We lease our headquarters in Chicago, Illinois. Our headquarters have approximately 34,000 square feet and our lease expires in 2020. We believe that our facility will support our future business requirements or that we will be able to lease additional space, if needed, on reasonable terms.
The net loss and loss adjustment expense ratio and the acquisition expense ratio are calculated by dividing the respective expense amounts by net premiums earned. The other operating expense ratio is calculated by dividing other operating expenses by gross premiums written. Gross premiums written represents all premiums written by an insurance company during a specified period. Net premiums written is the difference between gross premiums written and premiums ceded to reinsurers. Premiums are earned over the terms of the related policies. At the end of each accounting period, the portions of premiums that are not yet earned are included in unearned premiums and are realized as revenue in subsequent periods over the remaining terms of the policies. Our policies have terms of 12 months. Thus, for example, for a policy that is written on July 1, 2007, one-half of the premiums would be earned in 2007 and the other half would be earned in 2008. Premiums earned, represents the earned portion of our net premiums written.
In 2007 as compared to 2006, insurance revenues and investment income continued to increase and, after payment of operating expenses, were sufficient to generate increased operating profits. In addition, we continued to utilize the benefits of tax losses generated in earlier years. However, in our lines of business, we faced greater competition, lower rates and reduced exposure bases which led to lower premium growth.
Our written premium is still concentrated in four of our eight partner agents, though there was continued diversification in the percentage of premium written. We expect to see additional diversification as our relationship with these new partner agents mature. Premium breakdown by partner agent was as follows:
While more diversified, our business written for the year ended December 31, 2007 was heavily weighted in workers’ compensation. Our gross written premiums by line of business as a percentage of total gross written premiums for the years ended December 31, 2007 and 2006 were as follows:
Net investment income was $9.5 million for 2007 versus $6.1 million for 2006. The increase in net investment income reflects a significant growth in our cash and invested assets from $166.4 million at December 31, 2006 to $230.4 million at December 31, 2007. The net investment yield for average invested assets for 2007 and 2006 was 4.6%. There where no realized gains in 2007 and $0.3 million in 2006. The increases in average invested assets primarily relates to the cash flow from operations, including premium growth and favorable underwriting results.
Loss and loss adjustment expenses were $90.0 million for the year ended December 31, 2007, compared to $62.7 million for the year ended December 31, 2006. The increase in loss and loss adjustment expenses was driven by the increase in earned premium. Our net loss and loss adjustment expense ratio increased in 2007 compared to 2006 primarily due to an increase in large losses in our commercial automobile line of business partially offset by improvements in workers’ compensation and general liability in prior years. We have instituted price increases to address this loss ratio increase in our commercial automobile business.
Tax expense of $0.2 million and $0.3 million for the year ended December 31, 2007 and December 31, 2006, respectively, resulted from deferred tax liabilities associated with our acquisition of Potomac, which have an indefinite life and therefore cannot be offset with deferred tax assets, which consist primarily of tax loss carryforwards.
Net income for the year ended December 31, 2006 was $8.4 million, compared to a net loss for the year ended December 31, 2005 of $18.0 million. Earnings per share for 2006 were $0.55 versus a net loss per share of $1.22 for 2005.
Other operating expenses were $19.9 million for the year ended December 31, 2006, which consisted of salaries and benefit costs of $6.1 million, $4.2 million of professional and consulting fees, $2.6 million of depreciation and amortization and $7.0 million of other expenses. For the year ended December 31, 2005, other operating expenses were $14.1 million, comprised of salaries and benefit costs of $5.2 million, $3.0 million of professional and consulting fees, $1.8 million of depreciation and amortization and $4.1 million of other expenses. Other operating expenses for 2006 included $1.1 million associated with our stock option program. This expense represents a change in our accounting policy through the adoption of FAS No. 123 (revised 2004), “Share-Based Payment,” or FAS 123R, whereby we recognize compensation expense for stock options. Prior to the first quarter of 2006 we followed the accounting principles under the intrinsic value method of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25. For 2006, we did not incur any service company fees because we terminated our service company contract effective December 31, 2005. In 2005, we incurred $8.8 million of service company fees. We have assumed the responsibilities previously provided by our service company, which expenses are included in other operating expenses. We remain committed to operating efficiently and increasing staff only as our business volume requires.
Cash used for investment activities was $72.3 million for the year ended December 31, 2007, principally representing purchases of investments of $63.1 million and additions to equipment and capitalized software of $9.2 million. For the year ended December 31, 2006, cash used for investment activities was $66.4 million also principally representing increases in investments and additions to equipment and capitalized software. For the year ended December 31, 2005, cash used for investment activities was $13.6 million also principally representing increases in investments and additions to equipment and capitalized software.
We had cash flows from financing activities of $1.3 million from sales of Class B Shares to our partner agents during the year ended December 31, 2007. We had cash flows from financing activities of $3.1 million from sales of Class B Shares to our partner agents during the year ended December 31, 2006. For the year ended December 31, 2005, cash flows from financing activities from sales of Class B Shares to our partner agents was $1.5 million. The increase from 2005 to 2006 resulted from an increased number of partner agents, each of which is contractually obligated to purchase a set amount of Class B Shares over a negotiated period of time. The decrease from 2006 to 2007 resulted from a substantial number of our partner agents having fulfilled their contractual obligation to purchase Class B Shares during 2006 which was partially offset by our signing two new partner agents in 2007.
The aggregate fair market value of our fixed maturity investments at December 31, 2007 was $177.7 million, compared to amortized cost of $176.6 million. This amount compares to the aggregate fair market value of our fixed maturity investments of $144.5 million compared to amortized cost of $145.6 million, as of December 31, 2006.
We have concluded that none of the available-for-sale securities with unrealized losses at December 31, 2007 has experienced an “other-than-temporary” impairment. We considered our intent and ability to hold the securities for a sufficient time to allow for a recovery in value in this determination. As of December 31, 2007, we held $4.5 million in fair value, $5.0 million in book value, of investments with sub-prime exposure, all of which were rated “A” or better by established rating agencies.
Liquidity. SUA generates liquidity primarily by collecting and investing earned premiums in advance of paying claims. We believe that SUA maintains 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. The principal sources of liquidity are existing cash and short-term investments. Cash and short-term investments were $52.6 million at December 31, 2007, a $30.7 million increase over December 31, 2006.
The following table of contractual obligations includes information with respect to our known contractual obligations as of December 31, 2007:
“Loss & Loss Adjustment Expense Reserves” do not have a contractual maturity date and as discussed herein are subject to change due to a wide variety of factors and cannot be predicted with certainty. Actual future loss payments may differ materially from the current estimates shown in the table above.
Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our financial statements, which have been prepared in accordance with generally accepted accounting principals in the United States of America, or GAAP. The financial statements presented herein include all adjustments considered necessary by management to fairly present the financial position, results of operations and cash flows of the Company. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.
Net premiums written consist of direct premiums written less ceded premiums. The components of net premiums written are recognized as revenue over the period that coverage is provided. When premium rates change, the effect of the change will not immediately affect earned premium. Rather, the increase or decrease will be recognized ratably over the period of coverage which is twelve months. Unearned premiums and prepaid reinsurance premiums, which are recorded on the balance sheets, will represent that portion of premiums written that are applicable to the unexpired terms of policies in force. Certain policies are subject to adjustment based on changes in risk exposure over the period of coverage, such as payroll increases/decreases and changes in risk classifications and therefore direct written premiums are estimated during the policies term until final audit of the policy occurs.
We have classified all fixed maturity investment securities upon acquisition as available-for-sale securities. Available-for-sale fixed maturities securities are reported at fair value. Short-term investments are recorded at cost.
Loss and LAE reserves, by line of business at December 31, 2007, 2006 and 2005 for our insurance operations were as follows:
(1) On November 23, 2004, Specialty Underwriters’ Alliance, Inc. acquired Potomac, and subsequently renamed the company SUA Insurance Company. Prior to the acquisition, Potomac entered into a transfer and assumption agreement with OneBeacon, whereby all of its liabilities, including all direct liabilities under existing insurance policies, were ceded to and assumed by OneBeacon. We will not experience any gains or losses with respect to such legacy policies unless OneBeacon fails to honor its reinsurance obligation. To date, OneBeacon continues to handle, adjudicate and pay all claims that have arisen from such legacy policies.
Our general liability product line is considered a long-tail coverage, as it takes a relatively long period of time to finalize claims from a given accident year. General liability reserves are comprised primarily of bodily injury and, to a lesser extent, property damage. Bodily injury claims arise from physical injury as a result of the policyholder’s legal obligation arising from non-intentional acts such as negligence, subject to the insurance policy provisions. In some cases the damages can include future wage loss (which is a function of future earnings power and wage inflation) and future medical treatment. Property damage claims arise from damages to the claimant’s private property arising from the policyholder’s legal obligation for non-intentional acts. In most cases, property damage losses are a function of costs as of the loss date, or soon thereafter.
Instead of any single method, we use a combination of various actuarial and analytical methods to estimate the amount of reserves for each line of business on the basis of historical, statistical and industry information. The primary methods that we utilize to determine our ultimate losses and loss adjustment expenses include:
Incurred loss development methods assume that the ratio of losses in one period to losses in earlier periods will remain reasonably consistent in the future.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting for uncertainty in income tax positions. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of an income tax position taken, or expected to be taken, in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, and additional disclosures. The Company’s adoption of FIN 48 on January 1, 2007, did not require an adjustment to the liability for unrecognized tax benefits.
fair value measurements, the Company believes that the implementation of FAS 157 will have no material impact on its financial statements.
In February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” or FAS 159. FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. FAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within the year of adoption. The Company believes that the implementation of FAS 159 will have no material impact on its financial statements.