Expense ratio: The expense ratio is the ratio, expressed as a percentage, of acquisition and other operating expenses less fee income to net premiums earned. Our reported expense ratio excludes certain holding company expenses such as interest expense as well as real estate and rescission expenses.
Return on average shareholders’ equity: Return on average shareholders’ equity is the ratio, expressed as a percentage, of net earnings, excluding realized gains and losses, to the average of the beginning of period and end of period total shareholders’ equity, excluding accumulated other comprehensive income.
Net premiums written to equity: The net premiums written to equity is the ratio of net premiums written to the total shareholders’ equity.
We are a Bermuda-based specialty insurance and reinsurance company that provides customized products and solutions to small and medium-sized businesses in industries that we believe are underserved by the standard market. For over twenty years, we have developed specialized coverages and alternative risk transfer products not generally available to our customers in the standard market because of the unique characteristics of the risks involved and the associated needs of the insureds. We specialize in underwriting these products for insureds with certain environmental, products liability, construction, healthcare and property risks, as well as developing programs for other specialty classes of risks and providing third party reinsurance.
The other segment consists of amounts associated with realized gains and losses on investments, certain corporate expenses and real estate operations that were completed in 2005.
The following information is presented on the basis of accounting principles generally accepted in the United States of America (“GAAP”) and should be read in conjunction with “Business” and “Risk
Factors,” and our consolidated financial statements and the related notes included elsewhere in this report. All amounts and percentages are rounded.
Revenues for the year were $192.3 million, an increase of 6.3% over 2007. Excluding net realized losses on investments, revenues for the year were $206.7 million, an increase of $25.4 million, or 14.0%, over 2007, due to increased net premiums earned. Net premiums earned from our lines of business entered since 2006 from our diversification efforts totaled $56.8 million, an increase of $44.0 million over 2007. The increase from the newer lines was partially offset by a decrease in other lines, including a $29.1 million decrease in our construction line
4.7 percentage points. The 2007 combined ratio was impacted by unfavorable reserve development of $2.2 million and additional ceded reinsurance premiums of $2.3 million. During 2008, 33.4% of gross premiums written, compared to 16.7% for 2007, were generated by new products as part of our product diversification strategy, primarily assumed reinsurance and healthcare. As a result, the expense component of the combined ratio has increased due to our investment in these products and will remain higher than historical levels until we achieve critical mass for these products.
The property and casualty insurance market has softened significantly and the number of insurers competing for premium in the excess and surplus lines market has increased. These competitors include several start-up companies as well as larger excess and surplus lines and standard market insurers looking to capture market share by moving from the admitted market to the excess and surplus lines market. This increased competition has caused rates to decline in our targeted markets, in some cases, significantly. Despite this softening trend, we believe there are profitable business opportunities from which we can benefit resulting from our diversification into new geographic locations and lines of business.
Environmental. Net premiums earned decreased 6.4% to $34.0 million for the year ended December 31, 2008 compared to $36.4 million for 2007. As part of the detailed actuarial and underwriting review of the markets and lines of business in the environmental segment, the Company ceased writing contractor business in New York, reduced its focus on the more competitive middle market segment and has increased its efforts in the ProStar market. Net premiums earned for 2008 and 2007 were negatively affected by $1.6 million and $2.3 million, respectively, of additional premiums ceded to reinsurers as a result of large losses, primarily related to New York contractor business.
Surety. Net premiums earned increased 34.5% to $7.4 million for the year ended December 31, 2008 compared to $5.5 million for 2007. The increase in surety premiums is due to the Company continuing to
focus its growth efforts in the environmental contractor surety market due to the lack of capacity serving this segment of the market. During 2007 we entered into an agreement with a small specialty carrier to provide contract surety to small non-environmental contractors that do not fit the standard surety market.
The table below sets forth the prior year reserve development by the Company for the years ended December 31, 2008 and 2007 (dollars in thousands):
The 2008 prior year adverse reserve development primarily relates to increased paid and case reserves related to accident years 2002 through 2006 for environmental contractor business written in New York. In 2008, the Company decided to exit the New York contractor business by non-renewing policies. The adverse development in the runoff line relates to increased estimates of workers’ compensation claims related to site cleanup activities following the terrorist attack in New York on 9/11. The adverse development is partially offset by decreases in special programs primarily related to the pest control program.
The 2007 prior year adverse reserve development for the environmental line primarily relates to increased case reserves on 2004 claims for environmental contractors in New York. This development was partially offset by decreases in construction, surety and runoff business lines reserves.
Policy acquisition expenses are the cost of acquiring policies including commissions, premium taxes paid to states in which we are admitted to conduct business and excise taxes, offset by ceding
commissions we receive from our reinsurers. Policy acquisition expenses increased to $43.5 million for the year ended December 31, 2008 from $28.9 million for 2007. Policy acquisition expenses as a function of net premiums earned increased to 24.9% for the year ended December 31, 2008 from 19.4% for 2007. The increase is due to the change in the mix of business and increased acquisition expense in the specialty program line. The proportion of premiums generated by our assumed reinsurance segment, which is currently comprised primarily of quota share reinsurance treaties that carry higher acquisition expenses, resulted in an increase in acquisition expenses of $9.4 million. The increase related to the specialty program line was due to a change in our reinsurance structure for specialty programs from quota share, where we received a ceding commission to excess of loss, where no ceding commission is received. Specialty programs acquisition expenses increased by $7.8 million. Partially offsetting this increase was a decrease in acquisition expense for our construction line of business of $5.5 million due to a 43.8% reduction in net premiums earned.
Corporate and other expenses were $0.2 million and $3.0 million for the periods ended December 31, 2008 and 2007, respectively. The decrease was due to the $2.8 million reversal of an accrued warranty liability established in 2004 in connection with our former real estate project in Florida, which was essentially completed in 2005.
Minority interest expense was $1.2 million for the year ended December 31, 2008 compared to a negative expense of $1.2 million at December 31, 2007. Our minority interest expense relates to the net earnings of our non subsidiary affiliate, American Safety RRG. In 2008, American Safety RRG had net earnings of $1.2 million compared to a net loss of $1.2 million in 2007, due to adverse prior year reserve development.
The Company operates through its subsidiaries in the U.S. and Bermuda. Significant differences exist in the regulatory environment in each country. The table below describes the Company’s operations by geographic segment for the years ended December 31, 2008 and 2007 (dollars in thousands):
Assets. Assets from Bermuda operations increased to $428.6 million at the end of 2008 compared to $383.5 million at the end of 2007. This increase is primarily due to the 2008 net earnings, along with the increased cash flow from operations due to the increase in net premiums written. Assets from U.S. operations at the end of 2008 increased to $597.7 million as compared to $550.5 million at the end of 2007 due to higher cash flow from operations due primarily to the increase in net premiums written.
Equity. Equity of the Bermuda operations decreased to $136.6 million at the end of 2008 compared to $157.5 million at the end of 2007 due to higher net unrealized losses on the investment portfolio together with capital of $14.6 million transferred to the U.S operations as discussed below. Equity of U.S. operations increased to $80.4 million at the end of 2008 from $72.9 million at December 31, 2007 due to capital contributions of $14.6 million from the parent, $8.6 million of which was used to acquire the LTC Group, partially offset by current year losses.
Environmental. Net premiums earned increased 3.5% to $36.4 million for the year ended December 31, 2007 compared to $35.1 million for 2006. In 2007, $2.3 million of premium was ceded to reinsurers due to adverse loss development. The reserve development and ceded reinsurance adjustments predominantly relate to losses from policies covering New York contractors from accident years 2003 - 2004. The 2006 premium was decreased $3.7 million resulting from the accrual for reinsurance reinstatement premium resulting from one large New York loss. The Company instituted more restrictive policy forms and underwriting guidelines for such business during 2006 and 2007.
Products Liability. The Company’s general and products liability product began production in July 2006 with the acquisition of an underwriting team in Middletown, New Jersey producing $2.4 million of net premiums earned in 2007 compared to $0.7 million in 2006. The general and products liability business is offered to small and middle market accounts. The Company does not intend to write certain high severity classes of risks such as invasive medical products, pharmaceuticals and nutraceuticals.
Property. In 2007, the Company hired an experienced underwriting team to write property and CMP liability coverage with a focus on fire exposed premises liability risks with limited catastrophe exposure, primarily in the eastern United States. For the year ended December 31, 2007, net premiums earned from the property business line was $0.5 million.
Net investment income increased 39.1% to $30.3 million for the year ended December 31, 2007 from $21.8 million for 2006 due to an increase in the Company’s invested assets and higher investment yields. Average invested assets increased to $584.2 million as of December 31, 2007 from $483.6 million as of December 31, 2006. The increase in invested assets was due to $67.0 million of cash flow from operations and the $53.3 million secondary equity offering completed in June 2006. The average pre-tax investment yield increased from 4.5% to 5.1% from 2006 to 2007.
Net realized gains and losses from the sale of investments decreased to a net loss of $0.3 million for the year ended December 31, 2007 from a gain of $1.2 million for 2006. The Company from time to time may sell securities in response to market conditions or interest rate fluctuations in accordance with its investment guidelines (described under “Business-Investments”) and or to fund the cash needs of individual operating subsidiaries.
The table below sets forth the prior year reserve development by the Company for the years ended December 31, 2007 and 2006 (dollars in thousands):
Minority interest expense was a loss of $1.2 million for the year ended December 31, 2007 compared to a loss of $1.9 million at December 31, 2006. Our minority interest expense relates to our non subsidiary affiliate, American Safety RRG. In 2007 and 2006, American Safety RRG had a net loss due to reserve development on its environmental line of business.
The Company operates through its subsidiaries in the U.S. and Bermuda. Significant differences exist in the regulatory environment in each country. The table below describes the Company’s operations by geographic segment for the years ended December 31, 2007 and 2006 (dollars in thousands):
Assets. Assets from Bermuda operations increased to $383.5 million at the end of 2007 compared to $337.6 million at the end of 2006. This increase is primarily due to the 2007 net earnings, along with the increased unrealized gains on the investment portfolio. Assets from U.S. operations at the end of 2007 increased to $550.5 million as compared to $509.5 million at the end of 2006.
Equity. Equity of the Bermuda operations increased to $157.5 million at the end of 2007 compared to $129.3 million at the end of 2006 due to higher net income and an improvement in net unrealized gains on the investment portfolio. Equity of U.S. operations increased to $72.9 million at the end of 2007 from $66.9 million at December 31, 2006 due to an increase in net unrealized gains on the U.S. insurance operations invested assets.
Our Level 3 instruments include certain fixed maturity securities and an investment in an unrelated third party insurance entity. Fair value is based on internally developed criteria that use assumptions or other data that are not readily observable from objective sources.
After a review of the individual securities in the investment portfolio, the Company recorded $13.7 million of net realized losses due to other-than-temporary-impairment of its investments. All but $0.4 of the impairment relates to securities issued by companies in the financial services sector. Other-than-temporary-impairment totaled $9.5 million of fixed maturities, $3.2 million of preferred stock and $1.0 million of common stock. The analysis to determine other-than-temporary-impairment was completed on all securities with additional focus on securities with unrealized losses greater than 30% of book value and securities whose unrealized loss was greater than 20% of book value for more than three months.
Net cash used in investing activities was $93.8 million for the year ended December 31, 2008, compared to net cash used in investing activities of $66.4 million for the same period of 2007. The increase in net cash used in investing activities was primarily due to a net purchase of investments of $79.4 million for 2008 compared to a net purchase of investments during the 2007 period of $61.6 million. In addition, during 2008, consideration paid for acquired subsidiaries totaled $8.9 million including direct transaction costs.
In June 2006 the Company completed a secondary equity offering of 3,680,000 common shares, raising approximately $53.3 million net of underwriting expenses. The proceeds of the offering were used to support the growth in insurance operations. Additionally, in November 2005, in conjunction with American Safety Capital Trust III, the Company issued a 30-year trust preferred obligation in the amount of $25.0 million. This obligation bears a fixed interest rate of 8.31% for the first five years, and a floating rate of three-month LIBOR plus 3.4% thereafter. Interest is payable on a quarterly basis and the securities may be called solely at the Company’s option after five years.
The accounting policies described below are those we consider critical in preparing our financial statements. These policies include significant estimates made by management using information available at the time the estimates are made. However, as described below, these estimates could change materially if different information or assumptions were used and there is no assurance that actual results will not differ materially from the estimates.
If all securities carrying an unrealized loss were determined to be other than temporarily impaired, our future earnings would be reduced by the $20.8 million carried unrealized loss on investments at December 31, 2008. The Company’s portfolio managers routinely monitor and evaluate the difference between the cost and fair value of our investments. Additionally, credit analysis and/or credit rating issues related to
specific investments may trigger more intensive monitoring to determine if a decline in market value is other than temporary. For investments with a market value below cost, the process includes evaluating the length of time and the extent to which cost exceeds market value, the prospects and financial condition of the issuer, and evaluation for a potential recovery in market value, among other factors. As a result, management concluded that the recoverability of the principal and interest on these investments is reasonably assured and no additional impairments needed to be recognized.
At December 31, 2008, mortgage backed securities comprised 27.6% of the entire portfolio. All mortgage backed securities are issued by agencies of the U.S. Government. The single largest security in this class is a Ginnie Mae investment with a $7.4 million par value. In the corporate sector, the Company has concentrations in the industrial sector with par value of $155.8 million or 24.5% of the total portfolio, with the largest single security being McDonalds Corporation having a par value of $4.0 million. The Company also has concentrations in the financial services sector with $69.4 million or 10.9% of the total portfolio, with the largest single security being Goldman Sachs Group, Inc. with a par value of $4.8 million. U.S. Government securities were 5.3% of the total portfolio with the largest security being a U.S. Treasury note, having a par value of $5.6 million.
The carried gross loss reserves for each line of business are as follows (in thousands of dollars):
A number of assumptions were made in the determination of the best reserve estimates for each line of business at December 31, 2008. The key assumptions among them were the expected loss ratios and loss development patterns. If the actual future losses and loss adjustment expenses develop materially differently from those key assumptions, there could be a potential for significant variation in the development of loss reserves. The effect of any specific assumptions can vary by accident year and line of business. We performed sensitivity analyses that tested the effects on the loss reserve position of using alternative loss ratios and loss development patterns rather than those actually used in determining the net carried reserve at December 31, 2008. The tests addressed each major line of business for which a material deviation to the overall reserve position is believed reasonably possible and used what we believed was reasonably likely range of potential deviation for each line of business. If our net carried reserves were to decrease from our best estimate, this would increase our net earnings, while an increase in our net carried reserves would decrease our earnings.
Umbrella and Excess - $5 million quota share placed on a cessions basis for umbrella and excess business on policies written over primary general liability policies both written by the Company as well as other insurers.
Effective May 1, 2008, the Company entered a consolidated surety reinsurance treaty providing $7.5 million of limits with $1,000,000 per principal retention by the Company. Coverage extends to all of the Company’s surety operations.
For the period of July 1, 2007 through September 1, 2008, the Company was covered under an excess of loss reinsurance treaty on our casualty lines of business. Under this treaty, the Company retains the first $500,000 of a loss and has a 10% participation in the $4.5 million excess of $500,000 layer for its environmental, construction and products liability lines of business, as well as the general liability portion of its property line. The Company retains the first $250,000 of a loss on certain of its program lines of business, participates 50% of the next $250,000 and 10% of the $4.5 million in excess of $500,000. The treaty provides that the Company retains a 10% quota share on the first $5 million of loss on the excess line of business and provides coverage on policies up to a $10 million limit.
Policy Acquisition Costs. We defer commissions, premium taxes and other expenses that are related to the acquisition of insurance contracts. These costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This would also give effect to the premiums to be earned and anticipated losses and settlement expenses as well as certain other costs expected to be incurred as the premiums are earned. Judgments as to the ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the premiums written as well as investment income.
Recognition of Premium Income. Our premiums are primarily estimated based upon the annual revenues of the underlying insureds. Additional or return premiums are recognized for differences between provisional premiums billed and ultimate premiums due when a final audit is complete after the policy has expired. Our premiums are recorded ratably over the policy period with unearned premium calculated on a pro rata basis over the lives of the underlying coverages. The Company reviews the collectability of its premium receivables on a quarterly basis.