We own two adjacent buildings that house our corporate headquarters and the surrounding real estate located in Richfield, Ohio. The buildings consist of approximately 164,000 square feet of rentable office space on 17.5 acres. We occupy approximately 136,000 square feet and lease the remainder to unaffiliated tenants.
We lease office space in Fenton, Missouri; Kapolei, Hawaii; and Mechanicsburg, Pennsylvania. The leases account for approximately 50,000 square feet of office space. These leases expire within forty-three months. The monthly rents, exclusive of operating expenses, to lease these facilities currently total approximately $88,000. We believe that these leases could be renewed or replaced at commercially reasonable rates without material disruption to our business.
The statutory policyholder surplus of National Interstate Insurance Company ("NIIC"), which includes the statutory policyholder surplus of its subsidiaries, Vanliner Insurance Company, National Interstate Insurance Company of Hawaii, Inc. and Triumphe Casualty Company.
Our specialty property and casualty insurance companies are licensed in all 50 states, the District of Columbia and the Cayman Islands. Our goal is to generate underwriting profits by providing what we view as specialty insurance products, services and programs not generally available in the marketplace. While many companies write property and casualty insurance for transportation companies, we believe that few write passenger transportation coverage nationwide and very few write coverage for several of the classes of passenger transportation insurance written by our subsidiaries. We focus on niche insurance markets where we offer insurance products designed to meet the unique needs of targeted insurance buyers that we believe are underserved by the insurance industry. These niche markets typically possess what we view as barriers to entry, such as being too small, too remote or too difficult to attract or sustain most competitors. Examples of products that we write for these markets include captive programs for transportation companies that we refer to as our alternative risk transfer (“ART”) programs (54.3% of 2014 gross premiums written), property and casualty insurance for transportation companies (35.6%), specialty personal lines, primarily recreational vehicle (5.2%) and transportation and general commercial insurance in Hawaii and Alaska (3.1%). We strive to become a market leader in the specialty markets that we choose and serve by offering what we believe are specialized products, excellent customer service and superior claims response.
The property/casualty (“P/C”) insurance industry is cyclical, with periods of rising premium rates and shortages of underwriting capacity (“hard market”) followed by periods of substantial price competition and excess capacity (“soft market”). The P/C insurance industry generated a year-over-year increase in premiums written for the fifth consecutive year. The industry’s sustained improvement in premiums written was driven by both the exposure base’s recovery and the ongoing firming of rates, which began to moderate during 2014 as more competition entered the market, specifically for high quality large commercial accounts. According to A.M. Best, the P/C insurance industry is expected to report year-to-date profitable underwriting results in 2014 primarily due in part to improved pricing and a continued focus on underwriting margins.
Our stable operating expenses (which include both “Commissions and other underwriting expenses” and “Other operating and general expenses” on our Consolidated Statements of Income) have historically been at or below the revenue growth rate.
The P/C insurance industry had its second consecutive year of relatively low catastrophe losses in 2014, although there was an increase from the prior year due to prolonged periods of inclement weather experienced during the first quarter of 2014. For weather-related events such as hurricanes, tornados and hailstorms, we conduct an analysis at least annually pursuant to which we input our in-force exposures (vehicle values in all states and property limits in Hawaii) into an independent catastrophe model that predicts our probable maximum loss at various statistical confidence levels. Our estimated probable maximum loss is impacted by changes in our in-force exposures as well as changes to the assumptions inherent in the catastrophe model. Hurricane and other weather-related events have not had a material negative impact on our past or current results.
Our transportation insurance business in particular is also affected by loss cost trends that negatively impact profitability such as inflation in vehicle repair costs, vehicle replacement parts costs, used vehicle prices, fuel costs and medical care costs. We routinely
As described below, the average revenue dollar per personal lines policy is significantly lower than typical commercial policies. Profitability in the specialty personal lines component is dependent on proper pricing and the efficiency of underwriting and policy administration. We have continued to monitor rate levels and have adjusted them during 2014, as warranted. We continuously strive to improve our underwriting and policy issuance functions to keep this cost element as low as possible by utilizing current technological advances.
We derive our revenues primarily from premiums from our insurance policies and income from our investment portfolio. Our underwriting approach is to price our products to achieve an underwriting profit even if it requires us to forego volume. As with all P/C insurance companies, the impact of price changes is reflected in our financial results over time. Price changes on our in-force policies occur as they are renewed, which generally takes twelve months for our entire book of business and up to an additional twelve months to earn a full year of premium at the average renewal rate. Insurance rates charged on renewing policies reflected an approximate average increase of 7% in both 2014 and 2013.
We approach investment and capital management with the intention of supporting insurance operations by providing a stable source of income to supplement underwriting income and mitigate underwriting losses. The goals of our investment policy are to protect capital, optimize investment income and capital appreciation and to maintain appropriate liquidity. We follow a formal investment policy and the Board reviews the portfolio performance at least quarterly for compliance with the established guidelines. In 2014, investment yields on our existing portfolio increased as a result of a decline in market interest rates. The increase in yields of our existing portfolio during the year contributed to an overall increase in the unrealized gain position of our holdings. We recorded a $6.8 million pre-tax net realized gain on investments in 2014 as compared to $6.5 million recorded in 2013. Included in these pre-tax net realized gains are other-than-temporary impairment charges of $2.0 million and $0.2 million, respectively.
Other operating and general expenses consist primarily of personnel expenses (including salaries, benefits and certain costs associated with awards under our equity compensation plans, such as stock compensation expense) and other general operating expenses. Our personnel expenses are primarily fixed in nature and do not vary with the amount of premiums written. Interest expenses associated with outstanding debt and “Expense on amounts withheld” are disclosed separately from operating and general expenses. We invest funds in the participant loss layer for several of our ART programs. We receive investment income and generate gains or losses and incur an equal expense on the amounts owed to ART participants. “Expense on amounts withheld” represents investment income and net realized gains that we remit back to ART participants. The related investment income and net realized gains are included in the “Net investment income” and "Net realized gains" lines on our Consolidated Statements of Income.
Our net income for 2014 was $11.0 million ($0.56 per share diluted) compared to $17.6 million ($0.89 per share diluted) in 2013. Net income reflects an elevated loss and LAE ratio for the year ended December 31, 2014 of 83.8% compared to 81.7% for the same period in 2013. The loss ratio increase was primarily attributable to unfavorable development from prior years’ loss reserves including $20.0 million of reserve strengthening recorded in the second quarter of 2014, primarily for accident years 2011 and 2012 and, to a lesser extent, for 2013. The majority of such strengthening was concentrated in our commercial auto liability lines of business. In addition, net income was adversely impacted by after-tax transaction expenses of $1.4 million, ($0.07 per share
diluted) related to the Great American tender offer that was withdrawn during the 2014 first quarter. See Note 10 - “Transactions with Related Parties” to the Consolidated Financial Statements. Transaction expenses primarily consisted of financial advisory and legal services. No such expenses were incurred during 2013. Our after-tax net realized gains of $4.4 million ($0.22 per share diluted) in 2014 compared to $4.2 million ($0.22 per share diluted) in 2013 were primarily generated by net gains from sales or redemptions of securities as well as gains generated from our other invested assets. Other components of 2014 net income include an increase in net investment income due to higher average invested assets as well as maintaining relatively flat underwriting and operating expenses compared to 2013.
Our group ART programs, which focus on specialty or niche businesses, provide various services and coverages tailored to meet specific requirements of defined client groups and their members. These services include risk management consulting, claims administration and handling, loss control and prevention and reinsurance placement, along with providing various types of property and casualty insurance coverage. Insurance coverage is provided primarily to companies with similar risk profiles and to specified classes of business of our agent partners.
Our premiums earned increased $31.6 million, or 6.0%, to $557.3 million during the year ended December 31, 2014 compared to $525.7 million for the year ended December 31, 2013. The increase is primarily attributable to our ART and transportation components, which grew $17.2 million, or 6.1%, and $19.1 million, or 11.1%, respectively, and was partially offset by a $10.2 million, or 22.6%, decrease in our specialty personal lines component. The ART component growth in premiums earned is primarily associated with our existing group ART programs, due to rate increases and increased exposures on renewal business as well as the addition of new customers. This growth was partially offset by the impact of ending business relationships with two agents within the program portion of our ART component, which occurred in late 2012 and 2013, as well as taking rate actions and non-renewing unprofitable business during 2013 and 2014. The increase in the transportation component reflects our continued growth from new business written as well as rate and exposure increases on renewed business experienced throughout 2013 and 2014. The decrease in our specialty personal lines component was primarily due to our decision to stop selling our commercial vehicle product during the third quarter of 2013.
Our premiums earned increased $67.7 million, or 14.8%, to $525.7 million during the year ended December 31, 2013 compared to $458.0 million for the year ended December 31, 2012. The increase is primarily attributable to our ART and transportation components, which grew $42.4 million, or 17.6%, and $23.7 million, or 16.0%, respectively, during 2013 compared to 2012. The ART growth in premiums earned is primarily attributable to new business written during the fourth quarter of 2012 and earned in 2013 and an increase in assessment premium while the increase in the transportation component reflects growth in gross premiums written from new and existing programs experienced throughout 2012 and 2013.
2014 compared to 2013. Our loss and LAE ratio for the year ended December 31, 2014 increased 2.1 combined ratio points to 83.8% compared to 81.7% during the same period in 2013. This increase over the prior period is primarily attributable to adverse development on prior years' loss reserves, inclusive of $20.0 million in reserve strengthening recorded during the second quarter of 2014, as well as an elevated current accident year loss and LAE ratio compared to the undeveloped prior year loss and LAE ratio. For the year ended December 31, 2014, we had unfavorable development from prior years’ loss reserves of $30.6 million, or 5.5 combined ratio points, compared to unfavorable development of $23.1 million, or 4.4 combined ratio points, for the prior period. Unfavorable development is primarily related to settlements above the established case reserves and revisions to our estimated future settlements on an individual case by case basis.
Industry trends indicated that commercial auto policies written during the prolonged soft market conditions were at rates below those required to keep pace with changing economic and societal influences related to claims settlements. These influences, such as HIPAA regulations, increased litigation costs, lower spending on safety measures and increased fraud have resulted in adverse industry trends of prior year reserves in the commercial auto liability line. Similar to the industry, we had experienced unfavorable
Considering our results and industry trends, we continue to closely monitor the commercial auto liability line of business with enhanced focus on re-underwriting to improve performance, including our pricing and risk selection on new and renewal business. In 2013, we exited several unprofitable businesses including the commercial vehicle product, and we priced away or chose not to renew over $65 million of business. Applying the same disciplines, in 2014 we shed approximately $40 million in business through non-renewals or rate actions. We also have and continue to proactively enhance our process and related procedures surrounding reserving in response to both our own financial trends and those of the industry.
2013 compared to 2012. Losses and LAE increased $88.5 million, or 26.0%, in 2013 compared to 2012. Our consolidated loss and LAE ratio for the year ended December 31, 2013 increased 7.3 percentage points to 81.7% compared to 74.4% for the same period in 2012. This increase over the prior period was primarily attributable to a combination of uncharacteristically high claims severity and unfavorable development in prior years’ loss reserves. Three claims which occurred during the 2013 second quarter, two in our traditional passenger transportation business and one in our moving and storage business, represented a part of the severe claim activity in accident year 2013, and were related to long-term insureds with historically favorable loss histories. For the year ended December 31, 2013, we experienced unfavorable development from prior years’ loss reserves of $23.1 million, or 4.4 percentage points. The unfavorable development, which related to several accident years but was more prominent in accident years 2011 and 2010, was predominately in the commercial auto liability line of business with a portion related to business that is no longer in force. This compared to unfavorable development of $3.3 million, or 0.7 percentage points, for the prior period.
The consolidated underwriting expense ratio for the year ended December 31, 2013 decreased 2.4 percentage points to 20.7% compared to 23.1% for the same period in 2012. The 2.4 percentage point decrease was primarily attributable to a lower cost structure in our mix of business written during 2013 as compared to 2012, decreased variable compensation expense as compared to prior year and leveraging our operating costs while increasing our premium base during 2013. Specifically, costs associated with our insurance operations, such as product management, underwriting, sales and marketing costs, remained relatively flat during 2013 as compared to 2012.
2014 compared to 2013. Net investment income increased $2.1 million, or 6.4%, to $35.5 million in 2014 compared to 2013. The increase in net investment income is primarily due to higher average invested assets and our ability to invest in new securities with average yields that are comparable to maturing securities.
2014 compared to 2013. In 2014, we had pre-tax net realized gains of $6.8 million compared to $6.5 million for 2013. The pre-tax net realized gains for the year ended December 31, 2014 were primarily generated from the sales or redemptions of securities of $5.4 million, as well as net gains associated with other invested assets of $3.3 million. Offsetting these gains were other-than-temporary impairment charges of $2.0 million. The pre-tax net realized gains for the year ended December 31, 2013 were primarily generated from net realized gains from the sales or redemptions of securities of $5.2 million, as well as net gains associated with other invested assets of $1.5 million. Offsetting these gains were other-than-temporary impairment charges of $0.2 million.
2013 compared to 2012. Commissions and other underwriting expenses for the year ended December 31, 2013 increased $2.3 million, or 2.5%, to $92.2 million from $89.9 million in the comparable period in 2012, primarily due to the premium growth experienced in 2013. As a percentage of premiums earned, commissions and other underwriting expenses decreased to 17.5% for the year ended December 31, 2013 as compared to 19.6% for the same period in 2012. Such decrease is attributable to changes in our mix of business written, resulting in a lower overall expense structure, over an increase in earned premiums during 2013 and decreased variable compensation expenses as compared to the prior year.
2013 compared to 2012. For the year ended December 31, 2013, interest expense increased $0.1 million compared to the same period in 2012, primarily due to a $0.2 million increase in interest accrued related to contractual amounts payable to UniGroup under the balance sheet guaranty. Partially offsetting such increase was a decrease of $0.1 million in interest expense on long-term debt. In December 2012, long-term debt was temporarily increased to help fund our one-time special $2.00 per share dividend which increased interest expense on long-term debt in 2012.
2014 compared to 2013. The 2014 effective tax rate was 6.3%, decreasing 12.7 percentage points from a rate of 19.0% in 2013. The decrease in our effective tax rate can be attributed to the $9.9 million decrease in income before taxes while tax-exempt income remained stable.
Fixed maturity investments are generally invested in securities with intermediate-term maturities. At December 31, 2014, the weighted average maturity of our fixed maturity investments was approximately 5.9 years. At December 31, 2014, 89.9% of the fixed maturities in our portfolio were rated “investment grade” (credit rating of AAA to BBB-) by nationally recognized rating agencies. Investment grade securities generally bear lower degrees of risk and corresponding lower yields than those that are unrated or non-investment grade. Although we cannot provide any assurances, we believe that, in normal market conditions, our high quality investment portfolio should generate a stable and predictable investment return.
Included in fixed maturities at December 31, 2014 were $341.6 million of state and local government obligations, which represented approximately 35.0% of our fixed maturity portfolio, with approximately $285.3 million, or 83.5% of our state and local government obligations held in special revenue obligations, and the remaining amount held in general obligations. Our state and local government obligations portfolio is high quality, as 98.8% of such securities were rated investment grade at December 31, 2014. We had no state and local government obligations for any state, municipality or political subdivision that comprised 10% or more of the total amortized cost or fair value of such obligations at December 31, 2014. Also included in fixed maturities at December 31, 2014 were $192.6 million of residential mortgage-backed securities ("MBS"). We do not have significant exposure to the subprime lending sector and 58.2% of our residential MBS are backed by U.S. government agencies.
When a decline in the value of a specific investment is considered to be other-than-temporary, a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced. The determination of whether unrealized losses are other-than-temporary requires judgment based on subjective as well as objective factors. Included in equity securities unrealized losses one year or longer exceeding $50,000 is one investment grade nonredeemable preferred stock that has been in an unrealized loss position for twelve months or more. Factors considered and resources used by management include those discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Other-Than-Temporary Impairment.”
Net realized gains on securities sold, including net gains on other invested assets, and charges for other-than-temporary impairment on securities held were as follows:
Level 1 consists of publicly traded equity securities and highly liquid, direct obligations of the U.S. Government whose fair value is based on quoted prices that are readily and regularly available in an active market. Level 2 primarily consists of financial instruments whose fair value is based on quoted prices in markets that are not active and include U.S. government agency securities, fixed maturity investments and nonredeemable preferred stocks that are not actively traded. Included in Level 2 are $151.9 million of securities, which are valued based upon a non-binding broker quote and validated with other observable market data by management. Level 3 consists of financial instruments that are not traded in an active market, whose fair value is estimated by management based on inputs from independent financial institutions, which include non-binding broker quotes. We believe these estimates reflect fair value, but we are unable to verify inputs to the valuation methodology. We obtained at least one quote or price per instrument from brokers and pricing services for all Level 3 securities and did not adjust any quotes or prices that we obtained. Our internal and affiliated investment professionals review these broker quotes using any recent trades, if such information is available, or market prices of similar investments. We primarily use the market approach valuation technique for all investments.
We believe that our insurance subsidiaries maintain sufficient liquidity to pay claims and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies. Our principal sources of liquidity are our existing cash and cash equivalents. Cash and cash equivalents increased $17.9 million from $35.7 million at December 31, 2013 to $53.6 million at December 31, 2014. For 2014, 2013 and 2012, net cash provided by operating activities was $86.4 million, $50.4 million and $71.7 million, respectively. The $36.0 million increase in cash flow from operations in 2014 from 2013 is primarily attributable to an increase in premiums collected and relatively flat payments made for loss and loss adjustment expenses year-over-year. Cash flow from operations decreased $21.3 million in 2013 from 2012 primarily attributable to the $17.3 million payment made in June 2013 associated with the settlement of the Vanliner balance sheet guaranty, whereas the payment in 2012 was $3.6 million. See note 2 - "Significant Accounting Policies" for a discussion on the contingent consideration related to the Vanliner balance sheet guaranty.
Net cash used in investing activities was $61.5 million and $49.2 million for the years ended December 31, 2014 and 2013, respectively, as compared to net cash provided by investing activities of $0.6 million for the year ended December 31, 2012. This $12.3 million increase in cash used in investing activities during 2014, as compared to 2013, was primarily driven by investing net operating cash to purchase fixed maturity and equity securities which outpaced the proceeds from sales and redemptions of such securities. Proceeds from sales and redemptions of fixed maturity securities have decreased amid a relatively low interest rate environment which has lead to a shift in asset allocation from callable U.S. government agency bonds into longer duration state and local government bonds, residential mortgage-backed securities and corporate obligations. The $49.8 million increase in cash used by investing activities in 2013, as compared to 2012, was primarily driven by reinvesting funds in excess of cash requirements into fixed maturity and dividend yielding equity securities throughout 2013, whereas in 2012 investment securities that were sold or matured were used to fund the one-time special $2.00 per share dividend, which is reflected in our 2012 financing activities.
Net cash used in financing activities was $7.0 million, $7.5 million and $54.0 million for the years ended December 31, 2014, 2013 and 2012, respectively. The decrease in net cash used in financing activities in 2014, as compared to 2013, was primarily due to an increase in proceeds received from the issuance of common shares upon the exercise of stock options which was partially offset by an increase in dividends paid to shareholders. The $46.5 million decrease in net cash used in financing activities in 2013, as compared to 2012, was primarily due to our one-time special $2.00 per share dividend payment in December 2012 totaling $39.3 million and a $12.0 million reduction in net borrowings, whereas there was no such activity in 2013.
On November 19, 2012, we replaced our $50.0 million credit agreement with a $100.0 million unsecured credit agreement (the “Credit Agreement”) that terminates in November 2017, which includes a sublimit of $10.0 million for letters of credit. We have the ability to increase the line of credit to $125.0 million subject to the Credit Agreement’s accordion feature. Amounts borrowed bear interest at either (1) a LIBOR rate plus an applicable margin ranging from 0.75% to 1.00% based on our A.M. Best insurance group rating, or (2) a rate per annum equal to the greater of (a) the administrative agent’s prime rate, (b) 0.50% in excess of the federal funds effective rate, or (c) 1.00% in excess of the one-month LIBOR rate. Based on our A.M. Best insurance group rating of “A” at December 31, 2014, we would pay interest at the LIBOR rate plus 0.875%. At December 31, 2014, we had $12.0 million outstanding under the Credit Agreement, with the interest rate on this debt equal to the six-month LIBOR (0.323% at December 31, 2014) plus 87.5 basis points, with interest payments due quarterly.
The Credit Agreement requires us to maintain specified financial covenants measured on a quarterly basis, including minimum consolidated net worth and a maximum debt to capital ratio. In addition, the Credit Agreement contains certain affirmative and
negative covenants customary for facilities of this type, including negative covenants that limit or restrict our ability to, among other things, pay dividends, incur additional indebtedness, effect mergers or consolidations, make investments, enter into asset sales, create liens, enter into transactions with affiliates and other restrictions customarily contained in such agreements. As of December 31, 2014, we were in compliance with all covenants.
We believe that funds generated from operations, including dividends from insurance subsidiaries, parent company cash and funds available under our Credit Agreement will provide sufficient resources to meet our liquidity requirements for at least the next 12 months. However, if these funds are insufficient to meet fixed charges in any period, we would be required to generate cash through additional borrowings, sale of assets, sale of portfolio securities or similar transactions. If we were required to sell portfolio securities early for liquidity purposes rather than holding them to maturity, we would recognize gains or losses on those securities earlier than anticipated. If we find it necessary to borrow additional funds under our Credit Agreement in order to meet liquidity needs, we would incur additional interest expense, which could have a negative impact on our earnings. Since our ability to meet our obligations in the long-term (beyond a 12-month period) is dependent upon factors such as market changes, insurance regulatory changes and economic conditions, no assurance can be given that the available net cash flow will be sufficient to meet our long-term operating needs. We are not aware of any trends or uncertainties affecting our liquidity, including any significant future reliance on short-term financing arrangements.
Significant periods of time can elapse between the occurrence of an insured loss, the reporting of that loss to us and our final payment of that loss and its related LAE. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities. At December 31, 2014 and 2013, we had $883.1 million and $803.8 million, respectively, of gross loss and LAE reserves, representing management’s best estimate of the ultimate loss. Management records, on a monthly and quarterly basis, its best estimate of loss reserves.
The period of time from the occurrence of a loss through the settlement of the liability is referred to as the “tail.” Generally, the same actuarial methods are considered for both short-tail and long-tail lines of business because most of them work properly for both. The methods are designed to incorporate the effects of the differing length of time to settle particular claims. For short-tail lines, more weight tends to be given to the Case Incurred and Paid Development methods, although the various methods tend to produce similar results. For long-tail lines, more judgment is involved and more weight may be given to the Bornhuetter-Ferguson method. Liability claims for long-tail lines are more susceptible to litigation and can be significantly affected by changing contract interpretation and the legal environment. Therefore, the estimation of loss reserves for these classes is more complex and subject to a higher degree of variability.
Claims that management views as potentially significant are subject to a rigorous review process involving the adjuster, claims management and executive management. We seek to establish reserves at the maximum probable exposure based on our historic
An important assumption underlying reserve estimates is that the cost trends implicitly built into development patterns will continue into the future. However, future results could vary due to an unexpected change in underlying cost trends. This unexpected change could arise from a variety of sources including a general increase in economic inflation, inflation from social programs, new medical technologies or other factors such as those listed below in connection with our largest lines of business. It is not possible to isolate and measure the potential impact of just one of these variables, and future cost trends could be partially impacted by several such variables. However, it is reasonable to address the sensitivity of the reserves to a potential impact from changes in these variables by measuring the effect of a possible overall 1% change in future cost trends that may be caused by one or more variables. Utilizing the effect of a 1% change in overall cost trends enables changes greater than 1% to be estimated by extrapolation.
The following discussion describes key assumptions and important variables that affect the estimate of the reserve for loss and LAE of our two most significant lines of business, which represent 88.0% of our total reserves and explains what caused them to change from assumptions used in the preceding period. Management has not made any changes in key assumptions used in calculating current year reserves based on historical loss development patterns.
Within each line, Great American actuaries review the results of individual tests, supplementary statistical information and input from management to select their point estimate of the ultimate liability. This estimate may be one test, a weighted average of several tests or a judgmental selection as the actuaries determine is appropriate. The actuarial review is performed each quarter as a test of the reasonableness of management’s point estimate and to provide management with an actuarial estimate to consider in setting reserve assumptions. The Great American actuaries do not develop ranges of losses.
The level of detail at which data is analyzed varies among the different lines of business. Generally data is analyzed by major product or coverage, using countrywide data. The appropriate segmentation of the data is determined based on data volume, data credibility, mix of business and other actuarial considerations. Point estimates are selected by the actuaries based on test indications and judgment.
Commercial Auto Liability. In this line of business, we provide coverage protecting buses, limousines, other public transportation vehicles and trucks for accidents causing property damage or personal injury to others. Property damage liability and medical payments exposures are typically short-tail lines of business with relatively quick reporting and settlement of claims. Bodily injury exposure is long-tail because although the claim reporting of this line of business is relatively quick, the final settlement can take longer to achieve.
We recorded unfavorable development of $29.0 million, $32.5 million and $3.6 million in 2014, 2013 and 2012, respectively, for this line of business. We have experienced significantly higher than expected claim severity and case development from accident years 2010, 2011, 2012 and 2013. We continue to pay particular attention to the commercial auto liability line of business and are taking the necessary steps to restore our historically profitable underwriting results, including responding with rate increases, non-renewals or other corrective actions, as necessary. We continually monitor development trends in each line of business as a component of estimating future ultimate loss and related LAE liabilities.
We recorded unfavorable prior year loss development of $2.8 million, $1.2 million, and $4.3 million in 2014, 2013 and 2012, respectively. Economic conditions over the last couple years have led to longer duration of claims resulting in higher claim severity. Due to the long-tail nature of this business it is difficult to predict ultimate liabilities until a higher percentage of claims have been paid and the ultimate impact of these decisions can be estimated with more precision. Management continues to review the frequency, severity, and loss and LAE ratios implied by the indications from the standard tests while considering the uncertainties of future costs in determining the appropriate reserve level.
Under other-than-temporary impairment accounting guidance, if management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then an entity may separate the other-than-temporary impairments into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive income (loss)). The credit related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are required to be shown in the Consolidated Statements of Income. If management intends to sell an impaired security, or it is more
We closely monitor each investment that has a fair value that is below its amortized cost and make a determination each quarter for other-than-temporary impairment for each of those investments. During the years ended December 31, 2014 and 2013, we recorded other-than-temporary impairment charges of $2.0 million and $0.2 million, respectively, in earnings. The impairment charges during both 2014 and 2013 were primarily related to equity securities where management is uncertain of the timing and the extent of ultimate recovery. During the year ended December 31, 2012, we recorded other-than-temporary impairment charges of $0.9 million in earnings due to $0.5 million in charges on several common stock securities and $0.4 million in charges on two nonredeemable preferred stocks. The impairment charges on common stock securities during the year ended December 31, 2012 were due to uncertainty surrounding the timing of recovery as well as the length of time and the extent to which the securities had been in an unrealized loss position. The impairment charges on the nonredeemable preferred stocks were due to the uncertainty and timing of repayment. While it is not possible to accurately predict if or when a specific security will become impaired, given the inherent uncertainty in the market, charges for other-than-temporary impairment could be material to net income in subsequent quarters. Management believes it is not likely that future impairment charges will have a significant effect on our liquidity. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Investments.”
We, as management of National Interstate Corporation and its subsidiaries (the “Company”), are responsible for establishing and maintaining adequate internal control over financial reporting. Pursuant to the rules and regulations of the Securities and Exchange Commission, internal control over financial reporting is a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers or persons performing similar functions and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
We have audited National Interstate Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). National Interstate Corporation and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of National Interstate Corporation and subsidiaries as of December 31, 2014 and 2013 and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2014 of National Interstate Corporation and subsidiaries and our report dated March 6, 2015 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheets of National Interstate Corporation and subsidiaries as of December 31, 2014 and 2013, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2014. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Interstate Corporation and subsidiaries at December 31, 2014 and 2013, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), National Interstate Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated March 6, 2015 expressed an unqualified opinion thereon.
National Interstate Corporation (the “Company”) and its subsidiaries operate as an insurance holding company group that underwrites and sells traditional and alternative risk transfer property and casualty insurance products primarily to the passenger transportation, trucking and moving and storage industries, general commercial insurance to small businesses in Hawaii and Alaska and personal insurance to owners of recreational vehicles throughout the United States.
The consolidated financial statements include the accounts of the Company and its subsidiaries (NIIC, VIC, NIIC-HI, HIL, TCC, Hudson Management Group, Ltd., Vanliner Reinsurance Limited, National Interstate Insurance Agency, Inc. (“NIIA”), American Highways Insurance Agency, Inc., TransProtection Service Company, Explorer RV Insurance Agency, Inc. and Safety, Claims and Litigation Services, LLC) since their formation or acquisition. Significant intercompany transactions have been eliminated.
The total sum of the difference between acquired amounts and actual or expected settlement amounts for all balance sheet line items which were contractually guaranteed by UniGroup is the calculated contingent consideration. This amount is discounted based upon the appropriate treasury yield curve rate to obtain the discounted fair value at each reporting date. At December 31, 2014, the Company had a short-term receivable recorded at fair value for contingent consideration of $1.2 million compared to a short-term payable recorded at fair value for contingent consideration of $8.8 million at December 31, 2013. As the Agreement required UniGroup to escrow funds for the future settlement of the balance sheet guaranty, the Company believes any contingent consideration would be fully collectible.
The Company recognized certain intangible assets as part of the Vanliner acquisition in 2010 based on their fair value as required by ASC 805. These intangible assets consist of acquired insurance licenses, with an indefinite life, and an acquired relationship asset relating to renewal rights, trade names, customer relationships and distribution networks. Intangible assets with definite lives are amortized over their estimated useful life, which is five years for the acquired relationship asset. Amortization expense relating to this intangible asset was $0.3 million for the years ended December 31, 2014, 2013 and 2012. All identifiable intangible assets are tested for recoverability whenever events or changes in circumstances indicate that a carrying amount may not be recoverable. Indefinite-lived intangible assets are subject to annual impairment testing, which was performed during the fourth quarter of 2014. Based upon this review, no impairment losses were recognized in 2014.
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the periods in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided if it is more likely than not that some or all of the deferred tax assets will not be realized. Management evaluates the realizability of the deferred tax assets and assesses the need for a valuation allowance quarterly. The Company recognizes the tax benefits of uncertain tax positions only when the position is more likely than not to be sustained under examination by the appropriate taxing authority. Deferred tax liabilities approximating $2.7 million related to accumulated earnings of the Company's foreign subsidiary have not been recognized because management intends to permanently reinvest such amounts.
estimated defaults and losses and estimates of the rate of future prepayments. Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by the Company’s internal and affiliated investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, the Company’s internal investment professionals, who report to the Chief Investment Officer, compare the valuation received to independent third party pricing sources and consider widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. If the Company believes that significant discrepancies exist, the Company will perform additional procedures, which may include specific inquiry of the pricing source, to resolve the discrepancies.
Level 1 consists of publicly traded equity securities and highly liquid, direct obligations of the U.S. Government whose fair value is based on quoted prices that are readily and regularly available in an active market. Level 2 primarily consists of financial instruments whose fair value is based on quoted prices in markets that are not active and include U.S. government agency securities, fixed maturity investments and nonredeemable preferred stocks that are not actively traded. Included in Level 2 are $151.9 million of securities, which are valued based upon a non-binding broker quote and validated with other observable market data by management. Level 3 consists of financial instruments that are not traded in an active market, whose fair value is estimated by management based on inputs from independent financial institutions, which include non-binding broker quotes. The Company believes these estimates reflect fair value, but the Company is unable to verify inputs to the valuation methodology. The Company obtained at least one quote or price per instrument from its brokers and pricing services for all Level 3 securities and did not adjust any quotes or prices that it obtained. The Company’s internal and affiliated investment professionals review these broker quotes using any recent trades, if such information is available, or market prices of similar investments. The Company primarily uses the market approach valuation technique for all investments.
The tables above exclude other invested assets of $46.8 million and $40.4 million at December 31, 2014 and 2013, respectively. Other invested assets include investments in limited partnerships which are accounted for under the equity method. Equity method investments are not reported at fair value.
During the year ended December 31, 2013, the Company transferred eight nonredeemable preferred stocks with an aggregate value of $3.8 million, two common stocks with an aggregate value of $1.7 million, and one redeemable preferred stock with a value of $1.0 million, from Level 2 to Level 1 due to increases in trading activity. During the year ended December 31, 2012, the Company transferred four nonredeemable preferred stocks, with an aggregate value of $0.1 million, from Level 1 to Level 2 due to decreases in trading activity. In addition, the Company transferred one nonredeemable preferred stock with a value of $11 thousand and one redeemable preferred stock with a value of $0.2 million from Level 2 to Level 1 due to increases in trading activity.
The following tables present a reconciliation of the beginning and ending balances for all investments measured at fair value on a recurring basis using Level 3 inputs for the years ending December 31, 2014, 2013 and 2012. The transfers into Level 3 during the years ended December 31, 2014 and 2013 were due to decreases in the availability of market observable inputs. All transfers are reflected in the table at fair value as of the end of the reporting period.
Gains and losses on the sale of investments, including other-than-temporary impairment charges and other invested assets' gains or losses, were as follows:
The following table summarizes the Company’s gross unrealized losses on fixed maturities and equity securities and the length of time that individual securities have been in a continuous unrealized loss position:
The following table is a progression of the amount related to credit losses on fixed maturity securities for which the non-credit portion of an other-than-temporary impairment has been recognized in other comprehensive income:
At December 31, 2014 and 2013, the carrying value of all deposits with state insurance departments was $104.8 million and $94.9 million, respectively. These deposits consisted of fixed maturity investments, certificates of deposit and money market funds.
Long-term debt outstanding was $12.0 million at December 31, 2014 and December 31, 2013.
The Credit Agreement requires the Company to maintain specified financial covenants measured on a quarterly basis, including minimum consolidated net worth and a maximum debt to capital ratio. In addition, the Credit Agreement contains certain affirmative and negative covenants customary for facilities of this type, including negative covenants that limit or restrict the Company’s ability to, among other things, pay dividends, incur additional indebtedness, effect mergers or consolidations, make investments, enter into asset sales, create liens, enter into transactions with affiliates and other restrictions customarily contained in such agreements. As of December 31, 2014, the Company was in compliance with all covenants.
The Company files income tax returns in the U.S. federal jurisdiction and various state and U.S. territory jurisdictions. With limited exceptions, the Company is no longer subject to U.S. federal or state income tax examination for years before 2011.
The Company grants options and other stock awards to officers and key employees of the Company under the LTIP. At December 31, 2014, there were options for 286,853 shares outstanding and 860,636 of the Company’s common shares reserved for issuance under the LTIP. Treasury shares are used to fulfill the options exercised and other awards granted. Options and restricted shares vest pursuant to the terms of a written grant agreement. Options must be exercised no later than the tenth anniversary of the date of grant. As set forth in the LTIP, the Compensation Committee of the Board of Directors may accelerate vesting and exercisability of options.
The intrinsic value of options exercised was $1.1 million, $0.6 million and $1.7 million for the years ended December 31, 2014, 2013 and 2012, respectively. The total fair value of options vested during the years ended December 31, 2014, 2013, and 2012 was $0.3 million, $0.4 million, and $0.2 million, respectively.
The Company granted 12,534 shares of restricted stock (fair value of $32.33 per share) in 2013. There were no restricted stock grants in 2012. The fair value of shares vested was $0.3 million for each of the years ended December 31, 2014, 2013 and 2012.
support services. If Great American no longer controlled a majority of the Company’s common shares, it is possible that many of these services would cease or, alternatively, be provided at an increased cost to the Company. This could impact the Company’s personnel resources, require the Company to hire additional professional staff and generally increase the Company’s operating expenses. Management believes, based on discussions with Great American, that these services will continue to be provided by the affiliated entity in future periods and the relative impact on operating results is not material.
On February 5, 2014, Great American commenced an unsolicited tender offer to acquire all of the outstanding common shares of the Company not already owned by Great American. Great American stated that if it purchased common shares in the tender offer, such that it would own at least 90% of the issued and outstanding common shares, Great American or an affiliate of Great American, intended to effect a second-step merger with the Company. Also, as previously disclosed, on March 5, 2014, Alan R. Spachman, a director of the Company, filed a complaint and motion for a temporary restraining order in the United States District Court for the Northern District of Ohio regarding the tender offer. At a hearing on March 14, 2014, the court stated that it would grant a motion for preliminary injunction enjoining the consummation of the tender offer of AFG's wholly owned subsidiary Great American. In light of the court's stated intention, in a press release issued March 16, 2014, AFG announced that Great American had terminated the offer.
On April 18, 2014, the Company entered into an agreement with Alan R. Spachman, whereby the Company agreed to reimburse Mr. Spachman for a portion of the legal fees and expenses that he incurred personally in connection with the tender offer by Great American for all publicly traded shares of the Company that Great American did not already own. The agreement provided that the Company pay $0.6 million to Mr. Spachman, and that all parties to the proceeding captioned, Alan R. Spachman v. Great American Insurance Co., et al, in the United States District Court for the Northern District of Ohio, in Cleveland, case No. 14-CV-00509, including the Company, receive mutual releases for all matters regarding the tender offer. This proceeding named Messrs. Joseph E. (Jeff) Consolino, Gary J. Gruber, Keith A. Jenson, Donald D. Larson, David W. Michelson, and Vito C. Peraino individually and each of the aforementioned directors were parties to the agreement. Following the payment to Mr. Spachman, the parties filed a joint stipulation with the court to dismiss all claims with prejudice. Such amount is included in the "Transaction expenses" line item on our Consolidated Statements of Income. The Company recognized the expense in the first quarter and remitted the payment of $0.6 million on April 25, 2014.
The foregoing reconciliation shows unfavorable prior year development of $30.6 million, $23.1 million, and $3.3 million in the years ended December 31, 2014, 2013, and 2012, respectively. The unfavorable development in 2014, which related to several accident years but was more prominent in accident years 2011 through 2013, was predominately in the commercial auto liability line of business. Included in the $30.6 million of unfavorable development is $20.0 million related to reserve strengthening primarily in our commercial auto liability line of business for accident years 2011 through 2013 recorded during the second quarter of 2014. The unfavorable development in 2013, which related to several accident years but was more prominent in accident years 2010 and 2011, was predominately in the commercial auto liability line of business with a portion related to business that is no longer in force. Included in the $23.1 million of unfavorable development is $6.0 million related to reserve strengthening in our accident year 2011 commercial auto liability line recorded during the second quarter of 2013. The unfavorable development in 2012 was concentrated in the commercial auto liability and workers' compensation lines of business, partially offset by favorable development in our remaining lines of business. In 2014, the Company recorded no reserve development on the Vanliner reserves acquired in 2010 while in 2013 and 2012 the Company recorded favorable reserve development. This favorable development is subject to a contractual balance sheet guaranty. Accordingly, offsetting charges to loss and LAE expense were recorded in the Consolidated Statements of Income to record the $20.8 million and $19.0 million relating to the development in 2013 and 2012, respectively, as a payable to the guarantor. Management of the Company evaluates case and IBNR reserves based on data from a variety of sources including the Company’s historical experience, knowledge of various factors and industry data extrapolated from other insurers writing similar lines of business.
The Company invests funds in the participant loss layer for several of the ART programs. The Company has investment income and realized gains or losses, and incurs an equal expense on the amounts owed to ART participants. “Expense on amounts withheld” represents both investment income and realized gains or losses that the Company remits back to ART participants. The related investment income and realized gains or losses are included in the Company’s “Net investment income” and “Net realized gains on investments” lines, respectively, on its Consolidated Statements of Income.
NIIC paid dividends of $10.0 million to the Company in each of 2014 and 2013, and $60.0 million in 2012. Of the $60.0 million dividend paid in 2012, $39.0 million was in the form of an extraordinary dividend for which NIIC was required to receive regulatory approval by the State of Ohio. Also, in accordance with statutory restrictions each of the insurance companies’ subsidiaries must meet minimum Risk-Based Capital (“RBC”) levels. At December 31, 2014, NIIC, VIC, NIIC-HI and TCC exceeded the minimum RBC levels and are well in excess of minimum capital requirements set forth by the companies’ respective states of domicile.
As a direct writer of insurance, the Company receives assessments by state funds to cover losses to policyholders of insolvent or rehabilitated companies and other authorized fees. These mandatory assessments may be partially recovered through a reduction in future premium taxes in some states over several years. At December 31, 2014 and 2013, the liability for such assessments was $4.6 million and $6.4 million, respectively, and will be paid over several years as assessed by the various state funds.
The following table presents amounts related to unrealized gains and losses on available-for-sale securities which were reclassified out of AOCI during the years ended December 31, 2014, 2013, and 2012 categorized by the respective affected line items in the Consolidated Statement of Income: