Our management-led buyout occurred in October 2000. The summary financial information for the nine months ended September 30, 2000 is prepared based on historical results and does not include any purchase accounting adjustments related to the management-led buyout on October 5, 2000. The purchase accounting adjustments did not have a material impact on the financial information for the three-month period ended December 31, 2000.
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes to those statements included in this report. The discussion and analysis below includes certain forward-looking statements that are subject to risks, uncertainties and other factors described in “Risks Related to Our Business and Industry” and elsewhere in this report that could cause our actual growth, results of operations, performance and business prospects and opportunities in 2005 and beyond to differ materially from those expressed in, or implied by, those forward-looking statements. See “Forward-Looking Statements.”
We evaluate our insurance operations by monitoring key measures of growth and profitability. We measure our growth by examining our gross written premiums. We generally measure our operating results by examining our net income, return on equity and loss, expense and combined ratios. The following provides further explanation of the key measures that we use to evaluate our results:
Net Written Premiums. Net written premiums is the sum of direct written premiums and assumed written premiums less ceded written premiums. We use net written premiums, primarily in relation to gross written premiums, to measure the amount of business retained after cessions to reinsurers.
Our most critical accounting policies involve the reporting of loss and loss expense reserves (including losses that have occurred but were not reported to us by the financial reporting date), reinsurance recoverables, the impairment of investments, deferred policy acquisition costs and federal income taxes.
Reinsurance Recoverables. Reinsurance recoverables on paid and unpaid losses, net, are established for the portion of our loss and loss expense reserves that are ceded to reinsurers. Reinsurance recoverables are determined based in part on the terms and conditions of reinsurance contracts which could be subject to interpretations that differ from our own based on judicial theories of liability. In addition, we bear credit risk with respect to our reinsurers which can be significant considering that certain of the reserves remain outstanding for an extended period of time. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. See “Business - Reinsurance” and Note 5 to our audited consolidated financial statements, both included in this report.
temporary impairment losses result in a permanent reduction to the cost basis of the underlying investment. For additional detail regarding our investment portfolio at December 31, 2004 and 2003, including disclosures regarding other-than-temporary declines in investment value, see “Investment Portfolio” below and Note 2 to our audited consolidated financial statements, both included in this report.
Deferred Policy Acquisition Costs. We defer commissions, premium taxes and certain other costs that vary with and are primarily 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, which gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses and certain other costs expected to be incurred as the premium is earned. Judgments as to ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the written premiums. See Note 7 to our audited consolidated financial statements included in this report.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Net income increased to $15.0 million for the year ended December 31, 2004, compared to net income of $314,000 for the same period in 2003. The increase in net income was primarily attributable to an increase in net earned premium of $40.4 million principally from an increase in the volume of business and slightly offset by rate declines in both the property and casualty lines of business. In addition, we experienced $3.5 million of growth in our investment income that was driven by higher investment balances as a result of the IPO and operational cash flow and an increase in investment yield.
current accident year loss and expense ratios, an increase in premium volume that provided additional underwriting margins, and an increase in net investment income. In addition, in the years ended December 31, 2003 and 2002, we realized a pre-tax loss on sale of minority interest in subsidiary, net, of $503,000 (net of transaction fees of $815,000) and a pre-tax gain of $9.7 million (net of transaction fees of $450,000), respectively, from the sale of shares of Evergreen to certain waste companies.
The ratio of net written premiums (including discontinued operations) to our insurance subsidiaries’ combined statutory surplus. This ratio is not restated to exclude discontinued operations as the insurance subsidiaries’ combined statutory surplus is not allocated by line of business. Therefore, in computing the ratio of net written premiums to our insurance subsidiaries’ combined statutory surplus we do not restate the net written premium for discontinued operations to be consistent with that of the subsidiaries’ combined statutory surplus. Management believes this measure is useful in gauging our exposure to pricing errors in the current book of business. It may not be comparable to the definition of net writings ratio used by other companies.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002. Net written premiums for the year ended December 31, 2003 were $131.8 million, representing an increase of 68.2% compared to the same period in 2002. Net written premiums were 88.1% of gross written premiums for the year ended December 31, 2003, compared to 77.9% for the same period in 2002, reflecting a change in reinsurance agreements that resulted in a slightly lower percentage of business ceded during the current period. Net premiums earned, a function of net written premiums, amounted to $108.3 million for the year ended December 31, 2003 and equaled 82.1% of net written premiums, which is comparable to the relationship of net premiums earned to net written premiums during the same period in 2002.
In addition, during 2003, we made significant improvements in the collections of premiums in the course of collection. These improvements include hiring additional staff, weekly monitoring of account aging and improved communication with our agents. Due to these improvements we have significantly lowered our aged amounts, which has allowed us to maintain a lower provision for uncollectible accounts despite higher amounts of gross receivables. As of December 31, 2003, we had $11.5 million (before a $204,000 allowance for uncollectible amounts) of amounts recoverable compared to $2.0 million as of December 31, 2002 (before an $898,000 allowance for uncollectible amounts).
We evaluate the collectibility of our agents’ balances both individually and on a general basis. In the event that we determine that an individual agent balance is in question, we will record a provision in part or in whole for that agent’s balance. On a aggregate basis, we evaluate historical write-offs and premium growth rates to determine a general allowance. As of December 31, 2003, we have recorded a provision for uncollectible amounts of $204,000 compared to a provision of $898,000 in 2002. The $694,000 decrease in the allowance in 2003 is primarily due to the write-off of two individual reserves for $461,000 where all collection efforts had been exhausted and our improved agency management that has decreased the amount of outstanding receivables.
Our investment portfolio generally consists of liquid, readily marketable and investment-grade fixed-maturity securities. Net investment income is primarily comprised of interest earned on these securities, net of related investment expenses.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003. Net investment income increased to $10.0 million for the year ended December 31, 2004, compared to $6.5 million for the same period in 2003. The increase was due primarily to an increase in investments and cash, which was supplemented by a slight increase in investment yields. Investments and cash, increased 82.5% to $312.4 million as of December 31, 2004 from $171.2 million as of December 31, 2003 as a direct result of the proceeds from the IPO and an increase in our operational cash float. Our average investment yield for 2004 was 4.1%, compared to 4.0% for the same period in 2003.
In 2004, we increased our allocation to municipal bonds in an effort to increase our tax equivalent yield. On a tax equivalent yield basis, our yield increased to 4.8% in 2004 compared to 4.0% in 2003.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002. Net investment income increased to $6.5 million for the year ended December 31, 2003, compared to $5.1 million for the same period in 2002. The increase was due primarily to an increase in investments and cash, which was partially offset by a decrease in investment yields. Investments and cash increased 31.6% to $171.2 million as of December 31, 2003 from $130.1 million as of December 31, 2002. Our average investment yield for 2003 was 4.0%, compared to 4.4% for the same period in 2002. The decrease was a result of generally declining market interest rates during this period and our efforts to reduce the duration of our investment portfolio.
Our reserve for losses and loss expenses as of December 31, 2004 was $153.2 million (before the effects of reinsurance) and $123.8 million (after the effects of reinsurance), as estimated through our internal actuarial analysis. During 2004, we concluded, through our actuarial analysis, that the December 31, 2003 reserve for losses and loss expenses of $92.5 million (after the effects of reinsurance) was deficient by $11.1 million.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002. Net loss and loss expenses increased to $81.0 million for the year ended December 31, 2003 from $45.4 million for the same period in 2002, as a result of the factors as discussed below. Net loss and loss expense ratios for the year ended December 31, 2003 and 2002 were 74.8% and 71.7%, respectively.
Our reserve for losses and loss expenses as of December 31, 2003 was $129.2 million (before the effects of reinsurance) and $92.5 million (after the effects of reinsurance), as estimated through our internal actuarial analysis. During 2003, we concluded, through our actuarial analysis, that the December 31, 2002 reserve for losses and loss expenses of $59.0 million (after the effects of reinsurance) was deficient by $27.0 million.
Our reserve for losses and loss expenses (net of the effects of reinsurance) at December 31, 2003 by line was as follows:
An explanation of significant components of reserve development by segment (net of reinsurance unless otherwise indicated) is as follows:
During 2004, the Company’s newly reported construction defect claims were 36.9% greater than expected as of December 31, 2003. Based on the Company’s experience during 2004 and industry information, the Company substantially increased its projected ultimate construction defect claim count as of December 31,
Of our construction defects net loss and loss expense reserves at December 31, 2003, 52.5% was for incurred but not reported losses (which are referred to as IBNR), and 54.2% of our construction defect net loss and loss expense reserves at December 31, 2002 was for IBNR. As of December 31, 2003, we had 597 open claims relating to construction defects, compared to 596 open claims as of December 31, 2003. During 2003, 1,084 new claims were reported and 1,083 existing claims were settled or dismissed. Our net loss and loss expense reserves for construction defects as of December 31, 2003 were $18.6 million. The re-estimation of construction defect reserves primarily affected the 1996 and 1997 accident years and the 1999 to 2001 accident years.
Our change in reserve estimates for the years ended December 31, 2004 and 2003 for the casualty lines other than construction defect resulted in an increase in incurred losses and loss expenses of $4.6 million and $8.8 million, respectively. No reserve development was recognized in 2002 for the other than construction defect line of business. During 2004 and 2003, we incurred development above expectations on our non-construction defect casualty reserves for the 2000 through 2002 accident years. In 2004 and 2003, both closed claim severities and pending claims severities (as measured by average incurred amount per reported claim) increased. The increase in claim counts and average severities produced loss development during 2004, 2003 and 2002 exceeded our expectations, resulting in an increase in the loss development factors and initial expected loss ratios used in the December 31, 2004 and December 31, 2003 actuarial loss reserve analysis.
Our internal actuaries apply multiple actuarial techniques utilizing the same factors discussed above under “Casualty” to compute loss and loss expense reserve estimates for property claim liabilities. Each technique produces a unique loss and loss expense reserve estimate for the line being analyzed. The set of techniques applied produces a range of loss and loss expense reserve estimates. From these estimates, the actuaries form a best estimate that considers assumptions and factors, as discussed above, that influence ultimate claim costs. As of December 31, 2004, for property lines the low end of the actuarial range was 10.6% below the actuarial best estimate and the high end of the actuarial range was 17.2% above the actuarial best estimate. These low and high loss and loss expense reserve estimates reflect the fact that the methodologies applied do not produce identical estimates, and these estimates do not constitute the range of all possible outcomes. It is important to note that actual claim costs will vary from the selected estimate, perhaps by substantial amounts, due to the inherent variability of the business written, the potentially significant claim settlement lags and the fact that not all events affecting future claim costs can be estimated at this time.
We began writing commercial automobile coverage for vehicles and light trucks in 1997. In 2000, we exited the commercial automobile line of business due to unsatisfactory underwriting results. Our change in reserve estimate for the years ended December 31, 2004, 2003 and 2002 for the commercial automobile line resulted in an increase in incurred losses and loss expenses of $789,000 in 2004 related to the 2000 accident year, $1.4 million in 2003, of which $839,000 related to the 2000 accident year, $439,000 related to the 1999 accident year and $263,000 in 2002 related to the 1999 and 2000 accident years. This re-estimation was due to changes in the selected development patterns on the 2000 and 1999 accident years, as the number of claims and claim severity exceeded our expectations.
Of our net loss and loss expense reserves at December 31, 2004, 49.8% related to workers’ compensation claims IBNR, and 2.3% of our net loss and loss expense reserves at December 31, 2003 was for workers’ compensation IBNR. As of December 31, 2004, we had 257 open claims relating to workers’ compensation compared to 414 open claims as of December 31, 2003. During 2004, 13 new claims were reported, and 170 existing claims were settled or dismissed. Our net loss and loss expense reserves for workers’ compensation as of December 31, 2004 were $3.4 million.
Our change in reserve estimates for the years ended December 31, 2004, 2003 and 2002 for the workers’ compensation line resulted in an increase in incurred losses and loss expenses of $664,000, $1.2 million and $3.0 million, respectively. These re-estimations were due to changes in the selected development patterns on the 2000 to 2002 accident years, as the number of claims and claim severity exceeded our expectations.
We have historically filed a consolidated federal income tax return that has included all of our subsidiaries. However, Evergreen filed a separate federal income tax return in 2003. The statutory rate used in calculating our tax provision was 35.0% in 2004 and 2003 compared to 34.0% in 2002. Income tax expense (benefit) differed from the amounts computed at the statutory rate as demonstrated in the following table:
Century is required by law to maintain a certain minimum level of surplus on a statutory basis. Surplus is calculated by subtracting total liabilities from total admitted assets. The National Association of Insurance Commissioners (“NAIC”) has a risk-based capital standard designed to identify property and casualty insurers that may be inadequately capitalized based on inherent risks of each insurer’s assets and liabilities and its mix of net written premiums. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action. As of December 31, 2004, the statutory surplus of Century was in excess of the prescribed risk-based capital requirements that correspond to any level of regulatory action. Century’s statutory surplus at December 31, 2004 was $115.8 million and the regulatory action level was $29.3 million.
Net cash provided by financing activities was $62.0 million for the year ended December 31, 2004, compared to $16.2 million for the year ended December 31, 2003. This increase was primarily attributable to the 2004 proceeds from the issuance of common shares related to the current year IPO, which was offset by the redemption of Class B shares and principal payment on long-term debt in 2004.
Consolidated net cash provided by operating activities was $34.4 million for the year ended December 31, 2003, compared to $27.4 million for the year ended December 31, 2002. This improvement was primarily attributable to the increase in net written premiums offset by an increase in paid losses.
Net cash used by investing activities was $52.0 million for the year ended December 31, 2003, compared to $49.6 million for the year ended December 31, 2002. This increase was primarily attributable to the improved operating cash flows noted above that were used to purchase fixed maturities and equity securities.
Net cash provided by financing activities was $16.2 million for the year ended December 31, 2003, compared to $24.8 million for the year ended December 31, 2002. This decrease was primarily attributable to lower amount of proceeds received from the issuance of the $10 million trust preferred securities in May 2003 compared to the proceeds received from the issuance of $15 million trust preferred securities in December 2002.
Line of Credit. On September 8, 2004, we obtained a $5.0 million line of credit. As of December 31, 2004, no draws have been made. Interest on the note is payable quarterly and is based on a floating rate of LIBOR plus 2.5%. The note matures on September 8, 2006. Under the terms of the line of credit, 100% of the common shares of Century are pledged as collateral.
At December 31, 2004, our fixed-maturity portfolio of $264.5 million represented 84.7% of the carrying value of our total of cash and investments. Standard & Poor’s Rating Services (“Standard & Poor’s”) or Moody’s Investors Service, Inc. (“Moody’s”) rated 97.0% of these securities “A” or better. Equity securities, which consist of preferred and common shares and bond mutual funds, totaled $37.1 million or 11.9% of total cash and investments. The following is a summary of the credit quality of the fixed-maturity portfolio at December 31, 2004:
At December 31, 2004, our investment portfolio contained corporate fixed-maturity and corporate equity securities with a fair value of $61.4 million. The following is a summary of these securities by industry segment at December 31, 2004:
At December 31, 2004, the investment portfolio contained $75.5 million of mortgage-backed, asset-backed and collateralized mortgage obligations. Of these securities, 98.9% were rated “AA” or better and 95.8% were rated “AAA” by Standard & Poor’s or the equivalent rating by Moody’s. These securities are publicly registered and had fair values obtained from independent pricing services. Changes in estimated cash flows due to changes in prepayment assumptions from the original purchase assumptions are revised based on current interest rates and the economic environment. We had no derivative financial instruments, real estate or mortgages in the investment portfolio at December 31, 2004.
Under our accounting policy for equity securities and fixed-maturity securities that can be contractually prepaid or otherwise settled in a way that may limit our ability to fully recover cost, an impairment is deemed to be other-than-temporary unless we have both the ability and intent to hold the investment for a reasonable period until the security’s forecasted recovery and evidence exists indicating that recovery will occur in a reasonable period of time.
For other fixed-maturity and equity securities, an other-than-temporary impairment charge is taken when we do not have the ability and intent to hold the security until the forecasted recovery or if it is no longer probable that we will recover all amounts due under the contractual terms of the security. Many criteria are considered during this process including, but not limited to, the current fair value as compared to amortized cost or cost, as appropriate, of the security; the amount and length of time a security’s fair value has been below amortized cost or cost; specific credit issues and financial prospects related to the issuer; our intent to hold or dispose of the security; and current economic conditions.
Credit Risk. Credit risk is the potential economic loss principally arising from adverse changes in the financial condition of a specific debt issuer. We address this risk by investing in fixed-maturity securities that are either investment grade, which are those bonds rated “BBB-” or higher by Standard & Poor’s, or securities that although not investment grade, meet our credit requirements and targeted risk-adjusted return. We also independently and through our outside independent investment managers, monitor the financial condition of all of the issuers of fixed-maturity securities in our portfolio. We utilize a ratings changes report, a ratings watch list and an early warning report as part of this process. Finally, we employ stringent diversification rules that limit our credit exposure to any single issuer.
Equity Price Risk. Equity price risk is the potential that we will incur economic loss due to a decline in common stock prices. We manage this risk by focusing on a long-term, conservative, value oriented, dividend driven investment philosophy for our equity portfolio. The equity securities in our portfolio are primarily mid-to-large capitalization issues with strong dividend performance. Our strategy remains one of value
In March 2004, the Emerging Issues Task Force (“EITF”) reached consensus on further guidance concerning the identification of and accounting for other-than-temporary impairments and disclosures for cost method investments, as required by EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF 03-1), which was issued on October 23, 2003.
On September 8, 2004, the FASB exposed for comment FASB Staff Position (FSP) EITF Issue 03-1-a, which was intended to provide guidance related to the application of paragraph 16 of EITF 03-1, and proposed FSP EITF Issue 03-1-b, which proposed a delay in the effective date of EITF 03-1 for debt securities that are impaired because of interest rate and/or sector spread increases. Based on comments received on these proposals, on September 30, 2004 the FASB issued FSP EITF 03-1-1, Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, which delayed the effectiveness of the guidance in EITF 03-1 in its entirety, with the exception of certain disclosure requirements. The delay had no impact on our financial position or results of operations. We continue to actively monitor our portfolio for any securities deemed to be other-than-temporarily impaired based on the guidance in SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and the Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 59, Accounting for Noncurrent Marketable Equity Securities. Due to uncertainty regarding the ultimate guidance to be issued, we cannot reasonably estimate the impact on our financial position or results of operations, if any, of adopting EITF 03-1.
after June 15, 2003. Adjustments required as a result of the application of SFAS 150 to existing instruments should be reported as a cumulative effect of a change in accounting principle. In November 2003, the FASB issued FASB Staff Position 150-3, Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“FSP 150-3”). FSP 150-3 clarified that SFAS 150 does not apply to certain mandatorily redeemable financial instruments issued by limited-life subsidiaries, including those issued by our subsidiary trusts. The adoption of SFAS 150 on July 1, 2003 did not have any impact on our results of operations or financial position.
In April 2003, FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“SFAS 149”), which amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS 149 is generally effective for contracts entered into or modified after September 30, 2003. Our adoption of SFAS 149 on July 1, 2003 did not have an impact on our financial position or results of operations.
In June 2002, FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”), which we adopted January 1, 2003. Adoption of SFAS 146 did not have any impact on our financial position or results of operations.
In December 2002, the Financial Accounting Standards Board (FASB) published SFAS 148, Accounting for Stock-Based Compensation - Transition and Disclosure SFAS 148 amends SFAS 123, Accounting for Stock-Based Compensation and provides alternative methods of transition for a voluntary change to the fair-value-based method of accounting for stock-based employee compensation. Because we have not elected to adopt the fair-value-based method of accounting for stock compensation, the transitional provisions of this statement did not impact us. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation, including disclosures in interim financial statements. The transition guidance and annual disclosure provisions of SFAS 148 were effective for fiscal years ending after December 15, 2002. The disclosure provisions became effective for annual reporting in 2002 and interim reporting in 2003. In December 2004, the FASB revised Statement No. 123 (SFAS 123R), Share-Based Payment, which requires companies to expense the estimated fair value of employee stock options and similar awards. The accounting provisions of SFAS 123R will be effective for interim periods beginning after June 15, 2005. As permitted by SFAS 123R, we will adopt the statement effective July 1, 2005 using the modified prospective method. We expect to report stock compensation expense of $482,000, net of tax, in the second half of 2005 due to the adoption of SFAS 123R.
We have audited the accompanying consolidated balance sheets of ProCentury Corporation and subsidiaries (formerly ProFinance Holdings Corporation) (the Company) as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2004. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
As discussed in note 1(j) to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangibles in 2002.
The Company issued 8,000,000 Class A common shares and received net proceeds (before expenses) of $77.9 million;
Following is a description of the most significant risks facing the Company and how the Company mitigates those risks:
Legal/Regulatory Risk is the risk that changes in the legal or regulatory environment in which an insurer operates will occur and create additional loss costs or expenses not anticipated by the insurer in pricing its products. That is, regulatory initiatives designed to reduce insurer profits or new legal theories may create costs for the insurer beyond those recorded in the consolidated financial statements. This risk is reduced by underwriting and loss adjusting practices that identify and minimize the adverse impact of these risks.
Interest Rate Risk is the risk that interest rates will change and cause a change in the value of an insurer’s investments. The Company mitigates this risk by attempting to match the maturity schedule of its assets with the expected payouts of its liabilities. To the extent that liabilities come due more quickly than assets mature, an insurer may have to sell assets prior to maturity and recognize a gain or loss.
Ratings Risk is the risk that rating agencies change their outlook or rating of Century. The rating agencies generally utilize proprietary capital adequacy models in the process of establishing ratings for Century. Century is at risk to changes in these models and the impact that changes in the underlying business that it is engaged in can have on such models. To mitigate this risk, Century maintains regular communications with the rating agencies and evaluates the impact of significant transactions on such capital adequacy models and considers the same in the design of transactions to minimize the adverse impact of this risk.
could cause a severe impact to the Company’s financial position. The Company did, however, have a concentration of business transactions with a particular customer. See Note 12(d).
Immediately prior to the completion of the IPO, the common shares of Evergreen and its wholly owned subsidiary, Continental were distributed as dividends from Century to ProCentury and then by ProCentury to ProCentury’s existing Class A shareholders. Prior to the dividends, Evergreen was a 30.35% controlled subsidiary of Century. The operations of Evergreen and Continental consisted of ProCentury’s historical surety and assumed workers’ compensation lines of insurance, which were re-classified (net of minority interest and income taxes) as discontinued operations in the accompanying consolidated financial statements and notes for all periods presented.
In 2003 and 2002, the Company owned a controlling interest of Evergreen and therefore, consolidated 100% of Evergreen’s assets, liabilities, revenues, and expenses, with reductions on the balance sheets and statements of operations for the minority shareholders’ proportionate interest in Evergreen’s equity and earnings (see Note 3). As of the IPO, Evergreen is no longer a subsidiary of the Company (see Note 1(a)).
Other-than-temporary impairment losses result in a permanent reduction to the cost basis of the underlying investment.
The Company defers commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. These costs are capitalized and charged to
In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, which addresses financial account-
ing and reporting standards for goodwill and other intangible assets. Upon adoption, SFAS No. 142 requires that any unaccreted negative goodwill from a business combination for which the acquisition date was before July 1, 2001, be included in income. The Company adopted the provisions of SFAS No. 142 on January 1, 2002 and the remaining negative goodwill of $385,000 and the related tax benefit of $411,000, totaling $796,000, was recorded as income as a cumulative effect of a change in accounting principle in the accompanying 2002 consolidated statement of operations.
Prior to January 1, 2003, ProCentury and its subsidiaries, including Evergreen and Continental, filed a consolidated federal income tax return in accordance with a tax sharing agreement. Each entity within the consolidated group pays its share of federal income taxes primarily based on separate return calculations. ProCentury’s tax sharing agreement with its subsidiaries allowed it to make certain Internal Revenue Code (“Code”) elections in its consolidated federal tax return. In the event such code elections are made, any benefit or liability is the responsibility of ProCentury and is not accrued or paid by the subsidiary.
Beginning on January 1, 2003, Evergreen was no longer eligible to be a member of ProCentury’s consolidated tax group and therefore no longer participated in ProCentury’s tax sharing agreement (see Note 3). However, until April of 2004, Evergreen’s taxes were consolidated in the accompanying financial statements as Evergreen continued to be a consolidated subsidiary. All other consolidated subsidiaries continue to participate in ProCentury’s tax sharing agreement.
On April 21, 2004, the Company’s Class A common shares split on a 500 to 1 basis. Prior periods’ share and per share data has been adjusted to reflect this split. On April 26, 2004, the Company issued 8,000,000 common shares and 101,200 restricted common shares, which are reflected in the Company’s share and per share data for all periods after April 26, 2004. In addition, on August 5, 2004, the Company issued an additional 54,800 restricted common shares which are reflected in the Company’s share and per share data for all periods after August 5, 2004.
Other - The carrying amounts reported for premiums in the course of collection, reinsurance recoverables, accrued investment income, and other assets approximate their fair value. The Company’s long term debt, accrued expenses and other liabilities, reinsurance balances payable, and reinsurance payable on paid losses are either short term in nature or based on current market price, which also approximates fair value.
The fair values of the share options and restricted common shares are estimated on the dates of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
The components of net investment income in 2004, 2003 and 2002 were as follows:
For the years ended December 31, 2004, 2003 and 2002, net income tax expense on net realized investment gains were $18,000, $676,000, and $829,000, respectively.
Proceeds from the sale of fixed maturity securities available-for-sale were $28.0 million, $72.6 million, and $42.3 million for the years ended December 31, 2004, 2003 and 2002, respectively.
Century held fixed maturity securities with a carrying value of approximately $7.1 million and $4.7 million on deposit with regulatory authorities as required by law at December 31, 2004 and 2003, respectively.
At December 31, 2004 and 2003, Century maintained a trust fund (consisting of cash and investments) with a combined carrying value of approximately $234,000 and $235,000, respectively. The assets of the trust are recorded as cash and investments and are held as security for unearned premiums and outstanding loss reserves under an assumed reinsurance contract.
The Class A and B shareholders are entitled to receive (on a pro rata basis) the lesser of the total amount of the liquidation proceeds or $25 million.
In May of 2003 management of the Company began discussions and contemplation of adopting a formal plan of reorganization which included the disposition of the remaining interests of Evergreen. At this point, the Company determined that the result of all subsequent sales of subsidiary stock would be required to be reflected directly in shareholders’ equity, rather than in the statement of operations. This plan was formalized and approved at the November 2003 board meeting. As part of this plan, in August 2003 Century sold 299.5 Class A shares and 2,088.5 Class B shares for net proceeds of $2.8 million. Simultaneously, Evergreen issued to the acquirer of the shares .5 Class C share for net proceeds of $2.5 million. In addition, in December 2003, Century sold 299.5 Class A shares and 2,088.5 Class B
In conjunction with these transactions, Century entered into an agreement with the parties that purchased the shares of Evergreen that guarantees that (a) Evergreen’s loss reserves (including claim reserves, contingent commissions and unrecoverable reinsurance balances) as of the date of the sale of securities are adequate to pay Evergreen’s actual losses incurred prior to that date and (b) that Evergreen’s net unearned premiums for business in force, as reflected in Evergreen’s balance sheet at that date, will not run off at more than a 100% combined ratio. In 2003, the Company made an estimate related to these guarantees, approximately $919,000 of this amount was charged to expense in the accompanying 2003 consolidated statement of operations and $465,000 was contributed to Evergreen in order to restore Evergreen’s statutory surplus to $30.0 million. Effective January 1, 2004, the guarantee was assumed by Evergreen.
The Company increased incurred loss and loss expenses attributable to insured events of prior periods by approximately $11.1 million, $27.0 million and $16.8 million in 2004, 2003 and 2002, respectively.
A significant portion of these increases resulted principally from construction defect claims in the other liability line, which were new types of claims that were not anticipated when the Company wrote these policies primarily between 1994 and 1998. In 2004, 2003 and 2002, the Company received an unanticipated increased number of construction defect claims predominantly related to insureds that operated as sub-contractors primarily in the state of California. Prior to 2000, most construction defect litigation was targeted at general contractors and housing developers. However, as their policy limits became eroded due to the vast number of litigants, plaintiff attorneys sought additional recoveries from sub-contractors. Consequently, with the increased number of claims reported, combined with higher than expected costs to defend these construction defect claims, the Company increased its estimates. The Company received 986, 1,084 and 921 new construction defect claim counts in 2004, 2003 and 2002, respectively. The increases in incurred losses related to construction defect reserves were approximately $8.3 million, $13.4 million and $10.4 million in 2004, 2003 and 2002, respectively.
In addition, during 2004, 2003 and 2002, the Company also incurred development above expectations on our non-construction defect casualty reserves that led to reassessments of the initial loss ratio expectations and the claim reporting and settlement patterns. This reestimation resulted in approximately $4.6 million, $8.8 million and $3.1 million in 2004, 2003 and 2002, respectively of additional incurred loss and loss expenses.
Approximately 75% of the total reinsurance recoverable on paid and unpaid losses at December 31, 2004 was with reinsurance companies which had an A. M. Best rating of A or higher at December 31, 2004.
The amounts of ceded loss and loss expense reserves and ceded unearned premiums would represent a liability of the Company in the event that its reinsurers would be unable to meet existing obligations under reinsurance agreements.
Century paid initial consideration of $500,000 which was included as an offset to the funds held under retroactive reinsurance contract. Under the terms of the contract the remaining consideration was
The $4.4 million of additional transferred reserves during 2001 resulted in a deferred gain on retroactive reinsurance. The deferred gain is being amortized over the settlement period using the interest method. No additional reserves were transferred in 2002.
Interest on the funds held balance of $1.2 million and $878,000 was recorded as other operating expenses during 2002 and 2001, respectively. This amount was substantially offset by amortization of the deferred retroactive reinsurance gain of $1.1 million and $788,000 during 2002 and 2001, respectively, which was included in other operating expenses in the accompanying consolidated statements of operations. Paid losses of $10.5 million were reimbursed to Century under this contract in 2002 through a reduction of the funds held balance. No paid losses were reimbursed to Century under this contract in 2001.
The Company borrowed $10.0 million from Eaton National Bank & Trust Co., a subsidiary of Colonial Banc Corp., a shareholder of the Company, on October 5, 2000. The initial terms of the note were
The Trust Preferred Securities have a 30-year maturity and are redeemable by the Company at par on or after December 15, 2007 and May 15, 2008, respectively. Holders of the Trust Preferred Securities are
entitled to receive cumulative cash distributions accruing from the date of issuance and payable quarterly in arrears at a rate of 400 and 410 basis points, respectively, over the three-month London Interbank Offered Rates (“LIBOR”). The maximum distribution rate is 12.5% through December 4, 2007 and May 15, 2008, respectively. Under certain circumstances, the Company has the right to defer distributions and interest on the Trust Preferred Securities for up to five years. The obligations of the Trust are guaranteed by the Company with respect to distributions and payments of the Trust Preferred Securities. These distributions are recorded as interest expense in the accompanying consolidated statements of operations, as the Trust Preferred Securities are considered a debt instrument. Interest paid totaled $1.4 million and $1.1 million in 2004 and 2003, respectively. No interest was paid in 2002.
The income tax (benefit) expense differed from the amounts computed by applying the U.S. federal income tax rate of 35% in 2004 and 2003 and 34% in 2002 to income before minority interest and income taxes as a result of the following:
A summary of the status of the option plan at December 31, 2004, and changes during the year then ended are presented in the following table and narrative:
The fair market value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in 2004:
Information on the range of exercise prices for options outstanding as of December 31, 2004, is as follows:
In 2001, Century entered into an option agreement with Williams and Parish. Subject to the terms of the option agreement, Williams and Parish had a right to acquire 100% of the issued and outstanding common shares of Continental at the statutory book value on the date exercised. The option expired December 31, 2003. The option was not exercised, expired on December 31, 2003, and the liability of $450,000 was released as a reduction to other operating expenses in the accompanying 2003 consolidated statement of operations.
The Company is named from time to time as defendants in various legal actions that are incidental to our business and arise out of or are related to claims made in connection with our insurance policies, claims handling, premium finance agreements and other contracts and employment related disputes. The plaintiffs in some of these lawsuits have alleged bad faith or extracontractual damages and some have claimed punitive damages. The Company believes that the resolution of these legal actions will not have a material adverse effect on the Company’s financial position or results of operations.
In addition, state and federal regulators have commenced investigations or other proceedings relating to compensation and bidding arrangements and possible anti-competitive activities between insurance producers and brokers and issuers of insurance products, and unsuitable sales by producers on behalf of either the issuer or the purchaser. Related investigations and proceedings may be commenced in the future. The Company has not been formally contacted by regulatory agencies and state attorneys general for information relating to these investigations into compensation and bidding arrangements, anti-competitive activities and unsuitable sales practices. These proceedings are expected to continue in the future, and could result in legal precedents and new industry-wide legislation, rules and regulations that could significantly affect the financial services industry.
The Company does not expect such regulatory requirements to impair its ability to pay operating expenses and interest and principal during 2005.
ProCentury contributed $55.0 million, $9.0 million, and $10.9 million in 2004, 2003 and 2002, respectively, to Century.
Century maintains its accounts in conformity with accounting practices prescribed or permitted by the Ohio Department of Insurance that vary in certain respects from GAAP. In converting from statutory to GAAP, typical adjustments include deferral of policy acquisition costs, the inclusion of statutory nonadmitted assets, and the inclusion of net unrealized holdings gains or losses in shareholders’ equity relating to fixed maturity securities. The statutory capital and surplus of Century as of December 31, 2004 and 2003 was approximately $115.8 million and $59.7 million, respectively. The statutory net (loss) income of Century for the years ended December 31, 2004, 2003 and 2002, was approximately $13.8 million, $(2.4) million and $3.9 million, respectively.
The Company primarily operates in the Property and Casualty Lines (P/C) (including general liability, multi-peril, and commercial property).
The Company’s Other (including exited lines) include the surety business and the Company’s exited lines such as workers’ compensation and commercial auto. A limited amount of surety business is written in order to maintain Century’s U.S. Treasury listing.
The Company does not allocate assets to the P/C and Other (including exited lines) operating segments for management reporting purposes. The total investment portfolio and cash are allocated to the Investment operating segment.
The quarterly information for 2003 is not provided as the Company was privately held in 2003.
See accompanying notes to condensed financial information of Parent Company and accompanying
In 2001, ProCentury authorized 5,000 nonvoting $0 par Class B and 10,000 nonvoting $0 par Class C common stock shares. In September 2001, ProCentury issued 531.68 Class B shares to an unrelated third party for $5.0 million.
In 2002 and 2003, the Company sold approximately 69.65% of the outstanding shares of Evergreen in a series of transactions, see further information in note 3. As of December 31, 2003, the Company owned 65.06% of the voting shares of Evergreen and approximately 23.06% of the economic interest in Evergreen.
Immediately prior to the completion of the IPO, each outstanding Class A common share was converted into 500 common shares. After the conversion, but prior to the completion of the IPO, the Company had 4,999,995 Class A common shares outstanding. The share conversion is reflected for all periods presented.
Immediately prior to the completion of the IPO, the common shares of Evergreen were distributed as dividends from Century to ProCentury and then by ProCentury to ProCentury’s existing Class A shareholders.
In preparing the condensed financial statements, management is required to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements, and the reported amounts of revenue and expenses for the reporting period. Actual results could differ significantly from those estimates.
In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” which addresses financial accounting and reporting standards for goodwill and other intangible assets. Upon adoption, SFAS No. 142 requires that any unaccreted negative goodwill from a business combination for which the acquisition date was before July 1, 2001, be included in income. The Company adopted the provisions of SFAS No. 142 on January 1, 2002 and the remaining negative goodwill of $385,000 and the related tax benefit of $411,000, totaling $796,000, was recorded as income as a cumulative effect of a change in accounting principle in the accompanying 2002 consolidated statement of operations. Included in the consolidated negative goodwill was unallocated positive goodwill of $1.6 million that was recorded by ProCentury in the condensed financial information.
The Company utilizes the asset and liability method of accounting for income tax. Under this method, 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 and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under this method, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established when necessary to reduce the deferred tax assets to the amounts expected to be realized.
Comprehensive income encompasses all changes in shareholders’ equity (except those arising from transactions with shareholders) and includes net income and changes in net unrealized investment gains and losses on fixed maturity investments classified as available-for-sale and equity securities, net of minority interest and taxes.
The Company classifies its equity securities as available-for-sale. Available-for-sale securities are recorded at fair value. Unrealized gains and losses, on available-for-sale securities are excluded from earnings and are reported as a component of accumulated other comprehensive income within shareholders’ equity, until realized.
The Company follows the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), the Financial Accounting Standards Board (“FASB”) Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation (an interpretation of APB Opinion No. 25), and other related accounting interpretations for the Company’s share option and restricted common share plans utilizing the “intrinsic value method.” The Company also follows the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, for the Company’s share option grants, as amended by SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure; an amendment of FASB Statement No. 123. This disclosure requires pro forma net income (loss) and earnings (loss) per share information, which is calculated assuming the Company has accounted for its stock option plans under the “fair value method” described in SFAS No. 123 and SFAS No. 148.
The Company borrowed $10,000,000 from Eaton National Bank & Trust Co., a subsidiary of Colonial Banc Corp., a shareholder of the Company, on October 5, 2000. The initial terms of the note were interest only for the first year at 9.5%, with the first quarterly payment due April 5, 2001. Beginning October 5, 2001, principal and interest payments of $327,889 were due quarterly at a rate adjusted to the prime rate of 5.5%. In April of 2002, the terms of the note were changed from quarterly principal and interest payments to quarterly interest only payments for the April 2002 payment and the next three consecutive quarters.
On December 4, 2002, ProFinance Statutory Trust I (the “Trust”), a Connecticut statutory business trust formed by the Company, issued 15,000 floating rate capital securities (“Trust Preferred Securities”) generating gross proceeds of $15.0 million. Net proceeds were approximately $14.5 million, after deducting offering costs of $454,000. In addition, on May 15, 2003, ProFinance Statutory Trust II (the “Trust”), a Connecticut statutory business trust formed by the Company, issued 10,000 floating rate
Of the proceeds from the sale of the Trust Preferred Securities, ProCentury contributed and/or settled outstanding amounts with Century in the amounts of $9.0 million and $14.5 million in 2003 and 2002, respectively.
In 2004, 2003 and 2002, ProCentury paid approximately $484,000, $1.9 million and $2.0 million, respectively in fees relating to various consulting agreements with certain shareholders of ProCentury, including the following significant agreements:
Full Circle Consulting Arrangement. This agreement was effective from October 5, 2000 until December 31, 2003. Pursuant to this agreement, the Company paid Full Circle Holdings, LTD fees for managing the investment in the Company made by its members. Pursuant to this agreement the Company paid approximately $158,000, 625,000 and $620,000 in 2004, 2003 and 2002, respectively.
Approximately $483,000 was accrued at December 31, 2003 related to these agreements. No amounts were accrued at December 31, 2004.
ProCentury contributed $55.0 million, $9.0 million and $10.9 million in 2004, 2003 and 2002, respectively, to Century.
The Company is a defendant in various lawsuits. In the opinion of management, the effects, if any, of such lawsuits are not expected to be material to the Company’s financial position or results from operations.
With respect to non-qualified options, an employee may be granted an option to purchase shares at the grant date fair market value, payable as determined by the Company’s board of directors. An optionee must exercise an option within 10 years from the grant date. Full vesting of options granted occurs at the end of three years.
A summary of all employee restricted share activity during the years ended December 31 follows:
The Company entered into a Separation Agreement with Mr. John A. Marazza, Executive Vice President and Chief Operating Officer, effective January 28, 2005, setting forth the terms of his