(1) The building is owned through a subsidiary that is 50% owned.
In addition, we lease an aggregate of approximately 400,000 square feet of office space in 49 locations. See Item 13. “Certain Relationships and Related Transactions, and Director Independence.”
• Personal Lines Reinsurance. We reinsure 10% of the net premiums of the GMACI personal lines business, pursuant to the Personal Lines Quota Share with the GMACI personal lines insurance companies. See discussion below related to ACAC investment.
We evaluate our operations by monitoring key measures of growth and profitability, including return on equity and net combined ratio. Our return on equity was 21.2%, 22.2% and 21.5% for the years ended December 31, 2011, 2010 and 2009, respectively. Our overall financial objective is to produce a return on equity of 15.0% or more over the long term. In addition, we target a net combined ratio of 95.0% or lower over the long term, while seeking to maintain optimal operating leverage in our Insurance Subsidiaries commensurate with our A.M. Best rating objectives. Our net combined ratio was 89.0%, 85.3% and 79.8% for the years ended December 31, 2011, 2010 and 2009, respectively. A key factor in achieving our targeted net combined ratio is a continuous focus on our net expense ratio. Our strategy across our segments is to maintain premium rates, deploy capital judiciously, manage our expenses and focus on the sectors in which we have expertise, which we believe should provide opportunities for greater returns.
Investment income is also an important part of our business. Because the period of time between our receipt of premiums and the ultimate settlement of claims is often several years or longer, we are able to invest cash from premiums for significant periods of time. Our net investment income was $55.5 million, $50.5 million and $55.3 million for the years ended 2011, 2010 and 2009, respectively. We held 21.1% and 13.6% of total invested assets in cash and cash equivalents as of December 31, 2011 and 2010, respectively. This relatively high concentration of cash and cash equivalents as of December 31, 2011 resulted primarily from the issuance of $175 million of convertible senior notes in December 2011.
Acquisitions AHL During 2011 and 2010, AmTrust Holdings Luxembourg S.A.R.L (“AHL”) (formerly called AmTrust Captive Holdings Limited) completed a series of acquisitions described below. AHL is a holding company that purchases Luxembourg captive insurance entities that allows us to obtain the benefit of the captives’ capital and utilization of their existing and future loss reserves through a series of reinsurance arrangements with one of our subsidiaries. AHL is included in our Specialty Risk and Extended Warranty segment.
In December 2011, AHL acquired all the issued and outstanding stock of Reaal Reassurantie S.A., a Luxembourg domiciled captive insurance company, from SNS REAAL N.V. and REAAL N.V. The purchase price of Reaal Reassurantie S.A. was approximately $72 million. We recorded approximately $79 million of cash, intangible assets of $15 million and a deferred tax liability of $22 million. Reaal Reassurantie S.A. subsequently changed its name to AmTrust Re Kappa.
In December 2011, AHL acquired all the issued and outstanding stock of Vandermoortele International Reinsurance Company SA, a Luxembourg domiciled captive insurance company, from NV Vandermoortele, Vandemoortele International Finance SA and NV Safinco. The purchase price of Vandermoortele International Reinsurance Company SA was approximately $66 million. We recorded approximately $71 million of cash, intangible assets of $11 million and a deferred tax liability of $16 million. Vandermoortele International Reinsurance Company SA subsequently changed its name to AmTrust Re Zeta.
In June 2011, AHL acquired all the issued and outstanding stock of International Crédit Mutuel Reinsurance SA (“ICM Re”), a Luxembourg domiciled captive insurance company, from Assurance du Credit Mutuel IARD SA. The purchase price of ICM Re was approximately $315 million. We recorded approximately $347 million of cash, intangible assets of $56 million and a deferred tax liability of $88 million. ICM Re subsequently changed its name to AmTrust Re Alpha.
We have classified the intangible assets as contractual use rights and they will be amortized based on the actual use of the related loss reserves.
Cardinal Comp In September 2008, we entered into a managing general agency agreement with Cardinal Comp, LLC (“Cardinal Comp”), a workers’ compensation managing general agent for which we paid the agency a commission for the placement of insurance policies. The agency operated in eight states and primarily in the state of New York. In September 2011, one of our subsidiaries entered into a renewal rights and asset purchase agreement with Cardinal Comp and Cook Inlet Alternative Risk LLC. The existing managing general agency agreement entered into in 2008 was terminated as part of the new agreement and will enable us to reduce commissions on written premium generated from the renewal rights agreement. In accordance with FASB ASC 805-10 Business Combinations, we recorded a purchase price of $30.4 million primarily for goodwill and intangible assets consisting of distribution networks, renewal rights and a trademark. The intangible assets have a life of between 2 and 16 years and are included as a component of the Small Commercial Business segment.
We have completed our purchase price accounting related to the Reinsurance Agreement and, in accordance with ASC 944-805 Business Combinations, we are required to adjust to fair value Majestic’s loss and LAE reserves by taking the acquired loss reserves recorded and discounting them based on expected reserve payout patterns using a current risk-free rate of interest. This risk free interest rate is then adjusted based on different cash flow scenarios that use different payout and ultimate reserve assumptions deemed to be reasonably possible based upon the inherent uncertainties present in determining the amount and timing of payment of such reserves. The difference between the acquired loss and LAE reserves and the our best estimate of the fair value of such reserves at acquisition date is amortized ratably over the payout period of the acquired loss and LAE reserves. We determined the fair value of the loss reserves to be $328.9 million. Accordingly, the amortization will be recorded as an expense on our income statement until fully amortized.
As a result of entering into the Purchase Agreement, in accordance with FASB ASC 805 Business Combinations, we recorded $3.9 million of intangible assets related to distribution networks and trademarks. The distribution networks have a life of 13 years and the trademarks have a life of two years. Additionally, we recorded a liability for approximately $0.4 million related to an unfavorable lease assumed in the transaction and a liability for approximately $0.8 million related to the above mentioned profit sharing provision.
Warrantech In August 2010, we, through our wholly-owned subsidiary AMT Warranty Corp., acquired 100% of the issued and outstanding capital stock of Warrantech Corporation and its subsidiaries (“Warrantech”) from WT Acquisition Holdings, LLC for approximately $7.5 million in cash and an earnout payment to the sellers of a minimum of $2.0 million and a maximum and $3.0 million based on AMT Warranty Corp.’s EBITDA over the three-year period from January 1, 2011 through December 31, 2013. Prior to the acquisition, we had a 27% equity interest (in the form of preferred units) in WT Acquisition Holdings, LLC and a $20 million senior secured note due January 31, 2012 issued to us by Warrantech. Interest on the note was payable monthly at a rate of 15% per annum and consisted of a cash component at 11% per annum and 4% per annum for the issuance of additional notes in principal amount equal to the interest not paid in cash on such date.
Immediately prior to the consummation of this transaction, WT Acquisition Holdings, LLC redeemed our preferred units that had represented our 27% equity interest in that entity. In addition, immediately following the transaction, AMT Warranty Corp. was recapitalized and we contributed our note receivable from Warrantech in the approximate amount of $24.1 million to AMT Warranty Corp. in exchange for Series A preferred stock, par value $0.01 per share (the “Series A Preferred Stock”), of AMT Warranty Corp. valued at $24.1 million. We also received additional shares of Series A Preferred Stock such that the total value of our 100% preferred share ownership in AMT Warranty Corp. is equivalent to $50.7 million. Lastly, AMT Warranty Corp. issued 20% of its issued and outstanding common stock to the Chairman of Warrantech, which had a fair value of $6.9 million as determined using both a market and an income approach. Given our preference position, absent our waiver, we will be paid distributions on our Series A Preferred Stock before any common shareholder would be entitled to a distribution on the common stock.
As a result, the ultimate acquisition price of Warrantech was $48.9 million and we recorded goodwill and intangible assets of approximately $69.7 million and $29.6 million, respectively. We incurred less than $0.1 million of costs related to the acquisition. The intangible assets consisted of trademarks, agency relationships and non-compete agreements, which had estimated lives of between 3 and 18 years. The results of operations from Warrantech, which are included in our Specialty Risk and Extended Warranty segment as a component of service and fee income, have been recorded since the acquisition date and were approximately $53 million and $17 million for the years ended December 31, 2011 and 2010, respectively.
Risk Services During June 2010, we completed the acquisition of eight direct and indirect subsidiaries of RS Acquisition Holdings Corp., including Risk Services, LLC and PBOA, Inc. (collectively, “Risk Services”). The entities acquired include various risk retention and captive management companies, brokering entities
We have a majority ownership interest (80%) in Risk Acquisition Holdco, LLC, for which our total consideration was $11.7 million. Acquisition costs associated with the acquisition were approximately $0.2 million. As part of the purchase agreement, the non-controlling interest has the option under certain circumstances to require us to purchase the remaining ownership interest (20%) of Risk Services. In accordance with FASB ASC Topic 480, Distinguishing Liabilities from Equity, and FASB ASC Topic 815, Derivatives and Hedging, we have classified the remaining 20% ownership interest of Risk Services as mezzanine equity on the Consolidated Balance Sheet.
In accordance with FASB ASC 805, Business Combinations, our total consideration paid for Risk Services was $11.7 million, which included cash of $11.1 million and a value of $0.6 million that was assigned for the redeemable non-controlling interest. We assigned a value of approximately $5.0 million to intangible assets and $5.0 million to goodwill. The intangible assets consisted of trade names, customer relationships, renewal rights and non-compete agreements and have finite lives ranging from 4 years to 17 years. The results of operations from Risk Services, which are included in our Small Commercial Business segment as a component of service and fee income, have been recorded since the acquisition date and were approximately $7 million for each of the years ended December 31, 2011 and 2010.
We, the Trust and Michael Karfunkel, individually, each shall be required to make its or his proportionate share of deferred payments payable by ACAC to GMACI pursuant to the GMACI Securities Purchase Agreement, which are payable, annually on March 1 through March 1, 2013, to the extent that ACAC is unable to otherwise provide for such payments. Our proportionate share of such deferred payments will not exceed $15.0 million. In addition, in connection with our investment, ACAC will grant us a right of first refusal to purchase or to reinsure commercial auto insurance business acquired from GMACI.
Personal Lines Quota Share We, effective March 1, 2010, reinsure 10% of the net premiums of the GMACI Business, pursuant to a 50% quota share reinsurance agreement (“Personal Lines Quota Share”) among Integon National Insurance Company, lead insurance company on behalf of the GMACI Insurers, as cedents, and the Company, ACP Re, Ltd., a Bermuda reinsurer that is a wholly-owned indirect subsidiary of the Trust, and Maiden Insurance Company, Ltd., as reinsurers. The Personal Lines Quota Share provides that the reinsurers, severally, in accordance with their participation percentages, receive 50% of the net premium of the GMACI Insurers and assume 50% of the related net losses. We have a 20% participation in the Personal Lines Quota Share, by which we receive 10% of the net premiums of the personal lines business and assume 10% of the related net losses. The Personal Lines Quota Share has an initial term of three years and will renew automatically for successive three-year terms unless terminated by written notice not less than nine months prior to the expiration of the current term. In addition, either party is entitled to terminate on 60 days’ written notice or less upon the occurrence of certain early termination events, which include a default in payment, insolvency, change in control of the Company or the GMACI Insurers, run-off, or a reduction of 50% or more of the shareholders’ equity. The GMACI Insurers also may terminate on nine months’ written notice following the effective date of an initial public offering or private placement of stock by ACAC or a subsidiary. The Personal Lines Quota Share provides that the reinsurers pay a provisional ceding commission equal to 32.5% of ceded earned premium, net of premiums ceded by the personal lines companies for inuring reinsurance, subject to adjustment to a maximum of 34.5% if the loss ratio for the reinsured business is 60.5% or less and a minimum of 30.5% if the loss ratio is 64.5% or higher. The Personal Lines Quota Share is subject to a premium cap that limits the premium that could be ceded by the GMACI Insurers to TIC to $121 million during calendar year 2011 to the extent TIC was to determine, in good faith, that it could not assume additional premium. The premium cap increases by 10% per annum thereafter. As a result of this agreement, we assumed $102.6 million and $82.3 million of business from the GMACI Insurers during the years ended December 31, 2011 and 2010, respectively.
Information Technology Services Agreement We provide ACAC and its affiliates information technology development services in connection with the development of a policy management system at a price of cost plus 20% pursuant to a Master Services Agreement with GMAC Insurance Management Corporation, a wholly-owned subsidiary of ACAC. In addition, as consideration for a license for ACAC and its affiliates to use that system, we receive a license fee in the amount of 1.25% of gross premiums of ACAC and its affiliates plus our costs for support services. We recorded approximately $4.0 million and $2.0 million of fee income for the years ended December 31, 2011 and 2010, respectively, related to this agreement.
Life Settlement Contracts A life settlement contract is a contract between the policy owner of a life insurance policy and a third-party investor who obtains the ownership and beneficiary rights of the underlying life insurance policy. During 2010, we formed Tiger Capital LLC (“Tiger”) with a subsidiary of ACAC for the purposes of acquiring life settlement contracts. In 2011, we formed AMT Capital Alpha, LLC (“AMT Alpha”) with a subsidiary of ACAC and AMT Capital Holdings, S.A. (“AMTCH”) with ACP Re, LTD., an entity controlled by Michael Karfunkel, for the purposes of acquiring additional life settlement contracts. We have a fifty percent ownership interest in each of Tiger, AMT Alpha and AMTCH (collectively, the “LSC entities”). Tiger may also acquire premium finance loans made in connection with the borrowers’ purchase of life insurance policies that are secured by the policy, which are in default at the time of purchase. The LSC entities acquire the underlying policies through the borrowers’ voluntary surrender of the policy in satisfaction of the loan or foreclosure. A third party serves as the administrator of the Tiger life settlement contract portfolio, for which it receives an annual fee. Under the terms of an agreement for Tiger, the third party administrator is eligible to receive a percentage of profits after certain time and performance thresholds have been met. We provide for certain actuarial and finance functions related to the LSC entities. Additionally, in conjunction with our 21.25% ownership percentage of ACAC, we ultimately receive 60.6% of the profits and losses of Tiger and AMT Alpha. As such, in accordance with ASC 810-10, Consolidation, we have been deemed the primary beneficiary and, therefore, consolidate the LSC entities.
Ceding Commission Revenues. Ceding commission is a commission we receive from ceding gross written premium to third-party reinsurers. In connection with the Maiden Quota Share, which is our primary source of ceding commission, we receive a ceding commission of 30% or 34.375%, based on the business ceded. Prior to April 1, 2011, we received a ceding commission of 31% or 34.375%, based on the business ceded. Additionally, for European medical liability business ceded to Maiden Insurance, Maiden Insurance pays us a 5% ceding commission, and we earn a profit commission of 50% of the amount by which the ceded loss ratio is lower than 65%. We allocate earned ceding commissions to our segments based on each segment’s proportionate share of total acquisition costs and other underwriting expenses recognized during the period.
• Management services - We provide services to insurance consumers, traditional insurers and insurance producers by offering flexible and cost effective alternatives to traditional insurance tools in the form of various risk retention groups and captive management companies, as well as management of workers’ compensation and commercial property programs.
• Installment and reinstatement fees - We recognize fee income associated with the issuance of workers’ compensation policies for installment fees, in jurisdictions where it is permitted and approved, and reinstatement fees, which are fees charged to reinstate a policy after it has been cancelled for non-payment, in jurisdictions where it is permitted and approved.
Other Expense. Other expense includes those charges that are related to the amortization of tangible and intangible assets and non-insurance fee generating activities in which we engage, including salaries and benefits expenses and other charges directly attributable to non-insurance fee generating activities, such as those generated by Warrantech and Risk Services.
Net Expense Ratio. The net expense ratio is a measure of an insurance company’s operational efficiency in administering its business. Expressed as a percentage, this is the ratio of the sum of acquisition costs and other underwriting expenses less ceding commission revenue to net premiums earned. As we allocate certain acquisition costs and other underwriting expenses based on premium volume to our segments, net loss ratio on a segment basis may be impacted period over period by a shift in the mix of net written premium.
Notwithstanding the inherent uncertainty, we have not experienced material variability in our loss development factors. We believe that it is reasonably likely that we could experience a 5% deviation in our loss and loss adjustment expense reserves due to changes in the elements that underlie loss development, such as claims frequency or severity. For example, as of December 31, 2011, the average cost per workers’ compensation claim was $11,871, which was a 4.3% increase over the claims severity from 2001 - 2010 of $11,377. In 2011, claims frequency (number of claims per $1.0 million of payroll) decreased to .972 from .979, a decrease of 0.7%, for the period between 2001 and 2011.
In the event of a 5% increase in claims frequency as measured by our insureds’ payroll, which we believe is the most important assumption regarding our business, our loss reserves as of December 31, 2011 would be understated by $16.3 million and would result in an after tax reduction in shareholders’ equity of $10.6 million. In the event of a 5% increase in claim severity, which is the average incurred loss per claim, our loss and loss adjustment expense reserves would be understated by $8.8 million and would result in an after tax reduction in shareholders’ equity of $5.7 million.
On a quarterly basis, at a minimum, and in some cases more frequently, we review our reserves to determine whether they are consistent with our actual results. In the event of a discrepancy, we would seek to determine the causes (underwriting, claims, inflation, regulatory) and would adjust our reserves accordingly. For example, if the development of our total incurred losses were 5% greater than the loss development factors would have predicted, we would adjust our reserves for the periods in question. In 2009, our liabilities for unpaid losses and LAE attributable to prior years decreased by $4.8 million primarily as result of favorable development in the Small Commercial Business segment, partially offset by unfavorable development from our involuntary participation in NCCI pools. In 2010, our liabilities for unpaid losses and LAE attributable to prior years increased by $7.9 million primarily as result of unfavorable loss development, in our Specialty Program segment. In 2011, our liabilities for unpaid losses and LAE attributable to prior years increased by $12.5 million primarily as result of higher actuarial estimates based on actual losses in our Specialty Program segment. We do not anticipate that we will make any material reserve adjustments, but will continue to monitor the accuracy of our loss development factors and adequacy of our reserves. Additional information regarding our reserves for loss and loss adjustment expenses can be found in “Item 1A. Risk Factors” and “Item 1. Business - Loss Reserves.”
As of December 31, 2011, if the actual results of the future premiums audits were 1% lower than the historical results used in calculating EBUB, the result would be a decrease in EBUB and net earned premium of $2.9 million or $1.9 million after tax. If the actual results of the future premiums audits were 1% higher than the historical results used in calculating EBUB, the result would be an increase in EBUB, and net earned premium of $2.9 million or $1.9 million after tax.
• whether management intends to sell the security and, if not, whether it is not more than likely than not that we will be required to sell the security before recovery of its amortized cost basis;
Deferred income taxes reflect the impact of “temporary differences” between the amount of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws and regulations. The deferred tax asset primarily consists of book versus tax differences for premiums earned, loss and loss adjustment expense reserve discounting, policy acquisition costs, earned but unbilled premiums, and unrealized holding gains and losses on marketable equity securities. We record changes in deferred income tax assets and liabilities that are associated with components of other comprehensive income, primarily unrealized investment gains and losses and foreign currency translation gains and losses, directly to other comprehensive income. Otherwise, we include changes in deferred income tax assets and liabilities as a component of income tax expense.
Ceding Commission. Ceding commission represents commission earned primarily through the Maiden Quota Share, whereby AmTrust receives a 30% or 34.375% ceding commission, depending on the business ceded, on ceded written premiums to Maiden. The ceding commission earned during the year ended December 31, 2011 and 2010 was $154.0 million and $138.3 million, respectively. Ceding commission increased period over period as a result of increased premium writings. Additionally, effective April 1, 2011, we entered into a 40% quota share reinsurance agreement with Maiden covering our European medical liability business by which we receive a five percent ceding commission. Prior to April 1, 2011, this business was ceded to another reinsurer.
Net Realized Gains (Losses) on Investments. Net realized gains on investments were $2.8 million, compared to net realized gains of $5.9 million for the year ended December 31, 2011 and 2010, respectively. The decrease in realized gains of investments related to lower trading activity of equity securities in 2011 as we have deemphasized equity investments in our overall investment portfolio. The net realized gains were inclusive of non-cash impairment writedowns of $4.4 million and $21.2 million in 2011 and 2010, respectively.
Loss and Loss Adjustment Expenses; Loss Ratio. Loss and loss adjustment expenses increased $206.8 million, or 43.8%, to $678.3 million for the year ended December 31, 2011 from $471.5 million for the year ended December 31, 2010. Our loss ratio for the years ended December 31, 2011 and 2010 was 65.4% and 63.2%, respectively. The increase in the loss ratio in 2011 resulted from higher current year accident selected ultimate losses as compared to selected ultimate losses from the prior year.
Net Gain on Investment in Life Settlement Contracts. Gain on investment in life settlement contracts increased $35.0 million, or 294%, to $46.9 million from $11.9 million for the years ended December 31, 2011 and 2010, respectively, and primarily resulted from the gain realized upon a mortality event in 2011 and the acquisition of a higher number of life settlement contracts that were purchased by or surrendered to us in satisfaction of premium finance loans during the year ended December 31, 2011 as compared to the year ended December 31, 2010.
Provision for Income Tax. Income tax expense for the year ended December 31, 2011 was $42.4 million, which resulted in an effective tax rate of 18.5%. Income tax expense for the year ended December 31, 2010 was $47.1 million, which resulted in an effective tax rate of 27.5%. The decrease in our effective rate resulted primarily from increases in tax exempt interest and foreign source income not subject to tax for the year ended December 31, 2011 compared to the year ended December 31, 2010.
Equity in Earnings of Unconsolidated Subsidiaries - Related Parties. Equity in earnings of unconsolidated subsidiaries - related parties decreased by $16.2 million for the year ended December 31, 2011 to $7.8 million. The majority of the decrease related to the initial acquisition gain on ACAC of $10.4 million we recognized during the year ended December 31, 2010 that was adjusted downward during the year ended December 31, 2011 by $3.6 million. Absent this adjustment for purchase price accounting, earnings related to ACAC decreased to $11.4 million in 2011 from $14.9 million in 2010 and resulted primarily from higher loss ratios on the GMACI Business.
Consolidated Results of Operations 2010 Compared to 2009 Gross Written Premium. Gross written premium increased $362.0 million, or 30.2%, to $1,560.9 million from $1,198.9 million for the years ended December 31, 2010 and 2009, respectively. The increase of $362.0 million was primarily attributable to growth in our Specialty Risk and Extended Warranty segment of
$287.2 million. The increase in Specialty Risk and Extended Warranty business resulted primarily from new coverage plans in the U.S. and Europe, as well as additional premiums from growth in our European business related to general liability, employers’ liability and professional and medical liability business generated by new underwriting teams who joined us in 2009 and 2010. Additionally, gross written premium increased by $82.3 million in 2010 as a result of business assumed from the GMACI Insurers pursuant to the Personal Lines Quota share.
Net Earned Premium. Net earned premium increased $171.8 million, or 29.9%, to $745.7 million from $573.9 million for the years ended December 31, 2010 and 2009, respectively. The increase (decrease) by segment was: Small Commercial Business - $13.4 million; Specialty Risk and Extended Warranty - $113.4 million; Specialty Program - $(4.4) million; and Personal Lines - $49.4 million.
Ceding Commission. The ceding commission earned during the years ended December 31, 2010 and 2009 was $138.3 million and $113.9 million, respectively. Ceding commission increased period over period as a result of increased premium writings, which were partially offset by an increase in the percentage of business ceded at 31% instead of 34.375% in 2010 compared to 2009.
Service and Fee Income. Service and fee income increased $31.4 million, or 102.3%, to $62.1 million from $30.7 million for the years ended December 31, 2010 and 2009, respectively. The increase was attributable primarily to fees of approximately $24.7 million generated from Warrantech and Risk Services, which were acquired in 2010, as well as $2.9 million of incremental fees from ACAC in 2010.
December 31, 2010 and 2009, respectively. The increase from 2009 to 2010 resulted primarily from improvement in realized gains on our investment portfolio offset partially by a higher loss ratio in 2010.
Small Commercial Business Segment Results of Operations 2011 Compared to 2010 Gross Written Premium. Gross written premium increased $143.8 million, or 30.9%, to $609.8 million for the year ended December 31, 2011 from $466.0 million for the year ended December 31, 2010. The increase resulted primarily from new business associated with additional product offerings, workers’ compensation rate increases in New York and Florida, higher overall policy counts and an increase in California workers’ compensation production of approximately $43 million, as well as $26 million from the assumption of unearned premium in connection with the Majestic acquisition.
Net Written Premium. Net written premium increased $112.6 million, or 46.3%, to $355.7 million from $243.1 million for the years ended December 31, 2011 and 2010, respectively. The increase in net premium resulted from an increase in gross written premium for the year ended December 31, 2011 compared to the year ended December 31, 2010, as well as the assumption of $26 million of unearned premium from Majestic.
Specialty Risk and Extended Warranty Segment Results of Operations 2011 Compared to 2010 Gross Written Premium. Gross written premium increased $308 million, or 41.1%, to $1,057 million for the year ended December 31, 2011 from $749 million for the year ended December 31, 2010. A majority of the increase related to growth in new and existing programs in our European business from warranty coverage of approximately $73 million, medical liability of approximately $61 million, general liability of approximately $19 million and professional liability of approximately $16 million. Additionally, the segment benefited from the underwriting of new programs in the U.S., and the assumption of unearned premium of $19 million from a new customer.
for the twelve months ended December 31, 2009. The additional increase in the loss and loss adjustment expense ratio in the twelve months ended December 31, 2010 resulted primarily from higher actuarial estimates based on actual losses.
Net Earned Premium Less Expenses Included in Combined Ratio (Underwriting Income). Net earned premium less expenses included in combined ratio increased $0.1 million, or 0.2%, to $61.9 million for the year ended December 31, 2010 from $61.8 million for the years ended December 31, 2009. The slight increase was attributable primarily to higher premiums earned in 2010 offset by an increase in allocated policy acquisition costs and salary expense.
Specialty Program Segment Results of Operations 2011 Compared to 2010 Gross Written Premium. Gross written premium increased $117.4 million, or 44.5%, to $381.5 million for the year ended December 31, 2011 from $264.1 million for the year ended December 31, 2010. The increase in gross written premium related primarily to an increase in new and existing programs of approximately $192 million, including commercial auto and general liability programs, excess and surplus lines programs and public entity programs. The increases were offset by declines in other programs as a result of our maintenance of our pricing and administrative discipline, which resulted in the termination of certain programs representing approximately $73 million, of which three programs represented approximately 81% of this decrease. Additionally, we experienced a decrease of approximately $1.6 million in business we wrote on
Acquisition Costs and Other Underwriting Expenses; Expense Ratio. Acquisition costs and other underwriting expenses increased $21.5 million, or 35.8%, to $81.6 million for the year ended December 31, 2011 from $60.1 million for the year ended December 31, 2010. The expense ratio increased to 27.6% for the year ended December 31, 2011 from 25.7% for the year ended December 31, 2010. The increase in the expense ratio was attributable to the allocation to this segment of a higher proportion of our unallocated expenses as a result of the increase in premium compared to the year ended December 31, 2010, but was partially offset by a decline in acquisition costs resulting from the assumption of certain business from an arrangement we fronted in 2010.
Specialty Program Segment Results of Operations 2010 Compared to 2009 Gross Written Premium. Gross written premium decreased $3.9 million, or 1.5%, to $264.1 million for the year ended December 31, 2010 from $268.0 million for the year ended December 31, 2009. The decrease in Specialty Program gross written premium related primarily to maintenance of our pricing and administrative discipline, which resulted in the termination of two programs. Additionally we experienced a decline from business we wrote on behalf of HSBC Insurance Company of Delaware pursuant to a 100% fronting arrangement that was entered into as an accommodation to the seller in connection with our acquisition of WIC and is now in run-off. The decrease was partially offset from new business generated by the addition of underwriting teams and their specialty programs.
Net Earned Premium Less Expenses Included in Combined Ratio (Underwriting Income). Net earned premium less expenses included in combined ratio were $9.9 million and $12.8 million for the years ended December 31, 2010 and 2009, respectively. The decrease of $2.9 million resulted primarily from an increase to the loss ratio period over period.
We began assuming commercial auto business from the GMACI Insurers effective March 1, 2010 pursuant to the Personal Lines Quota Share. We assumed $102.6 million and $82.3 million of premium from the GMACI Insurers for the years ended December 31, 2011 and 2010, respectively. The increase in 2011 related primarily to assuming business for twelve months in 2011 compared to ten months in 2010. Net earned premium increased in 2011 compared to 2010 due to the earning cycle of assumed premium written in 2010 and earned in 2011. Loss and loss adjustment expense increased 103.1% in 2011 compared to 2010 and increased proportionally with net earned premium. The increase in the net loss ratio in 2011 from 2010 resulted primarily from higher actuarial estimates based on actual losses. The decrease in the net expense ratio in 2011 compared to 2010 resulted from the sliding scale commission structure, by which the ceding commission payable to GMACI decreases as the loss ratio increases.
The table below summarizes the average duration by type of fixed maturity as well as detailing the average yield as of December 31, 2011 and 2010:
The impairment charges of our fixed-maturities and equity securities for the years ended December 31, 2011, 2010 and 2009 are presented in the table below:
In addition to the other-than-temporary impairment of $4.4 million recorded during the year ended December 31, 2011, we had $41.3 million of gross unrealized losses, of which $3.7 million related to marketable equity securities and $37.6 million related to fixed maturity securities as of December 31, 2011.
Corporate bonds represent 49% of the fair value of our fixed maturities and 97% of the total unrealized losses of our fixed maturities. We own 232 corporate bonds in the industrial, bank and financial and other sectors, which have a fair value of approximately 9%, 37% and 3%, respectively, and 8%, 85% and 4% of total unrealized losses, respectively, of our fixed maturities. We believe that the unrealized losses in these securities are the result, primarily, of general economic conditions and not the condition of the issuers, which we believe are solvent and have the ability to meet their obligations. Therefore, we expect that the market
The table below summarizes the gross unrealized losses of our fixed maturity and equity securities by length of time the security has continuously been in an unrealized loss position as of December 31, 2011:
There are 173 securities at December 31, 2011 that account for the gross unrealized loss, none of which we deem to be OTTI. Significant factors influencing our determination that unrealized losses were temporary included the magnitude of the unrealized losses in relation to each security’s cost, the nature of the investment and management’s intent not to sell these securities and it being not more likely than not that we will be required to sell these investments before anticipated recovery of fair value to our cost basis.
payments, interest on debt, taxes and shareholder dividends. Our income is generated primarily from our Insurance Subsidiaries and investment income.
We may generate liquidity through a combination of debt or equity securities issuances, as well as financing through borrowing and sales of securities. In 2011, we issued ten-year, $175.0 million convertible senior notes (the $25.0 million overallotment was issued in January 2012) and entered into a three-year, $150 million credit facility that was initially used to pay off the remaining principal balance of a then outstanding $40 million term loan.
The laws of the jurisdictions in which our Insurance Subsidiaries are organized regulate and restrict, under certain circumstances, their ability to pay dividends to us. As of December 31, 2011 and 2010, respectively, the Insurance Subsidiaries would have been permitted to pay dividends in the aggregate of approximately $306.1 million and $253.0 million, respectively. Our Insurance Subsidiaries paid dividends to us of $5.8 million in 2011. There were $5.0 million and $4.5 million of dividends paid in 2010 and 2009, respectively. In addition, the terms of our debt arrangements limit our ability to pay dividends on our common stock, and future borrowings may include prohibitions and restrictions on dividends. Additional information regarding our dividends is presented in “Item 1. Business - Regulation”, in “Item 1A. Risk Factors” and in “Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchase of Equity Securities - Dividend Policy” appearing elsewhere in this Form 10-K.
Comparison of Years Ended December 31, 2011 and 2010 Net cash provided by operating activities was approximately $295 million for the year ended December 31, 2011, compared to $26 million for the same period in 2010. The increase in cash provided from operations resulted primarily from an increase in gross written premium written in 2011 compared to 2010. Additionally, we had increased cash collections in 2011 related to the earning of the tail end of premium written in 2010 for Specialty Risk and Extended Warranty segment policies that generally have a longer
policy life and therefore a longer cash collection cycle. The increase was partially offset by earnings from our equity investment in ACAC and gains from our investment in life settlement contracts, which were non-cash.
Net cash used in investing activities was $97 million for the year ended December 31, 2011. Net cash used in investing activities was $210 million for the year ended December 31, 2010. In 2011, net cash used in investing activities primarily included approximately $44 million for the net purchase of fixed and equity securities, approximately $53 million for the acquisition of and premium payments for life settlement contracts, approximately $39 million for capital expenditures and approximately $30 million for the Cardinal Comp acquisition, and was partially offset by the net receipt of cash in the approximate amount of $44 million obtained in the acquisition of Luxembourg captives and approximately $29 million obtained as part of the loss portfolio transfer from Majestic. In 2010, major components of net cash provided by investing activities included an equity investment in ACAC of $53 million, acquisitions of Warrantech and Risk Services of $20 million, net purchases of investments for $105 million and capital expenditures of $15 million.
Net cash provided by financing activities was $19 million for the year ended December 31, 2011 compared to net cash used in 2010 of $150 million. In 2011, cash provided by financing activities primarily included the receipt of $175 million from the issuance of our convertible senior notes and the contribution of approximately $25 million from non-controlling interests to our subsidiaries partially offset by the repayment on repurchase agreements in the amount of approximately $156 million, dividend payments of approximately $20 million and principal payment of debt obligations of approximately $15 million. In 2010, cash provided by financing activities included $175 million received from entering into repurchase agreements and capital contributions to a subsidiary of $11 million, partially offset by principal payments on debt of $21 million and dividend payments of $17 million.
In 2011, cash and cash equivalents increased $213.9 million and resulted primarily from generating cash from operations and the issuance of our convertible senior notes. Premium receivables increased $205.4 million as a result of the increase in premium writing in 2011, related primarily to organic growth in Europe in the Specialty Risk and Extended Warranty segment. Prepaid expenses and other assets increased $137.1 million and resulted primarily from our investment in life settlement contracts. Reinsurance recoverable increased $323.1 million as a result of ceding more premium in 2011 compared to 2010.
Reinsurance The following table summarizes the top eleven reinsurers that account for approximately 92% of our reinsurance recoverables on paid and unpaid losses and loss adjustment expenses as of December 31, 2011:
(2) Amount recoverable from Trinity Universal is the result of the UBI acquisition. Prior to our acquisition, MCIC, SNIC, AICK and ALIC ceded all of their net retention to Trinity Universal.
per annum on such losses. Effective August 19, 2011, we purchased a new layer of coverage providing $100 million in excess of $130 million per occurrence, providing us with total protection of $220 million for losses in excess of $10.0 million. The agreements have annual limits of coverage of twice the occurrence limit.
Our reinsurance for workers’ compensation losses caused by acts of terrorism is more limited than our reinsurance for other types of workers’ compensation losses and, effective August 19, 2011, provides coverage, per contract year, of $220.0 million in the aggregate, in excess of an aggregate retention of $10.0 million, but excludes acts of nuclear, biological or chemical terrorism (which are covered by the Terrorism Risk Insurance Act, as amended (“TRIA”)). The reinsurance for worker’s compensation losses caused by acts of terrorism is provided net of any recovery we receive from the federal government pursuant to TRIA. A limited amount of workers’ compensation and excess workers’ compensation exposures are written as reinsurance and were not, prior to January 1, 2012, protected by the excess reinsurance program listed above. The limit exposed to a single workers’ compensation occurrence loss for such exposures varies depending on the size of the loss occurrence. For smaller losses, the additional exposure can be as high as $6.625 million, while for larger losses (greater than $30.0 million for the group), the additional exposure is $0.525 million or less unless the group loss exceeds $230 million.
Specialty Risk and Extended Warranty Reinsurance We purchase quota share and/or excess of loss and/or facultative reinsurance for specific programs, specialty lines of business, or individual policies to limit our loss exposure and/or allow our program managers to share the risks and rewards of the business they produce.
Reinsurance Agreements with Maiden Holdings, Ltd. During the third quarter of 2007, we entered into a master agreement with Maiden, as amended, by which our Bermuda subsidiary, AII, and Maiden Insurance entered into a quota share reinsurance agreement (the “Maiden Quota Share”), as amended. Under this agreement, AII retrocedes to Maiden Insurance an amount equal to 40% of the premium written by our U.S., Irish and U.K. insurance companies (the “AmTrust Ceding Insurers”), net of the cost of unaffiliated inuring reinsurance (and in the case of our U.K. insurance subsidiary, AEL, net of commissions) and 40% of losses, excluding certain specialty risk programs that we commenced writing after the effective date and risks, other than workers’ compensation risks and certain business written by our Irish subsidiary, AIU, for which the AmTrust Ceding Insurers’ net retention exceeds $5.0 million, which Maiden has not expressly agreed to assume (“Covered Business”). Effective January 1, 2010, Maiden agreed to assume its proportionate share of our workers’ compensation exposure in excess of $5.0 million, and will share the benefit of our excess of loss reinsurance protection.
Effective April 1, 2011, the Maiden Quota Share, as amended, further provides that AII receives a ceding commission of 30% of ceded written premiums with respect to all Covered Business, except retail commercial package business, for which the ceding commission is 34.375%. Commencing January 1, 2012, the ceding commission, excluding the retail package business ceding commission (which remains at 34.375%), was adjusted to (a) 30% of ceded premium, if the Specialty Risk and Extended Warranty subject premium, excluding ceded premium related to our medical liability business discussed below, is greater than or equal to 42% of the total subject premium, (b) 30.5% of ceded premium, if the Specialty Risk and Extended Warranty subject premium is less than 42% but greater than or equal to 38%, or (c) 31% of ceded premium, if the Specialty Risk and Extended Warranty subject premium is less than 38% of the total subject premium. Prior to April 1, 2011, AII received a ceding commission of 31% of ceded premiums with respect to all Covered Business, except retail commercial package business, for which the ceding commission was 34.375%.
Effective September 1, 2010, we, through our subsidiary, SNIC, entered into a reinsurance agreement with Maiden Reinsurance Company and an unrelated third party. Under the agreement, which had an initial term of one year and has been extended to August 31, 2012, SNIC cedes 80% of the gross liabilities produced under the Southern General Agency program to Maiden Reinsurance Company and 20% of the gross liabilities produced to the unrelated third party. SNIC receives a five percent commission on ceded written premiums. We ceded written premium of $0.9 million for the year ended December 31, 2011 related to this agreement, for which we earned ceding commission of $0.2 million for the year ended December 31, 2011.
Other Reinsurance As part of our acquisition of AIIC, we acquired reinsurance recoverables as of the date of closing. The most significant reinsurance recoverable is from American Home Assurance Co. (“American Home”). AIIC’s reinsurance relationship with American Home incepted January 1, 1998 on a loss occurring basis. From January 1, 1998 through March 31, 1999, the American Home reinsurance covered losses in excess of $0.25 million per occurrence up to statutory coverage limits. Effective April 1, 1999, American Home provided coverage in the amount of $0.15 million in excess of $0.1 million. This additional coverage terminated on December 31, 2001 on a run-off basis. Therefore, for losses occurring in 2002 that attached to a 2001 policy, the retention was $0.1 million per occurrence. Effective January 1, 2002, American Home increased its attachment to $0.25 million per occurrence. The excess of loss treaty that had an attachment of $0.25 million was terminated on a run-off basis on December 31, 2002. Therefore, losses occurring in 2003 that attached to a 2002 policy were ceded to American Home at an attachment point of $0.25 million per occurrence.
The Credit Agreement contains certain restrictive covenants customary for facilities of this type (subject to negotiated exceptions and baskets), including restrictions on indebtedness, liens, acquisitions and investments, restricted payments and dispositions. There are also financial covenants that require us to maintain a minimum consolidated net worth, a maximum consolidated leverage ratio, a minimum fixed charge coverage ratio, a minimum risk-based capital and a minimum statutory surplus. We were in compliance with all covenants as of December 31, 2011.
As of December 31, 2011, we had no outstanding borrowings under this Credit Agreement. We had outstanding letters of credit in place under this Credit Agreement at December 31, 2011 for $49.8 million, which reduced the availability on the line of credit to $0.2 million and the availability under the facility to $100.2 million as of December 31, 2011.
We recorded approximately $1.0 million of deferred financing costs related to the Credit Agreement. Fees payable by us under the Credit Agreement include a letter of credit participation fee (which is the margin applicable to Eurodollar borrowings and was 2.25% at December 31, 2011), a letter of credit fronting fee with respect to each letter of credit (.125%) and a commitment fee on the available commitments of the lenders (a range of .35% to .45% based on our consolidated leverage ratio and was 0.40% at December 31, 2011).
The interest rate on the credit facility as of December 31, 2011 was 2.50%. We recorded interest expense of approximately $2.7 million for the year ended December 31, 2011, under the Credit Agreement. We recorded interest expense of approximately $0.07 million and $0.8 million for the years ended December 31, 2011 and 2010, respectively, related to the terminated term loan.
Secured Loan Agreement During February 2011, we entered into a seven-year secured loan agreement with Bank of America Leasing & Capital, LLC in the aggregate amount of $10.8 million to finance the purchase of an aircraft. The loan bears interest at a fixed rate of 4.45%, requires monthly installment payments of approximately $0.1 million, commencing on March 25, 2011 and ending on February 25, 2018, and a balloon payment of $3.2 million at the maturity date. We recorded approximately $0.07 million of deferred financing costs related this agreement. We recorded interest expense of approximately $0.4 million for the year ended December 31, 2011 related to this agreement. The loan is secured by an aircraft that one of our subsidiaries acquired in February 2011.
The agreement contains certain covenants that are similar to our revolving credit facility. Additionally, subsequent to February 25, 2012, but prior to payment in full, if the outstanding balance of this loan exceeds 90% of the fair value of the aircraft, we are required to pay the lender the entire amount necessary to reduce the outstanding principal balance to be equal or less than 90% of the fair value of the aircraft. The agreement allows us, under certain conditions, to repay the entire outstanding principal balance of this loan without penalty.
Promissory Note In connection with the stock and asset purchase agreement with a subsidiary of Unitrin, Inc. (now called Kemper Corporation), on June 1, 2008, we issued a promissory note to Unitrin, Inc. in the amount of $30 million. The note is non-interest bearing and requires four annual principal payments of $7.5 million. We paid the first three annual principal payments between 2009 and 2011, and the remaining principal payment is due on June 1, 2012. Upon entering into the promissory note, we calculated imputed interest of approximately $3.2 million based on interest rates available to us, which was 4.5%. Accordingly, the note’s carrying balance was adjusted to approximately $26.8 million at the acquisition. The note is required to be paid in full, immediately, under certain circumstances including a default of payment or change of control of the Company. We included approximately $0.5 million and $0.8 million of amortized discount on the note in our results of operations for the years ended December 31, 2011 and 2010, respectively. The note’s carrying value at December 31, 2011 was $7.4 million.
Comerica Letter of Credit Facility One of our subsidiaries, entered into a secured letter of credit facility with Comerica Bank, N.A. during 2011. The credit limit is for $75 million and was utilized for $49.8 million as of December 31, 2011. We are required to pay a letter of credit participation fee for each letter of credit in the amount of 0.40%.
Contractual Obligations and Commitments The following table sets forth certain of our contractual obligations as of December 31, 2011:
(5) The interest related to the debt by period is as follows: $19.2 million - less than 1 year, $36.4 million - 1 - 3 years, $29.5 million - 3 - 5 years and $135.4 million - more than 5 years. In addition, included within debt and interest is $168.0 million related to the Maiden collateral loan and $4.8 million of associated interest.