurrence/aggregate.
This treaty excludes all losses resulting from certified acts of terrorism.
The Company believes that its exposure to insured losses resulting from certified acts of terrorism will not have a material effect on its financial condition.
Reinsurance Recoverable. The Company’s reinsurance recoverable increased to $38.0 million as of December 31, 2003, compared with $27.8 million as of December 31, 2002. This increase was due primarily to the growth in unpaid losses and loss adjustment expenses, which increased 27.0 percent to $174.9 million as of December 31, 2003 from $137.8 million at December 31, 2002. The following table summarizes the Company’s outstanding reinsurance recoverable, net of a $150,000 allowance for doubtful accounts, as of December 31, 2003, by reinsurer:
The Company’s investment strategy emphasizes quality, liquidity and diversification, as well as total return. With respect to liquidity, the Company considers liability durations, specifically related to loss reserves, when determining desired investment maturities. In addition, maturities have been staggered to produce cash flows for loss payments and reinvestment opportunities. The Company out-sources the management of its investment portfolio to Gen Re New England Asset Management Inc. (“NEAMS”). In accordance with the asset management agreement between the Company and NEAMS, all investment transactions are approved by the Investment Committee of the Company within 60 days of their initiation by NEAMS.
Total cash and investments increased 24.8% to $345.7 million at December 31, 2003 from $277.0 at December 31, 2002. This increase resulted from net cash provided by operating activities of $57.3 million and net cash provided from financing activities of $13.2 million in 2003. For more information regarding net cash flows from operating and financing activities, see section entitled “Liquidity and Capital Resources” beginning on page 38 of this discussion and analysis. Total cash and investments of $345.7 at December 31, 2003 consisted of $323.5 million in fixed-maturity securities, $10.2 million in equity securities, consisting of preferred stocks and a mutual fund invested in adjustable rate mortgages, and $12.0 million in cash.
For information regarding contractual maturities of the Company’s fixed-maturity securities, see Note 5 to the Consolidated Financial Statements beginning on page 54 of Item 8, “Financial Statements and Supplementary Data”, of this report on Form 10-K.
As of December 31, 2003, the Company’s investment portfolio contained corporate fixed maturity and preferred stock securities with a market value of $98.4 million. A summary of these securities by industry segment was as follows:
The Company regularly evaluates its investment portfolio to identify other-than-temporary impairments of individual securities. The Company considers many factors in determining if an other-than-temporary impairment exists, including the length of time and extent to which the market value of the security has been less than cost, the financial condition and near-term prospects of the issuer of the security and the Company’s ability and willingness to hold the security until the market value is expected to recover. The following table contains an analysis of the Company’s securities with gross unrealized losses, categorized by the period that the securities were in a continuous unrealized loss position as of December 31, 2003:
For information regarding the market risk of the Company’s investment portfolio, see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk”, beginning on page 41 of this report on Form 10-K.
Capital Resources. PAGI is a holding company, the principal asset of which is the common stock of Penn-America Insurance Company. PAGI’s capital structure consists of common stockholders’ equity and junior subordinated debentures. The following table summarizes the capital resources at December 31:
Stockholders’ equity increased 12.2% to $130.8 million at December 31, 2003, compared with $116.6 million at December 31, 2002 due primarily to net income of $16.7 million for 2003 partially offset by $2.7 million in dividends paid to PAGI’s stockholders.
extent that all dividends in the past twelve months do not exceed the greater of 10% of total statutory surplus, or statutory net income for the prior year. Using these criteria, the available ordinary dividend for 2004 is $12,196,000. Ordinary dividends of $2,600,000, $1,100,000 and $1,600,000 where paid to PAGI in 2003, 2002 and 2001, respectively. Penn-America Insurance Company’s ability to pay future dividends to PAGI without advance regulatory approval is dependent upon maintaining a positive level of unassigned and statutory surplus, which in turn, is dependent upon Penn-America Insurance Company and Penn-Star Insurance Company generating net income in excess of dividends to PAGI. As of December 31, 2003, Penn-America Insurance Company’s statutory surplus was $121,960,000, and included unassigned surplus of $36,420,000.
Contractual Obligations. The following table summarizes the Company’s known contractual obligations as of December 31, 2003.
The property and casualty insurance industry is highly competitive and includes several thousand insurers, ranging from large companies offering a wide variety of products worldwide to smaller, specialized companies in a single state or region offering only a single product in some cases. The Company competes with a number of insurers in attracting quality general agents and in selling insurance products. Many of the Company’s existing or potential competitors are larger excess and surplus lines and specialty admitted insurers which have considerably greater financial and other resources, have greater experience in the insurance industry and offer a broader line of insurance products than the Company. The Company believes that in order to be successful in its market, it must be aware of pricing cycles and must be able to minimize the impact of such cycles through tight expense control and superior customer service.
Basis of Presentation and Description of Business. Penn-America Group, Inc. (“PAGI”) is an insurance holding company. Penn Independent Corporation (“Penn Independent”) owned approximately 31% of the outstanding common stock of PAGI at December 31, 2003. The accompanying consolidated financial statements include the accounts of PAGI and its wholly owned subsidiaries, Penn-America Insurance Company (“Penn-America”) and its wholly owned subsidiary Penn-Star Insurance Company (“Penn-Star”), Penn-America Statutory Trust I (“the Trust I”) and Penn-America Statutory Trust II (“the Trust II”) (collectively the “Company”). All significant inter-company accounts and transactions have been eliminated in consolidation. These financial statements are prepared in conformity with accounting principles generally accepted in the United States, which differ in some respects from those required by insurance regulatory authorities.
Revenue Recognition. Premiums written are recognized as earned ratably over the terms of the respective policies and include estimates for premiums earned but not yet billed, net of commissions, of approximately $1,200,000 at December 31, 2003, and 2002. Unearned premiums represent the portion of premiums written applicable to the unexpired terms of policies in force and are calculated on a semi-monthly pro-rata basis.
Cash and Cash Equivalents. Cash and cash equivalents include cash on hand and highly liquid short-term investments with an original maturity of three months or less.
Investments. At the time of purchase of fixed-maturity investments, management makes a determination as to the investment classification (“Available for Sale” or “Held to Maturity”). Factors taken into consideration by management in determining the appropriate investment category are: maturity, yield, cash flow requirements and anticipated changes in interest rates. Fixed maturities classified as “Available for Sale” are carried at fair value with unrealized investment gains or losses, net of deferred income taxes, included as a separate component of accumulated other comprehensive income in stockholders’ equity. “Held to Maturity” investments are carried at amortized cost.
Equity securities are carried at fair value with the change in unrealized investment gains or losses, net of deferred income taxes, included as a separate component of accumulated other comprehensive income in stockholders’ equity.
By using derivative instruments, the Company is exposed to credit risk based on current market conditions and potential payment obligations between the Company and its counterparty. The Company
has entered into the interest rate swap with a high quality counterparty, which is rated “A1” by Moody’s Investors Service Inc. (“Moody’s”). The Company’s interest rate swap contract is governed by an International Swaps and Derivatives Association Master Agreement, and includes provisions that require collateral to be pledged by the Company or its counterparty if the current value of the interest rate swap exceeds certain thresholds. As of December 31, 2003, approximately $700,000 of collateral was held by the Company’s counterparty.
Stock-Based Compensation for Stock Options. On December 31, 2002, the Financial Accounting Standards Board issued SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure (“SFAS 148”), which amends SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), to provide alternative methods of transition for companies that adopt the fair value method of accounting for stock-based compensation. The Company has a Stock Incentive Plan which is described more fully in Note 15.
On January 1, 2003, the Company adopted the fair value recognition provisions of SFAS 148 by implementing the modified prospective transition method permitted under SFAS 148. This method requires the Company to record compensation expense for stock options vested in 2003, and annually thereafter, as if the fair value recognition method had been used since January 1, 1995. Compensation expense for stock options of $119,000 was recorded for the year ended December 31, 2003.
Prior to January 1, 2003, the Company applied the recognition principles of APB No. 25, Accounting for Stock Issued to Employees, and, accordingly, no compensation expense was recognized. If the Company had applied the fair value recognition provisions of SFAS 123 in 2002 and 2001, compensation expense of $247,000 and $59,000 would have been recorded for the years ended December 31, 2002 and 2001. The following table illustrates the effect on net income and net income per share for the years ended December 31, 2003, 2002 and 2001 as if the Company had applied the fair value recognition provisions of SFAS 123.
Policy Acquisition Costs. Policy acquisition costs such as commissions, salaries, premium taxes and certain other underwriting expenses, which vary with and are directly related to the production of business, are deferred and amortized over the effective periods of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable values, which gives effect to the premium to be earned, related investment income, losses and loss adjustment expenses and certain other costs expected to be incurred as the premium is earned.
Reinsurance. In the ordinary course of business, the Company reinsures its risks, generally on an excess-of-loss basis, with other insurance companies which principally are rated “A” or higher by A.M. Best. Such reinsurance arrangements serve to limit the Company’s maximum loss. Reinsurance does not relieve the Company of its primary obligation to the policyholder. Amounts recoverable from reinsurers are estimated in a manner consistent with the determination of losses and loss adjustment expenses.
Insurance Related Assessments. The Company’s insurance subsidiaries are subject to state guaranty fund assessments, which enable states to meet policyholder requirements or meet other insurance obligations from insurance company insolvencies. The Company accrues for these assessments when it is probable that an assessment will be imposed, the obligatory event has occurred, and the amount of the assessment can be reasonably estimated.
In December 2003, the FASB issued a revision of FASB Interpretation No. 46 (“FIN 46R”), Consolidation of Variable Interest Entities, which is effective no later than the end of the first reporting period that ends after December 15, 2003 for variable interest entities considered special-purpose entities. The Company adopted FIN 46R in the fourth quarter of 2003. As a result, the Company is not permitted to consolidate the Company’s business trust subsidiaries, which in aggregate issued $30.0 million of floating rate capital securities (“Trust Preferred Securities”). The sole assets of the Company’s business trust subsidiaries are junior subordinated debentures issued by the Company, which have the same terms with respect to maturity, payments and distributions as the Trust Preferred Securities. Previously, the Company classified the Trust Preferred Securities as “company obligated mandatorily
Basic net income per share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding for each period. Diluted net income per share includes the potential dilution that could occur if outstanding contracts to issue common stock were exercised and converted to common stock. The following is a reconciliation of the basic and diluted net income per share computations:
The Company leases its home office facility from Irvin Saltzman and the lease is accounted for as a capital lease. The amount of property capitalized of $2,227,000 is presented net of accumulated amortization of $735,000 and $648,000 as of December 31, 2003 and 2002, respectively. Capitalized lease obligations of $1,273,000 and $1,428,000 were recorded at December 31, 2003 and 2002, respectively, representing the lease obligation arising from this lease, which carries an 8.5% interest rate. Penn Independent and its subsidiaries also lease a portion of the building in which the Company’s home office facility is located. Management believes that the lease terms are at market rates.
Gross written premiums produced by insurance agency affiliates of Penn Independent were $8,851,000, $6,201,000 and $3,888,000 in 2003, 2002 and 2001, respectively. Commissions paid to such affiliates were $1,875,000, $1,314,000 and $857,000 in 2003, 2002 and 2001 respectively. Premiums receivable includes receivables from affiliates of $549,000 and $353,000 as of December 31, 2003 and 2002, respectively.
Investment securities: Fair values are based on quoted market prices or on quoted market prices of comparable instruments or values obtained from independent pricing services.
The following table contains an analysis of the Company’s securities with gross unrealized losses, categorized by the period that the securities were in a continuous unrealized loss position as of December 31, 2003:
As of December 31, 2003, the Company’s fixed-maturity investment portfolio had forty-nine (49) securities with $653,000 of gross unrealized losses. No single issuer had a gross unrealized loss position greater than $50,000 or 2.8% of its original cost. The Company held one preferred stock, included in equity securities, in a gross unrealized loss position totaling $3,000 as of December 31, 2003.
Income tax expense was $681,000 and $433,000 on net realized investment gain for the years ended December 31, 2003 and 2002, respectively. Income tax benefit was $400,000 on net realized investment loss for the year ended December 31, 2001.
The change in unrealized gain (loss) on investments, which is recorded as a change in stockholders’ equity through other comprehensive income (loss) is as follows:
As of December 31, 2003, the Company recorded a $133,000 derivative liability, which is included in other liabilities in the Consolidated Balance Sheets. Accordingly, as of December 31, 2003 the Company recorded a net unrealized loss on this cash flow hedging instrument, net of income tax, of $86,000 in accumulated other comprehensive income.
Losses and loss adjustment expenses are net of amounts due under reinsurance contracts as follows: $19,934,000, $8,979,000 and $7,446,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
In 2003, the Company increased incurred losses and loss adjustment expenses attributable to insured events of prior years by $5,499,000. This increase was primarily due to an increase of $3,570,000 in the Company’s core commercial property and casualty lines of business. This increase consisted of a reduction in the Company’s estimate for the commercial property lines of business by $2,143,000 relating primarily to the 2002 accident year, offset by an increase in the Company’s estimate for the commercial liability lines of business of $5,713,000 due to the development of outstanding claim reserves on claims occurring in various accident years. The remaining increase of $1,929,000 in incurred losses and loss
In 2002, the Company increased incurred losses and loss adjustment expenses attributable to insured events of prior years by $2,406,000. The increase was attributable to an increase in estimates for loss and loss adjustment expense reserves by $5,100,000 for commercial liability lines of business, partially offset by reductions in estimates by $2,700,000 for the commercial property lines of business.
The Company’s change in estimates in 2002 for the commercial property lines resulted from lower costs per claim than expected for the 2001 accident year. As of December 31, 2001, the Company anticipated an increase in the average cost per claim of approximately 11% to $9,200 for the 2001 accident year as compared with $8,300 for the 2000 accident year. During 2002, the 2001 accident year developed more favorably than originally anticipated, as the average settlement per claim declined to approximately $8,000. Consequently, the Company reduced its estimates by $2,700,000 in 2002.
In 2001, the Company increased incurred losses and loss adjustment expenses attributable to insured events of prior years by $36,000. This increase related entirely to the commercial automobile line of business. Additionally, the Company increased its estimate for loss and loss adjustment expense reserves by $1,800,000 for commercial multi-peril liability and reduced its estimates by $1,400,000 for non-standard personal automobile and $400,000 for commercial multi-peril property.
The Company increased its estimate in 2001 for the commercial multi-peril liability line of business by $1,800,000 due to the development of outstanding claim reserves on claims occurring primarily in 1998 and 1999. In 2001, incurred losses on the 1998 and 1999 accident year were approximately $1,300,000 more than anticipated based on historical development patterns. The increase is attributed primarily to higher than expected average settlement costs per claim for the 1998 and 1999 accident years. This increase was almost entirely offset by a reduction in the Company’s estimate for the non-standard personal automobile line of business due to favorable settlements on closed claims. The decrease is attributed primarily to lower than expected average settlement costs per claim for the 1998 and 1999 accident years.
The actual income tax rate differed from the statutory income tax rate applicable to income before income taxes as follows:
The tax effects of temporary differences that result in a net deferred tax asset are summarized as follows:
The Company is required to establish a valuation allowance for any portion of the deferred tax asset that management believes will not likely be realized. In the opinion of management, it is more likely than not that the Company will realize the benefit of the deferred tax asset and, therefore, no such valuation allowance has been established.
On May 15, 2003, the Trust II, a business trust subsidiary formed by PAGI, issued $15.0 million of floating rate Trust Preferred Securities. These securities have a thirty-year maturity, with a provision that allows the Company to call these securities at par after five years from the date of issuance. Cash distributions are paid quarterly in arrears at a rate of 410 basis points over three-month London Interbank Offered Rates. Distributions on these securities can be deferred for up to five years, but in the event of such deferral, the Company may not declare or pay cash dividends on its common stock. PAGI guarantees all obligations of the Trust II with respect to distributions and payments of these securities.
Proceeds from the sale of these securities by the Trust II were used to acquire $15.0 million of Floating Rate Junior Subordinated Deferrable Interest Rate Debentures issued by the Company. These junior subordinated debentures have the same terms with respect to maturity, payments, and distributions as the floating rate Trust Preferred Securities issued by the Trust II. The proceeds from these junior subordinated debentures will be used to support growth in the Company’s insurance subsidiaries and for general corporate purposes.
During the fourth quarter of 2002, the Company issued 2,990,000 shares of its common stock through a public offering at a price of $8.50 per share. The shares of common stock were issued out of treasury. The 760,000 shares of treasury stock remaining after the public offering were retired. Proceeds from the offering amounted to $23.5 million, after deducting offering costs of $1.9 million. The Company contributed virtually all of the proceeds to Penn-America to support the business growth of its insurance subsidiaries.
Penn-America and Penn-Star are regulated by the state in which they are incorporated and the states in which they do business. Such regulations, among other things, limit the payment of dividends without prior regulatory approval. PAGI is dependent on dividends from Penn-America for payment of dividends to PAGI’s stockholders, general expenses, and interest on $30.0 million of Floating Rate Junior Subordinated Deferrable Interest Rate Debentures. Penn-America may pay dividends to PAGI without advance regulatory approval only from unassigned surplus and only to the extent that all dividends in the past twelve months do not exceed the greater of 10% of total statutory surplus or statutory net income for the prior year. Using these criteria, the maximum amount of dividends that may be paid to PAGI from Penn-America in 2004, without prior approval, is $12,196,000. Ordinary dividends of $2,600,000, $1,100,000 and $1,600,000 were paid to PAGI in 2003, 2002 and 2001, respectively.
The National Association of Insurance Commissioners (“NAIC”) has developed Property and Casualty Risk-Based Capital (“RBC”) standards that relate an insurer’s reported statutory surplus to the risks inherent to overall operations. The RBC formula uses the statutory annual statement to calculate the minimum indicated capital level to support asset risk and underwriting risk. The NAIC model law calls for various levels of regulatory action based on the magnitude of an indicated RBC capital deficiency, if any. The Company regularly monitors capital requirements along with the NAIC’s RBC developments. The Company has determined that its capital levels are in excess of the minimum capital levels required by the RBC standards.
The following tables reconcile statutory surplus and net income of the Company as determined in accordance with accounting principles prescribed by the insurance regulatory authorities to stockholders’ equity and net income of the Company calculated in accordance with accounting principles generally accepted in the United States as reported herein:
In May 2003, the Company’s stockholders ratified and approved the Company’s 2002 Stock Incentive Plan (the “Plan”). The purpose of the Plan is to enable officers, employees, directors, consultants, advisors and service providers of the Company and its affiliates (as defined in the Plan) to participate in the Company’s future and to enable the Company to attract and retain these persons by offering them proprietary interests in the Company. The Plan authorized the issuance of up to 1,837,500 shares of common stock pursuant to the exercise of stock options and restricted stock awards. At December 31, 2003, 586,145 shares have been issued, 630,060 shares have been reserved pursuant to outstanding stock options granted, 67,500 shares have expired and 553,795 shares are reserved for future issuance pursuant to options granted or the award of restricted stock.
Stock Options: Options are granted with an exercise price equal to market price at the date of grant and are exercisable according to the various terms under which they were granted, varying from one to ten years from the date of the grant. In general, options are subject to earlier termination if the optionee leaves the employ of the Company.
A summary of the status of and changes in the Company’s stock option plan is presented below:
The Company’s Agents’ Contingent Profit Commission Plan allows its agents to receive up to 100% of their contingent profit commission awards in PAGI common stock in lieu of cash. At December 31, 2003, there were 254,701 shares of common stock reserved for future issuance under the Company’s Agents’ Contingent Profit Commission Plan. Agents’ common stock awards for the 2002, 2001 and 2000 years, which were issued in 2003, 2002 and 2001, amounted to 33,313, 62,836, and 35,189 shares, respectively. The compensation expense recorded for 2003, 2002 and 2001 was based on the fair value of the Company’s common stock on the date the shares were issued to the agents.
Legal Matters: The Company’s insurance subsidiaries are subject to routine legal proceedings in connection with their property and casualty business. The Company is involved in no other pending or threatened legal or administrative proceedings which management believes might have a material adverse effect on the Company’s financial condition or results of operations.
Leases: The Company leases computer equipment for use by its insurance subsidiaries. These leases have terms primarily expiring in less than a three-year period. Rental expenses for these operating leases were $544,000, $489,000 and $391,000 for the years ended December 31, 2003, 2002 and 2001, respectively.